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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, 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 x 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 x Total shares of common stock without par value outstanding at April 19, 2004 is
12,590,199.




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QUALSTAR CORPORATION
FORM 10-Q For the quarterly period ended March 31, 2004
 Table of Contents PagePART I  FINANCIAL INFORMATIONITEM 1. Financial Statements:Consolidated Condensed Balance Sheets  March 31, 2004 and June 30, 2003
    
    
    3Consolidated Condensed Statements of Operations  Three months and nine months ended March 31, 2004 and 2003
    
    
    4Consolidated Condensed Statements of Cash Flows  Nine months ended March 31, 2004 and 2003
    
    
    5Consolidated Condensed Statement of Changes in Shareholders Equity  Nine months ended March 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
    
    
    14ITEM 4. Controls and Procedures
    
    
    15PART II OTHER INFORMATIONITEM 1. Legal Proceedings
    
    
    16ITEM 4. Submission of Matters to a Vote of Security Holders
    
    
    16ITEM 6. Exhibits and Reports on Form 8-K
    
    
    16Signatures
    
    
    17EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
 2




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PART I  FINANCIAL INFORMATION 
 ITEM 1. Financial Statements QUALSTAR CORPORATION 
 CONSOLIDATED CONDENSED BALANCE SHEETS
 MARCH 31, 2004 AND JUNE 30, 2003
 (in thousands)
 MARCH 31,
    
    JUNE 30,2004
    
    2003(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    3,206
    
    
    $
    6,236Marketable securities
    
    
    33,155
    
    
    
    29,857Receivables, net of allowances of $439 and $260 at March 31, 2004
and June 30, 2003, respectively
    
    
    3,927
    
    
    
    4,535Inventories
    
    
    7,131
    
    
    
    7,091Prepaid expenses and other current assets
    
    
    533
    
    
    
    234Prepaid income taxes
    
    
    1,128
    
    
    
    1,336Deferred income taxes
    
    
    939
    
    
    
    939Total current assets
    
    
    50,019
    
    
    
    50,228Property and equipment, net
    
    
    1,428
    
    
    
    1,557Other assets
    
    
    261
    
    
    
    311Total assets
    
    $
    51,708
    
    
    $
    52,096LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,244
    
    
    $
    1,136Accrued payroll and related liabilities
    
    
    687
    
    
    
    432Other accrued liabilities
    
    
    1,606
    
    
    
    1,469Total current liabilities
    
    
    3,537
    
    
    
    3,037Deferred income taxes
    
    
    191
    
    
    
    191Total liabilities
    
    
    3,728
    
    
    
    3,228Shareholders equity:Common stock, no par value; 50,000 shares authorized, 12,590
and 12,640 shares issued and outstanding at March 31, 2004 and
June 30, 2003, respectively
    
    
    20,090
    
    
    
    20,366Deferred compensation
    
    
    
    
    
    
    (140
    )Notes from directors
    
    
    (82
    )
    
    
    (156
    )Accumulated other comprehensive loss
    
    
    (133
    )
    
    
    (22
    )Retained earnings
    
    
    28,105
    
    
    
    28,820Total shareholders equity
    
    
    47,980
    
    
    
    48,868Total liabilities and shareholders equity
    
    $
    51,708
    
    
    $
    52,096
 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 NINE MONTHS ENDED MARCH 31, 2004 AND 2003
 (UNAUDITED)
 (in thousands, except per share data)
 THREE MONTHS ENDED
    
    NINE MONTHS ENDEDMARCH 31,
    
    MARCH 31,2004
    
    2003
    
    2004
    
    2003Net revenues
    
    $
    8,302
    
    
    $
    8,189
    
    
    $
    23,834
    
    
    $
    25,389Cost of goods sold
    
    
    5,295
    
    
    
    5,085
    
    
    
    14,993
    
    
    
    15,959Gross profit
    
    
    3,007
    
    
    
    3,104
    
    
    
    8,841
    
    
    
    9,430Operating expenses:Research and development
    
    
    1,070
    
    
    
    1,138
    
    
    
    3,291
    
    
    
    2,905Sales and marketing
    
    
    910
    
    
    
    921
    
    
    
    2,648
    
    
    
    2,826General and administrative
    
    
    1,697
    
    
    
    1,143
    
    
    
    4,484
    
    
    
