I/OMagic 10Q 2002 Q1 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2002

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

For the transition period from to

Commission file number 000-27267

I/OMAGIC CORPORATION
(Exact name of small business issuer as specified in its charter)

Nevada		88-0290623
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

1300 Wakeham, Santa Ana, CA 92705
(Address of principal executive offices)

(714) 953-3000
(Issuer’s telephone number)

(Former name, former address and former fiscal year, if changed since last report)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 ý No o

As of May 14, 2002, the number of shares of Common Stock issued and outstanding was 67,930,291.

Transitional Small Business Disclosure Format (check one):

Yes o No ý

I/OMAGIC CORPORATION AND SUBSIDIARY

INDEX

PART I - FINANCIAL INFORMATION

	Item 1. Financial Statements

	Balance Sheets - December 31. 2001 and March 31, 2002 (unaudited)

	Statements of Income - For the three months ended March 31, 2001 and 2002 (unaudited)

	Statements of Cash Flows - For the three months ended March 31, 2001 and 2002 (unaudited)

	Notes to Financial Statements

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

PART II - OTHER INFORMATION

	Item 1. Legal Proceedings
	Item 2. Changes in Securities
	Item 3. Defaults Upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K

SIGNATURES

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

FINANCIAL INFORMATION

PART 1 - ITEM 1

I/OMAGIC CORPORATION

BALANCE SHEETS

DECEMBER 31, 2001 AND MARCH 31, 2002 (UNAUDITED)

	DECEMBER 31, 2001		March 31, 2002
ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	4,423,623	$	5,312,212
Accounts receivable, net of allowance for doubtful accounts of $2,679,118 and $2,441,250	27,844,543		25,961,636
Inventory, net of allowance for obsolete inventory of $558,703 and $1,180,517	10,377,287		12,942,103
Inventory in transit	1,634,420		2,350,960
Income tax receivable	34,311		34,311
Prepaid expenses and other current assets	2,292,424		1,664,448
Current portion of deferred income taxes	1,556,000		1,556,000

TOTAL CURRENT ASSETS	48,162,608		49,821,670

PROPERTY AND EQUIPMENT, NET	1,266,216		1,195,133
TRADEMARK, net of accumulated amortization of $3,375,976 and $3,858,256	6,269,703		5,787,423
DEFERRED INCOME TAXES, net of current portion	165,000		165,000
OTHER ASSETS	40,240		40,240

TOTAL ASSETS	$	55,903,767	$	57,009,466

The accompanying notes are an integral part of these financial statements

I/OMAGIC CORPORATION

BALANCE SHEETS

DECEMBER 31, 2001 AND MARCH 31, 2002 (UNAUDITED)

	DECEMBER 31, 2001			MARCH 31, 2002
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Line of credit	$	9,622,241		$	12,994,734
Accounts payable and accrued expenses	12,027,498			10,739,287
Accounts payable to related parties	5,521,720			3,909,053
Current portion of capital lease obligation	10,978			6,910
Reserves for customer returns and allowances	2,605,679			2,228,590

TOTAL CURRENT LIABILITIES	29,788,116			29,878,574

COMMITMENTS AND CONTINGENCIES

REDEEMABLE CONVERTIBLE PREFERRED STOCK 10,000,000 shares authorized, $0.001 par value
Series A, 1,000,000 shares authorized 875,000 shares issued and outstanding	875			875
Series B, 1,000,000 shares authorized 250,000 shares issued and outstanding	250			250
Additional paid-in capital	8,998,875			8,998,875

TOTAL REDEEMABLE CONVERTIBLE PREFERRED STOCK	9,000,000			9,000,000

STOCKHOLDERS’ EQUITY
Class A common stock, $0.001 par value 100,000,000 shares authorized 67,930,291 and 67,930,291 (unaudited) shares issued and outstanding	67,931			67,931
Additional paid in capital	31,493,957			31,493,957
Accumulated deficit	(14,446,237		)	(13,430,996		)
TOTAL STOCKHOLDERS’ EQUITY	17,115,651			18,130,892
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	55,903,767		$	57,009,466

The accompanying notes are an integral part of these financial statements

I/OMAGIC CORPORATION

STATEMENTS OF INCOME

FOR THE THREE MONTHS ENDED
MARCH 31, 2002 (UNAUDITED) AND 2001 (UNAUDITED)

	Three Months Ended March 31,
	2001			2002
Net sales	$	10,048,506		$	26,719,632

Cost of sales	9,137,277			22,674,409
Gross profit	911,229			4,045,223

Operating expenses
Selling, marketing and advertising	382,516			397,200
General and administrative	1,455,834			1,998,507
Depreciation and amortization	554,911			559,504
Total operating expenses	2,393,261			2,955,211
Income (loss) from operations	(1,482,032		)	1,090,012

Other income (expense)
Interest income	29,105			—
Interest expense	(188,992		)	(74,771		)
Other income	10,170			—
Other expense	(18,116		)	—
Total other income (expense)	(167,833		)	(74,771		)

Income (loss) before provision for income taxes	(1,649,865		)	1,015,241
Provision for (benefit from) income taxes	427,091			—

Net income (loss)	$	(2,076,956	)	$	1,015,241

Basic earnings (loss) per share	$	(0.03	)	$	0.01

Diluted earnings (loss) per share	$	(0.03	)	$	0.01

Basic weighted-average shares outstanding	67,917,791			67,930,291

Diluted weighted-average shares outstanding	67,917,791			71,530,291

The accompanying notes are an integral part of these financial statements

I/OMAGIC CORPORATION

STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED

MARCH 31, 2002 (UNAUDITED) AND 2001 (UNAUDITED)

	Three Months Ended March 31,
	2001			2002
CASH FLOWS FROM OPERATING ACTIVITIES:
Income (loss) from operations	$	(2,076,956	)	$	1,015,241
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization	72,927			77,223
Amortization of trademark	482,284			482,280
Provision for allowance for doubtful accounts	26,427			(237,868		)
Reserve for obsolete inventory	(187,072		)	621,814
Deferred income tax	427,091			—
Reserve for customer returns and allowances	(415,832		)	(377,089		)
(Increase) decrease in:
Accounts receivable	(184,517		)	2,120,775
Accounts receivable from related parties	(590,675		)	—
Inventory	2,705,492			(3,186,630		)
Inventory in transit	—			(716,540		)
Prepaid expenses and other current assets	62,983			627,976
Increase (decrease) in:
Accounts payable and accrued expenses	(6,386,528		)	(1,288,211		)
Accounts payable to related parties	5,055,704			(1,612,667		)
Net cash (used in) operating activities	(1,016,572		)	(2,473,696		)

CASH FLOWS FROM INVESTING ACTIVITIES:
Property additions	(25,487		)	(6,140		)
Net cash (used in) investing activities	(25,487		)	(6,140		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings on line of credit	(1,012,114		)	3,372,493
Payments on capital lease obligations	(2,745		)	(4,068		)
Net cash provided by (used in) financing activities	(1,014,859		)	3,368,425
Net increase (decrease) in cash and cash equivalents	(2,056,918		)	888,589
Cash and cash equivalents at beginning of period	3,502,546			4,423,623
Cash and cash equivalents at end of period	$	1,445,628		$	5,312,212

Supplemental cash flow information:
Interest paid	$	188,992		$	65,438
Income taxes paid	$	0		$	0

The accompanying notes are an integral part of these financial statements

NOTES TO FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION AND BUSINESS

I/OMagic Corporation (the “Company”), a Nevada corporation, develops, manufactures through subcontractors, markets, and distributes multimedia and communication card devices for portable and desktop computers. The Company sells its products in the United States to distributors and retail customers.

