Smartdisk 10Q Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2002

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

COMMISSION FILE NUMBER: 000-27257

SMARTDISK CORPORATION

(Exact name of registrant as specified in its charter)

DELAWARE		65-0733580
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

3506 Mercantile Avenue, Naples, Florida 34104

(Address of principal executive offices)

(941) 436-2500

(Registrant’s telephone number, including area code)

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 ¨.

As of April 30, 2002, there were 17,762,901 shares of the Registrant’s Common Stock outstanding, par value $0.001.

SMARTDISK CORPORATION

INDEX

		Page

PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)	3

	1) Condensed Consolidated Balance Sheets as of March 31, 2002 and December 31, 2001	3

	2) Condensed Consolidated Statements of Operations for the three months ended March 31, 2002 and 2001	4

	3) Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2002 and 2001	5

	4) Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosure About Market Risk	33

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	35

Item 2.	Change in Securities and Use of Proceeds	35

Item 6.	Exhibits and Reports on Form 8-K	36

SIGNATURES		37

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SMARTDISK CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except par value)

	March 31, 2002			December 31, 2001
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	9,196		$	14,517
Accounts and notes receivable, net		4,902			4,924
Inventories		5,740			8,332
Prepaid expenses and other current assets		889			920

Total current assets		20,727			28,693
Property and equipment, net		1,421			1,869
Goodwill and other intangible assets, net		339			5,344
Deposits and other assets		166			172

TOTAL ASSETS	$	22,653		$	36,078

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	6,948		$	6,585
Bank line of credit		—			76
Income taxes payable		582			662
Other accrued liabilities		3,309			2,850

Total current liabilities		10,839			10,173
Deferred income taxes and other		—			791
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.001 par value; 5,000 shares authorized; none issued		—			—
Common stock, $0.001 par value; 60,000 shares authorized; 17,860 issued and 17,760 outstanding at March 31, 2002; 17,851 issued and 17,751 outstanding at December 31, 2001		18			18
Capital in excess of par value		146,724			146,716
Treasury stock, 100 shares at March 31, 2002 and December 31, 2001, at cost		(99	)		(99	)
Accumulated other comprehensive loss		(414	)		(634	)
Notes receivable from officers/employees		(295	)		(299	)
Unearned compensation		—			(3	)
Accumulated deficit		(134,120	)		(120,585	)

Total stockholders’ equity		11,814			25,114

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	22,653		$	36,078

See accompanying notes to condensed consolidated financial statements.

SMARTDISK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)

	Three Months Ended March 31,
	2002			2001
Revenues
Product sales, net	$	11,144		$	16,832
Royalty income and license fees		—			430

Total revenues		11,144			17,262
Cost of revenues
Cost of product sales		8,816			11,960
Inventory write-downs		4,803			469

Total cost of revenues		13,619			12,429

Gross (loss) profit		(2,475	)		4,833

Operating expenses
Research and development		904			2,194
Sales and marketing		1,800			2,269
General and administrative		2,874			2,574
Amortization and depreciation		2,553			8,180
Impairment of goodwill and other intangible assets		2,729			—
Business restructuring charges		841			—

Total operating expenses		11,701			15,217

Operating loss		(14,176	)		(10,384	)

Interest and other income (expense), net		(47	)		440

Net loss before income taxes		(14,223	)		(9,944	)

Income tax benefit		687			1,563

Net loss applicable to common stockholders	$	(13,536	)	$	(8,381	)

Basic and diluted earnings per share
Loss per share	$	(0.76	)	$	(0.48	)

Weighted average shares used to compute earnings per share—basic and diluted		17,723			17,328

See accompanying notes to condensed consolidated financial statements.

SMARTDISK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

	Three Months Ended March 31,
	2002			2001
Cash flows from operating activities:
Net loss	$	(13,536	)	$	(8,381	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization and depreciation		2,553			8,180
Impairment of goodwill and other intangible assets		2,729			—
Provision for uncollectible accounts, sales returns and other credits		1,789			288
Provision for inventory write-downs		4,803			469
Deferred income taxes		(791	)		(1,705	)
Other		179			(253	)
Changes in assets and liabilities:
Accounts and notes receivable		(1,767	)		(1,051	)
Inventories		(2,211	)		407
Prepaid expenses and other current assets		31			878
Deposits and other assets		6			(17	)
Accounts payable		363			(1,499	)
Income taxes payable		(80	)		(452	)
Deferred revenue		—			(363	)
Other accrued liabilities		459			(230	)

Net cash used in operating activities		(5,473	)		(3,729	)
Cash flows from investing activities:
Purchases of property and equipment, net of disposals		(7	)		(219	)
Cash paid for intellectual property		—			(250	)
Decrease in restricted cash		—			583
Sales and maturities of short-term investments		—			5,007

Net cash (used in) provided by investing activities		(7	)		5,121
Cash flows from financing activities:
Net repayments under lines of credit		(76	)		(696	)
Collections on notes receivable from officers/employees		3			3
Proceeds from exercise of stock options		9			12

Net cash used in financing activities		(64	)		(681	)

Effect of exchange rate fluctuations on cash		223			(277	)

Increase (decrease) in cash and cash equivalents		(5,321	)		434
Cash and cash equivalents at beginning of period		14,517			12,833

Cash and cash equivalents at end of period	$	9,196		$	13,267

See accompanying notes to condensed consolidated financial statements.

SMARTDISK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements for SmartDisk Corporation (“SmartDisk” or the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. In the opinion of management, all adjustments, including normal recurring accruals, considered necessary for a fair presentation have been included. Certain amounts in prior year’s condensed consolidated financial statements have been reclassified to conform to the current year’s presentation. The reclassifications had no effect on previously reported net loss or stockholders’ equity. Operating results for the three-month period ended March 31, 2002 are not necessarily indicative of the results that may be expected for the year ended December 31, 2002.

The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

The unaudited interim condensed consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in this report and the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, filed with the Securities and Exchange Commission.

Note 2. Inventories

Inventories are stated at the lower of cost or market (estimated net realizable value), with cost being determined on a first-in, first-out basis. Inventories consist of the following:

	March 31,		December 31,
	2002		2001
	(in thousands)
Finished goods	$	4,133	$	4,869
Raw materials		1,607		3,463

Total inventories	$	5,740	$	8,332

Note 3. Net Loss Per Share

For the three months ended March 31, 2002 and 2001, potential common shares totaling 336,735 and 559,155, respectively, were excluded from the computation of net loss per share because their effect was anti-dilutive. Potential common shares include stock options and shares of non-vested stock.

Note 4. Comprehensive Loss

Other comprehensive loss refers to revenues, expenses, gains, and losses that under accounting principles generally accepted in the United States are included in comprehensive loss but are excluded from net loss as these amounts are recorded directly as an adjustment to stockholders’ equity, net of tax. SmartDisk’s other comprehensive loss is composed of unrealized gains and losses on available-for-sale securities and foreign currency translation adjustments. The following table sets forth the computation of comprehensive loss for the periods indicated:

	Three Months Ended March 31,
	2002			2001
	(in thousands)
Net loss	$	(13,536	)	$	(8,381	)
Other comprehensive income (loss):
Unrealized gain (loss) on short-term investments, net of tax		—			1
Foreign currency translation		220			(425	)

Total comprehensive loss	$	(13,316	)	$	(8,805	)

Note 5. Business Restructuring

In the first quarter of 2002, the Company began the implementation of a restructuring plan in response to a decline in demand for its products and the competitive environment in which it operates and recorded a restructuring charge of $1.176 million. The restructuring plan includes an involuntary reduction in workforce of 21 employees across all business functions, the consolidation of the Company’s European facility and the curtailment of certain expenditures.

The elements of the restructuring costs related to the restructuring plan are as follows:

	Total Charge		Non-cash Charges		Cash Payments		Restructuring Liability at March 31, 2002
	(in thousands)
Workforce reduction	$	513	$	—	$	—	$	513
Facility lease and contract settlement costs	$	96	$	46	$	—	$	50
Write-down of property and equipment, net	$	232	$	232	$	—	$	—

Total	$	841	$	278	$	—	$	563

Note 6. Impairment of Goodwill and Other Intangible Assets

The Company continually evaluates the recoverability of its goodwill in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard (“SFAS”) No. 142,Goodwill and Other Intangible Assets. In addition, the Company continually evaluates the recoverability of its other intangible assets in accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets.

Under SFAS No. 142, goodwill of a reporting unit is tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances include, but are not limited to a significant adverse change in legal factors or in the business climate, unanticipated competition and a more-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of.

Under SFAS No. 142, goodwill is tested for impairment at a level of reporting referred to as a reporting unit. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. A two-step impairment test is used to identify potential goodwill impairment and measure the amount of a goodwill impairment loss to be recognized.

The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any.

The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.

The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in connection with a business combination is determined. That is, the fair value of a reporting unit is allocated to all assets and liabilities of that unit as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit. The excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill.

