**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

 
| **ý** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|------------|----------------------------------------------------------------------------------------------|

 

**Forthe quarterly period ended  March 31,2002**

 
| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------|

 

**For the transition period from             to            **

** **

**Commissionfile number 000-27267**

** **

| **I/OMAGIC  CORPORATION**                                                           |
|-------------------------------------------------------------------------------------|
| (Exact name of  small business issuer as specified in its charter)                  |
|                                                                                |   |   |
| **Nevada**                                                                          |   | **88-0290623** |
| (State or other  jurisdiction of incorporation or organization)                     |   | (IRS Employer  Identification No.) |
|                                                                                |   |   |
| **1300  Wakeham, Santa Ana, CA  92705**                                        |
| (Address of  principal executive offices)                                           |
|                                                                                |   |   |
| **(714)  953-3000**                                                                 |
| (Issuer’s  telephone number)                                                   |
|                                                                                |   |   |
| (Former name, former  address and former fiscal year, if changed since last report) |

 

Check whether the issuer(1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes  ý  No  o

 

As of May 14, 2002, thenumber of shares of Common Stock issued and outstanding was 67,930,291.

 

Transitional SmallBusiness Disclosure Format (check one):

Yes  o  No  ý

 

 

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**I/OMAGIC CORPORATION AND SUBSIDIARY**

 

**INDEX**

 
| PART I - FINANCIAL  INFORMATION |
|--------------------------------------|
|                                 |   |
|                                 | Item 1.  Financial Statements |
|                                 |   |
|                                 | Balance Sheets - December 31. 2001 and  March 31, 2002 (unaudited) |
|                                 |   |
|                                 | Statements  of Income - For the three months ended March 31, 2001 and 2002 (unaudited) |
|                                 |   |
|                                 | Statements  of Cash Flows - For the three months ended March 31, 2001 and 2002  (unaudited) |
|                                 |   |
|                                 | Notes to Financial  Statements |
|                                 |   |
|                                 | Item  2.   Management’s Discussion and Analysis of Financial Conditions and  Results of Operations |
|                                 |   |
| PART II - OTHER INFORMATION          |
|                                 |   |
|                                 | Item 1.  Legal Proceedings |
|                                 | Item  2.  Changes in Securities |
|                                 | Item 3.  Defaults Upon Senior Securities |
|                                 | Item  4.  Submission of Matters to a Vote of  Security Holders |
|                                 | Item 5.  Other Information |
|                                 | Item 6.  Exhibits and Reports on Form 8-K |
|                                 |   |
| SIGNATURES                           |

 

2

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**PARTI — FINANCIAL INFORMATION**

 

**Item1.  Financial Statements**

 

FINANCIALINFORMATION

PART 1 - ITEM 1

 

I/OMAGIC CORPORATION

BALANCE SHEETS

DECEMBER 31, 2001 ANDMARCH 31, 2002 (UNAUDITED)

 
|                                                                                      |   | **DECEMBER  31, 2001** |       | **March 31, 2002** |   |
|-------------------------------------------------------------------------------------------|--------|------------------------|------------|--------------------|--------|
| ASSETS                                                                                    |   |                   |       |               |   |
| CURRENT ASSETS                                                                            |   |                   |       |               |   |
| Cash and cash equivalents                                                                 |   | $                      | 4,423,623  |               | $      | 5,312,212 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $2,679,118 and $2,441,250 |   | 27,844,543             |       | 25,961,636         |   |
| Inventory, net of allowance for obsolete inventory  of $558,703 and $1,180,517            |   | 10,377,287             |       | 12,942,103         |   |
| Inventory in transit                                                                      |   | 1,634,420              |       | 2,350,960          |   |
| Income tax receivable                                                                     |   | 34,311                 |       | 34,311             |   |
| Prepaid expenses and other current assets                                                 |   | 2,292,424              |       | 1,664,448          |   |
| Current portion of deferred income taxes                                                  |   | 1,556,000              |       | 1,556,000          |   |
|                                                                                      |   |                   |       |               |   |
| TOTAL CURRENT ASSETS                                                                      |   | 48,162,608             |       | 49,821,670         |   |
|                                                                                      |   |                   |       |               |   |
| PROPERTY AND EQUIPMENT, NET                                                               |   | 1,266,216              |       | 1,195,133          |   |
| TRADEMARK, net of accumulated amortization of  $3,375,976 and $3,858,256                  |   | 6,269,703              |       | 5,787,423          |   |
| DEFERRED INCOME TAXES, net of current portion                                             |   | 165,000                |       | 165,000            |   |
| OTHER ASSETS                                                                              |   | 40,240                 |       | 40,240             |   |
|                                                                                      |   |                   |       |               |   |
| TOTAL ASSETS                                                                              |   | $                      | 55,903,767 |               | $      | 57,009,466 |   |

 

The accompanying notes are an integral part of these financialstatements

 

3

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I/OMAGIC CORPORATION

BALANCE SHEETS

DECEMBER 31, 2001 ANDMARCH 31, 2002 (UNAUDITED)

 

 
|                                                                                                                                       |   | **DECEMBER  31, 2001** |       | **MARCH 31, 2002** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|--------------------|--------|
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                 |   |                   |       |               |   |
| CURRENT LIABILITIES                                                                                                                        |   |                   |       |               |   |
| Line of credit                                                                                                                             |   | $                      | 9,622,241  |               | $      | 12,994,734 |   |
| Accounts payable and accrued expenses                                                                                                      |   | 12,027,498             |       | 10,739,287         |   |
| Accounts payable to related parties                                                                                                        |   | 5,521,720              |       | 3,909,053          |   |
| Current portion of capital lease obligation                                                                                                |   | 10,978                 |       | 6,910              |   |
| Reserves for customer returns and allowances                                                                                               |   | 2,605,679              |       | 2,228,590          |   |
|                                                                                                                                       |   |                   |       |               |   |
| TOTAL CURRENT LIABILITIES                                                                                                                  |   | 29,788,116             |       | 29,878,574         |   |
|                                                                                                                                       |   |                   |       |               |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                              |   |                   |       |               |   |
|                                                                                                                                       |   |                   |       |               |   |
| REDEEMABLE CONVERTIBLE PREFERRED STOCK  10,000,000 shares authorized, $0.001 par value                                                     |   |                   |       |               |   |
| Series A, 1,000,000 shares authorized  875,000 shares issued and outstanding                                                               |   | 875                    |       | 875                |   |
| Series B, 1,000,000 shares authorized  250,000 shares issued and outstanding                                                               |   | 250                    |       | 250                |   |
| Additional paid-in capital                                                                                                                 |   | 8,998,875              |       | 8,998,875          |   |
|                                                                                                                                       |   |                   |       |               |   |
| TOTAL REDEEMABLE CONVERTIBLE PREFERRED STOCK                                                                                               |   | 9,000,000              |       | 9,000,000          |   |
|                                                                                                                                       |   |                   |       |               |   |
| STOCKHOLDERS’ EQUITY                                                                                                                  |   |                   |       |               |   |
| Class A common stock, $0.001 par value 100,000,000  shares authorized 67,930,291 and 67,930,291 (unaudited) shares issued and  outstanding |   | 67,931                 |       | 67,931             |   |
| Additional paid in capital                                                                                                                 |   | 31,493,957             |       | 31,493,957         |   |
| Accumulated deficit                                                                                                                        |   | (14,446,237            | )          | (13,430,996        | )      |
| TOTAL STOCKHOLDERS’ EQUITY                                                                                                            |   | 17,115,651             |       | 18,130,892         |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                            |   | $                      | 55,903,767 |               | $      | 57,009,466 |   |

 

The accompanying notes are an integral part of these financialstatements

 

4

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I/OMAGIC CORPORATION

STATEMENTS OFINCOME

FOR THE THREE MONTHSENDEDMARCH 31,  2002 (UNAUDITED) AND 2001 (UNAUDITED)

 
|                                            |   | **Three Months Ended March 31,** |       |
|-------------------------------------------------|--------|----------------------------------|------------|
|                                            |   | **2001**                         |       | **2002** |   |
| Net sales                                       |   | $                                | 10,048,506 |   | $ | 26,719,632 |   |
|                                            |   |                             |       |   |   |
| Cost of sales                                   |   | 9,137,277                        |       | 22,674,409 |   |
| Gross profit                                    |   | 911,229                          |       | 4,045,223 |   |
|                                            |   |                             |       |   |   |
| Operating expenses                              |   |                             |       |   |   |
| Selling, marketing and advertising              |   | 382,516                          |       | 397,200 |   |
| General and administrative                      |   | 1,455,834                        |       | 1,998,507 |   |
| Depreciation and amortization                   |   | 554,911                          |       | 559,504 |   |
| Total operating expenses                        |   | 2,393,261                        |       | 2,955,211 |   |
| Income (loss) from operations                   |   | (1,482,032                       | )          | 1,090,012 |   |
|                                            |   |                             |       |   |   |
| Other income (expense)                          |   |                             |       |   |   |
| Interest income                                 |   | 29,105                           |       | — |   |
| Interest expense                                |   | (188,992                         | )          | (74,771 | ) |
| Other income                                    |   | 10,170                           |       | — |   |
| Other expense                                   |   | (18,116                          | )          | — |   |
| Total other income (expense)                    |   | (167,833                         | )          | (74,771 | ) |
|                                            |   |                             |       |   |   |
| Income (loss) before provision for income taxes |   | (1,649,865                       | )          | 1,015,241 |   |
| Provision for (benefit from) income taxes       |   | 427,091                          |       | — |   |
|                                            |   |                             |       |   |   |
| Net income (loss)                               |   | $                                | (2,076,956 | ) | $ | 1,015,241 |   |
|                                            |   |                             |       |   |   |
| Basic earnings (loss) per share                 |   | $                                | (0.03      | ) | $ | 0.01 |   |
|                                            |   |                             |       |   |   |
| Diluted earnings (loss) per share               |   | $                                | (0.03      | ) | $ | 0.01 |   |
|                                            |   |                             |       |   |   |
| Basic weighted-average shares outstanding       |   | 67,917,791                       |       | 67,930,291 |   |
|                                            |   |                             |       |   |   |
| Diluted weighted-average shares outstanding     |   | 67,917,791                       |       | 71,530,291 |   |

