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SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-Q    þ
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 2004  o
    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 000-30083 QUALSTAR CORPORATION Incorporated under the laws of the State of California
    
    (I.R.S. Employer Identification No.) 95-3927330
 3990-B Heritage Oak Court
Simi Valley, CA 93063
(805) 583-7744 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
þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). Yes
o No þ Total shares of common stock without par value outstanding at December 31, 2004 is 12,253,117.




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QUALSTAR CORPORATION
FORM 10-Q
For the quarterly period ended December 31, 2004 Table of Contents  
 PagePART I  FINANCIAL INFORMATIONITEM 1. Financial Statements:Consolidated Condensed Balance Sheets  December 31, 2004 and June 30, 2004
    
    
    3Consolidated Condensed Statements of Operations  Three months and six months ended December 31, 2004 and 2003
    
    
    4Consolidated Condensed Statements of Cash Flows  Six months ended December 31, 2004 and 2003
    
    
    5Consolidated Condensed Statement of Changes in Shareholders Equity  Six months ended December 31, 2004
    
    
    6Notes to Interim Consolidated Condensed Financial Statements
    
    
    7ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    10ITEM 3. Qualitative and Quantitative Disclosures About Market Risk
    
    
    15ITEM 4. Controls and Procedures
    
    
    15PART II OTHER INFORMATIONITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    16ITEM 6. Exhibits
    
    
    16Signatures
    
    
    17EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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##### Table of Contents



PART I  FINANCIAL INFORMATION 
 ITEM 1. Financial Statements QUALSTAR CORPORATION 
 CONSOLIDATED CONDENSED BALANCE SHEETS
DECEMBER 31, 2004 AND JUNE 30, 2004
(in thousands)
 DECEMBER,
    
    
    JUNE 30,2004
    
    
    2004(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    2,540
    
    
    $
    6,401Marketable securities
    
    
    31,492
    
    
    
    29,376Receivables, net of allowances of $212 and $217 at December 31, 2004
and June 30, 2004, respectively
    
    
    3,568
    
    
    
    4,628Inventories
    
    
    7,722
    
    
    
    7,418Prepaid expenses and other current assets
    
    
    596
    
    
    
    470Prepaid income taxes
    
    
    771
    
    
    
    1,072Deferred income taxes
    
    
    594
    
    
    
    594Total current assets
    
    
    47,283
    
    
    
    49,959Property and equipment, net
    
    
    1,343
    
    
    
    1,439Other assets
    
    
    223
    
    
    
    249Total assets
    
    $
    48,849
    
    
    $
    51,647LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    929
    
    
    $
    1,171Accrued payroll and related liabilities
    
    
    489
    
    
    
    500Other accrued liabilities
    
    
    1,561
    
    
    
    1,754Total current liabilities
    
    
    2,979
    
    
    
    3,425Deferred income taxes
    
    
    158
    
    
    
    158Shareholders equity:Common stock, no par value; 50,000 shares authorized, 12,253 and
12,596 shares issued and outstanding at December 31, 2004 and June
30, 2004, respectively
    
    
    18,370
    
    
    
    20,121Notes from directors
    
    
    
    
    
    
    (45
    )Accumulated other comprehensive loss
    
    
    (164
    )
    
    
    (101
    )Retained earnings
    
    
    27,506
    
    
    
    28,089Total shareholders equity
    
    
    45,712
    
    
    
    48,064Total liabilities and shareholders equity
    
    $
    48,849
    
    
    $
    51,647
 See the accompanying notes to these interim condensed consolidated financial statements. 3




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QUALSTAR CORPORATION 
 CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
THREE MONTHS AND SIX MONTHS ENDED DECEMBER 31, 2004 AND 2003
(UNAUDITED)
(in thousands, except per share data)
 THREE MONTHS ENDED
    
    
    SIX MONTHS ENDEDDECEMBER 31,
    
    
    DECEMBER 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Net revenues
    
    $
    6,392
    
    
    $
    9,556
    
    
    $
    12,697
    
    
    $
    15,532Cost of goods sold
    
    
    4,081
    
    
    
    5,962
    
    
    
    8,053
    
    
    
    9,698Gross profit
    
    
    2,311
    
    
    
    3,594
    
    
    
    4,644
    
    
    
    5,834Operating expenses:Research and development
    
    
    865
    
    
    
    1,064
    
    
    
    1,819
    
    
    
    2,221Sales and marketing
    
    
    868
    
    
    
    1,038
    
    
    
    1,715
    
    
    
    1,738General and administrative
    
    
    1,136
    
    
    
    1,428
    
    
    
    2,068
    
    
    
    2,787Total operating expenses
    
    
    2,869
    
    
    
    3,530
    
    
    
    5,602
    
    
    
    6,746Income (loss) from operations
    
    
    (558
    )
    
    
    64
    
    
    
    (958
    )
    
    
    (912
    )Investment income
    
    
    211
    
    
    
    192
    
    
    
    375
    
    
    
    346Income (loss) before income taxes
    
    
    (347
    )
    
    
    256
    
    
    
    (583
    )
    
    
    (566
    )Provision (benefit) for income taxes
    
    
    
    
    
