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, 2008
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______ to _______
Commission File Number: 000-27267
I/OMAGIC CORPORATION
(Exact name of registrant as specified in its charter)
NEVADA 33-0773180
(State or other jurisdiction (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, a non-accelerated filer, or a smaller reporting
company. See the definitions of "large accelerated filer," "accelerated filer"
and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer |_| Accelerated filer |_|
Non-accelerated filer |_| (Do not check if Smaller reporting company |X|
a smaller reporting company)
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 April 9, 2009 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 this report or in the
"Risk Factors" section of our Amendment No. 1 to Annual Report on Form 10-K for
the year ended December 31, 2007, 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-
TABLE OF CONTENTS
PART I
FINANCIAL INFORMATION
PAGE
----
Item 1. Financial Statements.........................................................................1
Condensed Consolidated Balance Sheets as of September 30, 2008 (unaudited) and
December 31, 2007.........................................................................1
Condensed Consolidated Statements of Operations for the Three and Nine Months Ended
September 30, 2008 (unaudited) and 2007 (unaudited, restated).............................2
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2008 (unaudited) and 2007 (unaudited, restated).............................3
Notes to Condensed Consolidated Financial Statements.........................................4
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.......15
Item 3. Quantitative and Qualitative Disclosures About Market Risk .................................26
Item 4. Controls and Procedures ....................................................................26
Item 4T. Controls and Procedures ....................................................................26
PART II
OTHER INFORMATION
Item 1. Legal Proceedings ..........................................................................27
Item 1A. Risk Factors ...............................................................................27
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 ...................................................................................28
Signatures ............................................................................................29
Exhibits Filed with this Report
-ii-
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I/OMAGIC CORPORATION AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31,
2008 2007
------------ ------------
(unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 278,737 $ 1,463,122
Restricted cash -- 341,899
Accounts receivable, net 670,076 6,941,856
Inventory, net 2,231,036 5,492,846
Prepaid expenses and other current assets 66,479 107,041
------------ ------------
Total current assets 3,246,328 14,346,764
EQUIPMENT, net 201,652 247,551
TRADEMARKS, net 241,320 293,016
OTHER ASSETS 41,928 41,928
------------ ------------
TOTAL ASSETS $ 3,731,228 $ 14,929,259
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Line of credit $ -- $ 3,864,942
Accounts payable, accrued expenses and other 812,735 1,153,188
Accounts payable - related parties 4,604,138 7,414,212
Capital lease obligations - current portion 51,203 47,593
Accrued mail-in rebates 238,141 432,046
------------ ------------
Total current liabilities 5,706,217 12,911,981
------------ ------------
LONG-TERM LIABILITIES
Capital lease obligations 28,498 65,885
------------ ------------
Total long-term liabilities 28,498 65,885
------------ ------------
Total liabilities 5,734,715 12,977,866
------------ ------------
STOCKHOLDERS' EQUITY (DEFICIT)
Preferred stock, $0.001 par value, 10,000,000 shares authorized
Series A, 1,000,000 shares authorized, no shares issued and outstanding -- --
Series B, 1,000,000 shares authorized, no shares issued and outstanding -- --
Common stock, $0.001 par value, 100,000,000 shares authorized, 4,540,292 and
4,540,292 shares issued and outstanding, respectively 4,541 4,541
Additional paid-in capital 31,832,971 31,794,655
Accumulated deficit (33,840,999) (29,847,803)
------------ ------------
Total stockholders' equity (deficit) (2,003,487) 1,951,393
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) $ 3,731,228 $ 14,929,259
============ ============
See accompanying notes to these consolidated financial statements
-1-
I/OMAGIC CORPORATION AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2008 2007 2008 2007
------------ ------------ ------------ ------------
(RESTATED) (RESTATED)
NET SALES $ 1,528,404 $ 5,772,340 $ 9,265,370 $ 19,951,373
COST OF SALES 1,661,992 5,345,129 10,038,337 17,967,986
------------ ------------ ------------ ------------
GROSS PROFIT (LOSS) (133,588) 427,211 (772,967) 1,983,387
------------ ------------ ------------ ------------
OPERATING EXPENSES
Selling, marketing and advertising 179,250 276,467 876,948 884,251
General and administrative 624,260 834,630 2,152,944 3,001,989
Depreciation and amortization 31,186 34,991 97,595 104,590
------------ ------------ ------------ ------------
Total operating expenses 834,696 1,146,088 3,127,487 3,990,830
------------ ------------ ------------ ------------
LOSS FROM OPERATIONS (968,284) (718,877) (3,900,454) (2,007,443)
------------ ------------ ------------ ------------
OTHER INCOME (EXPENSE)
Interest income -- -- -- 6
Interest expense (4,798) (83,561) (95,546) (316,756)
Currency transaction gain (loss) -- 66 (446) 55
Other income 1,059 76,089 4,050 81,741
------------ ------------ ------------ ------------
Total other income (expense) (3,739) (7,406) (91,942) (234,954)
------------ ------------ ------------ ------------
LOSS BEFORE PROVISION FOR INCOME TAXES (972,023) (726,283) (3,992,396) (2,242,397)
PROVISION FOR INCOME TAXES -- -- 800 800
------------ ------------ ------------ ------------
NET LOSS $ (972,023) $ (726,283) $ (3,993,196) $ (2,243,197)
============ ============ ============ ============
BASIC AND DILUTED LOSS PER SHARE $ (0.21) $ (0.16) $ (0.88) $ (0.49)
============ ============ ============ ============
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
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
2008 2007
----------- -----------
(RESTATED)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(3,993,196) $(2,243,197)
Adjustments to reconcile net loss to net cash provided by (used in)
operating activities:
Depreciation and amortization 45,899 52,894
Amortization of trademarks 51,696 51,696
Allowance for doubtful accounts (145,076) 15,128
Allowance for product returns (167,069) (146,725)
Reserves for sales incentives 24,224 (255,307)
Accrued point-of-sale rebates (92,490) (958,955)
Accrued market development funds, cooperative advertising costs and
cross dock fees (331,995) (534,304)
Allowance for obsolete inventory (78,333) (226,000)
Share-based compensation expense 38,316 54,188
Changes in assets and liabilities (net of dispositions and acquisitions)
Accounts receivable 6,984,186 9,529,212
Inventory 3,340,143 807,309
Prepaid expenses and other current assets 40,562 (23,307)
Other assets -- (30,342)
Accounts payable, accrued expenses and other (340,453) (2,402,586)
Accounts payable - related parties (2,810,074) (3,833,201)
Capital leases (33,777) --
Accrued mail-in rebates (193,905) (769,809)
----------- -----------
Net cash provided by (used in) operating activities 2,338,658 (913,306)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Restricted cash 341,899 893,167
Equipment additions -- (123,553)
----------- -----------
Net cash provided by investing activities 341,899 769,614
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Net payments on line of credit (3,864,942) (1,256,667)
----------- -----------
Net cash used in financing activities (3,864,942) (1,256,667)
----------- -----------
Net decrease in cash and cash equivalents (1,184,385) (1,400,359)
Cash and cash equivalents at beginning of period 1,463,122 1,833,481
----------- -----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 278,737 $ 433,122
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
INTEREST PAID $ 95,546 $ 316,756
=========== ===========
INCOME TAXES PAID $ 800 $ 800
=========== ===========
See accompanying notes to these consolidated financial statements
-3-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 -- ORGANIZATION AND BUSINESS
Nature of Business
- ------------------
I/OMagic Corporation ("I/OMagic"), a Nevada corporation, and its subsidiary IOM
Holdings, Inc. (collectively, the "Company"), develops, manufactures through
subcontractors or obtains from suppliers, markets and sells electronic data
storage and digital entertainment products for the consumer electronics market.
The Company sells its products in the United States and Canada to distributors
and retailers.
Liquidity and Going Concern
- ---------------------------
The Company experienced a net loss for the three and nine month periods ended
September 30, 2008 of $972,023 and $3,993,196, respectively, and has experienced
losses for the years ended December 31, 2007, 2006, 2005 and 2004 of $4,752,974,
$202,042, $1,818,250 and $8,056,864, respectively. At September 30, 2008, the
Company had cash and cash equivalents of $278,737 and as of April 9, 2009 the
Company had only $336,644 of cash on hand. Also, at September 30, 2008, the
Company had a stockholders' deficit of $2,003,487. Accordingly, the Company is
presently experiencing a lack of liquidity and may have insufficient liquidity
to fund its operations for the next twelve months or less. The Company's
restated consolidated financial statements as of and for the year ended December
31, 2007 and the accompanying condensed consolidated financial statements as of
and for the three and nine months ended September 30, 2008 have been prepared on
a going concern basis, which contemplates the realization of assets and
satisfaction of liabilities in the normal course of business. As discussed in
this report, the Company has incurred significant recurring losses, has working
capital and stockholders' deficits, has serious liquidity concerns and may
require additional financing in the foreseeable future. These factors, among
others, raise substantial doubt about the Company's ability to continue as a
going concern. The condensed consolidated financial statements included in this
document do not include any adjustments that might result from the outcome of
this uncertainty.