 

The accompanyingnotes are an integral part of these financial statements

 

5

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I/OMAGIC CORPORATION

STATEMENTS OF CASHFLOWS

FOR THE THREE MONTHS ENDED

MARCH 31, 2002(UNAUDITED) AND 2001 (UNAUDITED)

 
|                                                                                      |   | **Three Months Ended March 31,** |       |
|-------------------------------------------------------------------------------------------|--------|----------------------------------|------------|
|                                                                                      |   | **2001**                         |       | **2002** |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                     |   |                             |       |   |   |
| Income (loss) from operations                                                             |   | $                                | (2,076,956 | ) | $ | 1,015,241 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |   |                             |       |   |   |
| Depreciation and amortization                                                             |   | 72,927                           |       | 77,223 |   |
| Amortization of trademark                                                                 |   | 482,284                          |       | 482,280 |   |
| Provision for allowance for doubtful  accounts                                            |   | 26,427                           |       | (237,868 | ) |
| Reserve for obsolete inventory                                                            |   | (187,072                         | )          | 621,814 |   |
| Deferred income tax                                                                       |   | 427,091                          |       | — |   |
| Reserve for customer returns and allowances                                               |   | (415,832                         | )          | (377,089 | ) |
| (Increase) decrease in:                                                                   |   |                             |       |   |   |
| Accounts receivable                                                                       |   | (184,517                         | )          | 2,120,775 |   |
| Accounts receivable from related parties                                                  |   | (590,675                         | )          | — |   |
| Inventory                                                                                 |   | 2,705,492                        |       | (3,186,630 | ) |
| Inventory in transit                                                                      |   | —                           |       | (716,540 | ) |
| Prepaid expenses and other current assets                                                 |   | 62,983                           |       | 627,976 |   |
| Increase (decrease) in:                                                                   |   |                             |       |   |   |
| Accounts payable and accrued expenses                                                     |   | (6,386,528                       | )          | (1,288,211 | ) |
| Accounts payable to related parties                                                       |   | 5,055,704                        |       | (1,612,667 | ) |
| Net cash (used in) operating activities                                                   |   | (1,016,572                       | )          | (2,473,696 | ) |
|                                                                                      |   |                             |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                     |   |                             |       |   |   |
| Property additions                                                                        |   | (25,487                          | )          | (6,140 | ) |
| Net cash (used in) investing activities                                                   |   | (25,487                          | )          | (6,140 | ) |
|                                                                                      |   |                             |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                     |   |                             |       |   |   |
| Net borrowings on line of credit                                                          |   | (1,012,114                       | )          | 3,372,493 |   |
| Payments on capital lease obligations                                                     |   | (2,745                           | )          | (4,068 | ) |
| Net cash provided by (used in) financing activities                                       |   | (1,014,859                       | )          | 3,368,425 |   |
| Net increase (decrease) in cash and cash equivalents                                      |   | (2,056,918                       | )          | 888,589 |   |
| Cash and cash equivalents at beginning of period                                          |   | 3,502,546                        |       | 4,423,623 |   |
| Cash and cash equivalents at end of period                                                |   | $                                | 1,445,628  |   | $ | 5,312,212 |   |
|                                                                                      |   |                             |       |   |   |
| Supplemental cash flow information:                                                       |   |                             |       |   |   |
| Interest paid                                                                             |   | $                                | 188,992    |   | $ | 65,438 |   |
| Income taxes paid                                                                         |   | $                                | 0          |   | $ | 0 |   |

 

The accompanying notes are an integral part of these financialstatements

 

6

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NOTES TO FINANCIALSTATEMENTS

 

NOTE 1 -ORGANIZATION AND BUSINESS

 

I/OMagic Corporation (the “Company”), a Nevadacorporation, develops, manufactures through subcontractors, markets, anddistributes multimedia and communication card devices for portable and desktopcomputers. The Company sells its products in the United States to distributorsand retail customers.

 

In March 1996, I/O Magic Corporation, a Californiacorporation (“I/OMagic California”), originally incorporated on September 30,1993 entered into a Plan of Exchange and Acquisition Agreement (the“Acquisition Agreement”) with Silvercrest International, Inc. (“Silvercrest”),a Nevada corporation. Pursuant to the Acquisition Agreement, Silvercrestacquired all of the outstanding stock of I/OMagic California totaling 6,570,583shares in exchange for an aggregate 6,570,583 shares of newly-issued commonstock. In connection with the Acquisition Agreement, the Company issued 624,704shares of common stock. For accounting purposes, the acquisition has beentreated as a recapitalization of I/OMagic California, with I/OMagic Californiaas the accounting acquirer (reverse acquisition). The reverse acquisition wasrecorded at the historical cost of I/O Magic California. Prior to the executionof the Acquisition Agreement, Silvercrest was a public company listed onNASDAQ’s over-the-counter market with dormant operations and no assets orliabilities. Silvercrest subsequently changed its name to I/OMagic Corporation,a Nevada corporation.

 

NOTE 2 - SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

 

BASIS OFPRESENTATION

The accompanying unaudited condensed consolidatedfinancial statements have been prepared in accordance with the instructions toForm 10-Q and therefore, do not include all information and notes necessary fora fair presentation of financial position, results of operations, and cashflows in conformity with generally accepted accounting principles.  The unaudited condensed consolidatedfinancial statements include the accounts of I/OMagic Corporation andsubsidiary. The operating results for interim periods are unaudited and are notnecessarily an indication of the results to be expected for the full fiscalyear. In the opinion of management, the results of operations as reported forthe interim periods reflect all adjustments which are necessary for a fairpresentation of operating results.

 

USE OF ESTIMATES

The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosures of contingent assets and liabilities at thedate of the financial statements, as well as the reported amounts of revenuesand expenses during the reporting period.

 

Significant estimates made by management include, butare not limited to, the provisions for allowance of doubtful accounts and priceprotection on accounts receivable, the net realizability of inventory, theevaluation of potential impairment of furniture and equipment, and theprovision for sales returns and warranties. Actual results could materiallydiffer from those estimates.

 

7

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STOCK BASEDCOMPENSATION

SFAS No. 123, “Accounting for Stock-BasedCompensation,” establishes and encourages the use of the fair value basedmethod of accounting for stock-based compensation arrangements under whichcompensation cost is determined using the fair value of stock-basedcompensation determined as of the date of grant and is recognized over theperiods in which the related services are rendered. The statement also permitscompanies to elect to continue using the current implicit value accountingmethod specified in Accounting Principles Bulletin (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees,” to account for stock-basedcompensation issued to employees. The Company has elected to use the implicitvalue based method and has disclosed the pro forma effect of using the fairvalue based method to account for its stock-based compensation. For stock-basedcompensation issued to non-employees, the Company uses the fair value method ofaccounting under the provisions of SFAS No. 123.

 

RECLASSIFICATIONS

Certain amounts included in the March 31, 2001Statement of Income have been reclassified to conform with the current periodpresentation.  Such reclassification didnot have any effect on the reported net loss.

 

EARNINGS (LOSS)PER SHARE

The Company calculates earnings (loss) per share inaccordance with SFAS No. 128, “Earnings Per Share.” SFAS No. 128 replaced thepresentation of primary and fully diluted earnings per share with thepresentation of basic and diluted earnings (loss) per share.  Basic earnings (loss) per share excludesdilution and is calculated by dividing income (loss) available to commonstockholders by the weighted-average number of common shares outstanding forthe period.  Diluted earnings (loss) pershare includes the potential dilutive effects that could occur if securities orother contracts to issue common stock were exercised or converted into commonstock (“potential common stock”) that would then share in the earnings (loss)of the Company.