In March 1996, I/O Magic Corporation, a California corporation (“I/OMagic California”), originally incorporated on September 30, 1993 entered into a Plan of Exchange and Acquisition Agreement (the “Acquisition Agreement”) with Silvercrest International, Inc. (“Silvercrest”), a Nevada corporation. Pursuant to the Acquisition Agreement, Silvercrest acquired all of the outstanding stock of I/OMagic California totaling 6,570,583 shares in exchange for an aggregate 6,570,583 shares of newly-issued common stock. In connection with the Acquisition Agreement, the Company issued 624,704 shares of common stock. For accounting purposes, the acquisition has been treated as a recapitalization of I/OMagic California, with I/OMagic California as the accounting acquirer (reverse acquisition). The reverse acquisition was recorded at the historical cost of I/O Magic California. Prior to the execution of the Acquisition Agreement, Silvercrest was a public company listed on NASDAQ’s over-the-counter market with dormant operations and no assets or liabilities. Silvercrest subsequently changed its name to I/OMagic Corporation, a Nevada corporation.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and therefore, do not include all information and notes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. The unaudited condensed consolidated financial statements include the accounts of I/OMagic Corporation and subsidiary. The operating results for interim periods are unaudited and are not necessarily an indication of the results to be expected for the full fiscal year. In the opinion of management, the results of operations as reported for the interim periods reflect all adjustments which are necessary for a fair presentation of operating results.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period.

Significant estimates made by management include, but are not limited to, the provisions for allowance of doubtful accounts and price protection on accounts receivable, the net realizability of inventory, the evaluation of potential impairment of furniture and equipment, and the provision for sales returns and warranties. Actual results could materially differ from those estimates.

STOCK BASED COMPENSATION

SFAS No. 123, “Accounting for Stock-Based Compensation,” establishes and encourages the use of the fair value based method of accounting for stock-based compensation arrangements under which compensation cost is determined using the fair value of stock-based compensation determined as of the date of grant and is recognized over the periods in which the related services are rendered. The statement also permits companies to elect to continue using the current implicit value accounting method specified in Accounting Principles Bulletin (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for stock-based compensation issued to employees. The Company has elected to use the implicit value based method and has disclosed the pro forma effect of using the fair value based method to account for its stock-based compensation. For stock-based compensation issued to non-employees, the Company uses the fair value method of accounting under the provisions of SFAS No. 123.

RECLASSIFICATIONS

Certain amounts included in the March 31, 2001 Statement of Income have been reclassified to conform with the current period presentation. Such reclassification did not have any effect on the reported net loss.

EARNINGS (LOSS) PER SHARE

The Company calculates earnings (loss) per share in accordance with SFAS No. 128, “Earnings Per Share.” SFAS No. 128 replaced the presentation of primary and fully diluted earnings per share with the presentation of basic and diluted earnings (loss) per share. Basic earnings (loss) per share excludes dilution and is calculated by dividing income (loss) available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings (loss) per share includes the potential dilutive effects that could occur if securities or other contracts to issue common stock were exercised or converted into common stock (“potential common stock”) that would then share in the earnings (loss) of the Company.

As of March 31, 2002 (unaudited) and 2001 (unaudited), the Company had potential common stock as follows:

	2002	2001
Weighted-average common shares Outstanding during the period	67,930,291	67,917,791

Incremental shares from assumed conversion of convertible preferred stock	3,600,000	—

FULLY DILUTED WEIGHTED-AVERAGE COMMON SHARES AND POTENTIAL COMMON STOCK (UNAUDITED)	71,530,291	67,917,791

Since the Company had a net loss for the three months ended March 31, 2001 basic and diluted shares are the same.

NOTE 3 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES

Accounts payable and accrued liabilities consisted of the following:

	March 31, 2002
	(unaudited)
Accounts payable	$	1,348,410
Accrued rebates and marketing	8,209,581
Accrued compensation and related benefits	411,471
Other	769,825
TOTAL	$	10,739,287

NOTE 4 - INVENTORY

Inventory consisted of the following:

	March 31, 2002
	(unaudited)

Component parts	$	3,142,527
Finished goods	10,980,093
Reserves for inventory	(1,180,517		)
TOTAL	$	12,942,103

NOTE 5 - LINE OF CREDIT

The Company maintains a revolving line of credit with a financial institution that allows it to borrow a maximum of $14,000,000 with a sub-limit of $13,000,000. The line of credit expires December 31, 2002. The line is secured by a UCC filing on substantially all of the Company’s assets.

Within the sub-limit, up to $13,000,000 is available for maturities up to 150 days and up to $3,000,000 is available for maturities up to 60 days against 30% of inventory. Within the line of credit, a sub-line of $1,000,000 is available for uncollected funds availability.

The availability of the line of credit is subject to the borrowing base, which is 65% of eligible receivables. Advances on the line of credit bear interest at the Wall Street Journal Prime (4.75% as of March 31, 2002) plus 0.50%. As of March 31, 2002, the outstanding balance under the revolving line of credit was $12,994,734 (unaudited).

The line of credit provides for the maintenance of certain financial covenants and a compensating balance of $750,000, of which the Company was in compliance at March 31, 2002.

NOTE 6 - CREDIT LINES FROM RELATED PARTIES

In connection with a 1997 Strategic Alliance Agreement, the Company has available a trade line of credit through a stockholder and supplier for purchases up to $2,000,000. Purchases are non-interest bearing and are due 75 days from the date of receipt. The credit agreement can be terminated or changed at any time. As of December 31, 2001 and March 31, 2002 (unaudited), there were $0 and $0, respectively, in trade payables outstanding under this arrangement.

In connection with an April 1999 subscription agreement, the Company also has available an additional trade line of credit through a stockholder and vendor that provides a trade credit facility of up to $5,000,000 carrying net 75 day terms, as defined. As of December 31, 2001 and March 31, 2002 (unaudited), there were $3,001,926 and $1,984,053, respectively, in trade payables outstanding under this arrangement.

In connection with a December 2000 subscription agreement, the Company also has available an additional trade line of credit through a stockholder and vendor that provides a trade credit facility of up to $3,000,000 carrying net 60 day terms, as defined. As of December 31, 2001 and March 31, 2002 (unaudited), there were $1,273,250 and $1,925,000, respectively, in trade payables outstanding under this arrangement.

NOTE 7 - COMMITMENTS AND CONTINGENCIES

LEASES

The Company leases its facilities and certain equipment under non-cancelable, operating lease agreements, expiring through March 2010.