    
    49
    
    
    
    
    
    
    
    (197
    )Net income (loss)
    
    $
    (347
    )
    
    $
    207
    
    
    $
    (583
    )
    
    $
    (369
    )Earnings (loss) per share:Basic
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    (0.05
    )
    
    $
    (0.03
    )Diluted
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    (0.05
    )
    
    $
    (0.03
    )Shares used to compute earnings
(loss) per share:Basic
    
    
    12,477
    
    
    
    12,550
    
    
    
    12,541
    
    
    
    12,568Diluted
    
    
    12,477
    
    
    
    12,604
    
    
    
    12,541
    
    
    
    12,568
 See the accompanying notes to these interim condensed consolidated financial statements. 4




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QUALSTAR CORPORATION 
 CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED DECEMBER 31, 2004 AND 2003
(UNAUDITED)
(in thousands)
 Six Months EndedDecember 31,2004
    
    
    2003OPERATING ACTIVITIES:Net loss
    
    $
    (583
    )
    
    $
    (369
    )Adjustments to reconcile net loss to net cash provided by operating activities:Depreciation and amortization
    
    
    231
    
    
    
    208Provision for (recovery of) bad debts and returns
    
    
    (2
    )
    
    
    101Amortization of deferred compensation
    
    
    
    
    
    
    129Accrued interest on directors notes
    
    
    
    
    
    
    (4
    )Changes in operating assets and liabilities:Accounts receivable
    
    
    1,062
    
    
    
    (194
    )Inventories
    
    
    (304
    )
    
    
    629Prepaid expenses and other assets
    
    
    (124
    )
    
    
    (285
    )Prepaid income taxes
    
    
    301
    
    
    
    391Accounts payable
    
    
    (242
    )
    
    
    (514
    )Accrued payroll and related liabilities
    
    
    (11
    )
    
    
    61Other accrued liabilities
    
    
    (193
    )
    
    
    26Net cash provided by operating activities
    
    
    135
    
    
    
    179INVESTING ACTIVITIES:Purchases of property, equipment and leasehold improvements
    
    
    (111
    )
    
    
    (87
    )Proceeds from sale of marketable securities
    
    
    9,476
    
    
    
    25,455Purchases of marketable securities
    
    
    (11,655
    )
    
    
    (28,654
    )Net cash used in investing activities
    
    
    (2,290
    )
    
    
    (3,286
    )FINANCING ACTIVITIES:Proceeds from exercise of stock options
    
    
    76
    
    
    
    Repurchase of common stock
    
    
    (1,827
    )
    
    
    (314
    )Principal and interest payments on directors notes
    
    
    45
    
    
    
    79Net cash used in financing activities
    
    
    (1,706
    )
    
    
    (235
    )Net decrease in cash and cash equivalents
    
    
    (3,861
    )
    
    
    (3,342
    )Cash and cash equivalents at beginning of period
    
    
    6,401
    
    
    
    6,236Cash and cash equivalents at end of period
    
    $
    2,540
    
    
    $
    2,894Supplemental cash flow disclosure:Income taxes paid
    
    $
    
    
    
    $
    
 See the accompanying notes to these interim condensed consolidated financial statements. 5




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QUALSTAR CORPORATION 
 CONSOLIDATED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS EQUITY
SIX MONTHS ENDED DECEMBER 31, 2004
(UNAUDITED)
(in thousands)
 ACCUMULATEDNOTES
    
    
    OTHERCOMMON STOCK
    
    
    FROM
    
    
    COMPREHENSIVE
    
    
    RETAINEDSHARES
    
    
    AMOUNT
    
    
    DIRECTORS
    
    
    LOSS
    
    
    EARNINGS
    
    
    TOTALBalance at July 1, 2004
    
    
    12,596
    
    
    $
    20,121
    
    
    $
    (45
    )
    
    $
    (101
    )
    
    $
    28,089
    
    
    $
    48,064Proceeds from exercise of stock options
    
    
    16
    
    
    
    76
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    76Retirement of shares pursuant to stock repurchase
    
    
    (359
    )
    
    
    (1,827
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,827
    )Principal and interest payments on directors notes
    
    
    
    
    
    
    
    
    
    
    45
    
    
    
    
    
    
    
    
    
    
    
    45Comprehensive loss:Change in unrealized losses on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (63
    )
    
    
    
    
    
    
    (63
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (583
    )
    
    
    (583
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (646
    )Balance at December 31, 2004
    
    
    12,253
    
    
    $
    18,370
    
    
    $
    
    
    
    $
    (164
    )
    
    $
    27,506
    
    
    $
    45,712
 See the accompanying notes to these condensed consolidated financial statements. 6




