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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
______________________
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004
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)
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 May 17, 2004, there were 4,529,672 shares of the issuer's common stock
issued and outstanding.
I/OMAGIC CORPORATION AND SUBSIDIARIES
TABLE OF CONTENTS
Page
Number
------
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets - December 31, 2003
and March 31, 2004 (unaudited) 3
Consolidated Statements of Income - For the three and
months ended March 31, 2003 and 2004 (unaudited) 5
Consolidated Statements of Cash Flows - For the three months
ended March 31, 2003 and 2004 (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 27
Item 4. Controls and Procedures 27
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 28
Item 2. Changes in Securities and Use of Proceeds 29
Item 3. Defaults Upon Senior Securities 29
Item 4. Submission of Matters to a Vote of Security Holders 29
Item 5. Other Information 29
Item 6. Exhibits and Reports on Form 8-K 29
SIGNATURES 29
EXHIBITS FILED WITH THE REPORT 30
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I/OMAGIC CORPORATION
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2003 AND MARCH 31, 2004 (UNAUDITED)
ASSETS
DECEMBER 31, MARCH 31,
2003 2004
----------- ------------
(unaudited)
CURRENT ASSETS
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . $ 6,091,369 $ 5,422,934
Accounts receivable, net of allowance for doubtful
accounts of $20,553 and $25,953 (unaudited). . . . . . . . 18,439,893 12,196,446
Inventory, net of allowance for obsolete inventory of 505,029
and $479,075 (unaudited) . . . . . . . . . . . . . . . . . 9,706,708 8,286,613
Prepaid expenses and other current assets. . . . . . . . . . . . 407,260 823,151
------------ -----------
Total current assets. . . . . . . . . . . . . . . . . . . . 34,645,230 26,729,144
PROPERTY AND EQUIPMENT, net. . . . . . . . . . . . . . . . . . . 539,943 488,747
TRADEMARK, net of accumulated amortization
of $4,871,044 and $5,015,728 (unaudited) . . . . . . . . . 4,774,635 4,629,951
RESTRICTED CASH. . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000
OTHER ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . 52,984 52,984
------------ -----------
TOTAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . . $ 40,112,792 $32,000,826
============ ===========
The accompanying notes are an integral part of these financial statements.
3
I/OMAGIC CORPORATION
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2003 AND MARCH 31, 2004 (UNAUDITED)
LIABILITIES AND STOCKHOLDERS' EQUITY
DECEMBER 31, MARCH 31,
2003 2004
------------- -------------
(unaudited)
CURRENT LIABILITIES
Line of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,938,705 $ 5,931,125
Accounts payable and accrued expenses . . . . . . . . . . . . . . . . 5,572,878 3,360,178
Accounts payable - related parties. . . . . . . . . . . . . . . . . . 10,370,119 5,755,654
Reserves for customer returns and price protection. . . . . . . . . . 853,373 318,905
Current portion of settlement payable . . . . . . . . . . . . . . . . 1,000,000 -
------------- -------------
Total current liabilities . . . . . . . . . . . . . . . . . . . . . 23,735,075 15,365,862
------------- -------------
STOCKHOLDERS' EQUITY
Preferred Stock
10,000,000 shares authorized, $0.001 par value
Series A, 1,000,000 shares authorized, 0 and 0 shares
issued and outstanding. . . . . . . . . . . . . . . . . . . . . . . - -
Series B, 1,000,000 shares authorized, 0 and 0 shares
issued and outstanding. . . . . . . . . . . . . . . . . . . . . . . - -
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, 13,493 and 13,493 (unaudited) shares, at cost. . . . . (126,014) (126,014)
Accumulated deficit. . . . . . . . . . . . . . . . . . . . . . . . . . (15,058,787) (14,801,540)
------------- -------------
Total stockholders' equity. . . . . . . . . . . . . . . . . . . . . 16,377,717 16,634,964
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY. . . . . . . . . . . . $ 40,112,792 $ 32,000,826
============= =============
The accompanying notes are an integral part of these financial statements.
4
I/OMAGIC CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS ENDED MARCH 31,
(UNAUDITED)
THREE MONTHS ENDED MARCH 31,
2004 2003
---------------- ---------------
(unaudited) (unaudited)
NET SALES. . . . . . . . . . . . . . . . . . . . . . . . $ 15,654,220 $ 17,064,203
COST OF SALES. . . . . . . . . . . . . . . . . . . . . . 12,992,415 14,627,397
------------- -------------
GROSS PROFIT . . . . . . . . . . . . . . . . . . . . . . 2,661,805 2,436,806
------------- -------------
OPERATING EXPENSES
Selling, marketing, and advertising. . . . . . . . . . 774,113 335,917
General and administrative . . . . . . . . . . . . . . 1,366,359 1,456,839
Depreciation and amortization. . . . . . . . . . . . . 209,271 357,298
------------- -------------
Total operating expenses. . . . . . . . . . . . . . . 2,349,743 2,150,054
------------- -------------
INCOME FROM OPERATIONS . . . . . . . . . . . . . . . . . 312,062 286,752
------------- -------------
OTHER INCOME (EXPENSE)
Interest income. . . . . . . . . . . . . . . . . . . . - 166
Interest expense . . . . . . . . . . . . . . . . . . . (43,915) (103,567)
Other income (expense) . . . . . . . . . . . . . . . . (7,811) 23,263
------------- -------------
Total other income (expense) . . . . . . . . . (51,726) (80,138)
------------- -------------
INCOME BEFORE PROVISION FOR (BENEFIT FROM) INCOME TAXES. 260,336 206,614
PROVISION FOR (BENEFIT FROM) INCOME TAXES. . . . . . . . 3,088 (2,654)
------------- -------------
NET INCOME . . . . . . . . . . . . . . . . . . . . . . . $ 257,248 $ 209,268
============= =============
BASIC EARNINGS PER SHARE . . . . . . . . . . . . . . . . $ 0.06 $ 0.05
============= =============
DILUTED EARNINGS PER SHARE . . . . . . . . . . . . . . . $ 0.06 $ 0.05
============= =============
BASIC WEIGHTED-AVERAGE SHARES OUTSTANDING. . . . . . . . 4,529,672 4,529,672
------------- -------------
DILUTED WEIGHTED-AVERAGE SHARES OUTSTANDING. . . . . . . 4,594,047 4,529,672
============= =============
The accompanying notes are an integral part of these financial statements.
5
I/OMAGIC CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31,
(UNAUDITED)
THREE MONTHS ENDED MARCH 31,
2004 2003
---------------- ---------------
(unaudited) (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income. . . . . . . . . . . . . . . . . . . . . . . . $ 257,248 $ 209,268
Adjustments to reconcile net income to net cash
provided by (used in) operating activities
Depreciation and amortization . . . . . . . . . . . . 64,587 212,614
Amortization of trademarks. . . . . . . . . . . . . . 144,684 144,684
Allowance for doubtful accounts . . . . . . . . . . . 5,400 611
Reserve for customer returns and allowances . . . . . (534,468) (289,848)
Reserve for obsolete inventory. . . . . . . . . . . . (25,954) -
(Increase) decrease in
Accounts receivable . . . . . . . . . . . . . . . . 6,238,047 2,323,425
Inventory . . . . . . . . . . . . . . . . . . . . . 1,446,050 (2,781,088)
Inventory in transit. . . . . . . . . . . . . . . . - 675,000
Prepaid expenses and other current assets . . . . . (415,892) (137,119)
Increase (decrease) in
Accounts payable and accrued expenses . . . . . . . (2,212,701) (1,054,765)
Accounts payable - related parties. . . . . . . . . (4,614,465) 4,685,683
Settlement payable. . . . . . . . . . . . . . . . . (1,000,000) (3,000,000)
------------- -------------
Net cash provided by (used in) operating activities . (647,464) 988,465
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment . . . . . . . . (13,391) (25,217)
------------- -------------
Net cash used in investing activities. . . . . . . (13,391) (25,217)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings (payments) on line of credit . . . . . (7,580) (2,595,000)
Purchase of treasury shares . . . . . . . . . . . . . - (83,684)
------------- -------------
Net cash used in financing activities . . . . . . . . ( 7,580) (2,678,684)
------------- -------------
Net increase (decrease) in cash and cash equivalents. (668,435) (1,715,436)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD. . . . 6,091,369 7,320,143
------------- -------------
CASH AND CASH EQUIVALENTS, END OF PERIOD. . . . . . . $ 5,422,934 $ 5,604,707
============= =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
INTEREST PAID. . . . . . . . . . . . . . . . . . . . $ 42,682 $ 111,352
============= =============
INCOME TAXES PAID (REFUNDED) . . . . . . . . . . . . $ 3,088 $ (2,654)
============= =============
The accompanying notes are an integral part of these financial statements.
6
I/OMAGIC CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - ORGANIZATION AND BUSINESS
I/OMagic Corporation ("I/OMagic"), a Nevada corporation, and its subsidiaries
(collectively, the "Company") develop, manufacture through subcontractors,
market, and distribute data storage and digital entertainment products for the
consumer electronics markets.
