UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006
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)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (949) 707-4800
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, $.001 PAR VALUE
(TITLE OF CLASS)
Indicate by check mark if the registrant is a well-known seasoned
issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No |X|
Indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No |X|
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ ] No |X|
Indicate by check mark if disclosure of delinquent filers in response
to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. |X|
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. (Check one):
Large accelerated filer [ ] Non-accelerated filer |X|
Accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act). Yes [ ] No |X|
The aggregate market value of the voting common equity held by
nonaffiliates of the registrant computed by reference to the closing sale price
of such stock, was approximately $7.8 million as of June 30, 2006, the last
business day of the registrant's most recently completed second fiscal quarter.
The registrant has no non-voting common equity.
The registrant had 4,540,292 shares of common stock, $.001 par value,
outstanding as of July 9, 2007.
DOCUMENTS INCORPORATED BY REFERENCE: None.
TABLE OF CONTENTS
PAGE
PART I
Item 1. Business..........................................................1
Item 1A Risk Factors.....................................................15
Item 1B. Unresolved Staff Comments........................................24
Item 2. Properties.......................................................24
Item 3. Legal Proceedings................................................24
Item 4. Submission of Matters to a Vote of Security Holders..............25
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities................26
Item 6. Selected Financial Data..........................................27
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................29
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.......48
Item 8. Financial Statements and Supplementary Data......................48
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.........................................50
Item 9A. Controls and Procedures..........................................52
Item 9B. Other Information................................................53
PART III
Item 10. Directors, Executive Officers and Corporate Governance...........57
Item 11. Executive Compensation...........................................62
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters..................................64
Item 13. Certain Relationships and Related Transactions, and
Director Independence............................................66
Item 14. Principal Accounting Fees and Services...........................68
PART IV
Item 15. Exhibits, Financial Statement Schedules..........................82
Index to Consolidated Financial Statements and Supplemental Information......F-1
Index To Exhibits
Signatures
Exhibits Filed with this Report
ii
EXPLANATORY NOTE -- RESTATEMENTS OF FINANCIAL INFORMATION AND A CHANGE
IN ACCOUNTING PRINCIPLE
EXPLANATORY NOTE
This Form 10-K includes restatements and a change in accounting
principle for the years ended December 31, 2005 and 2004 and for the interim
periods for the years ended December 31, 2006, 2005 and 2004 that amend, restate
and adjust the following:
o consolidated statements of operations for the years ended December 31,
2005 and 2004;
o selected financial data for the years ended December 31, 2005 and 2004;
and
o certain financial data for the quarterly periods ended March 31, June
30, and September 30, 2006, and March 31, June 30, September 30, and
December 31, 2005 and 2004.
This Form 10-K also reflects the restatement and adjustment of
"Selected Financial Data" in Item 6 for the fiscal years ended December 31,
2005, 2004, 2003 and 2002, and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" in Item 7 for the fiscal years
ended December 31, 2005 and 2004.
We have not filed amendments to our previously filed Forms 10-K for the
fiscal years ended December 31, 2005, 2004, 2003 or 2002, or amendments to our
previously filed Forms 10-Q for the interim periods affected by the restatements
and change in accounting principle prior to and including September 30, 2006.
The consolidated financial statements and financial information, as previously
filed, should no longer be relied upon. The related audit report of Singer Lewak
Greenbaum & Goldstein LLP, our previous independent registered public accounting
firm, with respect to the consolidated financial statements referred to in this
paragraph, should also no longer be relied upon. The previously filed
information reported for the periods referred to in the previous paragraph is
superseded by the information contained in this Form 10-K.
For additional information, see Notes 2, 3 and 4 to our consolidated
financial statements beginning on page F-1 of this Form 10-K.
iii
PART I
CAUTIONARY STATEMENT
ALL STATEMENTS INCLUDED OR INCORPORATED BY REFERENCE IN THIS ANNUAL
REPORT ON FORM 10-K, OTHER THAN STATEMENTS OR CHARACTERIZATIONS OF HISTORICAL
FACT, ARE "FORWARD-LOOKING STATEMENTS." EXAMPLES OF FORWARD-LOOKING STATEMENTS
INCLUDE, BUT ARE NOT LIMITED TO, STATEMENTS CONCERNING PROJECTED NET SALES,
COSTS AND EXPENSES AND GROSS MARGINS; OUR ACCOUNTING ESTIMATES, ASSUMPTIONS AND
JUDGMENTS; THE DEMAND FOR OUR PRODUCTS; THE COMPETITIVE NATURE OF AND
ANTICIPATED GROWTH IN OUR INDUSTRY; AND OUR PROSPECTIVE NEEDS FOR ADDITIONAL
CAPITAL. THESE FORWARD-LOOKING STATEMENTS ARE BASED ON OUR CURRENT EXPECTATIONS,
ESTIMATES, APPROXIMATIONS AND PROJECTIONS ABOUT OUR INDUSTRY AND BUSINESS,
MANAGEMENT'S BELIEFS, AND CERTAIN ASSUMPTIONS MADE BY US, ALL OF WHICH ARE
SUBJECT TO CHANGE. FORWARD-LOOKING STATEMENTS CAN OFTEN BE IDENTIFIED BY SUCH
WORDS AS "ANTICIPATES," "EXPECTS," "INTENDS," "PLANS," "PREDICTS," "BELIEVES,"
"SEEKS," "ESTIMATES," "MAY," "WILL," "SHOULD," "WOULD," "COULD," "POTENTIAL,"
"CONTINUE," "ONGOING," SIMILAR EXPRESSIONS AND VARIATIONS OR NEGATIVES OF THESE
WORDS. THESE STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND ARE SUBJECT
TO RISKS, UNCERTAINTIES AND ASSUMPTIONS THAT ARE DIFFICULT TO PREDICT.
THEREFORE, OUR ACTUAL RESULTS COULD DIFFER MATERIALLY AND ADVERSELY FROM THOSE
EXPRESSED IN ANY FORWARD-LOOKING STATEMENTS AS A RESULT OF VARIOUS FACTORS, SOME
OF WHICH ARE LISTED UNDER "RISK FACTORS" IN ITEM 1A OF THIS REPORT. THESE
FORWARD-LOOKING STATEMENTS SPEAK ONLY AS OF THE DATE OF THIS REPORT. WE
UNDERTAKE NO OBLIGATION TO REVISE OR UPDATE PUBLICLY ANY FORWARD-LOOKING
STATEMENT FOR ANY REASON, EXCEPT AS OTHERWISE REQUIRED BY LAW.
ITEM 1. BUSINESS.
COMPANY OVERVIEW
We sell data storage, digital entertainment and personal computer, or
PC, peripheral products. We sell our products in the United States and Canada,
together known as the North American retail marketplace. During 2006, sales
generated within the United States accounted for approximately 84% of our net
sales and sales generated within Canada accounted for approximately 16% of our
net sales. For the years ended December 31, 2005 and 2004, sales generated
within the United States and Canada accounted for approximately 98% and 2% of
our net sales, respectively.
Our product offerings predominantly consist of both mobile and desktop
magnetic data storage products and optical data storage products. Our mobile
magnetic data storage products, which we call our Data-to-Go(TM) products,
consist of compact and mobile universal serial bus, or USB, hard disk drives
that plug into any standard USB port and that provide from 8 gigabytes, or 8,000
megabytes, to up to 160 gigabytes, or 160,000 megabytes of storage capacity. We
designed our Data-to-Go(TM) products as cost-effective portable alternatives to
flash media devices and standard hard disk drives. Our mobile magnetic data
storage products accounted for approximately 34% of our net sales for 2006. Our
desktop magnetic data storage products, which we call our GigaBank(TM) products,
require an independent power source and offer storage capacities ranging from
250 gigabytes, or 250,000 megabytes, to up to 1 terabyte, or 1,000,000
megabytes. Our desktop magnetic data storage products accounted for
approximately 23% of our net sales for 2006. Our optical data storage products
include recordable compact disc, or CD, drives and recordable digital video or
versatile disc, or DVD, drives. Our CD and DVD drives are primarily for use with
PCs. Our optical data storage products accounted for approximately 39% of our
net sales in 2006. Although we have sold various media in the past, such as
floppy disks and CDs, we do not currently sell media products. We also sell
digital entertainment and other products, which accounted for only approximately
4% of our net sales in 2006.
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We sell our products through computer, consumer electronics and office
supply superstores and other major North American retailers, including Best Buy
Canada, Circuit City, CompUSA, Costco, Fred Meyer Stores, Micro Center, Office
Depot, Office Max, RadioShack, Staples, Tech Data and Target. Our retailers sell
our products in retail locations throughout North America. We also have
relationships with other retailers, catalog companies and Internet retailers
such as Buy.com, Dell, PC Mall, Home Shopping Network and Tiger Direct,
predominantly through distribution by Tech Data.
Our sales have historically been seasonal. 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.
During 2006, our most significant retailers were Staples, Best Buy
Canada, Circuit City and Office Depot. Collectively, these four retailers
accounted for 69% of our net sales for 2006, or 28%, 14%, 14% and 13% of our net
sales, respectively. During 2005, our most significant retailers were Staples,
Office Depot, CompUSA and Circuit City. Collectively, these four retailers
accounted for 81% of our net sales, or 36%, 17%, 17% and 11% of our net sales,
respectively, during 2005.
We market our products primarily under our I/OMagic(R) brand name. From
time to time, we also market products under our Hi-Val(R) and Digital Research
Technologies(R) brand names. We sell our data storage products primarily under
our I/OMagic(R) brand name, bundling various hardware devices with different
software applications to meet different consumer needs.
We do not directly manufacture any of the components incorporated into
products that we sell. We subcontract the manufacturing of the majority of our
products or source our products from Asia, predominantly in Taiwan and China,
which allows us to offer products at highly competitive prices. Most of our
subcontract manufacturers and suppliers have substantial product development
resources and facilities, and are among the major component manufacturers and
suppliers in their product categories, which we believe affords us substantial
flexibility in offering new and enhanced products. Some of our largest
subcontract manufacturers and suppliers are also our stockholders, including
Behavior Tech Computer Corp. and its affiliated companies, or BTC, and Lung Hwa
Electronics Co., Ltd., or Lung Hwa. Both BTC and Lung Hwa provide us with
significant trade lines of credit. We believe that BTC is among the largest
optical storage drive manufacturers in the world and Lung Hwa is a major
supplier of USB hard disk drives, including some of our GigaBank(TM) products,
as well as a major manufacturer of digital entertainment products. Certain of
these subcontract manufacturers and suppliers provide us with significant
benefits by allowing us to purchase products on terms more advantageous than we
believe are generally available in our industry. These advantageous terms
include generous trade lines of credit and extended payment terms which allow us
to utilize more capital resources for other aspects of our business. See
"Certain Relationships and Related Transactions, and Director Independence."
I/OMagic Corporation was incorporated under the laws of the State of
Nevada in October 1992. We have one subsidiary, IOM Holdings, Inc., a Nevada
corporation. Our principal executive offices are located in Irvine, California
and our main telephone number is (949) 707-4800.
2
RECENT DEVELOPMENTS
Over the course of the past several months and through the beginning of
July 2007, the robust sales pace of magnetic data storage products experienced
in 2006 has slowed significantly. We believe that this is an industry-wide
effect. In addition, we are experiencing intense price competition from major
competitors such as Western Digital and Seagate Technology, which has
significantly reduced selling prices and eroded margins for magnetic data
storage products. In late 2006 and early 2007, we placed substantial orders for
magnetic data storage products based on our expectation of continuing robust
sales. As a result of these orders and the slowing market for these products, we
currently have high inventory levels. Due to intense price competition, we may
not be able to sell this inventory at positive gross margins. We are unable to
predict whether the market for and selling prices of magnetic data storage
products will stabilize, increase or further decline in the future. In response
to these market conditions, and also as part of its ongoing efforts to bring new
products to market, management is currently exploring other products with our
suppliers and retailers to sell through our sales channels.
INDUSTRY OVERVIEW
Storing, managing, protecting, retrieving and transferring electronic
data has become critical to individuals and businesses due to their increasing
dependence on and participation in data-intensive activities. The data storage
industry is growing in response to the needs of individuals and businesses to
store, manage, protect, retrieve and transfer increasing amounts of data
resulting from:
o the growth in the number of PCs, and the increase in the number,
size and complexity of computer operating systems, computer
networks and software programs;
o the emergence and development of new data-intensive activities,
such as e-mail, e-commerce, and the increasing availability of
products and services over the Internet, together with the rise in
bandwidth available to access and download data from the Internet;
and
o the existence and availability of increasing amounts of digital
entertainment data, such as movies, music, photos, video games and
other multi-media data.
Traditional PC data generally includes documents, e-mails, financial
information, software programs and other electronic data. The data storage
industry has grown significantly over the last two decades as the PC has become
a virtually indispensable tool in the home and office, resulting in increasing
amounts of traditional PC data. As a result of these and other developments,
traditional PC data storage requirements have correspondingly increased.
Digital entertainment data generally includes movies, music, photos,
video games and other multi-media data. For nearly two decades, music has been
offered on CDs as the prevailing standard. In the mid-to-late 1990s, the ability
to copy CDs, and to download, remix, and copy or "burn" music to a personalized
CD began to gain popularity and made the recordable CD drive, or "CD burner," a
desirable component of the PC. With the growth and acceptance of the Internet
and the advent of on-line music availability, the demand for on-line music has
increased and as a result, the demand for faster and easier data storage and
retrieval has grown.
We believe that the increasing amount of traditional PC and digital
entertainment data that is being generated and used is stimulating increased
demand for products offering data storage, management, protection, retrieval and
transfer capability. We also believe that those products that offer flexibility
and high-capacity storage in a cost-effective, user-friendly manner are in
highest demand.
3
KEY FACTORS DRIVING GROWTH IN THE DATA STORAGE INDUSTRY
We believe that the following factors, among others, are driving and
will continue to drive growth in the data storage industry:
o INCREASED USE OF THE INTERNET. As individuals and businesses
continue to increase their use of the Internet for communications,
commerce and data retrieval, the corresponding need to utilize
data storage devices for storage, management, protection,
retrieval and transfer of data -- especially high-capacity,
cost-effective data storage devices -- will continue to grow. In
addition, bandwidth is increasing and is expected to continue to
increase. Increasing bandwidth allows faster data transfer rates
over the Internet and makes use of the Internet for data-intensive
activities more convenient and cost-effective.
o GROWTH IN NEW TYPES OF DATA. The growth in new types of data such
as movies, music, photos, video games and other multi-media data,
including high-resolution audio and video data, requires far
greater storage capacity than traditional PC text data. We believe
that individual consumers and businesses increasingly depend on
their abilities to store, manage, protect, retrieve and transfer
these types of data using data storage devices.
o GROWTH IN THE CRITICAL IMPORTANCE OF DATA. Business databases
contain information about customers, suppliers, competitors and
industry trends that may be analyzed and potentially transformed
into a valuable asset and a competitive advantage. Efficiently
storing, managing, protecting, retrieving and transferring this
information has become increasingly important to many businesses.
o DECREASE IN THE COST OF STORING DATA. The cost of data storage
continues to decrease with advances in technology and improved
manufacturing processes. This decrease in cost encourages and
enables individuals and businesses to purchase more data storage
media and devices.
o CONVERGENCE OF TECHNOLOGIES. Product offerings are beginning to
embody the convergence of data storage and digital entertainment
playback technologies. For instance, a digital video recorder, or
DVR, can operate as the primary tool for storage, management,
protection, retrieval and transfer of traditional PC data as well
as digital entertainment data such as movies, music, photos, video
games and other multi-media data.
TYPES OF DATA STORAGE MEDIA
The following types of data storage media are the principal means
through which traditional PC data as well as digital entertainment data can be
stored, managed, protected, retrieved and transferred:
o MAGNETIC. Magnetic data storage drives store digital data by
magnetically altering minutely small areas of a magnetic media
surface so that specific areas represent either a "1" or a "0."
All digital data is comprised of different combinations of "1s"
and "0s" regardless of the media on which the data is stored.
Examples of magnetic data storage media include floppy disks,
Zip(R) disks, magnetic tape and hard disk drives, including
compact and portable hard disk drives, such as our Data-to-Go(TM)
products.
o OPTICAL. Optical data storage drives store digital data by using
lasers to alter minutely small areas of an optical media surface.
Examples of optical data storage media include CDs and DVDs.
o SOLID STATE. Solid state storage devices store digital data by
applying electronic charges to alter minutely small areas of a
memory chip or card. Examples of solid state media include flash
memory chips, flash memory cards and thumbdrives. Thumbdrives are
more commonly known as USB drives, which are small, portable flash
memory devices that plug into any standard USB drive. Solid state
media is typically used for digital data storage in digital
cameras, personal digital assistants, or PDAs, cellular phones and
MP3 players.
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RELATIVE ADVANTAGES AND DISADVANTAGES OF TYPES OF DATA STORAGE MEDIA
Each of the principal types of data storage media generally available
to consumers has certain advantages and disadvantages. These include:
MAGNETIC MEDIA
o HARD DISKS. Hard disks are fixed media and typically are not
removable, thus prohibiting the physical transport of data and
portability of the drive itself. Relative to other available
media, hard disks have higher capacities, holding up to
approximately 1 terabyte, or 1,000,000 megabytes, depending on the
user's operating system and other factors, and offer a low cost
per megabyte. Hard disks have a fixed storage capacity and are not
scalable. Hard disks offer fast data access times and data
transfer rates and generally good reliability, but data protection
and retrieval is dependent on drive reliability. Hard disks
require another device or medium for data back-up purposes or for
data transportability; however certain hard disk drives, such as
our mobile storage products, allow physical transport of data and
drive portability.
o FLOPPY DISKS. Floppy disks are removable media allowing physical
transport of data. External floppy disk drives allow portability
of the drive itself. Floppy disks benefit from being "legacy"
products with a large existing user base and a low cost per unit
for a floppy disk. Relative to other available media, floppy disks
have extremely low capacity, holding up to approximately 1.44
megabytes per disk depending on the user's operating system and
other factors, and represent a very high cost per megabyte. In
addition, floppy disks typically employ older, less efficient
storage, management, protection, retrieval and transfer
technology, and offer moderate data access times and data transfer
rates, moderate reliability and a tendency towards degradation
over time which risks the loss of data stored on the disk.
o ZIP(R) DISKS. Zip(R) disks are removable media allowing physical
transport of data. External Zip(R) disk drives allow portability
of the drive itself. Relative to other available media, Zip(R)
disks have moderate capacity, holding up to approximately 750
megabytes per disk depending on the user's operating system and
other factors, and represent a moderate cost per megabyte. Zip(R)
disks themselves have a moderate cost per unit and offer moderate
data access times and data transfer rates. A special Zip(R) drive
is required to utilize Zip(R) disk technology and media.
o MAGNETIC TAPE. Magnetic tape is a removable media allowing
physical transport of data. Magnetic tape drives are typically
larger than other storage drives, making them comparatively less
portable. Relative to other available media, magnetic tape has
moderate to high capacity, holding up to approximately 80
gigabytes, or 80,000 megabytes, depending on the user's operating
system and other factors, and represents a moderate cost per
megabyte. While magnetic tape itself is not expensive, magnetic
tape drives have a high cost per unit. Magnetic tape media
typically employs older, less efficient storage, management,
protection, retrieval and transfer technology, and offers slow
data access times but fast data transfer rates, moderate
reliability and a tendency towards degradation over time which
risks the loss of data stored on the tape.
OPTICAL MEDIA
o COMPACT DISCS. CDs are removable media allowing physical transport
of data. External CD drives allow portability of the drive itself.
Relative to other available media, CDs have moderate capacity,
holding up to approximately 700 megabytes, depending on the user's
operating system and other factors, and offer virtually unlimited
storage capacity with the use of additional low cost CDs. CDs
offer only moderate data access times and data transfer rates as
compared to hard disk technologies; however, new technology
continues to improve data access times for this media. CDs are
also compatible with numerous devices ranging from PCs to CD and
DVD players typically found in the home and office. Unlike hard
disks, the integrity of data protection and retrieval is not
drive-dependent, since a reliability problem with an optical drive
will not affect digital data already stored on a CD, and ease of
transport allows access to data using another drive if a problem
exists with a user's primary drive unit. In addition, unlike
magnetic media, repeated use of CDs results in limited or no
degradation of the CD itself.
5
o DIGITAL VIDEO OR DIGITAL VERSATILE DISCS. The relative advantages
and disadvantages of DVD drives and media are generally the same
as for CD drives and media. However, as compared to other
available media, DVDs are moderate to high capacity, holding up to
approximately 4.3 gigabytes, or 4,300 megabytes, on a single-layer
DVD drive and up to 8.5 gigabytes, or 8,500 megabytes, on a
double-layer DVD drive, depending on the user's operating system
and other factors.
SOLID STATE MEDIA
o FLASH MEMORY CHIPS. Flash memory chips are generally not removable
media. Typically, flash memory chips are used in portable devices
such as digital cameras, PDAs and cellular phones. Relative to
other available media, flash memory chips have moderate capacity,
holding up to approximately 2 gigabytes, or 2,000 megabytes,
depending on the user's operating system and other factors, and
offer very high cost per megabyte and high cost per unit. Flash
memory chips are highly reliable, consume very little power and
offer very fast data access times and data transfer rates, but
require another device or medium for data back-up purposes.
o FLASH MEMORY CARDS. The relative advantages and disadvantages of
flash memory cards are generally the same as for flash memory
chips. However, flash memory cards are removable media allowing
physical transport of data.
INDUSTRY CHALLENGES AND TRENDS
We believe that the challenges currently facing the data storage
industry include:
o NEED FOR HIGH-CAPACITY, COST-EFFECTIVE AND FLEXIBLE MEDIA AND
RELATED DATA STORAGE DEVICES. We believe that, as a result of the
rapid growth in electronic data and in new applications requiring
or using high data-content movies, music, photos, video games and
other multi-media content, the data storage industry needs to
offer higher capacity, more cost-effective and flexible media and
data storage devices. To meet this need, the data storage industry
has shifted its product offerings to DVD-based technologies as
well as to compact and portable hard disk drives such as our
Data-to-Go(TM) products.
o NEED TO IDENTIFY AND SATISFY CONSUMER DEMANDS AND PREFERENCES. The
data storage industry is characterized in part by rapidly changing
consumer demands and preferences for higher levels of product
performance and functionality. We believe that, to be successful,
companies in this industry must closely identify changes in
consumer demands and preferences and introduce both new and
enhanced data storage products to provide higher levels of
performance and functionality than existing products.
We believe that one of the trends in the data storage industry includes
the trend toward higher capacity optical storage media and related drives,
including the trend away from CD-based media and devices and towards DVD-based
media and devices.
Another trend in the data storage industry is the progression toward
smaller, more portable hard disk drives such as our DataBank(TM) and
Data-to-Go(TM) products. We expect that products with storage capacities of up
to 160 gigabytes, or 160,000 megabytes, on a single 2.5 inch hard disk drive,
and up to 1 terabyte, or 1,000,000 megabytes, on a single 3.5 inch hard disk
drive will be available in 2007. It is not clear when we will be able to offer
products with similar storage capacities at competitive prices.
Developing trends in the data storage industry include the adoption of
super-high-capacity optical data storage devices using technology such as
Blu-ray DVD or High-definition DVD. Blu-ray DVD technology is expected to expand
DVD capacity up to tenfold and is expected to allow, for the first time in a
device widely available to consumers, the storage and retrieval of high
definition videos and images for playback on high-definition DVD players and
compatible televisions and monitors. A competing new technology also exists
called High-definition DVD, or HD-DVD. The storage capacity of HD-DVD is limited
to approximately 60% of a Blu-ray DVD. Proponents of HD-DVD technology contend,
however, that it has less compatibility problems with existing DVD technology as
compared to Blu-ray DVD technology and that data compression software reduces
the importance of the greater storage capacity offered by Blu-ray DVD
technology.
6
It is not yet clear whether Blu-ray DVD or HD-DVD will become the
dominant technology, if they will coexist, or if a new technology will emerge.
Nonetheless, we believe that the increased performance offered by these
technologies will likely result in increased consumer demand for optical data
storage devices. Furthermore, we believe that regardless of which technology
becomes the dominant technology, we will be able to incorporate either
technology into our product offerings in much the same way as we do today with
the large number of format types ranging from recordable and rewritable CD-based
products to DVD-based products.
THE I/OMAGIC SOLUTION
We sell magnetic and optical data storage products in the North
American retail marketplace. We believe that we possess a combination of core
competencies that provide us with a competitive advantage, including the ability
to successfully identify consumer needs and preferences, use our sales channels
to sell new and enhanced products, efficiently bring to market newly developed
products and enhanced products, efficiently manage our product supply chain, and
use our brands and merchandising efforts to market and sell data storage
products. In addition, we sell digital entertainment and other products in the
North American retail marketplace.
Successfully executing our core competencies yields substantial
benefits including the ability to:
o rapidly bring both new and enhanced products to market in a
cost-effective manner;
o offer high-value products that combine performance, functionality
and reliability at competitive prices; and
o establish and maintain a large market presence for our core data
storage product offerings resulting in significant market share.
We work closely with our retailers to promote our products, monitor
consumer demands and preferences and stay at the forefront of the market for
data storage products. We also work closely with our subcontract manufacturers
and suppliers and benefit from their substantial research and development
resources and economies of scale. As a result of working with our retailers,
subcontract manufacturers and suppliers, we are able to rapidly bring new and
enhanced data storage products to market in a cost-effective manner.
The market intelligence we gain through consultation with our
retailers, subcontract manufacturers and suppliers enables us to deliver
products that combine the performance and functionality demanded by the
marketplace. Obtaining these products through our subcontract manufacturers and
suppliers, along with efficient management of our supply chain, allows us to
offer these products at competitive prices.
We sell our products through computer, consumer electronics and office
supply superstores and other retailers who collectively operate retail locations
throughout North America. Our network of retailers enables us to offer products
to consumers across North America, including nearly every major metropolitan
market in the United States. Over the past three years, our largest retailers
have included Best Buy Canada, Circuit City, CompUSA, Costco, Office Depot,
OfficeMax, Staples and Target.
Historically, we have focused on optical data storage products, such as
CD and DVD drives. We continue to sell and market our optical data storage
products but now focus primarily on our line of mobile and desktop magnetic data
storage products called our Data-to-Go(TM) products, which are compact and
portable USB hard disk drives that plug into any standard USB port, and our
GigaBank(TM) larger capacity desktop products that require an independent power
source. We believe that these products are cost-effective alternatives to flash
media devices and standard hard disk drives. We also believe that the market for
data storage products, especially "after-market" devices that can be purchased
separately from and easily used in conjunction with a standard PC, has shifted
its demand largely to mobile and desktop hard disk drives as well as optical
media and drives. While optical media and drives represent the optimal
combination of high-capacity storage capability, cost-effectiveness and
flexibility, magnetic hard-disk and drive technology is the closest competitor
to optical media in the contexts of storage capacity, cost-effectiveness and
flexibility. However, while the storage capacity of any given hard disk is
fixed, optical media has virtually unlimited storage capacity through the
addition of low-cost CDs or DVDs. Moreover, optical media has far more
flexibility than hard disk media, allowing users to store music, photos and
movies utilizing a stand-alone recorder or a desktop or laptop PC and then play
them back on standalone CD or DVD players. In addition, hard disk media is
usually built into a PC, lacking effective portability and ease of physical
transport of data.
7
We believe that our focus on mobile and desktop magnetic disk drives is
consistent with consumer demand for portability and larger capacity magnetic
disk drives and that our optical data storage products are also consistent with
the proliferation of digital entertainment devices. Digital cameras, MP3 players
and other digital entertainment devices are well complemented by the use of
optical media for data back-up and high-capacity storage purposes. Existing
solid state media, while convenient in many respects, offers relatively low
storage capacity and relatively poor cost effectiveness. Accordingly, optical
media, with its high storage capacity, cost effectiveness and convenience,
together with a related drive unit, is a complementary product for consumers who
desire to store, manage, protect, retrieve and transfer digital data used in
conjunction with their digital entertainment devices.
Over the course of the past several months and through the beginning of
July 2007, the robust sales pace of magnetic data storage products experienced
in 2006 has slowed significantly. We believe that this is an industry-wide
effect. In addition, we are experiencing intense price competition from major
competitors such as Western Digital and Seagate Technology, which has
significantly reduced selling prices and eroded margins for magnetic data
storage products. In late 2006 and early 2007, we placed substantial orders for
magnetic data storage products based on our expectation of continuing robust
sales. As a result of these orders and the slowing market for these products, we
currently have high inventory levels. Due to intense price competition, we may
not be able to sell this inventory at positive gross margins. We are unable to
predict whether the market for and selling prices of magnetic data storage
products will stabilize, increase or further decline in the future. In response
to these market conditions, and also as part of its ongoing efforts to bring new
products to market, management is currently exploring other products with our
suppliers and retailers to sell through our sales channels.
OUR STRATEGY
Our primary goal is to remain a leading provider of mobile and desktop
magnetic disk drives and optical data storage products and to expand our market
share in both product categories. Our business strategy to achieve this goal
includes the following elements:
o CONTINUE TO DEVELOP AND SOLIDIFY OUR NORTH AMERICAN RETAIL
NETWORK. We have developed, and plan to continue to develop,
broaden and solidify, close working relationships with leading
North American computer, consumer electronics and office supply
superstores and other retailers. These retailers carry many of the
products that we sell. As we offer both new and enhanced data
storage, digital entertainment and other products, we intend to
continue to utilize our existing relationships with these
retailers to offer and sell these products to consumers.
o CONTINUE TO DEVELOP AND EXPAND OUR STRATEGIC SUBCONTRACT AND
SUPPLY RELATIONSHIPS. We have developed, and plan to continue to
develop and expand, strategic relationships with subcontract
manufacturers and suppliers, such as BTC and Lung Hwa in Asia.
These relationships allow us to enhance our product offerings and
benefit from these subcontract manufacturers' and suppliers'
continued development of new and improved data storage, digital
entertainment and other products. Some of these relationships are
particularly strong because some of our subcontract manufacturers
and suppliers are also stockholders of I/OMagic. We plan to
continue to develop and explore other subcontract manufacturer and
supplier relationships as well. By continuing to subcontract
manufacture and source our products, we intend to continue to
increase our operating leverage by delivering products
incorporating new technology without having to make the
substantial investment in, or having to incur the fixed costs
associated with product development and manufacturing in an
industry characterized by rapid product innovation and
obsolescence.
o CONTINUE TO DEVELOP AND OFFER HIGH VALUE PRODUCTS. We intend to
continue to work in conjunction with our retailers, subcontract
manufacturers and suppliers to enhance existing products and
develop new products to satisfy consumer demands and preferences.
We believe that our target consumers seek high value products that
combine performance, functionality and reliability at prices
competitive with other leading products offered in the
marketplace. We believe that our core competencies such as our
ability to efficiently bring to market newly developed products
and enhanced products and to efficiently manage our product supply
chain will enable us to enhance our products and offer new
products in a cost-effective and timely manner. We intend to
continue to focus on high value product offerings by promoting and
offering our products that are affordable alternatives to
higher-priced products offered by some of our competitors.
8
o MARKET PRODUCTS TO OUR EXISTING CONSUMER BASE. We intend to market
new, enhanced and current products to existing purchasers of our
products. We also believe that existing users of our products can
be an important source of referrals for potential new purchasers
of our products. In addition, through our websites located at
http://www.iomagic.com, http://www.dr-tech.com and
http://www.hival.com, we plan to increase sales of our products
over the Internet by continuing to offer select products for
direct purchase by consumers, conduct special promotions and offer
downloads to existing and potential purchasers of our products.
OUR PRODUCTS
We have three primary data storage product categories: our mobile
magnetic data storage products, our desktop magnetic data storage products and
our optical data storage products. Our magnetic data storage products consist of
mobile products that we call our Data-to-Go(TM) products and desktop products
that we call our GigaBank(TM) products. These products are designed principally
for general data storage. Our optical data storage products consist of a range
CD and DVD drives that store traditional PC data as well as movies, music,
photos, video games and other multi-media data.
OUR OPTICAL DATA STORAGE PRODUCTS
Our optical data storage products are based on one or more of the
following technology formats which allow storage, management, protection,
retrieval and transfer of data:
DATA STORAGE
TECHNOLOGY MEANING AND RETRIEVAL CAPABILITY(1)
- ---------- ------- ---------------------------
CD-ROM Compact Disc-Read Only Memory Retrieval only
CD-R Compact Disc-Recordable Retrieval and single-session storage
CD-RW Compact Disc-Rewritable Retrieval and multi-session storage
DVD-ROM Digital Video Disc-Read Only Memory Retrieval only
DVD-R or DVD+R Digital Video Disc-Recordable Retrieval and single-session storage
DVD-RW or DVD+RW Digital Video Disc-Rewritable Retrieval and multi-session storage and
backward compatibility with CDs
DVD-RAM Digital Video Disc-Random Access Memory Retrieval and multi-session storage
DVD+/-RW+/-R Dual Format Digital Video Disc-Rewritable Retrieval and multi-session storage and
and Recordable backward compatibility with CDs and DVD-Rs
CD-RW+DVD Compact Disc-Rewritable DVD Retrieval and multi-session storage and
backward compatibility with CDs and
DVD-ROMs
- -----------------
(1) Single-session (R=write once/read only) storage media and devices allow
storage on a disc only a single time, whereas multi-session (RW=rewritable)
storage media and devices allow repeated storage, erasure and re-storage of
data. Backward compatible devices permit the use of media based on older
technology in devices employing newer technology, such as DVD-based devices
which permit the use of CD media.
Many of the technologies identified in the table above are competing
media formats. We seek to deliver optical data storage products that enable the
storage, management, protection, retrieval and transfer of data to and from all
major media formats to satisfy the needs of consumers regardless of their choice
of media format. Because certain media formats ultimately may be rejected or
disfavored by the marketplace, we do not base our products on a single format or
on a small number of media formats. We seek to offer products that are
cross-compatible over numerous formats to offer the most comprehensive solution
available to the broadest range of consumers.
Our optical data storage products currently include:
o Internal and external optical data storage drives based on the
following technologies: CD-ROM, CD-RW, DVD-ROM, DVD+R, DVD+RW,
DVD-RAM, DVD+/-RW+/-R or CD-RW+DVD; and
o Disc duplicator systems that are stand-alone units that do not
require a computer connection and that copy information from a
source disc, such as a CD, to a compatible target disc.
We also offer optical data storage products that use double-layer DVD
technology, which doubles DVD capacity to approximately 8.5 gigabytes, or 8,500
megabytes, depending on the user's media capability. We plan to continue our
efforts to enhance our optical data storage products by increasing performance
and functionality as well as reducing the size of their drive units and
enclosures to increase portability and ergonomics.
9
OUR PORTABLE MAGNETIC DATA STORAGE PRODUCTS
Our existing and planned portable magnetic data storage products
currently include:
o GIGABANK(TM) MICRO USB hard disk drives with dimensions measuring
1.4"W x 2.25"L x 0.4"H, provide from 8 gigabytes, or 8,000
megabytes up to 12 gigabytes, or 12,000 megabytes, of storage
capacity, depending on the user's operating system and other
factors;
o DATA-TO-GO(TM) AND DATA-TO-GO2(TM) compact and portable external
USB 2.0 hard disk drives with dimensions measuring 3.0"W x 5.25"L
x 0.6"H that provide from 80 gigabytes, or 80,000 megabytes up to
120 gigabytes, or 120,000 megabytes, of storage capacity,
depending on the user's operating system and other factors.
o GIGABANK(TM) external USB 2.0 hard disk drives with dimensions
measuring 5.0" W x 8.25" L x 1.5" H, provide from 200 gigabytes,
or 200,000 megabytes up to 1 terabyte, or up to 1,000,000
megabytes, of storage capacity, depending on the user's operating
system and other factors.
o EZ NETSHARE(TM) external network hard disk drives, with dimensions
measuring 5.25"W x 9.75"L x 1.5"H, provide up to 300 gigabytes, or
300,000 megabytes, of storage capacity, depending on the user's
operating system and other factors.
The growth in the availability of digital data, such as movies, music
and photos has generated new data storage applications and created significant
demand for portable data storage devices. The typical portable data storage
device is compact, often small enough to fit into a pocket, consumes low power,
is durable, re-writable and is versatile due to its ease of operation. In
addition, most of these portable data storage devices do not require a separate
power source other than through a standard USB port. USB portable storage
devices, such as USB flash drives and compact USB hard disk drives were
introduced in late 2002, compete with our CD- and DVD-based data storage
products. Sales of these devices have continued to represent an increased share
of the market for data storage products.
Our EZ NetShare(TM) external drives are designed for network data
storage needs. We believe that over the last few years there has been a
substantial increase in the number of households that have high-speed Internet
connections. Our EZ NetShare(TM) drives allow individuals to store documents,
music, videos and photos and share them with friends, family members and
coworkers throughout a personal network. Our EZ NetShare(TM) drives operate as
network data storage devices as well as standalone USB compatible data storage
drives. We believe that our EZ NetShare(TM) products represent a substantial
opportunity for sales growth. We also believe that over the next 12 months sales
of our EZ NetShare(TM) drives will increase as a percentage of our net sales.
OUR DIGITAL ENTERTAINMENT AND OTHER PRODUCTS
Our digital entertainment and other products include:
o DIGITAL PHOTO FRAMES in 7" and 9" widescreen formats with flat
panel displays. Our digital photo frames have flash media inputs
to accept flash memory cards from digital cameras to display
digital photos and play digital slide shows. This new product line
is a potential large new segment of the digital camera accessory
aftermarket.
o EXTERNAL FLOPPY DISK DRIVES that integrate a floppy disk drive and
a built-in 7-n-1 digital media card reader which we call our
DataStation devices.
o CASE ENCLOSURES for external or portable data storage drives for
2.5" or 3.5" drives.
We believe that the markets for digital entertainment and other
consumer electronics and peripheral products are expanding. We intend to
continue to monitor these markets and develop and sell digital entertainment and
other consumer electronics and peripheral products as we are able to identify
products that we believe we can sell competitively. Currently, our digital
entertainment and other consumer electronics and peripheral products represent
only a minor product category. These products accounted for only approximately
4% and 1% of our net sales during 2006 and 2005, respectively.
10
PRODUCT WARRANTIES
Our products are subject to limited warranties of up to one year in
duration. These warranties cover only repair or replacement of the product. Our
subcontract manufacturers and suppliers provide us with warranties of a duration
at least as long as the warranties provided to consumers. The warranties
provided by our subcontract manufacturers and suppliers cover repair or
replacement of the product.
PRODUCT OFFERINGS
Our product offerings are primarily directed toward satisfying the
demands of the North American retail marketplace for data storage products and
multi-media digital entertainment and other PC products. We operate in
industries that are subject to rapid technological change, product obsolescence
and rapid changes in consumer demands and preferences. We attempt to anticipate
and respond to these changes by focusing on the following primary objectives:
o ENHANCEMENT OF EXISTING PRODUCTS. We seek to offer products with
increased performance and expanded functionality to satisfy
existing and emerging consumer demands and preferences. Our
enhanced product offerings are directed toward, among other
things, offering increased data storage and retrieval speeds, and
enhanced user-friendliness and ease of product installation. These
product offerings are also focused on products with reduced
manufacturing costs to enable us to maintain and improve gross
margins while continuing to offer high-value products to
consumers.
o DEVELOPMENT OF NEW PRODUCTS. We seek to offer new products that,
among other things, use existing technology and adopt new
technology to satisfy existing and emerging consumer demands and
preferences. Our new product offerings typically focus on the
implementation of existing technology to offer products that are
compatible with a wide range of media formats. These offerings
also typically include implementation of new technology to offer
products that deliver better solutions to the core needs of the
data storage marketplace such as high-capacity, cost-effective,
flexible and portable data storage, management, protection,
retrieval and transfer. We believe that we are able to quickly
adopt new technologies and bring them to market through our
retailers faster than our competition.
Our retailers, subcontract manufacturers and our suppliers play an
important role in the enhancement of our existing products and the development
of new products. We work closely with our retailers, subcontract manufacturers
and our suppliers to identify existing market trends, predict future market
trends and monitor the sales performance of our products.
Many of our retailers are among the largest computer, consumer
electronics and office supply retailers in North America. Over the past three
years, our retailers have included Best Buy Canada, Circuit City, CompUSA,
Costco, Fred Myer Stores, Micro Center, Office Depot, OfficeMax, RadioShack,
Staples and Target. Through their close contact with the marketplace for data
storage products, our retailers are able to provide us with important
information about consumer demands and preferences.
