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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORT

PURSUANT TO SECTIONS 13 OF 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2003

OR

For the transition period from              to             

Commission file number: 000-27267

I/OMAGIC CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (949) 707-4800

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001 par value

(Title of class)

Indicate by check mark 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 mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

Yes  ¨    No  x

The aggregate market value of the voting common equity held by nonaffiliates of the registrant computed by reference to the closing sale price of such stock, was approximately $3,558,308, as of June 30, 2003, the last business day of the registrant’s most recently completed second fiscal quarter. The registrant has no non-voting common equity.

The number of shares of the registrant’s common stock, $.001 par value, outstanding as of April 8, 2004 was 4,529,672.

DOCUMENTS INCORPORATED BY REFERENCE: None.

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PART I

Item 1. Business.

Introductory Note

This Annual Report on Form 10-K contains “forward-looking statements.” These forward-looking statements include, but are not limited to, statements relating to our anticipated financial performance, business prospects, new developments, new strategies and similar matters, and/or statements preceded by, followed by or that include the words “believe,” “may,” “could,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “seek,” or similar expressions. We have based these forward-looking statements on our current expectations and projections about future events, based on the information currently available to us. These forward-looking statements are subject to risks, uncertainties and assumptions, including those described under the heading “Risk Factors” in Item 7 of this Annual Report on Form 10-K that may affect the operations, performance, development and results of our business. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date stated, or if no date is stated, as of the date of this Annual Report on Form 10-K. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or any other reason except as we may be required to do under applicable law. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this Annual Report on Form 10-K may not occur.

Interested readers can access our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, through the United States Securities and Exchange Commission’s website at http://www.sec.gov. These reports can be accessed free of charge.

For purposes of this Annual Report, unless the context indicates otherwise, references to “we,” “us,” “our,” “I/OMagic,” and the “Company” means or refers to I/OMagic Corporation.

Company Overview

We operate in the data storage and digital entertainment industries. We sell data storage and digital entertainment products primarily in the United States and to a lesser extent in Canada, together known as the North American marketplace. Our data storage product offerings are predominantly focused on optical data storage media and include recordable compact disc, or CD, drives and recordable digital video or versatile disc, or DVD, drives predominantly for personal computers, or PCs. Our digital entertainment product offerings are predominantly focused on products that complement our line of data storage products and include MP3 players, digital audio headphones and palm-sized 20 gigabyte hard disk drives that we call our Digital Photo Library^™ system. Our data storage products accounted for approximately 94% of our net sales during the year ended December 31, 2003, whereas our digital entertainment products accounted for approximately 6% of our net sales for that period.

For the years ended December 31, 2003 and 2002, according to NPD Intelect® Market Tracking, a provider of sales tracking services for, among others, the consumer electronics and information technology industries, we achieved the number one market share in both unit and dollar sales of “after-market” compact disc rewritable, or CD-RW, drives in North America. “After-market” products are

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products not built into a PC at the time of its initial purchase. For the year ended December 31, 2003, according to NPD Intelect® Market Tracking, despite offering dual-format recordable DVD drives since only July 2003, we achieved the number four market share in both unit and dollar sales of after-market recordable DVD drives in North America. We believe that the market for DVD-based data storage products will experience significant growth over the next few years and that we are in a position to benefit from this growth in terms of sales and market share.

We sell our products through computer, consumer electronics and office supply superstores and other major North American retailers, including Best Buy Co., Inc., Best Buy Canada Ltd., CompUSA, Circuit City Stores, Inc., Fred Meyer Stores, Microcenter the Ultimate Computer Store, Office Depot, Inc., OfficeMax, Inc., RadioShack Corporation, Staples, the Office Superstore, Inc., and Target Corporation. Our retailers collectively operate retail locations throughout North America. We also have relationships with other retailers, catalog companies and Internet retailers such as Buy.com, PC Mall, Inc., Tiger Direct, Inc. and Dell Inc.

We market our products under three brand names. Our three brand names are I/OMagic®, Digital Research Technologies® and Hi-Val®. We sell our data storage products under each of these brand names, bundling various hardware devices with different software applications to meet different consumer needs. Our digital entertainment products are currently sold under our I/OMagic® and Digital Research Technologies® brand names.

We employ a “good, better, best” marketing strategy, offering a range of products within some of our product categories. We believe that this strategy enables us to address different segments of the market for data storage and digital entertainment products by offering varying products with different levels of performance and functionality at multiple price points designed to satisfy the diverse needs and budgets of consumers.

We subcontract manufacture our products predominantly in Asian countries, which allows us to offer products at highly competitive prices and which we believe permits maximum flexibility in the development of new and enhanced products. Many of our subcontract manufacturers have substantial product development resources and facilities in Asia, and are among the major component manufacturers in their product categories. Some of our largest subcontract manufacturers are also our shareholders, including Behavior Tech Computer Corp., and its affiliated companies, or BTC, and Lung Hwa Electronics Co., Ltd. According to industry sources, BTC is among the largest optical storage drive manufacturers in the world and Lung Hwa Electronics is a major manufacturer of digital entertainment products. These subcontract manufacturers expend substantial resources on research, development and design of new technologies and efficient manufacturing processes.

I/OMagic Corporation was incorporated under the laws of the State of Nevada in October 1992. We have two subsidiaries, I/OMagic Corporation, a California corporation, and IOM Holdings, Inc., a Nevada corporation. Our principal executive offices are located in Irvine, California and our main telephone number is (949) 707-4800.

Industry Overview

Storing, managing, protecting, retrieving and transferring data has become critical to individuals and businesses due to their increasing dependence on and participation in data-intensive activities. The data storage industry is growing in response to the needs of individuals and businesses to store, manage, protect, retrieve and transfer increasing amounts of data resulting from:

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Traditional PC data generally includes document, e-mail, financial and historical, software program and other data. The data storage industry has grown significantly over the last two decades as the PC has become a virtually indispensable tool in the home and office, resulting in increasing amounts of traditional PC data. As a result of these and other developments, traditional PC data storage requirements have correspondingly increased.

Digital entertainment data generally includes music, photographic, movie and video game data. For nearly two decades, music has been offered on CDs as the prevailing standard. In the mid-to-late 1990s, the ability to copy CDs, and to download, remix, and copy or “burn” music to a personalized CD began to gain popularity and made the recordable CD drive, or “CD burner,” a desirable component of the PC. With the growth and acceptance of the Internet and the advent of on-line music availability, the demand for music has increased and as a result, the demand for faster and easier data storage and retrieval has grown.

We believe that the increasing amount of traditional PC and digital entertainment data that is being generated and used is stimulating increased demand for products offering data storage, management, protection, retrieval and transfer. We also believe that those products that offer flexibility and high-capacity storage in a cost-effective, user-friendly manner are in highest demand.

According to NPD Intelect® Market Tracking, the North American data storage industry, including all media (for example, floppy disks, CDs and DVDs) and drives, grew to approximately $2.2 billion in 2003, representing a 10% increase from approximately $2.0 billion in 2002. Also according to NPD Intelect® Market Tracking, unit sales in the data storage industry, including all media and drives, grew to approximately 82 million units in 2003, representing a 12.3% increase from approximately 73 million units in 2002.

Key Factors Driving Growth in the Data Storage and Digital Entertainment Industries

We believe that the following key factors, among others, are driving and will continue to drive growth in the data storage and digital entertainment industries:

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We believe that the factors listed above are driving growth in the major product categories of the data storage and digital entertainment industries, which include data storage devices for traditional PC data and digital entertainment data, digital photography products and digital audio products.

Data storage devices for traditional PC data include hard disk drives and optical CD and DVD drives. Data storage devices for digital entertainment data include hard disk drives and CD and DVD drives as well as digital video recorders, or DVRs. Digital photography products include digital cameras and related solid state memory devices. Digital audio products include MP3 players and their built-in hard disk drives and solid state memory devices. Some of these devices represent the convergence of data storage products for both traditional PC data and digital entertainment data. For instance, a DVD drive and DVD media can operate as the primary tool for storage, management, protection, retrieval and transfer of traditional PC data as well as digital entertainment data such as music, photos, movies, video games and other multi-media.

Types of Data Storage Media

The following types of data storage media are the principal means through which traditional PC data as well as digital entertainment data can be stored, managed, protected, retrieved and transferred:

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Relative Advantages and Disadvantages of Types of Data Storage Media

Each of the mainstream types of data storage media generally available to consumers has certain advantages and disadvantages. These include:

Magnetic Media

Optical Media

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transfer rates as compared to hard disk technologies; however, new technology continues to improve data access times for this media. CDs are also compatible with numerous devices ranging from PCs to CD and DVD players typically found in the home and office. Unlike hard disks, the integrity of data protection and retrieval is not drive-dependent, since a reliability problem with an optical drive will not affect digital data already stored on a CD, and ease of transport allows access to data using another drive if a problem exists with a user’s primary drive unit. In addition, unlike magnetic media, use of CDs results in limited or no degradation of the CD itself.

Solid State Media

Industry Challenges and Trends

We believe that the challenges currently facing the data storage and digital entertainment industries include:

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preferences and introduce both new and enhanced data storage and digital entertainment products to provide higher levels of performance and functionality than existing products.

Trends in the data storage and digital entertainment industries include the trend toward higher capacity optical storage media and related drives, including the trend away from CD-based media and devices and towards DVD-based media and devices. According to NPD Intelect^® Market Tracking, unit sales of recordable CD drives in the North American marketplace declined 14% from 2002 through 2003, while unit sales of recordable DVD drives increased by 447% from 2002 through 2003. We believe that this illustrates the transition from CD-based data storage products to DVD-based devices and we believe that this trend will continue into the future.

Developing trends in the data storage and digital entertainment industries include the early adoption of super-high-capacity optical data storage devices using technology such as Blu-ray^™ DVD or High-definition DVD. Blu-ray^™ DVD technology is expected to expand DVD capacity up to tenfold and is expected to allow, for the first time in a device widely available to consumers, the storage and retrieval of high definition videos and images for playback on high-definition DVD players and compatible televisions and monitors. A competing new technology also exists called High-definition DVD, or HD-DVD. The storage capacity of HD-DVD is limited to approximately 60% of a Blu-ray^™ DVD. Proponents of HD-DVD technology contend, however, that it has less compatibility problems with existing DVD technology as compared to Blu-ray^™ DVD technology and that data compression software reduces the importance of the greater storage capacity offered by Blu-ray^™ DVD technology.

It is not yet clear whether Blu-ray^™ DVD or HD-DVD will become the dominant technology, if they will coexist, or if a new technology will emerge. Nonetheless, we believe that the increased performance offered by these technologies will likely result in consumer acceptance of products using these technologies. Furthermore, we believe that regardless of which technology becomes the dominant technology, we will be able to incorporate either technology into our product offerings in much the same way as we do today with the large number of format types ranging from recordable and rewritable CD-based products to DVD-based products.

The I/OMagic Solution

We sell data storage and digital entertainment products to the North American retail marketplace. We believe that we possess a combination of core competencies that provide us with a competitive advantage, including the ability to successfully identify consumer needs and preferences, use our sales and distribution channels to sell new and enhanced products, efficiently manage product development cycles, efficiently manage our product supply chain, and use our brands and merchandising efforts to market and sell data storage and digital entertainment products.

Successfully executing our core competencies yields substantial benefits including the ability to:

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We work closely with our retailers to promote our products, monitor consumer demands and preferences and stay at the forefront of the market for data storage and digital entertainment products. We also work closely with our subcontract manufacturers and benefit from their substantial research and development resources and economies of scale. As a result of working with our retailers and subcontract manufacturers, we are able to rapidly bring new and enhanced data storage and digital entertainment products to market in a cost-effective manner.

The market intelligence we gain through consultation with our retailers and subcontract manufacturers enables us to deliver products that combine performance and functionality demanded by the marketplace. Obtaining these products through our subcontract manufacturers, along with efficient management of our supply chain, allows us to offer these products at competitive prices.

We sell our products through computer, consumer electronics and office supply superstores and other retailers who collectively operate retail locations throughout North America. Our network of retailers enables us to offer products to consumers across North America, including every major metropolitan market in the United States. Our largest retailers include Best Buy, Circuit City, CompUSA, Staples, Office Depot and OfficeMax.

