**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

**(Mark one)**

**x**                               ANNUAL REPORT UNDER SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2006**

**o**                                  TRANSITION REPORT UNDER SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from                             to                              .**

**CommissionFile No.:  000-09273**

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**MOCON, Inc.**

(Exact name of registrantas 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,  Minnesota**               |   | **55428**            |
| (Address of  principal executive offices) |   | (Zip Code)           |

 

**Registrant’s telephone number,including area code:**  (763) 493-6370

Securities registeredpursuant to Section 12(b) of the Act:

**CommonStock, $0.10 Par Value**

Securities registeredpursuant to Section 12(g) of the Act: **None**

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Indicateby check mark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act. 

YES o  NOx

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act.  

YES o  NOx

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. YES x  NOo

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§229.405 of this chapter) is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.   x

Indicate by check mark whether the registrant is a largeaccelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinitions of  “accelerated filer” and“large accelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):

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

 

Indicateby check mark whether registrant is a shell company (as defined inRule 12b-2 of the Act).  YES o  NO x

The aggregate market valueof the registrant’s common stock, excluding outstanding shares beneficiallyowned by directors and executive officers, computed by reference to the priceat which the common stock was last sold as of June 30, 2006 (the lastbusiness day of the registrant’s second quarter) as reported by the NasdaqGlobal Market System, was $48,041,967.

As of March 22, 2007,5,480,104 shares of common stock of the registrant were deemed outstanding.

**DOCUMENTS INCORPORATED BYREFERENCE**

Part IIIof this annual report on Form 10-K incorporates by referenceinformation (to the extent specific sections are referred to herein) from theregistrant’s Proxy Statement for its 2007 Annual Meeting of Shareholders to beheld May 17, 2007.

 

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**PART I**

*This annual reporton Form 10-K contains or incorporates by reference not onlyhistorical information, but also forward-looking statements within the meaningof Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended, and aresubject to the safe harbor created by those sections. We refer you to theinformation under the heading “Part I. Item 1. Business—Forward-LookingStatements.”*

*As used in thisannual report on Form 10-K, references to “MOCON,” the “Company,”“we,” “our” or “us,” unless the context otherwise requires, refer toMOCON, Inc. and our subsidiaries.*

*All trademarks or trade names referred to in thisreport are the property of their respective owners.*

**Item1.**                BUSINESS

MOCON, Inc. designs, manufactures, markets andservices products and provides consulting services primarily in the measurementand analytical instrument and services markets. Our products includeinstruments that detect, measure and monitor gases and chemical compounds.

Our gas and vapor permeation products were first usedin the food packaging industry to measure small amounts of moisture whichadversely affects dry cereal and other food packaging. Today our core business,the detection, measurement and analysis of vapors and gases, serves industriesfar beyond food packaging. Our products serve niche markets from foods,beverages, pharmaceuticals, and consumer products, to oil and gas exploration,industrial safety, and homeland security. For example, our gas analyzers detecthazardous gases in the workplace and detect the release or presence of toxicsubstances in public places, which is part of the homeland security market.

Our principal business strategy is to employ ourproduct development and technological capabilities, manufacturing processes andmarketing skills in market niches where we can successfully penetrate themarket and then strive to become a leader in the market segment. Our managementteam continually emphasizes product innovation, product performance, qualityimprovements, cost reductions and other value-adding activities. Although someof the markets for our products are maturing, we continually seek growthopportunities through technological and product improvement, by acquiring anddeveloping new products, and by acquiring new companies.

MOCON, Inc. was incorporated as a Minnesotacorporation in February 1966, and was initially involved in thecommercialization of technology developed for the measurement of water vaporpermeating through various materials. Prior to 1998, we expanded our businessprimarily through internally developing new products and technologies andlicensing products and technology. Since 1998, we have supplemented ourinternal growth through acquisitions that have provided us with additionaltechnologies, products and product development expertise.

We completed our most recent acquisition effectiveJanuary 1, 2004, by acquiring Paul Lippke Handels-GmbH Prozess-und Laborsysteme (Lippke), which is located near Koblenz, Germany. Lippke hadbeen the primary distributor of our products in Europe for approximately 30years, and also served in the capacity of distributor or agent for severalcompanies in addition to MOCON. Our acquisition of Lippke provides us with adirect presence in Europe. We acquired all of the shares of Lippke for a basepurchase price plus three earnout payments based on the net profits of Lippkein each of the years 2004, 2005 and 2006, with a minimum payment amount of100,000 euros per year. We made the final earnout payment near the end of thefirst quarter 2007.

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In the last 18months, we divested our Vaculok® vacuum insulated panel product line, which weacquired in 2003, and sold Lab Connections, Inc., which we acquired in1998, to allow us to better concentrate on our core product lines, particularlyour gas detection, measurement and analysis products.

Our principal executive offices and worldwideheadquarters are located at 7500 Boone Avenue North, Minneapolis, Minnesota55428, and our telephone number is (763) 493-6370. Our website address iswww.mocon.com. The information contained on our website or connected to ourwebsite is not incorporated by reference into this annual report onForm 10-K and should not be considered part of this report.

We make available, free ofcharge on our website, our annual reports on Form 10-K, quarterlyreports on Form 10-Q, current reports on Form 8-K, andamendments to those reports filed or furnished pursuant toSection 13(a) or 15(d) of the Securities Exchange Act of 1934,as amended, as soon as reasonably practicable after we electronically file suchmaterial with, or furnish it to, the Securities and Exchange Commission.  We also make available, free of charge andthrough our website, to any shareholder who requests, the charters of our boardcommittees and our Code of Ethics. Requests for copies can be directed to ourChief Financial Officer at the address and phone number above.

**Products andServices**

We develop, manufacture,market and service measurement, analytical, monitoring and consulting productsused to detect, measure and analyze gases and chemical compounds. Please seeour consolidated financial statements beginning on page F-1 forfinancial information concerning our business, including our revenues, net incomeand net assets. Our sales are grouped into three major categories as discussedbelow.

***Permeation Products and Services***

Our permeation products consist of systems andservices that measure the rate at which various gases and vapors transmitthrough various materials. These products perform measurements under precisetemperature and relative humidity conditions. The principal market for theseproducts consists of manufacturers of packaging materials (includingmanufacturers of papers, plastic films and container coatings) and the users ofsuch packaging materials, such as companies in the food, beverage,pharmaceutical and consumer product industries.

We also providecertain laboratory testing services to companies that have a need for ourpermeation products. These services consist primarily of testing film andpackage permeation for companies that:

·       haveinsufficient business to justify the purchase of our products;

·       arenot familiar with such equipment; or

·       havepurchased our products but have a need for additional capacity.

Our permeation productsand services accounted for approximately 56%, 56% and 57% of our consolidatedsales in 2006, 2005 and 2004, respectively. Permeation instruments that wecurrently manufacture include OX-TRAN® systems for oxygen transmission rates,PERMATRAN-W® systems for water vapor transmission rates,and PERMATRAN-CTM systems for carbon dioxide transmission rates.Our systems are available in a wide range of options for our customers,including high or low throughput, price, sensitivity and ease of use. They areprimarily marketed to both research and development departments as well asproduction and quality assurance groups.

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***Gas, Headspace and Other Analyzer Products andServices***

*Gas AnalyzerProducts*

Our Baseline-MOCON, Inc. subsidiary located nearBoulder, Colorado produces advanced gas analysis and monitoring instrumentationused in applications such as oil and gas exploration, process gas analysis,industrial hygiene and safety, environmental air monitoring, and homelandsecurity.

We sell two categories of gas analyzer products: 1)Permanent gas analyzers and systems which are installed in fixed locations atthe monitoring sites and generally perform their functions continually or atregular intervals, and 2) OEM gas sensors which are hand-held, compact and aresold OEM to manufacturers of mobile equipment. Our gas analyzer products arefor use in (1) industrial hygiene (detection of hazardous gases in theworkplace), (2) hydrocarbon gas analysis for oil and gas exploration,(3) contaminant detection in the manufacture of specialty gases, and(4) environmental monitoring (tracking the release of, or the presence of,toxic substances), such as the intentional release of toxic gases by terroristswhich would be a homeland security application.

Our gas analyzer productsaccounted for approximately 18%, 16% and 14% of our consolidated sales in 2006,2005 and 2004, respectively. We market these products under the namesBevAlertTM, PetroAlertTM, and piD-TECH®.

*Headspace Analyzerand Leak Detection Products*

Our headspace analyzer products are used to analyzethe amount and type of gas present in the headspace of flexible and rigid packages,as applied to gas flushing modified or controlled atmosphere packaging. Theprincipal market for these products consists of packagers of foods, beveragesand pharmaceuticals. Our headspace analyzer products include the PAC CHECK® series of headspace analyzers and the GSATM series of on-line gas stream analyzers forcontinuous and intermittent monitoring of modified atmosphere packaging (MAP)and other gas flushing operations.

Our leak detection products detect leaks in sterilemedical trays, food pouches, blister packs and a wide range of other packages.We currently manufacture three types of leak detection instruments. The firsttype of instrument is a non-destructive leak detector that senses small amountsof carbon dioxide escaping from a package or tray. The second type ofinstrument detects leaks and checks for seal integrity by applying andmeasuring pressure within a package. The third type pulls a vacuum on a packageand looks for vacuum or gas flow changes. The principal markets for theseproducts are packagers of sterile medical items, pharmaceuticals and foodproducts.

Our headspace analyzer andleak detection products accounted for 15%, 15% and 13% of our consolidatedsales in 2006, 2005 and 2004, respectively. We market these products under thenames PAC GUARD®,SKYE® and PAC CHECK®.

***Weighing and PharmaceuticalProducts***

Our weighing products automatically determine theweight of pharmaceutical capsules and tablets and reject those that are out ofacceptable limits. Our VERICAP® high-speed capsule weighing system runs atrates up to 2,000 capsules per minute and can be integrated into a capsuleproduction line in pharmaceutical factories. Our ABTM automatic balance weighing systems aredesigned for off-line use for both tablets and capsules, and we market theseproducts primarily to the pharmaceutical industry. In addition, we sell tabletinspection systems and blister packaging-related equipment through our Lippkesubsidiary, which is also an agent for other manufacturers.

Our gas, headspace andother analyzer products and services accounted for an aggregate ofapproximately 38%, 36% and 32% of our consolidated sales for 2006, 2005 and2004, respectively**.**

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***Other Instruments and Services***

*Consulting andAnalytical Services*

We provideconsulting and analytical services, on a special project basis, for customersthat require custom solutions to unique problems. Services that we typicallyprovide relate to:

·       absorptionor diffusion of various compounds;

·       shelf-lifeconcerns;

·       flavoror odor identification; or

·       otherspecial permeation applications.

In providing consultingand analytical services, we use our most advanced measurement technologies,including proprietary TRANSORPTION® technology. The principal market for ourconsulting and analytical services consists of manufacturers of foods,beverages, pharmaceuticals, plastics, chemicals, electronics and personal careproducts.

*Gas ChromatographyAnalyzer Products*

We sell various gas chromatographic (GC) instrumentsand provide services with an emphasis on multidimensional gas chromatographythrough our Microanalytics Instrumentation Corp. subsidiary, which is locatedin Austin, Texas. A variety of GC specific applications have been developed byour Microanalytics personnel, ranging from petroleum and petrochemical purityassay to aroma and off-odor analysis for the food, beverage, packaging andother industries. We integrate GC components that we purchase from thirdparties, with GCs purchased from third parties, to form multidimensional GCanalyzer systems. The multidimensional GC analyzers that are formed through theintegration of gas chromatography components with GCs representstate-of-the-art technology in gas chromatographic separations and are used inidentifying compounds causing off-odors in various products, in identifyingcritical aroma compounds, and in high purity analysis of single componentmatrixes. Our GC analyzer products include the AROMATRAX® systems for odor and aroma analysis andprofiling, the PURI-TRAXTM systems consisting of a vinyl chloride monomerpurity analysis system and a system for measuring trace levels of oxygenatedhydrocarbons in a variety of hydrocarbon products and process streams such asliquefied petroleum gases, and the VAPO-JECTTM automated vaporizing injector system forpermanent and liquefied petroleum gases. The principal markets for our GCanalyzer products consist of food, beverage, petroleum, chemical andpetrochemical manufacturers.

Our other instruments andservices groups accounted for an aggregate of approximately 6%, 8% and 11% ofour consolidated sales in 2006, 2005 and 2004, respectively.

**Competition**

We have severalcompetitors in both foreign and domestic markets for all of our products andservices. The principal competitive factors for our products and services are:

·       productquality and performance;

·       productreliability;

·       productsupport; and

·       price.

We compete with a varietyof companies in each market in which we sell our products. Some of ourcompetitors have greater assets and resources than we do, and some are smallerthan we are. To remain 

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competitive,we must continue to invest in research and development, marketing, customerservice and support, and manage our operating expenses. We believe that we havein place strategies to develop technological and other advantages that willgive us a competitive advantage over our competitors. However, there can be noassurance that we will have sufficient resources to execute these strategies,or that our competitors will not develop new technologies or other advantages whichwould require us to reduce our prices, result in lost orders or otherwiseadversely affect our financial results.

**Manufacturing andSupplies**

We manufacture products atour locations in Minnesota, Texas, Colorado and Germany. In February 2004,we closed our facility located near Boston, Massachusetts, and consolidatedthese operations into the operations at our Texas and Minnesota locations. Ourmanufacturing capabilities include electro-mechanical assembly, testing,integration of components and systems, calibration and validation of systems.Certain components that we use in our products are currently purchased fromsingle source suppliers. Although we purchase additional quantities of thesecomponents in the case of an interruption or delay in supply, an interruptionof one of these sources could result in delays in our production while welocate an alternative supplier, which in turn could result in a loss of salesand income. There are other single source components for which we havedetermined that other sources are readily available. To date, we haveexperienced no significant production delays because of a supplier’s inabilityto ship an acceptable component.

**Patents, Trademarksand Other Intellectual Property Rights**

**We believe that the protection affordedus by our patent rights is important to our business, and we will continue toseek patent protection for our technology and products. We require all of ouremployees and consultants to assign to us all inventions that are conceived anddeveloped during their employment, except to the extent prohibited byapplicable law. To protect our proprietary information, we have entered intoconfidentiality and non-compete agreements with those of our employees andconsultants who have access to sensitive information. We hold both UnitedStates and international patents and have U.S. and international patentspending. We currently hold 42 U.S. patents and 25 international patents. Thesepatents will expire during the period from 2008 through 2023.**

We own or have applied forcertain trademarks which protect and identify our products. Among thetrademarks we own is MOCON®, which we have designated as a house trademark underwhich all our products manufactured at our headquarters are sold. In addition,we hold the following trademarks and service marks:  VERICAP®, OX-TRAN®,PERMATRAN-W®, PROFILER®, COULOX®, HERSCH®, VERITAB®, AROMATRAN®, SKYE®, PAC CHECK 200®,TRANSORPTION®, AROMATRAX®, PAC GUARD®, INNOVATIVE TECHNOLOGY CONFERENCES®, HEALTHPACK®, PAC CHECK®, OPTIPERM® andpiD-TECH®. Ourtrademarks and service marks have a life, subject to periodic maintenance of 10to 20 years, which may be extended in accordance with applicable law.

**Marketing andCustomers**

We market our products and services throughout theUnited States and in over 60 foreign markets. We use a direct sales force ofapproximately 15 employees and approximately 10 independent salesrepresentatives to market our products and services in the United States,Canada and Germany, and use a network of approximately 50 independent salesrepresentatives to market and service our products and services in otherforeign countries. To our knowledge, none of our independent salesrepresentatives sell a material amount of product manufactured by any of ourcompetitors.

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For information concerningour export sales by geographic area, see note 13 of the notes to ourconsolidated financial statements. We market products and services to researchlaboratories, production environments and quality control applications in the lifescience, medical, food, pharmaceutical, plastics, paper, electronics, oil andgas and other industries. No single customer accounted for 10% or more of ourconsolidated sales in any of the fiscal years ended December 31, 2006,2005 and 2004, and we do not believe that the loss of any single customer wouldhave a material adverse effect on our business or financial performance. Oneindependent representative accounted for approximately 6%, 8% and 8% of ourconsolidated sales in the years 2006, 2005 and 2004, respectively.

**Backlog**

As of December 31,2006, our total backlog was $2,460,147 for all of our products as compared to$1,799,273 and $2,240,096 as of December 31, 2005 and 2004, respectively.We anticipate shipping the entire current backlog in 2007.

**Research andDevelopment**

We are committed to an ongoing engineering programdedicated to innovating new products and improving the quality and performanceof our existing products. Our engineering expenses are primarily incurred inconnection with the improvement of existing products, cost reduction efforts,and the development of new products that may have additional applications orrepresent extensions of existing product lines.

We incurred expenses of$1,942,786, $1,765,662 and $1,371,700 during the fiscal years endedDecember 31, 2006, 2005 and 2004, respectively, for research anddevelopment (R&D) of our products. R&D costs were approximately 7% ofour consolidated sales for each of the fiscal years ended December 31,2006 and 2005, respectively, and approximately 6% of our consolidated sales forthe fiscal year ended December 31, 2004. We currently intend to spend, onan annual basis, approximately 6% to 8% of our consolidated sales on R&D.

**Working CapitalPractices**

We strive to maintain alevel of inventory that is appropriate given our projected sales. Our standarddomestic payment terms are net 30 days and our international payment terms varybut generally range between 30 and 90 days. International sales are, in somecases, transacted pursuant to letters of credit.

**Seasonality**

Our business is notseasonal in nature.

**Employees**

As of December 31,2006, we had 118 full-time employees. Included in this total are approximately15 scientists and engineers who research and develop potential new products.None of our employees are represented by a labor union, and we consider ouremployee relations to be satisfactory.

**Forward-LookingStatements**

This annual report on Form 10-K contains orincorporates by reference not only historical information, but alsoforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended, and are subject to the safe harbor created bythose sections. In addition, we or others on our behalf may makeforward-looking statements from time to time in oral presentations, includingtelephone conferences and/or web casts open to the public, in press releases orreports, on our website or otherwise. All statements other than 

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statements of historicalfacts included in this report that address activities, events or developmentsthat we expect, believe or anticipate will or may occur in the future areforward-looking statements including, in particular, the statements about ourplans, objectives, strategies and prospects regarding, among other things, ourfinancial condition, results of operations and business. We have identifiedsome of these forward-looking statements with words like “believe,” “may,”“could,” “might,” “forecast,” “possible,” “potential,” “project,” “will,”“should,” “expect,” “intend,” “plan,” “predict,” “anticipate,” “estimate,”“approximate” or “continue” and other words and terms of similar meaning. Theseforward-looking statements may be contained in the notes to our consolidatedfinancial statements and elsewhere in this report, including under the heading“Management’s Discussion and Analysis of Financial Condition and Results ofOperations.”

Forward-looking statements involve risks anduncertainties. These uncertainties include factors that affect all businessesas well as matters specific to us. Some of the factors known to us that couldcause our actual results to differ materially from what we have anticipated inour forward-looking statements are described under the heading “Item 1A. RiskFactors” below.

We wish to caution readersnot to place undue reliance on any forward-looking statement that speaks onlyas of the date made and to recognize that forward-looking statements arepredictions of future results, which may not occur as anticipated. Actualresults could differ materially from those anticipated in the forward-lookingstatements and from historical results, due to the risks and uncertaintiesdescribed under the heading “Item 1A. Risk Factors” below, as well as othersthat we may consider immaterial or do not anticipate at this time. Although webelieve that the expectations reflected in our forward-looking statements arereasonable, we do not know whether our expectations will prove correct. The expectationsreflected in our forward-looking statements can be affected by inaccurateassumptions we might make or by known or unknown risks and uncertainties,including those described below under the heading “Item 1A. RiskFactors.”  The risks and uncertaintiesdescribed under the heading “Item 1A. Risk Factors” below are not exclusive andfurther information concerning us and our business, including factors thatpotentially could materially affect our financial results or condition, mayemerge from time to time. We assume no obligation to update forward-lookingstatements to reflect actual results or changes in factors or assumptionsaffecting such forward-looking statements. We advise you, however, to consultany further disclosures we make on related subjects in our quarterly reports onForm 10-Q and current reports on Form 8-K we file with orfurnish to the Securities and Exchange Commission.

**ITEM 1A.**        RISKFACTORS

The following aresignificant factors known to us that could have material adverse effects on ourbusiness, financial condition, or operating results.

***If we experience any increase in the cost of rawmaterials or supplies, we may experience a decrease in profit margins.***

In the past, the overall cost of the materials that wepurchase has not risen much more than the rate of inflation, although the priceof some of the components that we purchase has increased in the past severalyears due in part to our purchasing fewer of such components. Certain othermaterial and labor costs have increased, but we believe that such increases areapproximately consistent with overall inflation rates. We believe that theprice of our products and the prices of our competitors’ products is asignificant factor affecting our customers’ buying decisions and consequently,we may not be able to pass along any cost increases in raw materials andsupplies in the form of price increases or sustain profit margins that we haveachieved in prior years.