 

As of March 31, 2002 (unaudited) and 2001 (unaudited),the Company had potential common stock as follows:

 
|                                                                                 |   | **2002**   |   | **2001**   |   |
|--------------------------------------------------------------------------------------|--------|------------|--------|------------|--------|
| Weighted-average common shares Outstanding during  the period                        |   | 67,930,291 |   | 67,917,791 |   |
|                                                                                 |   |       |   |       |   |
| Incremental shares from assumed conversion of convertible  preferred stock           |   | 3,600,000  |   | —     |   |
|                                                                                 |   |       |   |       |   |
| FULLY DILUTED WEIGHTED-AVERAGE COMMON SHARES AND  POTENTIAL COMMON STOCK (UNAUDITED) |   | 71,530,291 |   | 67,917,791 |   |

 

Since the Company had a net loss for the three monthsended March 31, 2001 basic and diluted shares are the same.

 

8

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NOTE 3 - ACCOUNTSPAYABLE AND ACCRUED EXPENSES

 

Accounts payable and accrued liabilities consisted ofthe following:

 

|                                      |   | **March 31,  2002** |       |
|-------------------------------------------|--------|---------------------|------------|
|                                      |   | **(unaudited)**     | ** ** |
| Accounts payable                          |   | $                   | 1,348,410  |   |
| Accrued rebates and marketing             |   | 8,209,581           |       |
| Accrued compensation and related benefits |   | 411,471             |       |
| Other                                     |   | 769,825             |       |
| TOTAL                                     |   | $                   | 10,739,287 |   |

 

NOTE 4 - INVENTORY

 

Inventory consisted ofthe following:

 

|                   |   | **March 31,  2002** |       |
|------------------------|--------|---------------------|------------|
|                   |   | **(unaudited)**     | ** ** |
|                   |   |                |       |
| Component parts        |   | $                   | 3,142,527  |   |
| Finished goods         |   | 10,980,093          |       |
| Reserves for inventory |   | (1,180,517          | )          |
| TOTAL                  |   | $                   | 12,942,103 |   |

 

NOTE 5 - LINE OFCREDIT

 

The Company maintains a revolving line of credit witha financial institution that allows it to borrow a maximum of $14,000,000 witha sub-limit of $13,000,000. The line of credit expires December 31, 2002.  The line is secured by a UCC filing onsubstantially all of the Company’s assets.

 

Within the sub-limit, up to $13,000,000 is availablefor maturities up to 150 days and up to $3,000,000 is available for maturitiesup to 60 days against 30% of inventory. Within the line of credit, a sub-line of $1,000,000 is available foruncollected funds availability.

 

The availability of the line of credit is subject tothe borrowing base, which is 65% of eligible receivables.  Advances on the line of credit bear interestat the Wall Street Journal Prime (4.75% as of March 31, 2002) plus 0.50%.  As of March 31, 2002, the outstandingbalance under the revolving line of credit was $12,994,734 (unaudited).

 

The line of credit provides for the maintenance ofcertain financial covenants and a compensating balance of $750,000, of whichthe Company was in compliance at March 31, 2002.

 

NOTE 6 - CREDITLINES FROM RELATED PARTIES

 

In connection with a 1997 Strategic AllianceAgreement, the Company has available a trade line of credit through astockholder and supplier for purchases up to $2,000,000. Purchases arenon-interest bearing and are due 75 days from the date of receipt.  The credit agreement can be terminated orchanged at any time. As of December 31, 2001 and March 31, 2002 (unaudited),there were $0 and $0, respectively, in trade payables outstanding under thisarrangement.

 

In connection with an April 1999 subscriptionagreement, the Company also has available an additional trade line of creditthrough a stockholder and vendor that provides a trade credit facility of up to$5,000,000 carrying net 75 day terms, as defined. As of December 31, 2001 andMarch 31, 2002 (unaudited), there were $3,001,926 and $1,984,053, respectively,in trade payables outstanding under this arrangement.

 

9

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In connection with a December 2000 subscriptionagreement, the Company also has available an additional trade line of creditthrough a stockholder and vendor that provides a trade credit facility of up to$3,000,000 carrying net 60 day terms, as defined. As of December 31, 2001 andMarch 31, 2002 (unaudited), there were $1,273,250 and $1,925,000, respectively,in trade payables outstanding under this arrangement.

 

NOTE 7 -COMMITMENTS AND CONTINGENCIES

 

LEASES

The Company leases its facilities and certainequipment under non-cancelable, operating lease agreements, expiring throughMarch 2010.

 

Rent expense was $145,702 and $155,328 for the threemonths ended March 31, 2002 (unaudited) and 2001 (unaudited), respectively, andis included in general and administrative expenses in the accompanyingstatements of income.

 

LITIGATION

 

On March 9, 2002,the following individuals:  Mark Vakili,Mitra Vakili, Hi-Val, Inc., and Alex Properties, filed a Complaint in OrangeCounty Superior Court  ( the“Complaint”) naming IOM Holdings, Inc. (“IOMH”), the Company, Steele Su, TonyShahbaz and Mei Hsu. The Complaint alleges eight causes of action, however,only three claims are asserted against IOMH and the Company.

 

The three causes ofaction against IOMH and the Company all relate to an Asset Purchase Agreementexecuted by IOMH and Hi-Val in June 1999 for the purchase and sale of Hi-Valassets to IOMH.  The causes of actionare for breach of contract, fraud and negligent misrepresentation.  The allegations in the Complaint are thatIOMH and other defendants failed to deliver the consideration due under theAsset Purchase Agreement after taking control of Hi-Val.  The fraud and negligent misrepresentationclaims are based on alleged representations made by IOMH and others to induceHi-Val and Mark Vakili to enter into the Asset Purchase Agreement. The damagesclaimed by Plaintiffs in the causes of action are for $27,000,000.00.  Punitive damages are claimed on the fraudcause of action.

 

While the Company believes that it will prevail in thelitigation set forth in the Complaint, this litigation is at a very early stageand it is difficult to predict when such litigation will be resolved.  The Company intends to vigorously defendthis litigation.

 

EMPLOYMENT CONTRACT

The Company has entered into an employment contractwith one of its officers which expires upon written termination. The agreementcalls for a minimum base salary and provides for certain expenseallowances.  In addition, the agreementprovides for a bonus based on the “net profits” of the Company, as defined.  The bonus amount ranges from $20,000 to$70,000 for net profits up to $500,000. For net profits in excess of $500,000, the bonus is 7% of suchexcess.  $18,000 was paid during thethree months ended March 31, 2002.  Nobonuses were paid during the three months ended March 31, 2001.  As of March 31, 2002, there was $68,662(unaudited) accrued under this agreement.

 

RETAIL AGREEMENTS

In connection with certain retail agreements, theCompany has agreed to pay for certain marketing development and advertising onan ongoing basis. Marketing development and advertising costs are generallyagreed upon at the time of the event. The Company also records a liability forco-op marketing based on management’s evaluation of historical experience andcurrent industry and Company trends. During the three months ended March 31, 2002and 2001, the Company incurred $921,329 (unaudited) and $166,645 (unaudited),respectively, related to these agreements. Such is netted against sales revenue in the accompanying statements ofincome.

 

10

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NOTE 8 - CAPITALTRANSACTIONS

 

There were no capital transactions by the Companyduring the three months ended March 31, 2002 and 2001.

 

NOTE 9 - RELATEDPARTY TRANSACTIONS

 

During the three months ended March 31, 2002 and 2001,the Company had purchases from related parties totaling approximately$6,642,945 (unaudited) and $4,380,700 (unaudited), respectively.

 

At March 31, 2002 and 2001, the Company had accountspayable to related parties totaling approximately $3,909,053 (unaudited) and$4,878,994 (unaudited), respectively.

 

The Company leases its Santa Ana facility from an officer of the Companywhich requires initial minimum monthly payment of $28,673 and expires in March2010.  For the three months ended March31, 2002 and 2001, rent expense was $86,018 (unaudited) and $86,018 (unaudited),respectively, and is included in general and administrative expenses in theaccompanying statements of operations.

 

King Eagle Enterprises, Inc., a related party, isinvolved in printing and packaging services to the Company.  King Eagle Enterprises, Inc. is currentlyseeking investments in and/or acquisitions of printing and packaging facilitiesto better accommodate cost/support to the Company.

 

NOTE 10 - RECENTLYISSUED ACCOUNTING PRONOUNCEMENTS

 

In July 2001, the Financial Accounting Standards Board(“FASB”) issued SFAS No. 141, “Business Combinations.”  Management believes this statement will nothave a material impact on the Company’s financial statements.

 

In July 2001, the FASB issued SFAS No. 142, “Goodwilland Other Intangible Assets.” Management believes this statement will not have a material impact onthe Company’s financial statements.

 

In June 2001, the FASB issued SFAS No. 143,“Accounting for Asset Retirement Obligations.” This statement is not applicable to the Company.

 

In August 2001, the FASB issued SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.”  Management believes this statement will nothave a material impact, if any, on the Company’s financial statements.