Rent expense was $145,702 and $155,328 for the three months ended March 31, 2002 (unaudited) and 2001 (unaudited), respectively, and is included in general and administrative expenses in the accompanying statements of income.

LITIGATION

On March 9, 2002, the following individuals: Mark Vakili, Mitra Vakili, Hi-Val, Inc., and Alex Properties, filed a Complaint in Orange County Superior Court ( the “Complaint”) naming IOM Holdings, Inc. (“IOMH”), the Company, Steele Su, Tony Shahbaz and Mei Hsu. The Complaint alleges eight causes of action, however, only three claims are asserted against IOMH and the Company.

The three causes of action against IOMH and the Company all relate to an Asset Purchase Agreement executed by IOMH and Hi-Val in June 1999 for the purchase and sale of Hi-Val assets to IOMH. The causes of action are for breach of contract, fraud and negligent misrepresentation. The allegations in the Complaint are that IOMH and other defendants failed to deliver the consideration due under the Asset Purchase Agreement after taking control of Hi-Val. The fraud and negligent misrepresentation claims are based on alleged representations made by IOMH and others to induce Hi-Val and Mark Vakili to enter into the Asset Purchase Agreement. The damages claimed by Plaintiffs in the causes of action are for $27,000,000.00. Punitive damages are claimed on the fraud cause of action.

While the Company believes that it will prevail in the litigation set forth in the Complaint, this litigation is at a very early stage and it is difficult to predict when such litigation will be resolved. The Company intends to vigorously defend this litigation.

EMPLOYMENT CONTRACT

The Company has entered into an employment contract with one of its officers which expires upon written termination. The agreement calls for a minimum base salary and provides for certain expense allowances. In addition, the agreement provides for a bonus based on the “net profits” of the Company, as defined. The bonus amount ranges from $20,000 to $70,000 for net profits up to $500,000. For net profits in excess of $500,000, the bonus is 7% of such excess. $18,000 was paid during the three months ended March 31, 2002. No bonuses were paid during the three months ended March 31, 2001. As of March 31, 2002, there was $68,662 (unaudited) accrued under this agreement.

RETAIL AGREEMENTS

In connection with certain retail agreements, the Company has agreed to pay for certain marketing development and advertising on an ongoing basis. Marketing development and advertising costs are generally agreed upon at the time of the event. The Company also records a liability for co-op marketing based on management’s evaluation of historical experience and current industry and Company trends. During the three months ended March 31, 2002 and 2001, the Company incurred $921,329 (unaudited) and $166,645 (unaudited), respectively, related to these agreements. Such is netted against sales revenue in the accompanying statements of income.

NOTE 8 - CAPITAL TRANSACTIONS

There were no capital transactions by the Company during the three months ended March 31, 2002 and 2001.

NOTE 9 - RELATED PARTY TRANSACTIONS

During the three months ended March 31, 2002 and 2001, the Company had purchases from related parties totaling approximately $6,642,945 (unaudited) and $4,380,700 (unaudited), respectively.

At March 31, 2002 and 2001, the Company had accounts payable to related parties totaling approximately $3,909,053 (unaudited) and $4,878,994 (unaudited), respectively.

The Company leases its Santa Ana facility from an officer of the Company which requires initial minimum monthly payment of $28,673 and expires in March 2010. For the three months ended March 31, 2002 and 2001, rent expense was $86,018 (unaudited) and $86,018 (unaudited), respectively, and is included in general and administrative expenses in the accompanying statements of operations.

King Eagle Enterprises, Inc., a related party, is involved in printing and packaging services to the Company. King Eagle Enterprises, Inc. is currently seeking investments in and/or acquisitions of printing and packaging facilities to better accommodate cost/support to the Company.

NOTE 10 - RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141, “Business Combinations.” Management believes this statement will not have a material impact on the Company’s financial statements.

In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets.” Management believes this statement will not have a material impact on the Company’s financial statements.

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” This statement is not applicable to the Company.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Management believes this statement will not have a material impact, if any, on the Company’s financial statements.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13 and Technical Corrections.” SFAS No. 145 updates, clarifies, and simplifies existing accounting pronouncements. This statement rescinds SFAS No. 4, which required all gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in APB No. 30 will no be used to classify those gains and losses. SFAS No. 64 amended SFAS No. 4 and is no longer necessary as SFAS No. 4 has been rescinded. SFAS No. 44 has been rescinded as it is no longer necessary. SFAS No. 145 amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-lease transactions. This statement also makes technical corrections to existing pronouncements. While those corrections are not substantive in nature, in some instances, they may change accounting practice. The Company does not expect adoption of SFAS No. 145 to have a material impact, if any, on its financial position or results of operations.

NOTE 11 - SUBSEQUENT EVENTS

There are no subsequent events.

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

This report and the Company’s consolidated financial statements and notes to financial statements contain forward-looking statements, which generally include the plans and objectives of management for future operations, including plans and objectives relating to the Company’s future economic performance and its current beliefs regarding revenues it might earn if it was successful in implementing its business strategies. The Company does not undertake to update, revise or correct any forward-looking statements.

The information contained in this document is not a complete description of the Company’s business or the risks associated with an investment in the Company’s common stock. Before deciding to buy or maintain a position in the Company’s common stock, prospective investors should carefully review and consider the various disclosures made in this report, and in other materials filed with the Securities and Exchange Commission (“SEC”) that discuss the Company’s business in greater detail and that disclose various risks, uncertainties and other factors that may affect the Company’s business, results of operations or financial condition.

Any of the factors described above or in the “Certain Factors that may Affect Future Performance” section below could cause the Company’s financial results, including the Company’s net income (loss) or growth in net income (loss) to differ materially from prior results, which in turn could, among other things, cause the price of the Company’s common stock to fluctuate substantially.

Critical Accounting Policies and Estimates

The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principals generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to customer programs and incentives, product returns, bad debts, inventories, intangible assets, income taxes, and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. The Company records estimated reductions to revenue for customer programs and incentive offerings including special pricing agreements, price protection, promotions and other volume-based incentives. If market conditions were to decline, the Company may take actions to increase customer incentive offerings possibly resulting in an incremental reduction of revenue at the time the incentive is offered. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in the impairment of their ability to make payments, additional allowances may be required.

The Company writes down its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. The Company records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

Three Months ended March 31, 2002 and 2001

Results of Operations

Gross sales for the period ended March 31, 2002 (“2002”) increased 139% to $33,605,726 from $14,040,107 for the period ended March 31, 2001. The increase in gross sales is attributable to the re-introduction of the Hi-Val and Digital Research Technologies brands during Q3 and Q4 of 2001. Net sales for the period ended March 31, 2002 increased 166% to $26,719,632 from $10,048,506 for the period ended March 31, 2001.

