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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
______________________
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003
-------------
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
COMMISSION FILE NUMBER 000-27267
I/OMAGIC CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
Nevada 88-0290623
---------------- -------------
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)
1300 Wakeham, Santa Ana, CA 92705
----------------------------------
(Address of Principal Executive Offices)
(714) 953-3000
--------------
(Registrant's Telephone Number, Including Area Code)
Not Applicable
--------------
(Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report)
Indicate by check whether the registrant: (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [ X ] No [ ]
Indicate by check whether the registrant is an accelerated filer (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ]
As of August 18, 2003, the number of shares of the issuer's common stock issued
and outstanding was 4,529,672.
I/OMAGIC CORPORATION AND SUBSIDIARY
TABLE OF CONTENTS
Page
Number
------
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets - December 31, 2002 and
June 30, 2003 (unaudited) 3
Consolidated Statements of Income - for the three and
six months ended June 30, 2002 and 2003 (unaudited) 5
Consolidated Statements of Cash Flows - for the six
months ended June 30, 2002 and 2003 (unaudited) 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Conditions
and Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk 25
Item 4. Controls and Procedures 25
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 26
Item 2. Changes in Securities and Use of Proceeds 26
Item 3. Defaults Upon Senior Securities 26
Item 4. Submission of Matters to a Vote of Security Holders 26
Item 5. Other Information 26
Item 6. Exhibits and Reports on Form 8-K 26
SIGNATURES 27
EXHIBITS FILED WITH THIS FORM 10-Q 28
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2002 AND JUNE 30, 2003 (UNAUDITED)
ASSETS
DECEMBER 31, JUNE 30,
2002 2003
------------- -----------
(unaudited)
CURRENT ASSETS
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . $ 7,320,143 $ 4,150,705
Accounts receivable, net of allowance for doubtful
accounts of $2,135,660 and $3,450,191 (unaudited). . . . . . 19,055,201 11,853,960
Inventory, net of allowance for obsolete inventory of $1,046,812
and $485,083 (unaudited) . . . . . . . . . . . . . . . . . . 8,240,280 10,778,181
Inventory in transit . . . . . . . . . . . . . . . . . . . . . . . 675,000 -
Prepaid expenses and other current assets. . . . . . . . . . . . . 28,955 242,976
------------- -----------
Total current assets. . . . . . . . . . . . . . . . . . . . . 35,319,579 27,025,822
PROPERTY AND EQUIPMENT, net. . . . . . . . . . . . . . . . . . . . 1,059,067 689,827
TRADEMARK, net of accumulated amortization
of $4,292,308 and $4,581,676 (unaudited) . . . . . . . . . . . . . 5,353,371 5,064,004
OTHER ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,952 25,952
------------- -----------
TOTAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . . . $ 41,757,969 $32,805,605
============= ===========
The accompanying notes are an integral part of these financial statements.
3
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2002 AND JUNE 30, 2003 (UNAUDITED)
LIABILITIES AND STOCKHOLDERS' EQUITY
DECEMBER 31, JUNE 30,
2002 2003
-------------- -------------
(unaudited)
CURRENT LIABILITIES
Line of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,372,827 $ 5,005,827
Accounts payable and accrued expenses. . . . . . . . . . . . . . . 7,285,246 3,591,315
Accounts payable - related parties . . . . . . . . . . . . . . . . 2,607,278 7,379,971
Reserves for customer returns and allowances . . . . . . . . . . . 765,898 255,128
Current portion of settlement payable. . . . . . . . . . . . . . . 3,000,000 1,000,000
-------------- -------------
Total current liabilities. . . . . . . . . . . . . . . . . . . . 24,031,249 17,232,241
SETTLEMENT PAYABLE, net of current portion . . . . . . . . . . . . 1,000,000 -
Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . 25,031,249 17,232,241
-------------- -------------
STOCKHOLDERS' EQUITY
Preferred Stock
10,000,000 shares authorized, $0.001 par value,
0 and 0 (unaudited) shares issued and outstanding. . . . . . . . - -
Class A common stock, $0.001 par value,
100,000,000 shares authorized,
4,529,672 and 4,529,672 (unaudited) shares issued and outstanding. 4,530 4,530
Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . 31,557,988 31,557,988
Treasury stock, 4,226 and 13,493 (unaudited) shares, at cost. . . . (42,330) (126,014)
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . (14,793,468) (15,863,140)
-------------- -------------
Total stockholders' equity . . . . . . . . . . . . . . . . . . . 16,726,720 15,573,364
-------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY . . . . . . . . . . $ 41,757,969 $ 32,805,605
============== =============
The accompanying notes are an integral part of these financial statements.
4
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE SIX AND THREE MONTHS ENDED JUNE 30, 2003 AND 2002
(UNAUDITED)
SIX MONTHS ENDED JUNE 30, THREE MONTHS ENDED JUNE 30,
2003 2002 2003 2002
--------------------------- ----------------------- ----------------- ---------------
(unaudited) (unaudited) (unaudited) (unaudited)
NET SALES. . . . . . . . . . . . . . . $ 29,856,920 $ 40,806,067 $ 12,792,717 $ 14,086,435
COST OF SALES. . . . . . . . . . . . . 25,509,803 35,912,214 10,882,406 13,237,805
--------------------------- ---------------------- ----------------- ---------------
GROSS PROFIT . . . . . . . . . . . . . 4,347,117 4,893,853 1,910,311 848,630
--------------------------- ---------------------- ----------------- ---------------
OPERATING EXPENSES
Selling, marketing, and advertising. . 664,604 703,963 328,687 306,763
General and administrative . . . . . . 3,934,729 4,093,122 2,477,890 2,104,354
Depreciation and amortization. . . . . 712,585 781,227 355,287 221,723
--------------------------- ---------------------- ----------------- ---------------
Total operating expenses. . . . . . 5,311,918 5,578,312 3,161,864 2,632,840
--------------------------- ---------------------- ----------------- ---------------
LOSS FROM OPERATIONS . . . . . . . . . (964,801) (684,459) (1,251,553) (1,784,210)
--------------------------- ---------------------- ----------------- ---------------
OTHER INCOME (EXPENSE)
Interest income. . . . . . . . . . . . 271 112 105 112
Interest expense . . . . . . . . . . . (155,653) (192,140) (52,086) (117,369)
Other income (expense) . . . . . . . . 49,315 (73,305) 26,052 (63,567)
--------------------------- ---------------------- ----------------- ---------------
Total other income (expense) (106,067) (265,333) (25,929) (180,824)
--------------------------- ---------------------- ----------------- ---------------
LOSS BEFORE INCOME TAXES . . . . . . . (1,070,868) (949,792) (1,277,482) (1,965,034)
PROVISION FOR (BENEFIT FROM)
INCOME TAXES . . . . . . . . . . . . . (1,198) 500,000 1,456 500,000
--------------------------- ---------------------- ----------------- ---------------
NET LOSS . . . . . . . . . . . . . . . ($1,069,670) ($1,449,792) ($1,278,938) ($2,465,034)
=========================== ====================== ================= ===============
BASIC AND DILUTED EARNINGS PER SHARE . ($0.24) ($0.32) ($0.28) ($0.54)
=========================== ====================== ================= ===============
BASIC AND DILUTED WEIGHTED-
AVERAGE SHARES OUTSTANDING . . . . . . 4,529,672 4,529,672 4,529,672 4,529,672
=========================== ====================== ================= ===============
The accompanying notes are an integral part of these financial statements.
