SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
______________________
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2003
--------------
[ ] 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 small business issuer as specified in its charter)
Nevada 88-0290623
---------------- -------------
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
1300 Wakeham, Santa Ana, CA 92705
----------------------------------
(Address of principal executive offices)
(714) 953-3000
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant has (1) filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
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 an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ]
As of May 19, 2003, the number of shares of the issuer's common stock issued and
outstanding was 4,529,672.
I/OMAGIC CORPORATION AND SUBSIDIARY
TABLE OF CONTENTS
Page
Number
------
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets - December 31, 2002 and March 31, 2003 (unaudited) 3
Statements of Income - For the three months ended
March 31, 2002 and 2003 (unaudited) 5
Statements of Cash Flows - For the three months ended
March 31, 2002 and 2003 (unaudited) 6
Notes to Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Conditions
and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk 22
Item 4. Controls and Procedures 22
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 23
Item 2. Changes in Securities and Use of Proceeds 23
Item 3. Defaults Upon Senior Securities 23
Item 4. Submission of Matters to a Vote of Security Holders 23
Item 5. Other Information 23
Item 6. Exhibits and Reports on Form 8-K 23
SIGNATURES 24
CERTIFICATIONS 25
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2002 AND MARCH 31, 2003 (UNAUDITED)
ASSETS
DECEMBER 31, MARCH 31,
2002 2003
----------- -----------
(unaudited)
CURRENT ASSETS
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . $ 7,320,143 $ 5,604,707
Accounts receivable, net of allowance for doubtful
accounts of $2,135,660 and $1,608,254 (unaudited). . . . . . 19,055,201 16,940,064
Inventory, net of allowance for obsolete inventory of $1,046,812
and $871,534 (unaudited) . . . . . . . . . . . . . . . . . . 8,240,280 11,021,368
Inventory in transit . . . . . . . . . . . . . . . . . . . . . . . 675,000 -
Prepaid expenses and other current assets. . . . . . . . . . . . . 28,955 166,074
----------- -----------
Total current assets. . . . . . . . . . . . . . . . . . . . . 35,319,579 33,732,213
PROPERTY AND EQUIPMENT, net. . . . . . . . . . . . . . . . . . . . 1,059,067 871,670
TRADEMARK, net of accumulated amortization
of $4,292,308 and $4,436,992 (unaudited). . . . . . . . . . 5,353,371 5,208,687
OTHER ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,952 25,952
----------- -----------
TOTAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . . . $41,757,969 $39,838,522
=========== ===========
The accompanying notes are an integral part of these financial statements.
3
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2002 AND MARCH 31, 2003 (UNAUDITED)
LIABILITIES AND STOCKHOLDERS' EQUITY
DECEMBER 31, MARCH 31,
2002 2003
------------- -------------
(unaudited)
CURRENT LIABILITIES
Line of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,372,827 $ 7,777,827
Accounts payable and accrued expenses. . . . . . . . . . . . . . . . . 7,285,246 6,439,380
Accounts payable - related parties . . . . . . . . . . . . . . . . . . 2,607,278 7,292,961
Reserves for customer returns and allowances . . . . . . . . . . . . . 765,898 476,050
Current portion of settlement payable. . . . . . . . . . . . . . . . . 3,000,000 1,000,000
------------- -------------
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . 24,031,249 22,986,218
SETTLEMENT PAYABLE, net of current portion . . . . . . . . . . . . . . 1,000,000 -
Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . 25,031,249 22,986,218
------------- -------------
STOCKHOLDERS' EQUITY
Preferred Stock
10,000,000 shares authorized, $0.001 par value
0 and 0 (unaudited) shares issued and outstanding . . . . . . . . . . - -
Class A common stock, $0.001 par value
100,000,000 shares authorized
4,529,672 and 4,529,672 (unaudited) shares issued and outstanding . . 4,530 4,530
Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . . . 31,557,988 31,557,988
Treasury stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . (42,330) (126,014)
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . (14,793,468) (14,584,200)
------------- -------------
Total stockholders' equity . . . . . . . . . . . . . . . . . . . . . 16,726,720 16,852,304
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY . . . . . . . . . . . . $ 41,757,969 $ 39,838,522
============= =============
The accompanying notes are an integral part of these financial statements.
4
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS ENDED MARCH 31,
(UNAUDITED)
THREE MONTHS ENDED MARCH 31,
2002 2003
------------- ------------
(unaudited) (unaudited)
NET SALES. . . . . . . . . . . . . . . . . . $ 26,719,632 $17,064,203
COST OF SALES. . . . . . . . . . . . . . . . 22,674,409 14,627,397
------------- ------------
GROSS PROFIT . . . . . . . . . . . . . . . . 4,045,223 2,436,806
------------- ------------
OPERATING EXPENSES
Selling, marketing, and advertising. . . . . 397,200 335,917
General and administrative . . . . . . . . . 1,998,507 1,456,839
Depreciation and amortization. . . . . . . . 559,504 357,298
------------- ------------
Total operating expenses. . . . . . . . . 2,955,211 2,150,054
------------- ------------
INCOME FROM OPERATIONS . . . . . . . . . . . 1,090,012 286,752
------------- ------------
OTHER INCOME (EXPENSE)
Interest income. . . . . . . . . . . . . . . - 166
Interest expense . . . . . . . . . . . . . . (74,771) (103,567)
Other income (expense) . . . . . . . . . . . - 23,263
------------- ------------
Total other income (expense) . . . (74,771) (80,138)
------------- ------------
INCOME BEFORE BENEFIT FROM INCOME TAXES. . . 1,015,241 206,614
BENEFIT FROM INCOME TAXES. . . . . . . . . . - (2,654)
------------- ------------
NET INCOME . . . . . . . . . . . . . . . . . $ 1,015,241 $ 209,268
============= ============
BASIC EARNINGS PER SHARE . . . . . . . . . . $ 0.22 $ 0.05
============= ============
DILUTED EARNINGS PER SHARE . . . . . . . . . $ 0.21 $ 0.05
============= ============
BASIC WEIGHTED-AVERAGE SHARES OUTSTANDING. . 4,528,686 4,529,672
------------- ------------
DILUTED WEIGHTED-AVERAGE SHARES OUTSTANDING. 4,768,686 4,529,672
============= ============
The accompanying notes are an integral part of these financial statements.
5
I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31,
(UNAUDITED)
THREE MONTHS ENDED MARCH 31,
2002 2003
-------------------------
(unaudited) (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income. . . . . . . . . . . . . . . . . . .. . . $ 1,015,241 $ 209,268
Adjustments to reconcile net income to net cash
provided by (used in) operating activities
Depreciation and amortization . . . . . . . . . . . . 77,223 212,614
Amortization of trademarks. . . . . . . . . . . . . . 482,280 144,684
Allowance for doubtful accounts . . . . . . . . . . . (237,868) 611
Reserve for customer returns and allowances . . . . . (377,089) (289,848)
Reserve for obsolete inventory. . . . . . . . . . . . 621,814 -
(Increase) decrease in
Accounts receivable . . . . . . . . . . . . . . . . . 2,120,775 2,323,425
Inventory . . . . . . . . . . . . . . . . . . . . . . (3,186,630) (2,781,088)
Inventory in transit. . . . . . . . . . . . . . . . . (716,540) 675,000
Prepaid expenses and other current assets . . . . . . 627,976 (137,119)
Increase (decrease) in
Accounts payable and accrued expenses . . . . . . . . (1,288,211) (1,054,765)
Accounts payable - related parties. . . . . . . . . . (1,612,667) 4,685,683
Settlement payable. . . . . . . . . . . . . . . . . . - (3,000,000)
------------ ------------
Net cash provided by (used in) operating activities . (2,473,696) 988,465
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment . . . . . . . . (6,140) (25,217)
------------ ------------
Net cash used in investing activities. . . . . . . (6,140) (25,217)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings (payments) on line of credit . . . . . 3,372,493 (2,595,000)
Purchase of treasury shares . . . . . . . . . . . . . - (83,684)
Payments on capital lease obligations . . . . . . . . (4,068) -
------------ ------------
Net cash provided by (used in) financing activities . 3,368,425 (2,678,684)
------------ ------------
Net increase (decrease) in cash and cash equivalents. 888,589 (1,715,436)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD. . . . 4,423,623 7,320,143
------------ ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD. . . . . . . $ 5,312,212 $ 5,604,707
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
INTEREST PAID. . . . . . . . . . . . . . . . . . . . $ 65,438 $ 111,352
============ ============
INCOME TAXES REFUNDED. . . . . . . . . . . . . . . . $ - $ (2,654)
============ ============
The accompanying notes are an integral part of these financial statements.