 

In April 2002, the FASBissued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64,Amendment of FASB Statement No. 13 and Technical Corrections.”  SFAS No. 145 updates, clarifies, andsimplifies existing accounting pronouncements. This statement rescinds SFAS No. 4, which required all gains and lossesfrom extinguishments of debt to be aggregated and, if material, classified asan extraordinary item, net of related income tax effect.  As a result, the criteria in APB No. 30 willno be used to classify those gains and losses. SFAS No. 64 amended SFAS No. 4 and is no longer necessary as SFAS No. 4has been rescinded.  SFAS No. 44 hasbeen rescinded as it is no longer necessary. SFAS No. 145 amends SFAS No. 13 to require that certain lease modificationsthat have economic effects similar to sale-leaseback transactions be accountedfor in the same manner as sale-lease transactions.  This statement also makes technical corrections to existingpronouncements.  While those correctionsare not substantive in nature, in some instances, they may change accountingpractice.  The Company does not expectadoption of SFAS No. 145 to have a material impact, if any, on its financialposition or results of operations.

 

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NOTE 11 -SUBSEQUENT EVENTS

 

There are no subsequent events.

 

**Item 2.  Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

This report and the Company’s consolidated financial statementsand notes to financial statements contain forward-looking statements, whichgenerally include the plans and objectives of management for future operations,including plans and objectives relating to the Company’s future economicperformance and its current beliefs regarding revenues it might earn if it wassuccessful in implementing its business strategies.  The Company does not undertake to update, revise or correct anyforward-looking statements.

 

The information contained in this document is not a completedescription of the Company’s business or the risks associated with aninvestment in the Company’s common stock. Before deciding to buy or maintain aposition in the Company’s common stock, prospective investors should carefullyreview and consider the various disclosures made in this report, and in othermaterials filed with the Securities and Exchange Commission (“SEC”) thatdiscuss the Company’s business in greater detail and that disclose variousrisks, uncertainties and other factors that may affect the Company’s business, resultsof operations or financial condition.

 

Any of the factors described above or in the “Certain Factorsthat may Affect Future Performance” section below could cause the Company’sfinancial results, including the Company’s net income (loss) or growth in netincome (loss) to differ materially from prior results, which in turn could,among other things, cause the price of the Company’s common stock to fluctuatesubstantially.

 

**Critical Accounting Policies and Estimates**

 

The Company’s discussion and analysis of its financial conditionand results of operations are based upon the Company’s consolidated financialstatements, which have been prepared in accordance with accounting principalsgenerally accepted in the United States. The preparation of these financial statements requires the Company tomake estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities.  On an on-going basis,the Company evaluates its estimates, including those related to customerprograms and incentives, product returns, bad debts, inventories, intangibleassets, income taxes, and contingencies and litigation.  The Company bases its estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

The Company believes the following critical accountingpolicies affect its more significant judgments and estimates used in thepreparation of its consolidated financial statements.  The Company records estimated reductions torevenue for customer programs and incentive offerings including special pricingagreements, price protection, promotions and other volume-based incentives.  If market conditions were to decline, theCompany may take actions to increase customer incentive offerings possiblyresulting in an incremental reduction of revenue at the time the incentive isoffered.  The Company maintainsallowances for doubtful accounts for estimated losses resulting from theinability of its customers to make required payments.  If the financial condition of the Company’s customers were todeteriorate, resulting in the impairment of their ability to make payments,additional allowances may be required.

 

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The Company writes down its inventory for estimated obsolescenceor unmarketable inventory equal to the difference between the cost of inventoryand the estimated market value based upon assumptions about future demand andmarket conditions.  If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required. The Company records a valuation allowance to reduce its deferred taxassets to the amount that is more likely than not to be realized.  While the Company has considered futuretaxable income and ongoing prudent and feasible tax planning strategies inassessing the need for the valuation allowance, in the event the Company were todetermine that it would be able to realize its deferred tax assets in thefuture in excess of its net recorded amount, an adjustment to the deferred taxasset would increase income in the period such determination was made.  Likewise, should the Company determine thatit would not be able to realize all or part of its net deferred tax asset inthe future, an adjustment to the deferred tax asset would be charged to incomein the period such determination was made.

 

**ThreeMonths ended March 31, 2002 and 2001**

 

**Resultsof Operations**

 

Gross sales for the period ended March 31, 2002(“2002”) increased 139% to $33,605,726 from $14,040,107 for the period endedMarch 31, 2001.  The increase in grosssales is attributable to the re-introduction of the Hi-Val and Digital ResearchTechnologies brands during Q3 and Q4 of 2001. Net sales for the period ended March 31, 2002 increased 166% to$26,719,632 from $10,048,506 for the period ended March 31, 2001.

 

Net sales includereductions to gross sales for returns, price protection and marketingpromotions.  The reduction of sales formarketing promotions is in accordance with the Emerging Issues Task Force(“EITF”) issue No. 01-09, “Accounting for Consideration Given by a Vendor to aCustomer (Including a Reseller of the Vendor’s Products).”  This issue concluded that certain consumerand trade sales promotion expenses are presumed to be a reduction of theselling prices of the vendor’s products and, therefore, should be characterizedas a reduction of revenue as net sales. The provisions of this pronouncement are required to be applied withfiscal years beginning after December 15, 2001.  The Company has adopted this pronouncement with its March 31,2002 statement of operations and has reclassified its March 31, 2001 statementof operations.  The adoption of thispronouncement has resulted in adjustments to net sales, gross margin andselling and marketing expenses.  Thereis no impact on operating income, net income or earnings per share. Marketingexpenses now netted against sales for 2002 were $3,731,349 and for 2001 were$1,857,217.

 

Total cost of sales as apercentage of net sales decreased from 90.93% ($9,137,277) in 2001 to 84.86%($22,674,409) in 2002. This was primarily due to a change in product mix toproducts with a higher gross margin in 2002.

 

The Company believes that amore informative picture of its cost of sales is in relation to net salesbefore deductions for marketing expenses ($30,450,981 in 2002 and $11,905,723in 2001).  On this basis, cost of salesfor products decreased from 71.49% ($8,510,977) in 2001 to 67.10% ($20,434,091)in 2002.   This increase in margin onproducts of 4.39% was due to a change in product mix to products with a highergross margin percentage.  On this samesales basis, freight in/out increased from 4.88% ($581,300) in 2001 to 5.22%($1,590,318) in 2001.  This was due toincreased air freight in 2002 arising from unanticipated demand for productsrequiring expedited shipment caused by supply constraints resulting from theSeptember 11th terrorist attacks. On the same sales basis, inventory write-downs to lower of cost ormarket increased from 0.38% ($45,000) in 2001 to 2.13% ($650,000) in 2002.  This was primarily in relation to Hi-Valinventory received in the acquisition of IOM Holdings.

 

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Operating expenses as a percentage of net sales decreased from23.82% ($2,393,261) in 2001 to 11.06% ($2,955,211) in 2002.  This percentage decrease is primarily due toboth total operating expenses decreasing and net sales increasing 165.91%.  Selling, marketing, and advertising expensesincreased by $14,684, general and administrative expenses increased by $542,673and depreciation and amortization expenses increased by $4,593 in 2002.

 

Selling, marketing and advertising expenses in 2002 were$397,200 (1.49% of net sales) and in 2001 were $382,516 (3.81% of netsales).  2001 expenses were restated forreclassification of certain marketing expenses against net sales per EITF issueNo. 01-09.  Selling, marketing andadvertising expenses increased by $14,684 primarily due to higher commissionsfor outside rep groups (due to higher sales), offset primarily by lowersalaries and benefits due to less sales and marketing employees.

 

General and administrative expenses in 2002 were $1,998,507(7.48% of net sales) and in 2001 were $1,455,834 (14.49% of net sales).  General and administrative expensesincreased primarily due to increases to the reserve for bad debt expense inrelation to old Hi-Val accounts receivable and shipping supplies in 2002partially offset by less payroll expenses in 2002.

 

Depreciation and amortization expenses in 2002 were $559,504(2.09% of net sales) and in 2001 were $554,911 (5.52% of net sales).

 

Other income (expenses)decreased from ($167,833) (1.67% of net sales) expense in 2001 to  ($74,771) (0.28% of net sales) expense in2002.  This was primarily due to$114,221 less interest expense in 2002 offset by $29,105 less interest incomein 2002.  The decline in interestexpense stems from the partial conversion of Hi-Val institutional debt topreferred stock of the Company.

 

Income tax benefit for 2001 represents Federal taxesas a result of the Company’s estimated annualized taxable income being subjectto Alternative Minimum Taxes (AMT), California state franchise tax estimate,and the current period deferred benefit. There were no income taxes for 2002 as the Company has a net operatingloss carryforward from prior years.

 

The Company’s operations resulted in net income in2002 of $1,015,241 versus a net loss in 2001 of $2,076,956.  This was the result of a 166% increase innet sales in 2002 over 2001.

 

The Company’s backlog at March 31, 2002 was $6,239,326versus a backlog at March 31, 2001 of $1,903,770.  This increase is a result of increased sales volume primarily toOffice Max and Best Buy.

