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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended MARCH 31, 2007
| | 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: 0-27267
I/OMAGIC CORPORATION
(Exact name of registrant as specified in its charter)
NEVADA 33-0773180
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
4 MARCONI, IRVINE, CALIFORNIA 92618
(Address of principal executive offices) (Zip Code)
(949) 707-4800
(Registrant's telephone number, including area code)
NOT APPLICABLE.
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No | |
Indicate by check mark 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 | | Accelerated filer | | Non-accelerated filer |X|
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes | | No |X|
As of August 13, 2007, there were 4,540,292 shares of the issuer's common
stock issued and outstanding.
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CAUTIONARY STATEMENT
All statements included or incorporated by reference in this Quarterly
Report on Form 10-Q, 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 set forth in the "Risk Factors" section of our Annual Report on
Form 10-K for the year ended December 31, 2006, which could cause our financial
results, including our net income or loss or growth in net income or loss to
differ materially from prior results, which in turn could, among other things,
cause the price of our common stock to fluctuate substantially. 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.
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I/OMAGIC CORPORATION AND SUBSIDIARY
TABLE OF CONTENTS
PART I
FINANCIAL INFORMATION
PAGE
----
Item 1. Financial Statements .................................................1
Consolidated Balance Sheets as of March 31, 2007
(unaudited and December 31, 2006 ...................................1
Consolidated Statements of Operations for the Three Months
Ended March 31, 2007 and 2006 (unaudited) ........................2
Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 2007 and 2006 (unaudited) ........................3
Notes to Consolidated Financial Statements ...........................4
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations .........................................13
Item 3. Quantitative and Qualitative Disclosures About Market Risk ..........21
Item 4. Controls and Procedures .............................................21
Item 4T. Controls and Procedures .............................................24
PART II
OTHER INFORMATION
Item 1. Legal Proceedings ...................................................24
Item 1A. Risk Factors ........................................................25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds .........25
Item 3. Defaults Upon Senior Securities .....................................25
Item 4. Submission of Matters to a Vote of Security Holders .................25
Item 5. Other Information ...................................................25
Item 6. Exhibits ............................................................25
Signatures ...................................................................26
Exhibits Filed with this Report
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
MARCH 31, DECEMBER 31,
2007 2006
---------------- ----------------
(unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 79,507 $ 1,833,481
Restricted cash 137,122 893,167
Accounts receivables, net 4,459,800 11,534,687
Inventory, net 14,965,117 10,670,916
Prepaid expenses and other current assets 149,168 71,733
---------------- ----------------
Total current assets 19,790,714 25,003,984
EQUIPMENT, net 250,581 194,117
TRADEMARKS, net 344,712 361,944
OTHER ASSETS 41,928 41,928
---------------- ----------------
TOTAL ASSETS $ 20,427,935 $ 25,601,973
================ ================
LIABILITIES & STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit $ 4,762,645 $ 4,380,133
Accounts payable, accrued expenses and other 2,740,339 5,521,873
Accounts payable - related parties 6,033,974 7,945,980
Accrued mail-in rebates 894,044 1,269,996
---------------- ----------------
Total liabilities 14,431,002 19,117,982
---------------- ----------------
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 issues and outstanding - -
Common stock, $0.001 par value 100,000,000 shares authorized,
4,450,292 shares issued and outstanding 4,541 4,541
Additional paid-in capital 31,700,886 31,681,409
Accumulated deficit (25,708,494) (25,201,959)
---------------- ----------------
Total stockholders' equity 5,996,933 6,483,991
---------------- ----------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 20,427,935 $ 25,601,973
================ ================
See accompanying notes to these consolidated financial statements
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I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31,
2007 2006
---------------- ----------------
(unaudited) (unaudited)
NET SALES $ 7,691,165 $ 8,993,898
COST OF SALES 6,795,107 8,211,385
---------------- ----------------
GROSS PROFIT 896,058 782,513
---------------- ----------------
OPERATING EXPENSES
Selling, marketing and advertising 343,441 531,176
General and administrative 907,738 1,220,727
Depreciation and amortization 34,206 46,860
---------------- ----------------
Total operating expenses 1,285,385 1,798,763
---------------- ----------------
LOSS FROM OPERATIONS (389,327) (1,016,250)
OTHER INCOME (EXPENSE)
Interest income - 91
Interest expense (122,288) (80,139)
Currency transaction gain (loss) 842 (1,016)
Other income 5,038 -
---------------- ----------------
Total other income (expense) (116,408) (81,064)
---------------- ----------------
LOSS BEFORE PROVISION FOR INCOME TAXES (505,735) (1,097,314)
PROVISION FOR INCOME TAXES 800 -
---------------- ----------------
NET LOSS $ (506,535) $ (1,097,314)
================ ================