6
I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - ORGANIZATION AND BUSINESS
I/OMagic Corporation ("I/OMagic"), a Nevada corporation, and its subsidiary
(collectively, the "Company") develop, manufacture through subcontractors,
market, and distribute optical storage and media, multimedia, input-output
peripheral products and solutions for the desktop and mobile computing markets,
and digital entertainment products for the consumer electronics market. The
Company sells its products in the United States and Canada to distributors and
retail customers.
In March 1996, I/OMagic Corporation, a California corporation, originally
incorporated on September 30, 1993, entered into a Plan of Exchange and
Acquisition Agreement with Silvercrest International, Inc. ("Silvercrest"), a
Nevada corporation. Silvercrest subsequently changed its name to I/OMagic
Corporation, a Nevada corporation.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with the instructions to Form 10-Q and therefore, do not
include all information and notes necessary for a fair presentation of financial
position, results of operations, and cash flows in conformity with generally
accepted accounting principles. The unaudited condensed financial statements
include the accounts of I/OMagic and subsidiary. The operating results for
interim periods are unaudited and are not necessarily an indication of the
results to be expected for the full fiscal year. In the opinion of management,
the results of operations as reported for the interim periods reflect all
adjustments which are necessary for a fair presentation of operating results.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and the disclosures of
contingent assets and liabilities at the date of the financial statements, as
well as the reported amounts of revenues and expenses during the reporting
period.
Significant estimates made by management include, but are not limited to, the
provisions for allowance of doubtful accounts and price protection on accounts
receivable, the net realizability of inventory, the evaluation of potential
impairment of furniture and equipment, and the provision for sales returns and
warranties. Actual results could materially differ from those estimates.
STOCK BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation," establishes and
encourages the use of the fair value based method of accounting for stock-based
compensation arrangements under which compensation cost is determined using the
fair value of stock-based compensation determined as of the date of grant and is
recognized over the periods in which the related services are rendered. The
statement also permits companies to elect to continue using the current implicit
value accounting method specified in Accounting Principles Bulletin ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees," to account for
stock-based compensation issued to employees. The Company has elected to use the
implicit value based method and has disclosed the pro forma effect of using the
fair value based method to account for its stock-based compensation. For
stock-based compensation issued to non-employees, the Company uses the fair
value method of accounting under the provisions of SFAS No. 123.
7
EARNINGS PER SHARE
The Company calculates earnings per share in accordance with SFAS No. 128,
"Earnings Per Share." SFAS No. 128 replaced the presentation of primary and
fully diluted earnings per share with the presentation of basic and diluted
earnings per share. Basic earnings per share excludes dilution and is
calculated by dividing income available to common stockholders by the
weighted-average number of common shares outstanding for the period. Diluted
earnings per share includes the potential dilutive effects that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock ("potential common stock") that would then share in the
earnings of the Company.
As of March 31, 2003 (unaudited) and 2002 (unaudited), the Company had potential
common stock as follows:
2002 2003
--------- ----------
Weighted-average common shares
Outstanding during the period 4,528,686 4,529,672
Incremental shares assumed to be
outstanding since the beginning
of the period related to stock
options and warrants
outstanding (unaudited) 240,000 -
------------ -----------
FULLY DILUTED WEIGHTED-AVERAGE COMMON
SHARES AND POTENTIAL COMMON STOCK
UNAUDITED) 4,768,686 4,529,672
------------ -----------
The following potential common shares have been excluded from the computation of
diluted earnings per share as of March 31, 2003 and 2002 due to the exercise
price being higher than the market value.
2002 2003
--------- ----------
Stock Options 296,167 146,167
Warrants 8,000 -
Redeemable convertible preferred stock 240,000 -
--------- ----------
544,167 146,167
========= ==========
8
NOTE 3 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued liabilities consisted of the following:
March 31,
2003
-----------
(unaudited)
Accounts payable $ 1,105,437
Accrued rebates and marketing 4,307,058
Accrued compensation and related benefits 208,067
Other 818,818
-----------
TOTAL $ 6,439,380
===========
NOTE 4 - INVENTORY
Inventory consisted of the following:
March 31,
2003
-----------
(unaudited)
Component parts $ 4,573,624
Finished goods 7,319,278
Reserves for obsolete and slow moving inventory (871,534)
-----------
TOTAL $11,021,368
===========
NOTE 5 - LINE OF CREDIT
The Company maintains a revolving line of credit with a financial institution
that allows it to borrow a maximum of $9,000,000 with a sub-limit of $8,000,000.
The line of credit expires December 31, 2003 and is secured by a UCC filing on
substantially all of the Company's assets. Within the sub-limit, up to
$8,000,000 is available for issuance of sight letters of credit, refinancing
letters of credit, local purchase financing against invoice(s), and working
capital loans with maturities up to 150 days. Letters of credit have maturities
of up to 60 days. Each advance over a total outstanding line balance of
$4,000,000 is subject to the above maturity periods.
Within the line of credit, a sub-line of $1,000,000 is available for uncollected
funds. The availability of the line of credit is subject to the borrowing base,
which is 65% of eligible receivables. Advances on the line of credit bear
interest at the Wall Street Journal prime rate (4.25% as of March 31, 2003),
plus 0.75%, subject to a minimum interest rate of 5.5%. As of March 31, 2003,
the outstanding balance under the revolving line of credit was $7,777,827. The
Company is required to maintain a minimum, quarterly, combined average, cash
compensating balance of $750,000.
The line of credit is included in current liabilities in the accompanying
consolidated balance sheet. The line of credit provides for the maintenance of
certain financial covenants. As of December 31, 2002, we were in violation of
certain covenants. On April 11, 2003, we obtained a waiver, effective April 15,
2003, from ChinaTrust Bank (USA) as to our violation of the covenants. This
waiver also modified the original expiration date on the line of credit from
December 31, 2003 to October 15, 2003. The waiver stipulates that if the
defaults are not cured within 15 days, the bank is willing to forbear from
enforcing the defaults, provided that the Company pays in full the outstanding
amounts under the line of credit by October 15, 2003. This agreement will be
subject to the Company entering into a forbearance agreement with the bank on
9
terms and conditions satisfactory to the bank, at its sole discretion. As of
March 31, 2003, we were in violation of certain covenants. On May 15, 2003, we
obtained a waiver from ChinaTrust Bank (USA) as to our violation of the
covenants. The expiration date remains October 15, 2003. We are currently
engaged in discussions with financial institutions regarding a replacement line
of credit.
