**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

| **(Mark  one)**                                                                                                                                                                                                                                                              |                                                                                                   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                                                                                                        | **ANNUAL REPORT UNDER SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
| **For the fiscal year ended December 31, 2005**                                                                                                                                                                                                                         |
| **o**                                                                                                                                                                                                                                                                        | **TRANSITION REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| For  the transition period from                       to                     . |

 

**Commission File No.:  000-09273**

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**MOCON, Inc.**

(Exact name of registrantas specified in its charter)
| **Minnesota**  (State or other jurisdiction of  incorporation or organization)              |   | **41-0903312**  (I.R.S. Employer  Identification No.) |
|---------------------------------------------------------------------------------------------|--------|-------------------------------------------------------|
| **7500 Boone Avenue North  Minneapolis, Minnesota**(Address of principal executive offices) |   | **     55428**  (Zip Code)             |

 

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

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

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

**Common Stock, $0.10 Par Value**

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Indicate by check mark if theregistrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act. YES o  NO x

Indicate by check mark if theregistrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. YES o  NO x

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. YES x  NO o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

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

Large accelerated filer: o         Acceleratedfiler: o         Non-acceleratedfiler: x

Indicate by check mark whetherregistrant is a shell company (as defined in Rule 12b-2 of the Act). YES o  NO x

The aggregate market value of the registrant’s commonstock, excluding outstanding shares beneficially owned by directors andexecutive officers, computed by reference to the price at which the commonstock was last sold as of June 30, 2005 (the last business day of theregistrant’s second quarter) as reported by the Nasdaq National Market System,was $47,197,043.

As of March 24, 2006, 5,410,448 shares of commonstock of the registrant were deemed outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

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 2006 Annual Meeting of Shareholders to beheld May 18, 2006.

 

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**PART I**

*This annual reporton Form 10-K contains 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. We refer you to the information under the heading “Part I.Item 1. Business—Forward-Looking Statements.”*

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

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

**Item 1.**                        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, aswell as products that prepare samples of various substances for laboratoryanalysis.

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. During the last 9months, we divested two product lines to allow us to better concentrate on ourcore product lines, particularly our gas detection and measurement products.

In January 1998, we acquired MicroanalyticsInstrumentation Corp. (Microanalytics), which is located near Austin, Texas. Microanalyticsproduces various gas chromatographic (GC) instruments and provides serviceswith an emphasis on multidimensional gas chromatography. A variety of GCspecific applications have been developed by Microanalytics personnel, rangingfrom petroleum and petrochemical purity assay to aroma and off-odor analysisfor the food, beverage, packaging and other industries.

In December 1998, we acquired Lab Connections, Inc.(LCI), located near Boston, Massachusetts. LCI manufactures hardware andsoftware interfaces that allow the components of a particular substance to beidentified by spectrometry and spectroscopy after they have been separatedthrough liquid chromatography. LCI’s products are used by a variety ofcustomers, including bio-pharmaceutical, polymer and consumer productscompanies, as well as companies that analyze proteins, pharmaceuticalcompounds, polymers, adhesives and other materials. In order to reduce costsand increase operating efficiencies, our LCI subsidiary was relocated in 2004and consolidated with our operations in Texas and Minnesota. In February 2006,we sold LCI.

In October 2001, we acquired our Baseline-MOCON, Inc.subsidiary (Baseline). Baseline is located near Boulder, Colorado. Baselineproduces advanced gas analysis and monitoring instrumentation used in 

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applications such as oiland gas exploration, process gas analysis and industrial hygiene and safetyapplications.

In November 2003, we acquired the Vaculok® vacuum insulated panel product line fromAdvantek, Inc., a Minnesota-based provider of packaging products. Ourvacuum insulated panel product line was sold during 2005. Sales associated withour vacuum insulated panel product line were not significant. The results ofthis line of business are shown in the “discontinued operations” section of ourconsolidated statements of income, and further explained in the notes theretoincluded elsewhere in this report.

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. Lippke had been the primary distributor of ourproducts in Europe for approximately 30 years, and also served in the capacityof distributor or agent for several companies in addition to MOCON. Ouracquisition of Lippke provides us with a direct presence in Europe. We acquiredall of the shares of Lippke for a base purchase price plus three earnoutpayments based on the net profits of Lippke in each of the years 2004, 2005 and2006, with a minimum payment amount of 100,000 euros per year. It isanticipated that the remaining earnout payments will be made at or near the endof the first quarter of each of the years 2006 and 2007. The earnout paymentdue for 2005 based on Lippke’s 2005 net profits is $433,339.

Our principal executive offices are located at 7500Boone Avenue North, Minneapolis, Minnesota 55428, and our telephone number is(763) 493-6370. Our website address is www.mocon.com.

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 to Section 13(a) or15(d) of the Securities Exchange Act of 1934, as amended, as soon asreasonably practicable after we electronically file such material with, orfurnish it to, the Securities and Exchange Commission. The informationcontained on our website or connected to our website is not incorporated byreference into this annual report on Form 10-K and should not beconsidered part of this report.

**Products and Services**

We develop, manufacture,market and service measurement, analytical, monitoring, sample preparation andconsulting products used to detect, measure and analyze gases and chemical compounds.Please see our consolidated financial statements beginning on page F-1for financial information concerning our business, including our revenues, netincome and net assets. Our sales are grouped into three major categories asdiscussed below.

***Permeation Products and Services***

Our permeation products consist of systems andservices that measure the rate at which various gases and vapors aretransmitted through various materials. These products perform measurementsunder precise temperature and relative humidity conditions. The principalmarket for these products consists of manufacturers of packaging materials(including manufacturers of papers, plastics and coatings) and the users ofsuch packaging materials, such as companies in the food, beverage, pharmaceuticaland chemical industries.

We also providecertain laboratory testing services to companies that use our permeationproducts. These services consist primarily of testing film and packagepermeation 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.

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Our permeation productsand services accounted for approximately 56%, 57% and 60% of our consolidatedsales in 2005, 2004 and 2003, 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.

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

*Gas AnalyzerProducts*

We sell two categories of gas analyzer productsthrough our Baseline subsidiary. Our permanent gas analyzers and systems areinstalled in fixed locations at the monitoring sites and generally performtheir functions continually or at regular intervals. Our portable gas analyzersare hand-held, compact and are used on occasions requiring mobile equipment. Ourgas analyzer products are for use in (1) industrial hygiene (detection ofhazardous gases in the workplace), (2) hydrocarbon gas analysis for oiland gas exploration, and gas pipeline monitoring, (3) contaminantdetection in the manufacture of specialty gases, and (4) environmentalmonitoring (tracking the release of, or the presence of, toxic substances).

Our gas analyzer productsaccounted for approximately 16%, 14% and 15% of our consolidated sales in 2005,2004 and 2003, respectively.

*Headspace AnalyzerProducts*

Our headspace analyzerproducts are used to analyze the amount and type of gas present in theheadspace of flexible and rigid packages, as applied to gas flushing modifiedor controlled atmosphere packaging. The principal market for these productsconsists of packagers of foods, beverages and pharmaceuticals. The headspaceanalyzer products that we currently manufacture include the PAC CHECK® series of headspace analyzers and the GSATMseries of on-line gas stream analyzers for continuous and intermittentmonitoring of modified atmosphere packaging (MAP) and other gas flushingoperations.

*Leak DetectionProducts*

The leak detectionproducts that we manufacture detect leaks in sterile medical trays, foodpouches, blister packs and a wide range of other packages. We currentlymanufacture three types of leak detection instruments. The first type ofinstrument is a non-destructive leak detector that senses small amounts ofcarbon dioxide escaping from a package or tray. The second type of instrumentdetects leaks and checks for seal integrity by applying and measuring pressurewithin a package. The third type pulls a vacuum on a package and looks forvacuum or gas flow changes. The principal markets for these products arepackagers of sterile medical items, pharmaceuticals and food products.

*Weighing andPharmaceutical Products*

We manufacture weighing products that automaticallydetermine the weight of pharmaceutical capsules and tablets and reject thosethat are out of acceptable 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. The ABTM automatic balance weighingsystems that we sell are designed for off-line use for both tablets andcapsules, and we market these products primarily to the pharmaceutical industry.In addition, we sell tablet inspection systems and blister packaging-relatedequipment through our Lippke subsidiary, who is an agent for othermanufacturers.

Our gas, headspace andother analyzer products and services accounted for an aggregate ofapproximately 36%, 32% and 31% of our consolidated sales for 2005, 2004 and2003, 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 theconsulting and analytical services consists of manufacturers of foods,beverages, pharmaceuticals, plastics, chemicals, electronics and personal careproducts.

*Sample PreparationProducts*

Through our former LabConnections subsidiary, which was sold in February 2006, we designed,manufactured, marketed and serviced products used in sample preparation. Theseproducts consisted of hardware and software interfaces that allow the componentsof a particular substance to be identified by spectroscopy after they have beenseparated through chromatography. Often, the most time-consuming part ofchemical analysis is sample preparation and any product that reduces totalsample preparation time is of benefit to companies who analyze chemicalcompounds. Our products provided fully automatic sample collection from variousLiquid Chromatographs and Gel Permeation Chromatographs in a form suitable forimmediate examination by Fourier transform infra-red spectroscopy (FTIR) and/ormatrix-assisted laser desorption ionization mass spectrometry (MALDI-MS). Theprincipal market for these products is laboratories that analyze proteins,polymeric compounds and adhesives. The sample preparation products that wemanufactured were the LC-Transform® forinterfacing to FTIR and the LC-Transform for interfacing to MALDI-MS.

*Gas ChromatographyAnalyzer Products*

We integrate gas chromatography (GC) components thatwe purchase from third parties, with GCs purchased from third parties, to formmultidimensional GC analyzer systems. The multidimensional GC analyzers thatare formed through the integration of gas chromatography components with GCsrepresent state-of-the-art technology in gas chromatographic separations andare used in identifying compounds causing off-odors in various products, inidentifying critical aroma compounds, and in high purity analysis of singlecomponent matrixes. The GC analyzer products that we currently manufacture arethe AROMATRAX® systems for odor and aroma analysis andprofiling, the PURI-TRAXTM systems consisting of a vinyl chloride monomer purityanalysis 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 injectorsystem for permanent and liquefied petroleum gases. The principal markets forour GC analyzer products consist of food, beverage, petroleum, chemical andpetrochemical manufacturers.

Our consulting andanalytical services, sample preparation products and gas chromatographyanalyzer products accounted for an aggregate of approximately 8%, 11% and 9% ofour consolidated sales in 2005, 2004 and 2003, respectively.

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**Competition**

Wehave several competitors in both foreign and domestic markets for all of ourproducts and services. The principal competitive factors for our products andservices are:

·       productquality and performance;

·       productreliability;

·       productsupport; and

·       price.

We compete with a varietyof competitors 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 competitive, we must continue to invest in research anddevelopment, marketing, customer service and support, and manage our operatingexpenses. We believe that we have in place strategies to develop technologicaland other advantages over our competitors. However, there can be no assurancethat we will have sufficient resources to execute these strategies, or that ourcompetitors will not develop new technologies or other advantages which wouldrequire us to reduce our prices, result in lost orders or otherwise adverselyaffect our financial results.

**Manufacturing andSupplies**

We manufacture products atour Minnesota, Texas, Colorado and Germany locations. In February 2004, weclosed our facility located near Boston, Massachusetts, and consolidated theseoperations 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. Certaincomponents that we use in our products are currently purchased from singlesource 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,Trademarks and Other Intellectual Property Rights**

We believe that theprotection afforded us by our patent rights is important to our business, andwe will continue to seek patent protection for our technology and products. Werequire all of our employees and consultants to assign to us all inventionsthat are conceived and developed during their employment, except to the extentprohibited by applicable law. To protect our proprietary information, we haveentered into confidentiality and non-compete agreements with those of ouremployees and consultants who have access to sensitive information. We holdboth United States and international patents and have U.S. and internationalpatents pending. We currently hold 44 U.S. patents and 25 international patents.These patents will expire during the period from 2006 through 2022.

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, of10 to 20 years, which may be extended in accordance with applicable law.

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**Marketing andCustomers**

We market our products andservices throughout the United States and in over 60 foreign markets. We use adirect sales force of approximately 16 employees and approximately 13independent sales representatives to market our products and services in theUnited States, Canada and Germany, and use a network of approximately 50independent sales representatives to market and service our products andservices in other foreign countries. To our knowledge, none of our independentsales representatives sells a material amount of product manufactured by any ofour competitors.

For information concerningour export sales by geographic area, see note 11 of the notes to ourconsolidated financial statements contained on page F-18. We marketproducts and services to research laboratories, production environments andquality control applications in the life science, medical, food,pharmaceutical, plastics, paper, electronics, oil and gas and other industries.No single customer accounted for 10% or more of our consolidated sales in anyof the fiscal years ended December 31, 2005, 2004 and 2003, and we do notbelieve that the loss of any single customer would have a material adverseeffect on our business or financial performance. As previously explained, weacquired Lippke effective January 1, 2004. Lippke accounted forapproximately 23%, 24% and 10% of our consolidated sales in 2005, 2004 and2003, respectively. In addition, one independent representative accounted forapproximately 8% of our consolidated sales in each of the years 2005, 2004 and2003.

**Backlog**

As of December 31,2005, our total backlog was $1,799,273 for all of our products as compared to$2,240,096 and $1,021,159 as of December 31, 2004 and 2003, respectively. Weanticipate shipping the entire current backlog in 2006.

**Research andDevelopment**

We are committed to anongoing engineering program dedicated to innovating new products and improvingthe quality and performance of our existing products. Our engineering expensesare primarily incurred in connection with the improvement of existing products,cost reduction efforts, and the development of new products that may haveadditional applications or represent extensions of existing product lines.

We incurred expenses of$1,765,662, $1,371,700 and $1,313,379 during the fiscal years ended December 31,2005, 2004 and 2003, respectively, for research and development (R&D) ofour products. R&D costs were approximately 7% of our consolidated sales forthe fiscal year ended December 31, 2005 and approximately 6% and 7% of ourconsolidated sales for the fiscal years ended December 31, 2004 and 2003,respectively. For the foreseeable future, we expect to spend, on an annualbasis, 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 31,2005, we had 115 full-time employees. Included in this total are approximately13 scientists and engineers who research and develop potential newproducts. None of our employees are represented by a labor union, and weconsider our employee relations to be satisfactory.

