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UNITED STATES
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 September 30, 2003
------------------
OR
[ ] 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 88-029062
------------------------------ -------------------------------
(State or Other Jurisdiction of (IRS Employer Identification No.)
Incorporation or Organization)
4 Marconi, Irvine, CA 92618
------------------------ ----------
(Address of Principal Executive Offices) (Zip Code)
(949) 707-4800
--------------
(Registrant's Telephone Number, Including Area Code)
1300 E. Wakeham Avenue, Santa Ana, CA 92705
----------------------------------------------------
(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 November 14, 2003, there were 4,529,672 shares of the issuer's common
stock issued and outstanding.
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 September 30, 2003 (unaudited) 3
Consolidated Statements of Income - For the nine and
three months ended September 30, 2003 and 2002 (unaudited) 5
Consolidated Statements of Cash Flows - For the nine months
ended September 30, 2003 and 2002 (unaudited) 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk 23
Item 4. Controls and Procedures 24
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 24
Item 2. Changes in Securities and Use of Proceeds 24
Item 3. Defaults Upon Senior Securities 24
Item 4. Submission of Matters to a Vote of Security Holders 24
Item 5. Other Information 25
Item 6. Exhibits and Reports on Form 8-K 25
SIGNATURES 25
EXHIBITS FILED WITH THE REPORT 26
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2002 AND SEPTEMBER 30, 2003 (UNAUDITED)
ASSETS
DECEMBER 31, SEPTEMBER 30,
2002 2003
------------ -----------
(unaudited)
CURRENT ASSETS
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . $ 7,320,143 $ 1,588,261
Accounts receivable, net of allowance for doubtful
accounts of $2,135,660 and $2,031,310 (unaudited). . . . . . 19,055,201 15,300,838
Inventory, net of allowance for obsolete inventory of $1,046,812
and $324,485 (unaudited) . . . . . . . . . . . . . . . . . . 4,274,852 5,659,695
Inventory, consigned . . . . . . . . . . . . . . . . . . . . . . . 3,965,428 3,479,682
Inventory in transit . . . . . . . . . . . . . . . . . . . . . . . 675,000 140,584
Prepaid expenses and other current assets. . . . . . . . . . . . . 28,955 184,395
------------ -----------
Total current assets. . . . . . . . . . . . . . . . . . . . . 35,319,579 26,353,455
PROPERTY AND EQUIPMENT, net. . . . . . . . . . . . . . . . . . . . 1,059,067 587,106
TRADEMARK, net of accumulated amortization
of $4,292,308 and $4,726,360 (unaudited) . . . . . . . . . . 5,353,371 4,919,319
OTHER ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,952 52,984
------------ -----------
TOTAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . . . $ 41,757,969 $31,912,864
============ ===========
The accompanying notes are an integral part of these financial statements.
3
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2002 AND SEPTEMBER 30, 2003 (UNAUDITED)
LIABILITIES AND STOCKHOLDERS' EQUITY
DECEMBER 31, SEPTEMBER 30,
2002 2003
------------ -----------
(unaudited)
CURRENT LIABILITIES
Line of credit . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,372,827 $ 3,774,788
Accounts payable and accrued expenses . . . . . . . . . . . . . . 7,285,246 4,539,410
Accounts payable - related parties. . . . . . . . . . . . . . . . 2,607,278 6,179,351
Reserves for customer returns and allowances. . . . . . . . . . . 765,898 651,525
Current portion of settlement payable . . . . . . . . . . . . . . 3,000,000 1,000,000
------------- -------------
Total current liabilities . . . . . . . . . . . . . . . . . . . 24,031,249 16,145,074
SETTLEMENT PAYABLE, net of current portion. . . . . . . . . . . . 1,000,000 -
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . 25,031,249 16,145,074
------------- -------------
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) (15,668,714)
------------- -------------
Total stockholders' equity. . . . . . . . . . . . . . . . . . . 16,726,720 15,767,790
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY. . . . . . . . . . $ 41,757,969 $ 31,912,864
============= =============
The accompanying notes are an integral part of these financial statements.