BASIC AND DILUTED LOSS PER SHARE $ (0.11) $ (0.24)
================ ================
BASIC AND DILUTED WEIGHTED-AVERAGE SHARES OUTSTANDING 4,540,292 4,528,959
================ ================
See accompanying notes to these consolidated financial statements
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I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED MARCH 31,
2007 2006
---------------- ----------------
(unaudited) (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (506,535) $ (1,097,314)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization 16,974 29,627
Amortization of trademarks 17,232 17,232
Allowance for doubtful accounts (133) 48,429
Allowance for product returns (168,095) 56,770
Reserves for sales incentives 296,464 (1,792,705)
Allowance for obsolete inventory 212,620 (8,424)
Share-based compensation expense 19,477 39,558
Changes in assets and liabilities (net of
dispositions and acquisitions)
Accounts receivable 6,946,652 2,684,883
Inventory (4,506,821) 162,241
Prepaid expenses and other current assets (77,435) 122,247
Accounts payable, accrued expenses and other (2,781,534) 1,042,011
Accounts payable - related parties (1,912,006) (2,856,744)
Accrued mail-in rebates (375,952) 201,428
---------------- ----------------
Net cash used in operating activities (2,819,092) (1,350,761)
---------------- ----------------
CASH FLOWS FROM INVESTING ACTIVITIES
Restricted cash 756,045 13,698
Equipment additions (73,439) (899)
---------------- ----------------
Net cash provided by investing activities 682,606 12,799
---------------- ----------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings on line of credit 382,512 55,305
Proceeds from sales of common stock - 54,932
---------------- ----------------
Net cash provided by financing activities 382,512 110,237
---------------- ----------------
Net decrease in cash and cash equivalents (1,753,974) (1,227,725)
Cash and cash equivalents at beginning of period 1,833,481 4,056,541
---------------- ----------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 79,507 $ 2,828,816
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SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
INTEREST PAID $ 122,288 $ 77,877
================ ================
INCOME TAXES PAID $ 800 $ -
================ ================
See accompanying notes to these consolidated financial statements
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I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 electronic 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.
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. The Company experienced a loss for the quarter ended March 31, 2007
of $506,535 and 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.
At March 31, 2007, the Company had cash and cash equivalents of $79,507. The
Company currently has almost no amounts available to it for borrowing under its
credit facility with Silicon Valley Bank. In addition, as of August 10, 2007,
the Company had only $403,000 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 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 related-party suppliers, 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.
NOTE 2 - BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of I/OMagic
Corporation have been prepared pursuant to the rules and regulations of the
Securities and Exchange Commission regarding interim financial reporting.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for annual financial statements and
should be read in conjunction with the consolidated financial statements for the
year ended December 31, 2006, and notes thereto included in the Company's Annual
Report on Form 10-K, filed with the Securities and Exchange Commission on July
13, 2007. In the opinion of management, the accompanying unaudited consolidated
financial statements contain all adjustments, consisting only of adjustments of
a normal recurring nature, necessary for a fair presentation of the Company's
financial position as of March 31, 2007, and its results of operations for the
periods presented. These unaudited consolidated financial statements are not
necessarily indicative of the results to be expected for the entire year.
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I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The report of the Company's independent registered public accounting firm
contained in the Company's financial statements as of and for the year ended
December 31, 2006 includes a paragraph that explains that the Company has
incurred significant recurring losses, has serious liquidity concerns and may
require additional financing in the foreseeable future. The report concludes
that these matters, among others, raise substantial doubt about the Company's
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 the Company to raise additional financing necessary to grow or operate its
business. The Company urges potential investors to review this report before
making a decision to invest in I/OMagic.
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ materially from those estimates
and assumptions.
The unaudited consolidated financial statements include IOM Holdings, Inc.
Intercompany transactions and balances have been eliminated in consolidation.
Certain amounts from prior periods have been reclassified to conform with
current period presentation.
NOTE 3 - CONCENTRATION OF RISK
RETAILERS
During first quarter of 2007, the Company's most significant retailers were
Staples, Circuit City, Office Max and Office Depot. Collectively, these four
retailers accounted for 91.2% of the Company's net sales in the first quarter of
2007. During the first quarter of 2006, the Company's most significant retailers
were Staples, Office Depot, Costco and CompUSA. Collectively, these four
retailers accounted for 82.5% of the Company's net sales in the first quarter of
2006.
