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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 June 30, 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 88-0290623
------------------------------- -----------------------------------
(State or Other Jurisdiction of (I.R.S. 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 August 19, 2004, there were 4,529,672 shares of the issuer's common stock
issued and outstanding.
1
I/OMAGIC CORPORATION AND SUBSIDIARIES
TABLE OF CONTENTS
Page
Number
--------
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets - June 30, 2004 (unaudited)
and December 31, 2003 3
Consolidated Statements of Income - For the three and
six months ended June 30, 2004 and 2003 (unaudited) 5
Consolidated Statements of Cash Flows - For the six months
ended June 30, 2004 and 2003 (unaudited) 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 14
Item 3. Quantitative and Qualitative Disclosures About Market Risk 44
Item 4. Controls and Procedures 44
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 45
Item 2. Changes in Securities, Use of Proceeds and Issuer
Purchases of Equity Securities 46
Item 3. Defaults Upon Senior Securities 46
Item 4. Submission of Matters to a Vote of Security Holders 46
Item 5. Other Information 46
Item 6. Exhibits and Reports on Form 8-K 46
SIGNATURES 47
EXHIBITS FILED WITH THIS REPORT 48
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I/OMAGIC CORPORATION
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, 2004 (UNAUDITED) AND DECEMBER 31, 2003
ASSETS
JUNE 30, DECEMBER 31,
2004 2003
------------ -----------
(unaudited)
CURRENT ASSETS
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . $ 5,408,855 $ 6,091,369
Accounts receivable, net of allowance for doubtful
accounts of $35,392 (unaudited) and $20,553. . . . . . . . . 10,076,880 18,439,893
Inventory, net of allowance for obsolete inventory of $630,000
(unaudited) and $505,029 . . . . . . . . . . . . . . . . . . 6,803,721 9,706,708
Prepaid expenses and other current assets. . . . . . . . . . . . 783,644 407,260
----------- -----------
Total current assets. . . . . . . . . . . . . . . . . . . . 23,073,100 34,645,230
PROPERTY AND EQUIPMENT, net. . . . . . . . . . . . . . . . . . . 432,046 539,943
TRADEMARK, net of accumulated amortization
of $5,160,412 (unaudited) and $4,871,044 . . . . . . . . . . 4,485,267 4,774,635
RESTRICTED CASH. . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000
OTHER ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . 27,032 52,984
----------- -----------
TOTAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . . $28,117,445 $40,112,792
=========== ===========
The accompanying notes are an integral part of these financial statements.
3
I/OMAGIC CORPORATION
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, 2004 (UNAUDITED) AND DECEMBER 31, 2003
LIABILITIES AND STOCKHOLDERS' EQUITY
JUNE 30, DECEMBER 31,
2004 2003
------------- --------------
(unaudited)
CURRENT LIABILITIES
Line of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,516,309 $ 5,938,705
Accounts payable and accrued expenses. . . . . . . . . . . . . . . 4,382,661 5,572,878
Accounts payable - related parties . . . . . . . . . . . . . . . . 3,666,686 10,370,119
Reserves for customer returns and price protection . . . . . . . . 550,576 853,373
Current portion of settlement payable. . . . . . . . . . . . . . . - 1,000,000
------------- --------------
Total current liabilities. . . . . . . . . . . . . . . . . . . . 13,116,232 23,735,075
------------- --------------
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 (unaudited) and 4,529,672 shares issued and outstanding. 4,530 4,530
Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . 31,557,988 31,557,988
Treasury stock, 13,493 (unaudited) and 13,493 shares, at cost . . . (126,014) (126,014)
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . (16,435,291) (15,058,787)
------------- --------------
Total stockholders' equity . . . . . . . . . . . . . . . . . . . 15,001,213 16,377,717
------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY . . . . . . . . . . $ 28,117,445 $ 40,112,792
============= ==============
The accompanying notes are an integral part of these financial statements.
4
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2004 2003 2004 2003
--------------- ------------- ----------------- ---------------
(unaudited) (unaudited) (unaudited) (unaudited)
NET SALES. . . . . . . . . . . . . . . $ 7,191,541 $ 12,792,717 $ 22,551,760 $ 29,856,920
COST OF SALES. . . . . . . . . . . . . 6,940,415 10,882,406 19,932,830 25,509,803
--------------- ------------- ----------------- --------------
GROSS PROFIT . . . . . . . . . . . . . 251,126 1,910,311 2,618,930 4,347,117
OPERATING EXPENSES
Selling, marketing, and advertising. . 170,899 328,687 651,011 664,604
General and administrative . . . . . . 1,453,412 2,477,890 2,819,771 3,934,729
Depreciation and amortization. . . . . 208,969 355,287 418,240 712,585
--------------- ------------- ----------------- --------------
Total operating expenses. . . . . . 1,833,280 3,161,864 3,889,022 5,311,918
--------------- ------------- ----------------- --------------
LOSS FROM OPERATIONS . . . . . . . . . (1,582,154) (1,251,553) (1,270,092) (964,801)
--------------- ------------- ----------------- --------------
OTHER INCOME (EXPENSE)
Interest income. . . . . . . . . . . . 33 105 252 271
Interest expense . . . . . . . . . . . (39,912) (52,086) (84,047) (155,653)
Other income (expense) . . . . . . . . (12,610) 26,052 (20,421) 49,315
--------------- ------------- ----------------- --------------
Total other income (expense) (52,489) (25,929) (104,216) (106,067)
--------------- ------------- ----------------- --------------
LOSS BEFORE INCOME TAXES . . . . . . . (1,634,643) (1,277,482) (1,374,308) (1,070,868)
PROVISION FOR (BENEFIT FROM) INCOME
TAXES. . . . . . . . . . . . . . . . (892) 1,456 2,196 (1,198)
--------------- ------------- ----------------- --------------
NET LOSS . . . . . . . . . . . . . . . $ (1,633,751) $($1,278,938) $ (1,376,504) $ (1,069,670)
================ ============= ================= ==============
BASIC AND DILUTED LOSS PER SHARE . . . ($0.36) ($0.28) ($0.30) ($0.24)
================ ============= ================= ==============
BASIC AND DILUTED WEIGHTED-AVERAGE
SHARES OUTSTANDING . . . . . . . . . 4,529,672 4,529,672 4,529,672 4,529,672
================ ============= ================= ==============
The accompanying notes are an integral part of these financial statements.
5
I/OMAGIC CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
SIX MONTHS ENDED JUNE 30,
2004 2003
----------------------------
(unaudited) (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss. . . . . . . . . . . . . . . . . . . . . ($1,376,503) ($1,069,670)
Adjustments to reconcile net loss to net cash
provided by operating activities
Depreciation and amortization . . . . . . . . . . 128,872 423,217
Amortization of trademarks. . . . . . . . . . . . 289,368 289,368
Allowance for doubtful accounts . . . . . . . . . 120,000 2,288,018
Reserve for customer returns and allowances . . . (302,796) (510,770)
Reserve for obsolete inventory. . . . . . . . . . 368,596 (561,729)
(Increase) decrease in
Accounts receivable . . . . . . . . . . . . . . . 8,243,013 4,913,224
Inventory . . . . . . . . . . . . . . . . . . . . 2,534,392 (1,301,173)
Prepaid expenses and other current assets . . . . (376,385) (214,021)
Other assets. . . . . . . . . . . . . . . . . . . 25,952 -
Increase (decrease) in
Accounts payable and accrued expenses . . . . . . (1,190,219) (3,693,936)
Accounts payable - related parties. . . . . . . . (6,703,433) 4,772,693
Settlement payable. . . . . . . . . . . . . . . . (1,000,000) (3,000,000)
------------- -------------
Net cash provided by operating activities . . . . 760,857 2,335,221
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment . . . . . . (20,975) (53,975)
------------- -------------
Net cash used in investing activities. . . . . (20,975) (53,975)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net payments on line of credit. . . . . . . . . . (1,422,396) (5,367,000)
Purchase of treasury shares . . . . . . . . . . . - (83,684)
------------- -------------
Net cash used in financing activities . . . . . . (1,422,396) (5,450,684)
------------- -------------
Netdecrease in cash and cash equivalents. . . . . (682,514) (3,169,438)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD. . 6,091,369 7,320,143
------------- -------------
CASH AND CASH EQUIVALENTS, END OF PERIOD. . . . . $ 5,408,855 $ 4,150,705
============= =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
INTEREST PAID. . . . . . . . . . . . . . . . . . $ 86,111 $ 189,815
============= =============
INCOME TAXES PAID. . . . . . . . . . . . . . . . $ 2,196 $ 3,182
============= =============
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 to 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
SFAS No. 123, "Accounting for Stock-Based Compensation" as amended by SFAS No.
148, "Accounting for Stock-Based Compensation-Transition and Disclosure,"
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 based method and has disclosed the pro forma
effect of using the fair value based method to account for its stock-based
compensation. For stock-based compensation issued to non-employees, the Company
uses the fair value method of accounting under the provisions of SFAS No. 123.
Pro forma information regarding net loss and loss per share is required by SFAS
No. 123 and has been determined as if the Company had accounted for its employee
stock options under the fair value method of SFAS No. 123. For the six months
ended June 30, 2004, options to purchase an aggregate of 126,375 (unaudited)
shares of common stock were granted.
7
For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting period. Adjustments are made
for options forfeited prior to vesting. The effect on net loss and basic and
diluted loss per share had compensation costs for the Company's stock option
plans been determined based on a fair value at the date of grant consistent with
the provisions of SFAS No. 123 for the three and six months ended June 30, 2004
(unaudited) and 2003 (unaudited) is as follows:
THREE MONTHS ENDED SIX MONTHS ENDED
-------------------- -------------------
JUNE 30, JUNE 30,
------------ --------------
(unaudited) (unaudited)
2004 2003 2004 2003
------------- ------------- ------------ ------------
Net Loss
As reported . . . . . . . . . . . $ (1,633,751) $ (1,278,938) $ (1,376,504) $ (1,069,670)
Add stock based compensation
expense included in net income,
net of tax. . . . . . . . . . . - - - -
Deduct total stock based
employee compensation
expense determined under fair
value method for all awards,
net of tax . . . . . . . . . . (13,621) - (122,590) -
------------- ------------- ------------- -------------
PRO FORMA . . . . . . . . . . . . $ (1,647,372) $ (1,278,938) $ (1,499,094) $ (1,069,670)
============= ============= ============= =============
Loss per common share
Basic - as reported . . . . . . . $ (0.36) $ (0.28) $ (0.30) $ (0.24)
Basic - pro forma . . . . . . . . $ (0.36) $ (0.28) $ (0.33) $ (0.24)
Diluted - as reported . . . . . . $ (0.36) $ (0.28) $ (0.30) $ (0.24)
Diluted - pro forma . . . . . . . $ (0.36) $ (0.28) $ (0.33) $ (0.24)
For purposes of computing the pro forma disclosures required by SFAS No. 123,
the fair value of each option granted to employees and directors is estimated
using the Black-Scholes option-pricing model with the following weighted-average
assumptions for the six months ended June 30, 2004: dividend yield of 0%,
expected volatility of 100%, risk-free interest rate of 1.92%, and expected life
of three years. The weighted-average fair value of options granted during the
six months ended June 30, 2004 for which the exercise price was equal to the
market price on the grant date was $2.16, and the weighted-average exercise
price was $3.67. No stock options were granted during the six months ended June
30, 2004 for which the exercise price was less than the market price on the
grant date.
EARNINGS (LOSS) PER SHARE
The Company calculates earnings (loss) per share in accordance with SFAS No.
128, "Earnings Per Share." Basic earnings (loss) per share is computed by
dividing the net income (loss) available to common stockholders by the
weighted-average number of common shares outstanding. Diluted income (loss) per
share is computed similar to basic income (loss) per share, except that the
denominator is increased to include the number of additional common shares that
would have been outstanding if the potential common shares had been issued and
if the additional common shares were dilutive.
8
As of June 30, 2004 (unaudited) and June 30, 2003 (unaudited) the Company had
potential common stock as follows:
2004 2003
------ ------
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) - -
- -
Fully diluted weighted average common shares and
potential common stock 4,529,672 4,529,672
The following potential common shares have been excluded from the computation of
diluted earnings per share as of June 30, 2004 (unaudited) and 2003 (unaudited)
due to being anti-dilutive.