Many of our subcontract manufacturers and suppliers have substantial
product development resources and facilities in Asia, and are among the major
component manufacturers and suppliers in their product categories. Some of our
largest subcontract manufacturers and suppliers are also our stockholders,
including BTC and Lung Hwa. We believe that BTC is among the largest optical
storage drive manufacturers in the world and Lung Hwa is a major supplier of USB
hard disk drives, including some of our GigaBank(TM) products, as well as a
major manufacturer of digital entertainment products. These subcontract
manufacturers and suppliers expend substantial resources on research,
development and design of new technologies and efficient manufacturing
processes.
Our corporate headquarters in Irvine, California house a product
development team that coordinates and manages the subcontract logistics and
product development efforts of our subcontract manufacturers and suppliers in
Asia. At our Irvine facility, we also develop user manuals, product packaging
and marketing literature as well as installation guides and supplemental
materials, including software and hardware designed to permit user-friendly
product installation.
We do not have a traditional research and development program. Instead,
we work closely with our retailers, subcontract manufacturers and suppliers and
conduct various other activities in connection with the enhancement of our
existing products and the development of new products. We have not, in any
reporting period, made any material expenditures on research and development
activities relating to the development of new products, services or techniques
or the improvement of existing products, services or techniques. Our efforts are
largely directed at the evaluation of new products and enhancements to existing
products rather than the actual development of new products or product
enhancements.
11
Our representatives meet frequently with our subcontract manufacturers,
suppliers and our retailers to identify and discuss emerging trends and to
address the sales performance of our products. We provide and receive
product-related input to and from our subcontract manufacturers, suppliers and
our retailers. Much of the input that we provide arises from our technical
service department, which is responsible for assisting end-users in installing
and successfully utilizing our products. Problems in the installation or
utilization of our products are reported to management by our technical service
department and often provide the basis for existing product enhancements. New
products are developed and offered by our subcontract manufacturers and
suppliers, and offered by us and in turn by our retailers largely on the basis
of market research and trends identified in the data storage, digital
entertainment and computer peripheral industries. We also monitor industry trade
publications and technical papers to understand emerging trends and new
technologies and to plan for new product offerings.
We believe that these activities assist us in attempting to achieve our
goal of being among the first-to-market with new and enhanced product offerings
based on established and emerging technologies.
OPERATIONS
We do not directly manufacture any of the components incorporated into
the products that we sell. We subcontract manufacture the majority of our
products or source from our suppliers our data storage, digital entertainment
and other products. We believe that by outsourcing the manufacturing of our
products to our subcontract manufacturers or sourcing them from our suppliers,
we benefit from:
o LOWER OVERHEAD COSTS. By subcontract manufacturing or sourcing our
products we believe that we benefit from lower overhead costs
resulting from the elimination of capital expenditures related to
owning and operating manufacturing facilities, such as
expenditures related to acquiring a manufacturing plant, property
and equipment, and staffing, as well as the ongoing cash
requirements to fund such an operation.
o ECONOMIES OF SCALE. By subcontract manufacturing or sourcing our
products with some of the largest production facilities available
in the industry, we believe that we benefit from our subcontract
manufacturers' and suppliers' economies of scale, which enable us
to keep unit production costs low, our supply chain management
efficient and our expansion or contraction of product orders
flexible in response to changing consumer demands and preferences.
o ENGINEERING AND MANUFACTURING RESOURCES. By subcontract
manufacturing our products we believe that we benefit from our
subcontract manufacturers' substantial engineering and
manufacturing resources, which aid us in offering new and enhanced
products and enable us to rapidly bring them to market in a
cost-effective manner.
o DIVERSIFICATION OF MANUFACTURING RISKS. By subcontract
manufacturing to, or sourcing our products from, a group of
manufacturers or suppliers, we believe that we are able to
diversify the risks associated with employing a single
manufacturer or supplier. We also believe that we are potentially
able to expand our opportunities with respect to new products as
they arise by virtue of the varying expertise of those
manufacturers and suppliers.
o REDUCTION OF POTENTIAL LIABILITIES. By subcontract manufacturing
or sourcing our products we believe that we reduce potential
significant liabilities associated with direct product
manufacturing, including environmental liabilities and liabilities
resulting from warranty claims. We believe that the reduction in
potential liabilities decreases our business risks and results in
tangible economic benefits such as cost savings related to
insurance and the operation of compliance programs.
We believe that the relatively low overhead costs resulting from
subcontract manufacturing or sourcing the products we offer for sale, the
economies of scale of our subcontract manufacturers and suppliers, and the
engineering and manufacturing resources of our subcontract manufacturers and
suppliers enable us to offer products combining high levels of performance,
functionality and reliability at prices competitive with other leading products
offered in the marketplace.
We utilize a subcontract logistics and product development consultant
located in Taipei, Taiwan. Our consultant assists us in identifying new
products, qualifying prospective manufacturing facilities and coordinating
product purchases and shipments from some of our subcontract manufacturers and
suppliers. The majority of our products are shipped directly by our subcontract
manufacturers or suppliers to our assembly, packaging, storage and distribution
facility in Irvine. These products are then packaged and shipped by us either
directly to retail locations across North America or to a centralized
distribution center. Product shipments are primarily made through major
commercial carriers. We maintain a production staff in Irvine, California, that
assembles "quick turn" and pilot production runs and repackages bulk quantities
received from our subcontractors or suppliers.
12
QUALITY CONTROL
Our primary subcontract manufacturers and suppliers are among the major
computer and electronic component manufacturers and suppliers in Asia who we
believe have rigorous quality control and shipping guidelines. We regularly
inspect and test product samples, periodically tour our subcontract
manufacturers' and suppliers' facilities, monitor defective product returns and
test defective products.
SALES AND MARKETING
We sell our products primarily through retailers who collectively
operate locations throughout North America. These include nationally-recognized
computer, consumer electronics and office supply superstores. In addition, we
sell our products through Internet retailers and mail order catalogs.
We cooperate with our retailers to promote our products and brand
names. We participate in co-sponsored events with our retailers and industry
trade shows such as CES(R) and RetailVision(R). We participate in these events
and trade shows in order to develop new relationships with potential retailers
and maintain close relationships with our existing retailers. We also fund
cooperative advertising campaigns, develop custom product features and
promotions, provide direct personal contact with our sales representatives and
develop and procure certain products as requested by our retailers. We cooperate
with our retailers to use point-of-sale and mail-in rebate promotions to
increase sales of our products. We also utilize sales circulars and our close
working relationships with our significant retailers to obtain national exposure
for our products and our brands. We believe that these marketing efforts help
generate additional shelf-space for our products with our major retailers,
promote retail traffic and sales of our products, and enhance our goodwill with
these retailers.
We maintain a large database containing information regarding many
end-users of our products. Through a targeted, direct marketing strategy, we
intend to offer these end-users other products to establish repeat end-user
customers, increase our product sales and promote brand loyalty. We currently
sell and plan to continue to sell products, conduct special promotions, and
offer downloads on our websites to existing and potential end-user customers.
Our websites are located at http://www.iomagic.com, http://www.dr-tech.com and
http://www.hival.com.
COMPETITION
We operate primarily in the highly-competitive data storage industry.
We believe that our data storage products compete with other types of data
storage devices such as internal, external and portable hard disk drives,
magnetic tape drives, floppy disk drives and flash memory devices, as well as
internal and external optical data storage products offered by other companies.
Companies that offer products similar to our optical data storage
products include BenQ, Hewlett-Packard, Lite-On, Memorex, Philips Electronics,
Samsung Electronics, Sony and TDK. We also indirectly compete against original
equipment manufacturers such as Dell and Hewlett-Packard to the extent that they
manufacture their own computer peripheral products or incorporate the
functionalities offered by our products directly into PCs. Companies that offer
products similar to our mobile and desktop magnetic data storage products
include Iomega, LaCie, PNY Technologies, Sony, Seagate Technology and Western
Digital.
We believe that our ability to compete in the data storage industry
depends on many factors, including the following:
o PRODUCT VALUE. The performance, functionality, reliability and
price of our products are critical elements of our ability to
compete. We believe that we offer, and that our target consumers
seek, products that combine higher levels of performance,
functionality and reliability at lower prices than other leading
products offered in the marketplace. We focus on offering these
high value products by positioning them as affordable alternatives
to products offered by leading brands such as Hewlett-Packard,
Iomega, Memorex, Sony, Seagate Technology, TDK and Western
Digital.
o MARKET PENETRATION. Market penetration and brand recognition are
critical elements of our ability to compete. Most consumers
purchase products similar to ours from off-the-shelf retailers
such as large computer, consumer electronics and office supply
superstores. Market penetration in the industries in which we
compete is typically based on the number of retailers who offer a
company's products and the amount of shelf-space allocated to
those products. We believe that our broad-based, high value
product offerings, our retailer support, our consumer support and
our cooperative marketing and other promotional efforts promote
close working relationships with our retailers and improve our
ability to obtain critical shelf-space which enables us to
establish, maintain and increase market penetration.
13
o PRODUCT ENHANCEMENT AND DEVELOPMENT AND TIME-TO-MARKET.
Enhancement of our existing products, development of new products
and rapid time-to-market to satisfy evolving consumer demands and
preferences are key elements of our ability to compete. Consumers
continuously demand higher levels of performance and functionality
in data storage products. We attempt to compete successfully by
bringing products with higher levels of performance and
functionality rapidly to market to satisfy changing consumer
demands and preferences. We believe that the research and
development efforts and economies of scale of our major
subcontract manufacturers and suppliers enable us to rapidly
introduce enhanced products and new products offering higher
levels of performance and functionality. Our products are often
among the first-to-market with new features and technology made
widely available to consumers.
We are currently experiencing intense price competition from major
competitors such as Western Digital and Seagate Technology, which has
significantly reduced selling prices and eroded margins for magnetic data
storage products. In addition, we currently have high inventory levels and due
to intense price competition, we may not be able to sell this inventory at
positive gross margins. We are unable to predict whether the market for and
selling prices of magnetic data storage products will stabilize, increase or
further decline in the future.
INTELLECTUAL PROPERTY
We currently rely on a combination of contractual rights, copyrights,
trademarks and trade secrets to protect our proprietary rights. I/OMagic(R),
Hi-Val(R) and Digital Research Technologies(R) are our registered trademarks. We
also sell products under various product names such as Data Bank(TM),
"DataStation", Data-to-Go(TM), EZ NetShare(TM), GigaBank(TM) and "MediaStation".
As we develop new products, we may file federal trademark applications covering
the trademarks under which we sell those products. There can be no assurance
that we will eventually secure a registered trademark covering these products.
We currently do not have any issued or pending patents.
We own, license or have otherwise obtained the right to use certain
technologies incorporated into our products. We may receive infringement claims
from third parties relating to our products and technologies. In those cases, we
intend to investigate the validity of the claims and, if we believe the claims
have merit, to respond through licensing or other appropriate actions. To the
extent claims relate to technology included in components purchased from
third-party vendors incorporated into our products, we would forward those
claims to the appropriate vendor. If we or our product manufacturers or
suppliers are unable to license or otherwise provide any necessary technology on
a cost-effective basis, we could be prohibited from marketing products
containing that technology, incur substantial costs in redesigning products
incorporating that technology, or incur substantial costs defending any legal
action taken against us.
We have been, and may in the future be, notified of claims asserting
that we may be infringing certain patents, trademarks and other intellectual
property rights of third parties. We cannot predict the outcome of such claims
and there can be no assurance that such claims will be resolved in our favor. An
unfavorable resolution of such claims may have a material adverse effect on our
business, prospects, financial condition and results of operations. The data
storage industry, has been characterized by significant litigation relating to
infringement of patents and other intellectual property rights. We have in the
past been engaged in infringement litigation, both as plaintiff and defendant.
There can be no assurance that future intellectual property claims will not
result in litigation.
If infringement is established, we may be required to pay substantial
damages or we may be enjoined from manufacturing and selling an infringing
product. In addition, the costs of engaging in the prosecution or defense of
intellectual property claims may be substantial regardless of the outcome.
A number of our agreements with our retailers provide that we will
defend, indemnify and hold harmless our retailers from damages and costs that
arise from product warranty claims or claims for injury or damage resulting from
defects in our products. If such claims are asserted against us, our insurance
coverage may not be adequate to cover the costs associated with our defense of
those claims or any resulting liability we would incur if those claims are
successful. A successful claim brought against us for product defects that is in
excess of, or excluded from, our insurance coverage could have a material
adverse affect on our business, results of operations and financial condition.
14
GOVERNMENT REGULATION
Our products are designed by our subcontract manufacturers and
suppliers to comply with a significant number of regulations and industry
standards, some of which are evolving as new technologies are deployed. We
believe that we are currently in compliance with each applicable regulation and
industry standard. In the United States, our products must comply with various
regulations defined by the United States Federal Communications Commission, or
FCC, and Underwriters Laboratories, or other nationally recognized test
laboratories. We also must comply with numerous import/export regulations. The
regulatory process in the United States can be time-consuming and can require
the expenditure of substantial resources. We cannot assure you that the FCC will
grant the requisite approvals for any of our products on a timely basis, or at
all. The failure of our products to comply, or delays in compliance, with the
various existing and evolving standards could negatively impact our ability to
sell our products. United States regulations regarding the manufacture and sale
of data communications devices are subject to future change. We cannot predict
what impact, if any, such changes may have upon our business.
EMPLOYEES
As of July 9, 2007, we had approximately 50 full-time employees. We
have no collective bargaining agreements with our employees. We believe that our
relationship with our employees is good.
ITEM 1A RISK FACTORS.
AN INVESTMENT IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. IN
ADDITION TO THE OTHER INFORMATION IN THIS ANNUAL REPORT ON FORM 10-K AND IN OUR
OTHER FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION, INCLUDING OUR
SUBSEQUENT REPORTS ON FORMS 10-Q AND 8-K, YOU SHOULD CAREFULLY CONSIDER THE
FOLLOWING RISK FACTORS BEFORE DECIDING TO INVEST IN SHARES OF OUR COMMON STOCK
OR TO MAINTAIN OR INCREASE YOUR INVESTMENT IN SHARES OF OUR COMMON STOCK. THE
RISKS AND UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES WE FACE.
ADDITIONAL RISKS AND UNCERTAINTIES NOT PRESENTLY KNOWN TO US OR THAT WE
CURRENTLY DEEM IMMATERIAL MAY ALSO AFFECT OUR BUSINESS, FINANCIAL CONDITION AND
OPERATING RESULTS. IF ANY OF THE FOLLOWING RISKS, OR ANY OTHER RISKS NOT
DESCRIBED BELOW, ACTUALLY OCCUR, IT IS LIKELY THAT OUR BUSINESS, FINANCIAL
CONDITION AND OPERATING RESULTS COULD BE SERIOUSLY HARMED. AS A RESULT, THE
TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND YOU COULD LOSE PART OR ALL
OF YOUR INVESTMENT.
RISKS RELATED TO OUR BUSINESS
WE ARE PRESENTLY EXPERIENCING A LACK OF LIQUIDITY. IF WE ARE UNABLE TO
INCREASE OUR LIQUIDITY, WE WILL EXPERIENCE A MATERIAL AND ADVERSE EFFECT ON
OUR ABILITY TO OPERATE OUR BUSINESS.
We currently have almost no amounts available to us for borrowing under
our credit facility with Silicon Valley Bank. In addition, we had only $645,000
of cash on hand as of July 9, 2007. Accordingly, we are presently experiencing a
lack of liquidity and may have insufficient liquidity to fund our operations for
the next twelve months. If our capital requirements or cash flow vary materially
from our current projections, if we are unable to successfully negotiate
extended payment terms on amounts owed to certain related-party creditors, if we
are unable to timely collect our accounts receivable or unable to sell-through
inventory currently in our sales channels as anticipated, or if unforeseen
circumstances occur, we may be unable to increase our liquidity. If we are
unable to increase our liquidity, we could experience a material and adverse
effect on our ability to operate our business.
IF WE CONTINUE TO SUSTAIN LOSSES, WE WILL BE IN VIOLATION OF A LOAN
COVENANT WITH SILICON VALLEY BANK. WE HAVE VIOLATED LOAN COVENANTS IN THE
PAST WITH OUR PREVIOUS LENDER AND THERE IS NO ASSURANCE THAT WE WILL NOT BE
IN VIOLATION OF OUR CURRENT CREDIT FACILITY IN THE FUTURE. IF WE DO VIOLATE
THE LOAN COVENANT, WE MAY BE UNABLE TO BORROW FUNDS TO PURCHASE INVENTORY,
TO SUSTAIN OUR CURRENT SALES VOLUME AND TO FUND OUR DAY TO DAY OPERATIONS.
Our credit facility with Silicon Valley Bank has one financial covenant
that requires us to maintain at all times, on a consolidated basis, to be tested
as of the last day of each calendar month, tangible net worth of at least
$4,750,000, plus (i) 50% of all consideration received by us after the date of
the loan agreement for sales of equity securities and the issuance of
subordinated debt, plus (ii) 50% of our net income in each fiscal quarter ending
after the date of the loan agreement. If we continue to sustain losses, we will
be in violation of this tangible net worth covenant with Silicon Valley Bank. If
we violate the loan covenant, we may be unable to borrow funds to purchase
inventory, to sustain our current sales volume and to fund our day to day
operations.
15
OUR INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM HAS EXPRESSED SUBSTANTIAL
DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN. THIS REPORT MAY
IMPAIR OUR ABILITY TO RAISE ADDITIONAL FINANCING AND ADVERSELY AFFECT THE
PRICE OF OUR COMMON STOCK.
The report of our independent registered public accounting firm
contained in our financial statements as of and for the year ended December 31,
2006 includes a paragraph that explains that we have incurred significant
recurring losses, have serious liquidity concerns and may require additional
financing in the foreseeable future. The report concludes that these matters,
among others, raise substantial doubt about our ability to continue as a going
concern. Reports of independent auditors questioning a company's ability to
continue as a going concern are generally viewed unfavorably by analysts and
investors. This report may make it difficult for us to raise additional
financing necessary grow or operate our business. We urge potential investors to
review this report before making a decision to invest in I/OMagic.
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 SUSTAINING OR EXPANDING OUR BUSINESS.
We have incurred net losses in each of the last seven years. As of
December 31, 2006, we had an accumulated deficit of approximately $25.0 million.
During 2006, 2005, 2004, 2003 and 2002, we incurred net losses in the amounts of
approximately $309,000, $1.8 million, $8.1 million, $460,000 and $8.8 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, our negative cash flow will
continue and may hamper current operations and prevent us from sustaining or
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.
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 96% of
our net sales in 2006 and 99% of our net sales in each of 2005 and 2004 while
our digital entertainment and other products accounted for the remainder of our
net sales in each year. Over the course of the past several months and through
the beginning of July 2007, the robust sales pace of magnetic data storage
products experienced in 2006 has slowed significantly. We are also experiencing
intense price competition from major competitors such as Western Digital and
Seagate Technology, which has significantly reduced selling prices and eroded
margins for magnetic data storage products. We are unable to predict whether the
market for and selling prices of magnetic data storage products will stabilize,
increase or further decline in the future. 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.
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, Iomega, Lite-On, Memorex, Philips Electronics, Samsung
Electronics, Seagate Technology, Sony, TDK and Western Digital 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. For example, we are
experiencing intense price competition from major competitors such as Western
Digital and Seagate Technology, which has significantly reduced selling prices
and eroded margins for magnetic data storage products. 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,
sales and profitability.
16
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 sold 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. For example,
over the course of the past several months and through the beginning of July
2007, the robust sales pace of magnetic data storage products experienced in
2006 has slowed significantly. In addition, we are experiencing intense price
competition from major competitors such as Western Digital and Seagate
Technology, which has significantly reduced selling prices and eroded margins
for magnetic data storage products. In late 2006 and early 2007, we placed
substantial orders for magnetic data storage products based on our expectation
of continuing robust sales. As a result of these orders and the slowing market
for these products, we currently have high inventory levels. Due to intense
price competition, we may not be able to sell this inventory at positive gross
margins. We are unable to predict whether the market for and selling prices of
magnetic data storage products will stabilize, increase or further decline in
the future.
As of December 31, 2006 and 2005, we carried and financed inventory
valued at approximately $7.2 million and $3.4 million, respectively, in our
consignment sales channels. Sales generated through consignment sales were
approximately 19% and 33%, respectively, of our total net sales in 2006 and
2005. If we fail to select high turnover products for our consignment sales
channels, our sales, profitability and financial resources may decline.
WE HAVE IDENTIFIED MATERIAL WEAKNESSES IN OUR DISCLOSURE CONTROLS AND
PROCEDURES AND CANNOT ASSURE YOU THAT ADDITIONAL MATERIAL WEAKNESSES WILL
NOT BE IDENTIFIED IN THE FUTURE. IF OUR DISCLOSURE CONTROLS AND PROCEDURES
ARE NOT EFFECTIVE, THERE MAY BE ERRORS IN OUR CONSOLIDATED FINANCIAL
STATEMENTS THAT COULD REQUIRE A RESTATEMENT OR OUR FILINGS MAY NOT BE
TIMELY AND INVESTORS MAY LOSE CONFIDENCE IN OUR REPORTED FINANCIAL
INFORMATION, WHICH COULD LEAD TO A DECLINE ON OUR STOCK PRICE.
Following an 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, 2006. 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, 2006. The existence of one or more material weaknesses in our disclosure
controls and procedures could result in errors in our consolidated 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 and 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 2006, net sales to our four largest retailers, Staples, Best
Buy Canada, Circuit City and Office Depot represented approximately 28%, 14%,
14% and 13%, respectively, of our total net sales. During 2006, aggregate net
sales to these four retailers represented approximately 69% of our total net
sales. We expect that we will continue to depend upon a small number of
retailers for a significant majority of our sales for the foreseeable future.
Our agreements with these retailers do not require them to purchase any
specified number of products or dollar amount of sales or to make any purchases
whatsoever. Therefore, we cannot assure you that, in any future period, our
sales generated from these retailers, individually or in the aggregate, will
equal or exceed historical levels. We also cannot assure you that, if sales to
any of these retailers cease or decline, we will be able to replace these sales
with sales to either existing or new retailers in a timely manner, or at all. A
cessation or reduction of sales, or a decrease in the prices of products sold to
one or more of these retailers has significantly reduced our net sales for one
or more reporting periods in the past and could, in the future, cause a
significant decline in our net sales and profitability.
17
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.
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 with 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.
Data storage products and digital entertainment products are widely
available from manufacturers and other suppliers around the world. Our largest
retailers include Staples, Best Buy Canada, Circuit City and Office Depot.
Collectively, these four retailers accounted for 69% of our net sales in 2006.
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 suppliers around the world,
including from some of our own subcontract manufacturers and suppliers. Our
retailers may believe that higher profit margins can be achieved if they
implement a direct import or private-label program, excluding us from the sales
channel. Accordingly, one or more of our largest retailers may stop buying
products from us in favor of a direct import or private-label program. As a
consequence, our sales and profitability could decline significantly.
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 approximately 45% and 42% of our
total assets as of December 31, 2006 and 2005, respectively. As of December 31,
2006, 72% of our accounts receivable represented amounts owed by three
retailers, each of which represented over 10% of the total amount of our
accounts receivable. Similarly, as of December 31, 2005, 67% of our accounts
receivable represented amounts owed by two retailers, each of which represented
over 10% of the total amount of our accounts receivable. As a result of the
substantial amount and concentration of our accounts receivable, if any of our
major retailers fails to timely pay us amounts owed, we could suffer a
significant decline in cash flow and liquidity which would negatively affect our
ability to make payments under our line of credit with Silicon Valley Bank and
which, in turn, could adversely affect our ability to borrow funds to purchase
inventory to sustain or expand our current sales volume. Accordingly, if any of
our major retailers fails to timely pay us amounts owed, 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.
18
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 subcontract manufacturers, suppliers and
retailers. 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. See "Certain
Relationships and Related Transactions, and Director Independence." 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.
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 could 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 financial resources
with which to operate our business.
OUR TWO PRINCIPAL SUBCONTRACT MANUFACTURERS AND SUPPLIERS, WHO ARE ALSO OUR
SHAREHOLDERS, 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 and BTC, our two principal subcontract manufacturers and
suppliers, who are also our shareholders, 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 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. See "Certain Relationships and Related Transactions, and Director
Independence."
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.
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's
life cycle is extremely short, ranging from 3 to 12 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.
19
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 continue selling certain products,
to pay substantial monetary damages or to develop non-infringing technologies,
none of which may be feasible. Both infringement and indemnification claims
could be time-consuming and costly to defend or settle and would divert
management's attention and our financial 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, profitability and financial resources may be
adversely affected.
IF WE FAIL TO SUCCESSFULLY MANAGE THE EXPANSION OF OUR BUSINESS, OUR SALES
MAY NOT INCREASE COMMENSURATELY WITH OUR 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 magnetic and optical
media based products as well as products with heightened performance and added
functionality. We also plan to offer next-generation DVD-based product, such as
Blu-ray DVD or HD-DVD, depending on which of these competing media 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 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
PROFITABILITY, 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. 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, cause a decline in our sales and
profitability, 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
PROFITABILITY 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, emerging technologies or
technological enhancements. For instance, in introducing new and enhanced mobile
and desktop and optical data storage devices, 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
could decrease our net sales and profitability.
20
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
magnetic and optical media. Accordingly, future sales and any future profits
from magnetic and optical based products are substantially dependent upon
widespread consumer acceptance of these types of data storage devices. If this
widespread consumer acceptance of our magnetic and optical data storage products
does not occur, or is delayed, our sales, profitability and financial resources
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 that 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 Hi-Val(R) and Digital Research
Technologies(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 DataBank(TM), Data-to-Go(TM), DataStation, EZ
NetShare(TM), GigaBank(TM) and MediaStation. 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, cause our
sales to decline and profitability and financial resources could be adversely
affected .
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 2006, four of our retailers
collectively accounted for 69% of our total net sales. Similarly, during 2005,
four of our retailers collectively accounted for 81% of our total net sales. We
currently generate only a small number of direct sales of our products through
our Internet websites. We believe that many of our target consumers are
knowledgeable about technology and comfortable with the use of the Internet for
product purchases. Consumers may increasingly prefer alternative sales channels,
such as direct mail order or direct purchase from manufacturers. In addition,
Internet commerce is 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.
21
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, shipments, 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.
RISKS RELATED TO OUR COMMON STOCK
OUR COMMON STOCK HAS A SMALL PUBLIC FLOAT AND SHARES OF OUR COMMON STOCK
ELIGIBLE FOR PUBLIC SALES COULD CREATE THE MARKET PRICE OF OUR STOCK TO
DROP, EVEN IF OUR BUSINESS IS DOING WELL.
As of July 9, 2007, there were approximately 4.5 million shares of our
common stock outstanding. As a group, our executive officers, directors and 10%
stockholders beneficially own approximately 3.3 million of these shares.
Accordingly, our common stock has a public float of approximately 1.2 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 80,050 shares of common stock are outstanding under
our 2002 Stock Option Plan and 274,000 options are outstanding under our 2003
Sock 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 anticipation that such sales could occur, may,
materially and adversely affect prevailing market prices for our common stock.
OUR STOCK PRICE IS HIGHLY VOLATILE, WHICH COULD RESULT IN SUBSTANTIAL
LOSSES FOR INVESTORS PURCHASING SHARES OF OUR COMMON STOCK AND IN
LITIGATION AGAINST US.
The market price of our common stock has fluctuated significantly in
the past and may continue to fluctuate significantly in the future. During the
first three months of 2007, the high and low closing bid prices of a share of
our common stock were $2.75 and $1.95, respectively. During 2006, the high and
low closing bid prices of a share of our common stock were $5.50 and $1.53,
respectively. During 2005, the high and low closing bid prices of a share of our
common stock were $6.75 and $0.70, 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;
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;
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.
22
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 financial
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.
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 73% of our outstanding shares of
common stock (after giving effect to the exercise of all outstanding vested
options exercisable within 60 days from July 9, 2007). As a result, our current
executive officers, directors, and 10% stockholders, acting as a group, have
substantial control over the outcome of corporate actions requiring stockholder
approval, including the election of directors, any merger, consolidation or sale
of all or substantially all of our assets, or any other significant corporate
transaction. Some of these controlling stockholders may have interests different
than yours. For example, these stockholders may delay or prevent a change in
control of I/OMagic, even one that would benefit our stockholders, or pursue
strategies that are different from the wishes of other investors. The
significant concentration of stock ownership may adversely affect the trading
price of our common stock due to investors' perception that conflicts of
interest may exist or arise.
OUR ARTICLES OF INCORPORATION, OUR BYLAWS AND NEVADA LAW EACH CONTAIN
PROVISIONS THAT COULD DISCOURAGE TRANSACTIONS RESULTING IN A CHANGE IN
CONTROL OF I/OMAGIC, WHICH MAY NEGATIVELY AFFECT THE MARKET PRICE OF OUR
COMMON STOCK.
Our articles of incorporation and our bylaws contain provisions that
may enable our board of directors to discourage, delay or prevent a change in
the ownership of I/OMagic or in our management. In addition, these provisions
could limit the price that investors would be willing to pay in the future for
shares of our common stock. These provisions include the following:
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.
23
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
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 a 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 1B. UNRESOLVED STAFF COMMENTS.
None.
ITEM 2. PROPERTIES
Our corporate headquarters is located in Irvine, California in a leased
facility of approximately 55,000 square feet. This facility contains all of our
operations, including sales, marketing, finance, administration, production,
shipping and receiving. The lease term began on September 1, 2003 and expires on
August 31, 2009, with an option to extend the lease for another three year term
upon providing notice 180 days prior to expiration of the current lease term. We
believe this facility is adequate for our anticipated business purposes for the
foreseeable future. We have no other leased or owned real property.
ITEM 3. LEGAL PROCEEDINGS
On or about 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, Inc., Lawrence M. Cron, Horwitz &
Cron, Kevin J. Senn and Senn Palumbo Meulemans, LLP, our former attorneys and
their respective law firms, in the Superior Court of the State of California for
the County of Orange. The complaint sought 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 or about
November 6, 2003, we filed our First Amended Complaint against all defendants.
Defendants responded to our First Amended Complaint denying our allegations.
Defendants Lawrence W. Horwitz and Lawrence M. Cron also filed a Cross-Complaint
against I/OMagic for attorneys' fees in the approximate amount of $79,000. We
denied the allegations in the Cross-Complaint. Trial began on February 6, 2006
and on March 10, 2006, the jury ruled in our favor against Lawrence W. Horwitz,
Horwitz & Beam, Inc., Lawrence M. Cron, Horwitz & Cron and Senn Palumbo
Meulemans, LLP, and awarded I/OMagic $3.0 million in damages. We have not
collected any of this amount. Judgment was entered on or about April 5, 2006.
However, defendants have since filed a motion for new trial and a motion for
judgment notwithstanding the verdict. On May 31, 2006, the Court denied the
motion for new trial in its entirety, denied the motion for judgment
notwithstanding the verdict as to Lawrence W. Horwitz, Horwitz & Beam, Inc. and
Lawrence M. Cron, but granted the motion for judgment notwithstanding the
verdict as to Horwitz & Cron and Senn Palumbo Meulemans, LLP. An Amended
Judgment Notwithstanding the Verdict based upon the Court's ruling on the motion
for judgment notwithstanding the verdict was entered on or about July 7, 2006.
Appeals have since been filed as to both the original Judgment and the Amended
Judgment. These appeals remain pending.
24
On May 20, 2005, we 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, Case No. 05CC06433. The complaint sought
damages of in excess of $22 million arising out of the defendants' alleged
breach of contract under an agreement entered into in May 2001. On or about June
20, 2005, OfficeMax removed the case to the United States District Court for the
Central District of California, Case No. SA CV05-0592 DOC(MLGx). On August 1,
2005, OfficeMax filed its Answer and Counter-Claim against I/OMagic. The
Counter-Claim alleged four causes of action against I/OMagic: breach of
contract, unjust enrichment, quantum valebant, and an action for declaratory
relief. The Counter-Claim alleged, among other things, that we were liable to
OfficeMax in the amount of no less than $138,000 under the terms of a vendor
agreement executed between us and OfficeMax in connection with the return of
computer peripheral products to us for which OfficeMax alleged it was never
reimbursed. The Counter-Claim sought, among other things, at least $138,000 from
us, along with pre-judgment interest, attorneys' fees and costs of suit. We
filed a response denying all of the affirmative claims set forth in the
Counter-Claim, denying any wrongdoing or liability, and denying that OfficeMax
was entitled to obtain any relief. In April 2006, our case against OfficeMax
North America, Inc. was settled in its entirety. In settling the matter, each
party denied liability and wrongdoing and the settlement was entered into solely
for the purpose of compromising and settling the litigation and in order to
avoid the risk, cost, and burden of litigation and participation therein.
Pursuant to the settlement, OfficeMax paid us $2,375,000 during the second
quarter of 2006.
In addition to the matters described above, we may be 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 our financial position, results of operations or cash
flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
25
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
MARKET INFORMATION
Our common stock has been traded on the OTC Bulletin Board under the
symbol "IOMG" since December 20, 2002. Prior to that time, it traded on the OTC
Bulletin Board under the symbol "IOMC" since March 25, 1996. The table below
shows for each fiscal quarter indicated the high and low closing bid prices for
shares of our common stock. This information has been obtained from the OTC
Bulletin Board. The prices shown reflect inter-dealer prices, without retail
mark-up, mark-down, or commission and may not necessarily represent actual
transactions.
PRICE RANGE
------------------------
LOW HIGH
---------- ----------
2005:
First Quarter (January 1 - March 31)............. $ 1.74 $ 3.25
Second Quarter (April 1 - June 30)............... $ 0.70 $ 1.80
Third Quarter (July 1 - September 30)............ $ 0.85 $ 6.75
Fourth Quarter (October 1 - December 31)......... $ 4.15 $ 5.85
2006:
First Quarter.................................... $ 3.75 $ 5.50
Second Quarter................................... $ 2.40 $ 3.92
Third Quarter.................................... $ 1.53 $ 3.00
Fourth Quarter................................... $ 1.55 $ 2.80
SECURITY HOLDERS
As of July 9, 2007, we had 4,540,292 shares of common stock outstanding
held of record by approximately 70 stockholders. These holders of record include
depositories that hold shares of stock for brokerage firms which, in turn, hold
shares of stock for numerous beneficial owners.
DIVIDENDS
We have not paid dividends on our common stock to date. Our line of
credit with Silicon Valley Bank prohibits the payment of cash dividends on our
common stock. We currently intend to retain future earnings to fund the
development and growth of our business and, therefore, do not anticipate paying
cash dividends on our common stock within the foreseeable future. Any future
payment of dividends on our common stock will be determined by our board of
directors and will depend on our financial condition, results of operations,
contractual obligations and other factors deemed relevant by our board of
directors.
RECENT SALES OF UNREGISTERED SECURITIES
In November 2006, we issued options to purchase an aggregate of 50,000
shares of common stock under our 2003 Stock Option Plan at an exercise price of
$4.00 per share to one of our executive officers. The options expire on November
2, 2011.
The issuance of our securities in the above-referenced transaction was
effected in reliance upon the exemption from registration under Section 4(2) of
the Securities Act of 1933, as amended, or Securities Act, as transactions not
involving a public offering. Exemption from the registration provisions of the
Securities Act is claimed on the basis that such transactions did not involve
any public offering and the purchaser was sophisticated with access to the kind
of information registration would provide including our most recent Annual
Report on Form 10-K and our most recent Quarterly Report on Form 10-Q.
26
ITEM 6. SELECTED FINANCIAL DATA
The following financial information should be read in conjunction with
the consolidated audited financial statements and the notes to those
consolidated financial statements beginning on page F-1 of this report, and the
section entitled "Management's Discussion and Analysis of Financial Condition
and Results of Operations" included elsewhere in this report. The consolidated
statements of operations data for the years ended December 31, 2006, 2005 and
2004 and the consolidated balance sheet data at December 31, 2006 and 2005 are
derived from, and are qualified in their entirety by reference to, the
consolidated audited financial statements beginning on page F-1 of this report.
The consolidated statements of operations data with respect to the years ended
December 31, 2003 and 2002 and the consolidated balance sheet data at December
31, 2004, 2003 and 2002 have been restated, but such restated data has not been
audited and is derived from our books and records. The historical results that
appear below are not necessarily indicative of results to be expected for any
future periods. The information presented in the following tables has been
adjusted and restated to reflect the adjustment and restatements of our
financial results, which are more fully described in the "Explanatory Note"
immediately preceding Part I, Item 1 and in Notes 2, 3 and 4 to our consolidated
financial statements included elsewhere in this report.
We have not amended our previously-filed Annual Reports on Form 10-K or
our Quarterly Reports on Form 10-Q for the periods affected by these adjustments
and restatements. The financial information that has been previously filed or
otherwise reported for these periods is superseded by the information in this
Annual Report on Form 10-K, and the financial statements and related financial
information contained in such previously-filed reports should no longer be
relied upon.
YEAR ENDED DECEMBER 31,
----------------------------------------------------------------------------
2005 2004 2003 2002
(ADUSTED AND (ADJUSTED AND ADJUSTED AND (ADJUSTED AND
2006 RESTATED)(1) RESTATED)(1) RESTATED)(3) RESTATED)(3)
------------ ------------ ------------ ------------ ------------
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
- -------------------------------------------
Net sales $ 45,889,410 $ 37,772,754 $ 44,396,551 $ 63,587,454 $ 80,952,712
Cost of sales 39,463,484 33,480,899 41,262,733 54,347,090 73,178,189
------------ ------------ ------------ ------------ ------------
Gross profit (1) 6,425,926 4,291,855 3,133,818 9,240,364 7,774,523
Operating expenses (1) 8,784,346 5,820,360 11,037,034 9,533,188 10,408,742
------------ ------------ ------------ ------------ ------------
Loss from operations (2,358,420) (1,528,505) (7,903,216) (292,824) (2,634,219)
Other income (expense) 2,050,048 (287,345) (151,116) (194,342) (5,525,003)
------------ ------------ ------------ ------------ ------------
Loss before provision for income taxes (308,372) (1,815,850) (8,054,332) (487,166) (8,159,222)
Income tax (benefit) expense 800 2,400 2,532 (27,148) 685,372
------------ ------------ ------------ ------------ ------------
Net loss (1) $ (309,172) $ (1,818,250) $ (8,056,864) $ (460,018) (8,844,594)
============ ============ ============ ============ ============
Basic loss per share (1) $ (0.07) $ (0.40) $ (1.78) $ (0.10) $ (1.95)
============ ============ ============ ============ ============
Diluted loss per share (1) $ (0.07) $ (0.40) $ (1.78) $ (0.10) $ (1.95)
============ ============ ============ ============ ============
Weighted-average shares outstanding, basic 4,537,320 4,530,380 4,529,672 4,529,672 4,528,894
============ ============ ============ ============ ============
Weighted-average shares outstanding, diluted 4,537,320 4,530,380 4,529,672 4,529,672 4,528,894
============ ============ ============ ============ ============
YEAR ENDED DECEMBER 31,
2005 2004 2003 2002
2006 (RESTATED) (RESTATED)(2) (RESTATED)(2) (RESTATED)(2)
------------ ------------ ------------ ------------ ------------
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents $ 1,833,481 $ 4,056,541 $ 3,587,807 $ 4,005,705 $ 5,138,111
Working capital $ 5,886,002 $ 5,951,774 $ 7,527,474 $ 11,051,269 $ 11,524,143
Total assets $25,601,973 $ 22,572,607 $ 23,925,772 $ 37,792,181 $ 37,023,736
Stockholders' equity $ 6,483,991 $ 6,581,683 $ 8,361,967 $ 16,418,831 $ 16,962,536
- --------------
(1) Gross margin and operating expenses were affected by these adjustments and
restatements without impact to net loss or loss per share for these years.
For further explanation, see Notes 3 and 4 to our consolidated financial
statements included elsewhere in this report.