Net sales include reductions to gross sales for returns, price protection and marketing promotions. The reduction of sales for marketing promotions is in accordance with the Emerging Issues Task Force (“EITF”) issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” This issue concluded that certain consumer and trade sales promotion expenses are presumed to be a reduction of the selling prices of the vendor’s products and, therefore, should be characterized as a reduction of revenue as net sales. The provisions of this pronouncement are required to be applied with fiscal years beginning after December 15, 2001. The Company has adopted this pronouncement with its March 31, 2002 statement of operations and has reclassified its March 31, 2001 statement of operations. The adoption of this pronouncement has resulted in adjustments to net sales, gross margin and selling and marketing expenses. There is no impact on operating income, net income or earnings per share. Marketing expenses now netted against sales for 2002 were $3,731,349 and for 2001 were $1,857,217.

Total cost of sales as a percentage of net sales decreased from 90.93% ($9,137,277) in 2001 to 84.86% ($22,674,409) in 2002. This was primarily due to a change in product mix to products with a higher gross margin in 2002.

The Company believes that a more informative picture of its cost of sales is in relation to net sales before deductions for marketing expenses ($30,450,981 in 2002 and $11,905,723 in 2001). On this basis, cost of sales for products decreased from 71.49% ($8,510,977) in 2001 to 67.10% ($20,434,091) in 2002. This increase in margin on products of 4.39% was due to a change in product mix to products with a higher gross margin percentage. On this same sales basis, freight in/out increased from 4.88% ($581,300) in 2001 to 5.22% ($1,590,318) in 2001. This was due to increased air freight in 2002 arising from unanticipated demand for products requiring expedited shipment caused by supply constraints resulting from the September 11^th terrorist attacks. On the same sales basis, inventory write-downs to lower of cost or market increased from 0.38% ($45,000) in 2001 to 2.13% ($650,000) in 2002. This was primarily in relation to Hi-Val inventory received in the acquisition of IOM Holdings.

Operating expenses as a percentage of net sales decreased from 23.82% ($2,393,261) in 2001 to 11.06% ($2,955,211) in 2002. This percentage decrease is primarily due to both total operating expenses decreasing and net sales increasing 165.91%. Selling, marketing, and advertising expenses increased by $14,684, general and administrative expenses increased by $542,673 and depreciation and amortization expenses increased by $4,593 in 2002.

Selling, marketing and advertising expenses in 2002 were $397,200 (1.49% of net sales) and in 2001 were $382,516 (3.81% of net sales). 2001 expenses were restated for reclassification of certain marketing expenses against net sales per EITF issue No. 01-09. Selling, marketing and advertising expenses increased by $14,684 primarily due to higher commissions for outside rep groups (due to higher sales), offset primarily by lower salaries and benefits due to less sales and marketing employees.

General and administrative expenses in 2002 were $1,998,507 (7.48% of net sales) and in 2001 were $1,455,834 (14.49% of net sales). General and administrative expenses increased primarily due to increases to the reserve for bad debt expense in relation to old Hi-Val accounts receivable and shipping supplies in 2002 partially offset by less payroll expenses in 2002.

Depreciation and amortization expenses in 2002 were $559,504 (2.09% of net sales) and in 2001 were $554,911 (5.52% of net sales).

Other income (expenses) decreased from ($167,833) (1.67% of net sales) expense in 2001 to ($74,771) (0.28% of net sales) expense in 2002. This was primarily due to $114,221 less interest expense in 2002 offset by $29,105 less interest income in 2002. The decline in interest expense stems from the partial conversion of Hi-Val institutional debt to preferred stock of the Company.

Income tax benefit for 2001 represents Federal taxes as a result of the Company’s estimated annualized taxable income being subject to Alternative Minimum Taxes (AMT), California state franchise tax estimate, and the current period deferred benefit. There were no income taxes for 2002 as the Company has a net operating loss carryforward from prior years.

The Company’s operations resulted in net income in 2002 of $1,015,241 versus a net loss in 2001 of $2,076,956. This was the result of a 166% increase in net sales in 2002 over 2001.

The Company’s backlog at March 31, 2002 was $6,239,326 versus a backlog at March 31, 2001 of $1,903,770. This increase is a result of increased sales volume primarily to Office Max and Best Buy.

Liquidity and Capital Resources

Since its inception, the Company has financed its operations and capital expenditures primarily with cash provided by operating activities, private securities issuances and securities issuances for product (see “Private Placement Offerings”). The Company believes that working capital generated from operations is sufficient to meet current activity. However, should the Company grow significantly in size through additional large customers or acquisitions, securities issuances or other financing arrangements may be necessary. The Company currently has lines of credit with its major suppliers. Borrowing under these arrangements provides the Company with interest free trade credit.

The Company currently has a $14 million asset based line of credit with China Trust Bank which expires December 31, 2002. As of the date of this filing, the borrowings under this line were approximately $7.6 million. The Company believes that its current cash flow from operations, the amounts available under its existing vendor lines of credit and its asset based line of credit are sufficient to meet its working capital and capital expenditure requirements at the current sales volume for the next twelve months.

For the three months ended March 31, 2002, the Company had a net increase in cash relative to December 31, 2001 in the amount of $888,589. This was due to cash provided by financing activities of $3,368,425 offset by cash used in operating activities of $2,473,696 and cash used in investing activities of $6,140. Cash provided by financing activities was primarily provided by net borrowings on the line of credit. Cash used for investing activities was for leasehold improvements, furniture and computer equipment. Cash was used in operating activities as follows: $3,186,630 was used to increase inventory; $1,612,667 was used to decrease accounts payable to related parties; $1,288,211 was used to decrease accounts payable and accrued expenses; $716,540 was used to increase inventory in transit; $2,120,775 was provided by a decrease in accounts receivable; $1,015,241 was provided by income from operations; $627,976 was provided by a decrease in prepaid expenses and other current assets; $566,360 net was provided by non-cash adjustments such as depreciation, amortization, and provisions.

As the Company expands its distribution activities, it may experience net negative cash flows from operations, pending an increase in gross margins, and may be required to obtain additional financing to fund operations through proceeds from offerings, to the extent available, or to obtain additional financing to the extent necessary to augment its working capital through public or private issuance of equity or debt securities.

The high technology requirements of the Internet, music, data storage, gaming and various other applications increasingly require that consumers upgrade their personal computers to take full advantage of technology improvements in data storage, audio, video and various I/O devices. The Company believes that its current distribution channels currently fulfill and will continue to fulfill these trends in the computer peripherals marketplace. In the event the Company continues with the revenue growth it has experienced since June 2001, the Company believes that it will need additional capital. While there is no assurance that it will be successful in raising additional capital, the Company is currently actively seeking both institutional debt, as well as private sources of equity capital in order to assure that it will be capable of financing such growth. In the event the Company is unsuccessful in securing such financing, it may be required to curtail its sales growth.

The Company has no firm long-term sales commitments from any of its customers and enters into individual purchase orders with its customers. The Company has experienced cancellations of orders and fluctuations in order levels from period to period and expects it will continue to experience such cancellations and fluctuations in the future. In addition, customer purchase orders may be canceled and order volume levels can be changed, canceled or delayed with limited or no penalties. The replacement of canceled, delayed or reduced purchase orders with new business cannot be assured. Moreover, the Company’s business, financial condition and results of operations will depend upon its ability to obtain orders from new customers, as well as the financial condition and success of its customers, its customers products and the general economy. The factors affecting any of the Company’s major customers or their customers could have a material adverse effect on the Company’s business, financial condition and results of operations.