June 30,
-----------
(unaudited)
2004 2003
------- -------
Stock options outstanding 58,908 89,982
Warrants outstanding 40,004 -
-------- -------
TOTAL 98,912 89,982
-------- -------
NOTE 3 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued liabilities consisted of the following:
June 30, December 31,
2004 2003
--------- ------------
Accounts payable $ 687,264 $ 2,525,508
Accrued rebates and marketing 2,705,419 2,369,544
Accrued compensation and related benefits 158,650 192,002
Customer credits 301,965 -
Deferred revenue 184,525 -
Other 344,838 485,824
----------- ------------
TOTAL $ 4,382,661 $ 5,572,878
============ ===========
NOTE 4 - INVENTORY
Inventory consisted of the following:
June 30, December 31,
2004 2003
----------- ------------
(unaudited)
Component parts $ 2,851,361 $ 3,658,140
Finished goods - warehouse 2,089,473 2,317,765
Finished goods - consigned 2,492,887 4,235,832
Reserves for obsolete and slow
moving inventory (630,000) (505,029)
----------- -----------
TOTAL $ 6,803,721 $ 9,706,708
=========== ===========
9
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 $6.0 million. The line of credit
was to initially expire on September 1, 2004. On August 6, 2004, United
National Bank extended the expiration date to November 1, 2004. The line of
credit 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 June 30,
2004 and December 31, 2003, 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 June 30, 2004 and December 31, 2003.
The new line of credit was initially used to pay off the outstanding balance
with ChinaTrust Bank (USA) as of September 2, 2003, which was $3,379,827. The
outstanding balance with United National Bank as of June 30, 2004 was $4,516,309
(unaudited). The amount available to the Company for borrowing as of June 30,
2004 was $1,178,513 (unaudited).
NOTE 6 - TRADE CREDIT FACILITIES WITH 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 $10.0 million,
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. 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 $1.5 million, of which $750,000 may be
applied against outstanding accounts payable to the related party after six
months. As of June 30, 2004 (unaudited) and December 31, 2003, $750,000 had been
applied against outstanding accounts payable to the related party. The remaining
$750,000 deposit has been offset against Accounts Payable-Related Parties in the
accompanying financial statements. The agreement is for 12 months. At the end of
the 12-month period, either party may terminate the agreement upon 30 days'
written notice. Otherwise, the agreement will remain continuously valid without
effecting a newly signed agreement. Both parties have the right to terminate the
agreement one year following the inception date by giving the other party 30
days' prior written notice of termination. During the six months ended June 30,
2004, the Company purchased $4.1 million (unaudited) of inventory under this
arrangement. As of June 30, 2004, there were $1,044,466 (unaudited) in trade
payables net of the $750,000 deposit still outstanding under this arrangement.
In February 2003, the Company entered into an agreement with a related party,
whereby the related party agreed to supply and store at the Company's warehouse
up to $10.0 million 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
$10.0 million with payment terms of net 60 days, non-interest bearing. During
the six months ended June 30, 2004, the Company purchased $9.0 million
(unaudited) of inventory under this arrangement. As of June 30, 2004, there
were $2,622,220 (unaudited) in trade payables outstanding under this
arrangement.
NOTE 7 - COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases its facilities and certain equipment under non-cancelable,
operating lease agreements, expiring through August 2006.
The Company previously leased its facilities from a related party that was,
through March 2003, under the control of an officer of the Company. In March
2003, in connection with the settlement of the Vakili lawsuit (see Litigation),
an officer of the Company relinquished control to the Vakilis of the entity that
owned the warehouse and office space that was being leased by the Company. Under
the terms of the settlement agreement, the lease dated April 1, 2000, as amended
10
on June 1, 2000 and which originally expired in March 2010, was terminated and
replaced with a new lease. The new lease required monthly payments of $28,687
and expired on September 30, 2003. The Company moved to its current facilities
in September 2003.
Rent expense was $179,211 (unaudited) and $214,498 (unaudited) for the six
months ended June 30, 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 six months ended June 30, 2004
and 2003, the Company incurred expenses of $238,140 (unaudited) and $172,465
(unaudited), respectively, in connection with such arrangements. These expenses
are included in general and administrative expenses in the accompanying
statements of operations.
EMPLOYMENT CONTRACT
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 six
months ended June 30, 2004 and 2003, bonuses totaling $60,702 (unaudited) and
$14,649 (unaudited), respectively, were paid under the terms of this agreement.
As of June 30, 2004 and December 31, 2003, the accrued bonuses were $0
(unaudited) and $0, respectively.
RETAIL AGREEMENTS
In connection with certain retail agreements, the Company has agreed to pay for
certain marketing development and advertising costs on an ongoing basis.
Marketing development and advertising costs are generally agreed upon at the
time of the event. The Company also records a liability for co-op marketing
based on management's evaluation of historical experience and current industry
and Company trends. During the six months ended June 30, 2004 and 2003, the
Company incurred $861,655 (unaudited) and $1,370,675 (unaudited), respectively,
related to these agreements. These amounts are netted against sales revenue in
the accompanying statements of income.
CONSULTING AGREEMENT
On March 9, 2004, the Company entered into a consulting agreement for public
investor relations services. The agreement is on a month-to-month basis at
$2,500 per month. In addition, the consultant was issued warrants to purchase
20,000 shares of common stock, consisting of 10,000 warrants with an exercise
price of $4.00 and 10,000 warrants with an exercise price of $6.00. The warrants
vested immediately and expire eighteen months from issuance.
LITIGATION
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, the
Company's 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. The
final amended complaint alleged causes of action based upon breach of contract,
fraud, breach of fiduciary duty and negligent misrepresentation and sought
monetary damages and rescission. As a result of successful motions for summary
judgment, I/OMagic, Mr. Su and Ms. Hsu were dismissed as defendants. On February
18, 2003, a jury verdict adverse to the remaining defendants was rendered, and
on or about March 28, 2003, all parties to the action entered into a Settlement
Agreement and Release which settled this action prior to the entry of a final
judgment. As part of the Settlement Agreement and Release, Mr. Shahbaz and Mr.
Su relinquished their interests in Alex Properties and the Vakilis relinquished
66,667 shares of the Company's common stock, of which 13,333 shares were
11
transferred to a third party designated by the Vakilis. In addition, the Company
agreed to make payments totaling $4.0 million in cash and entered into a new
written lease agreement with Alex Properties relating to the real property in
Santa Ana, California, which the Company physically occupied. On September 30,
2003, pursuant to the terms of the lease agreement, the Company vacated this
real property. During the latter part of 2003 and continuing into the first
quarter of 2004, Mark and Mitra Vakili and Alex Properties alleged that the
Company 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
$1.0 million payment under the Settlement Agreement and Release by February 17,
2004, rather than on the original due date of March 15, 2004. The Company 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 Lawrence W. Horwitz, Gregory B. Beam,
Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and Senn Palumbo
Meulemans, LLP, the Company's 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 $15.0 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, the Company filed its
First Amended Complaint against all defendants. Defendants have responded to the
Company's First Amended Complaint denying the Company's allegations. Defendants
Lawrence W. Horwitz and Lawrence M. Cron have also filed a Cross-Complaint
against the Company for attorneys' fees in the approximate amount of $79,000.
The Company has 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, the Company believes that all of its 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 (Civil Action No. 04-135 (GMS)) against, among others,
the Company, 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. The Company has filed a response denying
plaintiff's claims and asserting defenses to plaintiff's causes of action
alleged in the complaint. The outcome of this action is presently uncertain.
However, at this time, the Company does not expect the defense or outcome of
this action to have a material adverse affect on its business, financial
condition or results of operations.
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 affect on the Company's
financial position or results of operations.
NOTE 8 - RELATED PARTY TRANSACTIONS
During the six months ended June 30, 2004 and 2003, the Company made purchases
from related parties totaling approximately $13,190,065 (unaudited) and
$14,026,990 (unaudited), respectively.
During the six months ended June 30, 2004 and 2003, the Company had trade
payables to related parties totaling approximately $3,666,686 (unaudited) and
$7,379,971 (unaudited), respectively.
12
NOTE 9 - SUBSEQUENT EVENTS
Merger (unaudited)
- -------------------
On July 6, 2004 the Company completed the merger of its wholly-owned subsidiary,
I/OMagic Corporation, a California corporation, with and into the Company.
Line of credit (unaudited)
- --------------------------
On August 6, 2004, United National Bank extended the expiration date of the
asset-based line of credit with the Company from September 1, 2004 to November
1, 2004.
13
NOTE 10 - RESTATEMENT OF STOCK OPTIONS
In January 2000, the Company granted an aggregate of 134,167 stock options (the
"2000 Options") under the Company's 1997 Incentive and Non-Statutory Stock
Option Plan (the "1997 Plan") and the 1998 Incentive and Non-Statutory Stock
Option Plan (the "1998 Plan"). On March 21, 2000, the Company's board of
directors approved, upon advice of prior legal counsel, the extension of the
termination date for each of the 1997 Plan and 1998 Plan to December 31, 2000 in
order to cover the grant of the 2000 Options that were intended to be made on
January 2000. The original termination date for the 1997 Plan and 1998 Plan was
December 31, 1997 and December 31, 1998, respectively. The notes to the
Company's consolidated financial statements dated March 31, 2004, contained in
the Company's quarterly report on Form 10-Q filed with the Securities and
Exchange Commission on May 18, 2004, reflected the grant of the 2000 Options.
On June 27, 2004, the Company was advised by its current legal counsel that the
Company did not have the authority to grant the 2000 Options under the 1997 Plan
and 1998 Plan because the board of directors did not have the authority to
extend the termination date of either the 1997 Plan or the 1998 Plan after the
date each of these plans had expired pursuant to their original terms. The 1997
Plan and the 1998 Plan terminated pursuant to their own terms on December 31,
1997 and December 31, 1998, respectively. As a result, the 2000 Options were
never granted by the Company and have never been outstanding. The notes to the
Company's consolidated financial statements dated March 31, 2004 have been
restated to reflect the foregoing.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with our
consolidated audited financial statements and the related notes and the other
financial information included 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 as a result of any number of
factors, including those set forth under "Risk Factors" and under other captions
contained elsewhere in this report.
OVERVIEW
We are a leading provider of optical data storage products. We also sell
digital entertainment products. Our data storage products consist of a range of
products that store traditional PC data as well as music, photos, movies, games
and other multi-media content. 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 in over 8,000 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. Over the last three years, our largest retailers have included
Best Buy, Circuit City, CompUSA, Office Depot, OfficeMax and Staples. We employ
a three-brand approach to differentiate products 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, computer keyboards and 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 DVD recordable drives 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 a 25.5% decline in net sales for 2003 as compared to 2002.
Despite this significant reduction in net sales for 2003 as compared to 2002, we
reduced our net loss from $8.3 million in 2002 to $265,000 in 2003. We believe
that this significant improvement in our operating results is due, in large
part, to the following factors:
- - Settlement of significant litigation. During 2003, we settled a
significant litigation matter. This settlement required us to record a $5.2
million expense in 2002, which contributed significantly to our net loss in
2002.
- - 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 eliminated or reduced certain low profit
product offerings.
- - Less costly shipment of goods from vendors. Some of our vendors have
agreed to absorb a portion of their freight charges, which reduced our overall
freight costs.
15
- - Elimination of accelerated leasehold amortization. During 2003, we
accelerated the amortization of our prior corporate headquarters and warehouse
facility because we relocated during the latter part of 2003. The amortization
of new leasehold improvements during 2004 is expected to be under normal
life-of-lease policy amortized over the term of our lease.
- - 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.
The $21.3 million decline in net sales during 2003 from 2002, as noted
above, occurred during a period of more rapidly declining net losses. This
decline in net sales was primarily the result of our mutual agreement with
OfficeMax to discontinue sales between April and October 2003 because we did not
want to offer rebates and sales incentives as heavily as OfficeMax believed was
necessary. Although we resumed sales of our dual-format DVD recordable drives to
OfficeMax in November and December 2003, we experienced other business issues
with OfficeMax and, as a result, discontinued sales in January 2004. We continue
to negotiate with OfficeMax to resume sales in 2004, but there can be no
assurance that sales to OfficeMax will resume.
We increased our net income 22.9% to $257,000 in the first quarter of 2004
from $209,000 in the first quarter of 2003, despite an 8.2% decline in net sales
to $15.7 million in the first quarter of 2004 from $17.1 million in the first
quarter of 2003. Our net loss increased 23.1% to $1.6 million in the second
quarter of 2004 from $1.3 million in the second quarter of 2003. This increase
in net loss primarily resulted from a 43.8% decline in net sales to $7.2 million
in the second quarter of 2004 from $12.8 million in the second quarter of 2003.