    3,083Total operating expenses
    
    
    3,677
    
    
    
    3,202
    
    
    
    10,423
    
    
    
    8,814Income (loss) from operations
    
    
    (670
    )
    
    
    (98
    )
    
    
    (1,582
    )
    
    
    616Investment income
    
    
    142
    
    
    
    116
    
    
    
    488
    
    
    
    502Income (loss) before provision (benefit) for income taxes
    
    
    (528
    )
    
    
    18
    
    
    
    (1,094
    )
    
    
    1,118Provision (benefit) for income taxes
    
    
    (182
    )
    
    
    7
    
    
    
    (379
    )
    
    
    526Net income (loss)
    
    $
    (346
    )
    
    $
    11
    
    
    $
    (715
    )
    
    $
    592Earnings
(loss) per share:Basic earnings (loss) per share
    
    $
    (0.03
    )
    
    $
    0.00
    
    
    $
    (0.06
    )
    
    $
    0.05Diluted earnings (loss) per share
    
    $
    (0.03
    )
    
    $
    0.00
    
    
    $
    (0.06
    )
    
    $
    0.05Shares used to compute earnings (loss) per share:Basic
    
    
    12,587
    
    
    
    12,614
    
    
    
    12,574
    
    
    
    12,579Diluted
    
    
    12,587
    
    
    
    12,641
    
    
    
    12,574
    
    
    
    12,667
 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 NINE MONTHS ENDED MARCH 31, 2004 AND 2003
 (UNAUDITED)
 (in thousands)
 Nine Months EndedMarch 31,2004
    
    2003OPERATING ACTIVITIES:Net income (loss)
    
    $
    (715
    )
    
    $
    592Adjustments to reconcile net income (loss) to cash
provided by operating activities:Depreciation and amortization
    
    
    314
    
    
    
    278Amortization of deferred compensation
    
    
    140
    
    
    
    237Provision for (recovery of) bad debts and returns
    
    
    308
    
    
    
    (25
    )Accrued interest on directors notes
    
    
    (5
    )
    
    
    (15
    )Changes in operating assets and liabilities:Accounts receivable
    
    
    300
    
    
    
    3,149Inventories
    
    
    (40
    )
    
    
    2,540Prepaid expenses and other assets
    
    
    (285
    )
    
    
    (41
    )Prepaid income taxes and income taxes payable
    
    
    208
    
    
    
    (366
    )Accounts payable
    
    
    108
    
    
    
    (746
    )Accrued liabilities
    
    
    392
    
    
    
    268Net cash provided by operating activities
    
    
    725
    
    
    
    5,871INVESTING ACTIVITIES:Purchases of property, equipment and leasehold improvements
    
    
    (149
    )
    
    
    (428
    )Proceeds from sale of marketable securities
    
    
    31,456
    
    
    
    28,857Purchase of marketable securities
    
    
    (34,865
    )
    
    
    (30,375
    )Purchase of assets of N2Power, Inc.
    
    
    
    
    
    
    (288
    )Net cash used in investing activities
    
    
    (3,558
    )
    
    
    (2,234
    )FINANCING ACTIVITIES:Proceeds from exercise of stock options
    
    
    38
    
    
    
    144Repurchase of common stock
    
    
    (314
    )
    
    
    (311
    )Principal and interest payments on directors notes
    
    
    79
    
    
    
    166Net cash used in financing activities
    
    
    (197
    )
    
    
    (1
    )Net (decrease) increase in cash and cash equivalents
    
    
    (3,030
    )
    
    
    3,636Cash and cash equivalents at beginning of period
    
    
    6,236
    
    
    
    4,859Cash and cash equivalents at end of period
    
    $
    3,206
    
    
    $
    8,495Supplemental cash flow disclosure:Income taxes paid
    
    $
    
    
    
    $
    340
 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
 NINE MONTHS ENDED MARCH 31, 2004
 (UNAUDITED)
 (in thousands)
 ACCUMULATEDCOMMON STOCK
    
    DEFERRED
    
    NOTESFROM
    
    OTHERCOMPREHENSIVE
    
    RETAINEDSHARES
    
    AMOUNT
    
    COMPENSATION
    
    DIRECTORS
    
    LOSS
    
    EARNINGS
    
    TOTALBalance at July 1, 2003
    
    
    12,640
    
    
    $
    20,366
    
    
    $
    (140
    )
    