On January 22, 2001 the Company issued to Finova Capital Corporation 875,000 shares of its Series A Preferred Stock and 250,000 shares of its Series B Preferred Stock. The original value of these shares was $9 million in the aggregate. The Company is obligated to redeem these shares at $8 per share upon the third anniversary of the issuance of the Series A and upon the second anniversary of the Series B. If the shares of the Company’s common stock trade at a price of $3 per share for 15 consecutive trading days, then the Company has the right to require the conversion of the Series A and Series B shares of preferred stock into shares of common stock at a price equal to the weighted average trading price (which shall be not less than $2.50 per share nor more than $7 per share, subject to adjustment for stock splits and similar reclassifications of the Company’s common stock) of the shares of common stock during the 20 day period of time prior to the notice of conversion issued by the Company. If the Company is unable to require the conversion of the preferred stock or to otherwise negotiate a discounted redemption of the preferred stock, then the Company would be required to expend $2 million to redeem the Series B Preferred Stock on January 22, 2003 and $6.6 million on January 22, 2004 to redeem the Series A Preferred Stock. If the Company was required to redeem either class of preferred stock its liquidity and other financial resources could be severely and adversely affected.

RISK FACTORS

AN INVESTMENT IN THE COMPANY’S COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. IN ADDITION TO THE OTHER INFORMATION IN THIS REPORT, POTENTIAL INVESTORS SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS BEFORE DECIDING TO INVEST OR MAINTAIN AN INVESTMENT IN SHARES OF THE COMPANY’S COMMON STOCK. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCURS, IT IS LIKELY THAT THE COMPANY’S BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS WOULD BE HARMED. AS A RESULT, THE TRADING PRICE OF THE COMPANY’S COMMON STOCK COULD DECLINE, AND AN INVESTOR COULD LOSE PART OR ALL OF AN INVESTMENT.

Competition

The market for the Company’s products is highly competitive. Competitors for the Company’s hardware products include Acer, Best Data, Buslink, Hewlett-Packard, Iomega, Phillips, Plextor, Samsung, Sony, TDK and Yamaha. Competitors for the Company’s media products include Fuji, Imation, Maxell, Memorex, PNY, TDK and Verbatim. The Company also indirectly competes against original equipment manufacturers such as Dell Computer and Compaq to the extent that they manufacture their own add-in subsystems or incorporate on PC motherboards the functionality provided by the Company’s products. In certain markets where the Company is a relatively new entrant, the Company may face dominant competitors including 3Com (modems), Creative Technologies, Inc. (sound cards, modems and Internet music players) and Sony Corp. (consumer electronic music players). In addition, the Company’s markets are expected to become increasingly competitive as multimedia functions continue to converge and companies that previously supplied products providing distinct functions (for example, companies today primarily in the sound, modem, CPU or motherboard markets) emerge as competitors across broader or more integrated product categories.

The Company also believes that the strategy of certain of its current and potential competitors is to compete largely on the basis of price, which may result in lower prices and lower margins for the Company’s products or otherwise adversely affect the market for the Company’s products. There can be no assurance that the Company will be able to continue to compete successfully in its current and future markets, or will be able to compete successfully against current and new competitors, as the Company’s technology, markets and products continue to evolve.

Proprietary Rights

The Company utilizes subcontractors to manufacture its products. Further, the Company is not the licensee or owner of any of the technology comprising its products. As a result, the Company does not have a proprietary interest in any of the software, hardware or related technology comprising its various products. The Company relies primarily on trademark protection for its I/OMagic, Hi-Val and Digital Research Technologies brand names. There can be no assurance that the Company’s measures to protect its proprietary rights will deter or prevent unauthorized use of the Company’s brands. In addition, the laws of certain foreign countries may not protect the Company’s proprietary rights to the same extent, as do the laws of the United States or the European Community. As is typical in its industry, the Company from time to time is subject to legal claims asserting that the Company has violated the proprietary rights of third parties. In the event that a third party was to sustain a valid claim against the Company, and any required licenses were not available on commercially reasonable terms, the Company’s operating results could be materially and adversely affected. Litigation, which could result in substantial cost and diversion of the resources of the Company, may also be necessary to enforce proprietary rights of the Company or to defend the Company against claimed infringement of the proprietary rights of others.

Impact of Recent Accounting Pronouncements

The Company is subject to Emerging Issues Task Force (“EITF”) issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” This issue concluded that certain consumer and trade sales promotion expenses are presumed to be a reduction of the selling prices of the vendor’s products and, therefore, should be characterized as a reduction of revenue as net sales. The provisions of this pronouncement are required to be applied with fiscal years beginning after December 15, 2001. The Company has adopted this pronouncement with its December 31, 2001 statement of operations and has restated its March 31, 2001 statement of operations. The adoption of this pronouncement has resulted in adjustments to net sales, gross margin and selling and marketing expenses. There is no impact on operating income, net income or earnings per share. While the Company believes that the application of EITF No. 01-09 will not have any effect upon its cash flow, potential investors may view the impact of EITF No. 01-09 upon the Company negatively. In the event this does occur, the price for the Company’s stock and as a result its ability to raise capital, may be adversely effected.

The Company’s financial reporting may be subject to other changes in accounting principles and procedures. In the event these changes negatively effect the Company’s reporting of the results of its operations, its ability to raise capital and to otherwise utilize its stock to attract key employees and finance potential acquisitions would be adversely effected.

Distribution Risks

The Company’s future success is dependent on the continued viability and financial stability of its customer base. The computer distribution and retail channels historically have been characterized by rapid change, including periods of widespread financial difficulties and consolidation and the emergence of alternative sales channels, such as direct mail order, telephone sales by PC manufacturers and electronic commerce on the worldwide web. The loss of, or reduction in, sales to certain of the Company’s key customers as a result of changing market conditions, competition, or customer credit problems could have a material adverse effect on the Company’s operating results. Likewise, changes in distribution channel patterns, such as increased commerce on the Internet, or increased use of mail-order catalogues, increased use of consumer-electronics channels for peripheral product sales, could affect the

Company in ways not yet known. For example, the rapid emergence of Internet-based e-commerce is putting substantial strain on some of the Company’s traditional channels. Moreover, additions to or changes in the types of products the Company sells, such as the digital entertainment products, may require specialized value-added reseller channels, relations with which the Company has only begun to establish. Aggressive strategies employed by customers to obtain reductions in the charged purchase price, such as claimed price protections, rebates and advertising funds, may materially and adversely impact upon the Company’s cash flow and financial results of operations. Finally, the Company’s customers frequently require that the Company expend substantial sums to promote distribution channels, advertise its products and reserve shelf space for the Company’s products. To the extent the Company’s financial resources decline, the Company might be unable to fulfill its obligations under such programs. Such a failure might adversely effect the Company’s relationship with its customers and as a result, its financial results of operations.

