UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
______________________
AMENDMENT NO. 1
TO
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
COMMISSION FILE NUMBER 000-27267
I/OMAGIC CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
Nevada 33-0773180
- ------------------------------- ------------------------------------
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
4 Marconi, Irvine, CA 92618
- ---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(949) 707-4800
--------------
(Registrant's telephone number, including Area Code)
Not Applicable
----------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check whether the registrant: (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check whether the registrant is an accelerated filer (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of June 29, 2005, there were 4,529,672 shares of the issuer's common stock
issued and outstanding.
I/OMAGIC CORPORATION AND SUBSIDIARY
TABLE OF CONTENTS
Page
Number
------
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets - March 31, 2005 (unaudited) and
December 31, 2004 3
Consolidated Statements of Income - For the three months ended
March 31, 2005 and 2004 (unaudited) 5
Consolidated Statements of Cash Flows - For the three months
ended March 31, 2005 and 2004 (unaudited) 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 14
Item 3. Quantitative and Qualitative Disclosures About Market Risk 42
Item 4. Controls and Procedures 42
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 44
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases
of Equity Securities 45
Item 3. Defaults Upon Senior Securities 45
Item 4. Submission of Matters to a Vote of Security Holders 45
Item 5. Other Information 45
Item 6. Exhibits 45
SIGNATURES 46
EXHIBITS FILED WITH THIS REPORT 47
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2005 (UNAUDITED) AND DECEMBER 31, 2004
ASSETS
MARCH 31, DECEMBER 31,
2005 2004
-------------------------
(unaudited)
CURRENT ASSETS
Cash and cash equivalents $ 1,658,446 $ 3,587,807
Restricted cash 266,446 1,044,339
Accounts receivable, net of allowance for doubtful
accounts of $103,934 (unaudited) and $24,946 12,802,120 14,598,422
Inventory, net of allowance for obsolete inventory
of $1,824,709 (unaudited) and $1,463,214 7,492,555 6,146,766
Inventory in transit 512,206 513,672
Prepaid expenses and other current assets 1,188,386 741,244
----------- -----------
Total current assets 23,920,159 26,632,250
PROPERTY AND EQUIPMENT, net of accumulated depreciation of
$1,317,377 (unaudited) and $1,256,036 247,574 307,661
TRADEMARK, net of accumulated amortization
of $5,467,012 (unaudited) and $5,449,780 482,568 499,800
OTHER ASSETS 27,032 27,032
----------- -----------
TOTAL ASSETS $24,677,333 $27,466,743
=========== ===========
The accompanying notes are an integral part of these financial statements.
3
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2005 (UNAUDITED) AND DECEMBER 31, 2004
LIABILITIES AND STOCKHOLDERS' EQUITY
MARCH 31, DECEMBER 31,
2005 2004
----------------------------
(unaudited)
CURRENT LIABILITIES
Line of credit $ 4,803,161 $ 5,962,891
Accounts payable and accrued expenses 4,626,039 5,221,719
Accounts payable - related parties 7,272,155 7,346,596
Reserves for customer returns and price protection 771,303 573,570
------------ ------------
Total current liabilities 17,472,658 19,104,776
------------ ------------
COMMITMENTS AND CONTINGENCIES -- --
STOCKHOLDERS' EQUITY
Preferred Stock
10,000,000 shares authorized, $0.001 par value
Series A, 1,000,000 shares authorized, 0 and 0 shares
Issued and outstanding -- --
Series B, 1,000,000 shares authorized, 0 and 0 shares
Issued and outstanding -- --
Common stock, $0.001 par value
100,000,000 shares authorized
4,529,672 (unaudited) and 4,529,672 shares
issued and outstanding 4,530 4,530
Additional paid-in capital 31,557,988 31,557,988
Treasury stock, 13,493 (unaudited) and 13,493 shares, at cost (126,014) (126,014)
Accumulated deficit (24,231,829) (23,074,537)
------------ ------------
Total stockholders' equity 7,204,675 8,361,967
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 24,677,333 $ 27,466,743
============ ============
The accompanying notes are an integral part of these financial statements.
4
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004
(UNAUDITED)
THREE MONTHS ENDED MARCH 31,
2004
2005 (RESTATED)
----------------------------
(unaudited) (unaudited)
NET SALES $ 9,036,812 $ 15,473,519
COST OF SALES 8,454,880 13,218,254
------------ ------------
GROSS PROFIT 581,932 2,255,265
------------ ------------
OPERATING EXPENSES
Selling, marketing, and advertising 174,201 480,112
General and administrative 1,417,465 1,366,359
Depreciation and amortization 78,573 209,271
------------ ------------
Total operating expenses 1,670,239 2,055,742
------------ ------------
INCOME (LOSS) FROM OPERATIONS (1,088,308) 199,523
------------ ------------
OTHER INCOME (EXPENSE)
Interest income 37 219
Interest expense (77,353) (44,135)
Other income (expense) 8,332 (7,811)
------------ ------------
Total other income (expense) (68,984) (51,727)
------------ ------------
INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES (1,157,291) 147,796
PROVISION FOR INCOME TAXES -- 3,088
------------ ------------
NET INCOME (LOSS) $ (1,157,291) $ 144,708
============ ============
BASIC INCOME (LOSS) PER SHARE $ (0.26) $ 0.03
============ ============
DILUTED INCOME (LOSS) PER SHARE $ (0.26) $ 0.03
============ ============
BASIC WEIGHTED-AVERAGE SHARES OUTSTANDING 4,529,672 4,529,672
------------ ------------
DILUTED WEIGHTED-AVERAGE SHARES OUTSTANDING 4,529,672 4,594,047
------------ ------------
The accompanying notes are an integral part of these financial statements.
5
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004
(UNAUDITED)
THREE MONTHS ENDED MARCH 31,
2005 2004
(RESTATED)
----------- -----------
(unaudited) (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $(1,157,292) $ 144,708
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities
Depreciation and amortization 61,341 64,587
Amortization of trademarks 17,232 144,684
Allowance for doubtful accounts 85,000 60,000
Reserve for customer returns and allowances 197,732 (421,929)
Reserve for obsolete inventory 361,663 100,000
(Increase) decrease in
Accounts receivable 1,711,302 6,183,447
Inventory (1,707,452) 1,320,096
Inventory in transit 1,467 --
Prepaid expenses and other current assets (447,142) (415,892)
Decrease in
Accounts payable and accrued expenses (595,678) (2,212,700)
Accounts payable - related parties (74,441) (4,614,465)
Settlement payable -- (1,000,000)
----------- -----------
Net cash used in operating activities (1,546,268) (647,464)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment (1,255) (13,391)
Restricted cash 777,892 1,175,697
----------- -----------
Net cash provided by investing activities 776,637 1,162,306
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Net payments on line of credit (1,159,730) (7,580)
----------- -----------
Net cash used in financing activities (1,159,730) (7,580)
----------- -----------
Net increase (decrease) in cash and cash equivalents (1,929,361) 507,262
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 3,587,807 4,005,705
----------- -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 1,658,446 $ 4,512,967
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
INTEREST PAID $ 79,724 $ 42,682
=========== ===========
INCOME TAXES PAID $ -- $ 3,088
=========== ===========
The accompanying notes are an integral part of these financial statements.
6
I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - ORGANIZATION AND BUSINESS
I/OMagic Corporation ("I/OMagic"), a Nevada corporation, and its subsidiary
(collectively, the "Company") develop, manufacture through subcontractors,
market, and distribute data storage and digital entertainment products to the
consumer electronics markets.
On July 6, 2004, the Company completed the merger of its wholly-owned
subsidiary, I/OMagic Corporation, a California corporation, with and into the
Company.
NOTE 2 - RESTATEMENT OF 2004 FINANCIAL STATEMENTS
The Company previously accounted for its sales incentives by reducing gross
sales at the time sales incentives were offered to its retailers. Upon further
examination of its accounting methodology for sales incentives, and a
quantitative analysis of its historical sales incentives, the Company determined
that it made an error in its application of the relevant accounting principles
under SFAS 48, as interpreted under Topic 13, and determined that it should have
estimated and recorded sales incentives at the time its products were sold.
Under SFAS 48, as interpreted under Topic 13, the eventual sales price must be
fixed or determinable before revenue can be recognized. Due to the nature and
extent of the Company's sales incentive history, the Company should have been
assessing its revenue recognition criteria to determine whether it was able to
effectively estimate or determine its eventual sales price. The Company has
determined the effect of the correction on its previously issued financial
statements and has restated the accompanying financial statements and the
financial information below for the three months ended March 31, 2004.
The Company previously accounted for product returns using a method that did not
take into account the different return characteristics of categories of similar
products and also did not adequately take into account the variability over time
of product return rates. The Company conducted a quantitative analysis of its
historical product return data to determine moving averages of product return
rates by groupings of similar products. Following completion of this analysis,
the Company determined that it made an error in its method of estimating product
returns. The Company has determined the effect of the correction on its
previously issued financial statements and has restated the accompanying
financial statements and the financial information below for the three months
ended March 31, 2004.
The effects of the restatement on net sales, cost of sales, gross profit, net
income, basic and diluted income per common share, reserves for product returns
and sales incentives, and stockholders' equity as of and for the three months
ended March 31, 2004 is as follows:
AS ORIGINALLY RESTATEMENT
REPORTED ADJUSTMENTS AS RESTATED
----------- ----------- -----------
Net sales ........................................... $15,360,219 $ 113,300 $15,473,519
Cost of sales ....................................... 12,992,415 225,839 13,218,254
Gross profit ........................................ 2,367,804 (112,539) 2,255,265
Net income .......................................... $ 257,247 $ (112,539) $ 144,708
PROFIT PER COMMON SHARE:
Basic ............................................ $ 0.06 $ (0.03) $ 0.03
Diluted .......................................... $ 0.06 $ (0.03) $ 0.03
Reserves for product returns and sales incentives ... $ 318,905 $ 71,424 $ 390,329
Stockholders' equity ................................ $16,634,964 $ (71,424) $16,563,540
7
NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared
in accordance with the rules and regulations of the Securities and Exchange
Commission and, therefore, do not include all information and notes necessary
for a fair presentation of financial position, results of operations, and cash
flows in conformity with generally accepted accounting principles. The unaudited
consolidated financial statements include the accounts of I/OMagic and its
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. These financial statements should be read in
conjunction with the Company's Form 10-K for the year ended December 31, 2004.
USE OF ESTIMATES
The preparation of financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Actual results could differ from those estimates.
STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation" as amended by SFAS No.
148, "Accounting for Stock-Based Compensation-Transition and Disclosure,"
establishes and encourages the use of the fair value based method of accounting
for stock-based compensation arrangements under which compensation cost is
determined using the fair value of stock-based compensation determined as of the
date of grant and is recognized over the periods in which the related services
are rendered. The statement also permits companies to elect to continue using
the current intrinsic value accounting method specified in Accounting Principles
Bulletin ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," to
account for stock-based compensation issued to employees. The Company has
elected to use the intrinsic value based method and has disclosed the pro forma
effect of using the fair value based method to account for its stock-based
compensation. For stock-based compensation issued to non-employees, the Company
uses the fair value method of accounting under the provisions of SFAS No. 123.
Pro forma information regarding net loss and loss per share is required by SFAS
No. 123 and has been determined as if the Company had accounted for its employee
stock options under the fair value method of SFAS No. 123. For the three months
ended March 31, 2005, no options to purchase common stock were granted. For the
three months ended March 31, 2004, 126,375 options to purchase common stock were
granted.
RECENT ACCOUNTING PRONOUNCEMENTS
In March 2005, the FASB issued FASB Interpretation ("FIN") No. 47, "Accounting
for Conditional Asset Retirement Obligations". FIN No. 47 clarifies that the
term conditional asset retirement obligation as used in FASB Statement No. 143,
"Accounting for Asset Retirement Obligations," refers to a legal obligation to
perform an asset retirement activity in which the timing and (or) method of
settlement are conditional on a future event that may or may not be within the
control of the entity. The obligation to perform the asset retirement activity
is unconditional even though uncertainty exists about the timing and (or) method
of settlement. Uncertainty about the timing and/or method of settlement of a
conditional asset retirement obligation should be factored into the measurement
of the liability when sufficient information exists. This interpretation also
clarifies when an entity would have sufficient information to reasonably
estimate the fair value of an asset retirement obligation. FIN No. 47 is
effective no later than the end of fiscal years ending after December 15, 2005
(which would be December 31, 2005 for calendar-year companies). Retrospective
application of interim financial information is permitted but is not required.
Management does not expect adoption of FIN No. 47 to have a material impact on
the Company's financial statements.
8
For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting periods. Adjustments are made
for options forfeited prior to vesting. The effect on net loss and basic and
diluted loss per share had compensation costs for the Company's stock option
plans been determined based on a fair value at the date of grant consistent with
the provisions of SFAS No. 123 for the three months ended March 31, 2005
(unaudited) and 2004 (unaudited) is as follows:
THREE MONTHS ENDED MARCH 31,
----------------------------
(unaudited)
2005 2004
------------- -----------
(RESTATED)
-----------
Net income (loss)
As reported $ (1,157,291) $ 144,708
Add stock based compensation expense included
in net income, net of tax -- --
Deduct total stock based employee compensation
expense determined under fair value method for
all awards, net of tax (22,077) (7,567)
------------- -----------
PRO FORMA $ (1,179,368) $ 137,141
============= ===========
Income (loss) per common share
Basic - as reported $ (0.26) $ 0.03
Basic - pro forma $ (0.26) $ 0.03
Diluted - as reported $ (0.26) $ 0.03
Diluted - pro forma $ (0.26) $ 0.03
EARNINGS (LOSS) PER SHARE
The Company calculates earnings (loss) per share in accordance with SFAS No.
128, "Earnings Per Share." Basic earnings (loss) per share is computed by
dividing the net income (loss) available to common stockholders by the
weighted-average number of common shares outstanding. Diluted income (loss) per
share is computed similar to basic income (loss) per share, except that the
denominator is increased to include the number of additional common shares that
would have been outstanding if the potential common shares had been issued and
if the additional common shares were dilutive.
As of March 31, 2005 (unaudited) and March 31, 2004 (unaudited) the Company had
potential common stock as follows:
2005 2004
--------- ---------
Weighted average common shares
outstanding during the period 4,529,672 4,529,672
Incremental shares assumed to be outstanding
since the beginning of the period related
to stock options and warrants outstanding (unaudited) -- 64,375
--------- ---------
Fully diluted weighted average common shares and
potential common stock 4,529,672 4,594,047
========= =========
9
The following potential common shares have been excluded from the computation of
diluted earnings per share for the three months ended March 31, 2005 (unaudited)
since their effect would have been anti-dilutive, and for the three months ended
March 31, 2004 (unaudited) due to the exercise price being greater than the
Company's weighted average stock price for the period.
March 31,
----------------------
(unaudited)
2005 2004
------- -------
Stock options outstanding 122,950 188,167
Warrants outstanding 20,000 20,004
------- -------
TOTAL 142,950 208,171
------- -------
NOTE 4 - INVENTORY
Inventory consisted of the following:
March 31, December 31,
2005 2004
----------- -----------
(unaudited)
Component parts $ 2,282,214 $ 2,123,173
Finished goods - warehouse 3,462,832 2,614,202
Finished goods - consigned 3,572,218 2,872,605
Reserves for obsolete and slow moving inventory (1,824,709) (1,463,214)
----------- -----------
TOTAL $ 7,492,555 $ 6,146,766
=========== ===========
NOTE 5 - PROPERTY AND EQUIPMENT
Property and equipment as of March 31, 2005 (unaudited) and December 31, 2004
consisted of the following:
March 31, December 31,
2005 2004
---------- ----------
(unaudited)
Computer equipment and software $1,052,740 $1,051,485
Warehouse equipment 55,238 55,238
Office furniture and equipment 266,889 266,889
Vehicles 91,304 91,304
Leasehold improvements 98,780 98,780
---------- ----------
1,564,951 1,563,696
Less accumulated depreciation and amortization 1,317,377 1,256,035
---------- ----------
TOTAL $ 247,574 $ 307,661
========== ==========
For the three months ended March 31, 2005 and 2004, depreciation and
amortization expense was $61,341 and $64,587, respectively.
NOTE 6 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consisted of the following:
March 31, December 31,
2005 2004
---------- ----------
(unaudited)
Accounts payable $ 801,990 $1,282,082
Accrued rebates and marketing 3,154,259 3,231,655
Accrued compensation and related benefits 200,328 158,896
Other 469,462 549,086
---------- ----------
TOTAL $4,626,039 $5,221,719
========== ==========
10
NOTE 7 - LINE OF CREDIT
On August 15, 2003, the Company entered into an agreement for an asset-based
line of credit with United National Bank, effective August 18, 2003. The line
allowed the Company to borrow up to a maximum of $6.0 million. The line of
credit was initially used to pay off the outstanding balance with ChinaTrust
Bank (USA) as of September 2, 2003, which was $3,379,827. On March 9, 2005 the
line of credit with United National Bank was replaced by a line of credit from
GMAC Commercial Finance. On March 9, 2005, the Company entered into a Loan and
Security Agreement for an asset-based line of credit with GMAC Commercial
Finance LLC ("GMAC"). The line of credit allows the Company to borrow up to a
maximum of $10.0 million. The line of credit expires on March 9, 2008 and is
secured by substantially all of the Company's assets. The line of credit allows
for a sublimit of $2.0 million for outstanding letters of credit. Advances on
the line of credit bear interest at the floating commercial loan rate initially
equal to the prime rate plus 0.75%. The prime rate as of March 9, 2005 was
5.50%. The Company also has the option to use the LIBOR rate plus an initial
amount of 3.50%.