    $
    (156
    )
    
    $
    (22
    )
    
    $
    28,820
    
    
    $
    48,868Amortization of deferred compensation
    
    
    
    
    
    
    
    
    
    
    140
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    140Proceeds from exercise of stock options
    
    
    13
    
    
    
    38
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    38Retirement of shares pursuant to stock repurchase
    
    
    (63
    )
    
    
    (314
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (314
    )Accrued interest on directors notes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5
    )
    
    
    
    
    
    
    
    
    
    
    (5
    )Principal and interest payments on directors notes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    79
    
    
    
    
    
    
    
    
    
    
    
    79Comprehensive loss:Change in unrealized losses on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (111
    )
    
    
    
    
    
    
    (111
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (715
    )
    
    
    (715
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (826
    )Balance at March 31, 2004
    
    
    12,590
    
    
    $
    20,090
    
    
    $
    
    
    
    $
    (82
    )
    
    $
    (133
    )
    
    $
    28,105
    
    
    $
    47,980
 See the accompanying notes to these condensed consolidated financial statements. 6




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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
 MARCH 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, 2003 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 26, 2003.
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 March 31, 2004, consolidated results of operations for
the three months and nine months ended March 31, 2004 and 2003, and
consolidated cash flows for the nine months ended March 31, 2004 and 2003.
Operating results for the three and nine month periods ended March 31, 2004 are
not necessarily indicative of results to be expected for a full year. NOTE 2. EARNINGS (LOSS) PER SHARE The following table sets forth the computation of basic and diluted net
income (loss) per share for the three months and nine months ended March 31, 2004 and
2003: THREE MONTHS ENDED
    
    NINE MONTHS ENDEDMARCH 31,
    
    MARCH 31,2004
    
    2003
    
    2004
    
    2003Numerator:Net income (loss)
    
    $
    (346
    )
    
    $
    11
    
    
    $
    (715
    )
    
    $
    592Denominator:Denominator for basic net income (loss) per
share  weighted average shares
    
    
    12,587
    
    
    
    12,614
    
    
    
    12,574
    
    
    
    12,579Dilutive potential common shares from employee
stock options and restricted stock
    
    
    
    
    
    
    27
    
    
    
    
    
    
    
    88Denominator for diluted net income (loss) per
share  adjusted weighted average shares and
assumed conversions
    
    
    12,587
    
    
    
    12,641
    
    
    
    12,574
    
    
    
    12,667Basic net income (loss) per share
    
    $
    (0.03
    )
    
    $
    0.00
    
    
    $
    (0.06
    )
    
    $
    0.05Diluted net income (loss) per share
    
    $
    (0.03
    )
    
    $
    0.00
    
    
    $
    (0.06
    )
    
    $
    0.05
 Shares issuable under stock options of 587,000 and 467,000 at March 31, 2004
and 2003, respectively, have been excluded from the computation of diluted
earnings (loss) 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. The Company
generally awards options for a fixed number of shares at an option price equal
to the fair value of the stock at the date of grant. The Company has adopted
the disclosure only provisions of the Financial Accounting Standards Boards
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 and earnings per share would have
been reduced to the pro forma amounts indicated below: 7




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THREE MONTHS
    
    NINE MONTHSENDED
    
    ENDEDMARCH 31,
    
    MARCH 31,2004
    
    2003
    
    2004
    
    2003Net income (loss) as reported
    
    $
    (346
    )
    
    $
    11
    
    
    $
    (715
    )
    
    $
    592Stock-based employee compensation cost included in reported
net income (loss)
    
    
    11
    
    
    
    65
    
    
    
    140
    
    
    
    237Pro forma stock-based employee compensation cost under SFAS 123
    
    
    (128
    )
    
    
    (162
    )
    
    
    (384
    )
    
    
    (486
    )Pro forma net income (loss)
    
    $
    (463
    )
    
    $
    (86
    )
    
    $
    (959
    )
    
    $
    343Earnings (loss) per share:Basic  as reported
    
    $
    (0.03
    )
    
    $
    0.00
    
    
    $
    (0.06
    )
    
    $
    0.05Basic  pro forma
    
    $
    (0.03
    )
    
    $
    0.00
    
    
    $
    (0.06
    )
    
    $
    0.05Diluted  as reported
    
    $
    (0.04
    )
    