Under SFAS No. 144, an impairment review is performed if events occur or circumstances change indicating that the carrying amount might not be recoverable. Factors considered important which could trigger an impairment review include, but are not limited to, a significant decrease in the market value, a significant adverse change in legal factors or in the business climate, a current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses a current expectation that more-likely-than-not a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. If any of the impairment indicators are present or if other circumstances indicate that an impairment may exist, the Company must then determine whether an impairment loss should be recognized. An impairment loss can only be recognized if the undiscounted cash flows used to test for recoverability are less than the carrying value. If the Company determines that an impairment loss should be recognized, the impairment measured is based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in the Company’s current business model.

As a result of the significant decline in the operating results and cash flows of personal storage products and European operations, combined with marginal historical operating and cash flow results, the Company undertook its impairment reviews. Based on impairment reviews performed at March 31, 2002, in relation to the carrying values of goodwill and other intangible assets recorded in connection with the acquisitions of VST Technologies, Inc. and Impleo Limited, as well as a license obtained from SanDisk Corporation to sell FlashPath for the MultiMediaCard (“MMC”), a $2.729 million impairment charge is being provided to reduce the carrying value of the aforementioned assets to zero. The fair values used in measuring the impairment charge was determined based upon estimated discounted future cash flows. The assumptions supporting future cash flows, including the discount rate, were determined using the Company’s best estimates.

The changes in the carrying amount of goodwill for the quarter ended March 31, 2002 are as follows, in thousands:

Balance as of December 31, 2001	$	2,481
Impairment loss		(2,481	)

Balance as of March 31, 2002	$	—

Other intangible assets subject to amortization consist of the following:

	Life	March 31, 2002			December 31, 2001
		(in thousands)
Patents	2-3 yrs.	$	8,369		$	10,149
Distribution channels	2 yrs.		—			200
Trade names	1-2 yrs.		—			150
Covenants not to compete	2 yrs.		—			21,450
Licenses	10 yrs.		240			540

Total other intangible assets			8,609			32,489
Accumulated amortization			(8,270	)		(29,627	)

Other intangible assets, net		$	339		$	2,862

The aggregate amortization expense related to other intangible assets amounted to $2.3 million and $5.2 million for the three months ended March 31, 2002 and 2001, respectively.

Note 7. Segment Information

During the first quarter of 2002, SmartDisk began reporting its operations as one business segment. Previously, we had reported two business segments: Personal storage and digital connectivity. The change to one business segment was made to conform to organizational changes we made in the management of our business to more effectively utilize and deploy our assets on a world-wide basis.

Note 8. Contingencies

The Company relies on a combination of patents, trademarks, copyright and trade secret laws, confidentiality procedures and licensing arrangements to protect its intellectual property rights. There can be no assurance that there will not be any disputes regarding the Company’s intellectual property rights. Specifically, there can be no assurance that any patents held by the Company will not be invalidated, that patents will be issued for any of the Company’s pending applications or that any claims allowed from existing or pending patents will be of sufficient scope or strength or be issued in the primary countries where the Company’s products can be sold that will provide meaningful protection or any commercial advantage to the Company. Additionally, competitors of the Company may be able to design around the Company’s patents.

On June 26, 2000, a party filed a complaint in the Central District Federal Court of the State of California alleging SmartDisk’s infringement of a patent. On November 20, 2000, the Company prevailed in moving the venue for such action from the State of California to the Middle District of Florida. The Company considers this claim to be wholly without merit and will vigorously defend against such claim. Accordingly, the ultimate loss, if any, that may result cannot be reasonably determined and, accordingly, no accrual for this matter has been recorded as of March 31, 2002.

On July 26, 2001, a securities class action suit was filed against SmartDisk, the following executive officers and directors: Addison M. Fischer, Michael S. Battaglia and Michael R. Mattingly, and the following underwriters of SmartDisk’s initial public offering: FleetBoston Robertson Stephens, Inc. (formerly BancBoston Robertson Stephens, Inc.), Hambrecht & Quist LLC, and U.S. Bancorp Piper Jaffray, Inc. The suit was filed in the United States District Court for the Southern District of New York on behalf of all persons who acquired SmartDisk securities between October 6, 1999 and December 6, 2000. The complaint charges defendants with violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 (and Rule 10b-5 promulgated thereunder), for issuing a Registration Statement and Prospectus (“Prospectus”) that contained material misrepresentations and/or omissions. The complaint alleges that the Prospectus was false and misleading because it

failed to disclose (i) the agreements between FleetBoston Robertson Stephens, Inc., Hambrecht & Quist LLC, and U.S. Bancorp Piper Jaffray, Inc. and certain investors to provide them with significant amounts of restricted SmartDisk shares in the initial public offering (“IPO”) in exchange for excessive and undisclosed commissions; and (ii) the agreements between FleetBoston Robertson Stephens, Inc., Hambrecht & Quist LLC, and U.S. Bancorp Piper Jaffray, Inc. and certain customers under which the underwriters would allocate shares in the IPO to those customers in exchange for the customers’ agreement to purchase SmartDisk shares in the after-market at pre-determined prices. The complaint seeks an undisclosed amount of damages, as well as attorney fees. SmartDisk considers this claim, as it relates to the Company, to be wholly without merit and SmartDisk will vigorously defend against such claim. Accordingly, the ultimate loss, if any, that may result cannot be reasonably determined and, accordingly, no accrual for this matter has been recorded as of March 31, 2002.

On November 30, 2001, a complaint was filed in the Southern District of New York by Dynacore Holdings Corporation and Dynacore Patent Litigation Trust alleging SmartDisk’s infringement of said parties’ patent relating to local area network (“LAN”) capabilities. The complaint seeks an undisclosed amount of damages, injunction and recall, as well as attorney fees. The Company considers this claim, as it relates to SmartDisk, to be wholly without merit and will vigorously defend against such claim. Accordingly, the ultimate loss, if any, that may result cannot be reasonably determined and, accordingly, no accrual for this matter has been recorded as of March 31, 2002.

Note 9. Recent Accounting Pronouncements

Effective January 1, 2002, the Company adopted SFAS No. 141,Business Combinations. SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and broadens the criteria for recording intangible assets apart from goodwill. The Company evaluated its goodwill and other intangibles acquired prior to June 30, 2001 using the SFAS No. 141 criteria. This evaluation did not result in any reclassification between other intangible assets and goodwill at January 1, 2002. The adoption of SFAS No. 141 did not have a material impact on the Company’s financial position, results of operations or cash flows, but it will impact the accounting treatment of future acquisitions.

Effective January 1, 2002, the Company adopted SFAS No. 142,Goodwill and Other Intangible Assets. SFAS No. 142 requires that purchased goodwill and certain indefinite-lived intangibles no longer be amortized, but instead be tested for impairment at least annually, or more frequently is impairment indicators arise. The Company evaluated its intangible assets and believes that all such assets have determinable lives.

In accordance with SFAS No. 142, the effect of the accounting change for goodwill amortization is reflected prospectively. Supplemental comparative disclosure as if the change had been retroactively applied to the prior year period is as follows:

	Three Months Ended March 31,
	2002			2001

	(in thousands, except per share amounts)
Net loss:
Reported net loss	$	(13,536	)	$	(8,381	)
Goodwill amortization	$	—		$	2,426

Adjusted net loss	$	(13,536	)	$	(5,955	)

Loss per share—basic and diluted:
Reported loss per share	$	(0.76	)	$	(0.48	)
Goodwill amortization	$	—		$	0.14

Adjusted net loss per share	$	(0.76	)	$	(0.34	)

Shares used in per share computation		17,723			17,328

See Note 6 for further discussion regarding the impact of this SFAS and related impairment charge.

Effective January 1, 2002, the Company adopted SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supercedes SFAS No. 121,Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS No. 144 applies to all long-lived assets (including discontinued operations) and consequently amends APB Opinion No. 30,Reporting the Results of Operations, Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144 develops one accounting model for long-lived assets that are to be disposed of by sale. SFAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. The adoption of SFAS No. 144 did not have a material impact on the Company’s financial position, results of operations or cash flows.

See Note 6 for further discussion regarding the impact of this SFAS and related impairment charge.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the unaudited interim condensed consolidated financial statements and the notes thereto included in Item 1 of this Quarterly Report.