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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS DECEMBER 31, 2004
(in thousands, except per share data)
(UNAUDITED)
 NOTE 1. BASIS OF PRESENTATION The accompanying condensed consolidated financial statements are unaudited, except for the
balance sheet at June 30, 2004 which is derived from our audited financial statements, and should
be read in conjunction with the consolidated financial statements and related notes included in
Qualstar Corporations (Qualstar, us, we, or our) Annual Report on Form 10-K filed with the
Securities and Exchange Commission (SEC) on September 24,2004. In the opinion of management, these
unaudited condensed consolidated financial statements include all adjustments, consisting primarily
of normal recurring items, which are necessary for the fair presentation of Qualstars consolidated
financial position as of December 31, 2004, consolidated results of operations for the three and
six months ended December 31, 2004, and consolidated cash flows for the six months ended December
31, 2004. Operating results for the three and six month periods ended December 31, 2004 are not
necessarily indicative of results to be expected for a full year. NOTE 2. EARNINGS PER SHARE The following table sets forth the computation of basic and diluted net income per share for
the three months and six months ended December 31, 2004 and 2003: THREE MONTHS ENDED
    
    
    SIX MONTHS ENDEDDECEMBER 31,
    
    
    DECEMBER 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Numerator:Net Income (loss)
    
    $
    (347
    )
    
    $
    207
    
    
    $
    (583
    )
    
    $
    (369
    )Denominator:Denominator for basic net income (loss) per
share  weighted average shares
    
    
    12,477
    
    
    
    12,550
    
    
    
    12,541
    
    
    
    12,568Dilutive potential common shares from employee
stock options and restricted stock
    
    
    
    
    
    
    54
    
    
    
    
    
    
    
    Denominator for diluted net income (loss) per
share  adjusted weighted average shares and
assumed conversions
    
    
    12,477
    
    
    
    12,604
    
    
    
    12,541
    
    
    
    12,568Basic net income (loss) per share
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    (0.05
    )
    
    $
    (0.03
    )Diluted net income (loss) per share
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    (0.05
    )
    
    $
    (0.03
    )
 All shares related to stock options are excluded for the three months and six months ended
December 31, 2004, respectively, from the computation of diluted earnings per share as the effect
would have been antidilutive. NOTE 3. STOCK BASED COMPENSATION Employee stock options are accounted for under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, as amended and interpreted, which requires recognition
of expense when the option price is less than the fair value of the stock at the date of grant.
Qualstar generally awards options for a fixed number of shares at an option price equal to the fair
value at the date of grant. Qualstar has adopted the disclosure-only provisions of the Financial
Accounting Standards Boards (FASB) Statement of Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-Based Compensation (SFAS 123). If the Company recognized employee stock option-related compensation expense in accordance
with SFAS 123 and used the minimum value method for grants prior to the Companys initial public
offering and the Black-Scholes method model afterward for determining the weighted average fair
value of options granted, the Companys net income (loss) and income (loss) per share would have
been reduced to the pro forma amounts indicated below: 7




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THREE MONTHS
    
    
    SIX MONTHSENDED
    
    
    ENDEDDECEMBER 31,
    
    
    DECEMBER 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Net income (loss) as reported
    
    $
    (347
    )
    
    $
    207
    
    
    $
    (583
    )
    
    $
    (369
    )Stock-based employee compensation cost included in reported
net income (loss)
    
    
    
    
    
    
    64
    
    
    
    
    
    
    
    129Pro forma stock-based employee compensation cost under SFAS 123
    
    
    (68
    )
    
    
    (130
    )
    
    
    (136
    )
    
    
    (260
    )Pro forma net income (loss)
    
    $
    (415
    )
    
    $
    141
    
    
    $
    (719
    )
    
    $
    (500
    )Earnings (loss) per share:Basic  as reported
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    (0.05
    )
    
    $
    (0.03
    )Basic  pro forma
    
    $
    (0.03
    )
    
    $
    0.01
    
    
    $
    (0.06
    )
    
    $
    (0.04
    )Diluted  as reported
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    (0.05
    )
    
    $
    (0.03
    )Diluted  pro forma
    
    $
    (0.03
    )
    
    $
    0.01
    
    
    $
    (0.06
    )
    
    $
    (0.04
    )Basic Weighted Average Shares
    
    
    12,477
    
    
    
    12,550
    
    
    
    12,541
    
    
    
    12,568Diluted Weighted Average Shares
    
    
    12,477
    
    
    
    12,604
    
    
    
    12,541
    
    
    
    12,568
 NOTE 4. MARKETABLE SECURITIES Marketable securities consist primarily of high-quality U.S. corporate securities and U.S.
federal government and state government debt securities. These securities are classified in one of
three categories: trading, available-for-sale, or held-to-maturity. Trading securities are bought
and held principally for the purpose of selling them in the near term. Held-to-maturity securities
are those securities which Qualstar has the ability and intent to hold until maturity. All other
securities not included in trading or held-to-maturity are classified as available-for-sale. All of
Qualstars marketable securities were classified as available-for-sale at December 31, 2004 and
June 30, 2004. Available-for-sale securities are recorded at market value. Unrealized holding gains and
losses, net of the related income tax effect, on available-for-sale securities are excluded from
earnings and are reported as a separate component of shareholders equity until realized. Dividend
and interest income are recognized when earned.

