UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549




FORM 10-Q


(Mark One)




[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




For the quarterly period ended September 30, 2010







[_]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




For the transition period from ______ to _______







Commission File Number: 000-27267




I/OMAGIC CORPORATION


(Exact name of registrant as specified in its charter)





Nevada

(State or other jurisdiction

of incorporation or organization)
33-0773180

(I.R.S. Employer

Identification No.)4 Marconi, Irvine, California

(Address of principal executive offices)
92618

(Zip Code)




(949) 707-4800


(Registrant’s telephone number, including area code)




Not applicable.


(Former name, former address and former fiscal year, if changed since last report)




Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.


Yes x No  ̈




Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).


Yes  ̈ No  ̈




Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.





Large accelerated filer   ̈
Accelerated filer   ̈Non-accelerated filer   ̈(Do not check if a smaller reporting company)
Smaller reporting company  x




Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ̈ No x




As of November 9, 2010, there were 4,540,292 shares of the issuer’s common stock issued and outstanding.












CAUTIONARY STATEMENT




All statements included or incorporated by reference in this Quarterly Report on Form 10-Q, other than statements or characterizations of historical fact, are “forward-looking statements.” Examples of forward-looking statements include, but are not limited to, statements concerning projected net sales, costs and expenses and gross margins; our accounting estimates, assumptions and judgments; the demand for our products; the competitive nature of and anticipated growth in our industry; and our prospective needs for additional capital. These forward-looking statements are based on our current expectations, estimates, approximations and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. Forward-looking statements can often be identified by such words as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are set forth in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2009, which could cause our financial results, including our net income or loss or growth in net income or loss to differ materially from prior results, which in turn could, among other things, cause the price of our common stock to fluctuate substantially. These forward-looking statements speak only as of the date of this report. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law.










TABLE OF CONTENTS




PART I


FINANCIAL INFORMATION





PageItem 1.
Financial Statements (unaudited)

1Condensed Consolidated Balance Sheets as of September 30, 2010 (unaudited) and December 31, 2009

1Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2010 and 2009 (unaudited)

2Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2010 and 2009 (unaudited)

3Notes to Condensed Consolidated Financial Statements

4Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

17Item 3.
Quantitative and Qualitative Disclosures About Market Risk

26Item 4.
Controls and Procedures

26  PART II OTHER INFORMATION
 Item 1.
Legal Proceedings

26Item 1A.
Risk Factors

27Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds

27Item 3.
Defaults Upon Senior Securities

27Item 4.
(Removed and Reserved)

27Item 5.
Other Information

27Item 6.
Exhibits

27Signatures

28




Exhibits Filed with this Report




i


PART I – FINANCIAL INFORMATION




ITEM 1.
FINANCIAL STATEMENTS




I/OMAGIC CORPORATION AND SUBSIDIARY


CONDENSED CONSOLIDATED BALANCE SHEETS





September 30,2010


December 31, 2009ASSETS

(unaudited)Current assetsCash and cash equivalents

$
707,310


$
445,675Accounts receivable, net


163,393



654,582Inventories, net


1,278,150



1,682,022Prepaid and other current assets


55,477



197,404Total current assets


2,204,330



2,979,683Property and equipment, net


100,079



139,089Other non-current assets


39,002



37,503Total assets

$
2,343,411


$
3,156,275LIABILITIES AND STOCKHOLDERS’ DEFICITCurrent liabilitiesAccounts payable and other accrued expenses

$
222,676


$
570,107Accounts payable – related party


60,000



4,388,253Capital lease obligations – current portion


-



13,704Accrued mail-in rebates


890



4,375Total current liabilities


283,566



4,976,439Long-term liabilitiesAccounts payable – related party


4,148,553



-Sub-lease deposit


9,703



9,703Total long-term liabilities


4,158,256



9,703Total liabilities


4,441,822



4,986,142Stockholders’ deficitPreferred stock, $0.001 par value, 10,000,000 shares authorizedSeries A, 1,000,000 shares authorized, no shares issued and outstanding