Certain statements in this report on Form 10-Q are forward-looking in nature within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Terminology such as “may,” “will,” “intend,” “expect,” “plan,” “anticipate,” “estimate,” “believe,” “continue,” “predict,” or other similar words identify forward-looking statements. Additional written or oral forward-looking statements may be made by the Company from time to time in press releases, annual or quarterly reports to stockholders, filings with the Securities and Exchange Commission, presentations or otherwise. These statements discuss future expectations, contain projections of results of operations or of financial condition or state other forward-looking information. Forward-looking statements appear in a number of places in this Form 10-Q and include statements regarding management’s intent, belief or current expectation about, among other things, the following: our anticipated growth strategies, including trends in revenues, costs, gross margins and profitability; our intention to develop, market and introduce new products; anticipated growth of digital appliances and technology industries; anticipated trends in our businesses, including trends in the demand for personal storage and digital appliances and, therefore, demand for our products; expectations of consumer preferences and desires; future projections of our financial performance, future expenditures for capital projects and research and development; the emergence of certain competing technologies; potential uses for and applications of our products; and our ability to continue to control costs and maintain quality. Although our management believes that the expectations reflected in these forward-looking statements are based on reasonable assumptions, forward-looking statements are not guarantees of future performance and involve risks and uncertainties that could cause actual results to differ materially from those in such forward-looking statements. Readers are cautioned not to place undue reliance on the forward-looking statements included in this document, which are based on information available to us on the date hereof and speak only as of the date hereof. We make no commitment to update or revise any such forward-looking statements or to disclose any facts, events, or circumstances after the date hereof that may affect the accuracy of any forward-looking statement. Actual results may differ materially from those predicted in the forward-looking statements as a result of various factors, including those set forth below in “Factors That May Affect Future Results of Operations” and in other documents that we file from time to time with the Securities and Exchange Commission.

All trade names referenced in this report are either trademarks or registered trademarks of their respective holders.

General

SmartDisk is a developer, manufacturer and marketer of a range of portable consumer electronic products and software solutions that are designed to enable the digital age and simplify the digital lifestyle. The Company’s products help users transfer, store, manage, share and preserve digital music, video, pictures and data. Headquartered in the U.S., with operations in Europe and Asia, SmartDisk sells its products worldwide.

We believe that rapid technology advances, consumer appetites for all things digital, and a worldwide economy increasingly dependent on computers and the Internet have created significant opportunities for SmartDisk. We provide consumer electronic devices and software solutions for moving, managing, creating, storing and preserving digital content among digital appliances, PCs and the Internet. Our products include external portable hard disk drives and floppy disk drives for desktop and notebook PCs, external CD-R/W recorders, flash memory card readers, and DVD and CD creation software. Our products are generally available for both Windows and Macintosh operating systems, allowing the retailers and original equipment manufacturers (OEMs) that market our products to reach a large installed base of potential users.

SmartDisk-branded products are now sold through many of the leading consumer electronics and computer retailers in the world as well as through the SmartDisk Web store. In addition, SmartDisk products can be found through distributors, value-added resellers, e-tailers and catalog companies.

Results of Operations

Revenues. Product revenues are recognized when title and risk of loss are transferred to customers, which is generally at the time of shipment. Recognition of revenue on shipments to certain distributors is deferred until the distributors have resold the products. In addition, a provision for estimated product returns is recorded at the time the related revenue is recognized on sales to certain resellers that have rights of return.

Total revenues were $11.144 million for the three months ended March 31, 2002 compared to $17.262 million for the three months ended March 31, 2001.

The decrease in revenues resulted from a decline in revenue generated from personal storage and digital connectivity products arising from ongoing weakness in product demand, competitive market and pricing pressures compounded by continued weakness in the worldwide economy, as well as the absence of royalty income and license fees in the three months ended March 31, 2002.

Product revenues from the sale of personal storage products decreased to approximately $8.4 million for the three months ended March 31, 2002 compared to approximately $10.6 million for the three months ended March 31, 2001.

The decrease in revenues from the sale of personal storage products is primarily attributable to a decline in demand for USB- and FireWire-based storage products arising from ongoing weakness in storage product demand. In addition, during the quarter, the sale prices of various personal storage products were reduced in order to stimulate product demand with the consequent impact on revenues. We expect the decline in sale prices of storage products to continue.

Product revenues from the sale of digital connectivity products decreased to approximately $2.8 million for the three months ended March 31, 2002 compared to approximately $6.2 million for the three months ended March 31, 2002.

The decrease in revenues from the sale of digital connectivity products is primarily attributable to a decline in sales of FlashPath products to OEM partners arising from the reduction in the use of the 3.5-inch floppy drive as a flash memory card interface. We expect the decline in sale of FlashPath products to continue as consumers move towards devices with higher transfer speeds resulting in lower revenue from digital connectivity products in 2002 than in 2001.

Royalty income and license fees primarily consist of fees earned from a license agreement on the Company’s SafeBoot intellectual property. This agreement terminated on June 30, 2001. We currently do not have plans to enter into any such licensing agreements.

Cost of Product Sales. Cost of product sales includes the purchased cost of product, packaging, storage, freight, scrap, as well as royalty payments payable on a number of personal storage and digital connectivity products.

Cost of product sales decreased to $8.816 million for the three months ended March 31, 2002 compared to $11.960 million for the three months ended March 31, 2001.

The decrease in cost of product sales is due primarily to lower sales volumes of personal storage and digital connectivity products.

Inventory Write-downs. Inventory write-downs relate to provisions associated with the carrying value of inventory, revaluing inventory to net realizable or market value, and excess and obsolete inventory.

Inventory write-downs for the three months ended March 31, 2002 increased to $4.803 million compared to $0.469 million for the three months ended March 31, 2001.

The increase in inventory write-downs is primarily due to (i) a reduction of approximately $3.2 million in the carrying value of a number of personal storage and software products necessitated by weak product sales and pricing pressures experienced during the quarter, (ii) a provision of approximately $0.7 million to cover excess and obsolete products and (iii) a provision of approximately $0.4 million to cover inventory issues in connection with the restructuring of the Company’s European facility associated with certain aging legacy storage products.

Gross (Loss) Profit. Gross loss for the three months ended March 31, 2002 was $2.475 million, or a negative 22.2% of total revenues compared to gross profit of $4.833 million, or 28.0% of total revenues, for the three months ended March 31, 2001. Excluding the impact of the inventory write-downs, gross profit for the three months ended March 31, 2002 amounted to $2.238 million, or 20.9% of total revenues, compared to $5.302 million, or 30.7% of total revenues, for the three months ended March 31, 2001.

The decrease in gross profit is primarily attributable to the inventory write-downs recorded during the quarter, lower sales volumes and associated gross profit, reduction in product demand and competitive pricing pressures. In addition, the impact of the reduction in carrying values of a number of personal storage and software products will adversely affect gross profit in future reporting periods in terms of absolute gross profit and as a percentage of total revenues earned.

Research and Development Expenses. Research and development expenses consist primarily of salaries and payroll-related expenses for design and development engineers, as well as prototype supplies and contract or professional services.

Research and development expenses decreased to $0.904 million, or 8% of total revenues, for the three months ended March 31, 2002 compared to $2.194 million, or 13% of total revenues, for the three months ended March 31, 2001.

The decrease in research and development expenses is primarily attributable to cost savings realized due to the closing of the Acton, Massachusetts operation as well as other actions taken to reduce operating expenses.

Research and development expenses related to personal storage and digital connectivity products were incurred to support the development of new products, such as our FireLite product range, as well as the maintenance and refresh of existing products.

Sales and Marketing Expenses. Sales and marketing expenses include salaries, benefits and travel expenses for our sales, marketing and product management personnel in the United

States, Japan and the United Kingdom. These expenses also include other selling and marketing expenditures for items such as trade shows, advertising, marketing and other promotional programs.

Sales and marketing expenses decreased to $1.800 million, or 16.2% of total revenues, for the three months ended March 31, 2002 compared to $2.269 million, or 13.1% of total revenues, for the three months ended March 31, 2001.

The decrease in sales and marketing expenses is primarily attributable to cost savings realized due to the closing of the Acton, Massachusetts operation as well as other actions taken to reduce operating expenses.

General and Administrative Expenses. General and administrative expenses include the salaries and related expenses of our executive management, finance, information systems, operations, human resources, legal and administrative functions, as well as bad debt expense, lease rental expense, utilities, maintenance expenses, taxes, insurance, and legal and accounting professional fees.

General and administrative expenses increased to $2.874 million, or 25.8% of total revenues, for the three months ended March 31, 2002 compared to $2.574 million, or 14.9% of total revenues, for the three months ended March 31, 2001.

The increase in general and administrative expenses is primarily attributable to cost savings realized due to the closing of the Acton, Massachusetts operation as well as other actions taken to reduce our operating expenses offset by an increase in the allowance for doubtful accounts of $0.933 million associated with certain aging receivables and provisions related to the restructuring of the Company’s European facility.

Amortization and Depreciation. Amortization includes the amortization of the purchase price allocated to the separately identified intangible assets acquired in the acquisitions of VST Technologies, Inc. and Impleo Limited and from El Gato Software LLC, as well as the amortization of other intangible assets, such as patents and licenses. The separately identified intangible assets acquired consist of non-compete agreements, distribution channels, trade names, patents, and workforce in place. These intangible assets have lives ranging from one to ten years from the date of acquisition. Depreciation includes the depreciation of property and equipment.

For the three months ended March 31, 2002, amortization and depreciation totaled $2.553 million compared to $8.180 million for the three months ended March 31, 2001.

