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 SEPTEMBER 30, 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 November 13, 2007, there were 4,540,292 shares of the issuer's common
stock issued and outstanding.
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.
-i-
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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 September 30, 2007 (unaudited) and
December 31, 2006................................................................................1
Consolidated Statements of Operations for the Three and Nine Months
Ended September 30, 2007 and 2006 (unaudited)....................................................2
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 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 .............14
Item 3. Quantitative and Qualitative Disclosures About Market Risk ........................................25
Item 4. Controls and Procedures ...........................................................................25
Item 4T. Controls and Procedures ...........................................................................27
PART II
OTHER INFORMATION
Item 1. Legal Proceedings .................................................................................27
Item 1A. Risk Factors ......................................................................................28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds .......................................28
Item 3. Defaults Upon Senior Securities ...................................................................28
Item 4. Submission of Matters to a Vote of Security Holders ...............................................28
Item 5. Other Information .................................................................................28
Item 6. Exhibits...........................................................................................29
Signatures ...................................................................................................30
Exhibits Filed with this Report
-ii-
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31,
2007 2006
------------ ------------
(unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 433,122 $ 1,833,481
Restricted cash -- 893,167
Accounts receivables, net 3,885,637 11,534,687
Inventory, net 9,904,695 10,670,916
Prepaid expenses and other current assets 95,040 71,733
------------ ------------
Total current assets 14,318,494 25,003,984
EQUIPMENT, net 264,776 194,117
TRADEMARKS, net 310,248 361,944
OTHER ASSETS 72,270 41,928
------------ ------------
TOTAL ASSETS $ 14,965,788 $ 25,601,973
============ ============
LIABILITIES & STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Line of credit $ 3,123,466 $ 4,380,133
Accounts payable, accrued expenses and other 2,740,713 5,521,873
Accounts payable - related parties 4,112,779 7,945,980
Accrued mail-in rebates 500,187 1,269,996
------------ ------------
Total liabilities 10,477,145 19,117,982
------------ ------------
STOCKHOLDERS' EQUITY
Preferred stock, 10,000,000 authorized, no shares outstanding -- --
Common stock, 100,000,000 authorized, 4,540,292 issued and outstanding 4,541 4,541
Additional paid-in capital 31,735,597 31,681,409
Accumulated deficit (27,251,495) (25,201,959)
------------ ------------
Total stockholders' equity 4,488,643 6,483,991
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 14,965,788 $ 25,601,973
============ ============
See accompanying notes to these consolidated financial statements
-1-
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2007 2006 2007 2006
------------ ------------ ------------ ------------
NET SALES $ 5,772,340 $ 11,458,673 $ 19,951,373 $ 30,334,312
COST OF SALES 5,373,492 9,473,305 18,152,898 26,233,005
------------ ------------ ------------ ------------
GROSS PROFIT 398,848 1,985,368 1,798,475 4,101,307
------------ ------------ ------------ ------------
OPERATING EXPENSES
Selling, marketing and advertising 276,467 427,059 884,251 1,474,335
General and administrative 783,392 1,378,067 2,623,417 4,948,213
Depreciation and amortization 34,991 42,936 104,590 133,858
------------ ------------ ------------ ------------
Total operating expenses 1,094,850 1,848,062 3,612,258 6,556,406
------------ ------------ ------------ ------------
INCOME (LOSS) FROM OPERATIONS (696,002) 137,306 (1,813,783) (2,455,099)
------------ ------------ ------------ ------------
OTHER INCOME (EXPENSE)
Interest income -- 1 6 107
Interest expense (83,561) (63,016) (316,756) (234,738)
Currency transaction gain 66 -- 55 --
Other income 76,089 8,701 81,741 11,185
Litigation settlement -- -- -- 2,375,000
------------ ------------ ------------ ------------
Total other income (expense) (7,405) (54,314) (234,954) 2,151,554
------------ ------------ ------------ ------------
INCOME (LOSS) BEFORE PROVISION FOR INCOME
TAXES (703,408) 82,992 (2,048,737) (303,545)
PROVISION FOR INCOME TAXES -- -- 800 800
------------ ------------ ------------ ------------
NET INCOME (LOSS) $ (703,408) $ 82,992 $ (2,049,537) $ (304,345)
============ ============ ============ ============
BASIC AND DILUTED INCOME (LOSS) PER SHARE $ (0.15) $ 0.02 $ (0.45) $ (0.07)
============ ============ ============ ============
BASIC AND DILUTED WEIGHTED-AVERAGE SHARES
OUTSTANDING 4,540,292 4,540,292 4,540,292 4,540,292
============ ============ ============ ============
See accompanying notes to these consolidated financial statements
-2-
I/OMAGIC CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
2007 2006
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(2,049,537) $ (304,345)
Adjustments to reconcile net loss to net cash provided by (used in)
operating activities:
Depreciation and amortization 52,894 82,162
Amortization of trademarks 51,696 51,696
Allowance for doubtful accounts 15,128 170,026
Allowance for product returns (425,733) 207,448
Reserves for sales incentives 23,702 (193,034)
Accrued point-of-sale rebates (958,955) (540,385)
Accrued market development funds, cooperative advertising costs and
cross dock fees (534,304) (967,441)
Allowance for obsolete inventory (226,000) 63,362
Share-based compensation expense 54,188 118,987
Capitalized offering costs -- 1,218,655
Changes in assets and liabilities (net of dispositions and acquisitions)
Accounts receivable 9,529,212 2,832,009
Inventory 992,221 (1,623,280)
Prepaid expenses and other current assets (23,307) 251,718
Other assets (30,342) (21,804)
Accounts payable, accrued expenses and other (2,781,160) 54,359
Accounts payable - related parties (3,833,201) (2,546,086)
Accrued mail-in rebates (769,809) (134,401)
----------- -----------
Net cash used in operating activities (913,306) (1,280,354)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Restricted cash 893,167 (511,409)
Equipment additions (123,553) (27,608)
----------- -----------
Net cash provided by (used in) investing activities 769,614 (539,017)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Net payments on line of credit (1,256,667) (1,054,790)
Proceeds from sales of common stock -- 62,432
----------- -----------
Net cash used in financing activities (1,256,667) (992,358)
----------- -----------
Net decrease in cash and cash equivalents (1,400,359) (2,811,729)
Cash and cash equivalents at beginning of period 1,833,481 4,056,541
----------- -----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 433,122 $ 1,244,812
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
INTEREST PAID $ 316,756 $ 235,333
=========== ===========
INCOME TAXES PAID $ 800 $ 800
=========== ===========
See accompanying notes to these consolidated financial statements
-3-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO 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 nine months ended September
30, 2007 of $2,049,537 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 substantial doubt about the Company's
liquidity and ability to fund future operations.