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***Some of the marketsin which we operate have experienced minimal growth in recent years, and ourability to increase our revenues will depend in part on our ability to developnew products, develop new applications for our existing products and to acquirecomplementary businesses and product lines.***

The analytical andmeasurement instrument markets in which we operate have not shown significantgrowth in recent years. Although we have identified a number of strategies thatwe believe will allow us to grow our business and increase our sales, includingdeveloping new products and technologies, developing new applications for ourtechnologies, acquiring complementary businesses and product lines, andstrengthening our sales force, we cannot assure you that we will be able tosuccessfully implement these strategies, or that these strategies will resultin the growth of our business or an increase in our sales.

***If we acquire businesses in the future, we couldexperience a decrease in our profit margins, a decrease in our net income, andother adverse consequences.***

One of our growth strategies is to supplement ourinternal growth with the acquisition of businesses and technologies thatcomplement or augment our existing products. Some of the businesses that wepreviously acquired have produced net operating losses or low levels ofprofitability. For example, in July 2005, we sold our Vaculok® vacuum insulated panel product line whichexperienced poor financial performance since we acquired it inNovember 2003. Other businesses that we may acquire in the future may bemarginally profitable or unprofitable, and may require us to improve theoperations and market penetration of such companies in order to achieve thelevel of profitability that we desire.

Further,acquisitions and the integration of those acquisitions involve a number ofrisks, which could be heightened if we complete several acquisitions within arelatively short period of time, including:

·       diversionof our management’s attention from our core businesses;

·       difficultiesin assimilating the operations and products of an acquired business or inrealizing projected efficiencies, cost savings and revenue synergies;

·       potentialloss of key employees or clients of the acquired businesses or adverse effectson existing business relationships with suppliers and clients;

·       reallocationof amounts of capital from operating initiatives and/or the incurrence ofindebtedness to pay the acquisition purchase prices, which could in turnrestrict our ability to access additional capital when needed or to pursueother important elements of our business strategy;

·       inaccurateassessment of undisclosed, contingent or other liabilities or problems; and

·       unanticipatedcosts associated with the acquisition, including additional expendituresrelated to Sarbanes-Oxley Act of 2002 compliance.

In addition, acquisitionsthat we believe will be beneficial to our business and financial results aredifficult to identify and complete for a number of reasons, including thecompetition among prospective buyers. We may not be able to completeacquisitions in the future and any acquisitions that we do complete may have anadverse effect on our financial performance and liquidity. It may be necessaryfor us to raise additional funds either through public or private debt orequity financing in order to finance any future acquisitions. Any equity ordebt financing, if available at all, may be on terms that are not favorable tous and may dilute the percentage ownership of our existing shareholders.

***We face risks of technologicalchanges that may render our products obsolete.***

The markets for ourproducts and services are characterized by rapid and significant technologicalchange and evolving industry standards. As a result of such changes andevolving standards, our products may become noncompetitive or obsolete and wemay have to develop new products in order to maintain or 

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increaseour revenues. New product introductions that are responsive to these factorsrequire significant planning, design, development and testing at thetechnological, product and manufacturing process levels, and we may not be ableto timely develop new products. In addition, industry acceptance of newtechnologies that we may develop may be slow due to, among other things,existing regulations or standards written specifically for older technologies andgeneral unfamiliarity of users with new technologies. As a result, any newproducts that we may develop may not generate any meaningful revenues orprofits for us for a number of years, if at all.

***Any reduction in the level of capital expenditures byour customers could negatively impact our sales.***

Our customers includepharmaceutical, food, medical and chemical companies, laboratories, governmentagencies and public and private research institutions. The capital spending ofthese entities can have a significant effect on the demand for our products.Any decrease in capital spending by any of these customer groups could have amaterial adverse effect on our revenues, business and results of operations.

***A significant portion of our sales are generated fromforeign countries and selling in foreign countries entails a number of riskswhich could result in a decrease in our sales or an increase in our operatingexpenses.***

Sales outside theUnited States accounted for approximately 55% of our sales in 2006 and approximately50% and 52% of our sales in 2005 and 2004, respectively. We expect that foreignsales will continue to account for a significant portion of our revenues in thefuture. Sales to customers in foreign countries are subject to a number ofrisks, including the following:

·       agreementsmay be difficult to enforce;

·       receivablesmay be difficult to collect;

·       certainregions are experiencing political unrest and conflict and economicinstability;

·       foreigncustomers may have longer payment cycles;

·       thecountries into which we sell may impose tariffs or adopt other restrictions onforeign trade;

·       currencyfluctuations could reduce reported profitability in future periods;

·       fluctuationsin exchange rates may affect product demand;

·       legaland regulatory requirements may be difficult to monitor and comply with,especially if inconsistent with U.S. laws and regulations;

·       customizingproducts for foreign countries and managing and staffing internationaloperations may lead to increased costs; and

·       protectionof intellectual property in foreign countries may be more difficult to enforce.

If any of these risks wereto materialize, our sales into foreign countries could decline, or ouroperating costs could increase, which would adversely affect our financialresults.

***Fluctuations in foreign currency exchange rates couldresult in declines in our reported net sales and net earnings.***

Because the functionalcurrency of our foreign operations is the applicable local currency, we areexposed to foreign currency exchange rate risk arising from transactions in thenormal course of business, such as sales to third party customers and purchasesfrom suppliers denominated in foreign currencies. Our reported net sales andnet earnings are subject to fluctuations in foreign exchange rates. Because ourproducts are manufactured or sourced primarily from the United States, astronger U.S. dollar generally 

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has anegative impact on results from operations outside the United States while aweaker dollar generally has a positive effect. Our primary exchange rateexposure is with the euro. We currently do not use hedging activities tominimize the volatility associated with foreign currency exchange rate changes.If we do use such activities in the future, they also involve some risk.

***Some of our competitors have greater resources than wedo, which may provide our competitors with an advantage in the development andmarketing of new products.***

We currently encounter,and expect to continue to encounter, competition in the sale of our products.We believe that the principal competitive factors affecting the market for ourproducts include product quality and performance, price, reliability andcustomer service. Our competitors include large multinational corporations.Some of our competitors have substantially greater financial, marketing andother resources than we do. As a result, they may be able to adapt more quicklyto new or emerging technologies and changes in customer requirements, or todevote greater resources to the promotion and sale of their products than wecan. In addition, competition could increase if new companies enter the marketor if existing competitors expand their product lines or intensify effortswithin existing product lines. Our current products, products under developmentand our ability to discover new technologies may be insufficient to enable usto compete effectively with our competitors.

***Our reliance upon patents,domestic trademark laws, trade secrets and contractual provisions to protectour proprietary rights may not be sufficient to protect our intellectualproperty from others who may sell similar products.***

We hold patents relating to various aspects of ourproducts and believe that proprietary technical know-how is critical to many ofour products. Proprietary rights relating to our products are protected fromunauthorized use by third parties only to the extent that they are covered byvalid and enforceable patents or are maintained in confidence as trade secrets.We cannot be certain that we will be issued any patents from any pending orfuture patent applications owned by or licensed to us or that the claimsallowed under any issued patents will be sufficiently broad to protect ourtechnology. In the absence of patent protection, we may be vulnerable tocompetitors who attempt to copy our products or gain access to our tradesecrets and know-how. Our competitors may initiate litigation to challenge thevalidity of our patents, or they may use their resources to design comparableproducts that do not infringe our patents. We may incur substantial costs ifour competitors initiate litigation to challenge the validity of our patents orif we initiate any proceedings to protect our proprietary rights and if theoutcome of any such litigation is unfavorable to us, it could have a materialadverse effect on our business and results of operations. There may also bepending or issued patents held by parties not affiliated with us that relate toour products or technologies and we may need to acquire licenses to any suchpatents to continue selling some or all of our products. If we had to obtainany such license in order to be able to continue to sell some or all of ourproducts, we may not be able to do so on terms that were favorable to us, if atall.

In addition, we rely ontrade secrets and proprietary know-how that we seek to protect, in part, byconfidentiality agreements with our collaborators, employees, and consultants.These agreements may be breached and we may not have adequate remedies for anysuch breach. Even if these confidentiality agreements are not breached, ourtrade secrets may otherwise become known or be independently developed bycompetitors.

***We rely on our management information systems forinventory management, distribution and other functions. If our informationsystems fail to adequately perform these functions or if we experience aninterruption in their operation, our business and results of operations couldbe adversely affected.***

Theefficient operation of our business depends on our management informationsystems. We rely on our management information systems to effectively manageaccounting and financial functions, order 

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entry, order fulfillment and inventory replenishment.The failure of our management information systems to perform could disrupt ourbusiness and could result in decreased revenues, increased overhead costs,excess inventory and product shortages, causing our business and results ofoperations to suffer. In addition, our management information systems arevulnerable to damage or interruption from natural or man-made disasters,terrorist attacks, computer viruses or hackers, power loss, or other computersystems, internet, telecommunications or data network failures. Any suchinterruption could adversely affect our business and results of operations.

***The market price of our commonstock has fluctuated significantly in the past and will likely continue to doso in the future and any broad market fluctuations may materially adverselyaffect the market price of our common stock.***

The market price of our common stock has been volatile in the past,ranging from a high sales price of $12.75 and a low sales price of $8.25 during2006, and several factors could cause the price to fluctuate substantially inthe future. These factors include:

·       announcementsof new products by us or our competitors;

·       quarterlyfluctuations in our financial results;

·       customercontract awards;

·       developmentsin regulation; and

·       generaleconomic and political conditions in the various markets where our products aresold.

In addition, the stockprices of instrumentation companies have experienced significant price andvolume fluctuations that often have been unrelated to the operating performanceof such companies. This market volatility may adversely affect the market priceof our common stock.

***Recently enacted and future changes in securities lawsand regulations will increase our costs.***

Changing laws, regulationsand standards relating to corporate governance and public disclosure, includingthe Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Global Marketrules, are creating challenges for publicly-held companies, including us. Weare committed to maintaining high standards of corporate governance and publicdisclosure. As a result, our efforts to comply with evolving laws, regulationsand standards have resulted in, and are likely to continue to result in,increased general and administrative expenses and a diversion of managementtime and attention from revenue-generating activities to compliance activities.In particular, our efforts to comply with Section 404 of theSarbanes-Oxley Act of 2002 and the related regulations regarding our assessmentof our internal control over financial reporting required the expenditure offinancial and managerial resources in 2006. Because management will be requiredto complete an assessment of the effectiveness of the Company’s internalcontrols over financial reporting in 2007, we expect these expenditures toincrease.

***We will also be exposed to risks relating toevaluations of controls required by Section 404 of the Sarbanes-Oxley Act.***

We are presentlyperforming the system and process evaluation, testing and any necessaryremediation required to comply with the management certification and auditor attestationrequirements of Section 404 of the Sarbanes-Oxley Act of 2002. While weanticipate being able to fully implement the requirements relating to internalcontrol and other aspects of Section 404 that will apply to us by ourDecember 31, 2007 deadline, we cannot be certain as to the timing of thecompletion of our evaluation, testing and remediation actions or their impacton our operations. If we are unable to conclude that our internal controls overfinancial reporting are effective or if, when required, our independentregistered 

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publicaccounting firm is unable to conclude that our assessment of our internalcontrol over financial reporting is sufficient or is unable to conclude thatour internal controls over financial reporting are effective and thereforeissues an adverse opinion, investors may lose confidence in our financialreports and our stock price may decline.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

Not applicable.

**ITEM 2.**                PROPERTIES

We lease an aggregate of 59,825 square feet of office,engineering, laboratory and production space in Minnesota, Texas and Germany.We believe that all of our facilities are generally adequate for their presentoperations and that suitable space is readily available if any of our leasesare not extended.

Our headquarters and operations occupy approximately47,200 square feet of space in Minneapolis, Minnesota. This space is leaseduntil June 2010.

Microanalytics’ operations occupy approximately 8,600square feet of space in the metropolitan area of Austin, Texas. This space isleased until June 2007 and we expect to renew the lease for at least twomore years.

Lippke’s operations are located in Neuwied, Germany,and occupy approximately 4,025 square feet. This space is leased untilJune 2008.

In addition to our leasedfacilities described above, we own a building located near Boulder, Coloradothat consists of approximately 9,300 square feet of office and production spacein which our Baseline-MOCON, Inc. subsidiary conducts its operations. Wealso own the land, consisting of approximately two acres, on which thisbuilding is located.

**ITEM 3.**                LEGALPROCEEDINGS

There are no materialpending legal, governmental, administrative or other proceedings to which weare a party or of which any of our property is the subject.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

No matter was submitted toa vote of our security holders during the fourth quarter of 2006.

**ITEM 4A.**        EXECUTIVEOFFICERS OF REGISTRANT

Ourexecutive officers, their ages and their offices held, as of March 22,2007, are as follows:
| Name                 | ** ** | ** ** | ** ** | **Age**                                                           | ** ** | **Title** |
|----------------------|------------|------------|------------|-------------------------------------------------------------------|------------|-----------|
| Robert L. Demorest   |       | 61         |       | Chairman of the Board,  President and Chief Executive Officer     |
| Daniel W. Mayer      |       | 56         |       | Executive Vice President                                          |
| Darrell B. Lee       |       | 58         |       | Vice President, Chief Financial  Officer, Treasurer and Secretary |
| Douglas J. Lindemann |       | 49         |       | Vice President and  General Manager                               |
| Ronald A. Meyer      |       | 56         |       | Vice President                                                    |

 

There are no family relationships among any of ourdirectors and executive officers. Information regarding the business experienceof our executive officers is set forth below.

Mr. Robert L. Demorest has been our President,Chief Executive Officer, and Chairman of the Board since April 2000. Priorto that time, Mr. Demorest had been our President for more than fiveyears.

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Mr. Daniel W. Mayer has been an Executive VicePresident for us since January 1995. Prior to that time, Mr. Mayerhad been our Vice President, Product Development for more than five years.

Mr. Darrell B. Lee has been our Chief FinancialOfficer, Vice President, Treasurer and Secretary since January 2006.Mr. Lee served as our Director of External Reporting from April 2005to January 2006. Prior to that time, Mr. Lee had served as VicePresident and Chief Financial Officer of Spinal Designs International, Inc.,a health-care company based in Minneapolis, Minnesota, since 1993.

Mr. Douglas J. Lindemann has been a VicePresident and General Manager for us since January 2001. FromJuly 2000 to December 2000, Mr. Lindemann served as a GeneralManager for us. Prior to that time, Mr. Lindemann had been one of ourBusiness Managers since 1995.

Mr. Ronald A. Meyer has been a Vice President forus for more than five years. From 1995 to April 2000, Mr. Meyer alsoserved as our Chief Financial Officer, Treasurer and Secretary.

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

**Market Informationand Dividends**

Ourcommon stock is quoted on the Nasdaq Global Market System under the symbol MOCO.The following table sets forth, for the fiscal periods indicated, the high andlow sales prices for our common stock as reported by the Nasdaq Global MarketSystem. These quotations reflect inter-dealer prices, without retail mark-up,mark-down or commission and may not necessarily represent actual transactions. Thefollowing table also sets forth, for the fiscal periods indicated, the amountof cash dividends declared on our common stock:

| ** **             | ** ** | **2006**   | ** ** | **2005** | ** ** |
|------------------------|------------|------------|------------|----------|------------|
| **Fiscal Period** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** |
| 1st Quarter            |       | $          | 9.75       |     | $          | 8.25 |   |   | $ | 0.075 |   |   | $ | 10.20 |   | $ | 8.98 |   |   | $ | 0.070 |   |   |
| 2nd Quarter            |       | $          | 10.02      |     | $          | 8.27 |   |   | $ | 0.075 |   |   | $ | 10.43 |   | $ | 8.76 |   |   | $ | 0.070 |   |   |
| 3rd Quarter            |       | $          | 10.05      |     | $          | 8.57 |   |   | $ | 0.075 |   |   | $ | 10.10 |   | $ | 9.08 |   |   | $ | 0.070 |   |   |
| 4th Quarter            |       | $          | 12.75      |     | $          | 9.00 |   |   | $ | 0.075 |   |   | $ | 9.73 |   | $ | 8.11 |   |   | $ | 0.075 |   |   |
|                        |            |            |            |          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We have paid quarterlycash dividends without interruption or decline since 1988. Cash dividends paidin 2006, 2005 and 2004 totaled $1,627,849, $1,502,284 and $1,842,593,respectively. The dividends paid in 2004 consisted of final dividend paymentsof $449,087 to Lippke’s former parent company and payments of $1,393,506 to ourshareholders). Our Board of Directors monitors and evaluates our dividendpractice quarterly, and the Board may elect at any time to increase, decreaseor not pay a dividend on our common stock based upon our financial condition,results of operations, cash requirements and future prospects and other factorsdeemed relevant by the Board.

**Record Holders**

As of March 22, 2007,there were 309 record holders of our common stock.

**Issuer Repurchasesof Equity Securities**

We did not repurchase anyshares of our common stock or other equity securities of MOCON registeredpursuant to Section 12 of the Securities Exchange Act of 1934, as amended,during the fourth quarter ended December 31, 2006. On November 9,2005, our Board of Directors authorized the repurchase of up to $2,000,000 inshares of our common stock. This repurchase program superseded the Board’sprevious stock repurchase authorizations. Our current stock repurchase programmay be suspended or discontinued at any time, and at December 31, 2006 had$1,636,875 available for purchase.

**Recent Sales ofUnregistered Securities**

During the fourth quarterand year ended December 31, 2006, we did not issue or sell any shares ofour common stock or other equity securities of MOCON without registration underthe Securities Act of 1933, as amended.

**Stock PerformanceGraph**

The following line-graph provides a five-yearcomparison of the cumulative returns for an investment in our common stock, theS&P 500 Index and an index comprised of our peer companies. For the pastsix years, we used companies that had a similar market capitalization as us andoperated in the same SIC code that we did when preparing the index of our peercompanies. The number of companies included in this 

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peer group had decreasedthrough the years as companies were purchased, declining from eleven companiesin 1999 to four companies in 2005. This year, we changed the companies that weuse to prepare our peer group index. We again selected companies that hadsimilar market capitalization as us and that operate in the same industry as wedo. The peer group that we are now using consists of 12 companies that operatein the scientific and technical instruments industry.

The total cumulativereturn (change in the year-end stock price plus reinvested dividends) is basedon the investment of $100 made on December 31, 2001 in each of our commonstock, the S&P 500 Index and an index comprised of our peer group. Totalcumulative return for each company in our peer group is weighted according tomarket capitalization at the beginning of each year.

**Comparison of CumulativeFive Year Total Return**

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*                    Aetrium, Inc.,Ciphergen Biosystems, Inc., Image Sensing Systems, Inc., Mechanical Technology, Inc.,Mikron Infrared, Inc., Misonix, Inc., New Brunswick Scientific Co., Inc.,Perceptron, Inc., Stockeryale, Inc., Therma-Wave, Inc., TVICorp., Wireless Telecom Group, Inc.

*The foregoing Stock Performance Graph shall notbe deemed to be ”filed” with the Securities and Exchange Commission orsubject to the liabilities of Section 18 of the Securities ExchangeAct of 1934, as amended. Notwithstanding anything to the contrary set forth inany of our previous filings under the Securities Act of 1933, as amended, orthe Securities Exchange Act of 1934, as amended, that might incorporate futurefilings, including this annual report on Form 10-K, in whole orin part, the foregoing Stock Performance Graph shall not beincorporated by reference into any such filings.*

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**ITEM6.**                SELECTED FINANCIALDATA

| ** **                                   | ** ** | **Years Ended December 31,**                        | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                   | ** ** | **(in thousands, except per share data)** | ** ** |
| CONSOLIDATED  STATEMENT OF INCOME DATA: |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales                                        |       | $                                                                  | 26,290     |   | $ | 24,582 |   | $ | 24,965 |   | $ | 19,615 |   | $ | 19,931 |   |
| Net income                                   |       | $                                                                  | 3,911      |   | $ | 2,915 |   | $ | 2,429 |   | $ | 2,211 |   | $ | 2,297 |   |
| Net income per  common share:                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                        |       | $                                                                  | 0.72       |   | $ | 0.54 |   | $ | 0.45 |   | $ | 0.41 |   | $ | 0.42 |   |
| Diluted                                      |       | $                                                                  | 0.71       |   | $ | 0.53 |   | $ | 0.44 |   | $ | 0.40 |   | $ | 0.41 |   |
| Cash dividends declared  per share           |       | $                                                                  | 0.30       |   | $ | 0.285 |   | $ | 0.265 |   | $ | 0.26 |   | $ | 0.24 |   |

 

| ** **                        | ** ** | **As of December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|
| ** **                        | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                        | ** ** | **(in thousands)**               | ** ** |
| CONSOLIDATED BALANCE  SHEET DATA: |       |                                  |       |   |   |   |   |   |   |   |   |
| Total assets                      |       | $                                     | 26,877     |   | $ | 23,657 |   | $ | 22,516 |   | $ | 19,978 |   | $ | 19,821 |   |
| Non-current  liabilities          |       | $                                     | 100        |   | $ | 441 |   | $ | 543 |   | $ | 198 |   | $ | 326 |   |
| Stockholders’ equity         |       | $                                     | 21,960     |   | $ | 18,799 |   | $ | 17,201 |   | $ | 16,715 |   | $ | 16,380 |   |

 

Our acquisition of Lippke in 2004 affects thecomparability of the information in the table above. The results of thissubsidiary have been included from the effective date of purchase, whichincludes $4,132,428, $3,631,918 and $3,824,782, respectively, in netincremental sales for 2006, 2005 and 2004.