Our net loss increased 27.3% to $1.4 million for the first six months of 2004
from $1.1 million for the first six months of 2003. This increase in net loss
primarily resulted from a 24.4% decline in net sales to $22.6 million in the
first six months of 2004 from $29.9 million in the first six months of 2003.
We believe that the significant decline in our net sales during the second
quarter of 2004, and accordingly during the first six months of 2004, resulted
in part from very short product life-cycles that led consumers to delay
purchases in anticipation of products incorporating faster drive speeds, which
allow users to more quickly store and access data. During 2004, DVD drives of
increasing speeds were introduced into the marketplace in very rapid succession.
However, during this time, we expected our DVD-based products to experience
longer product life-cycles similar in duration to the life-cycles of our
CD-based products. We believe that consumer perception of shorter product
life-cycles led consumers to delay purchases in anticipation of succeeding
products incorporating faster data storage and access speeds.
We also believe that the significant decline in our net sales during the
second quarter of 2004, and accordingly during the first six months of 2004,
resulted in part from consumers deciding to delay their purchases of DVD drives
in anticipation of rapid product obsolescence resulting from expected future
product offerings incorporating new technologies. In particular, we believe that
consumers delayed their purchases of single-layer DVD drives in anticipation of
the imminent availability of double-layer DVD drives which can increase storage
capacity to up to twice the capacity of single-layer DVD drives, depending on a
user's operating system and other factors. We expected that double-layer DVD
16
drives would be available commencing in the fourth quarter of 2004; however, the
market's transition from single-layer to double-layer DVD drives began earlier
than expected in the third quarter of 2004, confirming what we believe were
consumer expectations regarding the imminent availability of products
incorporating double-layer DVD technology. We expect to begin our shipment of
double-layer DVD drives at the end of the third quarter of 2004, and expect
significant shipments of these drives in the fourth quarter of 2004.
Another factor contributing significantly to the decline in our net sales
during the second quarter of 2004 and for the first six months of 2004, as
compared to the same periods in 2003, was the continued and expanded operation
of private label programs by Best Buy. Our sales to Best Buy, who was our
largest retailer during 2001, 2002 and 2003, declined in the second quarter of
2004 to $1.6 million, representing a decrease of 67% from $4.8 million in the
second quarter of 2003, and declined in the first six months of 2004 to $4.4
million, representing a decrease of 58% from $10.4 million in the first six
months of 2003. We believe that this decrease reflects, at least in part, Best
Buy's increased sales of private label products that compete with products that
we sell. Although we expect this decline in sales to Best Buy to continue in
subsequent reporting periods as a result of continued private label programs,
management intends to use its best efforts to insure that we retain Best Buy as
one of our major retailers. Management is currently in discussions with Best Buy
regarding the sale of other products not currently sold to, or private labeled
by, Best Buy. However, there can be no assurance that we will be successful in
selling any of these products, or any products at all, to Best Buy. If our sales
to Best Buy continue to decline, our business and results of operations will
continue to be materially and adversely affected.
Our business focus is predominantly on DVD-based products. DVD-based
products generally yield higher average selling prices and higher gross margins
than CD-based products. We expect market demand for data storage products to
continue to shift from CD- to DVD-based products. We expect that the very short
product life cycles of DVD-products experienced in 2004, as compared to other
data storage products that we have offered for sale in the past, including our
CD-based products, will lengthen following the introduction of double-layer DVD
drives; however, there can be no assurance that product life-cycles will
lengthen or that consumers will not continue to delay purchases in anticipation
of products incorporating faster data storage and access speeds or new
technologies, or both. Our business focus and the majority of the data storage
products that we sell, in both absolute terms and as a percentage of our net
sales, currently reflect our expectations regarding the continued shift in
market demand from CD- to DVD-based products. As noted above, we expect to begin
our shipment of double-layer DVD drives at the end of the third quarter of 2004,
and expect significant shipments of these drives in the fourth quarter of 2004.
One of our core strategies is to be among the first-to-market with new and
enhanced product offerings based on established technologies. We expect to apply
this strategy, as we have done in contexts of CD- and DVD-based technologies, to
next-generation super-high capacity optical data storage devices using
technology such as Blu-ray DVD or High-definition DVD. This strategy extends not
only to new products, but also to enhancements of existing products. We believe
that by employing this strategy, we will be able to maintain relatively high
average selling prices and margins and avoid relying on the highly competitive
market of last-generation and older devices.
In addition to CD- and DVD-based products, we plan to begin shipment of our
new GigaBank data storage product, a compact and portable external hard drive
with a built-in USB connector, at the end of the third quarter or at the
beginning of the fourth quarter of 2004.
Our business faces the significant risk that certain of our retailers will
implement a private label or direct import program, or expand their existing
programs, especially for higher margin products. 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. For example, as
noted above, our sales to Best Buy, who was our largest retailer during 2001,
17
2002 and 2003, declined in the first six months of 2004 to $4.4 million,
representing a decrease of 58% from $10.4 million in the first six months of
2003. We believe that this decrease reflects, at least in part, Best Buy's
increased sales of private label products that compete with products that we
sell. Our challenge will be to deliver products and provide service to our
retailers in a manner and at a level that makes private label or direct
importation of products less attractive to our retailers, while maintaining
product margins at levels sufficient to allow for profitability that meets or
exceeds our goals.
Operating Performance and Financial Condition
We focus on numerous factors in evaluating our operating performance and
our financial condition. In particular, in evaluating our operating performance,
we focus primarily on net sales, net product margins, net retailer margins,
rebates and sales incentives, and inventory turnover as well as operating
expenses and net income.
Net sales. Net sales is a key indicator of our operating performance. We
closely monitor overall net sales, as well as net sales to individual retailers,
and seek to increase net sales by expanding sales to additional retailers and
expanding sales to existing retailers both by increasing sales of existing
products and introducing new products. Management monitors net sales on a weekly
basis, but also considers sales seasonality, promotional programs and product
life-cycles in evaluating weekly sales performance. As net sales increase or
decrease from period to period, it is critical for management to understand and
react to the various causes of these fluctuations, such as successes or failures
of particular products, promotional programs, product pricing, retailer
decisions, seasonality and other causes. Where possible, management attempts to
anticipate potential changes in net sales and seeks to prevent adverse changes
and stimulate positive changes by addressing the expected causes of adverse and
positive changes. We believe that our good working relationships with our
retailers enable us to monitor closely consumer acceptance of particular
products and promotional programs which in turn enable us to better anticipate
changes in market conditions.
Net product margins. Net product margins, from product-to-product and
across all of our products as a whole, is an important measurement of our
operating performance. We monitor margins on a product-by-product basis to
ascertain whether particular products are profitable or should be phased out as
unprofitable products. In evaluating particular levels of product margins on a
product-by-product basis, we focus on attaining a level of net product margin
sufficient to contribute to normal operating expenses and to provide a profit.
The level of acceptable net product margin for a particular product depends on
our expected product sales mix. However, we occasionally sell products for
certain strategic reasons to, for example, complete a product line or for
promotional purposes, without the rigid focus on historical product margins or
contribution to operating expenses or profitability.
Net retailer margins. We seek to manage profitability on a retailer level,
not solely on a product level. Although we focus on net product margins on a
product-by-product basis and across all of our products as a whole, our primary
focus is on attaining and building profitability on a retailer-by-retailer
level. For this reason, our mix of products is likely to differ among our
various retailers. These differences result from a number of factors, including
retailer-to-retailer differences, products offered for sale and promotional
programs.
Rebates and sales incentives. Rebates and sales incentives offered to
customers and retailers are an important aspect of our business and are
instrumental in maintaining or obtaining market leadership through competitive
pricing in generating sales on a regular basis as well as stimulating sales of
slow moving products. We focus on rebates and sales incentives costs as a
18
proportion of our total net sales to ensure that we meet our expectations of the
costs of these programs and to understand how these programs contribute to our
profitability or result in unexpected losses.
Inventory turnover. Our product life-cycles typically ranges from 3-12
months, generating lower average selling prices as the cycle matures. We attempt
to keep our inventory levels at amounts adequate to meet our retailers' needs
while minimizing the danger of rapidly declining average selling prices and
inventory financing costs. By focusing on inventory turnover levels, we seek to
identify slow-moving products and take appropriate actions such as
implementation of rebates and sales incentives to increase inventory turnover.
Our use of a consignment sales model with certain retailers results in
increased amounts of inventory that we must carry and finance. Our use of a
consignment sales model results in greater exposure to the danger of declining
average selling prices, however our consignment sales model allows us to more
quickly implement promotional programs and pricing adjustments to sell off
slow-moving inventory and prevent further price erosion.
Our targeted inventory turnover levels for our combined sales models is 6
to 8 weeks of inventory, which equates to an annual inventory turnover level of
approximately 6.5 to 8.5. For the first six months of 2004, our annualized
inventory turnover level was 6.6 as compared to 5.5 for the first six months of
2003, representing a period-to-period increase of 20% primarily as a result of a
37% decrease in inventory offset by a 24% decrease in sales. For 2003, our
inventory turnover level was 6.4 as compared to 9.4 for 2002, representing a
period-to-period decrease of 32% primarily as a result of a 9% increase in
inventory and a 26% decrease in sales. For 2002, our inventory turnover level
was 9.4 as compared to 5.6 for 2001, representing a period-to-period increase of
68% primarily due to a reduction of inventory acquired in connection with our
acquisition of IOM Holdings, Inc. and a 23% increase in net sales.
Operating expenses. We focus on operating expenses to keep these expenses
within budgeted amounts in order to achieve or exceed our targeted
profitability. We budget certain of our operating expenses in proportion to our
projected net sales, including operating expenses relating to production,
shipping, technical support, and inside and outside commissions and bonuses.
However, most of our expenses relating to general and administrative costs,
product design and sales personnel are essentially fixed over large sales
ranges. Deviations that result in operating expenses in greater proportion than
budgeted signal to management that it must ascertain the reasons for the
unexpected increase and take appropriate action to bring operating expenses back
into the budgeted proportion.
Net income. Net income is the ultimate goal of our business. By managing
the above factors, among others, and monitoring our actual results of
operations, our goal is to generate net income at levels that meet or exceed our
targets. In evaluating our financial condition, we focus primarily on cash on
hand, available trade lines of credit, available bank line of credit,
anticipated near-term cash receipts, and accounts receivable as compared to
accounts payable. Cash on hand, together with our other sources of liquidity, is
critical to funding our day-to-day operations. Funds available under our line of
credit with United National Bank are also an important source of liquidity and a
measure of our financial condition. We use our line of credit on a regular basis
as a standard cash management procedure to purchase inventory and to fund our
day-to-day operations without interruption during periods of slow collection of
accounts receivable. Anticipated near-term cash receipts are also regarded as a
short-term source of liquidity, but are not regarded as immediately available
for use until receipt of funds actually occurs.
The proportion of our accounts receivable to our accounts payable and the
expected maturity of these balance sheet items is an important measure of our
financial condition. We attempt to manage our accounts receivable and accounts
payable to focus on cash flows in order to generate cash sufficient to fund our
day-to-day operations and satisfy our liabilities. Typically, we prefer that
accounts receivable are matched in duration to, or collected earlier than,
accounts payable. If accounts payable are either out of proportion to, or due
far in advance of, the expected collection of accounts receivable, we will
likely have to use our cash on hand or our line of credit to satisfy our
accounts payable obligations, without relying on additional cash receipts, which
will reduce our ability to purchase and sell inventory and may impact our
ability, at least in the short-term, to fund other parts of our business.
Consignment Sales
We employ two primary sales models: a consignment sales model and a
traditional term sales model. We generally use one of these two primary sales
models, or some combination of these sales models, with each of our retailers.
On occasion, we also utilize a third sales model, under which we generally do
not offer rebates or sales incentives.
Consignment sales represented a growing percentage of our net sales from
2001 through 2003. During the first six months of 2004 our consignment sales
model accounted for 31.4% of our total net sales as compared to 40.7% of our
total net sales in the first six months of 2003, representing a 22.9% decrease,
primarily as a result of consigning fewer products to Best Buy, which is our
largest consignment retailer. During 2003 our consignment sales model accounted
for 35.7% of our total net sales as compared to 31.5% of our total net sales in
2002, representing a 13.3% increase. During 2002 our consignment sales model
accounted for 31.5% of our total net sales as compared to 14% of our total net
sales in 2001, representing a 125% increase. Although consignment sales declined
as a percentage of our net sales in the first six months of 2004, it is not yet
clear whether consignment sales as a percentage of our total net sales will
continue to decline or resume growing.