The Company's plans for correcting these deficiencies include ongoing efforts to
bring new products to market and exploring other products with its suppliers and
retailers to sell through its sales channels, negotiating suitable repayment
terms for outstanding obligations owed to the Company's related-party supplier,
seeking new equity capital and new vendor partnerships, timely collection of
existing accounts receivable, and sell-through of inventory currently in the
Company's sales channels. The Company also needs to restructure its operations
to reduce its operating costs. If the Company's capital requirements or cash
flow vary materially from its current projections, if the Company is unable to
successfully negotiate suitable repayment terms for outstanding obligations owed
to a related-party supplier, if the Company is unable to successfully
restructure its operations and lower its operating costs, 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. In addition, if the Company is unable to bring
successful new products to market soon, the Company may be forced to
substantially curtail its operations.
If the Company's net losses continue or increase, the Company could experience
significant additional shortages of liquidity and its ability to purchase
inventory and to operate its business may be significantly impaired, which could
lead to further declines in its results of operations and financial condition.
NOTE 2 - RESTATEMENT OF SEPTEMBER 30, 2007 FINANCIAL STATEMENTS
The Company previously accrued audit fees in the period to which the
corresponding audit applied. Upon further examination of its accounting
methodology, the Company determined that it made an error in its application of
the relevant accounting principles and determined that it should have accrued
-4-
audit fees in the period in which they were incurred. In addition, the Company
accrued sales incentives but had not established any lower-of-cost-or-market
reserve to account for reduced sales prices of certain inventory consigned to
retailers. Upon further examination, the Company determined that it should
establish a lower-of-cost-or-market reserve in the amount of $264,000 at
December 31, 2006 for certain inventory consigned to retailers that was sold
subsequent to December 31, 2006 at prices below net realizable value.
The Company has determined the effect of the correction on its previously-issued
financial statements and has restated its financial statements and the financial
information below for the three and nine months ended December 31, 2007.
The effects of the restatement on cost of sales, gross profit, general and
administrative expenses, net loss, basic and diluted loss per common share, and
stockholders' equity as of and for the three months ended September 30, 2007 are
as follows:
AS ORIGINALLY RESTATEMENT
REPORTED ADJUSTMENTS AS RESTATED
-------- ----------- -----------
Net sales....................................... $ 5,772,340 $ - $ 5,772,340
Cost of sales................................... $ 5,373,492 $ (28,363) $ 5,345,129
Gross profit.................................... $ 398,848 $ 28,363 $ 427,211
General and administrative expenses............. $ 783,392 $ 51,238 $ 834,630
Net loss........................................ $ (703,408) $ (22,875) $ (726,283)
LOSS PER COMMON SHARE:
Basic........................................ $ (0.15) $ (0.01) $ (0.16)
Diluted...................................... $ (0.15) $ (0.01) $ (0.16)
Stockholders' equity........................... $ 4,488,643 $ (86,530) $ 4,402,113
The effects of the restatement on cost of sales, gross profit, general and
administrative expenses, net loss, basic and diluted loss per common share, and
stockholders' equity as of and for the nine months ended September 30, 2007 are
as follows:
AS ORIGINALLY RESTATEMENT
REPORTED ADJUSTMENTS AS RESTATED
-------- ----------- -----------
Net sales....................................... $ 19,951,373 $ - $ 19,951,373
Cost of sales................................... $ 18,152,898 $ (184,912) $ 17,967,986
Gross profit.................................... $ 1,798,475 $ 184,912 $ 1,983,387
General and administrative expenses............. $ 2,623,417 $ 378,572 $ 3,001,989
Net loss........................................ $ (2,049,537) $ (193,660) $ (2,243,197)
LOSS PER COMMON SHARE:
Basic........................................ $ (0.45) $ (0.04) $ (0.49)
Diluted...................................... $ (0.45) $ (0.04) $ (0.49)
Stockholders' equity............................ $ 4,488,643 $ (86,530) $ 4,402,113
NOTE 3 - BASIS OF PRESENTATION
The accompanying unaudited condensed 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, 2007, and notes thereto included in the Company's
Amendment No. 1 to Annual Report on Form 10-K, filed with the Securities and
-5-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Exchange Commission on April 6, 2009. In the opinion of management, the
accompanying unaudited condensed 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, 2008, and its results of operations for the periods presented.
These unaudited condensed 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 dated
April 3, 2009 contained in the Company's financial statements as of and for the
year ended December 31, 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 condensed 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 4 - CONCENTRATION OF RISK
Retailers
- ---------
During the nine months ended September 30, 2008, the Company's most significant
retailers were Staples, Target, Tech Data and MicroCenter. Collectively, these
four retailers accounted for 77.4% of the Company's net sales in the first nine
months of 2008. 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.
As of September 30, 2008, three of the Company's retailers represented 86.1% of
total accounts receivable. As a result of the substantial amount and
concentration of the Company's accounts receivable, if any of its major
retailers fails to timely pay the Company amounts owed, the Company could suffer
a significant decline in cash flow and liquidity which could adversely affect
the Company's ability to pay its liabilities and to purchase inventory to
sustain its operations.
Related Parties
- ---------------
During the nine months ended September 30, 2008, the Company purchased inventory
from a related-party, BTC USA, an affiliate of Behavior Tech Computer Corp.
("BTC"), in amounts totaling $723,600, which represented 14.0% of total
inventory purchases during the period. As of September 30, 2008, there were
$4,604,138 in trade payables outstanding to the related party.
-6-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - ACCOUNTS RECEIVABLE
Accounts receivable as of September 30, 2008 and December 31, 2007 consisted of
the following:
SEPTEMBER 30, DECEMBER 31,
2008 2007
---------------- ----------------
Accounts receivable $ 1,262,547 $ 8,246,733
Less: Allowance for doubtful accounts (1,052) (146,128)
Allowance for product returns (233,199) (400,268)
Reserve for sales incentives (65,212) (40,988)
Accrued point-of-sale rebates (168,039) (260,529)
Accrued market development funds, cooperative
advertising costs and cross-dock fees (124,969) (456,964)
---------------- ----------------
TOTAL $ 670,076 $ 6,941,856
================ ================
NOTE 6 - INVENTORY
Inventory as of September 30, 2008 and December 31, 2007 consisted of the
following:
SEPTEMBER 30, DECEMBER 31,
2008 2007
---------------- ----------------
Component parts $ 74,234 $ 270,083
Finished goods--warehouse 1,762,080 3,408,544
Finished goods--consigned 756,389 2,254,219
---------------- ----------------
2,592,703 5,932,846
Less: Allowance for obsolete and slow-moving inventory (361,667) (440,000)
---------------- ----------------
TOTAL $ 2,231,036 $ 5,492,846
================ ================
Consigned inventory is located at the stores and distribution centers of certain
retailers or distributors with which the Company has consignment agreements. The
inventory is owned by the Company until sold by the retailers.
NOTE 7 - EQUIPMENT
Equipment as of September 30, 2008 and December 31, 2007 consisted of the
following:
SEPTEMBER 30, DECEMBER 31,
2008 2007
---------------- ----------------
Computer equipment and software $ 975,523 $ 975,523
Warehouse equipment 138,065 138,065
Office furniture and equipment 281,155 281,155
Vehicles 74,742 74,742
Leasehold improvements 106,633 106,633
---------------- ----------------
1,576,118 1,576,118
Less: Accumulated depreciation (1,374,466) (1,328,567)
---------------- ----------------
TOTAL $ 201,652 $ 247,551
================ ================
-7-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the three and nine months ended September 30, 2008 and 2007, depreciation
and amortization expense was $13,954 and $45,899 and $17,758 and $52,894,
respectively.
NOTE 8 - TRADEMARKS
Trademarks as of September 30, 2008 and December 31, 2007 consisted of the
following:
SEPTEMBER 30, DECEMBER 31,
2008 2007
--------------- --------------
Trademarks $ 499,800 $ 499,800
Less: Amortization (258,480) (206,784)
--------------- --------------
TOTAL $ 241,320 $ 293,016
=============== ==============
Amortization expense on these intangible assets for the three and nine months
ended September 30, 2008 and 2007 was $17,232 and $51,696, respectively.