NOTE 6 - CREDIT LINES FROM RELATED PARTIES
In connection with a 1997 Strategic Alliance Agreement, the Company has
available a trade line of credit through a stockholder and supplier for
purchases up to $2,000,000. Purchases are non-interest bearing and are due 75
days from the date of receipt. The credit agreement can be terminated or
changed at any time. As of December 31, 2002 and March 31, 2003 (unaudited),
there were $0 and $0, respectively, in trade payables outstanding under this
arrangement.
In connection with a December 2000 subscription agreement, the Company also has
available an additional trade line of credit through a stockholder and vendor
that provides a trade credit facility of up to $3,000,000 carrying net 60 day
terms, as defined. As of December 31, 2002 and March 31, 2003 (unaudited), there
were $0 and $0, respectively, in trade payables outstanding under this
arrangement.
In January 2003, the Company entered into a trade credit facility with a related
party, whereby the related party has agreed to purchase inventory on behalf of
the Company. The agreement allows the Company to purchase up to $10,000,000,
with payment terms of 120 days following the date of invoice by the supplier.
The third party will charge the Company a 5% handling charge on the supplier's
unit price. A 2% discount to the handling fee will be applied if the Company
reaches an average running monthly purchasing volume of $750,000 a month.
Returns made by the Company, which are agreed by the supplier, will result in a
credit to the Company for the handling charge.
As security for the trade facility, the Company paid the related party a
security deposit of $1,500,000, which may be applied against outstanding trade
payables after six months. This deposit has been offset by Accounts Payables -
Related Parties in the accompanying financial statements. The agreement is for
12 months. At the end of the 12-month period, either party may terminate the
agreement upon 30 days' written notice. Otherwise, the agreement will remain
continuously valid without effecting a newly signed agreement. Both parties
have the right to terminate the agreement one year following the inception date
by giving the other party 30 days written notice of termination. As of March
31, 2003 (unaudited), there were $4,331,207 in trade payables net of the deposit
outstanding under this arrangement.
In February 2003, the Company entered into an agreement with a related party,
whereby the related party will supply and store at the Company's warehouse up to
$10,000,000 of inventory on a consignment basis. Under the agreement, the
Company will insure the consignment inventory, store the consignment inventory
for no charge, and furnish the related party with weekly statements indicating
all products received and sold and the current consignment inventory level. The
agreement may be terminated by either party with 60 days written notice. Also
in February 2003, the Company entered into an agreement with the related party
for a trade line of credit of up to $10,000,000 with payment terms of net 30
days, non-interest bearing. As of March 31, 2003 (unaudited), there were
$2,961,754 in trade payable outstanding under this arrangement. As of December
31, 2002, there were $2,607,278 in trade payables outstanding under a prior
arrangement with this related party.
NOTE 7 - COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases its facilities and certain equipment under non-cancelable,
operating lease agreements, expiring through October 2005.
Rent expense was $96,290 and $146,267 for the three months ended March 31, 2003
and 2002, respectively, and is included in general and administrative expenses
in the accompanying statements of income.
10
LITIGATION
Effective on or about March 28, 2003, the Company, among others, entered into a
settlement agreement and general release with Mark Vakili, Mitra Vakili, Hi-Val,
and others, in connection with a complaint filed in the Superior Court of the
State of California for the County of Orange (Case No. 01CC09894). Under the
terms of the settlement agreement and general release, the Company paid
$3,000,000 on March 31, 2003 and is obligated to pay an additional $1,000,000 on
March 15, 2004. The settlement agreement also provides, among other things, that
Mr. Shahbaz and Mr. Su, each a director of the Company, will each relinquish any
claims held by either of them to any interest in Alex Properties, a California
general partnership that holds title to the Company's corporate headquarters and
warehouse.
Pursuant to the settlement agreement and general release, Mr. Shahbaz and Mr. Su
will also transfer to parties designated by Mark and Mitra Vakili, an aggregate
of 13,333 shares of the Company's common stock from the 66,667 shares of the
Company's common stock being returned by Mark and Mitra Vakili to Mr. Shahbaz
and Mr. Su. Mr. Shahbaz and Mr. Su had previously transferred the 66,667 shares
to Mark and Mitra Vakili.
In addition, the Company is involved in certain legal proceedings and claims
which arise in the normal course of business. Management does not believe that
the outcome of these matters will have a material effect on the Company's
financial position or results of operations.
EMPLOYMENT CONTRACT
The Company entered into an employment contract with one of its officers on
October 15, 2002, which expires on October 15, 2007. The agreement, which is
effective as of January 1, 2002, calls for a minimum base salary and provides
for certain expense allowances. In addition, the agreement provides for a
quarterly bonus equal to 7% of the Company's quarterly net income. No bonuses
were paid during the three months ended March 31, 2003. $18,000 bonus was paid
during the three months ended March 31, 2002 under a prior employment contract.
RETAIL AGREEMENTS
In connection with certain retail agreements, the Company has agreed to pay for
certain marketing development and advertising on an ongoing basis. Marketing
development and advertising costs are generally agreed upon at the time of the
event. The Company also records a liability for co-op marketing based on
management's evaluation of historical experience and current industry and
Company trends. During the three months ended March 31, 2003 and 2002, the
Company incurred $724,827 (unaudited) and $921,329 (unaudited), respectively,
related to these agreements. Such is netted against sales revenue in the
accompanying statements of income.
NOTE 8 - RELATED PARTY TRANSACTIONS
During the three months ended March 31, 2003 and 2002, the Company had purchases
from related parties totaling approximately $8,039,904 (unaudited) and
$6,642,945 (unaudited), respectively.
During the three months ended March 31, 2003 and 2002, the Company had accounts
payable to related parties totaling approximately $7,292,961 (unaudited) and
$3,909,053 (unaudited), respectively.
Until March 28, 2003, the Company leased its warehouse and office space from a
related party under the control of an officer of the Company which required
minimum monthly payments of $28,673. As part of the settlement agreement in
Note 7 above, the Company's lease with the related party expired on March 28,
2003. For the three months ended March 31, 2003 and 2002, rent expense was
$86,018 and $86,018 respectively, and is included in general and administrative
expenses in the accompanying statements of operations.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction with
our unaudited consolidated financial statements and notes to financial
statements included elsewhere in this document. This report and our audited
consolidated financial statements and notes to financial statements contain
forward-looking statements, which generally include the plans and objectives of
management for future operations, including plans and objectives relating to our
future economic performance and our current beliefs regarding revenues we might
earn if we are successful in implementing our business strategies. The
forward-looking statements and associated risks may include, relate to or be
qualified by other important factors, including, without limitation:
- the projected growth or contraction in the computer peripherals and
consumer electronics markets in which we operate;
- our business strategy for expanding, maintaining or contracting our
presence in these markets;
- anticipated trends in our financial condition and results of operations;
and
- our ability to distinguish ourselves from our current and future
competitors.
We do not undertake to update, revise or correct any forward-looking
statements.
The information contained in this report is not a complete description of
our business or the risks associated with an investment in our common stock.
Before deciding to buy or maintain a position in our common stock, you should
carefully review and consider the various disclosures we made in this report,
and in our other materials filed with the Securities and Exchange Commission
that discuss our business in greater detail and that disclose various risks,
uncertainties and other factors that may affect our business, results of
operations or financial condition. In particular, you should review the "Risk
Factors" section of this report.