Capital Needs

There can be no assurance that additional capital beyond the amounts currently forecasted by the Company will not be required or that any required additional capital will be available on reasonable terms, if at all, at such time or times as required by the Company. Any shortfall in capital resources compared to the Company’s level of operations or any inability to secure additional capital as needed could impair the Company’s ability to finance inventory, accounts receivable and other operational needs. Such capital limitations could also impair the Company’s ability to invest in research and development, improve customer service and support, deploy information technology systems, and expand marketing and other operations. Failure to keep pace with competitive requirements in any of these areas could have a material adverse effect on the Company’s business and operating results. Moreover, any need to raise additional capital through the issuance of equity or debt securities may result in additional dilution to earnings per share.

Risks Associated with Vertical Integration

The Company pursues a strategy of continuously identifying and evaluating potential product vendors. Ideally, the Company prefers a number of competitive suppliers of each of its products in order to ensure that the Company is offering leading edge technology in each product line at prices with which the Company can compete with competitors. In the recent past there have been instances of Far East manufacturers of computer peripheral products acquiring distribution divisions in North America or otherwise establishing their own marketing organization in North America. While these expansions in and of themselves are not material to the operations of the Company, vertical integration by the Company’s suppliers into North American marketing channels may restrict the vendors available to the Company and thereby may reduce the likelihood that the Company will have access to leading edge technology at prices which allow the Company to compete with vertically integrated competitors.

Recent Financial Losses

The Company reported a net losses in fiscal years ended December 31, 2000 and 2001. These losses stemmed primarily from $5.1 million in inventory write-down during these years, mostly caused by the Hi-Val acquisition and increased product promotion expenses arising from the reintroduction of the Hi-Val and Digital Research Technologies brands. There is no assurance that the Company will be able to obtain or maintain profitable operations in the future. If it is unable to do so, there may be a material adverse effect on cash flow, which could cause violations in the covenants under the Line of Credit and could impede the Company’s ability to raise capital through debt or equity financing to the extent the Company may need it for continued operations or for planned

expansion. Consequently, future losses may have a material adverse effect on the Company’s business, prospects, financial condition, results of operations and cash flows.

Lack of Long Term Purchase Orders

The Company does not have any long term purchase orders from its customers. The Company’s product orders are typically received with one to three weeks lead time to deliver the products. Accordingly, the Company cannot rely on long-term purchase orders or commitments to protect it from the negative financial effects of a reduced demand for it’s products that could result from a general economic downturn, from changes in the PC peripheral marketplace, including the entry of new competitors into the market, and from the introduction by others of new or improved technology, from an unanticipated shift in the needs of it’s customers, or from other causes.

Dependence on Major Customers

During the three month period ended March 31, 2002 the Company had four major customers which accounted for approximately 87% of the Company’s net sales.

The amounts due from these major customers on March 31, 2002 amounted to approximately $24,865,624. The Company’s strategy is to constantly attempt to sign new major retail customers in order to both increase the Company’s growth and to reduce the impact of any one customer.

The Company does not have any contract with any of these customers requiring that any amount of product be purchased in the future. In the event any of these major customers were to cease ordering products from the Company or to reduce the level of their orders, the Company’s financial performance could be materially and adversely affected.

Potential Fluctuations in Future Operating Results

The Company develops and markets products in the highly competitive optical storage, digital entertainment, multimedia and input-output segments of the personal computer peripheral marketplace. These products are very susceptible to product obsolescence and typically exhibit a high degree of volatility of shipment volumes over relatively short product life cycles. The timing of introductions of new products in one calendar quarter as opposed to an adjacent quarter can materially affect the relative sales volumes in those quarters. In addition, product releases by competitors and accompanying pricing actions can materially and adversely affect the Company’s revenues and gross margins.

The Company sells its products to retail customers such as mass merchandisers and large chains who sell products primarily off-the-shelf directly to end users. Reliance on indirect channels of distribution means that the Company typically has little or no direct visibility into end user customer demand. The Company must rely upon sales forecasts provided by its retail customers in order to comply with lead times required by these customers. If these forecasts prove inaccurate, the Company could either have excess inventory (resulting in potential finance costs and obsolescence) or insufficient inventory (resulting in an inability to meet customer demands promptly). Accordingly, this means that future operating results are dependent on the Company accurately predicting in advance the demand for various product segments from its customers.

Revenue Volatility and Dependence on Orders Received and Shipped in a Quarter

The volume and timing of orders received during a quarter are difficult to forecast. Retail customers generally order with only limited or no forecast data on an as-needed basis. Moreover, the Company has emphasized its ability to respond quickly to

customer orders as part of its competitive strategy. This strategy, combined with current industry supply and demand conditions as well as the Company’s emphasis on minimizing inventory levels, has resulted in customers placing orders with relatively short delivery schedules and increased demand on the Company to carry inventory for its customer base, particularly for large national retail chains. This has the effect of increasing short lead-time orders as a portion of the Company’s business and reducing the Company’s ability to accurately forecast net sales. Because retail customers’ orders are at times difficult to predict, there can be no assurance that the combination of these orders, and backlog in any quarter will be sufficient to achieve either sequential or year-over-year growth in net sales during that quarter. If the Company does not achieve a sufficient level of retail orders in a particular quarter, the Company’s revenues and operating results would be materially adversely affected.

Management of Growth

In recent years, the Company has experienced a significant expansion in the overall level of its business and the scope of its operations, including marketing, technical support, customer service, sales and logistics. This expansion in scope has resulted in a need for significant investment in infrastructure, process development and information systems. This requirement includes, without limitation: securing adequate financial resources to successfully integrate and manage the growing businesses and acquired companies; retention of key employees; integration of management information, product data management, control, accounting, telecommunications and networking systems; establishment of a significant worldwide web and e-commerce presence; coordination of suppliers and distribution channels; establishment and documentation of business processes and procedures; and integration of various functions and groups of employees. Each of these requirements poses significant, material challenges.

During the year 2000, the Company acquired the Hi-Val brand name and became the world-wide exclusive licensee of the Digital Research Technologies brand name. In addition to managing the growing business of the Company and its previous acquisitions, the Company will be required to integrate and manage these brands. The Company faces significant challenges in terms of sales, marketing, and logistics with respect to integrating the products and businesses of Hi-Val and Digital Research Technologies into the procedures and operations of the Company. There can be no assurance that the Company will be able to successfully integrate these operations. If the Company fails to successfully integrate these brand names into the operations of the Company, there will likely be a material adverse impact on the operating results of the Company. Even if the integration is successfully achieved, there can be no assurance that the cost of such integration will not materially and adversely affect the Company’s operating results, or that the Company will be able to make a satisfactory return on such costs.

In the fourth quarter of 2001, the Company commenced shipping its first digital entertainment product, a portable MP3 player distributed under the name MyMP3. The Company has recently filed a trademark application for the name MyMP3. These products will pose new design, manufacturing and customer support issues to the Company and there can be no assurance that the Company can successfully meet these challenges, generate customer demand for such products or satisfy customer demand for the products. There can also be no assurance that the cost associated with meeting such challenges and satisfying demand will not have a material adverse impact on the Company’s operating results in future periods.