Sales for the years 2005, 2004 and 2003 do not include$22,397, $143,316 and $17,365, respectively, for sales from the Vaculok productline, which amounts have been included in the “discontinued operations” sectionof our Consolidated Statements of Income.

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**ThisManagement’s Discussion and Analysis provides material historical andprospective disclosures intended to enable investors and other users to assessour financial condition and results of operations. Statements that are nothistorical are forward-looking and involve risks and uncertainties includingthose discussed under the heading “Item 1A. Risk Factors” and elsewhere in thisreport. For more information, see “Business—Forward-Looking Statements” of thisreport. The following discussion of the results of the operations and financialcondition of MOCON should be read in conjunction with our consolidatedfinancial statements and the related notes thereto included elsewhere in thisreport.**

**Overview**

MOCON, Inc. designs, manufactures, markets andservices products and provides consulting services primarily in the measurementand analytical instrument and services markets. Our products includeinstruments that detect, measure and monitor gases and chemical compounds.Although some of the markets for our products are maturing, we continually seekgrowth opportunities through technological and product improvement, byacquiring and developing new products, and by acquiring new companies.

We have three primary operating locations in theUnited States—Minnesota, Colorado and Texas—and one in Germany. We use a directsales force and independent sales representatives to market our products andservices in the United States, Canada and Germany and use a network ofindependent sales representatives to market and service our products andservices in other foreign countries.

Prior to 1998, we expanded our business primarilythrough internally developing new products and technologies and licensingproducts and technology. Since 1998, we have supplemented our internal growththrough acquisitions that have provided us with additional technologies,products and product development expertise. 

We completed our most recent acquisition effective January 1,2004, by acquiring Paul Lippke Handels-GmbH Prozess- und Laborsysteme (Lippke),which is located in Germany. We acquired all of the shares of Lippke for a basepurchase price plus three earnout payments based on the net profits of Lippkein each of the years 2004, 2005 and 2006, with a minimum payment amount of100,000 euros per year. We made the final earnout payment near the end of thefirst quarter 2007. 

During the last 18 months, we divested two productlines to allow us to better concentrate on our core product lines, particularlyour gas detection, measurement and analysis products. In March 2005, wecommitted to a plan to discontinue production of our Vaculok® vacuum insulated panels and exit this productline which had experienced poor financial performance since it was acquired in November 2003.We recorded a pre-tax charge to earnings in our first quarter 2005, totalingapproximately $207,000, to reflect the results of operations and assetimpairment write-down associated with the discontinuation of our Vaculokbusiness. The $207,000 charge included a non-cash asset impairment charge of$162,000 relating to equipment and inventory used in the Vaculok business. Wesold the assets associated with the vacuum insulated panel product line in July 2005in exchange for an up front payment of $125,000, along with the right toreceive additional amounts upon the occurrence of certain post-closing events. Asa result of the sale, we recognized a pre-tax gain of approximately $69,000 inthe third quarter 2005. In the first quarter 2006, we received an additional$35,000 related to the sale which resulted in an after-tax gain of $22,225. Salesassociated with our vacuum insulated panel product line were not significant. Theresults of this line of business are shown in the “discontinued operations”section of our Consolidated Statements of Income, and further explained in Note16 to our consolidated financial statements included herein.

In February 2006, we sold the capital stock of ourLab Connections, Inc. subsidiary in exchange for $517,296 in cash, subjectto a purchase price adjustment based on the amount of Lab Connections’ net 

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tangible assets as of theclosing date. As a result of the sale, we recognized an after-tax gain of $92,345in the first quarter 2006. See Note 17 to our consolidated financialstatements.

Effective January 1,2006, we adopted Statement of Financial Accounting Standards No.123 (revised), *Share-Based Payment* (SFAS 123 (R)) whichrequires the measurement and recognition of compensation expense for allshare-based payment awards made to employees and directors. As a result, during2006, our results of operations reflected compensation expense for new stockoptions granted during 2006 to the extent they vested in 2006 and the unvestedportion of previous stock option grants which vested during 2006. The totalamount charged to operations in 2006 was $174,038. Our consolidated financialstatements for prior periods have not been restated to reflect, and do not include,the impact of SFAS 123(R). Therefore, the results for 2006 are not directlycomparable to prior periods.

**SignificantTransactions and Financial Trends**

Throughout these financial sections, you will readabout significant transactions or events that materially contribute to, orreduce our earnings, and materially affect our financial results and financialposition. Significant transactions and events that affected our 2006 financialresults and position included the $92,345 gain recorded in the first quarterrelating to the sale of our Lab Connections subsidiary as well as a $50,000reduction in income tax expense due to a favorable settlement with a statetaxing jurisdiction. In addition, we recognized a non-cash pre-tax expense of$187,553 in 2006 relating to the new stock option expensing rules whichbecame effective for us on January 1, 2006. Significant transactions, suchas the sale of our Lab Connections subsidiary, result from unique facts andcircumstances and, given their nature, some of these items will likely notrecur with similar materiality or impact on our continuing operations.

Our international sales have historically accountedfor a significant portion of our revenues, and we expect this trend to continuefor the foreseeable future, especially as a result of our acquisition ofLippke, which thus far has had, and is expected to continue to have, a positiveimpact on our sales and earnings, particularly on our foreign permeationproducts business.

Our research and development costs were approximately7% of our consolidated sales for 2006 and approximately 7% and 6% of ourconsolidated sales for 2005 and 2004, respectively. We currently intend tospend, on an annual basis, approximately 6% to 8% of our sales on research anddevelopment.

While these items areimportant in understanding and evaluating our financial results, certaintrends, such as the increase in the proportion of our international sales overthe past three years, and other transactions or events such as those discussedlater in this Management’s Discussion and Analysis may also have a materialimpact on our financial results.

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**Results ofOperations**

Thefollowing table sets forth the relationship between various components of ourresults of operations, stated as a percent of sales, for fiscal years ended December 31,2006, 2005 and 2004. Our historical financial data were derived from ourconsolidated financial statements and related notes included in Item 8 of thisreport.

| ** **                                           | ** ** | **Percent of Sales** | ** ** |
|------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Sales                                                |       | 100.0                          |       | 100.0 |   | 100.0 |   |
| Cost of sales                                        |       | 42.5                           |       | 43.9 |   | 46.1 |   |
| Gross profit                                         |       | 57.5                           |       | 56.1 |   | 53.9 |   |
| Selling, general,  and administrative expenses       |       | 30.0                           |       | 32.6 |   | 33.2 |   |
| Research and  development expenses                   |       | 7.3                            |       | 7.2 |   | 5.5 |   |
| Operating income                                     |       | 20.2                           |       | 16.3 |   | 15.2 |   |
| Other income                                         |       | 2.1                            |       | 1.4 |   | 0.5 |   |
| Income before income taxes                           |       | 22.3                           |       | 17.7 |   | 15.7 |   |
| Income taxes                                         |       | 7.5                            |       | 5.4 |   | 5.2 |   |
| Income from continuing operations                    |       | 14.8                           |       | 12.3 |   | 10.5 |   |
| Gain (loss) from discontinued operations, net of tax |       | 0.1                            |       | (0.4 | ) | (0.8 | ) |
| Net income                                           |       | 14.9                           |       | 11.9 |   | 9.7 |   |

 

Thefollowing table summarizes total sales by product line for 2006, 2005 and 2004:

| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Permeation  Products and Services                        |       | $                                           | 14,604,579 |   | 13,711,970 |   | 14,290,547 |   |
| Gas, Headspace  and Other Analyzer Products and Services |       | 10,072,101                                  |       | 8,875,847 |   | 8,083,951 |   |
| Other Instruments  and Services                          |       | 1,613,295                                   |       | 1,993,783 |   | 2,590,555 |   |
| Total Sales                                              |       | $                                           | 26,289,975 |   | 24,581,600 |   | 24,965,053 |   |

 

Thefollowing table sets forth the relationship between various components ofdomestic and foreign sales for 2006, 2005 and 2004:

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Domestic Sales      |       | $                                           | 11,924,805 |   | 12,294,985 |   | 11,874,933 |   |
| Foreign Sales:      |       |                                        |       |   |   |   |   |
| Europe              |       | 7,360,019                                   |       | 5,802,034 |   | 6,440,144 |   |
| Asia                |       | 4,842,523                                   |       | 5,093,417 |   | 4,533,682 |   |
| Other               |       | 2,162,628                                   |       | 1,391,164 |   | 2,116,294 |   |
| Total foreign sales |       | 14,365,170                                  |       | 12,286,615 |   | 13,090,120 |   |
| Total Sales         |       | $                                           | 26,289,975 |   | 24,581,600 |   | 24,965,053 |   |

 

***Sales***

*Fiscal 2006 vs.Fiscal 2005*

Sales for 2006 were $26,289,975, an increase of 7%compared to $24,581,600 for 2005. This increase in sales was primarily theresult of the increased foreign sales volume of our permeation products, gasanalyzer products and weighing and pharmaceutical products, together withincreased domestic sales 

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volume of our headspaceanalyzer products, partially offset by decreases in the domestic sales volumeof our permeation products and gas analyzer products. In addition, sales of oursample preparation products for 2006 were approximately $458,000 lower than2005 due to the sale of our Lab Connections subsidiary in the first quarter2006. Our domestic sales were $11,924,805, or 45% of total sales in 2006, adecrease of 3% compared to $12,294,985, or 50% of sales in 2005. Our foreignsales were $14,365,170, or 55% of total sales in 2006, an increase of 17%compared to $12,286,615, or 50% of sales in 2005. The overall sales volumeincrease in 2006 was generally the result of increased demand primarily in ourforeign markets. The impact of any price increases was not significant in 2006.

***Permeation Productsand Services—******Sales*** of ourpermeation products and services were $14,604,579 and $13,711,970 in 2006 and2005, respectively, or approximately 56% of our consolidated sales in bothyears. The $892,609, or 7% increase in permeation sales in 2006 compared to2005, was primarily due to a 13% increase in foreign sales partially offset bya decrease in domestic sales. Foreign permeation product sales benefited from alarge order received from China in our third quarter 2006, where we recentlynamed a new sales representative organization. Also, sales to our Europeanmarkets increased significantly in 2006 after a soft 2005. We believe that thedomestic market for our permeation products, which is where we initiallyintroduced our permeation products when our company was founded, is maturing. However,the market for our permeation products outside of the United States, where thedemand for sophisticated packaging and other products is continuing to develop,and the use of our equipment is still in many areas limited, is likely tocontinue to grow. No assurance can be provided, however, that the internationalmarket for our permeation products will grow.

***Gas, Headspace andOther Analyzer Products and Services—******Sales***of ourgas, headspace, and other analyzer products and services, which accounted for38% and 36% of our consolidated sales in 2006 and 2005, respectively, increased13%**in 2006 compared to 2005. Within thisgroup, sales of our gas analyzers and sensors through our Baseline subsidiary, whichaccounted for 18% and 16% of our 2006 and 2005 consolidated sales,respectively, increased 20% in 2006 to $4,738,220 compared to $3,959,426 in2005. This increase was due in part to shipments of our new Series 8900analyzers which began shipping in the second half of 2006. Baseline’s foreignsales increased 111% in 2006 compared to 2005, while domestic sales decreasedslightly over the same periods. The increase in foreign sales was primarily dueto sales of new products to the carbonated beverage and OEM portable sensorindustries, as well as ongoing sales of equipment to the oil and gas drillingand semiconductor markets.

Sales of our packaging products (headspace analyzersand leak detection), which accounted for 15% of our consolidated sales in both2006 and 2005, increased 4% in 2006 to $3,880,877 compared to $3,732,740 in2005. The increase resulted primarily from increased domestic demand forheadspace analyzer products and increased foreign sales of leak detectionanalyzers, offset somewhat by a decrease in foreign shipments of headspaceanalyzers. The increase in domestic headspace analyzer sales was due primarilyto new products, including the PAC CHECK® Model 333 hand-held tri-gas analyzer for themeat packing industry, as well as increased sales and marketing emphasis.

Sales of our weighing and pharmaceutical products,which accounted for 5% of our consolidated sales in both 2006 and 2005,increased 23% in 2006 compared to 2005. The increase resulted exclusively fromincreased demand in our foreign markets and represented a small volume increase.Our weighing and pharmaceutical products group consists of a relatively fewernumber of products compared to our other product groups and will typicallyexperience significant fluctuations in demand. Due to the significantcompetition in the market for weighing products, we do not expect the sales ofour weighing and pharmaceutical products to significantly increase.

***Other Instruments and Services—******Sales***of ourother instruments and services group, which accounted for 6% and 8% of ourconsolidated sales in 2006 and 2005, respectively, decreased 19% in 2006compared to 2005. This decrease was primarily due to a decrease in sales of$458,086 in 2006 compared to 2005 as a 

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result of the saleof Lab Connections which occurred in the first quarter 2006. This decrease waspartially offset by a 23% increase in contract analytical testing services andequipment sales through our Microanalytics subsidiary and a 5% increase in ourconsulting and testing laboratory services.

*Fiscal 2005 vs.Fiscal 2004*

Sales were $24,581,600 in 2005, a 2% decrease comparedto sales of $24,965,053 in 2004. This decrease in sales was primarily theresult of decreased domestic and foreign sales volume of our permeation products,foreign sales volume of our weighing and pharmaceutical products, domesticsales volume of our consulting and analytical services and foreign sales volumeof our sample preparation products, offset somewhat by increases in thedomestic and foreign sales volume of our headspace analyzer and gas analyzerproducts. These sales volume decreases were generally the result of decreaseddemand. The impact of any price increases was not significant in 2005.

Domestic sales were $12,294,985, or 50% of total salesin 2005, an increase of 4% compared to $11,874,933, or 48% of total sales in2004. Foreign sales were $12,286,615, or 50% of total sales in 2005, a decreaseof 6% compared to $13,090,120, or 52% of total sales in 2004.

***Permeation Productsand Services—******Sales***of ourpermeation products and services were $13,711,970 and $14,290,547,approximately 56% and 57% of our consolidated sales in 2005 and 2004,respectively. The 4% decrease in permeation sales in 2005 compared to 2004 wasprimarily due to decreases in foreign sales and, to a lesser extent, to adecrease in domestic sales. While we believe the domestic market for permeationproducts is mature, we are increasing our emphasis in the foreign markets withnew products and marketing efforts.

***Gas, Headspace and OtherAnalyzer Products and Services—******Sales***of ourgas, headspace, and other analyzer products and services, which accounted for36% and 32% of our consolidated sales in 2005 and 2004, respectively, increased10%**in 2005 compared to 2004. Within thisgroup, sales of our gas analyzers and sensors through our Baseline subsidiary,which accounted for 16% and 14% of our 2005 and 2004 consolidated sales,respectively, increased 11% in 2005 to $3,959,426 compared to $3,560,351 in2004. This increase was primarily due to continued customer acceptance ofBaseline’s products in both the domestic and foreign markets.

Sales of our packaging products (headspace analyzersand leak detection), which accounted for 15% and 13% of our 2005 and 2004consolidated sales, respectively, increased 16% in 2005 to $3,732,740 comparedto $3,208,749 in 2004. The increase was primarily due to continued increases insales of hand-held headspace analyzer products, primarily into our domesticmarket.

Sales of our weighing and pharmaceutical products,which accounted for 5% of our consolidated sales in both 2005 and 2004,decreased 10% in 2005 compared to 2004. The decrease was primarily due toreduced shipments to foreign customers, offset somewhat by increased sales toour domestic customers.

***Other Instruments and Services—******Sales***of ourother instruments and services group, which accounted for 8% and 10% of ourconsolidated sales in 2005 and 2004, respectively, decreased 23% in 2005compared to 2004. This decrease was primarily due to reduced demand for ourconsulting and testing services and our contract analytical testing, as well aslower shipments of our sample preparation products.

***Gross Profit***

*Fiscal 2006 vs.Fiscal 2005*

Our gross profitpercentages were 57.5% and 56.1% during 2006 and 2005, respectively. Theincrease in gross profit percentage resulted from numerous factors. A higherpercentage of our sales were from permeation equipment, which typically carry ahigher margin than most of our other products. We moved 

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most ofthe remaining production of certain equipment at our Baseline operation toMinnesota which allowed for increased operational efficiencies and plantutilization. In addition, the sale of our Lab Connections subsidiary in thefirst quarter 2006 helped our gross profit percentage by eliminatinginefficiencies due to the low and sporadic volume of sales at Lab Connections.

*Fiscal 2005 vs.Fiscal 2004*

Our gross profitpercentages were 56.1% and 53.9% during 2005 and 2004, respectively. Theincrease in gross profit percentage was due primarily to certain non-recurringcosts incurred in 2004. These costs were associated with: (1) the transferof the majority of our Baseline subsidiary’s production to our facility inMinneapolis, Minnesota, (2) expenses associated with the amortization ofintangible assets acquired as part of the purchase of Lippke and (3) thescrapping of inventory that had become obsolete. However, in 2005, our productmix included fewer permeation product sales, which on average carry a highergross margin and thus somewhat reduced the overall gross margin for 2005.

***Selling, General and Administrative Expenses***

*Fiscal 2006 vs.Fiscal 2005*

Selling, general andadministrative expenses were $7,876,219 and $8,008,326, or 30% and 33% of salesin 2006 and 2005, respectively. The decrease of $132,107 was due primarily to alower headcount in 2006 as well as reduced operating expenses in our LabConnections subsidiary which was sold during the first quarter 2006. Also, weincurred reduced consulting costs related to Sarbanes-Oxley Act of 2002 (SOX)compliance in 2006 as compared to 2005 due to a postponement of the effectivedate of Section 404 of SOX for non-accelerated filers until 2007.

*Fiscal 2005 vs.Fiscal 2004*

Selling, general andadministrative expenses were $8,008,326 and $8,275,637 in 2005 and 2004,respectively, or 33% of sales in both years. The decrease was primarily due todecreased number of sales personnel in 2005 and also the expense associatedwith the Lab Connections intangible technology rights one-time impairmentcharge in 2004.

***Research and Development Expenses***

*Fiscal 2006 vs.Fiscal 2005*

Research and development(R&D) expenses were $1,942,786 and $1,765,662, or 7.3% and 7.2% of sales in2006 and 2005, respectively. The increase of $177,124 in 2006 compared to 2005is the result of our focus on business development opportunities in our coreproduct areas. We believe continued R&D expenditures are necessary as wedevelop new products to expand in our niche markets and remain competitive. Forthe foreseeable future, we currently intend to allocate on an annual basisapproximately 6% to 8% of sales to research and development.

*Fiscal 2005 vs.Fiscal 2004*

Research and developmentexpenses were $1,765,662 and $1,371,700, or 7.2% and 5.5% of sales in 2005 and2004, respectively. This planned increase was in line with our presentintention to spend between 6% and 8% of sales to develop new products to expandin our niche markets.

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***Other Income, Net***

Otherincome, net for 2006, 2005 and 2004 was $549,597, $338,147 and $123,448,respectively. The following provides the details:

| ** **                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Interest income  on short-term investments |       | $                                           | 412,882    |   | 209,217 |   | 129,862 |   |
| Gain on sale of  Lab Connections           |       | 92,345                                      |       | — |   | — |   |
| Gain on sale of  fixed assets              |       | 61,037                                      |       | 45,522 |   | 8,129 |   |
| Foreign currency  exchange (loss) gain     |       | (19,152                                     | )          | 80,691 |   | (14,543 | ) |
| Other                                      |       | 2,485                                       |       | 2,717 |   | — |   |
| Total                                      |       | $                                           | 549,597    |   | 338,147 |   | 123,448 |   |

 

Interest income increasedapproximately $204,000 from 2005 to 2006 due to higher interest rates (primerate increased four times in 2006) and increased average cash and marketablesecurity balances. Total cash and marketable securities increased approximately$3,600,000 from December 31, 2005 to December 31, 2006.

***Income Tax Expense***

Our provision for income taxes from continuingoperations was 33.6% of income before income taxes in 2006, a three percentagepoint increase over 2005. The increase in the effective tax rate was dueprimarily to stock option compensation recognized in 2006 for the first time,which was not tax deductible, and a reduction in the tax contingency accrual in2005 resulting from an Internal Revenue Service examination. The provision for 2006was favorably impacted by the resolution of a proposed income tax assessment inthe state of New Jersey, which reduced income tax expense by approximately$50,000. Also, because the sale of Lab Connections generated a taxable loss,there was no provision applicable to the $92,345 gain that was realized in thefirst quarter 2006. The taxable loss of approximately $650,000 results in along-term capital loss carryforward which produces a deferred tax asset. Becauseit is currently unlikely that we will incur a long-term capital gain in theforeseeable future to offset against this loss, we have established a valuationallowance against the entire deferred tax asset relating to the capital losscarry-forward.