4
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE NINE AND THREE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(UNAUDITED)
NINE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
------------ ------------- ------------ -------------
(unaudited) (unaudited) (unaudited) (unaudited)
NET SALES. . . . . . . . . . . . . . . . . . . . . . . $43,362,247 $ 61,199,231 $13,505,327 $ 20,393,164
COST OF SALES. . . . . . . . . . . . . . . . . . . . . 36,953,579 54,750,691 11,443,776 18,838,477
------------ ------------- ------------ -------------
GROSS PROFIT . . . . . . . . . . . . . . . . . . . . . 6,408,668 6,448,540 2,061,551 1,554,687
------------ ------------- ------------ -------------
OPERATING EXPENSES
Selling, marketing, and advertising. . . . . . . . . . 940,539 1,147,916 275,935 443,953
General and administrative . . . . . . . . . . . . . . 5,137,422 5,767,854 1,202,693 1,674,732
Depreciation and amortization. . . . . . . . . . . . . 1,058,647 1,000,363 346,062 219,136
------------ ------------- ------------ -------------
Total operating expenses. . . . . . . . . . . . . . 7,136,608 7,916,133 1,824,690 2,337,821
------------ ------------- ------------ -------------
INCOME (LOSS) FROM OPERATIONS. . . . . . . . . . . . . (727,940) (1,467,593) 236,861 (783,134)
------------ ------------- ------------ -------------
OTHER INCOME (EXPENSE)
Interest income. . . . . . . . . . . . . . . . . . . . 307 1,411 36 1,299
Interest expense . . . . . . . . . . . . . . . . . . . (196,412) (282,818) (40,759) (90,678)
Other income (expense) . . . . . . . . . . . . . . . . 45,719 (242,473) (3,596) (169,168)
------------ ------------- ------------ -------------
Total other income (expense) . . . . . . . . (150,386) (523,880) (44,319) (258,547)
------------ ------------- ------------ -------------
INCOME (LOSS) BEFORE INCOME TAXES. . . . . . . . . . . (878,326) (1,991,473) 192,542 (1,041,681)
PROVISION FOR (BENEFIT FROM) INCOME TAXES. . . . . . . (3,083) 999,132 (1,885) 499,132
------------ ------------- ------------ -------------
NET INCOME (LOSS). . . . . . . . . . . . . . . . . . . ($875,243) ($2,990,605) $ 194,427 ($1,540,813)
============ ============= ============ =============
BASIC AND DILUTED EARNINGS PER SHARE . . . . . . . . . ($0.19) ($0.66) $ 0.04 ($0.34)
============ ============= ============ =============
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 NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30,
2003 2002
------------ -------------
(unaudited) (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net (loss). . . . . . . . . . . . . . . . . . . . . . . ($875,243) ($2,990,605)
Adjustments to reconcile net income to net cash
provided by (used in) operating activities
Depreciation and amortization . . . . . . . . . . . . . 624,594 228,715
Amortization of trademarks. . . . . . . . . . . . . . . 434,052 771,648
Allowance for doubtful accounts . . . . . . . . . . . . (104,350) 1,100,000
Reserve for customer returns and allowances . . . . . . (114,373) (1,475,326)
Reserve for obsolete inventory. . . . . . . . . . . . . (722,327) 1,425,000
Net (gain) loss from sale of property and equipment . . 61 (38,759)
Deferred income tax . . . . . . . . . . . . . . . . . . - 1,000,000
(Increase) decrease in
Accounts receivable . . . . . . . . . . . . . . . . . . 3,858,711 10,081,186
Inventory . . . . . . . . . . . . . . . . . . . . . . . 357,645 (335,483)
Prepaid expenses and other current assets . . . . . . . (155,440) 1,852,377
Other assets. . . . . . . . . . . . . . . . . . . . . . (27,032) -
Increase (decrease) in
Accounts payable and accrued expenses . . . . . . . . . (2,745,838) (5,523,788)
Accounts payable - related parties. . . . . . . . . . . 3,572,073 (2,379,658)
Settlement payable. . . . . . . . . . . . . . . . . . . (3,000,000) -
------------ -------------
Net cash provided by (used in) operating activities . . 1,102,533 3,715,307
------------ -------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment . . . . . . . . . (153,192) (140,328)
Proceeds from sale of property and equipment . . . . 500 74,000
------------ -------------
Net cash provided by (used in) investing activities. (152,692) (66,328)