We employ a three-brand strategy to sell some of the same or similar products through different retailers and to maintain consumer loyalty to at least one of our brands. Our three-brand marketing strategy enables us to provide each of our major industry retailers with their own distinct brand. We believe that this approach reduces price competition among our most important retailers as a result of brand differentiation and benefits us by making our products more attractive to those retailers. We also employ a “good, better, best” marketing strategy offering consumers a broad line of data storage products ranging from entry-level to state-of-the-art. Our “good, better, best” lines of products combine different levels of performance and functionality at various price points. We believe that our “good, better, best” strategy allows us to sell to consumers who seek a more attractive combination of performance and functionality at lower prices than other leading data storage products. We intend to adopt this strategy in expanding our digital entertainment product offerings.

As a result of our large retail network and our three-brand and “good, better, best” marketing strategies, we believe that we have established and will maintain a large market presence for our core data storage product offerings resulting in significant market share. For the years ended December 31, 2003 and 2002, according to NPD Intelect® Market Tracking, we achieved the number one market share in both unit and dollar sales of CD-RW drives in North America. For the year ended December 31, 2003, according to NPD Intelect® Market Tracking, despite offering recordable DVD drives since only July 2003, we achieved the number four market share in both unit and dollar sales of recordable DVD drives in North America. By using the same strategies in offering our digital entertainment products, we believe that we will be able to establish a large market presence resulting in significant market share for those products as well.

Our Data Storage Solution

We focus on optical data storage products to respond to the demands and preferences of the data storage marketplace. We believe that the market for data storage products, especially after-market devices that can be purchased separately from and easily used in conjunction with a standard PC, has shifted its demand largely to optical media and drives. We believe that optical media and drives represent the optimal combination of high-capacity storage capability, cost-effectiveness and flexibility. Magnetic hard-disk and drive technology is the closest competitor to optical media in the contexts of storage capacity, cost-effectiveness and flexibility. However, while the storage capacity of any given hard-disk is fixed, optical media has virtually unlimited storage capacity through the addition of low-cost CDs or DVDs. Moreover, optical media has far more flexibility than hard-disk media, allowing users to

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store music, photos and movies utilizing a stand-alone recorder or a desktop or laptop PC and then play them back on standard CD or DVD players. In addition, hard-disk media is usually built into a PC, lacking effective portability and ease of physical transport of data.

We believe that our focus on optical data storage products is also consistent with the proliferation of digital entertainment devices. Digital cameras, MP3 players and other digital entertainment devices are well-complemented by the use of optical media for data back-up and high-capacity storage purposes. Existing solid state media, while convenient in many respects, offers relatively low storage capacity and relatively poor cost effectiveness. Accordingly, optical media, with its high storage capacity, cost effectiveness and convenience is a complementary product for consumers who desire to store, manage, protect, retrieve and transfer digital data used in conjunction with their digital entertainment devices.

Our Digital Entertainment Solution

The acceptance of relatively new technologies such as data compression technologies, and the widespread availability of digital entertainment media such as music, photos, movies and games are stimulating the proliferation of digital entertainment products. We offer digital entertainment products incorporating these technologies to capitalize on the widespread availability of digital entertainment media. We seek to provide users of our digital entertainment products with enjoyable, user-friendly experiences from products that combine high levels of performance, functionality and reliability at competitive prices.

Some of the data storage products that we offer and plan to offer, such as CD and DVD duplicators and DVRs, can operate as both data storage and digital entertainment products. Due to their versatility, we believe that products that combine data storage and digital entertainment functionality are more attractive to many consumers. Accordingly, we believe that further convergence of data storage and digital entertainment products will offer additional opportunities to satisfy consumer demands and preferences.

To assist us in increasing sales of our digital entertainment products, we intend to emulate many of the methods employed in our data storage business, including our three-brand and “good, better, best” marketing strategies. We also intend to work closely with our retailers and subcontract manufacturers in developing and offering our digital entertainment products for sale.

Our Strategy

Our primary goal is to remain a leading provider of data storage products and to expand our market share in the data storage industry. Our secondary goal is to expand our digital entertainment product line to offer additional products that complement our data storage products. Our business strategy to achieve these goals includes the following elements:

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entertainment products. Some of these relationships are particularly strong because some of our important subcontract manufacturers are also our shareholders. By continuing to subcontract manufacture our products, we intend to continue to increase our operating leverage by delivering products incorporating new technology without the substantial investment and fixed costs associated with product development and manufacturing in an industry characterized by rapid product innovation and obsolescence.

Our Products

We have two product categories: our data storage product category and our digital entertainment product category. 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. 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, movies and photos. These products are designed principally for entertainment purposes.

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Our Data Storage Products

Our data storage products are based on one or more of the following technology formats which allow the storage, management, protection, retrieval and transfer of data:

Many of the technologies identified in the table above are competing formats. We seek to deliver data storage products that enable the storage, management, protection, retrieval and transfer of data to and from all major formats to satisfy the needs of consumers regardless of their choice of format. Because certain formats ultimately may be rejected or disfavored by the marketplace, we do not base our products on a single format or on a small number of formats. We seek to offer products that are cross-compatible over numerous formats to offer the most comprehensive solution available to the broadest range of consumers.

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Our data storage products currently include:

We plan to offer data storage products that use dual-layer DVD technology which is expected to double DVD capacity to approximately 8.5 gigabytes, or 8,500 megabytes, depending on the user’s operating system and other factors. We plan to continue our efforts to enhance our data storage products by increasing performance and functionality as well as reducing the size of their drive units and enclosures to increase portability and ergonomics.

According to NPD Intelect^® Market Tracking, sales of recordable CD drives in the North American marketplace declined to approximately $300 million in 2003, representing a 37% decrease from approximately $475 million in 2002. However, this was offset by substantial growth in recordable DVD drives and illustrates the transition from CD-based data storage products to DVD-based devices. According to NPD Intelect^® Market Tracking, sales of recordable DVD drives in the North American marketplace increased to approximately $225 million in 2003, representing a 234% increase from approximately $67 million in 2002. Unit sales of DVD recordable drives increased to approximately 1 million units in 2003, representing a 447% increase from approximately 187,000 units in 2002.

We believe that the market for data storage products is undergoing a transition from CD- to DVD-based data storage products. Compared to the CD format, the DVD format enables users to store substantially more data. We intend to continue to closely monitor the data storage market and, if the market continues its shift from CD-based data storage products to DVD-based data storage products, we expect to continue to shift our focus predominately to DVD products.

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Our Digital Entertainment Products

Our existing and planned digital entertainment products include:

We plan to expand our line of digital audio headphones. In addition, we are working with our subcontract manufacturers to develop new MP3 audio players and MP4 video players with imbedded MP3 technology for audio playback.

We believe that the market for digital entertainment products is expanding. We intend to continue to monitor the digital entertainment market and develop products to meet changing demands of the marketplace. Currently, our digital entertainment products represent a relatively new product category. These products accounted for approximately 6% of our net sales during 2003. We expect to continue to allocate resources to this product category to attempt to increase net sales. We believe that our strategic relationships with our retailers and our subcontract manufacturers will further our ability to achieve these goals.

Product Warranties

Each of our products sold to consumers is subject to a minimum warranty of one year. These warranties cover only repair or replacement of the product.

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Product Development

Our product development efforts are directed toward satisfying the demands of the North American marketplace for data storage and digital entertainment products. We operate in industries that are subject to rapid technological change, product obsolescence and rapid changes in consumer demands and preferences. We attempt to anticipate and respond to these changes by focusing on the following primary objectives:

Our retailers and our subcontract manufacturers play an important role in the enhancement of our existing products and the development of new products. We work closely with our retailers and our subcontract manufacturers to identify existing market trends, predict future market trends and monitor the sales performance of our products.

Many of our retailers are among the largest computer, consumer electronics and office supply retailers in North America such as Best Buy, Circuit City, CompUSA, Staples, Office Depot and OfficeMax. Through their close contact with the marketplace for data storage and digital entertainment products, our retailers are able to provide us with important information about consumer demands and preferences.

Many of our subcontract manufacturers have substantial product development resources and facilities in Asia, and are among the major component manufacturers in their product categories. Some of our largest subcontract manufacturers are also our shareholders, including BTC and Lung Hwa Electronics. According to industry sources, BTC is among the largest optical storage drive manufacturers in the world and Lung Hwa Electronics is a major manufacturer of digital entertainment products. These subcontract manufacturers expend substantial resources on research, development and design of new technologies and efficient manufacturing processes.

Our Irvine, California headquarters houses a product-development team that coordinates and manages the subcontract logistics and product development efforts of our subcontract manufacturers in Asia. At our Irvine facility, we also develop user manuals, product packaging and marketing literature as well as installation guides and supplemental materials, including software and hardware designed to permit user-friendly product installation.

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Operations

We subcontract manufacture our data storage and digital entertainment products. We believe that by outsourcing the manufacturing of our products to our subcontract manufacturers, we benefit from:

We believe that the relatively low overhead costs resulting from subcontract manufacturing the products we offer for sale, the economies of scale of our subcontract manufacturers, and the engineering and manufacturing resources of our subcontract manufacturers enable us to offer products combining high levels of performance, functionality and reliability at prices competitive with other leading products offered in the marketplace.

We utilize a subcontract logistics and product development consultant located in Taipei, Taiwan. Our consultant assists us in identifying new products, qualifying prospective manufacturing facilities and coordinating product purchases and shipments from some of our subcontract manufacturers. The majority of our products are shipped directly by our subcontract manufacturers to our packaging, storage and distribution facility in Irvine. These products are then packaged and shipped by us either directly to retail locations across North America or to a centralized distribution center. Product shipments are primarily made through major commercial carriers.

Quality Control

Our primary subcontract manufacturers are among the major computer and electronic component manufacturers in Asia with rigorous quality control and shipping guidelines. We regularly inspect product samples, periodically tour our subcontract manufacturing facilities and monitor defective product returns.

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Sales and Marketing

Three-Brand Marketing Strategy

We employ a three-brand approach to achieve our goal of product differentiation among various sales channels and price points. Our three brands are I/OMagic®, Digital Research Technologies® and Hi-Val®. We sell our data storage products under each of these brands, bundling various hardware devices with different software applications to meet different consumer needs. Currently, our digital entertainment products are sold under our I/OMagic® and Digital Research Technologies® brands. This three-brand approach enables us to provide each of our major industry retailers with their own distinct brand, to differentiate products sold through different channels and to stimulate competition among those channels. This enables us to capture market share and limit some of the negative effects of third-party competition.

“Good, Better, Best” Marketing Strategy

We utilize a “good, better, best” marketing strategy. We believe that this strategy helps us satisfy the demands and preferences of a diverse consumer base by offering a variety of products within some of our product lines. We offer “good” products that provide basic performance, functionality and value. We also offer “better” products that include higher performance and functionality than our “good” products, but at a higher price point. In addition, we offer “best” products that include greater performance and functionality than our “good” and “better” products, often incorporating sophisticated proprietary technology in addition to basic performance, functionality and value. Often our “best” products are among the first-to-market with new features and technology to be made widely available to consumers. Our “best” products are at the highest price points within each of our product lines, but we believe that these products still represent good values for consumers.

We believe that our “good, better, best” marketing strategy enables us to sell our three brands through multiple national retail sales channels, maintain high-value products and successfully coordinate a high frequency of sales promotions. We believe that this strategy also enables us to address different segments of the market for data storage and digital entertainment products by offering varying products with different levels of performance and functionality at multiple price points designed to satisfy the diverse needs and budgets of consumers.

Sales Channels

According to NPD Intelect® Market Tracking, in 2002 and 2003 we ranked as the leader in unit and dollar sales of CD-RW drives in the North American marketplace, competing against companies such as Sony Corp., TDK and Memorex Products, Inc. Our goal is to maintain this ranking for our CD-RW drives and to achieve and maintain a similar ranking for our DVD-based products. We believe that our ongoing transition from CD-based products to DVD-based products is consistent with the shift in market demand and will enable us to maintain or even increase our leadership position in the North American marketplace.

We primarily sell our products through 11 retailers who collectively operate retail locations throughout North America. These include nationally-recognized computer, consumer electronics and office supply superstores. In addition, we sell our products through Internet retailers and mail order catalogs.

Our North American retailers include Best Buy, Best Buy Canada, CompUSA, Circuit City, Fred Meyer Stores, Microcenter the Ultimate Computer Store, Office Depot, OfficeMax, RadioShack, Staples, and Target. We also have relationships with other retailers and with catalog companies and Internet retailers such as Buy.com, PC Mall, Tiger Direct and Dell.