Our provision for income taxes from continuing operationswas 30.6% of income before income taxes in 2005. The provision for 2005 wasfavorably impacted as the result of a $156,000 reduction in accrued incometaxes related to the completion of an Internal Revenue Service examination. Also,the American Jobs Creation Act of 2004 that was passed in October 2004,and took effect on January 1, 2005, provided for a new manufacturingdeduction that helped lower our effective tax rate.

Our provision for incometaxes from continuing operations was 32.9% of income before income taxes in2004.

**Critical AccountingPolicies**

Oursignificant accounting policies are described in Note 1 to our consolidatedfinancial statements included in Item 8 of this report. This Management’sDiscussion and Analysis of Financial Condition and Results of Operations isbased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The preparation of these consolidated financial statements requiresmanagement to make estimates and judgments that affect the reported amount ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. The Securities and Exchange Commission hasdefined a 

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company’s most critical accounting policies as thosethat are most important to the portrayal of its financial condition and resultsof operations, and which require the company to make its most difficult andsubjective judgments, often as a result of the need to make estimates ofmatters that are inherently uncertain. Based on this definition, we haveidentified the following critical accounting policies. Although we believe thatour estimates and assumptions are reasonable, they are based upon informationavailable when they are made. Actual results may differ significantly fromthese estimates under different assumptions or conditions.

***Allowance for Doubtful Accounts and Sales Returns***

Our allowance for doubtfulaccounts and sales returns is for accounts receivable balances that areestimated to be uncollectible as well as anticipated sales returns. The reserveis based on a number of factors, including: (1) an analysis of customeraccounts 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 December 31, 2006 and 2005, we had$179,861 and $192,446, respectively, reserved against our accounts receivablefor doubtful accounts and sales returns.

***Allowance for 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 products decreased becauseof economic or competitive conditions or otherwise. As of December 31,2006 and 2005, we had $642,433 and $756,183, respectively, accrued for excessand obsolete inventories.

***Recoverability of Long-Lived Assets***

We assess therecoverability of goodwill and other long-lived assets annually or wheneverevents or changes in circumstances indicate that expected future undiscountedcash flows might not be sufficient to support the carrying amount of an asset. Wedeem an asset to be impaired if a forecast of undiscounted future operatingcash flows is less than an asset’s carrying amount. If an asset is determinedto be impaired, the loss is measured as the amount by which the carrying valueof the asset exceeds its fair value. In the fourth quarter 2004, we recorded a$240,000 charge for the impairment of intangible technology rights associatedwith our Lab Connections subsidiary. Changes in our business strategies,changes in the economic environment in which we operate, competitiveconditions, and other factors could result in future impairment charges.

***Accrued Product Warranties***

Our products are generallycovered by a warranty, with warranty periods ranging from ninety days to oneyear from the date of sale. Estimated warranty costs are accrued in the sameperiod in which the related revenue is recognized, based on anticipated partsand labor costs, utilizing historical experience. Special warranty reserves arealso accrued for major rework campaigns. We periodically assess the adequacy ofour warranty reserves based on changes in these factors and record anynecessary adjustments if actual claim experience indicates that adjustments arenecessary. Although we believe the likelihood to be relatively low, warrantyclaims experience could be materially different from actual results due to 

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manufacturingchanges that could impact product quality, a change in our warranty policy inresponse to industry trends, as yet unrecognized defects in products sold, orother factors. As of December 31, 2006 and 2005, we had $246,737 and$327,015, respectively, accrued for future estimated warranty claims.

***Income Taxes***

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 actual currenttax exposures together with assessing temporary differences resulting fromdiffering treatment of items for tax and accounting purposes. These differencesresult in deferred tax assets and liabilities, which are included in our ConsolidatedBalance Sheets.

We have significantamounts of deferred tax assets. Management reviews the deferred tax assets forrecoverability on a quarterly basis and assesses the need for valuationallowances. These deferred tax assets are evaluated by considering historicallevels of income, estimates of future taxable income streams and the impact oftax planning strategies. A valuation allowance is recorded to reduce deferredtax assets when it is determined that it is more likely than not that we wouldnot be able to realize all or part of its deferred tax assets. At December 31,2006, we provided a valuation allowance in the approximate amount of $238,000against our net deferred tax assets.

**Inflation**

We do not believe thatinflation has had a material effect on our results of operations in recentyears; however, there can be no assurance that our business will not beadversely affected by inflation in the future.

**Liquidity andCapital Resources**

Total cash, cash equivalents and marketable securitiesincreased $3,615,181 during 2006 to $12,636,550 as of December 31, 2006,compared to $9,021,369 at December 31, 2005. We describe the reasons forthis increase below under the caption “Cash Flows from Operating Activities.”Our working capital as of December 31, 2006 increased $2,365,971 to$16,205,304, compared to $13,839,333 at December 31, 2005.

We invest a large portion of our available cash inhighly liquid certificates of deposit, municipal bonds, corporate bonds, UnitedStates treasury obligations and money market funds. Our investment policy is tomanage these assets to preserve principal, maintain adequate liquidity at alltimes, and maximize returns subject to investment guidelines we maintain.

We have historicallyfinanced our operations and capital equipment requirements through cash flowsgenerated from operations. 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 operations, capitalexpenditures, dividend payments and stock repurchases. Our belief is based oncurrent business operations and economic conditions and assumes that wecontinue to operate our business in the ordinary course. However, one of ourstrategic objectives is, as market and business conditions warrant, to consideracquisitions of businesses, products or technologies. If the cost of one ormore acquisition opportunities exceeds our existing cash resources, we may needto fund such activities, should they arise, with a portion of our cash balancesand debt and/or equity financing. We currently do not have any committed linesof credit or other credit facilities, and it is uncertain whether suchfacilities could be obtained in sufficient amounts or on acceptable terms. Anyplan to raise additional capital may involve an equity-based or equity-linkedfinancing, which may be dilutive to existing shareholders. If we raiseadditional funds by issuing debt, we may be subject to restrictive covenantsthat could limit our operational flexibility and higher interest expense coulddilute earnings per share.

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***Cash Flow***

*Cash Flows fromOperating Activities*

Our primary source offunds is cash provided by operating activities. Cash flow from operatingactivities of continuing operations totaled $4,978,197, $2,993,313 and$5,304,232 in 2006, 2005 and 2004, respectively. In 2006, cash provided byoperating activities of continuing operations increased by $1,984,884 comparedto 2005. This increase was due primarily to the increased year-over-year incomefrom continuing operations, a decrease in inventories, and an increase inaccounts payable and accrued compensation offset by a reduction in accruedincome taxes and an increase in trade accounts receivable. In 2005, cashprovided by operating activities of continuing operations decreased by$2,310,919 compared to 2004. This decrease was due primarily to the increasesin inventories and net deferred income taxes and the reduction in accountspayable and other accrued expenses, offset somewhat by higher year-over-yearincome from continuing operations. Working capital requirements typically willincrease or decrease with changes in the level of sales. In addition, thetiming of certain accrued payments will affect the annual cash flow. Income taxpayments and any employee incentive payments affect the timing of our operatingcash flow as they are accrued throughout the year but paid on a quarterly,semi-annually or annual basis.

*Cash Flows fromInvesting Activities*

Cash used in investing activities from continuingoperations totaled $3,354,756 in 2006 as compared to $1,642,339 in 2005 and$1,492,763 in 2004. Cash used for investment purposes (net of investment sales)was $2,949,807 and $1,096,578 in 2006 and 2005, respectively. Net cash proceedsfrom investments were $345,995 in 2004. Cash received from the sale of our LabConnections subsidiary was $478,721 in 2006. Purchases of property, plant andequipment totaled $462,324 in 2006, primarily for additions of office,manufacturing and laboratory equipment, as compared to $232,360 and $521,133 in2005 and 2004, respectively. We had no material commitments for capitalexpenditures as of December 31, 2006. We do not believe that any majorproperty, plant and equipment expenditures are required to accommodate ourcurrent level of operations, and we expect purchases in 2007 to be similar tothe levels in 2006.

Cash paid in acquisitions(net of cash acquired) in 2006, 2005 and 2004 of $454,718, $325,825 and$1,265,648, respectively, were related to our purchase of Lippke. The 2006 and2005 amounts resulted from an adjustment of the required earnout paymentsbetween the minimum amount originally recorded and the amount paid, based onactual earnings of Lippke.

*Cash Flows fromFinancing Activities*

Cash used in financing activities from continuingoperations totaled $1,183,512 in 2006 as compared to $1,102,685 in 2005 and$2,455,189 in 2004. The primary use of cash for financing activities in 2006,2005 and 2004 was for the payment of dividends to our shareholders, in theamounts of $1,627,849, $1,502,284 and $1,393,506, respectively. In addition,during 2004, we made final dividend payments of $449,087 to Lippke’s formerparent company.

Our Board of Directors has authorized, depending uponmarket conditions and other factors, the repurchase of up to a total of$2,000,000 of our common stock. During 2006, we repurchased a total of $363,125of our common stock, leaving a remaining balance of $1,636,875 in thisauthorization. We did not make any repurchases of our common stock during 2005.During 2004, we made repurchases of our common stock totaling $900,360 relatedto a previous authorization.

Cash flow from theexercise of stock options generated $725,881, $399,599 and $287,764, for theyears 2006, 2005 and 2004, respectively.

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***Contractual Obligations***

The followingtable summarizes our future contractual cash obligations as ofDecember 31, 2006 (in thousands):

| ** **                          | ** ** | **Payments Due By Period** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**    | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than 1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **After 5 years** | ** ** |
| Operating leases                    |       | $                                         | 1,072      |   |   | 360 |   |   |   | 712 |   |   |   | — |   |   |   | — |   |   |
| Inventory  purchase obligations     |       | 1,313                                     |       |   | 1,277 |   |   |   | 36 |   |   |   | — |   |   |   | — |   |   |
| Total contractual cash  obligations |       | $                                         | 2,385      |   |   | 1,637 |   |   |   | 748 |   |   |   | — |   |   |   | — |   |   |
|                                     |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In connection with the Lippke acquisition, we wereobligated to make three future earnout payments to Lippke’s former parentcompany based on the net profits of Lippke in each of the years 2004, 2005 and2006. We made payments of $549,257 and $433,339 in the first quarters 2005 and2006, respectively, and made the final payment of $574,568 in the first quarter2007.

We are parties to aseverance agreement with four of our executive officers which provides for thepayment to the executive of a lump sum amount upon the occurrence of certaintermination events. The payment could amount to one or two times theexecutive’s current annual salary depending on the reason for termination.

***Off-Balance Sheet Arrangements***

We do not have anyoff-balance sheet arrangements, as defined by the rules and regulations ofthe SEC, that have or are reasonably likely to have a material effect on ourfinancial condition, changes in financial condition, revenues or expenses,results of operations, liquidity, capital expenditures or capital resources. Asa result, we are not materially exposed to any financing, liquidity, market orcredit risk that could arise if we had engaged in these arrangements.

**Recently IssuedAccounting Pronouncements**

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements* (SAB 108). SAB 108 providesinterpretive guidance on how the effects of the carryover or reversal of prioryear misstatements should be considered in quantifying a current yearmisstatement. The SEC staff believes that registrants should quantify errorsusing both a balance sheet and an income statement approach and evaluatewhether either approach results in quantifying a misstatement that, when allrelevant quantitative and qualitative factors are considered, is material. SAB108 is effective for fiscal years ending on or after November 15, 2006,with early application encouraged. Accordingly, we have adopted SAB 108 for ourfiscal year ended December 31, 2006. Adoption of SAB 108 did not have aneffect on our financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS 157, *Fair Value Measurement* (SFAS 157). The standard providesguidance for using fair value to measure assets and liabilities. SFAS 157clarifies the principle that fair value should be based on the assumptionsmarket participants would use when pricing an asset or liability andestablishes a fair value hierarchy that prioritizes the information used todevelop those assumptions. Under the standard, fair value measurements would beseparately disclosed by level within the fair value hierarchy. The statement iseffective for us beginning in 2008; however, early adoption is permitted. Wehave not yet determined the impact, if any, that the implementation of SFAS 157will have on our financial position, results of operations or cash flows.

In June 2006, theFASB issued Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes* (FIN 48). FIN 48 clarifies theaccounting for income taxes by prescribing the minimum recognition 

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thresholda tax position is required to meet before being recognized in the financialstatements. FIN 48 also provides guidance on derecognition, measurement,classification, interest and penalties, accounting in interim periods,disclosure and transition. The requirements are effective for fiscal yearsbeginning after December 15, 2006. We currently do not expect that theadoption of this Interpretation will have a material impact on our consolidatedfinancial statements.

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

**Interest Rate Risk**

Substantially all of ourmarketable securities are at fixed interest rates. However, virtually all ofthe marketable securities mature in two years or less; therefore, we believethat the market risk arising from the holding of these financial instruments isminimal.

**Foreign CurrencyExchange 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 would be reflected as a foreign currencytranslation adjustment, a component of accumulated other comprehensive incomein stockholders’ equity, and would not impact our net income.

**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

Our consolidated financialstatements and Report of Independent Registered Public Accounting Firm areincluded beginning on page F-1 of this annual report on Form 10-Kand are incorporated herein by reference.

**SELECTED QUARTERLYFINANCIAL DATA (UNAUDITED)**

(in thousands, except per share data)

| ** **                    | ** ** | **Quarter** | ** ** |
|-------------------------------|------------|-------------|------------|
| ** **                    | ** ** | **1st**     | ** ** | **2nd** | ** ** | **3rd** | ** ** | **4th** | ** ** |
| 2006                          |       |        |       |   |   |   |   |   |   |
| Sales                         |       | $           | 6,519      |   | $ | 6,340 |   | $ | 6,647 |   | $ | 6,784 |   |
| Gross profit                  |       | $           | 3,818      |   | $ | 3,662 |   | $ | 3,807 |   | $ | 3,839 |   |
| Net income                    |       | $           | 1,135      |   | $ | 863 |   | $ | 969 |   | $ | 944 |   |
| Net income per common  share: |       |        |       |   |   |   |   |   |   |
| Basic                         |       | $           | 0.21       |   | $ | 0.16 |   | $ | 0.18 |   | $ | 0.17 |   |
| Diluted                       |       | $           | 0.21       |   | $ | 0.16 |   | $ | 0.18 |   | $ | 0.17 |   |
| 2005                          |       |        |       |   |   |   |   |   |   |
| Sales                         |       | $           | 6,445      |   | $ | 6,382 |   | $ | 5,670 |   | $ | 6,085 |   |
| Gross profit                  |       | $           | 3,562      |   | $ | 3,537 |   | $ | 3,221 |   | $ | 3,473 |   |
| Net income                    |       | $           | 794        |   | $ | 775 |   | $ | 594 |   | $ | 752 |   |
| Net income per common  share: |       |        |       |   |   |   |   |   |   |
| Basic                         |       | $           | 0.15       |   | $ | 0.14 |   | $ | 0.11 |   | $ | 0.14 |   |
| Diluted                       |       | $           | 0.14       |   | $ | 0.14 |   | $ | 0.11 |   | $ | 0.14 |   |

 

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**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

**ITEM 9A.**        CONTROLSAND PROCEDURES

**Evaluation ofDisclosure Controls and Procedures**

We maintain disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended) that are designed to reasonablyensure that information required to be disclosed by us in the reports we fileor submit under the Securities Exchange Act of 1934, as amended, is recorded,processed, summarized, and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms and that suchinformation is accumulated and communicated to our management, including ourprincipal executive and principal financial officers, or persons performingsimilar functions, as appropriate to allow timely decisions regarding requireddisclosure. In designing and evaluating our disclosure controls and procedures,we recognize that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and we are required to apply our judgment in evaluating thecost-benefit relationship of possible internal controls.

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 annual reporton Form 10-K. Based on that evaluation, our Chief Executive Officerand Chief Financial Officer concluded that our disclosure controls andprocedures were effective as of the end of such period to provide reasonableassurance that information required to be disclosed in our Exchange Act reportsis recorded, processed, summarized, and reported within the time periodsspecified in the SEC’s rules and forms, and that material informationrelating to our company is made known to management, including our ChiefExecutive Officer and Chief Financial Officer, particularly during the periodwhen our periodic reports are being prepared.

**Changes in InternalControl Over Financial Reporting**

There was no change in ourinternal control over financial reporting that occurred during our fourthquarter of the year ended December 31, 2006 that has materially affected,or is reasonably likely to materially affect our internal control overfinancial reporting.

**ITEM 9B.**       OTHERINFORMATION

None.

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**PART III**

**ITEM 10.**         DIRECTORSAND EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required under Item 10 of this reportis to be contained under the headings “Proposal One—Election of Directors—InformationAbout Board Nominees,” “Proposal One—Election of Directors—AdditionalInformation About Board Nominees,” “Corporate Governance—Information About ourBoard and its Committees” and “Section 16(a) Beneficial OwnershipReporting Compliance” in our definitive proxy statement to be filed with theSEC with respect to our next annual meeting of shareholders, which involves theelection of directors and is incorporated herein by reference, or, if suchproxy statement is not filed with the SEC within 120 days after the end of thefiscal year covered by this report, such information will be filed as part ofan amendment to this report not later than the end of the 120-day period.

The information concerning our executive officers isincluded in this report under Item 4A, “Executive Officers of Registrant” andis incorporated herein by reference.

During the fourth quarter 2006, we made no materialchanges to the procedures by which shareholders may recommend nominees to theboard of directors, as described in our most recent proxy statement.

Our Code of Ethics applies to all of our officers,directors and employees, including our principal executive officer andprincipal financial officer, and meets the requirements of the rules andregulations of the Securities and Exchange Commission. We will disclose anyamendments to, and any waivers from a provision of, our Code of Ethics on aForm 8-K filed with the Securities and Exchange Commission. We willprovide, free of charge, a copy of our Code of Ethics to any person whorequests a copy. To request a copy of our Code of Ethics, write to us at:

MOCON, Inc.7500 Boone Avenue NorthMinneapolis, Minnesota 55428Attention:  Chief Financial Officer

**ITEM 11.**         EXECUTIVECOMPENSATION

The information requiredunder Item 11 of this report is to be contained under the headings “DirectorCompensation” and “Executive Compensation” in our definitive proxy statement tobe filed with the SEC with respect to our next annual meeting of shareholders,which involves the election of directors and is incorporated herein byreference, or, if such proxy statement is not filed with the SEC within 120days after the end of the fiscal year covered by this report, such informationwill be filed as part of an amendment to this report not later than the end ofthe 120-day period.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The information required under Item 12 of this reportis to be contained under the headings “Principal Shareholders and BeneficialOwnership of Management” in our definitive proxy statement to be filed with theSEC with respect to our next annual meeting of shareholders, which involves theelection of directors and is incorporated herein by reference, or, if suchproxy statement is not filed with the SEC within 120 days after the end of thefiscal year covered by this report, such information will be filed as part ofan amendment to this report not later than the end of the 120-day period.

The following table summarizes outstanding optionsunder our equity compensation plans as of December 31, 2006. Our onlyequity compensation plans as of December 31, 2006 were theMOCON, Inc. 

31

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2006 Stock Incentive Plan, theMOCON, Inc. 1998 Stock Option Plan and the MOCON, Inc. 1992 StockOption Plan. The MOCON, Inc. 1998 Stock Option Plan and theMOCON, Inc. 1992 Stock Option Plan have terminated with respect to futuregrants. Options and other stock incentive awards to be granted in the futureunder the MOCON, Inc. 2006 Stock Incentive Plan are within the discretionof our Board of Directors and the Compensation Committee of our Board ofDirectors and therefore cannot be ascertained at this time.

| **Plan Category**                                      | ** ** | ** ** | ** ** | **Number of Securities to  be Issued upon Exercise of  Outstanding Options,   Warrants and Rights** | ** ** | **Weighted Average  Exercise Price of  Outstanding Options,   Warrants and Rights** | ** ** | **Number of Securities Remaining  Available for Future Issuance  Under Equity Compensation Plans  (Excluding Securities Reflected in  the First Column)** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation plans approved by security  holders     |       |       | 853,875    |                                                                                                                                                       |       |                                                                                                                   | $          | 8.52                                                                                                                                                                                                                            |       |   |   | 398,800 |   |   |
| Equity compensation plans not approved by security  holders |       |       | —     |                                                                                                                                                       |       |                                                                                                                   | —     |                                                                                                                                                                                                                            |       |   | — |   |   |
| Total                                                       |       |       | 853,875    |                                                                                                                                                       |       |                                                                                                                   | $          | 8.52                                                                                                                                                                                                                            |       |   |   | 398,800 |   |   |

 

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE

The information requiredunder Item 13 of this report is to be contained under the heading “RelatedParty Relationships and Transactions” in our definitive proxy statement to befiled with the SEC with respect to our next annual meeting of shareholders,which involves the election of directors and is incorporated herein byreference, or, if such proxy statement is not filed with the SEC within 120days after the end of the fiscal year covered by this report, such informationwill be filed as part of an amendment to this report not later than the end ofthe 120-day period.