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
its subsidiaries. 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, 2003.
USE OF ESTIMATES
The preparation of financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Actual results could differ from those estimates.
STOCK BASED COMPENSATION
Statement of Financial Accounting Standards ("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 intrinsic 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 intrinsic value 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 March 31, 2003 (unaudited) and March 31, 2004 (unaudited) the Company had
potential common stock as follows:
2003 2004
---------- ----------
Weighted average common shares
outstanding during the period 4,529,672 4,529,672
Incremental shares assumed to be outstanding
since the beginning of the period related
to stock options and warrants outstanding (unaudited) - 64,375
Fully diluted weighted average common shares and
potential common stock 4,529,672 4,594,047
The following potential common shares have been excluded from the computation of
diluted earnings per share as of March 31, 2003 and March 31, 2004 due to the
exercise price being greater than the Company's weighted average stock price for
the period.
2003 2004
---------- ----------
Stock Options 146,167 188,167
Warrants - 20,004
---------- ----------
146,167 208,171
---------- ----------
NOTE 3 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued liabilities consisted of the following:
March 31, December 31,
2004 2003
----------- ------------
(unaudited)
Accounts payable $ 1,017,685 $ 2,525,508
Accrued rebates and marketing 1,850,111 2,369,544
Accrued compensation and related benefits 217,277 192,002
Other 275,105 485,824
----------- -----------
TOTAL $ 3,360,178 $ 5,572,878
=========== ============
8
NOTE 4 - INVENTORY
Inventory consisted of the following:
March 31, December 31,
2004 2003
----------- ------------
(unaudited)
Component parts $ 2,864,477 $ 3,658,140
Finished goods - warehouse 2,952,994 2,317,765
Finished goods - consigned 2,948,217 4,235,832
Reserves for obsolete and slow moving inventory (479,075) (505,029)
----------- -----------
TOTAL $ 8,286,613 $ 9,706,708
=========== ===========
NOTE 5 - LINE OF CREDIT
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 a UCC filing on substantially all of
the Company's assets. Advances on the line bear interest at the floating
commercial loan rate equal to the prime rate as reported in the Wall Street
Journal plus 0.75%. As of March 31, 2004, the interest rate was 4.75%. The
agreement also calls for the Company to be in compliance with certain financial
covenants which the Company was in compliance with at March 31, 2004. The
outstanding balance with United National Bank as of March 31, 2004 was
$5,931,125. The amount available to the Company for borrowing as of March 31,
2004 was $68,875.
NOTE 6 - CREDIT FACILITIES FROM RELATED PARTIES
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. The third party
will charge the Company a 5% handling fee 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, of which
$750,000 may be applied against outstanding accounts payables to the related
party after six months. As of March 31, 2004, $750,000 has been applied against
outstanding accounts payables to the related party. The remaining $750,000
deposit has been offset against Accounts Payables - Related Parties in the
accompanying financial statements. The agreement is for 12 months, at the end
of which 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 March 31, 2004, there were $308,275 in trade
payables net of the deposit still outstanding ($750,000) 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 60 days, non-interest bearing. As of
March 31, 2004, there were $5,447,379 in trade payables outstanding under this
arrangement.
9
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 $90,870 (unaudited) and $96,290 (unaudited) for the three
months ended March 31, 2004 and 2003, respectively, and is included in general
and administrative expenses in the accompanying statements of income.
SERVICE AGREEMENTS
Periodically, the Company enters into various agreements for services including,
but not limited to, public relations, financial consulting, and manufacturing
consulting. The agreements generally are ongoing until such time they are
terminated, as defined. Compensation for services is paid either on a fixed
monthly rate or based on a percentage, as specified, and may be payable in
shares of the Company's common stock. During the three months ended March 31,
2004 and 2003, the Company incurred expenses of $127,177 (unaudited) and $78,538
(unaudited), respectively, in connection with such arrangements. These expenses
are included in general and administrative expenses in the accompanying
statements of operations.
EMPLOYMENT AGREEMENT
The Company entered into an employment agreement 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 an initial salary of $198,500, 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. For
the three months ended March 31, 2004 and 2003, bonuses totaling $0 (unaudited)
and $0 (unaudited), respectively, were paid under the terms of this agreement.
As of March 31, 2004 and December 31, the accrued bonuses were $0 (unaudited)
and $0 (unaudited), respectively.
The Company and the officer are presently in the process of negotiating a
revised employment agreement.
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 three months ended March 31, 2004 and 2003, the
Company incurred $452,416 (unaudited) and $724,827 (unaudited), respectively,
related to these agreements. These amounts are netted against sales revenue in
the accompanying statements of income.
10
LITIGATION
Effective on or about March 28, 2003, the Company, among others, entered into a
Settlement Agreement and Release with Mark Vakili, Mitra Vakili, Hi-Val, and
others, in connection with a complaint filed in the Superior Court of the State
of California for the County of Orange (Case No. 01CC09894). Under the terms of
that agreement, (i) the Company paid the plaintiffs an aggregate of $3,000,000
on March 31, 2003, (ii) the Company agreed to pay to the plaintiffs an aggregate
$1,000,000 on March 15, 2004, (iii) Mr. Shahbaz and Mr. Su, each a director of
the Company, relinquished any claims held by either of them to any interest in
Alex Properties, (iv) the Company entered into a new written lease agreement
with Alex Properties relating to the real property in Santa Ana, California,
which the Company had already physically occupied, and (v) Mr. Shahbaz and Mr.
Su transferred, to parties designated by Mark Vakili and Mitra Vakili, an
aggregate of 13,333 post-split shares of the Company's common stock from the
aggregate 66,667 post-split shares of the Company's common stock being returned
by Mark Vakili and Mitra Vakili to Mr. Shahbaz and Mr. Su. Mr. Shahbaz and Mr.
Su had previously transferred the 66,667 post-split shares to Mark Vakili and
Mitra Vakili. On September 30, 2003, pursuant to the terms of the lease
agreement, the Company vacated the real property in Santa Ana.
Thereafter, Mark Vakili, Mitra Vakili and Alex Properties alleged claims that
the Company had improperly caused damage to the Santa Ana facility (the "New
Lease Claims"). The Company denied, and continues to deny all of the New Lease
Claims, and denied, and continues to deny that any such New Lease Claims have
any merit. In early February 2004, all parties to the original Settlement
Agreement and Release executed a First Amendment to Settlement Agreement and
Release, releasing all defendants from all of the New Lease Claims in the event
the Company paid the above-mentioned $1,000,000 by February 17, 2004 (rather
than March 15, 2004). The Company paid the $1,000,000 on February 17, 2004,
thereby effectuating the release of all of the New Lease Claims on such date,
and directly causing the filing of a dismissal of the Vakili action with the
court on March 8, 2004.
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 IOM Holdings 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 subsidiaries.
A claim of $15 million in damages has been alleged against the defendants. On
November 6, 2003, the Company filed its First Amended Complaint against all
defendants. Defendants have responded to the Company's First Amended Complaint
denying its allegations. Defendants Horwitz and Cron have also filed a
Cross-Complaint against the Company for attorneys' fees in the amount of
$78,971.15 that they claim are owed to them for their work done in the matter in
which the Company is suing them in. The Company has denied their allegations in
the Cross-Complaint based on the fact that Defendants are not entitled to such
fees. As of the date of this report, discovery on all parties has commenced and
responses are now being prepared. 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.
NOTE 8 - RELATED PARTY TRANSACTIONS
During the three months ended March 31, 2004 and 2003, the Company made
purchases from related parties totaling approximately $7,307,338 (unaudited) and
$8,039,904 (unaudited), respectively.
During the three months ended March 31, 2004 and 2003, the Company had trade
payables to related parties totaling approximately $5,755,654 (unaudited) and
$7,292,961 (unaudited), respectively.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
You should read the following discussion together with our consolidated
financial statements and related notes appearing elsewhere in this report. This
discussion contains forward-looking statements regarding the data storage and
digital entertainment industries and our expectations regarding our future
performance, liquidity and capital resources. Our actual results could differ
materially from those expressed in these forward-looking statements.
We are a leading provider of data storage products. We also sell digital
entertainment products. Our data storage products consist of a range of products
that store traditional personal computer, or PC, data as well as music, photos,
movies, games and other multi-media. These products are designed principally for
general data storage purposes. Our digital entertainment products consist of a
range of products that focus on digital music, photos and movies. These products
are designed principally for entertainment purposes. We sell our products
through computer, consumer electronics and office supply superstores and other
retailers who collectively operate retail locations throughout North America.
Our network of retailers enables us to offer products to consumers across North
America, including every major metropolitan market in the United States. Our
largest retailers include Best Buy, Circuit City, CompUSA, Office Depot,
RadioShack, and Staples. We employ a three-brand approach to achieve our goal of
product differentiation among various sales channels and price points. Our three
brands are I/OMagic, Digital Research Technologies and Hi-Val.