Amortization expense related to these intangible assets at September 30, 2008 in
each of the next five fiscal years and beyond is as follows:
Remainder of 2008 $ 17,232
2009 68,928
2010 68,928
2011 68,928
2012 17,304
------------
$ 241,320
============
NOTE 9 - LINE OF CREDIT AND SUBSEQUENT EVENT
Silicon Valley Bank
- -------------------
On January 29, 2007, the Company entered into a Loan and Security Agreement with
Silicon Valley Bank which provided for a credit facility that was initially used
to pay off the Company's outstanding loan balance as of January 29, 2007 with
GMAC Commercial Finance, which balance was approximately $5.0 million, and was
also used to pay $62,000 of the Company's closing fees in connection with
securing the credit facility.
On April 18, 2008, the Company entered into a new Loan and Security Agreement
with Silicon Valley Bank which provided for a credit facility based on the
Company's accounts receivable. The Loan and Security Agreement served to amend
and restate the Company's prior Loan and Security Agreement dated January 29,
2007 with Silicon Valley Bank. On April 18, 2008, the Company also entered into
an Amendment to Loan Documents with Silicon Valley Bank, which provided that the
ancillary loan documents executed in connection with the Company's prior credit
facility with Silicon Valley Bank would apply to the new Loan and Security
Agreement.
The new credit facility allowed the Company to finance its accounts receivable
and borrow up to a maximum aggregate amount of $7.0 million; provided, that the
Company could only borrow up to a limit of 60% of each eligible account or such
other percentage as Silicon Valley Bank established. The credit facility was to
expire on January 29, 2009. Advances under the credit facility bore interest at
a floating rate equal to the prime rate published from time to time by Silicon
Valley Bank plus 2.5%. The credit facility required that the Company pay a
collateral handling fee of $2,000 per month and other customary fees and
expenses.
-8-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The Company's obligations under the Loan and Security Agreement were secured by
substantially all of its assets and were guaranteed by IOM Holdings, Inc. under
a Cross-Corporate Continuing Guaranty. The Company's obligations and the
guarantee obligations of IOM Holdings, Inc. were also secured under Intellectual
Property Security Agreements executed by the Company and IOM Holdings, Inc.
On July 31, 2008, the Company paid off its obligations owed under its Loan and
Security Agreement dated April 18, 2008 with Silicon Valley Bank and terminated
the Loan and Security Agreement.
Rexford Funding
- ---------------
On October 29, 2008, the Company entered into a Sale of Accounts and Security
Agreement (the "Agreement") dated as of October 24, 2008 with Rexford Funding,
LLC ("Lender"), which provides for an accounts receivable-based credit facility.
The credit facility allows the Company to sell accounts receivable to Lender
subject to a maximum amount equal to $1.5 million. The purchase price for each
purchased account is to equal the net invoice amount less Lender's commission.
Lender is entitled to a factoring commission equal to 0.033% of the gross
invoice amount of each purchased account receivable and an additional 0.033% for
each day the account receivable remains outstanding and unpaid.
Lender, in its sole and absolute discretion, may from time to time advance the
Company funds against the purchase price of the accounts receivable in an amount
of up to 75% (except as to accounts receivable of Staples which shall be up to
60%) of the aggregate purchase price of the purchased accounts receivable,
subject to customary reductions, including those based on (i) disputed accounts
receivable, (ii) any accounts receivable from a customer whom Lender deems not
credit worthy, (iii) any accounts receivable unpaid in excess of 60 days, (iv)
any accounts receivable from a past-due customer when 25% or more accounts
receivable from that customer are unpaid in excess of 60 days, (v) any accounts
receivable which Lender deems, in its sole and absolute discretion, are
ineligible, and (vi) any fees, actual or estimated, that are chargeable to the
Company's reserve account as to the credit facility. Lender is entitled to
interest charges on all advances at a rate equal to the Prime Rate plus 1.00%,
but in no case less than 5.50%.
The Agreement has an initial term through April 30, 2009 with automatic six
month extensions unless either party terminates the Agreement at least 60 but
not more than 90 days prior to the end of the initial term or any renewal term.
At all times Lender has the right to terminate the Agreement upon 30 days prior
notice.
If the Company terminates the Agreement prior to the end of the initial term or
any renewal term, the Company will be subject to an early termination fee equal
to Lender's average monthly commission and/or deficiency charges for the
preceding six month period, or the entire period from the date of the Agreement
if the preceding period is less than six months, multiplied by the number of
months remaining in the initial term or applicable renewal term.
The obligations of the Company under the Agreement are secured by the Company's
accounts receivable and all proceeds thereof and, with respect thereto, all
chattel paper, commercial tort claims, deposit accounts, documents, general
intangibles, goods, letters of credit, letter of credit rights and all
supporting obligations. The Agreement also contains other customary
representations, warranties, covenants and terms and conditions.
NOTE 10 - TRADE CREDIT FACILITIES WITH RELATED PARTIES
On June 6, 2005, the Company entered into a new trade credit facility with Lung
Hwa that replaced its previous $10.0 million trade credit facility. Under the
terms of the new facility, Lung Hwa agreed to purchase and manufacture inventory
on the Company's behalf. The Company was permitted to purchase an aggregate of
up to $15.0 million of inventory manufactured by Lung Hwa or manufactured by
-9-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
third parties, in which case the Company used Lung Hwa as an international
purchasing office. For inventory manufactured by third parties and purchased
through Lung Hwa, the payment terms were 120 days following the date of invoice
by Lung Hwa. Lung Hwa charged the Company a 5% handling fee on a supplier's unit
price. A 2% discount of the handling fee applied if the Company reached an
average running monthly purchasing volume of $750,000. Returns made by the
Company, which are agreed to by a supplier, resulted in a credit to the Company
for the handling charge. For inventory manufactured by Lung Hwa, the payment
terms were 90 days following the date of invoice by Lung Hwa. The Company was 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 had an initial term of one year after which the facility
was to 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 had 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, 2008,
the Company made no purchases under this arrangement. As of September 30, 2008,
there were no trade payables outstanding under this arrangement. The Company
does not currently utilize this trade credit facility as Lung Hwa is either not
able to supply certain products the Company currently sells, or in some cases,
the Company is able to source certain products at better prices directly from
other third-party manufacturers. This trade credit facility may not be available
to the Company in the future in the event the Company endeavors to attempt to
again utilize the facility.
In February 2003, the Company entered into a Warehouse Services and Bailment
Agreement with BTC USA. Under the terms of the agreement, BTC USA agreed to
supply and store at the Company's warehouse up to $10.0 million of inventory on
a consignment basis. The Company was 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 provided the Company with a
trade line of credit of up to $10.0 million with payment terms of net 60 days,
without interest. The agreement could be terminated by either party upon 60
days' prior written notice to the other party. BTC USA is a subsidiary of
Behavior Tech Computer Corp., one of the Company's significant stockholders. Mr.
Steel Su, a former director of I/OMagic, is the Chief Executive Officer of
Behavior Tech Computer Corp. During the nine months ended September 30, 2008,
the Company purchased $723,600 of inventory under this arrangement. As of
September 30, 2008, there were $4,604,138 in trade payables outstanding under
this arrangement. As of the filing of this report, the Company was out of
compliance with the payment terms of its agreement with BTC and the Company is
in continued negotiations with BTC USA to satisfy its obligations on a basis
that is acceptable to both parties. The Company does not currently utilize this
trade credit facility as BTC USA is either not able to supply certain products
the Company currently sells, or in some cases, the Company is able to source
certain products at better prices directly from other third-party manufacturers.
This trade credit facility may not be available to the Company in the future in
the event the Company endeavors to attempt to again utilize the facility.
NOTE 11 - 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
-10-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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. Judgment was entered on or about April 5, 2006.
Thereafter, defendants 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. Thereafter, appeals were filed
as to both the original Judgment and the Amended Judgment. On March 27, 2008,
the Court of Appeal issued an opinion against the Company as to all defendants,
which reversed the Judgments in the Company's favor as to Lawrence W. Horwitz,
Horwitz & Beam, Inc. and Lawrence M. Cron. The Court of Appeal also ordered that
the Company is to pay defendants' costs on appeal. The Company paid the
defendants' claim for costs.
In addition to the matter described above, the Company may be involved in
certain legal proceedings and claims which arise in the normal course of
business. Management does not believe that the outcome of these matters will
have a material effect on the Company's financial position, results of
operations or cash flows.