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**Forward-Looking Statements**

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 statements ofhistorical facts included in this report that address activities, events ordevelopments that we expect, believe or anticipate will or may occur in thefuture are forward-looking statements including, in particular, the statementsabout our plans, objectives, strategies and prospects regarding, among otherthings, our financial condition, results of operations and business. We haveidentified some 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’sDiscussion and Analysis of Financial Condition and Results of Operations.”

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. Ourexpectations reflected in our forward-looking statements can be affected byinaccurate assumptions we might make or by known or unknown risks anduncertainties, 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 are significant factors known to us thatcould have material adverse effects on our business, financial condition, oroperating 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 

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believe that the price ofour products and the prices of our competitors’ products is a significantfactor affecting our customers’ buying decisions and consequently, we may notbe able to pass along any cost increases in raw materials and supplies in theform of price increases or sustain profit margins that we have achieved inprior years.

***The markets in which we operate have experiencedminimal growth in recent years, and our ability to increase our revenues willdepend in part on our ability to develop new products, develop new applicationsfor our existing products and to acquire complementary businesses and productlines.***

The analytical and measurement instrument markets inwhich we operate have not shown significant growth in recent years. Although wehave identified a number of strategies that we believe will allow us to growour business and increase our sales, including developing new products andtechnologies, developing new applications for our technologies, acquiringcomplementary businesses and product lines, and strengthening our sales force,we cannot assure you that we will be able to successfully implement thesestrategies, or that these strategies will result in the growth of our businessor an increase in our sales.

***If we acquire businesses in the future, we could experiencea decrease in our profit margins, a decrease in our net income, and otheradverse 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 because ofpoor financial performance since we acquired it in November 2003. Werecently sold our Lab Connections subsidiary, which we had acquired in December 1998.Other businesses that we have previously acquired or may acquire in the futuremay be marginally 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. This could result in the diversion ofmanagement’s attention from other business concerns. 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.

***Our growth strategyto supplement our internal growth with the acquisition of businesses andtechnologies that complement or augment our existing products involves otherrisks, including integration risks, which could harm our business.***

As part of ourgrowth strategy, we have in the past acquired, and intend to acquire in the future,other businesses that have technologies and product lines that complement oraugment our existing products. We intend to continue to pursue otheracquisitions in the future. The benefits of any of these or future acquisitionsmay take more time than expected to develop, and we cannot guarantee that anyof our recent or future acquisitions will in fact produce any intendedbenefits. In addition, acquisitions and the integration of those acquisitionsinvolve a number of risks, 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;

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·       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.

Our ability to grow through acquisitions will depend,in part, on the availability of suitable acquisition candidates at anacceptable cost, our ability to compete effectively for these acquisitioncandidates and the availability of capital to complete such acquisitions. Theserisks could be heightened if we complete several acquisitions within arelatively short period of time.

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

The markets for our products and services arecharacterized by rapid and significant technological change and evolvingindustry standards. As a result of such changes and evolving standards, ourproducts may become noncompetitive or obsolete and we may have to develop newproducts in order to maintain or increase our revenues. New productintroductions that are responsive to these factors require significantplanning, design, development and testing at the technological, product andmanufacturing process levels, and we may not be able to timely develop newproducts. In addition, industry acceptance of new technologies that we maydevelop may be slow to develop due to, among other things, existing regulationsor standards written specifically for older technologies and generalunfamiliarity of users with new technologies. As a result, any new productsthat we may develop may not generate any meaningful revenues or profits for usfor a number of years, if at all.

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

Our customers include pharmaceutical, food, medicaland chemical companies, laboratories, government agencies and public andprivate research institutions. The capital spending of these entities can havea significant effect on the demand for our products. Any decrease in capitalspending by any of these customer groups could have a material adverse effecton our business and results of operations.

***A significantportion of our sales are generated from foreign countries and selling inforeign countries entails a number of risks which could result in a decrease toour sales or an increase in our operating expenses.***

Sales outside theUnited States accounted for approximately 50% of our sales in 2005 andapproximately 52% and 40% of our sales in 2004 and 2003, respectively. Weexpect that foreign sales will continue to account for a significant portion ofour revenues in the future. Sales to customers in foreign countries are subjectto a number of risks, including the following:

·       agreementsmay be difficult to enforce;

·       receivablesmay be difficult to collect;

·       certainregions are experiencing political unrest and conflict and economic instability;

·       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;

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·       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 were to materialize, our salesinto foreign countries could decline, or our operating costs could increase,which would adversely affect our financial results.

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

Because the functional currency of our foreignoperations is the applicable local currency, we are exposed to foreign currencyexchange rate risk arising from transactions in the normal course of business,such as sales to third party customers and purchases from suppliers denominatedin foreign currencies. Our reported net sales and net earnings are subject tofluctuations in foreign exchange rates. Because our products are manufacturedor sourced primarily from the United States, a stronger U.S. dollar generallyhas a negative impact on results from operations outside the United Stateswhile a weaker dollar generally has a positive effect. Our primary exchangerate exposure 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 toencounter, competition in the sale of our products. We believe that theprincipal competitive factors affecting the market for our products includeproduct quality and performance, price, reliability and customer service. Ourcompetitors include large multinational corporations. Some of our competitorshave substantially greater financial, marketing and other resources than we do.As a result, they may be able to adapt more quickly to new or emergingtechnologies and changes in customer requirements, or to devote greaterresources to the promotion and sale of their products than we can. In addition,competition could increase if new companies enter the market or if existingcompetitors expand their product lines or intensify efforts within existingproduct lines. Our current products, products under development and our abilityto discover new technologies may be insufficient to enable us to competeeffectively with our competitors.

***Our reliance uponpatents, domestic trademark laws and contractual provisions to protect ourproprietary rights may not be sufficient to protect our intellectual propertyfrom 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 effects 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.

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In addition, we rely on trade secrets and proprietaryknow-how that we seek to protect, in part, by confidentiality agreements withour collaborators, employees, and consultants. These agreements may be breachedand we may not have adequate remedies for any such breach. Even if theseconfidentiality agreements are not breached, our trade secrets may otherwisebecome known or be independently developed by competitors.

***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.***

The efficient operation of ourbusiness depends on our management information systems. We rely on ourmanagement information systems to effectively manage accounting and financialfunctions, order entry, order fulfillment and inventory replenishment. Thefailure 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 $10.43 and a low sales price of $8.11 during2005, 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 stock prices of instrumentationcompanies have experienced significant price and volume fluctuations that oftenhave been unrelated to the operating performance of such companies. This marketvolatility may adversely affect the market price of our common stock.

***Recently enacted and future changes in securities lawsand regulations are likely to increase our costs.***

Changing laws, regulations and standards relating tocorporate governance and public disclosure, including the Sarbanes-Oxley Act of2002, new SEC regulations and Nasdaq National Market rules, are creatingchallenges for publicly-held companies, including us. We are committed tomaintaining high standards of corporate governance and public disclosure. As aresult, our efforts to comply with evolving laws, regulations and standardshave resulted in, and are likely to continue to result in, increased generaland administrative expenses and a diversion of management time and attentionfrom revenue-generating activities to compliance activities. In particular, ourefforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 andthe related regulations regarding our assessment of our internal control overfinancial reporting and our external auditors’ audit of that assessmentrequired the expenditure of financial and managerial resources in 2005.Currently, we are awaiting further guidance from the Securities and ExchangeCommission to determine whether we will be required to commit ongoing financialand managerial resources in 2006 and beyond.

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***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 auditorattestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002.While we anticipate being able to fully implement the requirements relating tointernal control and other aspects of Section 404 by our December 31,2007 deadline, we cannot be certain as to the timing of the completion of ourevaluation, testing and remediation actions or their impact on our operations.If we are unable to conclude that our internal controls over financialreporting are effective or if our independent registered public accounting firmis unable to conclude that our assessment of our internal control overfinancial reporting is sufficient or is unable to conclude that our internalcontrols over financial reporting are effective and therefore issues an adverseopinion, investors may lose confidence in our financial reports and our stockprice 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. Webelieve 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.

Lippke’s operations are located in Neuwied, Germany,and occupy approximately 4,025 square feet. This space is leased until June 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 2005.

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**ITEM 4A.**        EXECUTIVEOFFICERS OF REGISTRANT

Ourexecutive officers, their ages and their offices held, as of March 24,2006, are as follows:

| **Name**             | ** ** | ** ** |   | **Age**                                                           | ** ** | **Title** |
|----------------------|------------|------------|--------|-------------------------------------------------------------------|------------|-----------|
| Robert L. Demorest   |       | 60         |   | Chairman of the Board,  President and Chief Executive Officer     |
| Daniel W. Mayer      |       | 55         |   | Executive Vice President                                          |
| Darrell B. Lee       |       | 57         |   | Vice President, Chief  Financial Officer, Treasurer and Secretary |
| Douglas J. Lindemann |       | 48         |   | Vice President and  General Manager                               |
| Ronald A. Meyer      |       | 55         |   | Vice President                                                    |

 

Mr. Robert L. Demorest has been our President, ChiefExecutive Officer, and Chairman of the Board since April 2000. Prior tothat time, Mr. Demorest had been our President for more than five years.

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 Vice President andGeneral Manager for us since January 2001. From July 2000 to December 2000,Mr. Lindemann served as a General Manager for us. Prior to that time, Mr. Lindemannhad been one of our Business Managers since 1995.

Mr. Ronald A. Meyer has been a Vice President for usfor 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 Information and Dividends**

Ourcommon stock is quoted on the Nasdaq National Market System under the symbolMOCO. The following table sets forth, for the fiscal periods indicated, thehigh and low sales prices for our common stock as reported by the NasdaqNational Market System. These quotations reflect inter-dealer prices, withoutretail mark-up, mark-down or commission and may not necessarily representactual transactions. The following table also sets forth, for the fiscalperiods indicated, the amount of cash dividends declared on our common stock.

| ** **  | ** ** | **2005**   | ** ** | **2004** | ** ** |
|-------------|------------|------------|------------|----------|------------|
| **Quarter** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** |
| 1st Quarter |       | $          | 10.20      |     | $          | 8.98 |   |   | $ | 0.070 |   |   | $ | 8.97 |   | $ | 7.70 |   |   | $ | 0.065 |   |   |
| 2nd Quarter |       | $          | 10.43      |     | $          | 8.76 |   |   | $ | 0.070 |   |   | $ | 8.72 |   | $ | 7.70 |   |   | $ | 0.065 |   |   |
| 3rd Quarter |       | $          | 10.10      |     | $          | 9.08 |   |   | $ | 0.070 |   |   | $ | 8.65 |   | $ | 7.73 |   |   | $ | 0.065 |   |   |
| 4th Quarter |       | $          | 9.73       |     | $          | 8.11 |   |   | $ | 0.075 |   |   | $ | 10.49 |   | $ | 7.95 |   |   | $ | 0.070 |   |   |
|             |            |            |            |          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

MOCON has paid quarterlycash dividends without interruption or decline since 1988. Cash dividends paidin 2005, 2004 and 2003 totaled $1,502,284, $1,842,593 (including final dividendpayments of $449,087 to Lippke’s former parent company and dividend payments of$1,393,506 to our shareholders) and $1,377,725, respectively. MOCON’s Board ofDirectors monitors and evaluates our dividend practice quarterly, and the Boardmay elect at any time to increase, decrease or not pay a dividend on MOCONcommon stock based upon our financial condition, results of operations, cashrequirements and future prospects and other factors deemed relevant by theBoard.

**Record Holders**

As of March 20, 2006,there were 333 record holders of our common stock.

**IssuerRepurchases of 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, 2005. 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 supersedes the Board’sprevious stock repurchase authorizations, under which $1,672,034 remainedavailable for purchase as of November 8, 2005. The repurchase program maybe suspended or discontinued at any time.

**RecentSales of Unregistered Securities**

During the fourth quarterended December 31, 2005, we did not issue or sell any equity securitieswithout registration under the Securities Act of 1933, as amended.

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**Item6.**                        SELECTEDFINANCIAL DATA

| ** **                                  | ** ** | **Years Ended December 31,**              | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                  | ** ** | **(in thousands, except per share data)** | ** ** |
| CONSOLIDATED STATEMENT  OF OPERATIONS DATA: |       |                                      |       |   |   |   |   |   |   |   |   |
| Sales                                       |       | $                                         | 24,582     |   | $ | 24,965 |   | $ | 19,615 |   | $ | 19,931 |   | $ | 19,261 |   |
| Net income                                  |       | $                                         | 2,915      |   | $ | 2,429 |   | $ | 2,211 |   | $ | 2,297 |   | $ | 3,421 |   |
| Net income per common  share:               |       |                                      |       |   |   |   |   |   |   |   |   |
| Basic                                       |       | $                                         | 0.54       |   | $ | 0.45 |   | $ | 0.41 |   | $ | 0.42 |   | $ | 0.62 |   |
| Diluted                                     |       | $                                         | 0.53       |   | $ | 0.44 |   | $ | 0.40 |   | $ | 0.41 |   | $ | 0.61 |   |
| Cash dividends  declared per share          |       | $                                         | 0.285      |   | $ | 0.265 |   | $ | 0.26 |   | $ | 0.24 |   | $ | 0.24 |   |
| ** **                                  | ** ** | **As of  December 31,**                   | ** ** |
| ** **                                  | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                        |       | **(in thousands)**                        |       |
| CONSOLIDATED BALANCE  SHEET DATA:           |       |                                      |       |   |   |   |   |   |   |   |   |
| Total assets                                |       | $                                         | 23,657     |   | $ | 22,516 |   | $ | 19,978 |   | $ | 19,821 |   | $ | 18,958 |   |
| Long-term liabilities                       |       | $                                         | 441        |   | $ | 543 |   | $ | 198 |   | $ | 326 |   | $ | 320 |   |

 

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, which includes$3,631,918 and $3,824,782, respectively, in net incremental sales for 2005 and2004. Our acquisition of Baseline-MOCON, Inc. in 2001 also affects thecomparability of the information in the table above. The results of thissubsidiary have been included from the effective date of purchase, whichincludes sales of $3,959,426, $3,560,351, $2,980,271, $3,881,781 and $1,348,101for 2005, 2004, 2003, 2002 and 2001, respectively.