5
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2003 AND 2002
(UNAUDITED)
SIX MONTHS ENDED JUNE 30,
2003 2002
--------------------------- --------------
(unaudited) (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net (loss). . . . . . . . . . . . . . . . . . . . . . . ($1,069,670) ($1,449,792)
Adjustments to reconcile net income to net cash
provided by (used in) operating activities
Depreciation and amortization . . . . . . . . . . . . . 423,217 154,263
Amortization of trademarks. . . . . . . . . . . . . . . 289,368 626,964
Allowance for doubtful accounts . . . . . . . . . . . . 2,288,018 287,127
Reserve for customer returns and allowances . . . . . . (510,770) (1,194,563)
Reserve for obsolete inventory. . . . . . . . . . . . . (561,729) 73,719
Deferred income tax . . . . . . . . . . . . . . . . . . - 500,000
(Increase) decrease in
Accounts receivable . . . . . . . . . . . . . . . . . . 4,913,224 12,688,401
Inventory . . . . . . . . . . . . . . . . . . . . . . . (1,301,173) (2,394,632)
Prepaid expenses and other current assets . . . . . . . (214,021) 786,354
Increase (decrease) in
Accounts payable and accrued expenses . . . . . . . . . (3,693,936) (5,184,417)
Accounts payable - related parties. . . . . . . . . . . 4,772,693 (1,714,093)
Settlement payable. . . . . . . . . . . . . . . . . . . (3,000,000) -
--------------------------- -------------
Net cash provided by (used in) operating activities . . 2,335,221 3,140,573
--------------------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment . . . . . . . . . (53,975) (30,142)
Proceeds from sale of property and equipment . . . . - 74,000
--------------------------- -------------
Net cash provided by (used in) investing activities. (53,975) 43,858
--------------------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings (payments) on line of credit . . . . . . (5,367,000) (55,558)
Purchase of treasury shares . . . . . . . . . . . . . . (83,684) (19,974)
Payments on capital lease obligations . . . . . . . . . - (4,068)
--------------------------- -------------
Net cash provided by (used in) financing activities . . (5,450,684) (79,600)
--------------------------- -------------
Net increase (decrease) in cash and cash equivalents. . (3,169,438) 3,104,831
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD. . . . . 7,320,143 4,423,623
--------------------------- -------------
CASH AND CASH EQUIVALENTS, END OF PERIOD. . . . . . . . $ 4,150,705 $ 7,528,454
=========================== =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
INTEREST PAID. . . . . . . . . . . . . . . . . . . . . $ 189,815 $ 169,688
=========================== =============
INCOME TAXES PAID. . . . . . . . . . . . . . . . . . . $ 3,182 $ 800
=========================== =============
The accompanying notes are an integral part of these financial statements.
6
I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - ORGANIZATION AND BUSINESS
I/OMagic Corporation ("I/OMagic"), a Nevada corporation, and its subsidiary
(collectively, the "Company") develop, manufacture through subcontractors,
market, and distribute optical storage and media, multimedia, input-output
peripheral products and solutions for the desktop and mobile computing markets,
and digital entertainment products for the consumer electronics market. The
Company sells its products in the United States and Canada to distributors and
retail customers.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared
in accordance with the rules and regulations of the Securities and Exchange
Commission and, therefore, do not include all information and notes necessary
for a fair presentation of financial position, results of operations, and cash
flows in conformity with generally accepted accounting principles. The
unaudited financial statements include the accounts of I/OMagic and subsidiary.
The operating results for interim periods are unaudited and are not necessarily
an indication of the results to be expected for the full fiscal year. In the
opinion of management, the results of operations as reported for the interim
periods reflect all adjustments which are necessary for a fair presentation of
operating results. It is suggested that the accompanying consolidated financial
statements be read in conjunction with the Company's audited consolidated
financial statements included in its 2002 annual report on Form 10-K.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and the disclosures of
contingent assets and liabilities at the date of the financial statements, as
well as the reported amounts of revenues and expenses during the reporting
period.
Significant estimates made by management include, but are not limited to, the
provisions for allowance of doubtful accounts and price protection on accounts
receivable, the net realizability of inventory, the evaluation of potential
impairment of furniture and equipment, and the provision for sales returns and
warranties. Actual results could materially differ from those estimates.
STOCK BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation," establishes and
encourages the use of the fair value based method of accounting for stock-based
compensation arrangements under which compensation cost is determined using the
fair value of stock-based compensation determined as of the date of grant and is
recognized over the periods in which the related services are rendered. The
statement also permits companies to elect to continue using the current implicit
value accounting method specified in Accounting Principles Bulletin ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees," to account for
stock-based compensation issued to employees. The Company has elected to use the
implicit value based method and has disclosed the pro forma effect of using the
fair value based method to account for its stock-based compensation. For
stock-based compensation issued to non-employees, the Company uses the fair
value method of accounting under the provisions of SFAS No. 123.
7
EARNINGS PER SHARE
The Company calculates earnings per share in accordance with SFAS No. 128,
"Earnings Per Share." SFAS No. 128 replaced the presentation of primary and
fully diluted earnings per share with the presentation of basic and diluted
earnings per share. Basic earnings per share excludes dilution and is
calculated by dividing income available to common stockholders by the
weighted-average number of common shares outstanding for the period. Diluted
earnings per share includes the potential dilutive effects that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock ("potential common stock") that would then share in the
earnings of the Company.
The following potential common shares have been excluded from the computation of
diluted earnings per share as of June 30, 2003 and 2002 due to being
anti-dilutive.
2003 2002
------- ---------
Stock Options 89,982 143,216
Redeemable convertible preferred stock - 75,000
------- ---------
89,982 218,216
------- ---------
Since the Company had a net loss for the three and six months ended June 30,
2002 and 2003, basic and diluted shares are the same.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In April 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No.
149, "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities." SFAS No. 149 amends and clarifies accounting and reporting for
derivative instruments and hedging activities under SFAS No. 133, "Accounting
for Derivative Instruments and Hedging Activities." SFAS No. 149 is effective
for derivative instruments and hedging activities entered into or modified after
June 30, 2003, except for certain forward purchase and sale securities. For
these forward purchase and sale securities, SFAS No. 149 is effective for both
new and existing securities after June 30, 2003. This statement is not
applicable to the Company.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150
establishes standards for how an issuer classifies and measures in its statement
of financial position certain financial instruments with characteristics of both
liabilities and equity. In accordance with the standard, financial instruments
that embody obligations for the issuer are required to be classified as
liabilities. SFAS No. 150 will be effective for financial instruments entered
into or modified after May 31, 2003 and otherwise will be effective at the
beginning of the first interim period beginning after June 15, 2003. This
statement is not applicable to the Company.
8
NOTE 3 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued liabilities consisted of the following:
June 30,
2003
--------------
(unaudited)
Accounts payable $ 207,344
Accrued rebates and marketing 2,744,996
Accrued compensation and related benefits 363,346
Other 275,629
--------------
TOTAL $ 3,591,315
==============
NOTE 4 - INVENTORY
Inventory consisted of the following:
June 30,
2003
--------------
(unaudited)
Component parts $ 4,487,530
Finished goods 6,775,734
Reserves for obsolete and slow moving inventory (485,083)
-------------
TOTAL $ 10,778,181
=============
NOTE 5 - LINE OF CREDIT
The Company maintains a revolving line of credit with a ChinaTrust Bank (USA)
that allows it to borrow a maximum of $9,000,000 with a sub-limit of $8,000,000.
The line of credit was to expire December 31, 2003 and is secured by
substantially all of the Company's assets. Within the sub-limit, up to
$8,000,000 is available for issuance of sight letters of credit, refinancing
letters of credit, local purchase financing against invoice(s), and working
capital loans with maturities up to 150 days. Letters of credit have maturities
of up to 60 days. Each advance over a total outstanding line balance of
$4,000,000 is subject to the above maturity periods.
Within the line of credit, a sub-line of $1,000,000 is available for uncollected
funds. The availability of the line of credit is subject to the borrowing base,
which is 65% of eligible receivables. Advances on the line of credit bear
interest at the Wall Street Journal prime rate (4.00% as of June 30, 2003), plus
0.75%, subject to a minimum interest rate of 5.5%. As of June 30, 2003, the
outstanding balance under the revolving line of credit was $5,005,827. The
Company is required to maintain a minimum, quarterly, combined average, cash
compensating balance of $750,000.
The line of credit is included in current liabilities in the accompanying
consolidated balance sheet. The line of credit provides for the maintenance of
certain financial covenants. As of December 31, 2002, the Company was in
violation of certain covenants. On April 11, 2003, the Company obtained a
waiver, effective April 15, 2003, from ChinaTrust Bank (USA) as to the Company's
violation of the covenants. This waiver also modified the original expiration
date on the line of credit from December 31, 2003 to October 15, 2003. The
waiver stipulates that if the defaults are not cured within 15 days, the bank is
willing to forbear from enforcing the defaults, provided that the Company pays
9
in full the outstanding amounts under the line of credit by October 15, 2003.
This waiver is subject to a Forbearance Agreement and Release entered into on
June 16, 2003 between ChinaTrust Bank (USA) and the Company. As of June 30,
2003, the Company was in violation of certain covenants. On August 14, 2003,
the Company obtained a waiver from ChinaTrust Bank (USA) as to its violation of
the covenants. The expiration date remains October 15, 2003. On August 15,
2003, the Company obtained a new line of credit with another bank (see Note 9 -
Subsequent Events).
NOTE 6 - CREDIT LINES FROM RELATED PARTIES
In connection with a 1997 Strategic Alliance Agreement, the Company has
available a trade line of credit through a stockholder and supplier for
purchases up to $2,000,000. Purchases are non-interest bearing and are due 75
days from the date of receipt. The credit agreement can be terminated or
changed at any time. As of December 31, 2002 and June 30, 2003 (unaudited),
there were $0 and $0, respectively, in trade payables outstanding under this
agreement.