(2) The consolidated balance sheet data for 2004, 2003 and 2002 has been
restated for the reasons described in Note 2 to our consolidated financial
statements included elsewhere in this report without impact to net loss or
loss per share for these years. As a result of this restatement, total
assets decreased, as follows:
27
AS ORIGINALLY
REPORTED RESTATEMENTS AS RESTATED
-------------- -------------- --------------
YEAR ENDED DECEMBER 31, 2004 (in thousands)
----------------------------
Cash and cash equivalents $ 3,588 $ - $ 3,588
Working capital $ 7,527 $ - $ 7,527
Total assets $ 27,467 $ (3,541) $ 23,926
Stockholders' equity $ 8,362 $ - $ 8,362
AS ORIGINALLY
REPORTED RESTATEMENTS AS RESTATED
-------------- -------------- --------------
YEAR ENDED DECEMBER 31, 2003 (in thousands)
----------------------------
Cash and cash equivalents $ 4,006 $ - $ 4,006
Working capital $ 11,051 $ - $ 11,051
Total assets $ 40,113 $ (2,321) $ 37,792
Stockholders' equity $ 16,419 $ - $ 16,419
AS ORIGINALLY
REPORTED RESTATEMENTS AS RESTATED
-------------- -------------- --------------
YEAR ENDED DECEMBER 31, 2002 (in thousands)
----------------------------
Cash and cash equivalents $ 5,138 $ - $ 5,138
Working capital $ 11,524 $ - $ 11,524
Total assets $ 41,758 $ (4,734) $ 37,024
Stockholders' equity $ 16,963 $ - $ 16,963
(3) The selected financial data for 2003 and 2002 has been adjusted and
restated for the reasons described in Notes 3 and 4 to our consolidated
financial statements included elsewhere in this report. As a result of
these adjustments and restatements, cost of sales increased, and operating
expenses decreased, by $1.0 million and $1.4 million for the years ended
December 31, 2003 and 2002, respectively, as follows:
AS ORIGINALLY ADJUSTMENTS AND AS ADJUSTED AND
REPORTED RESTATEMENTS RESTATED
-------------- -------------- --------------
YEAR ENDED DECEMBER 31, 2003 (in thousands, except per share data)
----------------------------
Net sales $ 63,587 $ - $ 63,587
Cost of sales 54,643 (296) 54,347
-------------- -------------- --------------
Gross profit 8,944 296 9,240
Operating expenses 9,237 296 9,533
-------------- -------------- --------------
Operating loss (293) - (293)
Other expense (194) - (194)
-------------- -------------- --------------
Pre-tax loss (487) - (487)
-------------- -------------- --------------
Net loss $ (460) $ - $ (460)
============== ============== ==============
Net loss per common share, diluted $ (0.10) $ - $ (0.10)
============== ============== ==============
YEAR ENDED DECEMBER 31, 2002
----------------------------
Net sales $ 80,953 $ - $ 80,953
Cost of sales 73,565 (386) 73,179
-------------- -------------- --------------
Gross profit 7,388 386 7,774
Operating expenses 10,022 386 10,408
-------------- -------------- --------------
Operating loss (2,634) - (2,634)
Other expense (5,525) - (5,525)
-------------- -------------- --------------
Pre-tax loss (8,159) - (8,159)
-------------- -------------- --------------
Net loss $ (8,845) $ - $ (8,845)
-------------- -------------- --------------
Net loss per common share, diluted $ (1.95) $ - $ (1.95)
============== ============== ==============
28
No cash dividends on our common stock were declared during any of the
periods presented above.
Various factors materially affect the comparability of the information
presented in the above table. These factors relate primarily to the acquisition
of the assets of Hi-Val, Inc. and Digital Research Technologies. Each of the
years ended December 31, 2004, 2003 and 2002 were significantly affected by our
acquisition of IOM Holdings, Inc. in December 2000. IOM Holdings, Inc. acquired
the assets of Hi-Val, Inc. in March 2000 and the assets of Digital Research
Technologies in November 2000. In addition, certain years were affected by
management's decisions regarding income tax benefit.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR
CONSOLIDATED FINANCIAL STATEMENTS AND THE RELATED NOTES AND THE OTHER FINANCIAL
INFORMATION INCLUDED ELSEWHERE IN THIS REPORT. THIS DISCUSSION CONTAINS
FORWARD-LOOKING STATEMENTS REGARDING THE DATA STORAGE AND DIGITAL ENTERTAINMENT
INDUSTRIES AND OUR EXPECTATIONS REGARDING OUR FUTURE PERFORMANCE, LIQUIDITY AND
FINANCIAL 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 sell data storage products. In addition, and to a much lesser
extent, we sell digital entertainment and PC peripheral products. Our data
storage products collectively accounted for approximately 96% of our net sales
in 2006 and our digital entertainment and other products collectively accounted
for approximately 4% of our net sales in 2006.
Our data storage products consist of a range of products that store
traditional PC data as well as movies, music, photos, video games and other
multi-media content. Our digital entertainment products consist of a range of
products that focus on digital movies, music and photos. These products are
designed principally for entertainment purposes.
We sell our products through computer, consumer electronics and office
supply superstores and other major North American retailers. Our network of
retailers enables us to offer products to consumers across North America,
including in every major metropolitan market in the United States. Over the last
three years, our largest retailers have included Best Buy Canada, Circuit City,
CompUSA, Costco, 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.
Notwithstanding the following discussion of our financial performance
for 2006, over the course of the past several months and through the beginning
of July 2007, the robust sales pace of magnetic data storage products
experienced in 2006 has slowed significantly. We believe that this is an
industry-wide effect. In addition, we are experiencing intense price competition
from major competitors such as Western Digital and Seagate Technology, which has
significantly reduced selling prices and eroded margins for magnetic data
storage products. In late 2006 and early 2007, we placed substantial orders for
magnetic data storage products based on our expectation of continuing robust
sales. As a result of these orders and the slowing market for these products, we
currently have high inventory levels. Due to intense price competition, we may
not be able to sell this inventory at positive gross margins. We are unable to
predict whether the market for and selling prices of magnetic data storage
products will stabilize, increase or further decline in the future. In response
to these market conditions, and also as part of its ongoing efforts to bring new
products to market, management is currently exploring other products with our
suppliers and retailers to sell through our sales channels.
FINANCIAL PERFORMANCE SUMMARY
Our net sales increased by $8.1 million, or approximately 22%, to $45.9
million in 2006 from $37.8 million in 2005. Our gross profit increased by $2.1
million, or approximately 50%, to $6.4 million in 2006 from $4.3 million in
2005. Our net loss decreased by $1.5 million, or approximately 83%, to $309,000
in 2006 from $1.8 million in 2005.
NET SALES. Our increase in net sales in 2006 as compared to 2005 was
primarily due to the following combination of factors:
o the 2006 launch of our 3.5" GigaBank(TM) external hard disk drives
which resulted in $10.8 million, or 23.6%, of our net sales in
2006;
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o a decrease in sales and price incentives to 14.4% in 2006, as
compared to 17.9% in 2005;
o an increase in the number of national retailers to our customer
base; and
o an increase in the number of products offered;
o all of which were partially offset by a continued decline in sales
of our optical data storage products of approximately $7.0
million, or approximately 25%.
GROSS PROFIT. Our gross profit margin increased to 14.0% in 2006, as
compared to 11.4% in 2005. This increase is attributed to the following
combination of factors:
o an increase in production expenses to 3.1% of net sales in 2006,
as compared to 2.2% in 2005; and
o a decrease in inventory reserves to 1.5% of net sales in 2006, as
compared to 2.2% in 2005.
OPERATING EXPENSES. Our operating expenses increased to 19.1% of net
sales in 2006, as compared to 15.4% in 2005. The increase in operating expenses
is attributed to the following combination of factors:
o selling expenses increased to 4.6% of net sales in 2006, as
compared to 4.4% in 2005; and
o general and administrative expenses increased in 2006 to 14.1% of
net sales, as compared to 10.4% in 2005.
OTHER INCOME. Our other income increased by approximately $2.3 million.
This increase was due to the receipt of approximately $2.4 million upon
settlement of a litigation matter with Office Max which was partially offset in
interest expenses of approximately $60,000.
A combination of the factors mentioned above affected our net sales,
including a continuation of sales in our mobile product line and the
introduction of our desktop product line that accounted for 22.5% of our total
net sales in 2006 after its initial introduction in the second quarter of 2006.
Sales of our optical data storage products continue to decline as we
de-emphasize CD and DVD-based products because we believe they are included as a
standard component in most new PC systems. In addition, the market for DVD-based
products in 2006 continued to be extremely competitive and was characterized by
abundant product supplies. The effects of these factors in sales of our
DVD-based products were substantially similar in this regard to that of the data
storage industry. Net sales of our optical data storage products decreased by
approximately 21% to $17.1 million in 2006, as compared to $21.6 million in 2005
In addition to the factors described above, we believe that mobile data
storage devices, including our DataBank(TM) and Data-to-Go(TM) products, and our
competitors' flash memory devices, thumbdrives and other mobile data storage
devices, which are an alternative to optical data storage products, have caused
a decline in the relative market share of optical data storage products and
likewise caused a decline in our sales of optical data storage products in 2006.
Sales of our mobile data storage products in 2006 declined by
approximately $500,000, or approximately 3%, as compared to 2005 and represented
34% of our net sales in 2006, as compared to 43% in 2005, while our desktop data
storage products accounted for $12.2 million, or 23%, of our net sales in 2006
after their introduction in the second quarter of 2006.
One of our core strategies is to be among the first-to-market with new
and enhanced product offerings based on established and emerging technologies
such as our desktop data storage products introduced in the second quarter of
2006. We expect to continue to apply this strategy, as we have done in the
contexts of optical data storage products and for our mobile data and desktop
magnetic storage products, to next-generation super-high capacity 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 gross
profit margins and avoid relying on the highly competitive market of
last-generation and older devices.
Our business faces the significant risk that certain of our retailers
will implement a private label or direct import program, or expand their
existing programs, especially for higher margin products. Our retailers may
believe that higher profit margins can be achieved if they implement a direct
import or private label program, excluding us from the sales channel. One of our
challenges will be to deliver products and provide services to our retailers in
a manner and at a level that makes private label or direct importation of
products less attractive to our retailers, while maintaining product margins at
levels sufficient to allow for profitability that meets or exceeds our goals.
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In addition, an industry-wide decline in CD-based product sales
occurred more rapidly than the industry-wide increase in sales of DVD-based data
storage products. We believe that lower than expected demand for DVD-based
products resulted in part from slower than anticipated growth in DVD-compatible
applications and infrastructure. Also, the market for DVD-based products was
extremely competitive during 2006 and was characterized by abundant product
supplies. 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.
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 by increasing sales of
existing products and by 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 closely monitor 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 lines 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. 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, provide a full line of a product category 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 lines, 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 acceptance 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.
INVENTORY TURNOVER. Our typical products' life-cycles ranges from 3 to
12 months, generating lower average selling prices as the cycle matures. We
attempt to keep our inventory levels at amounts adequate to meet our retailers'
needs while minimizing the danger of rapidly declining average selling prices
and inventory financing costs. By focusing on inventory turnover rates, we seek
to identify slow-moving products and take appropriate actions such as
implementation of rebates and sales incentives to increase inventory turnover.
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Our use of a consignment sales model with certain retailers results in
increased amounts of inventory that we must carry and finance. Our consignment
sales model results in greater exposure to 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 rates for our combined sales models is
6 to 8 weeks of inventory, which equates to an annual inventory turnover rate of
approximately 6.5 to 8.5. In 2006 our annualized inventory turnover was 4.3
times compared to 5.5 in 2005 and 7.2 in 2004, representing a period-to-period
decrease of 22% and 24%, respectively. The decrease in inventory turnover in
2006 is primarily a result of a 47% increase in inventory in 2006 as compared to
2005 to support the 22% increase in sales that occurred in 2006. The decrease in
inventory turnover in 2005 was primarily as a result of an increase in inventory
of 13% and a 15% decrease in net sales.
OPERATING EXPENSES. We focus on operating expenses to keep these
expenses within budgeted amounts in order to achieve or exceed our targeted
profitability. We budget certain of our operating expenses in proportion to our
projected net sales, including operating expenses relating to production,
shipping, technical support, and inside and outside commissions and bonuses.
However, most of our expenses relating to general and administrative costs,
product design and sales personnel are essentially fixed over large sales
ranges. Deviations that result in operating expenses in greater proportion than
budgeted signal to management that it must ascertain the reasons for the
unexpected increase and take appropriate action to bring operating expenses back
into 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 Silicon Valley Bank are also an important source of liquidity and a
measure of our financial condition. We use our line of credit on a regular basis
as a standard cash management procedure to purchase inventory and to fund our
day-to-day operations without interruption during periods of slow collection of
accounts receivable. Anticipated near-term cash receipts are also regarded as a
short-term source of liquidity, but are not regarded as immediately available
for use until receipt of funds actually occurs.
The proportion of our accounts receivable to our accounts payable and
the expected maturity of these balance sheet items is an important measure of
our financial condition. We attempt to manage our accounts receivable and
accounts payable to focus on cash flows in order to generate cash sufficient to
fund our day-to-day operations and satisfy our liabilities. Typically, we prefer
that accounts receivable are matched in duration to, or collected earlier than,
accounts payable. If accounts payable are either out of proportion to, or due 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, which could 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: standard terms, consignment sales
and special terms. 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 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. We typically collect payment from a retailer within 60 to 75 days
following the date title is transferred to the retailer.
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CONSIGNMENT
Under our consignment sales model, a retailer is obligated to pay us
for products sold by it within a specified number of days following notification
from the retailer of the sale of those products. Retailers notify us of their
sale of consigned products by delivering weekly or monthly sell-through reports.
A sell-through report discloses sales of products sold in the 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 sale by the retailer.
Consignment sales had represented a growing percentage of our net sales
through 2005. However, in 2006 our consignment model accounted for 19% of our
net sales compared to 33% of our net sales in 2005 and 31% of our net sales in
2004. Although consignment sales decreased as a percentage of our net sales in
2006, we believe that consignment sales as a percentage of our total net sales
will grow in the future.
We had 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
the sale 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 sold 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 standard
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 rates to ensure 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
rates for products in our consignment sales channels, we can implement price
modifications more quickly and efficiently as compared to 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
rates.
We retain most risks of ownership of products in our consignment sales
channels. These products remain our inventory until their sale 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 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.
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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.
RETAILERS
Historically, a limited number of retailers have accounted for a
significant percentage of our net sales. During 2006, 2005 and 2004, our six
largest retailers collectively accounted for approximately 85%, 92% and 84%,
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 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 and digital
entertainment and related industries 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 3 to 12 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 Iomega, LaCie, PNY Technologies, Sony, Seagate Technology
and Western Digital offer products similar to our magnetic storage 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 and 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.
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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.
GOING CONCERN ASSUMPTION
We have based our financial statements on the assumption of our
operations continuing as a going concern. As a result, we continue to depreciate
fixed assets and show certain debts as long-term. As of December 31, 2006, we
had working capital of approximately $5.9 million and cash of approximately $1.8
million and had incurred cumulative net losses of approximately $25.2 million.
As of July 9, 2007, we had cash on hand of $645,000. These factors, among
others, raise substantial doubt about our ability to continue as a going
concern. Our plans for correcting these deficiencies include negotiating
extended payment terms with BTC USA and Lung Hwa Electronics, our related-party
suppliers, timely collection of existing accounts receivable, and sell-through
of inventory currently in our sales channels. Our consolidated financial
statements do not include any adjustments relating to the recoverability and
classification of the recorded asset amounts or the amounts and classification
of liabilities that might be necessary should we be unable to continue our
existence.
REVENUE RECOGNITION
We recognize revenue in accordance with Staff Accounting Bulletin
("SAB") No. 104, REVENUE RECOGNITION, CORRECTED COPY. Under SAB No. 104, revenue
is recognized when persuasive evidence of an arrangement exists, delivery has
occurred or services have been rendered, the seller's price to the buyer is
fixed or determinable, and collectibility is reasonably assured. We apply the
specific provisions of SFAS No. 48, REVENUE RECOGNITION WHEN RIGHT OF RETURN
EXISTS. Under SFAS No. 48, product revenue is recorded at the transfer of title
to the products to a retailer, net of estimated allowances and returns and sales
incentives. 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. For transactions not satisfying the conditions for
revenue recognition under SFAS No. 48, product revenue is deferred until the
conditions are met, net of an estimate for cost of sales. Consignment sales are
recognized when our retailers sell our products to retail customers, at which
point the retailers incur an obligation to pay us.
In accordance with EITF Issue No. 01-9, ACCOUNTING FOR CONSIDERATION
GIVEN BY A VENDOR TO A CUSTOMER INCLUDING A RESELLER OF THE VENDOR'S PRODUCTS,
because we did not receive an identifiable benefit, we reduce our product
revenue for marketing promotions, market development fund and cooperative
advertising costs.
We recognize revenue under three primary sales models: standard terms,
consignment sales and special terms. We generally use one of these three primary
sales models, or some combination of these sales models, with each of our
retailers. Under each of these sales models our payment terms are explicitly
stated and agreed to by us and the retailer before goods are shipped, thereby
making our fee fixed or determinable before revenue is recognized.
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, net of an estimate for sales incentives, rebates and returns.
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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 notification
to us by the retailer of the sale of those products. Retailers notify us of
their sale 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. At the time of a
retailer's sale 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
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
sale of those products. Products held by a retailer under our consignment sales
model are recorded as our inventory at offsite locations until their sale by the
retailer. Because we retain title to products in our consignment sales channels
until their sale by a retailer, revenue is not recognized until the time of
sale. Accordingly, price modifications to inventory maintained in our
consignment sales channels do not have an effect on the timing of revenue
recognition.
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. However,
under our special terms sales model, we often require payment in advance or at
the time of 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 on the sale of those products. We
recognize revenue for special terms sales at the time title to products is
transferred to a retailer.
SALES INCENTIVES
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. We also record a corresponding accrual for our
estimated sales incentive liability. This accrual is reduced by deductions on
future payments taken by our retailers relating to actual sales incentives. Our
estimated sales incentive liability is offset against accounts receivable.
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.
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In 2006, our sales incentives were $836,200, or 1.6% of gross sales,
all of which were offset against gross sales, as compared to $1.3 million, or
2.6% of gross sales, in 2005, all of which were offset against gross sales. In
2004, our sales incentives were $2.5 million, or 4.2% of gross sales, all of
which were offset against gross sales.
MARKET DEVELOPMENT FUNDS AND COOPERATIVE ADVERTISING COSTS, REBATE
PROMOTION COSTS AND SLOTTING FEES
Market development funds and cooperative advertising costs, rebate
promotion costs, new store opening fees and slotting fees are offset against
gross sales in accordance with Emerging Issues Task Force Issue ("EITF") No.
01-9 because we did not receive an identifiable benefit. Market development
funds 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 and new store opening fees are
paid to assist in promoting the retailer's new store openings. In 2006, our
market development funds and cooperative advertising costs, rebate promotion
costs, new store opening fees and slotting fees were $6.8 million, or 13% of
gross sales, all of which were offset against gross sales, as compared to market
development funds and cooperative advertising costs, rebate promotion costs, new
store opening fees and slotting fees of $7.0 million, or 13% of gross sales, in
2005, all of which were offset against gross sales. In 2004, our market
development funds and cooperative advertising costs, rebate promotion costs, new
store opening fees and slotting fees were $7.8 million, or 13% of gross sales,
all of which were offset against gross sales. These costs and fees remain
approximately the same percentage of sales at 13% in 2006, 2005 and 2004.
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 other products
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 sale of slow
moving and obsolete inventories is considered through market research, analysis
of our retailers' current needs, and assumptions about future demand and market
conditions. The recorded cost of both slow-moving and obsolete inventories is
then reduced to its estimated market value based on current market pricing for
similar products. We utilize the Internet to provide indications of market value
from competitors' pricing, third party inventory liquidators and auction
websites. The recorded costs of our slow moving and obsolete products are
reduced to current market prices when the recorded costs exceed such market
prices. 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 such 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.
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 and suppliers) that 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 its general ledger are reconciled by our
Controller and any variances result in a corresponding inventory adjustment.
ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS
Trade accounts receivable are primarily from national retailers and are
recorded at the invoiced amount and do not accrue interest. The allowance for
doubtful accounts reflects management's best estimate of probable credit losses
inherent in the accounts receivable balance. We determine the allowance based on
historical experience, specifically identified nonpaying accounts and other
currently available evidence. We reviews our allowance for doubtful accounts
monthly with focus on significant individual past due balances over 90 days. All
other balances are reviewed on a pooled basis. Account balances are charged off
against the allowance after all means of collection have been exhausted and the
potential for recovery is considered remote. Since our current customers are
primarily national retailers with good payment histories with us, our allowance
for doubtful accounts is minimal. We do not have any off-balance sheet credit
exposure related to our customers.
37
In dealing with our national retailers, we occasionally have, and
expects that we will continue to have in the foreseeable future, disagreements
with these customers relating to the valuation and completeness of accounts
receivable which may result in a contingent gain or loss to us.
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 14 to 30 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 are reduced by estimated returns and
cost of sales is reduced by the estimated cost of those sales. We record a
corresponding allowance 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 allowance is offset each
period by actual product returns.
Our current estimated weighted average future product return rate is
approximately 10%. 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 our trailing 18-month return rate of similar products.
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 our trailing 18-month return rates, we will make appropriate
adjustments to our estimated return rates. Factors that could cause materially
different actual return rates as compared to our trailing 18-month return rates
include product modifications that simplify installation, or a new product line
within a product category that needs time to better reflect its return
performance and other factors. This allowance is recorded against accounts
receivable.
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
within the applicable warranty period 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 dollar 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.
38
YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005 (ADJUSTED AND RESTATED)
RESULTS AS A PERCENTAGE OF
NET SALES FOR THE YEARS ENDED
YEAR ENDED DECEMBER 31, DECEMBER 31,
---------------------------- ---------------------------
DOLLAR PERCENTAGE
2005 VARIANCE VARIANCE 2005
(ADJUSTED AND FAVORABLE FAVORABLE (ADJUSTED AND
2006 RESTATED)(1) (UNFAVORABLE) (UNFAVORABLE) 2006 RESTATED)(1)
------------ ------------ ------------ ------------ ------------ ------------
(in thousands)
Net sales $ 45,889 $ 37,773 $ 8,116 21.5% 100.0% 100.0%
Cost of sales 39,463 33,481 (5,982) (17.9)% 86.0% 88.6%
------------ ------------ ------------ ------------ ------------ ------------
Gross profit (1) 6,426 4,292 2,134 49.7% 14.0% 11.4%
Selling, marketing and advertising
expenses (1) 2,113 1,669 (444) (26.6)% 4.6% 4.4%
General and administrative expenses 6,505 3,916 (2,589) (66.1)% 14.1% 10.4%
Depreciation and amortization 166 236 70 29.7% 0.4% 0.6%
------------ ------------ ------------ ------------ ------------ ------------
Operating loss (2,358) (1,529) (829) (54.2)% (5.1)% (4.0)%
Net interest expense (356) (299) (57) (19.1)% 0.8% 0.8%
Other income 2,406 12 2,394 199.5% 5.2% 0.0%
------------ ------------ ------------ ------------ ------------ ------------
Loss from operations before
provision for income taxes (308) (1,816) 1,508 83.0% (0.7)% (4.8)%
Income tax provision 1 2 1 50.0% 0.0% 0.0%
------------ ------------ ------------ ------------ ------------ ------------
Net loss (1) $ (309) $ (1,818) $ 1,509 83.0% (0.7)% (4.8)%
============ ============ ============ ============ ============ ============
- ---------------
(1) Gross margin and operating expenses were affected by these adjustments and
restatements without impact to net loss or loss per share. For further
explanation, see Notes 3 and 4 to our consolidated financial statements
included elsewhere in this report.
NET SALES. The increase in net sales in 2006 as compared to 2005 was
primarily a result of adding new retailers to our customer base, the broadening
of our magnetic data storage product lines by adding increased capacities in our
mobile data storage line and the introduction of our higher capacity external
desktop hard drives in the second quarter of 2006, an increase in sales of our
PC products, which were partially offset by the continued decline in sales of
our CD-based products and greater than anticipated decline in sales of our
DVD-based products.
Our GigaBank(TM) line of external desktop hard drives, with capacities
ranging from 200 gigabytes up to 1 terabyte, gained quick acceptance and
accounted for approximately $10.8 million, or 23.6%, of our total net sales in
2006 after their introduction in June of 2006. We believe that acceptance of
these larger capacity disk drives corresponds with the increased demand for data
storage capacity resulting from the size and complexity of operating systems,
computer networks and software programs plus the continued growth of data
intensive activities such as email, digital entertainment data and other
multi-media data.
Net sales of our optical storage products decreased by $4.5 million to
$17.1 million in 2006, as compared to $21.6 million in 2005. This sales decline
was a result of our decision to deemphasize CD and DVD-based products because we
believe they are included as a standard component in most PCs and the fact that
portable USB data storage devices continue to gain market share. We believe that
this decrease is an industry-wide effect and that 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 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.
39
GROSS PROFIT. Our gross profit increased $2.1 million to $6.4 million
in 2006 from $4.3 million in 2005, representing a 49.7% increase. Our gross
profit margin increased to 14.0% in 2006 as compared to 11.4% in 2005. The
increase in gross profit margin is primarily a result of higher gross profit
margins on our new high capacity external disk drives. Net sales increased $8.1
million, or approximately 21.5%, to $45.9 million compared to $37.8 million in
2005. This increase in net sales was offset by an increase in cost of sales of
$6.0 million to $39.5 million, or 86.0% of net sales, compared to $33.5 million,
or 88.6%, of net sales in 2005. The percentage increase in cost of sales was not
as great as the percentage increase in net sales because of a reduction in total
sales incentives granted in 2006 compared to 2005 which was partially offset by
an increase in production costs in 2006 compared to 2005. For 2006, total sales
incentives and market development funds and cooperative advertising costs,
rebate promotion costs and slotting fees decreased by $600,000 to $7.7 million,
or 17.1% of gross sales, compared to $8.3 million, or 18.1% of gross sales in
2005; and, production costs increased by $600,000 to $1.4 million in 2006
compared to $900,000 in 2005 which resulted from a $300,000 increase in
temporary labor, a $200,000 increase in contract assembly costs, and a $100,000
increase in production supplies.
Our gross profit in 2005 was affected by an adjustment and a
restatement without impact to net loss or loss per share. We reclassified
certain shipping and handling expenses from cost of sales to selling expense. We
also restated certain direct labor and production expenses to include them as a
component of cost of sales. In 2005, the adjustment decreased cost of sales by
$892,000 and the restatement increased cost of sales by $851,000 for a net
decrease in cost of sales of $41,000. The adjustment and restatement had a
commensurate effect on our gross profit in 2005. For further explanation, see
Notes 3 and 4 to our consolidated financial statements included elsewhere in
this report.
Our gross profit in each of the first three quarters of 2006 and each
of the quarterly periods in 2005 was also affected by the adjustment and the
restatement without impact to net loss or loss per share. In the three quarters
ended September 30, 2006, the adjustment decreased cost of sales by $299,000,
$292,000 and $237,000, respectively, and the restatement increased cost of sales
by $270,000, $368,000 and $336,000, respectively, for a net decrease in cost of
sales of $29,000 and a net increase in cost of sales of $76,000 and $99,000,
respectively, in those periods, and a net cumulative increase in cost of sales
of $146,000 for the first three quarters of 2006. In the four quarters ended
December 31, 2005, the adjustment decreased cost of sales by $253,000, $209,000,
$180,000 and $250,000, respectively, and the restatement increased cost of sales
by $234,000, $179,000, $208,000 and $230,000, respectively, for a net decrease
in cost of sales of $19,000 and $29,000, a net increase in cost of sales of
$28,000 and a net decrease in cost of sales of $20,000, respectively, in those
periods. The adjustment and the restatement had a commensurate effect on our
gross profit in those periods. For further explanation, see Notes 22 and 23 to
our consolidated financial statements included elsewhere in this report.
Our inventory obsolescence expense, which is included in cost of sales,
was approximately $500,000 in 2006 as compared to $840,000 in 2005. This expense
is a result of our adjustment of the value of slow-moving and obsolete
inventory.
SELLING, MARKETING AND ADVERTISING EXPENSES. The increase in selling,
marketing and advertising expenses of $400,000 is primarily due to an increase
in shipping and handling expenses of $300,000 and an increase in total sales
compensation of $100,000, both resulting from the increased sales volume.
GENERAL AND ADMINISTRATIVE EXPENSES. The increase in general and
administrative expenses of $2.5 million is primarily due to $1.2 million of
offering costs expensed in the second quarter of 2006; an increase of $300,000
in interim accounting services while we were searching for a new Chief Financial
Officer; an increase in our bad debt expense of $200,000; an increase of
$353,000 for audit fees incurred from additional fees for the year-end and
interim financial statements; a $200,000 increase in legal fees related to
litigation; an increase of $100,000 for commercial insurance; an increase of
general legal fees for corporate matters; and, a $100,000 increase in stock
based compensation in 2006 as compared to 2005.
40
YEAR ENDED DECEMBER 31, 2005 (ADJUSTED AND RESTATED) COMPARED TO YEAR ENDED DECEMBER 31, 2004 (ADJUSTED AND RESTATED)
RESULTS AS A PERCENTAGE OF
NET SALES FOR THE YEARS ENDED
YEAR ENDED DECEMBER 31, DECEMBER 31,
---------------------------- ---------------------------
DOLLAR PERCENTAGE
2005 2004 VARIANCE VARIANCE 2005 2004
(ADJUSTED AND (ADJUSTED AND FAVORABLE FAVORABLE (ADJUSTED AND (ADJUSTED AND
RESTATED)(1) RESTATED)(1) (UNFAVORABLE) (UNFAVORABLE) RESTATED)(1) RESTATED)(1)
------------ ------------ ------------ ------------ ------------ ------------
(in thousands)
Net sales $ 37,773 $ 44,397 $ (6,624) (14.9)% 100.0% 100.0%
Cost of sales 33,481 41,263 7,782 18.9% 88.6% 92.9%
------------ ------------ ------------ ------------ ------------ ------------
Gross profit (1) 4,292 3,134 1,158 36.9% 11.4% 7.1%
Selling, marketing and
advertising expenses (1) 1,669 2,049 380 18.5% 4.4% 4.6%
General and administrative
expenses 3,916 4,458 542 12.2% 10.4% 10.0%
Depreciation and amortization 236 834 598 71.7% 0.6% 1.9%
Impairment of trademarks - 3,696 3,696 100.0% 0.0% 8.3%
------------ ------------ ------------ ------------ ------------ ------------
Operating loss (1,529) (7,903) 6,374 80.6% (4.0)% (17.8)%
Net interest expense 299 201 (98) (48.8)% 0.8% 0.5%
Other income 12 50 (38) (76.0)% 0.0% 0.1%
------------ ------------ ------------ ------------ ------------ ------------
Loss from operations before
provision for income taxes (1,816) (8,054) 6,238 77.9% (4.8)% (18.1)%
Income tax provision 2 3 1 33.3% 0.0% 0.0%
------------ ------------ ------------ ------------ ------------ ------------
Net loss (1) $ (1,818) $ (8,057) $ 6,239 77.4% (4.8)% (18.1)%
============ ============ ============ ============ ============ ============
- ------------
(1) Gross margin and operating expenses were affected by these adjustments and
restatements without impact to net loss or loss per share. For further
explanation, see Notes 3 and 4 to our consolidated financial statements
included elsewhere in this report.
NET SALES. We believe that the decline in our net sales during 2005 as
compared to 2004 resulted in part from the 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 CD-based
products declined by 74.1% to $2.8 million in 2005 from $10.8 million in 2004.
In addition, we also believe that part of the significant decline in
our net sales during 2005 as compared to 2004 resulted from the decline in sales
of our DVD-based products. For 2005, sales of our DVD-based products decreased
to $18.8 million, or by 34.7%, as compared to $28.8 million in sales for 2004.
We experienced a 30.9% decrease in our average selling price of DVD-based
products for 2005 as compared to 2004. We believe that this decrease is an
industry-wide effect and 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 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.
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 2005. Our business focus in 2004 was
predominantly on DVD-based optical data storage products. Our business focus in
2005 was predominantly on DVD-based optical data storage products and our line
of GigaBank(TM) products. In 2004, we began selling our GigaBank(TM) products.
Sales of our GigaBank(TM) products increased 282.5% to $15.3 million in 2005 as
compared to $4.0 million in 2004. Sales of our GigaBank(TM) products represented
39.9% of our total net sales in 2005. Our net sales to some of our retailers,
including CompUSA, Office Depot and Tech Data, increased during 2005 as compared
to 2004 due to their expanded offerings of our GigaBank(TM) line of products.
Other retailers, however, including Circuit City, RadioShack and Micro Center,
did not begin or expand sales of our GigaBank(TM) products as rapidly as
CompUSA, Office Depot and Tech Data and thus the general decline in sales of our
DVD-based products to these retailers was not offset by sales of our
GigaBank(TM) products to these retailers. In addition, we experienced a slight
decrease in sales to Staples in 2005 as compared to 2004.
41
Another factor contributing significantly to the decline in our net
sales during 2005 as compared to 2004 was the continued and expanded operation
of private label programs by Best Buy. We had only $61,000 in sales to Best Buy
in 2005, representing a decrease of nearly 100.0% from $5.0 million in sales to
Best Buy 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.
In addition, our sales to Circuit City decreased significantly by $3.5
million, or by 44.9%, to $4.3 million in 2005 from $7.8 million in 2004.
A change in our allowance for product returns also resulted in an
adjustment of $468,000 causing a decrease in net sales in 2005 as compared to an
adjustment of $1.1 million that resulted in an increase in net sales in 2004.
The overall $6.6 million decrease in net sales in 2005 was comprised of
a $5.7 million decrease in net sales resulting from a decrease in the volume of
products sold and a decrease of $1.3 million resulting from a change in our
reserves for future returns on sales. This decrease was partially offset by a
$262,000 increase from higher average product sales prices. We had a decrease of
$8.0 million in net sales for 2005 for our CD-based products resulting from a
decrease of $1.1 million due to lower average product sales prices and a
decrease of $6.9 million resulting from a decrease in the volume of products
sold. We had a decrease of $10.0 million in net sales for 2005 for our DVD-based
products resulting from a decrease of $8.4 million due to lower average product
sales prices and a decrease of $1.6 million due to a decrease in the volume of
products sold. The $11.2 million increase in net sales of our GigaBank(TM)
products in 2005 resulted from an increase of $13.3 million due to an increase
in the volume of products sold, which was partially offset by a decrease of $2.1
million in net sales due to lower average product sales prices.
GROSS PROFIT. Gross profit increased to $4.3 million, or by 36.9%, in
2005 from $3.1 million in 2004. Our gross profit margin increased to 11.4% as
compared to 7.1% in 2004. This increase in gross profit margin primarily
resulted from the increase in sales of our magnetic data storage products which
have a greater profit margin than our optical data storage products. Net sales
decreased $6.6 million, or by 14.9%, to $37.8 million in 2005 from $44.4 million
in 2004. This decrease was offset by a decrease in cost of sales of $7.8 million
to $33.5 million, or 88.7% of net sales in 2005, from $41.3 million, or 92.9% of
net sales in 2004. The percentage decrease in net sales was not as large as the
percentage decrease in cost of sales because of large increases in sales
incentives, market development/cooperative advertising funds, slotting fees and
point-of-sale rebates, which are dilutive factors to sales and contributed to
net sales for 2005 as compared to 2004. For 2005, slotting fees were none as
compared to $950,000 for 2004. For 2005, sales incentives, market
development/cooperative advertising funds and point-of-sale rebates declined by
$1.2 million compared to 2004.
Our inventory reserve increased by $841,000 in 2005 as compared to $2.0
million in 2004 due to our adjustment of the value of our slow-moving and
obsolete inventory. Most of our inventory over 2 years old was fully reserved
for in 2004. 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.
Our gross profit in each of 2005 and 2004 was affected by an adjustment
and a restatement without impact to net loss or loss per share. We reclassified
certain shipping and handling expenses from cost of sales to selling expense. We
also restated certain direct labor and production expenses to include them as a
component of cost of sales. In 2005, the adjustment decreased cost of sales by
$892,000 and the restatement increased cost of sales by $851,000 for a net
decrease in cost of sales of $41,000. In 2004, the adjustment decreased cost of
sales by $1,039,000 and the restatement increased cost of sales by $883,000 for
a net decrease in cost of sales of $156,000. The adjustment and restatement had
a commensurate effect on our gross profit in those periods. For further
explanation, see Notes 3 and 4 to our consolidated financial statements included
elsewhere in this report.
Our gross profit in each of the quarterly periods in 2005 and 2004 was
also affected by the adjustment and the restatement without impact to net loss
or loss per share. In the four quarters ended December 31, 2005, the adjustment
decreased cost of sales by $253,000, $209,000, $180,000 and $250,000,
respectively, and the restatement increased cost of sales by $234,000, $179,000,
$208,000 and $230,000, respectively, for a net decrease in cost of sales of
$19,000 and $29,000, a net increase in cost of sales of $28,000 and a net
decrease in cost of sales of $20,000, respectively, in those periods. In the
four quarters ended December 31, 2004, the adjustment decreased cost of sales by
$293,000, $168,000, $236,000 and $342,000, respectively, and the restatement
increased cost of sales by $241,000, $206,000, $204,000 and $232,000,
respectively, for a net decrease in cost of sales of $52,000, a net increase in
cost of sales of $38,000 and a net decrease in cost of sales of $32,000 and
$110,000, respectively, in those periods. The adjustment and the restatement had
a commensurate effect on our gross profit in those periods. For further
explanation, see Notes 22 and 23 to our consolidated financial statements
included elsewhere in this report.
42
SELLING, MARKETING AND ADVERTISING EXPENSES. The decrease of $380,000
in selling, marketing and advertising expenses was primarily due to a decrease
in advertising activities of $263,000, a decrease in commissions of $73,000 as a
result of reduced sales volume, and a decrease of $148,000 in shipping and
handling expense also as a result of reduced sales volume all of which were
offset by an increase in sales expenses of $77,000, and an increase in trade
show expenses of $32,000.
GENERAL AND ADMINISTRATIVE EXPENSES. The $800,000 decrease in general
and administrative expenses is primarily due to a reduction in payroll and
related expenses in the amount of $400,000 as a result of fewer personnel; a
reduction in bad debt expense in the amount of $100,000; a reduction in
financial relations expenses of $100,000 due to a reduction in outside financial
consultants; a decrease in bad debt expense of $100,000; and a $200,000 decrease
in administrative expenses, all of which were partially off set offset by a
$100,000 increase in commercial insurance expense and bank charges .
DEPRECIATION AND AMORTIZATION. The decrease in depreciation and
amortization expenses is primarily due to a reduction in trademarks amortization
of $510,000 due to the write down in the value of our Hi-Val(R) and Digital
Research Technologies(R) trademarks at December 31, 2004 due to impairment.
Depreciation for office equipment, computer hardware and software decreased
$88,000 as a many fixed assets became fully depreciated during the year.
IMPAIRMENT OF TRADEMARKS. We conducted a valuation on our Hi-Val(R) and
Digital Research Technologies(R) trademarks for possible impairment as of
December 31, 2005. Based upon this valuation, we determined that there had been
no impairment in the value of the trademarks.
We conducted a valuation on our Hi-Val(R) and Digital Research
Technologies(R) trademarks for possible impairment as of December 31, 2004.
Based upon this valuation, we determined that there had been a significant
impairment in the value of the trademarks due to lower sales of products under
the Hi-Val(R) and Digital Research Technologies(R) brands in 2004 and lower
sales forecasted by us for subsequent periods. Therefore, we recorded an
impairment in the value of the trademarks of $3.7 million as of December 31,
2004.
NET INTEREST EXPENSE. Net interest expense increased by $136,000 in
2005, as compared to 2004, primarily due to an increase in interest expense in
the amount of $98,000 to $299,000 in 2005 as compared to $201,000 in 2004 as a
result of higher rates of interest in 2005 on our credit facility due to
increases in the prime rate of interest.
LIQUIDITY AND CAPITAL RESOURCES
During 2006, our principal sources of liquidity were cash provided by
operations and borrowings under our bank and trade credit facilities. Our
principal uses of cash have been to finance working capital, capital
expenditures and debt service requirements. We anticipate that these uses will
continue to be our principal uses of cash in the future. As of December 31,
2006, we had working capital of $5.9 million, an accumulated deficit of $25.2
million, $2.7 million in cash and cash equivalents and $11.5 million in net
accounts receivable. This compares to working capital of $6.0 million, an
accumulated deficit of $24.9 million, $4.1 million in cash and cash equivalents
and $9.4 million in net accounts receivable as of December 31, 2005.