Sales for the years 2005, 2004 and 2003 have beenreduced by $22,397, $143,316 and $17,365, respectively, for sales from theVaculok product line, which amounts have been included in the “discontinuedoperations” section of our consolidated statements of income.

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

This Management’sDiscussion and Analysis provides material historical and prospectivedisclosures intended to enable investors and other users to assess our financialcondition and results of operations. Statements that are not historical areforward-looking and involve risks and uncertainties discussed under the heading“Item 1A. Risk Factors” and elsewhere in this report. For more information, see“Business—Forward-Looking Statements” of this report. The following discussionof the results of the operations and financial condition of MOCON should beread in conjunction with our consolidated financial statements and the relatednotes thereto included elsewhere in this report.

**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, aswell as products that prepare samples of various substances for laboratoryanalysis. Although some of the markets for our products are maturing, wecontinually seek growth opportunities through technological and productimprovement, by acquiring and developing new products, and by acquiring newcompanies.

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. During the last 9 months, wedivested two product lines to allow us to better concentrate on our coreproduct lines, particularly our gas detection and measurement products.

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. It is anticipated that the remaining earnout paymentswill be made at or near the end of the first quarter of each of the years 2006and 2007. The earnout payment due for 2005 based on Lippke’s 2005 net profitsis $433,339.

In March 2005, we committed to a plan todiscontinue production of our Vaculok® vacuum insulated panels and exit this productline as the result of the poor financial performance since it was acquired in November 2003.We recorded a one-time pre-tax charge to earnings in our first quarter 2005,totaling approximately $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 up to an additional $60,000 upon the occurrence of certain post-closingevents. As a result of the sale, we recognized a pre-tax gain of approximately$69,000 in the third quarter 2005. Sales associated with our vacuum insulatedpanel product line were not significant. The results of this line of businessare shown in the “discontinued operations” section of our consolidatedstatements of income, and further explained in the notes thereto includedelsewhere in this report.

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In February 2006, wesold the capital stock of Lab Connections, Inc. in exchange for $517,296in cash, subject to a purchase price adjustment based on the amount of LabConnections’ net tangible assets as of the closing date. As a result of thesale, we recognized an after-tax gain of approximately $90,000 in the firstquarter 2006.

**OverallSummary of Financial Results**

Sales for 2005 were $24,581,600, a decrease of 2%compared to $24,965,053 for 2004. This decrease in sales was primarily theresult of the decreased domestic and foreign sales volume of our permeationproducts, foreign sales volume of our weighing and pharmaceutical products,domestic sales volume of our consulting and analytical services and foreignsales volume of our sample preparation products, offset somewhat by increasesin the domestic and foreign sales volume of our headspace analyzer and gasanalyzer products. Our international sales have historically accounted for asignificant portion of our revenues. Our foreign sales were $12,286,615, or 50%of total sales in 2005, a decrease of 6% compared to $13,090,120, or 52% ofsales in 2004, and $7,785,071, or 40% of total sales in 2003.

Net income in 2005 was$2,915,269, a 20% increase compared to $2,428,688 in 2004, and net income perdiluted share was $0.53 in 2005, also a 20% increase compared to $0.44 for 2004.Our financial position as of December 31, 2005 reflects an increase inworking capital of $1,887,704 to $13,839,333, compared to $11,951,629 at December 31,2004.

**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 2005 financialresults and position included the $207,000 charge to earnings we recorded inthe first quarter 2005 to reflect the results of operations and assetimpairment write-down associated with the discontinuation of our Vaculokbusiness and the $240,000 charge we recorded in fourth quarter 2004 for theimpairment of intangible technology rights associated with our Lab Connections, Inc.subsidiary. Significant transactions, such as our sale of our vacuum insulatedpanel line, result from unique facts and circumstances and, given their nature,some of these items will likely not recur with similar materiality or impact onour continuing operations.

Our international sales have historically accountedfor a significant portion of our revenues, and despite the two percentage pointdecrease of our foreign sales to our total sales in 2005 compared to 2004, weexpect this trend to continue for the foreseeable future, especially as a resultof our acquisition of Lippke, which thus far has had, and is expected tocontinue to have, a positive impact on our sales and earnings, particularly onour foreign permeation products business.

Our research and development costs were approximately7% of our consolidated sales for 2005 and approximately 6% and 7% of ourconsolidated sales for 2004 and 2003, respectively. For the foreseeable future,we expect to spend, on an annual basis, approximately 6% to 8% of our sales onresearch and development.

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 the increase in our research and development spending,and other transactions or events such as those discussed later in thisManagement’s Discussion and Analysis may also have a material impact on ourfinancial results.

**Critical Accounting Policies**

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 

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Results of Operations is based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States of America. The preparationof these consolidated financial statements requires management to makeestimates and judgments that affect the reported amount of assets, liabilities,revenues and expenses, and related disclosure of contingent assets andliabilities. The Securities and Exchange Commission has defined a company’smost critical accounting policies as those that are most important to theportrayal of its financial condition and results of operations, and whichrequire the company to make its most difficult and subjective judgments, oftenas a result of the need to make estimates of matters that are inherentlyuncertain. Based on this definition, we have identified the following criticalaccounting policies. Although we believe that our estimates and assumptions arereasonable, they are based upon information available when they are made. Actualresults may differ significantly from these estimates under differentassumptions 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 sales returns. The reserve is based ona number of factors, including:  (1) ananalysis of customer accounts and (2) our historical experience withaccounts receivable write-offs and sales returns. The analysis includes the ageof the receivable, the financial condition of a customer or industry, andgeneral economic conditions. We believe our financial results could bematerially different if historical trends do not reflect actual results or ifeconomic conditions worsened for our customers. In the event we determined thata smaller or larger allowance for doubtful accounts is appropriate, we wouldrecord a credit or charge to selling, general and administrative expense in theperiod that we made such a determination. As of December 31, 2005 and2004, we had $192,446 and $222,040, respectively, reserved against our accountsreceivable for 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.

***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, Inc. subsidiary. Changes in our businessstrategies, changes in the economic environment in which we operate,competitive conditions, 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. 

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Specialwarranty reserves are also accrued for major rework campaigns. We periodicallyassess the adequacy of our warranty reserves based on changes in these factorsand record any necessary adjustments if actual claim experience indicates thatadjustments are necessary. Although we believe the likelihood to be relativelylow, warranty claims experience could be materially different from actualresults due to manufacturing changes that could impact product quality, achange in our warranty policy in response to industry trends, as yetunrecognized defects in products sold, or other factors. As of December 31,2005 and 2004, we had $327,015 and $352,634, respectively, accrued for futureestimated 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 ourconsolidated balance sheet.

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 historical levelsof income, estimates of future taxable income streams and the impact of taxplanning strategies. A valuation allowance is recorded to reduce deferred taxassets when it is determined that it is more likely than not that we would notbe able to realize all or part of its deferred tax assets. We carried novaluation allowance against our net deferred tax assets at either December 31,2005 or 2004.

**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.

**Results of Operations**

Thefollowing table sets forth the relationship between various components of ourresults of operations, stated as a percent of sales, for fiscal years ended December 31,2005, 2004 and 2003. Our historical financial data were derived from ourconsolidated financial statements and related notes included elsewhere in thisreport.

| ** **                                     | ** ** | **Percent of Sales** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|
| ** **                                     | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Sales                                          |       | 100.0                          |       | 100.0 |   | 100.0 |   |
| Cost of sales                                  |       | 43.9                           |       | 46.1 |   | 45.1 |   |
| Gross profit                                   |       | 56.1                           |       | 53.9 |   | 54.9 |   |
| Selling, general,  and administrative expenses |       | 32.6                           |       | 33.2 |   | 32.0 |   |
| Research and  development expenses             |       | 7.2                            |       | 5.5 |   | 6.7 |   |
| Operating income                               |       | 16.3                           |       | 15.2 |   | 16.2 |   |
| Other income                                   |       | 1.4                            |       | 0.5 |   | 0.7 |   |
| Income before income taxes                     |       | 17.7                           |       | 15.7 |   | 16.9 |   |
| Income taxes                                   |       | 5.4                            |       | 5.2 |   | 5.6 |   |
| Income from continuing operations              |       | 12.3                           |       | 10.5 |   | 11.3 |   |
| Loss from discontinued operations, net of tax  |       | (0.4                           | )          | (0.8 | ) | — |   |
| Net income                                     |       | 11.9                           |       | 9.7 |   | 11.3 |   |

 

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Thefollowing table summarizes total sales by product line for 2005, 2004 and 2003respectively:

| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Permeation  Products and Services                        |       | $                                           | 13,711,970 |   | $ | 14,290,547 |   | $ | 11,705,963 |   |
| Gas, Headspace  and Other Analyzer Products and Services |       | 8,875,847                                   |       | 8,083,951 |   | 6,098,348 |   |
| Other Instruments  and Services                          |       | 1,993,783                                   |       | 2,590,555 |   | 1,810,690 |   |
| Total Sales                                              |       | $                                           | 24,581,600 |   | $ | 24,965,053 |   | $ | 19,615,001 |   |

 

Thefollowing table sets forth the relationship between various components ofdomestic and foreign sales, for 2005, 2004 and 2003.

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Domestic Sales      |       | $                                           | 12,294,985 |   | $ | 11,874,933 |   | $ | 11,829,930 |   |
| Foreign Sales:      |       |                                        |       |   |   |   |   |
| Europe              |       | 5,802,034                                   |       | 6,440,144 |   | 2,467,457 |   |
| Asia                |       | 5,093,417                                   |       | 4,533,682 |   | 3,541,826 |   |
| Other               |       | 1,391,164                                   |       | 2,116,294 |   | 1,775,788 |   |
| Total foreign sales |       | 12,286,615                                  |       | 13,090,120 |   | 7,785,071 |   |
| Total Sales         |       | $                                           | 24,581,600 |   | $ | 24,965,053 |   | $ | 19,615,001 |   |

 

***Sales***

Sales were $24,581,600 in 2005, compared to$24,965,053 in 2004 and $19,615,001 in 2003. The $383,453, or 2% decrease insales in 2005 versus 2004 was primarily the result of the decreased domesticand foreign sales volume of our permeation products, foreign sales volume ofour weighing and pharmaceutical products, domestic sales volume of ourconsulting and analytical services and foreign sales volume of our samplepreparation products, offset somewhat by increases in the domestic and foreignsales volume of our headspace analyzer and gas analyzer products. These salesvolume decreases were generally the result of decreased demand. The impact ofprice increases was not significant in 2005. The 27% increase in sales from2003 to 2004 was primarily the result of the Lippke acquisition, which provided$3,824,782 in net incremental sales. On a product basis, the increase wasprimarily due to increased foreign sales volume of our permeation products,foreign sales volume of our leak detection products, domestic sales volume ofour gas analyzer products, foreign sales volume of our headspace analyzerproducts, and foreign sales volume of our weighing products, offset somewhat bydecreases in the domestic sales volume of our permeation products and domesticsales volume of our weighing products. These sales volume increases were generallythe result of increased demand. The impact of price increases in 2004 was notsignificant.

Domestic sales were$12,294,985, or 50% of total sales in 2005, an increase of 4% compared to$11,874,933, or 48% in 2004, and $11,829,930, or 60% in 2003. Foreign saleswere $12,286,615, or 50% of total sales in 2005, a decrease of 6% compared to$13,090,120, or 52% of sales in 2004, and $7,785,071, or 40% of total sales in2003.

*Permeation Productsand Services*

Sales of our permeationproducts were $13,711,970, $14,290,547 and $11,705,963, approximately 56%, 57%and 60% of our consolidated sales in 2005, 2004 and 2003, respectively. The$578,577, or 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. The increase in sales of $2,584,584 from 2003 to2004 

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included$1,962,576 in net incremental sales from Lippke into the European market. Webelieve that the domestic market for our permeation products, which is where weinitially introduced our permeation products when our company was founded, ismaturing, but that the market for our permeation products outside of the UnitedStates, where the demand for sophisticated packaging and other products iscontinuing to develop, and the use of our equipment is still in many areassomewhat limited, is likely to continue to grow. No assurance can be provided,however, that the international market for our permeation products will grow.

*Gas, Headspace andOther Analyzer Products and Services*

Sales of our gas analysis and monitoringinstrumentation products through our Baseline-MOCON, Inc. subsidiary were$3,959,426, $3,560,351 and $2,980,271, approximately 16%, 14% and 15% of ourconsolidated sales in 2005, 2004 and 2003, respectively. The $399,075, or 11%increase in sales in 2005 as compared to 2004 was primarily due to continuedcustomer acceptance of Baseline’s products in both the domestic and foreignmarkets. The $580,080, or 19% increase in sales in 2004 as compared to 2003 wasprimarily due to increased sales in 2004 of the piD-TECHTM photoionization detector on an OEM basis toother manufacturers. In order to reduce operating costs and increase operatingefficiencies, we moved the majority of Baseline’s production to our facility inMinneapolis, Minnesota in 2004.

Sales of our headspace analyzer and leak detectionproducts were approximately 15%, 13% and 10% of our consolidated sales, in2005, 2004 and 2003, respectively. The 16% increase in sales in 2005 compared to2004 was primarily due to continued increases in sales of hand-held headspaceanalyzer products, primarily into our domestic market. The 67% increase insales in 2004 compared to 2003 was primarily due to increases in foreign sales,the majority of which were attributable to net incremental sales from Lippke.

Sales of our weighing andpharmaceutical products were approximately 5%, 5% and 6% of our consolidatedsales in 2005, 2004 and 2003, respectively. Weighing and pharmaceutical productsales decreased 10% in 2005 versus 2004, primarily due to decreases in foreignsales, offset somewhat by increases in sales to domestic customers. Weighingand pharmaceutical product sales increased 10% in 2004 versus 2003, primarilydue to increases in foreign sales, offset somewhat by decreases in sales todomestic customers. The increase in foreign sales includes net incrementalsales from Lippke to customers in Europe, consisting primarily of commissionsearned relating to tablet inspection systems. Because of significantcompetition in the market for weighing products, we do not expect the sales ofour weighing and pharmaceutical products to increase in 2006.