In connection with a December 2000 subscription agreement, the Company also has
available an additional trade line of credit through a stockholder and vendor
that provides a trade credit facility of up to $3,000,000 carrying net 60 day
terms, as defined. As of December 31, 2002 and June 30, 2003 (unaudited), there
were $0 and $0, respectively, in trade payables outstanding under this
arrangement.
In January 2003, the Company entered into a trade credit facility with a related
party, whereby the related party has agreed to purchase inventory on behalf of
the Company. The agreement allows the Company to purchase up to $10,000,000,
with payment terms of 120 days following the date of invoice by the supplier.
The third party will charge the Company a 5% handling charge on the supplier's
unit price. A 2% discount to the handling fee will be applied if the Company
reaches an average running monthly purchasing volume of $750,000 a month.
Returns made by the Company, which are agreed by the supplier, will result in a
credit to the Company for the handling charge. As security for the trade
facility, the Company paid the related party a security deposit of $1,500,000,
which may be applied against outstanding trade payables after six months. This
deposit has been offset by "Accounts Payables - Related Parties" in the
accompanying financial statements. The agreement is for 12 months. At the end
of the 12-month period, either party may terminate the agreement upon 30 days'
written notice. Otherwise, the agreement will remain continuously valid without
effecting a newly signed agreement. As of June 30, 2003 (unaudited), there were
$3,005,929 in trade payables net of the deposit outstanding under this
arrangement.
In February 2003, the Company entered into an agreement with a related party,
whereby the related party will supply and store, at the Company's warehouse, up
to $10,000,000 of inventory on a consignment basis. Under the agreement, the
Company will insure the consignment inventory, store the consignment inventory
for no charge, and furnish the related party with weekly statements indicating
all products received and sold and the current consignment inventory level. The
agreement may be terminated by either party with 60 days written notice. Also
in February 2003, the Company entered into an agreement with this related party
for a trade line of credit of up to $10,000,000 with payment terms of net 30
days, non-interest bearing. As of June 30, 2003 (unaudited), there were
$4,374,042 in trade payable outstanding under this arrangement. As of December
31, 2002, there were $2,607,278 in trade payables outstanding under a prior
arrangement with this related party.
NOTE 7 - COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases its facilities and certain equipment under non-cancelable,
operating lease agreements, expiring through October 2005.
Rent expense was $214,498 and $213,832 for the six months ended June 30, 2003
and 2002, respectively, and is included in general and administrative expenses
in the accompanying statements of income.
10
LITIGATION
On May 30, 2003, an action for breach of contract and legal malpractice, IOM
Holdings, Inc. and I/OMagic Corporation v. Lawrence W. Horwitz, Gregory B. Beam,
Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn, and Senn
Palumbo Meulemans, LLP, was filed by the Company and its subsidiary against its
former attorneys and their law firms in the Superior Court of the State of
California for the County of Orange (Case no. 03CC07383). The claims alleged
arose out of the defendants' representation of the Company and its subsidiary.
A claim of $15 million in damages has been alleged against the defendants. As
of the date of this Report, the complaint is being amended by the Company and
defendants have not answered. The outcome of this action is presently
uncertain.
In addition, the Company is involved in certain legal proceedings and claims
which arise in the normal course of business. Management does not believe that
the outcome of these matters will have a material effect on the Company's
financial position or results of operations.
EMPLOYMENT CONTRACT
The Company entered into an employment contract with one of its officers on
October 15, 2002, which expires on October 15, 2007. The agreement, which is
effective as of January 1, 2002, calls for a minimum base salary and provides
for certain expense allowances. In addition, the agreement provides for a
quarterly bonus equal to 7% of the Company's quarterly net income. A $14,649
bonus was paid during the six months ended June 30, 2003. An $18,000 bonus was
paid during the six months ended June 30, 2002 under a prior employment
contract.
RETAIL AGREEMENTS
In connection with certain retail agreements, the Company has agreed to pay for
certain marketing development and advertising costs on an ongoing basis.
Marketing development and advertising costs are generally agreed upon at the
time of the event. The Company also records a liability for co-op marketing
based on management's evaluation of historical experience and current industry
and Company trends. During the six months ended June 30, 2003 and 2002, the
Company incurred $1,370,675 (unaudited) and $1,429,165 (unaudited),
respectively, related to these agreements. Such is netted against sales revenue
in the accompanying statements of income.
NOTE 8 - RELATED PARTY TRANSACTIONS
During the six months ended June 30, 2003 and 2002, the Company had purchases
from related parties totaling approximately $14,026,990 (unaudited) and
$10,880,505 (unaudited), respectively.
During the six months ended June 30, 2003 and 2002, the Company had accounts
payable to related parties totaling approximately $7,379,971 (unaudited) and
$3,809,279 (unaudited), respectively.
Until March 28, 2003, the Company leased its warehouse and office space from a
related party under the control of an officer of the Company which required
minimum monthly payments of $28,673. The Company's lease with the related party
expired on March 28, 2003. For the six months ended June 30, 2003 and 2002,
rent expense was $86,018 and $172,035 respectively, and is included in general
and administrative expenses in the accompanying statements of operations.
11
NOTE 9 - SUBSEQUENT EVENTS
On July 1, 2003, the Company signed a three year lease for a new facility in the
city of Irvine, California. The Company has an option for an additional three
year period at the end of the initial term. The monthly lease rates are $25,480
the first year, $26,244 the second year, and $27,032 in the third year. A
fourth year would be at the then prevailing market rate, and years five and six
would have 3% increases. The Company expects to occupy the new facility in
mid-September 2003.
On August 15, 2003, the Company entered into an agreement for an asset based
line of credit with United National Bank, effective August 18, 2003. The line
allows the Company to borrow up to a maximum of $6,000,000. The line of credit
expires September 1, 2004 and is secured by substantially all of the Company's
assets. Advances on the line bear interest at the floating commercial loan rate
of Wells Fargo Bank plus 0.75%. As of August 18, 2003, the interest rate would
be 4.75%.
The new line of credit will initially be used to pay off the outstanding balance
with ChinaTrust Bank (USA). Any remaining availability on the line may be used
for operations.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction with
our consolidated financial statements and notes to financial statements included
elsewhere in this report. This report and our consolidated financial statements
and notes to financial statements contain forward-looking statements, which
generally include the plans and objectives of management for future operations,
including plans and objectives relating to our future economic performance and
our current beliefs regarding revenues we might earn if we are successful in
implementing our business strategies. The forward-looking statements and
associated risks may include, relate to or be qualified by other important
factors, including, without limitation:
- the projected growth or contraction in the computer peripherals and
consumer electronics markets in which we operate;
- our business strategy for expanding, maintaining or contracting our
presence in these markets;
- anticipated trends in our financial condition and results of operations;
and
- our ability to distinguish ourselves from our current and future
competitors.
We do not undertake to update, revise or correct any forward-looking
statements.
The information contained in this report is not a complete description of our
business or the risks associated with an investment in our common stock. Before
deciding to buy or maintain a position in our common stock, you should carefully
review and consider the various disclosures we made in this report, and in our
other materials filed with the Securities and Exchange Commission that discuss
our business in greater detail and that disclose various risks, uncertainties
and other factors that may affect our business, results of operations or
financial condition. In particular, you should review the "Risk Factors" section
of this report.
Any of the factors described above or in the "Risk Factors" section of this
report could cause our financial results, including our net income (loss) or
growth in net income (loss) to differ materially from prior results, which in
turn could, among other things, cause the price of our common stock to fluctuate
OVERVIEW
We offer products in both the personal computer and the consumer
electronics marketplace. These products include a variety of peripheral
upgrades for desktop and portable applications. Our sales are to national North
America retail chains and major regional North America retail chains. We
experienced a 26.8% decrease in net sales for the six months ended June 30, 2003
over the six months ended June 30, 2002. While the current economic climate
makes it difficult for us to look forward into the balance of 2003, we believe
that our potential sales have been strengthened by the addition of new customers
in 2002 and the possibility of additional new customers in the latter half of
2003.
Our net loss for the six months ended June 30, 2003 decreased by 26.2% as
compared to the six months ended June 30, 2002, primarily due to the expensing
of $500,000 in deferred income taxes in 2002. Our loss before income taxes for
the six months ended June 30, 2003 increased by 11.3% as compared to the six
months ended June 30, 2002, primarily the result of a 26.8% decrease in net
sales.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of our financial condition and results of operations
are based upon our consolidated financial statements, which have been prepared
in accordance with accounting principals generally accepted in the United
States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
13
liabilities. On an on-going basis, we evaluate our estimates, including those
related to customer programs and incentives, product returns, bad debts,
inventories, intangible assets, income taxes, and contingencies and litigation.