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We cooperate with our retailers to promote our products and brand names. We participate in co-sponsored events with our retailers and industry trade shows such as COMDEX®, CES® and RetailVision®. We participate in these events and trade shows in order to develop new relationships with potential retailers and maintain close relationships with our existing retailers. We also fund co-operative advertising campaigns, develop custom product features and promotions, provide direct personal contact with our sales representatives, develop and procure certain products as requested by our retailers, and use our three-brand marketing strategy to provide each of our major industry retailers with their own distinct brand. We cooperate with our retailers to use point-of-sale and mail-in rebate promotions to increase sales of our products. We also utilize sales circulars and our close relationships with our significant retailers to obtain national exposure for our products and our brands. We believe that these marketing efforts help generate additional shelf-space for our products with our major retailers, promote retail traffic and sales of our products, and enhance our goodwill with these retailers.

We maintain a large database containing information regarding many end-users of our products. Through a targeted, direct marketing strategy, we intend to offer these end-users other products to establish repeat end-user customers, increase our product sales and promote brand loyalty. We also intend to communicate trends in the data storage and digital entertainment industries to these end-users, highlight new and existing products and direct existing and potential end-user customers to our retail websites.

We plan to expand our market penetration beyond traditional and Internet retailers to include corporate and government procurers, value-added resellers and value-added distributors. We currently sell and plan to continue to sell products, conduct special promotions, and offer downloads and upgrades on our company websites to existing and potential end-user customers. Our websites are located at http://www.iomagic.com, http://www.dr-tech.com and http://www.hi-val.com.

Competition

We operate in the highly competitive data storage and digital entertainment industries. We believe that our data storage products compete with other types of data storage devices such as internal and external hard drives, magnetic tape drives, floppy disk drives and flash memory devices, as well as internal and external optical data storage products offered by other companies.

Companies that offer products similar to our data storage products include Sony, Hewlett-Packard Company, TDK, Memorex, Philips Electronics, Samsung Electronics and Toshiba America, Inc. We also indirectly compete against original equipment manufacturers such as Dell and Hewlett-Packard to the extent that they manufacture their own computer peripheral products or incorporate the functionalities offered by our products directly into PCs. Companies that offer products similar to our digital entertainment products include Sony, Apple Computer Inc., Bose Corporation, Rio Audio and Creative Technology.

We believe that our ability to compete in the data storage and digital entertainment industries depends on many factors, including the following:

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Intellectual Property

We currently rely on a combination of contractual rights, copyrights, trademarks and trade secrets to protect our proprietary rights. I/OMagic^®, Hi-Val^® and Digital Research Technologies^® are our registered trademarks. We also sell products under various product names such as our MediaStation^™, DataStation^™, Digital Photo Library^™, EasyPrint^™ and Sound Assault^™ product names. As we develop new products, we may file federal trademark applications covering the trademarks under which we sell those products. There can be no assurance that we will eventually secure a registered trademark covering such products. We currently do not have any issued or pending patents.

We own, license or have otherwise obtained the right to use certain technologies incorporated in our products. We may receive infringement claims from third parties relating to our products and technologies. In those cases, we intend to investigate the validity of the claims and, if we believe the claims have merit, to respond through licensing or other appropriate actions. To the extent claims relate to technology included in components purchased from third-party vendors for incorporation into our products, we would forward those claims to the appropriate vendor. If we or our product manufacturers are unable to license or otherwise provide any necessary technology on a cost-effective basis, we could be prohibited from marketing products containing that technology, incur substantial costs in redesigning products incorporating that technology, or incur substantial costs defending any legal action taken against us.

We have been, and may in the future be, notified of claims asserting that we may be infringing certain patents, trademarks and other intellectual property rights of third parties. We cannot predict the outcome of such claims and there can be no assurance that such claims will be resolved in our favor. An unfavorable resolution of such claims may have a material adverse effect on our business, prospects, financial condition and results of operations. The data storage industry, has been characterized by significant litigation relating to infringement of patents and other intellectual property rights. We have in the past been engaged in infringement litigation, both as plaintiff and defendant. There can be no assurance that future intellectual property claims will not result in litigation. If infringement is

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established, we may be required to pay substantial damages or we may be enjoined from manufacturing and selling an infringing product. In addition, the costs of engaging in the prosecution or defense of intellectual property claims may be substantial regardless of the outcome.

A number of our agreements with our retailers provide that we will defend, indemnify and hold harmless our retailers from damages and costs that arise from product warranty claims or 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 any resulting liability we would incur if those claims are successful. A successful claim brought against us for product defects that is in excess of, or excluded from, our insurance coverage could have a material adverse affect on our business and results of operations.

Government Regulation

Our products are designed by our subcontract manufacturers to comply with a significant number of regulations and industry standards, some of which are evolving as new technologies are deployed. In the United States, our products must comply with various regulations defined by the United States Federal Communications Commission, or FCC, and Underwriters Laboratories, or other nationally recognized test laboratories. We also must comply with numerous import/export regulations. The regulatory process in the United States can be time-consuming and can require the expenditure of substantial resources. We cannot assure that the FCC will grant the requisite approvals for any of our products on a timely basis, or at all. The failure of our products to comply, or delays in compliance, with the various existing and evolving standards could negatively impact our ability to sell our products. United States regulations regarding the manufacture and sale of data communications devices are subject to future change. We cannot predict what impact, if any, such changes may have upon our business.

Employees

As of April 8, 2004, we had approximately 74 full-time permanent employees and one full-time temporary employee. We have no collective bargaining agreements with our employees. We believe that our relationship with our employees is good.

Item 2. Properties

Our corporate headquarters is located in Irvine, California in a leased facility of approximately 55,000 square feet. This facility contains all of our operations, including sales, marketing, finance, administration, production, shipping and receiving. The lease term began on September 1, 2003 and expires on August 31, 2006, with an option to extend the lease for another three year term upon providing notice 60 days prior to expiration of the current lease term. Our monthly lease payments are $25,480, $26,244, and $27,032 during the first, second, and third years of the lease, respectively. Under the option to extend the lease, monthly lease payments would be determined according to the then prevailing market price for the first year, and an increase of 3% per annum for years two and three. We believe this facility is adequate for our anticipated business purposes for the foreseeable future. We have no other leased or owned real property.

Item 3. 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 (Case No. 01CC09894) against Tony Shahbaz, our Chairman,

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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., our subsidiary, Steel Su, a director of I/OMagic, and Meilin Hsu, an officer of Behavior Tech. Computer Corp., as defendants. On or about March 28, 2003, all parties to the action entered into a Settlement Agreement and Release which settled this action. As part of the Settlement Agreement and Release, we entered into a new written lease agreement with Alex Properties relating to the real property in Santa Ana, California, which we physically occupied. On September 30, 2003, pursuant to the terms of the lease agreement, we vacated this real property. During the latter part of 2003 and continuing into the first quarter of 2004, counsel for Mark and Mitra Vakili and Alex Properties alleged, on their behalf, that we had improperly caused damage to the Santa Ana facility. On or about February 15, 2004, all parties to the original Settlement Agreement and Release executed a First Amendment to Settlement Agreement and Release, releasing all defendants from all of these new claims conditioned upon the making of the final $1,000,000 payment under the Settlement Agreement and Release by February 17, 2004, rather than on the original due date of March 15, 2004. We made this payment, and a dismissal of the case was filed with the court on March 8, 2004.

Horowitz & Beam

On May 30, 2003, I/OMagic and our subsidiary, IOM Holdings, Inc., filed a complaint for breach of contract and legal malpractice against our former attorneys and their respective law firms in the Superior Court of the State of California for the County of Orange (Case No. 03CC07383, captioned IOM Holdings, Inc. and I/OMagic Corporation v. Lawrence W. Horwitz, Gregory B. Beam, Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn, and Senn Palumbo Meulemans, LLP). 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 Horwitz and 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 (Civil Action No. 04-135 (GMS)) against, among others, I/OMagic Corporation, Sony Corp., Acer Inc., Asustek Computer, Inc., Iomega Corporation, LG Electronics, Inc., Lite-On Technology Corporation, and Memorex Products, Inc., or defendants. The complaint seeks to permanently enjoin defendants from, among other things, selling products that allegedly infringe one or more claims of plaintiff’s patents. The complaint also seeks damages of an unspecified amount, and treble damages based on defendants’ alleged willful infringement. In addition, the complaint seeks reimbursement of plaintiff’s costs as well as reasonable attorney’s fees, and a recall of all existing products of defendants that infringe one or more claims of plaintiff’s patents that are within the control of defendants or their wholesalers and retailers. Finally, the complaint seeks destruction (or reconfiguration to non-infringing embodiments) of all existing products in the possession of defendants that infringe one or more claims of plaintiff’s patents. We are presently evaluating the merits of this complaint and, as of the date of this report, have not yet responded to the allegations in the complaint. The outcome of this action is presently uncertain. However, at this time, we do not expect the defense or outcome of this action to have a material adverse affect on our business, financial condition or results of operations.

Item 4. Submission of Matters to a Vote of Security Holders

We held our 2003 annual meeting of stockholders on December 18, 2003. As of the close of business on October 31, 2003, the record date for the meeting, we had outstanding 4,529,672 shares of common stock. A total of 3,035,908 shares of common stock were represented in person or by proxy at the meeting and constituted a quorum. At the meeting, the following three proposals were presented and voted on:

(1) to elect the following six directors: Tony Shahbaz, Anthony Andrews, Steel Su, Daniel Hou, Daniel Yao and Young-Hyun Shin.

(2) to approve the adoption of the 2003 Stock Option Plan:

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(3) to ratify the selection of Singer Lewak Greenbaum & Goldstein LLP as our independent certified public accountants to audit our financial statements for the year ending December 31, 2003:

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PART II

Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

Our common stock has been traded on the OTC Bulletin Board under the symbol “IOMG” since December 20, 2002. Prior to that, it traded on the OTC Bulletin Board under the symbol “IOMC” since March 25, 1996. The table below shows for each fiscal quarter indicated the high and low closing bid prices for shares of our common stock. This information has been obtained from the OTC Bulletin Board. The prices shown reflect inter-dealer prices, without retail mark-up, mark-down, or commission and may not necessarily represent actual transactions. The prices listed below and elsewhere within this Annual Report reflect the one-for-fifteen reverse split of our common stock effected December 20, 2002.

Security Holders

As of April 8, 2004, we had 4,529,672 shares of common stock outstanding held of record by approximately 72 stockholders. Within the holders of record of our common stock are depositories such as Cede & Co. that hold shares of stock for brokerage firms which in turn, hold shares of stock for beneficial owners.

Dividends

We have not paid dividends on our common stock to date. Our line of credit with United National Bank prohibits the payment of cash dividends on our common stock. We currently intend to retain future earnings to fund the development and growth of our business and, therefore, do not anticipate paying cash dividends on our common stock within the foreseeable future. Any future payment of dividends on our common stock will be determined by our board of directors and will depend on our financial condition, results of operations, contractual obligations and other factors deemed relevant by our board of directors.

Recent Sales of Unregistered Securities

In October 2003, we issued warrants to purchase 20,004 shares of common stock at an exercise price of $7.19 per share, subject to adjustment. The warrants expired on March 31, 2004.

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In October 2003, we issued warrants to purchase 20,004 shares of common stock at an exercise price of $9.78 per share, subject to adjustment. The warrants expire on July 9, 2004.

The issuances of our securities in the above-referenced transactions were effected in reliance upon the exemption from registration under Section 4(2) of the Securities Act of 1933, as amended, as transactions not involving a public offering. Exemption from the registration provisions of the Securities Act is claimed on the basis that such transactions did not involve any public offering and the purchasers were sophisticated with access to the kind of information registration would provide.

Item 6. Selected Financial Data

The following selected consolidated historical financial data should be read in conjunction with the consolidated financial statements and the notes to those statements and the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report. The consolidated statements of operations and comprehensive income data with respect to the years ended December 31, 2003, 2002 and 2001 and the consolidated balance sheet data at December 31, 2003 and 2002 are derived from, and are qualified by reference to, the consolidated audited financial statements included elsewhere in this Annual Report. The historical results are not necessarily indicative of results to be expected for any future periods.

No cash dividends on our common stock were declared during any of the periods presented above.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion together with our consolidated financial statements and related notes appearing elsewhere in this report. This discussion contains forward-looking statements regarding the data storage and digital entertainment industries and our expectations regarding our future performance, liquidity and capital resources. Our actual results could differ materially from those expressed in these forward-looking statements.

Overview

We are a leading provider of data storage products. We also sell digital entertainment products. Our data storage products consist of a range of products that store traditional PC data as well as music, photos, movies, games and other multi-media. These products are designed principally for general data storage purposes. Our digital entertainment products consist of a range of products that focus on digital music, photos and movies. These products are designed principally for entertainment purposes.