------------ -------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings (payments) on line of credit . . . . . . (6,598,039) (4,407,066)
Purchase of treasury shares . . . . . . . . . . . . . . (83,684) (40,410)
Payments on capital lease obligations . . . . . . . . . - (9,188)
------------ -------------
Net cash provided by (used in) financing activities . . (6,681,723) (4,456,664)
------------ -------------
Net increase (decrease) in cash and cash equivalents. . (5,731,882) (807,685)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD. . . . . 7,320,143 4,423,623
------------ -------------
CASH AND CASH EQUIVALENTS, END OF PERIOD. . . . . . . . $ 1,588,261 $ 3,615,938
============ =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
INTEREST PAID. . . . . . . . . . . . . . . . . . . . . $ 229,379 $ 279,757
============ =============
INCOME TAXES PAID (REFUNDED) . . . . . . . . . . . . . ($3,083) $ 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 consolidated 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. These financial statements should be read in
conjunction with the Company's Form 10-K for the year ended December 31, 2002.
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.
As of September 30, 2002 (unaudited) and September 30, 2003 (unaudited) the
Company had potential common stock as follows:
2002 2003
---- ----
Weighted average common shares
outstanding during the period 4,528,686 4,529,672
Incremental shares assumed to be outstanding
since the beginning of the period
related to stock options and warrants
outstanding (unaudited) - -
Fully diluted weighted average common
shares and potential common stock 4,528,686 4,625,368
The following potential common shares have been excluded from the computation of
diluted earnings per share as of September 30, 2002 due to being anti-dilutive.
2002
----
Stock Options 111,309
Redeemable convertible preferred stock 75,000
----------
186,309
The following potential common shares have been excluded from the computation of
diluted earnings per share as of September 30, 2003 due to the exercise price
being greater than the Company's weighted average stock price for the period.
2003
----
Stock Options 126,167
Warrants (committed) 20,004
-----------
146,171
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 September 30, 2003. This statement is not
applicable to the Company.
8
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.
NOTE 3 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued liabilities consisted of the following:
September 30,
2003
----
(unaudited)
Accounts payable $ 1,638,701
Accrued rebates and marketing 2,247,509
Accrued compensation and related benefits 264,760
Other 388,440
------------
TOTAL $ 4,539,410
============
NOTE 4 - INVENTORY
Inventory consisted of the following:
September 30,
2003
----
(unaudited)
Component parts $ 2,937,140
Finished goods 3,047,040
Reserves for obsolete and
slow moving inventory (324,485)
------------
TOTAL $ 5,659,695
============
NOTE 5 - LINE OF CREDIT
On August 15, 2003, the Company entered into a business loan agreement with
United National Bank. Under the terms of the loan agreement, which became
effective August 18, 2003, the Company may borrow up to $6,000,000. The credit
facility 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 September 30, 2003, the
interest rate was 4.75%. The credit facility also requires the Company to be in
compliance with certain financial covenants, all of which were complied with at
September 30, 2003. The agreement also calls for the Company to be profitable
for the year ended December 31, 2003.
9
The new line of credit was initially used to pay off the outstanding balance
with ChinaTrust Bank (USA) as of September 2, 2003, which was $3,379,827. The
outstanding balance with United National Bank as of September 30, 2003 was
$3,774,788. The Company has available to it $2,225,212 of additional borrowings
under the credit facility as of September 30, 2003. The line of credit is
included in current liabilities in the accompanying consolidated balance sheet.
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 related party 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 September 30, 2003 (unaudited), there were $0 and $0,
respectively, in trade payables outstanding under this arrangement.