These rates are applicable if the average amount available for borrowing for the
prior six month period is between $1.0 million and $3.5 million. If the average
amount available for borrowing is less than $1.0 million, then the rates
applicable to all amounts borrowed increase by 0.25%. If the average amount
available for borrowing is greater than $3.5 million, then the rates applicable
to all amounts borrowed decrease by 0.25%. For the unused portion of the line,
the Company is to pay on a monthly basis, an unused line fee in the amount of
0.25% of the average unused portion of the line for the preceding month.
The Loan Agreement contains one financial covenant--that the Company maintain at
the end of each measurement period through and including September 30, 2005, a
fixed charge coverage ratio of at least 1.2 to 1.0 and a fixed charge coverage
ratio of at least 1.5 to 1.0 for all measurement periods thereafter. A
measurement period is defined in the Loan Agreement as the three month period
ending March 31, 2005, the six month period ending June 30, 2005, the nine month
period ending September 30, 2005, the 12 month period ending December 31, 2005,
and thereafter the twelve month period ending on March 31, June 30, September
30, and December 31 of each year during the term of the credit facility. As of
March 31 and April 30, 2005, the Company was in breach of the financial
covenant; however, as a result of a Letter Agreement and a First Amendment to
Loan Agreement between the Company and GMAC, the Company is no longer in breach
of this covenant. (See Note 11)
The obligations of the Company under the Loan Agreement are secured by
substantially all of the Company's assets and guaranteed by the Company's
wholly-owned subsidiary, IOM Holdings, Inc. (the "Subsidiary"). The obligations
of the Company and the guarantee obligations of its Subsidiary are secured
pursuant to a Pledge and Security Agreement executed by the Company, a
Collateral Assignment Agreement executed by the Company, a Guaranty Agreement
executed by its Subsidiary, a General Security Agreement executed by its
Subsidiary, an Intellectual Property Security Agreement and Collateral
Assignment executed by the Company, and an Intellectual Property Security
Agreement and Collateral Assignment executed by its Subsidiary.
The new credit facility was initially used to pay off the Company's outstanding
balance with United National Bank as of March 10, 2005, which balance was
$3,809,320, and was also used to pay $25,000 of the Company's closing fees for
the GMAC line of credit. The line of credit will be used for general operations.
The outstanding balance with GMAC as of March 31, 2005 was $4,803,161. The
amount available to the Company for borrowing as of March 31, 2005 was $283,758.
NOTE 8 - TRADE CREDIT FACILITIES WITH RELATED PARTIES
In January 2003, the Company entered into a trade credit facility with a related
party, whereby the related party has agreed to purchase inventory on behalf of
the Company. The agreement allows the Company to purchase up to $10.0 million,
with payment terms of 120 days following the date of invoice. The third party
will charge the Company a 5% handling fee on the supplier's unit price. A 2%
discount to the handling fee will be applied if the Company reaches an average
running monthly purchasing volume of $750,000. Returns made by the Company,
which are agreed by the supplier, will result in a credit to the Company for the
handling charge. As security for the trade facility, the Company paid the
related party a security deposit of $1.5 million, all of which may be applied
against outstanding accounts payable. As of March 31, 2005, $1.5 million had
been applied against outstanding accounts payable to the related party. The
agreement is for 12 months. At the end of the 12-month period, either party may
terminate the agreement upon 30 days' written notice; otherwise, the agreement
11
will remain continuously valid without effecting a newly signed agreement. Both
parties have the right to terminate the agreement one year following the
inception date by giving the other party 30 days' prior written notice of
termination. As of March 31, 2005, there were $487,878 in trade payables under
this arrangement.
In February 2003, the Company entered into an agreement with a related party,
whereby the related party agreed to supply and store at the Company's warehouse
up to $10.0 million of inventory on a consignment basis. Under the agreement,
the Company will insure the consignment inventory, store the consignment
inventory for no charge, and furnish the related party with weekly statements
indicating all products received and sold and the current consignment inventory
level. The agreement may be terminated by either party with 60 days written
notice. In addition, this agreement provides for a trade line of credit of up to
$10.0 million with payment terms of net 60 days, non-interest bearing. During
the three months ended March 31, 2005, the Company purchased $7.0 million
(unaudited) of inventory under this arrangement. As of March 31, 2005, there
were $6,784,277 (unaudited) in trade payables outstanding under this
arrangement.
NOTE 9 - COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases its facilities and certain equipment under non-cancelable
operating lease agreements that expire through December 2008. The Company moved
to its current facilities in September 2003.
Rent expense was $92,333 (unaudited) and $90,870 (unaudited) for the three
months ended March 31, 2005 and 2004, respectively, and is included in general
and administrative expenses in the accompanying statements of income.
LITIGATION
On May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for breach of
contract and legal malpractice against Lawrence W. Horwitz, Gregory B. Beam,
Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and Senn Palumbo
Mealemans, LLP, the Company's former attorneys and their respective law firms,
in the Superior Court of the State of California for the County of Orange. The
complaint seeks damages of $15.0 million arising out of the defendants'
representation of I/OMagic and IOM Holdings, Inc. in an acquisition transaction
and in a separate arbitration matter. On November 6, 2003, the Company filed its
First Amended Complaint against all defendants. Defendants have responded to the
Company's First Amended Complaint denying the Company's allegations. Defendants
Lawrence W. Horwitz and Lawrence M. Cron have also filed a Cross-Complaint
against the Company for attorneys' fees in the approximate amount of $79,000.
The Company has denied their allegations in the Cross-Complaint. As of the date
of this report, discovery has commenced and a trial date in this action has been
set for September 12, 2005. The outcome of this action is presently uncertain.
However, the Company believes that all of its claims are meritorious.
On March 15, 2004, Magnequench International, Inc., or plaintiff, filed an
Amended Complaint for Patent Infringement in the United States District Court of
the District of Delaware (Civil Action No. 04-135 (GMS)) against, among others,
the Company, Sony Corp., Acer Inc., Asustek Computer, Inc., Iomega Corporation,
LG Electronics, Inc., Lite-On Technology Corporation and Memorex Products, Inc.,
or defendants. The complaint seeks to permanently enjoin defendants from, among
other things, selling products that allegedly infringe one or more claims of
plaintiff's patents. The complaint also seeks damages of an unspecified amount,
and treble damages based on defendants' alleged willful infringement. In
addition, the complaint seeks reimbursement of plaintiff's costs as well as
reasonable attorney's fees, and a recall of all existing products of defendants
that infringe one or more claims of plaintiff's patents that are within the
control of defendants or their wholesalers and retailers. Finally, the complaint
seeks destruction (or reconfiguration to non-infringing embodiments) of all
existing products in the possession of defendants that infringe one or more
claims of plaintiff's patents. The Company has filed a response denying
plaintiff's claims and asserting defenses to plaintiff's causes of action
alleged in the complaint.
On March 9, 2005, the Company entered into a Settlement Agreement with
Magnequench International, Inc., releasing all claims against the Company in
exchange for certain information and covenants by the Company, including
disclosure of identities of certain of its suppliers of alleged infringing
products, a covenant to provide sample products for testing purposes and a
covenant to not source products from suppliers of alleged infringing products,
provided that, among other limitations, another supplier makes those products
available to the Company in sufficient quantities. A dismissal of the case was
filed with the court on April 15, 2005.
12
In addition, the Company is involved in certain legal proceedings and claims
which arise in the normal course of business. Management does not believe that
the outcome of these matters will have a material affect on the Company's
financial position or results of operations.
NOTE 10 - RELATED PARTY TRANSACTIONS
During the three months ended March 31, 2005 and 2004, the Company made
purchases from related parties totaling approximately $7,495,622 (unaudited) and
$8,274,670 (unaudited), respectively.
During the three months ended March 31, 2005 and 2004, the Company had trade
payables to related parties totaling approximately $7,272,155 (unaudited) and
$5,732,423 (unaudited), respectively.
NOTE 11 - SUBSEQUENT EVENTS
Litigation - OfficeMax North America, Inc.
- ------------------------------------------
On May 6, 2005, OfficeMax North America, Inc., or plaintiff, filed a Complaint
for Declaratory Judgment in the United States District Court of the Northern
District of Ohio against the Company. The complaint seeks declaratory relief
regarding whether plaintiff is still obligated to the Company under certain
previous agreements between the parties. The complaint also seeks plaintiff's
costs as well as reasonable attorneys' fees. The complaint arises out of the
Company's contentions that plaintiff is still obligated to the Company under an
agreement entered into in May 2001 and plaintiff's contention that it has been
released from such obligation. As of the date of this report, the Company has
filed a motion to dismiss, or in the alternative, a motion to stay the
plaintiff's action against the Company. The outcome of this action is presently
uncertain. However, at this time, the Company does not expect the defense or
outcome of this action to have a material adverse affect on its business,
financial condition or results of operations.
On May 20, 2005, the Company filed a complaint for breach of contract, breach of
implied covenant of good faith and fair dealing, and common counts against
OfficeMax North America, Inc., or defendant, in the Superior Court of the State
of California for the County of Orange. The complaint seeks damages in excess of
$22 million arising out of the defendants' breach of contract under an agreement
entered into in May 2001. On or about June 20, 2005, defendant removed this
complaint to the United States District Court for the Central District of
California. The Company and OfficeMax have jointly requested that the United
States District Court for the Central District of California temporarily stay
this case pending the outcome of the Company's motion to dismiss, or in the
alternative, the Company's motion to stay OfficeMax's action against the Company
in the United States District Court of the Northern District of Ohio. The
outcome of this action is presently uncertain. However, the Company believes
that all of its claims are meritorious.
Line of Credit
- --------------
On May 23, 2005, the Company entered into a Letter Agreement (the "Letter
Agreement") with GMAC with respect to a certain financial covenant under the
Company's Loan and Security Agreement with GMAC dated March 9, 2005 (the "Loan
Agreement"). The Letter Agreement amended the Loan Agreement to exclude the
required Fixed Charge Coverage Ratio for the Measurement Period ending March 31,
2005. As of March 31 2005, the Company was in breach of the financial covenant;
however, as a result of this Letter Agreement, the Company is no longer in
breach of this covenant. The Letter Agreement also amended the Loan Agreement to
include new Fixed Charge Coverage Ratio Measurement Periods ending April 30 and
May 31, 2005.
On June 30, 2005, the Company entered into a First Amendment to Loan and
Security Agreement (the "Amendment") with GMAC with respect to a certain
financial covenant under the Loan Agreement. The Amendment amended the Loan
Agreement to exclude the required Fixed Charge Coverage Ratio for the
Measurement Periods ending April 30 and May 31, 2005. As of April 30, 2005, the
Company was in breach of the financial covenant; however, as a result of this
Amendment, the Company is no longer in breach of this covenant.
Agreement with Lung Hwa Electronics Co., Ltd.
- ---------------------------------------------
On June 6, 2005, the Company entered into an agreement for a trade credit
facility with Lung Hwa Electronics Co., Ltd. ("LHE"). LHE is a stockholder and
subcontract manufacturer and supplier of I/OMagic. Under the terms of the
facility, LHE has agreed to purchase and manufacture inventory on behalf of the
Company. The Company can purchase up to $15.0 million of inventory either (i)
through LHE as an international purchasing office, or (ii) manufactured by LHE.
For inventory purchased through LHE the payment terms are 120 days following the
date of invoice by LHE and LHE charges the Company a 5% handling fee on a
supplier's unit price. A 2% discount of the handling fee is applied if the
Company reaches an average running monthly purchasing volume of $750,000.
Returns made by the Company, which are agreed to by a supplier, result in a
credit to the Company for the handling charge. For inventory manufactured by
LHE, the payment terms are 90 days following the date of the invoice by LHE.
Upon effectiveness of the Agreement, the Company is required to pay LHE $1.5
million as an early payment for all invoices coming due for payment. Any early
payment funds remaining three months after the date of the Agreement shall be
refunded to the Company immediately. Once the $1.5 million has been exhausted,
or three months from the date of the Agreement has expired, whichever is sooner,
the Company shall pay LHE 10% of the purchase price on any purchase orders
issued to LHE, as a down-payment for the order, within one week of the purchase
order. The Agreement has an initial term of one year after which the Agreement
will continue indefinitely if not terminated at the end of the initial term. At
the end of the initial term and at any time thereafter, either party has the
right to terminate the facility upon 30 days' prior written notice to the other
party.
In connection with the entry into the agreement with LHE described above, the
Company entered into a Termination Agreement effective June 6, 2005 that
terminated the Company's previous January 23, 2003 agreement with LHE that
provided a $10 million trade credit facility to the Company.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR
CONSOLIDATED AUDITED FINANCIAL STATEMENTS AND THE RELATED NOTES AND THE OTHER
FINANCIAL INFORMATION IN OUR MOST RECENT ANNUAL REPORT ON FORM 10-K AND OUR
CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS AND THE RELATED NOTES AND OTHER
FINANCIAL INFORMATION INCLUDED ELSEWHERE IN THIS REPORT. THIS DISCUSSION
CONTAINS FORWARD-LOOKING STATEMENTS REGARDING THE DATA STORAGE INDUSTRY AND OUR
EXPECTATIONS REGARDING OUR FUTURE PERFORMANCE, LIQUIDITY AND CAPITAL RESOURCES.
OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE EXPRESSED IN THESE
FORWARD-LOOKING STATEMENTS AS A RESULT OF ANY NUMBER OF FACTORS, INCLUDING THOSE
SET FORTH UNDER "RISK FACTORS" AND UNDER OTHER CAPTIONS CONTAINED ELSEWHERE IN
THIS REPORT.
OVERVIEW
We are a leading provider of optical data storage products and also
sell a range of portable magnetic data storage products which we call our
GigaBank(TM) products. In addition, and to a much lesser extent, we sell digital
entertainment and other products. Our data storage products collectively
accounted for approximately 99% of our net sales in 2004 and for the first
quarter of 2005, and our digital entertainment and other products collectively
accounted for only approximately 1% of our net sales in 2004 and for the first
quarter of 2005.
Our data storage products consist of a range of products that store
traditional PC data as well as music, photos, movies, games and other
multi-media content. These products are designed principally for general data
storage purposes. Our digital entertainment products consist of a range of
products that focus on digital music, photos and movies. These products are
designed principally for entertainment purposes.
We sell our products through computer, consumer electronics and office
supply superstores and other retailers in over 10,000 retail locations
throughout North America. Our network of retailers enables us to offer products
to consumers across North America, including every major metropolitan market in
the United States. In the past three years, our retailers have included Best
Buy, Circuit City, CompUSA, Office Depot, OfficeMax and Staples. Our principle
brand is I/OMagic(R), however, from time to time, we also sell products under
our Hi-Val(R) and Digital Research Technologies(R) brand names.
Our net sales declined by $6.5 million, or 41.9%, to $9.0 million in
the first quarter of 2005 from $15.5 million in the first quarter of 2004. Our
net loss increased by $1.3 million to $1.2 million in the first quarter of 2005
from net income of $145,000 in the first quarter of 2004. We believe that this
significant decline in our operating results is due, in large part, to the
following factors:
o DECREASED SALES. As discussed further below, we believe that
our substantial decline in net sales in the first quarter of
2005 as compared to the first quarter of 2004 was primarily
due to the following factors:
o the rapid and continued decline in sales of our
CD-based products;
o lower average selling prices of our DVD-based
products;
o slower than anticipated growth in sales of our
DVD-based products; and
o sales to Best Buy, our largest customer in 2003 and
2002, declined substantially, resulting in no sales
to Best Buy in the first quarter of 2005 as compared
to $2.8 million in net sales for the first quarter of
2004 due to the expanded operation of private label
programs.
14
o DECREASED GROSS MARGINS. Our gross margins declined by 56.2%
to 6.4% in the first quarter of 2005 as compared to gross
margins of 14.6% in the first quarter of 2004. This decline
was primarily due to an increase in market development fund
and cooperative advertising costs, rebate promotion costs and
slotting fees from $2.0 million, or 10.2% of gross sales,
during the first quarter of 2004 to $2.4 million, or 17.6% of
gross sales, during the first quarter of 2005.
We believe that the significant decline in our net sales during the
first quarter of 2005 as compared to the first quarter of 2004 resulted in part
from the rapid and continued decline in sales of our CD-based products. We
elected to de-emphasize CD-based products because we believe that they are
included as a standard component in most new computer systems and because
DVD-based products are backward-compatible with CDs. Predominantly based on
market forces, but also partly as a result of our decision to de-emphasize
CD-based products, our sales of recordable CD-based products declined by 72.1%
to $866,000 in the first quarter of 2005 from $3.1 million in the first quarter
of 2004.
We believe that another factor contributing to the significant decrease
in our net sales for the first quarter of 2005 as compared to the same period in
2004 was an industry-wide decrease over these periods of approximately 30% in
the average selling prices of recordable DVD drives. We believe that these lower
average selling prices were primarily the result of a slower than anticipated
growth in DVD-compatible applications and infrastructure, which resulted in
lower demand for DVD-based products. In addition, we believe that, based on
industry forecasts that predicted significant sales growth of DVD-based data
storage products, suppliers produced quantities of these products that were
substantial and excessive relative to the ultimate demand for those products. As
a result of these relatively substantial and excessive quantities, the market
for DVD-based data storage products experienced intense competition and downward
pricing pressures resulting in lower than expected overall dollar sales. The
effects of these factors on sales of our DVD-based products were substantially
similar in this regard to that of the data storage industry. For the first
quarter of 2005, our sales of recordable DVD-based products decreased 54.5% to
$4.6 million as compared to $10.1 million in sales of recordable DVD-based
products for the same period in 2004.