**ITEM 14.**         PRINCIPALACCOUNTANT FEES AND SERVICES

The information required under Item 14 of this reportis to be contained under the headings “Proposal Two—Ratification of Selectionof Independent Registered Public Accounting Firm—Audit, Audit-Related, Tax andOther Fees” and “Proposal Two—Ratification of Selection of IndependentRegistered Public Accounting Firm—Pre-Approval Policies and Procedures” in ourdefinitive proxy statement to be filed with the SEC with respect to our nextannual meeting of shareholders, which involves the election of directors and isincorporated herein by reference, or, if such proxy statement is not filed withthe SEC within 120 days after the end of the fiscal year covered by thisreport, such information will be filed as part of an amendment to this reportnot later than the end of the 120-day period.

32

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**PART IV**

**Item15.**         EXHIBITS AND FINANCIALSTATEMENT SCHEDULES 

**(a)****         1.      Financial Statements**

Thefollowing consolidated financial statements of MOCON, Inc. and its subsidiariesare included herein:

|                                                                                                                                     | ** ** | ** ** | **Page** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                            |       | F-1        |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                                       |       | F-2        |
| Consolidated Statements of Income for the years ended  December 31, 2006, 2005 and 2004                                             |       | F-3        |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Income for the years ended December 31, 2006, 2005 and 2004 |       | F-4        |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                                         |       | F-5        |
| Notes to Consolidated Financial Statements                                                                                          |       | F-6        |

 

**2.****                 FinancialStatement Schedule**

The following financial statement schedule is includedherein and should be read in conjunction with the consolidated financialstatements referred to above:  ScheduleII:  Valuation and Qualifying Accounts.

33

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**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and StockholdersMOCON, Inc.:

Under date of March 29, 2007, we reported on theconsolidated balance sheets of MOCON, Inc. and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of income, stockholders’equity and comprehensive income, and cash flows for each of the years in thethree-year period ended December 31, 2006, as contained in this annualreport on Form 10-K for the year 2006. In connection with our auditsof the aforementioned consolidated financial statements, we also audited therelated consolidated financial statement schedule. This financial statementschedule is the responsibility of the Company’s management. Our responsibilityis to express an opinion on this financial statement schedule based on ouraudits.

In our opinion, such financial statement schedule,when considered in relation to the basic consolidated financial statementstaken as a whole, presents fairly, in all material respects, the informationset forth therein.

Asdiscussed in Note 1 to the consolidated financial statements, the Companyadopted Statement of Financial Accounting Standards No. 123(R), *“Share-Based Payment,”* on January 1,2006.
|                        | /s/ KPMG LLP |   |
|------------------------|--------------|--------|
| Minneapolis, Minnesota |         |
| March 29, 2007    |         |

 

34

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**Financial StatementSchedule:**

**II—Valuation andQualifying Accounts**

All other schedules areomitted as the required information is inapplicable or the information ispresented in our consolidated financial statements or related notes.

**SCHEDULEII**

**MOCON, INC. ANDSUBSIDIARIES**

**Valuationand Qualifying Accounts**

| **Description**                                    | ** ** | ** ** | ** ** | **Balance at  beginning of  year** | ** ** | **Charged to costs  and expenses** | ** ** | **Deductions** | ** ** | **Balance at  end of year** | ** ** |
|----------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|---------------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Year ended  December 31, 2004                 |       |       |       |                                         |       |                                              |       |           |       |                                       |       |   |   |   |   |   |   |
| Allowance for doubtful accounts and sales returns  |       |       | $          | 243,677                                      |       |                                              |       | 173,147        | (1)        |                                       |       | 194,784 |   |   |   | 222,040 |   |   |
| Year ended  December 31, 2005                 |       |       |       |                                         |       |                                              |       |           |       |                                       |       |   |   |   |   |   |   |
| Allowance for doubtful accounts and sales returns  |       |       | 222,040    |                                         |       |                                              | 30,668     |           |       |                                       | 60,262     |   |   |   | 192,446 |   |   |
| Year ended  December 31, 2006                 |       |       |       |                                         |       |                                              |       |           |       |                                       |       |   |   |   |   |   |   |
| Allowance for  doubtful accounts and sales returns |       |       | 192,446    |                                         |       |                                              | 132,570    |           |       |                                       | 145,155    |   |   |   | 179,861 |   |   |
|                                                    |            |            |            |                                              |            |                                                   |            |                |            |                                            |            |  |  |  |  |  |  |  |  |  |

----

(1)          Includes adjustment foracquisition of Lippke.

35

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**3.**                 Exhibits

The exhibits to this Annual Report on Form 10-Kare listed in the Exhibit Index.

A copy of any of the exhibits listed or referred toabove will be furnished at a reasonable cost to any person who was ashareholder of MOCON as of March 22, 2007, upon receipt from any suchperson of a written request for any such exhibit. Such request should be sentto MOCON, Inc., 7500 Boone Avenue North, Minneapolis, Minnesota 55428;Attn: Shareholder Information.

The following is alist of each management contract or compensatory plan or arrangement requiredto be filed as an exhibit to this Annual Report on Form 10-Kpursuant to Item 15(a):

A.             MOCON, Inc. 1992Stock Option Plan (incorporated by reference to Exhibit 10.5 to our AnnualReport on Form 10-K for the fiscal year ended December 31, 1991(File No. 000-09273)).

B.              MOCON, Inc.1998 Stock Option Plan, as amended, (incorporated by reference to ourDefinitive Proxy Statement on Form DEF-14A filed on April 9,2002 (File No. 000-09273)).

C.              Form ofIncentive Stock Option Agreement between MOCON, Inc. and its ExecutiveOfficers under the MOCON, Inc. 1998 Stock Option Plan, as amended(incorporated by reference to Exhibit 99.1 to our Current Report on Form 8-Kfiled on December 29, 2004 (File No. 000-09273)).

D.             Form ofNon-Statutory Stock Option Agreement between MOCON, Inc. and itsNon-Employee Directors and Executive Officers under the MOCON, Inc. 1998Stock Option Plan, as amended (incorporated by reference to Exhibit 99.2to our Current Report on Form 8-K filed on December 29, 2004(File No. 000-09273)).

E.              MOCON, Inc.2006 Stock Incentive Plan (incorporated by reference to Exhibit 10.1 toour Current Report on Form 8-K filed on May 23, 2006 (File No. 000-09273)).

F.               Form ofIncentive Stock Option Agreement between MOCON, Inc. and its ExecutiveOfficers under the MOCON, Inc. 2006 Stock Incentive Plan (incorporated byreference to Exhibit 10.2 to our Current Report on Form 8-Kfiled on May 23, 2006 (File No. 000-09273)).

G.            Form ofNon-Statutory Stock Option Agreement between MOCON, Inc. and itsNon-Employee Directors and Executive Officers under the MOCON, Inc. 2006Stock Incentive Plan (incorporated by reference to Exhibit 10.3 to ourCurrent Report on Form 8-K filed on May 23, 2006 (File No. 000-09273)).

H.            Form of ExecutiveSeverance Agreement (incorporated by reference to Exhibit 10.13 to ourAnnual Report on Form 10-K for the fiscal year ended December 31,2000 (File No. 000-09273)).

I.                  2003Compensation Committee resolution setting forth the MOCON Incentive Pay Planfor 2003 and subsequent years (incorporated by reference to Exhibit 10.14to our Annual Report on Form 10-K for the fiscal year ended December 31,2002 (File No. 000-09273)).

J.                 Description ofNon-Employee Director Retirement Plan (incorporated by reference to Exhibit 10.20to our Annual Report on Form 10-K for the fiscal year ended December 31,2004 (File No. 000-09273)).

K.             Description ofNon-Employee Director Compensation Arrangements (incorporated by reference to Exhibit 10.21to our Annual Report on Form 10-K for the fiscal year ended December 31,2004 (File No. 000-09273)).

L.               Descriptionof Executive Officer Compensation Arrangements (filed herewith).

36

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**(b)**          Exhibits

The exhibits to thisannual report on Form 10-K are listed in the Exhibit Index.

**(c)**           FinancialStatement Schedule

See Item 15(a)(2) above for the financialstatement schedule filed herewith.

37

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
| Date:  March 30, 2007 | MOCON,  INC. |
|----------------------------|--------------|
|                       | By:          | /s/ Robert L. Demorest |
|                       |         | Robert L. Demorest, *Chairman  of the Board,* |
|                       |         | *President and Chief Executive Officer* |
|                       |         | *(principal executive officer)* |
|                       | By:          | /s/ Darrell B. Lee |
|                       |         | Darrell B. Lee, *Vice President, Chief* |
|                       |         | *Financial Officer, Treasurer and Secretary* |
|                       |         | *(principal financial and accounting officer)* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities indicated and on March 30, 2007.

| ** ** | Signature and Title                                                               | ** ** | ** ** |
|------------|-----------------------------------------------------------------------------------|------------|------------|
|       | /s/ Robert L.  Demorest                                                           |
|       | Robert L. Demorest,  Chairman of the Board, President and Chief Executive Officer |
|       | /s/ Dean B.  Chenoweth                                                            |
|       | Dean B. Chenoweth,  Director                                                      |
|       | /s/ Donald N.  DeMorett                                                           |
|       | Donald N. DeMorett,  Director                                                     |
|       | /s/ J. Leonard  Frame                                                             |
|       | J. Leonard Frame,  Director                                                       |
|       | /s/ Robert F.  Gallagher                                                          |
|       | Robert F. Gallagher,  Director                                                    |
|       | /s/ Daniel W.  Mayer                                                              |
|       | Daniel W. Mayer,  Director                                                        |
|       | /s/ Ronald A.  Meyer                                                              |
|       | Ronald A. Meyer,  Director                                                        |
|       | /s/ Richard A.  Proulx                                                            |
|       | Richard A. Proulx,  Director                                                      |
|       | /s/ Tom C. Thomas                                                                 |
|       | Tom C. Thomas, Director                                                           |

 

38

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**MOCON, INC. ANDSUBSIDIARIESConsolidated Financial StatementsDecember 31, 2006, 2005 and 2004**

**Tableof Contents**

|                                                                                | ** ** | **Page** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm                       |       |     | F-1        |   |   |
| Consolidated Balance Sheets                                                    |       |     | F-2        |   |   |
| Consolidated Statements of Income                                              |       |     | F-3        |   |   |
| Consolidated  Statements of Stockholders’ Equity and Comprehensive Income |       |     | F-4        |   |   |
| Consolidated Statements of Cash Flows                                          |       |     | F-5        |   |   |
| Notes to Consolidated Financial Statements                                     |       |     | F-6        |   |   |

 

39

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**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and StockholdersMOCON, Inc.:

We have audited the accompanying consolidated balancesheets of MOCON, Inc. and subsidiaries as of December 31, 2006 and 2005, andthe related consolidated statements of income, stockholders’ equity andcomprehensive income, and cash flows for each of the years in the three-yearperiod ended December 31, 2006. These consolidated financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of MOCON, Inc. and subsidiaries as of December 31, 2006 and 2005, andthe results of their operations and their cash flows for each of the years inthe three-year period ended December 31, 2006, in conformity with U.S.generally accepted accounting principles.

Asdiscussed in Note 1 to the consolidated financial statements, the Companyadopted Statement of Financial Accounting Standards No. 123(R), *“Share-Based Payment,”* on January 1, 2006.
|                        | /s/ KPMG  LLP |   |
|------------------------|---------------|--------|
| Minneapolis, Minnesota |
| March 29, 2007         |

 

F-1

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**MOCON, INC. AND SUBSIDIARIES**Consolidated Balance SheetsDecember 31, 2006 and 2005

| ** **                                                                                                                                      | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Assets**                                                                                                                                      |       |       |       |       |       |
| Current assets:                                                                                                                                 |       |       |       |       |       |
| Cash and cash  equivalents                                                                                                                      |       | $          | 3,549,042  |       | 2,889,323  |   |
| Marketable  securities, current                                                                                                                 |       | 8,710,390  |       | 5,961,793  |       |
| Trade accounts  receivable, less allowance for doubtful accounts of $179,861 in 2006 and $192,446  in 2005                                      |       | 4,384,808  |       | 4,237,240  |       |
| Other receivables                                                                                                                               |       | 166,697    |       | 124,403    |       |
| Inventories                                                                                                                                     |       | 3,619,644  |       | 4,057,514  |       |
| Prepaid expenses                                                                                                                                |       | 251,953    |       | 313,042    |       |
| Deferred income  taxes                                                                                                                          |       | 340,125    |       | 582,948    |       |
| Assets held for  sale                                                                                                                           |       | —     |       | 90,809     |       |
| Total current  assets                                                                                                                           |       | 21,022,659 |       | 18,257,072 |       |
| Marketable  securities, noncurrent                                                                                                              |       | 377,118    |       | 170,253    |       |
| Property, plant,  and equipment, net                                                                                                            |       | 1,556,984  |       | 1,551,883  |       |
| Other assets:                                                                                                                                   |       |       |       |       |       |
| Software development  costs, net of accumulated amortization of $1,006,421 in 2006 and $943,743 in  2005                                        |       | —     |       | 62,678     |       |
| Goodwill                                                                                                                                        |       | 3,096,317  |       | 2,641,599  |       |
| Technology rights  and other intangibles, net                                                                                                   |       | 624,917    |       | 808,266    |       |
| Other                                                                                                                                           |       | 199,251    |       | 165,137    |       |
| Total other assets                                                                                                                              |       | 3,920,485  |       | 3,677,680  |       |
| **Total  assets**                                                                                                                               |       | $          | 26,877,246 |       | 23,656,888 |   |
| **Liabilities and Stockholders’  Equity**                                                                                                  |       |       |       |       |       |
| Current liabilities:                                                                                                                            |       |       |       |       |       |
| Accounts payable                                                                                                                                |       | $          | 1,688,846  |       | 1,413,794  |   |
| Accrued  compensation and vacation                                                                                                              |       | 1,286,316  |       | 995,528    |       |
| Earnout payable                                                                                                                                 |       | 574,568    |       | 433,339    |       |
| Other accrued  expenses                                                                                                                         |       | 320,797    |       | 440,510    |       |
| Accrued product  warranties                                                                                                                     |       | 246,737    |       | 327,015    |       |
| Accrued income  taxes                                                                                                                           |       | 289,895    |       | 402,285    |       |
| Dividends payable                                                                                                                               |       | 410,196    |       | 405,268    |       |
| Total current  liabilities                                                                                                                      |       | 4,817,355  |       | 4,417,739  |       |
| Obligations to former  employees                                                                                                                |       | 99,918     |       | 93,735     |       |
| Minimum earnout  payable                                                                                                                        |       | —     |       | 107,514    |       |
| Deferred income  taxes                                                                                                                          |       | —     |       | 239,282    |       |
| Total non-current  liabilities                                                                                                                  |       | 99,918     |       | 440,531    |       |
| Total liabilities                                                                                                                               |       | 4,917,273  |       | 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 5,469,275  shares in 2006 and 5,403,573 shares in 2005 |       | 546,928    |       | 540,357    |       |
| Capital in excess  of par value                                                                                                                 |       | 1,218,115  |       | 592,796    |       |
| Retained earnings                                                                                                                               |       | 20,036,869 |       | 17,759,120 |       |
| Accumulated other  comprehensive income (loss)                                                                                                  |       | 158,061    |       | (93,655    | )          |
| Total  stockholders’ equity                                                                                                                |       | 21,959,973 |       | 18,798,618 |       |
| Commitments and contingencies (note 7)                                                                                                          |       |       |       |       |       |
| **Total  liabilities and stockholders’ equity**                                                                                            |       | $          | 26,877,246 |       | 23,656,888 |   |

 

See accompanying notes to consolidated financial statements.

F-2

----

**MOCON, INC. ANDSUBSIDIARIES**

**ConsolidatedStatements of Income**

**Yearsended December 31, 2006, 2005 and 2004**

| ** **                                            | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Sales:                                                |       |       |       |       |       |       |       |
| Products                                              |       | $          | 24,464,091 |       | 22,876,304 |       | 23,024,648 |   |
| Consulting services                                   |       | 1,825,884  |       | 1,705,296  |       | 1,940,405  |       |
| Total sales                                           |       | 26,289,975 |       | 24,581,600 |       | 24,965,053 |       |
| Cost of sales:                                        |       |       |       |       |       |       |       |
| Products                                              |       | 10,194,053 |       | 9,857,885  |       | 10,516,518 |       |
| Consulting services                                   |       | 969,988    |       | 930,765    |       | 999,373    |       |
| Total cost of sales                                   |       | 11,164,041 |       | 10,788,650 |       | 11,515,891 |       |
| Gross profit                                          |       | 15,125,934 |       | 13,792,950 |       | 13,449,162 |       |
| Selling, general and administrative expenses          |       | 7,876,219  |       | 8,008,326  |       | 8,275,637  |       |
| Research and  development expenses                    |       | 1,942,786  |       | 1,765,662  |       | 1,371,700  |       |
| Operating income                                      |       | 5,306,929  |       | 4,018,962  |       | 3,801,825  |       |
| Other income, net                                     |       | 549,597    |       | 338,147    |       | 123,448    |       |
| Income before income taxes                            |       | 5,856,526  |       | 4,357,109  |       | 3,925,273  |       |
| Income taxes                                          |       | 1,968,225  |       | 1,334,627  |       | 1,291,109  |       |
| Income from continuing operations                     |       | 3,888,301  |       | 3,022,482  |       | 2,634,164  |       |
| Gain (loss) from  discontinued operations, net of tax |       | 22,225     |       | (107,213   | )          | (205,476   | )          |
| Net income                                            |       | $          | 3,910,526  |       | 2,915,269  |       | 2,428,688  |   |
| Basic net income  per common share:                   |       |       |       |       |       |       |       |
| Income from continuing operations                     |       | $          | 0.72       |       | 0.56       |       | 0.49       |   |
| Gain (loss) from discontinued operations              |       | —     |       | (0.02      | )          | (0.04      | )          |
| Basic net income per common share                     |       | 0.72       |       | 0.54       |       | 0.45       |       |
| Basic weighted  average common shares outstanding:    |       | 5,429,511  |       | 5,370,335  |       | 5,351,106  |       |
| Diluted net  income per common share:                 |       |       |       |       |       |       |       |
| Income from continuing operations                     |       | $          | 0.71       |       | 0.55       |       | 0.48       |   |
| Gain (loss) from discontinued operations              |       | —     |       | (0.02      | )          | (0.04      | )          |
| Diluted net income per common share                   |       | 0.71       |       | 0.53       |       | 0.44       |       |
| Diluted weighted average common shares outstanding:   |       | 5,525,483  |       | 5,534,280  |       | 5,471,420  |       |

 

See accompanying notes to consolidated financial statements.

F-3

----

**MOCON, INC. AND SUBSIDIARIES**Consolidated Statements of Stockholders’ Equity andComprehensive IncomeYears ended December 31, 2006, 2005 and 2004

| ** **                                                             | ** ** | **Common stock** | ** ** | **Capital in** | ** ** | ** **         | ** ** | **Accumulated  other** | ** ** | ** **             | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|---------------------|------------|--------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                             | ** ** | **Number**            | ** ** | ** **          | ** ** | **excess of** | ** ** | **Retained**           | ** ** | **comprehensive**      | ** ** | ** ** | ** ** |
| ** **                                                             | ** ** | **of shares**    | ** ** | **Amount**          | ** ** | **par value** | ** ** | **earnings**           | ** ** | **income (loss)** | ** ** | **Total** | ** ** |
| Balance, December 31, 2003                                        |       | 5,406,189             |       | $                   | 540,619    |               | 118,333    |                   | 16,052,528 |                   |       | 3,218 |   |   | 16,714,698 |   |
| Stock options exercised                                                |       | 46,300                |       | 4,630               |       | 283,134            |       | —                 |       |                   | —     |   |   | 287,764 |   |
| Purchase and retirement of common stock                                |       | (114,000              | )          | (11,400             | )          | (201,762           | )          | (687,198               | )          |                   | —     |   |   | (900,360 | ) |
| Dividends declared ($.265 per share)                                   |       | —                |       | —              |       | —             |       | (1,416,309             | )          |                   | —     |   |   | (1,416,309 | ) |
| Net income                                                             |       | —                |       | —              |       | —             |       | 2,428,688              |       |                   | —     |   |   | 2,428,688 |   |
| Cumulative translation adjustment                                      |       | —                |       | —              |       | —             |       | —                 |       |                   | 92,043     |   |   | 92,043 |   |
| Adjustment for unrealized (loss) on marketable  equity securities |       | —                |       | —              |       | —             |       | —                 |       |                   | (5,978     | ) |   | (5,978 | ) |
| Comprehensive income                                                   |       |                  |       |                |       |               |       |                   |       |                   |       |   |   | 2,514,753 |   |
| Balance, December 31, 2004                                        |       | 5,338,489             |       | 533,849             |       | 199,705            |       | 16,377,709             |       |                   | 89,283     |   |   | 17,200,546 |   |
| Stock options exercised                                                |       | 70,404                |       | 7,040               |       | 443,496            |       | —                 |       |                   | —     |   |   | 450,536 |   |
| Purchase and retirement of common stock                                |       | (5,320                | )          | (532                | )          | (50,405            | )          | —                 |       |                   | —     |   |   | (50,937 | ) |
| Dividends declared ($.285 per share)                                   |       | —                |       | —              |       | —             |       | (1,533,858             | )          |                   | —     |   |   | (1,533,858 | ) |
| Net income                                                             |       | —                |       | —              |       | —             |       | 2,915,269              |       |                   | —     |   |   | 2,915,269 |   |
| Cumulative translation adjustment                                      |       | —                |       | —              |       | —             |       | —                 |       |                   | (178,566   | ) |   | (178,566 | ) |
| Adjustment for unrealized (loss) on marketable  equity securities |       | —                |       | —              |       | —             |       | —                 |       |                   | (4,372     | ) |   | (4,372 | ) |
| Comprehensive income                                                   |       |                  |       |                |       |               |       |                   |       |                   |       |   |   | 2,732,331 |   |
| Balance, December 31, 2005                                        |       | 5,403,573             |       | 540,357             |       | 592,796            |       | 17,759,120             |       |                   | (93,655    | ) |   | 18,798,618 |   |
| Stock options exercised                                                |       | 118,775               |       | 11,878              |       | 826,066            |       | —                 |       |                   | —     |   |   | 837,944 |   |
| Purchase and retirement of common stock                                |       | (53,073               | )          | (5,307              | )          | (469,881           | )          | —                 |       |                   | —     |   |   | (475,188 | ) |
| Dividends declared ($.30 per share)                                    |       | —                |       | —              |       | —             |       | (1,632,777             | )          |                   | —     |   |   | (1,632,777 | ) |
| Stock compensation expense                                             |       | —                |       | —              |       | 187,553            |       | —                 |       |                   | —     |   |   | 187,553 |   |
| Tax benefit on stock plans                                             |       | —                |       | —              |       | 81,581             |       | —                 |       |                   | —     |   |   | 81,581 |   |
| Net income                                                             |       | —                |       | —              |       | —             |       | 3,910,526              |       |                   | —     |   |   | 3,910,526 |   |
| Cumulative translation adjustment                                      |       | —                |       | —              |       | —             |       | —                 |       |                   | 246,061    |   |   | 246,061 |   |
| Adjustment for unrealized gain on marketable  equity securities   |       | —                |       | —              |       | —             |       | —                 |       |                   | 5,655      |   |   | 5,655 |   |
| Comprehensive income                                                   |       |                  |       |                |       |               |       |                   |       |                   |       |   |   | 4,162,242 |   |
| Balance,  December 31, 2006                                       |       | 5,469,275             |       | $                   | 546,928    |               | 1,218,115  |                   | 20,036,869 |                   |       | 158,061 |   |   | 21,959,973 |   |

 

See accompanying notes to consolidated financial statements.