Any of the factors described above or in the "Risk Factors" section of this
report could cause our financial results, including our net income (loss) or
growth in net income (loss) to differ materially from prior results, which in
turn could, among other things, cause the price of our common stock to fluctuate
OVERVIEW
We offer products in both the personal computer and the consumer
electronics marketplace. These products include a variety of peripheral
upgrades for desktop and portable applications. Our sales are to national North
America retail chains and major regional North America retail chains. We
experienced a 36.1% decrease in net sales in 2003 over 2002. While the current
economic climate makes it difficult for us to look forward into the balance of
2003, we believe that our potential sales have been strengthened by the addition
of new customers in 2002 and the possibility of additional new customers in the
latter half of 2003.
Our net income decreased by 79.4%, primarily due to the 36.1% decrease in
net sales, offset by a 27.3% decrease in operating expenses.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of our financial condition and results of operations
are based upon our consolidated financial statements, which have been prepared
in accordance with accounting principals generally accepted in the United
States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those
related to customer programs and incentives, product returns, bad debts,
inventories, intangible assets, income taxes, and contingencies and litigation.
We base our estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
12
liabilities that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements. We record estimated reductions to revenue for customer
programs and incentive offerings including special pricing agreements, price
protection, promotions and other volume-based incentives. If market conditions
were to decline, we may take actions to increase customer incentive offerings
possibly resulting in an incremental reduction of revenue at the time the
incentive is offered. We maintain allowances for doubtful accounts for
estimated losses resulting from the inability of our customers to make required
payments. If the financial condition of our customers were to deteriorate,
resulting in the impairment of their ability to make payments, additional
allowances may be required.
We write down our inventory for estimated obsolescence or unmarketable
inventory equal to the difference between the cost of inventory and the
estimated market value based upon assumptions about future demand and market
conditions. If actual market conditions are less favorable than those projected
by management, additional inventory write-downs may be required. We record a
valuation allowance to reduce our deferred tax assets to the amount that is more
likely than not to be realized. While we have considered future taxable income
and ongoing prudent and feasible tax planning strategies in assessing the need
for the valuation allowance, in the event we were to determine that we would be
able to realize our deferred tax assets in the future in excess of our net
recorded amount, an adjustment to the deferred tax asset would increase income
in the period such determination was made. Likewise, should we determine that
we would not be able to realize all or part of our net deferred tax asset in the
future, an adjustment to the deferred tax asset would be charged to income in
the period such determination was made.
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2003 (UNAUDITED) COMPARED TO THREE MONTHS ENDED
MARCH 31, 2002 (UNAUDITED)
Net sales decreased 36.1% from $26,719,632 for the three months ended March
31, 2002 ("2002") to $17,064,203 for the three months ended March 31, 2003
("2003"). The decrease in net sales is attributable to a significant decrease
in sales to two of our major customers due to a reduction in current products
carried in the optical storage category. We believe that the recent
introduction of new products such as our digital photo library, duplicator and
media station products will result in a reverse of the decrease in revenues.
Cost of sales as a percentage of net sales increased from 84.9%
($22,674,409) in 2002 to 85.7% ($14,627,397) in 2003. Cost of units increased
from 76.5% in 2002 to 81.0% in 2003 of net sales. Freight in/out decreased from
6.0% in 2002 to 4.7% in 2003 of net sales. Inventory shrink/adjustments
decreased from 2.4% in 2002 to 0.0% in 2003 of net sales. We wrote down to lower
of cost or market $650,000 in inventory in 2002 and $0 in 2003.
Operating expenses as a percentage of net sales increased from 11.1%
($2,955,211) in 2002 to 12.6% ($2,150,054) in 2003. This percentage increase is
primarily due to total operating expenses decreasing 27.3% in 2003 while net
sales decreased 36.1% in 2003. Selling, marketing and advertising expenses
decreased by $61,283 (15.4%) in 2003. General and administrative expenses
decreased by $541,668 (27.1%) in 2003. Depreciation and amortization expenses
decreased by $202,206 (36.1%) in 2003.
Selling, marketing and advertising expenses in 2003 were $335,917 (2.0% of
net sales) and in 2002 were $397,200 (1.5% of net sales). Selling, marketing and
advertising expenses decreased by $61,283 primarily due to $77,419 less outside
commissions as a result of lower sales in 2003.
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General and administrative expenses in 2003 were $1,456,839 (8.5% of net
sales) and in 2002 were $1,998,507 (7.5% of net sales). General and
administrative expenses decreased $541,668 primarily due to $499,389 less bad
debt expense (2002 writedown of Hi-Val accounts receivable acquired in 2000),
$42,863 less rent due to moving out of one facility in May 2002, $33,976 less
temporary help due to less sales, $31,396 less bank fees due to no letters of
credit fees, offset by $65,724 more product design costs.
Depreciation and amortization expenses in 2003 were $357,298 (2.1% of net
sales) and in 2002 were $559,504 (2.1% of net sales). The decrease of $202,206
was primarily due to $337,600 decreased amortization of trademarks offset by
$133,040 increased amortization of leasehold improvements. In 2002 we had an
outside valuation service review the value of the trademarks and their useful
lives for us. Based upon the valuation, we determined (with concurrence of our
independent auditors) that there had been no impairment to the value of the
trademarks and that the useful lives of the trademarks should be increased by
ten years due to additional historical information of their value. Therefore,
the amount of annual trademark amortization was decreased beginning in the
second quarter 2002. The amortization of the leasehold improvements at the
current Santa Ana location were accelerated due to an anticipated move to a
larger facility later this year.
Other income (expenses) increased to $80,138 (0.5% of net sales) expense in
2003 from $74,771 expense (0.3% of net sales) in 2002. This increase of $5,367
was primarily due to $28,796 more interest expense offset by $23,235 gain on
currency exchange in relation to sales to Canadian retailers.
LIQUIDITY AND CAPITAL RESOURCES
During the three months ended March 31, 2003 we had a net decrease in cash
relative to December 31, 2002 in the amount of $1,715,436. This was due to cash
provided by operating activities of $988,465 offset by cash used in financing
activities of $2,678,684 and cash used in investing activities of $25,217. Cash
provided by operations was from an increase in accounts payable to related
parties of $4,685,683, a decrease in accounts receivable of $2,323,425, a
decrease in inventory in transit of $675,000, net income of $209,268, an
increase in non-cash entries of $68,061, offset by a decrease in reserve for
settlements of $3,000,000, an increase in inventory of $2,781,088, an increase
in other current assets of $137,119, and a decrease in accounts payable and
accrued expenses of $1,054,765. Cash used for financing activities was for net
payments on the line of credit of $2,595,000 and purchase of treasury stock of
$83,684. Cash used for investing activities was for leasehold improvements,
furniture and computer equipment.
Effective January 1, 2003, we obtained a $9 million asset based line of
credit (with a sub-limit of $8 million) with ChinaTrust Bank (USA) which was to
expire December 31, 2003. ChinaTrust Bank (USA) renewed our prior $14 million
line of credit, but reduced the amount to $9 million due to our history of
losses the past three years. Within the sub-limit, up to $8,000,000 is
available for issuance of sight letters of credit, refinancing letters of
credit, local purchase financing against invoice(s), and working capital loans
with maturities up to 150 days. Letters of credit have maturities of up to 60
days. Each advance over a total outstanding line balance of $4,000,000 is
subject to the above maturity periods.
Within the line of credit, a sub-line of $1,000,000 is available for
uncollected funds. The availability of the line of credit is subject to the
borrowing base, which is 65% of eligible receivables. Advances on the line of
credit bear interest at the Wall Street Journal prime rate (4.25% as of March
31, 2003), plus 0.75%, subject to a minimum interest rate of 5.5%. As of March
31, 2003, the outstanding balance under the revolving line of credit was
$7,777,827. We are required to maintain a minimum, quarterly, combined average,
cash compensating balance of $750,000.