Another factor contributing significantly to the decline in our net
sales during the first quarter of 2005 as compared to the first quarter of 2004
was the continued and expanded operation of private label programs by Best Buy.
Our sales to Best Buy, who was our largest retailer during 2003 and 2002,
declined in the first quarter of 2005 to zero as compared to $2.8 million of
sales in the first quarter of 2004. We believe that this decrease reflects, at
least in part, Best Buy's increased sales beginning in 2004 of private label
products that compete with products that we sell.
In addition to the other factors described above, we believe that USB
portable data storage devices, which are an alternative to optical data storage
products, have caused a decline in the relative market share of CD- and
DVD-based optical data storage products and likewise caused a decline in our
sales of CD- and DVD-based products in the first quarter of 2005. Our business
focus is predominantly on DVD-based optical data storage products. In addition
to CD- and DVD-based optical data storage products, we also focus on and sell a
line of GigaBank(TM) products, which are compact and portable hard disk drives
with a built-in USB connector. We expect to broaden our range of data storage
products by expanding our GigaBank(TM) product line and we anticipate that sales
of these devices will increase as a percentage of our total net sales over the
next twelve months. In the third quarter of 2004, we began selling our
GigaBank(TM) products, and sales of these devices accounted for approximately
27.0% of our total net sales in the fourth quarter of 2004. Sales of our
GigaBank(TM) products increased to $2.9 million in the first quarter of 2005 as
compared to no sales of these products in the first quarter of 2004. Sales of
our GigaBank(TM) products represented 32.3% of our total net sales in the first
quarter of 2005.
15
One of our core strategies is to be among the first-to-market with new
and enhanced product offerings based on established technologies. We expect to
apply this strategy, as we have done in the contexts of CD- and DVD-based
technologies and for our GigaBank(TM) products, to next-generation super-high
capacity optical data storage devices. This strategy extends not only to new
products, but also to enhancements of existing products. We believe that by
employing this strategy, we will be able to maintain relatively high average
selling prices and margins and avoid relying on the highly competitive market of
last-generation and older devices.
OPERATING PERFORMANCE AND FINANCIAL CONDITION
We focus on numerous factors in evaluating our operating performance
and our financial condition. In particular, in evaluating our operating
performance, we focus primarily on net sales, net product margins, net retailer
margins, rebates and sales incentives, and inventory turnover as well as
operating expenses and net income.
NET SALES. Net sales is a key indicator of our operating performance.
We closely monitor overall net sales, as well as net sales to individual
retailers, and seek to increase net sales by expanding sales to additional
retailers and expanding sales to existing retailers both by increasing sales of
existing products and introducing new products. Management monitors net sales on
a weekly basis, but also considers sales seasonality, promotional programs and
product life-cycles in evaluating weekly sales performance. As net sales
increase or decrease from period to period, it is critical for management to
understand and react to the various causes of these fluctuations, such as
successes or failures of particular products, promotional programs, product
pricing, retailer decisions, seasonality and other causes. Where possible,
management attempts to anticipate potential changes in net sales and seeks to
prevent adverse changes and stimulate positive changes by addressing the
expected causes of adverse and positive changes. We believe that our good
working relationships with our retailers enable us to monitor closely consumer
acceptance of particular products and promotional programs which in turn enable
us to better anticipate changes in market conditions.
NET PRODUCT MARGINS. Net product margins, from product-to-product and
across all of our products as a whole, is an important measurement of our
operating performance. We monitor margins on a product-by-product basis to
ascertain whether particular products are profitable or should be phased out as
unprofitable products. In evaluating particular levels of product margins on a
product-by-product basis, we focus on attaining a level of net product margin
sufficient to contribute to normal operating expenses and to provide a profit.
The level of acceptable net product margin for a particular product depends on
our expected product sales mix. However, we occasionally sell products for
certain strategic reasons to, for example, complete a product line or for
promotional purposes, without a rigid focus on historical product margins or
contribution to operating expenses or profitability.
NET RETAILER MARGINS. We seek to manage profitability on a retailer
level, not solely on a product level. Although we focus on net product margins
on a product-by-product basis and across all of our products as a whole, our
primary focus is on attaining and building profitability on a
retailer-by-retailer level. For this reason, our mix of products is likely to
differ among our various retailers. These differences result from a number of
factors, including retailer-to-retailer differences, products offered for sale
and promotional programs.
REBATES AND SALES INCENTIVES. Rebates and sales incentives offered to
customers and retailers are an important aspect of our business and are
instrumental in obtaining and maintaining market leadership through competitive
pricing in generating sales on a regular basis as well as stimulating sales of
slow-moving products. We focus on rebates and sales incentives costs as a
proportion of our total net sales to ensure that we meet our expectations of the
costs of these programs and to understand how these programs contribute to our
profitability or result in unexpected losses.
16
INVENTORY TURNOVER. Our products' life-cycles typically range from 3-12
months, generating lower average selling prices as the cycles mature. We attempt
to keep our inventory levels at amounts adequate to meet our retailers' needs
while minimizing the danger of rapidly declining average selling prices and
inventory financing costs. By focusing on inventory turnover levels, we seek to
identify slow-moving products and take appropriate actions such as
implementation of rebates and sales incentives to increase inventory turnover.
Our use of a consignment sales model with certain retailers results in
increased amounts of inventory that we must carry and finance. Our use of a
consignment sales model results in greater exposure to the danger of declining
average selling prices, however our consignment sales model allows us to more
quickly and efficiently implement promotional programs and pricing adjustments
to sell off slow-moving inventory and prevent further price erosion.
Our targeted inventory turnover levels for our combined sales models is
6 to 8 weeks of inventory, which equates to an annual inventory turnover level
of approximately 6.5 to 8.5. For the first quarter of 2005, our annualized
inventory turnover level was 4.8 as compared to 7.5 for the first quarter of
2004, representing a period-to-period decrease of 36% primarily as a result of a
42% decrease in net sales, which was partially offset by a 10% decrease in
inventory. The decline in inventory turnover for the first quarter of 2005
included $362,000 in additional reserves for slow-moving and obsolete inventory
as compared to $100,000 in additional reserves for slow-moving and obsolete
inventory in the first quarter of 2004. For the year 2004, our annualized
inventory turnover level was 7.2 as compared to 6.6 in 2003, representing a
period-to-period increase of 9% primarily as a result of a 37% decline in
inventory offset by a 30% decrease in net sales. The decline in inventory in
2004 included $2.0 million in additional reserves for slow-moving and obsolete
inventory.
OPERATING EXPENSES. We focus on operating expenses to keep these
expenses within budgeted amounts in order to achieve or exceed our targeted
profitability. We budget certain of our operating expenses in proportion to our
projected net sales, including operating expenses relating to production,
shipping, technical support, and inside and outside commissions and bonuses.
However, most of our expenses relating to general and administrative costs,
product design and sales personnel are essentially fixed over large sales
ranges. Deviations that result in operating expenses in greater proportion than
budgeted signal to management that it must ascertain the reasons for the
unexpected increase and take appropriate action to bring operating expenses back
into the budgeted proportion.
NET INCOME. Net income is the ultimate goal of our business. By
managing the above factors, among others, and monitoring our actual results of
operations, our goal is to generate net income at levels that meet or exceed our
targets.
In evaluating our financial condition, we focus primarily on cash on
hand, available trade lines of credit, available bank line of credit,
anticipated near-term cash receipts, and accounts receivable as compared to
accounts payable. Cash on hand, together with our other sources of liquidity, is
critical to funding our day-to-day operations. Funds available under our line of
credit with GMAC Commercial Finance are also an important source of liquidity
and a measure of our financial condition. We use our line of credit on a regular
basis as a standard cash management procedure to purchase inventory and to fund
our day-to-day operations without interruption during periods of slow collection
of accounts receivable. Anticipated near-term cash receipts are also regarded as
a short-term source of liquidity, but are not regarded as immediately available
for use until receipt of funds actually occurs.
17
The proportion of our accounts receivable to our accounts payable and
the expected maturity of these balance sheet items is an important measure of
our financial condition. We attempt to manage our accounts receivable and
accounts payable to focus on cash flows in order to generate cash sufficient to
fund our day-to-day operations and satisfy our liabilities. Typically, we prefer
that accounts receivable are matched in duration to, or collected earlier than,
accounts payable. If accounts payable are either out of proportion to, or due
far in advance of, the expected collection of accounts receivable, we will
likely have to use our cash on hand or our line of credit to satisfy our
accounts payable obligations, without relying on additional cash receipts, which
will reduce our ability to purchase and sell inventory and may impact our
ability, at least in the short-term, to fund other parts of our business.
SALES MODELS
We employ three primary sales models: a standard terms sales model, a
consignment sales model and a special terms sales model. We generally use one of
these three primary sales models, or some combination of these sales models,
with each of our retailers.
STANDARD TERMS
Currently, the majority of our net sales are on a terms basis. Under
our standard terms sales model, a retailer is obligated to pay us for products
sold to it within a specified number of days from the date of sale of products
to the retailer. Our standard terms are typically net 60 days. We typically
collect payment from a retailer within 60 to 75 days following the sale of
products to a retailer.
CONSIGNMENT
Under our consignment sales model, a retailer is obligated to pay us
for products sold to it within a specified number of days following our
notification by the retailer of the resale of those products. Retailers notify
us of their resale of consigned products by delivering weekly or monthly
sell-through reports. A sell-through report discloses sales of products sold in
the prior period covered by the report - that is, a weekly or monthly
sell-through report covers sales of consigned products in the prior week or
month, respectively. The period for payment to us by retailers relating to their
sale of consigned products corresponding to these sell-through reports varies
from retailer to retailer. For sell-through reports generated weekly, we
typically collect payment from a retailer within 30 days of the receipt of those
reports. For sell-through reports generated monthly, we typically collect
payment from a retailer within 15 days of the receipt of those reports. Products
held by a retailer under our consignment sales model are recorded as our
inventory at offsite locations until their resale by the retailer.
Consignment sales represented a growing percentage of our net sales
from 2001 through 2003. However, during 2004, our consignment sales model
accounted for 32% of our total net sales as compared to 37% of our total net
sales in 2003, representing a 13% decrease, primarily as a result of consigning
fewer products to Best Buy, which was our largest consignment retailer, which
was partially offset by an increase in consigning more products to Staples.
During 2003, our consignment sales model accounted for 37% of our total net
sales as compared to 30% of our total net sales in 2002, representing a 23%
increase. During the first quarter of 2005 our consignment sales model accounted
for 38% of our total net sales as compared to 25% of our total net sales in the
first quarter of 2004, representing a 54% increase, primarily as a result of
consigning more products to Staples. Although consignment sales declined as a
percentage of our net sales in 2004, and increased as a percentage of our net
sales in the first quarter of 2005 as compared to the same period in 2004, it is
not yet clear whether consignment sales as a percentage of our total net sales
will continue to decline on an annual basis or resume growing.
18
During 2001, 2002 and 2003, we increased the use of our consignment
sales model based in part on the preferences of some of our retailers. Our
retailers often prefer the benefits resulting from our consignment sales model
over our standard terms sales model. These benefits include payment by a
retailer only in the event of resale of a consigned product, resulting in less
risk borne by the retailer of price erosion due to competition and technological
obsolescence. Deferring payment until following the sale of a consigned product
also enables a retailer to avoid having to finance the purchase of that product
by using cash on hand or by borrowing funds and incurring borrowing costs. In
addition, retailers also often operate under budgetary constraints on purchases
of certain products or product categories. As a result of these budgetary
constraints, the purchase by a retailer of certain products typically will cause
reduced purchasing power for other products. Products consigned to a retailer
ordinarily fall outside of these budgetary constraints and do not cause reduced
purchasing power for other products. As a result of these benefits, we believe
that we are able to sell more products by using our consignment sales model than
by using only our standard terms sales model.
Managing an appropriate level of consignment sales is an important
challenge. As noted above, the payment period for products sold on consignment
is based on the day consigned products are resold by a retailer, and the payment
period for products sold on a standard terms basis is based on the day the
product is sold initially to the retailer, independent of the date of resale of
the product. Accordingly, we generally prefer that higher-turnover inventory is
sold on a consignment basis while lower-turnover inventory is sold on a
traditional terms basis. Management focuses closely on consignment sales to
manage our cash flow to maximize liquidity as well as net sales. Close attention
is directed toward our inventory turnover levels to ensure that they are
sufficiently frequent to maintain appropriate liquidity. Our consignment sales
model enables us to have more pricing control over inventory sold through our
retailers as compared to our standard terms sales model. If we identify a
decline in inventory turnover levels for products in our consignment sales
channels, we can implement price modifications more quickly and efficiently as
compared to the implementation of sales incentives in connection with our
standard terms sales model. This affords us more flexibility to take action to
attain our targeted inventory turnover levels.
We retain most risks of ownership of products in our consignment sales
channels. These products remain as our inventory until their resale by our
retailers. The turnover frequency of our inventory on consignment is critical to
generating regular cash flow in amounts necessary to keep financing costs to
targeted levels and to purchase additional inventory. If this inventory turnover
is not sufficiently frequent, our financing costs may exceed targeted levels and
we may be unable to generate regular cash flow in amounts necessary to purchase
additional inventory to meet the demand for other products. In addition, as a
result of our products' short life-cycles, which generate lower average selling
prices as the cycles mature, low inventory turnover levels may force us to
reduce prices and accept lower margins to sell consigned products. If we fail to
select high turnover products for our consignment sales channels, our sales,
profitability and financial resources may decline.
SPECIAL TERMS
We occasionally employ a special terms sales model. Under our special
terms sales model, the payment terms for the purchase of our products are
negotiated on a case-by-case basis and typically cover a specified quantity of a
particular product. We ordinarily do not offer any rights of return or rebates
for products sold under our special terms sales model. Our payment terms are
ordinarily shorter under our special terms sales model than under our standard
terms or consignment sales models and we typically require payment in advance,
at the time of sale, or shortly following the sale of products to a retailer.
19
RETAILERS
Historically, a limited number of retailers have accounted for a
significant percentage of our net sales. During the first quarter of 2005 and
during the years 2004 and 2003, our six largest retailers accounted for
approximately 99%, 78% and 88%, respectively, of our total net sales. We expect
that sales of our products to a limited number of retailers will continue to
account for a majority of our sales in the foreseeable future. We do not have
long-term purchase agreements with any of our retailers. If we were to lose any
of our major retailers or experience any material reduction in orders from any
of them, and were unable to replace our sales to those retailers, it could have
a material adverse effect on our business and results of operations.
SEASONALITY
Our data storage products have historically been affected by seasonal
purchasing patterns. The seasonality of our sales is in direct correlation to
the seasonality experienced by our retailers and the seasonality of the consumer
electronics industry. After adjusting for the addition of new retailers, our
fourth quarter has historically generated the strongest sales, which correlates
to well-established consumer buying patterns during the Thanksgiving through
Christmas holiday season. Our first and third quarters have historically shown
some strength from time to time based on post-holiday season sales in the first
quarter and back-to-school sales in the third quarter. Our second quarter has
historically been our weakest quarter for sales, again following
well-established consumer buying patterns. The impact of seasonality on our
future results will be affected by our product mix, which will vary from quarter
to quarter.
PRICING PRESSURES
We face downward pricing pressures within our industry that arise from
a number of factors. The products we sell are subject to rapid technological
change and obsolescence. Companies within the data storage industry are
continuously developing new products with heightened performance and
functionality. This puts downward pricing pressures on existing products and
constantly threatens to make them, or causes them to be, obsolete. Our typical
product life-cycle is extremely short and ranges from only three to twelve
months, generating lower average selling prices as the cycle matures.
In addition, the data storage industry is extremely competitive.
Numerous large competitors such as BenQ, Hewlett-Packard, Sony, TDK and other
competitors such as Lite-On, Memorex, Philips Electronics and Samsung
Electronics compete with us in the optical data storage industry. Numerous large
competitors such as PNY Technologies, Sony, Seagate Technology and Western
Digital offer products similar to our GigaBank(TM) products. Intense competition
within our industry exerts downward pricing pressures on products that we offer.
Also, one of our core strategies is to offer our products as affordable
alternatives to higher-priced products offered by our larger competitors. The
effective execution of this business strategy results in downward pricing
pressure on products that we offer because our products must appeal to consumers
partially based on their attractive prices relative to products offered by our
large competitors. As a result, we are unable to rely as heavily on other
non-price factors such as brand recognition and must consistently maintain lower
prices.
Finally, the actions of our retailers often exert downward pricing
pressures on products that we offer. Our retailers pressure us to offer products
to them at attractive prices. In doing this, we do not believe that the overall
goal of our retailers is to increase their margins on these products. Instead,
we believe that our retailers pressure us to offer products to them at
attractive prices in order to increase sales volume and consumer traffic, as
well as to compete more effectively with other retailers of similar products.
Additional downward pricing pressure also results from the continuing threat
that our retailers may begin to directly import or private-label products that
are identical or very similar to our products. Our pricing decisions with regard
to certain products are influenced by the ability of retailers to directly
import or private-label identical or similar products. Therefore, we constantly
seek to maintain prices that are highly attractive to our retailers and that
offer less incentive to our retailers to commence or maintain direct import or
private-label programs.
20
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amount of net sales and expenses for
each period. The following represents a summary of our critical accounting
policies, defined as those policies that we believe are the most important to
the portrayal of our financial condition and results of operations and that
require management's most difficult, subjective or complex judgments, often as a
result of the need to make estimates about the effects of matters that are
inherently uncertain.
REVENUE RECOGNITION
We recognize revenue under three primary sales models: a standard terms
sales model, a consignment sales model and a special terms sales model. We
generally use one of these three primary sales models, or some combination of
these sales models, with each of our retailers.