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 12--Commitments and Contingencies" in the Company's
Amendment No. 1 to Annual Report on Form 10-K for the year ended December 31,
2007.
NOTE 12 - 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
Amendment No. 1 to Annual Report on Form 10-K for the year ended December 31,
2007.
As of September 30, 2008, there were options to acquire 353,775 shares of common
stock issued to employees and directors that were outstanding under the Plans.
-11-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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, 2008 were as follows:
WEIGHTED-
WEIGHTED- AVERAGE
AVERAGE REMAINING
NUMBER OF EXERCISE CONTRACTUAL INTRINSIC
OPTIONS SHARES PRICE LIFE (YEARS) VALUE(1)
------------------ ---------- ------------ ------------ ----------------
Outstanding 353,775 $ 3.15 1.61 $ 1,114,391
Expected to vest 348,508 $ 3.15 1.61 $ 1,097,800
Exercisable 321,588 $ 3.14 1.54 $ 1,009,786
----------
(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, 2008
and 2007. No cash was received from the exercise of stock options for the nine
months ended September 30, 2008 and 2007. As of September 30, 2008, there was
$52,007 of total unrecognized compensation costs related to non-vested
share-based compensation arrangements. That cost is expected to be recognized
over the weighted-average period of 1.26 years.
Share-based compensation expense was $38,316 and $54,188 for the nine months
ended September 30, 2008 and 2007, 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 13 - 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.
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
-12-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Company adopted and implemented the provisions of 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.
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, 2008 and December 31, 2007 the valuation allowance for deferred
tax assets totaled $16,443,970 and $14,851,966, respectively. For the nine month
periods ended September 30, 2008 and 2007, the net change in the valuation
allowance was $1,592,004 (increase) and $794,141 (increase), respectively.
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, 2008, the Company had net operating loss carryforwards for
federal and state income tax purposes of approximately $37,702,000 and
$26,886,000, respectively, that expire through 2028 and 2018, respectively. The
utilization of net operating loss carryforwards may be limited under the
provisions of Internal Revenue Code Section 382 and similar state provisions due
to the change in ownership.
FIN 48 not only impacts the amount of the Company's accrual for uncertain tax
positions but it also impacts the manner in which such accruals should be
classified in the Company's financial statements. In connection with the
implementation of FIN 48, and if an accrual is recorded, the Company will record
the aggregate accrual for uncertain tax positions as a component of current or
non-current income tax payable and the offsetting amounts as a component of the
Company's net deferred tax assets and liabilities.
The Company's continuing practice is to recognize interest and/or penalties
related to income tax matters in income tax expense. As of September 30, 2008
and December 31, 2007, the Company had no accrual for the payment of interest
and penalties.
NOTE 14 - 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 15 - 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, 2008 were in the United States.
-13-
I/OMAGIC CORPORATION AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 16 - RECENT ACCOUNTING PRONOUNCEMENTS
In March 2008, the FASB issued SFAS No. 161, DISCLOSURES ABOUT DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES. SFAS No. 161 is intended to improve
financial reporting about derivative instruments and hedging activities by
requiring enhanced disclosures to enable investors to better understand their
effects on an entity's financial position, financial performance, and cash
flows. SFAS No. 161 is effective for financial statements issued for fiscal
years and interim periods beginning after November 15, 2008. The Company
believes that the adoption of SFAS No. 161 will not have a material impact on
its consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (R), BUSINESS COMBINATIONS. SFAS
No. 141(R) requires an entity to recognize the assets acquired, liabilities
assumed, contractual contingencies, and contingent consideration at their fair
value on the acquisition date. It also requires acquisition-related costs to be
expensed as incurred, restructuring costs to generally be expensed in periods
subsequent to the acquisition date, and changes in accounting for deferred tax
asset valuation allowances and acquired income tax uncertainties after the
measurement period impact income tax expense. The adoption of SFAS No. 141(R)
will change the Company's accounting treatment for business combinations on a
prospective basis beginning January 1, 2009.
In December 2007, the FASB issued SFAS No. 160, NONCONTROLLING INTERESTS IN
CONSOLIDATED FINANCIAL STATEMENTS. SFAS No. 160 changes the accounting and
reporting for minority interests, which will be characterized as non-controlling
interests and classified as a component of equity. SFAS No. 160 is effective for
the Company on a prospective basis in the first quarter of fiscal year 2009. The
Company has not yet determined the impact on its consolidated financial
statements of adopting SFAS No. 160.
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 adopted SFAS No. 159 in the first quarter of
2008. The adoption of SFAS No. 159 did not have a material effect on the
Company's financial position, results of operations or cash flows for the third
quarter of 2008 and the Company has made no election under SFAS No. 159.
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. In February 2008, the FASB
issued FASB Staff Position 157-2, EFFECTIVE DATE OF FASB STATEMENT 157, which
deferred the effective date of SFAS No. 157 to fiscal years beginning after
November 15, 2008 for nonfinancial assets and nonfinancial liabilities. Early
adoption is encouraged, provided that the Company has not yet issued financial
statements for that fiscal year, including any financial statements for an
interim period within that fiscal year. The Company adopted SFAS No. 157
effective January 1, 2008. The adoption of SFAS No. 157 had no impact on the
Company's accounting or disclosure as to its assets and liabilities at September
30, 2008 and did not materially affect the Company's financial position, results
of operations or cash flows for the nine months ended September 30, 2008. The
Company will continue to make an evaluation of the fair value of its assets and
liabilities as of the end of each future reporting period.
-14-
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 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE
MONTHS ENDED SEPTEMBER 30, 2008 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 BELOW OR
UNDER THE "RISK FACTORS" SECTION OF OUR AMENDMENT NO. 1 TO ANNUAL REPORT ON FORM
10-K FOR THE YEAR ENDED DECEMBER 31, 2007 AND ELSEWHERE IN THIS REPORT.
OVERVIEW
We sell data storage products and other consumer electronics products.
We also sold televisions, most of which were high-definition televisions, or
HDTVs, utilizing liquid crystal display, or LCD, technology, in the first
quarter of 2008. Our data storage products collectively accounted for
approximately 85.2% of our net sales for the nine months of 2008, our HDTVs
accounted for approximately 14.1% of our net sales for the first nine months of
2008 and our other consumer electronics products collectively accounted for
approximately 0.7% of our net sales in the first nine months of 2008.
Our data storage products consist of a range of products that store
traditional personal computer data as well as movies, music, photos, video games
and other multi-media content. Our television products consist of a range of LCD
televisions of different sizes. Our other consumer electronics products consist
of a range of products that focus on digital movies, music and photos.
We sell our products through computer, consumer electronics and office
supply superstores, wholesale clubs, distributors, and other major North
American retailers. Our network of retailers enables us to offer products to
consumers across North America, including in every major metropolitan market in
the United States. During the first nine months of 2008, our most significant
retailers were Staples, Target, Tech Data and MicroCenter. Collectively, these
four retailers accounted for 77.4% of our net sales during that period. During
the first nine months of 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 that period.
We market our products primarily under our I/OMagic(R) and Digital
Research Technologies(R) brand names, but from time to time, we also market
products under our Hi-Val(R) brand name. We sell our data storage products
primarily under our I/OMagic(R) brand name, bundling various hardware devices
with different software applications to meet a range of consumer needs. We
market our televisions under our Digital Research Technologies(R) brand name.
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 from 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.
-15-
RECENT DEVELOPMENTS
On October 29, 2008, we entered into a Sale of Accounts and Security
Agreement dated as of October 24, 2008 with Rexford Funding, LLC, which provides
for an accounts receivable-based credit facility. The credit facility allows us
to sell accounts receivable to Rexford Funding subject to a maximum amount equal
to $1.5 million. The purchase price for each purchased account is to equal the
net invoice amount less Rexford Funding's commission. Rexford Funding is
entitled to a factoring commission equal to 0.033% of the gross invoice amount
of each purchased account receivable and an additional 0.033% for each day the
account receivable remains outstanding and unpaid. The Sale of Accounts and
Security Agreement has an initial term through April 30, 2009 with automatic six
month extensions unless either party terminates the Sale of Accounts and
Security Agreement at least 60 but not more than 90 days prior to the end of the
initial term or any renewal term. At all times Rexford Funding has the right to
terminate the Sales of Accounts and Security Agreement upon 30 days prior
notice.