*Other Instrumentsand Services*

Sales of our sample preparation products through LCIamounted to approximately 2% of our consolidated sales in each of the years2005, 2004 and 2003. Sales of sample preparation products decreased 17% in 2005as compared to 2004, due primarily to a decrease in foreign sales, offset by aslight increase in domestic sales. Sales of sample preparation productsincreased 53% in 2004 as compared to 2003, due primarily to an increase inforeign sales, particularly of a unit designed for high temperature polymeranalysis.

Sales of our gas chromatography analyzer productsthrough our Microanalytics Instrumentation Corp. (Microanalytics) subsidiarywere approximately 2%, 3% and 3% of our consolidated sales, in 2005, 2004 and2003, respectively. Sales in 2005 decreased 20% as compared to 2004 dueprimarily to decreased revenues associated with sales of Microanalytics’testing services in our domestic market. A 24% increase in sales in 2004 ascompared to 2003 was due primarily to increased revenues associated with salesof Microanalytics’ testing services. The majority of Microanalytics’ sales areto domestic customers.

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Consulting and analyticalservices (CAS) sales were approximately 2%, 3% and 4% of our consolidated salesin 2005, 2004 and 2003, respectively. The majority of CAS sales are to domesticcustomers.

***Gross Profit***

Our gross profits were$13,792,950, $13,449,162 and $10,761,490, approximately 56%, 54% and 55% of ourconsolidated sales, in 2005, 2004 and 2003, respectively. The 2005 gross profitmargin as a percentage of total sales was somewhat higher than 2004 dueprimarily to certain non-recurring costs incurred in 2004. These costs wereassociated with the transfer of the majority of our Baseline subsidiary’sproduction to our facility in Minneapolis, Minnesota, to expenses associatedwith the amortization of intangible assets acquired as part of the purchase ofLippke and to the scrapping of inventory that had become obsolete. However, in2005, our product mix included less permeation product sales, which on averagecarry a higher gross margin and thus somewhat reduced the overall gross marginfor 2005. The 2004 gross profit margin as a percentage of total sales wassomewhat lower than 2003 due primarily to the non-recurring costs noted above,offset somewhat by the product mix in 2004 including more permeation productsales, which on average carry a higher gross margin.

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

Selling, general andadministrative (SG&A) expenses in 2005 were $8,008,326, or 33% of sales,compared to $8,275,637, or 33% of sales in 2004, and $6,267,383, or 32% ofsales in 2003. The $267,311 decrease in SG&A expenses from 2004 to 2005 wasprimarily due to decreased number of sales personnel and also the expenseassociated with the LCI intangible technology rights one-time impairment chargein 2004. The increase in the dollar amount of SG&A expenses from 2003 to2004 was primarily due to the addition of Lippke’s SG&A expenses in 2004,to the expense associated with the LCI intangible technology rights one-timeimpairment charge in 2004, and to a lesser extent to recently enacted changesin securities laws and regulations more fully described under “Item1A. RiskFactors,” which increased certain general and administrative costs in 2004.

***Research and Development Expenses***

Research and development(R&D) expenses were $1,765,662, or approximately 7% of sales in 2005,compared to $1,371,700, or approximately 6% of sales in 2004, and $1,313,379,or approximately 7% of sales in 2003. The increase of $393,962 in 2005 comparedto 2004 is the result of our focus on business development opportunities in ourcore product areas. We believe continued R&D expenditures are necessary aswe develop new products to expand in our niche markets. For the foreseeablefuture, we expect to allocate on an annual basis approximately 6% to 8% of salesto research and development.

***Other Income***

Other income consistsprimarily of earnings on investments and currency exchange rate gains andlosses. Other income increased to $338,147 in 2005 from $123,448 in 2004 and$126,711 in 2003. The increase in 2005 compared to 2004 was primarily due togains on the exchange of foreign currency, higher average investment balancesand higher average investment yields and, to a lesser extent, gains on thesales of fixed assets. The slight decrease in 2004 compared to 2003 wasprimarily due to lower average investment balances and lower average investmentyields.

***Income Tax Expense***

Our provision for income taxes was 30.6% of incomebefore income taxes in 2005, 32.9% in 2004, and 33.0% in 2003. The provisionfor 2005 was favorably impacted as the result of a $156,000 reduction in 

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accrued income taxesrelated to the completion of an Internal Revenue Service examination. Thecurrent year provision would have been 34.2% without this adjustment. Based oncurrent operating conditions and income tax laws, we expect our core tax ratefor 2006 to be in the range of 33% to 35%.

The American Jobs CreationAct of 2004 (the Act) was passed in October 2004 and included numerous lawchanges, some of which affect our tax computations. The provisions of the Actinclude a new deduction for U.S. manufacturers, the repeal of theextraterritorial income exclusion and a provision regarding the repatriation offoreign earnings.

***Net Income***

Net income was $2,915,269in 2005 compared to $2,428,688 in 2004, and $2,211,305 in 2003. Diluted netincome per share was $0.53 in 2005 compared to $0.44 in 2004 and $0.40 in 2003.

***Liquidity and Capital Resources***

We have historicallyfinanced our operations and capital equipment requirements through cash flows generatedfrom operations. Total cash, cash equivalents and marketable securitiesincreased $1,332,650 during 2005 to $9,021,369 as of December 31, 2005,compared to $7,688,719 at December 31, 2004. Our working capital as of December 31,2005 increased $1,887,704 to $13,839,333, compared to $11,951,629 at December 31,2004. We believe that a combination of our existing cash, cash equivalents andmarketable securities, plus an expected continuation of cash flow fromoperations, will continue to be adequate to fund operations, capitalexpenditures, dividend payments, stock repurchases, and required earnoutpayments to the former parent company of Lippke, for at least the next twelvemonths. However, one of our strategic objectives is, as market and business conditionswarrant, to consider acquisitions of businesses, products or technologies. Wemay need to fund such activities, should they arise, with a portion of our cashbalances and debt and/or equity financing.

***Cash Flow***

*Cash Flows fromOperating Activities*

Our primary source offunds is cash provided by continuing operations. Cash flow from continuingoperations totaled $2,993,313, $5,304,232 and $3,438,183 in 2005, 2004 and2003, respectively. In 2005, cash provided by operating activities decreased by$2,310,919, or 44%, compared to 2004. This decrease was due primarily to theincreases in inventories and net deferred income taxes and the reduction inaccounts payable and other accrued expenses, offset somewhat by higher netincome. The 54% increase in 2004 compared to 2003 was primarily due to highernet income, the reduction in inventories and increases in accounts payable andother accrued expenses, offset somewhat by the increases in deferred incometaxes and trade accounts receivable.

*Cash Flows from InvestingActivities*

Cash used in investing activities from continuingoperations totaled $1,642,339 in 2005 as compared to $1,492,763 in 2004 and$3,008,278 in 2003. Net (purchases of)/proceeds from marketable securities were($1,096,578), $345,995 and ($2,312,942) in 2005, 2004 and 2003, respectively. Purchasesof property, plant and equipment totaled $232,360 in 2005, primarily foradditions of office, manufacturing and laboratory equipment, as compared to$521,133 and $118,254 in 2004 and 2003, respectively. We had no materialcommitments for capital expenditures as of December 31, 2005. We do notbelieve that any major property, plant and equipment expenditures are requiredto accommodate our current level of operations, and we expect purchases in 2006to be similar to the levels in 2005.

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Cash paid in acquisitions(net of cash acquired) in 2003 of $253,514 related to the purchase of theVaculok product line. The amounts in 2004 and 2005 of $1,265,648 and $325,825,respectively, were related to the purchase of Lippke. The 2005 amount resultedfrom an adjustment of the second earnout payment between the minimum amountoriginally recorded and the amount paid, based on actual earnings.

*Cash Flows fromFinancing Activities*

The primary use of cash in 2005, 2004 and 2003 was forthe payment of dividends to our shareholders, in the amounts of $1,502,284,$1,393,506 and $1,377,725, respectively. In addition, during 2004, we madefinal dividend payments of $449,087 to Lippke’s former parent 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. As of December 31, 2005, the entire$2,000,000 was remaining in the current authorization. During 2004 and 2003, wemade repurchases of our common stock totaling $900,360 and $627,606,respectively, related to a previous authorization.

Cash flow from theexercise of stock options was generated in the amounts of $399,599, $287,764and $149,999, for the years 2005, 2004 and 2003, respectively.

***Contractual Obligations***

Thefollowing table summarizes our future contractual cash obligations as of December 31,2005 (in thousands):

| ** **                          | ** ** | **Payments Due By Period** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**    | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3  years** | ** ** | **4-5  years** | ** ** | **After  5 years** | ** ** |
| Operating leases                    |       | $                                         | 1,453      |   |   | $ | 383 |   |   | $ | 934 |   | $ | 136 |   |   | $ | — |   |   |
| Total contractual cash  obligations |       | $                                         | 1,453      |   |   | $ | 383 |   |   | $ | 934 |   | $ | 136 |   |   | $ | — |   |   |
|                                     |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In connection with theLippke acquisition, we were obligated to make three future earnout payments toLippke’s former parent company based on the net profits of Lippke in each ofthe years 2004, 2005 and 2006. We made the first payment of $549,257 in thefirst quarter 2005, and expect to make the second payment of $433,339 in thefirst quarter 2006. The final payment is expected to be paid in the firstquarter 2007.

***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.

**New Accounting Pronouncements**

In December 2004, the Financial AccountingStandards Board (FASB) issued FASB Staff Position No. 109-1 “Applicationof FASB Statement No. 109, *Accountingfor Income Taxes,* to the Tax Deduction on Qualified ProductionActivities Provided by the American Jobs Creation Act of 2004” (FSP 109-1).FSP 109-1 provides accounting guidance for companies that will beeligible for a tax deduction resulting from “qualified production activitiesincome” as defined in the American Jobs Creation Act of 2004 (the Act). FSP 109-1requires this deduction be treated as a special deduction in accordance withSFAS 109, which does not require a revaluation of our U.S. deferredtax assets. We have applied the guidance in FSP 109-1 

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with regard to recognitionof this tax deduction during 2005. The application of FSP 109-1 did nothave a material impact on our results of operations or financial condition.

In November 2004, the FASB issued SFAS No. 151,“Inventory Costs,” an amendment of ARB No. 43, Chapter 4 (SFAS 151),to clarify that abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage) should be recognized as current periodcharges, and that fixed production overheads should be allocated to inventorybased on normal capacity of production facilities. This statement is effectivefor inventory costs incurred during fiscal years beginning after June 15,2005. Accordingly, we will adopt SFAS 151 in the fiscal year beginning January 1,2006. We do not expect the adoption of SFAS 151 to have a significantimpact on our results of operations or financial position.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123 (revised 2004) “Share-BasedPayments” (SFAS 123(R)), which is a revision of FASB Statement No. 123 “Accountingfor Stock-Based Compensation” (SFAS 123). This statement supersedes APB OpinionNo. 25, “Accounting for Stock Issued to Employees” (Opinion 25) which allowedcompanies to use the intrinsic value method of valuing share-based paymenttransactions and amends SFAS No. 95, “Statement of Cash Flows.” SFAS 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the income statement based on their fair values.Pro forma disclosure is no longer an alternative. SFAS 123(R) is effectiveat the beginning of the first annual period beginning after June 15, 2005.We expect to adopt SFAS 123(R) on January 1, 2006. The adoption ofSFAS 123(R)’s fair value method is expected to have an impact on our results ofoperations, though it will have no impact on our overall financial position.

SFAS 123(R) permits public companies to adopt itsrequirements using one of two methods. A “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS 123(R) for all share-based payments grantedafter the effective date and (b) based on the requirements of SFAS 123 forall awards granted to employees prior to the effective date of SFAS 123(R) thatremain unvested on the effective date. A “modified retrospective” method whichincludes the requirements of the modified prospective method described above, butalso permits entities to restate based on the amounts previously recognizedunder SFAS 123 for purposes of pro forma disclosures either (a) all priorperiods presented or (b) prior interim periods of the year of adoption. Weexpect to adopt SFAS 123(R) effective January 1, 2006 using themodified prospective method.

The impact of adoption of SFAS 123(R) cannot beaccurately predicted at this time since it will depend on levels of share-basedpayments granted in the future. However, had we adopted SFAS 123(R) inprior periods, the impact of the standard would have approximated the impact ofSFAS 123 as described in the disclosure of pro forma net income and earningsper share in Note 1 to our consolidated financial statements. Futurecompensation cost, net of tax effects, related to unvested stock compensationas of December 31, 2005 is expected to be approximately $173,000 in 2006,$63,000 in 2007, $25,000 in 2008 and $7,000 in 2009 (as valued and calculatedunder SFAS 123 for pro forma disclosures). Actual share-based compensationexpense in future periods will be dependent upon amounts and value of futureawards. SFAS 123(R) also requires the benefits of tax deductions in excessof recognized compensation cost to be reported as a financing cash flow, ratherthan as an operating cash flow as required under current literature. Thisrequirement will reduce net operating cash flows and increase net financingcash flows in periods after adoption. While we cannot estimate what thoseamounts will be in the future (because they depend on, among other things, whenemployees exercise stock options), there were no amounts of operating cashflows recognized in prior periods for such excess tax deductions in 2003, 2004and 2005.

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As permitted by SFAS 123,we currently account for share-based payments using Opinion 25’s intrinsicvalue method of valuing share-based payment transactions and, as such,generally recognize no compensation cost for employee stock options.

**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 Currency Exchange Risk**

Because our products aremanufactured or sourced primarily from the United States, a stronger U.S.dollar generally has a negative impact on our results from operations outsideof the United States while a weaker dollar generally has a positive effect. Wecurrently sell our products and services in United States dollars or the localcurrency of our foreign subsidiary (euros). Accordingly, our foreign operationsexpose us to foreign currency exchange risk when the euro currency results ofoperations are translated to United States dollars. While we historically havenot experienced any material foreign currency translation losses, we may engagein hedging activity in the future to minimize this risk. Our net investment inforeign subsidiary translated into U.S. dollars is not hedged. Any changes inforeign currency exchange rates 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 QUARTERLY FINANCIAL DATA (UNAUDITED)**

**(inthousands, except per share data)**

| ** **                    | ** ** | **Quarter** | ** ** |
|-------------------------------|------------|-------------|------------|
| ** **                    | ** ** | **1st**     | ** ** | **2nd** | ** ** | **3rd** | ** ** | **4th** | ** ** |
| **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 |   |
| **2004**                      |       |        |       |   |   |   |   |   |   |
| Sales                         |       | $           | 5,716      |   | $ | 6,091 |   | $ | 6,350 |   | $ | 6,808 |   |
| Gross profit                  |       | $           | 3,027      |   | $ | 3,383 |   | $ | 3,499 |   | $ | 3,540 |   |
| Net income                    |       | $           | 336        |   | $ | 630 |   | $ | 728 |   | $ | 735 |   |
| Net income per common  share: |       |        |       |   |   |   |   |   |   |
| Basic                         |       | $           | 0.06       |   | $ | 0.12 |   | $ | 0.14 |   | $ | 0.14 |   |
| Diluted                       |       | $           | 0.06       |   | $ | 0.12 |   | $ | 0.13 |   | $ | 0.13 |   |

 

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

None.