RELATED PARTIES
During the three months ended March 31, 2007, the Company purchased inventory
from two related-parties, Lung Hwa Electronics and BTC USA, an affiliate of
Behavior Tech Computer Corp, in amounts totaling $2,354,088 and $768,648, which
represented 22% and 7.5% of total inventory purchased, respectively. As of March
31, 2007, there were $5,282,058 and $751,916, respectively, in trade payables
outstanding to these related-parties.
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I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - ACCOUNTS RECEIVABLE
Accounts receivable as of March 31, 2007 and December 31, 2006 consisted of the
following:
MARCH 31, DECEMBER 31,
2007 2006
-------------- --------------
Accounts receivable $ 7,416,490 $ 14,363,142
Less: Allowance for doubtful accounts (34,867) (35,000)
Allowance for product returns (371,540) (466,407)
Reserve for sales incentives (222,752) (295,981)
Accrued point-of-sale rebates (1,610,057) (1,381,087)
Accrued market development funds,
cooperative advertising costs
and cross dock fees (717,474) (649,980)
-------------- --------------
TOTAL $ 4,459,800 $ 11,534,687
============== ==============
NOTE 5 - INVENTORY
Inventory as of March 31, 2007 and December 31, 2006 consisted of the following:
MARCH 31, DECEMBER 31,
2007 2006
-------------- --------------
Component parts $ 1,166,160 $ 870,484
Finished goods--warehouse 5,576,753 3,164,825
Finished goods--consigned 8,960,824 7,161,607
-------------- --------------
15,703,737 11,196,916
Less: Allowance for obsolete and
slow-moving inventory (738,620) (526,000)
-------------- --------------
TOTAL $ 14,965,117 $ 10,670,916
============== ==============
Consigned inventory is located at the stores and distribution centers of certain
retailers with which the Company has consignment agreements. The inventory is
owned by the Company until sold by the retailers.
NOTE 6 - EQUIPMENT
Equipment as of March 31, 2007 and December 31, 2006 consisted of the following:
MARCH 31, DECEMBER 31,
2007 2006
-------------- --------------
Computer equipment and software $ 975,523 $ 966,170
Warehouse equipment 133,098 69,013
Office furniture and equipment 236,007 236,007
Vehicles 74,742 74,742
Leasehold improvements 106,633 106,633
-------------- --------------
1,526,003 1,452,565
Less: Accumulated depreciation (1,275,422) (1,258,448)
-------------- --------------
TOTAL $ 250,581 $ 194,117
============== ==============
For the three months ended March 31, 2007, depreciation and amortization expense
was $34,206.
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I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7 - TRADEMARKS
Trademarks as of March 31, 2007 and December 31, 2006 consisted of the
following:
MARCH 31, DECEMBER 31,
2007 2006
-------------- --------------
Trademarks $ 499,800 $ 499,800
Less: Amortization (155,088) (137,856)
-------------- --------------
TOTAL $ 344,712 $ 361,944
============== ==============
Amortization expense on these intangible assets was $17,232 for each of the
quarters ended March 31, 2007 and 2006. Amortization expense related to these
intangible assets at March 31, 2007 in each of the next five fiscal years and
beyond is as follows:
Remainder of 2007 $ 51,696
2008 68,928
2009 68,928
2010 68,928
2011 68,928
2012 17,304
-------------
$ 344,712
=============
NOTE 8 - LINE OF CREDIT
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.
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I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 August 10, 2007 was
$3,179,630. As of August 10, 2007, no amounts were available to the Company for
borrowing.
NOTE 9 - TRADE CREDIT FACILITIES WITH RELATED PARTIES
Effective April 29, 2005, the Company entered into a trade credit facility with
a related party, Lung Hwa Electronics Co. Ltd., 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 the three months ended March 31, 2007, the Company purchased $2.3
million of inventory under this arrangement. As of March 31, 2007, there were
$5,282,058 in trade payables outstanding under this arrangement. As of March 31,
2007, the Company was out of compliance with the payment terms of the agreement
and has proposed a repayment schedule to Lung Hwa Electronics to retire the
balance due at March 31, 2007 over the next six months. At the date of filing of
this report the Company expects to meet the proposed payments.
In February 2003, the Company entered into an agreement with a related party,
whereby the related party, Behavior Tech Computer Corp. and its affiliated
companies, 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 is
to insure the consignment inventory, store the consignment inventory for no
charge, and furnish the related party with weekly statements indicating all
products received and sold and the current consignment inventory level. The
agreement may be terminated by either party with 60 days written notice. In
addition, this agreement provides for a trade line of credit of up to $10.0
million with payment terms of net 60 days, non-interest bearing. During the
three months ended March 31, 2007, the Company purchased $786,648 of inventory
under this arrangement. As of March 31, 2007, there were $751,916 in trade
payables outstanding under this arrangement. At March 31, 2007, the Company was
out of compliance with the payment terms of the agreement and has proposed a
repayment schedule to Behavior Tech Computer Corp. to retire the balance due at
March 31, 2007 over the next ten weeks and at the date of filing of this report
the Company expects to meet the proposed payments.