At September 30, 2007, the Company had cash and cash equivalents of $433,122 and
as of November 12, 2007, the Company had only $217,000 of cash on hand.
On November 7, 2007, the Company received notice from Silicon Valley Bank under
a Loan and Security Agreement dated February 2, 2007 between the Company, IOM
Holdings, Inc. and Silicon Valley Bank that the Company was in default of its
tangible net worth financial covenant. As of that date, the Company owed Silicon
Valley Bank approximately $4,081,908, all of which is due and payable upon
demand by Silicon Valley Bank. The Company is also unable to obtain advances
under its line of credit. In addition, Silicon Valley Bank has various other
remedies under the Loan and Security Agreement, including the ability to
foreclose on the Company's assets.
The Company is seeking a waiver of the default of its tangible net worth
financial covenant and believes that the Bank will ultimately waive the default
and allow additional advances under the line of credit. The Company cannot
provide any assurance, however, that a waiver will be obtained, that it will be
able to obtain additional advances under the line of credit or that the terms of
the line of credit following the waiver will be as advantageous as the terms
existing prior to the Company's default. The Company also may be required to pay
a substantial penalty or fee in order to induce Silicon Valley Bank to waive the
default and make available the line of credit.
As of the date of filing of this report, the Company had serious liquidity
concerns and will likely 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.
-4-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO FINANCIAL STATEMENTS
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 September 30, 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.
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, dated July 9, 2007, 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 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 the nine months ended September 30, 2007, the Company's most significant
retailers were Staples, Office Max, Office Depot and Circuit City. Collectively,
these four retailers accounted for 77.5% of the Company's net sales in the first
nine months of 2007. During the nine months ended September 30, 2006, the
Company's most significant retailers were Staples, Office Depot, Costco and
Circuit City. Collectively, these four retailers accounted for 69.2% of the
Company's net sales in the first nine months of 2006.
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO FINANCIAL STATEMENTS
Related Parties
- ---------------
During the nine months ended September 30, 2007, the Company purchased inventory
from two related-parties, Lung Hwa Electronics Co. Ltd. ("Lung Hwa") and BTC
USA, an affiliate of Behavior Tech Computer Corp. ("BTC"), in amounts totaling
$2.4 million and $2.2 million, respectively, which represented 15.3% and 14.6%
of total inventory purchases during the period, respectively. As of September
30, 2007, there were $2,589,786 and $1,522,993, respectively, in trade payables
outstanding to the related parties.
NOTE 4 - ACCOUNTS RECEIVABLE
Accounts receivable as of September 30, 2007 and December 31, 2006 consisted of
the following:
SEPTEMBER 30, DECEMBER 31,
2007 2006
------------ ------------
Accounts receivable $ 4,833,929 $ 14,363,142
Less: Allowance for doubtful accounts (50,128) (35,000)
Allowance for product returns (319,682) (466,407)
Reserve for sales incentives (40,674) (295,981)
Accrued point-of-sale rebates (422,132) (1,381,087)
Accrued market development funds, cooperative
advertising costs and cross dock fees (115,676) (649,980)
------------ ------------
TOTAL $ 3,885,637 $ 11,534,687
============ ============
NOTE 5 - INVENTORY
Inventory as of September 30, 2007 and December 31, 2006 consisted of the following:
SEPTEMBER 30, DECEMBER 31,
2007 2006
------------ ------------
Component parts $ 1,589,083 $ 870,484
Finished goods--warehouse 2,509,333 3,164,825
Finished goods--consigned 6,106,279 7,161,607
------------ ------------
10,204,695 11,196,916
Less: Allowance for obsolete and slow-moving
inventory (300,000) (526,000)
------------ ------------
TOTAL $ 9,904,695 $ 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.
-6-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO FINANCIAL STATEMENTS
NOTE 6 - EQUIPMENT
Equipment as of September 30, 2007 and December 31, 2006 consisted of the
following:
SEPTEMBER 30, DECEMBER 31,
2007 2006
------------ ------------
Computer equipment and software $ 975,523 $ 966,170
Warehouse equipment 138,065 69,013
Office furniture and equipment 281,155 236,007
Vehicles 74,742 74,742
Leasehold improvements 106,633 106,633
------------ ------------
1,576,118 1,452,565
Less: Accumulated depreciation (1,311,342) (1,258,448)
------------ ------------
TOTAL $ 264,776 $ 194,117
============ ============
For the nine months ended September 30, 2007 and 2006, depreciation and
amortization expense was $52,894 and $82,162, respectively.