-



-Series B, 1,000,000 shares authorized, no shares issued and outstanding


-



-Common stock, $0.001 par value, 100,000,000 shares authorized, 4,540,292 and 4,540,292 shares issued and outstanding, respectively


4,541



4,541Additional paid-in capital


31,858,651



31,858,651Accumulated deficit


(33,961,603
)


(33,693,059
)Total stockholders’ deficit


(2,098,411
)


(1,829,867
)Total liabilities and stockholders’ deficit

$
2,343,411


$
3,156,275














See accompanying notes to these condensed consolidated financial statements.


1


I/OMAGIC CORPORATION AND SUBSIDIARY


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(unaudited)





Three Months Ended

September 30,


Nine Months Ended

September 30,2010


2009


2010


2009Net sales

$
1,311,459


$
2,341,777


$
4,934,586


$
7,931,873Cost of sales


841,019



1,653,235



3,454,724



5,338,211Gross profit


470,440



688,542



1,479,862



2,593,662Operating expensesSelling, marketing and advertising


94,124



153,951



319,542



515,173General and administrative


462,437



461,985



1,388,480



1,798,970Depreciation and amortization


12,877



13,003



39,010



39,637Total operating expenses


569,438



628,939



1,747,032



2,353,780Income (loss) from operations


(98,998
)


59,603



(267,170
)


239,882Other income (expense)Interest expense


—



(1,169
)


—



(1,169
)Currency transaction loss


—



—



—



(2,762
)Other income


(4
)


216



(574
)


9,012Total other income (expense)


(4
)


(953
)


(267,744
)


5,081Income (loss) before provision for income taxes


(99,002
)


58,650



(267,744
)


244,963Provision for income taxes


—



—



800



800Net income (loss)

$
(99,002
)

$
58,650


$
(268,544
)

$
244,163Basic and diluted income (loss) per share

$
(0.02
)

$
0.01


$
(0.06
)

$
0.05Basic and diluted weighted-average shares outstanding


4,540,292



4,540,292



4,540,292



4,540,292

















See accompanying notes to these condensed consolidated financial statements.




2




I/OMAGIC CORPORATION AND SUBSIDIARY


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(unaudited)






Nine Months Ended

September 30,2010


2009Cash flows from operating activities:Net income (loss)

$
(268,544
)

$
244,163Adjustments to reconcile net income (loss) to net cash provided by operating activities:Depreciation and amortization


39,010



39,637Allowance for doubtful accounts


—



(1,053
)Allowance for product returns


(220,044
)


39,945Reserves for sales incentives


3,118



27,399Accrued point-of-sale rebates


79,163



(156,898
)Accrued market development funds, cooperative advertising costs and cross-dock fees


(48,520
)


(33,418
)Allowance for obsolete inventory


18,353



(245,824
)Share-based compensation expense


—



16,084Changes in assets and liabilities (net of dispositions and acquisitions):Accounts receivable


677,472



721,122Inventory


385,519



241,673Prepaid expenses and other current assets


141,927



26,716Other assets


(1,499
)


(2,500
)Accounts payable, accrued expenses and other


(347,431
)


(543,656
)Accounts payable - related party


(179,700
)


(66,385
)Deferred revenue


—



(26,400
)Sub-lease deposit


—



9,703Capital leases


(13,704
)


(43,242
)Accrued mail-in rebates


(3,485
)


(21,865
)Net cash provided by operating activities


261,635



225,201Net increase in cash and cash equivalents


261,635



225,201Cash and cash equivalents at beginning of period


445,675



425,495Cash and cash equivalents at end of period

$
707,310


$
650,696Supplemental disclosures of cash flow information:Interest paid

$
—


$
1,169Income taxes paid

$
800


$
800







See accompanying notes to these condensed consolidated financial statements.