We sell our products through computer, consumer electronics and office supply superstores and other retailers who collectively operate retail locations throughout North America. Our network of retailers enables us to offer products to consumers across North America, including every major metropolitan market in the United States. Our largest retailers include Best Buy, Circuit City, CompUSA, Staples, Office Depot and OfficeMax. We employ a three-brand approach to achieve our goal of product differentiation among various sales channels and price points. Our three brands are I/OMagic^®, Digital Research Technologies^® and Hi-Val^®.

Prior to 2003, we also emphasized the sale of other PC-related and consumer electronics products including, media, keyboards, mice, cameras, audio and graphic cards and flat panel television monitors. During the latter part of 2002 and the early part of 2003, we made a strategic decision to de-emphasize these additional product offerings in order to focus our management and financial resources on the manufacture and sale of our data storage and digital entertainment products, especially the manufacture and sale of dual-format DVD recordable devices that we introduced in July 2003. Because of our planned introduction of these devices in the third quarter of 2003, we reduced our promotional activities, such as rebates and point-of-sale discounts, for our CD-based products. This reduction in promotional activities, combined with our transition out of certain product offerings and other factors discussed below, resulted in a 25.5% decline in net sales for 2003 as compared to 2002.

Despite this significant reduction in net sales for 2003, we reduced our net loss from $8.3 million in 2002 to $265,000 for 2003. We believe that this significant improvement in our operating results is due, in large part, to the following factors:

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controls and procedures to better monitor personnel, legal and accounting costs. We spent more time and effort tracking consigned inventory that resides at our retailers. In doing so, we believe that we can better control overstocking of our products, which in turn allows us to better control price reductions and marketing programs in our efforts to sell inventory. We also spent additional time and effort in managing the shipment of products to our retailers to ensure that deliveries to these retailers were made on time in order to avoid penalties which many retailers assess on late shipments.

Retailers

Historically, a limited number of retailers have accounted for a significant percentage of our net sales. For the years ended December 31, 2001, 2002 and 2003, our six largest retailers accounted for approximately 92%, 88% and 78% of our net sales, respectively. We expect that sales of our products to a limited number of retailers will continue to account for a majority of our sales in the foreseeable future. We do not have long-term purchase agreements with any of our retailers. If we were to lose any of our major retailers or experience any material reduction in orders from any of them, it could have a material adverse effect on our business and results of operations.

Seasonality

Our data storage and digital entertainment products have historically been affected by seasonal purchasing patterns. Our products tend to have higher unit sales in the fourth quarter. These sales generally follow seasonal purchasing patterns of our end-user customers who purchase most of our products through retailers. Generally, our second quarter is the weakest. The impact of seasonality on our future results will be affected by our product mix, which will vary from quarter to quarter.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of net sales and expenses for each period. The following represents a summary of our critical accounting policies, defined as those policies that we believe are the most important to the portrayal of our financial condition and results of operations and that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Revenue Recognition

Currently, the majority of our net sales are non-consignment and are recognized upon shipment to retailers. A growing percentage of our net sales are consignment sales. Consignment sales are recognized when our retailers sell our products to the consumers. All of our sales include limited rights to return unsold inventory. We provide for estimated future returns of inventory based on historical experience. However, if certain returns in excess of our estimates occur, those amounts are accrued at the time we become aware of them, which may not be in the same period in which we book the initial sale. In addition, some retailers have limited price protection rights for inventories of our products held by them. If we reduce the list price of these previously purchased products, these retailers may be entitled to receive credits from us. We accrue for estimated cost for these limited price protection arrangements when the retailers is authorized to make the price change. We also offer to both consumers and retailers certain rebate arrangements. We accrue for the estimated cost of these rebate arrangements

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using actual sell through data supplied by our retailers and historical redemption percentages. Our net sales are defined as our gross sales less these estimated future returns, limited price protection arrangements, rebate arrangements and marketing development fund/cooperative arrangements.

Advertising and Market Development Costs

Advertising and market development costs are charged to operations or offset against gross sales in accordance with Emerging Issues Task Force Issue No. 01-9. For the year ended December 31, 2003, our advertising and market development costs were $8.5 million, of which $8.4 million was offset against gross sales. For the year ended December 31, 2002, our advertising and market development costs were $9.3 million, all of which was offset against gross sales. For the year ended December 31, 2001, our advertising and market development costs were $13.3 million, of which $13.2 million was offset against gross sales.

Consideration generally given by us to a retailer is presumed to be a reduction of selling price, and therefore, a reduction of gross sales. However, if we receive an identifiable benefit that is sufficiently separable from our sales to that retailer, such that we could have paid an independent company to receive that benefit and we can reasonably estimate the fair value of that benefit, then the consideration is characterized as an expense. We estimate the fair value of the benefits we receive by tracking the advertising done by our retailers on our behalf and calculating the value of that advertising using a comparable rate for similar publications.

Inventory Obsolescence Allowance

We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. These write-downs result in a charge to cost of sales. These write-downs relate directly to the amount of slow-moving or obsolete inventory which we have in our warehouse. This inventory usually is the result of returns by retailers at the end of a product’s life cycle. We plan to make a concerted effort in 2004 to sell this inventory more quickly than in prior years and thus reduce our write-downs.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our retailers to make required payments. Our current retailers consist of either large national or regional retailers with good payment histories with us. Since we have not experienced any previous payment defaults with any of our current retailers, our allowance for doubtful accounts is minimal. We perform periodic credit evaluations of our retailers. If the financial condition of our retailers were to deteriorate, resulting in the impairment of their ability to make payments, additional allowances may be required. New retailers are evaluated through Dunn & Bradstreet before terms are established. Although we expect to collect all amounts due, actual collections may differ.

Product Returns

Our policy is to allow return of product from consumers upon proper request by them and authorization by us. We have no time limit on product returns from consumers; however, our retailers generally have terms with their customers which range from fourteen to thirty days from date of purchase. This time period will generally flow through to us. We also include estimated time of product on the shelf and time to return product to us. Actual returns are recorded as

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reductions to gross sales for the period in which they are received. In addition, we maintain an allowance for sales returns for estimated future returns for products currently or previously sold for which we estimate we have not yet received. We use historical data and estimates based on observations to determine the allowance for each period. We estimate that sales for two months, the current and the prior, will be returned in future months. We use the actual return rate of the prior year to estimate what percent of the two months will be returned. Sales are adjusted by the estimated returns, while cost of sales are adjusted by the estimated cost of sales and the allowance is adjusted for the estimated gross margin. In periods in which sales are higher, such as normally our fourth quarter, the allowance is increased as we expect more returns. In periods in which sales are lower, such as normally our second quarter, the allowance is decreased as we expect less returns than we have already reserved for.

Results of Operations

The tables presented below, which compare our results of operations from one period to another, present the results for each period, the change in those results from one period to another in both dollars and percentage change and the results for each period as a percentage of net sales. The columns present the following:

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Fiscal Year Ended December 31, 2003 Compared to Fiscal Year Ended December 31, 2002

Net Sales. The significant decrease in net sales for 2003 is primarily due to our strategic decision to de-emphasize the sale of certain products, coupled with reduced sales of our CD-based products. The principal reason for the reduction in CD-based product sales was reduced promotional activities, such as rebates and point-of-sale discounts, for these products because of our concentration in the production and sale of our new dual-format DVD recordable devices which we introduced in July 2003. Also contributing to the overall decline in net sales for 2003 was a $14.4 million, or 70.2%, decrease in net sales to OfficeMax as compared to 2002. This decline was primarily the result of our mutual agreement with OfficeMax to discontinue sales from April 2003 through October 2003. During this period of time, we negotiated more favorable promotional programs with OfficeMax and, as a result, we began selling our dual-format DVD recordable drives to them beginning in November 2003.

Gross Profit. The increase in gross profit, both in dollar terms and as a percentage of net sales, is primarily due to a reduction in freight costs from $4.5 million in 2002 to $2.1 million in 2003. We were able to reduce these costs because throughout most of 2003 we were able to obtain products from our Asian subcontract manufacturers using normal freight methods, that is, ocean vessels rather than via airfreight which we were required to do during portions of 2002 due to west coast port strikes during that year.

Another contributing factor to our improvement in gross profit is a reduction in our inventory obsolescence charges from $2.1 million (2.5% of net sales) for 2002 to $0.1 million (0.2% of net sales) for 2003. During 2002, we wrote down to lower of cost or market a significant amount of slow-moving inventory. Due to the short life cycle of many of our products, we expect to continue to experience inventory obsolescence charges in the future. However, we can not predict with any certainty the future level of these write-downs.

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Selling, Marketing and Advertising Expenses. Selling, marketing and advertising expenses increased slightly in 2003. This increase was primarily due to an increase in slotting fees of $190,000 for new retailers, an increase in advertising costs of $157,000 and an increase in new store allowance for retailers of $57,000. Commissions were lower due to reduced sales volume.

General and Administrative Expenses. The decrease in general and administrative expenses is primarily due to a reduction in legal expenses of $411,000 as a result of the settlement of several litigation matters, a $223,000 reduction in payroll and related expenses due to our planned reduced headcount in 2003 for our U.S. operations, a $152,000 reduction in insurance expenses, and a $202,000 reduction in warehouse supplies and outside assembly of product due to lower sales in 2003. These reductions were partially offset by a $179,000 increase in bad debt expenses ($1.5 million in 2003 as compared to $1.3 million in 2002) and a $72,000 increase in product design expenses.

Depreciation and Amortization Expenses. The increase in depreciation and amortization expenses is primarily due to accelerated amortization on our prior Santa Ana facility which was originally to be leased through 2010. At the beginning of 2003, we decided to move to a larger facility by the end of September 2003 and thus, we accelerated our amortization by $389,000 in 2003. Amortization of our Hi-Val^® and Digital Research Technologies^® trademarks was reduced by $338,000 during 2003 because of our decision in 2002 to increase the useful lives of the trademarks by an additional ten years. As a result, during the second quarter of 2002, we decreased the amount of annual amortization of these trademarks, which was originally based on useful lives of five years.

Other Income (Expense). Other income (expense) decreased by $5.3 million as compared to 2002. This significant decrease is primarily due to a $5.2 million expense we recorded in 2002 relating to settlement costs and related legal expenses in connection with a significant litigation matter. During 2003, interest expense decreased by $137,000 to $249,000 due to reduced borrowings under our line of credit.

Income Tax Expense (Benefit). Income taxes provision decreased by $1.69 million in 2003 to a $27,000 benefit as compared to an expense of $1.68 million in 2002. In 2003, our income taxes represented primarily refunds we received. In 2002, our income tax provision represented the write-off of deferred tax assets.

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Fiscal Year Ended December 31, 2002 compared to Fiscal Year Ended December 31, 2001

Net sales. The increase in net sales for 2002 is primarily due to increased sales to our existing consignment retailers, sales to new retailers, and a $4.2 million increase in net sales resulting from a recalculation of our reserve for future returned products. The increase in net sales due to a change in our reserves for future returns on sales was based on a monthly calculation we make to adjust sales for estimated future product returns based on historical data. Two factors resulted in this increase. First, the overall increase in sales volume in 2002 as compared to 2001 resulted in $3.2 million of the increase. Second, the percentage of estimated returns was reduced in early 2002 based on actual returns showing that the return rate previously used should have been reduced. This resulted in a $975,000 increase in net sales. We believe that better installation manuals and improved technical support during 2001 resulted in a lower product return rate.

Gross Profit. The increase in gross profit, both in dollar terms and as a percentage of net sales, is primarily due to a reduction in inventory adjustments from $3.6 million for 2001 to $602,000 for 2002. Another contributing factor to our improvement in gross profit, both in dollar terms and as a percentage of net sales, is an increase in our inventory obsolescence charges from $410,000 for 2001 to $2.1 million for 2002.

Selling, Marketing and Advertising Expenses. Selling, marketing and advertising expenses decreased slightly in 2002. The slight reduction in these expenses was primarily due to a direct advertising expense of $121,000 in 2001 that we did not experience in 2002, $56,000 less retailer product evaluation expenses and $47,000 less payroll in 2002, offset by $136,000 higher commission expense during 2002 due to the increase in sales.