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I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10 - COMMITMENTS AND CONTINGENCIES
LEGAL MATTERS
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.
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.
OTHER CONTRACTUAL OBLIGATIONS
During its normal course of business, the Company has made commitments under
which it will or may be required to make payments in relation to certain
transactions. These include lease, service and retail agreements and employment
contracts. See "Note 15--Commitments and Contingencies" in the Company's Annual
Report on Form 10-K for the year ended December 31, 2006.
NOTE 11 - SHARE-BASED COMPENSATION
On January 1, 2006, the Company adopted Statement of Financial Accounting
Standards ("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 Accounting
Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, for
periods beginning in fiscal 2006. In March 2005, the Securities and Exchange
Commission issued Staff Accounting Bulletin ("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).
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I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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. The Plans are more fully described in the Company's
Annual Report on Form 10-K for the year ended December 31, 2006.
During the three months ended March 31, 2007, 150,000 warrants expired.
As of March 31, 2007, there were options to acquire 354,850 shares of common
stock issued to employees and directors that were outstanding under the Plans.
The weighted-average exercise prices, remaining contractual lives and aggregate
intrinsic values for options and warrants granted, exercisable, and expected to
vest under the Plans as of March 31, 2007 were as follows:
WEIGHTED-
WEIGHTED- AVERAGE
AVERAGE REMAINING
NUMBER OF EXERCISE CONTRACTUAL INTRINSIC
OPTIONS SHARES PRICE LIFE (YEARS) VALUE(1)
------------------ ----------- ---------- ------------- ------------
Outstanding 354,850 $ 3.09 3.43 $ 1,096,487
Expected to vest 351,425 $ 3.09 3.43 $ 1,085,903
Exercisable 266,600 $ 3.12 3.36 $ 831,792
----------
(1) Awards that are expected to vest take into consideration estimated
forfeitures for awards not yet vested.
There were no options granted during the three months ended March 31, 2007 and
2006. No cash was received from the exercise of stock options for the quarter
ended March 31, 2007 and $54,932 was received from the exercise of stock options
for the quarter ended March 31, 2006. As of March 31, 2007, there was $153,279
of total unrecognized compensation costs related to non-vested share-based
compensation arrangements granted. That cost is expected to be recognized over
the weighted-average period of 2.6 years.
Share-based compensation expense was $19,477 and $39,558, for the three months
ended March 31, 2007 and 2006, respectively. There was no tax deduction for
share-based compensation expense during those periods. When options are
exercised, the Company's policy is to issue new shares to satisfy share option
exercises.
The Company expenses share-based compensation in cost of goods sold or general
and administrative expenses depending on the job function of the employee.
NOTE 12 - INCOME TAXES
The Company is required to file federal and state tax returns in the United
States. The preparation of these tax returns requires the Company to interpret
the applicable tax laws and regulations in effect in such jurisdictions, which
could affect the amount of tax paid by the Company. The Company, in consultation
with its tax advisors, bases its tax returns on interpretations that are
believed to be reasonable under the circumstances. The tax returns, however, are
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I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
subject to routine reviews by the various federal and state taxing authorities
in the jurisdictions in which the Company files its returns. As part of these
reviews, a taxing authority may disagree with respect to the tax positions taken
by the Company ("uncertain tax positions") and therefore require the Company to
pay additional taxes. The Company prepares an accrual for uncertain tax
positions as more definitive information becomes available from taxing
authorities, completion of tax audits, expiration of statute of limitations, or
upon occurrence of other events.
As required, through December 31, 2006, the Company analyzed and determined no
accrual was required for uncertain tax positions based upon SFAS No. 5,
ACCOUNTING FOR CONTINGENCIES, which requires the Company to accrue for the
estimated additional amount of taxes for the uncertain tax positions if it was
probable the Company would be required to pay such additional taxes. Effective
January 1, 2007, the Company was required to adopt and implement the provisions
of Financial Accounting Standards Board ("FASB") Interpretation No. ("FIN") 48,
ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES, which requires Company's to accrue
for the estimated additional amount of taxes for the uncertain tax positions if
it is more likely than not that the Company would be required to pay such
additional taxes. As a result of the implementation of FIN 48, the Company
recognized no charge for uncertain tax positions.
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
March 31, 2007, the valuation allowance for deferred tax assets totaled
$13,322,379.
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 March 31, 2007, the Company had net operating loss carryforwards for
federal and state income tax purposes of approximately $28,406,923 and
$17,592,239, 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 changes in ownership.