We currently have almost no amounts available to us for borrowing under
our credit facility with Silicon Valley Bank. In addition, as of July 9, 2007,
we had only $645,000 of cash on hand. As a result of our financial condition,
our independent registered public accounting firm has issued a report expressing
substantial doubt about our ability to continue as a going concern. We are
presently experiencing a lack of liquidity that we believe will be resolved in
part once we are able to negotiate extended payment terms on amounts owed to
Behavior Tech Computer (USA) Corp., or BTC USA, and Lung Hwa Electronics. We
also expect that our liquidity will improve following timely collection of
existing accounts receivable and sell-through of inventory currently in our
sales channels. We have experienced similar short-term liquidity issues in the
past and have been successful in negotiating extended payment terms on amounts
owed to BTC USA and Lung Hwa Electronics, which we believe has enabled us to
continue to operate our business substantially without ill effects resulting
from lack of liquidity. We believe that, as in the past, we again will be able
to successfully resolve our short-term liquidity issues without significant
adverse effects on our business.
43
We presently have insufficient liquidity to fund our operations for the
next twelve months. However, 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 Silicon Valley Bank will be
sufficient to fund our anticipated working capital and capital expenditure
requirements at least for the next twelve months, provided that we are
successful in negotiating extended payments terms on amounts owed to BTC USA and
Lung Hwa Electronics, timely collecting existing accounts receivable and selling
inventory currently in our sales channels as anticipated. If, however, our
capital requirements or cash flow vary materially from our current projections,
if we are unable to successfully negotiate extended payment terms on amounts
owed to BTC USA or Lung Hwa Electronics, if we are unable to timely collect our
accounts receivable or unable to sell-through inventory currently in our sales
channels as anticipated, or if unforeseen circumstances occur, we may be unable
to increase our liquidity and may require additional financing. If we are unable
to increase our liquidity, we will experience a material and adverse effect on
our ability to operate our business. In addition, our failure to raise capital,
if needed, could restrict our growth, limit our development of new products,
hinder our ability to compete and may even have a material and adverse effect on
our ability to operate our business.
Over the course of the past several months and through the beginning of
July 2007, the robust sales pace of magnetic data storage products experienced
in 2006 has slowed significantly. We believe that this is an industry-wide
effect. In addition, we are experiencing intense price competition from major
competitors such as Western Digital and Seagate Technology, which has
significantly reduced selling prices and eroded margins for magnetic data
storage products. In late 2006 and early 2007, we placed substantial orders for
magnetic data storage products based on our expectation of continuing robust
sales. As a result of these orders and the slowing market for these products, we
currently have high inventory levels. Due to intense price competition, we may
not be able to sell this inventory at positive gross margins. We are unable to
predict whether the market for and selling prices of magnetic data storage
products will stabilize, increase or further decline in the future. In response
to these market conditions, and also as part of its ongoing efforts to bring new
products to market, management is currently exploring other products with our
suppliers and retailers to sell through our sales channels.
As indicated above, our consolidated financial statements as of and for
the year ended December 31, 2006, have been prepared on a going concern basis,
which contemplates the realization of assets and satisfaction of liabilities in
the normal course of business. As discussed in this report and in Note 1 to our
consolidated financial statements included elsewhere in this report, we have
incurred significant recurring losses, have serious liquidity concerns and may
require additional financing in the foreseeable future. These factors, among
others, raise substantial doubt about our ability to continue as a going
concern. Our independent registered public accounting firm has issued a report
expressing substantial doubt about our ability to continue as a going concern.
The consolidated financial statements included in this document do not include
any adjustments that might result from the outcome of this uncertainty.
For the year ended December 31, 2006, our cash decreased by $2.2
million, or 53.7%, from $4.1 million to $1.8 million as compared to an increase
of $469,000, or 13.0%, for the year ended December 31, 2005 from $3.6 million to
$4.1 million.
Cash used in our operating activities totaled $631,000 during the year
ended December 31, 2006 as compared to cash provided by our operating activities
of $1.0 million during the year ended December 31, 2005. This decrease of $1.6
million in cash used in our operating activities primarily resulted from:
o a $1.5 million decrease in our net loss in 2006 as compared to
2005;
o a $1.3 million increase in accounts receivable in 2006 as compared
to a $1.5 million decrease in 2005 resulting from an increase in
sales during our fourth quarter;
o a $4.2 million increase in inventory, primarily as a result of our
expanded consignment inventory program;
o a $288,000 increase in the allowance for product returns; and
o a $276,000 decrease in accounts payable to related parties.
These decreases in cash were partially offset by:
o a $1.2 million decrease in capitalized offering costs;
o a $1.2 million decrease in reserves for sales incentives;
o a $227,000 decrease in prepaid expenses and other current assets
primarily related to our write-off of offering costs;
o a $3.5 million increase in accounts payable and accrued expenses
primarily as a result of the increase in net sales in 2006 as
compared to 2005;
o a $496,000 increase in our reserve for slow-moving and obsolete
inventory;
o a $149,000 increase in share-based compensation expense; and
o a $554,000 increase in mail-in rebates.
44
Cash used in our investing activities totaled $981,000 during 2006 as
compared to cash provided by investing activities of $982,000 during 2005.
During 2006, restricted cash increased $862,000 as the result of collateral
requirements related to our credit facility. Cash used for equipment additions
were $119,000 during 2006 as compared to $31,000 during 2005.
Cash used in our financing activities totaled $611,000 during 2006 as
compared to $1.5 million during 2005. We paid down $673,000 of our prior credit
facility with GMAC Commercial Finance, or GMAC, through funds available at the
beginning of the year, and we received $62,000 in proceeds of from sales of our
common stock upon the exercise of employee stock options.
On March 9, 2005, we entered into an asset-based line of credit with
GMAC. Our asset-based line of credit with GMAC was to expire on January 15, 2007
and allowed us to borrow up to $5.0 million. The line of credit bore interest at
a floating interest rate equal to the prime rate of interest plus 2.75%. Our
obligations under our loan agreement with GMAC were secured by substantially all
of our assets and guaranteed by our wholly-owned subsidiary, IOM Holdings, Inc.
Until our entry into a forbearance agreement with GMAC, as discussed below, the
loan agreement had one financial covenant which required us to maintain a fixed
charge coverage ratio of at least 1.5 to 1.0 for the three months ended June 30,
2005, the six months ended September 30, 2005, the nine months ended December
31, 2005, the twelve months ended March 31, 2006 and for each twelve month
period ending on the end of each calendar quarter thereafter. We were in
violation of this financial covenant as of September 30, 2006.
On October 18, 2006, we entered into a forbearance agreement with GMAC
that provided for the forbearance by GMAC from enforcing its rights and remedies
under the loan agreement as a result of our failure to satisfy a financial
covenant contained in the loan agreement. The forbearance agreement was
effective through January 15, 2007, at which time all obligations to GMAC were
due and payable in full. The forbearance agreement also provided that from and
after the date of the agreement, advances under the credit facility would bear
interest at the post-default rate of prime plus 2.75% per annum. On October 18,
2006, the prime rate was 8.25%. As of December 31, 2006, we owed GMAC
approximately $4.4 million and had available to us approximately $569,000 of
additional borrowings.
On January 27, 2007, we entered into a Loan and Security Agreement with
Silicon Valley Bank, which provides for a revolving line of credit. The line of
credit allows us to borrow up to a maximum amount equal to the lesser of (i)
$10.0 million, or (ii) an amount equal to 60% of eligible accounts plus the
lesser of (a) 25% of the value of eligible inventory, (b) $3 million, or (c) 33%
of eligible accounts. The line of credit allows for a sublimit of $2.5 million
for all (x) outstanding letters of credit, (y) foreign exchange contracts to
purchase from or sell to Silicon Valley Bank a specific amount of foreign
currency, and (z) the amount of the revolving line used for cash management
services, including merchant services, direct deposit of payroll, business
credit card and check cashing services. The line of credit expires on January
29, 2009. Advances on the line of credit bear interest at a floating rate equal
to the prime rate plus 1.0%. Our obligations under the line of credit with
Silicon Valley Bank are secured by substantially all of our assets.
If we terminate the credit facility prior to the maturity date, we will
be subject to a termination fee as follows: (i) if the termination occurs on or
before the first anniversary of the effective date, the termination fee is equal
to 1.50% of the maximum line amount, and (ii) if the termination occurs after
the first anniversary of the effective date and on or before the second
anniversary of the effective date, the termination fee is equal to 0.50% of the
maximum line amount. The credit facility is subject to an unused line fee equal
to 0.25% per annum, payable monthly based on the average daily unused amount of
the line of credit, as determined by Silicon Valley Bank. The credit facility is
also subject to a commitment fee of $50,000, a monthly collateral monitoring fee
of $1,250 and an anniversary fee of $50,000. In addition, we must pay to Silicon
Valley Bank customary fees and expenses for the issuance or renewal of letters
of credit and all expenses incurred by Silicon Valley Bank related to the Loan
and Security Agreement.
The credit facility is subject to a financial covenant on a
consolidated basis relating to our tangible net worth for each month ending
after February 28, 2007, which must be at least $4,750,000, plus (i) 50% of all
consideration received by us for sales of equity securities and issuances of
subordinated debt, plus (ii) 50% of our net income for each fiscal quarter.
"Tangible net worth" is defined as our consolidated total assets minus (a) any
amounts attributable to (i) goodwill, (ii) intangible items, and (iii) notes,
accounts receivable and other obligations owing to us from our officers and
affiliates, and reserves not already deducted from assets, minus (b) total
liabilities, plus (c) subordinated debt. In the event of a default and
continuation of a default, Silicon Valley Bank may accelerate the payment of the
principal balance requiring us to pay the entire indebtedness outstanding on
that date. From and after an event of default, the outstanding principal balance
will bear interest until paid in full at an increased rate per annum equal to 5%
above the rate of interest in effect from time to time under the credit
facility. The Loan and Security Agreement also contains other customary
representations, warranties and covenants
45
Our new credit facility with Silicon Valley Bank was initially used to
pay off our outstanding loan balance as of January 27, 2007 with GMAC, which
balance was approximately $5.0 million, and was also used to pay $62,000 of our
closing fees in connection with securing the credit facility.
The outstanding balance with Silicon Valley Bank as of July 9, 2007 was
$3,459,787. The amount available to us for borrowing as of July 9, 2007 was
$5,000.
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 an aggregate of up to
$15.0 million of inventory manufactured by Lung Hwa Electronics or manufactured
by third parties, in which case we use Lung Hwa Electronics as an international
purchasing office. For inventory manufactured by third parties and 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.
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. The agreement containing the terms of
the new trade credit facility was amended and restated on July 21, 2005 to
provide that the new facility would be retroactive to April 29, 2005. As of
December 31, 2006, we owed Lung Hwa Electronics $7.6 million in trade payables.
In February 2003, we entered into a Warehouse Services and Bailment
Agreement with 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 December 31, 2006, we owed BTC USA
$334,000 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. See
"Certain Relationships and Related Transactions, and Director Independence."
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. See "Certain Relationships and Related Transactions, and Director
Independence."
Our net loss decreased by approximately 83% to $309,000 in 2006 from
$1.8 million in 2005. If our net losses continue or increase, 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. For example, as discussed
above, in late 2006 and early 2007, we placed substantial orders for magnetic
data storage products based on our expectation of continuing robust sales. As a
result of these orders and the slowing market for these products, we currently
have high inventory levels. Due to intense price competition, we may not be able
to sell this inventory at positive gross margins. We are unable to predict
whether the market for and selling prices of magnetic data storage products will
stabilize, increase or further decline in the future.
46
If 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 decline and our net
losses would likely increase, which in turn could have a material and adverse
impact on our liquidity, financial condition and capital resources.
BACKLOG
Our backlog at December 31, 2006 and 2005 was $900,000 and $3.7
million, respectively. The substantial decrease in backlog is a function of
inventory levels at our retailers based on their near-term inventory restocking
requirements. Based on historical trends, we anticipate that our December 31,
2006 backlog may be reduced by approximately 10%, or approximately $100,000, to
a net amount of $800,000 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.
CONTRACTUAL OBLIGATIONS
The following table outlines payments due under our significant
contractual obligations over the next five years, exclusive of interest:
PAYMENTS DUE BY PERIOD
CONTRACTUAL OBLIGATIONS AT
DECEMBER 31, 2006 LESS THAN 1 AFTER
TOTAL YEAR 1-3 YEARS 4-5 YEARS 5 YEARS
---------- ---------- ---------- ---------- ----------
Capital Lease Obligations $ 43,784 $ 14,595 $ 29,189 $ -- $ --
Credit Facility Fees 100,000 50,000 50,000 -- --
Operating Leases 980,880 359,240 621,640 -- --
---------- ---------- ---------- ---------- ----------
Total Contractual Cash Obligations $1,124,664 $ 423,835 $ 700,829 $ -- $ --
========== ========== ========== ========== ==========
The above table outlines our obligations as of December 31, 2006 and
does not reflect the changes in our obligations that occurred after that date.
IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS
In February 2007, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 159, THE FAIR
VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES. SFAS No. 159
permits entities to choose to measure, on an item-by-item basis, specified
financial instruments and certain other items at fair value. Unrealized gains
and losses on items for which the fair value option has been elected are
required to be reported in earnings at each reporting date. SFAS No. 159 is
effective for fiscal years beginning after November 15, 2007, the provisions of
which are required to be applied prospectively. We expect to adopt SFAS No. 159
in the first quarter of fiscal 2008.
In July 2006, the FASB released Financial Interpretation No. ("FIN")
48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES--AN INTERPRETATION OF FASB
STATEMENT NO. 109. FIN 48 clarifies the accounting and reporting for
uncertainties in income tax law. This interpretation prescribes a comprehensive
model for the financial statement recognition, measurement, presentation and
disclosure of uncertain tax positions taken or expected to be taken in income
tax returns. This statement is effective for fiscal years beginning after
December 15, 2006. We have evaluated the effect of FIN 48 and do not expect it
to have a material impact on our financial position, results of operations or
cash flows.
In September 2006, the FASB issued SFAS No. 157, FAIR VALUE
MEASUREMENTS, which defines the fair value, establishes a framework for
measuring fair value and expands disclosures about fair value measurements. This
statement is effective for financial statements issued for fiscal years
beginning after November 15, 2007, and interim periods within those fiscal
years. Early adoption is encouraged, provided that we have not yet issued
financial statements for that fiscal year, including any financial statements
for an interim period within that fiscal year. We are currently evaluating the
impact SFAS No. 157 may have on our financial position, results of operations or
cash flows.
47
In September 2006, the Securities and Exchange Commission issued Staff
Accounting Bulletin ("SAB") No. 108, CONSIDERING THE EFFECTS OF PRIOR YEAR
MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL
STATEMENTS. SAB No. 108 provides guidance on the consideration of the effects of
prior year misstatements in quantifying current year misstatements for the
purpose of a materiality assessment. SAB No. 108 establishes an approach that
requires quantification of financial statement errors based on the effects of
each of our balance sheets and statement of operations and the related financial
statement disclosures. SAB No. 108 permits existing public companies to record
the cumulative effect of initially applying this approach in the first year
ending after November 15, 2006 by recording the necessary correcting adjustments
to the carrying values of assets and liabilities as of the beginning of that
year with the offsetting adjustment recorded to the opening balance of retained
earnings. Additionally, the use of the cumulative effect transition method
requires detailed disclosure of the nature and amount of each individual error
being corrected through the cumulative adjustment and how and when it arose. We
implemented SAB No. 108 effective January 1, 2006 and it did not have a material
effect on our financial position, results of operations or cash flows for 2006.
In October 2006, the EITF issued EITF Issue No. 06-3, HOW TAXES
COLLECTED FROM CUSTOMERS AND REMITTED TO GOVERNMENTAL AUTHORITIES SHOULD BE
PRESENTED IN THE INCOME STATEMENT (THAT IS, GROSS VERSUS NET PRESENTATION) to
clarify diversity in practice on the presentation of different types of taxes in
the financial statements. The Task Force concluded that, for taxes within the
scope of the issue, a company may adopt a policy of presenting taxes either
gross within revenue or net. That is, it may include charges to customers for
taxes within revenues and the charge for the taxes from the taxing authority
within cost of sales, or, alternatively, it may net the charge to the customer
and the charge from the taxing authority. If taxes subject to EITF Issue No.
06-3 are significant, a company is required to disclose its accounting policy
for presenting taxes and the amounts of such taxes that are recognized on a
gross basis. The guidance in this consensus is effective for the first interim
reporting period beginning after December 15, 2006 (the first quarter of our
fiscal year 2007). We do not expect the adoption of EITF Issue No. 06-3 will
have a material impact on our financial position, results of operations or cash
flows.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Our operations were not subject to commodity price risk during 2006.
Our sales to a foreign country (Canada) were approximately 16% of our total net
sales, however, we experienced negligible foreign currency exchange rate risk.
We do not hedge against this risk.
On January 29, 2007, we replaced our then-existing asset-based line of
credit with GMAC with an asset-based line of credit with Silicon Valley Bank.
The new line of credit is for an amount of up to $10.0 million. The new line of
credit provides for an interest rate equal to the prime lending rate plus 1.0%.
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.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the consolidated financial statements and
accompanying notes included in this report, which begin on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
On December 12, 2006, we notified Singer Lewak Greenbaum & Goldstein
LLP, or SLGG, the independent registered public accounting firm that was engaged
as our principal accountant to audit our consolidated financial statements, that
we intended to engage new certifying accountants and thereby were terminating
our relationship with SLGG. Our decision to change accountants was approved by
our audit committee. The reason for the change was to allow us to engage an
alternative firm that we believe has adequate resources to provide us with the
auditing and tax services we require on a more cost-effective basis.
The audit reports of SLGG on our consolidated financial statements and
consolidated financial statement schedules as of and for the years ended
December 31, 2005 and 2004 did not contain any adverse opinion or disclaimer of
opinion, nor were they qualified or modified as to uncertainty, audit scope, or
accounting principles.
48
During the years ended December 31, 2005 and 2004 and the subsequent
interim period through December 12, 2006, there were no disagreements with SLGG
on any matter of accounting principles or practices, financial statement
disclosure, or auditing scope or procedures which disagreements, if not resolved
to SLGG's satisfaction, would have caused SLGG to make reference to the subject
matter of the disagreement in connection with its opinion.
During the years ended December 31, 2005 and 2004 and the subsequent
interim period through December 12, 2006, there were no reportable events as
described in Item 304(a)(1)(v) of Regulation S-K under the Securities Act of
1933, as amended, except as described below.
o 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
(the "Exchange Act"), as of December 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.
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 and SLGG identified the
following two material weaknesses which caused management to
conclude that, as of December 31, 2005, our disclosure controls
and procedures were not effective at the reasonable assurance
level:
1. As a result of our restatement of prior periods' 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, 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. Although we
were able to timely file our Forms 10-Q for the quarters ended
June 30, 2005 and September 30, 2005, and our Form 10-K for the
year ended December 31, 2005, management evaluated, in the first
quarter of 2006 and as of December 31, 2005, 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 concluded, in the first quarter of 2006 and as
of December 31, 2005, that the control deficiency that resulted in
the inability to timely make these filings represented a material
weakness.
2. 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. Although we were
able to timely file our Forms 10-Q for the quarters ended June 30,
2005 and September 30, 2005, and our Form 10-K for the year ended
December 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 concluded, in the first
quarter of 2006 and as of December 31, 2005, that the control
deficiency that resulted in our lack of sufficient personnel
represented a material weakness.
o Management and SLGG identified the following material weakness
which caused management to conclude that, as of June 30, 2006, our
disclosure controls and procedures were not effective at the
reasonable assurance level:
49
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. In addition, our
former Chief Financial Officer resigned in June 2006 and we have
not yet located a suitable candidate to fill that position.
Although we were able to timely file our Forms 10-Q for the
quarters ended June 30, 2005 and September 30, 2005, our Form 10-K
for the year ended December 31, 2005 and our Forms 10-Q for the
quarters ended March 31, 2006 and June 30, 2006, management
evaluated the impact of our lack of sufficient finance and
accounting personnel, including the departure of our former Chief
Financial Officer in June 2006, on our assessment of our
disclosure controls and procedures and concluded, in the third
quarter of 2006 and as of June 30, 2006, that the control
deficiency that resulted in our lack of sufficient personnel
represented a material weakness.
On December 12, 2006, we engaged Swenson Advisors LLP, or Swenson, as
our new independent registered public accounting firm. We had not consulted with
Swenson in the past regarding the application of accounting principles to a
specified transaction or the type of audit opinion that might be rendered on our
financial statements or as to any disagreement or reportable event as described
in Item 304(a)(1)(iv) and Item 304(a)(1)(v).
On December 15, 2006, we provided SLGG with a copy of the disclosures
we made in response to Item 304(a) of the Securities Act. We requested and
received from SLGG a letter addressed to the Securities and Exchange Commission
which stated that SLGG agreed with the statements we made in response to Item
304(a).
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
We conducted an evaluation under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief
Financial Officer of the effectiveness of the design and operation of our
disclosure controls and procedures. The term "disclosure controls and
procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
and Exchange Act of 1934, as amended ("Exchange Act"), means controls and other
procedures of a company that are designed to ensure that information required to
be disclosed by the company in the reports it files or submits under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the Securities and Exchange Commission's rules and forms.
Disclosure controls and procedures also include, without limitation, controls
and procedures designed to ensure that information required to be disclosed by a
company in the reports that it files or submits under the Exchange Act is
accumulated and communicated to the company's management, including its
principal executive and principal financial officers, or persons performing
similar functions, as appropriate, to allow timely decisions regarding required
disclosure. Based on this evaluation, our Chief Executive Officer and Chief
Financial Officer concluded as of December 31, 2006 that our disclosure controls
and procedures were not effective at the reasonable assurance level due to the
material weaknesses discussed immediately below.
A material weakness is defined by the Public Company Accounting
Oversight Board's Audit Standard No. 2 as being a significant deficiency, or
combination of significant deficiencies, that results in more than a remote
likelihood that a material misstatement of the financial statements would not be
prevented or detected. A significant deficiency is a control deficiency, or
combination of control deficiencies, that adversely affects the company's
ability to initiate, authorize, record, process, or report external financial
data reliably in accordance with generally accepted accounting principles such
that there is more than a remote likelihood that a misstatement of the company's
annual or interim financial statements that is more than inconsequential will
not be prevented or detected.
Management has identified the following material weaknesses which
caused management to conclude that, as of December 31, 2006, our disclosure
controls and procedures were not effective at the reasonable assurance level:
50
1. In conjunction with preparing our Form 10-K for the period ended
December 31, 2006, management reviewed, in the first quarter of 2007, our
accounting methodologies relating to (a) our accounting for reserves for sales
incentives, and (b) our accounting for direct labor and production expenses
related to production and handling of our products. As a result of this review,
management concluded, in the first quarter of 2007, that our accounting
methodologies were not in accordance with generally accepted accounting
principles and that our consolidated financial statements for the years ended
December 31, 2005, 2004, 2003 and 2002 and for each of the quarterly periods in
the years ended December 31, 2005, 2004 and 2003, and through the nine months
ended September 30, 2006, had been misstated. Based upon this conclusion, our
Audit Committee and senior management decided, in the second quarter of 2007, to
restate our consolidated financial statements as of and for the years ended
December 31, 2005, 2004, 2003 and 2002 and for each of the quarterly periods in
the years ended December 31, 2005, 2004 and 2003, and through the nine months
ended September 30, 2006, to reflect the corrections in our accounting
methodologies.
Management evaluated, in the second quarter of 2007 and as of
December 31, 2006, the impact of this restatement on our assessment of our
disclosure controls and procedures and concluded, in the second quarter of 2007
and as of December 31, 2006, that the control deficiency that resulted in the
incorrect accounting methodologies pertaining to (a) our accounting for reserves
for sales incentives, and (b) our accounting for direct labor and production
expenses related to production and handling of our products, represented a
material weakness.
2. 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, 2006. Management evaluated,
in the second quarter of 2007 and as of December 31, 2006, 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
concluded, in the second quarter of 2007 and as of December 31, 2006, that the
control deficiency that resulted in the inability to timely make these filings
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, 2006, in the periods specified below, which correspond to the two material
weaknesses identified above:
1. We have revised our accounting methodology as it relates to our
accounting for reserves for sales incentives.
Prior to the fourth quarter of 2006, we did not adequately disclose the
fair value of accounts receivable. According to vendor agreements with specific
customers, our customers have the right to offset approved sales incentives,
market development/cooperative advertising funds, cross dock fees and
point-of-sale rebates, which we previously reported as current liabilities,
against future payments on their accounts. We determined, as allowed by
Accounting Principles Bulletin No. 10, paragraph 7(1), and FASB Interpretation
No. 39, OFFSETTING AMOUNTS RELATED TO CERTAIN CONTRACTS, that it is appropriate
to offset such accruals against accounts receivable. We have determined the
effect of the correction on our previously issued financial statements and have
restated our financial statements for the year ended December 31, 2005 and for
each of the quarterly periods in the year ended December 31, 2005 and through
the nine months ended September 30, 2006. Beginning with the quarter ended
December 31, 2006, we offset these sales incentives against accounts receivable.
The revision of our accounting methodology as it relates to sales incentives was
completed in the second quarter of 2007. We began using this new methodology for
the quarter ended December 31, 2006 and all periods included in this report now
reflect this change. In addition, this methodology applies to all periods
subsequent to December 31, 2006.
51
We have revised our accounting methodology as it pertains to our
accounting for direct labor and production expenses related to production of our
products. Upon further examination of our accounting methodology for direct
labor and production expenses related to production of our products, we
determined that we made an error in our application of the relevant accounting
principles and determined that we should have classified these costs as part of
cost of goods sold rather than as general and administrative expenses. 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, 2005, 2004, 2003 and 2002 and for each of the quarterly periods in
the years ended December 31, 2005 and 2004 and through the nine months ended
September 30, 2006. Beginning with the quarter ended December 31, 2006, we
classified direct labor and production expenses related to production of our
products as an element of cost of goods sold rather than as general and
administrative expenses. The revision of our accounting methodology as it
relates to our accounting for direct labor and production expenses related to
production of our products was completed in the second quarter of 2007. We began
using this new methodology for the quarter ended December 31, 2006 and all
periods included in this report now reflect this change. In addition, this
methodology applies to all periods subsequent to December 31, 2006.
In addition, on November 15, 2006, we hired a new Chief Financial
Officer with several years of experience in our industry as well as with
publicly traded companies. We also retained additional professional accounting
consultants to assist us in preparing our restated financial statements and
other financial information contained in this report. We also 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 certain accounting matters.
Management believes that the remediation described in item 1
immediately above has remediated the corresponding material weakness also
described above. Management is unable, however, to estimate our capital or other
expenditures associated with this remediation.
2. Management believes that the procedures we implemented in connection
with the restatement of our financial statements, and the circumstances
surrounding the restatement, have led to improved and expedited financial
reporting processes which we expect will better enable us to timely file our
periodic reports. We intend, in 2007, 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.
In addition, as noted above, on November 15, 2006, we hired a new Chief
Financial Officer with many years of experience in our industry as well as with
publicly traded companies, we retained additional professional accounting
consultants to assist us in preparing our financial statements, and we also
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 certain accounting matters.
Management expects that the remediation described in item 2 above will
remediate the corresponding material weakness also described above by December
31, 2007. Management is unable, however, to estimate our capital or other
expenditures associated with this remediation.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
The change noted above, specifically, our hiring of a new Chief
Financial Officer on November 15, 2006, is the only change during our most
recently completed fiscal quarter that has materially affected or is reasonably
likely to materially affect, our internal control over financial reporting, as
defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.
ITEM 9B. OTHER INFORMATION
None.
52
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
DIRECTORS AND EXECUTIVE OFFICERS
The names, ages and positions held by our directors and executive
officers as of July 9, 2007 and their business experience are as follows:
NAME AGE TITLES
- ---- --- ------
Tony Shahbaz 45 Chairman of the Board, President, Chief
Executive Officer, Secretary, Director
Thomas L. Gruber 62 Chief Financial Officer and Chief Operating
Officer
Steel Su 55 Director
Daniel Yao(1) 51 Director
Dr. William Ting (1) 59 Director
______________
(1) Member of the Audit, Compensation and Nominating Committees.
TONY SHAHBAZ is a founder of I/OMagic and has served as our Chairman of
the Board, President, Chief Executive Officer, Secretary and as a director since
September 1993, and as our Chief Financial Officer from September 1993 to
October 2002. Prior to founding I/OMagic, Mr. Shahbaz was employed by Western
Digital Corporation from September 1986 to March 1993. During his tenure at
Western Digital Corporation, Mr. Shahbaz held several positions including Vice
President of Worldwide Sales for its Western Digital Paradise division, and
Regional Director of Asia Pacific Sales and Marketing Operations.
THOMAS L. GRUBER joined I/OMagic as our Chief Financial Officer on
November 15, 2006. Prior to assuming this position, and from July 2004 through
October 2006, Mr. Gruber was a Partner in a private investment group
specializing in management and leveraged buyouts. Prior to that time, and from
January 2001 to July 2004, Mr. Gruber was President and Chief Financial Officer
of nStor Technologies, an American Stock Exchange listed public company that
designed, developed and manufactured enterprise storage hardware and software.
Mr. Gruber received a BBA degree in Accounting from Ohio University and an MBA
from Pepperdine University with a concentration in Management/Marketing.
STEEL SU has served as a director of I/OMagic since September 2000 and
is a founder of Behavior Tech Computer Corp., one of our principal subcontract
manufacturers and stockholders and has served as its Chairman since 1980. Mr. Su
has served and continues to serve as a director or chairman of the following
affiliates of Behavior Tech Computer Corp.: Behavior Design Corporation
(chairman), Behavior Tech Computer (USA) Corp. (chairman), Behavior Tech
Computer Affiliates, N.V. (chairman) and BTC Korea Co., Ltd. (director). Mr. Su
has served as chairman of Gennet Technology Corp., Emprex Technologies Corp.,
Maritek Inc. and MaxD Technology Inc. since 1992, 1998, 1999 and 2000,
respectively. Mr. Su has also served as a director of Aurora Systems Corp. and
Wearnes Peripherals International (PTE) Limited since 1998 and 2000,
respectively. Mr. Su received a B.S. degree in Electronic Engineering from Ching
Yuan Christian University, Taiwan in 1974 and an M.B.A. degree from National
Taiwan University in 2001.
DANIEL YAO has served as a director of I/OMagic since February 2001 and
has been a Chief Strategy Officer for Ritek Corporation, an affiliate of Citrine
Group Limited, one of our stockholders, since July 2000. Prior to joining Ritek,
Mr. Yao served as the Senior Investment Consultant for Core Pacific Securities
Capital from July 1998 to July 2000. Prior to that, Mr. Yao was an Executive
Vice President for ABN Amro Bank in Taiwan from July 1996 to July 1998. Mr. Yao
received a B.A. degree in Business Management from National Taiwan University in
1978 and an M.B.A. degree from the University of Rochester in New York in 1984.
DR. WILLIAM TING has served as a director of I/OMagic since December
2005. Dr. Ting is currently Chairman of the Global Advisory Committee for
Redwood Securities. Prior to that, Dr. Ting was founder, Chairman and CEO of
US-Sino Gateway from 2002 to 2005. Prior to that, Dr. Ting was CEO of Adminisoft
in 2001, President and CEO of DataQuad in 2000, President and CEO of BMDP
Statistical Software from 1991 to 1992, and Corporate Director of Financial
Planning and Corporate Vice President of Information Technology of Geneva
Companies from 1989 to 1991. Dr. Ting served as Director of Strategic Planning
at Northrop EMD from 1986 to 1989. Dr. Ting served as Manager of Market
Research, Manager of International Offset and Director of Planning at General
Dynamics units from 1982 To 1986. Dr. Ting was an assistant professor of
political science at the University of Michigan from 1978 to 1982. Dr. Ting
received a B.A. degree in Political Science from Illinois State University in
1970, an M.A. in Political Science from Illinois State University in 1972 and a
Ph.D. in Political Science from the University of Washington in 1976.
53
Our directors are elected annually and hold office until the next
annual meeting of stockholders, until their respective successors are elected
and qualified or until their earlier death, resignation or removal.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934, as amended,
requires our executive officers, directors and persons who beneficially own more
than 10% of a registered class of our equity securities, or reporting persons,
to file initial reports of ownership and reports of changes in ownership of our
common stock and other equity securities with the Securities and Exchange
Commission. The reporting persons are required by the Securities and Exchange
Commission regulations to furnish us with copies of all reports that they file.
Based solely upon a review of copies of the reports furnished to us
during our fiscal year ended December 31, 2006 and thereafter, or any written
representations received by us from reporting persons that no other reports were
required, we believe that all Section 16(a) filing requirements applicable to
our reporting persons during 2006 were complied with.
CODES OF ETHICS
Our board of directors has adopted a Code of Business Conduct and
Ethics that applies to all of our directors, officers and employees and an
additional Code of Business Ethics that applies to our Chief Executive Officer
and senior financial officers. The Codes of Ethics, as applied to our principal
executive officer, principal financial officer and principal accounting officer
constitutes our "code of ethics" within the meaning of Section 406 of the
Sarbanes-Oxley Act of 2002. We intend to satisfy the disclosure requirement
under Item 5.05 of Form 8-K relating to amendments to or waivers from provisions
of these codes that relate to one or more of the items set forth in Item 406(b)
of Regulation S-K, by describing on our Internet website, located at
http://www.iomagic.com, within four business days following the date of a waiver
or a substantive amendment, the date of the waiver or amendment, the nature of
the amendment or waiver, and the name of the person to whom the waiver was
granted. Information on our Internet website is not, and shall not be deemed to
be, a part of this report or incorporated into any other filings we make with
the Securities and Exchange Commission.
BOARD OF DIRECTORS
Our business, property and affairs are managed under the direction of
our board of directors. Directors are kept informed of our business through
discussions with our executive officers, by reviewing materials provided to them
and by participating in meetings of our board of directors and its committees.
Our bylaws provide that our board of directors shall consist of at least six
directors.
During 2006, our board of directors held five meetings. During 2006,
each incumbent director attended at least 75% of the aggregate of the total
number of meetings of the board of directors for which he was a director and the
total number of meetings held by all committees of the board on which he served
during the periods that he served.
BOARD COMMITTEES
Our board of directors currently has Audit, Compensation and Nominating
Committees.
The Audit Committee selects our independent registered public
accounting firm, reviews the results and scope of the audit and other services
provided by our independent registered public accounting firm and reviews our
financial statements for each interim period and for our year end. This
committee consists of Mr. Yao and Dr. Ting. The Audit Committee held six
meetings during 2006. Our board of directors has determined that Mr. Yao and
Dr. Ting are Audit Committee financial experts. Our board of directors has also
determined that Mr. Yao and Dr. Ting are "independent" as defined in NASD
Marketplace Rule 4200(a)(15). The Audit Committee operates pursuant to a charter
approved by our board of directors and Audit Committee, according to the rules
and regulations of the Securities and Exchange Commission.
The Compensation Committee is responsible for establishing and
administering our policies involving the compensation of all of our executive
officers and establishing and recommending to our board of directors the terms
and conditions of all employee and consultant compensation and benefit plans.
Our entire board of directors also may perform these functions with respect to
our employee stock option plans. The Compensation Committee consists of Mr. Yao
and Dr. Ting. The Compensation Committee held one meeting during 2006. The
Compensation Committee operates pursuant to a charter approved by our board of
directors and Compensation Committee.
54
The Nominating Committee selects nominees for the board of directors.
The Nominating Committee consists of Mr. Yao and Dr. Ting. The Nominating
Committee utilizes a variety of methods for identifying and evaluating nominees
for director, including candidates that may be referred by stockholders.
Stockholders that desire to recommend candidates for evaluation may do so by
contacting I/OMagic in writing, identifying the potential candidate and
providing background information. Candidates may also come to the attention of
the Nominating Committee through current board members, professional search
firms and other persons. In evaluating potential candidates, the Nominating
Committee will take into account a number of factors, including, among others,
the following:
o independence from management;
o relevant business experience and industry knowledge;
o judgment, skill, integrity and reputation;
o existing commitments to other businesses;
o corporate governance background;
o financial and accounting background, to enable the Nominating
Committee to determine whether the candidate would be suitable for
Audit Committee membership; and
o the size and composition of the board.
The Nominating Committee held no meetings during 2006. The Nominating
Committee operates pursuant to a charter approved by our board of directors and
Nominating Committee.
SECURITY HOLDER COMMUNICATIONS WITH THE BOARD OF DIRECTORS
Our board of directors has established a process to receive
communications from security holders. Security holders and other interested
parties may contact any member (or all members) of the board of directors, or
the independent directors as a group, any committee of the board of directors or
any chair of any such committee, by mail. To communicate with the board of
directors, any individual directors or any group or committee of directors,
correspondence should be addressed to the board of directors or any such
individual directors or group or committee of directors by either name or title.
All such correspondence should be sent "c/o Secretary" at 4 Marconi, Irvine,
California 92618.
All communications received as set forth in the preceding paragraph
will be opened by the Secretary for the sole purpose of determining whether the
contents represent a message to our directors. Any contents that are not in the
nature of advertising, promotions of a product or service, patently offensive
material or matters deemed inappropriate for the board of directors will be
forwarded promptly to the addressee. In the case of communications to the board
of directors or any group or committee of directors, our Secretary will make
sufficient copies of the contents to send to each director who is a member of
the group or committee to which the envelope is addressed.
COMPENSATION OF DIRECTORS
Other than Dr. William Ting, our directors do not receive any cash
compensation for their services as members of our board of directors; however,
each director is entitled to reimbursement of his reasonable expenses incurred
in attending meetings of our board of directors. Dr. Ting receives $1,500 per
meeting for his attendance at meetings of our board of directors and its
committees. We do not have a predetermined or automatic annual or other
periodic program for grants of equity compensation to our directors. Equity
compensation is granted as and when determined appropriate by our Compensation
Committee or our full board.
COMPENSATION OF EMPLOYEE DIRECTOR
Mr. Shahbaz was compensated as a full-time employee and officer but
received no additional compensation for service as a board member during 2006.
Information regarding the compensation awarded to Mr. Shahbaz is included in the
"Summary Compensation Table" below.
DIRECTOR COMPENSATION TABLE
The following table summarizes the compensation of our directors for
the year ended December 31, 2006:
FEES EARNED
OR PAID OPTION ALL OTHER
IN CASH AWARDS COMPENSATION TOTAL
NAME ($) ($)(1) ($)(2) ($)
- --------------------------- --------------- --------------- --------------- ---------------
Steel Su(3) $ -- $ 7,959 $ -- $ 7,959
Daniel Yao(4) -- 9,309 -- 9,309
Dr. William Ting(5) 10,500 -- 3,550 14,050
- -----------
55
(1) The amounts shown are the compensation costs recognized in our financial
statements for 2006 related to grants of stock options to each director in
previous years, to the extent we recognized compensation cost in 2006 for
such awards in accordance with the provisions of SFAS No. 123R.
(2) The value of perquisites and other personal benefits was less than $10,000
in aggregate for each director. However, we paid Dr. Ting an aggregate of
$3,550 for his time spent with our management on strategic financial and
product review and analysis.
(3) At December 31, 2006, Mr. Su held options to purchase an aggregate of
28,000 shares of our common stock.
(4) At December 31, 2006, Mr. Yao held options to purchase an aggregate of
33,000 shares of our common stock.
(5) At December 31, 2006, Mr. Ting held no options to purchase shares of our
common stock.
INDEMNIFICATION OF DIRECTORS AND OFFICERS
Our amended and restated articles of incorporation, or Articles, and
our amended and restated bylaws, or Bylaws, provide that we shall, to the
fullest extent permitted by Section 78.751 of the Nevada Revised Statutes,
indemnify all persons that we have power to indemnify against all expenses,
liabilities or other matters covered by Section 78.751. This indemnification is
not exclusive of any other indemnification rights to which those persons may be
entitled and must cover action both in an official capacity and in another
capacity while holding office. Indemnification continues as to a person who has
ceased to be a director, officer, employee or agent and extends to the benefit
of the heirs, executors and administrators of that person. Section 78.751
provides that the expenses of our officers and directors incurred in defending a
civil or criminal action, suit or proceeding must be paid by us as they are
incurred and in advance of the final disposition of the action, suit or
proceeding, upon receipt of an undertaking by or on behalf of the director or
officer to repay the amount if it is ultimately determined by a court of
competent jurisdiction that the director or officer is not entitled to
indemnification.
Our Articles also provide that a director of I/OMagic shall not be
liable to us or our stockholders for monetary damages for breach of fiduciary
duty as a director, except to the extent exemption from limitation or liability
is not permitted under the Nevada Revised Statutes. Any amendment, modification
or repeal of this provision by our stockholders would not adversely affect any
right or protection of a director of I/OMagic in respect of any act or omission
occurring prior to the time of the amendment, modification or repeal. Our
Articles do not, however, eliminate or limit a director's liability for any act
or omission involving intentional misconduct, fraud or a knowing violation of
law, or the payment of unlawful distributions to stockholders. Furthermore, they
do not limit liability for claims against a director arising out of the
director's responsibilities under the federal securities laws or any other law.