    $
    (0.01
    )
    
    $
    (0.08
    )
    
    $
    0.03Diluted  pro forma
    
    $
    (0.04
    )
    
    $
    (0.01
    )
    
    $
    (0.08
    )
    
    $
    0.03Basic Weighted Average Shares
    
    
    12,587
    
    
    
    12,614
    
    
    
    12,574
    
    
    
    12,579Diluted Weighted Average Shares
    
    
    12,587
    
    
    
    12,641
    
    
    
    12,574
    
    
    
    12,667
 NOTE 4. MARKETABLE SECURITIES Marketable securities consist primarily of high-quality corporate, federal
and state government 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 the
Company 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 the Companys marketable securities were classified
as available-for-sale at March 31, 2004 and June 30, 2003. 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. NOTE 5. INVENTORIES Inventories are stated at the lower of cost (first-in, first-out basis) or
market. Inventory is comprised as follows: MARCH 31, 2004
    
    JUNE 30, 2003Raw materials.
    
    $
    6,570
    
    
    $
    6,454Finished goods
    
    
    561
    
    
    
    637$
    7,131
    
    
    $
    7,091
 NOTE 6. COMPREHENSIVE INCOME (LOSS) For the nine months ended March 31, 2004 and 2003, comprehensive income
(loss) amounted to approximately $(0.8) million and $0.5 million, respectively.
The difference between net income (loss) and comprehensive income (loss)
relates to the changes in the unrealized losses or gains the Company recorded
for its available-for-sale securities. NOTE 7. BUSINESS ACQUISITIONS On July 11, 2002, the Company acquired the assets and intellectual
properties of N2Power, Incorporated (N2Power), a privately held company which
designs and produces small and efficient open-frame switching power supplies.
The consideration for this acquisition was $250,000 plus acquisition expenses
of $38,000. The purchase price was primarily allocated to a patent which will
be amortized over 5 years. The accompanying consolidated financial statements
include the operations of N2Power from the date of acquisition. 8




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NOTE 8. 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 March 31, 2004, the Company did not repurchase any shares of its common
stock. During the nine month period ended March 31, 2004, the Company
repurchased a total of 62,910 shares of its common stock at a total cost of
$314,000. From February 12, 2003 through March 31, 2004, the Company had
repurchased a total of 139,477 shares of its common stock at a total cost of
approximately $658,084, or an average price of approximately $4.72 per share. NOTE 9. LEGAL PROCEEDINGS On January 10, 2003, Raytheon Company (Raytheon) filed a complaint in
the United States District Court for the Eastern District of Texas alleging
that Qualstar and eight other named defendants infringed on a patent owned by
Raytheon entitled Mass Data Storage Library. Raytheon filed an amended
complaint on or about February 6, 2003, which included an allegation that
Qualstars tape libraries infringed on Raytheons patent. On April 2, 2004,
Raytheon and Qualstar entered into a written settlement agreement pursuant to
which all claims between the parties alleged in the litigation were dismissed
with prejudice. The costs to settle this dispute have been included in our
results of operations in general and administrative expenses for the most
recent quarter and have not had a material adverse effect on our financial
position. Qualstar may be involved in litigation or other legal proceedings from
time to time in the normal course of business. 9