STANDARD TERMS
Under our standard terms sales model, a retailer is obligated to pay us
for products sold to it within a specified number of days from the date that
title to the products is transferred to the retailer. Our standard terms are
typically net 60 days from the transfer of title to the products to a retailer.
We typically collect payment from a retailer within 60 to 75 days from the
transfer of title to the products to a retailer. Transfer of title occurs and
risk of ownership passes to a retailer at the time of shipment or delivery,
depending on the terms of our agreement with a particular retailer. The sale
price of our products is substantially fixed or determinable at the date of sale
based on purchase orders generated by a retailer and accepted by us. A
retailer's obligation to pay us for products sold to it under our standard terms
sales model is not contingent upon the resale of those products. We recognize
revenue for standard terms sales at the time title to products is transferred to
a retailer.
CONSIGNMENT
Under our consignment sales model, a retailer is obligated to pay us
for products sold to it within a specified number of days following our
notification by the retailer of the resale of those products. Retailers notify
us of their resale of consigned products by delivering weekly or monthly
sell-through reports. A sell-through report discloses sales of products sold in
the prior period covered by the report - that is, a weekly or monthly
sell-through report covers sales of consigned products in the prior week or
month, respectively. The period for payment to us by retailers relating to their
resale of consigned products corresponding to these sell-through reports varies
from retailer to retailer. For sell-through reports generated weekly, we
typically collect payment from a retailer within 30 days of the receipt of those
reports. For sell-through reports generated monthly, we typically collect
payment from a retailer within 15 days of the receipt of those reports. At the
time of a retailer's resale of a product, title is transferred directly to the
consumer. Risk of theft or damage of a product, however, passes to a retailer
upon delivery of that product to the retailer. The sale price of our products is
substantially fixed or determinable at the date of sale based on a product
sell-through report generated by a retailer and delivered to us. Except in the
21
case of theft or damage, a retailer's obligation to pay us for products
transferred under our consignment sales model is entirely contingent upon the
resale of those products. Products held by a retailer under our consignment
sales model are recorded as our inventory at offsite locations until their
resale by the retailer. Because we retain title to products in our consignment
sales channels until their resale by a retailer, revenue is not recognized until
the time of resale. Accordingly, price modifications to inventory maintained in
our consignment sales channels do not have an effect on the timing of revenue
recognition. We recognize revenue for consignment sales in the period during
which resale occurs.
SPECIAL TERMS
Under our special terms sales model, the payment terms for the purchase
of our products are negotiated on a case-by-case basis and typically cover a
specified quantity of a particular product. The result of our negotiations is a
special agreement with a retailer that defines how and when transfer of title
occurs and risk of ownership shifts to the retailer. We ordinarily do not offer
any rights of return or rebates for products sold under our special terms sales
model. A retailer is obligated to pay us for products sold to it within a
specified number of days from the date that title to the products is transferred
to the retailer, or as otherwise agreed to by us. Our payment terms are
ordinarily shorter under our special terms sales model than under our standard
terms or consignment sales models and we typically require payment in advance,
at the time of transfer of title to the products or shortly following the
transfer of title to the products to a retailer. Transfer of title occurs and
risk of ownership passes to a retailer at the time of shipment, delivery,
receipt of payment or the date of invoice, depending on the terms of our
agreement with the retailer. The sale price of our products is substantially
fixed or determinable at the date of sale based on our agreement with a
retailer. A retailer's obligation to pay us for products sold to it under our
special terms sales model is not contingent upon the resale of those products.
We recognize revenue for special terms sales at the time title to products is
transferred to a retailer.
SALES INCENTIVES
From time to time, we enter into agreements with certain retailers
regarding price decreases that are determined by us in our sole discretion.
These agreements allow those retailers (subject to limitations) a credit equal
to the difference between our current price and our new reduced price on units
in the retailers' inventories or in transit to the retailers on the date of the
price decrease.
We record an estimate of sales incentives based on our actual sales
incentive rates over a trailing twelve-month period, adjusted for any known
variations, which are charged to operations and offset against gross sales at
the time products are sold with a corresponding accrual for our estimated sales
incentive liability. This accrual--our sales incentive reserve--is reduced by
deductions on future payments taken by our retailers relating to actual sales
incentives.
At the end of each quarterly period, we analyze our existing sales
incentive reserve and apply any necessary adjustments based upon actual or
expected deviations in sales incentive rates from our applicable historical
sales incentive rates. The amount of any necessary adjustment is based upon the
amount of our remaining field inventory, which is calculated by reference to our
actual field inventory last conducted, plus inventory-in-transit and less
estimated product sell-through. The amount of our sales incentive liability for
each product is equal to the amount of remaining field inventory for that
product multiplied by the difference between our current price and our new
reduced price to our retailers for that product. This data, together with all
data relating to all sales incentives granted on products in the applicable
period, is used to adjust our sales incentive reserve established for the
applicable period.
In the first quarter of 2005, our sales incentives were $453,000, or
3.3% of gross sales, as compared to $687,000, or 3.5% of gross sales, in the
first quarter of 2004, all of which was offset against gross sales. In 2004, our
sales incentives were $2.5 million, or 4.2% of gross sales, all of which was
offset against gross sales. In 2003, our sales incentives were $2.9 million, or
3.5% of gross sales, all of which was offset against gross sales.
22
MARKET DEVELOPMENT FUND AND COOPERATIVE ADVERTISING COSTS, REBATE PROMOTION
COSTS AND SLOTTING FEES
Market development fund and cooperative advertising costs, rebate
promotion costs and slotting fees are charged to operations and offset against
gross sales in accordance with Emerging Issues Task Force Issue No. 01-9. Market
development fund and cooperative advertising costs and rebate promotion costs
are each promotional costs. Slotting fees are fees paid directly to retailers
for allocation of shelf-space in retail locations. In the first quarter of 2005,
our market development fund and cooperative advertising costs, rebate promotion
costs and slotting fees were $2.4 million, or 17.8% of gross sales, all of which
was offset against gross sales, as compared to market development fund and
cooperative advertising costs, rebate promotion costs and slotting fees of $2.0
million, or 10.1% of gross sales, in the first quarter of 2004, all of which was
offset against gross sales. These costs and fees increased as a percentage of
our net sales in the first quarter of 2005, increasing to 17.8% of our gross
sales from 10.1% of our gross sales in the first quarter of 2004, primarily as a
result of instituting sales incentives and marketing promotions in order to
promote our double layer recordable DVD drives. In 2004, our market development
fund and cooperative advertising costs, rebate promotion costs and slotting fees
were $7.8 million, or 13.0% of gross sales, all of which was offset against
gross sales. In 2003, our market development fund and cooperative advertising
costs, rebate promotion costs and slotting fees were $8.4 million, or 10.3% of
gross sales, all of which was offset against gross sales.
Consideration generally given by us to a retailer is presumed to be a
reduction of selling price, and therefore, a reduction of gross sales. However,
if we receive an identifiable benefit that is sufficiently separable from our
sales to that retailer, such that we could have paid an independent company to
receive that benefit and we can reasonably estimate the fair value of that
benefit, then the consideration is characterized as an expense. We estimate the
fair value of the benefits we receive by tracking the advertising done by our
retailers on our behalf and calculating the value of that advertising using a
comparable rate for similar publications.
INVENTORY OBSOLESCENCE ALLOWANCE
Our warehouse supervisor, production supervisor and production manager
physically review our warehouse inventory for slow-moving and obsolete products.
All products of a material amount are reviewed quarterly and all products of an
immaterial amount are reviewed annually. We consider products that have not been
sold within six months to be slow-moving. Products that are no longer compatible
with current hardware or software are considered obsolete. The potential for
re-sale of slow-moving and obsolete inventories is considered through market
research, analysis of our retailers' current needs, and assumptions about future
demand and market conditions. The recorded cost of both slow-moving and obsolete
inventories is then reduced to its estimated market value based on current
market pricing for similar products. We utilize the Internet to provide
indications of market value from competitors' pricing, third party inventory
liquidators and auction websites. The recorded costs of our slow-moving and
obsolete products are reduced to current market prices when the recorded costs
exceed those market prices. For the first quarter of 2005 we increased our
inventory reserve and recorded a corresponding increase in cost of goods sold of
$362,000 for inventory for which recorded cost exceeded the current market price
of this inventory on hand. For the first quarter of 2004, we decreased our
inventory reserve and recorded a corresponding decrease in cost of goods sold of
$100,000. All adjustments establish a new cost basis for inventory as we believe
such reductions are permanent declines in the market price of our products.
Generally, obsolete inventory is sold to companies that specialize in the
liquidation of these items while we continue to market slow-moving inventories
until they are sold or become obsolete. As obsolete or slow-moving inventory is
sold, we reduce the reserve by proceeds from the sale of the products. During
the first quarter of 2005 and 2004, we sold inventories previously reserved for
and accordingly reduced the reserve by $0 and $126,000, respectively. For the
23
first quarter of 2005 and 2004, gains recorded as a result of sales of obsolete
inventory above the reserved amount were not significant to our results of
operations and accounted for less than 1% of our total net sales. Although we
have no specific statistical data on this matter, we believe that our practices
are reasonable and consistent with those of our industry.
INVENTORY ADJUSTMENTS
Our warehouse supervisor, production supervisor and production manager
physically review our warehouse inventory for obsolete or damaged
inventory-related items on a monthly basis. Inventory-related items (such as
sleeves, manuals or broken products no longer under warranty from our
subcontract manufacturers) which are considered obsolete or damaged are reviewed
by these personnel together with our Controller or Chief Financial Officer. At
the discretion of our Controller or Chief Financial Officer, these items are
physically disposed of and we make corresponding accounting adjustments
resulting in inventory adjustments. In addition, on a monthly basis, our detail
inventory report and our general ledger are reconciled by our Controller and any
variances result in a corresponding inventory adjustment. Although we have no
specific statistical data on this matter, we believe that our practices are
reasonable and consistent with those of our industry.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain allowances for doubtful accounts for estimated losses
resulting from the inability of our retailers to make required payments. Our
current retailers consist of either large national or regional retailers with
good payment histories with us. Since we have not experienced any previous
payment defaults with any of our current retailers, our allowance for doubtful
accounts is minimal. We perform periodic credit evaluations of our retailers and
maintain allowances for potential credit losses based on management's evaluation
of historical experience and current industry trends. If the financial condition
of our retailers were to deteriorate, resulting in the impairment of their
ability to make payments, additional allowances may be required. New retailers
are evaluated through Dunn & Bradstreet before terms are established. Although
we expect to collect all amounts due, actual collections may differ.
PRODUCT RETURNS
We have a limited 90-day to one year time period for product returns
from end-users; however, our retailers generally have return policies that allow
their customers to return products within only fourteen to thirty days after
purchase. We allow our retailers to return damaged or defective products to us
following a customary return merchandise authorization process. We have no
informal return policies. We utilize actual historical return rates to determine
our allowance for returns in each period. Gross sales is reduced by estimated
returns and cost of sales is reduced by the estimated cost of those sales. We
record a corresponding accrual for the estimated liability associated with the
estimated returns. This estimated liability is based on the gross margin of the
products corresponding to the estimated returns. This accrual is offset each
period by actual product returns.
Our current estimated weighted average future product return rate is
approximately 10.3%. As noted above, our return rate is based upon our past
history of actual returns and we estimate amounts for product returns for a
given period by applying this historical return rate and reducing actual gross
sales for that period by a corresponding amount. Our historical return rate for
a particular product is the life-to-date return rate of similar products. This
life-to-date return rate is updated monthly. We also compare this life-to-date
return rate to our trailing 18-month return rate to determine whether any
material changes in our return rate have occurred that may not be reflected in
the life-to-date return rate. We believe that using a trailing 18-month return
rate takes two key factors into consideration, specifically, an 18-month return
24
rate provides us with a sufficient period of time to establish recent historical
trends in product returns for each product category, and provides us with a
period of time that is short enough to account for recent technological shifts
in our product offerings in each product category. If an unusual circumstance
exists, such as a product category that has begun to show materially different
actual return rates as compared to life-to-date return rates, we will make
appropriate adjustments to our estimated return rates. Factors that could cause
materially different actual return rates as compared to life-to-date return
rates include product modifications that simplify installation, a new product
line, within a product category, that needs time to better reflect its return
performance and other factors.
Although we have no specific statistical data on this matter, we
believe that our practices are reasonable and consistent with those of our
industry.
Our warranty terms under our arrangements with our suppliers are that
any product that is returned by a retailer or retail customer as defective can
be returned by us to the supplier for full credit against the original purchase
price. We incur only minimal shipping costs to our suppliers in connection with
the satisfaction of our warranty obligations.
RESULTS OF OPERATIONS
The tables presented below, which compare our results of operations
from one period to another, present the results for each period, the change in
those results from one period to another in both dollars and percentage change
and the results for each period as a percentage of net sales. The columns
present the following:
o The first two data columns in each table show the absolute results
for each period presented.
o The columns entitled "Dollar Variance" and "Percentage Variance"
show the change in results, both in dollars and percentages. These
two columns show favorable changes as a positive and unfavorable
changes as negative. For example, when our net sales increase from
one period to the next, that change is shown as a positive number
in both columns. Conversely, when expenses increase from one period
to the next, that change is shown as a negative in both columns.
o The last two columns in each table show the results for each period
as a percentage of net sales.
25
THREE MONTHS ENDED MARCH 31, 2005 (UNAUDITED) COMPARED TO THREE MONTHS ENDED
MARCH 31, 2004 (UNAUDITED)
RESULTS AS A PERCENTAGE
DOLLAR PERCENTAGE OF NET SALES FOR THE
THREE MONTHS ENDED VARIANCE VARIANCE THREE MONTHS ENDED
MARCH 31, -------- -------- MARCH 31,
-------------------- FAVORABLE FAVORABLE --------------------
2004 2004
---- ----
2005 (RESTATED) (UNFAVORABLE) (UNFAVORABLE) 2005 (RESTATED)
---- ---------- ------------- ------------- ---- ----------
(in thousands)
Net sales..................................... $ 9,037 $ 15,473 $ (6,436) (41.6)% 100.0% 100.0%
Cost of sales................................. 8,455 13,218 4,763 36.0 93.6 85.4
--------- -------- ---------- ----- ----- -----
Gross profit.................................. 582 2,255 (1,673) (74.2) 6.4 14.6
Selling, marketing and advertising expenses... 174 480 306 63.8 1.9 3.1
General and administrative expenses .......... 1,417 1,366 (51) (3.7) 15.7 8.8
Depreciation and amortization ................ 79 209 130 62.2 0.9 1.4
--------- -------- ---------- ----- ----- -----
Operating income (loss)....................... (1,088) 200 (1,288) (644.0) (12.0) 1.3
Net interest expense.......................... (77) (44) (33) (75.0) (0.9) (0.3)
Other income (expense)........................ 8 (8) 16 200.0 0.1 (0.1)
--------- -------- ---------- ----- ----- -----
Income (loss) from operations before
provision for income taxes.................. (1,157) 148 (1,305) (881.8) (12.8) 0.9
Income tax provision ......................... -- 3 3 100.0 -- --
--------- -------- ---------- ----- ----- -----
Net income (loss)............................. $ (1,157) $ 145 $ (1,302) (897.9)% (12.8)% 0.9%
========= ======== ========== ===== ===== =====
NET SALES. As discussed above, we believe that the significant decrease
in the amount of $6.5 million in net sales from $15.5 million for the three
months ended March 31, 2004 to $9.0 million for the three months ended March 31,
2005 is primarily due to the following factors: the continued decline in sales
of our CD-based products; lower average selling prices of DVD-based products;
slower than anticipated growth and decrease in sales of our DVD-based products;
and the continued operation of private label programs by Best Buy. The decline
in net sales caused by these factors was partially offset by a substantial
increase in the sale of our GigaBank(TM) USB portable data storage devices.
We believe that the significant decline in our net sales during the
three months ended March 31, 2005 as compared to the three months ended March
31, 2004 resulted in part from the rapid and continued decline in sales of our
CD-based products. Predominantly based on market forces, but also partly as a
result of our decision to de-emphasize CD-based products, our sales of
recordable CD-based products declined by 72.1% to $866,000 in the first quarter
of 2005 from $3.1 million in the first quarter of 2004.
In addition, we believe that an industry-wide decrease of approximately
30% in the average selling prices of recordable DVD drives in the first quarter
of 2005 as compared to the first quarter of 2004 resulted in a significant
decline in our net sales. We believe that these lower average selling prices
were primarily the result of a slower than anticipated growth in DVD-compatible
applications and infrastructure, which resulted in lower demand for DVD-based
products. We believe that, based on industry forecasts that predicted
significant sales growth of DVD-based data storage products, suppliers produced
quantities of these products that were substantial and excessive relative to the
ultimate demand for those products. As a result of these relatively substantial
and excessive quantities, the market for DVD-based data storage products
experienced intense competition and downward pricing pressures resulting in
lower than expected overall dollar sales. The effects of these factors on sales
of our DVD-based products were substantially similar in this regard to that of
the data storage industry. For the first quarter of 2005, sales of our
recordable DVD-based products decreased 54.5% to $4.6 million as compared to
$10.1 million in sales of our recordable DVD-based products for the same period
in 2004.
