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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 September 30, 2004 [  ]
    
    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 [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X] Total shares of common stock without par value outstanding at September 30,
2004 is 12,608,199.




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QUALSTAR CORPORATION
FORM 10-Q
For the quarterly period ended September 30, 2004 Table of Contents PagePART I  FINANCIAL INFORMATIONITEM 1. Financial Statements:Consolidated Condensed Balance Sheets  September 30, 2004 and June 30, 2004
    
    
    3Consolidated Condensed Statements of Operations  Three months ended September, 2004 and 2003
    
    
    4Consolidated Condensed Statements of Cash Flows  Three months ended September, 2004 and 2003
    
    
    5Consolidated Condensed Statement of Changes in Shareholders Equity  Three months ended September, 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 6. Exhibits
    
    
    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
SEPTEMBER 30, 2004 AND JUNE 30, 2004
 (in thousands)
 SEPTEMBER,
    
    JUNE 30,2004
    
    2004(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    4,173
    
    
    $
    6,401Marketable securities
    
    
    31,997
    
    
    
    29,376Receivables, net of allowances of $206 and $217
at September 30, 2004 and June 30, 2004,
respectively
    
    
    3,763
    
    
    
    4,628Inventories
    
    
    7,400
    
    
    
    7,418Prepaid expenses and other current assets
    
    
    593
    
    
    
    470Prepaid income taxes
    
    
    826
    
    
    
    1,072Deferred income taxes
    
    
    594
    
    
    
    594Total current assets
    
    
    49,346
    
    
    
    49,959Property and equipment, net
    
    
    1,423
    
    
    
    1,439Other assets
    
    
    237
    
    
    
    249Total assets
    
    $
    51,006
    
    
    $
    51,647LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    597
    
    
    $
    1,171Accrued payroll and related liabilities
    
    
    613
    
    
    
    500Other accrued liabilities
    
    
    1,700
    
    
    
    1,754Total current liabilities
    
    
    2,910
    
    
    
    3,425Deferred income taxes
    
    
    158
    
    
    
    158Shareholders equity:Common stock, no par value; 50,000 shares
authorized, 12,608 and 12,596 shares issued
and outstanding at September 30, 2004 and June
30, 2004, respectively
    
    
    20,180
    
    
    
    20,121Notes from directors
    
    
    (4
    )
    
    
    (45
    )Accumulated other comprehensive loss
    
    
    (91
    )
    
    
    (101
    )Retained earnings
    
    
    27,853
    
    
    
    28,089Total shareholders equity
    
    
    47,938
    
    
    
    48,064Total liabilities and shareholders equity
    
    $
    51,006
    
    
    $
    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 ENDED SEPTEMBER 30, 2004 AND 2003
 (UNAUDITED)
(in thousands, except per share data)
 THREE MONTHS ENDEDSEPTEMBER 30,2004
    
    2003Net revenues
    
    $
    6,305
    
    
    $
    5,976Cost of goods sold
    
    
    3,972
    
    
    
    3,736Gross profit
    
    
    2,333
    
    
    
    2,240Operating expenses:Research and development
    
    
    954
    
    
    
    1,158Sales and marketing
    
    
    847
    
    
    
    701General and administrative
    
    
    932
    
    
    
    1,358Total operating expenses
    
    
    2,733
    
    
    
    3,217Loss from operations
    
    
    (400
    )
    
    
    (977
    )Investment income
    
    
    164
    
    
    
    155Loss before income taxes
    
    
    (236
    )
    
    
    (822
    )Benefit for income taxes
    
    
    
    
    
    
    (246
    )Net loss
    
    $
    (236
    )
    
    $
    (576
    )Loss per share:Basic
    
    $
    (0.02
    )
    
    $
    (0.05
    )Diluted
    
    $
    (0.02
    )
    
    $
    (0.05
    )Shares used to compute loss per share:Basic
    
    
    12,604
    
    
    
    12,586Diluted
    
    
    12,604
    
    
    
    12,586
 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 THREE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
 (UNAUDITED)
(in thousands)
 Three Months EndedSeptember 30,2004
    