**ITEM 9A.**        CONTROLSAND PROCEDURES

**Evaluationof Disclosure 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 annualreport on Form 10-K. Based on that evaluation, our Chief ExecutiveOfficer and 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.

**Changesin Internal Control Over Financial Reporting**

There was no change in ourinternal control over financial reporting that occurred during our fourthquarter of the year ended December 31, 2005 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 OF THE REGISTRANT

The information required under Item 10 of this reportis to be contained under the headings “Election of Directors—Information AboutNominees,” “Election of Directors—Other Information About Nominees,” “Electionof Directors—Information About the Board of Directors and its Committees” and “Section 16(a) BeneficialOwnership Reporting Compliance” in our definitive proxy statement to be filedwith the SEC with respect to our next annual meeting of shareholders, whichinvolves the election of directors and is incorporated herein by reference, or,if such proxy statement is not filed with the SEC within 120 days after the endof the fiscal year covered by this report, such information will be filed aspart of an amendment to this report not later than the end of the 120-dayperiod.

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

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 provide, free ofcharge, a copy of our Code of Ethics to any person who requests a copy. Torequest 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 “Election ofDirectors—Director Compensation” and “Executive Compensation and Other Benefits”in our definitive proxy statement to be filed with the SEC with respect to ournext annual meeting of shareholders, which involves the election of directorsand is incorporated herein by reference, or, if such proxy statement is notfiled with the SEC within 120 days after the end of the fiscal year covered bythis report, such information will be filed as part of an amendment to thisreport not later than the end of the 120-day period.

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

The information requiredunder Item 12 of this report is to be contained under the headings “PrincipalShareholders and Beneficial Ownership of Management” and “ExecutiveCompensation and Other Benefits—Equity Compensation Plan Information” 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.

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

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 

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the endof the fiscal year covered by this report, such information will be filed aspart of an amendment to this report not later than the end of the 120-dayperiod.

**ITEM 14.**         PRINCIPALACCOUNTANT FEES AND SERVICES

The information required under Item 14 of this reportis to be contained under the headings “Ratification of Selection of IndependentRegistered Public Accounting Firm—Audit, Audit-Related, Tax and Other Fees” and“Ratification of Selection of Independent Registered Public Accounting Firm—AuditorFees Pre-Approval Policy” in our definitive proxy statement to be filed withthe SEC with respect to our next annual meeting of shareholders, which involvesthe election 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 of anamendment to this report not later than the end of the 120-day period.

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**PART IV**

**ITEM 15.**         EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

**(a)   1.      Financial Statements**

The following consolidatedfinancial statements of MOCON, Inc. and its subsidiaries are includedherein:

|                                                                                                             |   | **Page** |
|------------------------------------------------------------------------------------------------------------------|--------|----------|
| Report of Independent  Registered Public Accounting Firm                                                         |   | F-1      |
| Consolidated Balance  Sheets as of December 31, 2005 and 2004                                               |   | F-2      |
| Consolidated Statements  of Income for the years ended December 31, 2005, 2004 and 2003                     |   | F-3      |
| Consolidated Statements  of Stockholders’ Equity for the years ended December 31, 2005, 2004 and  2003 |   | F-4      |
| Consolidated Statements  of Cash Flows for the years ended December 31, 2005, 2004 and 2003                 |   | F-5      |
| Notes to Consolidated Financial Statements                                                                       |   | F-6      |

 

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**2.****                 FinancialStatement Schedules**

The following financialstatement schedules are included herein and should be read in conjunction withthe consolidated financial statements referred to above:

**Report of Independent Registered Public AccountingFirm**

The Board of Directors and StockholdersMOCON, Inc.:

Under date of February 24, 2006, we reported onthe consolidated balance sheets of MOCON, Inc. and subsidiaries as of December 31,2005 and 2004, and the related consolidated statements of income, stockholders’equity and cash flows for each of the years in the three-year period ended December 31,2005, as contained in this annual report on Form 10-K for the year2005. In connection with our audits of the aforementioned consolidatedfinancial statements, we also audited the related consolidated financialstatement schedule. This financial statement schedule is the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thisfinancial statement schedule based on our audits.

In our opinion, suchfinancial statement schedule, when considered in relation to the basicconsolidated financial statements taken as a whole, presents fairly, in allmaterial respects, the information set forth therein.

|                   | /s/ KPMG LLP |
|------------------------|--------------|
| Minneapolis, Minnesota |         |
| February 24, 2006 |         |

 

32

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**Financial Statement Schedule:**

**II—Valuationand Qualifying Accounts**

All other schedules are omitted as the requiredinformation is inapplicable or the information is presented in our consolidatedfinancial statements or related notes.

**SCHEDULE IIMOCON, INC. AND SUBSIDIARIESValuation and Qualifying Accounts**

| Description                                        | ** ** | ** ** | ** ** | **Balance at  beginning  of year** | ** ** | **Charged  to costs and  expenses** | ** ** | **Deductions** | ** ** | **Balance at  end of year** | ** ** |
|----------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Year ended December 31,  2003                 |       |       |       |                                         |       |                                          |       |           |       |                                       |       |   |   |   |   |
| Allowance for doubtful  accounts and sales returns |       | $          | 202,074    |                                         |       | 43,500                                        |       |           |       | 1,897                                      |       |   |   | 243,677 |   |   |
| 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 |   |   |

----

(1)          Includes adjustment foracquisition of Lippke.

33

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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 20, 2006, 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.             1992 Stock OptionPlan (incorporated by reference to Exhibit 10.5 to our Annual Report on Form 10-Kfor the fiscal year ended December 31, 1991 (File No. 000-09273)).

B.              1998 Stock OptionPlan, as amended, (incorporated by reference to our Definitive Proxy Statement onForm DEF-14A filed on April 9, 2002 (File No. 000-09273)).

C.              Form ofExecutive Severance Agreement (incorporated by reference to Exhibit 10.13to our Annual Report on Form 10-K for the fiscal year ended December 31,2000 (File No. 000-09273)).

D.             2003 CompensationCommittee resolution setting forth the MOCON Incentive Pay Plan for 2003 andsubsequent years (incorporated by reference to Exhibit 10.14 to our AnnualReport on Form 10-K for the fiscal year ended December 31, 2002(File No. 000-09273)).

E.              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)).

F.               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)).

G.            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)).

H.            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)).

I.                  Description ofExecutive Officer Compensation Arrangements (filed herewith).

**(b)****         Exhibits**

The exhibits tothis Annual Report on Form 10-K are listed in the Exhibit Index.

**(c)****          FinancialStatement Schedules**

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

34

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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 31, 2006 |   | 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 31, 2006.

| ** ** | 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/ 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                                                                     |

 

35

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**MOCON, INC. AND SUBSIDIARIESConsolidated Financial StatementsDecember 31, 2005, 2004 and 2003**

**Table of 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     |       |     | F-4        |   |   |
| Consolidated Statements of Cash Flows                    |       |     | F-5        |   |   |
| Notes to Consolidated Financial Statements               |       |     | F-6        |   |   |

 

36

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**Reportof Independent 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, 2005 and2004, and the related consolidated statements of income, stockholders’ equityand cash flows for each of the years in the three-year period ended December 31,2005. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated 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 consolidatedfinancial statements referred to above present fairly, in all materialrespects, the financial position of MOCON, Inc. and subsidiaries as of December 31,2005 and 2004, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2005, inconformity with U.S. generally accepted accounting principles.

/s/ KPMG LLP

Minneapolis, MinnesotaFebruary 24, 2006

F-1

----

**MOCON, INC. AND SUBSIDIARIESConsolidated Balance SheetsDecember 31, 2005 and 2004**

| ** **                                                                                                                                       | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Assets**                                                                                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                  |       |       |       |       |       |
| Cash and cash  equivalents                                                                                                                       |       | $          | 2,889,323  |       | 2,648,879  |   |
| Marketable securities,  current                                                                                                                  |       | 5,961,793  |       | 4,808,840  |       |
| Trade accounts  receivable, less allowance for doubtful accounts of   $192,446 in 2005 and $222,040 in 2004                                      |       | 4,237,240  |       | 4,297,884  |       |
| Other receivables                                                                                                                                |       | 124,403    |       | 44,941     |       |
| Inventories                                                                                                                                      |       | 4,057,514  |       | 3,778,376  |       |
| Prepaid expenses                                                                                                                                 |       | 313,042    |       | 362,607    |       |
| Deferred income taxes                                                                                                                            |       | 582,948    |       | 435,864    |       |
| Assets held for sale                                                                                                                             |       | 90,809     |       | 346,150    |       |
| Total current assets                                                                                                                             |       | 18,257,072 |       | 16,723,541 |       |
| Marketable securities,  noncurrent                                                                                                               |       | 170,253    |       | 231,000    |       |
| Property, plant, and  equipment, net                                                                                                             |       | 1,551,883  |       | 1,830,641  |       |
| Other assets:                                                                                                                                    |       |       |       |       |       |
| Software development  costs, net of accumulated amortization of $943,743 in 2005 and $766,490 in  2004                                           |       | 62,678     |       | 239,931    |       |
| Goodwill                                                                                                                                         |       | 2,641,599  |       | 2,315,774  |       |
| Technology rights and  other intangibles, net                                                                                                    |       | 808,266    |       | 1,030,847  |       |
| Other                                                                                                                                            |       | 165,137    |       | 143,803    |       |
| Total other assets                                                                                                                               |       | 3,677,680  |       | 3,730,355  |       |
| **Total  assets**                                                                                                                                |       | $          | 23,656,888 |       | 22,515,537 |   |
| **Liabilities and Stockholders’  Equity**                                                                                                   |       |       |       |       |       |
| Current liabilities:                                                                                                                             |       |       |       |       |       |
| Accounts payable                                                                                                                                 |       | $          | 1,847,133  |       | 2,107,268  |   |
| Accrued compensation and  vacation                                                                                                               |       | 995,528    |       | 1,024,958  |       |
| Other accrued expenses                                                                                                                           |       | 440,510    |       | 457,640    |       |
| Accrued product  warranties                                                                                                                      |       | 327,015    |       | 352,634    |       |
| Accrued income taxes                                                                                                                             |       | 402,285    |       | 455,718    |       |
| Dividends payable                                                                                                                                |       | 405,268    |       | 373,694    |       |
| Total current  liabilities                                                                                                                       |       | 4,417,739  |       | 4,771,912  |       |
| Obligations to former  employees                                                                                                                 |       | 93,735     |       | 112,720    |       |
| Minimum earnout payable                                                                                                                          |       | 107,514    |       | 247,708    |       |
| Deferred income taxes                                                                                                                            |       | 239,282    |       | 182,651    |       |
| Total non-current  liabilities                                                                                                                   |       | 440,531    |       | 543,079    |       |
| Total liabilities                                                                                                                                |       | 4,858,270  |       | 5,314,991  |       |
| Stockholders’ equity:                                                                                                                       |       |       |       |       |       |
| Capital  stock—undesignated—authorized 3,000,000 shares                                                                                |       | —     |       | —     |       |
| Common stock—$0.10 par  value. Authorized 22,000,000 shares; issued   and outstanding 5,403,573 shares in 2005 and 5,338,489 shares in 2004 |       | 540,357    |       | 533,849    |       |
| Capital in excess of par  value                                                                                                                  |       | 592,796    |       | 199,705    |       |
| Retained earnings                                                                                                                                |       | 17,759,120 |       | 16,377,709 |       |
| Accumulated other  comprehensive (loss) income                                                                                                   |       | (93,655    | )          | 89,283     |       |
| Total stockholders’  equity                                                                                                                 |       | 18,798,618 |       | 17,200,546 |       |
| Commitments and contingencies (note 7)                                                                                                           |       |       |       |       |       |
| **Total  liabilities and stockholders’ equity**                                                                                             |       | $          | 23,656,888 |       | 22,515,537 |   |

 

See accompanying notes to consolidated financial statements.

F-2

----

**MOCON, INC. AND SUBSIDIARIESConsolidated Statements ofIncomeYears ended December 31, 2005, 2004 and 2003**

| ** **                                           | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Sales:                                               |       |       |       |       |       |       |       |
| Products                                             |       | $          | 22,876,304 |       | 23,024,648 |       | 17,733,898 |   |
| Consulting services                                  |       | 1,705,296  |       | 1,940,405  |       | 1,881,103  |       |
| Total sales                                          |       | 24,581,600 |       | 24,965,053 |       | 19,615,001 |       |
| Cost of sales:                                       |       |       |       |       |       |       |       |
| Products                                             |       | 9,857,885  |       | 10,516,518 |       | 7,936,183  |       |
| Consulting services                                  |       | 930,765    |       | 999,373    |       | 917,328    |       |
| Total cost of sales                                  |       | 10,788,650 |       | 11,515,891 |       | 8,853,511  |       |
| Gross profit                                         |       | 13,792,950 |       | 13,449,162 |       | 10,761,490 |       |
| Selling, general,  and administrative expenses       |       | 8,008,326  |       | 8,275,637  |       | 6,267,383  |       |
| Research and  development expenses                   |       | 1,765,662  |       | 1,371,700  |       | 1,313,379  |       |
| Operating income                                     |       | 4,018,962  |       | 3,801,825  |       | 3,180,728  |       |
| Other income                                         |       | 338,147    |       | 123,448    |       | 126,711    |       |
| Income before income taxes                           |       | 4,357,109  |       | 3,925,273  |       | 3,307,439  |       |
| Income taxes                                         |       | 1,334,627  |       | 1,291,109  |       | 1,091,604  |       |
| Income from continuing operations                    |       | 3,022,482  |       | 2,634,164  |       | 2,215,835  |       |
| Loss from  discontinued operations, net of tax       |       | (107,213   | )          | (205,476   | )          | (4,530     | )          |
| Net income                                           |       | $          | 2,915,269  |       | 2,428,688  |       | 2,211,305  |   |
| Basic net income per  common share:                  |       |       |       |       |       |       |       |
| Income from continuing operations                    |       | $          | 0.56       |       | 0.49       |       | 0.41       |   |
| Loss from discontinued operations                    |       | (0.02      | )          | (0.04      | )          | —     |       |
| Basic net income per common share                    |       | 0.54       |       | 0.45       |       | 0.41       |       |
| Basic weighted  average common shares outstanding:   |       | 5,370,335  |       | 5,351,106  |       | 5,410,010  |       |
| Diluted net income per  common share:                |       |       |       |       |       |       |       |
| Income from continuing operations                    |       | $          | 0.55       |       | 0.48       |       | 0.40       |   |
| Loss from discontinued operations                    |       | (0.02      | )          | (0.04      | )          | —     |       |
| Diluted net income per common share                  |       | 0.53       |       | 0.44       |       | 0.40       |       |
| Diluted weighted  average common shares outstanding: |       | 5,534,280  |       | 5,471,420  |       | 5,503,911  |       |

 

See accompanying notes to consolidated financial statements.