The line of credit provides for the maintenance of certain financial
covenants. As of December 31, 2002, we were in violation of certain covenants.
On April 11, 2003, we obtained a waiver, effective April 15, 2003, from
ChinaTrust Bank (USA) as to our violation of the covenants. This waiver
stipulates that if the defaults are not cured within 15 days, the bank is
14
willing to forbear from enforcing the defaults, provided that the Company pays
in full the outstanding amounts under the line of credit by October 15, 2003.
This waiver will be subject to the Company entering into a forbearance agreement
with the bank on terms and conditions satisfactory to the bank at its sole
discretion. As of March 31, 2003, we were in violation of certain covenants.
On May 15, 2003, we obtained a waiver from ChinaTrust Bank (USA) as to our
violation of the covenants. The expiration date remains October 15, 2003. We
are currently engaged in discussions with financial institutions regarding a
replacement line of credit.
We believe that our failure to either obtain a new bank line of credit or
increased trade credit facilities will require us to reduce our purchase of
products and thus our sales significantly; however, we believe that we can
continue operations at a greatly reduced sales volume. We believe if we are able
to either obtain a new line of credit or increased trade credit facilities, such
lines of credit and our current cash flow from operations will be sufficient to
meet our working capital and capital expenditure requirements at the current
sales volumes for the next 12 months.
In January 2003, we entered into a trade credit facility with Lung Hwa
Electronics Co., Ltd. ("Lung Hwa"), whereby Lung Hwa has agreed to purchase
inventory on our behalf. The agreement allows us to purchase up to $10,000,000,
with payment terms of 120 days following the date of invoice by the supplier.
Lung Hwa will charge us a 5% handling charge on the supplier's unit price. A 2%
discount to the handling fee will be applied if we reach an average running
monthly purchasing volume of $750,000 a month. Returns made by us, which are
agreed to by the supplier, will result in a credit to us for the handling
charge. As security for the trade facility, we paid Lung Hwa a security deposit
of $1,500,000 in 2003. This deposit has been offset against Accounts Payables
- -Related Parties in the accompanying financial statements, as the agreement
allows us the right to offset against outstanding trade payables after six
months. The agreement will remain in force continuously. Both parties have the
right to terminate the agreement one year following the inception date by giving
the other party 30 days' written notice. Otherwise, the agreement will remain in
force without effecting a new signed agreement. As of March 31, 2003, we owed
Lung Hwa $4,331,207.
In February 2003, we entered into an agreement with Behavior Tech Computer
(USA) Corp. ("BTC USA") whereby BTC USA will supply and store at our warehouse
up to $10,000,000 of inventory on a consignment basis. Under the agreement, we
will insure the consignment inventory, store the consignment inventory for no
charge, and furnish BTC USA with weekly statements indicating all products
received and sold and the current consignment inventory level. The agreement
may be terminated by either party upon 60 days' prior written notice. Also in
February 2003, we entered into an agreement with the related party for a trade
line of credit of up to $10,000,000 with payment terms of net 30 days,
non-interest bearing. As of March 31, 2002, we owed BTC $2,961,754.
In the event the last three quarters of 2003 continue with the revenue
growth we have experienced between 2001 and 2002, we may experience net negative
cash flows from operations, pending an increase in gross margins, and may be
required to obtain additional financing to fund operations through proceeds from
offerings, to the extent available, or to obtain additional financing to the
extent necessary to augment our working capital through public or private
issuance of equity or debt securities or increased trade credit facilities with
vendors. In the event we are unsuccessful in securing such financing, we may be
required to curtail our sales growth.
We have no firm long-term sales commitments from any of our customers and
enter into individual purchase orders with our customers. We have experienced
cancellations of orders and fluctuations in order levels from period to period
and expect we will continue to experience such cancellations and fluctuations in
the future. In addition, customer purchase orders may be canceled and order
volume levels can be changed, canceled or delayed with limited or no penalties.
The replacement of canceled, delayed or reduced purchase orders with new
business cannot be assured. Moreover, our business, financial condition and
results of operations will depend upon our ability to obtain orders from new
customers, as well as the financial condition and success of our customers, our
customers products and the general economy.
15
Our backlog at March 31, 2003 was $3,171,302 as compared to a backlog at
March 31, 2002 of $6,239,326. Based upon the history of the past twelve months,
the March 31, 2003 backlog may be reduced by $475,695 (15%) when
recognized as sales, due to returns and price protections.
RISK FACTORS
- -------------
An investment in our common stock involves a high degree of risk. In
addition to the other information in this report, you should carefully consider
the following risk factors before deciding to invest or maintain an investment
in shares of our common stock. If any of the following risks actually occurs, it
is likely that our business, financial condition and operating results would be
harmed. As a result, the trading price of our common stock could decline, and
you could lose part or all of your investment.
WE HAVE INCURRED SIGNIFICANT LOSSES AND MAY CONTINUE TO INCUR LOSSES. IF WE
CONTINUE TO INCUR LOSSES, WE MAY HAVE TO CURTAIL OUR OPERATIONS.
Although we were profitable in the first quarter 2003, we have not been
profitable the last three years and may not be profitable in the foreseeable
future. Historically, we have relied upon cash from operations and financing
activities to fund all of the cash requirements of our business and have
incurred significant losses. As of March 31, 2003, we had an accumulated deficit
of $14,584,200. During 2002, 2001, and 2000, we incurred net losses in the
amount of $8,347,231, $5,547,645, and $6,410,849, respectively. We cannot
predict if we will be profitable in future quarters and we may continue to incur
losses for an indeterminate period of time and may never achieve or sustain
annual profitability. An extended period of losses may result in negative cash
flow and may prevent us from operating or expanding our business. We cannot
assure you that our business will ever become continuously profitable or that we
will ever generate sufficient revenues to meet our expenses and support our
operations. Even if we are able to achieve profitability, we may be unable to
sustain or increase our profitability on a quarterly or annual basis.
OUR CURRENT BANK LINE OF CREDIT WILL EXPIRE ON OCTOBER 15, 2003. IF WE ARE
UNABLE TO OBTAIN ANOTHER BANK LINE OF CREDIT, OUR ABILITY TO PURCHASE ADDITIONAL
INVENTORY MAY BE ADVERSELY AFFECTED, WHICH WOULD ADVERSELY AFFECT OUR SALES AND
NET INCOME.
We are in violation of certain financial covenants in our agreement for our
banking line of credit due to the loss incurred in 2002. ChinaTrust Bank (USA)
has the ability to call our line of credit immediately, which could result in
impairment of the purchase of inventory. However, the bank has provided us a
waiver for violation of such financial covenants and has provided us with six
months to either find another banking facility or to pay off the outstanding
balance. We are currently in discussions with financial institutions for a new
line of credit. If we are unable to obtain a new line of credit then our
ability to expand or sustain our current sales volume will be adversely
affected.
OUR CONCENTRATION OF SALES TO THREE MAJOR CUSTOMERS MAY ADVERSELY AFFECT OUR
BUSINESS IF ANY ONE OR MORE OF THEM DECIDES TO DISCONTINUE PURCHASING OUR
PRODUCTS.
During the first quarter 2003, net sales to our three largest customers
represented 34%, 33% and 11%, respectively, of total net sales. Our sales and
our profitability would be adversely affected if any one or more of these
customers ceased purchasing from us. We have no guarantee that we would be able
to replace the loss of such sales with existing or new customers or in a timely
manner to avoid an adverse financial impact to our business.