Prior to 2003, we also emphasized the sale of other PC-related and consumer
electronics products including, media, keyboards, mice, cameras, audio and
graphic cards and flat panel television monitors. During the latter part of 2002
and the early part of 2003, we made a strategic decision to de-emphasize these
additional product offerings in order to focus our management and financial
resources on the manufacture and sale of our data storage and digital
entertainment products, especially the manufacture and sale of dual-format
digital video or digital versatile disc, or DVD, recordable devices that we
introduced in July 2003. Because of our planned introduction of these devices in
the third quarter of 2003, we reduced our promotional activities, such as
rebates and point-of-sale discounts, for our CD-based products. This reduction
in promotional activities, combined with our transition out of certain product
offerings and other factors discussed below, resulted in an 8.3% decline in net
sales for the first quarter of 2004 as compared to the first quarter of 2003.
Despite this reduction in net sales for 2004, we increased our net income 22.9%
from $209,000 for the first quarter of 2003 to $257,000 for the first quarter of
2004. We believe that this improvement in our operating results is due, in large
part, to the following factors:
- - Focus on Smaller Number of Product Offerings. Our decision to reduce the
number of product offerings in order to focus our attention on our data
storage and digital entertainment products has had the benefit of
eliminating or reducing product offerings that were not very profitable.
- - More Efficient Receipt of Goods From Vendors. We have worked with some of
our vendors in the shipment of inventory in which the vendors have agreed
to absorb some of the freight costs to us.
- - Elimination of Accelerated Leasehold Amortization. In fiscal 2003, we
accelerated the amortization on our prior facility due to our decision to
relocate later in the year. Our amortization of new leasehold
improvements in fiscal 2004 is expected to be under normal life of lease
policy.
12
- - More Efficient Management Reporting. We expanded our review and management
of operating expenses in order to reduce costs. In doing so, we
instituted improved financial controls and procedures to better monitor
personnel, legal and accounting costs. We spent more time and effort
tracking consigned inventory that resides at our retailers. In doing so,
we believe that we can better control overstocking of our products, which
in turn allows us to better control price reductions and marketing
programs in our efforts to sell inventory. We also spent additional time
and effort in managing the shipment of products to our retailers to ensure
that deliveries to these retailers were made on time in order to avoid
penalties which many retailers assess on late shipments.
RETAILERS
Historically, a limited number of retailers have accounted for a
significant percentage of our net sales. For the three months ended March 31,
2004 and 2003, our four largest retailers accounted for approximately 39%, 19%,
11% and 10% of our net sales, respectively. We expect that sales of our products
to a limited number of retailers will continue to account for a majority of our
sales in the foreseeable future. We do not have long-term purchase agreements
with any of our retailers. If we were to lose any of our major retailers or
experience any material reduction in orders from any of them, it could have a
material adverse effect on our business and results of operations.
SEASONALITY
Our data storage and digital entertainment products have historically been
affected by seasonal purchasing patterns. Our products tend to have higher unit
sales in the fourth quarter. These sales generally follow seasonal purchasing
patterns of our end-user customers who purchase most of our products through
retailers. Generally, our second quarter is the weakest. The impact of
seasonality on our future results will be affected by our product mix, which
will vary from quarter to quarter.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our 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 principles 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 and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amount of net sales and expenses for
each period. The following represents a summary of our critical accounting
policies, defined as those policies that we believe are the most important to
the portrayal of our financial condition and results of operations and that
require management's most difficult, subjective or complex judgments, often as a
result of the need to make estimates about the effects of matters that are
inherently uncertain.
Revenue Recognition
Currently, the majority of our net sales are non-consignment and are
recognized upon shipment to retailers. A growing percentage of our net sales are
consignment sales. Consignment sales are recognized when our retailers sell our
products to the consumers. All of our sales include limited rights to return
unsold inventory. We provide for estimated future returns of inventory based on
historical experience. However, if certain returns in excess of our estimates
occur, those amounts are accrued at the time we become aware of them, which may
not be in the same period in which we book the initial sale. In addition, some
retailers have limited price protection rights for inventories of our products
held by them. If we reduce the list price of these previously purchased
products, these retailers may be entitled to receive credits from us. We accrue
for estimated cost for these limited price protection arrangements when the
customer is authorized to make the price change. We also offer to both consumers
and retailers certain rebate arrangements. We accrue for the estimated cost of
these rebate arrangements using actual sell-through data supplied by our
retailers and historical redemption percentages. Our net sales are defined as
our gross sales less these estimated future returns, limited price protection
arrangements, rebate arrangements and marketing development fund/cooperative
arrangements.
13
Advertising and Market Development Costs
Advertising and market development costs are charged to operations or
offset against gross sales in accordance with Emerging Issues Task Force Issue
No. 01-9. For the three months ended March 31, 2004, our advertising and market
development costs were $1.9 million, of which $1.7 million was offset against
gross sales. For the three months ended March 31, 2003, our advertising and
market development costs were $2.6 million, all of which was offset against
gross sales. Consideration generally given by us to a retailer is presumed to
be a reduction of selling price, and therefore, a reduction of gross sales.
However, if we receive an identifiable benefit that is sufficiently separable
from our sales to that retailer, such that we could have paid an independent
company to receive that benefit and we can reasonably estimate the fair value of
that benefit, then the consideration is characterized as an expense. We estimate
the fair value of the benefits we receive by tracking the advertising done by
our retailers on our behalf and calculating the value of that advertising using
a comparable rate for similar publications.
Inventory Obsolescence Allowance
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. These
write-downs result in a charge to cost of sales. These write-downs relate
directly to the amount of slow-moving or obsolete inventory which we have in our
warehouse. This inventory usually is the result of returns by retailers at the
end of a product's life cycle. We plan to make a concerted effort in 2004 to
sell this inventory more quickly than in prior years and thus reduce our
write-downs.
Allowance for Doubtful Accounts
We maintain allowances for doubtful accounts for estimated losses resulting
from the inability of our retailers to make required payments. Our current
retailers consist of either large national or regional retailers with good
payment histories with us. Since we have not experienced any previous payment
defaults with any of our current retailers, our allowance for doubtful accounts
is minimal. We perform periodic credit evaluations of our retailers. If the
financial condition of our retailers were to deteriorate, resulting in the
impairment of their ability to make payments, additional allowances may be
required. New retailers are evaluated through Dunn & Bradstreet before terms
are established. Although we expect to collect all amounts due, actual
collections may differ.
Product Returns
Our policy is to allow return of product from consumers upon proper request
by them and authorization by us. We have no time limit on product returns from
consumers; however, our retailers generally have terms with their customers
which range from fourteen to thirty days from date of purchase. This time
period will generally flow through to us. We also include estimated time of
product on the shelf and time to return product to us. Actual returns are
recorded as reductions to gross sales for the period in which they are received.
In addition, we maintain an allowance for sales returns for estimated future
returns for products currently or previously sold for which we estimate we have
not yet received. We use historical data and estimates based on observations to
determine the allowance for each period. We estimate that sales for two months,
the current and the prior, will be returned in future months. We use the actual
return rate of the prior year to estimate what percent of the two months will be
returned. Sales are adjusted by the estimated returns, while cost of sales are
adjusted by the estimated cost of sales and the allowance is adjusted for the
14
estimated gross margin. In periods in which sales are higher, such as normally
our fourth quarter, the allowance is increased as we expect more returns. In
periods in which sales are lower, such as normally our second quarter, the
allowance is decreased as we expect less returns than we have already reserved
for.
RESULTS OF OPERATIONS
The tables presented below, which compare our results of operations from
one period to another, present the results for each period, the change in those
results from one period to another in both dollars and percentage change and the
results for each period as a percentage of net sales. The columns present the
following:
- - The first two data columns in each table show the absolute results for
each period presented.
- - The columns entitled "Dollar Variance" and "Percentage Variance" show the
change in results, both in dollars and percentages. These two columns show
favorable changes as a positive and unfavorable changes as negative. For
example, when our net sales increase from one period to the next, that
change is shown as a positive number in both columns. Conversely, when
expenses increase from one period to the next, that change is shown as a
negative in both columns.
- - The last two columns in each table show the results for each period as a
percentage of net sales.