We base our estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements. We record estimated reductions to revenue for customer
programs and incentive offerings including special pricing agreements, price
protection, promotions and other volume-based incentives. If market conditions
were to decline, we may take actions to increase customer incentive offerings
possibly resulting in an incremental reduction of revenue at the time the
incentive is offered. We maintain allowances for doubtful accounts for
estimated losses resulting from the inability of our customers to make required
payments. If the financial condition of our customers were to deteriorate,
resulting in the impairment of their ability to make payments, additional
allowances may be required.
We write down our inventory for estimated obsolescence or unmarketable
inventory equal to the difference between the cost of inventory and the
estimated market value based upon assumptions about future demand and market
conditions. If actual market conditions are less favorable than those projected
by management, additional inventory write-downs may be required. We record a
valuation allowance to reduce our deferred tax assets to the amount that is more
likely than not to be realized. While we have considered future taxable income
and ongoing prudent and feasible tax planning strategies in assessing the need
for the valuation allowance, in the event we were to determine that we would be
able to realize our deferred tax assets in the future in excess of our net
recorded amount, an adjustment to the deferred tax asset would increase income
in the period such determination was made. Likewise, should we determine that
we would not be able to realize all or part of our net deferred tax asset in the
future, an adjustment to the deferred tax asset would be charged to income in
the period such determination was made.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2003 (UNAUDITED) COMPARED TO THREE MONTHS ENDED JUNE
30, 2002 (UNAUDITED)
Net sales decreased 9.2% from $14,086,435 for the three months ended June
30, 2002 to $12,792,717 for the three months ended June 30, 2003 . The
decrease in net sales is attributable to a significant decrease in sales to two
of our major customers due to a reduction in current products carried in the
optical storage category. We believe that the recent introduction of new
products such as our digital photo library, duplicator and media station
products will result in an increase in revenues for the second half of 2003 as
compared to the first half of 2003.
Cost of sales as a percentage of net sales decreased from 94.0%
($13,237,805) in the three months ended June 30, 2002 to 85.1% ($10,882,406) in
the three months ended June 30, 2003. Cost of units decreased from 85.0%
($11,971,928) in the three months ended June 30, 2002 to 81.8% ($10,466,845) in
the three months ended June 30, 2003 of net sales. Freight in/out decreased
from 5.1% ($715,877) in the three months ended June 30, 2002 to 3.3% ($415,559)
in the three months ended June 30, 2003 of net sales. Inventory
shrink/adjustments decreased from 3.9% ($550,000) in the three months ended June
30, 2002 to 0.0% ($0) in the three months ended June 30, 2003 of net sales. We
wrote down to lower of cost or market $550,000 in inventory in 2002 and $0 in
2003.
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Operating expenses operating as a percentage of net sales increased from
18.7% ($2,632,840) in the three months ended June 30, 2002 to 24.7% ($3,161,864)
in the three months ended June 30, 2003. This percentage increase is primarily
due to total expenses increasing 20.1%, to $3,161,864 for the three months ended
June 30, 2003 from $2,632,840 in the three months ended June 30, 2002, while net
sales decreased 9.2% in the three months ended June 30, 2003 from the three
months ended June 30, 2002. Selling, marketing and advertising expenses
increased by $21,924 (7.1%), to $328,687 for the three months ended June 30,
2003 from $306,763 for the three months ended June 30, 2002. General and
administrative expenses increased by $373,536 (17.8%), to $2,477,890 for the
three months ended June 30, 2003 from $2,104,354 for the three months ended June
30, 2002. Depreciation and amortization expenses increased by $133,564 (60.2%),
to $355,287 for the three months ended June 30, 2003 from $221,723 for the three
months ended June 30, 2002.
Selling, marketing and advertising expenses for the three months ended June
30, 2003 were $328,687 (2.6% of net sales) and for the three months ended June
30, 2002 were $306,763 (2.2% of net sales). Selling, marketing and advertising
expenses increased by $21,924 primarily due to $56,453 greater customer
performance charges, $24,283 greater outside representative commissions and
$17,874 greater salaries and fringe benefits, offset by $51,161 less trade shows
expense and $20,000 less dues and subscriptions.
General and administrative expenses for the three months ended June 30,
2003 were $2,477,890 (19.4% of net sales) and for the three months ended June
30, 2002 were $2,104,355 (14.9% of net sales). General and administrative
expenses increased $373,535 primarily due to $878,089 more bad debt expense
offset by $258,229 less legal expenses primarily due to reducing 2002 estimated
accrual in relation to a lawsuit, $89,378 less insurance primarily due to
overaccrual of prior years, $47,613 less production supplies due to lower sales,
$46,738 less audit expenses due to adjustment of prior year expenses, and
$34,604 less offsite storage expense.
Depreciation and amortization expenses for the three months ended June 30,
2003 were $355,287 (2.8% of net sales) and for the three months ended June 30,
2002 were $221,723 (1.6% of net sales). The increase of $133,564 was primarily
due to increased amortization of leasehold improvements. The amortization of the
leasehold improvements at the current Santa Ana location was accelerated due to
an anticipated move to a larger facility later this year.
Other income (expenses) decreased to $25,929 (0.2% of net sales) expense
for the three months ended June 30, 2003 from $180,824 expense (1.3% of net
sales) for the three months ended June 30, 2002. This decrease of $154,895 was
primarily due to $102,325 legal fees for the three months ended June 30, 2002 in
connection with a litigation matter, as compared to $0 in legal fees for the
three months ended June 30, 2003 for the litigation matter, $65,283 less
interest expense for the three months ended June 30, 2003 due to less
borrowings, $26,020 in currency exchange gain in relation to sales to Canadian
retailers, offset by $38,759 gain in the three months ended June 30, 2002 on the
sale of fixed assets.
SIX MONTHS ENDED JUNE 30, 2003 (UNAUDITED) COMPARED TO SIX MONTHS ENDED JUNE 30,
2002 (UNAUDITED)
Net sales decreased 26.8% from $40,806,067 for the six months ended June
30, 2002 to $29,856,920 for the six months ended June 30, 2003 . The decrease
in net sales is attributable to a significant decrease in sales to two of our
major customers due to a reduction in current products carried in the optical
storage category. We believe that the recent introduction of new products such
as our digital photo library, duplicator and media station products will result
in an increase in revenues for the second half of 2003 as compared to the first
half of 2003.
Cost of sales as a percentage of net sales decreased from 88.0%
($35,912,214) for the six months ended June 30, 2002 to 85.3% ($25,509,803) for
the six months ended June 30, 20033. Cost of units increased from 79.4% of net
sales ($32,406,021) for the six months ended June 30, 2002 to 81.4% of net sales
($24,289,871) for the six months ended June 30, 2003. Freight in/out decreased
from 5.7% of net sales ($2,306,195) for the six months ended June 30, 2002 to
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4.1% of net sales ($1,219,932) for the six months ended June 30, 2003. Inventory
shrink/adjustments decreased from 2.9% of net sales ($1,200,000) for the six
months ended June 30, 2002 to 0.0% of net sales ($0) for the six months ended
June 30, 2003. We wrote down to lower of cost or market $1,200,000 in inventory
for the six months ended June 30, 2002 and $0 for the six months ended June 30,
2003.
Operating expenses as a percentage of net sales increased from 13.7%
($5,578,312) for the six months ended June 30, 2002 to 17.8% ($5,311,918) for
the six months ended June 30, 2003. This percentage increase is primarily due
to total operating expenses decreasing 4.8%for the six months ended June 30,
2003 from the six months ended June 30, 2002, while net sales decreased 26.8%
for the six months ended June 30, 2003 from the six months ended June 30, 2002.
Selling, marketing and advertising expenses decreased by $39,359 (5.6%), to
$664,604 for the six months ended June 30, 2003 from $703,963 for the six months
ended June 30, 2003. General and administrative expenses decreased by $158,393
(3.9%), to $3,934,729 for the six months ended June 30, 2003 from $4,093,122 for
the six months ended June 30, 2002. Depreciation and amortization expenses
decreased by $68,642 (8.8%), to $712,585 for the six months ended June 30, 2003
from $781,227 for the six months ended June 30, 2002.
Selling, marketing and advertising expenses for the six months ended June 30,
2003 were $664,604 (2.2% of net sales) and for the six months ended June 30 2002
were $703,963 (1.7% of net sales). Selling, marketing and advertising expenses
decreased by $39,359 primarily due to $53,135 less outside rep commissions,
$42,086 less trade shows expense, $20,000 less dues, offset by $56,453 greater
customer performance charges and $28,287 greater salaries and fringe benefits.