3


NOTE 1 – ORGANIZATION AND BUSINESS




Nature of Business




I/OMagic Corporation, a Nevada corporation (“I/OMagic” or the “Company”), develops, manufactures through subcontractors or obtains from suppliers, and markets and sells data storage products and other consumer electronics products. The Company sells its products in the United States and Canada to distributors and retailers.




Liquidity and Going Concern




The accompanying condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern. This contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company incurred a net loss of $268,544 for the nine months ended September 30, 2010, as compared to net income of $244,163 for the nine months ended September 30, 2009. The Company generated net income of $407,156 for the year ended December 31, 2009 but incurred net losses for the years ended December 31, 2008 and 2007, of $4,252,412 and $4,752,974, respectively, and incurred net losses in each of the prior seven years.




At September 30, 2010, the Company had cash and cash equivalents of $707,310. As of November 8, 2010, the Company had cash and cash equivalents of $696,246. As of those dates, the Company also had significant long-term liabilities.  The Company may have insufficient capital to fund its operations for the next twelve months or less. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern and the Company’s independent registered public accounting firm has issued a report expressing substantial doubt about the Company’s ability to continue as a going concern.




The Company’s plans for improving its financial condition include ongoing efforts to bring new products to market and explore other products with its customers, subcontract manufacturers and suppliers to sell through its sales channels, further negotiating suitable repayment terms for outstanding obligations owed to a related-party supplier, seeking new equity capital and new vendor partnerships, timely collection of existing accounts receivable, and sell-through of inventory currently in the Company’s sales channels. If the Company’s capital requirements or cash flow vary materially from its current projections, if the Company is unable to further successfully negotiate suitable repayment terms for outstanding obligations owed to a related-party supplier, if the Company is unable to timely collect its accounts receivable or unable to sell-through inventory currently in its sales channels as anticipated, or if unforeseen circumstances occur, the Company may have insufficient liquidity and may require additional financing to sustain its operations. In addition, if the Company is unable to bring successful new products to market soon, the Company may be forced to substantially curtail its operations.




The condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the inability of the Company to continue as a going concern.


4




NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND CONSOLIDATION




Basis of Presentation




The accompanying unaudited condensed consolidated financial statements of the Company have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements and should be read in conjunction with the consolidated financial statements for the year ended December 31, 2009, and notes thereto included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 19, 2010. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting only of adjustments of a normal recurring nature, necessary for a fair presentation of the Company’s financial position as of September 30, 2010, and its results of operations for the periods presented. These unaudited condensed consolidated financial statements are not necessarily indicative of the results to be expected for the entire year.




The report of the Company’s independent registered public accounting firm dated March 19, 2010 contained in the Company’s financial statements as of and for the year ended December 31, 2009 includes a paragraph that explains that the Company has incurred significant recurring losses, has serious liquidity concerns and may require additional financing in the foreseeable future. The report concludes that these matters, among others, raise substantial doubt about the Company’s ability to continue as a going concern. Reports of independent auditors questioning a company’s ability to continue as a going concern are generally viewed unfavorably by analysts and investors. This report may make it difficult for the Company to raise additional financing necessary to grow or operate its business. The Company urges potential investors to review this report before making a decision to invest in I/OMagic.




Critical Accounting Policies and Use of Estimates




The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions.




The condensed consolidated financial statements include IOM Holdings, Inc.’s intercompany transactions and balances, which have been eliminated in consolidation. On February 26, 2009, Articles of Merger were filed with the State of Nevada to merge the Company’s wholly-owned subsidiary, IOM Holdings, Inc., with and into the Company.




Certain amounts from prior periods have been reclassified to conform with current period presentation.




NOTE 3 – FAIR VALUE MEASUREMENTS




The Company’s financial assets that are measured on a recurring basis at fair value as of September 30, 2010 and December 31, 2009 consisted only of cash in the amount of $707,310 and $445,675, respectively.