General and Administrative Expenses. The increase in general and administrative expenses is primarily due to a $449,000 increase in bad debt expense as compared to 2001 ($1.3 million in 2002 as compared to $851,000 in 2001), a $198,000 increase in payroll expenses, a $149,000 increase in

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insurance expenses, a $125,000 increase in warehouse supplies, a $117,000 increase in financial relations expenses, and a $98,000 increase in subcontracting of product assembly. These increases in expenses were offset by a $153,000 decrease in rent expense in connection with our move from a second facility at the end of April 2002 and a $151,000 decrease in expenses for consultants.

Depreciation and Amortization Expenses. The decrease in depreciation and amortization expenses is primarily due to a reduction in the amount of amortization of our trademarks. During 2002, we engaged an outside valuation service to review the value of our trademarks and their useful lives. Based upon this valuation, we determined that the useful lives of our trademarks should be increased by ten years. As a result, the amount of annual amortization was decreased beginning in 2002.

Other Income (Expenses). Other income (expenses) increased to $5.5 million as compared to $376,000 in 2001. This increase was primarily due to $5.2 million of settlement costs and related legal expenses in connection with a significant litigation matter. We also recorded a small gain of $39,000 on the disposal of property and equipment which we sold in connection with vacating our second facility at the end of April 2002.

Income Tax Expense (Benefit). The income taxes provision for 2002 consisted of a $1.8 million write-off of deferred tax assets, offset by $92,000 of net income tax refund.

Liquidity and Capital Resources

Our principal sources of liquidity have been cash provided by operations and borrowings under our bank credit facility and trade credit facilities. Our principal uses of cash have been to finance working capital, capital expenditures and debt service requirements. We anticipate these uses will continue to be our principal uses of cash in the future. As of December 31, 2003, we had 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.

Cash provided by our operating activities totaled $3.6 million during 2003 as compared to $3.3 million for 2002. This increase in cash provided by operations during 2003 primarily resulted from a $7.8 million increase in cash from the use of our trade credit facilities from related parties, an $816,000 increase in accounts payable, a $689,000 increase provided by the depreciation and amortization of fixed assets, and an increase of $579,000 provided by the amortization of our trademarks. These increases were offset by a $3.0 million legal settlement payment, a $265,000 net loss from operations, the use of $542,000 in cash for reserves for obsolete inventory, a $378,000 increase in prepaid expenses, and a $2.6 million reduction in accrued expenses. Our accrued expenses had decreased to $2.6 million primarily due to a $1.7 million reduction in accrued promotions and marketing expenses due to fewer sales in 2003 than 2002 and a $705,000 reduction in accrued legal fees.

Cash used in our investing activities totaled $170,000 during 2003 as compared to $62,000 for 2002. Our investing activities in 2003 consisted of leasehold improvements, furniture and computer equipment.

Cash used in our financing activities totaled $4.5 million during 2003 as compared to $302,000 for 2002. Our financing activities in 2003 consisted of a $4.4 million payoff on the line of credit with our prior lender and $83,000 in the repurchase of shares of our common stock.

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,

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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 credit facility with United National Bank provides for a revolving loan of up to $6,000,000 secured by substantially all of our assets and expires September 1, 2004. Advances up to 65% of eligible accounts receivable bear interest at the floating interest rate equal to the prime rate of interest as reported in The Wall Street Journal plus 0.75%. As of December 31, 2003, the interest rate was 4.75%. The business loan agreement provides that if United National Bank calls the loan because of a default under the terms of the loan agreement, other than a payment default, we can repay the loan in six equal monthly installments unless we obtain a replacement credit facility in which case, all amounts would be due and payable. The business loan agreement also contains a number of restrictive financial covenants. We were in compliance with these covenants at December 31, 2003.

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 December 31, 2003, the outstanding balance with United National Bank was $5.9 million and we had available to us $61,000 of additional borrowings. Our credit facility with United National Bank expires on September 1, 2004.

In January 2003, we entered into a trade credit facility with Lung Hwa Electronics. Lung Hwa Electronics is a shareholder and subcontract manufacturer of I/OMagic. Under the terms of the facility, Lung Hwa Electronics has agreed to purchase inventory on our behalf. We can purchase up to $10,000,000 of inventory, with payment terms of 120 days following the date of invoice by Lung Hwa Electronics’ supplier. 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 December 31, 2003, $750,000 of this deposit had been applied against outstanding trade payables as the agreement allowed us to apply the security deposit against our outstanding trade payables. This trade credit facility is for an indefinite term, however, either party has the right to terminate the facility upon 30 days’ written notice to the other party. As of December 31, 2003, we owed Lung Hwa Electronics $2.0 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 $10,000,000 of inventory on a consignment basis. We are responsible for insuring the consigned inventory, storing the consigned inventory for no charge; and furnishing BTC USA with weekly statements indicating all products received and sold and the current level of consigned inventory. The agreement also provides us with a trade line of credit of up to $10,000,000 with payment terms of net 60 days, without interest. The agreement may be terminated by either party upon 60 days’ prior written notice to the other party. As of December 31, 2003, we owed BTC USA $8.3 million under this arrangement. BTC USA is a subsidiary of Behavior Tech Computer Corp., one of our significant shareholders. Mr. Steel Su, a director of I/OMagic, is the Chief Executive Officer of Behavior Tech Computer Corp. See “Certain Relationships and Related Transactions.”

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We believe current and future available capital resources, revenues generated from operations, and other existing sources of liquidity, including our trade credit facilities with Lung Hwa Electronics and BTC USA and our credit facility with United National Bank, will be sufficient to fund our anticipated working capital and capital expenditure requirements for at least the next twelve months. If, however, our capital requirements or cash flow vary materially from our current projections or if unforeseen circumstances occur, we may require additional financing. For example, if the level of consignment sales to our retailers were to increase substantially from current levels, our current credit facility with United National Bank, which is a receivables-based line of credit, may not meet all of our financing needs since the length of time between delivery of product and the creation of an account receivable that may be financed is longer for consignment sales as compared to non-consignment sales. Accordingly, we would need to obtain other financing, including possibly an inventory-based line of credit, to meet all of our liquidity needs. Our failure to raise capital, if needed, could restrict our growth, limit our development of new products or hinder our ability to compete.

Backlog

Our backlog at December 31, 2003 was $5.3 million as compared to a backlog at December 31, 2002 of $12.4 million. Based on historical trends, we anticipate that our December 31, 2003 backlog may be reduced by approximately 10%, or $500,000, to a net amount of $4.8 million as a result of returns and reclassification of certain expenses as reductions to net sales. Our backlog may not be indicative of our actual sales beyond a rotating six-week cycle. The amount of backlog orders represents revenue that we anticipate recognizing in the future, as evidenced by purchase orders and other purchase commitments received from retailers. The shipment of these orders for non-consigned retailers or the sell-through of our products by consigned retailers causes recognition of the purchase commitments as revenue. However, there can be no assurance that we will be successful in fulfilling such orders and commitments in a timely manner, that retailers will not cancel purchase orders, or that we will ultimately recognize as revenue the amounts reflected as backlog based upon industry trends, historical sales information, returns and price protections.

Contractual Obligations

The following table outlines payments due under our significant contractual obligations over the next five years, exclusive of interest:

The above table outlines our obligations as of December 31, 2003 and does not reflect the changes in our obligations that occurred after that date.

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Impacts of New Accounting Pronouncements

In January 2003, the FASB issued 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, the Financial Accounting Standards Board (FASB) issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting and reporting for derivative instruments and hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 is effective for derivative instruments and hedging activities entered into or modified after 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.

Risk Factors

An investment in our common stock involves a high degree of risk. In addition to the other information in this Annual Report and in our other filings with the Securities and Exchange Commission, including our subsequent reports on Forms 10-Q and 8-K, you should carefully consider the following risk factors before deciding to invest in shares of our common stock or to maintain or increase your investment in shares of our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business, financial condition and operating results. If any of the following risks, or any other risks not described below, actually occur, it is likely that our business, financial condition and operating results could be seriously harmed. As a result, the trading price of our common stock could decline, and you could lose part or all of your investment.

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Risks Related to Our Business

We have incurred significant losses in the past, and we may continue to incur significant losses in the future. If we continue to incur losses, our business will be adversely affected.

We have incurred net losses since the year ended December 31, 1999. As of December 31, 2003, we had an accumulated deficit of approximately $15,000,000. During the years ended December 31, 2003, 2002 and 2001, we incurred net losses in the amounts of approximately $265,000, $8,350,000, and $5,550,000, respectively. Historically, we have relied upon cash from operations and financing activities to fund all of the cash requirements of our business. An extended period of net losses would result in negative cash flow and may prevent us from operating or expanding our business. We cannot assure you that we will be able to attain, sustain or increase profitability on a quarterly or annual basis in the future. If we are not able to achieve, sustain or increase profitability, our business will be adversely affected and our stock price may decline.

We currently depend on a small number of major retailers for the vast majority of our net sales. A reduction in business from any of these retailers, or failure by any of these retailers to timely pay amounts owed to us, could adversely affect our net sales and could seriously harm our business and financial condition.

During the year ended December 31, 2003, net sales to our two largest retailers represented approximately 28% and 13%, respectively, of our total net sales, and net sales to our next four largest retailers represented approximately 10%, 10%, 9% and 8%, respectively. During the year ended December 31, 2003, aggregate net sales to these six retailers represented approximately 78% of our total net sales. Our sales are made by standard purchase orders rather than long-term contracts. We expect that we will continue to be dependent upon these retailers for a significant majority of our revenues for the foreseeable future. We cannot assure you that our net sales generated from these retailers, individually or in the aggregate, will reach or exceed historical levels in any future period. A cessation or reduction of business from, or a decrease in prices of products sold to, any of these retailers, has in the past, significantly reduced our net sales for a reporting period and could, in the future, harm our business and financial condition. We cannot assure you that, if sales to any of these retailers cease or decline, we will be able to replace these sales with sales to existing or new retailers in a timely manner, or at all. If we could not replace these sales, our business and financial condition would be adversely impacted. Further, should one or more of these retailers fail to timely pay us amounts owed, we could suffer a substantial decline in our profitability, which would have a material adverse affect on our business, financial condition and results of operations.

If we are unable to renew or replace our business loan agreement with United National Bank prior to its September 1, 2004 expiration date, our ability to purchase additional inventory and to fund day-to-day operations may be adversely affected, which would adversely affect our ability to expand or sustain our current sales volume.

Our business loan agreement with United National Bank expires on September 1, 2004. 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. If we are unable to obtain a new line of credit, or if United National Bank calls the loan due in advance of its expiration, we may be unable to acquire sufficient amounts of inventory and our ability to expand or sustain our current sales volume will be adversely affected. In addition, we may be unable to fund our day-to-day operations.

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Our consignment of inventory to our retailers is increasing, which requires us to carry and finance greater amounts of inventory. If we are unable to obtain satisfactory financing, we will not be able to carry sufficient amounts of inventory resulting in reduced sales of our products.

We are increasingly using product consignment as a sales model. Our existing credit facility with United National Bank is an asset-based facility under which our borrowing power is measured based on the value of certain of our assets. Currently, the amount that we are permitted to borrow under this facility is based on our accounts receivable only and not our inventory. Accordingly, the value of our inventory is not counted when determining the amounts we are permitted to borrow from United National Bank. Consignment models typically result in higher levels of inventory which must be financed until that inventory is sold by a retailer to the consumer resulting in corresponding accounts receivable. More traditional sales models (that is, non-consignment models) result in immediate sales and corresponding accounts receivable upon shipment of inventory to retailers. If we are not able to obtain satisfactory financing, which may be asset-based financing tied to our accounts receivable as well as our inventory, we may be unable to finance sufficient inventory levels which would result in our inability to fill orders in a timely manner or at all, which would cause reduced sales of our products. In addition, as we increase our use of a consignment sales model and as a result of the increased time it takes us to receive payment, we may need to convince our subcontract manufacturers to lengthen the duration of our payment terms to them. If we are unable to lengthen the duration of our payment terms with our subcontract manufacturers, we may be unable to finance sufficient inventory levels which could result in our inability to fill orders in a timely manner or at all, which would cause reduced sales of our products.

We rely heavily on our Chief Executive Officer, and the loss of his services could adversely affect our business and results of operations.

Our success depends, to a significant extent, upon the continued services of Tony Shahbaz, who is our Chairman of the Board, President, Chief Executive Officer and Secretary. Mr. Shahbaz has developed personal contacts and skills upon which we greatly rely in connection with our operations and the execution of business strategies. Mr. Shahbaz has also developed key personal relationships with our subcontract manufacturers and he is frequently extensively involved in our sales and promotional efforts with our key retailers. 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 and results of operations.