NOTE 7 - TRADEMARKS
Trademarks as of September 30, 2007 and December 31, 2006 consisted of the
following:
SEPTEMBER 30, DECEMBER 31,
2007 2006
------------ ------------
Trademarks $ 499,800 $ 499,800
Less: Amortization (189,552) (137,856)
------------ ------------
TOTAL $ 310,248 $ 361,944
===========- ============
Amortization expense on these intangible assets was $51,696 for the nine months
ended September 30, 2007 and 2006. Amortization expense related to these
intangible assets at September 30, 2007 in each of the next five fiscal years
and beyond is as follows:
Remainder of 2007 $ 17,232
2008 68,928
2009 68,928
2010 68,928
2011 68,928
2012 17,304
------------
$ 310,248
============
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%.
-7-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO FINANCIAL STATEMENTS
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. pursuant to a Cross-Corporate
Continuing Guaranty by the Company and IOM Holdings, Inc. The obligations of the
Company and the guarantee obligations of IOM Holdings, Inc. are secured pursuant
to an Intellectual Property Security Agreement executed by the Company and an
Intellectual Property Security Agreement executed by IOM Holdings, Inc.
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 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, 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.
The credit facility is subject to a financial covenant on a consolidated basis
measuring 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, if
any, 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.
On November 7, 2007, the Company received notice from Silicon Valley Bank under
the Loan and Security Agreement that the Company was in default of its tangible
net worth financial covenant. As of that date, the Company owed Silicon Valley
Bank approximately $4,081,908, all of which is due and payable upon demand by
Silicon Valley Bank. The Company is also unable to obtain advances under its
line of credit. In addition, Silicon Valley Bank has various other remedies
under the Loan and Security Agreement, including the ability to foreclose on the
Company's assets.
The Company is seeking a waiver of the default of its tangible net worth
financial covenant and believes that Silicon Valley Bank will ultimately waive
the default and allow additional advances under the line of credit. The Company
cannot provide any assurance, however, that a waiver will be obtained, that it
will be able to obtain additional advances under the line of credit or that the
terms of the line of credit following the waiver will be as advantageous as the
terms existing prior to the Company's default. The Company also may be required
to pay a substantial penalty or fee in order to induce Silicon Valley Bank to
waive the default and make available the line of credit.
-8-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO FINANCIAL STATEMENTS
NOTE 9 - TRADE CREDIT FACILITIES WITH RELATED PARTIES
On June 6, 2005, the Company entered into a trade credit facility with a related
party, Lung Hwa, 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 this 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. 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. During the nine months ended September 30, 2007, the Company
purchased $2.4 million of inventory under this arrangement. As of September 30,
2007, there were $2,589,786 in trade payables outstanding under this
arrangement. As of September 30, 2007, the Company was out of compliance with
the payment terms of the agreement and has proposed a repayment schedule to Lung
Hwa to retire the balance due at September 30, 2007 over three months. As of 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, BTC, one of our significant stockholders, 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. Mr. Steel Su, a director
of I/OMagic, is the Chief Executive Officer of Behavior Tech Computer Corp.
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 nine months ended September 30, 2007, the
Company purchased $2.2 million of inventory under this arrangement. As of
September 30, 2007, there were $1,522,993 in trade payables outstanding under
this arrangement. As of September 30, 2007, the Company was out of compliance
with the payment terms of the agreement and has proposed a repayment schedule to
BTC to retire the balance due at September 30, 2007 over three months and as of
the date of filing of this report the Company expects to meet the proposed
payments.
-9-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO 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. 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).
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.
-10-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO FINANCIAL STATEMENTS
During the nine months ended September 30, 2007, 150,000 warrants expired.
As of September 30, 2007, there were options to acquire 344,069 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 September 30, 2007 were as follows:
WEIGHTED-
WEIGHTED- AVERAGE
AVERAGE REMAINING
NUMBER OF EXERCISE CONTRACTUAL INTRINSIC
OPTIONS SHARES PRICE LIFE (YEARS) VALUE(1)
- ------- ------ ----- ------------ --------
Outstanding 344,069 $ 3.11 2.93 $ 1,070,055
Expected to vest 338,802 $ 3.11 2.93 $ 1,053,674
Exercisable 283,256 $ 3.11 2.87 $ 880,926
- ----------
(1) Awards that are expected to vest take into consideration estimated
forfeitures for awards not yet vested.
There were no options granted during the nine months ended September 30, 2007
and 2006. No cash was received from the exercise of stock options for the nine
months ended September 30, 2007 and $62,432 was received from the exercise of
stock options for the nine months ended September 30, 2006. As of September 30,
2007, there was $103,210 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 2.1 years.
Share-based compensation expense was $54,188 and $118,987 for the nine months
ended September 30, 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 income 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 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. 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.
-11-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO FINANCIAL STATEMENTS
Prior to January 1, 2007, 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 adopted and implemented the provisions of Financial Accounting Standards
Board ("FASB") Interpretation No. ("FIN") 48, ACCOUNTING FOR UNCERTAINTY IN
INCOME TAXES, which requires the Company 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.