FIN 48 not only impacts the amount of Company's accrual for uncertain tax
positions but it also impacts the manner in which such accruals should be
classified in Company's financial statements. In connection with the
implementation of FIN 48, and if an accrual is recorded, the Company will record
the aggregate accrual for uncertain tax positions as a component of current or
non-current income tax payable and the offsetting amounts as a component of the
Company's net deferred tax assets and liabilities.
The Company's continuing practice is to recognize interest and/or penalties
related to income tax matters in income tax expense. As of March 31, 2007 and
December 31, 2006, the Company had no accrual for the payment of interest and
penalties
The Company is subject to federal taxation and taxation in various states. With
few exceptions, the Company is no longer subject to United States federal, state
or local, or non-United States income tax examination by tax authorities for tax
years before 2001.
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I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - LOSS PER SHARE
Diluted earnings per share reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock. Options with an exercise price in excess of the average
market value of the Company's common stock during the period have been excluded
from the calculation as their effect would be antidilutive. Additionally,
potentially dilutive securities are excluded from the computation of earnings
per share in periods in which a net loss is reported as their effect would be
antidilutive. Thus, both basic and diluted weighted-average shares outstanding
are the same in periods when a net loss is reported as indicated in the quarters
ending March 31, 2007 and 2006.
NOTE 14 - SEGMENT INFORMATION
The Company currently operates in one business segment. All fixed assets are
located at the Company's headquarters in the United States. All sales for the
three months ended March 31, 2007 and 2006 were in the United States.
NOTE 15 - RECENT ACCOUNTING PRONOUNCEMENTS
In February 2007, the 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 is currently evaluating the impact SFAS No.
159 may have on its financial position, results of operations and 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 an entity 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 and cash flows.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR UNAUDITED
CONSOLIDATED FINANCIAL STATEMENTS AND THE RELATED NOTES FOR THE THREE MONTHS
ENDED MARCH 31, 2007 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 THE "RISK
FACTORS" SECTION OF OUR ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER
31, 2006 AND ELSEWHERE IN THIS REPORT.
OVERVIEW
We sell electronic 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.
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 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 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. 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.
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. W e 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.
During the first quarter of 2007, our most significant retailers were
Staples, Circuit City, Office Max and Office Depot. Collectively, these four
retailers accounted for 91.2% of our net sales during the first quarter of 2007.
During first quarter of 2006, our most significant retailers were Staples,
Office Depot, Costco and CompUSA. Collectively, these four retailers accounted
for 82.5% of our net sales during the first quarter of 2006.
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.
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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
"Liquidity and Capital Resources."
RECENT DEVELOPMENTS
Notwithstanding the following discussion of our financial performance for
the three months ended March 31, 2007, over the course of the past several
months and through most 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.
CRITICAL ACCOUNTING POLICIES
The preparation of our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America, requires us to make judgments and estimates that may have a significant
impact upon the portrayal of our financial condition and results of operations.
We believe that of our significant accounting policies, the following require
estimates and assumptions that require complex, subjective judgments by
management that can materially impact the portrayal of our financial condition
and results of operations: going concern assumption, revenue recognition; sales
incentives; market development funds and cooperative advertising costs, rebate
promotion costs and slotting fees; inventory obsolescence allowance; accounts
receivable and allowance for doubtful accounts; and product returns. These
significant accounting principles are more fully described in "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Critical Accounting Policies" in our Annual Report on Form 10-K for
the year ended December 31, 2006.
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RESULTS OF OPERATIONS
The table presented below, which compares our results of operations from
one period to another, presents 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.