General and administrative expenses for the six months ended June 30, 2003
were $3,934,729 (13.2% of net sales) and for the six months ended June 30, 2002
were $4,093,122 (10.0% of net sales). General and administrative expenses
decreased $158,393 primarily due to$245,824 less legal expenses primarily due to
reducing 2002 estimated accrual in relation to a lawsuit, $115,521 less
insurance primarily due to overaccrual of prior years, $67,899 less production
supplies due to lower sales, $44,073 less offsite storage expense, $42,836 less
bank charges, $38,297 less postage, $36,613 less temp help, offset by $378,089
more bad debt expense, $64,876 more product design, $53,262 more audit expense,
$40,572 more outside assembly.
Depreciation and amortization expenses for the six months ended June 30,
2003 were $712,585 (2.4% of net sales) and for the six months ended June 30,
2002 were $781,227 (1.9% of net sales). The decrease of $68,642 was due to
$337,596 decreased amortization of trademarks offset by $268,954 increased
amortization of leasehold improvements. In 2002 we had an outside valuation
service review the value of the trademarks and their useful lives. Based upon
the valuation, we determined (with concurrence of our independent auditors) that
there had been no impairment to the value of the trademarks and that the useful
lives of the trademarks should be increased by ten years due to additional
historical information of their value. Therefore, the amount of annual
trademark amortization was decreased beginning in the second quarter 2002. The
amortization of the leasehold improvements at the current Santa Ana location
were accelerated as of January 2003 due to an anticipated move to a larger
facility later this year.
Other income (expenses) decreased to $106,067 (0.4% of net sales) expense for
the six months ended June 30, 2003 from $265,333 expense (0.7% of net sales)
for the six months ended June 30, 2002. This decrease of $159,266 was primarily
due to $112,064 legal fees for the six months ended June 30, 2002 in connection
with a litigation matter, as compared to $0 in legal fees for the three months
ended June 30, 2003 for the litigation matter, $49,255 in currency exchange gain
in relation to sales to Canadian retailers for the six months ended June 30,
2003, $36,487 less interest expense due to less borrowings for the six months
ended June 30, 2003 as compared to June 30, 2002, offset by $38,759 gain in the
six months ended June 30, 2002 on the sale of fixed assets.
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LIQUIDITY AND CAPITAL RESOURCES
During the six months ended June 30, 2003 we had a net decrease in cash
relative to December 31, 2002 in the amount of $3,169,438. This was due to cash
provided by operating activities of $2,335,221 offset by cash used in financing
activities of $5,450,684 and cash used in investing activities of $53,975. Cash
provided by operations was from a decrease in accounts receivable of $4,913,224,
an increase in accounts payable to related parties of $4,772,693, an increase in
non-cash entries of $1,928,104, offset by a decrease in accounts payable and
accrued expenses of $3,693,936, a decrease in the reserve for settlements of
$3,000,000, an increase in inventory of $1,301,173, a net loss of $1,069,670, an
increase in other current assets of $214,021. Cash used for financing
activities was for net payments on the line of credit of $5,367,000 and purchase
of treasury stock of $83,684. Cash used for investing activities was for
leasehold improvements, furniture and computer equipment.
Effective January 1, 2003, we obtained a $9 million asset based line of
credit (with a sub-limit of $8 million) with ChinaTrust Bank (USA) which was to
expire December 31, 2003. ChinaTrust Bank (USA) renewed our prior $14 million
line of credit, but reduced the amount to $9 million due to our history of
losses the past three years. Within the sub-limit, up to $8,000,000 is
available for issuance of sight letters of credit, refinancing letters of
credit, local purchase financing against invoice(s), and working capital loans
with maturities up to 150 days. Letters of credit have maturities of up to 60
days. Each advance over a total outstanding line balance of $4,000,000 is
subject to the above maturity periods.
Within the line of credit, a sub-line of $1,000,000 is available for
uncollected funds. The availability of the line of credit is subject to the
borrowing base, which is 65% of eligible receivables. Advances on the line of
credit bear interest at the Wall Street Journal prime rate (4.00% as of June 30,
2003), plus 0.75%, subject to a minimum interest rate of 5.5%. As of June 30,
2003, the outstanding balance under the revolving line of credit was $5,005,827.
We are required to maintain a minimum, quarterly, combined average, cash
compensating balance of $750,000.
The line of credit provides for the maintenance of certain financial
covenants. As of December 31, 2002, we were in violation of certain covenants.
On April 11, 2003, we obtained a waiver, effective April 15, 2003, from
ChinaTrust Bank (USA) as to our violation of the covenants. This waiver
stipulates that if the defaults are not cured within 15 days, the bank is
willing to forbear from enforcing the defaults, provided that the Company pays
in full the outstanding amounts under the line of credit by October 15, 2003.
This agreement is subject to a Forbearance Agreement and Release entered into on
June 16, 2003 between ChinaTrust Bank (USA) and the Company. As of March 31,
2003, we were in violation of certain covenants. On May 15, 2003, we obtained a
waiver from ChinaTrust Bank (USA) as to our violation of the covenants. As of
June 30, 2003, we were in violation of certain covenants. On August 15, 2003,
we obtained a waiver from ChinaTrust Bank (USA) as to our violation of the
covenants. The expiration date remains October 15, 2003.
On August 15, 2003, we entered into an agreement for an asset based line of
credit with United National Bank, effective August 18, 2003. The line allows
us to borrow up to a maximum of $6,000,000. The line of credit expires
September 1, 2004 and is secured by a UCC filing on substantially all of our
assets. Advances on the line bear interest at the floating commercial loan rate
of Wells Fargo Bank plus 0.75%. As of August 18, 2003, the interest rate would
be 4.75%.
The new line of credit will initially be used to pay off the outstanding
balance with ChinaTrust Bank (USA). Any remaining availability on the line may
be used for operations.
In January 2003, we entered into a trade credit facility with Lung Hwa
Electronics Co., Ltd. ("Lung Hwa"), whereby Lung Hwa has agreed to purchase
inventory on our behalf. The agreement allows us to purchase up to $10,000,000,
with payment terms of 120 days following the date of invoice by the supplier.
Lung Hwa will charge us a 5% handling charge on the supplier's unit price. A 2%
discount to the handling fee will be applied if we reach an average running
17
monthly purchasing volume of $750,000 a month. Returns made by us, which are
agreed to by the supplier, will result in a credit to us for the handling
charge. As security for the trade facility, we paid Lung Hwa a security deposit
of $1,500,000 in 2003. This deposit has been offset against "Accounts Payables
- -Related Parties" in the accompanying financial statements, as the agreement
allows us the right to offset against outstanding trade payables after six
months. The agreement will remain in force continuously. Both parties have the
right to terminate the agreement one year following the inception date by giving
the other party 30 days' written notice. Otherwise, the agreement will remain in
force without effecting a new signed agreement. As of June 30, 2003, we owed
Lung Hwa $3,005,929.
In February 2003, we entered into an agreement with Behavior Tech Computer
(USA) Corp. ("BTC USA") whereby BTC USA will supply and store at our warehouse
up to $10,000,000 of inventory on a consignment basis. Under the agreement, we
will insure the consignment inventory, store the consignment inventory for no
charge, and furnish BTC USA with weekly statements indicating all products
received and sold and the current consignment inventory level. The agreement
may be terminated by either party upon 60 days' prior written notice. Also in
February 2003, we entered into an agreement with the related party for a trade
line of credit of up to $10,000,000 with payment terms of net 30 days,
non-interest bearing. As of June 30, 2003, we owed BTC $4,374,042.
In the event the next twelve months result in significant revenue growth
either through the addition of several high cost products or the addition of
several large national retailers, we may experience net negative cash flows from
operations, pending an increase in gross margins, and may be required to obtain
additional financing to fund operations through proceeds from offerings, to the
extent available, or to obtain additional financing to the extent necessary to
augment our working capital through public or private issuance of equity or debt
securities or increased trade credit facilities with vendors. In the event we
are unsuccessful in securing such financing, we may be required to curtail our
sales growth.
In the event the next twelve months result in moderate revenue growth
either through the addition of one or two high cost products or the addition of
one large national retailer, and the economy does not result in further margin
erosion, then we believe that cash flow from operations and our current bank
line of credit and trade facilities will be sufficient to fund such growth.
We have no firm long-term sales commitments from any of our customers and
enter into individual purchase orders with our customers. We have experienced
cancellations of orders and fluctuations in order levels from period to period
and expect we will continue to experience such cancellations and fluctuations in
the future. In addition, customer purchase orders may be canceled and order
volume levels can be changed, canceled or delayed with limited or no penalties.
The replacement of canceled, delayed or reduced purchase orders with new
business cannot be assured. Moreover, our business, financial condition and
results of operations will depend upon our ability to obtain orders from new
customers, as well as the financial condition and success of our customers, our
customers products and the general economy.