However, we have purchased directors and officers liability insurance to protect
our directors and executive officers against liability under circumstances
specified in the policy.
Section 2115 of the California General Corporation Law, or the
California Code, provides that corporations such as I/OMagic that are
incorporated in jurisdictions other than California and that meet various tests
are subject to several provisions of the California Code, to the exclusion of
the law of the jurisdiction in which the corporation is incorporated. We believe
that as of December 31, 2006, we met the tests contained in Section 2115.
Consequently, we are subject to, among other provisions of the California Code,
Section 317 which governs indemnification of directors, officers and others.
Section 317 generally eliminates the personal liability of a director for
monetary damages in an action brought by or in the right of I/OMagic for breach
of a director's duties to I/OMagic or our stockholders except for liability:
o for acts or omissions that involve intentional misconduct or a
knowing and culpable violation of law;
o for acts or omissions that a director believes to be contrary to
the best interests of I/OMagic or our stockholders or that involve
the absence of good faith on the part of the director;
o for any transaction from which a director derived an improper
personal benefit;
o for acts or omissions that show a reckless disregard for the
director's duty to I/OMagic or our stockholders in circumstances
in which the director was aware, or should have been aware, in the
ordinary course of performing a director's duties, of a risk of
serious injury to I/OMagic or our stockholders;
o for acts or omissions that constitute an unexcused pattern of
inattention that amounts to an abdication of the director's duty
to I/OMagic or our stockholders; and
56
o for engaging in transactions described in the California Code or
California case law which result in liability, or approving the
same kinds of transactions.
We may enter into separate indemnification agreements with each of our
directors and executive officers that provide the maximum indemnity allowed to
directors and executive officers by applicable law and which allow for certain
procedural protections. We also maintain directors and officers insurance to
insure such persons against certain liabilities.
These indemnification provisions and the indemnification agreements
that may be entered into between us and our directors and executive officers may
be sufficiently broad to permit indemnification of our directors and executive
officers for liabilities (including reimbursement of expenses incurred) arising
under the Securities Act.
To the extent indemnification for liabilities arising under the
Securities Act may be extended to directors, officers and controlling persons of
I/OMagic under the foregoing provisions, or otherwise, we have been advised that
in the opinion of the SEC such indemnification is against public policy as
expressed in the Securities Act, and is, therefore, unenforceable. In the event
that a claim for indemnification against such liabilities is asserted by any
director, officer or controlling person in connection with the securities being
registered (other than the payment by the registrant of expenses incurred or
paid by a director, officer or controlling person of the registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities being
registered, the registrant will, unless in the opinion of its counsel the matter
has been settled by controlling precedent, submit to a court of appropriate
jurisdiction the question of whether the proposed indemnification by it is
against public policy as expressed in the Securities Act and will be governed by
the court's final adjudication of the issue.
The inclusion of the above provisions in our Articles and Bylaws and in
our indemnification agreements with our officers and directors may have the
effect of reducing the likelihood of derivative litigation against our directors
and may discourage or deter stockholders or management from bringing a lawsuit
against our directors for breach of their duty of care, even though the action,
if successful, might otherwise have benefited us and our stockholders. At
present, there is no litigation or proceeding pending involving any of our
directors as to which indemnification is being sought, nor are we aware of any
threatened litigation that may result in claims for indemnification by any of
our directors.
ITEM 11. EXECUTIVE COMPENSATION.
COMPENSATION DISCUSSION AND ANALYSIS
COMPENSATION PHILOSOPHY AND COMPONENTS
This section discusses the principles underlying our executive
compensation policies and decisions and the most important factors relevant to
an analysis of these policies and decisions. It provides qualitative information
regarding the manner and context in which compensation is awarded to and earned
by our executive officers and places in perspective the data presented in the
tables and narrative that follow.
Our compensation committee is responsible for reviewing and approving
base salaries, bonuses and incentive awards for all executive officers,
reviewing and establishing the base salary, bonuses and incentive awards for the
chief executive officer, and reviewing, approving and recommending to the board
of directors the content, terms and conditions of all employee compensation and
benefit plans, or changes to those plans.
Our compensation philosophy is based upon four central objectives:
o To provide an executive compensation structure and system that is
both competitive in the outside industrial marketplace and also
internally equitable based upon the weight and level of
responsibilities in the respective executive positions;
o To attract, retain and motivate qualified executives within this
structure, and reward them for outstanding
performance-to-objectives and business results through financial
and other appropriate management incentives;
o To align our financial results and the compensation paid to our
executive officers with the enhancement of stockholder value; and
57
o To structure our compensation policy so that executive officers'
compensation is dependent, in one part, on the achievement of its
current year business plan objectives, and in another part, on the
long-term increase in company net worth and the resultant
improvement in stockholder value, and to maintain an appropriate
balance between short- and long-range performance objectives over
time.
Our executive officers' compensation currently has three primary
components -- base compensation or salary, annual discretionary cash bonuses,
and stock option awards granted pursuant to our 2002 and 2003 Stock Option
Plans. In addition, we provide our executive officers a variety of benefits that
generally are offered to all salaried employees in the geographical location
where they are based.
We view the various components of compensation as related but distinct.
Although our compensation committee does review total compensation, we do not
believe that significant compensation derived from one component of compensation
should negate or reduce compensation from other components. We determine the
appropriate level for each compensation component based in part, but not
exclusively, on our view of internal equity and consistency, and other
considerations we deem relevant, such as rewarding extraordinary performance.
Our compensation committee has not adopted any formal or informal policies or
guidelines for allocating compensation between long-term and short term
compensation, between cash and non-cash compensation, or among different forms
of non-cash compensation.
BASE COMPENSATION
Base compensation is targeted to recognize each executive officer's
unique value and historical contributions to our success in light of salary
norms in our industries and the general marketplace. The criteria for
measurement include data available from objective, professionally-conducted
market studies, integrated with additional competitive intelligence secured from
a range of industry and general market sources. Our compensation committee
reviews the base compensation of the chief executive officer, and with the chief
executive officer, the base compensation of all other executive officers,
periodically to assure that a competitive position is maintained.
EQUITY COMPENSATION
We use stock options to reward long-term performance. Our compensation
committee and/or our board of directors act as the manager of our option plans
and perform functions that include selecting option recipients, determining the
timing of option grants and whether options are incentive or non-qualified, and
assigning the number of shares subject to each option, fixing the time and
manner in which options are exercisable, setting option exercise prices and
vesting and expiration dates, and from time to time adopting rules and
regulations for carrying out the purposes of our plans. For compensation
decisions regarding the grant of equity compensation to executive officers, our
compensation committee typically considers recommendations from our chief
executive officer.
We do not have any program, plan or obligation that requires us to
grant equity compensation on specified dates. We have not made equity grants in
connection with the release or withholding of material non-public information.
Historically, options granted to our directors and executive officers have
generally had exercise prices above the then trading price of our common stock.
Information about outstanding options held by our named executive officers and
directors is contained in the "Outstanding Equity Awards at Fiscal Year End" and
"Director Compensation" tables.
CASH BONUSES
Executive bonuses are used to focus our management on achieving key
corporate financial objectives, to motivate certain desired individual behaviors
and to reward substantial achievement of these company financial objectives and
individual goals. We use cash bonuses to reward performance achievements
generally only as to years in which we are substantially profitable, and we use
salary as the base amount necessary to match our competitors for executive
talent.
Bonuses, if any, are determined and paid on an annual basis after
completion of the bonus year. We paid a total of $39,103 in bonuses to our named
executive officers for 2006.
In the past, our compensation committee has based bonuses for our named
executive officers on net income. However, our compensation committee believes a
profitable company with little or no growth is not acceptable. Our compensation
committee considers the chosen metrics of net income and growth in revenue to be
the best indicators of our financial success and creation of stockholder value
and expects to design future bonus plans to account for these different metrics.
58
Individual performance objectives are determined by the executive
officer to whom the potential bonus recipient reports or, in the case of our
chief executive officer, by our compensation committee. For example, the basis
for Mr. Shahbaz's bonus might include such objectives as developing bank and
equity financing, successfully concluding and integrating acquisitions,
developing strategic opportunities or developing our executive team.
Our compensation committee has not considered whether it would attempt
to recover bonuses paid based on our financial performance where our financial
statements are restated in a downward direction sufficient to reduce the amount
of bonus that should have been paid under applicable bonus criteria.
ACCOUNTING AND TAX TREATMENT
We account for share-based compensation paid to our employees under the
rules of SFAS No. 123R, which requires us to estimate and record an expense over
the service period of the award. Accounting rules also require us to record cash
compensation as an expense at the time the obligation is accrued. Unless and
until we achieve sustained profitability, the availability to us of a tax
deduction for compensation expense will not be material to our financial
position. We structure cash bonus compensation so that it is taxable to our
executives at the time it becomes available to them. We currently intend that
all cash compensation paid will be tax deductible for us. However, with respect
to equity compensation awards, while any gain recognized by employees from
nonqualified options should be deductible, to the extent that an option
constitutes an incentive stock option, gain recognized by the optionee will not
be deductible if there is no disqualifying disposition by the optionee. In
addition, if we grant restricted stock or restricted stock unit awards that are
not subject to performance vesting, they may not be fully deductible by us at
the time the award is otherwise taxable to the employee.
OTHER BENEFITS
We also maintain other executive benefits that we consider necessary in
order to offer fully competitive opportunities to our executive officers. These
include, without limitation, 401(k) retirement savings plans, car allowances and
employment agreements. The compensation committee continues to monitor and
evaluate our executive compensation system and its application throughout our
organization to assure that it continues to reflect our compensation philosophy
and objectives.
Executive officers are eligible to participate in all of our employee
benefit plans, such as medical, dental, vision, group life, disability, and
accidental death and dismemberment insurance, in each case on the same basis as
other employees.
THE FOLLOWING COMPENSATION COMMITTEE REPORT IS NOT DEEMED FILED WITH
THE SECURITIES AND EXCHANGE COMMISSION. NOTWITHSTANDING ANYTHING TO THE CONTRARY
SET FORTH IN ANY OF OUR PREVIOUS FILINGS MADE UNDER THE SECURITIES ACT OR UNDER
THE EXCHANGE ACT THAT MIGHT INCORPORATE FUTURE FILINGS MADE BY US UNDER THOSE
STATUTES, THE COMPENSATION COMMITTEE REPORT WILL NOT BE INCORPORATED BY
REFERENCE INTO ANY SUCH PRIOR FILINGS OR INTO ANY FUTURE FILINGS MADE BY US
UNDER THOSE STATUTES.
COMPENSATION COMMITTEE REPORT
The Compensation Committee has reviewed and discussed the foregoing
Compensation Discussion and Analysis with management, and based on that review
and discussion, the Compensation Committee recommended to the board of directors
that the Compensation Discussion and Analysis be included in the Annual Report
on Form 10-K for the year ended December 31, 2006.
Respectfully submitted,
Compensation Committee
Daniel Yao
Dr. William Ting
59
SUMMARY COMPENSATION TABLE
The following table sets forth summary information concerning the
compensation of our principal executive officer, our current chief operating
officer and principal financial officer, and our former principal financial
officer (collectively, the "named executive officers"), for all services
rendered in all capacities to us for the year ended December 31, 2006.
NON-EQUITY
OPTION INCENTIVE PLAN ALL OTHER
NAME AND SALARY BONUS AWARDS COMPENSATION COMPENSATION TOTAL
PRINCIPLE POSITION YEAR ($) ($) ($)(1) ($) ($)(2) ($)
- ------------------------------- ---- --------- --------- ---------- ------------ ------------ ----------
Tony Shahbaz
President, Chief Executive
Officer and Secretary 2006 $ 198,500 $ -- $ 66,192 $ 39,103(3) $ --(4) $ 303,795
Thomas L. Gruber(5)
Chief Operating Officer and
Chief Financial Officer 2006 20,274 -- 12,824 -- -- 33,098
Steve Gillings(6) 2006
Former Chief Financial Officer 49,521 -- -- -- -- 49,521
- ------------
(1) The amounts shown are the compensation costs recognized in our financial
statements for 2006 related to grants of stock options to certain named
executive officers in prior years, to the extent we recognized compensation
cost in 2006 for such awards in accordance with the provisions of SFAS No.
123R. For a discussion of valuation assumptions used in the SFAS No. 123R
calculations, see Notes 6 and 7 of Notes to Consolidated Financial
Statements included elsewhere in this report. The options were issued under
our 2002 and 2003 Stock Option Plans. Information regarding the vesting
schedule for Messrs. Shahbaz and Gruber is included in the footnotes to the
"Outstanding Equity Awards at Fiscal Year-End" table below.
(2) The value of perquisites and other personal benefits was less than $10,000
in aggregate for each executive other than Mr. Shahbaz.
(3) Represents compensation under Mr. Shahbaz's Employment Agreement based on
our quarterly net income. See "Employment Agreement--Tony Shahbaz" below.
(4) Mr. Shahbaz is entitled to an automobile allowance in the amount of $1,200
per month under his Employment Agreement. However, in lieu of this
allowance, Mr. Shahbaz used until December 2006 an automobile we purchased
in August 2005 for $84,597. In December 2006, we traded this automobile in
against another automobile that Mr. Shahbaz uses. We purchased the second
automobile for $68,034, not including the trade-in value of the first
vehicle.
(5) Mr. Gruber became an employee on November 2, 2006 and became our Chief
Financial Officer effective November 15, 2006.
(6) Mr. Gillings resigned and his employment terminated effective June 14,
2006.
EMPLOYMENT AGREEMENT
TONY SHAHBAZ
On October 15, 2002, we entered into an employment agreement with Tony
Shahbaz. Under the terms of the employment agreement, which were retroactively
effective as of January 1, 2002, Mr. Shahbaz serves as our President and Chief
Executive Officer and is entitled to receive an initial annual salary of
$198,500 and is eligible to receive quarterly bonuses equal to 7% of our
quarterly net income. Mr. Shahbaz is also entitled to a monthly car allowance
equal to $1,200. The employment agreement terminates on October 15, 2007;
however, it is subject to automatic renewal. Under the terms of the employment
agreement, if Mr. Shahbaz is terminated for cause, he is entitled to receive
four times his annual salary and any and all warrants and options granted to him
shall be extended an additional seven years from date of termination and upon
termination without cause, he is entitled to receive his remaining salary and
other benefits for the remaining term of the employment agreement. Mr. Shahbaz's
employment agreement further provides that the agreement shall not be terminated
without the prior written consent of Mr. Shahbaz in the event of a merger,
transfer of assets, or dissolution of I/OMagic, and that the rights, benefits,
and obligations under the employment agreement shall be assigned to the
surviving or resulting corporation or the transferee of our assets.
60
GRANTS OF PLAN-BASED AWARDS
The following table sets forth summary information regarding all grants
of plan-based awards made to our named executive officers during the year ended
December 31, 2006. As of the end of 2006, none of the named executive officers
held any performance-based equity or non-equity incentive awards.
ALL OTHER OPTION
AWARDS: NUMBER OF GRANT DATE FAIR VALUE
SECURITIES UNDERLYING OF STOCK AND OPTION
NAME GRANT DATE OPTIONS (#)(1) AWARDS($)(2)
- ----------------------------- ----------------- --------------------- ----------------------
Tony Shahbaz -- -- $ --
Thomas L. Gruber November 2, 2006 50,000 32,135
Steve Gillings -- -- --
______________
(1) The stock awards reported in the above table represent shares of stock
granted under our 2003 Stock Option Plan. Mr. Gruber's grant vested
immediately as to 25,000 shares and vests in 48 equal monthly installments
commencing on December 2, 2006. .
(2) The dollar value of the options shown represents the grant date fair value
estimated using the Black-Scholes option pricing model to determine grant
date fair value, in accordance with the provisions of SFAS 123R. For a
discussion of valuation assumptions used in the SFAS 123R calculations, see
Note 17 of Notes to Consolidated Financial Statements included elsewhere in
this report. The actual value, if any, that an executive may realize on
each option will depend on the excess of the stock price over the exercise
price on the date the option is exercised and the shares underlying such
option are sold. There is no assurance that the actual value realized by an
executive will be at or near the value estimated by the Black-Scholes
model.
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END
The following table sets forth information about outstanding equity
awards held by our named executive officers as of December 31, 2006.
OPTION AWARDS
-------------------------------------------------------------------
NUMBER NUMBER
OF OF
SECURITIES SECURITIES
UNDERLYING UNDERLYING
UNEXERCISED UNEXERCISED OPTION
OPTIONS OPTIONS EXERCISE OPTION
(#) (#) PRICE EXPIRATION
NAME EXERCISABLE UNEXERCISABLE ($) DATE
- --------------------------- ----------- ------------- ------------- -----------
Tony Shahbaz 57,032(1) 1,968(1) $ 3.85 03/09/2009
71,093(2) 33,907(2) 2.75 07/14/2010
Thomas L. Gruber 25,521(3) 24,479(3) 4.00 11/02/2011
Steve Gillings -- -- -- --
- -----------
(1) The option vested as to 40% of the underlying shares immediately with
the balance vesting in equal amounts in each of the 36 months
following the March 9, 2004 grant date.
(2) The option vested as to 50% of the underlying shares immediately with
the balance vesting in equal amounts in each of the 48 months
following the July 14, 2005 grant date.
(3) The option vested as to 50% of the underlying shares immediately with
the balance vesting in equal amounts in each of the 48 months
following the November 2, 2006 grant date.
OPTION EXERCISES AND STOCK VESTED
None of the named executive officers acquired shares through the
exercise of options and no stock grants vested during the year ended December
31, 2006.
61
POTENTIAL PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL
EMPLOYMENT AGREEMENT. We have entered into an agreement with a named
executive officer that provides certain benefits upon the termination of his
employment under certain prescribed circumstances. The agreement is described
above under "Employment Agreement--Tony Shahbaz."
CALCULATION OF POTENTIAL PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL
In accordance with the rules of the Securities and Exchange Commission,
the following table presents our estimate of the benefits payable to the named
executive officers under our 2002 and 2003 Stock Option Plans and their
employment agreements, if any, assuming that (i) for Mr. Shahbaz, (A) a change
in control occurred on December 29, 2006, the last business day of 2006 and none
of his equity awards were assumed by the successor corporation, (B) a qualifying
termination occurred on December 29, 2006, which is a termination by us without
"cause," (C) a non-qualifying termination occurred on December 29, 2006, which
is a termination by us for "cause," or (D) an other termination occurred on
December 29, 2006, which is a termination by executive voluntarily or by us upon
the executive's death or disability; and (ii) for Mr. Gruber, (A) a change in
control occurred on December 29, 2006 and his equity award was not assumed by
the successor corporation, or (B) any termination occurred on December 29, 2006.
Mr. Gillings resigned and his employment terminated effective June 14, 2006.
VALUE OF
SALARY CONTINUATION OPTION TOTAL
NAME TRIGGER AND BONUS OF BENEFITS ACCELERATION(1) VALUE(2)
- -------------------- --------------------------- -------------- ------------- -------------- --------------
Tony Shahbaz Change in Control $ -- $ -- $ -- $ --
Qualifying Termination 157,146(3) 22,429(4) -- 179,575
Non-Qualifying Termination 794,000(5) -- -- 794,000
Other Termination -- -- -- --
Thomas L. Gruber Change in Control -- -- -- --
Any Termination -- -- -- --
- ---------------
(1) Represents the aggregate value of the accelerated vesting of the executive
officer's unvested stock options and restricted stock grants. The amounts
shown as the value of the accelerated stock options and restricted stock
grants in connection with a change in control without a qualifying
termination are based solely on the intrinsic value of the options as of
December 29, 2006. This value was calculated by multiplying (a) the
difference between the fair market value of our common stock on December
29, 2006, which was $1.96, and the applicable exercise price by (b) the
assumed number of option shares vesting on an accelerated basis on
December 29, 2006.
(2) Excludes the value to the executive of the continuing right to
indemnification and continuing coverage under our directors' and officers'
liability insurance, if applicable.
(3) Represents 9.5 months additional salary through the end of the term of
executive's employment agreement based on executive's salary in 2006.
(4) Represents the aggregate value of the continuation of certain employee
benefits through the end of the term of executive's employment agreement
based on the cost of executive's employee benefits in 2006.
(5) Represents four times executive's salary based on executive's salary in
2006.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
No member of our board of directors has a relationship that would
constitute an interlocking relationship with executive officers or directors of
another entity.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
As of July 9, 2007, a total of 4,540,292 shares of our common stock
were outstanding. The following table sets forth information as of that date
regarding the beneficial ownership of our common stock by:
o each person known by us to own beneficially more than five
percent, in the aggregate, of the outstanding shares of our common
stock as of the date of the table;
o each of our directors;
o each of our current executive officers; and
o all of our directors and current executive officers as a group.
62
Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and generally includes voting or investment
power with respect to securities. Except as indicated in the footnotes to the
table, we believe each security holder possesses sole voting and investment
power with respect to all of the shares of common stock owned by such security
holder, subject to community property laws where applicable. In computing the
number of shares beneficially owned by a security holder and the percentage
ownership of that security holder, shares of common stock subject to options,
warrants or preferred stock held by that person that are currently exercisable
or convertible or are exercisable or convertible into shares of common stock
within 60 days after the date of the table are deemed outstanding. Those shares,
however, are not deemed outstanding for the purpose of computing the percentage
ownership of any other person or group.
AMOUNT AND NATURE
OF BENEFICIAL PERCENT
NAME AND ADDRESS OF BENEFICIAL OWNER(1) TITLE OF CLASS OWNERSHIP OF CLASS OF CLASS
- ---------------------------------------- -------------- -------------------- ----------
Tony Shahbaz........................................... Common 2,478,109(2) 52.97%
Steel Su............................................... Common 595,209(3) 13.05%
Sung Ki Kim............................................ Common 375,529(4) 8.27%
Daniel Yao............................................. Common 366,320(5) 8.02%
William Ting........................................... Common -- --
Thomas L. Gruber....................................... Common 29,167(6) *
All directors and executive officers as a group (5
persons)............................................ Common 3,468,805(7) 72.96%
- --------------
* Less than 1.0%.
(1) Unless otherwise indicated, the address of each person in this table is
c/o I/OMagic Corporation, 4 Marconi, Irvine, CA 92618. Messrs. Shahbaz
and Gruber are executive officers of I/OMagic Corporation. Messrs.
Shahbaz, Su, Yao and Ting are directors.
(2) Consists of: (i) 493,462 shares of common stock and 137,750 shares of
common stock underlying options held individually by Mr. Shahbaz; (ii)
1,240,423 shares of common stock held by Susha, LLC, a California
limited liability company, or Susha California; (iii) 566,668 shares of
common stock held by Susha, LLC, a Nevada limited liability company, or
Susha Nevada; and (iv) 39,806 shares of common stock held by King Eagle
Enterprises, Inc., a California corporation. Mr. Shahbaz has sole voting
and sole investment power over all of the shares held by Susha
California and Susha Nevada. Mr. Shahbaz and Behavior Tech Computer
Corp. are equal owners of the membership interests in Susha California
and Susha Nevada.
(3) Consists of 406,794 shares of common stock and 21,748 shares of common
stock underlying options held individually by Mr. Su, and 166,667 shares
of common stock held by Behavior Tech Computer Corp. Mr. Su is the Chief
Executive Officer of Behavior Tech Computer Corp. and has sole voting
and sole investment power over the shares held by Behavior Tech Computer
Corp.
(4) Represents 375,529 shares of common stock held by BTC Korea Co., Ltd.,
or BTC Korea. Since October 22, 2003, Mr. Kim has served as Chief
Executive Officer and President of BTC Korea and has sole voting and
sole investment power over the shares held by BTC Korea. The address for
Mr. Kim is c/o BTC Korea Co., Ltd., 160-5, Kajwa-Dong Seo-Ku, Incheon
City, Korea.
(5) Consists of 25,502 shares of common stock underlying options held
individually by Mr. Yao and 340,818 shares of common stock held by
Citrine Group Limited, a wholly owned subsidiary of Ritek Corporation.
Mr. Yao currently serves as the Chief Strategy Officer of Ritek
Corporation. Mr. Yao has sole voting and sole investment power over the
shares held by Citrine Group Limited. The address for Mr. Yao is c/o
Citrine Group Limited, No. 42, Kuanfu N. Road, 30316 R.O.C., HsinChu
Industrial Park, Taiwan.
(6) Represents 29,167 shares of common stock underlying options held
individually by Mr. Gruber.
(7) Includes 214,167 shares of common stock underlying options.
EQUITY COMPENSATION PLAN INFORMATION
The following table provides information about our common stock that
may be issued upon the exercise of options, warrants and rights under all of our
existing equity compensation plans as of December 31, 2006.
NUMBER OF
SECURITIES TO BE WEIGHTED-AVERAGE NUMBER OF
ISSUED UPON EXERCISE OF EXERCISE PRICE OF SECURITIES REMAINING
OUTSTANDING, OUTSTANDING AVAILABLE
OPTIONS, WARRANTS OPTIONS, WARRANTS FOR FUTURE ISSUANCE UNDER
PLAN CATEGORY OR STOCK RIGHTS AND RIGHTS EQUITY COMPENSATION PLANS
- ----------------------------------------- ----------------------- -------------------- --------------------------
Equity Compensation Plans Approved by
Security Holders.................... 354,050 $ 3.13 179,284
Equity Compensation Plans Not Approved
by Security Holders................. -- $ -- --
63
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE.
POLICIES AND PROCEDURES FOR APPROVAL OF RELATED PARTY TRANSACTIONS
Our board of directors has the responsibility to review and discuss
with management and approve interested transactions with related parties. During
this process, the material facts as to the related party's interest in a
transaction are disclosed to all board members or an applicable committee. Our
board of directors is to review each interested transaction with a related party
that requires approval and either approve or disapprove of the entry into the
interested transaction. An interested transaction is any transaction in which we
are a participant and any related party has or will have a direct or indirect
interest. Transactions that are in the ordinary course of business and would not
require disclosure pursuant to Item 404(a) of Regulation S-K or approval of the
board or an independent committee of the board would not be deemed interested
transactions. Our board of directors has determined that all of its directors
are "independent" as defined in NASD Marketplace Rule 4200(a)(15), except for
(i) Tony Shahbaz, who serves full-time as our Chief Executive Officer, President
and Secretary, and (ii) Steel Su, who is the Chief Executive Officer of BTC, an
entity with which we conduct significant business; BTC USA, its affiliates and
Mr. Su also have beneficial ownership in or are otherwise affiliated with the
following affiliates of BTC and BTC USA: BTC Korea Co., Ltd., Behavior Tech
Computer (BVI) Corp., BTC Taiwan, Susha, LLC, a Nevada limited liability
company, and Susha, LLC, a California limited liability company, each of which
is also a stockholder of our company. No director may participate in any
approval of an interested transaction with respect to which he or she is a
related party. Our board intends to approve only those related party
transactions that are in the best interests of I/OMagic and our stockholders.
Other than as described below or elsewhere in this report, since
January 1, 2006 there has not been a transaction or series of related
transactions to which I/OMagic was or is a party involving an amount in excess
of $120,000 and in which any director, executive officer, holder of more than 5%
of any class of our voting securities, or any member of the immediate family of
any of the foregoing persons, had or will have a direct or indirect material
interest. None of the below transactions were separately approved by our Board
as they occurred prior to our adoption of our policies and procedures for
approval of related party transactions.
MISCELLANEOUS
We are or have been a party to employment and compensation arrangements
with related parties, as more particularly described above. We have entered into
an indemnification agreement with each of our directors and executive officers.
The indemnification agreements and our certificate of incorporation and bylaws
require us to indemnify our directors and officers to the fullest extent
permitted by Nevada law.
LUNG HWA ELECTRONICS AND BTC USA
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 an aggregate of up to
$15.0 million of inventory manufactured by Lung Hwa Electronics or manufactured
by third parties, in which case we use Lung Hwa Electronics as an international
purchasing office. For inventory manufactured by third parties and 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.
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. The agreement containing the terms of
the new trade credit facility was amended and restated on July 21, 2005 to
provide that the new facility would be retroactive to April 29, 2005.
As of December 31, 2006, we owed Lung Hwa Electronics $7.6 million in
trade payables. During 2006, we purchased $22.2 million of inventory from Lung
Hwa Electronics.
64
We believe that many of the terms available to us under our trade
credit facility with Lung Hwa Electronics are advantageous as compared to terms
available from unrelated third parties. For example, Lung Hwa Electronics
extends us 120 day payment terms. We believe that the best payment terms that we
could likely obtain from unrelated third parties would be 60-day payment terms;
however, payment in advance or within 30 days is more customary. Also, Lung Hwa
Electronics charges us a 5% handling fee on a supplier's unit price, but applies
a 2% discount of the handling fee, so that the net handling fee is 3%, if we
reach an average running monthly purchasing volume of $750,000. In addition,
under our trade credit facility with Lung Hwa Electronics, the level of
collateral security provided by us to Lung Hwa Electronics was initially $1.5
million, and is currently only 10% of each product order, for a $15.0 million
trade credit facility. We believe that the payment terms, handling fee and the
level of security required are all substantially better terms that we could
obtain from unrelated third parties. In fact, we believe that our trade credit
facility is likely unique and could not be replaced through a relationship with
an unrelated third party.
Our relationship and our trade credit facility with Lung Hwa
Electronics enables us to acquire products from manufacturers who we believe are
some of the largest electronics manufacturers in the world. We buy products
through Lung Hwa Electronics by using Lung Hwa Electronics' size and purchasing
power as a source of credit strength. If we were to acquire these products
directly from the manufacturers, we would likely be required to send payment in
advance of shipment of those products. Due to our relatively small size, we
would likely be unable to qualify for extended payment terms of even 30 days.
Accordingly, we believe that our relationship and trade credit facility with
Lung Hwa Electronics is likely unique, could not be replaced through a
relationship with an unrelated third party and is important in enabling us to
secure certain products that we sell.
In February 2003, we entered into a Warehouse Services and Bailment
Agreement with BTC USA, an affiliate of several of our stockholders, namely BTC,
BTC Korea Co., Ltd., Behavior Tech Computer (BVI) Corp. and BTC Taiwan, as well
as an affiliate of one of our principal subcontract manufacturers, namely
Behavior Tech Computer Corp. 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 December 31, 2006, we owed BTC USA $0.3
million under this arrangement. During 2006, we purchased $1.2 million of
inventory from BTC USA. Steel Su, a director of I/OMagic, is the Chief Executive
Officer of BTC. BTC USA, its affiliates and Mr. Su also have beneficial
ownership in or are otherwise affiliated with the following affiliates of BTC
and BTC USA: BTC Korea Co., Ltd., Behavior Tech Computer (BVI) Corp., BTC
Taiwan, Susha, LLC, a Nevada limited liability company, and Susha, LLC, a
California limited liability company, each of which is also a stockholder of our
company. Mr. Shahbaz, our Chief Executive Officer, President, Secretary and a
Director, also has beneficial ownership in, and sole voting control of, Susha,
LLC, a Nevada limited liability company, and Susha, LLC, a California limited
liability company. See "Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters" above.
We believe that many of the terms available to us under our Warehouse
Services and Bailment Agreement with BTC USA are advantageous as compared to
terms available from unrelated third parties. For example, this Agreement allows
us to store up to $10.0 million of consigned inventory at our warehouse, without
obligation to pay BTC USA for the inventory until 60 days after we take title to
the inventory. We believe that it is unlikely that unrelated third parties would
permit this consignment arrangement and that we would instead be subject to
standard payment terms, the best of which would likely be 60-day payment terms;
however, either payment in advance or within 30 days is more customary. Our
$10.0 million line of credit with 60 days payment terms without interest may
also permit terms better than we could obtain from unrelated third parties. The
best payment terms under a line of credit with a unrelated third party
subcontract manufacturer or supplier would likely be 60 day payment terms;
however, payment in advance or within 30 days is more customary.
Our relationships with Lung Hwa Electronics and BTC USA provide us with
numerous advantages. We believe that both entities are significant suppliers
within their industries and have substantial manufacturing and product
development capabilities and resources. The advantageous terms we are able to
obtain from them allow us to utilize more capital resources for other aspects of
our business and to remain competitive with larger, more established companies.
In addition, we are better able to manage our cash flow as a result of our
significant trade line of credit with Lung Hwa Electronics and our consignment
arrangement with BTC USA. We believe that these advantageous terms contribute
positively to our results of operations.
65
In the past, equity investments by Lung Hwa Electronics and BTC USA, or
its affiliates, have enabled us to obtain inventory with little or no cash
expenditures, which we believe has helped us establish, maintain and grow our
business. We believe that our relationships with these related parties has in
the past benefited our business and contributed positively to our historical
results of operations.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The following table presents the aggregate fees billed to us for
professional audit services rendered by Swenson Advisors, LLP, or Swenson, for
the years ended December 31, 2006 and 2005. We appointed Swenson as our
independent registered public accounting firm on December 12, 2006.
2006 2005
-------- --------
Audit Fees $354,000 $ --
Audit-Related Fees -- --
Tax Fees -- --
All Other Fees -- --
-------- --------
Total $354,000 $ --
======== ========
The following table presents the aggregate fees billed to us for
professional audit services rendered by Singer Lewak Greenbaum & Goldstein LLP,
or SLGG, for the years ended December 31, 2006 and 2005. We replaced SLGG as our
independent registered public accounting firm on December 12, 2006.
2006 2005
-------- --------
Audit Fees $260,609 $287,000
Audit-Related Fees 1,882 136,000
Tax Fees 10,714 5,000
All Other Fees -- --
-------- --------
Total $273,205 $428,000
======== ========
AUDIT FEES. Consist of amounts billed for professional services
rendered for the audit of our annual consolidated financial statements included
in our Annual Reports on Forms 10-K, and reviews of our interim consolidated
financial statements included in our Quarterly Reports on Forms 10-Q and our
Registration Statements on Forms S-1 and S-8, including amendments thereto.
AUDIT-RELATED FEES. Audit-Related Fees consist of fees billed for
professional services that are reasonably related to the performance of the
audit or review of our consolidated financial statements but are not reported
under "Audit Fees."
TAX FEES. Tax Fees consist of fees for professional services for tax
compliance activities, including the preparation of federal and state tax
returns and related compliance matters.
ALL OTHER FEES. Consists of amounts billed for services other than
those noted above.
Our Audit Committee has determined that all non-audit services provided
by Swenson and SLGG are and were compatible with maintaining those firm's audit
independence.
Our Audit Committee is responsible for approving all audit,
audit-related, tax and other services. The Audit Committee pre-approves all
auditing services and permitted non-audit services, including all fees and terms
to be performed for us by our independent registered public accounting firm at
the beginning of the fiscal year. Non-audit services are reviewed and pre-
approved by project at the beginning of the fiscal year. Any additional non-
audit services contemplated by us after the beginning of the fiscal year are
submitted to the Audit Committee chairman for pre-approval prior to engaging
the independent auditor for such services. These interim pre-approvals are
reviewed with the full Audit Committee at its next meeting for ratification.
During 2006, all services performed by Swenson or SLGG were pre-approved by
our Audit Committee in accordance with these policies and applicable Securities
and Exchange Commission regulations.
66
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)(1), (a)(2) and (d) Financial Statements and Financial Statement Schedules
------------------------------------------------------
Reference is made to the financial statements and financial statement
schedule listed on and attached following the Index to Consolidated Financial
Statements and Supplemental Information contained on page F-1 of this report.
(a)(3) and (c) Exhibits
--------
Reference is made to the exhibits listed on the Index to Exhibits that
follows the financial statements and financial statement schedule.
67
I/OMAGIC CORPORATION AND SUBSIDIARY
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND SUPPLEMENTAL INFORMATION
PAGE
REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMS................... F-2
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets as of December 31, 2006 and 2005
(Restated)......................................................... F-4
Consolidated Statements of Operations for the Years Ended
December 31, 2006, 2005 (Adjusted and Restated) and 2004
(Adjusted and Restated)............................................ F-5
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 2006, 2005 and 2004............................. F-6
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2006, 2005 (Adjusted and Restated) and 2004
(Adjusted and Restated)............................................ F-7
Notes to Consolidated Financial Statements (Adjusted and Restated). F-8
SUPPLEMENTAL INFORMATION
Report of Independent Registered Public Accounting Firm on
Financial Statement Schedule.......................................F-52
Schedule II - Valuation and Qualifying Accounts....................F-53
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
I/OMagic Corporation and subsidiary
We have completed our audit of I/OMagic Corporation and subsidiary's
consolidated financial statements as of December 31, 2006 in accordance with the
standards of the Public Company Accounting Oversight Board (United States). Our
opinion, based on our audit, is presented below.
Consolidated financial statements and financial statement schedule
- ------------------------------------------------------------------
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15 present fairly, in all material respects, the financial
position of I/OMagic Corporation and subsidiary (the "Company") at December 31,
2006 and the results of their operations and their cash flows for the year then
ended in conformity with accounting principles generally accepted in the United
States of America. In addition, in our opinion, the information for the year
ended December 31, 2006 in the financial statement Schedule II presents fairly,
in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements. These
consolidated financial statements and consolidated financial statement schedule
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements and consolidated
financial statement schedule based on our audit. We conducted our audit of these
statements in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit of financial statements
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
As discussed in Note 3 and Note 6 to the consolidated financial statements, the
Company changed the manner in which it accounts for shipping and handling costs
and share-based compensation, respectively, in the year ended December 31, 2006.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company has incurred significant
operating losses, serious liquidity concerns and may require additional
financing in the foreseeable future. These matters, among others, raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plans in regard to these matters are also described in Note 1. The
accompanying consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.
/s/ SWENSON ADVISORS, LLP
San Diego, California
July 9, 2007
F-2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
I/OMagic Corporation and Subsidiary
Irvine, California
We have audited the accompanying consolidated balance sheet of I/OMagic
Corporation and subsidiary (collectively, the "Company") as of December 31, 2005
(restated), and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the two years in the period ended December
31, 2005 (restated). These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the restated consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
I/OMagic Corporation and subsidiary as of December 31, 2005 (restated), and the
results of their operations and their cash flows for each of the two years in
the period ended December 31, 2005 (restated) in conformity with accounting
principles generally accepted in the United States of America.
As described in Notes 2, 3 and 4 to the financial statements, the Company has
restated its financial statements for each of the two years in the period ended
December 31, 2005 for correction of errors related to recording direct labor
costs as part of cost of sales and for offsetting its reserves for sales
incentives against accounts receivable and a change in the method of applying
the accounting principle related to recording shipping and handling expenses as
part of selling expense.
/s/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP
Los Angeles, California
February 24, 2006, except for Notes 2, 3 and 4, as to
which the date is July 9, 2007
F-3
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
----------------------------
2005
2006 (RESTATED)(1)
------------ ------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 1,833,481 $ 4,056,541
Restricted cash 893,167 30,864
Accounts receivable, net 11,534,687 9,386,853
Inventory, net 10,670,916 6,984,356
Prepaid expenses and other current assets 71,733 265,429
Capitalized offering costs -- 1,218,655
------------ ------------
Total current assets 25,003,984 21,942,698
EQUIPMENT, net 194,117 172,005
TRADEMARKS, net 361,944 430,872
OTHER ASSETS 41,928 27,032
------------ ------------
TOTAL ASSETS $ 25,601,973 $ 22,572,607
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit $ 4,380,133 $ 5,053,582
Accounts payable, accrued expenses and other 5,521,873 1,999,365
Accounts payable - related parties 7,945,980 8,222,078
Accrued mail-in rebates 1,269,996 715,899
------------ ------------
Total current liabilities 19,117,982 15,990,924
------------ ------------
STOCKHOLDERS' EQUITY
Preferred stock, $0.001 par value 10,000,000 shares authorized
Series A, 1,000,000 shares authorized, no shares issued and outstanding -- --
Series B, 1,000,000 shares authorized, no shares issued and outstanding -- --
Common stock, $0.001 par value 100,000,000 shares authorized, 4,540,292 and
4,531,572 shares issued and outstanding, respectively 4,541 4,532
Additional-paid-in capital 31,681,409 31,595,952
Treasury stock, 0 and 13,439 shares at cost, respectively -- (126,014)
Accumulated deficit (25,201,959) (24,892,787)
------------ ------------
Total stockholders' equity 6,483,991 6,581,683
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 25,601,973 $ 22,572,607
============ ============
____________
(1) See Notes to Consolidated Financial Statements--"Note 2 -- Correction of Error for Not Offsetting
Reserves for Sales Incentives Against Accounts Receivable."