F-4

----

**MOCON, INC. AND SUBSIDIARIES**Consolidated Statements of Cash FlowsYears ended December 31, 2006, 2005 and 2004

| ** **                                                                                                                          | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Cash flows from operating activities:                                                                                               |       |       |       |       |       |       |       |
| Net income                                                                                                                          |       | $          | 3,910,526  |       | 2,915,269  |       | 2,428,688  |   |
| (Gain) loss from  discontinued operations, net of tax                                                                               |       | (22,225    | )          | 107,213    |       | 205,476    |       |
| Income from  continuing operations                                                                                                  |       | 3,888,301  |       | 3,022,482  |       | 2,634,164  |       |
| Adjustments to reconcile  income from continuing operations to net cash provided by operating  activities of continuing operations: |       |       |       |       |       |       |       |
| Share-based  compensation expense                                                                                                   |       | 187,553    |       | —     |       | —     |       |
| (Gain) loss on  disposition of long-term assets                                                                                     |       | (147,457   | )          | (23,408    | )          | 7,375      |       |
| Depreciation and  amortization                                                                                                      |       | 733,183    |       | 914,503    |       | 1,393,140  |       |
| Impairment of  technology rights and other intangibles                                                                              |       | —     |       | —     |       | 240,000    |       |
| Deferred income  taxes                                                                                                              |       | 23,228     |       | (187,096   | )          | (502,202   | )          |
| Excess tax benefit  from employee stock plans                                                                                       |       | (81,581    | )          | —     |       | —     |       |
| Changes in operating  assets and liabilities, net of effect of acquisitions:                                                        |       |       |       |       |       |       |       |
| Trade accounts  receivable                                                                                                          |       | (149,279   | )          | (63,932    | )          | (152,696   | )          |
| Other receivables                                                                                                                   |       | (41,033    | )          | (80,144    | )          | 40,711     |       |
| Inventories                                                                                                                         |       | 331,593    |       | (339,529   | )          | 489,635    |       |
| Prepaid expenses                                                                                                                    |       | 61,798     |       | 46,540     |       | (641       | )          |
| Accounts payable                                                                                                                    |       | 271,564    |       | (120,810   | )          | 615,418    |       |
| Accrued  compensation and vacation                                                                                                  |       | 276,279    |       | (6,236     | )          | 63,627     |       |
| Other accrued  expenses                                                                                                             |       | (234,340   | )          | (196,171   | )          | 313,326    |       |
| Accrued product  warranties                                                                                                         |       | (53,748    | )          | (16,813    | )          | 19,280     |       |
| Accrued income  taxes                                                                                                               |       | (87,864    | )          | 43,927     |       | 143,095    |       |
| Net cash provided  by continuing operations                                                                                         |       | 4,978,197  |       | 2,993,313  |       | 5,304,232  |       |
| Net cash provided  by (used in) discontinued operations                                                                             |       | —     |       | 114,580    |       | (168,003   | )          |
| Net cash provided  by operating activities                                                                                          |       | 4,978,197  |       | 3,107,893  |       | 5,136,229  |       |
| Cash flows from investing activities:                                                                                               |       |       |       |       |       |       |       |
| Purchases of  marketable securities                                                                                                 |       | (9,512,296 | )          | (6,769,402 | )          | (4,519,996 | )          |
| Proceeds from  sales or maturities of marketable securities                                                                         |       | 6,562,489  |       | 5,672,824  |       | 4,865,991  |       |
| Cash paid in  acquisitions, net of cash acquired                                                                                    |       | (454,718   | )          | (325,825   | )          | (1,265,648 | )          |
| Proceeds from sale  of subsidiary                                                                                                   |       | 478,721    |       | —     |       | —     |       |
| Purchases of  property, plant and equipment                                                                                         |       | (462,324   | )          | (232,360   | )          | (521,133   | )          |
| Proceeds from sale  of fixed assets                                                                                                 |       | 139,534    |       | 93,012     |       | —     |       |
| Purchases of  patents and trademarks                                                                                                |       | (99,291    | )          | (59,254    | )          | (45,320    | )          |
| Other                                                                                                                               |       | (6,871     | )          | (21,334    | )          | (6,657     | )          |
| Net cash used in  continuing operations                                                                                             |       | (3,354,756 | )          | (1,642,339 | )          | (1,492,763 | )          |
| Net cash provided  by (used in) discontinued operations                                                                             |       | 22,225     |       | —     |       | (6,127     | )          |
| Net cash used in  investing activities                                                                                              |       | (3,332,531 | )          | (1,642,339 | )          | (1,498,890 | )          |
| Cash flows from financing activities:                                                                                               |       |       |       |       |       |       |       |
| Proceeds from the  exercise of stock options                                                                                        |       | 725,881    |       | 399,599    |       | 287,764    |       |
| Purchase and  retirement of common stock                                                                                            |       | (363,125   | )          | —     |       | (900,360   | )          |
| Excess tax benefit  from employee stock plans                                                                                       |       | 81,581     |       | —     |       | —     |       |
| Dividends paid to  former parent company of Paul Lippke Handels                                                                     |       | —     |       | —     |       | (449,087   | )          |
| Dividends paid to  MOCON shareholders                                                                                               |       | (1,627,849 | )          | (1,502,284 | )          | (1,393,506 | )          |
| Net cash used in  financing activities                                                                                              |       | (1,183,512 | )          | (1,102,685 | )          | (2,455,189 | )          |
| Effect of exchange  rate changes on cash and cash equivalents                                                                       |       | 197,565    |       | (122,425   | )          | 66,892     |       |
| Net increase in  cash and cash equivalents                                                                                          |       | 659,719    |       | 240,444    |       | 1,249,042  |       |
| Cash and cash equivalents:                                                                                                          |       |       |       |       |       |       |       |
| Beginning of year                                                                                                                   |       | 2,889,323  |       | 2,648,879  |       | 1,399,837  |       |
| End of year                                                                                                                         |       | $          | 3,549,042  |       | 2,889,323  |       | 2,648,879  |   |
| Supplemental disclosures of cash flow information:                                                                                  |       |       |       |       |       |       |       |
| Cash paid during  the year for income taxes                                                                                         |       | $          | 2,038,775  |       | 1,419,415  |       | 1,010,222  |   |
| Supplemental schedule of noncash investing and  financing activities:                                                               |       |       |       |       |       |       |       |
| Dividends accrued                                                                                                                   |       | $          | 410,196    |       | 405,268    |       | 373,694    |   |
| Unrealized holding  gain (loss) on available-for-sale securities                                                                    |       | 5,655      |       | (4,372     | )          | (5,978     | )          |
| Noncash purchase  and retirement of common stock                                                                                    |       | 112,063    |       | 50,937     |       | —     |       |
| Noncash exercise  of stock options                                                                                                  |       | 112,063    |       | 50,937     |       | —     |       |

 

See accompanying notes to consolidated financial statements.

F-5

----

**MOCON,INC. AND SUBSIDIARIESNotes to Consolidated Financial StatementsDecember 31, 2006, 2005 and 2004**

**(1)**          Summaryof Significant Accounting Policies

MOCON, Inc.(the Company) operates in a single industry segment: the developing,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. The following is a summary of thesignificant accounting policies used in the preparation of the Company’sconsolidated financial statements.

***(a)******         Principles of Consolidation***

Theconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries. All material intercompany balances and transactionshave been eliminated in consolidation.

***(b)******          Foreign Currency Translation***

The financial statementsfor operations outside the United States are maintained in their local currency.All assets and liabilities of the Company’s foreign subsidiary are translatedto United States dollars at period-end exchange rates, while revenue andexpense accounts are translated at the average exchange rates during the periodtransactions occurred. Translation adjustments arising from the use ofdiffering exchange rates are included in accumulated other comprehensive incomeor loss in stockholders’ equity. Gains and losses on foreign currencytransactions are included in other income or loss.

***(c)******           Statements of Cash Flows***

The Company considers all highly liquid investmentspurchased with an original maturity of three months or less to be cashequivalents.

Cash equivalents consistof short-term investments which are readily convertible to cash.

***(d)******          Marketable Securities***

Marketable securities at December 31, 2006consist of United States government obligations, municipal bonds, andcertificates of deposit. The Company classifies its debt and marketable equitysecurities as available-for-sale.

Available-for-sale securities are recorded at fairvalue. Unrealized holding gains and losses on available-for-sale securities areexcluded from income and are reported as a separate component of stockholders’equity until realized.

A decline in the market value of anyavailable-for-sale security below cost that is deemed other than temporary ischarged to income resulting in the establishment of a new cost basis for thesecurity.

Premiums and discounts are amortized or accreted overthe life of the related available-for-sale security as an adjustment to yield.Dividend and interest income are recognized when earned. Realized gains andlosses for securities classified as available-for-sale are included in incomeand are derived using the specific identification method for determining thecost of securities sold.

F-6

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

***(e)******           Inventories***

Inventoriesare stated at the lower of cost or market. Cost is determined by the first-in,first-out (FIFO) method, and market represents the lower of replacement cost orestimated net realizable value.

***(f)******            Property, Plant and Equipment***

Property,plant and equipment are carried at cost. Depreciation and amortization aretypically computed using the straight-line method. When assets are retired orotherwise disposed of, the cost and related accumulated depreciation areremoved from the accounts, and any resulting gain or loss is recognized inincome for the period. The cost of maintenance and repairs is charged to incomeas incurred and significant renewals and betterments are capitalized.

***(g)******          Goodwill, Other Intangible Assets andSoftware Development Costs***

Goodwill represents the excess of the purchase priceover the fair value of assets acquired. The Company adopted the provisions ofFASB Statement No. 142 (SFAS 142), *Goodwilland Other Intangible Assets*, as of January 1, 2002. Pursuant toSFAS 142, goodwill and intangible assets acquired in a purchase businesscombination and determined to have an indefinite useful life are not amortized,but instead tested for impairment at least annually in accordance with theprovisions of SFAS 142. SFAS 142 also requires that intangible assets withestimable useful lives be amortized over their respective estimated usefullives to their estimated residual values, and reviewed for impairment inaccordance with FASB Statement No. 144, *Accountingfor Impairment or Disposal of Long-Lived Assets*.

Intangible assets consist of technology rights,patents, trademarks and other intangibles. Technology rights, patents,trademarks and other intangibles are carried at cost less accumulatedamortization. Costs incurred in connection with applications for new patentsare deferred until a final determination, with respect to the application, ismade by appropriate regulatory agencies. Costs of patents abandoned are chargedto income in the period of abandonment. Technology rights costs are amortizedon a straight-line basis over 7 to 10 years. Patent costs are amortized overthe lesser of 17 years or their estimated useful lives using thestraight-line method. Trademarks are amortized over five years.

Softwaredevelopment costs are carried at cost less accumulated amortization. Softwaredevelopment costs are amortized on a straight-line basis over 3 years.

***(h)******         Impairment of Long-Lived Assets and Long-LivedAssets to be Disposed Of***

The Company reviews its long-lived assets and certainidentifiable intangibles for impairment annually or whenever events or changesin circumstances indicate that the carrying amount of an asset may not berecoverable. Recoverability of assets to be held and used is measured by acomparison of the carrying amount of an asset to future undiscounted net cashflows expected to be generated by the asset. If such assets are considered tobe impaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the assets exceeds the fair value of the assets. Assetsto be disposed of are reported at the lower of the carrying amount or fairvalue less costs to sell.

F-7

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

***(i)******            Use of Estimates***

Thepreparation of consolidated financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the consolidated financial statements and the reported amountsof revenues and expenses during the reporting period. Actual results coulddiffer from those estimates.

***(j)******             Income Taxes***

TheCompany uses the asset-and-liability method for computing its deferred taxes.Under the asset-and-liability method, deferred taxes are based on thedifference between the financial statement and tax basis of assets andliabilities and the enacted tax rates that will be in effect when thesedifferences reverse. Deferred tax expense represents the change in deferred taxassets and liabilities during the year.

***(k)******          Fair Value of Financial Instruments***

TheCompany’s financial instruments are recorded in its Consolidated Balance Sheets.The carrying amount for cash and cash equivalents, accounts receivable,accounts payable and accrued liabilities approximates fair value due to theimmediate or short-term maturity of these financial instruments. The fairvalues of investments in marketable securities are based on quoted marketprices and are summarized in Note 2.

***(l)******             Revenue Recognition***

The Company recognizes revenue when it is realized orrealizable and earned. In accordance with the Securities and ExchangeCommission Staff Accounting Bulletin No. 104 (SAB 104), *Revenue Recognition,*the Company considersrevenue realized or realizable when persuasive evidence of an arrangementexists, the product has been shipped or the services have been provided to thecustomer, title and risk of loss of products has passed to the customer, thesales price is fixed or determinable, and collectibility is reasonably assured.The Company’s terms are F.O.B. shipping point with no right of return, andcustomer acceptance of its products is not required. The revenue recognition policydoes not differ among the various product lines, the marketing venues, orvarious geographic destinations. The Company does not have distributors whostock its equipment. The Company does not offer rebates, price protection, orother similar incentives, and discounts when offered are recorded as areduction in revenue.

Revenue for preventive maintenance agreements isrecognized on a per visit basis and extended warranties on a straight-linebasis over the life of the contracts, in accordance with FASB TechnicalBulletin No. 90-1, *Accounting for SeparatelyPriced Extended Warranty and Product Maintenance Contracts*.

Emerging Issues Task Force (EITF) Issue No. 00-21,*Revenue Arrangements with Multiple Deliverables*,provides revenue recognition guidance for arrangements with multipledeliverables, and the criteria to determine if items in a multiple deliverableagreement should be accounted for separately. The elements of the Company’ssales transactions are clearly and separately stated and sufficient evidence oftheir fair value exists to separately account for the elements.

F-8

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

***(m)******      Advertising Costs***

TheCompany incurs advertising costs associated with trade shows, print advertisingand brochures. Such costs are charged to expense as incurred. Advertising expensewas $458,000, $480,000 and $432,000 in 2006, 2005 and 2004, respectively.

***(n)******         Net Income Per Common Share***

Basic net income percommon share is computed by dividing net income by the weighted average ofcommon shares outstanding during the year. Diluted net income per share iscomputed by dividing net income by the weighted average of common and dilutivepotential common shares outstanding during the year.

***(o)******          Stock-Based Compensation***

In December 2004 the FASB issued Statement ofFinancial Accounting Standard No. 123(R), *Share BasedPayment*(SFAS 123(R)).  SFAS123(R) is a revision of FASB Statement No. 123, *Accountingfor Stock-Based Compensation*, and supersedes APB OpinionNo. 25, *Accounting for Stock Issued to Employees,*andamends SFAS 95, *Statement of Cash Flows*, and itsrelated implementation guidance. SFAS 123(R) focuses primarily onaccounting for transactions in which an entity obtains employee servicesthrough share-based payment transactions. SFAS 123(R) requires an entityto measure the cost of employee services received in exchange for the award ofequity instruments based on the fair value of the award at the date of grant.The cost is to be recognized over the period during which an employee isrequired to provide services in exchange for the award. SFAS 123(R) alsorequires the benefits of tax deductions in excess of recognized compensationexpense to be reported as a financing cash flow, rather than as an operatingcash flow as prescribed under the prior accounting rules. This requirement reducesnet operating cash flows and increases net financing cash flows in periodsafter adoption. Total cash flow remains unchanged from what would have beenreported under prior accounting rules.

The Company implementedthe provisions of SFAS 123(R) effective January 1, 2006 using themodified prospective method, and therefore has not restated prior periods’results. Under this method, the Company recognizes compensation expense on astraight-line basis over the vesting period for all stock-based awards grantedon or after January 1, 2006, and for previously granted awards not yetvested as of January 1, 2006. Under the provisions of SFAS 123(R), thecompany recognizes stock-based compensation net of an estimated forfeiturerate, resulting in the recognition of compensation cost for only those sharesexpected to vest. Prior to the adoption of SFAS 123(R), the Company followedthe intrinsic value method in accordance with APB 25 to account for theissuance of stock incentives to employees and directors. Accordingly, nocompensation expense was recognized relating to stock-based awards prior toJanuary 1, 2006. Results of operations for periods prior to 2006 have notbeen restated to reflect recognition of stock-based compensation expense.

***(p)******          Recently Issued Accounting Pronouncements***

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements* (SAB 108). SAB 108 provides interpretive guidanceon how the effects of the carryover or reversal of 

F-9

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

prior year misstatementsshould be considered in quantifying a current year misstatement. The SEC staffbelieves that registrants should quantify errors using both a balance sheet andan income statement approach and evaluate whether either approach results inquantifying a misstatement that, when all relevant quantitative and qualitativefactors are considered, is material. SAB 108 is effective for fiscal yearsending on or after November 15, 2006, with early application encouraged.Accordingly, the Company has adopted SAB 108 for the fiscal year endedDecember 31, 2006. Adoption of SAB 108 did not have an effect on theCompany’s financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS 157, *Fair Value Measurement* (SFAS 157). The standard providesguidance for using fair value to measure assets and liabilities. SFAS 157clarifies the principle that fair value should be based on the assumptionsmarket participants would use when pricing an asset or liability andestablishes a fair value hierarchy that prioritizes the information used todevelop those assumptions. Under the standard, fair value measurements would beseparately disclosed by level within the fair value hierarchy. The statement iseffective for the Company beginning in 2008; however, early adoption ispermitted. The Company has not yet determined the impact, if any, that theimplementation of SFAS 157 will have on its financial position, results ofoperations or cash flows.

InJune 2006, the FASB issued Interpretation No. 48, *Accounting for Uncertainty in Income Taxes* (FIN 48). FIN 48clarifies the accounting for income taxes by prescribing the minimumrecognition threshold a tax position is required to meet before beingrecognized in the financial statements. FIN 48 also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. The requirements are effective forfiscal years beginning after December 15, 2006. The Company currently doesnot expect that the adoption of this Interpretation will have a material impacton its consolidated financial statements.

***(q)******          Reclassifications***

Certain 2005 balance sheetamounts have been reclassified to conform to the 2006 presentation.