Product Shortages; Reliance on Sole or Limited Source Suppliers

The Company is dependent on sole or limited source suppliers for certain key products. If any of these suppliers were to experience a disruption in their manufacturing capacity, the financial performance of the Company could be materially adversely effected. There can be no assurances that the Company can obtain adequate inventory of each of its product categories, or that such shortages or the costs of these products will not adversely affect future operating results. The Company’s dependence on sole or limited source suppliers, and the risks associated with any delay or shortfall in supply, can be exacerbated by the short life cycles that characterize the Company’s product mix. Although the Company maintains ongoing efforts to identify new suppliers of its products, shortages may continue to exist from time to time, and there can be no assurances that the Company can continue to obtain adequate supplies or obtain such supplies at their historical or competitive cost levels. In its attempt to counter actual or perceived shortages, the Company may over-purchase certain products or pay expediting or other surcharges, resulting in excess inventory or inventory at higher than normal costs and reducing the Company’s liquidity, or in the event of unexpected inventory obsolescence or a decline in the market value of such inventory, causing inventory write-offs or sell-offs that adversely affect the Company’s gross margin and profitability.

Dependence on Optical Storage and Optical Media Market

Sales of optical storage and related media products accounted for approximately 80% of the Company’s net sales in 2001. Although the Company has introduced products in the digital entertainment and multimedia segments of the PC peripheral market, optical storage and optical media devices are expected to continue to account for a majority of the Company’s sales for the foreseeable future. A decline in demand or average selling prices for optical storage or optical media products, whether as a result of new competitive product introductions, price competition, excess supply, widespread cost reduction, technological change, incorporation of the products’ functionality onto personal computer motherboards or otherwise, would have a material adverse effect on the Company’s sales and operating results.

Migration to Personal Computer Motherboards

Many of the Company’s products are individual PC peripheral products that function within personal computers to provide additional functionality. Historically, as a given functionality becomes technologically stable and widely accepted by personal computer users, the cost of providing such functionality is typically reduced by means of large scale integration into semiconductor chips, which can be subsequently incorporated onto personal computer motherboards. The Company recognizes that such migration could occur with respect to the functionality provided by some of the Company’s current products. While the Company believes that a market will continue to exist for add-in subsystems that provide advanced or multiple functions and offer flexibility in systems and connectivity, such as audio and video upgrade cards, there can be no assurance that the incorporation of new multimedia functions onto personal computer motherboards or into CPU microprocessors, will not adversely affect the future market for the Company’s products.

Acquisition and Licensing Risks

In the year 2000, the Company completed the acquisition of the Hi-Val tradename and the license of the Digital Research Technologies tradename. It is possible that a third party could attempt to impose certain liabilities associated with the prior operations of these brand names upon the Company. In the event such an event would occur, the Company could be severely adversely effected.

Dependence on Key Personnel

The Company’s future success will depend to a significant extent upon the efforts and abilities of its senior management and professional, technical, sales and marketing personnel, including the Company’s president Tony Shahbaz. Mr. Shahbaz has been instrumental in virtually all aspects of the Company’s operations. He has developed the key personal relationships with principals of the Company’s vendors and frequently is extensively involved in the Company’s sales and promotional efforts with its key customers. The loss of his services would certainly severely and adversely effect the financial results of operations of the Company. The competition for such personnel is intense, particularly in the Orange County, California area. There can be no assurance that the Company will be successful in retaining its existing key personnel or in attracting and retaining the additional key personnel that it requires. The loss of services of one or more of its key personnel or the inability to add or replace key personnel could have a material adverse effect on the Company. The salary, performance bonus and stock option packages necessary to recruit or retain key personnel, may significantly increase the Company’s expense levels or result in dilution to the Company’s earnings per share. The Company does not carry “key person” life insurance on any of its employees.

Government Regulation and Industry Standards

The Company frequently jointly designs its products with its manufacturing suppliers. These products are sometimes subject to various government regulations and industry standards, such as Underwriters Laboratories compliance. It is difficult to predict the direction of evolution of these regulations and standards and what, if any impact they might have upon the operations of the Company. For example, the Federal Drug Administration has inspected Company products containing laser components for potential health risks. The Company’s failure to comply with the various existing and evolving standards and regulations could adversely impact its ability to sell its products.

Declining Selling Prices and Other Factors Affecting Gross Margins

The Company’s markets are characterized by intense ongoing competition coupled with a history, as well as a current trend, of declining average selling prices. A decline in selling prices may cause the net sales in a quarter to be lower than those of a preceding quarter or corresponding prior year’s quarter even if more units were sold during such quarter than in the preceding or corresponding prior year’s quarter. Accordingly, it is possible that the Company’s average selling prices will decline, and that the Company’s net sales and margins may decline in the future, from the levels experienced to date (See also “-Short Product Life Cycles; Dependence on New Products”). The Company’s gross margins may also be adversely affected by shortages of, or higher prices for, key components for the Company’s products. The availability of new products is sometimes restricted in volume early in a product’s life cycle and, should customers choose to wait for the new version of a product rather than to purchase the current version, the ability of the Company to procure sufficient volumes of such new products to meet higher customer demand is limited. Such a failure to meet demand for new products may have a material adverse effect on the revenues and operating margins of the Company.

Asian Political and Economic Climate

The Company is dependent upon political and economic stability in the Far East. Specifically, the Company orders virtually all of its products from large manufacturing facilities located primarily in Taiwan, Korea and the People’s Republic of China. In the event of a severe political disruption in the governments of any country located in the Far East, the economic ramifications for the Company’s supplier base could be devastating. As a result, the Company’s ability to conduct profitable operations might be materially and adversely effected. The Company’s suppliers acquire components and raw materials for the manufacturing of the

Company’s products from a number of countries, many of which do not conduct operations in United States dollars. Any severe fluctuation in the value of such currencies could materially increase the cost to the Company’s suppliers of manufacturing the Company’s products. Upon such an occurrence, the Company’s operations could be severely and adversely effected.

Seasonality

The Company believes that, due to industry seasonality, demand for its products is strongest during the fourth quarter of each year and is generally slower in the period from April through August. This seasonality may become more pronounced and material in the future to the extent that a greater proportion of the Company’s sales consist of sales of more consumer-oriented or entertainment-driven products. These seasonal fluctuations may be exaggerated by general economic conditions and other factors outside the control of the Company. A failure by the Company to accurately forecast seasonal fluctuations may have a material adverse effect on the revenues and operating margins of the Company.

Short Product Life Cycles; Dependence on New Products

The market for the Company’s products is characterized by frequent new product introductions and rapid product obsolescence. These factors typically result in short product life cycles, frequently ranging from three to six months. The Company must develop and introduce new products in a timely manner that compete effectively on the basis of price and performance and that address customer requirements. To do this, the Company must continually monitor industry trends and make difficult choices regarding the selection of new technologies and features to incorporate into its new products, as well as the timing of the introduction of such new products, all of which may impair the orders for or the prices of the Company’s existing products. The success of new product introductions depends on various factors, some of which are outside the Company’s direct control. Such factors may include: selection of new products; selection of controller or memory chip architectures; implementation of the appropriate standards or protocols; timely completion and introduction of new product designs; trade-offs between the time of first customer shipment and the optimization of software drivers and hardware for speed, stability and compatibility; development and production of collateral product literature; ability to rapidly ramp manufacturing volumes to meet customer demand in a timely fashion; and coordination of advertising, press relations, channel promotion and evaluation programs with the availability of new products. For example, selection of the appropriate standards and protocols will be a key factor in determining the future success of the Company’s digital entertainment products.