Level 1. The Company utilizes the market approach to determine the fair value of its assets and liabilities under Level 1 of the fair value hierarchy. The market approach pertains to transactions in active markets involving identical or comparable assets or liabilities.




Level 2. The fair values determined through Level 2 of the fair value hierarchy are derived principally from or corroborated by observable market data. Inputs include quoted prices for similar assets, liabilities (risk adjusted), and market-corroborated inputs, such as market comparables, interest rates, yield curves, and other items that allow value to be determined.


5




Level 3. The fair values determined through Level 3 of the fair value hierarchy are derived principally from unobservable inputs to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset (or similar assets) at the measurement date.




The Company adopted Financial Accounting Standards Board (“FASB”), Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures, effective January 1, 2008. The adoption of ASC 820 had no impact on the Company’s accounting or disclosure as to its assets and liabilities at September 30, 2010, and did not materially affect the Company’s financial position, results of operations or cash flows for the three and nine months ended September 30, 2010. The Company will continue to make an evaluation of the fair value of its assets and liabilities as of the end of each future reporting period.




There were no changes in the Company’s valuation techniques during the three and nine months ended September 30, 2010.




The Company is generally not exposed to changes in interest rates which could result in cash flow risks.




The carrying values of cash, accounts receivable, accounts payable and accrued expenses approximate fair value for all periods presented due to the short-term maturity of these assets and liabilities.




NOTE 4 – CONCENTRATION OF RISK




Cash and Cash Equivalents




The Company maintains its cash and cash equivalent balances in several banks and a financial institution located in Southern California that from time to time exceed amounts insured by the Federal Deposit Insurance Corporation up to $250,000 and $100,000 per bank and by the Securities Investor Protection Corporation up to $500,000 per financial institution. As of September 30, 2010 and December 31, 2009, balances totaling $422,851 and $141,213, respectively, were uninsured. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents.




Accounts Receivable




As of September 30, 2010, the Company had a retailer and two distributors that collectively represented 94.2% of gross accounts receivable. The amounts due from the retailer and two distributors were 49.0%, 25.1% and 20.1% of gross accounts receivable, respectively.




As of September 30, 2009, the Company had a retailer and two distributors that collectively represented 87.4% of gross accounts receivable. The amounts due from the retailer and two distributors were 44.4%, 24.6%, and 18.4% of gross accounts receivable, respectively.




As a result of the substantial amount and concentration of the Company’s accounts receivable, if any of its major distributors or retailers fails to timely pay the Company amounts owed, the Company could suffer a significant decline in cash flow and liquidity which would negatively affect the Company’s ability to make payments under its credit facility with Bay View Funding and which, in turn, could adversely affect the Company’s ability to borrow funds to pay its liabilities, purchase inventory and sustain its operations.




Retailers and Distributors




During the nine months ended September 30, 2010, the Company’s most significant retailer and distributors were Staples, Tech Data and D&H Distributing. Collectively, this retailer and these distributors accounted for 92.3% of the Company’s net sales in the first nine months of 2010. During the nine months ended September 30, 2009, the Company’s most significant retailer and distributors were Staples, D&H Distributing and Tech Data. Collectively, this retailer and these distributors accounted for 86.7% of the Company’s net sales in the first nine months of 2009.


6




Related Parties




The Company did not purchase inventory from a related party during the three and nine months ended September 30, 2010. As of September 30, 2010 and December 31, 2009, there were $4,208,553 and $4,388,253, respectively, in trade payables outstanding to BTC USA, an affiliate of Behavior Tech Computer Corp., which is a stockholder of the Company.