As of April 9, 2009, we had only $336,644 of cash on hand. Accordingly,
we are presently experiencing a lack of liquidity and may have insufficient
capital to fund our operations for the next twelve months or less. If our
capital requirements or cash flow vary materially from our current projections,
if we are unable to timely collect our accounts receivable or unable to
sell-through inventory currently in our sales channels as anticipated, or if
unforeseen circumstances occur, we may be unable to increase our liquidity. If
we are unable to increase our liquidity, we will experience a material adverse
effect on our ability to operate our business. These factors, among others,
raise substantial doubt about our ability to continue as a going concern and our
independent registered public accounting firm has issued a report expressing
substantial doubt about our ability to continue as a going concern.
We continue to experience significant declines in sales of our data
storage products as we are experiencing intense price competition for magnetic
data storage products from major competitors such as Western Digital and Seagate
Technology/Maxtor who are original equipment manufacturers of hard disk drives,
which has significantly reduced selling prices and eroded our margins for
magnetic data storage products. Due to this intense price competition, we may
not be able to sell our inventory of magnetic data storage products 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.
We have not been able to obtain supplies of our HDTVs due to the
substantial working capital requirements needed to sustain HDTV inventories. As
a result, our HDTV sales have declined substantially and without negotiating a
new supply arrangement, we will not be able to continue selling HDTVs.
Behavior Tech Computer Corp. and its affiliated companies, or BTC, and
Lung Hwa Electronics Co., Ltd., or Lung Hwa, two of our significant
stockholders, provided us with significantly preferential trade credit terms.
These terms included extended payment terms, substantial trade lines of credit
and other preferential buying arrangements. We believe that these terms were
substantially better terms than we could likely obtain from other subcontract
manufacturers or suppliers. In fact, we believe that our trade credit facility
with Lung Hwa was likely unique and could not be replaced through a relationship
with an unrelated third party. We do not currently utilize these trade credit
facilities as BTC and Lung Hwa are either not able to supply certain products we
currently sell, or in some cases, we are able to source certain products at
better prices directly from other third-party manufacturers. These trade credit
facilities may not be available to us in the future in the event we endeavor to
attempt to again utilize the facilities. Additionally, due to substantial
-16-
outstanding obligations owed to BTC, it is highly unlikely that we will be able
to obtain additional inventory supplies from BTC unless, and at least until, we
are able to negotiate repayment terms acceptable to BTC. Even if we are able to
negotiate repayment terms acceptable to BTC, we may be unable to obtain
additional inventory supplies from BTC on the same terms as before, on
satisfactory terms, or at all. See "--Liquidity and Capital Resources."
SEASONALITY
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 in general. After adjusting for
the addition of new retailers, our fourth quarter has historically generated the
strongest sales, which correlates to well-established consumer buying patterns
during the Thanksgiving through Christmas holiday season. Our first and third
quarters have historically shown some strength from time to time based on
post-holiday season sales in the first quarter and back-to-school sales in the
third quarter. Our second quarter has historically been our weakest quarter for
sales, again following well-established consumer buying patterns. The impact of
seasonality on our future results will be affected by our product mix, which
will vary from quarter to quarter.
CRITICAL ACCOUNTING POLICIES
The preparation of our financial statements, which have been prepared
in accordance with accounting principles generally accepted in the United States
of America, requires us to make judgments and estimates that may have a
significant impact upon the portrayal of our financial condition and results of
operations. We believe that of our significant accounting policies, the
following require estimates and assumptions that require complex, subjective
judgments by management that can materially impact the portrayal of our
financial condition and results of operations: going concern assumption, revenue
recognition; sales incentives; market development funds and cooperative
advertising costs, rebate promotion costs and slotting fees; inventory
obsolescence allowance; lower-of-cost-or-market reserve; 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 Amendment No. 1 to Annual Report on Form 10-K for the year
ended December 31, 2007.
RESULTS OF OPERATIONS
The tables presented below, which compare our results of operations
from one period to another, present the results for each period, the change in
those results from one period to another in both dollars and percentage change
and the results for each period as a percentage of net sales. The columns
present the following:
o The first two data columns in each table show the dollar
results for each period presented.
o The columns entitled "Dollar Variance" and "Percentage
Variance" show the change in results, both in dollars and
percentages. These two columns show favorable changes as
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.
-17-
THREE MONTHS ENDED SEPTEMBER 30, 2008 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2007
Three Months Ended Percentage Results as a
September 30, Dollar Variance Variance Percentage of
-------------------------- Favorable Favorable Net Sales
2008 2007 (Unfavorable) (Unfavorable) 2008 2007
----------- ------------ ----------------- ------------------ --------- ---------
(DOLLARS IN THOUSANDS) (RESTATED) (RESTATED)
Net sales $ 1,528 $ 5,772 $ (4,244) (73.4)% 100.0% 100.0%
Cost of sales 1,662 5,345 3,683 68.9% 108.8% 92.6%
----------- ------------ ---------------- ------------------ --------- ---------
Gross profit (loss) (134) 427 (561) (131.4)% (8.8)% 7.4%
Selling, marketing and
advertising expenses 179 277 98 35.4% 11.7% 4.8%
General and administrative
expenses 624 834 210 25.20% 40.8% 14.4%
Depreciation and amortization 31 35 4 11.4% 2.0% 0.6%
----------- ------------ ---------------- ------------------ --------- ---------
Operating loss (968) (719) (249) (34.6)% (63.3)% (12.4)%
Net interest expense -- (83) 83 100.0% 0.0% (1.4)%
Other (expense) income (4) 76 (80) (105.3)% 0.3% 1.3%
----------- ------------ ---------------- ------------------ --------- ---------
Loss from operations before
provision for income taxes (972) (726) (246) (33.9)% (63.6)% (12.5)%
Income tax provision -- -- -- --% --% --%
----------- ------------ ---------------- ------------------ --------- ---------
Net loss $ (972) $ (726) $ (246) (33.9)% (63.6)% (12.5)%
=========== ============ ================ ================== ========= =========
NET SALES. Net sales decreased by $4,244,000, or 73%, to $1,528,000 in
the third quarter of 2008 as compared to $5,772,000 in the third quarter of
2007. A combination of factors affected our net sales, including a $3.4 million,
or 96%, decrease in sales of our magnetic data storage products. Sales of our
magnetic data storage products totaled $171,000, or 11% of net sales, for the
third quarter of 2008, as compared to $3.5 million, or 61% of net sales, for the
third quarter of 2007. Sales of our optical data storage products decreased 26%
to $1.4 million, or 90% of net sales, for the third quarter of 2008, as compared
to $1.9 million, or 33% of net sales, for the third quarter of 2007. Sales of
our media and entertainment products decreased by 99% to $3,000, for the third
quarter of 2008, as compared to $341,000, or 6% of net sales, for the third
quarter of 2007. In addition, our overall product return rate was 16.5% in the
third quarter of 2008 compared to 9.7% in the third quarter of 2007. The
increase in our overall product return rate resulted from our magnetic data
storage products 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,
increased to 18.7%, all of which were offset against gross sales, in the third
quarter of 2008, as compared to 13.9% in the third quarter of 2007. The increase
in our overall rate of sales incentives, market development funds and
cooperative advertising costs, rebate promotion costs and slotting fees resulted
primarily from a increase in promotions of our magnetic data storage products in
the third quarter of 2008 as compared to the third quarter of 2007, due to
increased competitive pressures for these products in the third quarter of 2008
as compared to the third quarter of 2007.
GROSS PROFIT. Gross profit declined by $561,000, or 131%, to a gross
loss of $134,000 in the third quarter of 2008 as compared to gross profit of
$427,000 in the third quarter of 2007. The decline in gross profit resulted
primarily from a decrease in net sales and related competitive pricing pressures
causing substantially lower unit sales prices for our data storage products and
substantial increases in our inventory reserves for obsolescence and lower of
cost or market adjustments. Our gross profit margin as a percentage of net sales
decreased to a negative 9% in the third quarter of 2008 as compared to a
-18-
positive gross margin of 7% in the third quarter of 2007. The decline in our
gross profit margin predominantly resulted from substantially lower unit selling
prices for both our magnet and optical data storage products caused by
competitive pricing pressures and substantial increases in our inventory
reserves for obsolescence and lower of cost or market adjustments.
SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses decreased by $98,000, or 35%, to $179,000 in the third
quarter of 2008 as compared to $277,000 in the third quarter of 2007. This
decrease was primarily due to decreases of $54,000 in outside commissions,
$41,000 in shipping and handling costs, $10,000 in temporary help, $3,000 in
travel and entertainment expenses, and $2,000 in vendor training programs, all
of which were partially offset by deceases of $7,000 in salaries and benefits,
$5,000 in system support and $2,000 in sales expenses.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative
expenses decreased by $210,000, or 25%, to $624,000 in the third quarter of 2008
as compared to $834,000 in the third quarter of 2007. This decrease is due
primarily to decreases of $104,000 in audit fees, $37,000 in bank charges,
$34,000 in legal fees primarily related to prior-year litigation expenses,
$26,000 in salaries and benefits, $19,000 in insurance expenses, $15,000 in bad
debt expense, $13,000 in outside services, $8,000 in system support, $4,000 in
equipment rentals, and $3,000 in office supplies, all of which were partially
offset by increases of $11,000 in facilities costs, $21,000 in settlement costs
for the Horwitz litigation, $8,000 in temporary help, $6,000 in directors fees,
$5,000 in financial relations expenses, $4,000 in travel and entertainment
expenses, and $3,000 in financing charges.
We have restated our general and administrative expenses for the three
months ended September 30, 2007 to correct an error in the manner in which we
accrued audit fees. We previously accrued audit fees in the period to which the
corresponding audit applied despite the fact that the audit fees were incurred
in a subsequent period. We have corrected our methodology for accruing audit
fees so that our audit fees are accrued in the period in which they are
incurred. Our previously-reported general and administrative expenses for the
three months ended September 30, 2007 were $783,392. Our restated general and
administrative expenses for the three months ended September 30, 2007 are
$834,630. Our restatement also resulted in a lower-of-cost-or-market reserve at
December 31, 2006 that reduced by $264,000 the value of certain inventory
consigned to retailers that was sold subsequent to December 31, 2006 at prices
below net realizable value. We previously accrued for sales incentives to
account for the reduced sales prices but deemed it necessary to account for the
lower-of-cost-or-market valuation at December 31, 2006. See "Note 2 -
Restatement of September 30, 2007 Financial Statements" included elsewhere in
this report.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
decreased in the third quarter of 2008 as compared to the third quarter of 2007.
This decrease primarily resulted from certain of our fixed assets becoming fully
depreciated since September, 2007.
NET INTEREST EXPENSE. Net interest expense decreased by $83,000, or
100%, to $0 in the third quarter of 2008 as compared to $83,000 in the third
quarter of 2007. This decrease primarily resulted from lower borrowings on our
line of credit in the third quarter of 2008 as compared to the third quarter of
2007.
OTHER (EXPENSE) INCOME. Other income decreased by $79,000, or 104%, in
the third quarter of 2008 as compared to the third quarter of 2007 primarily as
a result of miscellaneous income related to an insurance settlement in 2007.
-19-
NINE MONTHS ENDED SEPTEMBER 30, 2008 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2007
Nine Months Ended Percentage Results as a
September 30, Dollar Variance Variance Percentage of
-------------------------- Favorable Favorable Net Sales
2008 2007 (Unfavorable) (Unfavorable) 2008 2007
----------- ------------ ----------------- ------------------ --------- ---------
(DOLLARS IN THOUSANDS) (RESTATED) (RESTATED)
Net sales $ 9,265 $ 19,951 $ (10,606) (53.2)% 100.0% 100.0%
Cost of sales 10,038 17,968 7,930 44.1% 108.3% 90.1%
----------- ------------ ----------------- ------------------ --------- ---------
Gross profit (loss) (773) 1,983 (2,756) (139.0)% (8.3)% 9.9%
Selling, marketing and
advertising expenses 877 884 7 0.8% 9.5% 4.4%
General and administrative
expenses 2,153 3,002 849 28.3% 23.3% 15.0%
Depreciation and amortization 97 104 7 6.7% 1.0% 0.5%
----------- ------------ ----------------- ------------------ --------- ---------
Operating loss (3,900) (2,007) (1,893) (94.3)% (42.1)% (10.0)%
Net interest expense (96) (317) 221 69.7% 1.0% 1.6%
Other income 4 82 (78) (95.1)% --% 0.4%
----------- ------------ ----------------- ------------------ --------- ---------
Loss from operations before
provision for income taxes (3,992) (2,242) (1,750) (78.1%) (43.1)% (11.2)%
Income tax provision 1 1 -- --% --% --%
----------- ------------ ----------------- ------------------ --------- ---------
Net loss $ (3,993) $ (2,243) $ (1,750) (78.1)% (43.1)% (11.2)%
=========== ============= ================== ================== ========= =========
NET SALES. Net sales decreased by $10,606,000, or 53%, to $9,265,000 in
the nine months ended September 30, 2008 as compared to $19,951,000 in the nine
months ended September 30, 2007. A combination of factors affected our net
sales, including a $938,000 decrease in sales of our optical data storage
products. Sales of our optical data storage products decreased by 17% to $4.6
million, or 50% of our net sales, in the nine months ended September 30, 2008 as
compared to $5.6 million, or 28% of our net sales, in the nine months ended
September 30, 2007. Sales of our CD- and DVD-based products continued to
decrease in the nine months ended September 30, 2008 compared to the nine months
ended September 30, 2007 because they are generally included as a standard
component in most new computer systems. Also, sales of our magnetic data storage
products decreased by $10.3 million, or 77%, to $3.1 million, or 34% of our net
sales, in the nine months ended September 30, 2008 as compared to $13.4 million,
or 67% of our net sales, in the nine months ended September 30, 2007. Net sales
for our HDTV products totaled $1.4 million in the nine months ended September
30, 2008, or 15% of our net sales for the period. Our HDTV product line was
introduced in the fourth quarter of 2007.
In addition, our overall product return rate was 20.9% in the nine
months ended September 30, 2008 compared to 10.2% in the nine months ended
September 30, 2007. The increase in our overall product return rate resulted
from increased returns for all of our products including our HDTVs which was
introduced in the fourth quarter of 2007. Sales incentives, market development
funds and cooperative advertising costs, rebate promotion costs and slotting
fees, collectively as a percentage of gross sales, were 9.4%, all of which were
offset against gross sales, in the nine months ended September 30, 2008 compared
to 14.9% in the nine months ended September 30, 2007. The decrease in our
overall rate of sales incentives, market development funds and cooperative
advertising costs, rebate promotion costs and slotting fees resulted from a
decrease in promotional support for our optical data storage products and mobile
data storage products, partially offset by an increase in the rate of sales
incentives, market development funds and cooperative advertising costs, rebate
promotion costs and slotting fees for our desktop data storage products which
experienced substantial market pressure for these incentives.
-20-
GROSS PROFIT. Gross profit decreased by $2.8 million, or 139%, to a
gross loss of $773,000 in the nine months ended September 30, 2008 as compared
to gross profit of $1,983,000 in the nine months ended September 30, 2007. The
decrease in gross profit primarily resulted from a decrease in net sales, a
substantial decrease in average unit sales prices for our data storage products
and increases in our inventory reserves for obsolescence and lower of cost or
market adjustments. Our gross profit margin as a percentage of net sales
decreased to a negative 8% in the nine months ended September 30, 2008 as
compared to a gross profit margin of 10% in the nine months ended September 30,
2007. The decline in our gross profit margin predominantly resulted from higher
product costs and therefore higher cost of sales which increased to 108% in the
nine months ended September 30, 2008 compared to 90% in the nine months ended
September 30, 2007 and lower unit selling prices for both our optical and
magnetic data storage products caused by competitive pricing pressures.
SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses decreased by $7,000, or 1%, to $877,000 in the nine months
ended September 30, 2008 as compared to $884,000 in the nine months ended
September 30, 2007. This decrease was primarily due to decreases of $49,000 in
shipping and handling costs, $ 40,000 in outside sales commissions, $17,000 in
travel and entertainment expenses, $14,000 in temporary help, $10,000 in vendor
training programs, and $3,000 in outside services, all of which were partially
offset by increases of $46,000 in trade show expenses, $25,000 in system
support, $22,000 in sales expenses, $18,000 in customer penalties and $17,000 in
personnel costs.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative
expenses decreased by $849,000, or 28%, to $2,153,000 in the nine months ended
September 30, 2008 as compared to $3,002,000 in the nine months ended September
30, 2007. This decrease was primarily due to decreases of $402,000 in audit
fees, $154,000 in legal expenses primarily related to litigation in the prior
period, $134,000 in bank charges, $90,000 in outside services, $107,000 in
personnel costs, $40,000 in travel and entertainment expenses, $29,000 in
financial relations expenses, $19,000 in system support, $15,000 in equipment
rentals, $15,000 in supplies and $10,000 in product design expenses all of which
were partially offset by increases of $45,000 in bad debt expense, $32,000 in
temporary help, $31,000 in miscellaneous expenses, $20,000 in insurance expense,
$16,000 in facilities costs, $14,000 in finance charges and $9,000 in directors
fees.