26
In addition to the other factors described above, we believe that USB
portable data storage devices, which are an alternative to optical data storage
products, have caused a decline in the relative market share of CD- and
DVD-based optical data storage products and likewise caused a decline in our
sales of CD- and DVD-based products in the first quarter of 2005. Our business
focus is predominantly on DVD-based optical data storage products. In addition
to CD- and DVD-based optical data storage products, we also focus on and sell a
line of GigaBank(TM) products, which are compact and portable hard disk drives
with a built-in USB connector. We expect to broaden our range of data storage
products by expanding our GigaBank(TM) product line and we anticipate that sales
of these devices will increase as a percentage of our total net sales over the
next twelve months. In the third quarter of 2004, we began selling our
GigaBank(TM) products, and sales of these devices accounted for approximately
27.0% of our total net sales in the fourth quarter of 2004. Sales of our
GigaBank(TM) products increased to $2.9 million in the first quarter of 2005 as
compared to no sales of these products in the first quarter of 2004. Sales of
our GigaBank(TM) products represented 32.3% of our total net sales in the first
quarter of 2005.
Another factor contributing significantly to the decline in our net
sales during the first quarter of 2005 as compared to the same period in 2004
was the continued and expanded operation of private label programs by Best Buy.
We had no sales to Best Buy in the first quarter of 2005, representing a
decrease of 100% from $2.8 million in sales to Best Buy in the same period in
2004. We believe that this decrease reflects, at least in part, Best Buy's
increased sales of private label products that compete with products that we
sell.
The decrease in gross profit as a percentage of our net sales was
primarily due to an increase in market development fund and cooperative
advertising costs, rebate promotion costs and slotting fees from $2.0 million,
or 10.2% of gross sales, during the first quarter of 2004, to $2.4 million, or
17.6% of gross sales, during the first quarter of 2005. These costs and fees
increased primarily as a result of our more extensive marketing and rebate
promotions used to promote our double-layer recordable DVD drives.
A change in the allowance for product returns also resulted in an
adjustment of $409,000 causing an increase in sales in the first quarter of 2005
as compared to an adjustment of $1.1 million that resulted in an increase in
sales in the first quarter of 2004.
The significant decrease in net sales for the first quarter of 2005 was
comprised of a decrease in net sales in the amount of $5.3 million resulting
from a decrease in the volume of CD- and DVD-based products sold and a decrease
in the amount of $1.2 million resulting from a change in our reserves for future
returns on sales. These decreases were partially offset by an increase in net
sales in the amount of $79,000 resulting from higher average product sales
prices associated with our GigaBank(TM) products. The decrease in the volume of
products sold was consistent with reduced sales of our CD-based products as well
as our DVD-based products, as noted above.
GROSS PROFIT. The decrease in gross profit of $1.7 million from $2.3
million for the first quarter of 2004 to $582,000 for the first quarter of 2005
is primarily due to a decline in net sales of $6.5 million, an increase in
market development fund and cooperative advertising costs, rebate promotion
costs and slotting fees and an increase in our reserve for slow-moving
inventory. The decrease in gross profit as a percentage of our net sales was
primarily due to an increase in market development fund and cooperative
advertising costs, rebate promotion costs and slotting fees from 10.2% of gross
sales during the first quarter of 2004 to 17.6% of gross sales during the first
quarter of 2005. These costs and fees increased primarily as a result of
instituting marketing promotions in order to promote our double-layer recordable
DVD drives. Our direct product costs, inventory shrinkage and related freight
costs increased from 85.4% of net sales for the first quarter of 2004 to 93.6%
of net sales for the first quarter of 2005, primarily due to the increase in
market development fund and cooperative advertising costs, rebate promotion
costs and slotting fees.
27
Our inventory reserve increased by $362,000 in the first quarter of
2005 as compared to $100,000 in the first quarter of 2004 due to our adjustment
of the value of our slow-moving and obsolete inventory. As a result of the short
life cycles of many of our products resulting from, in part, the effects of
rapid technological change, we expect to experience additional slow-moving and
obsolete inventory charges in the future. However, we cannot predict with any
certainty the future level of these charges.
SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses decreased by $306,000 in the first quarter of 2005 as
compared to the first quarter of 2004. This decrease was primarily due to no
advertising expenses incurred in the first quarter of 2005 as compared to
advertising expenses of $240,000 incurred in the first quarter of 2004. In
addition, this decrease partially resulted from lower commissions as a result of
reduced sales volume and reduced payroll and related expenses due to fewer
personnel and lower retailer performance charges.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative
expenses increased by $51,000 in the first quarter of 2005 as compared to the
first quarter of 2004. This increase was primarily due to an $82,000 increase in
financing fees related to our new line of credit and a $69,000 increase in legal
fees. The increase in general and administrative expenses was partially offset
by a $54,000 decrease in payroll and related expenses and a $54,000 decrease in
financial relations expenses.
DEPRECIATION AND AMORTIZATION EXPENSES. The $130,000 decrease in
depreciation and amortization expenses is primarily due to decreased
amortization of our trademarks resulting from an impairment in the value of our
Hi-Val(R) and Digital Research Technologies(R) trademarks in the aggregate
amount of $3.7 million recorded as of December 31, 2004.
OTHER INCOME (EXPENSE). Other income (expense) increased by $16,000 in
the first quarter of 2005 as compared to the first quarter of 2004. Net interest
expense increased by $33,000 due to both greater borrowings under our lines of
credit and higher interest rates in the first quarter of 2005 as compared to the
first quarter of 2004. This was partially offset by an increase in income in the
amount of $12,000 related to foreign currency transactions in connection with
our sales in Canada.
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of liquidity have been cash provided by
operations and borrowings under our bank and trade credit facilities. Our
principal uses of cash have been to finance working capital, capital
expenditures and debt service requirements. We anticipate that these sources and
uses will continue to be our principal sources and uses of cash in the future.
As of March 31, 2005, we had working capital of $6.4 million, an accumulated
deficit of $24.2 million, $1.7 million in cash and cash equivalents and $12.8
million in net accounts receivable. This compares with working capital of $7.5
million, an accumulated deficit of $23.1 million, $3.6 million in cash and cash
equivalents and $14.6 million in net accounts receivable as of December 31,
2004.
For the quarter ended March 31, 2005, our cash decreased $1.9 million,
or 52.8%, from $3.6 million to $1.7 million as compared to an increase of
$507,000, or 12.7%, for the quarter ended March 31, 2004 from $4.0 million to
$4.5 million.
Cash used in our operating activities totaled $1.5 million during the
first quarter of 2005 as compared to cash used in our operating activities of
$600,000 during the first quarter of 2004. This $900,000 increase in cash used
in our operating activities primarily resulted from a decrease of $6.5 million
in net sales in the first quarter of 2005 as compared to the first quarter of
2004. This decrease in net sales and other factors resulted in a $4.5 million
decrease in cash resulting from an increase in accounts receivable and a $3.0
million decrease in cash from an increase in our inventory. These decreases in
cash were partially offset by increases in cash resulting from a $1.6 million
increase in accounts payable and accrued expenses, a $4.5 million increase in
the use of our trade credit facilities with related parties, a decrease in legal
settlements payable of $1.0 million as we made the final payment in the first
quarter of 2004 on the settlement of a litigation matter, a $620,000 increase in
reserves for product returns and allowances, and a $261,000 increase in our
reserve for obsolete inventory.
28
Cash provided by our investing activities totaled $777,000 during the
first quarter of 2005 as compared to cash provided by our investing activities
of $1.2 million during the first quarter of 2004. Our investing activities
consisted of restricted cash related to our United National Bank loan and
purchases of property and equipment.
Cash used in our financing activities totaled $1.2 million during the
first quarter of 2005 as compared to $8,000 for the first quarter of 2004. We
paid down $2.2 million of our United National Bank loan through funds generated
by our operations during the first quarter of 2005. We paid down the balance of
$3.8 million of our United National Bank loan through our new line of credit
with GMAC Commercial Finance and we borrowed an additional $1.0 million on our
GMAC Commercial Finance line of credit during the first quarter of 2005.
On August 15, 2003, we entered into an asset-based business loan
agreement with United National Bank. The agreement provided for a revolving loan
of up to $6.0 million secured by substantially all of our assets and initially
was to expire on September 1, 2004 and which, on numerous occasions in 2004 and
2005, was extended to its final expiration date on March 11, 2005. Advances of
up to 65% of eligible accounts receivable bore interest at a floating interest
rate equal to the prime rate of interest as reported in THE WALL STREET JOURNAL
plus 0.75%. On March 9, 2005, we replaced our asset-based line of credit with
United National Bank with an asset-based line of credit with GMAC Commercial
Finance.
Our asset-based line of credit with GMAC Commercial Finance expires on
March 9, 2008 and allows us to borrow up to $10.0 million. The line of credit
bears interest at a floating interest rate equal to the prime rate of interest
plus 0.75%. This interest rate is adjustable upon each movement in the prime
lending rate. If the prime lending rate increases, our interest rate expense
will increase on an annualized basis by the amount of the increase multiplied by
the principal amount outstanding under our credit facility. Our obligations
under our loan agreement with GMAC Commercial Finance are secured by
substantially all of our assets and guaranteed by our wholly-owned subsidiary,
IOM Holdings, Inc. The loan agreement has one financial covenant which requires
us to have a fixed charge coverage ratio of at least 1.2 to 1.0 for the three
months ended June 30, 2005 and the six months ended September 30, 2005. The
ratio becomes 1.5 to 1.0 for the nine months ended December 31, 2005, for the
twelve month period ending March 31, 2006 and for each twelve month period
ending on the end of each calendar quarter thereafter. We have been in violation
of this financial covenant in the past and may be in violation of this financial
covenant in the future. If we are unable to attain the financial covenant
ratios, then GMAC Commercial Finance has the option to immediately terminate the
line of credit and the unpaid principal balance and all accrued interest on
the unpaid balance will then be immediately due and payable. If the loan were to
be called and we were unable to obtain alternative financing, we would lack
adequate funds to acquire inventory in amounts sufficient to sustain or expand
our current sales operation. In addition, we would be unable to fund our
day-to-day operations.
Our new credit facility was initially used to pay off our outstanding loan
balance as of March 10, 2005 with United National Bank, which balance was
approximately $3.8 million, and was also used to pay $25,000 of our closing fees
in connection with securing the credit facility. As of March 31, 2005, we owed
GMAC Commercial Finance approximately $4.8 million and had available to us
approximately $284,000 of additional borrowings.
On June 6, 2005, we entered into a new trade credit facility with Lung
Hwa Electronics that replaced our previous $10.0 million trade credit facility.
Under the terms of the new facility, Lung Hwa Electronics has agreed to purchase
and manufacture inventory on our behalf. We can purchase up to $15.0 million of
inventory through Lung Hwa Electronics as an international purchasing office or
manufactured by Lung Hwa Electronics. For inventory purchased through Lung Hwa
Electronics, the payment terms are 120 days following the date of invoice by
Lung Hwa Electronics. Lung Hwa Electronics charges us a 5% handling fee on a
supplier's unit price. A 2% discount of the handling fee is applied if we reach
an average running monthly purchasing volume of $750,000. Returns made by us,
which are agreed to by a supplier, result in a credit to us for the handling
charge. For inventory manufactured by Lung Hwa Electronics, the payment terms
are 90 days following the date of invoice by Lung Hwa Electronics. Upon
effectiveness of the trade credit facility, we paid $1.5 million to Lung Hwa
Electronics as an early payment for all invoices coming due for payment. Any
early payment funds remaining three months after the date of the commencement of
the trade credit facility are to be refunded to us immediately. Once the $1.5
million has been exhausted, or three months from the date of the commencement of
the trade credit facility has expired, whichever is sooner, we are to pay Lung
Hwa Electronics, within one week of the purchase order, 10% of the purchase
price on any purchase orders issued to Lung Hwa Electronics as a down-payment
for the order. The trade credit facility has an initial term of one year after
which the facility will continue indefinitely if not terminated at the end of
the initial term. At the end of the initial term and at any time thereafter,
either party has the right to terminate the facility upon 30 days' prior written
notice to the other party. As of March 31, 2005, we owed Lung Hwa Electronics
$488,000 in trade payables.
29
In February 2003, we entered into a Warehouse Services and Bailment
Agreement with Behavior Tech Computer (USA) Corp., or BTC USA. Under the terms
of the agreement, BTC USA has agreed to supply and store at our warehouse up to
$10.0 million of inventory on a consignment basis. We are responsible for
insuring the consigned inventory, storing the consigned inventory for no charge,
and furnishing BTC USA with weekly statements indicating all products received
and sold and the current level of consigned inventory. The agreement also
provides us with a trade line of credit of up to $10.0 million with payment
terms of net 60 days, without interest. The agreement may be terminated by
either party upon 60 days' prior written notice to the other party. As of March
31, 2005, we owed BTC USA $6.8 million under this arrangement. BTC USA is a
subsidiary of Behavior Tech Computer Corp., one of our significant stockholders.
Mr. Steel Su, a director of I/OMagic, is the Chief Executive Officer of Behavior
Tech Computer Corp.
Lung Hwa Electronics and BTC USA provide us with significantly
preferential trade credit terms. These terms include extended payment terms,
substantial trade lines of credit and other preferential buying arrangements. We
believe that these terms are substantially better terms than we could likely
obtain from other subcontract manufacturers or suppliers. In fact, we believe
that our trade credit facility with Lung Hwa Electronics is likely unique and
could not be replaced through a relationship with an unrelated third party. If
either of Lung Hwa Electronics or BTC USA does not continue to offer us
substantially the same preferential trade credit terms, our ability to finance
inventory purchases would be harmed, resulting in significantly reduced sales
and profitability. In addition, we would incur additional financing costs
associated with shorter payment terms which would also cause our profitability
to decline.
Our net loss increased 898% to $1.2 million for the first quarter of
2005 from $145,000 for the first quarter of 2004, primarily resulting from a
41.9% decline in net sales to $9.0 million in the first quarter of 2005 from
$15.5 million in the first quarter of 2004. If either the absolute level or the
downward trend of our net loss or net sales continues or increases, we could
experience significant shortages of liquidity and our ability to purchase
inventory and to operate our business may be significantly impaired, which could
lead to further declines in our operating performance and financial condition.
We retain most risks of ownership of products in our consignment sales
channels. These products remain our inventory until their resale by our
retailers. The turnover frequency of our inventory on consignment is critical to
generating regular cash flow in amounts necessary to keep financing costs to
targeted levels and to purchase additional inventory. If this inventory turnover
is not sufficiently frequent, our financing costs may exceed targeted levels and
we may be unable to generate regular cash flow in amounts necessary to purchase
additional inventory to meet the demand for other products. In addition, as a
result of our products' short life-cycles, which generate lower average selling
prices as the cycles mature, low inventory turnover levels may force us to
reduce prices and accept lower margins to sell consigned products. If we fail to
select high turnover products for our consignment sales channels, our sales,
profitability and financial resources may decline.
If, like Best Buy, any other of our major retailers, or a significant
number of our smaller retailers, implement or expand private label programs
covering products that compete with our products, our net sales will likely
continue to decline and our net losses are likely to increase, which in turn
could have a material and adverse impact on our liquidity, financial condition
and capital resources. We expect the decline in our sales to Best Buy to
continue in subsequent reporting periods as a result of continued private label
programs; however, management intends to use its best efforts to insure that we
retain Best Buy as one of our major retailers. We cannot assure you that Best
Buy will remain one of our major retailers or that we will successfully sell any
products through Best Buy.
30
We believe that the significant decline in our net sales during the
first quarter of 2005, as compared to the same period in 2004, resulted in part
from a continued decline in sales of our CD-based products, lower average
selling prices of DVD-based products, slower than anticipated growth and a
decline in sales of our DVD-based products, and the continued operation of
private label programs by Best Buy.
Despite the decline in our results of operations during the first
quarter of 2005, we believe that current and future available capital resources,
revenues generated from operations, and other existing sources of liquidity,
including our trade credit facilities with Lung Hwa Electronics and BTC USA and
our credit facility with GMAC Commercial Finance will be sufficient to fund our
anticipated working capital and capital expenditure requirements for at least
the next twelve months. If, however, our capital requirements or cash flow vary
materially from our current projections or if unforeseen circumstances occur, we
may require additional financing. Our failure to raise capital, if needed, could
restrict our growth, limit our development of new products or hinder our ability
to compete.
BACKLOG
Our backlog at March 31, 2005 was $4.4 million as compared to a backlog
at March 31, 2004 of $3.6 million. Based on historical trends, we anticipate
that our March 31, 2005 backlog may be reduced by approximately 10.3%, or
$453,000, to a net amount of $4.0 million as a result of returns and
reclassification of certain expenses as reductions to net sales.
Our backlog may not be indicative of our actual sales beyond a rotating
six-week cycle. The amount of backlog orders represents revenue that we
anticipate recognizing in the future, as evidenced by purchase orders and other
purchase commitments received from retailers. The shipment of these orders for
non-consigned retailers or the sell-through of our products by consigned
retailers causes recognition of the purchase commitments as revenue. However,
there can be no assurance that we will be successful in fulfilling such orders
and commitments in a timely manner, that retailers will not cancel purchase
orders, or that we will ultimately recognize as revenue the amounts reflected as
backlog based upon industry trends, historical sales information, returns and
sales incentives.
IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS
In March 2005, the FASB issued FASB Interpretation ("FIN") No. 47,
"Accounting for Conditional Asset Retirement Obligations". FIN No. 47 clarifies
that the term conditional asset retirement obligation as used in FASB Statement
No. 143, "Accounting for Asset Retirement Obligations," refers to a legal
obligation to perform an asset retirement activity in which the timing and (or)
method of settlement are conditional on a future event that may or may not be
within the control of the entity. The obligation to perform the asset retirement
activity is unconditional even though uncertainty exists about the timing and
(or) method of settlement. Uncertainty about the timing and/or method of
settlement of a conditional asset retirement obligation should be factored into
the measurement of the liability when sufficient information exists. This
interpretation also clarifies when an entity would have sufficient information
to reasonably estimate the fair value of an asset retirement obligation. FIN No.