Our backlog at June 30, 2003 was $4,300,114 as compared to a backlog at
June 30, 2002 of $3,743,040. Based upon the history of the past twelve months,
the June 30, 2003 backlog may be reduced by $399,911 (9%) when
recognized as sales, due to returns and price protections.
RISK FACTORS
- -------------
An investment in our common stock involves a high degree of risk. In
addition to the other information in this report, you should carefully consider
the following risk factors before deciding to invest or maintain an investment
in shares of our common stock. If any of the following risks actually occurs, it
is likely that our business, financial condition and operating results would be
harmed. As a result, the trading price of our common stock could decline, and
you could lose part or all of your investment.
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WE HAVE INCURRED SIGNIFICANT LOSSES AND MAY CONTINUE TO INCUR LOSSES. IF WE
CONTINUE TO INCUR LOSSES, WE MAY HAVE TO CURTAIL OUR OPERATIONS.
We have not been profitable the last three years and the first six months
of 2003 and may not be profitable in the foreseeable future. Historically, we
have relied upon cash from operations and financing activities to fund all of
the cash requirements of our business and have incurred significant losses. As
of June 30, 2003, we had an accumulated deficit of $15,863,140. During 2002,
2001, and 2000, we incurred net losses in the amount of $8,347,231, $5,547,645,
and $6,410,849, respectively, and we have incurred a net loss of $1,069,670 for
the first six months of 2003. We cannot predict if we will be profitable in
future quarters and we may continue to incur losses for an indeterminate period
of time and may never achieve or sustain annual profitability. An extended
period of losses may result in negative cash flow and may prevent us from
operating or expanding our business. We cannot assure you that our business
will ever become continuously profitable or that we will ever generate
sufficient revenues to meet our expenses and support our operations. Even if we
are able to achieve profitability, we may be unable to sustain or increase our
profitability on a quarterly or annual basis.
OUR CONCENTRATION OF SALES TO THREE MAJOR CUSTOMERS MAY ADVERSELY AFFECT OUR
BUSINESS IF ANY ONE OR MORE OF THEM DECIDES TO DISCONTINUE PURCHASING OUR
PRODUCTS.
During the first six months of 2003, net sales to our four largest
customers represented 35%, 18%, 12% and 12%, respectively, of total net sales.
Our sales and our profitability would be adversely affected if any one or more
of these customers ceased purchasing from us. We have no guarantee that we
would be able to replace the loss of such sales with existing or new customers
or in a timely manner to avoid an adverse financial impact to our business.
FIERCE COMPETITION IN THE COMPUTER PERIPHERAL AND CONSUMER ELECTRONICS
MARKETPLACE MAY CAUSE A DECLINE IN OUR REVENUES AND FORCE US TO REDUCE PRICES
FOR OUR PRODUCTS.
The market for our products is highly competitive. Our competitors for our
hardware products include Hewlett-Packard, Iomega, Memorex, Phillips, Samsung,
Sony, TDK and Yamaha. Our competitors for our media products include
Fuji,Imation, Maxell, Memorex, PNY, TDK and Verbatim. We also indirectly compete
against original equipment manufacturers such as Dell Computer and
Hewlett-Packard to the extent that they manufacture their own computer
peripheral products or incorporate on personal computer motherboards the
functionalities provided by our products. We believe that the strategy of
certain of our current and potential competitors is to compete largely on the
basis of price, which may result in lower prices and lower margins for our
products or otherwise adversely affect the market for our products. There can be
no assurance that we will be able to continue to compete successfully in the
marketplace.
MANY OF OUR COMPETITORS HAVE GREATER RESOURCES THAN US. IN ORDER TO COMPETE
SUCCESSFULLY, WE MUST KEEP PACE WITH OUR COMPETITORS IN ANTICIPATING AND
RESPONDING TO RAPID CHANGES IN THE COMPUTER PERIPHERAL AND CONSUMER ELECTRONICS
INDUSTRIES. IF WE FAIL TO DO SO, OUR BUSINESS WILL SUFFER.
Our future success will depend upon our ability to enhance our current
products and services and to develop and introduce new products and services
that keep pace with technological developments, respond to the growth in the
computer peripheral and consumer electronics markets in which we compete,
encompass evolving consumer requirements, provide a broad range of products and
achieve market acceptance of our products. Many of our existing and potential
competitors have larger technical staffs, more established and larger marketing
19
and sales organizations and significantly greater financial resources than we
do. Our lack of resources relative to our competitors may cause us to fail to
anticipate or respond adequately to technological developments and consumer
requirements or may cause us to experience significant delays in developing or
introducing new products and services. These failures or delays could reduce our
competitiveness, revenues, profit margins and market share.
OUR LACK OF LONG-TERM PURCHASE ORDERS OR COMMITMENTS MAY ADVERSELY AFFECT OUR
BUSINESS IF DEMAND DECLINES.
During the six months ended June 30, 2003, sales of our computer peripheral
products accounted for 97.5% of our total net sales, and sales of our consumer
electronics products accounted for 2.5% of our total net sales. In many cases we
have long-term contracts with our computer peripheral and consumer electronics
retailers that cover the general terms and conditions of our relationships with
them but that do not include long-term purchase orders or commitments. Rather,
our retailers issue purchase orders requesting the quantities of computer
peripheral or consumer electronics products that they desire to purchase from
us, and if we are able and willing to fill those orders, then we fill them under
the terms of the contracts. Accordingly, we cannot rely on long-term purchase
orders or commitments to protect us from the negative financial effects of a
decline in demand for our products that could result from a general economic
downturn, from changes in the computer peripheral and consumer electronics
marketplaces, including the entry of new competitors into the market, from the
introduction by others of new or improved technology, from an unanticipated
shift in the needs of our retailers, or from other causes.
OUR BUSINESS COULD SUFFER IF WE ARE UNABLE TO OBTAIN OUR PRODUCTS FROM OUR
SUPPLIERS.
Most of our products are available from multiple sources. However, we
currently obtain most of our products from single or limited sources. We have,
from time to time, experienced difficulty in obtaining some products. We do not
have guaranteed supply arrangements with any of our suppliers, and there can be
no assurance that our suppliers will continue to meet our requirements. If our
existing suppliers are unable to meet our requirements, we could be required to
find other suppliers or even eliminate products from our product line. Product
shortages could limit our sales capacity and also could result in lower margins
due to higher product costs resulting from limited supply or the need to obtain
substitute products which are available only at higher costs. Significant
increases in the prices of our products could adversely affect our results of
operations because our products compete on price and, therefore, we may not be
able to pass along price increases to our retailers. Also, an extended
interruption in the supply of products or a reduction in their quality or
reliability would adversely affect our financial condition and results of
operations by operations by impairing our ability to timely deliver quality
products to our retailers. Delayed product deliveries due to product shortages
or other factors may result in cancellation by our retailers of all or part of
their orders. We cannot assure you that cancellations will not occur.
OUR DEPENDENCE ON SALES OF OUR OPTICAL STORAGE AND OPTICAL MEDIA PRODUCTS COULD
HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS IF THE MARKET FOR THOSE PRODUCTS
DECLINES.
Net sales of our optical storage and related media products accounted for
approximately 88.5% of our net sales for the six months ended June 30, 2003.
Although we have introduced products in other segments of the computer
peripheral market and in the consumer electronics market, optical storage and
optical media products are expected to continue to account for a majority of our
sales for at least the next year. A decline in the demand or average selling
prices for optical storage or optical media products, whether as a result of new
competitive product introductions, price competition, excess supply,
technological changes, incorporation of the products' functionality onto
personal computer motherboards or otherwise, would have a material adverse
effect on our sales and operating results.
20
IF WE FAIL TO KEEP PACE WITH THE RAPID TECHNOLOGICAL CHANGES THAT CHARACTERIZE
THE MARKETPLACE FOR OUR PRODUCTS, WE WILL LIKELY EXPERIENCE A SIGNIFICANT
DECLINE IN OUR COMPETITIVE ADVANTAGE RESULTING IN A MATERIALLY NEGATIVE IMPACT
ON OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The markets for our products are characterized by rapidly changing
technology, evolving industry standards, frequent new product introductions and
rapid product obsolescence. Product life cycles in the markets for our products
often range from as few as three up to twelve months. We believe that our
success will be substantially dependent upon our ability to continue to develop
and introduce competitive products and technologies on a timely basis with
features and functions that meet changing consumer requirements in a
cost-effective manner. Even if we are successful in the development and market
introduction of new products, we still must correctly forecast consumer demand
for those products to avoid either excessive unsold inventory or excessive
unfilled orders related to our products. The task of forecasting consumer demand
is extremely difficult for new products for which there is little or no sales
history, and for indirect channels, where our customers are not the final
end-users. Moreover, whenever we offer new products, we also must successfully
manage the resulting obsolescence and price erosion of our older products, as
well as any resulting price protection charges and inventory returns from our
retailers. Accordingly, if we are unable to keep pace with the rapid
technological changes within the marketplace for our products, or unable to
manage effectively the introduction of new products, our business, financial
condition and results of operations will be negatively impacted.