We obtain many of our products from single or limited subcontract manufacturing sources. If these sources fail to satisfy our supply requirements or cease production of our products, we may lose sales, experience increased product costs and reduced profitability.

Our product inventory strategy is to maintain as little inventory as is necessary for the efficient operation of our business, which creates the risk that any shortage or delay in the supply of our products from our subcontract manufacturers could harm our ability to meet demand for our products. We obtain most of our products from single or limited subcontract manufacturing sources on a purchase order basis. In the past, we have experienced difficulty in obtaining products from these sources. Our subcontract manufacturers may experience financial difficulties, manufacturing difficulties or other problems which could adversely affect their ability to fulfill our product inventory needs on a timely basis, or at all. This, in turn, would adversely affect our ability to satisfy demand for our products, which would result in lost sales. We do not have any guaranteed supply arrangements or similar contractual commitments from our subcontract manufacturers. We cannot assure you that our subcontract manufacturers will continue to meet our supply requirements.

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If demand for a specific product increases, we may not be able to obtain an adequate supply of that product in a timely or cost-effective manner, or at all, since our subcontract manufacturers may be unable to supply enough products or may fill other orders before ours. It could be difficult, costly and time-consuming, or impossible, to obtain products from alternative sources. Offering high-value products is a key element to our ability to compete. Increases in product costs may therefore result in reduced sales if we increase our product prices or may result in reduced profitability if we are not able to pass along these costs to consumers in the form of increased product prices. In addition, difficulties in transitioning from an existing to a new subcontract manufacturer could create delays in product availability that would have a significant impact on our ability to fulfill orders for our products. Moreover, replacing some of our existing subcontract manufacturers could harm our business and financial condition because of the favorable terms we receive from these subcontract manufacturers, some of which are our shareholders.

Our inability to obtain products, prevent increased products costs, our transition to new subcontract manufacturers or our termination of our relationships with any of our existing subcontract manufacturers, especially those who are our shareholders, would adversely impact our ability to meet demand for our products, and damage our brands and reputation with our retailers and in the marketplace, which could have a material adverse affect on our business and results of operations.

The high concentration of our sales in our data storage product category could have a material adverse effect on our business and results of operations if demand for those products declines or if competition within the industry intensifies.

Sales of our data storage products for the year ended December 31, 2003 accounted for approximately 94% of our net sales. Except for our digital entertainment products, which accounted for only a small fraction of our net sales in the year ended December 31, 2003, we have not diversified our product categories. We expect data storage products to continue to account for the vast majority of our sales for the foreseeable future. As a result, our business and results of operations will be significantly and adversely impacted by a downturn in the market for data storage products.

Our failure to manage growth effectively could impair our business.

We plan to expand our business into new data storage and digital entertainment product categories. In particular, we plan to offer additional DVD-based products, including DVRs, and to offer products with heightened performance and added functionality. We also plan to offer a next-generation DVD-based product, such as Blu-ray^® DVD or HD-DVD, depending on which of these competing formats we believe is most likely to prevail in the marketplace. These planned product offerings will require significant investments of capital and management attention. Also, with respect to our planned expansion within the digital entertainment marketplace, our resources and personnel are likely to be especially strained because our experience in efficiently allocating resources, as well as the overall experience of our personnel, arose in the context of the data storage industry and we have little experience in the digital entertainment industry.

We also plan to expand our business into additional sales channels, such as corporate and government procurers, value-added resellers and value-added distributors, and 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.hi-val.com. This planned expansion will require significant resources, including with respect to our improvement of our information systems, management of product data, control accounting, expansion of the capabilities of our administrative and operational personnel, and attracting, training, managing and retaining additional qualified personnel.

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Consequently, our failure to effectively manage growth in our product offerings and in our sales channels is likely to impair our business, and have a material adverse affect on our financial condition and results of operations.

If our products are not among the first-to-market, or if consumers do not respond favorably to either our new or enhanced products, our sales and profits may be adversely affected.

One of our core 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 our retailers and end-users of our products as among the leaders in the data storage industry. We also believe that our retailers and end-users of our products view products offered under these brands as representing new innovations based on early adoption of technological enhancements. For instance, in introducing new and enhanced optical data storage products, we seek to be among the first-to-market, offering heightened product performance such as faster data recordation and access speeds. If our products are not among the first-to-market, our competitors who are able to bring products to market more rapidly may gain market share at our expense, harming our sales and profits.

As a consequence of our strategy to be among the first-to-market with new and enhanced products based on established technologies, we are exposed to consumer rejection of these 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 consumer demand for DVD-based products displacing 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 our new and enhanced DVD-based products does not occur, or is delayed, our business, financial condition and results of operations will be adversely affected.

If we fail to manage our product rebate programs or other promotions, our business and financial condition as well as our brand image may be harmed.

We rely heavily on product rebates and other promotional programs to increase sales of our products. An important aspect of planning any promotion is the accurate forecasting of the costs associated with that promotion. If we fail to accurately forecast the costs of our promotional efforts, we may fail to allocate sufficient resources to that promotion, such as keeping sufficient funds available for mail-in product rebates. If we are unable to satisfy our promotional obligations, such as providing cash rebates to consumers, our brand image and goodwill with those consumers, as well as our retailers, would be harmed, which would result in harm to our business and financial condition.

Failure to adequately protect our trademark rights could harm our business and cause us to lose market share and sales.

We sell our products under three brand names, I/OMagic^®, Digital Research Technologies^® and Hi-Val^®, all of which are trademarks registered by us with the United States Patent & Trademark Office. We also sell products under various product names such as our MediaStation^™, DataStation^™, Digital Photo Library^™, EasyPrint^™ and Sound Assault^™ product names. One of our key business strategies is to use our brand names to successfully compete in the marketplace for data storage and digital entertainment products. We have expended significant resources promoting our brand names and our products under the names under which they are sold. We cannot assure you that our registration of our brand name trademarks with the United States Patent & Trademark Office will deter or prevent their

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unauthorized use. We also cannot assure you that other companies, including our competitors, will not use our product names. If other companies, including our competitors, use our brand names or product names, consumer confusion as to the source of the products could result which would reduce the value of goodwill associated with these trademarks. This consumer confusion and the resulting reduction in goodwill could cause us to lose market share and cause our sales to decline.

Our indemnification obligations to our retailers for product defects could require us to pay substantial damages, resulting in a material adverse affect on our business and results of operations.

A number of our agreements with our retailers provide that we will defend, indemnify and hold harmless our retailers from damages and costs that arise from product warranty claims or 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 any resulting liability we would incur if those claims are successful. A successful claim brought against us for product defects that is in excess of, or excluded from, our insurance coverage could have a material adverse affect on our business and results of operations.

Our insurance does not cover shipment of products via ocean or air freight. As a result, loss or damage to our products shipped in this manner could result in significant losses to us and harm our business and financial condition.

Our insurance does not cover shipment of products via ocean or air freight. We occasionally take delivery of products in Asia from our subcontract manufacturers and ship those products to our headquarters in Irvine, California. In addition, we periodically ship products from Asia via air freight. We also occasionally ship products from our headquarters to our retailers or to a distribution center via air freight. In these circumstances, we are allocated the risk of loss of those products. Accordingly, loss or damage to our products in transit shipped via ocean or air freight could result in significant losses to us and harm our business and financial condition.

Our operations are vulnerable to natural disasters and other events because we have limited backup systems.

We have limited backup systems and have experienced system failures and electrical outages from time to time, which have disrupted our operations. We have a limited disaster recover plan in the event of damage from fire, floods, earthquakes, power loss, telecommunications failures, break-ins and similar events. Our operations are dependent on our ability to protect our computer systems against these unexpected adverse events.

If any of the above occurs, we may experience a complete system shutdown. The business interruption insurance that we carry is unlikely to be sufficient to compensate us for loss of business in the event of a significant catastrophe. In addition, interruptions in our services could result from the failure of our telecommunications providers to provide the necessary data communications capacity in the time frame we require. Our internal order system through which our retailers place orders for our products is an electronic purchase order system. This system’s continued and uninterrupted performance is critical to our business. Despite precautions that we have taken, unanticipated problems have from time to time caused, and in the future could cause, interruptions in our computer and telecommunications systems, including our electronic purchase order system. We have limited ability and personnel to process purchase orders in any other manner such as traditional facsimile acceptance of purchase orders. To prevent disruption of our computer and telecommunications systems, we may have to make substantial investments to obtain adequate system backup and redundancies. Our business, financial condition and results of operations could be materially and adversely affected by any damage or failure that interrupts or delays our operations.

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A significant product defect or product recall could have a material adverse affect on our brand image and our business, financial condition and results of operations.

Our products are complex and may contain defects. Although we and our subcontract manufacturers test our products, it is possible that errors or defects may be found in existing or future products after they have been purchased by consumers. These errors or defects could result in increased product returns, loss of sales, adverse publicity, delay in market acceptance of our products, decrease in demand for our existing or future products, reduction in the value of one or more of our brand names, or the bringing of product warranty or other legal claims against us by our retailers or by consumers. As a result, of any one or more of these events, our business could be negatively affected.

We believe that our retailers and end-users of our products view our I/OMagic^®, Digital Research Technologies^® and Hi-Val^® brands as offering high-value products that combine performance, functionality and reliability at prices competitive with other leading products offered in the marketplace. 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. A product recall would likely require a significant allocation of administrative and financial resources and may detract management’s attention from implementing our core business strategies. As a result, a significant product defect and product recall could materially and adversely affect our brand image and our business, financial condition and results of operations.

Risks Related to Our Industry

Our retailers may directly import or private label products, causing a decline in our sales and an adverse impact on our business, financial condition and results of operations.

Optical data storage products and digital entertainment products are widely available from suppliers and manufacturers around the world. Our major retailers include Best Buy, Circuit City, Comp USA, Staples, Office Depot and Office-Max. Collectively, these six retailers accounted for 78% of our net sales for the year ended December 31, 2003. Each of these retailers has substantial resources and has the ability to directly import or private label, or both, data storage and digital entertainment products from suppliers and manufacturers around the world, including from our own subcontract manufacturers. Our retailers may believe that higher product margins and profitability can be achieved if they implement a direct import or private label program, excluding us from the sales channel. Accordingly, one or more of our retailers may stop buying products from us. As a consequence, our sales and profitability would be adversely affected, which would have an adverse impact on our business, financial condition and results of operations.

Competition within the data storage and digital entertainment industries is intense. Many of our competitors have greater resources than we do. Our competitors could use these resources to gain market share, causing us to lose market share and causing a decline in our sales.

The data storage and digital entertainment industries are extremely competitive and subject to rapid technological changes and product obsolescence. Our data storage products compete with several types of data storage devices such as internal and external hard drives, magnetic tape drives, floppy disk drives and flash memory devices, as well as internal and external optical data storage products offered by other companies. Our digital entertainment products compete with products such as portable CD players, Minidisc players, cassette tape players and various digital entertainment PC peripheral devices.

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Rapid technological changes can shift market share among various types of data storage and digital entertainment devices. 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. Companies within the data storage and digital entertainment industries are continuously developing products with heightened performance and functionality causing pricing pressure on, and constantly threatening obsolescence of, existing products. For instance, we believe that the market for optical data storage products is rapidly shifting its focus from CD-based products to DVD-based products, the consequences of which have included the shift in market share away from CD-based products and intense downward pricing pressure on those products.

Our competitors in the data storage industry include Sony, Hewlett-Packard, TDK, Memorex, Philips Electronics, Samsung Electronics, Toshiba and Mad Dog Multimedia. Companies that offer products similar to our digital entertainment products include Sony, Apple Computer, Bose Corporation, Rio Audio and Creative Technology. We also indirectly compete against original equipment manufacturers such as Dell and Hewlett-Packard to the extent that they manufacture their own computer peripheral products or incorporate the functionalities offered by our products directly into PCs.

Many of our competitors have substantially greater production, financial, research and development and marketing resources than we do. As a result, these companies may be able to compete more aggressively over a longer period of time than we can. In addition, our lack of resources relative to many of our competitors may cause us to fail to anticipate or respond adequately to technological developments and changing consumer demands and preferences, or may cause us to experience significant delays in developing or introducing products. These failures and delays could reduce our competitiveness and cause a decline in our market share and sales.

Our lack of long-term purchase orders and commitments may adversely affect our business and results of operations.