    2003OPERATING ACTIVITIES:Net loss
    
    $
    (236
    )
    
    $
    (576
    )Adjustments to reconcile net loss to net cash provided by operating activities:Depreciation and amortization
    
    
    114
    
    
    
    103Recovery of bad debts and returns
    
    
    (12
    )
    
    
    (1
    )Amortization of deferred compensation
    
    
    
    
    
    
    65Accrued interest on directors notes
    
    
    
    
    
    
    (2
    )Changes in operating assets and liabilities:Accounts receivable
    
    
    877
    
    
    
    1,203Inventories
    
    
    18
    
    
    
    (217
    )Prepaid expenses and other assets
    
    
    (123
    )
    
    
    (308
    )Prepaid income taxes
    
    
    246
    
    
    
    341Accounts payable
    
    
    (574
    )
    
    
    262Accrued payroll and related liabilities
    
    
    113
    
    
    
    144Other accrued liabilities
    
    
    (54
    )
    
    
    (11
    )Net cash provided by operating activities
    
    
    369
    
    
    
    1,003INVESTING ACTIVITIES:Purchases of property, equipment and leasehold improvements
    
    
    (86
    )
    
    
    (18
    )Proceeds from sale of marketable securities
    
    
    1,000
    
    
    
    10,555Purchase of marketable securities
    
    
    (3,611
    )
    
    
    (8,995
    )Net cash provided by (used in) investing activities
    
    
    (2,697
    )
    
    
    1,542FINANCING ACTIVITIES:Proceeds from exercise of stock options
    
    
    59
    
    
    
    Principal and interest payments on directors notes
    
    
    41
    
    
    
    Net cash provided by financing activities
    
    
    100
    
    
    
    Net increase (decrease) in cash and cash equivalents
    
    
    (2,228
    )
    
    
    2,545Cash and cash equivalents at beginning of period
    
    
    6,401
    
    
    
    6,236Cash and cash equivalents at end of period
    
    $
    4,173
    
    
    $
    8,781Supplemental cash flow disclosure:Income taxes paid
    
    $
    3
    
    
    $
    10
 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
THREE MONTHS ENDED SEPTEMBER 30, 2004
 (UNAUDITED)
(in thousands)
 ACCUMULATEDCOMMON STOCK
    
    NOTES
    
    OTHERFROM
    
    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
    
    
    12
    
    
    
    59
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    59Principal and interest payments on directors notes
    
    
    
    
    
    
    
    
    
    
    41
    
    
    
    
    
    
    
    
    
    
    
    41Comprehensive loss:Change in unrealized losses on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10
    
    
    
    
    
    
    
    10Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (236
    )
    
    
    (236
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (226
    )Balance at September 30, 2004
    
    
    12,608
    
    
    $
    20,180
    
    
    $
    (4
    )
    
    $
    (91
    )
    
    $
    27,853
    
    
    $
    47,938
 See the accompanying notes to these condensed consolidated financial statements. 6




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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
SEPTEMBER 30, 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 September 30, 2004, consolidated results of operations
for the three months ended September 30, 2004, and consolidated cash flows for
the three months ended September 30, 2004. Operating results for the three
month period ended September 30, 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 ended September 30, 2004 and 2003: THREE MONTHS ENDEDSEPTEMBER 30,2004
    
    2003Numerator:Net loss
    
    $
    (236
    )
    
    $
    (576
    )Denominator:Denominator for basic net loss per share -
weighted average shares
    
    
    12,604
    
    
    
    12,586Dilutive potential common shares from
employee stock options and restricted stock
    
    
    
    
    
    
    Denominator for diluted net loss per share -
adjusted weighted average shares and assumed
conversions
    
    
    12,604
    
    
    
    12,586Basic net loss per share
    
    $
    (0.02
    )
    
    $
    (0.05
    )Diluted net loss per share
    
    $
    (0.02
    )
    
    $
    (0.05
    )
 All shares related to stock options are excluded at September, 2004 and 2003,
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 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 loss and loss per share would have been
reduced to the pro forma amounts indicated below: 7




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THREE MONTHSENDEDSEPTEMBER 30,2004
    