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.
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
September 30, 2007, the valuation allowance for deferred tax assets totaled
$13,783,279.
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 September 30, 2007, the Company had net operating loss carryforwards for
federal and state income tax purposes of approximately $30,231,953 and
$19,417,269, 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.
The Company's continuing practice is to recognize interest and/or penalties
related to income tax matters in income tax expense. As of September 30, 2007
and December 31, 2006, the Company had no accrual for the payment of interest
and penalties.
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 all periods presented.
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
nine months ended September 30, 2007 were in the United States.
-12-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO FINANCIAL STATEMENTS
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 will adopt SFAS No. 159 effective as of
January 1, 2007 and does not believe that the adoption of SFAS No. 159 will have
a material impact on its financial position, results of operations or cash
flows.
In September 2006, the FASB issued SFAS No. 157, FAIR VALUE MEASUREMENTS, which
defines the fair value, establishes a framework for measuring fair value and
expands disclosures about fair value measurements. This statement is effective
for financial statements issued for fiscal years beginning after November 15,
2007, and interim periods within those fiscal years. Early adoption is
encouraged, provided that 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 will adopt SFAS No. 157 effective as of
January 1, 2007. The Company is assessing whether the adoption of SFAS No. 157
will have a material impact on its financial position, results of operations or
cash flows.
-13-
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR UNAUDITED
CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER
30, 2007 AND THE RELATED NOTES AND THE OTHER FINANCIAL INFORMATION INCLUDED
ELSEWHERE IN THIS REPORT. THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS
REGARDING THE DATA STORAGE AND DIGITAL ENTERTAINMENT INDUSTRIES AND OUR
EXPECTATIONS REGARDING OUR FUTURE PERFORMANCE, LIQUIDITY AND FINANCIAL
RESOURCES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE EXPRESSED IN
THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF ANY NUMBER OF FACTORS, INCLUDING
THOSE SET FORTH UNDER 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.
In the fourth quarter 2007, we began selling our new line of Liquid
Crystal Display (LCD) Televisions.
We sell our products through computer, consumer electronics and office
supply superstores and other major North American retailers, including Best Buy
Canada, Circuit City, CompUSA, Costco, Fred Meyer Stores, Micro Center, Office
Depot, Office Max, RadioShack, Staples, Tech Data and Target. Our retailers sell
our products in retail locations throughout North America. We also have
relationships with other retailers, catalog companies and Internet retailers
such as Buy.com, Dell, PC Mall, Home Shopping Network and Tiger Direct,
predominantly through distribution by Tech Data.
During the nine months ended September 30, 2007, our most significant
retailers were Staples, Office Max, Office Depot and Circuit City. Collectively,
these four retailers accounted for 77.5% of our net sales during the first nine
months of 2007. During the nine months ended September 30, 2006, our most
significant retailers were Staples, Office Depot, Costco and Circuit City.
Collectively, these four retailers accounted for 69.2% of our net sales during
the first nine months of 2006.
-14-
Over the course of the past several months, 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 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.
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."
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 assumptions, 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.
-15-
RESULTS OF OPERATIONS
The tables presented below compare our results of operations from one
period to another, as follows:
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 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.
<s> <c>
THREE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2006
Three Months Ended Dollar Percentage Results as a
(in thousands) September 30, Variance Variance Percentage of
-------------------------- Favorable Favorable Net Sales
2007 2006 (Unfavorable) (Unfavorable) 2007 2006
----------- ----------- ----------- ----------- ----------- -----------
Net sales $ 5,772 $ 11,459 $ (5,687) (49.6)% 100.0% 100.0%
Cost of sales 5,373 9,474 4,101 43.3% 93.1% 82.7%
----------- ----------- ----------- ----------- ----------- -----------
Gross profit 399 1,985 (1,586) (79.9)% 6.9% 17.3%
Selling, marketing and
advertising expenses 277 427 150 35.1% 4.8% 3.7%
General and administrative
expenses 783 1,378 595 43.2% 13.6% 12.0%
Depreciation and amortization 35 43 8 18.6% 0.6% 0.4%
----------- ----------- ----------- ----------- ----------- -----------
Operating income (loss) (696) 137 (833) (608.0)% (12.1)% 1.2%
Net interest expense (83) (62) 21 (33.9)% (1.4)% (0.5)%
Other income 76 8 68 850.0% 1.3% 0.1%
----------- ----------- ----------- ----------- ----------- -----------
Income (loss) from operations
before provision for income
taxes (703) 83 786 947.0% (12.2)% 0.7%
Income tax provision -- -- -- 0.0% 0.0% 0.0%
----------- ----------- ----------- ----------- ----------- -----------
Net income (loss) $ (703) $ 83 $ 786 947.0% (12.2)% 0.7%
=========== =========== =========== =========== =========== ===========
NET SALES. Net sales decreased by $5,687,000, or 49%, to $5,772,000 in
the third quarter of 2007 as compared to $11,459,000 in the third quarter of
2006. A combination of factors affected our net sales, including a $2.2 million
decrease in sales of our optical data storage products. Sales of our optical
data storage products decreased by 54% to $1.9 million, or 33% of our net sales,
in the third quarter of 2007 as compared to $4.1 million, or 36% of our net
sales, in the third quarter of 2006. Sales of our CD- and DVD-based products
continue to decrease in the third 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 $3.3 million, or 66%, to $1.7
million, or 28% of our net sales, in the third quarter of 2007 as compared to
$5.0 million, or 60% of our net sales, in the third quarter of 2006, which was
partially offset by an increase in net sales of our desktop data storage
products during the third quarter of 2007 of $1.8 million, or 31% of our net
sales, as compared to $2.1 million, or 18% of our net sales, for the third
quarter of 2006.