16
FIERCE COMPETITION IN THE COMPUTER PERIPHERAL AND CONSUMER ELECTRONICS
MARKETPLACE MAY CAUSE A DECLINE IN OUR REVENUES AND FORCE US TO REDUCE PRICES
FOR OUR PRODUCTS.
The market for our products is highly competitive. Our competitors for our
hardware products include Hewlett-Packard, Iomega, Memorex, Phillips, Samsung,
Sony, TDK and Yamaha. Our competitors for our media products include
Fuji,Imation, Maxell, Memorex, PNY, TDK and Verbatim. We also indirectly compete
against original equipment manufacturers such as Dell Computer and
Hewlett-Packard to the extent that they manufacture their own computer
peripheral products or incorporate on personal computer motherboards the
functionalities provided by our products. We believe that the strategy of
certain of our current and potential competitors is to compete largely on the
basis of price, which may result in lower prices and lower margins for our
products or otherwise adversely affect the market for our products. There can be
no assurance that we will be able to continue to compete successfully in the
marketplace.
MANY OF OUR COMPETITORS HAVE GREATER RESOURCES THAN US. IN ORDER TO COMPETE
SUCCESSFULLY, WE MUST KEEP PACE WITH OUR COMPETITORS IN ANTICIPATING AND
RESPONDING TO RAPID CHANGES IN THE COMPUTER PERIPHERAL AND CONSUMER ELECTRONICS
INDUSTRIES.
Our future success will depend upon our ability to enhance our current
products and services and to develop and introduce new products and services
that keep pace with technological developments, respond to the growth in the
computer peripheral and consumer electronics markets in which we compete,
encompass evolving consumer requirements, provide a broad range of products and
achieve market acceptance of our products. Many of our existing and potential
competitors have larger technical staffs, more established and larger marketing
and sales organizations and significantly greater financial resources than we
do. Our lack of resources relative to our competitors may cause us to fail to
anticipate or respond adequately to technological developments and consumer
requirements or may cause us to experience significant delays in developing or
introducing new products and services. These failures or delays could reduce our
competitiveness, revenues, profit margins and market share.
OUR LACK OF LONG-TERM PURCHASE ORDERS OR COMMITMENTS MAY ADVERSELY AFFECT OUR
BUSINESS IF DEMAND DECLINES.
During the quarter ended March 31, 2003, sales of our computer peripheral
products accounted for 94.7% of our total net sales, and sales of our consumer
electronics products accounted for 5.3% of our total net sales. In many cases we
have long-term contracts with our computer peripheral and consumer electronics
retailers that cover the general terms and conditions of our relationships with
them but that do not include long-term purchase orders or commitments. Rather,
our retailers issue purchase orders requesting the quantities of computer
peripheral or consumer electronics products that they desire to purchase from
us, and if we are able and willing to fill those orders, then we fill them under
the terms of the contracts. Accordingly, we cannot rely on long-term purchase
orders or commitments to protect us from the negative financial effects of a
decline in demand for our products that could result from a general economic
downturn, from changes in the computer peripheral and consumer electronics
marketplaces, including the entry of new competitors into the market, from the
introduction by others of new or improved technology, from an unanticipated
shift in the needs of our retailers, or from other causes.
OUR BUSINESS COULD SUFFER IF WE ARE UNABLE TO OBTAIN OUR PRODUCTS FROM OUR
SUPPLIERS.
Most of our products are available from multiple sources. However, we
currently obtain most of our products from single or limited sources. We have,
from time to time, experienced difficulty in obtaining some products. We do not
have guaranteed supply arrangements with any of our suppliers, and there can be
no assurance that our suppliers will continue to meet our requirements. If our
existing suppliers are unable to meet our requirements, we could be required to
17
find other suppliers or even eliminate products from our product line. Product
shortages could limit our sales capacity and also could result in lower margins
due to higher product costs resulting from limited supply or the need to obtain
substitute products which are available only at higher costs. Significant
increases in the prices of our products could adversely affect our results of
operations because our products compete on price and, therefore, we may not be
able to pass along price increases to our retailers. Also, an extended
interruption in the supply of products or a reduction in their quality or
reliability would adversely affect our financial condition and results of
operations by operations by impairing our ability to timely deliver quality
products to our retailers. Delayed product deliveries due to product shortages
or other factors may result in cancellation by our retailers of all or part of
their orders. We cannot assure you that cancellations will not occur.
OUR DEPENDENCE ON SALES OF OUR OPTICAL STORAGE AND OPTICAL MEDIA PRODUCTS COULD
HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS IF THE MARKET FOR THOSE PRODUCTS
DECLINES.
Net sales of our optical storage and related media products accounted for
approximately 82.2% of our net sales for the first quarter 2003. Although we
have introduced products in other segments of the computer peripheral market and
in the consumer electronics market, optical storage and optical media products
are expected to continue to account for a majority of our sales for at least the
next year. A decline in the demand or average selling prices for optical storage
or optical media products, whether as a result of new competitive product
introductions, price competition, excess supply, technological changes,
incorporation of the products' functionality onto personal computer motherboards
or otherwise, would have a material adverse effect on our sales and operating
results.
IF WE FAIL TO KEEP PACE WITH THE RAPID TECHNOLOGICAL CHANGES THAT CHARACTERIZE
THE MARKETPLACE FOR OUR PRODUCTS, WE WILL LIKELY EXPERIENCE A SIGNIFICANT
DECLINE IN OUR COMPETITIVE ADVANTAGE RESULTING IN A MATERIALLY NEGATIVE IMPACT
ON OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The markets for our products are characterized by rapidly changing
technology, evolving industry standards, frequent new product introductions and
rapid product obsolescence. Product life cycles in the markets for our products
often range from as few as three up to twelve months. We believe that our
success will be substantially dependent upon our ability to continue to develop
and introduce competitive products and technologies on a timely basis with
features and functions that meet changing consumer requirements in a
cost-effective manner. Even if we are successful in the development and market
introduction of new products, we still must correctly forecast consumer demand
for those products to avoid either excessive unsold inventory or excessive
unfilled orders related to our products. The task of forecasting consumer demand
is extremely difficult for new products for which there is little or no sales
history, and for indirect channels, where our customers are not the final
end-users. Moreover, whenever we offer new products, we also must successfully
manage the resulting obsolescence and price erosion of our older products, as
well as any resulting price protection charges and inventory returns from our
retailers. Accordingly, if we are unable to keep pace with the rapid
technological changes within the marketplace for our products, or unable to
manage effectively the introduction of new products, our business, financial
condition and results of operations will be negatively impacted.
OUR FAILURE TO FORECAST SALES IN THE VOLATILE COMPUTER PERIPHERAL AND CONSUMER
ELECTRONICS MARKETPLACES COULD RESULT IN LOST REVENUES AND SIGNIFICANT LOSSES.
We develop and market products in the highly competitive computer
peripheral and consumer electronics marketplaces. Our products are very
susceptible to obsolescence and typically exhibit a high degree of volatility of
shipment volumes over relatively short product life-cycles. The timing of
introductions of new products can materially affect sales volumes. In addition,
new product releases by competitors and accompanying price adjustments to
competing products can materially and adversely affect our revenues and gross
margins.