The decrease is primarily attributable to the adoption of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standard (SFAS) No. 142,Accounting for Goodwill and Other Intangible Assets; whereby, starting on January 1, 2002, purchased goodwill is no longer amortized, and the decrease in the carrying amount of the separately identifiable intangible assets associated with the acquisitions of VST Technologies and Impleo Limited due to the impairment write-downs recorded in the three months ended September 30, 2001 and December 31, 2001, respectively.

Impairment of Goodwill and Other Intangible Assets. The Company continually evaluates the recoverability of its goodwill in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard (“SFAS”) No. 142,Goodwill and Other Intangible Assets. In addition, the Company continually evaluates the recoverability of its other intangible assets in accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets.

Business Restructuring Charges. In the first quarter of 2002, the Company began the implementation of a restructuring plan in response to a decline in demand for its products and the competitive environment in which it operates and recorded a restructuring charge of $0.841 million. The restructuring plan includes an involuntary reduction in workforce of 21 employees across all business functions, the consolidation of the Company’s European facility and the curtailment of certain expenditures.

The elements of the restructuring costs related to the restructuring plan are as follows:

	Total Charge		Non-cash Charges		Cash Payments		Restructuring Liability at March 31, 2002
	(in thousands)
Workforce reduction	$	513	$	—	$	—	$	513
Facility lease and contract settlement costs	$	96	$	46	$	—	$	50
Write-down of property and equipment, net	$	232	$	232	$	—	$	—

Total	$	841	$	278	$	—	$	563

Interest and Other Income (Expense), net. The primary components of interest and other income or expense are interest earned on cash, cash equivalents and short-term investments, gains or losses on foreign exchange and property and equipment write-downs.

Provision for Income Taxes. The Company is subject to tax in Japan, Switzerland, the United Kingdom and the United States. These jurisdictions have different marginal tax rates. For the three months ended March 31, 2002, the Company recorded an income tax benefit of $0.687 million. This benefit results from an income tax expense of $0.104 million, offset by income tax benefits of $0.791 million resulting from amortization expense on certain intangible assets related to the VST and Impleo acquisitions. A valuation allowance is provided to reduce deferred tax assets to the amount that will more likely than not be realized.

Liquidity and Capital Resources

Cash and cash equivalents decreased to $9.196 million at March 31, 2002 from $14.517 million at December 31, 2001.

The decrease in cash and cash equivalents of $5.312 million reflected (i) net cash used in operating activities of $5.473 million, (ii) net cash used in investing and financing activities of $0.071 million and (iii) the positive effect of exchange rate fluctuation on cash of $0.223 million.

Net cash used in operating activities was $5.473 million for the three months ended March 31, 2002 compared to $3.729 million for the three months ended March 31, 2001.

Net cash used in operating activities of $5.473 million in the quarter ended March 31, 2002 reflected (i) net cash loss of $2.274 million and (ii) investment in working capital of $3.199 million predominatly to fund increased accounts receivable of $1.767 million due to the phasing of sales in the quarter, increased inventory of $2.211 million due to a reduction in sales activity for certain products and purchases of new products offset by increases in accounts payable of $0.363 million due to inventory purchases and other accrued liabilities of $0.459 million due to business restructuring charges.

The increase in cash used in operating activities of $1.744 million for the three months ended March 31, 2002 compared to the three months ended March 31, 2001 reflected (i) increased cash loss of $1.303 million and (ii) increased investment in working capital of $0.441 million.

Net cash used in investing activities was $0.007 million for the three months ended March 31, 2002 compared to cash provided by investing activities of $5.121 million for the three months ended March 31, 2001.

The decrease in net cash provided by investing activities of $5.128 million resulted primarily from the absence of activity from sales and maturities of short-term investments of $5.007 million and the release of restricted cash of $0.583 million in the quarter ended March 31, 2001 offset by the reduction in fixed asset investment of $0.462 million.

Net cash used in financing activities was $0.064 million and $0.681 million for the three months ended March 31, 2002 and 2001, respectively.

The decrease in net cash used in financing activities was primarily due to the decrease in repayments under lines of credit.

The Company maintains a line of credit in the United States under which it may borrow up to $4.8 million. Any amounts borrowed under the line of credit bear interest at 2% over the 30-day LIBOR rate and is secured by certain short-term investments. The line of credit expires in July 2002. As of March 31, 2002, the Company had not borrowed against the line of credit.

At March 31, 2002, the Company had $2.750 million in standby letters of credit outstanding, which were issued to certain vendors to guarantee credit terms. Vendors may not draw against the standby letters of credit as long as vendor invoices are paid within established credit terms. As of March 31, 2002, none of the standby letters of credit had been drawn on.

In light of the Company’s loss and decline in cash, the Company may need to raise additional capital to fund losses, expand sales, develop and market new or enhanced products, respond to competitive pressures or acquire complementary products, businesses or technologies during 2002. Such capital, if required, may not be available to the Company or may be available on terms unacceptable to the Company.

Critical Accounting Policies and Significant Estimates

Our significant accounting policies are outlined within Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2001. Some of those accounting policies require us to make estimates and assumptions that affect the amounts reported by us. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. For the quarter ended March 31, 2002, the following items required the most significant judgments and involved complex estimation:

Allowance for Doubtful Accounts

We evaluate the collectibility of our accounts receivable based on a combination of factors. In circumstances where we are aware of a specific customer’s inability to meet its financial obligations to us (e.g., bankruptcy filings, substantive downgrading of credit scores), we record a specific reserve for bad debts against amounts due to reduce the net recognized receivable to the amount we reasonably believe will be collected. For all other customers, we recognize reserves for bad debts based on the length of time the receivables are past due ranging from 3% for current amounts to 100% for amounts more than 90 days past due based on our historical experience on a weighted average basis over the prior two years. If circumstances change (i.e., higher than expected defaults or an unexpected material adverse change in a major customer’s ability to meet its financial obligations to us), our estimates of the recoverability of amounts due us could be reduced by a material amount.

Inventory Reserves

We evaluate the need for reserves based on a quarterly review of forecasted demand and market values for our products. Inventory reserves are established to the extent that the cost of the inventory exceeds the estimated market value of the inventory based on assumptions regarding future demand in relation to existing inventory balances and market conditions. Inventory reserves are applied directly to specific items. Short product life cycles are inherent in the high-technology market. Product and technology transitions announced by us or our competitors, delays in the availability of new products, changes in the purchasing patterns of our customers and distribution partners, or adverse global economic conditions may materially affect estimates of our inventory reserve requirements resulting in additional inventory write-downs.

Recent Accounting Pronouncements

Effective January 1, 2002, the Company adopted SFAS No. 141,Business Combinations. SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and broadens the criteria for recording intangible assets apart from goodwill. The Company evaluated our goodwill and other intangibles acquired prior to June 30, 2001 using the SFAS No. 141 criteria. This evaluation did not result in any reclassification between other intangible assets and goodwill at January 1, 2002. The adoption of SFAS No. 141 did not have a material impact on the Company’s financial position, results of operations or cash flows, but it will impact the accounting treatment of future acquisitions.

Effective January 1, 2002, the company adopted SFAS No. 142,Goodwill and Other Intangible Assets. SFAS No. 142 requires that purchased goodwill and certain indefinite-lived intangibles no longer be amortized, but instead be tested for impairment at least annually, or more frequently is impairment indicators arise. We evaluated our intangible assets and believe that all such assets have determinable lives. If SFAS No. 142 had been in effect during the comparative quarter in 2001, the Company’s net loss would have been reduced by approximately $2.4 million, or $0.14 per share.

See Note 6 to the condensed consolidated financial statements for further discussion regarding the impact of this statement and related impairment charge.

Effective January 1, 2002, the Company adopted SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supercedes SFAS No. 121,Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.SFAS No. 144 applies to all long-lived assets (including discontinued operations) and consequently amends APB Opinion No. 30,Reporting the Results of Operations, Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.SFAS No. 144 develops one accounting model for long-lived assets that are to be disposed of by sale. SFAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. The adoption of SFAS No. 144 did not have a material impact on the Company’s financial position, results of operations or cash flows.

See Note 6 to the condensed consolidated financial statements for further discussion regarding the impact of this statement and related impairment charge.

Factors That May Affect Future Results of Operations

Our business, results of operations and financial condition could be adversely affected by a number of factors, including the following:

We have incurred net losses and cannot guarantee that we will be profitable in the future.

Except for the third and fourth quarters of 1999, we have incurred net losses on a quarterly basis since inception. We had a net loss of approximately $13.5 million for the quarter ended March 31, 2002. In addition, as of March 31, 2002, we had an accumulated deficit of approximately $134.1 million. In light of our loss history, we cannot assure you that we will be profitable in the future.

Reduced consumer demand for our FlashPath products may have a significant impact on our business.