 

**Liquidity and Capital Resources**

 

Since its inception, the Company has financed its operations andcapital expenditures primarily with cash provided by operating activities,private securities issuances and securities issuances for product (see “PrivatePlacement Offerings”). The Company believes that working capital generated fromoperations is sufficient to meet current activity. However, should the Companygrow significantly in size through additional large customers or acquisitions,securities issuances or other financing arrangements may be necessary.  The Company currently has lines of creditwith its major suppliers.  Borrowingunder these arrangements provides the Company with interest free trade credit.

 

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The Company currently has a $14 million asset based line ofcredit with China Trust Bank which expires December 31, 2002.  As of the date of this filing, theborrowings under this line were approximately $7.6 million.  The Company believes that its current cashflow from operations, the amounts available under its existing vendor lines ofcredit and its asset based line of credit are sufficient to meet its workingcapital and capital expenditure requirements at the current sales volume forthe next twelve months.

 

For the three months ended March 31, 2002, the Company had a netincrease in cash relative to December 31, 2001 in the amount of $888,589.  This was due to cash provided by financingactivities of $3,368,425 offset by cash used in operating activities of$2,473,696 and cash used in investing activities of $6,140.  Cash provided by financing activities wasprimarily provided by net borrowings on the line of credit.  Cash used for investing activities was forleasehold improvements, furniture and computer equipment.  Cash was used in operating activities asfollows: $3,186,630 was used to increase inventory; $1,612,667 was used todecrease accounts payable to related parties; $1,288,211 was used to decreaseaccounts payable and accrued expenses; $716,540 was used to increase inventoryin transit; $2,120,775 was provided by a decrease in accounts receivable;$1,015,241 was provided by income from operations; $627,976 was provided by adecrease in prepaid expenses and other current assets; $566,360 net wasprovided by non-cash adjustments such as depreciation, amortization, andprovisions.

 

As the Company expands itsdistribution activities, it may experience net negative cash flows fromoperations, pending an increase in gross margins, and may be required to obtainadditional financing to fund operations through proceeds from offerings, to theextent available, or to obtain additional financing to the extent necessary toaugment its working capital through public or private issuance of equity ordebt securities.

 

The high technologyrequirements of the Internet, music, data storage, gaming and various otherapplications increasingly require that consumers upgrade their personalcomputers to take full advantage of technology improvements in data storage,audio, video and various I/O devices. The Company believes that its current distribution channels currentlyfulfill and will continue to fulfill these trends in the computer peripheralsmarketplace.  In the event the Companycontinues with the revenue growth it has experienced since June 2001, theCompany believes that it will need additional capital. While there is noassurance that it will be successful in raising additional capital, the Companyis currently actively seeking both institutional debt, as well as privatesources of equity capital in order to assure that it will be capable offinancing such growth.  In the event theCompany is unsuccessful in securing such financing, it may be required tocurtail its sales growth.

 

The Company has no firm long-term salescommitments from any of its customers and enters into individual purchaseorders with its customers.  The Companyhas experienced cancellations of orders and fluctuations in order levels fromperiod to period and expects it will continue to experience such cancellationsand fluctuations in the future.  Inaddition, customer purchase orders may be canceled and order volume levels canbe changed, canceled or delayed with limited or no penalties.  The replacement of canceled, delayed orreduced purchase orders with new business cannot be assured.  Moreover, the Company’s business, financialcondition and results of operations will depend upon its ability to obtainorders from new customers, as well as the financial condition and success ofits customers, its customers products and the general economy.  The factors affecting any of the Company’smajor customers or their customers could have a material adverse effect on theCompany’s business, financial condition and results of operations.

 

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On January 22, 2001 the Company issued to FinovaCapital Corporation 875,000 shares of its Series A Preferred Stock and 250,000shares of its Series B Preferred Stock. The original value of these shares was $9 million in the aggregate. TheCompany is obligated to redeem these shares at $8 per share upon the thirdanniversary of the issuance of the Series A and upon the second anniversary ofthe Series B.  If the shares of the Company’scommon stock trade at a price of $3 per share for 15 consecutive trading days,then the Company has the right to require the conversion of the Series A andSeries B shares of preferred stock into shares of common stock at a price equalto the weighted average trading price (which shall be not less than $2.50 pershare nor more than $7 per share, subject to adjustment for stock splits andsimilar reclassifications of the Company’s common stock) of the shares ofcommon stock  during the 20 day period oftime prior to the notice of conversion issued by the Company. If the Company isunable to require the conversion of the preferred stock or to otherwisenegotiate a discounted redemption of the preferred stock, then the Companywould be required to expend $2 million to redeem the Series B Preferred Stockon January 22, 2003 and $6.6 million on January 22, 2004 to redeem the Series APreferred Stock. If the Company was required to redeem either class ofpreferred stock its liquidity and other financial resources could be severelyand adversely affected.

 

**RISKFACTORS**

 

AN INVESTMENT IN THE COMPANY’S COMMON STOCK INVOLVES AHIGH DEGREE OF RISK. IN ADDITION TO THE OTHER INFORMATION IN THIS REPORT,POTENTIAL INVESTORS SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS BEFOREDECIDING TO INVEST OR MAINTAIN AN INVESTMENT IN SHARES OF THE COMPANY’S COMMONSTOCK. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCURS, IT IS LIKELY THAT THECOMPANY’S BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS WOULD BE HARMED.AS A RESULT, THE TRADING PRICE OF THE COMPANY’S COMMON STOCK COULD DECLINE, ANDAN INVESTOR COULD LOSE PART OR ALL OF AN INVESTMENT.

 

**Competition**

 

The market for the Company’s products is highlycompetitive. Competitors for the Company’s hardware products include Acer, BestData, Buslink, Hewlett-Packard, Iomega, Phillips, Plextor, Samsung, Sony, TDKand Yamaha.  Competitors for theCompany’s media products include Fuji, Imation, Maxell, Memorex, PNY, TDK andVerbatim.  The Company also indirectlycompetes against original equipment manufacturers such as Dell Computer andCompaq to the extent that they manufacture their own add-in subsystems orincorporate on PC motherboards the functionality provided by the Company’sproducts. In certain markets where the Company is a relatively new entrant, theCompany may face dominant competitors including 3Com (modems), CreativeTechnologies, Inc. (sound cards, modems and Internet music players) and SonyCorp. (consumer electronic music players). In addition, the Company’s markets are expected to become increasinglycompetitive as multimedia functions continue to converge and companies thatpreviously supplied products providing distinct functions (for example,companies today primarily in the sound, modem, CPU or motherboard markets)emerge as competitors across broader or more integrated product categories.

 

The Company also believes that the strategy of certainof its current and potential competitors is to compete largely on the basis ofprice, which may result in lower prices and lower margins for the Company’sproducts or otherwise adversely affect the market for the Company’sproducts.  There can be no assurancethat the Company will be able to continue to compete successfully in itscurrent and future markets, or will be able to compete successfully againstcurrent and new competitors, as the Company’s technology, markets and productscontinue to evolve.

 

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**ProprietaryRights**

 

The Company utilizes subcontractors to manufacture itsproducts.  Further, the Company is notthe licensee or owner of any of the technology comprising its products.  As a result, the Company does not have aproprietary interest in any of the software, hardware or related technologycomprising its various products. The Company relies primarily on trademarkprotection for its I/OMagic, Hi-Val and Digital Research Technologies brandnames.  There can be no assurance thatthe Company’s measures to protect its proprietary rights will deter or prevent unauthorizeduse of the Company’s brands.  Inaddition, the laws of certain foreign countries may not protect the Company’sproprietary rights to the same extent, as do the laws of the United States orthe European Community.  As is typicalin its industry, the Company from time to time is subject to legal claimsasserting that the Company has violated the proprietary rights of thirdparties. In the event that a third party was to sustain a valid claim againstthe Company, and any required licenses were not available on commerciallyreasonable terms, the Company’s operating results could be materially andadversely affected. Litigation, which could result in substantial cost anddiversion of the resources of the Company, may also be necessary to enforce proprietaryrights of the Company or to defend the Company against claimed infringement ofthe proprietary rights of others.

 

**Impactof Recent Accounting Pronouncements**

 

The Company is subject to Emerging Issues Task Force(“EITF”) issue No. 01-09, “Accounting for Consideration Given by a Vendor to aCustomer (Including a Reseller of the Vendor’s Products).”  This issue concluded that certain consumerand trade sales promotion expenses are presumed to be a reduction of theselling prices of the vendor’s products and, therefore, should be characterizedas a reduction of revenue as net sales. The provisions of this pronouncement are required to be applied withfiscal years beginning after December 15, 2001.  The Company has adopted this pronouncement with its December 31,2001 statement of operations and has restated its March 31, 2001 statement ofoperations.  The adoption of thispronouncement has resulted in adjustments to net sales, gross margin andselling and marketing expenses.  Thereis no impact on operating income, net income or earnings per share.  While the Company believes that theapplication of EITF No. 01-09 will not have any effect upon its cash flow,potential investors may view the impact of EITF No. 01-09 upon the Companynegatively. In the event this does occur, the price for the Company’s stock andas a result its ability to raise capital, may be adversely effected.