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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, 2003 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. Tape libraries consist of cartridge tape drives, arrays
of tape cartridges and robotics. The robotics move the tape cartridges from/to
their storage locations to/from the tape drives under software control. Our
tape libraries provide storage solutions for organizations requiring backup,
recovery and archival storage of critical electronic information. Our tape
libraries also can provide near-online storage as an alternative to disk
drives. Our products are compatible with commonly used computer operating
systems, including UNIX, Windows NT, NetWare and Linux. Our tape libraries also
are compatible with a wide range of third party storage management software
packages, such as those supplied by Computer Associates, EMC, Tivioli and
Veritas. We offer tape libraries for multiple tape drive technologies, including
those using Advanced Intelligent Tape(AIT), Super Advanced Intelligent
Tape(SAIT), Super Digital Linear Tape(SDLT), and Linear Tape Open(LTO)tape
drives and media. These tape drive technologies compete with each other in
terms of their native storage capacity as well as their ability to quickly and
efficiently read and write data. Since all models of our tape libraries are
required to have tape drives to operate, the overall storage performance of our
tape libraries is associated with the performance of the tape drives they
contain. Historically, our business has been focused on selling tape libraries
that incorporate AIT technology, as the majority of our revenue has been
generated from this product line. The current generation of AIT tape drives
(AIT3) contain a maximum native capacity of 100 gigabytes per tape. In February
of 2003, the capacity of tape drives using the LTO (Linear Tape Open) half-inch
tape format was increased to a maximum of 200 gigabytes, native, surpassing
that of AIT tape drives. In recent quarters, we have noticed a downward trend
in the amount of library shipments which incorporate AIT technology and an
upward trend in shipments of libraries which incorporate tape drive technology
based upon a half-inch formats such as LTO, SDLT, and SAIT. We sell our tape libraries worldwide, primarily to value added resellers,
system integrators, and original equipment manufacturers. These customers
integrate our products with software from third party vendors to provide
storage solutions, which they in turn resell to end users. We custom configure
each of our libraries based on each customers individual requirements, with a
normal delivery time of one to three working days. This rapid fulfillment of
customer orders allows our resellers to minimize their inventory levels and
allows us to compete effectively with distribution channels used by our
competitors. Qualstar was incorporated in California in 1984. The 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 8mm and other tape drive technologies and tape media
formats. 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 other OEM customers for incorporation into their products.
Most of the N2Power products are sold under the N2Power brand name through
outside sales representatives and distributors to OEMs. Some N2Power products
are sold under private label brands. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of our financial condition and results of
operations is based upon our financial statements, which 10




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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 products to our customers. Title
and risk of loss transfer to the customer when the product leaves our dock in
Simi Valley, California. In general, these customers are allowed to return the
product, free of penalty, within 30 days of shipment if the product does not
meet specification. 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 maintain an allowance for doubtful accounts and returns 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
an impairment of their ability to make payments, additional allowances may be
required. In addition, if the financial condition of our customers for which
we have already established allowances were to improve, then their ability to
make payments to us would be less impaired, potentially making such allowances
unnecessary. Inventory Reserves 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 Costs 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 actively 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. Accounting for Income Taxes We do not currently record a valuation allowance to reduce our deferred
tax assets because we believe that the assets are 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 a valuation
allowance, in the event we were to determine that we would not be able to
realize all or part of our deferred tax assets 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 The following table sets forth items in our statement of operations as a
percentage of net revenues for the periods presented. The data has been
derived from our unaudited condensed consolidated financial statements. 11




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Three Months Ended
    
    Nine Months EndedMarch 31,
    
    March 31,2004
    
    2003
    
    2004
    
    2003Net revenues
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of goods sold
    
    
    63.8
    
    
    
    62.1
    
    
    
    62.9
    
    
    
    62.9Gross profit
    
    
    36.2
    
    
    
    37.9
    
    
    
    37.1
    
    
    
    37.1Operating expenses:Research and development
    
    
    12.9
    
    
    
    13.9
    
    
    
    13.8
    
    
    
    11.4Sales and marketing
    
    
    11.0
    
    
    
    11.2
    
    
    
    11.1
    
    
    
    11.1General and administrative
    
    
    20.4
    
    
    
    14.0
    
    
    
    18.8
    
    
    
    12.1Total operating expenses
    
    
    44.3
    
    
    
    39.1
    
    
    
    43.7
    
    
    
    34.6Income (loss) from operations
    
    
    (8.1
    )
    
    
    (1.2
    )
    
    
    (6.6
    )
    
    
    2.5Investment income
    
    
    1.7
    
    
    
    1.4
    
    
    
    2.0
    
    
    
    2.0Income (loss) before provision
(benefit) for income taxes
    
    
    (6.4
    )
    
    
    0.2
    
    
    
    (4.6
    )
    
    
    4.5Provision (benefit) for income taxes
    
    
    (2.2
    )
    
    
    0.1
    
    
    
    (1.6
    )
    
    
    2.2Net income (loss)
    
    
    (4.2
    )%
    
    
    0.1
    %
    
    
    (3.0
    )%
    
    
    2.3
    %
 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
    
    Nine Months EndedMarch 31,
    
    March 31,2004
    
    2003
    
    2004
    
    2003Tape library revenues:TLS
    
    
    56.9
    %
    
    
    67.9
    %
    
    
    58.3
    %
    
    
    67.7
    %RLS
    
    
    17.5
    
    
    