During the year ended December 31, 2003, sales of our data storage products accounted for approximately 94% of our net sales and sales of our digital entertainment products accounted for approximately 6% of our net sales. Although we have long-term contracts with most of our retailers, these contracts typically cover the general terms and conditions of our relationships with these retailers, but do not include any purchase order commitments or purchase quantity obligations. Rather, most of our retailers issue purchase orders solely in their own discretion and then typically only one to two weeks before the requested date of shipment. Our retailers are generally able to cancel orders or delay the delivery of products on short notice. Accordingly, we cannot assure you that any of these retailers will continue to purchase our products in the future.

We cannot rely on long-term purchase orders or commitments to protect us from the negative financial effects of a decline in demand for our products that could result from a general economic downturn, from changes in the data storage and digital entertainment marketplaces, including the entry of new competitors into the market, from the introduction by others of new or improved technology, from an unanticipated shift in the purchasing patterns of our retailers, or from other causes. In addition, the lack of significant backlog and the limited certainty of product orders can make it difficult for us to forecast our sales and allocate our resources accordingly. Moreover, our expense levels are based in part on our expectations of future sales and we may be unable to reduce costs in a timely manner to adjust for sales shortfalls. As a result, our lack of long-term purchase orders and purchase commitments may adversely affect our business and results of operations.

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The products we sell are subject to rapidly changing technologies and obsolescence. If we are unable to effectively manage product obsolescence, our business and results of operations will be harmed.

The data storage and digital entertainment industries are characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and product obsolescence. Our product life cycles typically range from three to twelve months. We manage our inventory based on our expectations as to the introduction of new technology and the duration of a product’s life cycle. If we fail to accurately anticipate the introduction of new technologies or product obsolescence, we may end up holding significant amounts of inventory that can only be liquidated at substantially lower prices and profit margins than we expected. In particular, it is critical that we accurately anticipate and respond to the continued transition within the data storage industry from CD-based products to DVD-based products. In addition, it is critical that we accurately anticipate the possible transition from DVD-based products to next-generation DVD-based products such as Blu-ray^® DVD or HD-DVD products. Our failure to accurately anticipate these transitions could result in material amounts of obsolete CD- or DVD-based products which are saleable only at substantially reduced prices and profit margins.

In addition, when we offer our own new or enhanced products, we must successfully manage the resulting obsolescence and price erosion of our older products, as well as any resulting price protection charges and inventory returns from our retailers. Average selling prices of our products decline over the duration of their life cycle. If our retailers are unable to sell their inventory in a timely manner, we may choose or be required to lower the prices of our products or allow our retailers to exchange the slow-moving products for newer products. The introduction by us of new or enhanced products with heightened performance or expanded functionality may exert substantial downward pricing pressure on our older products. In the past, we have experienced this downward pricing pressure as we have introduced new data storage devices, for example, when we shifted our product offering from basic CD-ROM devices to CD-RW drives and then to recordable DVD drives. We have also experienced this downward pricing pressure as we have introduced new data storage devices with substantially the same functionality as existing products, but with higher performance, such as faster data access times, than existing devices. Accordingly, if we are unable to effectively manage the introduction of new or enhanced products and product obsolescence, our business and results of operations will be harmed.

If we fail to accurately forecast consumer demand for our products, our business and our results of operations will be adversely affected.

We sell our products to retailers such as computer, consumer electronics and office supply superstores. These retailers in turn sell products primarily off-the-shelf directly to consumers. We rely upon sales forecasts provided by our retailers to anticipate their purchase orders. We also generate our own internal forecasts based on input from our retailers, market data and other information, as well as our knowledge of the data storage and digital entertainment industries. If these forecasts are inaccurate, we could either have excess inventory, resulting in significant financing costs and product obsolescence, or insufficient inventory, resulting in lost sales due to our inability to promptly meet consumer demand. Insufficient inventory can also result in additional shipping costs as we are forced to replenish our inventory or provide our retailers with products shipped on an expedited basis. Moreover, many of our retailers impose penalties for late shipments, which can result in significant additional costs. Accordingly, our future operating results are largely dependent on our ability to accurately forecast consumer demand for our products. Our failure to accurately forecast consumer demand for our products could result in significant losses from inventory obsolescence, financing charges, lost sales, expedited shipping costs and late shipment penalties, any of which could adversely affect our business and results of operations.

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Consumer acceptance of alternative sales channels may increase. Our inability to adapt to these alternative sales channels may result in reduced sales of our products.

We are accustomed to conducting business through traditional retail sales channels. Consumers purchase our products predominantly through six retailers who collectively accounted for approximately 78% of our net sales for the year ended December 31, 2003. Consumers may increasingly prefer alternative sales channels, such as direct mail order, direct sales by PC manufacturers and Internet commerce. Internet commerce in particular is becoming increasingly accepted by consumers as a convenient, secure and cost-effective method of purchasing data storage and digital entertainment products. We believe that many of our target consumers are knowledgeable about technology and comfortable with the use of the Internet for product purchases. The migration of consumer purchasing habits from traditional retailers to Internet retailers could have a significant impact on our ability to sell our products. We cannot assure you that we will be able to predict and respond to increasing consumer preference of alternative sales channels such as Internet commerce.

Core technologies contained in our products are widely available to our competitors, which could cause competition with our products to intensify.

We are not the exclusive licensee or owner of most of the intellectual property related to the core technologies used in our products. Most of the core technologies in our CD- and DVD-based optical data storage drives as well as our MP3 digital entertainment devices are generally widely available to our competitors or to new entrants in the data storage and digital entertainment marketplaces. Most, if not all, of our other products also contain core technologies that are widely available. We expect that the core technologies contained in most products we offer in the future also will be widely available. We cannot assure you that competing products will not use the core technologies contained in our products. As a result, competition among products we offer and products our competitors offer could intensify because our products use core technologies that are widely available to our competitors. If product competition intensifies, we could experience downward pricing pressures and lose market share, which would cause a decline in our sales and adversely affect our results of operations.

If we are subjected to a protracted infringement claim or one that results in a significant damages award, our results of operations may be adversely affected.

Our current products rely on key technologies developed or licensed by third parties. We expect that our future product offerings will also rely on third-party technologies. Our ability to compete successfully depends upon our ability to operate without infringing the proprietary rights of others. Due to the complexity of technology used and the multitude of patents, trade secrets, copyrights and other overlapping intellectual property rights, the data storage and digital entertainment industries are characterized by frequent litigation regarding patent, trade secret, copyright and other intellectual property rights. It is common for intellectual property rights holders to assert their rights against a host of parties, including a party such as us who subcontract manufactures products for ultimate sale through retail and other sales channels. From time to time we receive communications from third parties asserting that their intellectual property rights cover certain of the technologies embodied in our products and alleging infringement of their intellectual property rights. We expect to continue to receive such communications in the future. In the event any third party is successful in a claim against us or our subcontract manufacturers that we or our subcontract manufacturers have infringed its intellectual property rights, we or our subcontract manufacturers could be required to:

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In addition, third parties, some of which are potential competitors, may initiate litigation against our subcontract manufacturers alleging infringement of their proprietary rights with respect to manufacturing processes. In the event of a successful claim of infringement and the failure or inability to license or independently develop alternative, non-infringing technology on a timely basis by us or our subcontract manufacturers, we may be unable to obtain sufficient manufacturing capacity or offer competitive products. As a result, our product offerings could be limited and our sales could decline.

Third parties may also claim that our retailers are infringing upon their intellectual property rights as a result of selling our products. As a consequence, our retailers could attempt to assert indemnification claims against us. Both the infringement and indemnification claims could be time-consuming and costly to defend or settle and would divert management’s attention and our resources away from our business.

Any one of these developments could place substantial financial and administrative burdens on us and harm our business. We may not have sufficient litigation defense resources. If we fail to obtain necessary licenses or if litigation relating to patent infringement or other intellectual property matters occurs, our business, financial condition and results of operations could be adversely affected.

We subcontract manufacture products in Asia, which subjects us to risks, such as risks associated with foreign currency fluctuations, and which could adversely affect our results of operations.

General economic conditions and fluctuations in currency exchange rates affect the prices of our products and certain of our costs. During the year ended December 31, 2003, we obtained all of our products from suppliers and subcontract manufacturers based in Asia. Most of our purchases from these suppliers and subcontract manufacturers are denominated in United States dollars but our suppliers’ and subcontract manufacturers’ costs are predominantly denominated in their local currencies. A significant appreciation of any of these currencies against the United States dollar would cause our product costs to increase.

Our subcontract manufacturing operations are subject to a number of other risks as well, including:

We subcontract manufacture or otherwise obtain all of our products in Asia. In the event of political, social or economic disruption in the governments of any country located in Asia, the economic ramifications to our suppliers and subcontract manufacturers could be significant. As a result, our ability to obtain products from them, and therefore our ability to conduct our operations, could be materially and adversely affected. For example, in 2003, many companies and governments imposed travel restrictions to and from, and quarantines in, certain Asian countries affected by Severe Acute Respiratory Syndrome, or SARS. Similar medical crises in the future may disrupt manufacturing processes and the economies of affected countries. Taiwan also has suffered earthquakes and typhoons, resulting in temporary communications and supply disruptions, and is presently suffering political disruptions following a disputed presidential election outcome. There can be no assurance that any or all of these disruptions will not occur in the future.

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Any or all of these factors could adversely affect our ability to operate our business and could have a material adverse affect on our business and results of operations.

A labor strike at a shipping port at which our products are shipped or received would prevent us from taking timely delivery of inventory, which would cause our sales to decline and harm our business and results of operations.

From time to time, shipping ports experience labor strikes or work stoppages which prevent the delivery of products shipped internationally via ocean freight. The shipping port located in Long Beach, California, through which we receive most of our products shipped by our subcontract manufacturers in Asia, experienced a labor strike in September 2002, which lasted for nearly two weeks. As a result, there was a significant disruption in our ability to deliver products to our retailers, which caused our sales to decline. Any future labor strike or work stoppage at a shipping port at which our products are shipped by or received from our subcontract manufacturers would prevent us from taking timely delivery of inventory and cause our sales to decline. To meet our obligations to our retailers, we may be required to arrange for alternative means of product shipment, such as air freight, which could add significantly to our product costs which we likely would be unable to pass along to either our retailers or to consumers. Also, because the average selling prices of our products decline during their short product life cycle, inventory that has been purchased by us that is unable to clear a shipping port could yield significantly less sales than planned, adversely affecting our business and results of operations.

If our products fail to comply with existing and evolving government regulations and industry standards, we may have difficulty selling our products and could be subjected to liability for selling products that do not comply with applicable regulations.

Our products are designed to comply with industry standards and government regulations, some of which are evolving as new technologies are deployed. In the United States, our products must comply with regulations imposed by the United States Federal Communications Commission, or FCC, and Underwriters Laboratories, as well as numerous industry standards such as technological standards related to CD– or DVD–based products. We also must comply with numerous import/export regulations. In particular, our data communications devices in our data storage and digital entertainment product categories are subject to numerous FCC regulations. The failure of our products to comply, or delays in compliance, with the various existing and evolving regulations or standards could negatively impact our ability to sell our products and could result in liability on our part for selling products that fail to comply with applicable regulations.

Risks Related to Our Common Stock

Our stock price is highly volatile, which could result in substantial losses for investors purchasing shares of our common stock and in litigation against us.

The market price of our common stock has fluctuated significantly in the past and may continue to fluctuate significantly in the future. During the year ended December 31, 2003, the high and low closing sale prices of a share of our common stock were $11.00 and $3.00, respectively.

The market price of our common stock may continue to fluctuate in response to the following factors, many of which are beyond our control:

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The price at which you purchase shares of common stock may not be indicative of the price of our stock that will prevail in the trading market. You may be unable to sell your shares of common stock at or above your purchase price, which may result in substantial losses to you. Moreover, in the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We may in the future be the target of similar litigation. Securities litigation could result in substantial costs and divert management’s attention and our resources from our business.

Our common stock has an extremely small public float and future sales of our common stock may negatively affect the market price of our common stock.

As of April 8, 2004, there were approximately 4.5 million shares of our common stock outstanding. As a group, our officers and directors and all other persons who beneficially own more than 10% of our total outstanding shares, beneficially own an aggregate of approximately 3.5 million shares of our common stock. Accordingly, our common stock has a public float of approximately 1,000,000 shares, which are shares in the hands of public investors, and which, as the term public float is defined by Nasdaq, excludes shares that are held directly or indirectly by any of our officers or directors or any other person who is the beneficial owner of more than 10% of our total shares outstanding. These approximately 1,000,000 shares are held by a relatively small number of shareholders of record. We cannot predict the effect, if any, that future sales of shares of our common stock into the market will have on the market price of our common stock. However, sales of substantial amounts of common stock, including shares issued upon the exercise of stock options, or the preception 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.