 

The Company’s financial reporting may be subject toother changes in accounting principles and procedures. In the event these changesnegatively effect the Company’s reporting of the results of its operations, itsability to raise capital and to otherwise utilize its stock to attract keyemployees and finance potential acquisitions would be adversely effected.

 

**DistributionRisks**

 

The Company’s future success is dependent on thecontinued viability and financial stability of its customer base. The computerdistribution and retail channels historically have been characterized by rapidchange, including periods of widespread financial difficulties andconsolidation and the emergence of alternative sales channels, such as directmail order, telephone sales by PC manufacturers and electronic commerce on theworldwide web.  The loss of, orreduction in, sales to certain of the Company’s key customers as a result ofchanging market conditions, competition, or customer credit problems could havea material adverse effect on the Company’s operating results. Likewise, changesin distribution channel patterns, such as increased commerce on the Internet,or increased use of mail-order catalogues, increased use ofconsumer-electronics channels for peripheral product sales, could affect the 

 

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Company in ways not yet known. For example, the rapid emergence of Internet-based e-commerce is puttingsubstantial strain on some of the Company’s traditional channels. Moreover,additions to or changes in the types of products the Company sells, such as thedigital entertainment products, may require specialized value-added resellerchannels, relations with which the Company has only begun to establish.Aggressive strategies employed by customers to obtain reductions in the chargedpurchase price, such as claimed price protections, rebates and advertising funds,may materially and adversely impact upon the Company’s cash flow and financialresults of operations.  Finally, theCompany’s customers frequently require that the Company expend substantial sumsto promote distribution channels, advertise its products and reserve shelfspace for the Company’s products.  Tothe extent the Company’s financial resources decline, the Company might beunable to fulfill its obligations under such programs.  Such a failure might adversely effect theCompany’s relationship with its customers and as a result, its financialresults of operations.

 

**CapitalNeeds**

 

There can be no assurance that additional capitalbeyond the amounts currently forecasted by the Company will not be required orthat any required additional capital will be available on reasonable terms, ifat all, at such time or times as required by the Company. Any shortfall incapital resources compared to the Company’s level of operations or anyinability to secure additional capital as needed could impair the Company’sability to finance inventory, accounts receivable and other operational needs.Such capital limitations could also impair the Company’s ability to invest inresearch and development, improve customer service and support, deployinformation technology systems, and expand marketing and other operations.Failure to keep pace with competitive requirements in any of these areas couldhave a material adverse effect on the Company’s business and operating results.Moreover, any need to raise additional capital through the issuance of equityor debt securities may result in additional dilution to earnings per share.

 

**RisksAssociated with Vertical Integration**

 

The Company pursues a strategy of continuouslyidentifying and evaluating potential product vendors.  Ideally, the Company prefers a number of competitive suppliers ofeach of its products in order to ensure that the Company is offering leadingedge technology in each product line at prices with which the Company cancompete with competitors.  In the recentpast there have been instances of Far East manufacturers of computer peripheralproducts acquiring distribution divisions in North America or otherwiseestablishing their own marketing organization in North America.  While these expansions in and of themselvesare not material to the operations of the Company, vertical integration by theCompany’s suppliers into North American marketing channels may restrict thevendors available to the Company and thereby may reduce the likelihood that theCompany will have access to leading edge technology at prices which allow theCompany to compete with vertically integrated competitors.

 

**RecentFinancial Losses**

 

The Company reported a net losses in fiscal yearsended December 31, 2000 and 2001.  Theselosses stemmed primarily from $5.1 million in inventory write-down during theseyears, mostly caused by the Hi-Val acquisition and increased product promotionexpenses arising from the reintroduction of the Hi-Val and Digital ResearchTechnologies brands.  There is no assurancethat the Company will be able to obtain or maintain profitable operations inthe future.  If it is unable to do so,there may be a material adverse effect on cash flow, which could causeviolations in the covenants under the Line of Credit and could impede theCompany’s ability to raise capital through debt or equity financing to theextent the Company may need it for continued operations or for planned

 

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expansion.  Consequently, futurelosses may have a material adverse effect on the Company’s business, prospects,financial condition, results of operations and cash flows.

 

**Lack ofLong Term Purchase Orders**

 

The Company does not have any long term purchaseorders from its customers.  TheCompany’s product orders are typically received with one to three weeks leadtime to deliver the products. Accordingly, the Company cannot rely on long-term purchase orders orcommitments to protect it from the negative financial effects of a reduceddemand for it’s products that could result from a general economic downturn,from changes in the PC peripheral marketplace, including the entry of newcompetitors into the market, and from the introduction by others of new orimproved technology, from an unanticipated shift in the needs of it’scustomers, or from other causes.

 

**Dependence on Major Customers**

 

During the three month period ended March 31, 2002 theCompany had four major customers which accounted for approximately 87% of theCompany’s net sales.

 

The amounts due from these major customers on March31, 2002 amounted to approximately $24,865,624.  The Company’s strategy is to constantly attempt to sign new majorretail customers in order to both increase the Company’s growth and to reducethe impact of any one customer.

 

The Company does not have any contract with any ofthese customers requiring that any amount of product be purchased in thefuture.  In the event any of these majorcustomers were to cease ordering products from the Company or to reduce thelevel of their orders, the Company’s financial performance could be materiallyand adversely affected.

 

**PotentialFluctuations in Future Operating Results**

 

The Company develops and markets products in thehighly competitive optical storage, digital entertainment, multimedia andinput-output segments of the personal computer peripheral marketplace.  These products are very susceptible toproduct obsolescence and typically exhibit a high degree of volatility ofshipment volumes over relatively short product life cycles. The timing ofintroductions of new products in one calendar quarter as opposed to an adjacentquarter can materially affect the relative sales volumes in thosequarters.  In addition, product releasesby competitors and accompanying pricing actions can materially and adverselyaffect the Company’s revenues and gross margins.

 

The Company sells its products to retail customerssuch as mass merchandisers and large chains who sell products primarilyoff-the-shelf directly to end users. Reliance on indirect channels of distribution means that the Companytypically has little or no direct visibility into end user customerdemand.  The Company must rely uponsales forecasts provided by its retail customers in order to comply with leadtimes required by these customers.  Ifthese forecasts prove inaccurate, the Company could either have excessinventory (resulting in potential finance costs and obsolescence) orinsufficient inventory (resulting in an inability to meet customer demandspromptly). Accordingly, this means that future operating results are dependenton the Company accurately predicting in advance the demand for various productsegments from its customers.

 

**RevenueVolatility and Dependence on Orders Received and Shipped in a Quarter**

 

The volume and timing of orders received during aquarter are difficult to forecast. Retail customers generally order with onlylimited or no forecast data on an as-needed basis.  Moreover, the Company has emphasized its ability to respondquickly to 

 

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customer orders as part of its competitive strategy.  This strategy, combined with currentindustry supply and demand conditions as well as the Company’s emphasis onminimizing inventory levels, has resulted in customers placing orders withrelatively short delivery schedules and increased demand on the Company tocarry inventory for its customer base, particularly for large national retailchains.  This has the effect of increasingshort lead-time orders as a portion of the Company’s business and reducing theCompany’s ability to accurately forecast net sales.  Because retail customers’ orders are at times difficult topredict, there can be no assurance that the combination of these orders, andbacklog in any quarter will be sufficient to achieve either sequential oryear-over-year growth in net sales during that quarter.  If the Company does not achieve a sufficientlevel of retail orders in a particular quarter, the Company’s revenues andoperating results would be materially adversely affected.

 

**Managementof Growth**

 

In recent years, the Company has experienced asignificant expansion in the overall level of its business and the scope of itsoperations, including marketing, technical support, customer service, sales andlogistics.  This expansion in scope hasresulted in a need for significant investment in infrastructure, processdevelopment and information systems. This requirement includes, without limitation:  securing adequate financial resources to successfully integrateand manage the growing businesses and acquired companies; retention of keyemployees; integration of management information, product data management,control, accounting, telecommunications and networking systems; establishmentof a significant worldwide web and e-commerce presence; coordination ofsuppliers and distribution channels; establishment and documentation ofbusiness processes and procedures; and integration of various functions andgroups of employees.  Each of theserequirements poses significant, material challenges.

 

During the year 2000, the Company acquired the Hi-Valbrand name and became the world-wide exclusive licensee of the Digital ResearchTechnologies brand name.  In addition tomanaging the growing business of the Company and its previous acquisitions, theCompany will be required to integrate and manage these brands.  The Company faces significant challenges interms of sales, marketing, and logistics with respect to integrating theproducts and businesses of Hi-Val and Digital Research Technologies into theprocedures and operations of the Company. There can be no assurance that the Company will be able to successfullyintegrate these operations.  If theCompany fails to successfully integrate these brand names into the operationsof the Company, there will likely be a material adverse impact on the operatingresults of the Company.  Even if theintegration is successfully achieved, there can be no assurance that the costof such integration will not materially and adversely affect the Company’soperating results, or that the Company will be able to make a satisfactoryreturn on such costs.