    6.4
    
    
    
    16.0
    
    
    
    4.074.4
    
    
    
    74.3
    
    
    
    74.3
    
    
    
    71.7Other revenues:Service
    
    
    5.8
    
    
    
    6.8
    
    
    
    7.3
    
    
    
    6.2Media
    
    
    11.7
    
    
    
    9.3
    
    
    
    6.4
    
    
    
    8.19 Track, Spares, Upgrades, Power Supplies
    
    
    8.1
    
    
    
    9.6
    
    
    
    12.0
    
    
    
    14.0100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
 Three Months Ended March 31, 2004 Compared to Three Months Ended March 31,
2003. NET REVENUES. Net revenues for the three months ended March 31, 2004 were
$8.3 million, compared with net revenues of $8.2 million for the three months
ended March 31, 2003, an increase of $0.1 million. Although overall revenue was
relatively unchanged in the third quarter of fiscal 2004, compared to the same
quarter a year ago, there was a change in the composition of net revenues.
During the quarter ended March 31, 2004, we derived more of our net revenues
from the sale of RLS tape libraries, as a percentage of net revenues, than we
did in the same quarter a year ago. 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 $3.0 million, or 36.2% of net revenues, for the three months
ended March 31, 2004, compared to $3.1 million, or 37.9% of net revenues, for
the three months ended March 31, 2003. The decrease in our gross profit as a
percentage of net revenues was primarily due to a shift in our product mix.
During the three month period ended March 31, 2004, we sold fewer large
libraries than we did in the same period one year prior. In general, larger
tape libraries (up to 12 tape drives and 120  600 tape slots per library) have
higher gross margins than do smaller libraries (up to 6 tape drives and 10 
120 tape slots per library). Although a majority of our net revenue comes from
the sale of tape libraries and drives, other products such as tape media and
service contracts can influence our overall gross profit margin. Tape media,
which is available through general distribution channels, historically has had
lower gross margins when compared to the tape libraries and drives in which it
is used. During the 12