Realized gains and losses for securities classified as available-for-sale are included in earnings
when the underlying securities are sold and are derived using the specific identification method
for determining the cost of securities sold. On March 31, 2004, the Emerging Issues Task Force (EITF) reached a consensus on Issue No.
03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,
(EIFT 03-1) effective for annual financial statements with fiscal years ending after June 15, 2004.
EITF 03-1 provides guidance for determining when an investment is other-than-temporarily impaired,
and states that an investment is considered other-than-temporarily impaired when its fair value is
less than its amortized cost basis and is deemed other than temporary. The application of EITF 03-1
to the Companys marketable securities portfolio has not resulted in the identification of an
other-than-temporarily impaired investment in the three and six month period ended December 31,
2004. In accordance with EITF 03-1, the Company recognized an impairment loss for
other-than-temporary decline in investments of $160,000 equal to the difference between the
amortized cost basis and its fair value in the three month period ended June 30, 2004. NOTE 5. INVENTORIES Inventories are stated at the lower of cost (first-in, first-out basis) or market. Inventory
is comprised as follows: DECEMBER 31, 2004
    
    
    JUNE 30, 2004Raw materials
    
    $
    6,577
    
    
    $
    6,370Finished goods
    
    
    1,145
    
    
    
    1,048$
    7,722
    
    
    $
    7,418
 8




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NOTE 6. COMPREHENSIVE LOSS For the six months ended December 31, 2004 and 2003, comprehensive loss amounted to
approximately $646,000 and $453,000, respectively. The difference between net loss and
comprehensive loss relates to the changes in the unrealized losses or gains the Company recorded
for its available-for-sale securities. NOTE 7. STOCK REPURCHASE On February 12, 2003, the Company announced that the Board of Directors had authorized a stock
repurchase program of up to 500,000 shares of the Companys common stock. The stock repurchase is
funded by available working capital. There is no time limit for the completion of the stock
repurchase program and it may be discontinued at any time. During the three month period ended
December 31, 2004, the Company repurchased 359,082 shares of its common stock at a total cost of
$1,826,877, or an average price of $5.09 per share. From February 12, 2003 through December 31,
2004, the Company repurchased 498,559 shares of its common stock at a total cost of
$2,484,961, or an average price of $4.98 per share. NOTE 8. LEGAL PROCEEDINGS We are not currently a party to any material legal proceeding. We may from time to time
become involved in litigation relating to claims arising in the ordinary course of business. These
claims, even if not meritorious, could result in the expenditure of significant financial and
managerial resources. NOTE 9. INCOME
TAXES The Company does not record deferred taxes on domestic pretax income or losses due to the
availability of net operating loss carryforwards which have been fully reserved through valuation
allowances and due to the uncertainty surrounding the timing of realizing net operating loss
carryforwards generated in the current period in future periods. The Company currently has a prior fiscal year under audit by the Internal Revenue Service (IRS).
The IRS has proposed an adjustment which Qualstar believes will ultimately not result in any
significant adjustments to the previously filed return. If the proposed adjustment requires an
amendment of the prior year tax return, the Company believes that any additional taxes that we may
be required to pay will not have a significant effect on Qualstars financial position or results
of operations. NOTE 10. RECENT
ACCOUNTING PRONOUNCEMENTS On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), Share-Based Payment
(SFAS 123(R), which is a revision of FASB Statement No. 123, Accounting for Stock-Based
Compensation. SFAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees,
and amends FASB Statement No. 95, Statement of Cash Flows.
Generally, the approach in SFAS 123(R)
is similar to the approach described in Statement 123. However, SFAS
123(R) requires all
share-based payments to employees, including grants of employee stock options, to be recognized in
the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in
periods in which financial statements have not yet been issued. We expect to adopt SFAS 123(R) on
July 1, 2005. SFAS 123(R) permits public companies to adopt its requirements using one of two methods. The first
method is a modified prospective transition method whereby a company would recognize share-based
employee costs from the beginning of the fiscal period in which the recognition provisions are
first applied as if the fair-value-based accounting method had been used to account for all
employee awards granted, modified, or settled after the effective date and to any awards that were
not fully vested as of the effective date. Measurement and attribution of compensation cost for
awards that are nonvested as of the effective date of SFAS 123(R) would be based on the same
estimate of the grant-date fair value and the same attribution method used previously under SFAS
123. 9