 

In the fourth quarter of 2001, the Company commencedshipping its first digital entertainment product, a portable MP3 playerdistributed under the name MyMP3.  TheCompany has recently filed a trademark application for the name MyMP3. Theseproducts will pose new design, manufacturing and customer support issues to theCompany and there can be no assurance that the Company can successfully meetthese challenges, generate customer demand for such products or satisfycustomer demand for the products. There can also be no assurance that the costassociated with meeting such challenges and satisfying demand will not have amaterial adverse impact on the Company’s operating results in future periods.

 

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**ProductShortages; Reliance on Sole or Limited Source Suppliers**

 

The Company is dependent on sole or limited sourcesuppliers for certain key products.  Ifany of these suppliers were to experience a disruption in their manufacturingcapacity, the financial performance of the Company could be materiallyadversely effected.  There can be noassurances that the Company can obtain adequate inventory of each of itsproduct categories, or that such shortages or the costs of these products willnot adversely affect future operating results. The Company’s dependence on sole or limited source suppliers, and the risksassociated with any delay or shortfall in supply, can be exacerbated by theshort life cycles that characterize the Company’s product mix. Although theCompany maintains ongoing efforts to identify new suppliers of its products,shortages may continue to exist from time to time, and there can be noassurances that the Company can continue to obtain adequate supplies or obtainsuch supplies at their historical or competitive cost levels. In its attempt tocounter actual or perceived shortages, the Company may over-purchase certainproducts or pay expediting or other surcharges, resulting in excess inventoryor inventory at higher than normal costs and reducing the Company’s liquidity,or in the event of unexpected inventory obsolescence or a decline in the marketvalue of such inventory, causing inventory write-offs or sell-offs thatadversely affect the Company’s gross margin and profitability.

 

**Dependenceon Optical Storage and Optical Media Market**

 

Sales of optical storage and related media productsaccounted for approximately 80% of the Company’s net sales in 2001.  Although the Company has introduced productsin the digital entertainment and multimedia segments of the PC peripheralmarket, optical storage and optical media devices are expected to continue toaccount for a majority of the Company’s sales for the foreseeable future. Adecline in demand or average selling prices for optical storage or opticalmedia products, whether as a result of new competitive product introductions,price competition, excess supply, widespread cost reduction, technologicalchange, incorporation of the products’ functionality onto personal computermotherboards or otherwise, would have a material adverse effect on theCompany’s sales and operating results.

 

**Migrationto Personal Computer Motherboards**

 

Many of the Company’s products are individual PCperipheral products that function within personal computers to provideadditional functionality. Historically, as a given functionality becomestechnologically stable and widely accepted by personal computer users, the costof providing such functionality is typically reduced by means of large scaleintegration into semiconductor chips, which can be subsequently incorporatedonto personal computer motherboards. The Company recognizes that such migration could occur with respect tothe functionality provided by some of the Company’s current products.  While the Company believes that a marketwill continue to exist for add-in subsystems that provide advanced or multiplefunctions and offer flexibility in systems and connectivity, such as audio andvideo upgrade cards, there can be no assurance that the incorporation of newmultimedia functions onto personal computer motherboards or into CPUmicroprocessors, will not adversely affect the future market for the Company’sproducts.

 

**Acquisitionand Licensing Risks**

 

In the year 2000, the Company completed theacquisition of the Hi-Val tradename and the license of the Digital ResearchTechnologies tradename.  It is possiblethat a third party could attempt to impose certain liabilities associated withthe prior operations of these brand names upon the Company.  In the event such an event would occur, theCompany could be severely adversely effected.

 

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**Dependenceon Key Personnel**

 

The Company’s future success will depend to asignificant extent upon the efforts and abilities of its senior management andprofessional, technical, sales and marketing personnel, including the Company’spresident Tony Shahbaz. Mr. Shahbaz has been instrumental in virtually allaspects of the Company’s operations. He has developed the key personalrelationships with principals of the Company’s vendors and frequently isextensively involved in the Company’s sales and promotional efforts with itskey customers. The loss of his services would certainly severely and adverselyeffect the financial results of operations of the Company.  The competition for such personnel isintense, particularly in the Orange County, California area.  There can be no assurance that the Companywill be successful in retaining its existing key personnel or in attracting andretaining the additional key personnel that it requires. The loss of servicesof one or more of its key personnel or the inability to add or replace key personnelcould have a material adverse effect on the Company. The salary, performancebonus and stock option packages necessary to recruit or retain key personnel,may significantly increase the Company’s expense levels or result in dilutionto the Company’s earnings per share. The Company does not carry “key person” life insurance on any of itsemployees.

 

**GovernmentRegulation and Industry Standards**

 

The Company frequently jointly designs its productswith its manufacturing suppliers. These products are sometimes subject tovarious government regulations and industry standards, such as UnderwritersLaboratories compliance. It is difficult to predict the direction of evolutionof these regulations and standards and what, if any impact they might have uponthe operations of the Company.  Forexample, the Federal Drug Administration has inspected Company productscontaining laser components for potential health risks.  The Company’s failure to comply with thevarious existing and evolving standards and regulations could adversely impactits ability to sell its products.

 

**DecliningSelling Prices and Other Factors Affecting Gross Margins**

 

The Company’s markets are characterized by intenseongoing competition coupled with a history, as well as a current trend, of decliningaverage selling prices.  A decline inselling prices may cause the net sales in a quarter to be lower than those of apreceding quarter or corresponding prior year’s quarter even if more units weresold during such quarter than in the preceding or corresponding prior year’squarter.  Accordingly, it is possiblethat the Company’s average selling prices will decline, and that the Company’snet sales and margins may decline in the future, from the levels experienced todate (See also “-Short Product Life Cycles; Dependence on New Products”).  The Company’s gross margins may also beadversely affected by shortages of, or higher prices for, key components forthe Company’s products.  Theavailability of new products is sometimes restricted in volume early in aproduct’s life cycle and, should customers choose to wait for the new versionof a product rather than to purchase the current version, the ability of theCompany to procure sufficient volumes of such new products to meet highercustomer demand is limited.  Such afailure to meet demand for new products may have a material adverse effect onthe revenues and operating margins of the Company.

 

**AsianPolitical and Economic Climate**

 

The Company is dependent upon political and economicstability in the Far East. Specifically, the Company orders virtually all of its products fromlarge manufacturing facilities located primarily in Taiwan, Korea and thePeople’s Republic of China.  In theevent of a severe political disruption in the governments of any countrylocated in the Far East, the economic ramifications for the Company’s supplierbase could be devastating.  As a result,the Company’s ability to conduct profitable operations might be materially andadversely effected.  The Company’ssuppliers acquire components and raw materials for the manufacturing of the 

 

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Company’s products from a number of countries, many of which do notconduct operations in United States dollars. Any severe fluctuation in the value of such currencies could materiallyincrease the cost to the Company’s suppliers of manufacturing the Company’sproducts.  Upon such an occurrence, theCompany’s operations could be severely and adversely effected.

 

**Seasonality**

 

The Company believes that, due to industryseasonality, demand for its products is strongest during the fourth quarter ofeach year and is generally slower in the period from April through August.  This seasonality may become more pronouncedand material in the future to the extent that a greater proportion of theCompany’s sales consist of sales of more consumer-oriented orentertainment-driven products.  Theseseasonal fluctuations may be exaggerated by general economic conditions and otherfactors outside the control of the Company. A failure by the Company to accurately forecast seasonal fluctuationsmay have a material adverse effect on the revenues and operating margins of theCompany.

 

**ShortProduct Life Cycles; Dependence on New Products**

 

The market for the Company’s products is characterizedby frequent new product introductions and rapid product obsolescence.  These factors typically result in shortproduct life cycles, frequently ranging from three to six months. The Companymust develop and introduce new products in a timely manner that competeeffectively on the basis of price and performance and that address customerrequirements.  To do this, the Companymust continually monitor industry trends and make difficult choices regardingthe selection of new technologies and features to incorporate into its newproducts, as well as the timing of the introduction of such new products, allof which may impair the orders for or the prices of the Company’s existingproducts.  The success of new productintroductions depends on various factors, some of which are outside theCompany’s direct control.  Such factorsmay include:  selection of new products;selection of controller or memory chip architectures; implementation of theappropriate standards or protocols; timely completion and introduction of newproduct designs; trade-offs between the time of first customer shipment and theoptimization of software drivers and hardware for speed, stability andcompatibility; development and production of collateral product literature; abilityto rapidly ramp manufacturing volumes to meet customer demand in a timelyfashion; and coordination of advertising, press relations, channel promotionand evaluation programs with the availability of new products.  For example, selection of the appropriatestandards and protocols will be a key factor in determining the future successof the Company’s digital entertainment products.