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quarter, a larger portion of our net revenues were attributable to media
shipments. Furthermore, our service revenues are reported net of cost,
therefore decreasing overall company gross margin in periods where service
revenues have declined. During the three month period ended March 31, 2004, we
generated a lower percentage of our net revenue from service than in the same
period last year. RESEARCH AND DEVELOPMENT. Research and development expenses consist
primarily of employee salaries and benefits, consulting fees, purchased parts
and supplies used in development activities of our Advanced Development Group
located in Boulder, Colorado, as well as our engineering group located in Simi
Valley, California. Research and development expenses for the three months
ended March 31, 2004 were $1.1 million, or 12.9% of net revenues, as compared
to $1.1 million, or 13.9% of net revenues, for the three months ended March 31,
2003. The level of research and development expenses in absolute dollars
remained the same, and is attributed to our ongoing release / improvement of
our RLS and TLS library series as well as our Advanced Development Groups
multi-year research and development initiative, which we established in late
fiscal 2002 to develop a new line of enterprise-class tape libraries. We
expect research and development expenses to remain at approximately the current
level in absolute terms in the fourth quarter of fiscal 2004. 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 March 31, 2004 were $0.9 million or 11.0% of net revenues,
compared to $0.9 million, or 11.2% of net revenues, for the three months ended
March 31, 2003. We expect sales and marketing expenses to remain equal to or
slightly increase from prior levels. GENERAL AND ADMINISTRATIVE. General and administrative expenses consist of
employee salaries and benefits, business insurance, provision for doubtful
accounts and returns, professional fees, legal expenses, and deferred
compensation related to stock options and deferred equity incentives. General
and administrative expenses for the three months ended March 31, 2004 were $1.7
million, or 20.4% of net revenues, compared with $1.1 million, or 14.0% of net
revenues, for the three months ended March 31, 2003. The increase in general
and administrative expenses was due primarily to legal fees and costs
associated with the settlement of the Raytheon patent infringement lawsuit. We
do not expect to incur any additional costs related to this litigation in the
future. In addition, we increased our provision for bad debts by $0.2 million
in the current quarter as the result of financial difficulties experienced by
two customers. We expect general and administrative expenses to decrease
during the fourth quarter of fiscal 2004. INVESTMENT INCOME. Investment income was $142,000 in the quarter ended
March 31, 2004, comparable with investment income of $116,000 in the quarter
ended March 31, 2003. PROVISION (BENEFIT) FOR INCOME TAXES. We recorded a benefit for income
taxes of $(182,000) equal to 34.5% of our pre-tax loss, for the three months
ended March 31, 2004. This compares with a provision for income taxes of
$7,000, or 38.9% of pre-tax income for the three months ended March 31, 2003.
The percentage of the provision for income taxes to pre-tax loss, for the three
months ended March 31, 2004, was recorded to yield an annualized effective tax
rate of 34.6% based on a year to date tax provision estimate, and is comparable
to our fiscal year 2003 rate of 33.3%. Future operating results may change
this estimate. Nine Months Ended March 31, 2004 Compared to Nine Months Ended March 31, 2003. NET REVENUES. Net revenues for the nine months ended March 31, 2004 were
$23.8 million, compared with net revenues of $25.4 million for the nine months
ended March 31, 2003, a decrease of $1.6 million. Revenue was lower for the
nine months ended March 31, 2004 due to reduced demand for our tape libraries
which incorporate AIT (Advanced Intelligent Tape) technology. Although we offer
all major tape formats in our libraries, historically we have sold mostly
AIT-based tape libraries. Recently, sales of our libraries incorporating
half-inch tape technologies, such as LTO, SAIT (Super Advanced Intelligent
Tape), and SDLT have been increasing, but these increases have not been
sufficient to offset the decline in sales of our libraries using AIT tape
technology. GROSS PROFIT. Gross profit was $8.8 million or 37.1% of net revenues, for
the nine months ended March 31, 2004, compared to $9.4 million, or 37.1% of net
revenues, for the nine months ended March 31, 2003. Gross profit as a
percentage of net revenues was comparable. RESEARCH AND DEVELOPMENT. Research and development expenses for the nine
months ended March 31, 2004 were $3.3 million, or 13.8% of net revenues, as
compared to $2.9 million, or 11.4% of net revenues, for the nine months ended
March 31, 2003. The increase in research and development costs is primarily due
to an increase in employee salary and benefit costs associated with our
multi-year research and development initiative at our Advanced Development
Group, which we established in late fiscal 2002 in Boulder, Colorado. 13




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SALES AND MARKETING. Sales and marketing expenses for the nine months
ended March 31, 2004 were $2.6 million, or 11.1% of net revenues, compared to
$2.8 million, or 11.1% of net revenues, for the nine months ended March 31,
2003. GENERAL AND ADMINISTRATIVE. General and administrative expenses for the
nine months ended March 31, 2004 were $4.5 million, or 18.8% of net revenues,
compared with $3.1 million, or 12.1% of net revenues, for the nine months ended
March 31, 2003. The increase in general and administrative expenses was due
primarily to legal fees and costs associated with our settlement of the
Raytheon patent infringement lawsuit. We do not expect to incur any additional
costs related to this litigation in the future. In addition, our provision for
bad debts is higher in the current fiscal year than compared to the prior year. INVESTMENT INCOME. Investment income for the nine months ended March 31,
2004 was $488,000 comparable with investment income of $502,000 for the nine
months ended March 31, 2003. PROVISION (BENEFIT) FOR INCOME TAXES. The benefit for income taxes was
$(379,000), or 34.6% of pre-tax loss, for the nine months ended March 31, 2004,
compared to a provision for income taxes of $526,000, or 47.0% of pre-tax
income, for the nine months ended March 31, 2003. The decrease in the
percentage of the provision (benefit) for income taxes to pre-tax income (loss)
was primarily due to $60,000 of additional provision, net of certain items,
taken during the three months ended December 31, 2002 for items relating to
prior years. LIQUIDITY AND CAPITAL RESOURCES Historically, we have funded our capital requirements with net cash
provided by operating activities. Net cash provided by operating activities was
$0.7 million in the nine months ended March 31, 2004 and $5.9 million in the
nine months ended March 31, 2003. For the nine months ended March 31, 2004,
cash provided by operating activities was primarily provided by collection of
accounts receivable and the receipt of a tax refund. For the nine months ended
March 31, 2003, cash provided by operating activities was primarily provided by
collection of accounts receivable and reductions in inventory levels. Net cash used in investing activities was $3.6 million and $2.2 million
during the first nine months of fiscal years 2004 and 2003, respectively. The
cash used in investing activities for these periods was primarily attributed to
purchases of marketable securities. There was no significant cash used or provided by financing activities
during the nine month period ended March 31, 2004, or March 31, 2003. On February 12, 2003, we announced that our Board of Directors had
authorized a program to repurchase up to 500,000 shares of our common stock in
open market transactions, block purchases or private transactions. These stock
repurchases will be funded by available working capital and are not expected to
negatively impact our liquidity. There is no time limit for the completion of
the stock repurchase program and it may be discontinued at any time. We used
$314,000 to repurchase common stock during the nine months ended March 31,
2003. As of March 31, 2004, we had $3.2 million in cash and cash equivalents and
$33.2 million in marketable securities. We believe our existing cash and cash
equivalents, plus anticipated cash flows from our operating activities, and
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 we believe are strategic. We periodically evaluate other companies
and technologies for possible investment by us. In addition, we have made and
expect to 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.
Since all sales are currently made in U.S. dollars, a strengthening of the US
dollar could make our products less competitive in foreign markets. Our
investment income is sensitive to changes in the general level of US 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 14