See accompanying notes to these consolidated financial statements
F-4
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31,
--------------------------------------------
2005 2004
(ADJUSTED AND (ADJUSTED AND
2006 RESTATED)(1) RESTATED)(1)
------------ ------------ ------------
NET SALES $ 45,889,410 $ 37,772,754 $ 44,396,551
COST OF SALES 39,463,484 33,480,899 41,262,733
------------ ------------ ------------
GROSS PROFIT 6,425,926 4,291,855 3,133,818
------------ ------------ ------------
OPERATING EXPENSES
Selling, marketing, and advertising 2,113,578 1,668,879 2,049,136
General and administrative 6,504,985 3,915,646 4,458,254
Depreciation and amortization 165,783 235,835 833,545
Impairment of trademarks -- -- 3,696,099
------------ ------------ ------------
Total operating expenses 8,784,346 5,820,360 11,037,034
------------ ------------ ------------
LOSS FROM OPERATIONS (2,358,420) (1,528,505) (7,903,216)
------------ ------------ ------------
OTHER INCOME (EXPENSE)
Interest income 113 695 430
Interest expense (356,586) (299,592) (201,310)
Currency transaction gain 6,952 11,552 49,764
Gain on disposal of equipment 9,403 -- --
Other income 15,166 -- --
Litigation settlement 2,375,000 -- --
------------ ------------ ------------
Total other income (expense) 2,050,048 (287,345) (151,116)
------------ ------------ ------------
LOSS BEFORE PROVISION FOR INCOME TAXES (308,372) (1,815,850) (8,054,332)
PROVISION FOR INCOME TAXES 800 2,400 2,532
------------ ------------ ------------
NET LOSS $ (309,172) $ (1,818,250) $ (8,056,864)
============ ============ ============
BASIC AND DILUTED LOSS PER SHARE $ (0.07) $ (0.40) $ (1.78)
============ ============ ============
BASIC AND DILUTED WEIGHTED-AVERAGE SHARES OUTSTANDING 4,537,320 4,530,380 4,529,672
============ ============ ============
_________
(1) See Notes to Consolidated Financial Statements--"Note 3 -- Change in Accounting Principle --
Reclassification of Shipping and Handling Expense from Cost of Sales to Selling Expense" and
"Note 4 -- Correction of Error for Accounting for Direct Labor and Production Expenses."
See accompanying notes to these consolidated financial statements
F-5
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
COMMON STOCK ADDITIONAL TOTAL
---------------------------- PAID-IN TREASURY ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT CAPITAL STOCK DEFICIT EQUITY
------------ ------------ ------------ ------------ ------------ ------------
Balances at December 31, 2003 4,529,672 $ 4,530 $ 31,557,988 $ (126,014) $(15,017,673) $ 16,418,831
Net loss -- -- -- -- (8,056,864) (8,056,864)
------------ ------------ ------------ ------------ ------------ ------------
Balances at December 31, 2004 4,529,672 4,530 31,557,988 (126,014) (23,074,537) 8,361,967
Sales of common stock pursuant
to exercises of stock options
at an average price of
$3.50 per share 1,900 2 6,648 -- -- 6,650
Valuation of warrants granted
for services rendered -- -- 31,316 -- -- 31,316
Net loss -- -- -- -- (1,818,250) (1,818,250)
------------ ------------ ------------ ------------ ------------ ------------
Balances at December 31, 2005 4,531,572 4,532 31,595,952 (126,014) (24,892,787) 6,581,683
Retirement of treasury shares (13,493) (13) (126,001) 126,014 -- --
Sales of common stock pursuant
to exercises of stock options at
an average price of $2.86 per share 22,213 22 62,410 -- -- 62,432
Share-based compensation expense -- -- 149,048 -- -- 149,048
Net loss -- -- -- -- (309,172) (309,172)
------------ ------------ ------------ ------------ ------------ ------------
Balances at December 31, 2006 4,540,292 $ 4,541 $ 31,681,409 $ -- $(25,201,959) $ 6,483,991
============ ============ ============ ============ ============ ============
See accompanying notes to these consolidated financial statements
F-6
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
-----------------------------------------
2005 2004
2006 (RESTATED)(1) (RESTATED)(1)
----------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (309,172) $(1,818,250) $(8,056,864)
Adjustments to reconcile net loss to net cash provided
by (used in) operating activities:
Depreciation and amortization 96,855 166,907 254,809
Amortization of trademarks 68,928 68,928 578,736
Impairment of trademarks -- -- 3,696,099
Allowance for doubtful accounts 31,855 (21,801) 4,393
Allowance for product returns 288,352 (92,651) (94,283)
Reserves for sales incentives (1,199,591) 256,373 1,314,645
Allowance for obsolete inventory 496,310 (1,433,524) 958,185
Share-based compensation expense 149,048 -- --
Capitalized offering costs 1,218,655 -- --
Warrants issued for services rendered -- 31,316 --
Changes in assets and liabilities (net of dispositions
and acquisitions)
Accounts receivable (1,268,450) 1,528,677 3,837,078
Inventory (4,182,870) 1,109,606 2,088,085
Prepaid expenses and other current assets 193,696 (128,147) 269,978
Other assets (14,896) -- 25,952
Accounts payable, accrued expenses and other 3,522,508 89,217 (1,243,354)
Accounts payable - related party (276,098) 875,482 (3,023,523)
Accrued mail-in rebates 554,097 371,729 (566,856)
Settlement payment -- -- (1,000,000)
----------- ----------- -----------
Net cash provided by (used in) operating activities (630,773) 1,003,862 (956,920)
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Restricted cash (862,303) 1,013,475 1,141,325
Equipment additions (118,967) (31,252) (22,526)
----------- ----------- -----------
Net cash provided by (used in) investing activities (981,270) 982,223 1,118,799
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Net (payments) borrowings on line of credit (673,449) (909,309) 24,186
Proceeds from sales of common stock 62,432 6,650 --
Capitalized offering costs -- (614,692) (603,963)
----------- ----------- -----------
Net cash (used in) financing activities (611,017) (1,517,351) (579,777)
----------- ----------- -----------
Net increase (decrease) in cash and cash equivalents (2,223,060) 468,734 (417,898)
Cash and cash equivalents at beginning of year 4,056,541 3,587,807 4,005,705
----------- ----------- -----------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 1,833,481 $ 4,056,541 $ 3,587,807
=========== =========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
INTEREST PAID $ 356,586 $ 299,592 $ 201,310
=========== =========== ===========
INCOME TAXES PAID $ 800 $ 2,400 $ 2,532
=========== =========== ===========
_________________
(1) See Notes to Consolidated Financial Statements--"Note 2 -- Correction of Error for Not
Offsetting Reserves for Sales Incentives Against Accounts Receivable."
See accompanying notes to these consolidated financial statements
F-7
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 1 - ORGANIZATION AND BUSINESS
Nature of Business
- ------------------
I/OMagic Corporation ("I/OMagic"), a Nevada corporation, and its subsidiary IOM
Holdings, Inc. (collectively, the "Company"), develops, manufactures through
subcontractors or obtains from suppliers, markets, and sells data storage and
digital entertainment products for the consumer electronics market. The Company
sells its products in the United States and Canada to distributors and
retailers. 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.
Liquidity and Going Concern
- ---------------------------
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. This contemplates the
realization of assets and the satisfaction of liabilities in the normal course
of business. As shown in the consolidated financial statements, the Company has
experienced losses for the years ended December 31, 2006, 2005 and 2004 of
$309,172, $1,818,250 and $8,056,864, respectively. These matters, among others,
raise doubt about the Company's liquidity and ability to fund future operations.
The Company has, however, achieved certain success as a result of its
substantial efforts to increase its customer base, broaden its product lines and
focus on more profitable products. Previous efforts include the Company's
introduction of its higher capacity external disk drives in the second quarter
of 2006 that gained quick acceptance with its customers.
At December 31, 2006, the Company had cash and cash equivalents of $1,883,481.
The Company currently has almost no amounts available to it for borrowing under
its credit facility with Silicon Valley Bank. In addition, as of July 9, 2007,
the Company had only $645,000 of cash on hand. Accordingly, as of the date of
filing of this report, the Company had serious liquidity concerns and may
require additional financing in the foreseeable future. The Company presently
may not have sufficient liquidity to fund its operating needs for the next
twelve months.
The Company's plans for correcting these deficiencies include negotiating
extended payment terms with BTC USA and Lung Hwa Electronics, the Company's
related-party suppliers, timely collection of existing accounts receivable, and
sell-through of inventory currently in the Company's sales channels. If,
however, the Company's capital requirements or cash flow vary materially from
its current projections, if the Company is unable to successfully negotiate
extended payment terms on amounts owed to BTC USA or Lung Hwa Electronics, if
the Company is unable to timely collect its accounts receivable or unable to
sell-through inventory currently in its sales channels as anticipated, or if
unforeseen circumstances occur, the Company may be unable to increase its
liquidity and may require additional financing.
The consolidated financial statements do not include any adjustments to reflect
the possible future effects on the recoverability and classification of assets
or the amounts and classification of liabilities that may result from the
inability of the Company to continue as a going concern.
F-8
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 2 - CORRECTION OF ERROR FOR NOT OFFSETTING RESERVES FOR SALES INCENTIVES
AGAINST ACCOUNTS RECEIVABLE
Prior to the fourth quarter of 2006, the Company did not adequately disclose the
fair value of accounts receivable. According to vendor agreements with specific
customers, the Company's customers have the right to offset approved sales
incentives, market development/cooperative advertising funds, cross dock fees
and point-of-sale rebates, which the Company previously reported as current
liabilities, against future payments on their accounts. The Company determined,
as allowed by Accounting Principles Bulletin ("APB") No. 10, paragraph 7(1), and
FASB Interpretation No. ("FIN") 39, OFFSETTING AMOUNTS RELATED TO CERTAIN
CONTRACTS, that it is appropriate to offset such accruals against accounts
receivable. Accordingly, the Company has restated prior periods to correct this
error.
For the year ended December 31, 2005, the effect of the change decreased current
assets and current liabilities by $3,704,000. There was no effect to net loss or
loss per share for the years ended December 31, 2005 and 2004. In addition,
there was no cumulative effect of the change to accumulated deficit or any other
components of stockholders' equity as of January 1, 2005.
Based on the foregoing, the Company has determined the effect of the correction
of this error on its previously issued financial statements for the year ended
December 31, 2005, as presented below, and restated the unaudited quarterly
information as presented in Note 21 -- Quarterly Financial Data -- Correction of
Error for Not Offsetting Reserves for Sales Incentives Against Accounts
Receivable.
CONSOLIDATED BALANCE SHEET AS ORIGINALLY AS
DECEMBER 31, 2005 REPORTED RESTATEMENTS RESTATED
-------- -------- --------
(in thousands, except number of shares)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 4,057 $ -- $ 4,057
Restricted cash 31 -- 31
Accounts receivable, net 13,091 (3,704) 9,387
Inventory, net 6,984 -- 6,984
Prepaid expenses and other current assets 265 -- 265
Capitalized offering costs 1,219 -- 1,219
-------- -------- --------
Total current assets 25,647 (3,704) 21,943
EQUIPMENT, net 172 -- 172
TRADEMARKS, net 431 -- 431
OTHER ASSETS 27 -- 27
-------- -------- --------
TOTAL ASSETS $ 26,277 $ (3,704) $ 22,573
======== ======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit $ 5,053 $ -- $ 5,053
Accounts payable, accrued expenses and other 5,210 (3,210) 2,000
Accounts payable - related parties 8,222 -- 8,222
Accrued mail-in rebates 716 -- 716
Reserves for product returns and sales incentives 494 (494) --
-------- -------- --------
Total current liabilities 19,695 (3,704) 15,991
-------- -------- --------
STOCKHOLDERS' EQUITY
Preferred stock, $0.001 par value 10,000,000 shares
authorized -- -- --
Series A, 1,000,000 shares authorized, no shares issued and
outstanding -- -- --
Series B, 1,000,000 shares authorized, no shares issued and
outstanding -- -- --
Common stock, $0.001 par value 100,000,000 shares
authorized, 4,531,572 shares issued and outstanding 5 -- 5
Additional paid-in capital 31,596 -- 31,596
Treasury stock, 13,439 shares at cost (126) -- (126)
Accumulated deficit (24,893) -- (24,893)
-------- -------- --------
Total stockholders' equity 6,582 -- 6,582
-------- -------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 26,277 $ (3,704) $ 22,573
======== ======== ========
F-9
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CASH FLOW
DECEMBER 31, 2005
AS ORIGINALLY AS
REPORTED RESTATEMENTS RESTATED
----------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(1,818,250) $ -- $(1,818,250)
Adjustments to reconcile net loss to net cash provided
by (used in) operating activities:
Depreciation and amortization 166,907 -- 166,907
Amortization of trademarks 68,928 -- 68,928
Impairment of trademarks -- -- --
Allowance for doubtful accounts (21,801) -- (21,801)
Allowance for product returns (92,652) -- (92,652)
Reserves for sales incentives 13,370 243,003 256,373
Allowance for obsolete inventory (1,433,524) -- (1,433,524)
Warrants issued for services rendered 31,316 -- 31,316
Changes in assets and liabilities
Accounts receivable 1,528,677 -- 1,528,677
Inventory 1,109,607 -- 1,109,607
Prepaid expenses and other current assets (128,147) -- (128,147)
Accounts payable and accrued expenses 332,220 (243,003) 89,217
Accounts payable - related party 875,482 -- 875,482
Accrued mail-in rebates 371,729 -- 371,729
----------- ----------- -----------
Net cash provided by operating activities 1,003,862 -- 1,003,862
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Restricted cash 1,013,475 -- 1,013,475
Equipment additions (31,252) -- (31,252)
----------- ----------- -----------
Net cash provided by investing activities 982,223 -- 982,223
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Net payments on line of credit (909,309) -- (909,309)
Proceeds from sales of common stock 6,650 -- 6,650
Capitalized offering costs (614,692) -- (614,692)
----------- ----------- -----------
Net cash used in financing activities (1,517,351) -- (1,517,351)
----------- ----------- -----------
Net increase in cash and cash equivalents 468,734 -- 468,734
Cash and cash equivalents at beginning of year 3,587,807 -- 3,587,807
----------- ----------- -----------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 4,056,541 $ -- $ 4,056,541
=========== =========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
INTEREST PAID $ 299,592 $ -- $ 299,592
=========== =========== ===========
INCOME TAXES PAID $ 2,400 $ -- $ 2,400
=========== =========== ===========
F-10
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CASH FLOW
DECEMBER 31, 2004
AS ORIGINALLY AS
REPORTED RESTATEMENTS RESTATED
----------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(8,056,864) $ -- $(8,056,864)
Adjustments to reconcile net loss to net cash provided
by (used in) operating activities:
Depreciation and amortization 254,809 -- 254,809
Amortization of trademarks 578,736 -- 578,736
Impairment of trademarks 3,696,099 -- 3,696,099
Allowance for doubtful accounts 4,393 -- 4,393
Allowance for product returns (94,283) -- (94,283)
Reserves for sales incentives (144,405) 1,459,050 1,314,645
Allowance for obsolete inventory 958,185 -- 958,185
Changes in assets and liabilities
Accounts receivable 3,837,078 -- 3,837,078
Inventory 2,088,084 -- 2,088,084
Prepaid expenses and other current assets 269,979 -- 269,979
Other assets 25,952 -- 25,952
Accounts payable and accrued expenses 215,696 (1,459,050) (1,243,354)
Accounts payable - related party (3,023,523) -- (3,023,523)
Accrued mail-in rebates (566,856) -- (566,856)
Settlement payment (1,000,000) -- (1,000,000)
----------- ----------- -----------
Net cash used in operating activities (956,920) -- (956,920)
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Restricted cash 1,141,325 -- 1,141,325
Equipment additions (22,526) -- (22,526)
----------- ----------- -----------
Net cash provided by investing activities 1,118,799 -- 1,118,799
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings on line of credit 24,186 -- 24,186
Capitalized offering costs (603,963) -- (603,963)
----------- ----------- -----------
Net cash provided by financing activities (579,777) -- (579,777)
----------- ----------- -----------
Net decrease in cash and cash equivalents (417,898) -- (417,898)
Cash and cash equivalents at beginning of year 4,005,705 -- 4,005,705
----------- ----------- -----------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 3,587,807 $ -- $ 3,587,807
=========== =========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
INTEREST PAID $ 201,310 $ -- $ 201,310
=========== =========== ===========
INCOME TAXES PAID $ 2,532 $ -- $ 2,532
=========== =========== ===========
F-11
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 3 - CHANGE IN ACCOUNTING PRINCIPLE--RECLASSIFICATION OF SHIPPING AND
HANDLING EXPENSES FROM COST OF SALES TO SELLING EXPENSE
During the fourth quarter of 2006, the Company changed its method of accounting
for shipping and handling expenses. Prior to the change, the Company accounted
for shipping and handling expenses as a component of cost of sales pursuant to
Emerging Issues Task Force ("EITF") Issue No. 00-10, ACCOUNTING FOR SHIPPING AND
HANDLING FEES AND COSTS. Under the new method, as also allowed for under EITF
Issue No. 00-10, shipping and handling expenses are classified as selling
expenses. The Company believes this change is preferable because it more
accurately reports cost of sales, gross profit, and selling, marketing and
advertising expenses as it relates to the way management operates the Company.
For the year ended December 31, 2006, the effect of the change decreased cost of
sales, and increased gross profit and selling, marketing and advertising
expenses by $1,200,000. There was no effect of the change to net loss or loss
per share for the years ended December 31, 2006, 2005 and 2004. In addition,
there was no cumulative effect of the change to accumulated deficit or any other
components of stockholders' equity as of January 1, 2005. Based on the
foregoing, the Company has adjusted the audited annual information for the years
ended December 31, 2005 and 2004, as presented below, and adjusted the unaudited
quarterly information as presented in Note 23 -- Quarterly Financial Data --
Change in Accounting Principle - Reclassification of Shipping and Handling
Expense from Cost of Sales to Selling Expense.
AS ORIGINALLY AS
YEAR ENDED DECEMBER 31, 2005 REPORTED ADJUSTMENTS ADJUSTED(1)
- ---------------------------- ------------ ------------ ------------
(in thousands, except per share data)
Net sales $ 37,773 $ -- $ 37,773
Cost of sales 33,523 (892) 32,631
------------ ------------ ------------
Gross profit 4,250 892 5,142
Operating expenses 5,778 892 6,670
------------ ------------ ------------
Operating loss (1,528) -- (1,528)
Other expense (287) -- (287)
------------ ------------ ------------
Pre-tax loss (1,815) -- (1,815)
------------ ------------ ------------
Net loss $ (1,818) $ -- $ (1,818)
============ ============ ============
Net loss per common share, diluted $ (0.40) $ -- $ (0.40)
============ ============ ============
__________
(1) The Company's results of operations are also restated. See Note 4 --
Correction of Error for Accounting for Direct Labor and Production
Expenses.
AS ORIGINALLY AS
YEAR ENDED DECEMBER 31, 2004 REPORTED ADJUSTMENTS ADJUSTED(1)
- ---------------------------- ------------ ------------ ------------
(in thousands, except per share data)
Net sales $ 44,397 $ -- $ 44,397
Cost of sales 41,419 (1,039) 40,380
------------ ------------ ------------
Gross profit 2,978 1,039 4,017
Operating expenses 10,881 1,039 11,920
------------ ------------ ------------
Operating loss (7,903) -- (7,903)
Other expense (151) -- (151)
------------ ------------ ------------
Pre-tax loss (8,054) -- (8,054)
------------ ------------ ------------
Net loss $ (8,057) $ -- $ (8,057)
============ ============ ============
Net loss per common share, diluted $ (1.78) $ -- $ (1.78)
============ ============ ============
___________
(1) The Company's results of operations are also restated. See Note 4 --
Correction of Error for Accounting for Direct Labor and Production
Expenses.
F-12
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 4 - CORRECTION OF ERROR FOR ACCOUNTING FOR DIRECT LABOR AND PRODUCTION
EXPENSES
Prior to the fourth quarter of 2006, the Company included direct labor and
production expenses directly associated with goods sold as general and
administrative expenses. Accounting principles generally accepted in the United
States of America require that costs directly associated with the manufacturing
of goods sold be reported as cost of sales. Accordingly, the Company has
restated prior annual and interim periods to correct this error. As a result of
this restatement, cost of sales increased and gross profit and general and
administrative expenses decreased by $851,000 and $885,000 for the years ended
December 31, 2005 and 2004, respectively. There was no effect of the change to
net loss or loss per share for the years ended December 31, 2005 and 2004. In
addition, there was no cumulative effect of the change to accumulated deficit or
any other components of stockholders' equity as of January 1, 2005.
Based on the foregoing, the Company has determined the effect of the correction
of this error on its previously issued financial statements for the years ended
December 31, 2005 and 2004, as presented below, and restated the unaudited
quarterly information as presented in Note 24 -- Quarterly Financial Data --
Correction of Error for Accounting for Direct Labor and Production Expenses.
AS AS ADJUSTED
YEAR ENDED DECEMBER 31, 2005 ADJUSTED(1) RESTATEMENT AND RESTATED
- ---------------------------- ------------ ------------ ------------
(in thousands, except per share data)
Net sales $ 37,773 $ -- $ 37,773
Cost of sales 32,631 851 33,482
------------ ------------ ------------
Gross profit 5,142 (851) 4,291
Operating expenses 6,670 (851) 5,819
------------ ------------ ------------
Operating loss (1,528) -- (1,528)
Other expense (287) -- (287)
------------ ------------ ------------
Pre-tax loss (1,815) -- (1,815)
------------ ------------ ------------
Net loss $ (1,818) $ -- $ (1,818)
============ ============ ============
Net loss per common share, diluted $ (0.40) $ -- $ (0.40)
============ ============ ============
___________
(1) See Note 3 -- Change in Accounting Principle -- Reclassification of
Shipping and Handling Expense from Cost of Sales to Selling Expense.
AS AS ADJUSTED
YEAR ENDED DECEMBER 31, 2004 ADJUSTED(1) RESTATEMENT AND RESTATED
- ---------------------------- ------------ ------------ ------------
(in thousands, except per share data)
Net sales $ 44,397 $ -- $ 44,397
Cost of sales 40,380 883 41,263
------------ ------------ ------------
Gross profit 4,017 (883) 3,134
Operating expenses 11,920 (883) 11,037
------------ ------------ ------------
Operating loss (7,903) -- (7,903)
Other expense (151) -- (151)
------------ ------------ ------------
Pre-tax loss (8,054) -- (8,054)
------------ ------------ ------------
Net loss $ (8,057) $ -- $ (8,057)
============ ============ ============
Net loss per common share, diluted $ (1.78) $ -- $ (1.78)
============ ============ ============
____________
(1) See Note 3 -- Change in Accounting Principle -- Reclassification of
Shipping and Handling Expense from Cost of Sales to Selling Expense.
F-13
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 5 - SUBSEQUENT EVENTS
Capital Investment
- ------------------
On May 9, 2007, the Company entered into a Strategic Alliance Share Purchase
Agreement with Jiangxi Greatsource Display Tech Co. Ltd. ("KHD"). Under the
agreement, the Company was to sell, in three separate closings over
approximately the next twelve months, an aggregate of 21,750,000 shares of the
Company's common stock to KHD for an aggregate of $95.0 million. The agreement
also offered the Company the opportunity to co-develop and market in the North
American and Chinese markets next generation liquid-crystal-on-silicon, known as
LCOS, high definition televisions and assemble digital light processing, known
as DLP, and liquid crystal display, known as LCD, high definition televisions.
The closings under the agreement were subject to customary conditions, including
(i) KHD obtaining governmental approvals in the People's Republic of China to
secure the funds necessary to purchase the Company's common stock; (ii)
expiration or termination of the waiting period under the Hart-Scott-Rodino
Antitrust Act of 1976; (iii) the Company's common stock being designated for
quotation or listed on the OTC Bulletin Board; (iv) filing of all reports that
the Company was obligated to file under the Securities Exchange Act of 1934, as
amended; and (v) removal of the "E" modifier appended to the Company's trading
symbol. Also, either party was entitled terminate the agreement on or before
June 8, 2007 based on the results of such party's due diligence. KHD terminated
the agreement on June 8, 2007.
Loan Agreement
- --------------
On January 27, 2007, the Company entered into a Loan and Security Agreement with
Silicon Valley Bank which provides for a revolving line of credit. The line of
credit allows the Company to borrow up to a maximum amount equal to the lesser
of (i) $10.0 million, or (ii) an amount equal to 60% of eligible accounts, plus
the lesser of (a) 25% of the value of eligible inventory, (b) $3 million, or (c)
33% of eligible accounts. The line of credit allows for a sublimit of $2.5
million for all (x) outstanding letters of credit, (y) foreign exchange
contracts to purchase from or sell to Silicon Valley Bank a specific amount of
foreign currency, and (z) the amount of the revolving line used for cash
management services, including merchant services, direct deposit of payroll,
business credit card and check cashing services. The line of credit expires on
January 29, 2009. Advances on the line of credit bear interest at a floating
rate equal to the prime rate plus 1.0%.
The obligations of the Company under the Loan and Security 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") pursuant to a
Cross-Corporate Continuing Guaranty by the Company and the Subsidiary. The
obligations of the Company and the guarantee obligations of the Subsidiary are
secured pursuant to an Intellectual Property Security Agreement executed by the
Company and an Intellectual Property Security Agreement executed by the
Subsidiary.
If the Company terminates the Loan and Security Agreement prior to the maturity
date, the Company will be subject to a termination fee as follows: (i) if the
termination occurs on or before the first anniversary of the effective date, the
termination fee is equal to 1.50% of the maximum line amount, and (ii) if the
termination occurs after the first anniversary of the effective date and on or
before the second anniversary of the effective date, the termination fee is
equal to 0.50% of the maximum line amount. The credit facility is subject to an
unused line fee equal to 0.25% per annum, payable monthly based on the average
daily unused amount of the line of credit, as determined by the Bank. The credit
facility is also subject to a commitment fee of $50,000, a monthly collateral
monitoring fee of $1,250 and an anniversary fee of $50,000. In addition, the
Company must pay to Silicon Valley Bank customary fees and expenses for the
issuance or renewal of letters of credit and all expenses incurred by Silicon
Valley Bank related to the Loan and Security Agreement.
F-14
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
The credit facility is subject to a financial covenant on a consolidated basis
for the tangible net worth of the Company for each month ending after February
28, 2007, which must be at least $4,750,000, plus (i) 50% of all consideration
received by the Company for sales of equity securities and issuances of
subordinated debt, plus (ii) 50% of the Company's net income for each fiscal
quarter. "Tangible net worth" is defined as the consolidated total assets of the
Company and its subsidiaries, minus (a) any amounts attributable to (1)
goodwill, (2) intangible items, and (3) notes, accounts receivable and other
obligations owing to the Company from its officers and affiliates, and reserves
not already deducted from assets, minus (b) total liabilities, plus (c)
subordinated debt.
In the event of a default and continuation of a default, Silicon Valley Bank may
accelerate the payment of the principal balance requiring the Company to pay the
entire indebtedness outstanding on that date. From and after an event of
default, the outstanding principal balance will bear interest until paid in full
at an increased rate per annum equal to 5% above the rate of interest in effect
from time to time under the credit facility. The Loan and Security Agreement
also contains other customary representations, warranties and covenants.
The outstanding balance with Silicon Valley Bank as of July 9, 2007 was
$3,459,787. The amount available to the Company for borrowing as of July 9, 2007
was $5,000.
NOTE 6 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
- ---------------------------
The consolidated financial statements include the accounts of I/OMagic and its
subsidiary, IOM Holdings, Inc. All material intercompany accounts and
transactions have been eliminated.
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.
Reclassifications
- -----------------
Certain prior year amounts have been reclassified to conform to the current
presentation. Such reclassification had no effect on the net loss reported in
the consolidated statements of operations.
Cash and Cash Equivalents
- -------------------------
For purposes of the consolidated statements of cash flows, the Company considers
all highly liquid investments purchased with original maturities of three months
or less to be cash equivalents.
F-15
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Restricted Cash
- ---------------
Restricted cash primarily represents time deposits that are pledged as
collateral for the Company's line of credit with GMAC Commercial Finance.
Fair Value of Financial Instruments
- -----------------------------------
For certain of the Company's financial instruments, including cash and cash
equivalents, accounts receivable, inventory, prepaid expenses and other current
assets, line of credit, accounts payable, accrued expenses and other, accounts
payable-related parties and accrued mail-in rebates, the carrying amounts
approximate fair value due to their short maturities.
Accounts Receivable and Allowance for Doubtful Accounts
- -------------------------------------------------------
Trade accounts receivable are primarily from national retailers and are recorded
at the invoiced amount and do not accrue interest. The allowance for doubtful
accounts reflects management's best estimate of probable credit losses inherent
in the accounts receivable balance. The Company determines the allowance based
on historical experience, specifically identified nonpaying accounts and other
currently available evidence. The Company reviews its allowance for doubtful
accounts monthly with focus on significant individual past due balances over 90
days. All other balances are reviewed on a pooled basis. Account balances are
charged off against the allowance after all means of collection have been
exhausted and the potential for recovery is considered remote. Since the
Company's current customers are primarily national retailers with good payment
histories with the Company, its allowance for doubtful accounts is minimal. The
Company does not have any off-balance sheet credit exposure related to its
customers.
The Company occasionally has, and it expects that it will continue to have in
the foreseeable future, disagreements with its national retailers relating to
the valuation and completeness of accounts receivable which may result in a
contingent gain or loss to the Company.
Sales Incentive Reserve
- -----------------------
The Company enters into agreements with certain retailers regarding price
decreases that are determined by the Company in its sole discretion. These
agreements allow those retailers (subject to limitations) a credit equal to the
difference between the Company's current price and its new reduced price on
units in the retailers' inventories or in transit to the retailers on the date
of the price decrease.
The Company records an estimate of sales incentives based on its 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. The Company also records a corresponding accrual for
its estimated sales incentive liability. This accrual is reduced by deductions
on future payments taken by the Company's retailers relating to actual sales
incentives. The Company's estimated sales incentive liability is offset against
accounts receivable.
At the end of each quarterly period, the Company analyzes its existing sales
incentive reserve and applies any necessary adjustments based upon actual or
expected deviations in sales incentive rates from the Company's applicable
historical sales incentive rates. The amount of any necessary adjustment is
based upon the amount of the Company's remaining field inventory, which is
calculated by reference to the Company's actual field inventory last conducted,
plus inventory-in-transit and less estimated product sell-through. The amount of
the Company's sales incentive liability for each product is equal to the amount
of remaining field inventory for that product multiplied by the difference
between the Company's current price and its new reduced price to its 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 the
Company's sales incentive reserve established for the applicable period.
F-16
Point-of-Sale Rebate Promotions Accruals
- ----------------------------------------
The Company periodically offers rebate promotions to retailers that are in turn
provided to the retailers' end-user customers. During the period of the rebate
promotion, the Company reduces sales by the estimated amount of the rebate
promotion with a corresponding accrual for the estimated liability. Estimates
for rebate promotions are based on a number of variable factors that depend on
the specific program or product. These variables include the length of the
rebate promotion, the estimated sales during the promotion and the anticipated
redemption rate of the program based on historical experience. These accruals
are offset against accounts receivable.
Market Development Funds/Cooperative Advertising Accruals
- ---------------------------------------------------------
The Company has agreements with certain retailers in which the retailer is
allowed to use a specified percentage of its purchases of the Company's products
for various marketing purposes. The purpose of these agreements is to encourage
advertising and promotional events to promote the sale of the Company's
products. Each period the Company reduces sales by the estimated amounts to be
deducted by the retailers on future payments. These accruals are offset against
accounts receivable.
Product Returns
- ---------------
The Company has a limited 90-day to one year time period for product returns
from end-users. However, its retailers generally have return policies that allow
their customers to return products within only 14 to 30 days after purchase. The
Company allows its retailers to return damaged or defective products to it
following a customary return merchandise authorization process. The Company has
no informal return policies. The Company utilizes actual historical return rates
to determine its allowance for returns in each period. Gross sales are reduced
by estimated returns and cost of sales is reduced by the estimated cost of those
sales. The Company records a corresponding allowance 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
allowance is offset each period by actual product returns.
As noted above, the Company's return rate is based upon its past history of
actual returns and the Company estimates 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. The Company's historical return rate
for a particular product is its trailing 18-month return rate of similar
products. The Company believes that using a trailing 18-month return rate takes
two key factors into consideration, specifically, an 18-month return rate
provides the Company with a sufficient period of time to establish recent
historical trends in product returns for each product category, and provides the
Company with a period of time that is short enough to account for recent
technological shifts in its 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 the Company's trailing
18-month return rates, the Company will make appropriate adjustments to its
estimated return rates. Factors that could cause materially different actual
return rates as compared to the Company's trailing 18-month return rates include
product modifications that simplify installation, or a new product line within a
product category that needs time to better reflect its return performance and
other factors. This allowance is recorded against accounts receivable.
F-17
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Inventory
- ---------
Inventory is stated at the lower of cost, using the weighted-average method,
which approximates the first-in, first-out method, or market.
Inventory Obsolescence Allowance
- --------------------------------
The Company's warehouse supervisor, production supervisor and production manager
physically review the Company's 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. The Company considers
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 sale of slow moving and obsolete inventories is
considered through market research, analysis of the Company's 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. The
Company utilizes the Internet to provide indications of market value from
competitors' pricing, third party inventory liquidators and auction websites.
The recorded costs of the Company's slow moving and obsolete products are
reduced to current market prices when the recorded costs exceed such market
prices. All adjustments establish a new cost basis for inventory as the Company
believes such reductions are permanent declines in the market price of its
products. Generally, obsolete inventory is sold to companies that specialize in
the liquidation of such items while the Company continues to market slow-moving
inventories until they are sold or become obsolete. As obsolete or slow moving
inventory is sold, the Company reduces the reserve by proceeds from the sale of
the products.
The Company's warehouse supervisor, production supervisor and production manager
physically review the Company's 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 the Company's
subcontract manufacturers and suppliers) that are considered obsolete or damaged
are reviewed by these personnel together with the Company's Controller or Chief
Financial Officer. At the discretion of the Company's Controller or Chief
Financial Officer, these items are physically disposed of and the Company makes
corresponding accounting adjustments resulting in inventory adjustments. In
addition, on a monthly basis, the Company's detail inventory report and its
general ledger are reconciled by the Company's Controller and any variances
result in a corresponding inventory adjustment.
F-18
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Equipment
- ---------
Equipment is recorded at cost, less accumulated depreciation and amortization.
Depreciation and amortization are calculated using the straight-line method over
estimated useful lives as follows:
Computer equipment and software 5 years
Warehouse equipment 7 years
Office furniture and equipment 5 to 7 years
Equipment under capital leases 5 years
Vehicles 5 years
Leasehold improvements Estimated useful life or lease term,
whichever is shorter
Expenditures for major renewals and betterments that extend the useful lives of
equipment are capitalized. Expenditures for maintenance and repairs are charged
to expense as incurred. Depreciation expense on assets acquired under capital
leases is included with depreciation expense.
Intangible Assets
- -----------------
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 142,
GOODWILL AND OTHER INTANGIBLE ASSETS, the Company evaluates the remaining useful
life of an intangible asset that is being amortized each reporting period to
determine whether events and circumstances warrant a revision to the remaining
period of amortization. Trademarks are being amortized over an estimated useful
life of ten years.
Accounting for the Impairment of Long-Lived Assets
- --------------------------------------------------
The Company has adopted SFAS No. 144 which requires impairment losses to be
recorded on long-lived assets, including intangible assets, used in operations
when indicators of impairment are present and the undiscounted cash flows
estimated to be generated by those assets are less than the assets' carrying
amount.
Accrued Mail-in-Rebates
- -----------------------
The Company periodically offers mail-in rebates to end-user customers as sales
incentives. During the period of the mail-in rebates, the Company reduces sales
by the estimated amount of the mail-in rebate with a corresponding accrual for
the estimated liability. Estimates for mail-in rebate promotions are based on a
number of variable factors that depend on the specific program or product. These
variables include the length of the mail-in rebate promotion, the estimated
sales during the promotion and the anticipated redemption rate of the program
based on historical experience.
F-19
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Revenue Recognition
- -------------------
The Company recognizes revenue in accordance with Staff Accounting Bulletin
("SAB") No. 104, REVENUE RECOGNITION, CORRECTED COPY. Under SAB No. 104, revenue
is recognized when persuasive evidence of an arrangement exists, delivery has
occurred or services have been rendered, the seller's price to the buyer is
fixed or determinable, and collectibility is reasonably assured. The Company
applies the specific provisions of SFAS No. 48, REVENUE RECOGNITION WHEN RIGHT
OF RETURN EXISTS. Under SFAS No. 48, product revenue is recorded at the transfer
of title to the products to a retailer, net of estimated allowances and returns
and sales incentives. Transfer of title occurs and risk of ownership passes to a
retailer at the time of shipment or delivery, depending on the terms of the
Company's agreement with a particular retailer. For transactions not satisfying
the conditions for revenue recognition under SFAS No. 48, product revenue is
deferred until the conditions are met, net of an estimate for cost of sales.
Consignment sales are recognized when the Company's retailers sell its products
to retail customers, at which point the retailers incur an obligation to pay the
Company.
In accordance with EITF Issue No. 01-9, ACCOUNTING FOR CONSIDERATION GIVEN BY A
VENDOR TO A CUSTOMER INCLUDING A RESELLER OF THE VENDOR'S PRODUCTS, because the
Company did not receive an identifiable benefit, the Company reduces its product
revenue for marketing promotions, market development fund and cooperative
advertising costs.
The Company recognizes revenue under three primary sales models: standard terms,
consignment sales and special terms. The Company generally uses one of these
three primary sales models, or some combination of these sales models, with each
of its retailers. Under each of these sales models the Company's payment terms
are explicitly stated and agreed to by the Company and the retailer before goods
are shipped, thereby making the Company's fee fixed or determinable before
revenue is recognized.
STANDARD TERMS
Under the Company's standard terms sales model, a retailer is obligated to pay
the Company for products sold to it within a specified number of days from the
date that title to the products is transferred to the retailer. The Company's
standard terms are typically net 60 days from the transfer of title to the
products to a retailer. The Company typically collects 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 the Company's agreement with
a particular retailer. The sale price of the Company's products is substantially
fixed or determinable at the date of sale based on purchase orders generated by
a retailer and accepted by the Company. A retailer's obligation to pay the
Company for products sold to it under the Company's standard terms sales model
is not contingent upon the resale of those products. The Company recognizes
revenue for standard terms sales at the time title to products is transferred to
a retailer, net of an estimate for sales incentives, rebates and returns.
CONSIGNMENT
Under the Company's consignment sales model, a retailer is obligated to pay the
Company for products sold to it within a specified number of days following
notification to the Company by the retailer of the sale of those products.
Retailers notify the Company of their sale 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 the Company 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, the Company typically collects payment from a retailer within 30 days of
the receipt of those reports. For sell-through reports generated monthly, the
Company typically collects payment from a retailer within 15 days of the receipt
F-20
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
of those reports. At the time of a retailer's sale 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 the Company's 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 the Company. Except in the case of theft or damage, a
retailer's obligation to pay the Company for products transferred under the
Company's consignment sales model is entirely contingent upon the sale of those
products. Products held by a retailer under the Company's consignment sales
model are recorded as the Company's inventory at offsite locations until their
sale by the retailer. Because the Company retains title to products in its
consignment sales channels until their sale by a retailer, revenue is not
recognized until the time of sale. Accordingly, price modifications to inventory
maintained in the Company's consignment sales channels do not have an effect on
the timing of revenue recognition. The Company recognizes revenue for
consignment sales in the period during which the sale occurs.
SPECIAL TERMS
Under the Company's special terms sales model, the payment terms for the
purchase of the Company's products are negotiated on a case-by-case basis and
typically cover a specified quantity of a particular product. The result of the
Company's 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.
The Company ordinarily does not offer any rights of return or rebates for
products sold under its special terms sales model. A retailer is obligated to
pay the Company 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 the Company. The Company's payment terms are ordinarily
shorter under its special terms sales model than under its standard terms or
consignment sales models and the Company typically requires 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. However, under its special
terms sales model, the Company often requires payment in advance or at the time
of 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 the
Company's agreement with the retailer. The sale price of the Company's products
is substantially fixed or determinable at the date of sale based on the
Company's agreement with a retailer. A retailer's obligation to pay the Company
for products sold to it under the Company's special terms sales model is not
contingent on the sale of those products. The Company recognizes revenue for
special terms sales at the time title to products is transferred to a retailer.