In connection with a December 2000 subscription agreement, the Company also has
available an additional trade line of credit through a related party 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 September 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. As of September 30, 2003, $500,000 has been applied
against outstanding trade payables. 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 September 30, 2003 (unaudited), there were $3,345,578 in trade payables net
of the deposit still outstanding ($1,000,000) 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. In
addition, this agreement provides for a trade line of credit of up to
$10,000,000 with payment terms of net 30 days, non-interest bearing. As of
September 30, 2003 (unaudited), there were $2,833,773 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 August 2006.
Rent expense was $332,024 and $340,966 for the nine months ended September 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 defendant's 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 Company filed its first amended complaint 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 nine months ended September 30, 2003. An $18,000
bonus was paid during the nine months ended September 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 nine months ended September 30, 2003 and 2002,
the Company incurred $2,045,470 (unaudited) and $2,009,730 (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 nine months ended September 30, 2003 and 2002, the Company made
purchases from related parties totaling approximately $22,158,082 (unaudited)
and $13,039,419 (unaudited), respectively.
During the nine months ended September 30, 2003 and 2002, the Company had
accounts payable to related parties totaling approximately $6,179,351
(unaudited) and $3,142,062 (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 nine months ended September 30, 2003 and
2002, rent expense to the related party was $86,018 and $258,053 respectively,
and is included in general and administrative expenses in the accompanying
statements of operations.
11
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
unaudited 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
29.1% decrease in net sales for the nine months ended September 30, 2003
compared to the nine months ended September 30, 2002. While the current
economic climate makes it difficult for us to look forward into the fourth
quarter of 2003 and the year 2004, we believe that the introduction of our
advanced DVD/RW products in the third quarter of 2003, which have higher average
selling prices and higher margins than our other products, as well as our
addition of Staples as a customer in September 2003, have strengthened our
potential for profitability in the fourth quarter 2003 and for the year 2004.
Our net loss for the nine months ended September 30, 2003 decreased by 70.7% as
compared to the nine months ended September 30, 2002, primarily due to the
expensing of $1,000,000 in deferred income taxes in the first nine months of
2002 and the reduction of operating expenses by $779,000 and the reduction of
other expenses by $373,000 during the first nine months of 2003.
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
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.
12
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 SEPTEMBER 30, 2003 (UNAUDITED) COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 2002 (UNAUDITED)
Net sales decreased by $6,887,837 (33.8%) from $20,393,164 for the three months
ended September 30, 2002 to $13,505,327 for the three months ended September
30, 2003. The decrease in net sales is primarily due to the fact that we did
not sell any of our products to Office Max during the three months ended
September 30, 2003. We mutually agreed with Office Max to discontinue the sale
of our products to them. We anticipate making a new proposal to Office Max in
the near future as we introduce new products.
Cost of sales as a percentage of net sales decreased from 92.4% ($18,838,477) in
the three months ended September 30, 2002 to 84.7% ($11,443,776) in the three
months ended September 30, 2003. Cost of units decreased from 83.0%
($16,929,775) of net sales in the three months ended September 30, 2002 to 81.8%
($11,046,403) of net sales in the three months ended September 30, 2003 due to a
change in product mix. Freight in/out decreased from 5.6% ($1,146,115) of net
sales in the three months ended September 30, 2002 to 2.4% ($322,373) of net
sales in the three months ended September 30, 2003. Freight in decreased from
$539,942 for the three months ended September 30, 2002 to $19,017 for the three
months ended September 30, 2003 as a result of higher freight in costs in 2002
when we shipped products by airfreight to meet customers' shipping deadlines.
Freight out decreased from $606,173 for the three months ended September 30,
2002 to $303,355 for the three months ended September 30, 2003 due to lower
sales in 2003. Inventory shrink/adjustments decreased from 3.7% ($762,587) of
net sales in the three months ended September 30, 2002 to 0.6% ($75,000) of net
sales in the three months ended September 30, 2003 since we wrote down to lower
of cost or market $762,587 in inventory in 2002 and $75,000 in 2003.