18
We sell our products to retailers such as mass merchandisers and large
electronics chains which sell products primarily off-the-shelf directly to end
users. Our reliance on indirect channels of distribution typically results in
little or no ability to predict end user demand. We rely upon sales forecasts
provided by our retailers in order to comply with order placement demands by
these retailers. If these forecasts are inaccurate, we could either have excess
inventory, resulting in significant finance costs and product obsolescence, or
insufficient inventory, resulting in lost revenues due to our inability to
promptly meet consumer demand. Accordingly, our future operating results are
largely dependent on our ability to accurately predict the demand for our
products. Our failure to accurately predict the demand for our products could
result in significant losses from inventory obsolescence and finance charges or
substantial lost revenues.
WE RELY HEAVILY ON OUR MANAGEMENT, AND THE LOSS OF THEIR SERVICES COULD
ADVERSELY AFFECT OUR BUSINESS.
Our success is highly dependent upon the continued services of key members
of our management, including our Chairman of the Board, President, Chief
Executive Officer and Secretary, Tony Shahbaz. Mr. Shahbaz has developed
personal contacts and other skills that we rely upon in connection with our
financing, acquisition and general business strategies. Mr. Shahbaz has also
developed key personal relationships with our vendors and frequently is
extensively involved in our sales and promotional efforts with our key
customers. Although we have entered into an employment agreement with Mr.
Shahbaz, that agreement is of limited duration and is subject to early
termination by Mr. Shahbaz under some circumstances. Consequently, the loss of
Mr. Shahbaz or one or more other key members of management could adversely
affect our business.
OUR FAILURE TO MANAGE GROWTH EFFECTIVELY COULD IMPAIR OUR BUSINESS.
Our expansion into new product categories in the computer peripheral and
consumer electronics marketplaces has required and will continue to require
significant investment and management attention to improve our information
systems, product data management, control accounting, telecommunications and
networking systems, coordination of suppliers and distribution channels, and
general business processes and procedures. We are continuing to expand our
product base in the consumer electronics marketplace and expect significant
challenges in coordinating supply and distribution processes in what we hope
will be a rapidly growing product category.
Our strategy envisions a period of rapid growth that may impose a
significant burden on our administrative and operational resources. Our ability
to effectively manage growth will require us to substantially expand the
capabilities of our administrative and operational resources and to attract,
train, manage and retain qualified marketing, technical support, customer
service, sales and other personnel. There can be no assurance that we will be
able to do so. If we are unable to successfully manage our growth, our business,
prospects, results of operations and financial condition could be materially and
adversely affected.
THE EMERGENCE OF NEW SALES CHANNELS AND THE ACCEPTANCE OF EXISTING ALTERNATIVE
SALES CHANNELS MAY RESULT IN FEWER SALES OF OUR PRODUCTS DUE TO OUR INABILITY TO
ADAPT TO THESE SALES CHANNELS.
We are accustomed to conducting business through traditional distribution
and retail sales channels. Traditional computer peripheral and consumer
electronics distribution and retail channels have suffered from the emergence of
alternative sales channels, such as direct mail order, telephone sales by
personal computer manufacturers and Internet commerce. The emergence of
additional alternative sales channels or increased acceptance of existing
alternative sales channels by retailers or consumers may cause a rapid decline
in the sales of our products unless we are able to capitalize on those new or
more widely accepted sales channels. In addition, new products or changes in the
types of products we sell, such as our digital entertainment products, may
require specialized value-added reseller channels, which we have not yet fully
established. We may be unable to effectively compete in a marketplace that
supports numerous alternative sales channels because we do not have experience
19
in sales channels other than traditional distribution and retail sales channels.
As a result, in a marketplace in which alternative sales channels continue to
emerge, we may suffer from a competitive disadvantage which may have a material
and adverse effect on our business.
POLITICAL AND ECONOMIC INSTABILITY IN EAST ASIA COULD HAVE AN ADVERSE IMPACT ON
THE SUPPLY OF OUR PRODUCTS WHICH COULD MATERIALLY AND ADVERSELY AFFECT OUR
BUSINESS.
We order nearly all of our products from large manufacturing facilities
located primarily in Taiwan, Korea and the People's Republic of China. In the
event of a severe political disruption in the governments of any country located
in East Asia, the economic ramifications to our suppliers could be devastating.
As a result, our ability to conduct operations might be materially and adversely
affected. In addition, our suppliers acquire components and raw materials for
the manufacturing of our products from a number of countries, many of which do
not conduct business in United States dollars. Any severe fluctuation in the
value of foreign currencies could materially increase our costs to purchase
products. Accordingly, as a result of political or economic instability in East
Asia, our operations could be materially and adversely affected. In addition,
an expansion of the outbreak of SARS could result in disruption of the
manufacturing of our suppliers, which would materially and adversely affect our
operations.
THE MIGRATION OF OUR PRODUCTS' FUNCTIONALITIES TO PERSONAL COMPUTER MOTHERBOARDS
COULD MAKE SOME OF OUR COMPUTER PERIPHERAL PRODUCTS OBSOLETE WHICH COULD
ADVERSELY AFFECT OUR BUSINESS.
Many of our products are individual computer peripheral products that
operate in conjunction with personal computers to provide additional
functionalities. Historically, as new functionalities become technologically
stable and widely accepted by personal computer users, the cost of providing
such functionalities declines dramatically by means of large-scale integration
into semiconductor chips, which can be incorporated into personal computer
motherboards. If the migration of the functionalities of our products into
personal computer motherboards occurs, demand for our products will likely
decline significantly. There can be no assurance that the incorporation of new
functionalities into personal computer motherboards will not adversely affect
the market for our products.
IF OUR PRODUCTS FAIL TO COMPLY WITH EVOLVING GOVERNMENT AND INDUSTRY STANDARDS
AND REGULATIONS, WE MAY HAVE DIFFICULTY SELLING OUR PRODUCTS.
Our products are designed to comply with a significant number of industry
standards and regulations, some of which are evolving as new technologies are
deployed. In the United States, our products must comply with various
regulations defined by the United States Federal Communications Commission,
Underwriters Laboratories and the Food and Drug Administration as well as
numerous industry standards. The failure of our products to comply, or delays in
compliance, with the various existing and evolving regulations or standards
could negatively impact our ability to sell our products.
BECAUSE WE BELIEVE THAT PROPRIETARY RIGHTS ARE MATERIAL TO OUR SUCCESS,
MISAPPROPRIATION OF THESE RIGHTS COULD ADVERSELY IMPACT OUR FINANCIAL CONDITION.
We are not the licensee or owner of any of the intellectual property
contained in our products other than our I/OMagic, Hi-Val and Digital Research
Technologies brand names, all of which we own. As a result, we do not have a
proprietary interest in any of the software, hardware or related technology
incorporated in our products. We rely primarily on trademark protection for our
I/OMagic, Hi-Val and Digital Research Technologies brand names. There can be no
assurance that our means of protecting our proprietary rights in these brand
names will deter or prevent their unauthorized use. Our financial condition
would be adversely affected if we were to lose our competitive position due to
our inability to adequately protect our proprietary rights in our brand names.
20
We own, license or have otherwise obtained the right to use certain
technologies incorporated in our products. We may receive infringement claims
from third parties relating to our products and technologies. In those cases, we
intend to investigate the validity of the claims and, if we believe the claims
have merit, to respond through licensing or other appropriate actions. To the
extent claims relate to technology included in components purchased from
third-party vendors for incorporation into our products, we would forward those
claims to the appropriate vendor. If we or our component manufacturers are
unable to license or otherwise provide any necessary technology on a
cost-effective basis, we could be prohibited from marketing products containing
that technology, incur substantial costs in redesigning products incorporating
that technology, or incur substantial costs defending any legal action taken
against us.