Product Warranties
- ------------------
The Company's products are subject to limited warranties ranging in duration of
up to one year. These warranties cover only repair or replacement of the
product. The Company's subcontract manufacturers and suppliers provide the
Company with warranties of a duration at least as long as the warranties
provided by the Company to consumers. The warranties provided by the Company's
subcontract manufacturers and suppliers cover repair or replacement of the
product. The Company has a specific right of offset against its subcontract
manufacturers and suppliers for defective products, therefore the amount of the
Company's warranty claims is not material. The Company incurs only minimal
shipping costs to its suppliers in connection with the satisfaction of its
warranty obligations.
Advertising Costs
- -----------------
The Company expenses advertising costs as incurred. For the years ended December
31, 2006, 2005, and 2004, advertising costs were $0, $0 and $262,584,
respectively.
F-21
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Shipping and Handling Costs
- ---------------------------
Shipping and handling costs incurred in a sales transaction to ship products to
a customer are included in selling, marketing and advertising expenses. For the
years ended December 31, 2006, 2005 and 2004, shipping and handling costs were
approximately $1,200,000, $893,000 and $1,000,000, respectively. Amounts billed
to customers for shipping and handling are included in revenues. For the years
ended December 31, 2006, 2005 and 2004, there were no shipping and handling
costs billed to customers. See Note 3 -- Change in Accounting Principle --
Reclassification of Shipping and Handling Expense from Cost of Sales to Selling
Expense.
Share-Based Compensation
- ------------------------
On January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), SHARE-BASED
PAYMENT, which requires the measurement and recognition of compensation expense
for all share-based payment awards made to employees and directors based on
estimated fair values. SFAS No. 123(R) supersedes the Company's previous
accounting under APB Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES,
for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange
Commission issued SAB No. 107 relating to SFAS No. 123(R). The Company has also
applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R).
The Company adopted SFAS No. 123(R) using the modified prospective transition
method, which requires the application of the accounting standard as of January
1, 2006. The Company's consolidated financial statements as of and for the year
ended December 31, 2006 reflect the impact of SFAS No. 123(R). In accordance
with the modified prospective transition method, the Company's consolidated
financial statements for prior periods have not been restated to reflect, and do
not include, the impact of SFAS No. 123(R). Share-based compensation expense
recognized under SFAS No. 123(R) for employee and directors for the year ended
December 31, 2006 was $149,048 and is included in general and administrative
expenses. For the year ended December 31, 2006, cash flows from operations and
cash flows from financing activities were not affected by the adoption of SFAS
No. 123(R).
The following table illustrates the effect on net loss and loss per share if the
Company had applied the fair value recognition provisions of SFAS No. 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION, to share-based awards granted under the
Company's stock option plans for the years ended December 31, 2005 and 2004. For
purposes of this pro-forma disclosure, the fair value of the options is
estimated using the Black-Scholes-Merton option-pricing formula ("Black-Scholes
model") and amortized to expense generally over the options' requisite service
periods (vesting periods).
F-22
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
2005 2004
------------- -------------
Net loss
As reported $ (1,818,250) $ (8,056,864)
Add share-based compensation expense included
in net loss, net of tax -- --
Deduct total share-based employee compensation expenses
determined under fair value method for all awards, net of tax (474,040) (75,673)
------------- -------------
PRO FORMA NET LOSS $ (2,292,290) $ (8,132,537)
============= =============
Loss per common share
Basic - as reported $ (0.40) $ (1.78)
============= =============
Basic - pro forma $ (0.51) $ (1.80)
============= =============
Diluted - as reported $ (0.40) $ (1.78)
============= =============
Diluted - pro forma $ (0.51) $ (1.80)
============= =============
SFAS No. 123(R) requires companies to estimate the fair value of share-based
payment awards to employees and directors on the date of grant using an
option-pricing model. The value of the portion of the award that is ultimately
expected to vest is recognized as expense over the requisite service periods in
the Company's consolidated statements of operations. Share-based compensation
expense recognized in the consolidated statements of operations for the year
ended December 31, 2006 included compensation expense for share-based payment
awards granted prior to, but not yet vested as of, January 1, 2006, based on the
grant date fair value estimated in accordance with the pro-forma provisions of
SFAS No. 123 and compensation expense for the share-based payment awards granted
subsequent to January 1, 2006, based on the grant date fair value estimated in
accordance with the provisions of SFAS No. 123(R). For share-based awards issued
to employees and directors, share-based compensation is attributed to expense
using the straight-line single option method, which is consistent with how the
prior-period pro formas were provided. As share-based compensation expense
recognized in the consolidated statements of operations for the year ended
December 31, 2006 is based on awards ultimately expected to vest, it has been
reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates. In its pro-forma information
required under SFAS No. 123 for the periods prior to 2006, the Company accounted
for forfeitures as they occurred.
Prior to the adoption of SFAS No. 123(R), the Company accounted for share-based
awards to employees and directors using the intrinsic value method in accordance
with APB No. 25. Under the intrinsic value method, the Company recognized
share-based compensation equal to the award's intrinsic value at the time of
grant over the requisite service periods using the straight-line method.
Forfeitures were recognized as incurred. During the years ended December 31,
2005 and 2004, there was no share-based compensation expense recognized in the
consolidated statements of operations for awards issued to employees and
directors as the awards had no intrinsic value at the time of grant because
their exercise prices equaled the fair values of the common stock at the time of
grant.
The Company's determination of fair value of share-based payment awards to
employees and directors on the date of grant using the Black-Scholes model,
which is affected by the Company's stock price as well as assumptions regarding
a number of highly complex and subjective variables. These variables include,
but are not limited to the Company's expected stock price volatility over the
expected term of the awards, and actual and projected employee stock option
exercise behaviors. Prior to 2006, when valuing awards, the Company used the
awards' contractual term as a proxy for the expected life of the award and
historical volatility to approximate expected volatility. During 2006, the
Company used the simplified-method under SAB No. 107 to determine an award's
expected term and the Company's historical volatility to approximate expected
volatility.
F-23
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
The Company has elected to adopt the detailed method provided in SFAS No. 123(R)
for calculating the beginning balance of the additional paid-in capital pool
("APIC pool") related to the tax effects of employee share-based compensation,
and to determine the subsequent impact on the APIC pool and consolidated
statements of cash flows of the tax effects of employee share-based compensation
awards that are outstanding upon adoption of SFAS No. 123(R).
The Company expenses share-based compensation in cost of goods sold or general
and administrative expenses depending on the job function of the employee.
Comprehensive Income
- --------------------
The Company applies SFAS No. 130, REPORTING COMPREHENSIVE INCOME. This statement
establishes standards for reporting comprehensive income and its components in a
financial statement. Comprehensive income as defined includes all changes in
equity (net assets) during a period from non-owner sources. Examples of items to
be included in comprehensive income, which are excluded from net income, include
foreign currency translation adjustments and unrealized gains and losses on
available-for-sale securities.
Foreign Currency
- ----------------
Gains and losses from foreign currency transactions, such as those resulting
from the settlement of foreign receivables, are included in the consolidated
statement of operations.
Income Taxes
- ------------
Deferred income taxes are recognized for the tax consequences in future years of
differences between the tax basis of assets and liabilities and their financial
reporting amounts at each period end, based on enacted tax laws and statutory
tax rates applicable to the periods in which the differences are expected to
affect taxable income. Valuation allowances are established, when necessary, to
reduce deferred tax assets to the amount expected to be realized. The provision
for income taxes represents the tax payable for the period, if any, and the
change during the period in deferred tax assets and liabilities.
Loss Per Share
- --------------
The Company calculates loss per share in accordance with SFAS No. 128, EARNINGS
PER SHARE. Basic loss per share is computed by dividing the net loss available
to common stockholders by the weighted-average number of common shares
outstanding. Diluted loss per share is computed similar to basic 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.
The following potential common shares have been excluded from the computations
of diluted net loss per share for the years ended December 31, 2006, 2005 and
2004 because the effect would have been anti-dilutive.
F-24
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
YEAR ENDED DECEMBER 31,
-------------------------------------
2006 2005 2004
--------- --------- ---------
Stock options outstanding 354,050 478,550 126,000
Warrants outstanding 150,000 180,000 20,000
--------- --------- ---------
TOTAL 504,050 658,550 146,000
========= ========= =========
Recently Issued Accounting Pronouncements
- -----------------------------------------
In February 2007, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 159, THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES.
SFAS No. 159 permits entities to choose to measure, on an item-by-item basis,
specified financial instruments and certain other items at fair value.
Unrealized gains and losses on items for which the fair value option has been
elected are required to be reported in earnings at each reporting date. SFAS No.
159 is effective for fiscal years beginning after November 15, 2007, the
provisions of which are required to be applied prospectively. The Company
expects to adopt SFAS No. 159 in the first quarter of fiscal 2008. The Company
does not expect SFAS No. 159 to have a material effect on its financial
position, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 157, FAIR VALUE MEASUREMENTS, which
defines the fair value, establishes a framework for measuring fair value and
expands disclosures about fair value measurements. This statement is effective
for financial statements issued for fiscal years beginning after November 15,
2007, and interim periods within those fiscal years. Early adoption is
encouraged, provided that the Company has not yet issued financial statements
for that fiscal year, including any financial statements for an interim period
within that fiscal year. The Company is currently evaluating the impact SFAS No.
157 may have on its financial position, results of operations or cash flows.
In September 2006, the Securities and Exchange Commission issued SAB No. 108,
CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING
MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENT. SAB No. 108 provides guidance
on the consideration of the effects of prior year misstatements in quantifying
current year misstatements for the purpose of a materiality assessment. SAB No.
108 establishes an approach that requires quantification of financial statement
errors based on the effects of each of the Company's balance sheets and
statement of operations and the related financial statement disclosures. SAB No.
108 permits existing public companies to record the cumulative effect of
initially applying this approach in the first year ending after November 15,
2006 by recording the necessary correcting adjustments to the carrying values of
assets and liabilities as of the beginning of that year with the offsetting
adjustment recorded to the opening balance of retained earnings. Additionally,
the use of the cumulative effect transition method requires detailed disclosure
of the nature and amount of each individual error being corrected through the
cumulative adjustment and how and when it arose. The Company implemented SAB No.
108 effective January 1, 2006 and it did not have a material effect on the
Company's financial position, results of operations or cash flows for 2006.
In July 2006, the FASB released FIN 48, ACCOUNTING FOR UNCERTAINTY IN INCOME
TAXES -- INTERPRETATION OF FASB STATEMENT NO. 109. FIN 48 clarifies the
accounting and reporting for uncertainties in income tax law. This
interpretation prescribes a comprehensive model for the financial statement
recognition, measurement, presentation and disclosure of uncertain tax positions
taken or expected to be taken in income tax returns. This statement is effective
for fiscal years beginning after December 15, 2006. The Company has evaluated
the effect of FIN 48 and does not expect it to have a material impact on its
financial position, results of operations or cash flows.
F-25
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
In October 2006, the EITF issued EITF Issue No. 06-3, HOW TAXES COLLECTED FROM
CUSTOMERS AND REMITTED TO GOVERNMENTAL AUTHORITIES SHOULD BE PRESENTED IN THE
INCOME STATEMENT (THAT IS, GROSS VERSUS NET PRESENTATION), to clarify diversity
in practice on the presentation of different types of taxes in the financial
statements. The Task Force concluded that, for taxes within the scope of the
issue, a company may adopt a policy of presenting taxes either gross within
revenue or net. That is, it may include charges to customers for taxes within
revenues and the charge for the taxes from the taxing authority within cost of
sales, or, alternatively, it may net the charge to the customer and the charge
from the taxing authority. If taxes subject to EITF Issue No. 06-3 are
significant, a company is required to disclose its accounting policy for
presenting taxes and the amounts of such taxes that are recognized on a gross
basis. The guidance in this consensus is effective for the first interim
reporting period beginning after December 15, 2006 (the first quarter of the
Company's fiscal year 2007). The Company does not expect that the adoption of
EITF Issue No. 06-3 will have a material impact on its financial position,
results of operations or cash flows.
NOTE 7 - CONCENTRATION OF RISK
Cash and Cash Equivalents
- -------------------------
The Company maintains its cash and cash equivalent balances in several banks and
a financial institution located in Southern California that from time to time
exceed amounts insured by the Federal Deposit Insurance Corporation up to
$100,000 per bank and by the Securities Investor Protection Corporation up to
$500,000 per financial institution. As of December 31, 2006 and 2005, balances
totaling $2,558,051 and $3,885,426, respectively, were uninsured. The Company
has not experienced any losses in such accounts and believes it is not exposed
to any significant credit risk on cash.
Retailers
- ---------
During the years ended December 31, 2006, the Company had net sales to four
major retailers that represented 28%, 14%, 14% and 13%, respectively, of total
net sales. As of December 31, 2006, accounts receivable from these four
retailers were 24%, 32%, 16% and 5%, respectively.
During the years ended December 31, 2005, the Company had net sales to four
major retailers that represented 36%, 17%, 17% and 11%, respectively, of total
net sales. As of December 31, 2005, accounts receivable from these four
retailers were 43%, 8%, 24% and 7%, respectively.
During the year ended December 31, 2004, the Company had net sales to five major
retailers that represented 32%, 17%, 11%, 10% and 10%, respectively, of total
net sales. As of December 31, 2004, accounts receivable from these five
retailers were 57%, 6%, 0%, 3% and 16% of accounts receivable, respectively.
Segment and Foreign Operations
- ------------------------------
The Company operates in one segment - data storage. The Company sells its
products in the United States and Canada, together known as the North American
retail marketplace.
During the years ended December 31, 2006, 2005 and 2004, the Company had net
sales to Canadian retailers that represented 16%, 2% and 2%, respectively. As of
December 31, 2006, 2005 and 2004 the Canadian retailers represented 32%, 5% and
3% of accounts receivable, respectively.
F-26
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Suppliers
- ---------
During the year ended December 31, 2006, the Company purchased inventory from
two related party vendors that represented 61% and 3% of total purchases
respectively. As of December 31, 2006, these two suppliers represented 100% of
accounts payable - due to related parties.
During the year ended December 31, 2005, the Company purchased inventory from
two related party vendors that represented 52% and 25% of purchases. As of
December 31, 2005, these two suppliers represented 100% of accounts payable -
due to related parties.
During the year ended December 31, 2004, the Company purchased inventory from
two related party vendors that represented 55% and 13% of purchases. As of
December 31, 2004, these two suppliers represented 100% of accounts payable -
due to related parties.
NOTE 8 - ACCOUNTS RECEIVABLE
Accounts receivable as of December 31, 2006 and 2005 consisted of the following:
2005
2006 (RESTATED)(1)
------------ ------------
Accounts receivable $ 14,363,142 $ 13,094,692
Less: Allowance for doubtful accounts (35,000) (3,145)
Allowance for product returns (466,407) (178,055)
Reserve for sales incentives (295,981) (316,235)
Accrued point-of-sale rebates (1,381,087) (1,579,833)
Accrued market development fund and
cooperative advertising costs and cross
dock (649,980) (1,630,571)
------------ ------------
TOTAL $ 11,534,687 $ 9,386,853
============ ============
_____________
(1) See Note 2 -- Correction of Error for Not Offsetting Reserves for Sales
Incentives Against Accounts Receivable.
NOTE 9 - INVENTORY
Inventory as of December 31, 2006 and 2005 consisted of the following:
2006 2005
------------ ------------
Component parts $ 870,484 $ 2,491,594
Finished goods--warehouse 3,164,825 1,101,355
Finished goods--consigned 7,161,607 3,421,097
------------ ------------
11,196,916 7,014,046
Less: allowance for obsolete and slow moving
inventory (526,000) (29,690)
------------ ------------
TOTAL $ 10,670,916 $ 6,984,356
============ ============
F-27
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 10 - EQUIPMENT
Equipment as of December 31, 2006 and 2005 consisted of the following:
2006 2005
------------ ------------
Computer equipment and software $ 966,170 $ 1,059,799
Warehouse equipment 69,013 55,238
Office furniture and equipment 236,007 281,974
Vehicles 74,742 91,304
Leasehold improvements 106,633 106,633
------------ ------------
1,452,565 1,594,948
Less: accumulated depreciation and amortization (1,258,448) (1,422,943)
------------ ------------
TOTAL $ 194,117 $ 172,005
============ ============
For the years ended December 31, 2006, 2005 and 2004, depreciation and
amortization expense was $96,855, $166,908 and $254,809, respectively.
NOTE 11 - TRADEMARKS
Trademarks as of December 31, 2006 and 2005 consisted of the following:
2006 2005
------------ ------------
Trademarks $ 499,800 $ 499,800
Less: accumulated amortization (137,856) (68,928)
------------ ------------
TOTAL $ 361,944 $ 430,872
============ ============
Aggregate amortization expense on these intangible assets was $68,928, $68,928
and $578,736, for the years ended December 31, 2006, 2005 and 2004,
respectively. Amortization expense related to intangible assets at December 31,
2006 in each of the next five fiscal years and beyond is expected to be incurred
as follows:
2007 $ 68,928
2008 68,928
2009 68,928
2010 68,928
2011 68,928
Thereafter 17,304
-------------
$ 361,944
=============
In accordance with SFAS No. 142, the Company performed its required valuation on
its Hi-Val(R) and Digital Research Technologies(R) trademarks for possible
impairment as of December 31, 2004. The Income approach is considered the most
appropriate method for valuing trademarks, and served as the basis for the
Company's analysis. The fair value of the trademarks is the present value of the
projected royalties for the remaining period, plus the amortization benefit.
Based upon this valuation, the Company determined that there had been a
significant impairment in the value of the trademarks due to lower sales of
products under the Hi-Val(R) and Digital Research Technologies(R) brands in 2004
and lower sales forecasted by the Company for subsequent periods. Therefore, the
Company recorded an impairment of the value of the trademarks of $3,696,099 as
of December 31, 2004. No impairment was recorded for the years ended December
31, 2006 and 2005.
F-28
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 12- ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses as of December 31, 2006 and 2005 consisted
of the following:
2005
2006 (RESTATED)(1)
------------ ------------
Trade accounts payable $ 4,357,535 $ 1,477,458
Accrued compensation and related benefits 99,580 113,183
Other 1,064,758 408,724
------------ ------------
TOTAL $ 5,521,873 $ 1,999,365
============ ============
_____________
(1) See Note 2 -- Correction of Error for Not Offsetting Reserves for Sales
Incentives Against Accounts Receivable.
NOTE 13 - LINES OF CREDIT
On August 15, 2003, the Company 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 the Company's 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, the Company replaced the
Company's asset-based line of credit with United National Bank with an
asset-based line of credit with GMAC Commercial Finance ("GMAC").
The Company's asset-based line of credit with GMAC was to expire on January 15,
2007 and allowed the Company to borrow up to $5.0 million. The line of credit
bore interest at a floating interest rate equal to the prime rate of interest
plus 2.75%. The Company's obligations under its loan agreement with GMAC were
secured by substantially all of its assets and guaranteed by its wholly-owned
subsidiary, IOM Holdings, Inc. Until the Company's entry into a forbearance
agreement with GMAC, as discussed below, the loan agreement had one financial
covenant which required the Company to maintain a fixed charge coverage ratio of
at least 1.5 to 1.0 for the three months ended June 30, 2005, the six months
ended September 30, 2005, the nine months ended December 31, 2005, the twelve
months ended March 31, 2006 and for each twelve month period ending on the end
of each calendar quarter thereafter. The Company was in violation of this
financial covenant as of September 30, 2006.
On October 18, 2006, the Company entered into a forbearance agreement with GMAC
that provided for the forbearance by GMAC from enforcing its rights and remedies
under the loan agreement as a result of the Company's failure to satisfy a
financial covenant contained in the loan agreement. The forbearance agreement
was effective through January 15, 2007, at which time all obligations to GMAC
were due and payable in full. The forbearance agreement also amended the loan
agreement to (i) delete inventory from the calculation of the borrowing base,
(ii) reduce the maximum amount that may be borrowed under the loan agreement
from $10.0 million to $5.0 million, (iii) increase the static reserve from
$1,000,000 to $1,350,000, and (iv) increase the fixed charge coverage ratio from
1.2:1.0 to 1.5:1.0. The forbearance agreement also provided that from and after
the date of the agreement, advances under the credit facility would bear
interest at the post-default rate of prime plus 2.75% per annum. On October 18,
2006, the prime rate was 8.25%.
F-29
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
The outstanding balance with GMAC as of December 31, 2006 was $4,380,133. The
amount available to the Company for borrowing as of December 31, 2006 was
$568,612. As of December 31, 2006, the Company was in compliance with the
Forbearance Agreement. The weighted average outstanding loan balance and the
weighted average interest rate of the GMAC facility during 2006 were $3,432,319
and 9.16% and for 2005 was $3,903,444 and 6.94%, respectively.
On January 27, 2007, the Company entered into a Loan and Security Agreement with
Silicon Valley Bank which provides for a revolving line of credit. See Note 5 -
Subsequent Events. The outstanding balance with Silicon Valley Bank as of July
9, 2007 was $3,459,787. The amount available to the Company for borrowing as of
July 9, 2007 was $5,000.
NOTE 14 - ACCOUNTS PAYABLE - RELATED PARTIES
Effective April 29, 2005, the Company entered into a trade credit facility with
a related party whereby the related party 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 the related party as an international purchasing
office, or (ii) manufactured by the related party. For inventory purchased
through the related party, the terms are 120 days following the date of invoice
by the related party and the related party 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 the
related party, the payment terms are 90 days following the date of the invoice
by the related party. The Company is to pay the related party 10% of the
purchase price on any purchase orders issued to the related party, 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. During 2006
and 2005, the Company purchased $22.2 million and $7.9 million, respectively, of
inventory under this arrangement. As of December 31, 2006 and 2005, there were
$7.6 million and $4.5 million, respectively, in trade payables under this
arrangement. Fees under this agreement were not material.
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
2006 and 2005, the Company purchased $1.2 million and $16.6 million of
inventory, respectively, under this arrangement. As of December 31, 2006 and
2005, there were $300,000 and $3.8 million, respectively, in trade payables
outstanding under this arrangement.
F-30
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 15 - COMMITMENTS AND CONTINGENCIES
Operating Lease Commitments
- ---------------------------
The Company leases its facilities and certain equipment under non-cancelable
operating lease agreements expiring through August 2009.
Future minimum lease payments under these non-cancelable operating lease
obligations at December 31, 2006 are as follows:
YEAR ENDING
DECEMBER 31,
------------
2007 $ 359,240
2008 370,040
2009 251,600
---------------
TOTAL $ 980,880
===============
Rent expense was $334,816, $378,674 and $366,574 for the years ended December
31, 2006, 2005 and 2004, respectively, and is included in general and
administrative expenses in the accompanying consolidated statements of
operations.
Financial Agreements
- --------------------
The Company entered into a Loan and Security Agreement in January 2007 which
provides for a loan commitment fee of $50,000, a monthly collateral monitoring
fee of $1,250 and an anniversary fee of $50,000. In addition, the Company must
pay customary fees and expenses for the issuance or renewal of letters of credit
and all expenses incurred by the lender related to the Loan and Security
Agreement. See Note 5 - Subsequent Events.
Service Agreements
- ------------------
Periodically, the Company enters into various agreements for services including,
but not limited to, public relations, financial consulting, and manufacturing
consulting. The agreements generally are ongoing until such time as they are
terminated. Compensation for services is paid either on a fixed monthly rate or
based on a percentage, as specified, and may be payable in shares of the
Company's common stock. During the years ended December 31, 2006, 2005 and 2004,
the Company incurred expenses of $672,575, $276,388 and $364,588 respectively,
in connection with such arrangements. These expenses are included in general and
administrative expenses in the accompanying consolidated statements of
operations.
Employment Contract
- -------------------
The Company entered into an employment agreement with one of its officers on
October 15, 2002, which expires on October 15, 2007. The agreement, which was
effective as of January 1, 2002, calls for an initial salary of $198,500, and
provides for certain expense allowances. In addition, the agreement provides for
a quarterly bonus equal to 7% of the Company's quarterly net income. For the
years ended December 31, 2006, 2005 and 2004, bonuses totaling $39,103, $15,888
and $60,702, respectively, were paid under the terms of this agreement. As of
December 31, 2006 and 2005, accrued bonuses under this agreement were $12,200
and $0, respectively.
F-31
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Retail Agreements
- -----------------
In connection with certain retail agreements, the Company has agreed to pay for
certain marketing development and advertising on an ongoing basis. Marketing
development and advertising costs are generally agreed upon at the time of the
event. The Company also records a liability for market development/cooperative
advertising funds based on management's evaluation of historical experience and
current industry and Company trends.
For the years ended December 31, 2006, 2005 and 2004, the Company incurred
$1,359,503, $1,804,702 and $1,701,178, respectively, related to its retail
agreements with its retailers. These amounts are netted against revenue in the
accompanying consolidated statements of operations.
The Company has obligations to two of its retailers to provide "back-end" market
development funds if the retailer exceeds certain purchase thresholds. The
Company reviews these two commitments on a quarterly basis to determine the
probability of the retailers exceeding the thresholds. If in management's
opinion, the thresholds will be exceeded, additional accruals will be required
to account for these "back-end" fees. As of December 31, 2006, 2005 and 2004, no
such fees were incurred or accrued.
Indemnification Obligations
- ---------------------------
A number of the Company's agreements with its retailers provide that the Company
must 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 the Company's products. The Company has
historically not had any material liabilities arising from these obligations.
Litigation
- ----------
On or about May 30, 2003, the Company and IOM Holdings, Inc. filed a complaint
for breach of contract and legal malpractice against Lawrence W. Horwitz,
Gregory B. Beam, Horwitz & Beam, Inc., Lawrence M. Cron, Horwitz & Cron, Kevin
J. Senn and Senn Palumbo Meulemans, LLP, the Company's former attorneys and
their respective law firms, in the Superior Court of the State of California for
the County of Orange. The complaint sought damages of $15.0 million arising out
of the defendants' representation of the Company and IOM Holdings, Inc. in an
acquisition transaction and in a separate arbitration matter. On or about
November 6, 2003, the Company filed its First Amended Complaint against all
defendants. Defendants responded to the First Amended Complaint denying the
Company's allegations. Defendants Lawrence W. Horwitz and Lawrence M. Cron also
filed a Cross-Complaint against I/OMagic for attorneys' fees in the approximate
amount of $79,000. The Company denied the allegations in the Cross-Complaint.
Trial began on February 6, 2006 and on March 10, 2006, the jury ruled in the
Company's favor against Lawrence W. Horwitz, Horwitz & Beam, Inc., Lawrence M.
Cron, Horwitz & Cron and Senn Palumbo Meulemans, LLP, and awarded the Company
$3.0 million in damages. The Company has not collected any of this amount.
Judgment was entered on or about April 5, 2006. However, defendants have since
filed a motion for new trial and a motion for judgment notwithstanding the
verdict. On May 31, 2006, the Court denied the motion for new trial in its
entirety, denied the motion for judgment notwithstanding the verdict as to
Lawrence W. Horwitz, Horwitz & Beam, Inc. and Lawrence M. Cron, but granted the
motion for judgment notwithstanding the verdict as to Horwitz & Cron and Senn
Palumbo Meulemans, LLP. An Amended Judgment Notwithstanding the Verdict based
upon the Court's ruling on the motion for judgment notwithstanding the verdict
was entered on or about July 7, 2006. Appeals have since been filed as to both
the original Judgment and the Amended Judgment. These appeals remain pending.
F-32
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
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, Case No. 05CC06433. The complaint sought
damages of in excess of $22 million arising out of the defendants' alleged
breach of contract under an agreement entered into in May 2001. On or about June
20, 2005, OfficeMax removed the case to the United States District Court for the
Central District of California, Case No. SA CV05-0592 DOC(MLGx). On August 1,
2005, OfficeMax filed its Answer and Counter-Claim against the Company. The
Counter-Claim alleged four causes of action against the Company: breach of
contract, unjust enrichment, quantum valebant, and an action for declaratory
relief. The Counter-Claim alleged, among other things, that the Company was
liable to OfficeMax in the amount of no less than $138,000 under the terms of a
vendor agreement executed between the Company and OfficeMax in connection with
the return of computer peripheral products to the Company for which OfficeMax
alleged it was never reimbursed. The Counter-Claim sought, among other things,
at least $138,000 from the Company, along with pre-judgment interest, attorneys'
fees and costs of suit. The Company filed a response denying all of the
affirmative claims set forth in the Counter-Claim, denying any wrongdoing or
liability, and denying that OfficeMax was entitled to obtain any relief. In
April 2006, the case against OfficeMax North America, Inc. was settled in its
entirety. In settling the matter, each party denied liability and wrongdoing and
the settlement was entered into solely for the purpose of compromising and
settling the litigation and in order to avoid the risk, cost, and burden of
litigation and participation therein. Pursuant to the settlement, OfficeMax paid
the Company $2,375,000 during the second quarter of 2006, which is included in
other income.
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 16 - REDEEMABLE CONVERTIBLE PREFERRED STOCK
During December 2000, the Company amended its Articles of Incorporation to
authorize 10,000,000 shares of preferred stock, of which 1,000,000 shares are
designated as Series A preferred stock and 1,000,000 shares are designated as
Series B preferred stock. Series A preferred stockholders do not have voting
powers and are entitled to receive dividends on an equal basis with the holders
of the Company's common stock. Series B preferred stockholders have the same
rights as Series A preferred stockholders, except the Company is obligated to
redeem any issued shares that have been outstanding for two years. At December
31, 2006 and 2005, no shares of Series A or Series B preferred stock were
outstanding,
NOTE 17 - COMMON STOCK, WARRANTS AND STOCK OPTIONS
Common Stock Issued in Connection with the Exercise of Options
- --------------------------------------------------------------
During the year ended December 31, 2006, the Company issued an aggregate of
22,213 shares of common stock in connection with the exercise of 6,900 employee
stock options issued in March 2004 for cash of $24,150 or at a price of $3.50
per share and with the exercise of 15,313 employee stock options issued in July
2005 for cash of $38,282 or at a per share price of $2.50.
During the year ended December 31, 2005, the Company issued an aggregate of
1,900 shares of common stock in connection with the exercise of employee stock
options issued March 9, 2004 for cash of $6,650 or at a per share price of
$3.50.
F-33
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Treasury Stock
- --------------
On February 12, 2002, the Company announced the approval by the Board of
Directors of the Company to redeem its own stock in open market transactions of
up to $500,000. During the year ended December 31, 2002, the Company purchased
4,226 shares of common stock for $42,330 on the open market. During the year
ended December 31, 2003, the Company purchased 9,267 shares of common stock for
$83,684 on the open market. The Company cancelled those shares in 2006.
Warrants
- --------
During the year ended December 31, 2004, the Company issued warrants to purchase
20,000 shares of common stock to a financial advisory firm, 10,000 of which are
exercisable at $4.00 per share and 10,000 of which are exercisable at $6.00 per
share. These warrants vested immediately. None of the warrants were exercised,
and such warrants expired in September 2005.
During the year ended December 31, 2005, the Company issued warrants to purchase
150,000 shares of common stock to a financial advisory firm, 50,000 of which are
exercisable at $3.00 per share, 50,000 of which are exercisable at $4.00 per
share and 50,000 of which are exercisable at $5.00 per share. These warrants
vested immediately. None of the warrants have been exercised, and such warrants
expire in January 2007.
During the year ended December 31, 2005, the Company issued warrants to purchase
30,000 shares of common stock to a financial advisory firm, 15,000 of which are
exercisable at $8.00 per share and 15,000 of which are exercisable at $10.00 per
share. These warrants vested immediately. None of the warrants were exercised,
and such warrants expired in November 2006.
Stock Option Plans
- ------------------
The Company has a 2002 Stock Option Plan (the "2002 Plan") and a 2003 Stock
Option Plan (the "2003 Plan"). The 2002 Plan and 2003 Plan are collectively
referred to as the "Plans."
The total number of shares of the Company's common stock authorized for issuance
under the 2002 Plan and the 2003 Plan are 133,334, and 400,000, respectively.
Under the Plans, options granted may be either "incentive stock options," within
the meaning of Section 422 of the Internal Revenue Code, or "nonqualified
options." Incentive options granted under the Plans must have an exercise price
of not less than the fair market value of a share of common stock on the date of
grant unless the optionee owns more than 10% of the total voting securities of
the Company. In this case, the exercise price will not be less than 110% of the
fair market value of a share of common stock on the date of grant. Incentive
stock options may not be granted to an optionee under the Plans if the aggregate
fair market value, as determined on the date of grant, of the stock with respect
to which incentive stock options are exercisable by such optionee in any
calendar year under the Plans, exceeds $100,000. Nonqualified options granted
under the Plans must have an exercise price of not less than the fair market
value of a share of common stock on the date of grant. Nonqualified options
granted under the Plans must have an exercise price of not less than 85% of the
fair market value of a share of common stock on the date of grant.
F-34
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Under the Plans, options may be exercised during a period of time fixed by the
committee administering the Plans (which could include the entire Board of
Directors). Options granted under the Plans must vest at a rate not less than
20% per year over a consecutive five-year period. No option granted under any of
the Plans may be exercised more than 10 years after the date of grant. Incentive
stock options granted to an optionee who owns more than 10% of the voting
securities of the Company may not be exercised more than five years after the
date of grant.
A summary of option and warrant activity under the Plans as of December 31, 2006
and changes during the three-year period then ended is presented below:
WEIGHTED-
WEIGHTED- AVERAGE
AVERAGE REMAINING AGGREGATE
EXERCISE CONTRACTUAL INTRINSIC
OPTIONS AND WARRANTS SHARES PRICE TERM VALUE
- ----------------------------------------- ----------- ------------ ------------- -----------
Outstanding at December 31, 2003 40,008 $ 8.49 2.1 years
Granted 146,375 $ 3.85
Forfeited (40,383) $ 8.44
---------
Outstanding at December 31, 2004 146,000 $ 3.85 8.1 years
Granted 550,000 $ 3.32
Exercised (1,900) $ 3.50
Forfeited (35,550) $ 4.34
---------
Outstanding at December 31, 2005 658,550 $ 3.38 4.2 years $ 1,280,000
=========
Exercisable at December 31, 2005 467,491 $ 3.65 3.3 years $ 815,000
=========
Vested or expected to vest at December 31, 2005 645,000 $ 3.39 3.7 years $ 1,250,000
=========
Outstanding at January 1, 2006 658,550
Granted 50,000 $ 4.00
Exercised (22,213) $ 2.81
Forfeited (182,287) $ 3.82
---------
Outstanding at December 31, 2006 504,050 $ 3.36 2.5 years -
---------
Exercisable at December 31, 2006 407,208 $ 3.45 2.7 years -
=========
Vested or expected to vest at December 31, 2006 490,000 $ 3.36 2.5 years -
=========
Aggregate intrinsic value excludes those options that are not "in-the-money."
Awards that are expected to vest take into consideration estimated forfeitures
for awards not yet vested.
The weighted-average grant date fair value of awards granted under the Plans
during 2006 and 2005 was $1.40 and $1.41 per share, respectively. Fair value was
determined using the Black-Scholes model and the following assumptions:
2006 2005 2004
-------- ---------- -----------
Weighted-average volatility 120% 100% 100%
Expected dividends - - -
Expected term (in years) 3.25 1.00 - 5.00 3.00
Risk-free rate 4.60% 3.60% - 4.20% 1.92%
The total fair value of shares vested during the years ended December 31, 2005
and 2006 were $12,275 and $463,781, respectively.
F-35
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Prior to 2005, there were no options exercised. Options exercised in 2005 were
immaterial. Cash received from options exercised in 2006 was $62,400. The
intrinsic value of options exercised in 2006, at the time of exercise, was
$48,600. The Company did not receive a tax deduction from options exercised in
2006. When options are exercised, the Company's policy is to issue new shares to
satisfy share option exercises.
As of December 31, 2006, there was $170,979 of total unrecognized compensation
costs related to non-vested share-based compensation arrangements granted,
including warrants. That cost is expected to be recognized over the
weighted-average period of 2.8 years.
The following table is a summary of the stock options and warrants as of
December 31, 2006:
WEIGHTED- AVERAGE WEIGHTED-
WEIGHTED- EXERCISE PRICE OF AVERAGE EXERCISE
STOCK OPTIONS STOCK OPTIONS AND AVERAGE OPTIONS AND PRICE OF OPTIONS
RANGE OF EXERCISE AND WARRANTS WARRANTS REMAINING WARRANTS AND WARRANTS
PRICES OUTSTANDING EXERCISABLE CONTRACTUAL LIFE OUTSTANDING EXERCISABLE
- -------------------- ----------------- ---------------- -------------------- ----------------- ------------------
$ 2.50-3.85 354,050 257,208 3.3 years $3.09 $3.13
$ 4.00-6.00 150,000 150,000 .08 years $4.50 $4.50
504,050 407,208 3.00 years $3.36 $3.18
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options, which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
NOTE 18 - INCOME TAXES
The components of the income tax provision (benefit) for the years ended
December 31, 2006, 2005 and 2004 were as follows:
2006 2005 2004
------ ------ ------
Current $ 800 $2,400 $2,532
Deferred -- -- --
------ ------ ------
TOTAL $ 800 $2,400 $2,532
====== ====== ======
F-36
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
Income tax expense (benefit) for the years ended December 31, 2006, 2005 and
2004 differed from the amounts computed applying the federal statutory rate of
34% to pre-tax income as a result of:
2006 2005 2004
----------- ----------- -----------
Computed "expected" tax benefit $ (52,984) $ (617,389) $(2,738,340)
Income in income taxes resulting from expenses
not deductible for tax purposes 8,785 8,672 7,955
Change in the valuation allowance for deferred
tax assets net of return to provision adjustment 52,056 713,989 3,199,890
State and local income taxes, net of tax benefit (7,057) (102,872) (466,973)
----------- ----------- -----------
Total $ 800 $ 2,400 $ 2,532
=========== =========== ===========
Significant components of the Company's deferred tax assets and liabilities for
federal income taxes at December 31, 2006 and 2005 consisted of the following:
2006 2005
------------ ------------
Current deferred tax assets
Allowance for doubtful accounts $ 14,994 $ 1,347
Allowances for product returns 193,937 76,279
Allowances for sales incentives 126,798 135,475
Accrued compensation 24,514 65,599
Inventory 400,607 312,271
Other 46,117 10,967
State taxes effect of deferred tax assets (41,479) (32,252)
Valuation allowance (765,488) (569,686)
------------ ------------
Net current deferred tax assets -- --
------------ ------------
Long-term deferred tax assets
Net operating loss carryforward $ 10,772,676 $ 10,853,808
Amortization of trademarks 2,113,318 2,363,610
State taxes effect of deferred tax assets (662,346) (708,203)
Valuation allowance (12,223,648) (12,509,215)
------------ ------------
Net long-term deferred tax assets -- --
------------ ------------
NET DEFERRED TAX ASSETS $ -- $ --
============ ============
SFAS No. 109, ACCOUNTING FOR INCOME TAXES, requires that a valuation allowance
be established when it is more likely than not that its recorded net deferred
tax asset will not be realized. In determining whether a valuation allowance is
required, a company must take into account all positive and negative evidence
with regard to the utilization of a deferred tax asset. SFAS No. 109 further
states that it is difficult to conclude that a valuation allowance is not needed
when there is negative evidence such as cumulative losses in recent years. As of
December 31, 2006 and 2005, the valuation allowance for deferred tax assets
totaled $12,989,136 and $13,078,901, respectively. For the years ended December
31, 2006, 2005 and 2004, the net change in the valuation allowance was $89,765
(decrease), $979,902 (increase) and $3,199,890 (increase), respectively.
F-37
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
The Company plans to continue to provide a full valuation allowance on future
tax benefits until it can sustain an appropriate level of profitability and
until such time, the Company would not expect to recognize any significant tax
benefits in its future results of operations.
As of December 31, 2006, the Company had net operating loss carryforwards for
federal and state income tax purposes of approximately $27,377,740 and
$16,563,856, respectively, that expire through 2026 and 2016, respectively. The
utilization of net operating loss carryforwards may be limited under the
provisions of Internal Revenue Code Section 382 and similar state provisions due
to the change in ownership.
NOTE 19 - RELATED PARTY TRANSACTIONS
During the years ended December 31, 2006, 2005 and 2004, the Company made
purchases from related parties totaling $23,362,905, $24,510,810 and
$21,725,485, respectively. See Note 14 -- Accounts Payable - Related Parties.