    2003Net loss as reported
    
    $
    (236
    )
    
    $
    (576
    )Stock-based employee compensation cost included in reported net loss
    
    
    
    
    
    
    65Pro forma stock-based employee compensation cost under SFAS 123
    
    
    (69
    )
    
    
    (120
    )Pro forma net loss
    
    $
    (305
    )
    
    $
    (631
    )Loss per share:Basic  as reported
    
    $
    (0.02
    )
    
    $
    (0.05
    )Basic  pro forma
    
    $
    (0.02
    )
    
    $
    (0.05
    )Diluted  as reported
    
    $
    (0.02
    )
    
    $
    (0.05
    )Diluted  pro forma
    
    $
    (0.02
    )
    
    $
    (0.05
    )Basic Weighted Average Shares
    
    
    12,604
    
    
    
    12,586Diluted Weighted Average Shares
    
    
    12,604
    
    
    
    12,586
 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 September 30,
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 as of September 30, 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 as of 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: SEPTEMBER 30, 2004
    
    JUNE 30, 2004Raw materials
    
    $
    6,186
    
    
    $
    6,370Finished goods
    
    
    1,214
    
    
    
    1,048$
    7,400
    
    
    $
    7,418
 8




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NOTE 6. COMPREHENSIVE LOSS For the three months ended September 30, 2004 and 2003, comprehensive loss
amounted to approximately $226,000 and $533,000 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 September 30, 2004, the Company did not repurchase any shares of its
common stock. From February 12, 2003 through September 30, 2004, the Company
has repurchased a total of 139,477 shares of its common stock at a total cost
of approximately $658,084 or an average cost of approximately $4.72 per share. NOTE 8. LEGAL PROCEEDINGS Qualstar may be involved in litigation or legal matters from time to time
in the normal course of business. 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 for pretax income and 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 In October 2004, the Financial Accounting Standards Board (FASB) concluded that
SFAS No. 123R (SFAS 123R), Share-Based Payment, which would require all
companies to measure compensation cost for all share-based payments (including
employee stock options) at fair value, would be effective for interim or annual
periods beginning after June 15, 2005. SFAS 123R provides two tentative adoption 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 123R would be based
on the same estimate of the grant-date fair value and the same attribution
method used previously under SFAS 123. 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
123R 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 123R
unless those changes represent a correction of an error. For periods after the
date of adoption of SFAS 123R, the modified prospective transition method
described above would be applied. The Company currently expects to adopt SFAS 123R using the modified prospective
transition method, although the Company continues to review its options for
adoption under this new pronouncement, at the beginning of fiscal 2005,
assuming SFAS 123R is implemented as scheduled, 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. 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, 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. 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. 10




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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. 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. 11




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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 EndedSeptember 30,2004
    
    2003Net revenues
    
    
    100.0
    %
    
    
    100.0
    %Cost of goods sold
    
    
    63.0
    
    
    
    62.5Gross profit
    
    
    37.0
    
    
    
    37.5Operating expenses:Research and development
    
    
    15.1
    
    
    
    19.4Sales and marketing
    
    
    13.4
    
    
    
    11.7General and administrative
    
    
    14.8
    
    
    
    22.7Total operating expenses
    
    
    43.3
    
    
    
    53.8Loss from operations
    
    
    (6.3
    )
    
    
    (16.3
    )Investment income
    
    
    2.6
    
    
    
    2.6Loss before income taxes
    
    
    (3.7
    )
    
    
    (13.7
    )Benefit for income taxes
    
    
    
    
    
    
    (4.1
    )Net income (loss)
    
    
    (3.7
    )%
    
    
    (9.6
    )%
 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 EndedSeptember 30,2004
    
    2003Tape library revenues:TLS
    
    
    59.7
    %
    
    
    66.4
    %RLS
    
    
    8.6
    
    
    
    9.568.3
    
    
    
    75.9Other revenues:Service
    
    
    11.0
    
    
    
    9.2Media
    
    
    10.0
    
    
    
    9.1Power Supplies, Spares, Upgrades, 9 Track
    
    
    10.7
    
    
    