**(2)**          MarketableSecurities

Theamortized cost, gross unrealized holding gains, gross unrealized holdinglosses, and fair value for available-for-sale securities by major security typeat December 31, 2006 and 2005 were as follows:

| ** **              | ** ** | **2006**      | ** ** |
|-------------------------|------------|---------------|------------|
| ** **              | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **    | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **Amortized** | ** ** | **holding** | ** ** | **holding** | ** ** | **Fair** | ** ** |
| ** **              | ** ** | **cost**      | ** ** | **gains** | ** ** | **losses** | ** ** | **value** | ** ** |
| Available for sale:     |       |          |       |   |   |   |   |   |   |   |   |   |   |
| Municipal bonds         |       | $             | 4,115,512  |   |   | 437 |   |   |   | (1,851 | ) |   | 4,114,098 |   |
| Certificates of deposit |       | 4,773,472     |       |   | 119 |   |   |   | (81 | ) |   | 4,773,510 |   |
| Government bonds        |       | 200,000       |       |   | — |   |   |   | (100 | ) |   | 199,900 |   |
|                    |       | $             | 9,088,984  |   |   | 556 |   |   |   | (2,032 | ) |   | 9,087,508 |   |

 

F-10

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

 

| ** **              | ** ** | **2005**      | ** ** |
|-------------------------|------------|---------------|------------|
| ** **              | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **    | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **Amortized** | ** ** | **holding** | ** ** | **holding** | ** ** | **Fair** | ** ** |
| ** **              | ** ** | **cost**      | ** ** | **gains** | ** ** | **losses** | ** ** | **value** | ** ** |
| Available-for-sale:     |       |          |       |   |   |   |   |   |   |   |   |   |   |
| Municipal bonds         |       | $             | 2,385,176  |   |   | 152 |   |   |   | (6,300 | ) |   | 2,379,028 |   |
| Certificates of deposit |       | 3,754,001     |       |   | 69 |   |   |   | (1,052 | ) |   | 3,753,018 |   |
|                    |       | $             | 6,139,177  |   |   | 221 |   |   |   | (7,352 | ) |   | 6,132,046 |   |

 

There were no gross realized gains or losses for theyears ended December 31, 2006, 2005 and 2004.

Maturitiesof investment securities classified as available-for-sale were as follows atDecember 31, 2006 and 2005:

| ** **          | ** ** | **2006**      | ** ** | **2005**  | ** ** |
|---------------------|------------|---------------|------------|-----------|------------|
| ** **          | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **          | ** ** | **cost**      | ** ** | **value** | ** ** | **cost** | ** ** | **value** | ** ** |
| Available-for-sale: |       |          |       |      |       |   |   |   |   |
| Due within one year |       | $             | 8,711,746  |      | 8,710,390  |   | 5,968,720 |   | 5,961,793 |   |
| Due after one year  |       | 377,238       |       | 377,118   |       | 170,457 |   | 170,253 |   |
|                |       | $             | 9,088,984  |      | 9,087,508  |   | 6,139,177 |   | 6,132,046 |   |

 

**(3)**          Inventories

Themajor components of inventories at December 31, 2006 and 2005 were asfollows:

| ** **        | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|-------------------|------------|-----------|------------|-----------|------------|
| Finished products |       | $         | 526,918    |      | 656,587    |   |
| Work-in-process   |       | 1,261,119 |       | 1,511,314 |       |
| Raw materials     |       | 1,831,607 |       | 1,889,613 |       |
|              |       | $         | 3,619,644  |      | 4,057,514  |   |

 

**(4)**          Property,Plant and Equipment

Property,plant and equipment at December 31, 2006 and 2005 consisted of thefollowing:

| ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **Estimated**         | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2006**   | ** ** | **2005**   | ** ** | **useful lives** | ** ** |
| Land                                 |       | $          | 200,000    |       | 200,000    |                  | —     |   |
| Buildings                            |       | 445,833    |       | 445,833    |       | 27 years              |       |
| Machinery and  equipment             |       | 3,427,430  |       | 3,517,045  |       | 3 to 10 years         |       |
| Office equipment                     |       | 1,116,501  |       | 979,199    |       | 2 to 15 years         |       |
| Leasehold  improvements              |       | 655,254    |       | 665,014    |       | 1 to 5 years          |       |
| Vehicles                             |       | 208,662    |       | 205,351    |       | 3 to 5 years          |       |
| Total property, plant, and equipment |       | 6,053,680  |       | 6,012,442  |       |                  |       |
| Less accumulated  depreciation       |       | (4,496,696 | )          | (4,460,559 | )          |                  |       |
| Net property,  plant, and equipment  |       | $          | 1,556,984  |       | 1,551,883  |                  |       |   |

 

F-11

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

Depreciation andamortization of property, plant and equipment charged to income was $397,017,$486,495 and $550,382 for the years ended December 31, 2006, 2005 and2004, respectively.

**(5)**          Goodwilland Other Intangible Assets

*Goodwill*

As of December 31, 2006,goodwill amounted to $3,096,317, which includes the addition in 2006 of$454,718 for an earnout payment related to the acquisition of Paul LippkeHandels-GmbH. As of December 31, 2005, goodwill amounted to $2,641,599,which included a 2005 addition of $325,825 for an earnout payment related tothe acquisition of Paul Lippke Handels-GmbH. The Company completed its annualimpairment tests during the fourth quarters of 2006 and 2005 and determinedthere was no impairment.

*Impairment of OtherIntangible Assets*

During 2004, the Companycompleted a review and analysis of its Lab Connections, Inc. (LCI)subsidiary and the carrying amount of the remaining net balance of intangibletechnology rights. LCI experienced operating losses during 2003 and 2004, and forecastedoperating results indicated that the subsidiary’s undiscounted cash flows werenot adequate to allow LCI sufficient cash flow to fully realize the remainingintangible technology rights value. In accordance with Statement of FinancialAccounting Standards No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*, the Company recorded an impairmentcharge of $240,000. The charge, recorded in selling, general and administrativeexpenses, is equal to the difference between the carrying amount of theintangible technology rights and its fair value as estimated, based ondiscounted projected cash flows. As further explained in Note 17, LCI was soldin February 2006.

*Other IntangibleAssets*

Otherintangible assets (all of which are being amortized except projects in process)are as follows:

| ** **                  | ** ** | **As of December 31, 2006** | ** ** |
|-----------------------------|------------|-------------------------------------------------|------------|
| ** **                  | ** ** | **Carrying  Amount**                            | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| Patents                     |       | $                                               | 710,549    |   |   | (289,430 | ) |   | 421,119 |   |
| Trademarks and  trade names |       | 397,338                                         |       |   | (233,993 | ) |   | 163,345 |   |
| Technology rights           |       | 184,008                                         |       |   | (173,055 | ) |   | 10,953 |   |
| Other intangibles           |       | 698,596                                         |       |   | (669,096 | ) |   | 29,500 |   |
|                        |       | $                                               | 1,990,491  |   |   | (1,365,574 | ) |   | 624,917 |   |

 

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

 

F-12

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

Amortization expense was $276,717, $292,486 and$439,073 in 2006, 2005 and 2004, respectively.

Estimated amortizationexpense for the fiscal years 2007 to 2011 and thereafter is $152,993, $108,973,$40,550, $32,866, $19,210 and $85,251, respectively.

**(6)**          Warranty

The Company provides a warranty for most of its products.Warranties are for periods ranging from ninety days to one year, and coverparts and labor for non-maintenance repairs, at the Company location. Operatorabuse, improper use, alteration, damage resulting from accident, or failure tofollow manufacturer’s directions are excluded from warranty coverage.

Warranty expense is accrued at the time of sale basedon historical claims experience. Special warranty reserves are also accrued forspecial rework campaigns for known major product modifications. The Companyalso offers service contracts for select products when the factory warrantyperiod expires.

Warrantyprovisions and claims for the years ended December 31, 2006, 2005 and 2004were as follows:

| ** **                         | ** ** | **Balance at** | ** ** | ** **       | ** ** | ** **     | ** ** | **Balance**     | ** ** |
|------------------------------------|------------|---------------------|------------|------------------|------------|----------------|------------|-----------------|------------|
| ** **                         | ** ** | **beginning**       | ** ** | **Warranty**     | ** ** | **Warranty**   | ** ** | **at end** | ** ** |
| **Years:**                         | ** ** | ** **          | ** ** | **of year** | ** ** | **Provisions** | ** ** | **Claims**      | ** ** | **of year** | ** ** |
| Year ended  December 31, 2004 |       |                |       |             |       |           |       |            |       |   |   |   |   |
| Allowance for product warranties   |       | $                   | 279,639    |             |       | 480,132        | (1)        |            |       | 407,137 |   |   | 352,634 |   |
| Year ended December 31, 2005  |       |                |       |             |       |           |       |            |       |   |   |   |   |
| Allowance for product warranties   |       | 352,634             |       |             | 318,635    |           |       |            | 344,254    |   |   | 327,015 |   |
| Year ended December 31, 2006  |       |                |       |             |       |           |       |            |       |   |   |   |   |
| Allowance for  product warranties  |       | 327,015             |       |             | 266,706    | (2)            |       |            | 346,984    |   |   | 246,737 |   |
|                                    |            |                     |            |                  |            |                |            |                 |            |  |  |  |  |  |  |  |

----

(1)          Includes adjustment foracquisition of Lippke.

(2)          Includesadjustment for sale of Lab Connections.

**(7)**          Commitmentsand Contingencies

***(a)******         Leases***

The Company leases its facilities and certainequipment pursuant to operating leases. The facility leases expire at varioustimes through June 2010 and require the Company to pay operating costs,including real estate taxes.

Rental expense, including charges for operating costs,was $386,077, $382,765 and $487,776 in 2006, 2005 and 2004, respectively.

F-13

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

Thefollowing is a schedule of future minimum lease payments, excluding charges foroperating costs, for operating leases as of December 31, 2006:

| **Year ending December 31:** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| 2007                                        |       | $          | 360,436    |       |
| 2008                                        |       | 304,459    |       |
| 2009                                        |       | 271,446    |       |
| 2010                                        |       | 135,723    |       |
| 2011 and thereafter                         |       | —     |       |
|                                        |       | $          | 1,072,064  |       |

 

***(b)******          Executive Severance Agreements***

The Company is a party to a severance agreement withfour of its executive officers which provides for the payment to the executiveof a lump sum amount upon the occurrence of certain termination events. Thepayment could amount to one or two times the executive’s current annual salarydepending on the reason for termination.

***(c)******           Inventory Purchase Obligations***

At December 31, 2006,the Company had approximately $1.3 million of purchase order commitments tosuppliers of the Company for delivery of inventory during 2007 and 2008.

**(8)**          IncomeTaxes

Incomefrom continuing operations before income taxes was as follows:

| ** **                 | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004** | ** ** |
|----------------------------|------------|-----------|------------|-----------|------------|----------|------------|
| Income before income taxes |       |      |       |      |       |     |       |
| Domestic                   |       | $         | 4,288,000  |      | 3,283,000  |     | 3,217,000  |   |
| Foreign                    |       | 1,569,000 |       | 1,074,000 |       | 708,000  |       |
| Total                      |       | $         | 5,857,000  |      | 4,357,000  |     | 3,925,000  |   |

 

Theprovision for income taxes consists of the following:

| ** **                 | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|----------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Current tax expense:       |       |      |       |      |       |      |       |
| Federal                    |       | $         | 1,131,000  |      | 909,000    |      | 1,149,000  |   |
| State                      |       | 137,000   |       | 147,000   |       | 131,000   |       |
| Foreign                    |       | 677,000   |       | 466,000   |       | 513,000   |       |
| Total current expense      |       | 1,945,000 |       | 1,522,000 |       | 1,793,000 |       |
| Deferred tax expense:      |       |      |       |      |       |      |       |
| Federal                    |       | 86,000    |       | (124,000  | )          | (256,000  | )          |
| State                      |       | 10,000    |       | (10,000   | )          | (21,000   | )          |
| Foreign                    |       | (73,000   | )          | (53,000   | )          | (225,000  | )          |
| Total deferred expense     |       | 23,000    |       | (187,000  | )          | (502,000  | )          |
| Provision for income taxes |       | $         | 1,968,000  |      | 1,335,000  |      | 1,291,000  |   |

 

F-14

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

Theeffective income tax rate varies from the federal statutory tax rate for thefollowing reasons:

| ** **                                       | ** ** | **Percentage of pretax income  for years ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **  2006  **                                                                 | ** ** | **  2005  ** | ** ** | **  2004  ** | ** ** |
| Tax at statutory  federal income tax rate        |       |                                                                                             | 34.0       | % |   |   | 34.0 | % |   |   | 34.0 | % |   |
| Increases (reductions)  in taxes resulting from: |       |                                                                                             |       |   |   |   |   |   |   |   |   |   |   |
| State income taxes, net of federal benefit       |       |                                                                                             | 1.7        |   |   |   | 2.0 |   |   |   | 2.0 |   |   |
| Sale of stock of subsidiary                      |       |                                                                                             | (4.3       | ) |   |   | — |   |   |   | — |   |   |
| Change in valuation allowance                    |       |                                                                                             | 4.1        |   |   |   | — |   |   |   | — |   |   |
| Export incentives                                |       |                                                                                             | (1.4       | ) |   |   | (2.1 | ) |   |   | (3.5 | ) |   |
| Domestic manufacturing deduction                 |       |                                                                                             | (0.6       | ) |   |   | (0.8 | ) |   |   | — |   |   |
| Effect of foreign operations                     |       |                                                                                             | 1.2        |   |   |   | 1.1 |   |   |   | 1.3 |   |   |
| Tax-exempt interest                              |       |                                                                                             | (0.4       | ) |   |   | (0.4 | ) |   |   | (0.3 | ) |   |
| Reduction of tax contingency accrual             |       |                                                                                             | (0.9       | ) |   |   | (3.6 | ) |   |   | — |   |   |
| Stock option compensation                        |       |                                                                                             | 0.9        |   |   |   | — |   |   |   | — |   |   |
| Other                                            |       |                                                                                             | (0.7       | ) |   |   | 0.4 |   |   |   | (0.9 | ) |   |
| Effective income  tax rate                       |       |                                                                                             | 33.6       | % |   |   | 30.6 | % |   |   | 32.6 | % |   |

 

Thetax effect of significant temporary differences representing deferred taxassets and liabilities at December 31, 2006 and 2005 were as follows:

| ** **                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:            |       |     |       |     |       |
| Allowance for doubtful accounts |       | $        | 61,000     |     | 68,000     |   |
| Inventory items                 |       | 240,000  |       | 320,000  |       |
| Reserves and accruals           |       | 205,000  |       | 206,000  |       |
| Capital loss carryforward       |       | 238,000  |       | —   |       |
| Intangibles                     |       | 63,000   |       | —   |       |
| Subtotal                        |       | 807,000  |       | 594,000  |       |
| Less: Valuation allowance       |       | (238,000 | )          | —   |       |
| Total deferred tax assets       |       | 569,000  |       | 594,000  |       |
| Deferred tax  liabilities:      |       |     |       |     |       |
| Fixed assets                    |       | (140,000 | )          | (250,000 | )          |
| Other                           |       | (61,000  | )          | —   |       |
| Total deferred tax liabilities  |       | (201,000 | )          | (250,000 | )          |
| Net deferred tax  asset         |       | $        | 368,000    |     | 344,000    |   |

 

During 2006, the Company determined that establishinga valuation allowance for the deferred tax assets was required since it is morelikely than not that the tax benefit of $238,000 from the capital losscarryforward related to the sale of Lab Connections would not be realizedthrough future taxable income. However, the Company believed that the remainderof its deferred tax assets would be realized either through future taxable incomeor net operating loss carry-backs.

F-15

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

As of December 31,2006, there were approximately $2,700,000 of accumulated undistributed earningsof subsidiaries outside the United States that are considered to be reinvestedindefinitely. No deferred tax liability has been provided on such earnings. Ifthey were remitted to the Company, applicable U.S. federal and foreignwithholding taxes would be partially offset by available foreign tax credits.

**(9)**          Stock-BasedCompensation

As of December 31, 2006, the Company has reserved398,800 shares of common stock for options and other stock-based incentiveawards that are still available for grant under the Company’s 2006 stockincentive plan, and 853,875 shares for options that have been granted undereither the Company’s 2006 stock incentive plan, 1998 stock option plan or 1992stock option plan but have not yet been exercised.

Under the Company’s stock-based incentive plans,option exercise prices are 100% of the market value of the common stock at thedate of grant, except for incentive options granted under the 1992, 1998 and2006 plans to persons owning more than 10% of the Company’s stock, in whichcase the option price is 110% of the market value, and nonqualified optionsgranted under the 1992, 1998 and 2006 plans, which may be granted at optionprices no less than 25% of the market value. Exercise periods are generally forseven to ten years. Certain of the plans allow for the granting of nonqualifiedstock options. Upon the exercise of these nonqualified options, the Company mayrealize a compensation deduction allowable for income tax purposes. Theafter-tax effect of these tax deductions is included in the accompanyingconsolidated financial statements as an addition to capital in excess of parvalue.

Effective January 1, 2006, the Company adoptedStatement of Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment* (SFAS 123(R)) which requires themeasurement and recognition of compensation expense for all share-based paymentawards made to employees and directors. SFAS 123(R) supersedes theCompany’s previous accounting under Accounting Principles Board OpinionNo. 25, *Accounting for Stock Issued to Employees*(APB 25).

The Company adopted the modified prospectivetransition method of applying SFAS 123(R) which requires the applicationof the standard as of January 1, 2006. As a result, as ofDecember 31, 2006, the Company’s results of operations reflectedcompensation expense for new stock options granted and vested during 2006 andthe unvested portion of previous stock option grants vested during the yearended 2006. The Company’s consolidated financial statements for prior periodshave not been restated to reflect, and do not include, the impact of SFAS123(R). Therefore, the results for 2006 are not directly comparable to theprior periods.

SFAS 123(R) requires companies to estimate thefair value of share-based payment awards on the date of grant using anoption-pricing model. The value of the portion of the award ultimately expectedto vest is recognized as expense over the requisite service period. Share-basedcompensation expense recognized in the Company’s Consolidated Statements ofIncome for 2006 included compensation expense for share-based payment awardsgranted prior to, but not yet vested as of January 1, 2006. Thiscompensation expense is based on the grant date fair value estimated inaccordance with the pro forma provisions of Statement of Financial AccountingStandards No. 123, *Accounting for Stock-BasedCompensation* (SFAS 123). Compensation expense for the share-basedpayment awards granted subsequent to January 1, 2006 is based on the grantdate fair value estimated in accordance with the provisions of SFAS 123(R).Share-based compensation expense recognized in the Consolidated Statements ofIncome for 2006 is based on awards ultimately expected to vest, and thereforeit has been 

F-16

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

reduced for estimatedforfeitures. SFAS 123(R) requires forfeitures to be estimated at the timeof grant and revised, if necessary, in subsequent periods if actual forfeituresdiffer materially from those estimates.