 

**MarketAnticipation of New Products, New Technologies or Lower Prices**

 

Since the environment in which the Company operates ischaracterized by rapid new product and technology introductions and generallydeclining prices for existing products, the Company’s customers may from timeto time postpone purchases in anticipation of such new product introductions orlower prices.  If such anticipatedchanges are viewed as significant by the market, such as the introduction of adata storage format change, then this may have the effect of temporarilyslowing overall market demand and negatively impacting the Company’s operatingresults.  For example, during the fourthquarter of 2001 the Company initially introduced a 32 megabyte version of its“MyMP3” portable digital music system. As technology quickly advanced the Company’s customers immediatelydemanded expanded memory capability. In response, the Company is developing a64 megabyte version of the same product. This demand for more technologically advanced products took place withina period of three months.

 

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**ProductReturns; Price Protection**

 

The Company frequently grants limited rights tocustomers to return certain unsold inventories of the Company’s products inexchange for new purchases (“Stock Rotation”), as well as price protection onunsold inventory.  Moreover, certain ofthe Company’s retail customers will readily accept returned products from theirown retail customers, and these returned products are, in turn, returned to theCompany for credit.  The Companyestimates returns and potential price protection on unsold channelinventory.  The Company accrues reservesfor estimated returns, including warranty returns, and price protection.  The Company may be faced with furthersignificant price protection charges as the Company and its competitors move toreduce channel inventory levels of current products, as new productintroductions are made.  However, therecan be no assurance that any estimates, reserves or accruals will be sufficientor that any future returns or price reductions will not have a material adverseeffect on operating results, including through the mechanisms of Stock Rotationor price protection, particularly in light of the rapid product obsolescencewhich often occurs during product transitions.

 

**RapidTechnological Change**

 

The markets for the Company’s products arecharacterized by rapidly changing technology, evolving industry standards,frequent new product introductions and rapid product obsolescence.  Product life cycles in the Company’s marketsfrequently range from three to six months. The Company’s success will be substantially dependent upon its abilityto continue to develop and introduce competitive products and technologies on atimely basis with features and functions that meet changing customerrequirements in a cost-effective manner. Further, if the Company is successful in the development and marketintroduction of new products, it must still correctly forecast customer demandfor such new products so as to avoid either excessive unsold inventory orexcessive unfilled orders related to the products.  The task of forecasting such customer demand is unusuallydifficult for new products, for which there is little sales history, and forindirect channels, where the Company’s customers are not the final endcustomers.  Moreover, whenever theCompany launches new products, it must also successfully manage the corollaryobsolescence and price erosion of those of its older products that are impactedby such new products, as well as any resulting price protection charges andStock Rotations from its distribution channels.

 

**Quantitativeand Qualitative Disclosures About Interest Rate Risk**

 

The Company is exposed to financial market risks dueprimarily to changes in interest rates. As the Company continues to grow, it is finding that its vendors areincreasingly refusing to provide credit. As a result, the Company frequently is required to draw down upon itsLine of Credit in order to finance its operations.  Fluctuations in interest rates may increase the cost of theCompany drawing down upon its Line of Credit. The Company does not use derivatives to alter the interestcharacteristics of its investment securities or its debt instruments.  The Company has no holdings of derivative orcommodity instruments and does not conduct business in foreign currencies.

 

**“PennyStock” Rules**

 

Broker-dealer practices in connection withtransactions in “penny stocks” are regulated by penny stock rules adopted bythe Securities and Exchange Commission. Penny stocks, like shares of theCompany’s common stock, generally are equity securities with a price of lessthan $5.00 (other than securities registered on some national securitiesexchanges or quote on NASDAQ).  Thepenny stock rules require a broker-dealer, prior to a transaction in a pennystock not otherwise exempt from the rules, to deliver a standardized riskdisclosure document that provides information about penny stocks and the natureand level of  risks in the penny 

 

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stock market.  The broker-dealermust also provide current bid and offer quotations for the penny stock, thecompensation of the broker-dealer and its sales person in the transaction, andif the broker-dealer is the sole market maker, the broker dealer must disclosethis fact and the broker dealer’s presumed control over the market, and themonthly account statements showing the market value of each penny stock held inthe customer’s account.  In addition,broker-dealers who sell these securities to persons other than establishedcustomers and “accredited investors” must make a special written determinationthat the penny stock is a suitable investment for the purchaser and receive thepurchaser’s written agreement to the transaction.  Consequently, these requirements may have the effect of reducingthe level of trading activity, if any, in the secondary market for a securitysubject to the penny stock rules, and investors in the Company’s common stockmay find it difficult to sell their shares.

 

**BulletinBoard Listing**

 

The Company’s stock is currently quoted upon the NASDOver-the-Counter Bulletin Board under the symbol “IOMC.OB.”  Because the Company’s stock trades upon theBulletin Board rather than on a national stock exchange, investors may find itdifficult to either dispose of, or to obtain quotations as to the price of theCompany’s common stock. In the event the Company does not timely file allreports and related forms required to maintain “reporting status” under theSecurities Exchange Act of 1934, the Company would be delisted from theBulletin Board.  In the event of such adelisting, investors in the Company’s stock might be unable to sell theirshares and might be required to maintain their investment in the Companyindefinitely.

 

**StockPrice Volatility**

 

The trading price of the Company’s Common Stock hasbeen subject to significant fluctuations to date, and could be subject to widefluctuations in the future in response to quarter-to-quarter variations inoperating results, announcements of technological innovations, new product introductionsby the Company or its competitors, general conditions in the markets for theCompany’s products or the computer industry, the price and availability of theCompany’s products, general financial market conditions, market conditions forPC or semiconductor stocks, changes in earnings estimates by analysts, or otherevents or factors.  In this regard, theCompany does not endorse and accepts no responsibility for the estimates orrecommendations issued by stock research analysts from time to time.  In addition, the public stock markets ingeneral, and technology stocks in particular, have experienced extreme priceand trading volume volatility.  Thisvolatility has significantly affected the market prices of securities of manyhigh technology companies for reasons frequently unrelated to the operatingperformance of the specific companies. These broad market fluctuations may adversely affect the market price ofthe Company’s Common Stock.

 

**PART II — OTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

In August 1999, theCompany filed an arbitration proceeding in Orange County, California againstits former accountants and auditors, Ernst & Young, LLP, for failure tocomplete the 1997 audit of the Company in a timely fashion and for excessivebilling in connection with the 1997 audit. In January 2002 a ruling was issued determining that the Company owedErnst & Young $8,000 in fees for the 1997 audit.

 

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On March 9, 2002,the following individuals:  Mark Vakili,Mitra Vakili, Hi-Val, Inc., and Alex Properties, filed a Complaint in OrangeCounty Superior Court  ( the“Complaint”) naming IOM Holdings, Inc. (“IOMH”), the Company, Steele Su, TonyShahbaz and Mei Hsu. The Complaint alleges eight causes of action, however,only three claims are asserted against IOMH and the Company.

 

Thethree causes of action against IOMH and the Company all relate to an AssetPurchase Agreement executed by IOMH and Hi-Val in June 1999 for the purchaseand sale of Hi-Val assets to IOMH.  Thecauses of action are for breach of contract, fraud and negligentmisrepresentation.  The allegations inthe Complaint are that IOMH and other defendants failed to deliver theconsideration due under the Asset Purchase Agreement after taking control ofHi-Val.  The fraud and negligentmisrepresentation claims are based on alleged representations made by IOMH andothers to induce Hi-Val and Mark Vakili to enter into the Asset PurchaseAgreement. The damages claimed by Plaintiffs in the causes of action are for$27,000,000.00.  Punitive damages areclaimed on the fraud cause of action.

 

While the Companybelieves that it will prevail in the litigation set forth in the Complaint,this litigation is at a very early stage and it is difficult to predict whensuch litigation will be resolved.  TheCompany intends to vigorously defend this litigation.

 

**Item2.  Changes in Securities and Use ofProceeds**

 

Incorporated by reference from Registrant’s Report on Form 10-Kfiled with the Securities and Exchange Commission on March 31, 2001 (seeManagement’s Discussion and Analysis and ­Liquidity and CapitalResources).  See Financial Statement ­SupplementalSchedule of Non-Cash Investing and Financing Activities and Note 6.

 

**Item3.  Defaults Upon Senior Securities**

 

None

 

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

 

None.

 

**Item5.  Other Information**

 

None.

 

**Item6.  Exhibits and Reports on Form 8-K**

 

The following documents are filed as part of this report:

 

1.     Reports on Form 8-Kfiled:                 None

 

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**Signatures**

 

In accordance withthe Exchange Act, the registrant caused this report to be signed on its behalfby the undersigned, duly authorized.

 
|   |         |   | I/OMAGIC CORPORATION                        |
|--------|--------------|--------|---------------------------------------------|
|   |         |   |                                        |
| DATED: | May 14, 2002 |   | By:                                         | /s/ Tony Shahbaz |
|   |         |   | Tony Shahbaz, President and Chief Executive |
|   |         |   | Officer, Chief Financial Officer            |

 

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