Over the past three years, we have increased the use of our consignment
sales model based partly on the preferences of some of our retailers, but also
in large part based on the advantages that a consignment sales model offers to
us. Managed properly, and balanced with our traditional term sales model, our
consignment sales model enables us to have more pricing control over inventory
sold through our retailers without any significant negative effects. Our
consignment sales model is also designed to increase our ability to generate
cash on a short-term basis by reducing the period between when we sell products
to our retailers and when we are paid for those products by our retailers. Under
a traditional term sales model, we customarily have to wait up to 60 days before
our retailers pay for inventory shipped to them. However, under a consignment
sales model a retailer typically pays us for a product within 30 days of the
sale of that product to the retailer's customer. Accordingly, we believe that
the consignment sales model is an ideal model for fast-moving products as it
allows us to more quickly generate cash to finance additional purchases of
inventory and to fund our business.
Managing an appropriate mix of consignment and traditional term sales is an
important challenge. We generally prefer that high-turnover inventory is sold on
a consignment basis while lower-turnover inventory is sold on a traditional
terms basis. If we do not properly manage the proportion of consignment to
traditional term sales, we may have excessive inventory in our consignment sales
channels, which could result in a lack of short-term financial resources and
declining liquidity as a result of incorrectly anticipating consignment
inventory turnover levels. This may, in turn, result in our inability to fund
additional purchases of inventory to supply our traditional term sales
retailers. Management focuses closely on consignment sales and the proportion of
consignment sales to traditional term sales to achieve the optimal level of each
sales model and to manage our cash flow to maximize liquidity and net sales.
Close attention is directed toward our inventory turnover levels to ensure that
they are sufficiently frequent to maintain appropriate liquidity. At this time,
we believe that the risks associated with our consignment sales model are
immaterial.
19
RETAILERS
Historically, a limited number of retailers have accounted for a
significant percentage of our net sales. During 2003, 2002 and 2001, and during
the first six months of 2004, our six largest retailers accounted for
approximately 78%, 88% and 92%, and 83%, respectively, of our total net sales.
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, and were unable to replace our sales to those retailers, 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. The seasonality of our sales is in
direct correlation to the seasonality experienced by our retailers and the
seasonality of the consumer electronics industry. After adjusting for the
addition of new retailers, our fourth quarter has historically generated the
strongest sales, which correlates to well-established consumer buying patterns
during the Thanksgiving through Christmas holiday season. Our first and third
quarters have historically shown some strength from time to time based on
post-holiday season sales in the first quarter and back-to-school sales in the
third quarter. Our second quarter has historically been our weakest quarter for
sales, again following well-established consumer buying patterns. 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 on a terms basis and are
recognized upon shipment to retailers. Our consignment sales are recognized when
our retailers sell our products to the consumers. Some of our sales include
limited rights to return 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, we offer some retailers sales incentives 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 sales incentive arrangements when the
retailer is authorized by us to implement a 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 sales incentives
arrangements, rebate arrangements and marketing development fund/cooperative
arrangements.
20
Market Development Fund and Cooperative Advertising Costs, Promotion Costs and
Slotting Fees
Market development fund and cooperative advertising costs, promotion costs
and slotting fees are charged to operations and offset against gross sales in
accordance with Emerging Issues Task Force Issue No. 01-9. Market development
fund and cooperative advertising costs and promotion costs are each promotional
costs. Slotting fees are fees paid directly to retailers for allocation of
shelf-space in retail locations. In the first six months of 2004, our market
development fund and cooperative advertising costs, promotion costs and slotting
fees were $3.5 million, or 15.5% of net sales, all of which was offset against
gross sales, as compared to market development fund and cooperative advertising
costs, promotion costs and slotting fees of $4.2 million, or 14.0% of net sales,
in the first six months of 2003, all of which was offset against gross sales.
These costs and fees increased as a percentage of our net sales, especially in
the second quarter of 2004, increasing to 29.2% of our net sales from 13.9% of
our net sales in the second quarter of 2003, primarily as a result of
instituting sales incentives and marketing promotions in order to lower the
quantity of single-layer DVD recordable drives in our retail sales channels to
enable a more rapid transition to sales of double-layer DVD recordable drives.
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
Our warehouse supervisor, production supervisor and production manager
physically review our warehouse inventory for slow moving and obsolete products.
All products of a material amount are reviewed quarterly and all products of an
immaterial amount are reviewed annually. We consider products that have not been
sold within six months to be slow moving. Products that are no longer compatible
with current hardware or software are considered obsolete. The potential for
re-sale of slow moving and obsolete inventories is considered through market
research, analysis of our retailers' current needs, and assumptions about future
demand and market conditions. The recorded cost of both slow-moving and obsolete
inventories is then reduced to its estimated market value based on current
market pricing for similar products. We utilize the Internet to provide
indications of market value from competitors' pricing, third party inventory
liquidators and auction websites. The recorded costs of our slow-moving and
obsolete products are reduced to current market prices when the recorded costs
exceed such market prices. For the first six months of 2004 we increased our
inventory reserve and recorded a corresponding increase in cost of goods sold of
$368,000 for inventory for which recorded cost exceeded the current market price
of this inventory on hand. For the first six months of 2003, we decreased our
inventory reserve and recorded a corresponding decrease in cost of goods sold of
$150,000. All adjustments establish a new cost basis for inventory as we
believe such reductions are permanent declines in the market price of our
products. Generally, obsolete inventory is sold to companies that specialize in
the liquidation of these items while we continue to market slow-moving
inventories until they are sold or become obsolete. As obsolete or slow moving
inventory is sold, we reduce the reserve by proceeds from the sale of the
products. During the first six months of 2004 and 2003, we sold inventories
previously reserved for and accordingly reduced the reserve by $244,000 and
$414,000, respectively.
21
Inventory Adjustments
Our warehouse supervisor, production supervisor and production manager
physically review our warehouse inventory for obsolete or damaged
inventory-related items on a monthly basis. Inventory-related items (such as
sleeves, manuals or broken products no longer under warranty from our
subcontract manufacturers) which are considered obsolete or damaged are reviewed
by these personnel together with our Controller or Chief Financial Officer. At
the discretion of our Controller or Chief Financial Officer, these items are
physically disposed of and we make corresponding accounting adjustments
resulting in inventory adjustments. In addition, on a monthly basis, our detail
inventory report and our general ledger are reconciled by our Controller and any
variances result in a corresponding inventory adjustment. Although we have no
specific statistical data on this matter, we believe that our practices are
reasonable and consistent with those of our industry.
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 and maintain
allowances for potential credit losses based on management's evaluation of
historical experience and current industry trends. 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
We allow our retailers to return defective products to us following a
customary return merchandise authorization process. We utilize historical return
rates to determine our allowance for returns in each period. Sales are adjusted
by the estimated returns while cost of sales are adjusted by the estimated cost
of those sales. Given the seasonality of our business, we expect greater sales
and consequently a greater allowance during our fourth quarter of the fiscal
year. In deriving our allowance for future returns, we consider several factors
to be significant. These factors are relatively predictable based upon
historical return rates. These factors include the amount of time from actual
sale to the product being returned, the estimated return rates, and the
estimated gross margin on the products sold.
We include estimated time of product on the shelf and time to return
product to us. We have a limited 90-day to one year time period for product
returns from end-users; however, our retailers generally have return policies
that allow their customers to return products within only fourteen to thirty
days after purchase. While we believe that most returns occur shortly after
purchase, we use a two-month window in our estimate to cover individuals who
take more time to return product plus the time it takes for the return request
to be received by us.
Our return rate is based upon our past history of actual returns. We
believe that return rates are dependent on our ability to provide technical
support for our products. As we have been selling the same lines of products for
several years, we believe that our technical support staff has developed
knowledge and expertise in solving the end-users' issues which has lead to
diminishing product returns by the end users. In 2002, we reduced our estimated
future return rate from 13.9% to 8.5%. We believe the reduction in historical
product return rates in 2002 was a direct result of improved product
installation manuals and a higher level of technical support. If we encounter
problems with our technical support, either with current products or with new
products we might introduce in the future, then we would need to reconsider this
22
factor. Our estimated future return rate remained at this level throughout 2003.
In 2004, we increased our estimated future return rate to 11.0% to reflect the
actual return rate in 2003.
Finally, we use an estimate of an average gross margin realized on our
products. This average rate is derived from historical results and estimated
product mix in future years. If we have a significant change in actual gross
margin due to increased costs of current products or the introduction of large
quantities of new products which have a significantly different gross margin,
then we would recalculate the gross margin to be used for estimated future
returns. Although we have no specific statistical data on this matter, we
believe that our practices are reasonable and consistent with those of our
industry.
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 JUNE 30, 2004 (UNAUDITED) COMPARED TO THREE MONTHS ENDED JUNE
30, 2003 (UNAUDITED)
RESULTS AS A
PERCENTAGE
OF NET SALES FOR
DOLLAR PERCENTAGE THE THREE MONTHS
VARIANCE VARIANCE ENDED
THREE MONTHS ENDED --------------- ------------- JUNE 30,
JUNE 30, FAVORABLE FAVORABLE ----------------
----------------------------------
2004 2003 (UNFAVORABLE) (UNFAVORABLE) 2004 2003
-------------------- ------------ ----------------- ------------- ------- -------
(in thousands)
Net sales. . . . . . . . . . . . . . $ 7,192 $ 12,793 $ (5,601) (43.8)% 100.0% 100.0%
Cost of sales. . . . . . . . . . . . 6,941 10,883 3,942 36.2 96.5 85.1
-------------------- ------------ ----------------- ------------- ------- -------
Gross profit . . . . . . . . . . . . 251 1,910 (1,659) (86.9) 3.5 14.9
Selling, marketing and
advertising expenses . . . . . . . 171 329 158 48.0 2.4 2.5
General and administrative expenses. 1,453 2,478 1,025 41.4 20.2 19.4
Depreciation and amortization. . . . 209 355 146 41.1 2.9 2.8
-------------------- ------------ ----------------- ------------- ------- -------
Operating loss . . . . . . . . . . . (1,582) (1,252) (330) (26.4) (22.0) (9.8)
Net interest expense . . . . . . . . (40) (52) 12 23.1 (0.5) (0.4)
Other income (expense) . . . . . . . (13) 26 (39) (150.0) 0.2) 0.2
-------------------- ------------ ----------------- ------------- ------- -------
Loss from operations before
provision for income taxes. . . . (1,635) (1,278) (357) (27.9) (22.7) (10.0)
Income tax provision (benefit) . . . (1) 1 2 200.0 - -
-------------------- ------------ ----------------- ------------- ------- -------
Net loss . . . . . . . . . . . . . . $ (1,634) $ (1,279) $ (355) (27.8)% (22.7)% (10.0)%
==================== ============ ================= ============= ======= =======
Net Sales. The decrease of $5.6 million in net sales from $12.8 million for
the second quarter of 2003 to $7.2 million for the second quarter of 2004 is
primarily due to the following significant factors: very short product
life-cycles that led consumers to delay purchases in anticipation of products
23
incorporating faster data storage and access speeds and in anticipation of rapid
product obsolescence resulting from expected future product offerings
incorporating new double-layer DVD drive technologies, and the continued
operation of private label programs by Best Buy.
As discussed above, we believe that the significant decline in our net
sales during the second quarter of 2004 as compared to the second quarter of
2003, resulted in part from very short product life-cycles that led consumers to
delay purchases in anticipation of products incorporating faster drive speeds,
which allow users to more quickly store and access data. During 2004, DVD drives
of increasing speeds were introduced into the marketplace in very rapid
succession. However, during this time, we expected our DVD-based products to
experience longer product life-cycles similar in duration to the life-cycles of
our CD-based products. We believe that consumer perception of shorter product
life-cycles led consumers to delay purchases in anticipation of succeeding
products incorporating faster data storage and access speeds.