47 is effective no later than the end of fiscal years ending after December 15,
2005 (which would be December 31, 2005 for calendar-year companies).
Retrospective application of interim financial information is permitted but is
not required. We do not expect adoption of FIN No. 47 to have a material impact
on our financial statements.
31
RISK FACTORS
AN INVESTMENT IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. IN
ADDITION TO THE OTHER INFORMATION IN THIS QUARTERLY REPORT AND IN OUR OTHER
FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION, INCLUDING OUR SUBSEQUENT
REPORTS ON FORMS 10-Q, 10-K AND 8-K , YOU SHOULD CAREFULLY CONSIDER THE
FOLLOWING DISCUSSION, WHICH SUMMARIZES MATERIAL RISKS, BEFORE DECIDING TO INVEST
IN SHARES OF OUR COMMON STOCK OR TO MAINTAIN OR INCREASE YOUR INVESTMENT IN
SHARES OF OUR COMMON STOCK. ANY OF THE FOLLOWING RISKS, IF THEY ACTUALLY OCCUR,
WOULD LIKELY HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
AS A RESULT, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND YOU COULD
LOSE ALL OR PART OF THE MONEY YOU PAID TO BUY OUR COMMON STOCK.
IF WE CONTINUE TO SUSTAIN LOSSES, WE WILL BE IN VIOLATION OF THE GMAC
COMMERCIAL FINANCE COVENANT AND WE MAY BE UNABLE TO BORROW FUNDS TO PURCHASE
INVENTORY, TO SUSTAIN OR EXPAND OUR CURRENT SALES VOLUME AND TO FUND OUR
DAY-TO-DAY OPERATIONS.
Our credit facility with GMAC Commercial Finance has one covenant which
requires us to have a fixed charge coverage ratio of at least 1.2 to 1.0 for the
three months ended June 30, 2005 and the six months ended September 30, 2005.
The ratio becomes 1.5 to 1.0 for the nine months ended December 31, 2005, for
the twelve month period ending March 31, 2006 and for each twelve month period
ending on the end of each calendar quarter thereafter. We have been in violation
of this financial covenant in the past and may be in violation of this financial
covenant in the future.If we are unable to attain the financial covenant ratios,
then GMAC Commercial Finance has the option to immediately terminate the line of
credit and the unpaid principal balance and all accrued interest on the unpaid
balance will then be immediately due and payable. If the loan were to be called
and we were unable to obtain alternative financing, we would lack adequate funds
to acquire inventory in amounts sufficient to sustain or expand our current
sales operation. In addition, we would be unable to fund our day-to-day
operations.
WE HAVE INCURRED SIGNIFICANT LOSSES IN THE PAST, AND WE MAY CONTINUE TO INCUR
SIGNIFICANT LOSSES IN THE FUTURE. IF WE CONTINUE TO INCUR LOSSES, WE WILL
EXPERIENCE NEGATIVE CASH FLOW WHICH MAY HAMPER CURRENT OPERATIONS AND MAY
PREVENT US FROM EXPANDING OUR BUSINESS.
We have incurred net losses in each of the last five years and for the
quarter ended March 31, 2005. As of March 31, 2005, we had an accumulated
deficit of approximately $24.2 million. During 2004, 2003, 2002, 2001, 2000 and
the quarter ended March 31, 2005, we incurred net losses in the amounts of
approximately $8.1 million, $460,000, $8.8 million, $5.4 million, $6.2 million
and $1.2 million, respectively. Historically, we have relied upon cash from
operations and financing activities to fund all of the cash requirements of our
business. If our extended period of net losses continues, this will result in
negative cash flow and may hamper current operations and may prevent us from
expanding our business. We cannot assure you that we will attain, sustain or
increase profitability on a quarterly or annual basis in the future. If we do
not achieve, sustain or increase profitability, our business will be adversely
affected and our stock price may decline.
WE HAVE IDENTIFIED MATERIAL WEAKNESSES IN OUR DISCLOSURE CONTROLS AND
PROCEDURES. OUR BUSINESS AND STOCK PRICE MAY BE ADVERSELY AFFECTED IF WE DO
NOT REMEDIATE THESE MATERIAL WEAKNESSES OR IF WE HAVE OTHER MATERIAL
WEAKNESSES IN OUR DISCLOSURE CONTROLS AND PROCEDURES.
Following their evaluation of our disclosure controls and procedures,
our Chief Executive Officer and Chief Financial Officer concluded that certain
material weaknesses in our disclosure controls and procedures existed as of
December 31, 2004 and as of March 31, 2005. As a result of these material
weaknesses, our Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures were not effective at the reasonable
assurance level as of December 31, 2004 and as of March 31, 2005. The existence
of one or more material weaknesses in our disclosure controls and procedures
could result in errors in our financial statements and substantial costs and
resources may be required to rectify these material weaknesses. If we are unable
to produce reliable financial reports, investors could lose confidence in our
reported financial information, the market price of our stock could decline
significantly, we may be unable to obtain additional financing to operate and
expand our business, and our business and financial condition could be harmed.
WE DEPEND ON A SMALL NUMBER OF RETAILERS FOR THE VAST MAJORITY OF OUR SALES.
A REDUCTION IN BUSINESS FROM ANY OF THESE RETAILERS COULD CAUSE A SIGNIFICANT
DECLINE IN OUR SALES AND PROFITABILITY.
The vast majority of our sales are generated from a small number of
retailers. During the first three months of 2005, net sales to our three largest
retailers, Staples, CompUSA and Office Depot represented approximately 40%, 25%
and 20%, respectively, or an aggregate of approximately 85%, of our total net
sales. During 2004, net sales to our five largest retailers, Staples, Circuit
City, Best Buy, Office Depot and CompUSA represented approximately 32%, 17%,
11%, 10% and 10%, respectively, or an aggregate of approximately 80%, of our
total net sales. We expect that we will continue to depend upon a small number
of retailers for a significant majority of our sales for the foreseeable future.
32
Our agreements with these retailers do not require them to purchase any
specified number of products or dollar amount of sales or to make any purchases
whatsoever. Therefore, we cannot assure you that, in any future period, our
sales generated from these retailers, individually or in the aggregate, will
equal or exceed historical levels. We also cannot assure you that, if sales to
any of these retailers cease or decline, we will be able to replace these sales
with sales to either existing or new retailers in a timely manner, or at all. A
cessation or reduction of sales, or a decrease in the prices of products sold to
one or more of these retailers has significantly reduced our net sales for one
or more reporting periods in the past and could, in the future, cause a
significant decline in our net sales and profitability.
OUR LACK OF LONG-TERM PURCHASE ORDERS AND COMMITMENTS COULD LEAD TO A RAPID
DECLINE IN OUR SALES AND PROFITABILITY.
All of our significant retailers issue purchase orders solely in their
own discretion, often only one to two weeks before the requested date of
shipment. Our retailers are generally able to cancel orders or delay the
delivery of products on short notice. In addition, our retailers may decide not
to purchase products from us for any reason. Accordingly, we cannot assure you
that any of our current retailers will continue to purchase our products in the
future. As a result, our sales volume and profitability could decline rapidly
with little or no warning whatsoever. For example, in 2004, our sales to Best
Buy decreased 73% from $18.2 million in 2003 to $5.0 million in 2004. In
addition, in 2004, we had no sales to OfficeMax, as compared to $6.3 million in
2003 and $19.9 million in 2002. These significant declines in sales to Best Buy
and OfficeMax were two of the primary reasons for the 30% decline in net sales
for 2004 as compared to 2003.
We cannot rely on long-term purchase orders or commitments to protect
us from the negative financial effects of a decline in demand for our products.
The limited certainty of product orders can make it difficult for us to forecast
our sales and allocate our resources in a manner consistent with our actual
sales. Moreover, our expense levels are based in part on our expectations of
future sales and, if our expectations regarding future sales are inaccurate, we
may be unable to reduce costs in a timely manner to adjust for sales shortfalls.
Furthermore, because we depend on a small number of retailers for the vast
majority of our sales, the magnitude of the ramifications of these risks, is
greater than if our sales were less concentrated within a small number of
retailers. As a result of our lack of long-term purchase orders and purchase
commitments we may experience a rapid decline in our sales and profitability.
ONE OR MORE OF OUR LARGEST RETAILERS MAY DIRECTLY IMPORT OR PRIVATE LABEL
PRODUCTS THAT ARE IDENTICAL OR VERY SIMILAR TO OUR PRODUCTS. THIS COULD CAUSE
A SIGNIFICANT DECLINE IN OUR SALES AND PROFITABILITY.
Optical data storage products and digital entertainment products are
widely available from manufacturers and other suppliers around the world. Our
retailers have included Best Buy, Circuit City, CompUSA, Office Depot, Radio
Shack and Staples. Sales to these six retailers collectively accounted for 84%
of our net sales for 2004 and for the first quarter of 2005. Each of these
retailers has substantially greater resources than we do, and has the ability to
directly import or private-label data storage and digital entertainment products
from manufacturers and other suppliers around the world, including from some of
our own subcontract manufacturers and suppliers. For example, Best Buy, our
largest retailer, already has a private label program and sells certain products
that compete with some of our products. We did not have any sales to Best Buy in
the first three months of 2005, representing a decrease of 100% from $2.8
million in the first three months of 2004. We believe that this decrease
reflects, at least in part, Best Buy's increased sales of private label products
that compete with products that we sell. Our retailers may believe that higher
33
profit margins can be achieved if they implement a direct import or
private-label program, excluding us from the sales channel. Accordingly, one or
more of our largest retailers may stop buying products from us in favor of a
direct import or private-label program. As a consequence, our sales and
profitability could decline significantly.
HISTORICALLY, A SUBSTANTIAL PORTION OF OUR ASSETS HAVE BEEN COMPRISED OF
ACCOUNTS RECEIVABLE REPRESENTING AMOUNTS OWED BY A SMALL NUMBER OF RETAILERS.
WE EXPECT THIS TO CONTINUE IN THE FUTURE. IF ANY OF THESE RETAILERS FAILS TO
TIMELY PAY US AMOUNTS OWED, WE COULD SUFFER A SIGNIFICANT DECLINE IN CASH
FLOW AND LIQUIDITY WHICH, IN TURN, COULD CAUSE US TO BE UNABLE PAY OUR
LIABILITIES AND PURCHASE AN ADEQUATE AMOUNT OF INVENTORY TO SUSTAIN OR EXPAND
OUR CURRENT SALES VOLUME.
Our accounts receivable represented 53% and 46% of our total assets as
of December 31, 2004 and 2003, respectively. As of March 31, 2005, 83% of our
accounts receivable represented amounts owed by three retailers, each of whom
represented over 10% of the total amount of our accounts receivable. Similarly,
as of December 31, 2004, 73% of our accounts receivable represented amounts owed
by two retailers, each of whom represented over 10% of the total amount of our
accounts receivable. As a result of the substantial amount and concentration of
our accounts receivable, if any of our major retailers fails to timely pay us
amounts owed, we could suffer a significant decline in cash flow and liquidity
which would negatively affect our ability to make payments under our line of
credit with GMAC Commercial Finance and which, in turn, could adversely affect
our ability to borrow funds to purchase inventory to sustain or expand our
current sales volume. Accordingly, if any of our major retailers fails to timely
pay us amounts owed, our sales and profitability may decline.
WE RELY HEAVILY ON OUR CHIEF EXECUTIVE OFFICER, TONY SHAHBAZ. THE LOSS OF HIS
SERVICES COULD ADVERSELY AFFECT OUR ABILITY TO SOURCE PRODUCTS FROM OUR KEY
SUPPLIERS AND OUR ABILITY TO SELL OUR PRODUCTS TO OUR RETAILERS.
Our success depends, to a significant extent, upon the continued
services of Tony Shahbaz, who is our Chairman of the Board, President, Chief
Executive Officer and Secretary. For example, Mr. Shahbaz has developed key
personal relationships with our suppliers and retailers, including with our
subcontract manufacturers. We greatly rely on these relationships in the conduct
of our operations and the execution of our business strategies. Mr. Shahbaz and
some of these subcontract manufacturers and suppliers have acquired interests in
business entities that own shares of our common stock. Further, some of these
manufacturers also directly hold shares of our common stock. The loss of Mr.
Shahbaz could, therefore, result in the loss of our favorable relationships with
one or more of our subcontract manufacturers or suppliers. Although we have
entered into an employment agreement with Mr. Shahbaz, that agreement is of
limited duration and is subject to early termination by Mr. Shahbaz under
certain circumstances. In addition, we do not maintain "key person" life
insurance covering Mr. Shahbaz or any other executive officer. The loss of Mr.
Shahbaz could significantly delay or prevent the achievement of our business
objectives. Consequently, the loss of Mr. Shahbaz could adversely affect our
business, financial condition and results of operations.
THE HIGH CONCENTRATION OF OUR SALES WITHIN THE DATA STORAGE INDUSTRY COULD
RESULT IN A SIGNIFICANT REDUCTION IN NET SALES AND NEGATIVELY AFFECT OUR
EARNINGS IF DEMAND FOR THOSE PRODUCTS DECLINES.
Sales of our data storage products accounted for approximately 99% of
our net sales in the first three months of 2005 and in the year 2004. Except for
our digital entertainment and other products, which accounted for only
approximately 1% of our net sales in the first three months of 2005 and in the
year 2004, we have not diversified our product categories outside of the data
storage industry. We expect data storage products to continue to account for the
vast majority of our net sales for the foreseeable future. As a result, our net
sales and profitability would be significantly and adversely impacted by a
downturn in the demand for data storage products.
34
IF WE FAIL TO ACCURATELY FORECAST THE COSTS OF OUR PRODUCT REBATE OR OTHER
PROMOTIONAL PROGRAMS, WE MAY EXPERIENCE A SIGNIFICANT DECLINE IN CASH FLOW
AND OUR BRAND IMAGE MAY BE ADVERSELY AFFECTED RESULTING IN REDUCED SALES AND
PROFITABILITY.
We rely heavily on product rebates and other promotional programs to
establish, maintain and increase sales of our products. If we fail to accurately
forecast the costs of these programs, we may fail to allocate sufficient
resources to these programs. For example, we may fail to have sufficient funds
available to satisfy mail-in product rebates. If we are unable to satisfy our
promotional obligations, such as providing cash rebates to consumers, our brand
image and goodwill with consumers and retailers would be harmed, which may
result in reduced sales and profitability. In addition, our failure to
adequately forecast the costs of these programs may result in unexpected
liabilities causing a significant decline in cash flow and capital resources
with which to operate our business.
OUR TWO PRINCIPAL SUBCONTRACT MANUFACTURERS PROVIDE US WITH SIGNIFICANTLY
PREFERENTIAL TRADE CREDIT TERMS. IF EITHER OF THESE MANUFACTURERS DOES NOT
CONTINUE TO OFFER US SUBSTANTIALLY THE SAME PREFERENTIAL CREDIT TERMS, OUR
SALES AND PROFITABILITY WOULD DECLINE SIGNIFICANTLY.
Lung Hwa Electronics and Behavior Tech Computer Corp., our two
principal subcontract manufacturers and suppliers, provide us with significantly
preferential trade credit terms. These terms include extended payment terms,
substantial trade lines of credit and other preferential buying arrangements. We
believe that these terms are substantially better terms than we could likely
obtain from other subcontract manufacturers or suppliers. In fact, we believe
that our trade credit facility with Lung Hwa Electronics is likely unique and
could not be replaced through a relationship with an unrelated third party. If
either of these subcontract manufacturers and suppliers does not continue to
offer us substantially the same preferential trade credit terms, our ability to
finance inventory purchases would be harmed, resulting in significantly reduced
sales and profitability. In addition, we would incur additional financing costs
associated with shorter payment terms which would also cause our profitability
to decline.
THE DATA STORAGE INDUSTRY IS EXTREMELY COMPETITIVE. ALL OF OUR SIGNIFICANT
COMPETITORS HAVE GREATER FINANCIAL AND OTHER RESOURCES THAN WE DO, AND ONE OR
MORE OF THESE COMPETITORS COULD USE THEIR GREATER RESOURCES TO GAIN MARKET
SHARE AT OUR EXPENSE.
The data storage industry is extremely competitive. All of our
significant competitors in the data storage industry, including BenQ,
Hewlett-Packard, Lite-On, Memorex, Philips Electronics, Samsung Electronics,
Sony and TDK have substantially greater production, financial, research and
development, intellectual property, personnel and marketing resources than we
do. As a result, each of these companies could compete more aggressively and
sustain that competition over a longer period of time than we could. Our lack of
resources relative to all of our significant competitors may cause us to fail to
anticipate or respond adequately to technological developments and changing
consumer demands and preferences, or may cause us to experience significant
delays in obtaining or introducing new or enhanced products. These failures or
delays could reduce our competitiveness and cause a decline in our market share
and sales.
DATA STORAGE PRODUCTS ARE SUBJECT TO RAPID TECHNOLOGICAL CHANGES. IF WE FAIL
TO ACCURATELY ANTICIPATE AND ADAPT TO THESE CHANGES, THE PRODUCTS WE SELL
WILL BECOME OBSOLETE, CAUSING A DECLINE IN OUR SALES AND PROFITABILITY.