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The second adoption method is a modified retrospective transition method whereby a company would
recognize employee compensation cost for periods presented prior to the adoption of SFAS 123(R) in
accordance with the original provisions of SFAS 123; that is, an entity would recognize employee
compensation cost in the amounts reported in the pro forma disclosures provided in accordance with
SFAS 123. A company would not be permitted to make any changes to those amounts upon adoption of
SFAS 123(R) unless those changes represent a correction of an error. For periods after the date of
adoption of SFAS 123(R), the modified prospective transition method described above would be
applied. The Company currently expects to adopt SFAS 123(R) using the modified prospective transition
method, and expects the adoption to have an effect on Qualstars results of operations similar to
the amounts reported historically in the Companys footnotes under the pro forma disclosure
provisions of SFAS 123. 
 ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Statements in this Quarterly Report on Form 10-Q concerning the future business, operating results
and financial condition of Qualstar are forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These
forward-looking statements inherently are subject to risks and uncertainties, some of which we
cannot predict or quantify. Our actual results may differ materially from the results projected in
the forward-looking statements. Factors that might cause such a difference include, but are not
limited to, those discussed in our Annual Report on Form 10-K for the fiscal year ended June 30,
2004 in ITEM 1 Business, including the section therein entitled Risk Factors, and in ITEM 7-
Managements Discussion and Analysis of Financial Condition and Results of Operations. You
generally can identify forward-looking statements by the use of forward-looking terminology such as
believes, may, expects, intends, estimates, anticipates, plans, seeks, or
continues, or the negative thereof or variations thereon or similar terminology. Except as
required by law, we undertake no obligation to publicly update or revise any forward-looking
statements to reflect the occurrence of events or circumstances in the future. OVERVIEW We design, develop, manufacture and sell automated magnetic tape libraries used to store,
retrieve and manage electronic data primarily in network computing environments. We offer tape
libraries for multiple tape drive technologies including AIT, Super AIT, SuperDLT, and LTO tape
drives and media. Many enterprises now routinely manage very large databases, in addition to storing information
on local desktop computers. This, coupled with the growth in the amount of data from new sources
and applications, is increasing the need for managing and storing data efficiently. Anticipating
the increased demand for tape libraries, we have developed tape libraries spanning a broad range of
tape formats, prices, capacity and performance. We expect our products to continue to evolve in the
future in response to emerging tape technologies and changing customer preferences. We have developed a network of value added resellers who specialize in delivering complete
storage solutions to end users. End users of our products range from small businesses requiring
simple automated backup solutions to large organizations needing complex storage management
solutions. We also sell our products to original equipment manufacturers who incorporate our
products with theirs, which they sell as a complete system or solution. We assist our customers
with marketing and technical support. In May 2004 we entered into a non-exclusive agreement with Ingram Micro, Inc. to sell our
products to smaller VARs who in turn sell to end users. Under the agreement, select RLS Series
models called TeraLoaders are available through Ingram Micro. Commercial distribution is a new
sales channel for us and there were no revenues from this channel in fiscal 2004. Qualstar was incorporated in California in 1984. Our initial products were IBM compatible
9-track reel-to-reel tape drives. In 1995, we entered the tape automation market with a series of
tape libraries incorporating 8mm tape drives. Since that time, we have introduced a succession of
tape library models designed to work with the leading automation capable tape drive technologies.
We announced the end of life for 9-track tape drives in September 2002 with final revenue shipments
in the second quarter of fiscal 2004. In July 2002, we purchased the assets of N2Power, Incorporated, a supplier of ultra small high
efficiency open-frame switching power supplies. Power supplies provided by N2Power are utilized
within our tape library products as well as sold to original equipment manufacturers for
incorporation into their products. N2Power products are sold under the N2Power brand name as well
as under a private label brand name through independent sales representatives and distributors.
Revenues from N2Power products have not been material as a percentage of total revenues for fiscal
2004 and fiscal 2003. 10




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CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of our financial condition and results of operations is based upon
our 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 promotional offers, sales returns, bad
debts, inventories, warranty costs, investments, and income taxes. 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 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. Revenue Recognition Revenue is recognized upon shipment of product to our customers. Title and risk of loss
transfer to the customer when the product leaves our dock in Simi Valley, California, or another
shipping location designated by us. In general, these customers are allowed to return the product,
free of penalty, within thirty days of shipment, if the product does not meet specifications.
Revenues from technical support services and other services are recognized at the time services are
performed. We record an allowance for estimated sales returns based on past experience and current
knowledge of our customer base. Our experience has been such that only a very small percentage of
libraries are returned. Should our experience change, however, we may require additional allowances
for sales returns. Allowance for Doubtful Accounts We estimate our allowance for doubtful accounts based on an assessment of the collectibility
of specific accounts and the overall condition of accounts receivable. In evaluating the adequacy
of the allowance for doubtful accounts, we analyze specific trade receivables, historical bad
debts, customer credits, customer credit-worthiness and changes in customers payment terms and
patterns. If the financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make additional payments, then we may need to make additional
allowances. Likewise, if we determine that we could realize more of our receivables in the future
than previously estimated, we would adjust the allowance to increase income in the period we made
this determination. Inventory Valuation We record inventories at the lower of cost or market value. We assess the value of our
inventories periodically based upon numerous factors including expected product or material demand,
current market conditions, technological obsolescence, current cost and net realizable value. If
necessary, we write down our inventory for estimated obsolescence, potential shrinkage, 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 technology
changes more rapidly than expected, or market conditions become less favorable than those projected
by management, additional inventory write-downs may be required. Warranty
Obligations We provide for the estimated cost of product warranties at the time revenue is recognized. We
engage in extensive product quality programs and processes, including active monitoring and
evaluation of product failure rates, material usage and estimation of service delivery costs
incurred in correcting a product failure. However, should actual product failure rates, material
usage, or service delivery costs differ from our estimates, revisions to the estimated warranty
liability would be required. Historically our warranty costs have not been significant. 11