THREE MONTHS ENDED MARCH 31, 2004 COMPARED TO THREE MONTHS ENDED MARCH 31, 2003
RESULTS AS A PERCENTAGE
OF NET SALES FOR THE
THREE MONTHS ENDED DOLLAR PERCENTAGE THREE MONTHS ENDED
MARCH 31, VARIANCE VARIANCE MARCH 31,
------------------------ ----------- -------------- -------------------
FAVORABLE FAVORABLE
2004 2003 (UNFAVORABLE) (UNFAVORABLE) 2004 2003
--------- ----------- ----------- -------------- ------ ------
(IN THOUSANDS)
Net sales. . . . . . . . . . . $ 15,654 $ 17,064 $ (1,410) (8.3%) 100.0% 100.0%
Cost of sales. . . . . . . . . 12,992 14,627 1,635 11.2 83.0 85.7
---------- ---------- ----------- -------- ------ ------
Gross profit . . . . . . . . . 2,662 2,437 225 9.2 17.0 14.3
Selling, marketing and
advertising expenses. . . . . 774 336 (438) (130.4) 4.9 2.0
General and administrative
expenses . . . . . . . . . . 1,367 1,457 90 6.2 8.8 8.5
Depreciation and amortization. 209 357 148 41.5 1.3 2.1
---------- ---------- ----------- -------- ------ ------
Operating income . . . . . . . 312 287 25 8.7 2.0 1.7
Net interest expense . . . . . (44) (103) 59 57.3 (0.3) (0.6)
Other income (expense) . . . . (8) 23 (31) (134.8) - 0.1
----------- ---------- ----------- -------- ------ ------
Income from operations
before provision for
income taxes . . . . . . . . 260 207 53 25.6 1.7 1.2
Income tax provision (benefit) 3 (2) (5) (250.0) - -
---------- ---------- ----------- -------- ------ ------
Net income . . . . . . . . . . $ 257 $ 209 $ 48 23.0% 1.7% 1.2%
========== ========== =========== ======== ======= =====
Net Sales. The decrease of $1.4 million in net sales from $17.1 million
for the three months ended March 31, 2003 to $15.7 million for the three months
ended March 31, 2004 is primarily due to our strategic decision to de-emphasize
the sale of certain products and to reduce sales of our CD-based products,
partially offset by a large increase in the sales of our DVD-based products.
The principal reason for the reduction in CD-based product sales was reduced
15
promotional activities, such as rebates and point-of-sale discounts, for these
products because of our concentration in the production and sale of our new
dual-format DVD recordable devices which we introduced in July 2003. As a
result, we experienced a decline of $7.6 million in the sales of CD-based
products from $11.2 million for the first quarter of 2003 as compared to $3.6
million for the same quarterly period in 2004. In addition, sales of our
de-emphasized products declined by approximately $4.8 million to $54,000 for the
first quarter 2004. Partially offsetting this decrease in first quarter 2004
sales was an increase in sales of DVD-based products of $10.2 million from $1.0
million during the first quarter 2003 to $11.2 million for the first quarter
2004. In addition, a change in the allowance for sales returns resulted in a
$900,000 adjustment increase to sales for the first quarter 2004 as compared to
a $300,000 adjustment increase to sales for the first quarter 2003, resulting in
a $600,000 increase in sales in the first quarter 2004 compared to the first
quarter 2003. Also, net sales to OfficeMax declined by $5.8 million, or 100%,
during the three months ended March 31, 2004, while we placed OfficeMax on
shipment hold due to unresolved business issues. Sales to OfficeMax during the
three months ended March 31, 2003 consisted primarily of CD-based products and
those products we have de-emphasized. We hope to resolve our business issues
with OfficeMax and recommence sales later in 2004, but there can be no assurance
that these sales will resume. The decrease in sales to OfficeMax in the first
quarter of 2004 have been replaced by an increase in sales to our other
customers in the first quarter of 2004.
Gross Profit. The increase in gross profit of $225,000 from $2.4 million
for the three months ended March 31, 2003 to $2.6 million for the three months
ended March 31, 2004, is primarily due to a reduction in cost of sales from
$14.6 million during the first quarter of 2003 to $13.0 million for the first
quarter of 2004. This was primarily due to a reduction in the direct costs of
products and related freight from $14.6 million during the first quarter of 2003
to $12.8 million during the first quarter of 2004. The increase as a percentage
of net sales was due to no sales during the first quarter of 2004 of certain
products, such as media, which had a low margin percentage during the first
quarter of 2003 and reduced the blended margin percentage.
The improvement of our gross profit during the first quarter of 2004 as
compared to the first quarter of 2003 was partially offset by an increase in
inventory adjustments from $0 during the first quarter of 2003 to $69,000 during
the first quarter of 2004 and an increase in our inventory obsolescence charges
from $0 during the first quarter of 2003 to $100,000 during the first quarter of
2003. Due to the short life cycle of many of our products, we expect to
continue to experience inventory obsolescence charges in the future. However, we
can not predict with any certainty the future level of these write-downs.
Selling, Marketing and Advertising Expenses. Selling, marketing and
advertising expenses increased by $438,000 in 2004. This increase was primarily
due to an increase in advertising costs and slotting fees of $525,000. These
increases were partially offset by lower commissions due to reduced sales volume
and reduced payroll and related expenses due to less personnel.
General and Administrative Expenses. The decrease in general and
administrative expenses is primarily due to a reduction in audit expenses of
$90,000 and a $79,000 reduction in product design, partially offset by a $62,000
increase in bad debt expenses ($63,000 during the first quarter of 2004 as
compared to $1,000 during the first quarter of 2003).
Depreciation and Amortization Expenses. The decrease in depreciation and
amortization expenses is due to accelerated amortization during the first
quarter of 2003 on our prior Santa Ana facility which was originally to be
leased through 2010. At the beginning of 2003, we decided to move to another
facility by the end of September 2003 and thus, we accelerated our amortization
by $133,000 during the first quarter of 2003.
Other Income (Expense). Other income (expense) decreased by $28,000 as
compared to the first quarter of 2003. During the first quarter of 2004,
interest expense decreased by $59,000 to $44,000 due to reduced borrowings under
our line of credit. This was offset by a $31,000 increase in expense related to
currency transactions in connection with our sales in Canada.
16
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of liquidity have been cash provided by operations
and borrowings under our bank credit facility and trade credit facilities. Our
principal uses of cash have been to finance working capital, capital
expenditures and debt service requirements. We anticipate these uses will
continue to be our principal uses of cash in the future. As of March 31, 2004,
we had working capital of $11.4 million, an accumulated deficit of $14.8
million, $5.4 million in cash and cash equivalents and $12.2 million in net
accounts receivable.
Cash used by our operating activities totaled $647,000 during the first
quarter of 2004 as compared to cash provided by our operating activities of
$988,000 during the first quarter of 2003. This increase in cash used by
operations during the first quarter of 2004 primarily resulted from a $4.6
million decrease in cash from the use of our trade credit facilities with
related parties, a $2.2 million decrease in accounts payable and accrued
expenses, a $1.0 million decrease in settlements payable, a $534,000 decrease in
reserve for customer returns and allowances, and a $416,000 increase in prepaid
expenses. These decreases were offset by a $6.2 million decrease in accounts
receivable, a $1.4 million decrease in inventory, net income of $257,000, and
$145,000 for trademark amortization.
Cash used in our investing activities totaled $13,000 during the first
quarter of 2004 as compared to $25,000 for the first quarter of 2003. Our
investing activities in the first quarter of 2004 consisted of leasehold
improvements, furniture and computer equipment.
Cash used in our financing activities totaled $8,000 during the first
quarter of 2004 as compared to $2.7 million for the first quarter of 2003. Our
financing activities during the first quarter of 2003 consisted of a $2.6
million payment on our line of credit with our prior lender and $83,000 in the
repurchase of shares of our common stock.
On August 15, 2003, we entered into an asset-based business loan agreement
with United National Bank. The credit facility with United National Bank
provides for a revolving loan of up to $6,000,000 secured by substantially all
of our assets and expires September 1, 2004. Advances up to 65% of eligible
accounts receivable bear interest at the floating commercial loan rate equal to
the prime rate of interest as reported in the Wall Street Journal plus 0.75%. As
of March 31, 2004, the interest rate was 4.75%. The business loan agreement
provides that if United National Bank calls the loan because of a default under
the terms of the loan agreement, other than a payment default, we can repay the
loan in six equal monthly installments unless we obtain a replacement credit
facility in which case, all amounts would be due and payable. The business loan
agreement also contains a number of restrictive financial covenants. We were in
compliance with these covenants at March 31, 2004. As of March 31, 2004, the
outstanding balance with United National Bank was $5.9 million and we had
available to us $69,000 of additional borrowings. Our credit facility with
United National Bank expires on September 1, 2004.
In January 2003, we entered into a trade credit facility with Lung Hwa
Electronics Co., Ltd. Lung Hwa Electronics is a shareholder and subcontract
manufacturer of I/OMagic. Under the terms of the facility, Lung Hwa Electronics
has agreed to purchase inventory on our behalf. We can purchase up to
$10,000,000 of inventory, with payment terms of 120 days following the date of
invoice by Lung Hwa Electronics. Lung Hwa Electronics charges us a 5% handling
fee on a supplier's unit price. A 2% discount of the handling fee is applied if
we reach an average running monthly purchasing volume of $750,000. Returns made
by us, which are agreed to by a supplier, result in a credit to us for the
handling charge. As security for the trade credit facility, we paid Lung Hwa
Electronics a $1.5 million security deposit during 2003. As of March 31, 2004,
$750,000 of this deposit had been applied against outstanding trade payables as
the agreement allowed us to apply the security deposit against our outstanding
trade payables. This trade credit facility is for an indefinite term, however,
either party has the right to terminate the facility upon 30 days' written
notice to the other party after the initial 12 months of the agreement. As of
March 31, 2004, we owed Lung Hwa Electronics $308,000 in trade payables net of
the remaining $750,000 deposit.