Our current FlashPath products and other flash media readers are designed to provide connectivity between personal computers and digital appliances that use flash memory cards. Our current dependence on sales of FlashPath exposes us to a substantial risk of loss in the event that the flash memory market does not continue or if a competing technology replaces flash memory cards. If a competing memory storage device replaces or takes significant market share from the

flash memory cards which our digital connectivity products support, we will not be able to sell our products in quantities sufficient to grow or maintain our current business.

Since our FlashPath products work only in conjunction with the 3.5-inch floppy disk drive, advances in flash memory cards may make these products less competitive because of the increased time needed to transfer data using the 3.5-inch floppy disk drive.

Consumer acceptance of our FlashPath products depends upon their ability to quickly transfer information from flash memory cards to PCs. However, the time needed to transfer information using a 3.5-inch disk drive increases as more data is transferred. As more memory is condensed onto flash memory cards, the time necessary to transfer all of the data from a single card will increase. As technological advances make it possible and feasible to produce higher density cards, FlashPath will be constrained by the inherent limitations of the 3.5-inch disk drive. In that case, FlashPath would be less attractive to consumers and our sales would decline.

A reduction in the use of the 3.5-inch floppy disk drive by consumers and manufacturers is contributing to the decrease in sales of our FlashPath products.

Our current FlashPath products only work in conjunction with the standard 3.5-inch floppy disk drive. While the 3.5-inch floppy disk drive is found today in most PCs, a number of newer PC models do not have this device and new industry standards may emerge that render the 3.5-inch floppy disk drive obsolete. Advances in input devices such as CD-ROM and external data storage disk drives, such as Zip drives, are reducing the need for the 3.5-inch floppy diskette, which is contributing to the decrease in sales of our FlashPath products. In the future, we will have to rely on our other products and develop or acquire new products that use a different interface between personal computers and digital appliances.

Our sales of digital connectivity products may also be harmed if a single standard for flash memory cards emerges.

We believe that demand for our flash memory connectivity products is also driven, to a large extent, by the absence of a single standard for flash memory cards. There are currently five major flash memory cards, none of which has emerged as the industry standard. Should one of these cards or a new technology emerge as an industry standard, flash memory card readers could be built into PCs, eliminating the need for our current flash memory connectivity products.

We may not be able to sell sufficient quantities of our personal storage products to sustain our future growth if PC manufacturers do not adopt IEEE 1394 as a high-speed peripheral interface or if a competing CPU interface displaces or prevents the widespread adoption of IEEE 1394.

A substantial portion of our business depends on the adoption of Institute of Electrical and Electronics Engineering, or IEEE, 1394 technology by PC manufacturers. IEEE 1394 is a high speed PC interface that is replacing Small Computer System Interface, or SCSI, and parallel interfaces. If these manufacturers do not include an IEEE 1394 interface on their PCs or notebook computers, then we may not be able to sell sufficient quantities of our FireWire personal storage products to support our future growth. FireWire is Apple’s trade name for

IEEE 1394. For example, a competing high-speed interface, such as Universal Serial Bus, or USB, 2.0, could emerge as an industry standard, thus limiting the demand for our FireWire technology and related personal storage products.

We may not be able to sell sufficient quantities of our personal storage products to support our business if suppliers of our drives develop native FireWire-based personal storage products that do not require our FireWire conversion technology.

We embed conversion ASICs and integrated software drivers in the hard disk drives we obtain from our suppliers, which enables our FireWire-based personal storage products to be used with FireWire-equipped computers. We license this technology and the firmware from LSI Logic, Texas Instruments and other integrated circuit suppliers. If our suppliers of drives were to develop a native FireWire solution that does not require the conversion ASICs and drivers embedded in our products, then we may not be able to sell sufficient quantities of our FireWire personal storage products to support our business.

Most of our revenue is derived from only a few major products and our business is being seriously harmed as demand for those products declines.

To date, substantially all of our revenue has been derived from the sale of only a few major products. While our long-term strategy is to derive revenue from multiple products, we anticipate that the sale of our FlashPath products and our USB and FireWire storage products will continue to represent the most substantial portion of our net revenue through 2002 and into 2003. During the quarter ended March 31, 2002, we derived approximately 70% of our product revenue from the sale of FlashPath and USB- and FireWire–based personal storage products. Sales of these products have been declining for the past three consecutive quarters, which is seriously harming our business.

The decrease in revenues from the sale of personal storage products is primarily attributable to a decline in demand for USB- and FireWire-based storage products arising from ongoing weakness in storage product demand. In addition, during the three months ended March 31, 2002, the sale prices of various personal storage products were reduced in order to stimulate product demand with the consequent impact on revenues. We expect the decline in sale prices of storage products to continue.

We must develop or acquire new products and introduce them in a timely manner in order to remain competitive.

We operate in an industry that is subject to evolving industry standards, rapid technological changes, rapid changes in consumer demands and the rapid introduction of new, higher performance products that shorten product life cycles. To be competitive in this demanding market, we must both continue to refine current products so that they remain competitive, and continually design, develop and introduce, in a timely manner, new products that meet the performance and price demands of OEMs and consumers. To date, we have not developed new products that reduce our dependence on FlashPath and USB- and FireWire-based personal storage products. If we are unable to develop new products in a timely manner, then we must acquire new products or product technologies. Product development is inherently risky because it is difficult to foresee developments in technology, coordinate our technical personnel and strategic relationships, and identify and eliminate design flaws. These development activities will require the investment of substantial resources before revenue is derived from product sales. Any significant delay in releasing new products would adversely affect our reputation, provide a competitor a first-to-market opportunity or allow a competitor to achieve greater market share. Further, we may not be able to recoup research and development expenditures if new products are not widely commercially accepted.

We may not be able to develop or maintain the strategic relationships necessary to provide us with the insight we need to develop commercially viable products.

We may not be able to produce commercially viable products if we are unable to anticipate market trends and the price, performance and functionality requirements of flash memory card, PC and digital appliance manufacturers. We must continue to collaborate closely with our customers, our OEM manufacturers and our other contract manufacturers to ensure that critical development projects proceed in a coordinated manner. This collaboration is also important because our ability to anticipate trends and plan our product development activities depends to a significant degree upon our continued access to information derived from these strategic relationships. We currently rely on strategic relationships with flash memory card manufacturers, such as Toshiba and PC manufacturers, such as Apple, and consumer product OEMs, such as Olympus and FujiFilm. If we cannot maintain our relationship with these manufacturers, we may not be able to continue to develop products that are compatible with their flash memory cards, PCs and digital appliances. However, collaboration is more difficult because many of these companies are located overseas. If any of our current relationships deteriorates or is terminated, or if we are unable to enter into future alliances that provide us with comparable insight into market trends, we will be hindered in our ability to produce commercially viable products.

We may not be able to sustain our relationship with Apple Computer which would greatly hinder our ability to timely develop products which are compatible with Macintosh operating systems.

Historically, Apple has provided us, as an Apple developer, access to selected product road maps, which has allowed us to timely develop and engineer many of our current products, including our current FireWire and USB storage products. As a result of this collaborative relationship, we have received a substantial portion of our historical revenue from direct sales to Apple users. Moreover, we anticipate that a significant portion of our product revenue will continue to be derived from sales of our Apple compatible products in the near future. If there was a material deterioration of our relationship with Apple, we would not be able to timely develop new technologies that are compatible with Apple’s product road maps and this would have an adverse effect on our business. Moreover, we currently sell a number of our Apple products through the Apple Web Store, where our products may be sold separately or may be configured and ordered along with a Macintosh computer. While we do not anticipate any change in this arrangement, Apple is not contractually obligated to offer our products on their website.

A decline in the demand for Apple products would further reduce the market for many of our products.

Our growth depends to a large extent on both our strategic relationship with Apple and demand for Apple products. This dependence is due primarily to the fact that, to date, Apple has been the principal PC manufacturer using the FireWire interface technology on which many of our products are based. If a decline in the demand for Apple products occurs or if Apple suffers a material change in its business, the market for many of our products would be negatively impacted.

Our operating results have fluctuated significantly and may fluctuate significantly in the future, which could lead to decreases in our stock price.

Our operating results have fluctuated significantly in the past and we expect that they will continue to fluctuate in the future. If our future operating results materially fluctuate or are below the expectations of stock market analysts, our stock price would likely decline further. Future fluctuations may result from a variety of factors including the following:

The timing and amount of orders we receive from our customers, which may be tied to seasonal demand for the consumer products manufactured and sold by OEMs;

Cancellations or delays of customer product orders, or the loss of a significant customer;

Reductions in consumer demand for our customers’ products in general, such as Apple products, or for our products in particular, such as FlashPath;

The timing and amount of research and development expenditures;

The availability of manufacturing capacity necessary to make our products;

General business conditions in our markets in the United States, Japan and Europe, as well as general economic and political conditions;

Any new product introductions, or delays in product introductions, by us or our competitors;

Increased costs charged by our suppliers or changes in the delivery of products to us;

Increased competition or reductions in the average selling prices that we are able to charge;

Fluctuations in the value of foreign currencies, particularly the Japanese yen and British Pound, against the U.S. dollar; and

Changes in our product mix as well as possible seasonal demand for our products.