F-3

----

**MOCON, INC. AND SUBSIDIARIESConsolidated Statementsof Stockholders’ EquityYears ended December 31, 2005, 2004 and 2003**
|                                                                   | ** ** | ** **            | ** ** | ** **          | ** ** | ** **         | ** ** | ** **   | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|---------------------|------------|--------------------|------------|--------------|------------|------------------------|------------|------------|------------|
| ** **                                                        | ** ** | **Common stock** | ** ** | **Capital in** | ** ** | ** **         | ** ** | **other**    | ** ** | ** **             | ** ** |
| ** **                                                        | ** ** | **Number**            | ** ** | ** **          | ** ** | **excess of** | ** ** | **Retained** | ** ** | **comprehensive**      | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | **of shares**    | ** ** | **Amount**          | ** ** | **par value** | ** ** | **earnings** | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
| Balance, December 31, 2002                                   |       | 5,470,189             |       | $                   | 547,019    |               |       | 45,567       |       |                   | 15,785,601 |       |       | 1,635 |   |   | 16,379,822 |   |
| Stock options exercised                                           |       | 28,501                |       | 2,850               |       |               | 167,375    |         |       | —                 |       |       | —     |   |   | 170,225 |   |
| Purchase and retirement of common stock                           |       | (92,501               | )          | (9,250              | )          |               | (94,609    | )            |       | (540,342               | )          |       | —     |   |   | (644,201 | ) |
| Dividends declared ($.26 per share)                               |       | —                |       | —              |       |               | —     |         |       | (1,404,036             | )          |       | —     |   |   | (1,404,036 | ) |
| Net income                                                        |       | —                |       | —              |       |               | —     |         |       | 2,211,305              |       |       | —     |   |   | 2,211,305 |   |
| Adjustment for unrealized gain on marketable equity  securities   |       | —                |       | —              |       |               | —     |         |       | —                 |       |       | 1,583      |   |   | 1,583 |   |
| Comprehensive income                                              |       |                  |       |                |       |               |       |         |       |                   |       |       |       |   |   | 2,212,888 |   |
| Balance, December 31, 2003                                   |       | 5,406,189             |       | 540,619             |       |               | 118,333    |         |       | 16,052,528             |       |       | 3,218      |   |   | 16,714,698 |   |
| Stock options exercised                                           |       | 46,300                |       | 4,630               |       |               | 283,134    |         |       | —                 |       |       | —     |   |   | 287,764 |   |
| Purchase and retirement of common stock                           |       | (114,000              | )          | (11,400             | )          |               | (201,762   | )            |       | (687,198               | )          |       | —     |   |   | (900,360 | ) |
| Dividends declared ($.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 |   |
|                                                                   |            |                       |            |                     |            |                    |            |              |            |                        |            |            |            |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

F-4

----

**MOCON, INC. AND SUBSIDIARIESConsolidated Statementsof Cash FlowsYears ended December 31, 2005, 2004 and 2003**

| ** **                                                                                                                          | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Cash flows from operating activities:                                                                                               |       |       |       |       |       |       |       |
| Net income                                                                                                                          |       | $          | 2,915,269  |       | 2,428,688  |       | 2,211,305  |   |
| Loss from  discontinued operations, net of tax                                                                                      |       | 107,213    |       | 205,476    |       | 4,530      |       |
| Income from  continuing operations                                                                                                  |       | 3,022,482  |       | 2,634,164  |       | 2,215,835  |       |
| Adjustments to reconcile  income from continuing operations to net cash provided by operating  activities of continuing operations: |       |       |       |       |       |       |       |
| (Gain) loss on  disposition of long-term assets                                                                                     |       | (23,408    | )          | 7,375      |       | 35,494     |       |
| Depreciation and  amortization                                                                                                      |       | 914,503    |       | 1,393,140  |       | 983,033    |       |
| Impairment of  technology rights and other intangibles                                                                              |       | —     |       | 240,000    |       | —     |       |
| Deferred income  taxes                                                                                                              |       | (187,096   | )          | (502,202   | )          | (183,998   | )          |
| Changes in operating  assets and liabilities, net of effect of acquisitions:                                                        |       |       |       |       |       |       |       |
| Trade accounts  receivable                                                                                                          |       | (63,932    | )          | (152,696   | )          | 422,517    |       |
| Other receivables                                                                                                                   |       | (80,144    | )          | 40,711     |       | (12,826    | )          |
| Inventories                                                                                                                         |       | (339,529   | )          | 489,635    |       | 75,266     |       |
| Prepaid expenses                                                                                                                    |       | 46,540     |       | (641       | )          | (24,195    | )          |
| Accounts payable                                                                                                                    |       | (120,810   | )          | 615,418    |       | (157,960   | )          |
| Accrued  compensation and vacation                                                                                                  |       | (6,236     | )          | 63,627     |       | 145,348    |       |
| Other accrued  expenses                                                                                                             |       | (196,171   | )          | 313,326    |       | (4,871     | )          |
| Accrued product  warranties                                                                                                         |       | (16,813    | )          | 19,280     |       | 12,706     |       |
| Accrued income  taxes                                                                                                               |       | 43,927     |       | 143,095    |       | (68,166    | )          |
| Net cash provided  by continuing operations                                                                                         |       | 2,993,313  |       | 5,304,232  |       | 3,438,183  |       |
| Net cash provided  by (used in) discontinued operations                                                                             |       | 114,580    |       | (168,003   | )          | (39,806    | )          |
| Net cash provided  by operating activities                                                                                          |       | 3,107,893  |       | 5,136,229  |       | 3,398,377  |       |
| Cash flows from investing activities:                                                                                               |       |       |       |       |       |       |       |
| Purchases of  marketable securities                                                                                                 |       | (6,769,402 | )          | (4,519,996 | )          | (5,303,838 | )          |
| Proceeds from  sales or maturities of marketable securities                                                                         |       | 5,672,824  |       | 4,865,991  |       | 2,990,896  |       |
| Cash paid in  acquisitions, net of cash acquired                                                                                    |       | (325,825   | )          | (1,265,648 | )          | (253,514   | )          |
| Purchases of  property, plant and equipment                                                                                         |       | (232,360   | )          | (521,133   | )          | (118,254   | )          |
| Proceeds from sale  of fixed assets                                                                                                 |       | 93,012     |       | —     |       | —     |       |
| Purchases and  development of software                                                                                              |       | —     |       | —     |       | (205,127   | )          |
| Purchases of  patents and trademarks                                                                                                |       | (59,254    | )          | (45,320    | )          | (111,950   | )          |
| Other                                                                                                                               |       | (21,334    | )          | (6,657     | )          | (6,491     | )          |
| Net cash used in  continuing operations                                                                                             |       | (1,642,339 | )          | (1,492,763 | )          | (3,008,278 | )          |
| Net cash used in  discontinued operations                                                                                           |       | —     |       | (6,127     | )          | (217,540   | )          |
| Net cash used in  investing activities                                                                                              |       | (1,642,339 | )          | (1,498,890 | )          | (3,225,818 | )          |
| Cash flows from financing activities:                                                                                               |       |       |       |       |       |       |       |
| Proceeds from the  exercise of stock options                                                                                        |       | 399,599    |       | 287,764    |       | 149,999    |       |
| Purchase and  retirement of common stock                                                                                            |       | —     |       | (900,360   | )          | (627,606   | )          |
| Dividends paid to  former parent company of Paul Lippke Handels                                                                     |       | —     |       | (449,087   | )          | —     |       |
| Dividends paid to  MOCON shareholders                                                                                               |       | (1,502,284 | )          | (1,393,506 | )          | (1,377,725 | )          |
| Net cash used in  financing activities                                                                                              |       | (1,102,685 | )          | (2,455,189 | )          | (1,855,332 | )          |
| Effect of exchange  rate changes on cash and cash equivalents                                                                       |       | (122,425   | )          | 66,892     |       | —     |       |
| Net increase  (decrease) in cash and cash equivalents                                                                               |       | 240,444    |       | 1,249,042  |       | (1,682,773 | )          |
| Cash and cash equivalents:                                                                                                          |       |       |       |       |       |       |       |
| Beginning of year                                                                                                                   |       | 2,648,879  |       | 1,399,837  |       | 3,082,610  |       |
| End of year                                                                                                                         |       | $          | 2,889,323  |       | 2,648,879  |       | 1,399,837  |   |
| Supplemental disclosures of cash flow information:                                                                                  |       |       |       |       |       |       |       |
| Cash paid during  the year for income taxes                                                                                         |       | $          | 1,419,415  |       | 1,010,222  |       | 1,341,163  |   |
| Supplemental schedule of  noncash investing and financing activities:                                                               |       |       |       |       |       |       |       |
| Dividends accrued                                                                                                                   |       | $          | 405,268    |       | 373,694    |       | 350,891    |   |
| Unrealized holding  (loss) gain on available-for-sale securities                                                                    |       | (4,372     | )          | (5,978     | )          | 1,583      |       |
| Noncash purchase  and retirement of common stock                                                                                    |       | 50,937     |       | —     |       | 16,595     |       |
| Noncash exercise  of stock options                                                                                                  |       | 50,937     |       | —     |       | 20,226     |       |

 

See accompanying notes to consolidated financial statements.

F-5

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2005, 2004 and 2003**

**(1)**          Summaryof Significant Accounting Policies

MOCON, Inc.(the Company) operated in a single industry segment: the development,manufacturing and marketing of measurement, analytical, monitoring, samplepreparation 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. The following is asummary of the significant accounting policies used in the preparation of theCompany’s consolidated financial statements.

***(a)***    Principlesof 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)***     ForeignCurrency Translation

Thefinancial statements for operations outside the United States are maintained intheir local currency. All assets and liabilities of our foreign subsidiary aretranslated to United States dollars at period-end exchange rates, while revenueand expense accounts are translated at the average exchange rates during theperiod transactions 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)***      Statementsof Cash Flows

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

Cashequivalents consist of short-term investments which are readily convertible tocash.

***(d)***     MarketableSecurities

Marketable securities at December 31, 2005consist 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.

F-6

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

Premiumsand discounts are amortized or accreted over the life of the relatedavailable-for-sale security as an adjustment to yield. Dividend and interestincome are recognized when earned. Realized gains and losses for securitiesclassified as available-for-sale are included in income and are derived usingthe specific identification method for determining the cost of securities sold.

***(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 and Software 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, “Accounting for 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.

F-7

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

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

***(h)***    IncomeTaxes

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.

***(i)***       Useof 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)***        Impairmentof Long-Lived Assets and Long-Lived Assets to be Disposed Of

TheCompany reviews its long-lived assets and certain identifiable intangibles forimpairment annually or whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to future undiscounted net cash flows expected to be generated bythe asset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount of the assetsexceeds the fair value of the assets. Assets to be disposed of are reported atthe lower of the carrying amount or fair value less costs to sell.

***(k)***     FairValue of Financial Instruments

TheCompany’s financial instruments are recorded in its consolidated balance sheet.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)***        RevenueRecognition

TheCompany recognizes revenue when it is realized or realizable and earned. Inaccordance with the Securities and Exchange Commission Staff AccountingBulletin No. 104 (SAB 104), *RevenueRecognition,*we consider revenue realized or realizable whenpersuasive evidence of an arrangement exists, the product has been shipped orthe services have been provided to the customer, title and risk of loss ofproducts has passed to the customer, the sales price is fixed or determinable,and collectibility is reasonably assured. Our terms are F.O.B. shipping pointwith no right of return, and customer acceptance of our products is notrequired. Our revenue recognition policy does not differ among our variousproduct lines, our marketing venues, or various geographic destinations. We donot have distributors who stock our 

F-8

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**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

equipment. We do not offer rebates, price protection,or other similar incentives, and discounts when offered are recorded as areduction in revenue.

***(m)***      AdvertisingCosts

TheCompany incurs advertising costs associated with trade shows, print advertisingand brochures. Such costs are charged to expense as incurred. Advertisingexpense was $480,000, $432,000 and $420,000 in 2005, 2004 and 2003,respectively.

***(n)***    NetIncome Per Common Share

Basicnet income per common share is computed by dividing net income by the weightedaverage of common shares outstanding during the year. Diluted net income pershare is computed by dividing net income by the weighted average of common anddilutive potential common shares outstanding during the year.