-16-
In addition, our overall product return rate was 9.7% in the third
quarter of 2007 compared to 6.2% in the third quarter of 2006. The increase in
our overall product return rate resulted from an increase in sales of our
desktop magnetic data storage products in the third quarter of 2007 compared to
the third quarter of 2006, which experienced a high rate of return. Also, sales
incentives, market development funds and cooperative advertising costs, rebate
promotion costs and slotting fees, collectively as a percentage of gross sales,
were 13.6%, all of which were offset against gross sales, in the third quarter
of 2007 compared to 10.0% in the third quarter of 2006. The increase 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 significant market pressure for these promotions, and a decrease in
sales of our optical data storage products, but which experienced increased
market pressure for these promotions during the third quarter of 2007 as
compared to the third quarter of 2006.
GROSS PROFIT. Gross profit decreased by $1,586,000, or 80%, to $399,000
in the third quarter of 2007 as compared to $1,985,000 in the third quarter of
2006. The decrease in gross profit primarily resulted from a decrease in net
sales and related competitive pricing pressures. Our gross profit margin as a
percentage of net sales decreased to 6.9% in the third quarter of 2007 as
compared to 17.3% in the third quarter of 2006. The decline in our gross profit
margin predominantly resulted from substantially lower unit selling prices for
our mobile data and desktop storage products caused by competitive pricing
pressures and a shift in our product mix to a higher proportion of desktop data
storage products. The average unit selling prices for our optical data storage
products remained stable.
SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses decreased by $150,000, or 35%, to $277,000 in the third
quarter of 2007 as compared to $427,000 in the third quarter of 2006. This
decrease was primarily due to decreases of $18,000 in personnel costs, $4,000 in
travel expenses, $5,000 in trade show expenses, $5,000 in vendor training
programs expenses, $29,000 in outside sales commissions, and a $117,000 decrease
in shipping and handling costs as a result of lower sales, all of which were
partially offset by increases of $18,000 in sales expenses and $10,000 in costs
for temporary personnel.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased by $595,000, or 43%, to $783,000 in the third quarter of 2007 as
compared to $1,378,000 in the third quarter of 2006. This decrease was primarily
due to a decrease of $85,000 in salaries and benefits, $18,000 in travel
expenses, $24,000 in facilities costs, $81,000 in legal fees primarily related
to prior-year litigation expenses, $126,000 in audit fees, $100,000 in outside
services expenses, $41,000 in financial relations expenses, $52,000 in insurance
expenses, $13,000 in share-based compensation expense, $35,000 in bad debt
expense and $39,000 in general expenses, all of which were partially offset by
increases of $15,000 in bank financing expenses and $4,000 in information
technology support expenses.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased by
$8,000, or 19%, to $35,000 in the third quarter of 2007 as compared to $43,000
in the third quarter of 2006. This decrease primarily resulted from certain of
our fixed assets becoming fully depreciated since September 30, 2006.
-17-
NET INTEREST EXPENSE. Net interest expense increased by $21,000, or 34%,
to $83,000 in the third quarter of 2007 as compared to $62,000 in the third
quarter of 2006. This increase primarily resulted from higher borrowings on our
line of credit and higher effective rates of interest on those borrowings in the
third quarter of 2007 as compared to the third quarter of 2006.
OTHER INCOME. Other income increased by $68,000, or 850%, in the third
quarter of 2007 as compared to the third quarter of 2006 primarily as a result
of an insurance claim filed in the third quarter of 2007.
NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2006
Nine Months Ended Dollar Percentage Results as a
(in thousands) September 30, Variance Variance Percentage of
-------------------------- Favorable Favorable Net Sales
2007 2006 (Unfavorable) (Unfavorable) 2007 2006
----------- ----------- ----------- ----------- ----------- -----------
Net sales $ 19,951 $ 30,334 $ (10,383) (34.2)% 100.0% 100.0%
Cost of sales 18,153 26,233 8,080 30.8% 91.0% 86.5%
----------- ----------- ----------- ----------- ----------- -----------
Gross profit 1,798 4,101 (2,303) (56.2)% 9.0% 13.5%
Selling, marketing and
advertising expenses 884 1,474 590 40.0% 4.4% 4.9%
General and administrative
expenses 2,623 4,948 2,325 47.0% 13.1% 16.3%
Depreciation and amortization 105 134 29 21.6% 0.5% 0.4%
----------- ----------- ----------- ----------- ----------- -----------
Operating loss (1,814) (2,455) 641 (26.1)% (9.1)% (8.1)%
Net interest expense (317) (234) 83 (35.5)% (1.6)% (0.8)%
Other income 82 2,386 (2,304) (96.6)% 0.4% 7.9%
----------- ----------- ----------- ----------- ----------- -----------
Loss from operations before
provision for income taxes (2,049) (303) 1,746 (576.2)% (10.3)% (1.0)%
Income tax provision 1 1 -- 0.0% 0.0% 0.0%
----------- ----------- ----------- ----------- ----------- -----------
Net loss $ (2,050) $ (304) $ 1,746 (574.3)% (10.3)% (1.0)%
=========== =========== =========== =========== =========== ===========
NET SALES. Net sales decreased by $10,383,000, or 34%, to $19,951,000 in
the nine months ended September 30, 2007 as compared to $30,334,000 in the nine
months ended September 30, 2006. A combination of factors affected our net
sales, including a $9.0 million decrease in sales of our optical data storage
products. Sales of our optical data storage products decreased by 65% to $4.8
million, or 24% of our net sales, in the nine months ended September 30, 2007 as
compared to $13.8 million, or 46% of our net sales, in the nine months ended
September 30, 2006. Sales of our CD- and DVD-based products continued to
decrease in the nine months ended September 30, 2007 compared to the nine months
ended September 30, 2006 because they are generally included as a standard
component in most new computer systems. Also, sales of our mobile data storage
products decreased by $7.0 million, or 53%, to $6.2 million, or 31% of our net
sales, in the nine months ended September 30, 2007 as compared to $13.2 million,
or 44% of our net sales, in the nine months ended September 30, 2006, which was
partially offset by an increase in net sales of our desktop data storage
products of $2.9 million, or 114%, to $5.4 million, or 27% of our net sales,
during the nine months ended September 30, 2007, as compared to $2.5 million, or
8% of our net sales, for the nine months ended September 30, 2006.