Market Anticipation of New Products, New Technologies or Lower Prices

Since the environment in which the Company operates is characterized by rapid new product and technology introductions and generally declining prices for existing products, the Company’s customers may from time to time postpone purchases in anticipation of such new product introductions or lower prices. If such anticipated changes are viewed as significant by the market, such as the introduction of a data storage format change, then this may have the effect of temporarily slowing overall market demand and negatively impacting the Company’s operating results. For example, during the fourth quarter of 2001 the Company initially introduced a 32 megabyte version of its “MyMP3” portable digital music system. As technology quickly advanced the Company’s customers immediately demanded expanded memory capability. In response, the Company is developing a 64 megabyte version of the same product. This demand for more technologically advanced products took place within a period of three months.

Product Returns; Price Protection

The Company frequently grants limited rights to customers to return certain unsold inventories of the Company’s products in exchange for new purchases (“Stock Rotation”), as well as price protection on unsold inventory. Moreover, certain of the Company’s retail customers will readily accept returned products from their own retail customers, and these returned products are, in turn, returned to the Company for credit. The Company estimates returns and potential price protection on unsold channel inventory. The Company accrues reserves for estimated returns, including warranty returns, and price protection. The Company may be faced with further significant price protection charges as the Company and its competitors move to reduce channel inventory levels of current products, as new product introductions are made. However, there can be no assurance that any estimates, reserves or accruals will be sufficient or that any future returns or price reductions will not have a material adverse effect on operating results, including through the mechanisms of Stock Rotation or price protection, particularly in light of the rapid product obsolescence which often occurs during product transitions.

Rapid Technological Change

The markets for the Company’s products are characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and rapid product obsolescence. Product life cycles in the Company’s markets frequently range from three to six months. The Company’s success will be substantially dependent upon its ability to continue to develop and introduce competitive products and technologies on a timely basis with features and functions that meet changing customer requirements in a cost-effective manner. Further, if the Company is successful in the development and market introduction of new products, it must still correctly forecast customer demand for such new products so as to avoid either excessive unsold inventory or excessive unfilled orders related to the products. The task of forecasting such customer demand is unusually difficult for new products, for which there is little sales history, and for indirect channels, where the Company’s customers are not the final end customers. Moreover, whenever the Company launches new products, it must also successfully manage the corollary obsolescence and price erosion of those of its older products that are impacted by such new products, as well as any resulting price protection charges and Stock Rotations from its distribution channels.

Quantitative and Qualitative Disclosures About Interest Rate Risk

The Company is exposed to financial market risks due primarily to changes in interest rates. As the Company continues to grow, it is finding that its vendors are increasingly refusing to provide credit. As a result, the Company frequently is required to draw down upon its Line of Credit in order to finance its operations. Fluctuations in interest rates may increase the cost of the Company drawing down upon its Line of Credit. The Company does not use derivatives to alter the interest characteristics of its investment securities or its debt instruments. The Company has no holdings of derivative or commodity instruments and does not conduct business in foreign currencies.

“Penny Stock” Rules

Broker-dealer practices in connection with transactions in “penny stocks” are regulated by penny stock rules adopted by the Securities and Exchange Commission. Penny stocks, like shares of the Company’s common stock, generally are equity securities with a price of less than $5.00 (other than securities registered on some national securities exchanges or quote on NASDAQ). The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from the rules, to deliver a standardized risk disclosure document that provides information about penny stocks and the nature and level of risks in the penny

stock market. The broker-dealer must also provide current bid and offer quotations for the penny stock, the compensation of the broker-dealer and its sales person in the transaction, and if the broker-dealer is the sole market maker, the broker dealer must disclose this fact and the broker dealer’s presumed control over the market, and the monthly account statements showing the market value of each penny stock held in the customer’s account. In addition, broker-dealers who sell these securities to persons other than established customers and “accredited investors” must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written agreement to the transaction. Consequently, these requirements may have the effect of reducing the level of trading activity, if any, in the secondary market for a security subject to the penny stock rules, and investors in the Company’s common stock may find it difficult to sell their shares.

Bulletin Board Listing

The Company’s stock is currently quoted upon the NASD Over-the-Counter Bulletin Board under the symbol “IOMC.OB.” Because the Company’s stock trades upon the Bulletin Board rather than on a national stock exchange, investors may find it difficult to either dispose of, or to obtain quotations as to the price of the Company’s common stock. In the event the Company does not timely file all reports and related forms required to maintain “reporting status” under the Securities Exchange Act of 1934, the Company would be delisted from the Bulletin Board. In the event of such a delisting, investors in the Company’s stock might be unable to sell their shares and might be required to maintain their investment in the Company indefinitely.

Stock Price Volatility

The trading price of the Company’s Common Stock has been subject to significant fluctuations to date, and could be subject to wide fluctuations in the future in response to quarter-to-quarter variations in operating results, announcements of technological innovations, new product introductions by the Company or its competitors, general conditions in the markets for the Company’s products or the computer industry, the price and availability of the Company’s products, general financial market conditions, market conditions for PC or semiconductor stocks, changes in earnings estimates by analysts, or other events or factors. In this regard, the Company does not endorse and accepts no responsibility for the estimates or recommendations issued by stock research analysts from time to time. In addition, the public stock markets in general, and technology stocks in particular, have experienced extreme price and trading volume volatility. This volatility has significantly affected the market prices of securities of many high technology companies for reasons frequently unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of the Company’s Common Stock.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

In August 1999, the Company filed an arbitration proceeding in Orange County, California against its former accountants and auditors, Ernst & Young, LLP, for failure to complete the 1997 audit of the Company in a timely fashion and for excessive billing in connection with the 1997 audit. In January 2002 a ruling was issued determining that the Company owed Ernst & Young $8,000 in fees for the 1997 audit.

Item 2. Changes in Securities and Use of Proceeds

Incorporated by reference from Registrant’s Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 2001 (see Management’s Discussion and Analysis and Liquidity and Capital Resources). See Financial Statement Supplemental Schedule of Non-Cash Investing and Financing Activities and Note 6.

Item 3. Defaults Upon Senior Securities

None

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

None.

Item 5. Other Information

None.

Item 6. Exhibits and Reports on Form 8-K

The following documents are filed as part of this report:

1. Reports on Form 8-K filed: None

Signatures

In accordance with the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, duly authorized.

		I/OMAGIC CORPORATION

DATED:	May 14, 2002	By:	/s/ Tony Shahbaz
		Tony Shahbaz, President and Chief Executive
		Officer, Chief Financial Officer

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I/OMagic (IOMG) Inactive 10-Q2002 Q1 Quarterly report

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