As a result of these and other factors, we believe that period-to-period comparisons of our historical results of operations are not a good predictor of our future performance.

The stock market has experienced significant price and volume fluctuations that have particularly affected the market prices of the stocks of technology companies. Recently, the market price of our common stock, like that of many technology companies, has experienced significant fluctuations. For instance, from October 6, 1999, the date of our IPO, to April 30, 2002, the reported last sale price for our common stock ranged from $1.10 to $65.13 per share. On April 30, 2002, the reported last sale price of our common stock was $1.20 per share.

The market price of our common stock also has been and is likely to continue to be significantly affected by expectations of analysts and investors. Reports and statements of

analysts do not necessarily reflect our views. The fact that we have in the past met or exceeded analyst or investor expectations does not necessarily mean that we will do so in the future.

We may fail to adequately protect our intellectual property and, therefore, lose our competitive advantage.

Our proprietary technology with respect to 3.5-inch floppy disk drive interfaces and USB and FireWire source codes is critical to our future growth. We rely in part on patent, trade secret, trademark and copyright law to protect our intellectual property. However, the patents issued to us may not be adequate to protect our proprietary rights, to deter misappropriation or to prevent an unauthorized third party from copying our technology, designing around the patents we own or otherwise obtaining and using our products, designs or other information. In addition, we may not receive trademark protection for our “SmartDisk” name. We have filed for trademark registration of the name “SmartDisk,” but this has not yet been granted. We are aware of a trademark application for the name “SmartDisk” that was filed by another company. Our application could be denied and we could be prohibited from using the “SmartDisk” name. In that event, we would be required to incur substantial costs to establish new name recognition.

We also claim copyright protection for some proprietary software and documentation. We attempt to protect our trade secrets and other proprietary information through agreements with our customers, employees and consultants, and through other security measures. However, despite our efforts to protect our intellectual property, unauthorized parties may attempt to copy aspects of our products or obtain and use information and software that we regard as proprietary. Those parties may have substantially greater financial resources than we have, and we may not have the resources available to challenge their use of our proprietary technology. If we fail to adequately protect our intellectual property, it will be easier for our competitors to sell competing products.

We may face competition from Intel if it decides to utilize its competing patent.

Intel Corporation was issued a patent in 1997 disclosing and claiming technology substantially similar to that disclosed in one of our key patents. The Intel patent was filed four years after our effective filing date, and we do not believe that the Intel patent can be validly applied to any of the technology disclosed in our patent. However, given the substantial resources available to Intel, our financial condition could suffer if we engage in a dispute with Intel. Our business could also be harmed if Intel’s patent is determined to be valid and Intel or any licensee of Intel decides to sue our customers or develop and commercialize products based on its patent.

Infringement claims by third parties could result in costly litigation and otherwise adversely impact our business.

From time to time we may receive communications from third parties asserting that our products infringe, or may infringe, the proprietary rights of these third parties. These claims of infringement may result in protracted and costly litigation that could require us to pay substantial damages or have sales of our products stopped by an injunction. Infringement claims could also cause product shipment delays, require us to redesign our products or require us to enter into

royalty or licensing agreements, any of which could harm our business. For example, we received communications alleging that our FlashPath products infringed a third party’s patent rights. We have met with this third party, a non-public limited liability company, to gain a better understanding of its claim and attempted to resolve the dispute through mediation. Such mediation did not yield a resolution to the dispute and such party subsequently filed a complaint in the Central District Federal Court of the State of California. On November 20, 2000, we prevailed in moving the venue for such action from the State of California to the Middle District of Florida. While we believe that we do not infringe upon this third party’s patent and that such claim is wholly without merit, we cannot guarantee that the effects or outcome of this litigation will be favorable to us. Further, a complaint was filed on November 30, 2001 in the Southern District of New York by Dynacore Holdings Corporation and Dynacore Patent Litigation Trust alleging our infringement of said parties’ patent relating to local area network capabilities. The complaint seeks an undisclosed amount of damages, injunction and recall, as well as attorney fees. While we consider this claim, as it relates to us, to be wholly without merit, we cannot guarantee that the effects or outcome of this litigation will be favorable to us. In addition, we license a portion of the intellectual property included in our products from third parties, which may increase our exposure to infringement actions because we rely upon those third parties for information about the origin and ownership of the licensed intellectual property. We may also lose our license rights with respect to the intellectual property for which infringement is claimed. Further, if our customers are required to obtain a license on other than commercially reasonable terms, our business could be jeopardized.

We have indemnification obligations related to our intellectual property, which may require us to pay damages.

Our arrangements with Fuji Photo USA, Iomega, SanDisk, Sony, Toshiba and others require us to indemnify them for any damages they may suffer if a third party claims that we are violating their intellectual property rights. While, to date, we have not received indemnification claims, there may be future claims. For example, Fuji Photo USA has been named as a co-defendant in the above referenced complaint initiated in California. We have agreed to indemnify Fuji Photo USA with respect to expenses or damages incurred by Fuji Photo USA in connection with this matter. Any indemnification claim may require us to pay substantial damages, which could negatively impact our financial condition.

Any settlement or claim awarded against us as a result of the securities class action suit filed against us could negatively affect our operating results and financial condition.

registration statement and prospectus that contained material misrepresentations and/or omissions. The complaint alleges that the prospectus was false and misleading because it failed to disclose (i) the agreements between FleetBoston Robertson Stephens, Inc., Hambrecht & Quist LLC, and U.S. Bancorp Piper Jaffray, Inc. and certain investors to provide them with significant amounts of restricted shares of our common stock in the IPO in exchange for excessive and undisclosed commissions; and (ii) the agreements between FleetBoston Robertson Stephens, Inc., Hambrecht & Quist LLC, and U.S. Bancorp Piper Jaffray, Inc. and certain customers under which the underwriters would allocate shares of our common stock in the IPO to those customers in exchange for the customers’ agreement to purchase shares of our common stock in the after-market at pre-determined prices. The complaint seeks an undisclosed amount of damages, as well as attorney fees. We consider this claim, as it relates to us, to be wholly without merit and we will vigorously defend against such claim. Any settlement or claim awarded against us as a result of the securities class action suit filed against us could negatively affect our operating results and financial condition.

During 2001, three additional class action suits were filed against one of the underwriters in our initial public offering, FleetBoston Robertson Stephens, Inc. The suits were also filed in the United States District Court for the Southern District of New York on behalf of all persons who acquired our common stock between October 6, 1999 and December 6, 2000. These complaints make similar allegations that the registration statement and prospectus violate section 10(b) of the Exchange Act and Rule 10b-5 as a result of the undisclosed agreements between FleetBoston Robertson Stephens and certain inventors and customers. The complaints seek an undisclosed amount of damages, as well as attorney fees.

We may have particular difficulty protecting our intellectual property rights overseas.

The laws of some foreign countries do not protect proprietary rights to as great an extent as do the laws of the United States, and many U.S. companies have encountered substantial infringement problems in some foreign countries. Because many of our products are sold and a portion of our business is conducted overseas, primarily Japan and Europe, our exposure to intellectual property risks may be higher.

Because most of our sales are to a relatively small number of customers the loss of any of our key customers would seriously harm our business.

Our business will be seriously harmed if we lose any of our significant customers, particularly Apple, Ingram Micro or Sony, or suffer a substantial reduction in or cancellation of orders from these customers. Our current distribution strategy results in sales to a limited number of customers, which account for a significant portion of our net revenue. Some of our products are sold as stand-alone products by OEMs and, to a lesser extent, are bundled together and sold with systems manufactured by third party OEMs. During the quarter ended March 31, 2002, CompUSA, Apple, and Ingram Micro accounted for approximately 12%, 13% and 20% of our revenue, respectively, and our top five customers collectively accounted for approximately 58% of our revenue. We expect sales of our products to a limited number of customers to account for a significant portion of our net revenue during 2002.

Since we sell our products to a limited number of large customers, we expect that those customers may pressure us to make price concessions, which would reduce our future gross margins.

Our reliance on sales to a limited number of large customers may expose us to pressure for price concessions. Because of this reliance and because of our dependence on OEMs and distributors as a significant distribution channel, we expect that they may seek price concessions from us, which would reduce our average selling prices and our gross margins. Since we do not manufacture our own products, we may be unable to reduce our manufacturing costs in response to declining average per unit selling prices.

Our customers could stop purchasing our products at any time because we do not have long-term purchase contracts with them.

No OEM or other customer is contractually obligated to purchase products from us. As a result, our customers are free to cancel their orders or stop ordering our products at any time. In addition, even if we are able to demonstrate that our products are superior, OEMs may still choose not to bundle our products with theirs or market and distribute our products on a stand-alone basis. OEMs may also change their business strategies and manufacturing practices, which could cause them to purchase fewer of our products, find other sources for products we currently manufacture or manufacture these products internally.