    5.8100.0
    %
    
    
    100.0
    %
 12




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Three Months Ended September 30, 2004 Compared to Three Months Ended September
30, 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 September 30, 2004 were $6.3
million, compared with net
revenues of $6.0 million for the three months ended September, 2003, an
increase of $0.3 million. The increase in revenues is attributed to higher
revenues from tape libraries incorporating LTO and SAIT tape drives and higher
revenues from service agreements and power supplies, partially offset by a
decline in AIT and SDLT based library revenues. We derived approximately 10%
of our revenues from one customer in the three months ended September 30, 2004.
There were no customers providing greater than 10% of our revenues for the
three months ended September 30, 2003. 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 37.0% of net revenues, for the three months
ended September 30, 2004, compared to $2.2 million, or 37.5% of net revenues,
for the three months ended September 30, 2003. Research and Development. Research and development expenses consist of
engineering salaries, benefits, outside consultant fees, purchased parts and
supplies used in development activities. Research and development expenses for
the three months ended September 30, 2004 were $954,000, or 15.1% of net
revenues, as compared to $1.2 million, or 19.4% of net revenues, for the three
months ended September 30, 2003. The decrease in research and development
expenses is due primarily to lower prototype and engineering material costs
incurred by our Advanced Development Group, who are developing a new line of enterprise-class tape
libraries. 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 September 30, 2004 were $847,000, or 13.4% of net revenues,
compared to $701,000, or 11.7% of net revenues, for the three months ended
September 30, 2003. The increase in sales and marketing expenses was primarily
due to increased 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
September 30, 2004 were $932,000, or 14.8% of net revenues, compared with $1.4
million, or 22.7% of net revenues, for the three months ended September 30,
2003. Qualstar did not incur any costs associated with its previous patent
infringement dispute with Raytheon Company in the first quarter of fiscal 2005,
resulting in a significant reduction in general and administrative expenses
compared to the year-ago period. The dispute with Raytheon was settled in April
2004. Further, the decrease is also due to not incurring any amortization of deferred
compensation expense related to stock options for the three months ended September 30, 2004 compared
to the year-ago period. Investment Income.Investment income was $164,000 in the three months
ended September 30, 2004, compared to $155,000 for the three months ended
September 30, 2003. Benefit for Income Taxes. We recorded no benefit for income taxes for the
three months ended September 30, 2004 as compared to a benefit of income taxes
of $(246,000) equal to 29.9% of our pre-tax loss, for the three months ended
September 30, 2003. In the first quarter of fiscal 2005, we did not have any net
operating loss carryback availability, and due to the 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 $369,000 in the
three months ended September 30, 2004 as compared to cash provided by
operations of $1.0 million in the three months ended September 30, 2003. For
the three months ended September 30, 2004, cash provided by operating
activities was primarily provided by a reduction of accounts receivable
partially offset by a decrease in accounts payable. For the three months ended
September 30, 2003, cash provided by operating activities was primarily
provided by a reduction of accounts receivable. 13




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Cash used in investing activities was $2.7 million during the first three
months of fiscal 2005, primarily attributed to the net purchase of marketable
securities. Cash provided by investing activities during the first three months
of fiscal 2004 was $1.5 million, related primarily to the net sales of
marketable securities. As of September 30, 2004, we had $4.2 million in cash and cash equivalents
and $32.0 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 our
Chief Financial Officer, of the effectiveness of the design and operation of
Qualstars disclosure controls and procedures as of September 30, 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. We did not make any changes in our internal control over financial
reporting during the first quarter of fiscal 2005 that materially affected, or
are reasonably likely to materially affect, our internal control over financial
reporting. 14




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PART II  OTHER INFORMATION 
 ITEM 1. Legal Proceedings Qualstar may be involved in litigation or legal matters from time to time
in the normal course of business. 
 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.
 15




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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:
November 12, 2004
    
    By:
    
    /s/ WILLIAM J. GERVAISWilliam J. Gervais, President,Chief Executive OfficerDated: November 12, 2004
    
    By:
    
    /s/ FREDERIC T. BOYERFrederic T. BoyerPrincipal Financial Officer
 16




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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.
 17