NOTE 5 – ACCOUNTS RECEIVABLE




Accounts receivable as of September 30, 2010 and December 31, 2009 consisted of the following:





September 30,


December 31,2010


2009(unaudited)Accounts receivable

$
604,557


$
1,282,029Less:       Allowance for product returns


(85,659
)


(305,703
)Reserves for sales incentives


(36,764
)


(33,646
)Accrued point-of-sale rebates


(260,809
)


(181,646
)Accrued market development funds, cooperative advertising costs and cross-dock fees


(57,932
)


(106,452
)Total

$
163,393


$
654,582





NOTE 6 – INVENTORY




Inventory as of September 30, 2010 and December 31, 2009 consisted of the following:





September 30,


December 31,2010


2009(unaudited)Component parts

$
78,835


$
48,176Finished goods—warehouse


392,108



696,496Finished goods—consigned


836,207



947,9971,307,150



1,692,669Less:  Allowance for obsolete inventory


(29,000
)


(10,647
)Total

$
1,278,150


$
1,682,022




Consigned inventory is located at the stores and distribution centers of certain distributors and retailers with which the Company has consignment agreements. The inventory is owned by the Company until sold by the distributors or retailers.




The Company’s inventories are made up of component parts and finished goods and are valued at the lower of cost or market using the weighted-average cost method, which approximates the first-in, first-out method. Average cost includes the direct purchase price of inventory, net of vendor allowances and cash discounts, and allocated overhead costs associated with the Company’s warehouse and distribution center.


7




NOTE 7 – PROPERTY AND EQUIPMENT




Property and equipment as of September 30, 2010 and December 31, 2009 consisted of the following:





September 30,


December 31,2010


2009(unaudited)Computer equipment and software

$
276,598


$
979,623Warehouse equipment


112,343



138,065Office furniture and equipment


191,338



281,155Vehicles


68,035



74,742Leasehold improvements


104,521



106,633752,835



1,580,218Less:Accumulated depreciation


(652,756
)


(1,441,129
)Total

$
100,079


$
139,089




For the three months ended September 30, 2010 and 2009, depreciation and amortization expense was $12,877 and $13,033, respectively. For the nine months ended September 30, 2010 and 2009, depreciation and amortization expense was $39,010 and $39,637, respectively.




The Company adjusted its fixed assets at June 30, 2010 to reflect fully depreciated assets that had been abandoned or are no longer used. These adjustments resulted in reducing the December 31, 2009 balances by $827,383 as indicated above. There were no additions to fixed assets during the three and nine months ended September 30, 2010.




NOTE 8 – CREDIT FACILITY




Bay View Funding




On October 29, 2008, the Company entered into a Sale of Accounts and Security Agreement (the “Agreement”) dated as of October 24, 2008 with Rexford Funding, LLC, which was acquired by Bay View Funding (“Lender”) on November 11, 2009. The Agreement provides for an accounts receivable-based credit facility.




The credit facility allows the Company to sell accounts receivable to Lender subject to a maximum amount equal to $1,500,000. The purchase price for each purchased account is to equal the net invoice amount less Lender’s commission. Lender is entitled to a factoring commission equal to 0.033% of the gross invoice amount of each purchased account receivable and an additional 0.033% for each day the account receivable remains outstanding and unpaid.




Lender, in its sole and absolute discretion, may from time to time advance the Company funds against the purchase price of the accounts receivable in an amount of up to 75% (except as to accounts receivable of Staples which shall be up to 60%) of the aggregate purchase price of the purchased accounts receivable, subject to customary reductions, including those based on (i) disputed accounts receivable, (ii) any accounts receivable from a customer whom Lender deems not credit worthy, (iii) any accounts receivable unpaid in excess of 60 days, (iv) any accounts receivable from a past-due customer when 25% or more accounts receivable from that customer are unpaid in excess of 60 days, (v) any accounts receivable which Lender deems, in its sole and absolute discretion, are ineligible, and (vi) any fees, actual or estimated, that are chargeable to the Company’s reserve account as to the credit facility. Lender is entitled to interest charges on all advances at a rate equal to the Prime Rate plus 1.00%, but in no case less than 5.50%.