35
Data storage products are subject to rapid technological changes which
often cause product obsolescence. Companies within the data storage industry are
continuously developing new products with heightened performance and
functionality. This puts pricing pressure on existing products and constantly
threatens to make them, or causes them to be, obsolete. Our typical product life
cycle is extremely short and ranges from only three to twelve months, generating
lower average selling prices as the cycle matures. If we fail to accurately
anticipate the introduction of new technologies, we may possess significant
amounts of obsolete inventory that can only be sold at substantially lower
prices and profit margins than we anticipated. In addition, if we fail to
accurately anticipate the introduction of new technologies, we may be unable to
compete effectively due to our failure to offer products most demanded by the
marketplace. If any of these failures occur, our sales, profit margins and
profitability will be adversely affected.
IF WE FAIL TO SELECT HIGH TURNOVER PRODUCTS FOR OUR CONSIGNMENT SALES
CHANNELS, OUR FINANCING COSTS MAY EXCEED TARGETED LEVELS, WE MAY BE UNABLE TO
FUND ADDITIONAL PURCHASES OF INVENTORY AND WE MAY BE FORCED TO REDUCE PRICES
AND ACCEPT LOWER MARGINS TO SELL CONSIGNED PRODUCTS, WHICH WOULD CAUSE OUR
SALES, PROFITABILITY AND FINANCIAL RESOURCES TO DECLINE.
We retain most risks of ownership of products in our consignment sales
channels. These products remain our inventory until their resale by our
retailers. The turnover frequency of our inventory on consignment is critical to
generating regular cash flow in amounts necessary to keep financing costs to
targeted levels and to purchase additional inventory. If this inventory turnover
is not sufficiently frequent, our financing costs may exceed targeted levels and
we may be unable to generate regular cash flow in amounts necessary to purchase
additional inventory to meet the demand for other products. In addition, as a
result of our products' short life-cycles, which generate lower average selling
prices as the cycles mature, low inventory turnover levels may force us to
reduce prices and accept lower margins to sell consigned products. As of March
31, 2005 and December 31, 2004, we carried and financed inventory valued at
approximately $3.6 million and $2.9 million, respectively, in our consignment
sales channels. Sales generated through consignment sales were approximately 38%
and 32%, respectively, of our total net sales for the three months ended March
31, 2005 and for the year ended December 31, 2004. If we fail to select high
turnover products for our consignment sales channels, our sales, profitability
and financial resources may decline.
OUR INDEMNIFICATION OBLIGATIONS TO OUR RETAILERS FOR PRODUCT DEFECTS COULD
REQUIRE US TO PAY SUBSTANTIAL DAMAGES, WHICH COULD HAVE A SIGNIFICANT
NEGATIVE IMPACT ON OUR PROFITABILITY AND FINANCIAL RESOURCES.
A number of our agreements with our retailers provide that we will
defend, indemnify and hold them, and their customers, harmless from damages and
costs that arise from product warranty claims or from claims for injury or
damage resulting from defects in our products. If such claims are asserted
against us, our insurance coverage may not be adequate to cover the costs
associated with our defense of those claims or the cost of any resulting
liability we incur if those claims are successful. A successful claim brought
against us for product defects that is in excess of, or excluded from, our
insurance coverage could adversely affect our profitability and financial
resources and could make it difficult or impossible for us to adequately fund
our day-to-day operations.
IF WE ARE SUBJECTED TO ONE OR MORE INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS,
OUR SALES, EARNINGS AND FINANCIAL RESOURCES MAY BE ADVERSELY AFFECTED.
Our products rely on intellectual property developed, owned or licensed
by third parties. From time to time, intellectual property infringement claims
have been asserted against us. We expect to continue to be subjected to such
claims in the future. Intellectual property infringement claims may also be
asserted against our retailers as a result of selling our products. As a
consequence, our retailers could assert indemnification claims against us. If
any third party is successful in asserting an infringement claim against us, we
could be required to acquire licenses, which may not be available on
commercially reasonable terms, if at all, to discontinue selling certain
products to pay substantial monetary damages or to develop non-infringing
36
technologies, none of which may be feasible. Both infringement and
indemnification claims could be time-consuming and costly to defend or settle
and would divert management's attention and our resources away from our
business. In addition, we may lack sufficient litigation defense resources,
therefore any one of these developments could place substantial financial and
administrative burdens on us and our sales and earnings may be adversely
affected.
IF WE FAIL TO SUCCESSFULLY MANAGE THE EXPANSION OF OUR BUSINESS, OUR SALES
MAY NOT INCREASE COMMENSURATELY WITH OUR CAPITAL INVESTMENTS, WHICH WOULD
CAUSE OUR PROFITABILITY TO DECLINE.
We plan to offer new data storage and digital entertainment products in
the future. In particular, we plan to offer additional DVD-based products and
additional products in our line of GigaBank(TM) products, as well as products
with heightened performance and added functionality. We also plan to offer a
next-generation DVD-based product, such as Blu-ray DVD or HD-DVD, depending on
which of these competing formats we believe is most likely to prevail in the
marketplace. These planned product offerings will require significant
investments of capital and management's close attention. In offering new digital
entertainment products, our resources and personnel are likely to be strained
because we have little experience in the digital entertainment industry.
Our failure to successfully manage our planned product expansion could
result in our sales not increasing commensurately with our capital investments,
causing a decline in our profitability.
A SIGNIFICANT PRODUCT DEFECT OR PRODUCT RECALL COULD MATERIALLY AND ADVERSELY
AFFECT OUR BRAND IMAGE, CAUSING A DECLINE IN OUR SALES, AND COULD REDUCE OR
DEPLETE OUR FINANCIAL RESOURCES.
A significant product defect could materially harm our brand image and
could force us to conduct a product recall. This could result in damage to our
relationships with our retailers and loss of consumer loyalty. Because we are a
small company, a product recall would be particularly harmful to us because we
have limited financial and administrative resources to effectively manage a
product recall and it would detract management's attention from implementing our
core business strategies. As a result, a significant product defect or product
recall could materially and adversely affect our brand image, causing a decline
in our sales, and could reduce or deplete our financial resources.
IF OUR PRODUCTS ARE NOT AMONG THE FIRST-TO-MARKET, OR IF CONSUMERS DO NOT
RESPOND FAVORABLY TO EITHER OUR NEW OR ENHANCED PRODUCTS, OUR SALES AND
EARNINGS WILL DECLINE.
One of our core business strategies is to be among the first-to-market
with new and enhanced products based on established technologies. We believe
that our I/OMagic(R) brand is perceived by the retailers and end-users of our
products as among the leaders in the data storage industry. We also believe that
these retailers and end-users view products offered under our I/OMagic(R) brand
as embodying newly established technologies or technological enhancements. For
instance, in introducing new and enhanced optical data storage products and
portable magnetic data storage devices such as our GigaBank(TM) products, we
seek to be among the first-to-market, offering heightened product performance
such as faster data recordation and access speeds. If our products are not among
the first-to-market, our competitors may gain market share at our expense, which
would decrease our net sales and earnings.
As a consequence of this core strategy, we are exposed to consumer
rejection of our new and enhanced products to a greater degree than if we
offered products later in their industry life cycle. For example, our
anticipated future sales are largely dependent on future consumer demand for
DVD-based products displacing current consumer demand for CD-based products as
well as increasing demand for portable magnetic data storage devices such as our
GigaBank(TM) products. Accordingly, future sales and any future profits from
37
DVD-based products and our GigaBank(TM) line of products are substantially
dependent upon widespread consumer acceptance of DVD-based products and portable
data storage devices. If this widespread consumer acceptance of DVD-based
products and our GigaBank(TM) products does not occur, or is delayed, our sales
and earnings will be adversely affected.
A LABOR STRIKE OR CONGESTION AT A SHIPPING PORT AT WHICH OUR PRODUCTS ARE
SHIPPED OR RECEIVED COULD PREVENT US FROM TAKING TIMELY DELIVERY OF
INVENTORY, WHICH COULD CAUSE OUR SALES AND PROFITABILITY TO DECLINE.
From time to time, shipping ports experience labor strikes, work
stoppages or congestion which delay the delivery of imported products. The port
of Long Beach, California, through which most of our products are imported from
Asia, experienced a labor strike in September 2002 which lasted nearly two
weeks. As a result, there was a significant disruption in our ability to deliver
products to our retailers, which caused our sales to decline. Any future labor
strike, work stoppage or congestion at a shipping port at which our products are
shipped or received would prevent us from taking timely delivery of inventory
and cause our sales to decline. In addition, many of our retailers impose
penalties for both early and late product deliveries, which could result in
significant additional costs to us. In the event of a similar labor strike or
work stoppage in the future, or in the event of congestion, in order to meet our
delivery obligations to our retailers and avoid penalties for missed delivery
dates, we may be required to arrange for alternative means of product shipment,
such as air freight, which could add significantly to our product costs. We
would typically be unable to pass these extra costs along to either our
retailers or to consumers. Also, because the average selling prices of our
products decline, often rapidly, during their short product life cycle, delayed
delivery of products could yield significantly less than expected sales and
profits.
FAILURE TO ADEQUATELY PROTECT OUR TRADEMARK RIGHTS COULD CAUSE US TO LOSE
MARKET SHARE AND CAUSE OUR SALES TO DECLINE.
We sell our products primarily under our I/OMagic(R) brand name and,
from time to time, also sell products under our Digital Research Technologies(R)
and Hi-Val(R) brand names. Each of these trademarks has been registered by us
with the United States Patent & Trademark Office. We also sell products under
various product names such as "MediaStation," "DataStation," Digital Photo
Library(TM), EasyPrint(TM) and GigaBank(TM). One of our key business strategies
is to use our brand and product names to successfully compete in the data
storage industry. We have expended significant resources promoting our brand and
product names and we have registered trademarks for our three brand names.
However, we cannot assure you that the registration of our brand name
trademarks, or our other actions to protect our non-registered product names,
will deter or prevent their unauthorized use by others. We also cannot assure
you that other companies, including our competitors, will not use our product
names. If other companies, including our competitors, use our brand or product
names, consumer confusion could result, meaning that consumers may not recognize
us as the source of our products. This would reduce the value of goodwill
associated with these brand and product names. This consumer confusion and the
resulting reduction in goodwill could cause us to lose market share and cause
our sales to decline.
CONSUMER ACCEPTANCE OF ALTERNATIVE SALES CHANNELS MAY INCREASE. IF WE ARE
UNABLE TO ADAPT TO THESE ALTERNATIVE SALES CHANNELS, SALES OF OUR PRODUCTS
MAY DECLINE.
We are accustomed to conducting business through traditional retail
sales channels. Consumers purchase our products predominantly through a small
number of retailers. For example, during the first three months of 2005, six of
our retailers accounted for 99% of our total net sales. Similarly, during 2004,
five of our retailers accounted for 80% of our total net sales. We currently
generate only a small number of direct sales of our products through our
Internet websites. We believe that many of our target consumers are
knowledgeable about technology and comfortable with the use of the Internet for
product purchases. Consumers may increasingly prefer alternative sales channels,
such as direct mail order or direct purchase from manufacturers. In addition,
38
Internet commerce is becoming increasingly accepted by consumers as a
convenient, secure and cost-effective method of purchasing data storage and
digital entertainment products. The migration of consumer purchasing habits from
traditional retailers to Internet retailers could have a significant impact on
our ability to sell our products. We cannot assure you that we will be able to
predict and respond to increasing consumer preference of alternative sales
channels. If we are unable to adapt to alternative sales channels, sales of our
products may decline.
OUR OPERATIONS ARE VULNERABLE BECAUSE WE HAVE LIMITED REDUNDANCY AND BACKUP
SYSTEMS.
Our internal order, inventory and product data management system is an
electronic system through which our retailers place orders for our products and
through which we manage product pricing, shipment, returns and other matters.
This system's continued and uninterrupted performance is critical to our
day-to-day business operations. Despite our precautions, unanticipated
interruptions in our computer and telecommunications systems have, in the past,
caused problems or stoppages in this electronic system. These interruptions, and
resulting problems, could occur in the future. We have extremely limited ability
and personnel to process purchase orders and manage product pricing and other
matters in any manner other than through this electronic system. Any
interruption or delay in the operation of this electronic system could cause a
significant decline in our sales and profitability.
OUR STOCK PRICE IS HIGHLY VOLATILE, WHICH COULD RESULT IN SUBSTANTIAL LOSSES
FOR INVESTORS PURCHASING SHARES OF OUR COMMON STOCK AND IN LITIGATION AGAINST
US.
The market price of our common stock has fluctuated significantly in
the past and may continue to fluctuate significantly in the future. During the
first three months of 2005, the high and low closing bid prices of a share of
our common stock were $3.75 and $1.74, respectively. During 2004, the high and
low closing bid prices of a share of our common stock were $4.50 and $3.00,
respectively. The market price of our common stock may continue to fluctuate in
response to one or more of the following factors, many of which are beyond our
control:
o changes in market valuations of similar companies;
o stock market price and volume fluctuations generally;
o economic conditions specific to the data storage or digital
entertainment products industries;
o announcements by us or our competitors of new or enhanced products
or technologies or of significant contracts, acquisitions,
strategic relationships, joint ventures or capital commitments;
o the loss of one or more of our top retailers or the cancellation
or postponement of orders from any of those retailers;
o delays in our introduction of new products or technological
innovations or problems in the functioning of these new products
or innovations;
o disputes or litigation concerning our rights to use third parties'
intellectual property or third parties' infringement of our
intellectual property;
o changes in our pricing policies or the pricing policies of our
competitors;
o changes in foreign currency exchange rates affecting our product
costs and pricing;
39
o regulatory developments or increased enforcement;
o fluctuations in our quarterly or annual operating results;
o additions or departures of key personnel; and
o future sales of our common stock or other securities.
The price at which you purchase shares of our common stock may not be
indicative of the price that will prevail in the trading market. You may be
unable to sell your shares of common stock at or above your purchase price,
which may result in substantial losses to you.
In the past, securities class action litigation has often been brought
against a company following periods of stock price volatility. We may be the
target of similar litigation in the future. Securities litigation could result
in substantial costs and divert management's attention and our resources from
our business. Any of the risks described above could have an adverse effect on
our business, financial condition and results of operations and therefore on the
price of our common stock.
OUR COMMON STOCK HAS A SMALL PUBLIC FLOAT AND SHARES OF OUR COMMON STOCK
ELIGIBLE FOR PUBLIC SALE COULD CAUSE THE MARKET PRICE OF OUR STOCK TO DROP,
EVEN IF OUR BUSINESS IS DOING WELL.
As of June 29, 2005, there were approximately 4.5 million shares of our
common stock outstanding. As a group, our executive officers, directors and 10%
shareholders beneficially own approximately 3.5 million of these shares.
Accordingly, our common stock has a public float of approximately 1.0 million
shares held by a relatively small number of public investors. In addition, we
have a registration statement on Form S-8 in effect covering 133,334 shares of
common stock issuable upon exercise of options under our 2002 Stock Option Plan
and a registration statement on Form S-8 in effect covering 400,000 shares of
common stock issuable upon exercise of options under our 2003 Stock Option Plan.
Currently, options covering 121,950 shares of common stock are outstanding under
our 2002 Stock Option Plan and no options are outstanding under our 2003 Stock
Option Plan. The shares of common stock issued upon exercise of these options
will be freely tradable without restriction or further registration, except to
the extent purchased by one of our affiliates.
We cannot predict the effect, if any, that future sales of shares of
our common stock into the public market will have on the market price of our
common stock. However, as a result of our small public float, sales of
substantial amounts of common stock, including shares issued upon the exercise
of stock options or warrants, or an anticipation that such sales could occur,
may materially and adversely affect prevailing market prices for our common
stock.
IF THE OWNERSHIP OF OUR COMMON STOCK CONTINUES TO BE HIGHLY CONCENTRATED, IT
MAY PREVENT YOU AND OTHER STOCKHOLDERS FROM INFLUENCING SIGNIFICANT CORPORATE
DECISIONS AND MAY RESULT IN CONFLICTS OF INTEREST THAT COULD CAUSE OUR STOCK
PRICE TO DECLINE.
As a group, our executive officers, directors, and 10% stockholders
beneficially own or control approximately 75% of our outstanding shares of
common stock (after giving effect to the exercise of all outstanding vested
options exercisable within 60 days from June 29, 2005). As a result, our
executive officers, directors, and 10% stockholders, acting as a group, have
substantial control over the outcome of corporate actions requiring stockholder
approval, including the election of directors, any merger, consolidation or sale
of all or substantially all of our assets, or any other significant corporate
transaction. Some of these controlling stockholders may have interests different
than yours. For example, these stockholders may delay or prevent a change in
40
control of I/OMagic, even one that would benefit our stockholders, or pursue
strategies that are different from the wishes of other investors. The
significant concentration of stock ownership may adversely affect the trading
price of our common stock due to investors' perception that conflicts of
interest may exist or arise.
OUR ARTICLES OF INCORPORATION, OUR BYLAWS AND NEVADA LAW EACH CONTAIN
PROVISIONS THAT COULD DISCOURAGE TRANSACTIONS RESULTING IN A CHANGE IN
CONTROL OF I/OMAGIC, WHICH MAY NEGATIVELY AFFECT THE MARKET PRICE OF OUR
COMMON STOCK.
Our articles of incorporation and our bylaws contain provisions that
may enable our board of directors to discourage, delay or prevent a change in
the ownership of I/OMagic or in our management. In addition, these provisions
could limit the price that investors would be willing to pay in the future for
shares of our common stock. These provisions include the following:
o our board of directors is authorized, without prior stockholder
approval, to create and issue preferred stock, commonly referred
to as "blank check" preferred stock, with rights senior to those
of our common stock;
o our stockholders are permitted to remove members of our board of
directors only upon the vote of at least two-thirds of the
outstanding shares of stock entitled to vote at a meeting called
for such purpose or by written consent; and
o our board of directors are expressly authorized to make, alter or
repeal our bylaws.