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##### Table of Contents



Accounting for Income Taxes We estimate our tax liability based on current tax laws in the statutory jurisdictions in
which we operate. These estimates include judgments about deferred tax assets and liabilities
resulting from temporary differences between assets and liabilities recognized for financial
reporting purposes and such amounts recognized for tax purposes, as well as about the realization
of deferred tax assets. We maintain a valuation allowance to reduce our deferred tax assets due to the uncertainty
surrounding the timing of realizing the benefits of specific deferred tax assets in future years.
We have considered future taxable income and ongoing prudent and feasible tax planning strategies
in assessing the need for such a valuation allowance. In the event we were to determine that we
would 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. We may periodically undergo examinations by the federal and state regulatory authorities and
the Internal Revenue Service. We may be assessed additional taxes and or penalties contingent on
the outcome of these examinations. Our previous examinations have not resulted in any unfavorable
or significant assessments. We currently have a prior fiscal year under audit by the Internal Revenue Service (IRS). The
IRS has proposed an adjustment which we believe will ultimately not result in any significant
adjustments to the previously filed return. If the proposed adjustment requires an amendment of the
prior year tax return, we believe that any additional taxes that we may be required to pay will not
have a significant effect on our financial position or results of operations. RESULTS OF OPERATIONS The following table reflects, as a percentage of net revenues, statements of operations data for
the periods indicated: Three Months Ended
    
    
    Six Months EndedDecember 31,
    
    
    December 31,2004
    
    
    2003
    
    
    2004
    
    
    2003Net revenues
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of goods sold
    
    
    63.8
    
    
    
    62.4
    
    
    
    63.4
    
    
    
    62.4Gross profit
    
    
    36.2
    
    
    
    37.6
    
    
    
    36.6
    
    
    
    37.6Operating expenses:Research and development
    
    
    13.5
    
    
    
    11.1
    
    
    
    14.3
    
    
    
    14.3Sales and marketing
    
    
    13.6
    
    
    
    10.9
    
    
    
    13.5
    
    
    
    11.2General and administrative
    
    
    17.8
    
    
    
    14.9
    
    
    
    16.3
    
    
    
    17.9Total operating expenses
    
    
    44.9
    
    
    
    36.9
    
    
    
    44.1
    
    
    
    43.4Income (loss) from operations
    
    
    (8.7
    )
    
    
    0.7
    
    
    
    (7.5
    )
    
    
    (5.8
    )Investment income
    
    
    3.3
    
    
    
    2.0
    
    
    
    3.0
    
    
    
    2.2Income (loss) before income taxes
    
    
    (5.4
    )
    
    
    2.7
    
    
    
    (4.5
    )
    
    
    (3.6
    )Provision (benefit) for income taxes
    
    
    
    
    
    
    0.5
    
    
    
    
    
    
    
    (1.2
    )Net income (loss)
    
    
    (5.4
    )%
    
    
    2.2
    %
    
    
    (4.5
    )
    
    
    (2.4
    )%
 12




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Revenues are recognized upon shipment of the product to the customer, less estimated returns, for
which provision is made at the time of sale. The following table summarizes our revenue by major
product line: Three Months Ended
    
    
    Six Months EndedDecember 31,
    
    
    December 31,Tape library revenues:
    
    2004
    
    
    2003
    
    
    2004
    
    
    2003TLS
    
    
    48.0
    %
    
    
    54.6
    %
    
    
    53.8
    %
    
    
    59.1
    %RLS
    
    
    16.5
    
    
    
    18.7
    
    
    
    12.6
    
    
    
    15.164.5
    
    
    
    73.3
    
    
    
    66.4
    
    
    
    74.2Other revenues:Service
    
    
    9.3
    
    
    
    7.5
    
    
    
    10.2
    
    
    
    8.1Media
    
    
    9.6
    
    
    
    7.5
    
    
    
    9.8
    
    
    
    8.1Power Supplies, Spares, Upgrades, 9 Track
    
    
    16.6
    
    
    
    11.7
    
    
    
    13.6
    
    
    