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We carried out an evaluation, under the supervision and with the
participation of our management, including our Chief Executive Officer and our
Chief financial Officer, of the effectiveness of the design and operation of
Qualstars disclosure controls and procedures as of March 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 those disclosure controls and procedures were adequate to ensure that
information required to be disclosed in this report is recorded, processed,
summarized and reported in a timely basis. There have been no significant changes made in our internal controls over
financial reporting (as defined in rules 13a-15(f) and 15d-15(f) of the
Exchange Act) during the most recent fiscal quarter. 15




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##### Table of Contents



PART II  OTHER INFORMATION 
 ITEM 1. Legal Proceedings On January 10, 2003, Raytheon Company (Raytheon) filed a complaint in
the United States District Court for the Eastern District of Texas alleging
that Qualstar and eight other named defendants infringed on a patent owned by
Raytheon entitled Mass Data Storage Library. Raytheon filed an amended
complaint on or about February 6, 2003, which included an allegation that
Qualstars tape libraries infringed on Raytheons patent. On April 2, 2004,
Raytheon and Qualstar entered into a written settlement agreement pursuant to
which all claims between the parties alleged in the litigation were dismissed
with prejudice. The costs to settle this dispute have been included in our
results of operations in general and administrative expenses for the most
recent quarter and have not had a material adverse effect on our financial
position. Qualstar may be involved in litigation or other legal proceedings from
time to time in the normal course of business. 
 ITEM 4. Submission of Matters to a Vote of Security Holders The following matters were voted upon at the Annual Meeting of
Stockholders of the Company held on February 12, 2004:  1.
    
    The following persons were elected as directors to serve a one year
term expiring at the Annual Meeting of Stockholders to be held in 2005
or until their successors are elected and qualified: Number of Votes CastName
    
    For
    
    Authority WithheldWilliam J. Gervais
    
    
    11,311,830
    
    
    
    264,228Richard A. Nelson
    
    
    11,312,330
    
    
    
    263,728Bruce E. Gladstone
    
    
    11,491,601
    
    
    
    84,457Robert E. Rich
    
    
    11,341,530
    
    
    
    234,528Trude C. Taylor
    
    
    11,491,344
    
    
    
    84,714Robert T. Webber
    
    
    11,491,601
    
    
    
    84,457
 
 ITEM 6. Exhibits and Reports on Form 8-K (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.
 (b) Reports on Form 8-K. We filed or furnished the following current reports on
Form 8-K during the third quarter of fiscal 2004: (1) On January 5, 2004, we furnished information pursuant to Item 12 of Form
8-K relating to higher than anticipated revenues for the second quarter of
fiscal 2004. (2) On February 5, 2004, we furnished information pursuant to Item 12 of
Form 8-K relating to our results of operations for the second quarter of
fiscal 2004. 16




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. QUALSTAR CORPORATIONDated: May 10, 2004
    
    By:
    
    /s/ WILLIAM J. GERVAISWilliam J. Gervais, President,Chief Executive OfficerDated: May 10, 2004
    
    By:
    
    /s/ FREDERIC T. BOYERFrederic T. BoyerPrincipal Financial Officer
 17




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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