17
In February 2003, we entered into a Warehouse Services and Bailment
Agreement with Behavior Tech Computer (USA) Corp., or BTC USA. Under the terms
of the agreement, BTC USA has agreed to supply and store at our warehouse up to
$10,000,000 of inventory on a consignment basis. We are responsible for insuring
the consigned inventory, storing the consigned inventory for no charge; and
furnishing BTC USA with weekly statements indicating all products received and
sold and the current level of consigned inventory. The agreement also provides
us with a trade line of credit of up to $10,000,000 with payment terms of net 60
days, without interest. The agreement may be terminated by either party upon 60
days' prior written notice to the other party. As of March 31, 2004, we owed BTC
USA $5.4 million under this arrangement. BTC USA is a subsidiary of Behavior
Tech Computer Corp., one of our significant shareholders. Mr. Steel Su, a
director of I/OMagic, is the Chief Executive Officer of Behavior Tech Computer
Corp.
We believe current and future available capital resources, revenues
generated from operations, and other existing sources of liquidity, including
our trade credit facilities with Lung Hwa Electronics and BTC USA and our credit
facility with United National Bank, will be sufficient to fund our anticipated
working capital and capital expenditure requirements for at least the next
twelve months. If, however, our capital requirements or cash flow vary
materially from our current projections or if unforeseen circumstances occur, we
may require additional financing. For example, if the level of consignment sales
to our retailers were to increase substantially from current levels, our current
credit facility with United National Bank, which is a receivables-based line of
credit, may not meet all of our financing needs since the length of time between
delivery of product and the creation of an account receivable that may be
financed is longer for consignment sales as compared to non-consignment sales.
Accordingly, we would need to obtain other financing, including possibly an
inventory-based line of credit, to meet all of our liquidity needs. Our failure
to raise capital, if needed, could restrict our growth, limit our development of
new products or hinder our ability to compete.
BACKLOG
Our backlog at March 31, 2004 was $3.6 million as compared to a backlog at
March 31, 2003 of $3.2 million. Based on historical trends, we anticipate that
our March 31, 2004 backlog may be reduced by approximately 10%, or $360,000, to
a net amount of $3.2 million as a result of returns and reclassification of
certain expenses as reductions to net sales. Our backlog may not be indicative
of our actual sales beyond a rotating six-week cycle. 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
retailers. The shipment of these orders for non-consigned retailers or the
sell-through of our products by consigned retailers causes recognition of the
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 retailers 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.
RISK FACTORS
------------
An investment in our common stock involves a high degree of risk. In
addition to the other information in this Quarterly Report and in our other
filings with the Securities and Exchange Commission, including our subsequent
reports on Forms 10-Q, 10-K, and 8-K, you should carefully consider the
following risk factors before deciding to invest in shares of our common stock
or to maintain or increase your investment in shares of our common stock. The
risks and uncertainties described below are not the only ones we face.
Additional risks and uncertainties not presently known to us or that we
currently deem immaterial may also affect our business, financial condition and
operating results. If any of the following risks, or any other risks not
described below, actually occur, it is likely that our business, financial
condition and operating results could be seriously harmed. As a result, the
trading price of our common stock could decline, and you could lose part or all
of your investment.
18
WE HAVE INCURRED SIGNIFICANT LOSSES IN THE PAST, AND WE MAY CONTINUE TO INCUR
SIGNIFICANT LOSSES IN THE FUTURE. IF WE CONTINUE TO INCUR LOSSES, OUR BUSINESS
WILL BE ADVERSELY AFFECTED.
We have incurred net losses in each year since the year ended December 31, 1999.
As of March 31, 2004, we had an accumulated deficit of approximately
$14,800,000. During the years ended December 31, 2003, 2002 and 2001, we
incurred net losses in the amounts of approximately $265,000, $8,350,000, and
$5,550,000, respectively. Historically, we have relied upon cash from operations
and financing activities to fund all of the cash requirements of our business.
An extended period of net losses would result in negative cash flow and may
prevent us from operating or expanding our business. We cannot assure you that
we will be able to attain, sustain or increase profitability on a quarterly or
annual basis in the future. If we are not able to achieve, sustain or increase
profitability, our business will be adversely affected and our stock price may
decline.
WE CURRENTLY DEPEND ON A SMALL NUMBER OF MAJOR RETAILERS FOR THE VAST MAJORITY
OF OUR NET SALES. A REDUCTION IN BUSINESS FROM ANY OF THESE RETAILERS, OR THE
FAILURE BY ANY OF THESE RETAILERS TO TIMELY PAY AMOUNTS OWED TO US, COULD
ADVERSELY AFFECT OUR NET SALES AND COULD SERIOUSLY HARM OUR BUSINESS AND
FINANCIAL CONDITION.
During the three months ended March 31, 2004, net sales to our four largest
retailers represented approximately 39%, 19%, 11% and 10%, respectively, of our
total net sales. We expect that we will continue to be dependent upon these
retailers for a significant majority of our revenues for the foreseeable future.
Our agreements with these retailers do not require them to purchase any
specified number of products or dollar amount of sales. Therefore, we cannot
assure you that our net sales generated from these retailers, individually or in
the aggregate, will reach or exceed historical levels in any future period. A
cessation or reduction of business from, or a decrease in prices of products
sold to, any of these retailers has significantly reduced our net sales for one
or more reporting periods in the past and could, in the future, harm our
business and financial condition. We cannot assure you that, if sales to any of
these retailers cease or decline, we will be able to replace these sales with
sales to either existing or new retailers in a timely manner, or at all. If we
could not replace these sales, our business and financial condition would be
adversely affected. Further, should one or more of these retailers fail to pay
us amounts owed in a timely manner, we could suffer a substantial decline in our
profitability, which would have a material adverse affect on our business,
financial condition and results of operations.
IF WE ARE UNABLE TO RENEW OR REPLACE OUR BUSINESS LOAN AGREEMENT WITH UNITED
NATIONAL BANK PRIOR TO ITS SEPTEMBER 1, 2004 EXPIRATION DATE, OUR ABILITY TO
PURCHASE ADDITIONAL INVENTORY AND TO EXPAND OR SUSTAIN OUR CURRENT SALES VOLUME
WOULD BE ADVERSELY AFFECTED. IN ADDITION, WE MAY BE UNABLE TO FUND OUR
DAY-TO-DAY OPERATIONS.
Our business loan agreement with United National Bank expires on September 1,
2004. This agreement provides that if United National Bank calls the loan
because of a default under the terms of the agreement, other than a payment
default, we can repay the loan in six equal monthly installments unless we
obtain a replacement credit facility, in which case all amounts would be due and
payable. If we are unable to renew or replace this agreement, or if United
National Bank calls the loan due in advance of its expiration as a result of a
default by us, we may lack the funds to acquire sufficient amounts of inventory
and our ability to expand or sustain our current sales volume will be adversely
affected. In addition, we may be unable to fund our day-to-day operations.
ONE OR MORE OF OUR RETAILERS MAY DIRECTLY IMPORT OR PRIVATE LABEL PRODUCTS THAT
ARE IDENTICAL, OR VERY SIMILAR, TO OUR PRODUCTS. THIS COULD CAUSE A DECLINE IN
OUR SALES AND COULD HAVE AN ADVERSE IMPACT ON OUR BUSINESS, FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.
19
Optical data storage products and digital entertainment products are widely
available from manufacturers and other suppliers around the world. Our major
retailers include Best Buy, Circuit City, CompUSA, Office Depot, RadioShack, and
Staples. Collectively, these six retailers accounted for 86% of our net sales
for the three months ended March 31, 2004. Each of these retailers has
substantially greater resources than we do, and has the ability to directly
import or private label, data storage and digital entertainment products from
manufacturers and other suppliers around the world, including from some of our
own subcontract manufacturers. Our retailers may believe that higher profit
margins can be achieved if they implement a direct import or private label
program, excluding us from the sales channel. Accordingly, one or more of our
retailers may stop buying products from us in favor of a direct import or
private label program. As a consequence, our sales and profitability would be
adversely affected, which could have an adverse impact on our business,
financial condition and results of operations.
WE RELY HEAVILY ON OUR CHIEF EXECUTIVE OFFICER, AND THE LOSS OF HIS SERVICES
COULD ADVERSELY AFFECT OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
Our success depends, to a significant extent, upon the continued services of
Tony Shahbaz, who is our Chairman of the Board, President, Chief Executive
Officer and Secretary. For example, Mr. Shahbaz has developed key personal
relationships with our suppliers and retail customers, including with our
subcontract manufacturers, upon which we greatly rely in connection with our
operations and the execution of our business strategies. 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
certain circumstances. In addition, we do not maintain "key person" life
insurance covering Mr. Shahbaz or any other executive officer. The loss of Mr.
Shahbaz could significantly delay or prevent the achievement of our business
objectives. Consequently, the loss of Mr. Shahbaz could adversely affect our
business, financial condition and results of operations.
THE HIGH CONCENTRATION OF OUR SALES WITHIN THE DATA STORAGE INDUSTRY COULD HAVE
A MATERIAL ADVERSE AFFECT ON OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF
OPERATIONS IF DEMAND FOR THOSE PRODUCTS DECLINES OR IF COMPETITION WITHIN THE
INDUSTRY INTENSIFIES.