In addition, we may be subject to the restrictions contained in
Sections 78.378 through 78.3793 of the Nevada Revised Statutes which provide,
subject to certain exceptions and conditions, that if a person acquires a
"controlling interest," which is equal to either one-fifth or more but less than
one-third, one-third or more but less than a majority, or a majority or more of
the voting power of a corporation, that person is an "interested stockholder"
and may not vote that person's shares. The effect of these restrictions may be
to discourage, delay or prevent a change in control of I/OMagic.
WE CANNOT ASSURE YOU THAT AN ACTIVE MARKET FOR OUR SHARES OF COMMON STOCK
WILL DEVELOP OR, IF IT DOES DEVELOP, WILL BE MAINTAINED IN THE FUTURE. IF AN
ACTIVE MARKET DOES NOT DEVELOP, YOU MAY NOT BE ABLE TO READILY SELL YOUR
SHARES OF OUR COMMON STOCK.
On March 25, 1996, our common stock commenced trading on the OTC
Bulletin Board. Since that time, there has been limited trading in our shares,
at widely varying prices, and the trading to date has not created an active
market for our shares. We cannot assure you that an active market for our shares
will be established or maintained in the future. If an active market is not
established or maintained, you may not be able to readily sell your shares of
our common stock.
BECAUSE WE ARE SUBJECT TO "PENNY STOCK" RULES, THE LEVEL OF TRADING ACTIVITY
IN OUR COMMON STOCK MAY BE REDUCED. IF THE LEVEL OF TRADING ACTIVITY IS
REDUCED, YOU MAY NOT BE ABLE TO READILY SELL YOUR SHARES OF OUR COMMON STOCK.
Broker-dealer practices in connection with transactions in "penny
stocks" are regulated by penny stock rules adopted by the Securities and
Exchange Commission. Penny stocks are, generally, equity securities with a price
of less than $5.00 per share that trade on the OTC Bulletin Board or the Pink
Sheets. The penny stock rules require a broker-dealer, prior to a transaction in
a penny stock not otherwise exempt from the rules, to deliver a standardized
41
risk disclosure document that provides information about penny stocks and the
nature and level of risks in investing in the penny stock market. The
broker-dealer also must provide the prospective investor with current bid and
offer quotations for the penny stock and the amount of compensation to be paid
to the broker-dealer and its salespeople in the transaction. Furthermore, if the
broker-dealer is the sole market maker, the broker-dealer must disclose this
fact and the broker-dealer's presumed control over the market, and must provide
each holder of penny stock with a monthly account statement showing the market
value of each penny stock held in the customer's account. In addition,
broker-dealers who sell penny stocks to persons other than established customers
and "accredited investors" must make a special written determination that the
penny stock is a suitable investment for the prospective investor and receive
the purchaser's written agreement to the transaction. These requirements may
have the effect of reducing the level of trading activity in a penny stock, such
as our common stock, and investors in our common stock may find it difficult to
sell their shares.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations were not subject to commodity price risk during the
first three months of 2005. Our sales to a foreign country (Canada) were
approximately 1.8% of our total sales for the first three months of 2005, and
thus we experienced negligible foreign currency exchange rate risk. We do not
hedge against this risk.
We currently have an asset-based business loan agreement with GMAC
Commercial Finance in the amount of up to $10.0 million. The line of credit
provides for an interest rate equal to the prime lending rate as reported in THE
WALL STREET JOURNAL plus 0.75%. This interest rate is adjustable upon each
movement in the prime lending rate. If the prime lending rate increases, our
interest rate expense will increase on an annualized basis by the amount of the
increase multiplied by the principal amount outstanding under the GMAC
Commercial Finance business loan agreement.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We conducted an evaluation, with the participation of our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures, as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended, or the Exchange Act, as of March 31, 2005, to ensure that information
required to be disclosed by us in the reports filed or submitted by us under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the Securities Exchange Commission's rules and forms,
including to ensure that information required to be disclosed by us in the
reports filed or submitted by us under the Exchange Act is accumulated and
communicated to our management, including our principal executive and principal
financial officers, or persons performing similar functions, as appropriate to
allow timely decisions regarding required disclosure. Based on that evaluation,
our Chief Executive Officer and Chief Financial Officer have concluded that as
of March 31, 2005, our disclosure controls and procedures were not effective at
the reasonable assurance level due to the material weaknesses described below.
In light of the material weaknesses described below, we performed
additional analysis and other post-closing procedures to ensure our consolidated
financial statements were prepared in accordance with generally accepted
accounting principles. Accordingly, we believe that the consolidated financial
statements included in this report fairly present, in all material respects, our
financial condition, results of operations and cash flows for the periods
presented.
A material weakness is a control deficiency (within the meaning of the
Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or
combination of control deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim financial
statements will not be prevented or detected. Management has identified the
following four material weaknesses which have caused management to conclude
that, as of March 31, 2005, our disclosure controls and procedures were not
effective at the reasonable assurance level:
42
1. In conjunction with preparing our Form 10-K for the period ended
December 31, 2004 and our registration statement on Form S-1, management
reviewed our revenue recognition methodologies as they relate to sales
incentives and product returns. As a result of this review, management concluded
that our controls over the selection and monitoring of appropriate assumptions
and factors affecting the recording of revenue and the related sales incentives
and product returns were not in accordance with generally accepted accounting
principles and that our revenue for the years ended December 31, 2003 and 2002
and for each of the quarterly periods in the years ended December 31, 2003 and
2002, and through the nine months ended September 30, 2004, had been misstated.
Based upon this conclusion, our Audit Committee and senior management decided to
restate our financial statements as of and for the years ended December 31, 2003
and 2002 and for each of the quarterly periods in the years ended December 31,
2003 and 2002, and through the nine months ended September 30, 2004, to reflect
the corrections in our revenue recognition methodologies.
Management evaluated the impact of this restatement on our assessment
of our disclosure controls and procedures and has concluded that the control
deficiency that resulted in the incorrect recording of revenue and the related
sales incentives and product returns represented a material weakness.
2. We did not maintain documentation supporting certain inventory
reserves and did not analyze our inventory reserve account on a timely basis.
Management evaluated the impact of our inventory accounting practices on our
assessment of our disclosure controls and procedures and has concluded that the
control deficiency that resulted in the failure to maintain documentation
supporting certain inventory reserves and the failure to analyze our inventory
reserve account on a timely basis represented a material weakness. This control
deficiency did not result in a material misstatement of our consolidated
financial statements.
3. As a result of our restatement of prior periods' financial results,
as discussed above, we were unable to meet our requirements to timely file our
Form 10-K for the year ended December 31, 2004 and our Form 10-Q for the quarter
ended March 31, 2005. Management evaluated the impact of our inability to timely
file periodic reports with the Securities and Exchange Commission on our
assessment of our disclosure controls and procedures and has concluded that the
control deficiency that resulted in the inability to timely make these filings
represented a material weakness.
4. We did not maintain a sufficient complement of finance and
accounting personnel with adequate depth and skill in the application of
generally accepted accounting principles with respect to: (i) revenue
recognition, specifically relating to sales incentives and product returns, and
(ii) inventory reserves, specifically relating to maintenance of documentary
support of certain inventory reserves and the timeliness and frequency of our
analysis of our inventory reserve account. In addition, we did not maintain a
sufficient complement of finance and accounting personnel to handle the matters
necessary to timely file our Form 10-K for the year ended December 31, 2004 and
our Form 10-Q for the quarter ended March 31, 2005. Management evaluated the
impact of our lack of sufficient finance and accounting personnel on our
assessment of our disclosure controls and procedures and has concluded that the
control deficiency that resulted in our lack of sufficient personnel represented
a material weakness.
To address these material weaknesses, management performed additional
analyses and other procedures to ensure that the financial statements included
herein fairly present, in all material respects, our financial position, results
of operations and cash flows for the periods presented.
Remediation of Material Weaknesses
To remediate the material weaknesses in our disclosure controls and
procedures identified above, we have done the following subsequent to December
31, 2004, which correspond to the four material weaknesses identified above:
1. We have revised our revenue recognition methodology as it relates to
sales incentives. We previously accounted for sales incentives by reducing gross
sales at the time sales incentives were offered to our retailers. Upon further
examination of our accounting methodology for sales incentives, and a
quantitative analysis of our historical sales incentives, we determined that we
made an error in our application of the relevant accounting principles under
SFAS 48, as interpreted under Topic 13, and determined that we should have
estimated and recorded sales incentives at the time our products were sold.
Under SFAS 48, as interpreted under Topic 13, the eventual sales price must be
fixed or determinable before revenue can be recognized. Due to the nature and
extent of our sales incentive history, we should have been assessing our revenue
recognition criteria to determine whether we were able to effectively estimate
43
or determine our eventual sales price. We have determined the effect of the
correction on our previously issued financial statements and have restated our
financial statements for the years ended December 31, 2002 and 2003. Beginning
with the quarter ended December 31, 2004, we recorded an estimate of sales
incentives based on our actual sales incentive rates over a trailing twelve
month period, adjusted for any known variations, which we charged to operations
and offset against gross sales at the time products were sold with a
corresponding accrual for our estimated sales incentive liability. This accrual
- - our sales incentive reserve - is to be reduced by deductions on future
payments taken by our retailers relating to actual sales incentives.
We have revised our revenue recognition methodology as it relates to
product returns. We previously accounted for product returns using a method that
did not take into account the different return characteristics of categories of
similar products and also did not adequately take into account the variability
over time of product return rates. We conducted a quantitative analysis of our
historical product return data to determine moving averages of product return
rates by groupings of similar products. Following completion of this analysis,
we determined that we made an error in our method of estimating product returns.
As a result of this analysis, we determined that a more appropriate method would
be to apply an actual trailing 18-month return rate by product category against
actual gross sales for the period. We believe that using a trailing 18-month
return rate takes two key factors into consideration, specifically, an 18-month
return rate provides us with a sufficient period of time to establish recent
historical trends in product returns for each product category, and provides us
with a period of time that is short enough to account for recent technological
shifts in our product offerings in each product category. If an unusual
circumstance exists, such as a product category that has begun to show
materially different actual return rates as compared to life-to-date return
rates, we will make appropriate adjustments to our estimated return rates. We
have determined the effect of the correction on our previously issued financial
statements and have restated our financial statements for the years ended
December 31, 2002 and 2003. We began using this new methodology in the quarter
ended December 31, 2004.
2. We have implemented additional review procedures over the selection
and monitoring of appropriate assumptions and factors affecting our inventory
reserves to ensure that inventory balances are reduced to their net realizable
values on a timely basis. We have also revised our methodology in relation to
slow-moving or obsolete inventory. Slow-moving inventory is comprised of
products that have not been sold within six months. Obsolete inventory is
comprised of products that are no longer compatible with current hardware or
software. We previously reviewed our slow-moving and obsolete inventory in
detail twice a year, during our June 30 and December 31 physical inventories, in
regards to our lower of cost or market valuations. Our inventory reviews for the
quarters ended March 31 and September 30 were less detailed. We have implemented
a new procedure that requires that our purchasing manager review slow-moving and
obsolete inventory in detail at the end of each quarter and propose any
necessary increases to our inventory reserve. This procedure became effective
for the quarter ended December 31, 2004 and is effective for each quarter
thereafter.
3. In connection with making the changes discussed above to our
disclosure controls and procedures, in addition to working with our independent
auditors, we retained a third-party consultant, who is an experienced partner of
a registered public accounting firm specializing in public company financial
reporting, to advise us and our Audit Committee regarding our financial
reporting process. We also engaged another third-party accounting firm, other
than our independent auditors, to assist us with our financial reporting
process. Additionally, as of the date of this report, we have created a new
position--Vice President of Corporate Compliance--to further assist us in timely
making required filings with the Securities and Exchange Commission and ensuring
the accuracy of our financial reporting and the effectiveness of our disclosure
controls and procedures. We are currently in the process of filling this
position with an appropriate candidate. We also intend, in 2005, to implement
enhancements to our financial reporting processes, including increased training
of our finance and accounting staff regarding financial reporting requirements
and the evaluation and further implementation of automated procedures within our
MIS financial reporting system.
4. Please see item 3 immediately above.
Changes in Internal Control over Financial Reporting
Except as noted above, there were no changes in our internal control
over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the
Exchange Act, during our most recently completed fiscal quarter that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
44
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
HORWITZ AND BEAM
On May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for
breach of contract and legal malpractice against Lawrence W. Horwitz, Gregory B.
Beam, Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and Senn
Palumbo Mealemans, LLP, our former attorneys and their respective law firms, in
the Superior Court of the State of California for the County of Orange. The
complaint seeks damages of $15 million arising out of the defendants'
representation of I/OMagic and IOM Holdings, Inc. in an acquisition transaction
and in a separate arbitration matter. On November 6, 2003, we filed our First
Amended Complaint against all defendants. Defendants have responded to our First
Amended Complaint denying our allegations. Defendants Lawrence W. Horwitz and
Lawrence M. Cron have also filed a Cross-Complaint against us for attorneys'
fees in the approximate amount of $79,000. We have denied their allegations in
the Cross-Complaint. As of the date of this report, discovery has commenced and
a trial date in this action has been set for September 12, 2005. The outcome of
this action is presently uncertain. However, we believe that all of our claims
are meritorious.
MAGNEQUENCH INTERNATIONAL, INC.
On March 15, 2004, Magnequench International, Inc., or plaintiff, filed
an Amended Complaint for Patent Infringement in the United States District Court
of the District of Delaware against, among others, I/OMagic, Sony Corp., Acer
Inc., Asustek Computer, Inc., Iomega Corporation, LG Electronics, Inc., Lite-On
Technology Corporation and Memorex Products, Inc., or defendants. The complaint
seeks to permanently enjoin defendants from, among other things, selling
products that allegedly infringe one or more claims of plaintiff's patents. The
complaint also seeks damages of an unspecified amount, and treble damages based
on defendants' alleged willful infringement. In addition, the complaint seeks
reimbursement of plaintiff's costs as well as reasonable attorney's fees, and a
recall of all existing products of defendants that infringe one or more claims
of plaintiff's patents that are within the control of defendants or their
wholesalers and retailers. Finally, the complaint seeks destruction (or
reconfiguration to non-infringing embodiments) of all existing products in the
possession of defendants that infringe one or more claims of plaintiff's
patents. On March 9, 2005, we entered into a Settlement Agreement with
Magnequench International, Inc., releasing all claims against us in exchange for
certain information and covenants by us, including disclosure of identities of
certain of our suppliers of alleged infringing products, a covenant to provide
sample products for testing purposes and a covenant to not source products from
suppliers of alleged infringing products, provided that, among other
limitations, another supplier makes those products available to us in sufficient
quantities. A dismissal of the case was filed with the court on April 15, 2005.
OFFICEMAX NORTH AMERICA, INC.
On May 6, 2005, OfficeMax North America, Inc., or plaintiff, filed a
Complaint for Declaratory Judgment in the United States District Court of the
Northern District of Ohio against I/OMagic. The complaint seeks declaratory
relief regarding whether plaintiff is still obligated to us under certain
previous agreements between the parties. The complaint also seeks plaintiff's
costs as well as reasonable attorneys' fees. The complaint arises out of our
contentions that plaintiff is still obligated to us under an agreement entered
into in May 2001 and plaintiff's contention that it has been released from such
obligation. As of the date of this report, we have filed a motion to dismiss, or
in the alternative, a motion to stay the plaintiff's action against us. The
outcome of this action is presently uncertain. However, at this time, we do not
expect the defense or outcome of this action to have a material adverse affect
on our business, financial condition or results of operations.
45
On May 20, 2005, I/OMagic filed a complaint for breach of contract,
breach of implied covenant of good faith and fair dealing, and common counts
against OfficeMax North America, Inc., or defendant, in the Superior Court of
the State of California for the County of Orange. The complaint seeks damages in
excess of $22 million arising out of the defendants' breach of contract under an
agreement entered into in May 2001. On or about June 20, 2005, defendant removed
this complaint to the United States District Court for the Central District of
California. I/OMagic and OfficeMax have jointly requested that the United States
District Court for the Central District of California temporarily stay this case
pending the outcome of our motion to dismiss, or in the alternative, our motion
to stay OfficeMax's action against us in the United States District Court of the
Northern District of Ohio. The outcome of this action is presently uncertain.
However, we believe that all of our claims are meritorious.
In addition, we are involved in certain legal proceedings and claims
which arise in the normal course of business. Management does not believe that
the outcome of these matters will have a material effect on our financial
position or results of operations.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
Exhibit
Number Description
------ -----------
10 GMAC Letter dated May 23, 2005 Amending Financial Covenant(1)
31 Certifications Required by Rule 13a-14(a) of the Securities
Exchange Act of 1934, as amended, as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002*
32 Certifications of Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*
------------------------
* Filed herewith
(1) Filed as an exhibit to the Registrant's initial filing on May
27, 2005 of this quarterly report on Form 10-Q for the
quarterly period ended March 31, 2005 (File No. 0-27267)
46
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
I/OMAGIC CORPORATION
Dated: July 1, 2005 By: /s/ Tony Shahbaz
--------------------------------------------
Tony Shahbaz, President and Chief Executive
Officer (principal executive officer)
Dated: July 1, 2005 By: /s/ Steve Gillings
--------------------------------------------
Steve Gillings, Chief Financial Officer
(principal financial and accounting officer)
47
EXHIBITS FILED WITH THIS REPORT
Exhibit
Number Description
- ------ -----------
31 Certifications Required by Rule 13a-14(a) of the Securities
Exchange Act of 1934, as amended, as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
32 Certifications of Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
48