Our ability to sell our products will be limited if the OEMs’ products do not achieve market acceptance or if the OEMs do not adequately promote our products.

We depend upon our OEM customers to market certain of our products. Failure of the OEMs’ products to achieve market acceptance, the failure of the OEMs to bundle our products with theirs, or any other event causing a decline in our sales to the OEMs could seriously harm our business. Even if consumers buy OEMs’ products, their ultimate decision to buy our products depends on OEM packaging, distribution and sales efforts, which may not be sufficient to maintain or increase sales of our products. If we cannot achieve or maintain a sufficient consumer acceptance rate of our products concurrent with their purchases of OEM products, our future sales to OEM customers will be adversely affected.

A new or competing data transfer solution that achieves significant market share or receives significant support from manufacturers would jeopardize our business.

Our products currently compete with a number of cable and non-cable interfaces between personal computers and digital appliances, including ports, PCMCIA slots and infrared interfaces, all of which are PC peripheral interfaces. It is possible that one of these competing data transfer solutions, or another existing or new technology, could achieve a significant market presence or become supported by a number of significant flash memory card, personal storage or digital appliance manufacturers. Regardless of the relative benefits of our products, if a competing product gains significant market share or significant support of flash card manufacturers, this product would likely emerge as the industry standard and thereby achieve a dominant market position that would jeopardize our survival.

We expect to continue outsourcing key operational functions and our ability to do so will be impaired if we are unable to maintain our strategic relationships.

We have formed strategic relationships with a number of significant industry participants, including Apple, FujiFilm, Mitsumi, Olympus, Sony, Toshiba and Yamaichi. We depend upon these corporations to provide technical assistance and perform key manufacturing, marketing, distribution and other functions. For example, Yamaichi and Mitsumi currently manufacture some of our products, Toshiba and Apple provide technological assistance in the development of our products and Sony and Olympus market certain of our products. We expect that these and similar types of relationships will be critical to our business because we intend to continue outsourcing many key operational functions and we do not currently have the resources to perform these functions ourselves.

We must overcome geographic and cultural differences in order to maintain our strategic relationships.

There are inherent difficulties in developing and maintaining relationships with foreign entities. Language and cultural differences often impair relationships, and geographical distance, at times, is also an impediment. If any of our current relationships is impaired, or if we are unable to develop additional strategic relationships in the future, our product development costs would significantly increase and our business would be materially and adversely affected.

A portion of our sales and expenses are geographically concentrated in Japan, and, therefore, we could suffer from exchange rate fluctuations and economic and political difficulties.

Approximately 12% and 9% of our revenue for the quarter ended March 31, 2002 was attributable to sales to Japanese and European customers, respectively. We expect sales to Japanese and European customers will continue to account for a significant portion of our total revenue for the foreseeable future. All of our Japanese sales, as well as the related expenses, are denominated in Japanese yen. Fluctuations in exchange rates between the yen and the U.S. dollar, particularly with respect to Japanese transactions denominated in a currency other than the yen, could adversely impact our financial results. All of our European sales, as well as the related expenses, are denominated in British pounds. Fluctuations in exchange rates between the pound and the U.S. dollar, particularly with respect to European transactions denominated in a currency other than the pound, could adversely impact our financial results. Some transactions and accounts of our Japanese and European subsidiary are U.S. dollar denominated. Since the foreign subsidiaries’ accounting records are kept in local currency, those U.S. dollar denominated transactions are accounted for using the local currency at the time of the transaction. U.S. dollar denominated accounts are remeasured at the end of the accounting period. This remeasurement results in adjustments to income. In addition, the balance sheet accounts of our foreign subsidiaries are translated to the U.S. dollar for financial reporting purposes and resulting adjustments are made to stockholders equity. The value of the Japanese yen and the British pound may deteriorate against the dollar, which would impair the value of stockholders’ investment in us. Fluctuations in the value of the Japanese yen and the British pound against the dollar have occurred in the quarter ended March 31, 2002. These fluctuations resulted in a foreign currency translation adjustment to increase stockholders’ equity by approximately $0.2

million as of March 31, 2002. Further, we do not currently hedge against foreign currency exposure. In the future, we could be required to denominate our product sales in other currencies, which would make the management of currency fluctuations more difficult and expose us to greater currency risks.

We depend on a limited number of contract and offshore manufacturers, and it may be difficult to find replacement manufacturers if our existing relationships are impaired.

We contract with offshore manufacturers to produce some of our products and our dependence on a limited number of contract manufacturers exposes us to a variety of risks, including shortages of manufacturing capacity, reduced control over delivery schedules, quality assurance, production yield and costs. For example, Yamaichi and Mitsumi are the sole manufacturers of our FlashPath products and Jess-Link is the sole manufacturer of our hard drive products. If Yamaichi, Mitsumi or Jess-Link terminates production, or cannot meet our production requirements, we may have to rely on other contract manufacturing sources or identify and qualify new contract manufacturers. The lead-time required to qualify a new manufacturer could range from three to six months. Despite efforts to do so, we may not be able to identify or qualify new contract manufacturers in a timely manner and these new manufacturers may not allocate sufficient capacity to us in order to meet our requirements. Any significant delay in our ability to obtain adequate quantities of our products from our current or alternative contract manufacturers would cause our sales to decline.

Our dependence on foreign manufacturing and international sales exposes us to difficulties often not encountered by exclusively domestic companies.

Many of our products are manufactured overseas and a significant portion of our revenue is derived from overseas sales. Approximately 21% of our revenue during the quarter ended March 31, 2002 was derived from customers located outside the United States. Our dependence on foreign manufacturers and international sales poses a number of risks, including:

Difficulties in monitoring production;

Transportation delays and interruptions;

Unexpected changes in regulatory requirements;

Currency exchange risks;

Tariffs and other trade barriers, including import and export restrictions;

Difficulties in staffing and managing disparate branch operations;

Political or economic instability;

Compliance with foreign laws;

Difficulties in protecting intellectual property rights in foreign countries;

Exchange controls; and

Potential adverse tax consequences, including with respect to repatriation of earnings.

We intend to continue manufacturing our products overseas and we anticipate that international sales will continue to account for a significant portion of our revenue. Therefore, we expect to be subject to the risks outlined above for the foreseeable future.

We have a limited number of suppliers of key components and our ability to produce finished products will be impaired if we are unable to obtain sufficient quantities of some components.

Rohm is our sole provider of application specific integrated circuits, or ASICs, for our FlashPath products. In our FlashPath products, the specific function of these integrated circuits is the conversion of digital and analog data. In addition, LSI Logic and Texas Instruments are our primary suppliers of ASICs for our FireWire products. Our dependence on a limited number of suppliers and our lack of long-term supply contracts exposes us to several risks, including a potential inability to obtain an adequate supply of components, price increases, late deliveries and poor component quality. Disruption or termination of the supply of components could delay shipments of our products. The lead-time required for orders of some of our components is as much as six months. In addition, the lead-time required to qualify new suppliers for our components is as much as 12 months. If we are unable to accurately predict our component needs, or if our component supply is disrupted, we may miss market opportunities by not being able to meet the demand for our products. This may damage our relationships with current and prospective customers.

Our current and potential competitors have significantly greater resources than we do, and increased competition could harm sales of our products.

Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing and other resources than we do. As a result, some of our competitors may be able to respond more quickly to new or emerging technologies or standards or to changes in customer requirements. Our competitors may also be able to devote greater resources to the development, promotion and sale of products, and may be able to deliver competitive products at a lower end-user price. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our prospective customers. Therefore, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions, reduced operating margins and loss of market share. Any of these factors could have a material adverse effect on our business and operating results.

Our business may suffer if we are unable to manage our restructuring or growth.

Restructuring or material growth, should it occur, is likely to place a burden on our operating and financial systems as well as our senior management and other personnel. Existing and new members of management may not be able to improve existing systems and controls or implement new systems and controls in response to such restructuring or growth. Management of our operations in diverse locations may also complicate the task of managing this change.

We may not be able to integrate the business of companies we acquire and therefore these acquisitions may not provide additional value to our stockholders.

We continually evaluate potential acquisitions of complementary businesses, products and technologies. We acquired VST in March 2000 and Impleo in April 2000. We may not realize the desired benefits of these transactions or of future transactions. In order to successfully integrate acquired companies we must, among other things:

Continue to attract and retain key management and other personnel;

Integrate the acquired products from both an engineering and sales and marketing prospective;

Establish a common corporate culture; and

Integrate geographically distant facilities, systems and employees.

If our management’s attention to day-to-day operations is diverted to integrating acquired companies or if problems in the integration process arise, our business could be adversely affected and we could be required to use a significant portion of our available cash.

If an acquisition is made utilizing our securities, a significant dilution to our stockholders and significant acquisition related charges to earnings could occur.