Sales of our data storage products for the three months ended March 31, 2004
accounted for approximately 99% of our net sales. Except for our digital
entertainment products, which accounted for only a small fraction of our net
sales in the three months ended March 31, 2004, we have not diversified our
product categories, and all of these product categories are within the data
storage industry. We expect data storage products to continue to account for the
vast majority of our sales for the foreseeable future. As a result, our
business, financial condition and results of operations would be significantly
and adversely impacted by a downturn in the market for data storage products.
IF WE FAIL TO ACCURATELY FORECAST THE COSTS OF OUR PRODUCT REBATE OR OTHER
PROMOTIONAL PROGRAMS, OUR BRAND IMAGE, AND OUR BUSINESS, FINANCIAL CONDITION AND
RESULTS OF OPERATIONS MAY BE ADVERSELY AFFECTED.
We rely heavily on product rebates and other promotional programs to maintain
and increase sales of our products. If we fail to accurately forecast the costs
of these rebate or other promotional programs, we may fail to allocate
sufficient resources to these programs. For example, we may fail to keep
sufficient funds available for mail-in product rebates. If we are unable to
satisfy our promotional obligations, such as providing cash rebates to
consumers, our brand image and goodwill with those consumers and our retailers
would be harmed, which may adversely affect our business, financial condition
and results of operations.
COMPETITION WITHIN THE DATA STORAGE AND DIGITAL ENTERTAINMENT INDUSTRIES IS
INTENSE. ALL OF OUR SIGNIFICANT COMPETITORS HAVE GREATER RESOURCES THAN WE DO
AND COULD USE THESE RESOURCES TO GAIN MARKET SHARE AND CAUSE US TO LOSE SALES
AND MARKET SHARE.
20
The data storage and digital entertainment industries are extremely competitive.
All of our significant competitors have substantially greater production,
financial, research and development, and marketing resources than we do. As a
result, these companies may be able to compete more aggressively over a longer
period of time than we can. In addition, our lack of resources relative to all
of our significant competitors may cause us to fail to anticipate or respond
adequately to technological developments and changing consumer demands and
preferences, or may cause us to experience significant delays in developing or
introducing new or enhanced products. These failures or delays could reduce our
competitiveness and cause a decline in our market share and sales.
DATA STORAGE AND DIGITAL ENTERTAINMENT PRODUCTS ARE SUBJECT TO RAPID
TECHNOLOGICAL CHANGES. IF WE FAIL TO ACCURATELY ANTICIPATE AND ADAPT TO THESE
RAPID TECHNOLOGICAL CHANGES, THE PRODUCTS WE SELL WILL BECOME OBSOLETE, AND OUR
BUSINESS, SALES, FINANCIAL CONDITION AND RESULTS OF OPERATIONS WILL BE ADVERSELY
AFFECTED.
The data storage and digital entertainment industries are extremely competitive
and subject to rapid technological changes which cause product obsolescence.
Companies within the data storage and digital entertainment industries are
continuously developing new products with heightened performance and
functionality. This puts pricing pressure on, and constantly threatens the
obsolescence of, existing products. Our typical product life cycle is extremely
short and ranges from only three to twelve months, generating lower average
selling prices as the cycle matures. If we fail to accurately anticipate the
introduction of new technologies, we may end up holding significant amounts of
obsolete inventory that can only be sold at substantially lower prices and
profit margins than we expected. In addition, if we fail to accurately
anticipate the introduction of new technologies, we may be unable to compete
effectively due to our failure to offer products most demanded by the
marketplace. If any of these failures occur, our business, sales, financial
condition and results of operations will be adversely affected.
OUR INDEMNIFICATION OBLIGATIONS TO OUR RETAILERS FOR PRODUCT DEFECTS COULD
REQUIRE US TO PAY SUBSTANTIAL DAMAGES, RESULTING IN AN ADVERSE AFFECT ON OUR
BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
A number of our agreements with our retailers provide that we will defend,
indemnify and hold them, and their customers, harmless from damages and costs
that arise from product warranty claims or from claims for injury or damage
resulting from defects in our products. If such claims are asserted against us,
our insurance coverage may not be adequate to cover the costs associated with
our defense of those claims or the cost of any resulting liability we would
incur if those claims are successful. A successful claim brought against us for
product defects that is in excess of, or excluded from, our insurance coverage
could have an adverse affect on our business, financial condition and results of
operations.
IF WE ARE SUBJECTED TO ONE OR MORE INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS,
OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS MAY BE ADVERSELY
AFFECTED.
Our products rely on intellectual property developed, owned or licensed by third
parties. From time to time in the past, intellectual property infringement
claims have been asserted against us. We expect to continue to be subjected to
such claims in the future. Intellectual property infringement claims may also be
asserted against our retailers as a result of selling our products. As a
consequence, our retailers could assert indemnification claims against us. If
any third party is successful in asserting an infringement claim against us, we
could be required to acquire licenses, which may not be available on
commercially reasonable terms, if at all, to discontinue selling certain
products to pay substantial monetary damages or to develop non-infringing
technologies, none of which may be feasible. Both infringement and
indemnification claims could be time-consuming and costly to defend or settle
and would divert management's attention and our resources away from our
business. Because we are a small company and may not have sufficient litigation
defense resources, any one of these developments could place substantial
financial and administrative burdens on us and our business, financial condition
and results of operations could be adversely affected.
21
WE ARE SUBJECT TO PENALTIES FOR BOTH EARLY AND LATE PRODUCT DELIVERIES, WHICH
MAY ADVERSELY AFFECT OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
Our future operating results are dependent upon our ability to deliver products
to our retailers in a timely manner. Often, the purchase orders placed by our
retailers require us to deliver products on a specific date. Many of our
retailers impose penalties for both early and late product deliveries, which
could result in significant additional costs to us. Our failure to timely
deliver products to our retailers could result in significant losses which would
adversely affect our business, financial condition and results of operations.
OUR FAILURE TO SUCCESSFULLY MANAGE OUR PLANNED PRODUCT EXPANSION AND OUR PLANNED
EXPANSION INTO NEW SALES CHANNELS COULD HAVE A MATERIAL ADVERSE AFFECT ON OUR
BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
We plan to offer new data storage and digital entertainment products in the
future. In particular, we plan to offer additional DVD-based products, including
digital video recorders, or DVRs, and to offer products with heightened
performance and added functionality. We also plan to offer a next-generation
DVD-based product, such as Blu-ray DVD or HD-DVD, depending on which of these
competing formats we believe is most likely to prevail in the marketplace. These
planned product offerings will require significant investments of capital and
management's close attention. In offering new digital entertainment products,
our resources and personnel are likely to be strained because we have little
experience in the digital entertainment industry.
We also plan to expand our sales of new and existing products into additional
sales channels, such as corporate and government procurers, value-added
resellers and value-added distributors. In addition, we plan to further develop
our product offerings over the Internet at our company websites located at
http://www.iomagic.com, http://www.dr-tech.com and http://www.hival.com. These
planned expansions will require significant resources, including for improvement
of our information systems and accounting controls, management of product data,
expansion of the capabilities of our administrative and operational personnel,
and attracting, training, managing and retaining additional qualified personnel.
Our failure to successfully manage any of the above tasks associated with our
planned product expansion and our expansion into new sales channels could have a
material adverse affect on our business, financial condition and results of
operations.
A SIGNIFICANT PRODUCT DEFECT OR PRODUCT RECALL COULD HAVE A MATERIAL ADVERSE
AFFECT ON OUR BRAND IMAGE AND OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
A significant product defect could materially harm our brand image and could
force us to conduct a product recall. This could result in damage to our
relationships with our retailers and loss of consumer loyalty. Because we are a
small company, a product recall would be particularly harmful to us because we
have limited financial and administrative resources to effectively manage a
product recall and it would detract management's attention from implementing our
core business strategies. As a result, a significant product defect or product
recall could materially and adversely affect our brand image and our business,
financial condition and results of operations.
IF OUR PRODUCTS ARE NOT AMONG THE FIRST-TO-MARKET, OR IF CONSUMERS DO NOT
RESPOND FAVORABLY TO EITHER OUR NEW OR ENHANCED PRODUCTS, OUR SALES AND PROFITS
WOULD DECLINE AND OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS
COULD BE ADVERSELY AFFECTED.
One of our core strategies is to be among the first-to-market with new and
enhanced product offerings based on established technologies. We believe that
our I/OMagic , Digital Research Technologies and Hi-Val brands are perceived
by the retailers and end-users of our products as among the leaders in the data
storage industry. We also believe that the retailers and end-users of our
products view products offered under our brands as embodying newly established
technologies or technological enhancements. For instance, in introducing new and
enhanced optical data storage products, we seek to be among the first-to-market,
offering heightened product performance such as faster data recordation and
22
access speeds. If our products are not among the first-to-market, our
competitors may be able to bring products to market more rapidly than we do and
therefore may gain market share at our expense, harming our sales and profits.