-18-
In addition, our overall product return rate was 13.2% in the nine months
ended September 30, 2007 compared to 8.2% in the nine months ended September 30,
2006. The increase in our overall product return rate resulted from an increase
in returns of our mobile data and desktop data storage products in the nine
months ended September 30, 2007 compared to the nine months ended September 30,
2006, which experienced a high rate of return. Also, sales incentives, market
development funds and cooperative advertising costs, rebate promotion costs and
slotting fees, collectively as a percentage of gross sales, were 22.0%, all of
which were offset against gross sales, in the nine months ended September 30,
2007 compared to 19.6% in the nine months ended September 30, 2006. The increase
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 promotional support for our optical storage and our mobile
and desktop magnetic data storage products, which experienced substantial market
pressure for these promotions.
The increases in our overall product return rate and our sales
incentives, market development funds and cooperative advertising costs, rebate
promotion costs and slotting fees, collectively added to the decrease in our net
sales resulting from lower sales of our optical data storage products and our
mobile and desktop data storage products.
GROSS PROFIT. Gross profit decreased by $2,303,000, or 56%, to $1,798,000
in the nine months ended September 30, 2007 as compared to $4,101,000 in the
nine months ended September 30, 2006. The decrease in gross profit primarily
resulted from a decrease in net sales and lower sales prices. Our gross profit
margin as a percentage of net sales decreased to 9.0% in the nine months ended
September 30, 2007 as compared to 13.5% in the nine months ended September 30,
2006. The decline in our gross profit margin predominantly resulted from higher
product costs and therefore higher cost of sales which increased to 91% in the
nine months ended September 30, 2007 compared to 87% in the nine months ended
September 30, 2006 and lower unit selling prices for all of our data storage
products which were caused by competitive pricing pressures.
SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses decreased by $590,000, or 40%, to $884,000 in the nine
months ended September 30, 2007 as compared to $1,474,000 in the nine months
ended September 30, 2006. This decrease was primarily due to decreases of
$36,000 in trade show expenses, $79,000 in other sales expenses, $114,000 in
outside sales commissions, $25,000 in personnel costs and $341,000 in shipping
and handling costs as a result of lower sales, all of which were partially
offset by a $5,000 increase in customer training expenses.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased by $2,325,000, or 47%, to $2,623,000 in the nine months ended
September 30, 2007 as compared to $4,948,000 in the nine months ended September
30, 2006. This decrease was primarily due to decreases of $1,221,000 in offering
costs, $343,000 in legal fees related to prior-year litigation expenses,
$282,000 in audit fees, $130,000 in insurance expenses, $91,000 in bad debt
expense, $95,000 in financial relations expense, $15,000 in share-based
compensation expense, $21,000 in dues and subscriptions expenses, $148,000 in
personnel expenses, $40,000 in facilities costs and $54,000 in supplies and
expenses, all of which were partially offset by increases of $7,000 in bank
fees, $12,000 in travel expenses, $50,000 in fees for early termination of a
credit facility, $25,000 in fees to initiate our Silicon Valley Bank credit
facility, and $21,000 in information technology support expenses.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased by
$29,000, or 22%, to $105,000 in the nine months ended September 30, 2007 as
compared to $134,000 in the nine months ended September 30, 2006. This decrease
primarily resulted from certain of our fixed assets becoming fully depreciated
since September 30, 2006.
NET INTEREST EXPENSE. Net interest expense increased by $83,000, or 36%,
to $317,000 in the nine months ended September 30, 2007 as compared to $234,000
in the nine months ended September 30, 2006. This increase primarily resulted
from higher borrowings on our line of credit and higher effective rates of
interest on those borrowings in the nine months ended September 30, 2007 as
compared to the nine months ended September 30, 2006.
-19-
OTHER INCOME. Other income decreased by $2,304,000, or 97%, in the nine
months ended September 30, 2007 as compared to the nine months ended September
30, 2006 primarily as a result of a litigation settlement in the amount of
$2,375,000 in the nine months ended September 30, 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 September 30, 2007, we had working capital of $3.8 million, an
accumulated deficit of $27.3 million, $433,000 in cash and cash equivalents and
$3.9 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 nine months ended September 30, 2007, our cash decreased $1.4
million, or 78%, from $1.8 million to $433,000. As of November 12, 2007, we had
only $217,000 of cash on hand.