***(o)***     Stock-BasedEmployee Compensation

TheCompany uses the intrinsic-value method for employee stock-based compensationpursuant to Accounting Principles Board Opinion No. 25(Opinion 25), “Accounting forStock Issued to Employees.” Under the guidelines of Opinion 25,compensation cost for stock-based employee compensation plans is recognizedbased on the difference, if any, between the quoted market price of the stockon the date of grant and the amount an employee must pay to acquire the stock.The Company has adopted the disclosure-only provisions for employee stock-basedcompensation and the fair-value method for non-employee stock-basedcompensation of Statement of Financial Accounting Standards No. 123(SFAS 123), “Accounting forStock-based Compensation.” Accordingly, no compensation cost has been recognized with respect tothe Company’s stock option plans. Had compensation cost for these plans beendetermined based on the fair value methodology prescribed by SFAS 123, theCompany’s net income and net income per common share would have been reduced tothe pro forma amounts indicated below:

| ** **                                                                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income—as  reported                                                                                                                  |       | $        | 2,915,269  |     | 2,428,688  |     | 2,211,305  |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (141,097 | )          | (196,203 | )          | (253,317 | )          |
| Net income—pro  forma                                                                                                                    |       | $        | 2,774,172  |     | 2,232,485  |     | 1,957,988  |   |
| Net income per  common share—as reported:                                                                                                |       |     |       |     |       |     |       |
| Basic                                                                                                                                         |       | $        | 0.54       |     | 0.45       |     | 0.41       |   |
| Diluted                                                                                                                                       |       | 0.53     |       | 0.44     |       | 0.40     |       |
| Net income per common  share—pro forma:                                                                                                  |       |     |       |     |       |     |       |
| Basic                                                                                                                                         |       | 0.52     |       | 0.42     |       | 0.36     |       |
| Diluted                                                                                                                                       |       | 0.50     |       | 0.41     |       | 0.36     |       |

 

F-9

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

Thepro forma amounts may not be representative of the effects on reported netincome for future years. The fair value of each option grant is estimated onthe date of grant using the binomial option-pricing model with the followingweighted average assumptions used for grants in 2005, 2004 and 2003:

| ** **                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Dividend yield             |       |     | 3.0        | %        |       |     | 3.1        | % |   |   | 3.3 | % |   |
| Expected  volatility       |       |     | 31         | %        |       |     | 32         | % |   |   | 37 | % |   |
| Risk-free  interest rate   |       |     | 4.0        | %        |       |     | 3.4        | % |   |   | 3.0 | % |   |
| Expected lives (in  years) |       |     | 7.9        |     |       |     | 7.8        |   |   |   | 7.9 |   |   |

 

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123 (revised 2004) “Share-BasedPayments” (SFAS 123(R)), which is a revision of SFAS 123. This statementsupersedes Opinion 25 which allowed companies to use the intrinsic value methodof valuing share-based payment transactions and amends SFAS Statement No. 95,“Statement of Cash Flows.”  SFAS 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the income statement based on their fair values.Pro forma disclosure is no longer an alternative. This standard will beeffective for the Company starting with the first quarter of 2006. The adoptionof SFAS 123(R)’s fair value method is expected to have an impact on the Company’sresults of operations, though it will have no impact on the Company’s overallfinancial position.

SFAS 123(R) permits public companies to adopt itsrequirements using one of two methods. The Company plans to adopt the “modifiedprospective” transition method, whereby compensation cost related to unvestedawards as of the effective date will be recognized as calculated for pro formadisclosures under SFAS 123, and costs related to new awards will be recognizedin accordance with SFAS 123(R). The Company also plans to continue using theBlack-Scholes option-pricing model to value option grants. Actual share-basedcompensation expense in future periods will be dependent upon amounts and valueof future awards.

Aspermitted by SFAS 123, we currently account for share-based payments usingOpinion 25’s intrinsic value method of valuing share-based payment transactionsand, as such, generally recognize no compensation cost for employee stockoptions.

***(p)***     Reclassifications

Certain 2004 and 2003amounts have been reclassified to conform to the 2005 presentation.

F-10

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

**(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, 2005 and 2004 were as follows:

| ** **              | ** ** | **2005**      | ** ** |
|-------------------------|------------|---------------|------------|
| ** **              | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **    | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **Amortized** | ** ** | **holding** | ** ** | **holding** | ** ** | **Fair** | ** ** |
| ** **              | ** ** | **cost**      | ** ** | **gains** | ** ** | **losses** | ** ** | **value** | ** ** |
| Available for sale:     |       |          |       |   |   |   |   |   |   |   |   |   |   |
| Municipal bonds         |       | $             | 2,385,177  |   |   | 152 |   |   |   | (6,301 | ) |   | 2,379,028 |   |
| Certificates of deposit |       | 3,754,001     |       |   | 69 |   |   |   | (1,052 | ) |   | 3,753,018 |   |
|                    |       | $             | 6,139,178  |   |   | 221 |   |   |   | (7,353 | ) |   | 6,132,046 |   |

 

| ** **              | ** ** | **2004**      | ** ** |
|-------------------------|------------|---------------|------------|
| ** **              | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **    | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | ** ** | ** ** |
| ** **              | ** ** | **Amortized** | ** ** | **holding** | ** ** | **holding** | ** ** | **Fair** | ** ** |
| ** **              | ** ** | **cost**      | ** ** | **gains** | ** ** | **losses** | ** ** | **value** | ** ** |
| Available for sale:     |       |          |       |   |   |   |   |   |   |   |   |   |   |
| Municipal bonds         |       | $             | 1,996,790  |   |   | 972 |   |   |   | (3,864 | ) |   | 1,993,898 |   |
| Certificates of deposit |       | 3,045,810     |       |   | 175 |   |   |   | (43 | ) |   | 3,045,942 |   |
|                    |       | $             | 5,042,600  |   |   | 1,147 |   |   |   | (3,907 | ) |   | 5,039,840 |   |

 

There were no gross realized gains or losses for theyears ended December 31, 2005, 2004 and 2003.

Maturitiesof investment securities classified as available-for-sale were as follows at December 31,2005 and 2004:

| ** **          | ** ** | **2005**      | ** ** | **2004**  | ** ** |
|---------------------|------------|---------------|------------|-----------|------------|
| ** **          | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **          | ** ** | **cost**      | ** ** | **value** | ** ** | **cost** | ** ** | **value** | ** ** |
| Available-for-sale: |       |          |       |      |       |   |   |   |   |
| Due within one year |       | $             | 5,968,720  |      | 5,961,793  |   | 4,811,600 |   | 4,808,840 |   |
| Due after one year  |       | 170,458       |       | 170,253   |       | 231,000 |   | 231,000 |   |
|                |       | $             | 6,139,178  |      | 6,132,046  |   | 5,042,600 |   | 5,039,840 |   |

 

**(3)**          Inventories

Themajor components of inventories at December 31, 2005 and 2004 were asfollows:

| ** **        | ** ** | **2005**   | ** ** | **2004**  | ** ** |
|-------------------|------------|------------|------------|-----------|------------|
| Finished products |       | $          | 656,587    |      | 717,507    |   |
| Work-in-process   |       | 1,511,314  |       | 1,395,364 |       |
| Raw materials     |       | 1,889,613  |       | 1,665,505 |       |
|              |       | $4,057,514 |       | 3,778,376 |       |
|                   |            |            |            |           |            |  |

 

F-11

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

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

Property,plant and equipment at December 31, 2005 and 2004 consisted of thefollowing:

| ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **Estimated**         | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2005**   | ** ** | **2004**   | ** ** | **useful lives** | ** ** |
| Land                                 |       | $          | 200,000    |       | 200,000    |                  | —     |   |
| Buildings                            |       | 445,833    |       | 445,833    |       | 27 years              |       |
| Machinery and  equipment             |       | 3,517,045  |       | 3,639,415  |       | 3 to 10 years         |       |
| Office equipment                     |       | 979,199    |       | 1,066,399  |       | 2 to 15 years         |       |
| Leasehold  improvements              |       | 665,014    |       | 658,775    |       | 1 to 5 years          |       |
| Vehicles                             |       | 205,351    |       | 186,038    |       | 3 to 5 years          |       |
| Total property, plant, and equipment |       | 6,012,442  |       | 6,196,460  |       |                  |       |
| Less accumulated  depreciation       |       | (4,460,559 | )          | (4,365,819 | )          |                  |       |
| Net property,  plant, and equipment  |       | $          | 1,551,883  |       | 1,830,641  |                  |       |   |

 

Depreciation andamortization of property, plant and equipment charged to income was $486,495,$550,382 and $529,542 for the years ended December 31, 2005, 2004 and2003, respectively.

**(5)**          Goodwilland Other Intangible Assets

We adopted SFAS 142effective January 1, 2002. As required by SFAS 142, we performed atransitional goodwill impairment assessment to determine whether there was anindication that goodwill was impaired at the date of adoption. In connectiontherewith, the Company determined that it consisted of a single reporting unitand determined the Company’s fair value and compared it to the Company’scarrying amount. As of January 1, 2002, the Company’s fair value exceededits carrying amount. Therefore, there was no indication that goodwill wasimpaired, and the Company did not record any transitional impairment loss. Inaddition to its transitional goodwill impairment assessment, the Company alsocompleted its annual impairment tests during the fourth quarters of 2005 and2004 and determined there was no impairment.

*Goodwill*

As of December 31,2005, goodwill amounted to $2,641,599, which includes the addition in 2005 of$325,825 related to the acquisition of Paul Lippke Handels-GmbH. As of December 31,2004, goodwill amounted to $2,315,774, which included a 2004 addition of$968,979 related to the acquisition of Paul Lippke Handels-GmbH.

*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, andforecasted operating results indicated that the subsidiary’s undiscounted cashflows were not adequate to allow LCI sufficient cash flow to fully realize theremaining intangible technology rights value. In accordance with Statement ofFinancial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,”the Company recorded an impairment charge of $240,000. The charge, recorded inselling, general and administrative 

F-12

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

expenses,is equal to the difference between the carrying amount of the intangibletechnology rights and its fair value as estimated, based on discountedprojected cash flows. As further explained in Note 15, LCI was sold in February 2006.

*Other IntangibleAssets*

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

| ** **                 | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------|------------|-------------------------------------------------|------------|
| ** **                 | ** ** | **Carrying  Amount**                            | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| Patents                    |       | $                                               | 614,594    |   | $ | (249,713 | ) | $ | 364,881 |   |
| Trademarks and  tradenames |       | 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 |   |

 

| ** **                 | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------|------------|-------------------------------------------------|------------|
| ** **                 | ** ** | **Carrying  Amount**                            | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| Patents                    |       | $                                               | 548,748    |   |   | $ | (221,288 | ) |   | $ | 327,460 |   |
| Trademarks and  tradenames |       | 392,015                                         |       |   | (90,413 | ) |   | 301,602 |   |
| Technology rights          |       | 184,008                                         |       |   | (120,481 | ) |   | 63,527 |   |
| Other intangibles          |       | 715,043                                         |       |   | (376,785 | ) |   | 338,258 |   |
|                       |       | $                                               | 1,839,814  |   |   | $ | (808,967 | ) |   | $ | 1,030,847 |   |

 

Amortization expense was $292,486, $439,073 and$180,403 in 2005, 2004 and 2003, respectively.

Estimated amortizationexpense for the fiscal years 2006 to 2010 and thereafter is $275,797, $164,603,$107,871, $45,032, $29,411 and $90,170, respectively.

**(6)**          Warranty

The Company provides a warranty for most of itsproducts. Warranties are for periods ranging from ninety days to one year, andcover parts and labor for non-maintenance repairs, at our 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.

F-13

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

Warrantyprovisions and claims for the years ended December 31, 2005, 2004 and 2003were as follows:

|                                    | ** ** | **Balance at** | ** ** | ** **       | ** ** | ** **     | ** ** | **Balance**     | ** ** |
|------------------------------------|------------|---------------------|------------|------------------|------------|----------------|------------|-----------------|------------|
| ** **                         | ** ** | **beginning**       | ** ** | **Warranty**     | ** ** | **Warranty**   | ** ** | **at end** | ** ** |
| **Years:**                         | ** ** | ** **          | ** ** | **of year** | ** ** | **Provisions** | ** ** | **Claims**      | ** ** | **of year** | ** ** |
| Year ended December 31,  2003 |       |                |       |             |       |           |       |            |       |   |   |   |   |
| Allowance for product  warranties  |       | $                   | 266,933    |             |       | 336,346        |       |            |       | 323,640 |   |   | 279,639 |   |
| 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 |   |
|                                    |            |                     |            |                  |            |                |            |                 |            |  |  |  |  |  |  |  |

----

(1)          Includesadjustment for acquisition of Lippke.

**(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 $382,765, $487,776 and $443,929 in 2005, 2004 and 2003, respectively.

Thefollowing is a schedule of future minimum lease payments, excluding charges foroperating costs, for operating leases as of December 31, 2005:

| Year ending December 31: |   |    |      |
|-----------------------------------------|--------|---------|-----------|
| 2006                                    |   | $       | 383,129   |   |
| 2007                                    |   | 358,971 |      |
| 2008                                    |   | 303,960 |      |
| 2009                                    |   | 271,446 |      |
| 2010                                    |   | 135,723 |      |
| Thereafter                              |   | —  |      |
|                                    |   | $       | 1,453,229 |   |

 

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

The Company has entered into severance agreements withthree executives that require payment of two times their annual salary if theyare terminated within 24 months after a change of control occurs or uponthe occurrence of other events as described in the agreements.