    9.6100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
 Three Months Ended December 31, 2004 Compared to Three Months Ended December 31, 2003. Net Revenues. Revenues are recognized upon shipment of the product to the customer, less
estimated returns, for which provision is made at the time of sale. Net revenues for the three
months ended December 31, 2004 were $6.4 million, compared with net revenues of $9.6 million for
the three months ended December, 2003, a decrease of $3.2 million. The decrease in revenues is
attributed to lower revenues from tape libraries incorporating LTO and AIT tape drives. In
addition, revenue was higher in the second quarter of fiscal 2004 primarily due to a $1.4 million
shipment to a video surveillance OEM which accounted for approximately 14.5% of our net revenues
for the quarter. There were no customers providing greater than 10% of our revenues for the three
months ended December 31, 2004. Gross Profit. Gross profit represents the difference between our net revenues and cost of
goods sold. Cost of goods sold consists primarily of purchased parts, direct and indirect labor
costs, rent, technical support costs, depreciation of plant and equipment, utilities, and packaging
costs. Gross profit was $2.3 million, or 36.2% of net revenues, for the three months ended December
31, 2004, compared to $3.6 million, or 37.6% of net revenues, for the three months ended December
31, 2003. The decline in gross profit was primarily the result of lower overhead absorption. Research and Development. Research and development expenses consist of engineering salaries,
benefits, outside consultant fees, and purchased parts and supplies used in development activities.
Research and development expenses for the three months ended December 31, 2004 were $865,000, or
13.5% of net revenues, as compared to $1.1 million, or 11.1% of net revenues, for the three months
ended December 31, 2003. The decrease in research and development expenses in absolute dollars was
due to lower compensation expense resulting from fewer employees, and lower prototype material
costs and consulting fees incurred by our Advanced Development Group, as the multi-year
development initiative that was established to develop a new line of enterprise-class tape
libraries moves towards completion. Sales and Marketing. Sales and marketing expenses consist primarily of employee salaries and
benefits, sales commissions, trade show costs, advertising and travel related expenses.Sales and
marketing expenses for the three months ended December 31, 2004 were $868,000, or 13.6% of net
revenues, compared to $1.0 million, or 10.9% of net revenues, for the three months ended December
31, 2003. The decrease in sales and marketing expenses in absolute dollars, was primarily due to
lower commissions correlated to lower sales volumes and decreased advertising and promotion
expenses during the quarter. General and Administrative. General and administrative expenses include employee salaries and
benefits, deferred compensation related to stock options and restricted stock, provision for
doubtful accounts and professional service fees. General and administrative expenses for the
three months ended December 31, 2004 were $1.1 million, or 17.8% of net revenues, compared with
$1.4 million, or 14.9% of net revenues, for the three months ended December 31, 2003. The decrease
in general and administrative expenses in absolute dollars, was due to a decrease in compensation
expense resulting from fewer employees, the absence of the deferred stock compensation amortization
related to stock options and restricted stock, and the absence of legal costs related to the
Companys dispute with Raytheon Company. The dispute with Raytheon was settled in April 2004. 13




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##### Table of Contents



Investment Income.Investment income was $211,000 in the three months ended December 31,
2004, compared to $192,000 for the three months ended December 31, 2003. The slight increase is
due to shifting a portion of our portfolio to higher yielding securities and benefiting from the
overall higher interest rate environment. Provision (Benefit) for Income Taxes. We did not record a benefit for income taxes for the
three months ended December 31, 2004 as compared to a provision of income taxes of $49,000 equal to
19.1% of our pre-tax income, for the three months ended December 31, 2003. In the second quarter of
fiscal 2005, we did not have any net operating loss carryback availability, and due to uncertainty
surrounding the timing of realizing net operating loss carryforwards, we did not record a tax
benefit. Six Months Ended December 31, 2004 Compared to Six Months Ended December 31, 2003. Net Revenues. Net revenues for the six months ended December 31, 2004 were $12.7 million,
compared with net revenues of $15.5 million for the six months ended December, 2003, a decrease of
$2.8 million. The decrease in revenues is attributed to lower revenues from tape libraries
incorporating LTO and AIT tape drives. In addition, revenue was higher in the first half of fiscal
2004 primarily due to a $1.4 million shipment to a video surveillance OEM which accounted for
approximately 9.0% of our net revenues for the six months ended December 31, 2003. There were no
customers providing greater than 10% of our revenues for the six months ended December 31, 2004. Gross Profit. Gross profit was $4.6 million, or 36.6% of net revenues, for the six months
ended December 31, 2004, compared to $5.8 million, or 37.6% of net revenues, for the six months
ended December 31, 2003. The decline in gross profit was primarily the result of lower overhead
absorption. Research and Development. Research and development expenses for the six months ended
December 31, 2004 were $1.8 million, or 14.3% of net revenues, as compared to $2.2 million, or
14.3% of net revenues, for the six months ended December 31, 2003. The decrease in research and
development expenses in absolute dollars was due to lower compensation expense resulting from fewer
employees, and lower prototype material costs and consulting fees incurred by our Advanced
Development Group, as the multi-year development initiative that was established to develop a new
line of enterprise-class tape libraries moves towards completion. Sales and Marketing. Sales and marketing expenses for the six months ended December 31, 2004
were $1.7 million, or 13.5% of net revenues, compared to $1.7 million, or 11.2% of net revenues,
for the six months ended December 31, 2003. The increase in sales and marketing expenses as a
percent of revenues, was primarily due to increased promotion expenses correlated to revenues
during the six months ended December 31, 2004. General and Administrative. General and administrative expenses for the six months ended
December 31, 2004 were $2.1 million, or 16.3% of net revenues, compared with $2.8 million, or 17.9%
of net revenues, for the six months ended December 31, 2003. The decrease in general and
administrative expenses was due to a decrease in compensation expense resulting from fewer
employees, the absence of the deferred stock compensation amortization related to stock options and
restricted stock and the absence of legal costs related to the Companys dispute with Raytheon
Company. The dispute with Raytheon was settled in April 2004. Investment Income.Investment income was $375,000 in the six months ended December 31, 2004,
compared to $346,000 for the six months ended December 31, 2003. The slight increase is due to
shifting a portion of our portfolio to higher yielding securities and benefiting from the overall
higher interest rate environment. Benefit for Income Taxes. We did not record a benefit for income taxes for the six months
ended December 31, 2004 as compared to a benefit for income taxes of $(197,000), equal to 34.8% of
our pre-tax income, for the six months ended December 31, 2003. In fiscal 2005, we do not have any
net operating loss carryback availability, and due to uncertainty surrounding the timing of
realizing net operating loss carryforwards, we did not record a tax benefit. LIQUIDITY AND CAPITAL RESOURCES Historically, we have funded our capital requirements with cash provided by operations. Net
cash provided by operating activities was $135,000 in the six months ended December 31, 2004 as
compared to cash provided by operations of $179,000 in the six months ended December 31, 2003. For
the six months ended December 31, 2004, cash was provided by operating activities primarily by a 14