We have restated our general and administrative expenses for the nine
months ended September 30, 2007 to correct an error in the manner in which we
accrued audit fees. We previously accrued audit fees in the period to which the
corresponding audit applied despite the fact that the audit fees were incurred
in a subsequent period. We have corrected our methodology for accruing audit
fees so that our audit fees are accrued in the period in which they are
incurred. Our previously-reported general and administrative expenses for the
nine months ended September 30, 2007 were $2,623,417. Our restated general and
administrative expenses for the nine months ended September 30, 2007 are
$3,001,989. Our restatement also resulted in a lower-of-cost-or-market reserve
at December 31, 2006 that reduced by $264,000 the value of certain inventory
consigned to retailers that was sold subsequent to December 31, 2006 at prices
below net realizable value. We previously accrued for sales incentives to
account for the reduced sales prices but deemed it necessary to account for the
lower-of-cost-or-market valuation at December 31, 2006. See "Note 2 -
Restatement of September 30, 2007 Financial Statements" included elsewhere in
this report.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased
by $6,000, or 6%, to $98,000 in the nine months ended September 30, 2008 as
compared to $104,000 in the nine months ended September 30, 2007. This decrease
primarily resulted from certain of our fixed assets becoming fully depreciated
since September 30, 2007.
NET INTEREST EXPENSE. Net interest expense decreased by $221,000, or
70%, to $96,000 in the nine months ended September 30, 2008 as compared to
$317,000 in the nine months ended September 30, 2007. This decrease primarily
resulted from lower borrowings on our line of credit in the nine months ended
September 30, 2008 as compared to the nine months ended September 30, 2007.
-21-
OTHER INCOME. Other income decreased by $78,000, or 95%, in the nine
months ended September 30, 2008 as compared to the nine months ended September
30, 2007 and related primarily to an insurance settlement in 2007.
LIQUIDITY AND CAPITAL RESOURCES
OVERVIEW
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, 2008, we had a working
capital deficit of $2.5 million, an accumulated deficit of $33.8 million,
$278,737 in cash and cash equivalents and $670,076 in net accounts receivable.
This compares with working capital of $1.4 million, an accumulated deficit of
$29.9 million, $1.5 million in cash and cash equivalents and $6.9 million in net
accounts receivable as of December 31, 2007. For the nine months ended September
30, 2008, our cash decreased $1.2 million, or 81%, from $1.5 million to
$278,737.
As of April 9, 2009, we had only $336,644 of cash on hand. Accordingly,
we are presently experiencing a lack of liquidity and may have insufficient
capital to fund our operations for the next twelve months or less.
Our condensed consolidated financial statements as of and for the three
and nine months ended September 30, 2008, have been prepared on a going concern
basis, which contemplates the realization of assets and satisfaction of
liabilities in the normal course of business. As discussed in this report and in
Note 1 to our condensed consolidated financial statements included elsewhere in
this report, we have incurred significant recurring losses, have working capital
and stockholders' deficits, have serious liquidity concerns and may require
additional financing in the foreseeable future. These factors, among others,
raise substantial doubt about our ability to continue as a going concern. The
condensed consolidated financial statements included in this report do not
include any adjustments that might result from the outcome of this uncertainty.
Our plans for correcting these deficiencies include ongoing efforts to
bring new products to market and exploring other products with our suppliers and
retailers to sell through our sales channels, negotiating suitable repayment
terms for outstanding obligations owed to our related-party supplier, seeking
new equity capital and new vendor partnerships, timely collection of existing
accounts receivable, and sell-through of inventory currently in our sales
channels. We also need to restructure our operations to reduce our operating
costs. If our capital requirements or cash flow vary materially from our current
projections, if we are unable to successfully negotiate suitable repayment terms
for outstanding obligations owed to a related-party supplier, if we are unable
to successfully restructure our operations and lower our operating costs, if we
are unable to timely collect our accounts receivable or unable to sell-through
inventory currently in our sales channels as anticipated, or if unforeseen
circumstances occur, we may be unable to increase our liquidity and may require
additional financing. In addition, if we are unable to bring successful new
products to market soon, we may be forced to substantially curtail our
operations.
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 results of operations and financial condition.
-22-
CASH FLOWS
Cash provided by our operating activities totaled $2.3 million during
the nine months ended September 30, 2008, as compared to cash used in our
operating activities of $913,000 during the nine months ended September 30,
2007, and resulted primarily from the following combination of factors:
o a $7.0 million decrease in accounts receivable resulting from
significantly lower sales and normal collections;
o a $3.3 million decrease in inventory;
o a $1.8 million increase in net loss;
o a $40,000 decrease in prepaid expenses and other current
assets; and
o a $24,000 decrease in our reserves for sales incentives.
These increases in cash were partially offset by:
o a $2.8 million decrease in accounts payable - related parties,
resulting from the payment of outstanding invoices;
o a $340,000 decrease in accounts payable, accrued expenses and
other;
o a $332,000 decrease in accruals for market development funds,
cooperative advertising costs and cross-dock fees;
o a $194,000 decrease in mail-in rebates accruals;
o a $167,000 decrease in our allowance for product returns;
o a $145,000 decrease in allowance for doubtful accounts;
o a $92,000 decrease in point-of-sale rebates accruals;
o a $78,000 decrease in allowance for obsolete inventory; and
o a $34,000 decrease in our capital leases.
Cash provided by our investing activities totaled $342,000 during the
nine months ended September 30, 2008 as compared to cash provided by our
investing activities of $770,000 during the nine months ended September 30,
2007. Our investing activities during the nine months ended September 30, 2008
consisted of a $342,000 decrease in restricted cash related to our credit
facility. Our investing activities during the nine months ended September 30,
2007 consisted of an $893,000 decrease in restricted cash related to our credit
facility and $124,000 in purchases of property and equipment.
Cash used in our financing activities totaled $3.9 million during the
nine months ended September 30, 2008 as compared to cash used in our financing
activities of $1.3 million for the nine months ended September 30, 2007. We made
$3.9 million in net payments on our line of credit in the nine months ended
September 30, 2008 compared to net payments of $1.3 million on our line of
credit in the nine months ended September 30, 2007.
CREDIT FACILITY -- SILICON VALLEY BANK
On January 29, 2007, we entered into a Loan and Security Agreement with
Silicon Valley Bank which provided for a new credit facility. Our credit
facility with Silicon Valley Bank was initially used to pay off our outstanding
loan balance with GMAC Commercial Finance in the approximate amount of $5.0
million. On April 18, 2008, we entered into a new Loan and Security Agreement
with Silicon Valley Bank which provided for a credit facility based on our
accounts receivable. The Loan and Security Agreement amended and restated our
prior Loan and Security Agreement dated January 29, 2007 with Silicon Valley
Bank. On April 18, 2008, we also entered into an Amendment to Loan Documents
with Silicon Valley Bank, which provided that the ancillary loan documents
executed in connection with our prior credit facility with Silicon Valley Bank
would apply to the new Loan and Security Agreement.
-23-
The new credit facility allowed us to finance our accounts receivable
and borrow up to a maximum aggregate amount of $7.0 million; provided, that we
could only borrow up to a limit of 60% of each eligible account or such other
percentage as Silicon Valley Bank established. The credit facility was to expire
on January 29, 2009. Advances under the credit facility bore interest at a
floating rate equal to the prime rate of interest published from time to time by
Silicon Valley Bank plus 2.5%. The credit facility required that we pay a
collateral handling fee of $2,000 per month and other customary fees and
expenses.
Our obligations under the new Loan and Security Agreement were secured
by substantially all of our assets and were guaranteed by our subsidiary under a
Cross-Corporate Continuing Guaranty. Our obligations and the guarantee
obligations of our subsidiary were also secured under Intellectual Property
Security Agreements executed by us and our subsidiary.
On July 31, 2008, we paid off our obligations under the Loan and
Security Agreement dated April 18, 2008 with Silicon Valley Bank and terminated
the Loan and Security Agreement.
CREDIT FACILITY -- REXFORD FUNDING
On October 29, 2008, we entered into a Sale of Accounts and Security
Agreement, or the Agreement, dated as of October 24, 2008 with Rexford Funding,
LLC, which provides for an accounts receivable-based credit facility.
The credit facility allows us to sell accounts receivable to Rexford
Funding subject to a maximum amount equal to $1.5 million. The purchase price
for each purchased account is to equal the net invoice amount less Rexford
Funding's commission. Rexford Funding is entitled to a factoring commission
equal to 0.033% of the gross invoice amount of each purchased account receivable
and an additional 0.033% for each day the account receivable remains outstanding
and unpaid.