F-14

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

**(8)**          IncomeTaxes

Incomefrom continuing operations before income taxes was as follows:

| ** **                  | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|-----------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Income before income  taxes |       |      |       |      |       |      |       |
| Domestic                    |       | $         | 3,283,000  |      | 3,217,000  |      | 3,307,000  |   |
| Foreign                     |       | 1,074,000 |       | 708,000   |       | —    |       |
| Total                       |       | 4,357,000 |       | 3,925,000 |       | 3,307,000 |       |
|                             |            |           |            |           |            |           |            |  |

 

Theprovision for income taxes consists of the following:

| ** **                  | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|-----------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Current tax expense:        |       |      |       |      |       |      |       |
| Federal                     |       | $         | 909,000    |      | 1,149,000  |      | 1,143,000  |   |
| State                       |       | 147,000   |       | 131,000   |       | 133,000   |       |
| Foreign                     |       | 466,000   |       | 513,000   |       | —    |       |
| Total current expense       |       | 1,522,000 |       | 1,793,000 |       | 1,276,000 |       |
| Deferred tax  expense:      |       |      |       |      |       |      |       |
| Federal                     |       | (124,000  | )          | (256,000  | )          | (177,000  | )          |
| State                       |       | (10,000   | )          | (21,000   | )          | (7,000    | )          |
| Foreign                     |       | (53,000   | )          | (225,000  | )          | —    |       |
| Total deferred expense      |       | (187,000  | )          | (502,000  | )          | (184,000  | )          |
| Provision for income  taxes |       | $         | 1,335,000  |      | 1,291,000  |      | 1,092,000  |   |

 

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

| ** **                                       | ** ** | **Percentage of pretax income for years ended  December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| 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       |       | 2.0                                                                |       | 2.0 |   | 2.5 |   |
| Export incentives                                |       | (2.1                                                               | )          | (3.5 | ) | (3.8 | ) |
| Domestic manufacturing deduction                 |       | (0.8                                                               | )          | — |   | — |   |
| Effect of foreign operations                     |       | 1.1                                                                |       | 1.3 |   | — |   |
| Tax-exempt investment earnings                   |       | (0.4                                                               | )          | (0.3 | ) | (0.2 | ) |
| Reduction of tax contingency accrual             |       | (3.6                                                               | )          | — |   | — |   |
| Other                                            |       | 0.4                                                                |       | (0.9 | ) | 0.5 |   |
| Effective income  tax rate                       |       | 30.6                                                               | %          | 32.6 | % | 33.0 | % |

 

F-15

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

Thetax effect of significant temporary differences representing deferred taxassets and liabilities at December 31, 2005 and 2004 were as follows:

| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets:           |       |     |       |     |       |
| Allowance for doubtful accounts |       | $        | 68,000     |     | 78,000     |   |
| Inventory costs                 |       | 72,000   |       | 63,000   |       |
| Inventory accrual               |       | 248,000  |       | 174,000  |       |
| Warranty accrual                |       | 102,000  |       | 111,000  |       |
| Other accruals                  |       | 104,000  |       | 97,000   |       |
| Total deferred tax assets       |       | 594,000  |       | 523,000  |       |
| Deferred tax liabilities:       |       |     |       |     |       |
| Fixed assets and intangibles    |       | (250,000 | )          | (270,000 | )          |
| Total deferred tax liabilities  |       | (250,000 | )          | (270,000 | )          |
| Net deferred tax  asset         |       | $        | 344,000    |     | 253,000    |   |

 

The Company has determined that establishing avaluation allowance for the deferred tax assets is not required since it ismore likely than not that the deferred tax assets will be realized throughfuture taxable income.

As of December 31,2005, there were approximately $1,100,000 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)**          Stockholders’Equity

From time to time, the Company’s board of directorsauthorizes the repurchase of common stock. On November 9, 2005, theCompany’s board of directors authorized the repurchase of up to $2,000,000 inshares of the Company’s common stock. As of December 31, 2005, $2,000,000was remaining in this authorization.

As of December 31, 2005, the Company has reserved75,193 shares of common stock for options that are still available for grantunder the Company’s stock option plans, and 850,449 shares for options thathave been granted but have not yet been exercised.

Under the stock option plans, option exercise pricesare 100% of the market value of the common stock at the date of grant, exceptfor incentive options granted under the 1992 and 1998 plans to persons owningmore than 10% of the Company’s stock, in which case the option price is 110% ofthe market value, and nonqualified options granted under the 1992 and 1998plans, which may be granted at option prices no less than 25% of the marketvalue. Exercise periods are generally for five to ten years. Certain of theplans allow for the granting of nonqualified stock options. Upon the exerciseof these nonqualified options, the Company may realize a compensation deductionallowable for income tax purposes. The after-tax effect of these tax deductionsis included in the accompanying consolidated financial statements as anaddition to capital in excess of par value.

F-16

----

**MOCON, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

Informationregarding the Company’s stock option plans for 2005, 2004 and 2003 was asfollows:

| ** **                                   | ** ** | **Shares** | ** ** | **Weighted   average   exercise   price** | ** ** |
|----------------------------------------------|------------|------------|------------|----------------------------------------------------------|------------|
| Options  outstanding, December 31, 2002 |       | 686,587    |       |                                                     | $          | 6.89 |   |   |
| Granted                                      |       | 174,250    |       |                                                     | 8.08       |   |   |
| Exercised                                    |       | (28,501    | )          |                                                     | 5.97       |   |   |
| Canceled or expired                          |       | (21,924    | )          |                                                     | 6.86       |   |   |
| 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 |   |   |

 

| ** **                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Weighted average  fair value of options, granted during the year        |       | $        | 2.00       |     | 2.58       |     | 2.46       |   |
| Weighted average  exercise price of options, exercisable at end of year |       | 7.47     |       | 7.24     |       | 7.06     |       |
| Options exercisable, at  end of year                                    |       | 674,562  |       | 636,943  |       | 563,921  |       |
|                                                                         |            |          |            |          |            |          |            |  |

 

At December 31, 2005, the weighted averageremaining contractual life of outstanding options was 6.7 years.

**(10)**                       NetIncome Per Common 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, 2005, 2004 and 2003:

| ** **                                                              | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|-------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Weighted shares  of common stock outstanding—basic                 |       | 5,370,335 |       | 5,351,106 |       | 5,410,010 |       |
| Weighted shares  of common stock assumed upon exercise of stock options |       | 163,945   |       | 120,314   |       | 93,901    |       |
| Weighted shares of  common stock outstanding—diluted               |       | 5,534,280 |       | 5,471,420 |       | 5,503,911 |       |

 

Outstanding stock options totaling 150,020, 157,120and 64,695 at December 31, 2005, 2004 and 2003, have been excluded fromthe net income per common share calculations because the effect on net incomeper common share would not have been dilutive.

F-17

----

**MOCON, INC. AND SUBSIDIARIES  Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

**(11)        Product Line, Geographical andSignificant Customer Information**

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

Thefollowing table summarizes total sales by product line for 2005, 2004 and 2003respectively:

| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Permeation  Products and Services                        |       | $                                           | 13,711,970 |   | $ | 14,290,547 |   | $ | 11,705,963 |   |
| Gas, Headspace  and Other Analyzer Products and Services |       | 8,875,847                                   |       | 8,083,951 |   | 6,098,348 |   |
| Other Instruments  and Services                          |       | 1,993,783                                   |       | 2,590,555 |   | 1,810,690 |   |
| Total Sales                                              |       | $                                           | 24,581,600 |   | $ | 24,965,053 |   | $ | 19,615,001 |   |

 

Thefollowing table summarizes total sales, based upon the country to which salesto external customers were made for fiscal years 2005, 2004 and 2003. 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,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Domestic Sales      |       | $                                           | 12,294,985 |   | $ | 11,874,933 |   | $ | 11,829,930 |   |
| Foreign Sales:      |       |                                        |       |   |   |   |   |
| Europe              |       | 5,802,034                                   |       | 6,440,144 |   | 2,467,457 |   |
| Asia                |       | 5,093,417                                   |       | 4,533,682 |   | 3,541,826 |   |
| Other               |       | 1,391,164                                   |       | 2,116,294 |   | 1,775,788 |   |
| Total foreign sales |       | 12,286,615                                  |       | 13,090,120 |   | 7,785,071 |   |
| Total Sales         |       | $                                           | 24,581,600 |   | $ | 24,965,053 |   | $ | 19,615,001 |   |

 

The Company’s products are marketed outside of NorthAmerica through various independent representatives. Our Lippke subsidiary inGermany, which was acquired effective January 1, 2004, accounted for 23%,24% and 10% of sales in 2005, 2004 and 2003, respectively. See Note 13. Inaddition, one independent representative accounted for approximately 8% ofconsolidated sales in each of the years 2005, 2004 and 2003.

No single customer accounted for 10% or more of ourconsolidated revenues in any of the fiscal years ended December 31, 2005,2004 and 2003.

**(12)        Savings and Retirement Plan**

The Company has a 401(k) Savings and RetirementPlan covering substantially all of its employees. The Company provides matchingcontributions in accordance with the plan. The Company’s contributions to thisplan in 2005, 2004 and 2003 were $78,265, $72,749 and $75,862, respectively.

F-18

----

**MOCON, INC. AND SUBSIDIARIES  Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

**(13)        Acquisitions**

EffectiveJanuary 1, 2004, we acquired Paul Lippke Handels-GmbH Prozess- undLaborsysteme (Lippke) which is located in Germany. Lippke had been the primarydistributor of our products in Europe for approximately 30 years, and alsoserved in the capacity of distributor or agent for several companies inaddition to MOCON. The acquisition of Lippke provides us with a direct presencein Europe. We acquired all of the shares of Lippke for a base purchase price of$802,688. In addition, we are obligated to make three earnout payments toLippke’s former parent company based on the net profits of Lippke in each ofthe years 2004, 2005 and 2006, with a minimum payment amount of 100,000 eurosper year which is included in the financial statements. The first payment wasmade during the first quarter of 2005 in the amount of $549,257, and we expectto make the second payment in the first quarter of 2006 in the amount of  $433,339. The purchase price of theacquisition 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 Price Allocation**

Thepurchase price was allocated to the tangible and identifiable intangible assetsacquired and liabilities assumed based on their estimated fair values at theacquisition date. The following table summarizes the estimated fair values ofthe assets acquired 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 the purchase price was based, inpart, on a third-party valuation of the fair value of identifiable intangibleassets, and certain property, plant and equipment. Other non-currentliabilities includes deferred income taxes of $264,683 and obligations payableto two former employees totaling $107,080. The cost of the identifiableintangible assets will be amortized on a straight-line basis over 

F-19

----

**MOCON, INC. AND SUBSIDIARIES  Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004 and 2003**

periods of less than 1 to5 years. We expect that substantially all of the amount allocated to goodwillwill not be deductible for tax purposes.

Theresults of Lippke have been included in the consolidated financial statementssince the date of acquisition of January 1, 2004. Unaudited pro formaresults of operations for the year ended December 31, 2003 are includedbelow. Such pro forma information assumes that the above acquisition hadoccurred as of January 1, 2003. This summary is not necessarily indicativeof what our results of operations would have been had we been a combined entityduring the period ended December 31, 2003, nor does it purport torepresent results of operations for any future periods. Pro forma adjustmentsconsist primarily of amortization of intangible assets.

| ** **                    | ** ** | **2003**             | ** ** |
|-------------------------------|------------|----------------------|------------|
| ** **                    | ** ** | **As reported** | ** ** | **Proforma** | ** ** |
| Net sales                     |       | $                    | 19,615,001 |   | 22,692,713 |   |
| Net income                    |       | 2,211,305            |       | 2,830,468 |   |
| Net income per  common share: |       |                 |       |   |   |
| Basic                         |       | 0.41                 |       | 0.52 |   |
| Diluted                       |       | 0.40                 |       | 0.51 |   |
|                               |            |                      |            |  |  |  |

 

**(14)        Discontinued Operations**

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

Pursuant to the saleagreement, the Company received an up-front payment of $125,000, along with theright to receive up to an additional $60,000 upon the occurrence of certainpost-closing events. As a result of the sale, the Company recognized a pre-taxgain on disposal of approximately $69,000. When combined with additionaloperating expenses, this produced a pre-tax loss of approximately $169,000 forthe year which is reported as discontinued operations in the consolidated statementsof income. After tax, the total loss recognized from discontinued operationswas approximately $107,000.

**(15)**                       SubsequentEvent

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 $517,000in exchange for all the outstanding shares of LCI. As a result of the sale, theCompany will have recognized an after-tax gain of approximately $90,000 in thefirst quarter ended March 31, 2006. The sale agreement calls for theCompany to enter into and to negotiate the terms of a one-year manufacturingagreement with the purchaser, on terms mutually acceptable to both parties.

Sales of sample preparation products sold through LCIwere approximately $505,000, $606,000 and $396,000 for 2005, 2004 and 2003,respectively.

F-20

----

**MOCON,INC.**

**EXHIBITINDEX TO ANNUAL REPORT ON FORM 10-KFOR THE YEAR ENDED DECEMBER 31, 2005**

| **Exhibit No.** | ** ** | ** ** | **Exhibit** | ** **                                                                                                  | ** ** | ** **                                                                                                                                                          | **Method of Filing** | ** ** |
|----------------------|------------|------------|-------------|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------|------------|
|                 | 3.1        |       |        | Restated Articles of Incorporation of  MOCON, Inc.                                                     |       | Incorporated by reference to Exhibit 3.2 to our  Annual Report on Form 10-K for the fiscal year ended  January 31, 1984 (File No. 000-09273)    |
|                 | 3.2        |       |        | Amendment to Restated Articles of Incorporation of  MOCON, Inc., effective May 27, 1987           |       | Incorporated by reference to Exhibit 3.1-1 to our Annual Report on  Form 10-K for the fiscal year ended December 31, 1987 (File  No. 000-09273) |
|                 | 3.3        |       |        | Amendment to Restated Articles of Incorporation of  MOCON, Inc., effective June 28, 1991          |       | Incorporated by reference to Exhibit 4.3 to our Registration Statement  on Form S-8 filed on August 15, 1991 (File No. 33-42255)                |
|                 | 3.4        |       |        | Amendment to Restated Articles of Incorporation of  MOCON, Inc., effective May 21, 1998           |       | Incorporated by reference to Exhibit 3.4 to our Annual Report on  Form 10-K for the fiscal year ended December 31, 1998 (File  No. 000-09273)   |
|                 | 3.5        |       |        | Amendment to Restated Articles of Incorporation of  MOCON, Inc., effective May 26, 1999           |       | Incorporated by reference to Exhibit 3.5 to our Annual Report on  Form 10-K for the fiscal year ended December 31, 1999 (File  No. 000-09273)   |
|                 | 3.6        |       |        | 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 |   |   | 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 |   |   | 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 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) |
|   | 10.7 |   |   | 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)                              |
|   | 10.8 |   |   | 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) |
|   | 10.9 |   |   | 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)                      |

----

 

|   | 10.10 |   |   | 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)                      |
|--------|-------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | 10.11 |   |   | 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)                    |
|   | 10.12 |   |   | 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)                    |
|   | 10.13 |   |   | 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)                        |
|   | 10.14 |   |   | 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) |
|   | 10.15 |   |   | 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) |
|   | 10.16 |   |   | Description of Executive Officer Compensation  Arrangements                                                                                                                                      |   | Filed herewith                                                                                                                                                      |
|   | 21.1  |   |   | Subsidiaries of MOCON, Inc.                                                                                                                                                                 |   | Filed herewith                                                                                                                                                      |
|   | 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                                                                                                                                                  |

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|   | 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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