On November 7, 2007, we received notice from Silicon Valley Bank under a
Loan and Security Agreement dated February 2, 2007 between us, our subsidiary,
IOM Holdings, Inc., and Silicon Valley Bank that we were in default of our
tangible net worth financial covenant. As of that date, we owed Silicon Valley
Bank approximately $4,081,908, all of which is due and payable upon demand. We
are also unable to obtain advances under our line of credit. In addition,
Silicon Valley Bank has various other remedies under the Loan and Security
Agreement, including the ability to foreclose on our assets.
We are seeking a waiver of the default of our tangible net worth
financial covenant and believe that Silicon Valley Bank will ultimately waive
the default and allow additional advances under the line of credit. We cannot,
however, provide any assurance that a waiver will be obtained, that we will be
able to obtain additional advances under the line of credit or that the terms of
the line of credit following the waiver will be as advantageous as the terms
existing prior to our default. We also may be required to pay a substantial
penalty or fee in order to induce Silicon Valley Bank to waive the default and
make available the line of credit.
We presently have insufficient liquidity to fund our operations for the
next twelve months. However, we believe that if we are successful in (i)
obtaining a waiver from Silicon Valley Bank and reestablishing our ability to
borrow under our credit facility on substantially the same terms, (ii)
negotiating extended payments terms on amounts owed to BTC USA and Lung Hwa,
(iii) timely collecting existing accounts receivable, and (iv) selling inventory
currently in our sales channels as anticipated, then current and future
available capital resources, revenues generated from operations, and other
existing sources of liquidity, including our trade credit facilities with Lung
Hwa 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. 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, 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 will likely 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 will likely have a material and adverse effect on our
ability to operate our business.
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Over the course of the past several months, 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 September 30, 2007 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 will
likely 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
as of December 31, 2006, dated July 9, 2007, 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.
Cash used in our operating activities totaled $913,000 during the nine
months ended September 30, 2007 as compared to $1.3 million during the nine
months ended September 30, 2006, and resulted primarily from the following
combination of factors:
o a $1.7 million increase in net loss;
o a $2.8 million decrease in accounts payable caused by the payment
of outstanding invoices;
o a $3.8 million decrease in accounts payable - related parties,
caused by the payment of outstanding invoices;
o a $770,000 decrease in mail-in rebates;
o a $23,000 increase in prepaid expenses and other current assets;
o a $226,000 increase in our allowance for obsolete inventory;
o a $959,000 decrease in point-of-sale accruals;
o a $534,000 decrease in market development funds and cooperative
advertising cost accruals;
o a $426,000 decrease in our allowance for product returns; and
o a $23,000 increase in our reserves for sales incentives.
These decreases in cash were partially offset by:
o a $9.5 million decrease in accounts receivable resulting from
normal collections and lower sales in the nine months ended
September 30, 2007;
-21-
o a $15,000 decrease in our allowance for doubtful accounts; and
o a $992,000 decrease in inventory.
Cash provided by our investing activities totaled $770,000 during the
nine months ended September 30, 2007 as compared to cash used in investing
activities of $539,000 during the nine months ended September 30, 2006. Our
investing activities during the nine months ended September 30, 2007 consisted
of an $893,000 decrease in restricted cash related to our line of credit and
$124,000 in purchases of property and equipment. Our investing activities during
the nine months ended September 30, 2006 consisted of a $511,000 increase in
restricted cash related to our line of credit and $28,000 in purchases of
property and equipment.
Cash used in our financing activities totaled $1.3 million during the
nine months ended September 30, 2007 as compared to $992,000 for the nine months
ended September 30, 2006. We had $1.3 million in net borrowings on our line of
credit in the nine months ended September 30, 2007 compared to $1.1 million of
net borrowings on our line of credit in the nine months ended September 30,
2006. We also received proceeds of $62,000 from the exercise of stock options in
the nine months ended September 30, 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
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 measuring 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.
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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 discussed above, we are in default under our credit facility with
Silicon Valley Bank and no amounts are available to us for borrowing under the
facility.
On June 6, 2005, we entered into a new trade credit facility with Lung
Hwa that replaced our previous $10.0 million trade credit facility. Under the
terms of the new facility, Lung Hwa 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 or manufactured by third parties, in which
case we use Lung Hwa as an international purchasing office. For inventory
manufactured by third parties and purchased through Lung Hwa, the payment terms
are 120 days following the date of invoice by Lung Hwa. Lung Hwa 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 this supplier, result in a credit to
us for the handling charge. For inventory manufactured by Lung Hwa, the payment
terms are 90 days following the date of invoice by Lung Hwa. We are to pay Lung
Hwa, within one week of the purchase order, 10% of the purchase price on any
purchase orders issued to Lung Hwa 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. During the nine months ended September 30, 2007
we purchased approximately $2.4 million in products from Lung Hwa and as of
September 30, 2007, we owed Lung Hwa $2.6 million in trade payables. As of
September 30, 2007, we were out of compliance with the payment terms of the
agreement and have proposed a repayment schedule to Lung Hwa to retire the
balance due at September 30, 2007 over three months. As of the date of filing
this report, we expect to meet the proposed payment schedule.
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. During the nine months ended September 30,
2007, we purchased approximately $2.2 million in products from BTC USA and as of
September 30, 2007, we owed BTC USA $1.5 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. As of September 30, 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 September 30, 2007 over three months and as of the
date of filing this report, we expect to meet the proposed payment schedule.