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reduction of accounts receivable. For the six months ended December 31, 2003, cash provided
by operating activities was primarily provided by a reduction in inventories and the receipt of a
cash tax refund from the Internal Revenue Service, partially offset by a decrease in accounts
payable. Cash used in investing activities was $2.3 million during the first six months of fiscal 2005,
primarily attributed to the purchase of marketable securities. Cash used by investing activities
during the first six months of fiscal 2004 was $3.3 million, related primarily to the purchase of
marketable securities. Cash used in financing activities was $1.7 million during the first six months of fiscal 2005,
primarily attributed to the repurchase of 359,082 shares of our common stock. Cash
used by investing activities during the first six months of fiscal 2004 was $0.2 million, related
primarily to the repurchase of 62,910 shares of our common stock. As of December 31, 2004, we had $2.5 million in cash and cash equivalents and $31.5 million in
marketable securities. We believe that our existing cash and cash equivalents and anticipated cash
flows from our operating activities, plus funds available from the sale of our marketable
securities, will be sufficient to fund our working capital and capital expenditure needs for at
least the next 12 months. We may utilize cash to invest in businesses, products or technologies
that we believe are strategic. We regularly evaluate other companies and technologies for possible
investment by us. In addition, we have made and may in the future make investments in companies
with whom we have identified potential synergies. However, we have no present commitments or
agreements with respect to any material acquisition of other businesses or technologies. 
 ITEM 3. Quantitative and Qualitative Disclosures About Market Risk We develop products in the United States and sell them worldwide. As a result, our financial
results could be affected by factors such as changes in foreign currency exchange rates or weak
economic conditions in foreign markets. As all sales are currently made in U.S. dollars, a
strengthening of the U.S. dollar could make our products less competitive in foreign markets. Our
interest income is sensitive to changes in the general level of U.S. interest rates, particularly
since the majority of our investments are in short-term instruments. We have no outstanding debt
nor do we utilize derivative financial instruments. Therefore, no quantitative tabular disclosures
are required. 
 ITEM 4. Controls and Procedures We carried out an evaluation, under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness
of the design and operation of Qualstars disclosure controls and procedures as of December 31,
2004, pursuant to Rule 13a-15 under the Securities Exchange Act of 1934. Based upon that
evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure
controls and procedures are effective to ensure that information required to be disclosed by us in
reports that we file or submit under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in the Commissions rules and forms, and to ensure that
the information required to be disclosed by us in reports that we file or submit under the Exchange
Act is accumulated and communicated to our management, including our Chief Executive Officer and
Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. We did not make any changes in our internal control over financial reporting during the second
quarter of fiscal 2005 that materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting. 15




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##### Table of Contents



PART II  OTHER INFORMATION 
 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds ISSUER PURCHASES OF EQUITY SECURITIES(d)Maximum Number(c)
    
    
    
    (or ApproximateTotal Number of
    
    
    
    Dollar Value) ofShares Purchased
    
    
    
    Shares that May(a)
    
    
    
    (b)
    
    
    
    as Part of Publicly
    
    
    
    Yet Be PurchasedTotal Number of
    
    
    
    Average Price Paid
    
    
    
    Announced Plans
    
    
    
    Under the Plans orPeriod
    
    
    Shares Purchased
    
    
    
    per Share
    
    
    
    or Programs
    
    
    
    ProgramsMonth #1
(October 1 to
October 31, 2004)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    360,523Month #2
(November 1 to
November 30, 2004)
    
    
    
    274,552
    
    
    
    
    $5.12
    
    
    
    
    274,552
    
    
    
    
    85,971Month #3
(December 1 to
December 31, 2004)
    
    
    
    84,530
    
    
    
    
    $4.75
    
    
    
    
    84,530
    
    
    
    
    1,441Total
    
    
    
    359,082
    
    
    
    
    $5.09
    
    
    
    
    359,082
    
    
    
    
    1,441
   (1)
    
    On February 12, 2003, we announced that our board had approved a stock repurchase program of
up to 500,000 shares of our common stock. We did not set a time limit for completion of this
program, and it may be discontinued at any time. 
 ITEM 6. Exhibits (a) Exhibits: Exhibit No.
    
    Description31.1
    
    Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 16




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##### Table of Contents



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. QUALSTAR CORPORATIONDated: February 11, 2005
    
    By:
    
    /s/ WILLIAM J. GERVAISWilliam J. Gervais, President,Chief Executive OfficerDated: February 11, 2005
    
    By:
    
    /s/ FREDERIC T. BOYERFrederic T. BoyerPrincipal Financial Officer
 17




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##### Table of Contents



EXHIBIT INDEX Exhibit No.
    
    Description31.1
    
    Certification of Principal
Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
Act of 200231.2
    
    Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 18