We may incur additional charges in the future resulting from redundancies in product lines, personnel and fixed assets associated with these acquisitions. For instance, on May 31, 2001, we announced our intention to close our Acton, Massachusetts facility and move those operations into our Naples, Florida headquarters. This closing allowed us to centralize our operations and marketing and development efforts, improve operational efficiencies and otherwise increase the effectiveness of our business. In connection with this closing, we recognized approximately $0.5 million in severance costs in the quarter ended June 30, 2001. The closing was substantially complete as of September 30, 2001. As a result, we incurred additional costs of approximately $1.2 million during the quarter ended September 30, 2001 associated with employee separation costs, excess facility costs and the disposal of fixed assets. Acquisitions may also cause us to incur or assume additional liabilities or indebtedness, including liabilities that are unknown or not fully known to us at the time of the acquisition,

which could have an adverse effect on us. Furthermore, we cannot assure that any products we acquire in connection with any acquisition will gain acceptance in our markets.

We could be held liable for product defects, which could require us to pay substantial damages and harm our reputation with our customers.

Complex products such as ours can contain errors, defects and bugs when first introduced or as new versions are released. Delivery of products with production defects or reliability, quality or compatibility problems could hinder market acceptance of our products, which could damage our reputation and harm our ability to attract and retain customers. Errors, defects or bugs could also cause interruption, delays or a cessation of sales to our customers, and could subject us to warranty claims from our customers. We would have to expend significant capital and resources to remedy these problems. Errors, defects or bugs could be discovered in our new products after we begin commercial production of them, despite testing by us and our suppliers and customers. This could result in additional development costs, loss of, or delays in, market acceptance, diversion of technical and other resources from our other development efforts, claims by our customers or others against us or the loss of credibility with our current and prospective customers.

Our executive officers and key personnel are critical to our business, and these officers and personnel may not remain with us in the future.

We depend upon the continuing contributions of our key management, sales and product development personnel. The loss of any of those personnel could seriously harm us. Although some of our officers are subject to employment agreements, we cannot be sure that we will retain their services. In addition, we have not obtained key-person life insurance on any of our executive officers or key employees.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

Interest Rate Risk. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve our invested funds while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline in value. If market interest rates were to increase immediately and uniformly by 10 percent from levels at March 31, 2002, this would not materially change the fair market value of our portfolio. To minimize this risk, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities including U.S. government and government agency notes, corporate bonds and money market funds. In general, money market funds are not subject to interest rate risk because the interest paid on such funds fluctuates with the prevailing interest rate. During the quarter, our investment portfolio included marketable securities with contractual maturities of less than one year and active secondary or resale markets to ensure portfolio liquidity.

As of March 31, 2002, we did not hold amounts of cash equivalents and short-term investments that were subject to market risk.

We do not currently hold or issue derivative securities, derivative commodity instruments or other financial instruments for trading purposes.

Foreign Exchange Risk. We conduct operations and sell products in several different countries. Some balance sheet accounts of our U.S., Japanese and European operations are denominated in currencies other than the respective local currency and are remeasured to the respective local currency at the end of the accounting period. This remeasurement results in an adjustment to income. Additionally, the balance sheet accounts of our Japanese and European operations are translated to U.S. dollars for financial reporting purposes and resulting adjustments are made to stockholders’ equity. The value of the respective local currency may strengthen or weaken against the U.S. dollar, which would impact the value of stockholders’ investment in our common stock. Fluctuations in the value of the Japanese yen and the British pound against the U.S. dollar have occurred in 2002. Such fluctuations resulted in an accumulated unrealized foreign currency translation gain of approximately $0.4 million as of March 31, 2002, which is included in accumulated other comprehensive income and shown in the equity section of our balance sheet.

While most of the transactions of our U.S., Japanese and European operations are denominated in the respective local currency, some transactions are denominated in other currencies. Since the accounting records of our foreign operations are kept in the respective local currency, any transactions denominated in other currencies are accounted for in the respective local currency at the time of the transaction. Upon settlement of such a transaction, any foreign currency gain or loss results in an adjustment to income.

Our operating results may be impacted by the fluctuating exchange rates of foreign currencies, especially the Japanese yen and the British pound, in relation to the U.S. dollar. Most of the revenue and expense items of our Japanese and European subsidiaries are denominated in the respective local currency. In both regions, we believe this serves as a natural hedge against exchange rate fluctuations because although an unfavorable change in the exchange rate of the foreign currency against the U.S. dollar will result in lower revenues when translated into U.S. dollars, operating expenses will also be lower in these circumstances. For example, a decrease in the Japanese yen to U.S. dollar of 10 percent would have resulted in a decrease in revenues of approximately $0.1 million and a decrease in the net loss before income tax of approximately $0.1 million. Further, a decrease in the British pound to U.S. dollar of 10 percent would have resulted in a decrease in revenues of approximately $0.1 million and a decrease in the net loss before income tax of approximately $0.1 million.

We do not currently engage in hedging activities with respect to our foreign currency exposure; however, we continually monitor our exposure to currency fluctuations. We have not incurred significant realized losses on exchange transactions. If realized losses on foreign transactions were to become significant, we would evaluate appropriate strategies, including the possible use of foreign exchange contracts, to reduce such losses.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On June 26, 2000, a complaint was filed in the Central District Federal Court of the State of California by a party alleging our infringement of that party’s patent. On November 20, 2000, we prevailed in moving the venue for such action from the State of California to the Middle District of Florida. We consider this claim to be wholly without merit. We intend to vigorously defend against this claim. See “Factors That May Affect Future Results of Operations—Infringement claims by third parties could result in costly litigation and otherwise adversely impact our business.”

On July 26, 2001, a securities class action suit was filed against us, several of our executive officers and directors, including Addison M. Fischer, Michael S. Battaglia and Michael R. Mattingly, and the following underwriters of our initial public offering: FleetBoston Robertson Stephens, Inc. (formerly BancBoston Robertson Stephens, Inc.), Hambrecht & Quist LLC, and U.S. Bancorp Piper Jaffray, Inc. The suit was filed in the United States District Court for the Southern District of New York on behalf of all persons who acquired our common stock between October 6, 1999 and December 6, 2000. The complaint charges defendants with violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 (and Rule 10b-5 promulgated thereunder), for issuing a registration statement and prospectus that contained material misrepresentations and/or omissions. The complaint alleges that the prospectus was false and misleading because it failed to disclose (i) the agreements between FleetBoston Robertson Stephens, Inc., Hambrecht & Quist LLC, and U.S. Bancorp Piper Jaffray, Inc. and certain investors to provide them with significant amounts of restricted shares of our common stock in the IPO in exchange for excessive and undisclosed commissions; and (ii) the agreements between FleetBoston Robertson Stephens, Inc., Hambrecht & Quist LLC, and U.S. Bancorp Piper Jaffray, Inc. and certain customers under which the underwriters would allocate shares of our common stock in the IPO to those customers in exchange for the customers’ agreement to purchase shares of our common stock in the after-market at pre-determined prices. The complaint seeks an undisclosed amount of damages, as well as attorney fees. We consider this claim, as it relates to us, to be wholly without merit and we will vigorously defend against such claim.

On November 30, 2001, a complaint was filed in the Southern District of New York by Dynacore Holdings Corporation and Dynacore Patent Litigation Trust alleging our infringement of said parties’ patent relating to local area network capabilities. The complaint seeks an undisclosed amount of damages, injunction and recall, as well as attorney fees. We consider this claim, as it relates to us, to be wholly without merit and we will vigorously defend against such claim.

Item 2. Change in Securities and Use of Proceeds.

On October 6, 1999, we completed our initial public offering of 3,450,000 shares of common stock from which we realized net proceeds of approximately $39.1 million. These shares were registered under the Securities Act of 1933, as amended, on a registration statement on Form S-1 (No. 333-82793), which the Securities and Exchange Commission declared effective on October 5, 1999.

Through March 31, 2002, we used $19.0 million of the net proceeds from our initial public offering for the acquisitions of VST Technologies, Inc., Impleo Limited, the intellectual property of El Gato Software LLC and Multimedia Technology Center. In addition, we used $4.3 million to pay VST’s outstanding line of credit and the remaining $15.8 million for the purchase of equipment and funding of operations.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits:

Exhibit Number		Description
10.1		Employment Agreement with Michael S. Battaglia
10.2		Employment Agreement with Peter J. Quinn

(b) Reports on Form 8-K:

No reports on Form 8-K were filed by the Company during the quarter ended March 31, 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

SMARTDISK CORPORATION

By:		/s/ MICHAEL S. BATTAGLIA
		Michael S. Battaglia President and Chief Executive Officer (Principal Executive Officer)

By:		/s/ Peter J. Quinn
		Peter J. Quinn Chief Financial Officer (Principal Financial and Accounting Officer)

Dated: May 15, 2002

EXHIBIT INDEX

Exhibit Number		Description
10.1		Employment Agreement with Michael S. Battaglia
10.2		Employment Agreement with Peter J. Quinn

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Good

Smartdisk (SMDK) Inactive 10-QQuarterly report

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