We also believe that the significant decline in our net sales during the
second quarter of 2004 as compared to the second quarter of 2003, resulted in
part from consumers deciding to delay their purchases of DVD drives in
anticipation of rapid product obsolescence resulting from expected future
product offerings incorporating new technologies. In particular, we believe that
consumers delayed their purchases of single-layer DVD drives in anticipation of
the imminent availability of double-layer DVD drives which can increase storage
capacity to up to twice the capacity of single-layer DVD drives, depending on a
user's operating system and other factors. We expected that double-layer DVD
drives would be available commencing in the fourth quarter of 2004; however, the
market's transition from single-layer to double-layer DVD drives began earlier
than expected in the third quarter of 2004, confirming what we believe were
consumer expectations regarding the imminent availability of products
incorporating double-layer DVD technology.
Another factor contributing significantly to the decline in our net sales
during the second quarter of 2004 was the continued and expanded operation of
private label programs by Best Buy. Our sales to Best Buy, who was our largest
retailer during 2001, 2002 and 2003, declined in the second quarter of 2004 to
$1.6 million, representing a decrease of 67% from $4.8 million in the second
quarter of 2003. We believe that this decrease reflects, at least in part, Best
Buy's increased sales of private label products that compete with products that
we sell.
In addition, we instituted additional sales incentives and marketing
promotions in the second quarter of 2004 in order to lower the quantity of
single-layer DVD recordable drives in our retail sales channels to enable a more
rapid transition to sales of double-layer DVD recordable drives. Our market
development fund and cooperative advertising costs, promotion costs and slotting
fees in the second quarter of 2004 were $2.1 million, or 29.2% of net sales, all
of which was offset against gross sales, as compared to $1.8 million, or 13.9%
of net sales, in the second quarter of 2003, all of which was offset against
gross sales.
Also, sales of our de-emphasized products declined by approximately
$1.4 million to $253,000 for the second quarter of 2004. A change in the
allowance for sales returns also resulted in a $77,000 adjustment causing an
increase in sales for the second quarter of 2004 as compared to a $421,000
adjustment causing an increase to sales for the second quarter of 2003,
resulting in a $344,000 decrease in sales in the second quarter of 2004 compared
to the second quarter of 2003. Sales in the second quarter of 2004 were also
reduced by $285,000 for slotting fees as compared to $0 in the second quarter of
2003.
The $5.6 million decrease in net sales for the second quarter of 2004 was
comprised of a decrease in sales of $6.9 million resulting from a decrease in
the volume of products sold. This decrease was partially offset by an increase
in sales of $1.3 million resulting from higher average product sales prices.
24
Gross Profit. The decrease in gross profit of $1.7 million from $1.9
million for the second quarter of 2003 to $251,000 for the second quarter of
2004 is primarily due to a decline in net sales of $5.6 million, increased sales
incentives and promotion costs, and an increase in our reserve for slow moving
inventory. The decrease in gross profit as a percentage of our net sales was
primarily due to an increase in market development fund and cooperative
advertising costs, promotion costs and slotting fees from 13.9% of net sales
during the second quarter of 2003 to 29.2% of net sales during the second
quarter of 2004. These costs and fees increased primarily as a result of our
institution of sales incentives and marketing promotions in order to lower the
quantity of single-layer DVD recordable drives in our retail sales channels to
enable a more rapid transition to sales of double-layer DVD recordable drives.
Our direct product costs and related freight costs increased from 86.5% of net
sales for the second quarter of 2003 to 92.8% of net sales for the second
quarter of 2004, mainly due to the increased reduction in net sales resulting
from an increase in market development fund and cooperative advertising costs,
promotion costs and slotting fees.
In addition, our inventory reserve increased by $419,000 in the second
quarter of 2004 as compared to the second quarter of 2003 due to our adjustment
of the value of our slow-moving and obsolete inventory. As a result of the short
life cycles of many of our products resulting from, in part, the effects of
rapid technological change, we expect to experience additional slow-moving and
obsolete inventory charges in the future. However, we cannot predict with any
certainty the future level of these charges.
Selling, Marketing and Advertising Expenses. Selling, marketing and
advertising expenses decreased by $158,000 in the second quarter of 2004 as
compared to the second quarter of 2003. This decrease was primarily due to lower
commissions as a result of reduced sales volume, and reduced payroll and related
expenses due to fewer personnel and lower retailer performance charges.
General and Administrative Expenses. The $1.0 million decrease in general
and administrative expenses is primarily due to a $1.4 million decrease in bad
debt expense to $60,000 in the second quarter of 2004 from $1.5 million in the
second quarter of 2003, which was partially offset by a $221,000 increase in
legal fees in the second quarter of 2004 after accounting for a $206,000
reversal of an over-accrual of estimated legal fees related to a lawsuit in the
second quarter of 2003. The decrease in general and administrative expenses was
also partially offset by an $82,000 increase in payroll and related expenses
relating to contractual incentives in the second quarter of 2004 as compared to
the second quarter of 2003.
Depreciation and Amortization Expenses. The $146,000 decrease in
depreciation and amortization expenses is primarily due to accelerated
amortization during the second 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
accordingly accelerated our amortization by $133,000 during the second quarter
of 2003. We did not experience any accelerated amortization during the second
quarter of 2004. Other Income (Expense). Other income (expense) increased by
$27,000 in the second quarter of 2004 as compared to the second quarter of 2003.
During the second quarter of 2004, expense related to currency transactions in
connection with our sales in Canada increased by $39,000. This was partially
offset by a $12,000 decrease in interest expense from $52,000 in the second
quarter of 2004 to $40,000 in the second quarter of 2003 due to reduced
borrowings under our line of credit.
25
SIX MONTHS ENDED JUNE 30, 2004 (UNAUDITED) COMPARED TO SIX MONTHS ENDED JUNE 30,
2003 (UNAUDITED)
RESULTS AS A
PERCENTAGE
OF NET SALES FOR
DOLLAR PERCENTAGE THE SIX MONTHS
VARIANCE VARIANCE ENDED
SIX MONTHS ENDED ------------ ---------------- JUNE 30,
JUNE 30, FAVORABLE FAVORABLE
-------------------------------- -------------
2004 2003 (UNFAVORABLE) (UNFAVORABLE) 2004 2003
------------------ ------------ ---------------- ------------- ------ ------
(in thousands)
Net sales. . . . . . . . . . . . . . $ 22,552 $ 29,857 $ (7,305) (24.5)% 100.0% 100.0%
Cost of sales. . . . . . . . . . . . 19,933 25,510 5,577 21.9 88.4 85.4
------------------ ------------ ---------------- ------------- ------ ------
Gross profit . . . . . . . . . . . . 2,619 4,347 (1,728) (39.8) 11.6 14.6
Selling, marketing and
advertising expenses. . . . . . . 651 665 14 2.1 2.9 2.2
General and administrative expenses. 2,820 3,935 1,115 28.3 12.5 13.2
Depreciation and amortization. . . . 418 712 294 41.3 1.8 2.4
------------------ ------------ ---------------- ------------- ------ ------
Operating loss . . . . . . . . . . . (1,270) (965) (305) (31.6) (5.6) (3.2)
Net interest expense . . . . . . . . (84) (155) 71 45.8 (0.4) (0.5)
Other income (expense) . . . . . . . (21) 49 (70) (142.9) (0.1) 0.1
------------------ ------------ ---------------- ------------- ------ ------
Loss from operations before
provision for income taxes . . . . (1,375) (1,071) (304) (28.4) (6.1) (3.6)
Income tax provision (benefit) . . . 2 (1) (3) (300.0) - -
------------------ ------------ ---------------- ------------- ------ ------
Net loss . . . . . . . . . . . . . . $ (1,377) $ (1,070) $ (307) (28.7)% (6.1)% (3.6)%
================== ============ ================ ============= ====== ======
Net Sales. The decrease of $7.3 million in net sales from $29.9 million for
the first six months of 2003 to $22.6 million for the first six months of 2004
is primarily due to the following significant factors: very short product
life-cycles that led consumers to delay purchases in anticipation of products
incorporating faster data storage and access speeds and in anticipation of rapid
product obsolescence resulting from expected future product offerings
incorporating new double-layer DVD drive technologies, the continued operation
of private label programs by Best Buy and the decline in sales to OfficeMax. The
decline in net sales caused by these factors was partially offset by a
substantial increase in sales to Staples.
As discussed above, we believe that the significant decline in our net
sales during the first six months of 2004 as compared to the first six months of
2003, resulted in part from very short product life-cycles that led consumers to
delay purchases in anticipation of products incorporating faster drive speeds,
which allow users to more quickly store and access data. During 2004, DVD drives
of increasing speeds were introduced into the marketplace in very rapid
succession. However, during this time, we expected our DVD-based products to
experience longer product life-cycles similar in duration to the life-cycles of
our CD-based products. We believe that consumer perception of shorter product
life-cycles led consumers to delay purchases in anticipation of succeeding
products incorporating faster data storage and access speeds.
We also believe that the significant decline in our net sales during the
first six months of 2004 as compared to the first six months of 2003, resulted
in part from consumers deciding to delay their purchases of DVD drives in
anticipation of rapid product obsolescence resulting from expected future
product offerings incorporating new technologies. In particular, we believe that
consumers delayed their purchases of single-layer DVD drives in anticipation of
the imminent availability of double-layer DVD drives which can increase storage
capacity to up to twice the capacity of single-layer DVD drives, depending on a
user's operating system and other factors. We expected that double-layer DVD
drives would be available commencing in the fourth quarter of 2004; however, the
market's transition from single-layer to double-layer DVD drives began earlier
than expected in the third quarter of 2004, confirming what we believe were
consumer expectations regarding the imminent availability of products
incorporating double-layer DVD technology.
26
Another factor contributing significantly to the decline in our net sales
during the first six months of 2004 was the continued and expanded operation of
private label programs by Best Buy. Our sales to Best Buy, who was our largest
retailer during 2001, 2002 and 2003, declined in the first six months of 2004 to
$4.4 million, representing a decrease of 58% from $10.4 million in the first six
months of 2003. We believe that this decrease reflects, at least in part, Best
Buy's increased sales of private label products that compete with products that
we sell.
Also, net sales to OfficeMax declined by $5.3 million, or 100%, during the
first six months of 2004 as compared to the first six months of 2003. This
decline was primarily the result of our mutual agreement with OfficeMax to
discontinue sales between April and October 2003 because we did not want to
offer rebates and sales incentives as heavily as OfficeMax believed was
necessary. Although we resumed sales of our dual-format DVD recordable drives to
OfficeMax in November and December 2003, we experienced other business issues
with OfficeMax and, as a result, discontinued sales in January 2004. We are
negotiating with OfficeMax to resume sales in 2004, but there can be no
assurance that sales to OfficeMax will resume.
These decreases in net sales to Best Buy and OfficeMax were partially
offset by an increase in net sales to Staples of $6.3 million, or 100% for the
first six months of 2003 as compared to the first six months of 2004.
In addition, we instituted additional sales incentives and marketing
promotions in the second quarter of 2004 in order to lower the quantity of
single-layer DVD recordable drives in our retail sales channels to enable a more
rapid transition to sales of double-layer DVD recordable drives. Our market
development fund and cooperative advertising costs, promotion costs and slotting
fees in the second quarter of 2004 were $2.1 million, or 29.2% of net sales, all
of which was offset against gross sales, as compared to $1.8 million, or 13.9%
of net sales, in the second quarter of 2003, all of which was offset against
gross sales. Our market development fund and cooperative advertising costs,
promotion costs and slotting fees in the first six months of 2004 were $4.8
million, or 21.2% of net sales, all of which was offset against gross sales, as
compared to $4.9 million, or 16.6% of net sales, in the first six months of
2003, all of which was offset against gross sales.
Also, sales of our de-emphasized products declined by approximately $5.7
million to $758,000 for the first six months of 2004. A change in the allowance
for sales returns also resulted in a $1.0 million adjustment causing an increase
in sales for the first six months of 2004 as compared to a $761,000 adjustment
causing an increase to sales for the first six months of 2003, resulting in a
$242,000 decrease in sales in the first six months of 2004 compared to the first
six months of 2003. Sales in the first six months of 2004 were also reduced by
$570,000 for slotting fees as compared to $0 in the first six months of 2003.
The $7.3 million decrease in net sales for the first six months of 2004 was
comprised of a decrease in sales in the amount of $16.8 million resulting from a
decrease in the volume of products sold. This decrease was partially offset by
an increase in sales in the amount of $9.5 million resulting from higher average
product sales prices.