Three Months Ended Dollar Percentage Results as a
(in thousands) March 31, Variance Variance Percentage of
------------------- Favorable Favorable Net Sales
2007 2006 (Unfavorable) (Unfavorable) 2007 2006
-------- -------- ------------- ------------- -------- --------
Net sales $ 7,691 $ 8,994 $ (1,303) (14.5)% 100.0% 100.0%
Cost of sales 6,795 8,211 1,416 17.2% 88.3% 91.3%
-------- -------- ------------- ------------- -------- --------
Gross profit 896 783 113 14.5% 11.7% 8.7%
Selling, marketing and advertising
expenses 343 531 188 35.4% 4.5% 5.9%
General and administrative expenses 908 1,221 313 25.6% 11.8% 13.6%
Depreciation and amortization 34 47 13 27.7% 0.4% 0.5%
-------- -------- ------------- ------------- -------- --------
Operating loss (389) (1,016) 627 61.7% (5.1)% (11.3)%
Net interest expense 122 80 (42) (52.1)% 1.6% 0.9%
Other income (expense) 5 (1) (6) 600.0% 0.1% 0.0%
-------- -------- ------------- ------------- -------- --------
Loss from operations before
provision for income taxes (506) (1,097) 591 (53.9)% (6.6)% (12.2)%
Income tax provision 1 - (1) 100.0% 0.0% 0.0%
-------- -------- ------------- ------------- -------- --------
Net loss $ (507) $(1,097) $ 590 (53.8)% (6.6)% (12.2)%
======== ======== ============= ============= ======== ========
NET SALES. Net sales decreased by $1,303,000, or 14.5%, to $7,691,000 in
the first quarter of 2007 as compared to $8,994,000 in the first quarter in
2006. A combination of factors affected our net sales, including a $2.7 million
decrease in sales of our optical data storage products. Sales of our optical
data storage products decreased by 63% to $1.6 million, or 22% of our net sales,
in the first quarter of 2007 as compared to $4.3 million, or 48% of our net
sales, in the first quarter of 2006. Sales of our CD- and DVD-based products
continued to decline in the first quarter of 2007 because they are generally
included as a standard component in most new computer systems. Also, sales of
our mobile data storage products decreased by 28% to $3.3 million, or 45% of our
net sales, in the first quarter of 2007 as compared to $4.6 million, or 51% of
our net sales, in the first quarter of 2006, which was partially offset by an
increase in net sales of our desk-top data storage products during the first
quarter of 2007 of $2.4 million, or 33% of our net sales, as compared to none
for the first quarter of 2006.
In addition, our overall product return rate was 7.3% in the first quarter
of 2007 compared to 9.9% in the first quarter of 2006. The decline in our
overall product return rate resulted from an increase in sales of our desktop
magnetic data storage products in the first quarter of 2007 compared to the
first quarter of 2006, which generally have lower rates of return. Also, sales
incentives, market development funds and cooperative advertising costs, rebate
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promotion costs and slotting fees, collectively as a percentage of gross sales,
were 15.7%, all of which were offset against gross sales, in the first quarter
of 2007 compared to 21.6% in the first quarter of 2006. The decline in our
overall rate of sales incentives, market development funds and cooperative
advertising costs, rebate promotion costs and slotting fees resulted from an
increase in sales of our desktop magnetic data storage products, which
experienced less market pressure for these promotions, and a decrease in sales
of our optical data storage products, which experienced higher market pressure
for these promotions.
The reductions in our overall product return rate and our sales
incentives, market development funds and cooperative advertising costs, rebate
promotion costs and slotting fees, collectively, partially offset the decrease
in our net sales resulting from lower sales of our optical data storage products
and our mobile data storage products.
GROSS PROFIT. Gross profit increased by $113,000, or 14.5%, to $896,000 in
the first quarter of 2007 as compared to $783,000 in the first quarter in 2006.
The increase in gross profit primarily resulted from an increase in net sales.
Our gross profit margin as a percentage of net sales increased to 11.7% in the
first quarter of 2007 as compared to 8.7% in the first quarter of 2006. The
increase in our gross profit margin predominantly resulted from higher gross
margins as a result of the significant reduction in promotion expenses which
were partially offset by increased production costs and lower unit selling
prices for our magnetic data storage products. Lower unit selling prices of our
magnetic data storage products were caused by competitive pricing pressures.
SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses decreased by $188,000, or 35%, to $343,000 in the first
quarter of 2007 as compared to $531,000 in the first quarter in 2006. This
decrease was primarily due to a $76,000 decrease in trade show and other sales
expenses, a $25,000 decrease in outside sales commissions, and a $91,000
decrease in shipping and handling costs as a result of lower sales.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased by $313,000, or 30%, to $848,000 in the first quarter of 2007 as
compared to $1,221,000 in the first quarter in 2006. This decrease was primarily
due to a $197,000 decrease in legal fees related to prior year litigation
expenses, a $64,000 decrease in audit fees, a $50,000 decrease in insurance
expenses, a $56,000 decrease in bad debt expense, and a $19,000 decrease in
share-based compensation expense, all of which were partially offset by a
$28,000 increase in travel expenses, a $53,000 increase in outside services
expenses, a $50,000 increase in fees for early termination of a credit facility,
a $25,000 increase in fees to initiate our Silicon Valley Bank credit facility,
and a $11,000 increase in information technology support.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased by
$13,000, or 28%, to $34,000 in the first quarter of 2007 as compared to $47,000
in the first quarter in 2006. This decrease primarily resulted from certain of
our fixed assets becoming fully depreciated since the first quarter of 2006.
NET INTEREST EXPENSE. Net interest expense increased by $41,000, or 51%,
to $121,000 in the first quarter of 2007 as compared to $80,000 in the first
quarter in 2006. This increase primarily resulted from higher borrowings on our
line of credit and higher effective rates of interest on those borrowings in the
first quarter of 2007 as compared to the first quarter of 2006.