OUR FAILURE TO FORECAST SALES IN THE VOLATILE COMPUTER PERIPHERAL AND CONSUMER
ELECTRONICS MARKETPLACES COULD RESULT IN LOST REVENUES AND SIGNIFICANT LOSSES.
We develop and market products in the highly competitive computer
peripheral and consumer electronics marketplaces. Our products are very
susceptible to obsolescence and typically exhibit a high degree of volatility of
shipment volumes over relatively short product life cycles. The timing of
introductions of new products can materially affect sales volumes. In addition,
new product releases by competitors and accompanying price adjustments to
competing products can materially and adversely affect our revenues and gross
margins.
We sell our products to retailers such as mass merchandisers and large
electronics chains which sell products primarily off-the-shelf directly to end
users. Our reliance on indirect channels of distribution typically results in
little or no ability to predict end user demand. We rely upon sales forecasts
provided by our retailers in order to comply with order placement demands by
these retailers. If these forecasts are inaccurate, we could either have excess
inventory, resulting in significant finance costs and product obsolescence, or
insufficient inventory, resulting in lost revenues due to our inability to
promptly meet consumer demand. Accordingly, our future operating results are
largely dependent on our ability to accurately predict the demand for our
products. Our failure to accurately predict the demand for our products could
result in significant losses from inventory obsolescence and finance charges or
substantial lost revenues.
WE RELY HEAVILY ON OUR MANAGEMENT, AND THE LOSS OF THEIR SERVICES COULD
ADVERSELY AFFECT OUR BUSINESS.
Our success is highly dependent upon the continued services of key members
of our management, including our Chairman of the Board, President, Chief
Executive Officer and Secretary, Tony Shahbaz. Mr. Shahbaz has developed
personal contacts and other skills that we rely upon in connection with our
financing, acquisition and general business strategies. Mr. Shahbaz has also
developed key personal relationships with our vendors and frequently is
extensively involved in our sales and promotional efforts with our key
customers. Although we have entered into an employment agreement with Mr.
Shahbaz, that agreement is of limited duration and is subject to early
termination by Mr. Shahbaz under some circumstances. Consequently, the loss of
Mr. Shahbaz or one or more other key members of management could adversely
affect our business.
21
OUR FAILURE TO MANAGE GROWTH EFFECTIVELY COULD IMPAIR OUR BUSINESS.
Our expansion into new product categories in the computer peripheral and
consumer electronics marketplaces has required and will continue to require
significant investment and management attention to improve our information
systems, product data management, control accounting, telecommunications and
networking systems, coordination of suppliers and distribution channels, and
general business processes and procedures. We are continuing to expand our
product base in the consumer electronics marketplace and expect significant
challenges in coordinating supply and distribution processes in what we hope
will be a rapidly growing product category.
Our strategy envisions a period of rapid growth that may impose a
significant burden on our administrative and operational resources. Our ability
to effectively manage growth will require us to substantially expand the
capabilities of our administrative and operational resources and to attract,
train, manage and retain qualified marketing, technical support, customer
service, sales and other personnel. There can be no assurance that we will be
able to do so. If we are unable to successfully manage our growth, our business,
prospects, results of operations and financial condition could be materially and
adversely affected.
THE EMERGENCE OF NEW SALES CHANNELS AND THE ACCEPTANCE OF EXISTING ALTERNATIVE
SALES CHANNELS MAY RESULT IN FEWER SALES OF OUR PRODUCTS DUE TO OUR INABILITY TO
ADAPT TO THESE SALES CHANNELS.
We are accustomed to conducting business through traditional distribution
and retail sales channels. Traditional computer peripheral and consumer
electronics distribution and retail channels have suffered from the emergence of
alternative sales channels, such as direct mail order, telephone sales by
personal computer manufacturers and Internet commerce. The emergence of
additional alternative sales channels or increased acceptance of existing
alternative sales channels by retailers or consumers may cause a rapid decline
in the sales of our products unless we are able to capitalize on those new or
more widely accepted sales channels. In addition, new products or changes in the
types of products we sell, such as our digital entertainment products, may
require specialized value-added reseller channels, which we have not yet fully
established. We may be unable to effectively compete in a marketplace that
supports numerous alternative sales channels because we do not have experience
in sales channels other than traditional distribution and retail sales channels.
As a result, in a marketplace in which alternative sales channels continue to
emerge, we may suffer from a competitive disadvantage which may have a material
and adverse effect on our business.
POLITICAL AND ECONOMIC INSTABILITY IN EAST ASIA COULD HAVE AN ADVERSE IMPACT ON
THE SUPPLY OF OUR PRODUCTS WHICH COULD MATERIALLY AND ADVERSELY AFFECT OUR
BUSINESS.
We order nearly all of our products from large manufacturing facilities
located primarily in Taiwan, Korea and the People's Republic of China. In the
event of a severe political disruption in the governments of any country located
in East Asia, the economic ramifications to our suppliers could be devastating.
As a result, our ability to conduct operations might be materially and adversely
affected. In addition, our suppliers acquire components and raw materials for
the manufacturing of our products from a number of countries, many of which do
not conduct business in United States dollars. Any severe fluctuation in the
value of foreign currencies could materially increase our costs to purchase
products. Accordingly, as a result of political or economic instability in East
Asia, our operations could be materially and adversely affected.
22
THE MIGRATION OF OUR PRODUCTS' FUNCTIONALITIES TO PERSONAL COMPUTER MOTHERBOARDS
COULD MAKE SOME OF OUR COMPUTER PERIPHERAL PRODUCTS OBSOLETE WHICH COULD
ADVERSELY AFFECT OUR BUSINESS.
Many of our products are individual computer peripheral products that
operate in conjunction with personal computers to provide additional
functionalities. Historically, as new functionalities become technologically
stable and widely accepted by personal computer users, the cost of providing
such functionalities declines dramatically by means of large-scale integration
into semiconductor chips, which can be incorporated into personal computer
motherboards. If the migration of the functionalities of our products into
personal computer motherboards occurs, demand for our products will likely
decline significantly. There can be no assurance that the incorporation of new
functionalities into personal computer motherboards will not adversely affect
the market for our products.
IF OUR PRODUCTS FAIL TO COMPLY WITH EVOLVING GOVERNMENT AND INDUSTRY STANDARDS
AND REGULATIONS, WE MAY HAVE DIFFICULTY SELLING OUR PRODUCTS.
Our products are designed to comply with a significant number of industry
standards and regulations, some of which are evolving as new technologies are
deployed. In the United States, our products must comply with various
regulations defined by the United States Federal Communications Commission,
Underwriters Laboratories and the Food and Drug Administration as well as
numerous industry standards. The failure of our products to comply, or delays in
compliance, with the various existing and evolving regulations or standards
could negatively impact our ability to sell our products.
BECAUSE WE BELIEVE THAT PROPRIETARY RIGHTS ARE MATERIAL TO OUR SUCCESS,
MISAPPROPRIATION OF THESE RIGHTS COULD ADVERSELY IMPACT OUR FINANCIAL CONDITION.
We are not the licensee or owner of any of the intellectual property
contained in our products other than our I/OMagic, Hi-Val and Digital Research
Technologies brand names, all of which we own. As a result, we do not have a
proprietary interest in any of the software, hardware or related technology
incorporated in our products. We rely primarily on trademark protection for our
I/OMagic, Hi-Val and Digital Research Technologies brand names. There can be no
assurance that our means of protecting our proprietary rights in these brand
names will deter or prevent their unauthorized use. Our financial condition
would be adversely affected if we were to lose our competitive position due to
our inability to adequately protect our proprietary rights in our brand names.
We own, license or have otherwise obtained the right to use certain
technologies incorporated in our products. We may receive infringement claims
from third parties relating to our products and technologies. In those cases, we
intend to investigate the validity of the claims and, if we believe the claims
have merit, to respond through licensing or other appropriate actions. To the
extent claims relate to technology included in components purchased from
third-party vendors for incorporation into our products, we would forward those
claims to the appropriate vendor. If we or our component manufacturers are
unable to license or otherwise provide any necessary technology on a
cost-effective basis, we could be prohibited from marketing products containing
that technology, incur substantial costs in redesigning products incorporating
that technology, or incur substantial costs defending any legal action taken
against us.
OUR STOCK PRICE HAS BEEN VOLATILE, WHICH COULD RESULT IN SUBSTANTIAL LOSSES FOR
INVESTORS PURCHASING SHARES OF OUR COMMON STOCK AND IN LITIGATION AGAINST US.