As a consequence of this core strategy, we are exposed to consumer rejection of
our new and enhanced product offerings to a greater degree than if we offered
products later in their industry life cycle. For example, our anticipated future
sales are largely dependent on future consumer demand for DVD-based products
displacing current consumer demand for CD-based products. Accordingly, future
sales and any future profits from DVD-based products are substantially dependent
upon widespread consumer acceptance of DVD-based products. If this widespread
consumer acceptance of DVD-based products does not occur, or is delayed, our
business, financial condition and results of operations will be adversely
affected.
FAILURE TO ADEQUATELY PROTECT OUR TRADEMARK RIGHTS COULD HARM OUR BUSINESS AND
CAUSE US TO LOSE MARKET SHARE AND SALES.
We sell our products under three brand names, I/OMagic , Digital Research
Technologies and Hi-Val . Each of these trademarks has been registered by us
with the United States Patent & Trademark Office. We also sell products under
various product names such as "MediaStation," "DataStation," Digital Photo
Library , EasyPrint and Sound Assault . One of our key business strategies is
to use our brand names and product names to successfully compete in the data
storage and digital entertainment industries. We have expended significant
resources promoting our brand names and our product names. We cannot assure you
that the registration of our brand name trademarks, or our other actions to
protect our non-registered product names, will deter or prevent their
unauthorized use by others. We also cannot assure you that other companies,
including our competitors, will not use our product names. If other companies,
including our competitors, use our brand names or product names, consumer
confusion could result, meaning that consumers may not recognize us as the
source of our products. This would reduce the value of goodwill associated with
these trademarks. This consumer confusion and the resulting reduction in
goodwill could cause us to lose market share and cause our sales to decline.
OUR USE OF A CONSIGNMENT SALES MODEL IS INCREASING, WHICH REQUIRES US TO CARRY
AND FINANCE GREATER AMOUNTS OF INVENTORY. IF WE ARE UNABLE TO CARRY AND FINANCE
GREATER AMOUNTS OF INVENTORY, SALES OF OUR PRODUCTS WILL BE REDUCED.
We are increasingly using a consignment sales model, which requires us to carry
and finance greater amounts of inventory. Our existing financing sources may be
inadequate to fund inventory levels required by our increasing use of a
consignment sales model. If we are unable to obtain additional financing, we may
be unable to finance sufficient inventory levels and we may be unable to fill
orders in a timely manner, or at all, which would cause reduced sales of our
products and would adversely affect our business, financial condition and
results of operations.
CONSUMER ACCEPTANCE OF ALTERNATIVE SALES CHANNELS MAY INCREASE. IF WE ARE UNABLE
TO ADAPT TO THESE ALTERNATIVE SALES CHANNELS, THIS MAY RESULT IN REDUCED SALES
OF OUR PRODUCTS.
We are accustomed to conducting business through traditional retail sales
channels. Consumers purchase our products predominantly through six retailers,
who collectively accounted for approximately 86% of our net sales for the three
months ended March 31, 2004. We currently generate a small number of direct
sales of our products over the Internet, through our websites. We believe that
many of our target consumers are knowledgeable about technology and comfortable
with the use of the Internet for product purchases. Consumers may increasingly
prefer alternative sales channels, such as direct mail order or direct purchase
from manufacturers. In addition, Internet commerce, or direct purchase via the
Internet, is becoming increasingly accepted by consumers as a convenient, secure
and cost-effective method of purchasing data storage and digital entertainment
products. The migration of consumer purchasing habits from traditional retailers
to Internet retailers could have a significant impact on our ability to sell our
products. We cannot assure you that we will be able to predict and respond to
increasing consumer preference of alternative sales channels such as Internet
commerce.
23
IF OUR PRODUCTS FAIL TO COMPLY WITH EXISTING AND EVOLVING GOVERNMENT REGULATIONS
AND INDUSTRY STANDARDS, WE MAY HAVE DIFFICULTY SELLING OUR PRODUCTS AND COULD BE
SUBJECTED TO LIABILITY FOR SELLING PRODUCTS THAT DO NOT COMPLY WITH APPLICABLE
REGULATIONS.
Our products are designed to comply with industry standards and government
regulations, some of which are evolving as new technologies are deployed. In the
United States, our products must comply with regulations imposed by the United
States Federal Communications Commission, or FCC, and Underwriters Laboratories,
as well as numerous industry standards such as technological standards related
to CD- or DVD-based products. We also must comply with numerous import/export
regulations. In particular, our data communications devices in our data storage
and digital entertainment product categories are subject to numerous FCC
regulations. 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 and could result in liability on our
part for selling products that fail to comply with applicable regulations.
A LABOR STRIKE AT A SHIPPING PORT AT WHICH OUR PRODUCTS ARE SHIPPED OR RECEIVED
WOULD PREVENT US FROM TAKING TIMELY DELIVERY OF INVENTORY, WHICH WOULD CAUSE OUR
SALES TO DECLINE AND COULD HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
From time to time, shipping ports experience labor strikes or work stoppages
which prevent the delivery of products shipped internationally via ocean
freight. The shipping port located in Long Beach, California, through which we
receive most of our products shipped by our subcontract manufacturers in Asia,
experienced a labor strike in September 2002 which lasted for nearly two weeks.
As a result, there was a significant disruption in our ability to deliver
products to our retailers, which caused our sales to decline. Any future labor
strike or work stoppage at a shipping port at which our products are received
would prevent us from taking timely delivery of inventory and cause our sales to
decline. In addition, many of our retailers impose penalties for both early and
late product deliveries, which could result in significant additional costs to
us. To meet our obligations to our retailers, we may be required to arrange for
alternative means of product shipment, such as air freight, which could add
significantly to our product costs. We would typically be unable to pass these
extra costs along to either our retailers or to consumers. Also, because the
average selling prices of our products decline during their short product life
cycle, delayed delivery of products could yield significantly less sales or
profits than planned, adversely affecting our business, financial condition and
results of operations.
OUR LACK OF LONG-TERM PURCHASE ORDERS AND COMMITMENTS MAY ADVERSELY AFFECT OUR
BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
All of our significant retailers issue purchase orders solely in their own
discretion, often only one to two weeks before the requested date of shipment.
Our retailers are generally able to cancel orders or delay the delivery of
products on short notice. Accordingly, we cannot assure you that any of these
retailers will continue to purchase our products in the future. In addition, 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. The limited
certainty of product orders can make it difficult for us to forecast our sales
and allocate our resources accordingly. Moreover, our expense levels are based
in part on our expectations of future sales and, should our expectations
regarding future product orders and sales be inaccurate, we may be unable to
reduce costs in a timely manner to adjust for sales shortfalls. As a result, our
lack of long-term purchase orders and purchase commitments may adversely affect
our business, financial condition and results of operations.
24
OUR OPERATIONS ARE VULNERABLE BECAUSE WE HAVE LIMITED REDUNDANCY AND BACKUP
SYSTEMS.
Our internal order and product data management system is an electronic system
through which our retailers place orders for our products and through which we
manage product pricing, shipment, return and other matters. This system's
continued and uninterrupted performance is critical to our daily business
operations. Despite precautions that we have taken, unanticipated interruptions
in our computer and telecommunications systems have, in the past, caused
problems or stoppages in this electronic system. These interruptions could occur
in the future. We have limited ability and personnel to process purchase orders
and manage product pricing and other matters in any manner other than through
this electronic system. Our business, financial condition and results of
operations could be adversely affected by any damage or failure that interrupts
or delays this electronic system.
OUR STOCK PRICE IS HIGHLY VOLATILE, WHICH COULD RESULT IN SUBSTANTIAL LOSSES FOR
INVESTORS PURCHASING SHARES OF OUR COMMON STOCK AND IN LITIGATION AGAINST US.
The market price of our common stock has fluctuated significantly in the past
and may continue to fluctuate significantly in the future. During the year ended
December 31, 2003, the high and low closing bid prices of a share of our common
stock were $8.50 and $3.50, respectively. Additionally, during the quarter
ended March 31, 2004, the high and low closing bid prices of a share of our
common stock were $4.20 and $3.00, respectively. The market price of our
common stock may continue to fluctuate in response to one or more of the
following factors, many of which are beyond our control:
- changes in market valuations of similar companies;
- stock market price and volume fluctuations generally;
- - economic conditions specific to the data storage and digital
entertainment products industries;
- announcements by us or our competitors of new or enhanced products or
technologies or of significant contracts, acquisitions, strategic
relationships, joint ventures or capital commitments;
- the loss of one or more of our top six retailers or the cancellation
or postponement of orders from any of those retailers;
- delays or problems in our introduction of new products or
technological innovations;
- disputes or litigation concerning our rights to use third parties'
intellectual property;
- changes in our pricing policies or the pricing policies of our
competitors;
- changes in foreign currency exchange rates affecting our product
costs and pricing;
- regulatory developments or enforcement;
- 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 our common stock in this offering may
not be indicative of the price 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 stock price volatility. We may be the target of similar litigation in
the future. Securities litigation could result in substantial costs and divert
management's attention and our resources from our business. Any of the risks
described above could have an adverse effect on our business, financial
condition and results of operations.