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of liquidity have been cash provided by operations
and borrowings under our bank and trade credit facilities. Our principal uses of
cash have been to provide working capital, finance capital expenditures and to
satisfy our debt service requirements. We anticipate that these sources and uses
will continue to be our principal sources and uses of cash in the foreseeable
future. As of March 31, 2007, we had working capital of $5.4 million, an
accumulated deficit of $25.8 million, $80,000 in cash and cash equivalents and
$4.5 million in net accounts receivable. This compares with working capital of
$5.9 million, an accumulated deficit of $25.2 million, $1.8 million in cash and
cash equivalents and $11.5 million in net accounts receivable as of December 31,
2006. For the first quarter of 2007, our cash decreased $1.7 million, or 94%,
from $1.8 million to $80,000 as compared to a decrease of $1.3 million, or 32%,
for the first quarter of 2006 from $4.1 million to $2.8 million.
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We currently have no amounts available to us for borrowing under our
credit facility with Silicon Valley Bank. In addition, as of August 10, 2007, we
had only $403,000 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.
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 most 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 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. 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 report do not include any adjustments that might result from
the outcome of this uncertainty.
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Cash used in our operating activities totaled $2.8 million during the
first quarter of 2007 as compared to $1.4 million during the first quarter of
2006, and resulted primarily from the following combination of factors:
o a $2.8 million decrease in accounts payable caused by the payment of
outstanding invoices;
o a $1.9 million decrease in accounts payable - related parties,
caused by the payment of outstanding invoices;
o a $376,000 decrease in mail-in rebates;
o a $4.5 million increase in inventory;
o a $77,000 increase in prepaid expenses; and
o a $168,000 decrease in our allowance for product returns.
These decreases in cash were partially offset by:
o a $591,000 decrease in net loss;
o a $6.9 million decrease in accounts receivable resulting from normal
collections and lower sales in the first quarter of 2007 compared to
the first quarter of 2006;
o a $213,000 increase in our allowance for obsolete inventory; and
o a $296,000 increase in our reserve for sales incentives.
Cash provided by our investing activities totaled $683,000 during the
first quarter of 2007 as compared to cash provided by investing activities of
$13,000 during the first quarter of 2006. Our investing activities during the
first quarter of 2007 consisted of a $756,000 decrease in restricted cash
related to our line of credit and $73,000 in purchases of property and
equipment. Our investing activities during the first quarter of 2006 consisted
of a $14,000 decrease in restricted cash related to our line of credit and
nominal purchases of property and equipment.
Cash provided by our financing activities totaled $383,000 during the
first quarter of 2007 as compared to $110,000 for the first quarter of 2006. We
had $383,000 in net borrowings on our line of credit in the first quarter of
2007 compared to $55,000 of net borrowings on our line of credit in the first
quarter of 2006. We also received proceeds of $55,000 from the exercise of stock
options in the first quarter of 2006.
On March 9, 2005, we entered into an asset-based line of credit with GMAC
Commercial Finance, or 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.
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
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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.
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.
As of March 31, 2007, we owed Silicon Valley Bank approximately $4.8
million and had no amounts available for borrowing under our credit facility.
The outstanding balance with Silicon Valley Bank as of August 10, 2007 was
$3,179,630. We had no amounts available to us for borrowing as of that date.
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
March 31, 2007, we owed Lung Hwa Electronics $5,282,058 in trade payables. As of
March 31, 2007, we were out of compliance with the payment terms of the
agreement and have proposed a repayment schedule to Lung Hwa Electronics to
retire the balance due at March 31, 2007 over the next six months and at the
date of filing this report we expect to meet the proposed payments.
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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 March 31, 2007, we owed BTC USA
$751,916 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. At
March 31, 2007, we were out of compliance with the payment terms of the
agreement and have proposed a repayment schedule to BTC USA to retire the
balance due at March 31, 2007 over the next ten weeks and at the date of filing
this report we expect to meet the proposed payments.
Lung Hwa Electronics and BTC USA provide us with significantly
preferential trade credit terms. These terms include extended payment terms,
substantial trade lines of credit and other preferential buying arrangements. We
believe that these terms are substantially better terms than we could likely
obtain from other subcontract manufacturers or suppliers. In fact, we believe
that our trade credit facility with Lung Hwa Electronics is likely unique and
could not be replaced through a relationship with an unrelated third party. If
either of Lung Hwa Electronics or BTC USA does not continue to offer us
substantially the same preferential trade credit terms, our ability to finance
inventory purchases would be harmed, resulting in significantly reduced sales
and profitability. In addition, we would incur additional financing costs
associated with shorter payment terms which would also cause our profitability
to decline.