13
Operating expenses as a percentage of net sales increased from 11.5%
($2,337,821) in the three months ended September 30, 2002 to 13.5% ($1,824,690)
in the three months ended September 30, 2003. This percentage increase was
primarily due to total operating expenses decreasing 21.9%, to $1,824,690 for
the three months ended September 30, 2003 from $2,337,821 in the three months
ended September 30, 2002, while net sales decreased 33.8% in the three months
ended September 30, 2003 from the three months ended September 30, 2002.
Operating expenses declined primarily as a result of the following: (1) selling,
marketing and advertising expenses decreased by $168,018 (37.8%), to $275,935
for the three months ended September 30, 2003 from $443,953 for the three months
ended September 30, 2002; (2) general and administrative expenses decreased by
$472,039 (28.2%), to $1,202,693 for the three months ended September 30, 2003
from $1,674,732 for the three months ended September 30, 2002; and (3)
depreciation and amortization expenses increased by $126,926 (57.9%), to
$346,062 for the three months ended September 30, 2003 from $219,136 for the
three months ended September 30, 2002.
Selling, marketing and advertising expenses for the three months ended September
30, 2003 were $275,935 (2.0% of net sales) and for the three months ended
September 30, 2002 were $443,953 (2.2% of net sales). Selling, marketing and
advertising expenses decreased by $168,018 primarily as a result of $89,467 less
outside sales representative commissions due to less sales, $49,216 less travel
and related expenses and $30,036 less customer performance charges.
General and administrative expenses for the three months ended September 30,
2003 were $1,202,693 (8.9% of net sales) and for the three months ended
September 30, 2002 were $1,674,732 (8.2% of net sales). General and
administrative expenses decreased $472,039 primarily as a result the following:
(1) an aggregate of $272,963 less in legal expenses as a result of an accrual
for a $180,000 settlement in 2002 and abnormally high legal fees in 2002 in
connection with the preparation of reports filed with the Securities and
Exchange Commission; (2) $89,277 less payroll and related fringe benefits due to
lower sales; (3) $86,389 less subcontract work due to lower sales; and (4)
$38,384 less warehouse supplies due to lower sales.
Depreciation and amortization expenses for the three months ended September 30,
2003 were $346,062 (2.6% of net sales) and for the three months ended September
30, 2002 were $219,136 (1.1% of net sales). The increase of $126,926 was
primarily the result of increased amortization of leasehold improvements. The
amortization of the leasehold improvements at the Santa Ana location was
accelerated due to an anticipated move to a larger facility that occurred in
September 2003.
Other income (expenses) decreased to $44,319 (0.3% of net sales) expense for the
three months ended September 30, 2003 from $258,547 expense (1.3% of net sales)
for the three months ended September 30, 2002. This decrease of $214,228 was
primarily due to $175,630 of legal fees in 2002 versus $0 in 2003 for a
litigation matter and $49,919 less interest expense in 2003 due to less
borrowings.
NINE MONTHS ENDED SEPTEMBER 30, 2003 (UNAUDITED) COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 2002 (UNAUDITED)
Net sales decreased by $17,836,984 (29.1%) from $61,199,231 for the nine months
ended September 30, 2002 to $43,362,247 for the nine months ended September 30,
2003 . The decrease in net sales is primarily attributable to no sales to
Office Max after March 2003 and 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 mutually agreed with Office Max to discontinue the sale of
our products to them. We anticipate making a new proposal to Office Max in the
near future as we introduce new products. We believe that the recent
introduction of new products such as our dual format DVD Rewritable drives,
digital photo library, duplicator and media station products will result in a
reverse of the decrease in revenues.