25
IF THE OWNERSHIP OF OUR COMMON STOCK CONTINUES TO BE HIGHLY CONCENTRATED, IT MAY
PREVENT YOU AND OTHER STOCKHOLDERS FROM INFLUENCING SIGNIFICANT CORPORATE
DECISIONS AND MAY RESULT IN CONFLICTS OF INTEREST THAT COULD CAUSE OUR STOCK
PRICE TO DECLINE.
As a group, our executive officers, directors, 10% stockholders beneficially own
or control approximately 80% of our outstanding shares of common stock (after
giving effect to the exercise of all outstanding vested options exercisable
within 60 days from May 3, 2004). As a result, our executive officers,
directors, and 10% stockholders, acting as a group, have substantial control
over the outcome of corporate actions requiring stockholder approval, including
the election of directors, any merger, consolidation or sale of all or
substantially all of our assets, or any other significant corporate transaction.
Some of these controlling stockholders may have interests different than yours.
For example, these stockholders may delay or prevent a change of control of
I/OMagic, even one that would benefit our stockholders, or pursue strategies
that are different from the wishes of other investors. The significant
concentration of stock ownership may adversely affect the trading price of our
common stock due to investors' perception that conflicts of interest may exist
or arise.
OUR AMENDED AND RESTATED ARTICLES OF INCORPORATION, AMENDED AND RESTATED BYLAWS
AND NEVADA LAW CONTAIN PROVISIONS THAT COULD DISCOURAGE TRANSACTIONS RESULTING
IN A CHANGE IN CONTROL OF I/OMAGIC, WHICH MAY NEGATIVELY AFFECT THE MARKET PRICE
OF OUR COMMON STOCK.
Our articles of incorporation and our bylaws contain provisions that may enable
our management or our board of directors to discourage, delay or prevent a
change in the ownership of I/OMagic or in our management. In addition, these
provisions could limit the price that investors would be willing to pay in the
future for shares of our common stock. These provisions include the following:
our board of directors is authorized, without prior stockholder
approval, to create and issue preferred stock, commonly referred to
as "blank check" preferred stock, with rights senior to those of our
common stock;
stockholders are permitted to remove members of our board of
directors only upon the vote of at east two-thirds of the outstanding
shares of stock entitled to vote at a meeting called for such purpose
or by written consent; and
our board of directors are expressly authorized to make, alter or
repeal our bylaws.
We may be subject to the restrictions contained in Sections 78.378 through
78.3793 of the Nevada Revised Statutes which provide, subject to certain
exceptions and conditions, that if a person acquires a "controlling interest,"
which is equal to one-fifth, one-third, or one-half or more of the voting power
of a corporation, that person is an "interested stockholder" and may not vote
that person's shares. The effect of these restrictions may be to discourage,
delay or prevent a change in control of I/OMagic.
WE CANNOT ASSURE YOU THAT AN ACTIVE MARKET FOR OUR SHARES OF COMMON STOCK WILL
DEVELOP OR, IF IT DOES DEVELOP, WILL BE MAINTAINED IN THE FUTURE.
On March 25, 1996, our common stock commenced trading on the OTC Bulletin Board.
Since that time, there has been limited trading in our shares, at widely varying
prices, and the trading to date has not created an active market for our shares.
We cannot assure you that an active market for our shares will be established or
maintained in the future. If an active market is not established or maintained,
you may not be able to readily sell your shares of our common stock.
26
BECAUSE WE ARE SUBJECT TO "PENNY STOCK" RULES, THE LEVEL OF TRADING ACTIVITY IN
OUR COMMON 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, are, generally, 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 investing in the penny stock
market. The broker-dealer also must provide the prospective investor with
current bid and offer quotations for the stock and the compensation to be paid
to the broker-dealer and its salespeople in the transaction. Furthermore, 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 must provide
each holder of penny stock with a monthly account statement showing the market
value of each penny stock held in the customer's account. In addition,
broker-dealers who sell penny stocks 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 prospective investor and receive
the purchaser's written agreement to the transaction. These requirements may
have the effect of reducing the level of trading activity in a penny stock, such
as our common stock, and investors in our common stock may find it difficult to
sell their shares.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations were not subject to commodity price risk during the three
months ended March 31, 2004. Our sales to a foreign country (Canada) were less
than 2% of our total sales, and thus we experienced negligible foreign currency
exchange rate risk. We have entered into a line of credit with United National
Bank, effective August 18, 2003. The line of credit provides for an interest
rate equal to the prime lending rate as reported in the Wall Street Journal 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 March 31, 2004, that the design and operation of
our "disclosure controls and procedures" (as defined in Rule 13a-15(e) 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 March 31, 2004, there were no 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.
27
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On August 2, 2001, Mark and Mitra Vakili filed a complaint in the Superior
Court of the State of California for the County of Orange against Tony Shahbaz,
our Chairman, President, Chief Executive Officer and Secretary. This complaint
was later amended to add Alex Properties and Hi-Val, Inc. as plaintiffs, and
I/OMagic, IOM Holdings, Inc., Steel Su, a director of I/OMagic, and Meilin Hsu,
an officer of Behavior Tech. Computer Corp., as defendants. On or about March
28, 2003, all parties to the action entered into a Settlement Agreement and
Release which settled this action. As part of the Settlement Agreement and
Release, we entered into a new written lease agreement with Alex Properties
relating to the real property in Santa Ana, California, which we physically
occupied. On September 30, 2003, pursuant to the terms of the lease agreement,
we vacated this real property. During the latter part of 2003 and continuing
into the first quarter of 2004, counsel for Mark and Mitra Vakili and Alex
Properties alleged, on their behalf, that we had improperly caused damage to the
Santa Ana facility. On or about February 15, 2004, all parties to the original
Settlement Agreement and Release executed a First Amendment to Settlement
Agreement and Release, releasing all defendants from all of these new claims
conditioned upon the making of the final $1,000,000 payment under the Settlement
Agreement and Release by February 17, 2004, rather than on the original due date
of March 15, 2004. We made this payment, and a dismissal of the case was filed
with the court on March 8, 2004.
On May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for
breach of contract and legal malpractice against our former attorneys and their
respective law firms in the Superior Court of the State of California for the
County of Orange. The complaint seeks damages of $15 million arising out of the
defendants' representation of I/OMagic and IOM Holdings, Inc. in an acquisition
transaction and in a separate arbitration matter. On November 6, 2003, we filed
our First Amended Complaint against all defendants. Defendants have responded to
our First Amended Complaint denying our allegations. Defendants Lawrence W.
Horwitz and Lawrence M. Cron have also filed a Cross-Complaint against us for
attorneys' fees in the approximate amount of $79,000. We have denied their
allegations in the Cross-Complaint. As of the date of this report, discovery has
commenced. The outcome of this action is presently uncertain. However, we
believe that all of our claims are meritorious.
On March 15, 2004, Magnequench International, Inc., or plaintiff, filed an
Amended Complaint for Patent Infringement in the United States District Court of
the District of Delaware against, among others, I/OMagic, Sony Corp., Acer Inc.,
Asustek Computer, Inc., Iomega Corporation, LG Electronics, Inc., Lite-On
Technology Corporation and Memorex Products, Inc., or defendants. The complaint
seeks to permanently enjoin defendants from, among other things, selling
products that allegedly infringe one or more claims of plaintiff's patents. The
complaint also seeks damages of an unspecified amount, and treble damages based
on defendants' alleged willful infringement. In addition, the complaint seeks
reimbursement of plaintiff's costs as well as reasonable attorney's fees, and a
recall of all existing products of defendants that infringe one or more claims
of plaintiff's patents that are within the control of defendants or their
wholesalers and retailers. Finally, the complaint seeks destruction (or
reconfiguration to non-infringing embodiments) of all existing products in the
possession of defendants that infringe one or more claims of plaintiff's
patents. We are presently evaluating the merits of this complaint and, as of the
date of this report, have responded by denying the plaintiff's allegations in
the complaint. The outcome of this action is presently uncertain. However, at
this time, we do not expect the defense or outcome of this action to have a
material adverse affect on our business, financial condition or results of
operations.
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.
28
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On March 9, 2004, we issued warrants to purchase 10,000 shares of common
stock at an exercise price of $4.00 per share, and 10,000 shares of common stock
at an exercise price of $6.00 per share, subject to adjustment. The warrants
expire eighteen months from the date of issuance.
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
------ -----------
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 of 2002.
32.1 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 of 2002.
(b) Reports on Form 8-K:
----------------------
We filed a Form 8-K on January 27, 2004, which contained an Item 12
Disclosure in accordance with SEC Release Nos. 33-8216 and 34-47226 in
connection with our press release issued on January 27, 2004 reporting
selected financial results for the fourth quarter 2003.
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: May 17, 2004 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)
29
EXHIBITS FILED WITH THIS REPORT
Exhibit
Number Description
- ------ -----------
31.1 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 of 2002.
32.1 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 of 2002.
30