Priorto January 1, 2006, the Company accounted for share-based employeecompensation arrangements in accordance with the provisions and relatedinterpretations of APB 25, using the intrinsic-value method. Under theguidelines of APB 25, compensation cost for share-based employee compensationplans was recognized based on the difference, if any, between the quoted marketprice of the stock on the date of grant and the amount an employee must pay toacquire the stock. The Company had adopted the disclosure-only provisions foremployee share-based compensation, and therefore, had not recorded compensationcost in its financial statements. Had compensation cost for share-basedcompensation been determined consistent with SFAS 123(R), net income and netincome per share would have been adjusted to the following pro forma amounts:

| ** **                                                                                                                                         | ** ** | **Year Ended  December 31,  2005** | ** ** | **Year Ended  December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Net income—as  reported                                                                                                                       |       |                                         | $          | 2,915,269                                    |       |   |   | 2,428,688 |   |   |
| Deduct: Total  share-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       |                                         | (141,097   | )                                            |       |   | (196,203 | ) |   |
| Net income—pro  forma                                                                                                                         |       |                                         | $2,774,172 |                                         |       |   | 2,232,485 |   |   |
| Net income per  common share—as reported:                                                                                                     |       |                                         |       |                                         |       |   |   |   |   |
| Basic                                                                                                                                              |       |                                         | $          | 0.54                                         |       |   |   | 0.45 |   |   |
| Diluted                                                                                                                                            |       |                                         | $          | 0.53                                         |       |   |   | 0.44 |   |   |
| Net income per common  share—pro forma:                                                                                                       |       |                                         |       |                                         |       |   |   |   |   |
| Basic                                                                                                                                              |       |                                         | $          | 0.52                                         |       |   |   | 0.42 |   |   |
| Diluted                                                                                                                                            |       |                                         | $          | 0.50                                         |       |   |   | 0.41 |   |   |

 

Share-basedcompensation expense recognized in the consolidated financial statements underSFAS 123(R) for 2006 was $174,038 as shown below:

| ** **                                                  | ** ** | **Year Ended  December 31,  2006** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------|------------|
| Total cost of  share-based compensation                     |       |                                         | $          | 187,553 |   |   |
| Amount  capitalized in inventory and property and equipment |       |                                         | —     |   |   |
| Amounts charged  against income, before income taxes        |       |                                         | 187,553    |   |   |
| Amount of income  tax benefit recognized in earnings        |       |                                         | (13,515    | ) |   |
| Amount charged  against net income                          |       |                                         | $          | 174,038 |   |   |
| Impact on net income per common share:                      |       |                                         |       |   |   |
| Basic                                                       |       |                                         | $          | 0.03 |   |   |
| Diluted                                                     |       |                                         | $          | 0.03 |   |   |

 

F-17

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

Share-basedcompensation expense was reflected in the statements of income for the year2006 as follows:

| ** **                                           | ** ** | **Year Ended  December 31,  2006** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------|------------|
| Cost of sales                                        |       |                                         | $          | 56,297 |   |   |
| Selling, general  and administrative expenses        |       |                                         | 107,150    |   |   |
| Research and  development expenses                   |       |                                         | 24,106     |   |   |
| Amounts charged against  income, before income taxes |       |                                         | 187,553    |   |   |
| Tax benefit  recognized in earnings                  |       |                                         | (13,515    | ) |   |
| Amount charged against  net income                   |       |                                         | $          | 174,038 |   |   |

 

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option-pricing model (Black-Scholes). The Company uses historicaldata to estimate the expected price volatility, expected option life andexpected forfeiture rate. The Company based its estimate of expected volatilityfor awards granted in 2006 on daily historical trading data of its common stockfor a period equivalent to the expected term of the award. The risk-freeinterest rate is based on the U.S. Treasury yield curve in effect at the timeof grant for the estimated life of the option. The Company estimated theexpected term consistent with historical exercise and cancellation activity ofits previous share-based grants with a ten-year contractual term.Forfeitures were based on historical experience. The dividend yield iscalculated based upon the dividend payments made during the prior four quartersas a percent of the average stock price for that period. The followingassumptions were used to estimate the fair value of options granted during2006, 2005 and 2004 using the Black-Scholes model:

| ** **                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Dividend yield             |       |     | 3.1        | %        |       |     | 3.0        | % |   |   | 3.1 | % |   |
| Expected  volatility       |       |     | 37         | %        |       |     | 31         | % |   |   | 32 | % |   |
| Risk-free  interest rate   |       |     | 4.6        | %        |       |     | 4.0        | % |   |   | 3.4 | % |   |
| Expected lives (in  years) |       |     | 5.2        |     |       |     | 7.9        |   |   |   | 7.8 |   |   |

 

F-18

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

Informationregarding the Company’s stock option plans for 2006, 2005 and 2004 was asfollows:

| ** **                                   | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|----------------------------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **                                   | ** ** | ** ** | ** ** | **Weighted** | ** ** | **average**     | ** ** | ** **    | ** ** |
| ** **                                   | ** ** | ** ** | ** ** | **average**  | ** ** | **remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                                   | ** ** | ** ** | ** ** | **exercise** | ** ** | **contractual** | ** ** | **intrinsic** | ** ** |
| ** **                                   | ** ** | **Shares** | ** ** | **price**    | ** ** | **term**        | ** ** | **value**     | ** ** |
| Options outstanding,  December 31, 2003 |       | 810,412    |       |         | $          | 7.17            |       |          |       |   |   |   |   |   |
| Granted                                      |       | 102,000    |       |         | 9.18       |            |       |          |       |   |   |   |   |
| Exercised                                    |       | (46,300    | )          |         | 6.22       |            |       |          |       |   |   |   |   |
| Canceled or expired                          |       | (27,673    | )          |         | 7.38       |            |       |          |       |   |   |   |   |
| Options outstanding, December 31, 2004  |       | 838,439    |       |         | 7.46       |            |       |          |       |   |   |   |   |
| Granted                                      |       | 106,200    |       |         | 8.91       |            |       |          |       |   |   |   |   |
| Exercised                                    |       | (70,404    | )          |         | 6.40       |            |       |          |       |   |   |   |   |
| Canceled or expired                          |       | (23,786    | )          |         | 8.43       |            |       |          |       |   |   |   |   |
| Options outstanding, December 31, 2005  |       | 850,449    |       |         | 7.70       |            |       |          | 6.7        |   |   |   |   |
| Granted                                      |       | 154,200    |       |         | 12.00      |            |       |          | 10.0       |   |   |   |   |
| Exercised                                    |       | (118,775   | )          |         | 7.05       |            |       |          |       |   |   |   |   |
| Canceled or expired                          |       | (31,999    | )          |         | 9.09       |            |       |          |       |   |   |   |   |
| Options outstanding, December 31, 2006  |       | 853,875    |       |         | $          | 8.52            |       |          |       | 6.6 |   |   | $ | 3,359,907 |   |
| Options  exercisable, December 31, 2006 |       | 618,666    |       |         | $          | 7.62            |       |          |       | 5.6 |   |   | $ | 2,994,214 |   |

 

The weighted average grant date fair value based onthe Black-Scholes model for options granted in 2006 was $3.34. The Companyissues new shares of common stock upon exercise of stock options. The totalintrinsic value of options exercised was $290,942 and $220,836 during the yearsended December 31, 2006 and 2005, respectively.

Asummary of the status of the Company’s unvested option shares as of December 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                     |       |                       | 154,200    |                                                |       |   | 3.34 |   |   |
| Options cancelled                   |       |                       | (13,074    | )                                                   |       |   | 2.30 |   |   |
| Options vested                      |       |                       | (81,804    | )                                                   |       |   | 2.29 |   |   |
| Unvested at  December 31, 2006 |       |                       | 235,209    |                                                |       |   | $ | 2.95 |   |   |

 

As of December 31,2006, there was $694,601 of total unrecognized compensation cost related tounvested share-based compensation granted under the Company’s plans. That costis expected to be recognized over a weighted-average period of 1.7 years. Thetotal fair value of option shares vested during the year 2006 was $187,576.

F-19

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**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

**(10)   Other Income**

Other income, net for 2006, 2005 and 2004 was$549,597, $338,147 and $123,448, respectively.

Thefollowing table provides the details:

| ** **                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Interest income  on short-term investments |       | $                                           | 412,882    |   | 209,217 |   | 129,862 |   |
| Gain on sale of  Lab Connections           |       | 92,345                                      |       | — |   | — |   |
| Gain on sale of  fixed assets              |       | 61,037                                      |       | 45,522 |   | 8,129 |   |
| Foreign currency  exchange (loss) gain     |       | (19,152                                     | )          | 80,691 |   | (14,543 | ) |
| Other                                      |       | 2,485                                       |       | 2,717 |   | — |   |
| Total                                      |       | $                                           | 549,597    |   | 338,147 |   | 123,448 |   |

 

**(11)   Stockholders’Equity**

From time to time, theCompany’s board of directors authorizes the repurchase of common stock. On November 5,2005 the Company’s board of directors authorized the repurchase of up to$2,000,000 in shares of the Company’s common stock. As of December 31,2006, there was $1,636,875 remaining in this authorization.

**(12)   Net Income perCommon Share**

Thefollowing table presents a reconciliation of the denominators used in thecomputation of net income per common share—basic and net income per commonshare—diluted for the years ended December 31, 2006, 2005 and 2004:

| ** **                                                              | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Weighted shares  of common stock  outstanding—basic                |       | 5,429,511 |       | 5,370,335 |       | 5,351,106 |       |
| Weighted shares of common stock assumed  upon exercise of stock options |       | 95,972    |       | 163,945   |       | 120,314   |       |
| Weighted shares  of common stock  outstanding—diluted              |       | 5,525,483 |       | 5,534,280 |       | 5,471,420 |       |

 

Outstanding stock optionstotaling 179,200, 150,020 and 157,120 at December 31, 2006, 2005 and 2004,have been excluded from the net income per common share calculations becausethe effect on net income per common share would not have been dilutive.

**(13)   Product Line,Geographical and Significant Customer Information**

The Company operates in a single industry segment: thedevelopment, manufacturing and marketing of measurement, analytical,monitoring, and consulting products used to detect, measure and analyze gasesand chemical compounds for customers in the barrier packaging, food,pharmaceutical and other industries throughout the world.

F-20

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**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

Thefollowing table summarizes total sales by product line for 2006, 2005 and 2004respectively:

| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Permeation  Products and Services                        |       | $                                           | 14,604,579 |   | 13,711,970 |   | 14,290,547 |   |
| Gas, Headspace  and Other Analyzer Products and Services |       | 10,072,101                                  |       | 8,875,847 |   | 8,083,951 |   |
| Other Instruments  and Services                          |       | 1,613,295                                   |       | 1,993,783 |   | 2,590,555 |   |
| Total Sales                                              |       | $                                           | 26,289,975 |   | 24,581,600 |   | 24,965,053 |   |

 

Thefollowing table summarizes total sales, based upon the country to which salesto external customers were made for fiscal years 2006, 2005 and 2004. All ofthe Company’s tangible long-lived assets are located in the United States,except for an insignificant amount of property and equipment in Germany.

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Domestic Sales      |       | $                                           | 11,924,805 |   | 12,294,985 |   | 11,874,933 |   |
| Foreign Sales:      |       |                                        |       |   |   |   |   |
| Europe              |       | 7,360,019                                   |       | 5,802,034 |   | 6,440,144 |   |
| Asia                |       | 4,842,523                                   |       | 5,093,417 |   | 4,533,682 |   |
| Other               |       | 2,162,628                                   |       | 1,391,164 |   | 2,116,294 |   |
| Total foreign sales |       | 14,365,170                                  |       | 12,286,615 |   | 13,090,120 |   |
| Total Sales         |       | $                                           | 26,289,975 |   | 24,581,600 |   | 24,965,053 |   |

 

The Company’s products are marketed outside of NorthAmerica through various independent representatives. Its Lippke subsidiary inGermany, which was acquired effective January 1, 2004, accounted for 26%,23% and 24% of sales in 2006, 2005 and 2004, respectively. In addition, oneindependent representative accounted for approximately 6%, 8% and 8% in 2006,2005 and 2004, respectively.

No single customeraccounted for 10% or more of the Company’s consolidated revenues in any of thefiscal years ended December 31, 2006, 2005 and 2004.

**(14)   Savings andRetirement Plan**

The Company has a 401(k) Savingsand Retirement Plan covering substantially all of its employees. The Companyprovides matching contributions in accordance with the plan. The Company’scontributions to this plan in 2006, 2005 and 2004 were $77,915, $78,265 and$72,749, respectively.

**(15)   Acquisitions**

EffectiveJanuary 1, 2004, the Company acquired Paul Lippke Handels-GmbH Prozess-und Laborsysteme (Lippke) which is located in Germany. Lippke had been theprimary distributor of its products in Europe for approximately 30 years, andalso served in the capacity of distributor or agent for several companies inaddition to MOCON. The acquisition of Lippke provides us with a direct presencein Europe. The Company acquired all of the shares of Lippke for a base purchaseprice of $802,688. In 

F-21

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**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

addition, the Company was obligated to make threeearnout payments to Lippke’s former parent company based on the net profits ofLippke in each of the years 2004, 2005 and 2006, with a minimum payment amountof 100,000 euros per year. The Company made the third and final payment in thefirst quarter 2007 in the amount of $574,568. The results of Lippke have beenincluded in the consolidated financial statements since the date of acquisitionof January 1, 2004. The purchase price of the acquisition was:

| Cash  consideration (625,000 euros)               |   | $       | 802,688   |   |
|---------------------------------------------------|--------|---------|-----------|--------|
| Present value of  future minimum earnout payments |   | 796,965 |      |
| Costs associated  with the transaction            |   | 184,975 |      |
|                                              |   | $       | 1,784,628 |   |

 

Purchase PriceAllocation

The purchase price was allocated to the tangible andidentifiable intangible assets acquired and liabilities assumed based on theirestimated fair values at the acquisition date. The following table summarizes the estimated fair values of the assetsacquired and liabilities assumed as of the acquisition date:

| Cash and  marketable securities                                  |   | $          | 518,980   |   |
|------------------------------------------------------------------|--------|------------|-----------|--------|
| Current assets,  principally accounts receivable and inventories |   | 1,088,824  |      |
| Property, plant  and equipment                                   |   | 166,021    |      |
| Identifiable intangible  assets:                                 |   |       |      |
| Domain names                                                     |   | 5,700      |      |
| Trademark and trade name                                         |   | 335,000    |      |
| Commercial agent/subagent network                                |   | 70,000     |      |
| Sales order backlog                                              |   | 84,896     |      |
| Compiled customer list                                           |   | 48,000     |      |
| Manufacturer’s representative contracts                     |   | 225,000    |      |
| Goodwill                                                         |   | 968,979    |      |
| Current  liabilities                                             |   | (1,355,009 | )         |
| Other non-current  liabilities                                   |   | (371,763   | )         |
|                                                             |   | $          | 1,784,628 |   |

 

The allocation of thepurchase price was based, in part, on a third-party valuation of the fair valueof identifiable intangible assets, and certain property, plant and equipment. Othernon-current liabilities include deferred income taxes of $264,683 andobligations payable to two former employees totaling $107,080. The cost of theidentifiable intangible assets will be amortized on a straight-line basis overperiods of less than 1 to 5 years. The Company expects that substantially allof the amounts allocated to goodwill and other identifiable intangibles willnot be deductible for tax purposes.

**(16)   DiscontinuedOperations**

In July 2005, the Company sold substantially allof the assets used in its discontinued Vaculok product line. As previouslyreported in the first quarter 2005, the decision had been made to ceaseproduction of Vaculok vacuum insulated panels and exit the product line.

F-22

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**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005 and 2004**

Pursuant to the saleagreement, the Company received an up-front payment of $125,000, along with theright to receive additional amounts upon the occurrence of certain post-closingevents. As a result of the sale, the Company recognized a pre-tax gain ondisposal of approximately $69,000. When combined with additional operatingexpenses, this produced a pre-tax loss of approximately $169,000 for 2005 whichis reported as discontinued operations in the Consolidated Statements of Income.After tax, the total loss recognized from discontinued operations wasapproximately $107,000. The Company received an additional payment of $35,000($22,225 after-tax) in 2006 related to the sale which is shown as a gain fromdiscontinued operations on the Consolidated Statements of Income.

**(17)   Sale ofSubsidiary**

In February 2006, the Company sold all of theoutstanding capital stock of Lab Connections, Inc. (LCI). Pursuant to thesale agreement, the Company received a cash payment of approximately $517,000 inexchange for all the outstanding shares of LCI. As a result of the sale, theCompany recognized an after-tax gain of approximately $92,000 in the firstquarter ended March 31, 2006. As a result of the sale, the Company enteredinto a one-year manufacturing agreement with the purchaser to be the exclusivesupplier of sample preparation products previously made and sold by LCI.

Sales of sample preparation products wereapproximately $47,000, $505,000 and $606,000 for 2006, 2005 and 2004,respectively.

F-23

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**MOCON, INC.**

**EXHIBITINDEX TO ANNUAL REPORT ON FORM 10-KFOR THE YEAR ENDED DECEMBER 31, 2006**
| Exhibit No. | ** ** | ** **                                                                                                                                                                                        | ** ** | **Exhibit**                                                                                                                                                        | ** ** | **Method of   Filing** |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|
| 3.1              |       | Restated Articles of  Incorporation of MOCON, Inc.                                                                                                                                           |       | Filed herewith                                                                                                                                                     |
| 3.2              |       | Third Restated  Bylaws of MOCON, Inc.                                                                                                                                                        |       | Incorporated by  reference to Exhibit 3.3 to our Annual Report on Form 10-K  for the fiscal year ended December 31, 1988 (File No. 000-09273)  |
| 10.1             |       | Office/Warehouse  Lease, dated July 29, 1994, by and between MOCON, Inc. and DRESCO  III, Inc.                                                                                     |       | Incorporated by  reference to Exhibit 10.1 to our Annual Report on Form 10-K  for the fiscal year ended December 31, 1994 (File No. 000-09273) |
| 10.2             |       | Lease  Notification and Extension Agreement, dated June 6, 1997, by and between  MOCON, Inc. and DRESCO III, Inc.                                                                  |       | Incorporated by  reference to Exhibit 10.2 to our Annual Report on Form 10-K  for the fiscal year ended December 31, 1997 (File No. 000-09273) |
| 10.3             |       | Second Lease  Notification and Extension Agreement, dated November 17, 1999, by and  between MOCON, Inc. and Boone Associates LLC                                                       |       | Incorporated by  reference to Exhibit 10.3 to our Annual Report on Form 10-K  for the fiscal year ended December 31, 1999 (File No. 000-09273) |
| 10.4             |       | MOCON, Inc.  1992 Stock Option Plan                                                                                                                                                          |       | Incorporated by  reference to Exhibit 10.5 to our Annual Report on Form 10-K  for the fiscal year ended December 31, 1991 (File No. 000-09273) |
| 10.5             |       | MOCON, Inc.  1998 Stock Option Plan, as amended                                                                                                                                              |       | Incorporated by  reference to our Definitive Proxy Statement on Form DEF-14A filed  on April 9, 2002 (File No. 000-09273)                           |
| 10.6             |       | Form of  Incentive Stock Option Agreement between MOCON, Inc. and its Executive  Officers under the MOCON, Inc. 1998 Stock Option Plan, as amended                                 |       | Incorporated by  reference to Exhibit 99.1 to our Current Report on Form 8-K  filed on December 29, 2004 (File No. 000-09273)                  |
| 10.7             |       | Form of  Non-Statutory Stock Option Agreement between MOCON, Inc. and its  Non-Employee Directors and Executive Officers under the MOCON, Inc. 1998  Stock Option Plan, as amended |       | Incorporated by  reference to Exhibit 99.2 to our Current Report on Form 8-K  filed on December 29, 2004 (File No. 000-09273)                  |
| 10.8             |       | MOCON, Inc.  2006 Stock Incentive Plan                                                                                                                                                       |       | Incorporated by  reference to Exhibit 10.1 to our Current Report on Form 8-K  filed on May 23, 2006 (File No. 000-09273)                       |

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| 10.9  |   | Form of Incentive  Stock Option Agreement between MOCON, Inc. and its Executive Officers  under the MOCON, Inc. 2006 Stock Incentive Plan                                 |   | Incorporated by  reference to Exhibit 10.2 to our Current Report on Form 8-K  filed on May 23, 2006 (File No. 000-09273)                        |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.10 |   | Form of  Non-Statutory Stock Option Agreement between MOCON, Inc. and its  Non-Employee Directors and Executive Officers under the MOCON, Inc. 2006  Stock Incentive Plan |   | Incorporated by  reference to Exhibit 10.3 to our Current Report on Form 8-K  filed on May 23, 2006 (File No. 000-09273)                        |
| 10.11 |   | Form of  Executive Severance Agreement                                                                                                                                              |   | Incorporated by  reference to Exhibit 10.13 to our Annual Report on Form 10-K  for the fiscal year ended December 31, 2000 (File No. 000-09273) |
| 10.12 |   | 2003 Compensation  Committee resolution setting forth the MOCON Incentive Pay Plan                                                                                                       |   | Incorporated by  reference to Exhibit 10.14 to our Annual Report on Form 10-K  for the fiscal year ended December 31, 2002 (File No. 000-09273) |
| 10.13 |   | Purchase and Sale  Agreement dated October 24, 2001 by and among MOCON, Inc., Questar  InfoComm, Inc. and Questar Corporation                                             |   | Incorporated by  reference to Exhibit 2.1 to our Report on Form 8-K filed on  November 6, 2001 (File No. 000-09273)                             |
| 10.14 |   | Share Purchase  Agreement, dated as of December 19, 2003 by and between Ahlström Capital  Oy and MOCON, Inc.                                                              |   | Incorporated by  reference to Exhibit 2.1 to our Current Report on Form 8-K  filed on January 29, 2004 (File No. 000-09273)                     |
| 10.15 |   | Transfer Deed  dated as of January 29, 2004 by and between Ahlström Capital Oy and  MOCON, Inc.                                                                           |   | Incorporated by  reference to Exhibit 2.2 to our Current Report on Form 8-K  filed on January 29, 2004 (File No. 000-09273)                     |
| 10.16 |   | Stock Purchase  Agreement, dated February 27, 2006, by and among Leap Technologies, Lab  Connections, Inc. and MOCON, Inc.                                                |   | Incorporated by  reference to Exhibit 10.1 to our Current Report on Form 8-K  filed on March 2, 2006 (File No. 000-09273)                       |
| 10.17 |   | Description of  Non-Employee Director Retirement Plan                                                                                                                                    |   | Incorporated by  reference to Exhibit 10.20 to our Annual Report on Form 10-K  for the fiscal year ended December 31, 2004 (File No. 000-09273) |
| 10.18 |   | Description of  Non-Employee Director Compensation Arrangements                                                                                                                          |   | Incorporated by  reference to Exhibit 10.21 to our Annual Report on Form 10-K  for the fiscal year ended December 31, 2004 (File No. 000-09273) |
| 10.19 |   | Description of  Executive Officer Compensation Arrangements                                                                                                                              |   | Filed herewith                                                                                                                                                      |
| 21.1  |   | Subsidiaries of  MOCON, Inc.                                                                                                                                                        |   | Filed herewith                                                                                                                                                      |

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| 23.1 |   | Consent of Independent  Registered Public Accounting Firm                                                  |   | Filed herewith      |
|------|--------|------------------------------------------------------------------------------------------------------------|--------|---------------------|
| 31.1 |   | Principal  Executive Officer Certification Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 |   | Furnished  herewith |
| 31.2 |   | Principal  Financial Officer Certification Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 |   | Furnished  herewith |
| 32.1 |   | Certification  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief  Executive Officer)   |   | Filed herewith      |
| 32.2 |   | Certification Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief Financial Officer)    |   | Filed herewith      |

 

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