NOTE 20 - SELECTED QUARTERLY FINANCIAL DATA-UNAUDITED
Quarterly Financial Data
The following tables are summaries of the unaudited quarterly financial
information for the years ended December 31, 2006 and 2005.
YEAR ENDED DECEMBER 31, 2006
FIRST SECOND THIRD
QUARTER QUARTER QUARTER
(ADJUSTED (ADJUSTED (ADJUSTED
AND AND AND FOURTH
RESTATED)(1) RESTATED)(1) RESTATED)(1) QUARTER TOTAL
------------ ------------ ------------ ------------ ------------
(in thousands, except per share data)
Net sales $ 8,994 $ 9,882 $ 11,459 $ 15,554 $ 45,889
Cost of Sales 8,212 8,548 9,474 13,229 39,463
------------ ------------ ------------ ------------ ------------
Gross profit 782 1,334 1,985 2,325 6,426
Operating expenses 1,798 2,910 1,848 2,228 8,784
------------ ------------ ------------ ------------ ------------
Operating income (loss) (1,016) (1,576) 137 97 (2,358)
Other income (expense) (81) 2,287 (54) (102) 2,050
------------ ------------ ------------ ------------ ------------
Pre-tax income (loss) (1,097) 711 83 (5) (308)
Income tax provision -- 1 -- -- 1
------------ ------------ ------------ ------------ ------------
Net income (loss) $ (1,097) $ 710 $ 83 $ (5) $ (309)
============ ============ ============ ============ ============
Net income (loss) per common share diluted $ (0.24) $ 0.16 $ 0.02 $ (0.01) $ (0.07)
============ ============ ============ ============ ============
(1) See Note 22 -- Quarterly Financial Data -- Change in Accounting
Principle - Reclassification of Shipping and Handling Expense from Cost
of Sales to Selling Expense.
F-38
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
YEAR ENDED DECEMBER 31, 2005
FIRST SECOND THIRD
QUARTER QUARTER QUARTER
(ADJUSTED (ADJUSTED (ADJUSTED
AND AND AND FOURTH
RESTATED)(1) RESTATED)(1) RESTATED)(1) QUARTER TOTAL
------------ ------------ ------------ ------------ ------------
(in thousands, except per share data)
Net sales $ 9,037 $ 9,558 $ 8,423 $ 10,755 $ 37,773
Cost of Sales 8,435 8,009 7,102 9,935 33,481
------------ ------------ ------------ ------------ ------------
Gross profit 602 1,549 1,321 820 4,292
Operating expenses 1,690 1,258 1,457 1,416 5,821
------------ ------------ ------------ ------------ ------------
Operating income (loss) (1,088) 291 (136) (596) (1,529)
Other expense (69) (62) (76) (80) (287)
------------ ------------ ------------ ------------ ------------
Pre-tax income (loss) (1,157) 229 (212) (676) (1,816)
Income tax provision -- 2 -- -- 2
------------ ------------ ------------ ------------ ------------
Net income (loss) $ (1,157) $ 227 $ (212) $ (676) $ (1,818)
============ ============ ============ ============ ============
Net income (loss) per common share diluted $ (0.26) $ 0.05 $ (0.05) $ (0.14) $ (0.40)
============ ============ ============ ============ ============
(1) See Note 22 -- Quarterly Financial Data -- Change in Accounting
Principle - Reclassification of Shipping and Handling Expense from Cost
of Sales to Selling Expense.
F-39
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 21 - QUARTERLY FINANCIAL DATA - CORRECTION OF ERROR FOR NOT OFFSETTING
RESERVES FOR SALES INCENTIVES AGAINST ACCOUNTS RECEIVABLE
As discussed in Note 2 -- Correction of Error for Not Offsetting Reserves for
Sales Incentives Against Accounts Receivable, this note reflects the unaudited
quarterly effect of the indicated correction of this error whereas Note 2
reflects the annual audited periods presented therein.
Based on the foregoing, the Company has determined the effect of the correction
of this error on its previously issued financial statements and has restated the
unaudited quarterly financial information below, reconciling the restatements on
a quarterly basis for the quarterly periods in the years ended December 31, 2006
and 2005.
MARCH 31, 2006
- --------------
AS ORIGINALLY
REPORTED RESTATEMENTS AS RESTATED
----------- ----------- -----------
ASSETS (in thousands, except number of shares)
CURRENT ASSETS
Cash and cash equivalents $ 2,829 $ -- $ 2,829
Restricted cash 17 -- 17
Accounts receivable, net 10,358 (1,969) 8,389
Inventory, net 6,831 -- 6,831
Prepaid expenses and other current assets 1,362 -- 1,362
----------- ----------- -----------
Total current assets 21,397 (1,969) 19,428
EQUIPMENT, net 143 -- 143
TRADEMARKS, net 413 -- 413
OTHER ASSETS 27 -- 27
----------- ----------- -----------
Total assets $ 21,980 $ (1,969) $ 20,011
=========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit $ 5,109 $ -- $ 5,109
Accounts payable, accrued expenses and other 4,459 (1,418) 3,041
Accounts payable - related parties 5,365 -- 5,365
Accrued mail-in rebates 917 -- 917
Reserves for product returns and sales incentives 551 (551) --
----------- ----------- -----------
Total liabilities 16,401 (1,969) 14,432
----------- ----------- -----------
STOCKHOLDERS' EQUITY
Preferred stock, $0.001 par value 10,000,000 shares
authorized -- -- --
Series A, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Series B, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Common stock, $0.001 par value 100,000,000 shares
authorized, 4,537,292 shares issued and outstanding 5 -- 5
Additional paid-in capital 31,564 -- 31,564
Accumulated deficit (25,990) -- (25,990)
----------- ----------- -----------
TOTAL STOCKHOLDERS' EQUITY 5,579 -- 5,579
----------- ----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 21,980 $ (1,969) $ 20,011
=========== =========== ===========
F-40
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
JUNE 30, 2006
- -------------
AS ORIGINALLY
REPORTED RESTATEMENTS AS RESTATED
----------- ----------- -----------
ASSETS (in thousands, except number of shares)
Current assets
Cash and cash equivalents $ 1,363 $ -- $ 1,363
Restricted cash 12 -- 12
Accounts receivable, net 9,032 (1,830) 7,202
Inventory, net 9,415 -- 9,415
Prepaid expenses and other current assets 149 -- 149
----------- ----------- -----------
Total current assets 19,971 (1,830) 18,141
EQUIPMENT, net 131 -- 131
TRADEMARKS, net 397 -- 397
OTHER ASSETS 38 -- 38
----------- ----------- -----------
Total assets $ 20,537 $ (1,830) $ 18,707
=========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit $ 3,767 $ -- $ 3,767
Accounts payable, accrued expenses and other 2,867 (1,428) 1,439
Accounts payable - related parties 6,510 -- 6,510
Accrued mail-in rebates 649 -- 649
Reserves for product returns and sales incentives 402 (402) --
----------- ----------- -----------
Total liabilities 14,195 (1,830) 12,365
----------- ----------- -----------
STOCKHOLDERS' EQUITY
Preferred stock, $0.001 par value 10,000,000 shares
authorized -- -- --
Series A, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Series B, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Common stock, $0.001 par value 100,000,000 shares authorized,
4,540,292 shares issued and outstanding 5 -- 5
Additional paid-in capital 31,617 -- 31,617
Accumulated deficit (25,280) -- (25,280)
----------- ----------- -----------
TOTAL STOCKHOLDERS' EQUITY 6,342 -- 6,342
----------- ----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 20,537 $ (1,830) $ 18,707
=========== =========== ===========
F-41
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
SEPTEMBER 30, 2006
- ------------------
AS ORIGINALLY
REPORTED RESTATEMENTS AS RESTATED
----------- ----------- -----------
ASSETS (in thousands, except number of shares)
CURRENT ASSETS
Cash and cash equivalents $ 1,245 $ -- $ 1,245
Restricted cash 542 -- 542
Accounts receivable, net 10,090 (2,211) 7,879
Inventory, net 8,544 -- 8,544
Prepaid expenses and other current assets 14 -- 14
----------- ----------- -----------
Total current assets 20,435 (2,211) 18,224
EQUIPMENT, net 117 -- 117
TRADEMARKS, net 379 -- 379
OTHER ASSETS 49 -- 49
----------- ----------- -----------
Total assets $ 20,980 $ (2,211) $ 18,769
=========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit $ 3,999 $ -- $ 3,999
Accounts payable, accrued expenses and other 3,756 (1,702) 2,054
Accounts payable - related parties 5,676 -- 5,676
Accrued mail-in rebates 581 -- 581
Reserves for product returns and sales incentives 509 (509) --
----------- ----------- -----------
Total liabilities 14,521 (2,211) 12,310
----------- ----------- -----------
STOCKHOLDERS' EQUITY
Preferred stock, $0.001 par value 10,000,000 shares
authorized Series A, 1,000,000 shares authorized,
no shares issued and outstanding -- -- --
Series B, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Common stock, $0.001 par value 100,000,000 shares
authorized, 4,540,292 shares issued and outstanding 5 -- 5
Additional paid-in capital 31,651 -- 31,651
Accumulated deficit (25,197) -- (25,197)
----------- ----------- -----------
TOTAL STOCKHOLDERS' EQUITY 6,459 -- 6,459
----------- ----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 20,980 $ (2,211) $ 18,769
=========== =========== ===========
F-42
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
MARCH 31, 2005
- --------------
AS ORIGINALLY
REPORTED RESTATEMENTS AS RESTATED
----------- ----------- -----------
ASSETS (in thousands, except number of shares)
CURRENT ASSETS
Cash and cash equivalents $ 1,659 $ -- $ 1,659
Restricted cash 266 -- 266
Accounts receivable, net 12,802 (3,666) 9,136
Inventory, net 8,005 -- 8,005
Prepaid expenses and other current assets 1,188 -- 1,188
----------- ----------- -----------
Total current assets 23,920 (3,666) 20,254
EQUIPMENT, net 248 -- 248
TRADEMARKS, net 482 -- 482
OTHER ASSETS 27 -- 27
----------- ----------- -----------
Total assets $ 24,677 $ (3,666) $ 21,011
=========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit $ 4,803 $ -- $ 4,803
Accounts payable, accrued expenses and other 4,267 (2,895) 1,372
Accounts payable - related parties 7,272 -- 7,272
Accrued mail-in rebates 359 -- 359
Reserves for product returns and sales incentives 771 (771) --
----------- ----------- -----------
Total liabilities 17,472 (3,666) 13,806
----------- ----------- -----------
STOCKHOLDERS' EQUITY
Preferred stock, $0.001 par value 10,000,000 shares
authorized -- -- --
Series A, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Series B, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Common stock, $0.001 par value 100,000,000 shares
authorized, 4,529,672 shares issued and outstanding 5 -- 5
Additional paid-in capital 31,558 -- 31,558
Treasury stock, 13,439 shares at cost (126) -- (126)
Accumulated deficit (24,232) -- (24,232)
----------- ----------- -----------
TOTAL STOCKHOLDERS' EQUITY 7,205 -- 7,205
----------- ----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 24,677 $ (3,666) $ 21,011
=========== =========== ===========
F-43
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
JUNE 30, 2005
- -------------
AS ORIGINALLY
REPORTED RESTATEMENTS AS RESTATED
----------- ----------- -----------
ASSETS (in thousands, except number of shares)
CURRENT ASSETS
Cash and cash equivalents $ 1,705 $ -- $ 1,705
Restricted cash 219 -- 219
Accounts receivable, net 12,456 (3,717) 8,739
Inventory, net 8,264 -- 8,264
Prepaid expenses and other current assets 1,259 -- 1,259
----------- ----------- -----------
Total current assets 23,903 (3,717) 20,186
EQUIPMENT, net 204 -- 204
TRADEMARKS, net 465 -- 465
OTHER ASSETS 27 -- 27
----------- ----------- -----------
Total assets $ 24,599 $ (3,717) $ 20,882
=========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Line of credit $ 4,191 $ -- $ 4,191
Accounts payable, accrued expenses and other 4,335 (3,247) 1,088
Accounts payable - related parties 7,743 -- 7,743
Accrued mail-in rebates 428 -- 428
Reserves for product returns and sales incentives 470 (470) --
----------- ----------- -----------
Total liabilities 17,167 (3,717) 13,450
----------- ----------- -----------
STOCKHOLDERS' EQUITY
Preferred stock, $0.001 par value 10,000,000 shares
authorized -- -- --
Series A, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Series B, 1,000,000 shares authorized, no shares issued
and outstanding
Common stock, $0.001 par value 100,000,000 shares
authorized, 4,529,672 shares issued and outstanding 5 -- 5
Additional paid-in capital 31,558 -- 31,558
Treasury stock, 13,439 shares at cost (126) -- (126)
Accumulated deficit (24,005) -- (24,005)
----------- ----------- -----------
TOTAL STOCKHOLDERS' EQUITY 7,432 -- 7,432
----------- ----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 24,599 $ (3,717) $ 20,882
=========== =========== ===========
F-44
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
SEPTEMBER 30, 2005
- ------------------
AS ORIGINALLY
REPORTED RESTATEMENTS AS RESTATED
----------- ----------- -----------
ASSETS (in thousands, except number of shares)
CURRENT ASSETS
Cash and cash equivalents $ 2,782 $ -- $ 2,782
Restricted cash 38 -- 38
Accounts receivable, net 12,090 (4,349) 7,741
Inventory, net 7,259 -- 7,259
Prepaid expenses and other current assets 1,525 -- 1,525
----------- ----------- -----------
Total current assets 23,694 (4,349) 19,345
EQUIPMENT, net 195 -- 195
TRADEMARKS, net 448 -- 448
OTHER ASSETS 27 -- 27
----------- ----------- -----------
Total assets $ 24,364 $ (4,349) $ 20,015
=========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit $ 5,509 $ -- $ 5,509
Accounts payable, accrued expenses and other 5,141 (3,848) 1,293
Accounts payable - related parties 5,617 -- 5,617
Accrued mail-in rebates 370 -- 370
Reserves for product returns and sales incentives 501 (501) --
----------- ----------- -----------
Total liabilities 17,138 (4,349) 12,789
----------- ----------- -----------
STOCKHOLDERS' EQUITY
Preferred stock, $0.001 par value 10,000,000 shares
authorized -- -- --
Series A, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Series B, 1,000,000 shares authorized, no shares issued
and outstanding -- -- --
Common stock, $0.001 par value 100,000,000 shares
authorized, 4,531,572 shares issued and outstanding 5 -- 5
Additional paid-in capital 31,565 -- 31,565
Treasury stock, 13,439 shares at cost (126) -- (126)
Accumulated deficit (24,218) -- (24,218)
----------- ----------- -----------
TOTAL STOCKHOLDERS' EQUITY 7,226 -- 7,226
----------- ----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 24,364 $ (4,349) $ 20,015
=========== =========== ===========
F-45
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 22 - QUARTERLY FINANCIAL DATA - CHANGE IN ACCOUNTING PRINCIPLE -
RECLASSIFICATION OF SHIPPING AND HANDLING EXPENSE FROM COST OF SALES
TO SELLING EXPENSE.
As discussed in Note 3 -- Change in Accounting Principle -- Reclassification of
Shipping and Handling Expense from Cost of Sales to Selling Expense, this note
reflects the unaudited quarterly effect of the indicated change in accounting
principle whereas Note 3 reflects the annual audited periods presented therein.
Based on the foregoing, the Company has determined the effect of this change in
accounting principle on its previously issued financial statements and has
adjusted the unaudited quarterly financial information below, reconciling the
adjustments on a quarterly basis for the quarterly periods in the years ended
December 31, 2006, 2005 and 2004.
AS
ORIGINALLY AS
REPORTED ADJUSTMENTS ADJUSTED(1)
----------- ----------- -----------
FIRST QUARTER ENDED MARCH 31, 2006 (in thousands, except per share data)
- ----------------------------------
Net sales $ 8,994 $ -- $ 8,994
Cost of sales 8,241 (299) 7,942
----------- ----------- -----------
Gross profit 753 299 1,052
Operating expenses 1,769 299 2,068
----------- ----------- -----------
Operating loss (1,016) -- (1,016)
Other expense (81) -- (81)
----------- ----------- -----------
Pre-tax loss (1,097) -- (1,097)
----------- ----------- -----------
Net loss $ (1,097) $ -- $ (1,097)
=========== =========== ===========
Net loss per common share, diluted $ (0.24) $ -- $ (0.24)
=========== =========== ===========
SECOND QUARTER ENDED JUNE 30, 2006
- ----------------------------------
Net sales $ 9,882 $ -- $ 9,882
Cost of sales 8,472 (292) 8,180
----------- ----------- -----------
Gross profit 1,410 292 1,702
Operating expenses 2,986 292 3,278
----------- ----------- -----------
Operating loss (1,576) -- (1,576)
Other income 2,287 -- 2,287
----------- ----------- -----------
Pre-tax income 711 -- 711
----------- ----------- -----------
Net income $ 710 $ -- $ 710
=========== =========== ===========
Net income per common share, diluted $ 0.16 $ -- $ 0.16
=========== =========== ===========
THIRD QUARTER ENDED SEPTEMBER 30, 2006
- --------------------------------------
Net sales $ 11,459 $ -- $ 11,459
Cost of sales 9,375 (237) 9,138
----------- ----------- -----------
Gross profit 2,084 237 2,321
Operating expenses 1,947 237 2,184
----------- ----------- -----------
Operating income 137 -- 137
Other expense (54) -- (54)
----------- ----------- -----------
Pre-tax income 83 -- 83
----------- ----------- -----------
Net income $ 83 $ -- $ 83
=========== =========== ===========
Net income per common share, diluted $ 0.02 $ -- $ 0.02
=========== =========== ===========
- --------------
(1) The Company's results of operations were also restated. See Note 23 --
Quarterly Financial Data -- Correction of Error for Accounting for
Direct Labor and Production Expenses.
F-46
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
AS
ORIGINALLY AS
REPORTED ADJUSTMENTS ADJUSTED(1)
----------- ----------- -----------
FIRST QUARTER ENDED MARCH 31, 2005 (in thousands, except per share data)
- ----------------------------------
Net sales $ 9,037 $ -- $ 9,037
Cost of sales 8,455 (253) 8,202
----------- ----------- -----------
Gross profit 582 253 835
Operating expenses 1,670 253 1,923
----------- ----------- -----------
Operating loss (1,088) -- (1,088)
Other expense (69) -- (69)
----------- ----------- -----------
Pre-tax loss (1,157) -- (1,157)
----------- ----------- -----------
Net loss $ (1,157) $ -- $ (1,157)
=========== =========== ===========
Net loss per common share, diluted $ (0.26) $ -- $ (0.26)
=========== =========== ===========
SECOND QUARTER ENDED JUNE 30, 2005
- ----------------------------------
Net sales $ 9,558 $ -- $ 9,558
Cost of sales 8,041 (209) 7,832
----------- ----------- -----------
Gross profit 1,517 209 1,726
Operating expenses 1,226 209 1,435
----------- ----------- -----------
Operating income 291 -- 291
Other expense (62) -- (62)
----------- ----------- -----------
Pre-tax income 229 -- 229
----------- ----------- -----------
Net income $ 227 $ -- $ 227
=========== =========== ===========
Net income per common share, diluted $ 0.05 $ -- $ 0.05
=========== =========== ===========
THIRD QUARTER ENDED SEPTEMBER 30, 2005
- --------------------------------------
Net sales $ 8,423 $ -- $ 8,423
Cost of sales 7,074 (180) 6,894
----------- ----------- -----------
Gross profit 1,349 180 1,529
Operating expenses 1,485 180 1,665
----------- ----------- -----------
Operating loss (136) -- (136)
Other expense (76) -- (76)
----------- ----------- -----------
Pre-tax loss (212) -- (212)
----------- ----------- -----------
Net loss $ (212) $ -- $ (212)
=========== =========== ===========
Net loss per common share, diluted $ (0.05) $ -- $ (0.05)
=========== =========== ===========
FOURTH QUARTER ENDED DECEMBER 31, 2005
- --------------------------------------
Net sales $ 10,755 $ -- $ 10,755
Cost of sales 9,955 (250) 9,705
----------- ----------- -----------
Gross profit 800 250 1,050
Operating expenses 1,396 250 1,646
----------- ----------- -----------
Operating loss (596) -- (596)
----------- ----------- -----------
Other expense (80) -- (80)
----------- ----------- -----------
Pre-tax loss (676) -- (676)
----------- ----------- -----------
Net loss $ (676) $ -- $ (676)
=========== =========== ===========
Net loss per common share, diluted $ (0.14) $ -- $ (0.14)
=========== =========== ===========
(1) The Company's results of operations were also restated. See Note 23 --
Quarterly Financial Data -- Correction of Error for Accounting for
Direct Labor and Production Expenses.
F-47
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
AS
ORIGINALLY AS
REPORTED ADJUSTMENTS ADJUSTED(1)
------------ ------------ ------------
FIRST QUARTER ENDED MARCH 31, 2004 (in thousands, except per share data)
- ----------------------------------
Net sales $ 15,474 $ -- $ 15,474
Cost of sales 13,218 (293) 12,925
------------ ------------ ------------
Gross profit 2,256 293 2,549
Operating expenses 2,056 293 2,349
------------ ------------ ------------
Operating income 200 -- 200
Other expense (52) -- (52)
------------ ------------ ------------
Pre-tax income 148 -- 148
------------ ------------ ------------
Net income $ 145 $ -- $ 145
============ ============ ============
Net income per common share, diluted $ 0.03 $ -- $ 0.03
============ ============ ============
SECOND QUARTER ENDED JUNE 30, 2004
- ----------------------------------
Net sales $ 7,490 $ -- $ 7,490
Cost of sales 7,052 (168) 6,884
------------ ------------ ------------
Gross profit 438 168 606
Operating expenses 1,834 168 2,002
------------ ------------ ------------
Operating loss (1,396) -- (1,396)
Other expense (52) -- (52)
------------ ------------ ------------
Pre-tax loss (1,448) -- (1,448)
------------ ------------ ------------
Net loss $ (1,447) $ -- $ (1,447)
============ ============ ============
Net loss per common share, diluted $ (0.32) $ -- $ (0.32)
============ ============ ============
THIRD QUARTER ENDED SEPTEMBER 30, 2004
- --------------------------------------
Net sales $ 9,947 $ -- $ 9,947
Cost of sales 9,392 (236) 9,156
------------ ------------ ------------
Gross profit 555 236 791
Operating expenses 1,698 236 1,934
------------ ------------ ------------
Operating loss (1,143) -- (1,143)
Other expense (26) -- (26)
------------ ------------ ------------
Pre-tax loss (1,169) -- (1,169)
------------ ------------ ------------
Net loss $ (1,169) $ -- $ (1,169)
============ ============ ============
Net loss per common share, diluted $ (0.26) $ -- $ (0.26)
============ ============ ============
FOURTH QUARTER ENDED DECEMBER 31, 2004
- --------------------------------------
Net sales $ 11,486 $ -- $ 11,486
Cost of sales 11,757 (342) 11,415
------------ ------------ ------------
Gross profit (271) 342 71
Operating expenses 5,293 342 5,635
------------ ------------ ------------
Operating loss (5,564) -- (5,564)
Other expense (21) -- (21)
------------ ------------ ------------
Pre-tax loss (5,585) -- (5,585)
------------ ------------ ------------
Net loss $ (5,586) $ -- $ (5,586)
============ ============ ============
Net loss per common share, diluted $ (1.23) $ -- $ (1.23)
============ ============ ============
(1) The Company's results of operations were also restated. See Note 23 --
Quarterly Financial Data -- Correction of Error for Accounting for
Direct Labor and Production Expenses.
F-48
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
NOTE 23 - QUARTERLY FINANCIAL DATA - CORRECTION OF ERROR FOR ACCOUNTING FOR
DIRECT LABOR AND PRODUCTION EXPENSES As discussed in Note 4 -- Correction of
Error for Accounting for Direct Labor and Production Expenses, this note
reflects the unaudited quarterly effect of the indicated correction of an error
whereas Note 4 reflects the annual audited periods presented therein. Based on
the foregoing, the Company has determined the effect of the correction of this
error on its previously issued financial statements and has restated the
unaudited quarterly financial information below, reconciling the restatement
adjustments on a quarterly basis for the quarterly periods in the years ended
December 31, 2006, 2005 and 2004.
AS AS ADJUSTED
ADJUSTED(1) RESTATEMENTS AND RESTATED
----------- ----------- -----------
FIRST QUARTER ENDED MARCH 31, 2006 (in thousands, except per share data)
- ----------------------------------
Net sales $ 8,994 $ -- $ 8,994
Cost of sales 7,942 270 8,212
----------- ----------- -----------
Gross profit 1,052 (270) 782
Operating expenses 2,068 (270) 1,798
----------- ----------- -----------
Operating loss (1,016) -- (1,016)
Other expense (81) -- (81)
----------- ----------- -----------
Pre-tax loss (1,097) -- (1,097)
----------- ----------- -----------
Net loss $ (1,097) $ -- $ (1,097)
=========== =========== ===========
Net loss per common share, diluted $ (0.24) $ -- $ (0.24)
=========== =========== ===========
SECOND QUARTER ENDED JUNE 30, 2006
- ----------------------------------
Net sales $ 9,882 $ -- $ 9,882
Cost of sales 8,180 368 8,548
----------- ----------- -----------
Gross profit 1,702 (368) 1,334
Operating expenses 3,278 (368) 2,910
----------- ----------- -----------
Operating loss (1,576) -- (1,576)
Other income 2,287 -- 2,287
----------- ----------- -----------
Pre-tax income 711 -- 711
----------- ----------- -----------
Net income $ 710 $ -- $ 710
=========== =========== ===========
Net income per common share, diluted $ 0.16 $ -- $ 0.16
=========== =========== ===========
THIRD QUARTER ENDED SEPTEMBER 30, 2006
- --------------------------------------
Net sales $ 11,459 $ -- $ 11,459
Cost of sales 9,138 336 9,474
----------- ----------- -----------
Gross profit 2,321 (336) 1,985
Operating expenses 2,184 (336) 1,848
----------- ----------- -----------
Operating income 137 -- 137
Other expense (54) -- (54)
----------- ----------- -----------
Pre-tax income 83 -- 83
----------- ----------- -----------
Net income $ 83 $ -- $ 83
=========== =========== ===========
Net income per common share, diluted $ 0.02 $ -- $ 0.02
=========== =========== ===========
(1) See Note 22 -- Quarterly Financial Data -- Change in Accounting
Principle - Reclassification of Shipping and Handling Expense from Cost
of Sales to Selling Expense.
F-49
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
AS AS ADJUSTED
ADJUSTED(1) RESTATEMENTS AND RESTATED
----------- ----------- -----------
FIRST QUARTER ENDED MARCH 31, 2005 (in thousands, except per share data)
- ----------------------------------
Net sales $ 9,037 $ -- $ 9,037
Cost of sales 8,202 233 8,435
----------- ----------- -----------
Gross profit 835 (233) 602
Operating expenses 1,923 (233) 1,690
----------- ----------- -----------
Operating income (loss) (1,088) -- (1,088)
Other income (expense) (69) -- (69)
----------- ----------- -----------
Pre-tax income (loss) (1,157) -- (1,157)
----------- ----------- -----------
Net income (loss) $ (1,157) $ -- $ (1,157)
=========== =========== ===========
Net income (loss) per common share diluted $ (0.26) $ -- $ (0.26)
=========== =========== ===========
SECOND QUARTER ENDED JUNE 30, 2005
- ----------------------------------
Net sales $ 9,558 $ -- $ 9,558
Cost of sales 7,832 177 8,009
----------- ----------- -----------
Gross profit 1,726 (177) 1,549
Operating expenses 1,435 (177) 1,258
----------- ----------- -----------
Operating income (loss) 291 -- 291
Other income (expense) (62) -- (62)
----------- ----------- -----------
Pre-tax income (loss) 229 -- 229
----------- ----------- -----------
Net income (loss) $ 227 $ -- $ 227
=========== =========== ===========
Net income (loss) per common share diluted $ 0.05 $ -- $ 0.05
=========== =========== ===========
THIRD QUARTER ENDED SEPTEMBER 30, 2005
- --------------------------------------
Net sales $ 8,423 $ -- $ 8,423
Cost of sales 6,894 208 7,102
----------- ----------- -----------
Gross profit 1,529 (208) 1,321
Operating expenses 1,665 (208) 1,457
----------- ----------- -----------
Operating income (loss) (136) -- (136)
Other income (expense) (76) -- (76)
----------- ----------- -----------
Pre-tax income (loss) (212) -- (212)
----------- ----------- -----------
Net income (loss) $ (212) $ -- $ (212)
=========== =========== ===========
Net income (loss) per common share diluted $ (0.05) $ -- $ (0.05)
=========== =========== ===========
FOURTH QUARTER ENDED DECEMBER 31, 2005
- --------------------------------------
Net sales $ 10,755 $ -- $ 10,755
Cost of sales 9,705 230 9,935
----------- ----------- -----------
Gross profit 1,050 (230) 820
Operating expenses 1,646 (230) 1,416
----------- ----------- -----------
Operating income (loss) (596) -- (596)
Other income (expense) (80) -- (80)
----------- ----------- -----------
Pre-tax income (loss) (676) -- (676)
----------- ----------- -----------
Net income (loss) $ (676) $ -- $ (676)
=========== =========== ===========
Net income (loss) per common share diluted $ (0.15) $ -- $ (0.15)
=========== =========== ===========
(1) See Note 22 -- Quarterly Financial Data -- Change in Accounting
Principle - Reclassification of Shipping and Handling Expense from Cost
of Sales to Selling Expense.
F-50
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (ADJUSTED AND RESTATED)
AS AS ADJUSTED
ADJUSTED(1) RESTATEMENTS AND RESTATED
------------ ------------ ------------
FIRST QUARTER ENDED MARCH 31, 2004 (in thousands, except per share data)
- ----------------------------------
Net sales $ 15,474 $ -- $ 15,474
Cost of sales 12,925 241 13,166
------------ ------------ ------------
Gross profit 2,549 (241) 2,308
Operating expenses 2,349 (241) 2,108
------------ ------------ ------------
Operating income 200 -- 200
Other expense (52) -- (52)
------------ ------------ ------------
Pre-tax income 148 -- 148
------------ ------------ ------------
Net income (loss) $ 145 $ -- $ 145
============ ============ ============
Net income (loss) per common share, diluted $ 0.03 $ -- $ 0.03
============ ============ ============
SECOND QUARTER ENDED JUNE 30, 2004
- ----------------------------------
Net sales $ 7,490 $ -- $ 7,490
Cost of sales 6,884 206 7,090
------------ ------------ ------------
Gross profit 606 (206) 400
Operating expenses 2,002 (206) 1,796
------------ ------------ ------------
Operating loss (1,396) -- (1,396)
Other expense (52) -- (52)
------------ ------------ ------------
Pre-tax loss (1,448) -- (1,448)
------------ ------------ ------------
Net loss $ (1,447) $ -- $ (1,447)
============ ============ ============
Net loss per common share, diluted $ (0.32) $ -- $ (0.32)
============ ============ ============
THIRD QUARTER ENDED SEPTEMBER 30, 2004
- --------------------------------------
Net sales $ 9,947 $ -- $ 9,947
Cost of sales 9,156 204 9,360
------------ ------------ ------------
Gross profit 791 (204) 587
Operating expenses 1,934 (204) 1,730
------------ ------------ ------------
Operating loss (1,143) -- (1,143)
Other expense (26) -- (26)
------------ ------------ ------------
Pre-tax loss (1,169) -- (1,169)
------------ ------------ ------------
Net loss $ (1,169) $ -- $ (1,169)
============ ============ ============
Net loss per common share, diluted $ (0.26) $ -- $ (0.26)
============ ============ ============
FOURTH QUARTER ENDED DECEMBER 31, 2004
- --------------------------------------
Net sales $ 11,486 $ -- $ 11,486
Cost of sales 11,415 232 11,647
------------ ------------ ------------
Gross profit 71 (232) (161)
Operating expenses 5,635 (232) 5,403
------------ ------------ ------------
Operating loss (5,564) -- (5,564)
Other expense (21) -- (21)
------------ ------------ ------------
Pre-tax loss (5,585) -- (5,585)
------------ ------------ ------------
Net loss $ (5,586) $ -- $ (5,586)
============ ============ ============
Net loss per common share, diluted $ (1.23) $ -- $ (1.23)
============ ============ ============
(1) See Note 22 -- Quarterly Financial Data -- Change in Accounting
Principle - Reclassification of Shipping and Handling Expense from Cost
of Sales to Selling Expense.
F-51
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
I/OMagic Corporation
Irvine, California
Our audits of the consolidated financial statements referred to in our report
dated February 24, 2006 (included elsewhere in this restated Annual Report on
Form 10-K) also included the restated financial statement schedules of I/OMagic
Corporation, listed in Item 15(a) of this Form 10-K. This schedule is the
responsibility of I/OMagic Corporation's management. Our responsibility is to
express an opinion based on our audits of the consolidated financial statements.
In our opinion, the financial statement schedule, when considered in relation to
the basic restated consolidated financial statements taken as a whole, presents
fairly in all material respects the information set forth therein.
/s/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP
Los Angeles, California
February 24, 2006, except for Notes 2, 3 and 4, as to
which the date is July 9, 2007
F-52
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
BALANCE ADDITIONS ADDITIONS
BEGINNING OF CHARGED TO (DEDUCTIONS) BALANCE
YEAR OPERATIONS FROM RESERVE END OF YEAR
------------ ------------ ------------ ------------
ALLOWANCE FOR DOUBTFUL ACCOUNTS
DECEMBER 31, 2006 $ 3,145 $ 293,088 $ (261,233) $ 35,000
DECEMBER 31, 2005 $ 24,946 $ 52,604 $ (74,405) $ 3,145
DECEMBER 31, 2004 $ 20,553 $ 202,654 $ (198,261) $ 24,946
RESERVES FOR PRODUCT RETURNS
DECEMBER 31, 2006 $ 178,055 $ 1,085,458 $ (797,106) $ 466,407
DECEMBER 31, 2005 (RESTATED)(1) $ 270,706 $ 1,350,687 $ (1,443,338) $ 178,055
DECEMBER 31, 2004 (RESTATED)(1) $ 364,989 $ 3,183,261 $ (3,277,544) $ 270,706
RESERVES FOR SALES INCENTIVES AND OTHER RELATED
SALES COSTS
DECEMBER 31, 2006 $ 3,526,639 $ 6,799,640 $ (7,999,231) $ 2,327,048
DECEMBER 31, 2005 (RESTATED)(1) $ 3,270,266 $ 6,994,575 $ (6,738,202) $ 3,526,639
DECEMBER 31, 2004 (RESTATED)(1) $ 1,955,621 $ 13,335,546 $(12,020,901) $ 3,270,266
RESERVES FOR OBSOLETE INVENTORY
DECEMBER 31, 2006 $ 29,690 $ 705,023 $ (208,713) $ 526,000
DECEMBER 31, 2005 $ 1,463,214 $ 841,090 $ (2,274,614) $ 29,690
DECEMBER 31, 2004 $ 505,029 $ 2,046,217 $ (1,088,032) $ 1,463,214
(1) See Notes to Consolidated Financial Statements - "Note 2 - Correction
of Error for Not Offsetting Reserves for Sales Incentives Against
Accounts Receivable."
F-53
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
- -------------- --------------------
3.1 Amended and Restated Articles of Incorporation of I/OMagic
Corporation filed with the Secretary of State of Nevada on
December 6, 2002 (7)
3.2 Amended and Restated Bylaws of I/OMagic Corporation dated July
25, 2002 (1)
10.1 Employment Agreement dated October 15, 2002 between I/OMagic
Corporation and Tony Shahbaz (#) (2)
10.2 I/OMagic Corporation 2002 Stock Option Plan (#) (3)
10.3 Warehouse Services and Bailment Agreement dated February 3, 2003
between I/OMagic Corporation and Behavior Tech Computer (USA)
Corp. (4)
10.4 I/OMagic Corporation 2003 Stock Option Plan (#) (6)
10.5 Standard Industrial/Commercial Single-Tenant Lease-Net dated
July 1, 2003 between Laro Properties, L.P. and I/OMagic
Corporation (5)
10.6 Form of Indemnification Agreement (8)
10.7 Trademark License Agreement dated July 24, 2004 by and between
IOM Holdings, Inc. and I/OMagic Corporation (8)
10.8 Amended and Restated Agreement between Lung Hwa Electronics Co.
Ltd., and I/OMagic Corporation, dated July 21, 2005 (12)
10.9 Loan and Security Agreement between Silicon Valley Bank and
I/OMagic Corporation dated January 29, 2007 (13)
14.1 I/OMagic Corporation Code of Business Conduct and Ethics dated
March 15, 2004 (7)
14.2 I/OMagic Corporation Code of Business Ethics for CEO and Senior
Financial Officers dated March 15, 2004 (7)
14.3 Charter of the Audit Committee of the Board of Directors of
I/OMagic Corporation dated March 15, 2004 (7)
18.1 Preferability Letter (*)
21.1 Subsidiaries of the Registrant (8)
23.1 Consent of Independent Registered Public Accounting Firm -
Swenson Advisors LLP (*)
23.2 Consent of Independent Registered Public Accounting Firm -
Singer Lewak Greenbaum & Goldstein LLP (*)
31.1 Certification 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 (*)
31.2 Certification 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 (*)
32.1 Certification of Chief Executive Officer and Chief Financial
Officer Pursuant to 18 U.S. C. Section 350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002 (*)
- ------------
(*) Filed herewith.
(#) Management contract or compensatory plan, contract or arrangement
required to be filed as an exhibit.
(1) Incorporated by reference to the Registrant's quarterly report on Form
10-Q for the quarterly period ended June 30, 2002 (File No. 000-27267).
(2) Incorporated by reference to the Registrant's quarterly report on Form
10-Q for the quarterly period ended September 30, 2002 (File No.
000-27267).
(3) Incorporated by reference to Registrant's definitive proxy statement for
the annual meeting of stockholders held November 4, 2002.
(4) Incorporated by reference to the Registrant's annual report on Form 10-K
for the year ended December 31, 2002 (File No. 000-27267).
(5) Incorporated by reference to the Registrant's quarterly report on Form
10-Q for the quarterly period ended June 30, 2003 (File No. 000-27267).
(6) Incorporated by reference to the Registrant's definitive proxy statement
for the annual meeting of stockholders held December 18, 2003.
(7) Incorporated by reference to the Registrant's annual report on Form 10-K
for the year ended December 31, 2003 (File No. 000-27267).
(8) Incorporated by reference to the Registrant's registration statement on
Form S-1/A No. 1 filed by the Registrant with the Securities and Exchange
Commission on July 30, 2004 (Reg. No. 333-115208).
(9) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
March 14, 2005 (File No. 000-27267).
(10) Incorporated by reference to the Registrant's quarterly report on Form
10-Q for the quarterly period ended March 31, 2005 (File No. 000-27267).
(11) Incorporated by reference to the Registrant's registration statement on
Form S-1/A No. 5 filed by the Registrant with the Securities and Exchange
Commission on July 1, 2005 (Reg. No. 333-115208).
(12) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
July 27, 2005 (File No. 000-27267).
(13) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
February 8, 2007 (File No. 000-27267).
(14) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
May 15, 2007 (File No. 000-27267).
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized on this 12th day of
July, 2007.
I/OMAGIC CORPORATION
By: /s/ TONY SHAHBAZ
------------------------------------------------
Tony Shahbaz
Chief Executive Officer, President and Secretary
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ TONY SHAHBAZ Chief Executive Officer, President and July 12, 2007
- ------------------------- Secretary (Principle Executive Officer)
Tony Shahbaz
/s/ THOMAS L. GRUBER Chief Operating Officer and Chief Financial July 12, 2007
- ------------------------- Officer (Principle Accounting and Financial
Thomas L. Gruber Officer)
/s/ DANIEL YAO Director July 12, 2007
- -------------------------
Daniel Yao
/s/ STEEL SU Director July 12, 2007
- -------------------------
Steel Su
/s/ WILLIAM TING Director July 12, 2007
- -------------------------
William Ting
EXHIBITS FILED WITH THIS REPORT
EXHIBIT
NUMBER DESCRIPTION
- ------------ ---------------
18.1 Preferability Letter
23.1 Consent of Independent Registered Public Accounting Firm -
Swenson Advisors LLP
23.2 Consent of Independent Registered Public Accounting Firm - Singer
Lewak Greenbaum & Goldstein LLP
31.1 Certification 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
31.2 Certification 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
32.1 Certification 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