14
Cost of sales as a percentage of net sales decreased from 89.5% ($54,750,691)
for the nine months ended September 30, 2002 to 85.2% ($36,953,579) for the nine
months ended September 30, 2003. Cost of units increased from 80.6% of net
sales ($49,335,795) for the nine months ended September 30, 2002 to 81.5% of net
sales ($35,336,274) for the nine months ended September 30, 2003 due to product
mix. Freight in/out decreased from 5.6% of net sales ($3,452,310) for the nine
months ended September 30, 2002 to 3.6% of net sales ($1,542,305) for the nine
months ended September 30, 2003. Freight in decreased from $1,677,776 for the
nine months ended September 30, 2002 to $467,398 for the nine months ended
September 30, 2003 due to less product shipped in by airfreight in 2003 to meet
shipping deadlines to customers. Freight out decreased from $1,774,534 for the
nine months ended September 30, 2002 to $1,074,907 for the nine months ended
September 30, 2003 due to lower sales in 2003. Inventory shrink/adjustments
decreased from 3.2% of net sales ($1,962,587) for the nine months ended
September 30, 2002 to 0.2% of net sales ($75,000) for the nine months ended
September 30, 2003. We wrote down to lower of cost or market $1,962,587 in
inventory for the nine months ended September 30, 2002 and $75,000 for the nine
months ended September 30, 2003.
Operating expenses as a percentage of net sales increased from 12.9%
($7,916,133) for the nine months ended September 30, 2002 to 16.5% ($7,136,608)
for the nine months ended September 30, 2003. This percentage increase was
primarily the result of total operating expenses decreasing $779,525 (9.8%) for
the nine months ended September 30, 2003 from the nine months ended September
30, 2002, while net sales decreased $17,836,984 (29.1%) for the nine months
ended September 30, 2003 from the nine months ended September 30, 2002.
Operating expenses declined primarily as a result of the following: (1)
selling, marketing and advertising expenses decreased by $207,377 (18.1%), to
$940,539 for the nine months ended September 30, 2003 from $1,147,916 for the
nine months ended September 30, 2002; (2) general and administrative expenses
decreased by $630,432 (10.9%), to $5,137,422 for the nine months ended September
30, 2003 from $5,767,854 for the nine months ended September 30, 2002; (3)
depreciation and amortization expenses increased by $58,284 (5.8%), to
$1,058,647 for the nine months ended September 30, 2003 from $1,000,363 for the
nine months ended September 30, 2002.
Selling, marketing and advertising expenses for the nine months ended September
30, 2003 were $940,539 (2.2% of net sales) and for the nine months ended
September 30 2002 were $1,147,916 (1.9% of net sales). Selling, marketing and
advertising expenses decreased by $207,377 mainly due to $142,604 less outside
sales representatives commissions due to lower sales, $39,208 less travel
expense and $33,137 less trade shows expense.
General and administrative expenses for the nine months ended September 30,
2003 were $5,137,422 (11.8% of net sales) and for the nine months ended
September 30, 2002 were $5,767,854 (9.4% of net sales). General and
administrative expenses decreased $630,432 primarily as a result of the
following: (1) an aggregate of $518,784 less in legal expenses due to the
reduction in 2002 in estimated accruals relating to a lawsuit, a 2002
settlement, and higher legal fees in 2002 in connection with the preparation of
reports filed with the Securities and Exchange Commission; (2) $133,671 less
insurance primarily due to overaccrual of prior years, $114,743 less payroll and
related fringe benefits due to lower sales; (3) $106,285 less warehouse supplies
due to lower sales; (4) $69,108 less offsite storage expense; (5) $55,370 less
travel; (6) $45,817 less outside assembly due to lower sales; (7) offset by
$378,700 more bad debt expense related to the additional write down of accounts
receivable acquired from Hi-Val; (8) $70,264 more product design for new product
tooling; (9) $53,262 more audit expense; and (10) $50,000 more in moving
expense.
15
Depreciation and amortization expenses for the nine months ended September 30,
2003 were $1,058,647 (2.4% of net sales) and for the nine months ended
September 30, 2002 were $1,000,363 (1.6% of net sales). The increase of $58,284
was mainly as a result of $397,572 increased amortization of leasehold
improvements offset by $337,596 decreased amortization of trademarks. 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 that occurred in September 2003.
Other income (expenses) decreased to $150,386 (0.3% of net sales) expense for
the nine months ended September 30, 2003 from $523,880 expense (0.9% of net
sales) for the nine months ended September 30, 2002. This decrease of $373,494
was primarily due to $287,694 legal fees in 2002 versus $0 in 2003 for a
litigation matter, $40,940 in currency exchange gain in relation to sales to
Canadian retailers, $86,406 less interest expense due to less borrowings, offset
by $38,759 gain in 2002 on the sale of fixed assets.