-23-
Lung Hwa 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 is likely unique and could not be replaced through a
relationship with an unrelated third party. If either of Lung Hwa or BTC USA
does not continue to offer us substantially the same preferential trade credit
terms, our ability to finance inventory purchases would be harmed, resulting in
significantly reduced sales and profitability. In addition, we would incur
additional financing costs associated with shorter payment terms which would
also cause our profitability to decline.
Our net loss increased by approximately 576% to $2,049,000 in the nine
months ended September 30, 2007 from $304,000 in the nine months ended September
30, 2006. If our net losses continue or increase, we could experience
significant additional 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.
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.
-24-
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations were not subject to commodity price risk during the three
and nine months ended September 30, 2007. We had negligible sales to foreign
countries in the three and nine months ended September 30, 2007, and thus we
experienced negligible foreign currency exchange rate risk. We do not hedge
against this risk.
On January 29, 2007, we replaced our then-existing asset-based line of
credit with GMAC with an asset-based line of credit with Silicon Valley Bank.
The new line of credit is for an amount of up to $10.0 million. The new line of
credit provides for an interest rate equal to the prime lending rate plus 1.0%.
This interest rate is adjustable upon each movement in the prime lending rate.
If the prime lending rate increases, our interest rate expense will increase on
an annualized basis by the amount of the increase multiplied by the principal
amount outstanding under our credit facility. As discussed above, we are in
default under our credit facility with Silicon Valley Bank and no amounts are
available to us for borrowing under the 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 September 30, 2007 that our disclosure
controls and procedures were not effective at the reasonable assurance level due
to the material weakness 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.
EXISTING MATERIAL WEAKNESS
Management has identified the following material weakness which caused
management to conclude that, as of September 30, 2007, our disclosure controls
and procedures were not effective at the reasonable assurance level: as a result
of our restatement of prior periods' financial results, we were unable to meet
our requirements to timely file our Form 10-K for the year ended December 31,
2006 and our Form 10-Q for the quarter ended March 31, 2007. We were, however,
able to timely file our Form 10-Q for the quarter ended June 30, 2007.
Management evaluated, in the fourth quarter of 2007 and as of September 30,
2007, the impact of our inability to timely file those periodic reports with the
Securities and Exchange Commission on our assessment of our disclosure controls
and procedures and concluded, in the fourth quarter of 2007 and as of September
30, 2007, that the control deficiency that resulted in the inability to timely
make these filings represented a material weakness.
-25-
REMEDIATION OF EXISTING MATERIAL WEAKNESS
To remediate the material weakness in our disclosure controls and
procedures identified above, we have done the following in the periods specified
below. Management believes that the procedures we implemented in connection with
the restatement of prior-period 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. In 2007, we have implemented 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, 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. Also, on November
5, 2007, we hired a Corporate Controller with many years of experience related
to our industry as well as with publicly traded companies.
Management expects that the actions described above will remediate the
corresponding material weakness by December 31, 2007. Management is unable,
however, to estimate our capital or other expenditures associated with this
remediation.
PRIOR MATERIAL WEAKNESS
Management previously identified the following material weakness which
caused management to conclude that, as of June 30, 2007, our disclosure controls
and procedures were not effective at the reasonable assurance level: 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, approximately
$40,000 over the course of a five year period. Management evaluated, in the
third quarter of 2007 and as of June 30, 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 June 30, 2007,
that, although immaterial from a financial perspective, the control deficiency
that resulted in our inadequate segregation of duties represented a material
weakness.
REMEDIATION OF PRIOR MATERIAL WEAKNESS
To remediate our prior material weakness in our disclosure controls and
procedures identified above, we have done the following in the period specified
below. 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
issuance 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 issuance 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.
-26-
Management believes that the actions described above have remediated the
corresponding material weakness also described above. Our expenditures
associated with this remediation were negligible.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
The changes noted above, specifically, our new procedures for processing
and reviewing product rebate submissions and issuing checks for product rebate
payments were the only 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
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.
-27-
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
On November 7, 2007, we received notice from Silicon Valley Bank under a
Loan and Security Agreement dated February 2, 2007 between us, our subsidiary,
IOM Holdings, Inc., and Silicon Valley Bank that we were in default of our
tangible net worth financial covenant. As of that date, we owed Silicon Valley
Bank approximately $4,081,908, all of which is due and payable upon demand by
Silicon Valley Bank. We are also unable to obtain advances under our line of
credit. In addition, Silicon Valley Bank has various other remedies under the
Loan and Security Agreement, including the ability to foreclose on our assets.
We are seeking a waiver of the default of our tangible net worth
financial covenant and believe that Silicon Valley Bank will ultimately waive
the default and allow additional advances under the line of credit. We cannot,
however, provide any assurance that a waiver will be obtained, that we will be
able to obtain additional advances under the line of credit or that the terms of
the line of credit following the waiver will be as advantageous as the terms
existing prior to our default. We also may be required to pay a substantial
penalty or fee in order to induce Silicon Valley Bank to waive the default and
make available the line of credit.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
-28-
ITEM 6. EXHIBITS
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 (*)
- -------------------
(*) Filed herewith.
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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: November 13, 2007 By: /s/ THOMAS L. GRUBER
--------------------------------------------
Thomas L. Gruber, Chief Financial Officer
(principal financial and accounting officer)
-30-
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