Gross Profit. The decrease in gross profit of $1.7 million from $4.3
million for the first six months of 2003 to $2.6 million for the first six
months of 2004, is primarily due to a decline in net sales of $7.3 million, and
increased sales incentives, promotion costs and slotting fees, and an increase
in our reserve for slow moving inventory. The decrease in gross profit as a
percentage of net sales was primarily due to an increase in market development
fund and cooperative advertising costs, promotion costs and slotting fees from
16.6% of net sales during the first six months of 2003 to 21.2% of net sales
during the first six months of 2004. These costs and fees increased primarily as
a result of our institution of sales incentives and marketing promotions in
order to lower the quantity of single-layer DVD recordable drives in our retail
27
sales channels to enable a more rapid transition to sales of double-layer DVD
recordable drives. Our direct product costs and related freight costs increased
from 86.0% of net sales for the first six months of 2003 to 86.4% of net sales
for the first six months of 2004.
In addition, our inventory reserve increased by $519,000 in the first six
months of 2004 as compared to the first six months of 2003 due to our adjustment
of the value of our slow-moving and obsolete inventory. Also, our inventory
adjustment increased by $97,000 in the first six months of 2004 as compared to
the first six months of 2003. As a result of the short life cycles of many of
our products resulting from, in part, the effects of rapid technological change,
we expect to experience additional slow-moving and obsolete inventory charges in
the future. However, we cannot predict with any certainty the future level of
these charges.
Selling, Marketing and Advertising Expenses. Selling, marketing and
advertising expenses decreased by $14,000 in the first six months of 2004 as
compared to the first six months of 2003. This decrease was primarily due to
$108,000 in lower commissions as a result of reduced sales volume, $96,000 in
reduced payroll and related expenses due to fewer personnel and $56,000 in lower
retailer performance charges. These decreases were partially offset by $241,000
in higher advertising costs in the first six months of 2004 as compared to the
first six months of 2003.
General and Administrative Expenses. The $1.1 million decrease in general
and administrative expenses is primarily due to a $1.4 million decrease in bad
debt expense to $123,000 during the first six months of 2004 from $1.5 million
during the first six months of 2003, and $82,000 less product design expense.
These increased expenses were partially offset by a $258,000 increase in legal
fees in the first six months of 2004 after accounting for a $206,000 reversal of
an over-accrual of estimated legal fees related to a lawsuit in the first six
months of 2003, an increase of $86,000 in insurance expense and an increase of
$71,000 in payroll and related expenses relating to contractual incentives
during the first six months of 2004 as compared to the first six months of 2003.
Depreciation and Amortization Expenses. The $294,000 decrease in
depreciation and amortization expenses is primarily due to accelerated
amortization during the first six months 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
accordingly accelerated our amortization by $266,000 during the first six months
of 2003. We did not experience any accelerated amortization during the first six
months of 2004.
Other Income (Expense). Other income (expense) decreased by $2,000 in the
first six months of 2004 as compared to the first six months of 2003. During the
first six months of 2004, interest expense decreased to $84,000 from $156,000 in
the first six months of 2003 due to reduced borrowings under our line of credit.
This decrease in interest expense was partially offset by a $70,000 increase in
expense related to currency transactions in connection with our sales in Canada
during the first six months of 2004.
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of liquidity have been cash provided by operations
and borrowings under our bank and trade credit facilities. Our principal uses of
cash have been to finance working capital, capital expenditures and debt service
requirements. We anticipate that these uses will continue to be our principal
uses of cash in the future. As of June 30, 2004, we had working capital of $10.0
million, an accumulated deficit of $16.4 million, $5.4 million in cash and cash
equivalents and $10.1 million in net accounts receivable. This compares with
working capital of $11.0 million, an accumulated deficit of $15.1 million, $6.2
million in cash and cash equivalents and $18.4 million in net accounts
receivable as of December 31, 2003.
28
For the six months ended June 30, 2004, our cash decreased $683,000, or
11.2%, from $6.1 million to $5.4 million as compared to a decrease of $3.2
million, or 43.3%, for the six months ended June 30, 2003 from $7.3 million to
$4.2 million.
Cash provided by our operating activities totaled $761,000 during the first
six months of 2004 as compared to cash provided by our operating activities of
$2.3 million during the first six months of 2003. This decrease of $1.6 million
in cash provided by our operating activities primarily resulted from the
decrease of $7.3 million in net sales during the first six months of 2004 as
compared to the first six months of 2003. This decrease in net sales and other
factors resulted in an $11.5 million decrease in the use of our trade credit
facilities. The decrease in cash provided by our operating activities also
partially resulted from a $2.2 million decrease in our allowance for doubtful
accounts. These decreases in cash were partially offset by increases in cash
resulting from a $3.8 million decrease in warehouse and consigned inventory, a
$3.3 million decrease in accounts receivable, and a $2.8 million increase in
accrued expenses, including increased accrued market development fund and
cooperative advertising costs, promotion costs and slotting fees. In addition,
legal settlements payable decreased by $2.0 million as we made the initial
payment on the settlement of a litigation matter in the first quarter of 2003 in
the amount of $3.0 million and we made the final payment in the first quarter of
2004 in the amount of $1.0 million.
Decreases in our use of our trade credit facility and in our allowance for
doubtful accounts each decreased cash. Decreases in inventory, accounts
receivable, and legal settlements payable, and increases in accrued expenses,
each increased cash.
Cash used in our financing activities totaled $1.4 million during the first
six months of 2004 as compared to $5.5 million for the first six months of 2003.
We paid down $5.4 million of our ChinaTrust Bank loan balance during the first
six months of 2003 through funds generated by our operations and we paid down
$1.4 million of our United National Bank loan balance during the first six
months of 2004 through funds generated by our operations. We repurchased $84,000
of our common stock in the first six months of 2003.
Effective January 1, 2002, we obtained a $9.0 million asset-based line of
credit (with a sub-limit of $8.0 million) with ChinaTrust Bank (USA) that was to
expire December 15, 2003. The credit facility contained a number of restrictive
financial covenants. On each of December 31, 2002, March 31, 2003, and June 30,
2003, we were not in compliance with certain of those financial covenants.
However, we subsequently obtained waivers with respect to our noncompliance with
these financial covenants from the lender which, among other things, on December
31, 2002 modified the original expiration date of the line of credit from
December 15, 2003 to October 15, 2003.
On August 15, 2003, we entered into an asset-based business loan agreement
with United National Bank. The agreement provides for a revolving loan of up to
$6.0 million secured by substantially all of our assets and initially was to
expire on September 1, 2004. On August 6, 2004, United National Bank extended
the expiration date of the agreement until November 1, 2004. We are in
discussions with United National Bank to renew the agreement. Advances up to 65%
of eligible accounts receivable bear interest at the floating interest rate
equal to the prime rate of interest as reported in The Wall Street Journal plus
0.75%. As of June 30, 2004, the interest rate was 4.75%. The 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 agreement also contains
five restrictive financial covenants: our quick ratio must be at least 1.0; our
tangible net worth must be no lower than $10.5 million; our debt to tangible net
worth ratio must not exceed 2.0; our current ratio must be no lower than 1.25
29
and we must be profitable for the year ended December 31, 2004. As of December
31, 2003 and June 30, 2004, we were in compliance with the first four covenants
and the last covenant was not yet applicable.
Effective September 2, 2003, we borrowed $3.4 million under the United
National Bank credit facility to pay off the outstanding balance on our
ChinaTrust Bank (USA) credit facility. As of June 30, 2004, the outstanding
balance with United National Bank was $4.5 million and we had available to us
$1.2 million of additional borrowings. Our credit facility with United National
Bank expires on November 1, 2004.
In January 2003, we entered into a trade credit facility with Lung Hwa
Electronics. Lung Hwa Electronics is a stockholder 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 $10.0 million 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 June 30, 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' prior written notice
to the other party. As of June 30, 2004, we owed Lung Hwa Electronics $1.0
million in trade payables net of the remaining $750,000 deposit.
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
$10.0 million 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 $10.0 million 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 June
30, 2004, we owed BTC USA $2.6 million under this arrangement. BTC USA is a
subsidiary of Behavior Tech Computer Corp., one of our significant stockholders.
Mr. Steel Su, a director of I/OMagic, is the Chief Executive Officer of Behavior
Tech Computer Corp.
Our net loss increased 27.3% to $1.4 million for the first six months of
2004 from $1.1 million for the first six months of 2003, primarily resulting
from a 24.4% decline in net sales to $22.6 million in the first six months of
2004 from $29.9 million in the first six months of 2003. If either the absolute
level or the downward trend of our net loss or net sales continues or increases,
we could experience significant shortages of liquidity and our ability to
purchase inventory and to operate our business may be significantly impaired,
which could lead to further declines in our operating performance and financial
condition.
If, like Best Buy, any other of our major retailers, or a significant
number of our smaller retailers, implement or expand private label programs
covering products that compete with our products, our net sales will likely
continue to decline and our net losses are likely to increase, which in turn
could have a material and adverse impact on our liquidity, financial condition
and capital resources. We expect the decline in our sales to Best Buy to
continue in subsequent reporting periods as a result of continued private label
programs; however, management intends to use its best efforts to insure that we
retain Best Buy as one of our major retailers. We cannot assure you that Best
Buy will remain one of our major retailers or that we will successfully sell any
products through Best Buy.
30
We believe that the significant decline in our net sales during the first
six months of 2004 resulted in part from very short product life-cycles leading
consumers to delay purchases of single-layer DVD drives in anticipation of DVD
drives with faster data storage and access speeds, and also to delay purchases
of single-layer DVD drives in anticipation of the imminent availability of
higher capacity double-layer DVD drives. We expect that the very short product
life cycles of DVD-products experienced in 2004, as compared to other data
storage products that we have offered for sale in the past, including our
CD-based products, will lengthen following the introduction of double-layer DVD
drives; however, there can be no assurance that product life-cycles will
lengthen or that consumers will not continue to delay purchases in anticipation
of products incorporating faster data storage and access speeds or new
technologies, or both. We expect to begin our shipment of double-layer DVD
drives at the end of the third quarter of 2004, and expect significant shipments
of these drives in the fourth quarter of 2004.
Despite the decline in our results of operations during the first and
second quarters of 2004, we believe that 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 which we believe will
be renewed or replaced, 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. 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 June 30, 2004 was $2.6 million as compared to a backlog at
June 30, 2003 of $4.3 million. Based on historical trends, we anticipate that
our June 30, 2004 backlog may be reduced by approximately 11.1%, or $288,000, to
a net amount of $2.3 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
sales incentives.
PAYMENTS DUE BY PERIOD
-----------------------
CONTRACTUAL OBLIGATIONS
AT JUNE 30, 2004
- ---------------------------------- LESS THAN 1 1-3 4-5 AFTER 5
TOTAL YEAR YEARS YEARS YEARS
- ---------------------------------- ------------ ----------- -------- -------- --------
Long Term Debt . . . . . . . . . . $ - $ - $ - $ - $ -
Capital Lease Obligations. . . . . - - - - -
Operating Leases . . . . . . . . . 793,409 372,152 412,527 8,730 -
Unconditional Purchase Obligations - - - - -
------------ ----------- -------- -------- --------
Total Contractual Cash Obligations $ 793,409 $372,152 $ 412,527 $ 8,730 $ -
============ =========== ========= ======== ========
31
The above table outlines our obligations as of June 30, 2004 and does not
reflect the changes in our obligations that occurred after that date.
IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest
Entities" which addresses the consolidation of business enterprises (variable
interest entities) to which the usual condition (ownership of a majority voting
interest) of consolidation does not apply. The interpretation focuses on
financial interests that indicate control. It concludes that in the absence of
clear control through voting interests, a company's exposure (variable interest)
to the economic risks and potential rewards from the variable interest entity's
assets and activities are the best evidence of control. Variable interests are
rights and obligations that convey economic gains or losses from changes in the
values of the variable interest entity's assets and liabilities. Variable
interests may arise from financial instruments, service contracts, nonvoting
ownership interests and other arrangements. If an enterprise holds a majority of
the variable interests of an entity, it would be considered the primary
beneficiary. The primary beneficiary would be required to include the assets,
liabilities and the results of operations of the variable interest entity in its
financial statements. In December 2003, the FASB issued a revision to FIN 46 to
address certain implementation issues. This statement is not applicable to us.