Our executive officers, directors, major stockholders and their affiliates collectively 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 April 8, 2004). As a result, our executive officers, directors, major stockholders and their affiliates, 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 transactions. Some of these persons or entities may have interests different than yours. For example, these stockholders may delay or prevent a change of control of us, even if such a change of control would benefit our other 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.

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Our amended and restated articles of incorporation, amended and restated bylaws and Nevada law contain provisions that could discourage transactions resulting in a change in control, which may negatively affect the market price of our common stock.

Our amended and restated articles of incorporation and our amended and restated bylaws contain provisions that may enable our management to resist a change in control. These provisions may allow management to discourage, delay or prevent a change in the ownership of our company or a change 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. Such provisions include:

We are subject to the restrictions contained in Sections 78.378 through 78.3793 of the Nevada Revised Statutes, which provide, subject to certain exceptions, that if a person acquires a “controlling interest,” which is equal to one-fifth, one-third, or one-half or more of the voting power of a corporation, that person is an “interested stockholder” and may not vote such shares. Accordingly, the effect of Sections 78.378 through 78.3793 of the Nevada Revised Statutes may be to discourage, delay or prevent a change in control of our company.

Because we are subject to the “penny stock” rules, the level of trading activity in our stock may be reduced.

Broker-dealer practices in connection with transactions in “penny stocks” are regulated by penny stock rules adopted by the Securities and Exchange Commission. Penny stocks, like shares of our common stock, generally are equity securities with a price of less than $5.00 (other than securities registered on some national securities exchanges or quoted on Nasdaq). The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from the rules, to deliver a standardized risk disclosure document that provides information about penny stocks and the nature and level of risks in the penny stock market. The broker-dealer also must provide the customer with current bid and offer quotations for the penny stock, the compensation of the broker-dealer and its salesperson in the transaction, and, if the broker-dealer is the sole market maker, the broker-dealer must disclose this fact and the broker-dealer’s presumed control over the market, and monthly account statements showing the market value of each penny stock held in the customer’s account. In addition, broker-dealers who sell these securities to persons other than established customers and “accredited investors” must make a

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special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written agreement to the transaction. Consequently, these requirements may have the effect of reducing the level of trading activity, if any, in the secondary market for a security subject to the penny stock rules, and investors in our common stock may find it difficult to sell their shares.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

Our operations were not subject to commodity price risk during 2003. Our sales to a foreign country (Canada) were less than 1.5% of our total sales, and thus we experienced negligible foreign currency exchange rate risk. We do not hedge against this risk.

We currently have a business loan agreement with United National Bank in an amount of up to $6 million. The line of credit provides for an interest rate equal to the prime lending rate plus three-quarters of one percent. This interest rate is adjustable upon each movement in the prime lending rate. If the prime lending rate increases, our interest rate expense will increase on an annualized basis by the amount of the increase multiplied by the principal amount outstanding under the United National Bank business loan agreement.

Item 8. Financial Statements and Supplementary Data

Reference is made to the financial statements included in this report, which begin at Page F-1.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A. 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 December 31, 2003, that the design and operation of our “disclosure controls and procedures” (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)) are effective to ensure that information required to be disclosed by us in the reports filed or submitted by us under the Exchange Act is accumulated, recorded, processed, summarized and reported to our management, including our principal executive officer and our principal financial officer, as appropriate to allow timely decisions regarding whether or not disclosure is required.

During the quarter ended December 31, 2003, there were no significant changes in our “internal controls over financial reporting” (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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PART III

Item 10. Directors and Executive Officers of the Registrant

Directors and Executive Officers

The names, ages and positions held by our directors and executive officers as of April 12, 2004 and their business experience are as follows:

Tony Shahbaz is a founder of I/OMagic Corporation and has served as our Chairman of the Board, President, Chief Executive Officer, Secretary and as a director since September 1993, and as our Chief Financial Officer from September 1993 to October 2002. Prior to founding I/OMagic Corporation, Mr. Shahbaz was employed by Western Digital Corporation from September 1986 to March 1993. During his tenure at Western Digital Corporation, Mr. Shahbaz held several positions including Vice President of Worldwide Sales for Western Digital Paradise, and Regional Director of Asia Pacific Sales and Marketing Operations. From 1985 to 1986, Mr. Shahbaz held management positions with Lapin Technology and from 1979 to 1984, Mr. Shahbaz held management positions with Tandon Corporation.

Steve Gillings has served as our Chief Financial Officer since October 2002. Prior to that, Mr. Gillings served as our Vice President of Finance from October 2000 to October 2002 and as our Controller from November 1997 to October 2000. Mr. Gillings earned a B.S. degree in Accounting from the University of California at Berkeley in 1971 and an M.B.A. degree in Finance from California State University Fullerton in 1992.

Anthony Andrews has served as our Vice President of Product Development and Engineering since he joined I/OMagic Corporation in March 1994 and has served as a director since October 1995. From 1988 to 1994, Mr. Andrews was a principal engineer at Western Digital Corporation, where he was involved in product and software design and played a key role in the development of portable notebook power management designs that are used by companies such as IBM and AST. Prior to that, Mr. Andrews was a staff engineer with Rockwell International from 1985 to 1988. Mr. Andrews earned a B.S. degree in Math and Computer Science from the University of California at Los Angeles in 1985.

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Steel Su has served as a director of I/OMagic Corporation since September 2000 and is a founder of Behavior Tech Corporation and has served as its Chairman since 1980. Mr. Su has served and continues to serve as a director or chairman of the following affiliates of Behavior Tech Corporation: Behavior Design Corporation (chairman), Behavior Tech Computer (USA) Corp. (chairman), Behavior Tech Computer Affiliates, N.V. (chairman) and BTC Korea Co., Ltd. (director). Mr. Su has served as chairman of Gennet Technology Corp., Emprex Technologies Corp., MaxD Technology Inc. and Maritek Inc. since 1992, 1998, 2000 and 1999, respectively. Mr. Su has also served as a director of Aurora Systems Corp. and Wearnes Peripherals International (PTE) Limited since 1998 and 2000, respectively. Mr. Su earned a B.S. degree in Electronic Engineering from Ching Yuan Christian University in 1974 and an M.B.A. from National Taiwan University in 2001.

Daniel Hou has served as a director of I/OMagic Corporation since January 1998. Since 1986, Mr. Hou has served as the President of Hou Electronics, Inc., a computer peripheral supplier that he founded. Mr. Hou is a prior President of the Southern California Chinese Computer Association and is an active member of the American Chemistry Society. Mr. Hou earned a B.A. degree in Chemistry from National Chung-Hsing University, Taiwan in 1973 and a Masters degree in Material Science from the University of Utah in 1978.

Daniel Yao has served as a director of I/OMagic Corporation since February 2001 and has been a Chief Strategy Officer for Ritek Corporation since July 2000. Prior to joining Ritek, Mr. Yao served as the Senior Investment Consultant for Core Pacific Securities Capital from July 1998 to July 2000. Prior to that, Mr. Yao was an Executive Vice President for ABN Amro Bank in Taiwan from July 1996 to July 1998. Mr. Yao earned a B.A. degree in Business Management from National Taiwan University in 1978 and a M.B.A. degree from the University of Rochester in New York.

Young-Hyun Shin has served as a director of I/OMagic Corporation since September 2000. Mr. Shin was the former President and Chief Executive Officer of BTC Korea Co., Ltd. from March 1988 through October 2003. Mr. Shin has served and continues to serve as a director of BTC Korea Co., Ltd. since March 1988. Mr. Shin earned a B.S. degree in Electronics from Yonsei University in 1979.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our executive officers, directors and persons who beneficially own more than 10% of a registered class of our equity securities (“reporting persons”) to file initial reports of ownership and reports of changes in ownership of our common stock and other equity securities with the Securities and Exchange Commission. The reporting persons are required by the Securities and Exchange Commission regulations to furnish us with copies of all reports that they file.

Based solely upon a review of copies of the reports furnished to us during our fiscal year ended December 31, 2003 and thereafter, or any written representations received by us from reporting persons that no other reports were required, we believe that all Section 16(a) filing requirements applicable to our reporting persons were met, except that Mr. Young-Huyn Shin filed a late Form 4 to report one transaction.

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Code of Ethics

Our board of directors has adopted a Code of Business Conduct and Ethics that applies to all of our directors, officers and employees and an additional Code of Business Ethics that applies to our Chief Executive Officer and Senior Financial Officers. We have filed these codes as exhibits to this report.

We intend to satisfy the disclosure requirement under Item 10 of Form 8-K relating to amendments to or waivers from provision of these codes that relate to one or more of the items set forth in Item 406(b) of Regulation S-K, by describing on our Internet website, within five business days following the date of a waiver or a substantive amendment, the date of the waiver or amendment, the nature of the amendment or waiver, and the name of the person to whom the waiver was granted.

Information on our Internet website is not, and shall not be deemed to be, a part of this report or incorporated into any other filings we make with the Securities and Exchange Commission.

Item 11. Executive Compensation

Compensation of Executive Officers

The following table provides information concerning the annual and long-term compensation for the years ended December 31, 2003, 2002 and 2001 earned for services in all capacities as an employee by our Chief Executive Officer and each of our other executive officers who received an annual salary and bonus of more than $100,000 for services rendered to us during 2003 (collectively, the “named executive officers”):

Summary Compensation Table

Option Grants in Last Fiscal Year

We did not grant any stock options or stock appreciation rights to Mr. Shahbaz or Mr. Gillings during 2003.

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Aggregated Option Exercises and Fiscal Year-End Values

The following table provides information regarding the value of unexercised options held by Mr. Shahbaz and Mr. Gillings as of December 31, 2003. Mr. Shahbaz and Mr. Gillings did not acquire shares through the exercise of any options during the year ended December 31, 2003.

Employment Contracts and Termination of Employment and Change-in-Control Arrangements

On October 15, 2002, we entered into an employment agreement with Tony Shahbaz for Mr. Shahbaz to serve as our President and Chief Executive Officer. Under the terms of the employment agreement, which are effective as of January 1, 2002, Mr. Shahbaz is entitled to receive an initial annual salary of $198,500 and is eligible to receive quarterly bonuses equal to 7% of our quarterly net income. Mr. Shahbaz is also entitled to a monthly car allowance equal to $1,200. The employment agreement terminates on October 15, 2007; however, it is subject to automatic renewal. Under the terms of the employment agreement, if Mr. Shahbaz is terminated for cause, Mr. Shahbaz is entitled to receive four times his annual salary and any and all warrants and options granted to him shall be extended an additional seven years from date of termination. Under the employment agreement, upon termination without cause, Mr. Shahbaz shall be paid his remaining salary amount for the remaining outstanding term of the agreement. Mr. Shahbaz’s employment agreement further provides that the agreement shall not be terminated without the prior written consent of Mr. Shahbaz in the event of a merger, transfer of assets, or dissolution of I/OMagic, and that the rights, benefits, and obligations under the agreement shall be assigned to the surviving or resulting corporation or the transferee of I/OMagic’s assets.

I/OMagic and Mr. Shahbaz are presently in the process of negotiating a revised employment agreement.

Board Committees

Our board of directors currently has an audit committee, a compensation committee and a nominating committee.

The audit committee selects our independent auditors, reviews the results and scope of the audit and other services provided by our independent auditors and reviews our financial statements for each interim period and for our year end. Since November 2002, this committee has consisted of Mr. Daniel Hou and Mr. Daniel Yao. Our board of directors has determined that Mr. Yao is an audit committee financial expert. Our board of directors has also determined that Mr. Hou and Mr. Yao are “independent” as defined in NASD Marketplace Rule 4200(a)(15).

The compensation committee is responsible for establishing and administering our policies involving the compensation of all of our executive officers and establishing and recommending to our board of directors the terms and conditions of all employee and consultant compensation and benefit plans. Since April 2004, this committee has consisted of Mr. Hou and Mr. Yao.

The nominating committee selects nominees for the board of directors. Beginning in and since April 2004, the nominating committee has consisted of Mr. Hou and Mr. Yao. The nominating committee utilizes a variety of methods for identifying and evaluating nominees for director, including candidates that may be referred by stockholders. Stockholders that desire to recommend candidates for the board for evaluation may do so by contacting I/OMagic in writing, identifying the potential candidate and providing background information. Candidates may also come to the attention of the nominating committee through current board members, professional search firms and other persons. In evaluating potential candidates, the nominating committee will take into account a number of factors, including, among others, the following:

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