The market prices of securities of technology-based companies have
historically been highly volatile. The market price of our common stock has
fluctuated significantly in the past. In fact, from January 1, 2003 through June
30, 2003, the high and low closing sale prices of a share of our common stock
were $10.00 and $3.00 respectively. The market price of our common stock may
23
continue to fluctuate in response to the following factors, many of which are
beyond our control:
- changes in market valuations of similar companies and stock market price
and volume fluctuations generally;
- economic conditions specific to the computer peripheral and consumer
electronics industries;
- announcements by us or our competitors of new or enhanced products,
technologies or services or significant contracts, acquisitions,
strategic relationships, joint ventures or capital commitments;
- regulatory developments;
- fluctuations in our quarterly or annual operating results;
- additions or departures of key personnel; and
- future sales of our common stock or other securities.
The price at which you purchase shares of common stock may not be
indicative of the price of our stock that will prevail in the trading market.
You may be unable to sell your shares of common stock at or above your purchase
price, which may result in substantial losses to you. Moreover, in the past,
securities class action litigation has often been brought against a company
following periods of volatility in the market price of its securities. We may in
the future be the target of similar litigation. Securities litigation could
result in substantial costs and divert management's attention and resources.
BECAUSE WE MAY BE SUBJECT TO THE "PENNY STOCK" RULES, THE LEVEL OF TRADING
ACTIVITY IN OUR STOCK MAY BE REDUCED.
Broker-dealer practices in connection with transactions in "penny stocks"
are regulated by penny stock rules adopted by the Securities and Exchange
Commission. Penny stocks, like shares of our common stock, generally are equity
securities with a price of less than $5.00 (other than securities registered on
some national securities exchanges or quoted on Nasdaq). The penny stock rules
require a broker-dealer, prior to a transaction in a penny stock not otherwise
exempt from the rules, to deliver a standardized risk disclosure document that
provides information about penny stocks and the nature and level of risks in the
penny stock market. The broker-dealer also must provide the customer with
current bid and offer quotations for the penny stock, the compensation of the
broker-dealer and its salesperson in the transaction, and, if the broker-dealer
is the sole market maker, the broker-dealer must disclose this fact and the
broker-dealer's presumed control over the market, and monthly account statements
showing the market value of each penny stock held in the customer's account. In
addition, broker-dealers who sell these securities to persons other than
established customers and "accredited investors" must make a special written
determination that the penny stock is a suitable investment for the purchaser
and receive the purchaser's written agreement to the transaction. Consequently,
these requirements may have the effect of reducing the level of trading
activity, if any, in the secondary market for a security subject to the penny
stock rules, and investors in our common stock may find it difficult to sell
their shares.
BECAUSE OUR STOCK IS NOT LISTED ON A NATIONAL SECURITIES EXCHANGE, YOU MAY FIND
IT DIFFICULT TO DISPOSE OF OR OBTAIN QUOTATIONS FOR OUR COMMON STOCK.
Our common stock trades under the symbol "IOMG" on the OTC Bulletin Board.
Because our stock trades on the OTC Bulletin Board rather than on a national
securities exchange, you may find it difficult to either dispose of, or to
obtain quotations as to the price of, our common stock.
24
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations were not subject to commodity price risk during the six
months ended June 30, 2003. Our sales to a foreign country (Canada) were less
than 1% of our total sales, and thus we experienced negligible foreign currency
exchange rate risk. We have entered into a new line of credit with United
National Bank, effective August 18, 2003. The line of credit provides for an
interest rate equal to the floating commercial loan rate of Wells Fargo Bank
plus three quarters of one percent. This interest rate is adjustable upon each
movement in the prime lending rate. If the prime lending rate increases, our
interest rate expense will increase on an annualized basis by the amount of the
increase multiplied by the principal amount outstanding under the United
National Bank line of credit.
ITEM 4. CONTROLS AND PROCEDURES
Our Chief Executive Officer and Chief Financial Officer (our principal
executive officer and principal financial officer, respectively) have concluded,
based on their evaluation as of August 18, 2003, that the design and operation
of our "disclosure controls and procedures" (as defined in Rules 13a-14(c) and
15d-14(c) under the Securities Exchange Act of 1934, as amended ("Exchange
Act")) are effective to ensure that information required to be disclosed by us
in the reports filed or submitted by us under the Exchange Act is accumulated,
recorded, processed, summarized and reported to our management, including our
principal executive officer and our principal financial officer, as appropriate
to allow timely decisions regarding whether or not disclosure is required.
During the quarter ended June 30, 2003, there were no significant changes
in our internal controls over financial reporting (as defined in Rule 13a-15(f)
under the Exchange Act) that have materially affected, or are reasonably likely
to materially affect, our internal controls over financial reporting.
25
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On May 30, 2003, an action for breach of contract and legal malpractice,
IOM Holdings, Inc. and I/OMagic Corporation v. Lawrence W. Horwitz, Gregory B.
Beam, Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn, and Senn
Palumbo Meulemans, LLP, was filed by the Company and its subsidiary against its
former attorneys and their law firms in the Superior Court of the State of
California for the County of Orange (Case no. 03CC07383). The claims alleged
arose out of the defendants' representation of the Company and its subsidiary.
A claim of $15 million in damages has been alleged against the defendants. As
of the date of this Report, the complaint is being amended by the Company and
defendants have not answered. The outcome of this action is presently
uncertain.
In addition, the Company is involved in certain legal proceedings and
claims which arise in the normal course of business. Management does not
believe that the outcome of these matters will have a material effect on the
Company's financial position or results of operations.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Number Description
------ -----------
10.1 Forbearance Agreement and Release entered into as of
June 16, 2003 by ChinaTrust Bank (USA) and I/OMagic
Corporation.
10.2 Lease Agreement entered into on July 1, 2003 between
Laro Properties LP and I/OMagic Corporation
Business Loan Agreement entered into as of August 15, 2003
between United National Bank and I/OMagic Corporation
Promissory Note dated August 15, 2003 between United
National Bank and I/OMagic Corporation
Commercial Security Agreement dated August 15, 2003 between
United National Bank and I/OMagic Corporation
26
Certifications of Chief Executive Officer under Exchange
Act Rule 13a-14(a)/15d-14(a) (Section 302 of the Sarbanes-
Oxley Act), dated August 18, 2003
Certifications of Chief Financial Officer under Exchange
Act Rule 13a-14(a)/15d-14(a) (Section 302 of the Sarbanes-
Oxley Act), dated August 18, 2003
Certifications of Chief Executive Officer and Chief Financial
Officer pursuant to Rule Exchange Act Rules 13a-14(b) and
19d-14(b) (Section 906 of the Sarbanes-Oxley Act), dated August
18, 2003
(b) Reports on Form 8-K:
----------------------
Form 8-K was filed on April 10, 2003 reporting Items 7 and 9
in compliance with Regulation FD Disclosure (Information
Furnished Under Item 12) in connection with the Company's
Press Release issued on April 8, 2003 reporting selected
financial results for the fourth quarter 2002.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
I/OMAGIC CORPORATION
DATED: August 18, 2003 By: /s/ Tony Shahbaz
------------------
Tony Shahbaz, President and Chief
Executive Officer (principal executive officer)
By: /s/ Steve Gillings
--------------------
Steve Gillings, Chief Financial Officer
(principal financial and accounting officer)
27
EXHIBITS FILED WITH THIS REPORT
Exhibit
Number Description
- ------ -----------
10.1 Forbearance Agreement and Release entered into as of June 16, 2003 by
ChinaTrust Bank (USA) and I/OMagic Corporation.
10.2 Lease Agreement entered into on July 1, 2003 between Laro Properties LP
and I/OMagic Corporation
10.3 Business Loan Agreement entered into as of August 15, 2003 between
United National Bank and I/OMagic Corporation
10.4 Promissory Note dated August 15, 2003 between United National Bank and
I/OMagic Corporation
10.5 Commercial Security Agreement dated August 15, 2003 between United
National Bank and I/OMagic Corporation
31.1 Certifications of Chief Executive Officer under Exchange Act Rule
13a-14(a)/15d-14(a) (Section 302 of the Sarbanes-Oxley Act), dated
August 18, 2003
31.2 Certifications of Chief Financial Officer under Exchange Act Rule
13a-14(a)/15d-14(a) (Section 302 of the Sarbanes-Oxley Act), dated
August 18, 2003
32.1. Certifications of Chief Executive Officer and Chief Financial Officer
pursuant to Rule Exchange Act Rules 13a-14(b) and 19d-14(b) (Section
906 of the Sarbanes-Oxley Act), dated August 18, 2003
28