In April 2003, FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting and reporting for derivative instruments and hedging
activities under SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." SFAS No. 149 is effective for derivative instruments and
hedging activities entered into or modified after September 30, 2003, except for
certain forward purchase and sale securities. For these forward purchase and
sale securities, SFAS No. 149 is effective for both new and existing securities
after September 30, 2003. This statement is not applicable to us.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity." SFAS
No. 150 establishes standards for how an issuer classifies and measures in its
statement of financial position certain financial instruments with
characteristics of both liabilities and equity. In accordance with the standard,
financial instruments that embody obligations for the issuer are required to be
classified as liabilities. SFAS No. 150 will be effective for financial
instruments entered into or modified after May 31, 2003 and otherwise will be
effective at the beginning of the first interim period beginning after June 15,
2003. This statement is not applicable to us.
32
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
discussion, which summarizes material risks, before deciding to invest in shares
of our common stock or to maintain or increase your investment in shares of our
common stock. Any of the following risks, if they actually occur, would likely
harm our business, financial condition and results of operations. As a result,
the trading price of our common stock could decline, and you could lose all or
part of the money you paid to buy our common stock.
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, WE WILL
EXPERIENCE NEGATIVE CASH FLOW WHICH MAY HAMPER CURRENT OPERATIONS AND MAY
PREVENT US FROM EXPANDING OUR BUSINESS.
We have incurred net losses in each of the last three years and for the six
months ended June 30, 2004. As of June 30, 2004, we had an accumulated deficit
of approximately $16.4 million. During 2003, 2002, 2001 and the six months ended
June 30, 2004, we incurred net losses in the amounts of approximately $265,000,
$8.3 million, $5.5 million and $1.4 million, respectively. Historically, we have
relied upon cash from operations and financing activities to fund all of the
cash requirements of our business. If our extended period of net losses
continues, this will result in negative cash flow and may hamper current
operations and may prevent us from expanding our business. We cannot assure you
that we will attain, sustain or increase profitability on a quarterly or annual
basis in the future. If we do not achieve, sustain or increase profitability,
our business will be adversely affected and our stock price may decline.
WE DEPEND ON A SMALL NUMBER OF RETAILERS FOR THE VAST MAJORITY OF OUR SALES. A
REDUCTION IN BUSINESS FROM ANY OF THESE RETAILERS COULD CAUSE A SIGNIFICANT
DECLINE IN OUR SALES AND PROFITABILITY.
The vast majority of our sales are generated from a small number of
retailers. During the first six months of 2004, net sales to our two largest
retailers, Staples and Best Buy, represented approximately 28% and 19%,
respectively, of our total net sales, and net sales to our next four largest
retailers, Office Depot, Circuit City, Radio Shack and CompUSA, represented
approximately 12%, 10%, 8% and 5%, respectively, of our total net sales. During
the first six months of 2004, aggregate net sales to these six retailers
represented approximately 83% of our total net sales. During 2003, net sales to
our two largest retailers, Best Buy and Circuit City, represented approximately
28% and 13%, respectively, of our total net sales, and net sales to our next
four largest retailers, Office Depot, OfficeMax, CompUSA and Staples represented
approximately 10%, 10%, 9% and 8%, respectively, of our total net sales. During
2003, aggregate net sales to these six retailers represented approximately 78%
of our total net sales. We expect that we will continue to depend upon a small
number of retailers for a significant majority of our sales 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 or to make any purchases
whatsoever. Therefore, we cannot assure you that, in any future period, our
sales generated from these retailers, individually or in the aggregate, will
equal or exceed historical levels. We also 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. A
cessation or reduction of sales, or a decrease in the prices of products sold to
one or more of these retailers has significantly reduced our net sales for one
or more reporting periods in the past and could, in the future, cause a
significant decline in our net sales and profitability.
33
OUR LACK OF LONG-TERM PURCHASE ORDERS AND COMMITMENTS COULD LEAD TO A RAPID
DECLINE IN OUR SALES AND PROFITABILITY.
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. In addition, our retailers may decide not to purchase
products from us for any reason. Accordingly, we cannot assure you that any of
our current retailers will continue to purchase our products in the future. As a
result, our sales volume and profitability could decline rapidly with little or
no warning whatsoever. For example, in 2003 we did not sell any of our products
to OfficeMax for a period of several months which resulted in a 70% decrease in
sales to OfficeMax in 2003 as compared to 2002. This significant decline in
sales was one of the primary reasons for the 26% decline in net sales for 2003
as compared to 2002. The decision to suspend sales was a mutual decision between
us and OfficeMax because we did not want to offer rebates and sales incentives
as heavily as OfficeMax believed was necessary.
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 in a manner consistent with our actual sales.
Moreover, our expense levels are based in part on our expectations of future
sales and, if our expectations regarding future sales are inaccurate, we may be
unable to reduce costs in a timely manner to adjust for sales shortfalls.
Furthermore, because we depend on a small number of retailers for the vast
majority of our sales, the magnitude of the ramifications of these risks, is
greater than if our sales were less concentrated within a small number of
retailers. As a result of our lack of long-term purchase orders and purchase
commitments we may experience a rapid decline in our sales and profitability.
ONE OR MORE OF OUR LARGEST RETAILERS MAY DIRECTLY IMPORT OR PRIVATE LABEL
PRODUCTS THAT ARE IDENTICAL OR VERY SIMILAR TO OUR PRODUCTS. THIS COULD CAUSE A
SIGNIFICANT DECLINE IN OUR SALES AND PROFITABILITY.
Optical data storage products and digital entertainment products are widely
available from manufacturers and other suppliers around the world. Our largest
retailers include Best Buy, Circuit City, CompUSA, Staples, Office Depot and
OfficeMax. Collectively, these six retailers accounted for 78% of our net sales
in 2003. Sales to Staples, Best Buy, Office Depot, Circuit City, Radio Shack and
CompUSA collectively accounted for 83% of our net sales for the six months ended
June 30, 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. For example, Best Buy,
our largest retailer, already has a private label program and sells certain
products that compete with some of our products. Sales to Best Buy in the first
six months of 2004 totaled $4.4 million representing a decrease of 58% from
$10.4 million in the first six months of 2003. We believe that this decrease
reflects, at least in part, Best Buy's increased sales of private label products
that compete with products that we sell. 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 largest retailers may stop buying products from us in favor of a direct
import or private label program. As a consequence, our sales and profitability
could decline significantly.
34
HISTORICALLY, A SUBSTANTIAL PORTION OF OUR ASSETS HAVE BEEN COMPRISED OF
ACCOUNTS RECEIVABLE REPRESENTING AMOUNTS OWED BY A SMALL NUMBER OF RETAILERS. WE
EXPECT THIS TO CONTINUE IN THE FUTURE. IF ANY OF THESE RETAILERS FAILS TO TIMELY
PAY US AMOUNTS OWED, WE COULD SUFFER A SIGNIFICANT DECLINE IN CASH FLOW AND
LIQUIDITY WHICH, IN TURN, COULD CAUSE US TO BE UNABLE PAY OUR LIABILITIES AND
PURCHASE AN ADEQUATE AMOUNT OF INVENTORY TO SUSTAIN OR EXPAND OUR CURRENT SALES
VOLUME.
Our accounts receivable represented 46%, 46%, 50% and 36% of our total
assets as of December 31, 2003, 2002 and 2001, and as of the six months ended
June 30, 2004, respectively. As of June 30, 2004, 78% of our accounts receivable
represented amounts owed by four retailers, each of which represented over 10%
of the total amount of our accounts receivable. Similarly, as of December 31,
2003, 63% of our accounts receivable represented amounts owed by three
retailers, each of which represented over 10% of the total amount of our
accounts receivable. As a result of the substantial amount and concentration of
our accounts receivable, if any of our major retailers fails to timely pay us
amounts owed, we could suffer a significant decline in cash flow and liquidity
which would negatively affect our ability to make payments under our line of
credit with United National Bank and which, in turn, could adversely affect our
ability to borrow funds to purchase inventory to sustain or expand our current
sales volume. Accordingly, if any of our major retailers fails to timely pay us
amounts owed, our sales and profitability may decline.
IF WE ARE UNABLE TO RENEW OR REPLACE OUR CREDIT FACILITY WITH UNITED NATIONAL
BANK PRIOR TO ITS NOVEMBER 1, 2004 EXPIRATION DATE, WE MAY BE UNABLE TO BORROW
FUNDS TO PURCHASE INVENTORY TO SUSTAIN OR EXPAND OUR CURRENT SALES VOLUME AND TO
FUND OUR DAY-TO-DAY OPERATIONS.
Our credit facility with United National Bank expires on November 1, 2004.
Our agreement with United National Bank provides that if the bank calls the loan
due because of a default, other than a payment default, we may repay the loan in
six equal monthly installments unless we obtain a replacement credit facility,
in which case all amounts would be immediately due and payable. In the event of
a payment default, United National Bank may accelerate the loan and declare all
amounts immediately due and payable. If we are unable to renew or replace this
credit facility prior to November 1, 2004, or if United National Bank calls the
loan due in advance of its expiration as a result of a default, we may lack
adequate funds to acquire inventory in amounts sufficient to sustain or expand
our current sales volume. In addition, we may be unable to fund our day-to-day
operations.
WE RELY HEAVILY ON OUR CHIEF EXECUTIVE OFFICER, TONY SHAHBAZ. THE LOSS OF HIS
SERVICES COULD ADVERSELY AFFECT OUR ABILITY TO SOURCE PRODUCTS FROM OUR KEY
SUPPLIERS AND OUR ABILITY TO SELL OUR PRODUCTS TO OUR RETAILERS.
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 retailers, including with our subcontract
manufacturers. We greatly rely on these relationships in the conduct of our
operations and the execution of our business strategies. Mr. Shahbaz and some of
these subcontract manufacturers have acquired interests in business entities
that own shares of our common stock. Further, some of these manufacturers also
directly hold shares of our common stock. The loss of Mr. Shahbaz could,
therefore, result in the loss of our favorable relationships with one or more of
our subcontract manufacturers. 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.
35
THE HIGH CONCENTRATION OF OUR SALES WITHIN THE DATA STORAGE INDUSTRY COULD
RESULT IN A SIGNIFICANT REDUCTION IN NET SALES AND NEGATIVELY AFFECT OUR
EARNINGS IF DEMAND FOR THOSE PRODUCTS DECLINES.
Sales of our data storage products in the first six months of 2004 and in
the year 2003 accounted for approximately 99% and 94% of our net sales,
respectively. Except for our digital entertainment products, which accounted for
only approximately 1% and 6% of our net sales in the first six months of 2004
and in the year 2003, respectively, we have not diversified our product
categories outside of the data storage industry. We expect data storage products
to continue to account for the vast majority of our net sales for the
foreseeable future. As a result, our net sales and profitability would be
significantly and adversely impacted by a downturn in the demand for data
storage products.
IF WE FAIL TO ACCURATELY FORECAST THE COSTS OF OUR PRODUCT REBATE OR OTHER
PROMOTIONAL PROGRAMS, WE MAY EXPERIENCE A SIGNIFICANT DECLINE IN CASH FLOW AND
OUR BRAND IMAGE MAY BE ADVERSELY AFFECTED RESULTING IN REDUCED SALES AND
PROFITABILITY.
We rely heavily on product rebates and other promotional programs to
establish, maintain and increase sales of our products. If we fail to accurately
forecast the costs of these programs, we may fail to allocate sufficient
resources to these programs. For example, we may fail to have sufficient funds
available to satisfy 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 consumers and retailers would be harmed, which may
result in reduced sales and profitability. In addition, our failure to
adequately forecast the costs of these programs may result in unexpected
liabilities causing a significant decline in cash flow and capital resources
with which to operate our business.
OUR TWO PRINCIPAL SUBCONTRACT MANUFACTURERS PROVIDE US WITH SIGNIFICANTLY
PREFERENTIAL TRADE CREDIT TERMS. IF EITHER OF THESE MANUFACTURERS DOES NOT
CONTINUE TO OFFER US SUBSTANTIALLY THE SAME PREFERENTIAL CREDIT TERMS, OUR SALES
AND PROFITABILITY WOULD DECLINE SIGNIFICANTLY.
Lung Hwa Electronics and Behavior Tech Computer Corp., our two principal
subcontract manufacturers, provide us with significantly preferential trade
credit terms. These terms include extended payment terms, substantial trade
lines of credit and other preferential buying arrangements. We believe that
these terms are substantially better terms than we could likely obtain from
other subcontract manufacturers or suppliers. If either of these subcontract
manufacturers does not continue to offer us substantially the same preferential
trade credit terms, our ability to finance inventory purchases would be harmed,
resulting in significantly reduced sales and profitability. In addition, we
would incur additional financing costs associated with shorter payment terms
which would also cause our profitability to decline.