LIQUIDITY AND CAPITAL RESOURCES
During the nine months ended September 30, 2003 we had a net decrease in cash
relative to December 31, 2002 in the amount of $5,731,882 to $1,558,261 from
$7,320,143, respectively. This was due to cash provided by operating activities
of $1,102,533 offset by cash used in financing activities of $6,681,723 and cash
used in investing activities of $152,692. Cash provided by operations was from a
decrease in accounts receivable of $3,858,711, an increase in accounts payable
to related parties of $3,572,073, a decrease in inventory of $357,645, an
increase in non-cash entries of $117,657, offset by a decrease in the reserve
for settlements of $3,000,000, a decrease in accounts payable and accrued
expenses of $2,745,838, a net loss of $875,243, an increase in prepaid expenses
and other current assets of $155,440, and an increase in other assets of
$27,032. Cash used for financing activities was for net payments on the line of
credit of $6,598,039 and purchase of treasury stock of $83,684. Cash used for
investing activities was for leasehold improvements, furniture and computer
equipment. Leasehold improvements of $634,453 were written off. They were
fully amortized and, thus, had no effect on the statement of operations. These
leasehold improvements pertained to the Santa Ana facility, which was vacated in
September 2003.
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) that was to expire
December 31, 2003. The ChinaTrust Bank (USA) line of credit provided for the
maintenance of certain financial covenants. As of December 31, 2002, March 31,
2003, and June 30, 2003, we were in violation of certain covenants. On April
11, 2003 (effective April 15, 2003), May 15, 2003, and August 15, 2003,
respectively, we obtained waivers from ChinaTrust Bank (USA) as to our violation
of such covenants. The waivers for the violations of the convenants were
subject to a Forbearance Agreement and Release entered into June 16, 2003
between ChinaTrust Bank and us. The expiration date of the line of credit was
October 15, 2003.
On August 15, 2003, we entered into a business loan agreement with United
National Bank. Under the terms of the loan agreement, which became effective
August 18, 2003, we may borrow up to $6,000,000. The credit facility expires
September 1, 2004 and is secured by 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 September 30, 2003, the interest rate was 4.75%. The
credit facility also requires us to be in compliance with certain financial
covenants, all of which were complied with at September 30, 2003. The agreement
also calls for us to be profitable for the year ended December 31, 2003.
The new line of credit was initially used to pay off the outstanding balance
with ChinaTrust Bank (USA) as of September 2, 2003, which was $3,379,827. The
outstanding balance with United National Bank as of September 30, 2003 was
$3,774,788. The Company has available to it $2,225,212 of additional borrowings
under the credit facility as of September 30, 2003. The line of credit is
included in current liabilities in the accompanying consolidated balance sheet.
16
In 1997, we entered into a trade credit facility with Hou Electronics for up to
$2,000,000 with 75 day terms. We owed $0 and $0 on December 31, 2002 and
September 30, 2003, respectively. We purchased $0 and $0 for the twelve months
ended December 31, 2002 and for the nine months ended September 30, 2003,
respectively.
In 2000, we entered into a trade credit facility with Ritek Corporation for up
to $3,000,000 with 60 day terms. We owed $0 and $0 on December 31, 2002 and
September 30, 2003, respectively. We purchased $0 and $0 for the twelve months
ended December 31, 2002 and for the nine months ended September 30, 2003,
respectively.
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
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. As of September 30, 2003, $500,000 has been applied
against outstanding trade payables. 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 September 30,
2003, we owed Lung Hwa $3,345,578 in trade payables net of the $1,000,000
deposit outstanding under this arrangement.
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 September 30, 2003, we owed BTC USA $2,833,773.