Our net loss decreased by approximately 25% to $507,000 in the first
quarter of 2007 from $1.1 million in the first quarter of 2006. 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 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 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.
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.
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IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS
The disclosure requirements and impacts of new accounting pronouncements
are described in "Note 15--Recent Accounting Pronouncements" of the notes to
consolidated financial statements contained elsewhere in this report.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations were not subject to commodity price risk during the three
months ended March 31, 2007. We had no sales to any foreign country in the first
quarter of 2007, and thus we experienced no 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 4. 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 March 31, 2007 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. 5 as being a deficiency, or combination of
deficiencies, in internal control over financial reporting, such that there is a
reasonable possibility of leading to a material misstatement that will not be
prevented or detected on a timely basis. A significant deficiency, which is less
severe than a material weakness yet merits attention of those responsible for
the oversight of the company's financial reporting, 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 a reasonable possibility 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 March 31, 2007, our disclosure controls and
procedures were not effective at the reasonable assurance level:
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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 March 31,
2007, 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
March 31, 2007, 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 March 31, 2007, 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 March 31, 2007, that the control deficiency
that resulted in the inability to timely make these filings represented a
material weakness.
3. We did not adequately segregate the duties of different personnel
within our accounting group. Activities that were not adequately segregated
included the processing and review of product rebate submissions and the issuing
of checks for product rebate payments. Partly as a result of our inadequate
segregation of duties, we believe that an ex-employee was able to embezzle,
through repeated issuances of product rebate checks in the name of the
ex-employee's spouse, the total approximate amount of $40,000 over the course of
a 5-year period. Management evaluated, in the third quarter of 2007 and as of
March 31, 2007, the impact of our inadequate segregation of duties on our
assessment of our disclosure controls and procedures and concluded, in the third
quarter of 2007 and as of March 31, 2007, that, although immaterial from a
financial perspective, the control deficiency that resulted in our inadequate
segregation of duties 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 March 31,
2007, 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.
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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.
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, as of the filing of this report, 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.
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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.
3. We have addressed our failure to adequately segregate the duties of
different personnel within our accounting group through revised procedures and
staff training. As noted above, activities that were not adequately segregated
included the processing and review of product rebate submissions and the issuing
of checks for product rebate payments. In the third quarter of 2007, we began
requiring that the processing and review of product rebate submissions and the
issuing of checks for product rebate payments be conducted by at least three
distinct individuals, one of whom processes product rebate submissions, one of
whom reviews the results of the processing of product rebate submissions and one
of whom issues checks for product rebate payments.
Management believes that the remediation described in item 3 immediately
above has, as of the filing of this report, remediated the corresponding
material weakness also described above. Management believes that our capital or
other expenditures associated with this remediation were negligible.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There were no changes during our most recently completed fiscal quarter
that have materially affected or are 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 4T. CONTROLS AND PROCEDURES
Not applicable.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are subject to legal proceedings, claims and litigation arising in the
ordinary course of business. While the amounts claimed may be substantial, the
ultimate liability cannot presently be determined because of considerable
uncertainties that exist. Therefore, it is possible that the outcome of those
legal proceedings, claims and litigation could adversely affect our quarterly or
annual operating results or cash flows when resolved in a future period.
However, based on facts currently available, management believes such matters
will not adversely affect our financial position, results of operations or cash
flows.
HORWITZ & BEAM
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
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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.
ITEM 1A. RISK FACTORS
In addition to the other information set forth in this report, you should
carefully consider the factors discussed under "Risk Factors" in our Annual
Report on Form 10-K for the year ended December 31, 2006, which could materially
affect our business, financial condition and results of operations. The risks
described in our Annual Report on Form 10-K for the year ended December 31, 2006
are not the only risks we face. Additional risks and uncertainties not currently
known to us or that we currently deem to be immaterial also may materially
adversely affect our business, financial condition and results of operations.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
Exhibit
Number Description
- ------ -----------
10.1 Loan and Security Agreement dated February 2, 2007 between I/OMagic
Corporation, IOM Holdings, Inc. and Silicon Valley Bank (2)
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 (1)
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 (1)
32.1 Certification of President 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 (1)
- -----------------
(1) Filed herewith.
(2) 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).
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
I/OMAGIC CORPORATION
Dated: August 13, 2007 By: /s/ Thomas L. Gruber
--------------------------------------------
Thomas L. Gruber, Chief Financial Officer
(principal financial and accounting officer)
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EXHIBITS FILED WITH THIS REPORT
Exhibit
Number Description
- ------ -----------
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 President 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