THE DATA STORAGE AND DIGITAL ENTERTAINMENT INDUSTRIES ARE EXTREMELY COMPETITIVE.
ALL OF OUR SIGNIFICANT COMPETITORS HAVE GREATER FINANCIAL AND OTHER RESOURCES
THAN WE DO, AND ONE OR MORE OF THESE COMPETITORS COULD USE THEIR GREATER
RESOURCES TO GAIN MARKET SHARE AT OUR EXPENSE.
The data storage and digital entertainment industries are extremely
competitive. All of our significant competitors in the data storage industry,
including Hewlett-Packard, Memorex, Philips Electronics, Samsung Electronics,
Sony, TDK and Toshiba, and all of our significant competitors in the digital
36
entertainment industry, including Apple Computer, Bose and Sony have
substantially greater production, financial, research and development,
intellectual property, personnel and marketing resources than we do. As a
result, each of these companies could compete more aggressively and sustain that
competition over a longer period of time than we could. 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 obtaining 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
CHANGES, THE PRODUCTS WE SELL WILL BECOME OBSOLETE, CAUSING A DECLINE IN OUR
SALES AND PROFITABILITY.
Data storage and digital entertainment products are subject to rapid
technological changes which often 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 existing products and constantly threatens to make them, or
causes them to be, obsolete. 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 possess significant amounts of obsolete
inventory that can only be sold at substantially lower prices and profit margins
than we anticipated. 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 sales, profit margins and profitability will be adversely
affected.
OUR INDEMNIFICATION OBLIGATIONS TO OUR RETAILERS FOR PRODUCT DEFECTS COULD
REQUIRE US TO PAY SUBSTANTIAL DAMAGES, WHICH COULD HAVE A SIGNIFICANT NEGATIVE
IMPACT ON OUR PROFITABILITY AND FINANCIAL RESOURCES.
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 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
adversely affect our profitability and financial resources and could make it
difficult or impossible for us to adequately fund our day-to-day operations.
IF WE ARE SUBJECTED TO ONE OR MORE INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS,
OUR SALES, EARNINGS AND FINANCIAL RESOURCES MAY BE ADVERSELY AFFECTED.
Our products rely on intellectual property developed, owned or licensed by
third parties. From time to time, 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
37
resources away from our business. In addition, we may lack sufficient litigation
defense resources, therefore any one of these developments could place
substantial financial and administrative burdens on us and our sales and
earnings may be adversely affected.
IF WE FAIL TO SUCCESSFULLY MANAGE THE EXPANSION OF OUR BUSINESS, OUR SALES MAY
NOT INCREASE COMMENSURATELY WITH OUR CAPITAL INVESTMENTS, WHICH WOULD CAUSE OUR
PROFITABILITY TO DECLINE.
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
DVRs, as well as 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 result in our sales not increasing
commensurately with our capital investments and causing a decline in our
profitability.
A SIGNIFICANT PRODUCT DEFECT OR PRODUCT RECALL COULD MATERIALLY AND ADVERSELY
AFFECT OUR BRAND IMAGE, CAUSING A DECLINE IN OUR SALES, AND COULD REDUCE OR
DEPLETE OUR FINANCIAL RESOURCES.
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, causing a decline
in our sales, and could reduce or deplete our financial resources.
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 EARNINGS
WILL DECLINE.
One of our core business strategies is to be among the first-to-market with
new and enhanced products 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 these retailers and end-users 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
38
heightened product performance such as faster data recordation and access
speeds. If our products are not among the first-to-market, our competitors may
gain market share at our expense, which would decrease our net sales and
earnings.
As a consequence of this core strategy, we are exposed to consumer
rejection of our new and enhanced products 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 sales and earnings will be adversely affected.
FAILURE TO ADEQUATELY PROTECT OUR TRADEMARK RIGHTS COULD CAUSE US TO LOSE MARKET
SHARE AND CAUSE OUR SALES TO DECLINE.
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 , Sound Assault and PolarTech . One of our key business
strategies is to use our brand and product names to successfully compete in the
data storage and digital entertainment industries. We have expended significant
resources promoting our brand and product names and we have registered
trademarks for our three brand names. However, 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 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 brand and product
names. This consumer confusion and the resulting reduction in goodwill could
cause us to lose market share and cause our sales to decline.
CONSUMER ACCEPTANCE OF ALTERNATIVE SALES CHANNELS MAY INCREASE. IF WE ARE UNABLE
TO ADAPT TO THESE ALTERNATIVE SALES CHANNELS, SALES OF OUR PRODUCTS MAY DECLINE.
We are accustomed to conducting business through traditional retail sales
channels. Consumers purchase our products predominantly through a small number
of retailers. For example, during the first six months of 2004, six of our
retailers accounted for 83% of our total net sales. Similarly, during 2003, six
of our retailers accounted for 78% of our total net sales. We currently generate
only a small number of direct sales of our products through our Internet
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
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. If we are unable
to adapt to alternative sales channels, sales of our products may decline.
A LABOR STRIKE AT A SHIPPING PORT AT WHICH OUR PRODUCTS ARE SHIPPED OR RECEIVED
COULD PREVENT US FROM TAKING TIMELY DELIVERY OF INVENTORY, WHICH COULD CAUSE OUR
SALES AND PROFITABILITY TO DECLINE.
From time to time, shipping ports experience labor strikes or work
stoppages which delay the delivery of imported products. The port of Long Beach,
California, through which most of our products are imported from Asia,
experienced a labor strike in September 2002 which lasted nearly two weeks. As a
result, there was a significant disruption in our ability to deliver products to
39
our retailers, which caused our sales to decline. Any future labor strike or
work stoppage at a shipping port at which our products are shipped or 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. In the event of a similar labor strike or work stoppage in the future, in
order to meet our delivery obligations to our retailers and avoid penalties for
missed delivery dates, 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, often rapidly, during their short product life cycle,
delayed delivery of products could yield significantly less than expected sales
and profits.
OUR OPERATIONS ARE VULNERABLE BECAUSE WE HAVE LIMITED REDUNDANCY AND BACKUP
SYSTEMS.
Our internal order, inventory 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, returns and other matters.
This system's continued and uninterrupted performance is critical to our
day-to-day business operations. Despite our precautions, unanticipated
interruptions in our computer and telecommunications systems have, in the past,
caused problems or stoppages in this electronic system. These interruptions, and
resulting problems, could occur in the future. We have extremely limited ability
and personnel to process purchase orders and manage product pricing and other
matters in any manner other than through this electronic system. Any
interruption or delay in the operation of this electronic system could cause a
significant decline in our sales and profitability.
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
second quarter of 2004, the high and low closing bid prices of a share of our
common stock were $4.50 and $3.45, respectively. During 2003, the high and low
closing bid prices of a share of our common stock were $8.50 and $3.50,
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 or 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 in our introduction of new products or technological innovations or
problems in the functioning of these new products or innovations;
- - disputes or litigation concerning our rights to use third parties'
intellectual property or third parties' infringement of our intellectual
property;
40
- - 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 increased 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 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.
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 and therefore on the
price of our common stock.
OUR COMMON STOCK HAS A SMALL PUBLIC FLOAT AND SHARES OF OUR COMMON STOCK
ELIGIBLE FOR PUBLIC SALE COULD CAUSE THE MARKET PRICE OF OUR STOCK TO DROP, EVEN
IF OUR BUSINESS IS DOING WELL.
As of August 19, 2004, there were approximately 4.5 million shares of our
common stock outstanding. As a group, our executive officers, directors and 10%
shareholders beneficially own approximately 3.5 million of these shares.
Accordingly, our common stock has a public float of approximately 1.0 million
shares held by a relatively small number of public investors. In addition, we
have a registration statement on Form S-8 in effect covering 133,334 shares of
common stock issuable upon exercise of options under our 2002 Stock Option Plan
and a registration statement on Form S-8 in effect covering 400,000 shares of
common stock issuable upon exercise of options under our 2003 Stock Option Plan.
Currently, options covering approximately 126,275 shares of common stock are
outstanding under our 2002 Stock Option Plan and no options are outstanding
under our 2003 Stock Option Plan. The shares of common stock issued upon
exercise of these options will be freely tradable without restriction or further
registration, except to the extent purchased by one of our affiliates.
We cannot predict the effect, if any, that future sales of shares of our
Common stock into the public market will have on the market price of our common
stock. However, as a result of our small public float, sales of substantial
amounts of common stock, including shares issued upon the exercise of stock
options or warrants, or an anticipation that such sales could occur, may
materially and adversely affect prevailing market prices for our common stock.
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, and 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 August 19, 2004). As a result, our
41
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 in
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 ARTICLES OF INCORPORATION, OUR BYLAWS AND NEVADA LAW EACH 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 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;
- - our stockholders are permitted to remove members of our board of directors
only upon the vote of at least 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.
In addition, 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 either one-fifth or more but less than one-third,
one-third or more but less than a majority, or a majority 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. IF AN ACTIVE
MARKET DOES NOT DEVELOP, YOU MAY NOT BE ABLE TO READILY SELL YOUR SHARES OF OUR
COMMON STOCK.
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.
BECAUSE WE ARE SUBJECT TO "PENNY STOCK" RULES, THE LEVEL OF TRADING ACTIVITY IN
OUR COMMON STOCK MAY BE REDUCED. IF THE LEVEL OF TRADING ACTIVITY IS REDUCED,
YOU MAY NOT BE ABLE TO READILY SELL YOUR SHARES OF OUR COMMON STOCK.
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
42
than $5.00 per share that trade on the OTC Bulletin Board or the Pink Sheets.
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 penny stock and the amount of 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.
43
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations were not subject to commodity price risk during the first
six months of 2004. Our sales to a foreign country (Canada) were approximately
1.1% of our total sales for the first six months of 2004, and thus we
experienced negligible foreign currency exchange rate risk. We do not hedge
against this risk.
We currently have an asset-based business loan agreement with United
National Bank in an amount of up to $6.0 million. The line of credit provides
for an interest rate equal to the prime lending rate as reported in The Wall
Street Journal plus 0.75%. 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
business loan agreement.
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 June 30, 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 six months ended June 30, 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.
44
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Hi-Val, Inc.
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. The final amended
complaint alleged causes of action based upon breach of contract, fraud, breach
of fiduciary duty and negligent misrepresentation and sought monetary damages
and rescission. As a result of successful motions for summary judgment,
I/OMagic, Mr. Su and Ms. Hsu were dismissed as defendants. On February 18, 2003,
a jury verdict adverse to the remaining defendants was rendered, and on or about
March 28, 2003, all parties to the action entered into a Settlement Agreement
and Release which settled this action prior to the entry of a final judgment. As
part of the Settlement Agreement and Release, Mr. Shahbaz and Mr. Su
relinquished their interests in Alex Properties and the Vakilis relinquished
66,667 shares of our common stock, of which 13,333 shares were transferred to a
third party designated by the Vakilis. In addition, we agreed to make payments
totaling $4.0 million in cash and 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, Mark and Mitra Vakili and
Alex Properties alleged 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 $1.0 million 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.
Horwitz and Beam
On May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for breach of
contract and legal malpractice against Lawrence W. Horwitz, Gregory B. Beam,
Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and Senn Palumbo
Meulemans, LLP, 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.
Magnequench International, Inc.
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
45
possession of defendants that infringe one or more claims of plaintiff's
patents. As of the date of this report, we have filed a response denying
plaintiff's claims and asserting defenses to plaintiff's causes of action
alleged 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.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
Number Description
------ -----------
10 Change in Terms Agreement, dated August 6, 2004, between I/OMagic
Corporation and United National Bank
31 Certifications Required by Rule 13a-14(a) of the Securities Exchange Act
of 1934, as amended, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
32 Certifications of Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K:
----------------------
None.
46
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
I/OMAGIC CORPORATION
Dated: August 20, 2004 By: /s/ Tony Shahbaz
-----------------------
Tony Shahbaz, President and Chief
Executive Officer
(principal executive officer)
Dated: August 20, 2004 By: /s/ Steve Gillings
------------------------
Steve Gillings, Chief Financial
Officer (principal financial and
accounting officer)
47
EXHIBITS FILED WITH THIS REPORT
Exhibit
Number Description
- ------ -----------
10 Change in Terms Agreement, dated August 6, 2004, between I/OMagic
Corporation and United National Bank
31 Certifications Required by Rule 13a-14(a) of the Securities Exchange Act
of 1934, as amended, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
32 Certifications of Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
48