OUR STOCK PRICE HAS BEEN VOLATILE, WHICH COULD RESULT IN SUBSTANTIAL LOSSES FOR
INVESTORS PURCHASING SHARES OF OUR COMMON STOCK AND IN LITIGATION AGAINST US.
The market prices of securities of technology-based companies have
historically been highly volatile. The market price of our common stock has
fluctuated significantly in the past. In fact, during 2003, the high and low
closing sale prices of a share of our common stock were $10.00 and $3.00
respectively. The market price of our common stock may continue to fluctuate in
response to the following factors, many of which are beyond our control:
- changes in market valuations of similar companies and stock market price
and volume fluctuations generally;
- economic conditions specific to the computer peripheral and consumer
electronics industries;
- announcements by us or our competitors of new or enhanced products,
technologies or services or significant contracts, acquisitions,
strategic relationships, joint ventures or capital commitments;
- regulatory developments;
- fluctuations in our quarterly or annual operating results;
- additions or departures of key personnel; and
- future sales of our common stock or other securities.
The price at which you purchase shares of common stock may not be
indicative of the price of our stock that will prevail in the trading market.
You may be unable to sell your shares of common stock at or above your purchase
price, which may result in substantial losses to you. Moreover, in the past,
securities class action litigation has often been brought against a company
following periods of volatility in the market price of its securities. We may in
the future be the target of similar litigation. Securities litigation could
result in substantial costs and divert management's attention and resources.
BECAUSE WE ARE SUBJECT TO THE "PENNY STOCK" RULES, THE LEVEL OF TRADING ACTIVITY
IN OUR STOCK MAY BE REDUCED.
Broker-dealer practices in connection with transactions in "penny stocks"
are regulated by penny stock rules adopted by the Securities and Exchange
Commission. Penny stocks, like shares of our common stock, generally are equity
securities with a price of less than $5.00 (other than securities registered on
some national securities exchanges or quoted on Nasdaq). The penny stock rules
require a broker-dealer, prior to a transaction in a penny stock not otherwise
exempt from the rules, to deliver a standardized risk disclosure document that
provides information about penny stocks and the nature and level of risks in the
penny stock market. The broker-dealer also must provide the customer with
current bid and offer quotations for the penny stock, the compensation of the
broker-dealer and its salesperson in the transaction, and, if the broker-dealer
is the sole market maker, the broker-dealer must disclose this fact and the
broker-dealer's presumed control over the market, and monthly account statements
showing the market value of each penny stock held in the customer's account. In
addition, broker-dealers who sell these securities to persons other than
established customers and "accredited investors" must make a special written
determination that the penny stock is a suitable investment for the purchaser
and receive the purchaser's written agreement to the transaction. Consequently,
these requirements may have the effect of reducing the level of trading
21
activity, if any, in the secondary market for a security subject to the penny
stock rules, and investors in our common stock may find it difficult to sell
their shares.
BECAUSE OUR STOCK IS NOT LISTED ON A NATIONAL SECURITIES EXCHANGE, YOU MAY FIND
IT DIFFICULT TO DISPOSE OF OR OBTAIN QUOTATIONS FOR OUR COMMON STOCK.
Our common stock trades under the symbol "IOMG" on the OTC Bulletin Board.
Because our stock trades on the OTC Bulletin Board rather than on a national
securities exchange, you may find it difficult to either dispose of, or to
obtain quotations as to the price of, our common stock.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations were not subject to commodity price risk during the three
months ended March 31, 2003. Our sales to a foreign country (Canada) were less
than 1% of our total sales, and thus we experienced negligible foreign currency
exchange rate risk. We currently have a line of credit with ChinaTrust Bank
(USA) in an amount of up to $9 million with a sub-limit of $8 million. The line
of credit provides for an interest rate equal to the prime lending rate plus
three-quarters of one percent, subject to a minimum interest rate of 5.50%. This
interest rate is adjustable upon each movement in the prime lending rate. If the
prime lending rate increases, our interest rate expense will increase on an
annualized basis by the amount of the increase multiplied by the principal
amount outstanding under the ChinaTrust Bank (USA) line of credit.
ITEM 4. CONTROLS AND PROCEDURES
Our Chief Executive Officer and Chief Financial Officer (our principal
executive officer and principal financial officer, respectively) have concluded,
based on their evaluation as of May 15, 2003 ("Evaluation Date"), that the
design and operation of our "disclosure controls and procedures" (as defined in
Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as
amended ("Exchange Act")) are effective to ensure that information required to
be disclosed by us in the reports filed or submitted by us under the Exchange
Act is accumulated, recorded, processed, summarized and reported to our
management, including our principal executive officer and our principal
financial officer, as appropriate to allow timely decisions regarding whether or
not disclosure is required.
There were no significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent to the Evaluation
Date, nor were there any significant deficiencies or material weaknesses in our
internal controls. As a result, no corrective actions were required or
undertaken.
22
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Effective on or about March 28, 2003, we, among others, entered into a
settlement agreement and general release with Mark Vakili, Mitra Vakili, Hi-Val,
and others, in connection with a complaint filed in the Superior Court of the
State of California for the County of Orange (Case No. 01CC09894). Under the
terms of the settlement agreement and general release, we paid $3,000,000 on
March 31, 2003 and are obligated to pay an additional $1,000,000 on March 15,
2004. The settlement agreement also provides, among other things, that Mr.
Shahbaz and Mr. Su, each one of our director's, will each relinquish any claims
held by either of them to any interest in Alex Properties, a California general
partnership that holds title to our corporate headquarters and warehouse.
Pursuant to the settlement agreement and general release, Mr. Shahbaz and Mr. Su
will also transfer to parties designated by Mark and Mitra Vakili, an aggregate
of 13,333 shares of our common stock from the 66,667 shares of our common stock
being returned by Mark and Mitra Vakili to Mr. Shahbaz and Mr. Su. Mr. Shahbaz
and Mr. Su had previously transferred the 66,667 shares to Mark and Mitra
Vakili.
In addition, we are involved in certain legal proceedings and claims which
arise in the normal course of business. Management does not believe that the
outcome of these matters will have a material effect on our financial position
or results of operations.
ITEM 2. CHANGES IN SECURITIES 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 AND REPORTS ON FORM 8-K
(a) Exhibits:
Number Description
------ -----------
99.1 Certifications of Chief Executive Officer and Chief
Financial Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
(b) Reports on Form 8-K:
----------------------
Form 8-K was filed on April 10, 2003 reporting Items 7 and 9 in
compliance with Regulation FD Disclosure (Information Furnished
Under Item 12) in connection with the Company's Press Release
issued on April 8, 2003 reporting selected financial results for
the fourth quarter 2002.
23
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: May 19, 2003 By: /s/ Tony Shahbaz
------------------
Tony Shahbaz, President and Chief Executive
Officer (principal executive officer)
By: /s/ Steve Gillings
--------------------
Steve Gillings, Chief Financial Officer
(principal financial and accounting officer)
24
CERTIFICATIONS
--------------
I, Tony Shahbaz, certify that:
1. I have reviewed this quarterly report on Form 10-Q of I/OMagic Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 19, 2003 /s/ Tony Shahbaz
------------ -------------------------------------
Tony Shahbaz, Chief Executive Officer
25
CERTIFICATIONS
--------------
I, Steve Gillings, certify that:
1. I have reviewed this quarterly report on Form 10-Q of I/OMagic Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 19, 2003 /s/ Steve Gillings
------------ ---------------------------------------
Steve Gillings, Chief Financial Officer
26
EXHIBITS FILED WITH THIS REPORT
Number Description
- ------ -----------
99.1 Certifications of Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
27