Rexford Funding, in its sole and absolute discretion, may from time to
time advance us funds against the purchase price of the accounts receivable in
an amount of up to 75% (except as to accounts receivable of Staples which shall
be up to 60%) of the aggregate purchase price of the purchased accounts
receivable, subject to customary reductions, including those based on (i)
disputed accounts receivable, (ii) any accounts receivable from a customer whom
Rexford Funding deems not credit worthy, (iii) any accounts receivable unpaid in
excess of 60 days, (iv) any accounts receivable from a past-due customer when
25% or more accounts receivable from that customer are unpaid in excess of 60
days, (v) any accounts receivable which Rexford Funding deems, in its sole and
absolute discretion, are ineligible, and (vi) any fees, actual or estimated,
that are chargeable to our reserve account as to the credit facility. Rexford
Funding is entitled to interest charges on all advances at a rate equal to the
Prime Rate plus 1.00%, but in no case less than 5.50%.
The Agreement has an initial term through April 30, 2009 with automatic
six month extensions unless either party terminates the Agreement at least 60
but not more than 90 days prior to the end of the initial term or any renewal
term. At all times Rexford Funding has the right to terminate the Agreement upon
30 days prior notice.
If we terminate the Agreement prior to the end of the initial term or
any renewal term, we will be subject to an early termination fee equal to
Rexford Funding's average monthly commission and/or deficiency charges for the
preceding six month period, or the entire period from the date of the Agreement
if the preceding period is less than six months, multiplied by the number of
months remaining in the initial term or applicable renewal term.
-24-
Our obligations under the Agreement are secured by our accounts
receivable and all proceeds thereof and, with respect thereto, all chattel
paper, commercial tort claims, deposit accounts, documents, general intangibles,
goods, letters of credit, letter of credit rights and all supporting
obligations.
TRADE CREDIT FACILITIES
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 agreed to purchase and manufacture inventory
on our behalf. We were permitted to purchase an aggregate of up to $15.0 million
of inventory manufactured by Lung Hwa or manufactured by third parties, in which
case we used Lung Hwa as an international purchasing office. For inventory
manufactured by third parties and purchased through Lung Hwa, the payment terms
were 120 days following the date of invoice by Lung Hwa. Lung Hwa charged us a
5% handling fee on a supplier's unit price. A 2% discount of the handling fee
applied if we reached an average running monthly purchasing volume of $750,000.
Returns made by us, which are agreed to by a supplier, resulted in a credit to
us for the handling charge. For inventory manufactured by Lung Hwa, the payment
terms were 90 days following the date of invoice by Lung Hwa. We were 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 had an initial term of one year after which the facility
was to 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 had 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, 2008,
we made no purchases under this arrangement. As of September 30, 2008, there
were no trade payables outstanding under this arrangement. We do not currently
utilize this trade credit facility as Lung Hwa is either not able to supply
certain products we currently sell, or in some cases, we are able to source
certain products at better prices directly from other third-party manufacturers.
This trade credit facility may not be available to us in the future in the event
we endeavor to attempt to again utilize the facility.
In February 2003, we entered into a Warehouse Services and Bailment
Agreement with BTC USA. Under the terms of the agreement, BTC USA agreed to
supply and store at our warehouse up to $10.0 million of inventory on a
consignment basis. We were 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 provided us with a trade line
of credit of up to $10.0 million with payment terms of net 60 days, without
interest. The agreement could be terminated by either party upon 60 days' prior
written notice to the other party. BTC USA is a subsidiary of Behavior Tech
Computer Corp., one of our significant stockholders. Mr. Steel Su, a former
director of I/OMagic, is the Chief Executive Officer of Behavior Tech Computer
Corp. During the nine months ended September 30, 2008, we purchased $723,600 of
inventory under this arrangement. As of September 30, 2008, there were
$4,604,138 in trade payables outstanding under this arrangement. As of the
filing of this report, we were out of compliance with the payment terms of the
agreement with BTC and we are in continued negotiations with BTC USA to satisfy
our obligations on a basis that is acceptable to both parties. We do not
currently utilize this trade credit facility as BTC USA is either not able to
supply certain products the Company currently sells, or in some cases, the
Company is able to source certain products at better prices directly from other
third-party manufacturers. This trade credit facility may not be available to
the Company in the future in the event the Company endeavors to attempt to again
utilize the facility. Additionally, due to substantial outstanding obligations
owed to BTC, it is highly unlikely that we will be able to obtain additional
inventory supplies from BTC unless, and at least until, we are able to negotiate
repayment terms acceptable to BTC. Even if we are able to negotiate repayment
terms acceptable to BTC, we may be unable to obtain additional inventory
supplies from BTC on the same terms as before, on satisfactory terms, or at all.
-25-
Lung Hwa and BTC USA provided us with significantly preferential trade
credit terms. These terms included extended payment terms, substantial trade
lines of credit and other preferential buying arrangements. We believe that
these terms were substantially better terms than we could likely obtain from
other subcontract manufacturers or suppliers. In fact, we believe that our trade
credit facility with Lung Hwa was likely unique and could not be replaced
through a relationship with an unrelated third party. These trade credit
facilities may not be available to us in the future in the event we endeavor to
attempt to again utilize them.
LIQUIDITY IMPACT OF CONSIGNMENT INVENTORY MODEL
We retain most risks of ownership of our consignment inventory. These
products remain our inventory until their sale by our retailers. For example,
both Office Depot and OfficeMax returned substantial consigned inventory in the
fourth quarter of 2007 and the first quarter of 2008, respectively, each in
anticipation of discontinuing sales of our products. The return of this
inventory resulted in significant inventory valuation adjustments caused by the
declining value of the inventory, principally, our magnetic data storage
products. In addition, 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 inventory model,
our sales, profitability and financial resources will likely decline.
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 condensed consolidated financial statements contained elsewhere in
this report.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 4. CONTROLS AND PROCEDURES
Not applicable.
ITEM 4T. 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
Acting 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
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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 Acting
Chief Financial Officer concluded as of September 30, 2008 that our disclosure
controls and procedures were effective at the reasonable assurance level.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There was no change during our most recently completed fiscal quarter
that has materially affected or is reasonably likely to materially affect, our
internal control over financial reporting, as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act.
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.
ITEM 1A. RISK FACTORS
In addition to the other information set forth in this report and the
additional risk factors below, you should carefully consider the factors
discussed under "Risk Factors" in our Amendment No. 1 to Annual Report on Form
10-K for the year ended December 31, 2007, which could materially affect our
business, financial condition and results of operations. The risks described in
our Amendment No. 1 to Annual Report on Form 10-K for the year ended December
31, 2007 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.
WE HAVE EXTREMELY LIMITED LIQUIDITY AND ONLY A SMALL CREDIT FACILITY AND
THEREFORE MAY BE UNABLE TO FULLY FUND OUR OPERATIONS FOR THE NEXT TWELVE
MONTHS OR LESS.
As of April 9, 2009, we had cash on hand of only $336,644 and a credit
facility limited to $1.5 million. Accordingly, we have extremely limited
liquidity and access to capital. If our capital requirements or cash flow vary
materially from our current projections, 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 other unforeseen circumstances occur, we may have
insufficient liquidity to fully fund our operations for the next twelve months
or less.
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WE HAVE INCURRED SIGNIFICANT LOSSES AND EXPERIENCED NEGATIVE OPERATING CASH
FLOW IN THE PAST AND WE EXPECT THIS TO CONTINUE FOR THE FORESEEABLE FUTURE.
CONTINUED LOSSES AND NEGATIVE OPERATING CASH FLOW WILL LIKELY HAMPER OUR
BUSINESS AND MAY PREVENT US FROM SUSTAINING OUR OPERATIONS.
We have incurred net losses and, for the most part, experienced
negative operating cash flow in each of the last nine years and have a
substantial accumulated deficit. We expect to incur losses and experience
negative operating cash flow for the foreseeable future. Continued losses and
negative operating cash flow will likely hamper our business and may prevent us
from sustaining our operations.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
Exhibit
Number Description
- ------ -----------
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: April 9, 2009 By: /s/ TONY SHAHBAZ
-----------------------------------------------
Tony Shahbaz
Acting Chief Financial Officer
(principal financial and accounting officer)
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EXHIBITS FILED WITH THIS REPORT
Exhibit
Number Description
- ------ -----------
31.1 Certification Required by Rule 13a-14(a) of the Securities
Exchange Act of 1934, as amended, as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification Required by Rule 13a-14(a) of the Securities
Exchange Act of 1934, as amended, as Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of President and Chief Financial Officer
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002