We believe that current and future available capital resources, revenues
generated from operations, and other existing sources of liquidity, including
the credit facilities we have, will be adequate to meet our anticipated working
capital and capital requirements for at least the next twelve months under
current operating conditions. If, however, our capital requirements or cash
flow vary materially from our current projections or if unforeseen circumstances
occur, we may require additional financing. Deteriorating global economic
conditions may cause prolonged declines in investor confidence in and
accessibility to capital markets. Our failure to raise capital, if needed, could
restrict our growth, limit our development of new products or hinder our ability
to compete.
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 September 30, 2003 was $6,273,514 as compared to a backlog at
September 30, 2002 of $21,767,978. Over one-half of the September 30, 2002
backlog, which was significantly greater than all previous quarters, was later
17
cancelled by customers as customer sell-through was not as high as anticipated.
The amount of backlog orders represents revenue that we anticipate recognizing
in the future, as evidenced by purchase orders and other purchase commitments
received from customers. The shipment of such orders for non-consigned
customers or the sell-through of our product by consigned customers causes
recognition of such purchase commitments as revenue. However, there can be no
assurance that we will be successful in fulfilling such orders and commitments
in a timely manner, that customers will not cancel purchase orders, or that we
will ultimately recognize as revenue the amounts reflected as backlog based upon
industry trends, historical sales information, returns and price protections.
Accordingly, our backlog may not be indicative of our actual sales beyond a
rotating six-week cycle.
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.
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 nine 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
September 30, 2003, we had an accumulated deficit of $15,668,714. 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 $875,243 for
the nine months ended September 30, 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 FIVE MAJOR CUSTOMERS MAY ADVERSELY AFFECT OUR
BUSINESS IF ANY ONE OR MORE OF THEM DECIDES TO DISCONTINUE PURCHASING OUR
PRODUCTS.
During the first nine months of 2003, net sales to our five largest customers
represented 31%, 15%, 11%, 10% and 10%, 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.
18
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.
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
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 nine months ended September 30, 2003, sales of our computer
peripheral products accounted for 98.3% of our total net sales, and sales of our
consumer electronics products accounted for 1.7% 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 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.
19
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 91.4% of our net sales for the nine months ended September 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.
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.
20
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.
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
21
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.
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 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, during 2003, the high and low closing sale
22
prices of a share of our common stock were $10.00 and $3.00, respectively. The
market price of our common stock may 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.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations were not subject to commodity price risk during the nine months
ended September 30, 2003. Our sales to a foreign country (Canada) were less
than 3% 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
23
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 September 30, 2003 ("Evaluation Date"), 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 Chief Executive Officer and our Chief Financial Officer, as
appropriate to allow timely decisions regarding whether or not disclosure is
required.
During the quarter ended September 30, 2003, there were no changes in our
"internal controls over financial reporting" (as defined in Rules 13a - 15(f)
under the Exchange Act) that have materially affected, or are reasonably likely
to materially affect, our internal controls over financial reporting.
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 defendant's 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 Company filed its first amended complaint and
defendants have not answered. The outcome of this action is presently
uncertain.
In addition, we are 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 our financial position or
results of operations.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
To date we have not paid dividends on our common stock. Our line of credit with
United National Bank prohibits the payment of cash dividends on our common
stock. We currently intend to retain future earnings to fund the development and
growth of our business and, therefore, do not anticipate paying cash dividends
on our common stock within the foreseeable future. Any future payment of
dividends on our common stock will be determined by our board of directors and
will depend on our financial condition, results of operations, contractual
obligations and other factors deemed relevant by our board of directors.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
24
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Number Description
------ -----------
Certifications Required by Rule 13a-14(a) of the Securities
Exchange Act of 1934, as amended, as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act.
Certifications of Chief Executive Officer and Chief
Financial Officer pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act.
(b) Reports on Form 8-K:
----------------------
None
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: November 14, 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)
25
EXHIBITS FILED WITH THIS REPORT
Exhibit
Number Description
- ------ -----------
31 Certifications Required by Rule 13a-14(a) of the Securities Exchange
Act of 1934, as amended, as Adopted Pursuant to Section 302
of the Sarbanes-Oxley Act
32 Certifications of Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act
26