8




The Agreement had an initial term through April 30, 2009 with automatic six month extensions unless either party terminated the Agreement at least 60 but not more than 90 days prior to the end of the initial term or any renewal term. In August 2009, the Company modified the Agreement to include a month-to-month term. At all times Lender has the right to terminate the Agreement upon 30 days prior notice.




If the Company terminates the Agreement prior to the end of any renewal term, the Company will be subject to an early termination fee equal to Lender’s average monthly commission and/or deficiency charges for the preceding six month period, or the entire period from the date of the Agreement if the preceding period is less than six months, multiplied by the number of months remaining in the applicable renewal term.




The obligations of the Company under the Agreement are secured by the Company’s accounts receivable and all proceeds thereof and, with respect thereto, all chattel paper, commercial tort claims, deposit accounts, documents, general intangibles, goods, letters of credit, letter of credit rights and all supporting obligations. The Agreement also contains other customary representations, warranties, covenants and terms and conditions.




NOTE 9 – ACCOUNTS PAYABLE AND ACCRUED EXPENSES




Accounts payable and accrued expenses as of September 30, 2010 and December 31, 2009, consisted of the following:





September 30,


December 31,2010


2009(unaudited)Trade accounts payable

$
130,338


$
365,074Accrued compensation and related benefits


76,664



144,627Other


15,674



60,406Total

$
222,676


$
570,107




NOTE 10 – ACCOUNTS PAYABLE—RELATED PARTY




In February 2003, the Company entered into a Warehouse Services and Bailment Agreement with BTC USA. Under the terms of the agreement, BTC USA agreed to supply and store at the Company’s warehouse up to $10,000,000 of inventory on a consignment basis. The Company was responsible for insuring the consigned inventory, storing the consigned inventory for no charge, and furnishing BTC USA with weekly statements indicating all products received and sold and the current level of consigned inventory. The agreement also provided the Company with a trade line of credit of up to $10,000,000 with payment terms of net 60 days, without interest. The agreement may be terminated by either party upon 60 days’ prior written notice to the other party. BTC USA is a subsidiary of Behavior Tech Computer Corp., one of the Company’s significant stockholders. Mr. Steel Su, who is the Chief Executive Officer of Behavior Tech Computer Corp., is a former director of the Company. The Company made no purchases under this arrangement during the nine months ended September 30, 2010 and 2009. As of September 30, 2010 and December 31, 2009, there were $4,208,553 and $4,388,253, respectively, in trade payables outstanding under this arrangement. On July 20, 2010, the Company agreed to make a one-time payment of $50,000 and monthly payments each in the amount of $5,000 over the next 23 months to BTC USA.  In accordance with the repayment schedule, the Company classified the payments due within one year as a current liability and the balance due in excess of one year as a long-term liability on its balance sheet. The Company and BTC USA are to reach agreement on or before September 1, 2011 on repayment of the balance owed.


9




BTC USA provided the Company with significantly preferential trade credit terms. These terms included extended payment terms, substantial trade lines of credit and other preferential buying arrangements. The Company believes that these terms were substantially better terms than it could likely obtain from other subcontract manufacturers or suppliers. The Company does not currently utilize this trade credit facility as BTC USA is either not able to supply certain products the Company currently sells, or in some cases, the Company is able to source certain products at better prices directly from other third-party manufacturers. Additionally, due to substantial outstanding obligations owed to BTC USA, it is highly unlikely that the Company will be able to obtain additional inventory supplies from BTC USA unless, and at least until, its trade payables owed to BTC USA are repaid. Even if the Company is able to repay its trade payables owed to BTC USA, the Company may be unable to obtain additional inventory supplies from BTC USA on the same terms as before, on satisfactory terms, or at all.




NOTE 11 – COMMITMENTS AND CONTINGENCIES




Operating Lease Commitments




The Company leases its facilities under non-cancelable operating lease agreements expiring through December 31, 2012. The Company has the right to extend the lease for one three-year period under the same terms and conditions, except that the base rent for each year during the option period is to increase at the rate of three percent per annum.




On July 6, 2009, the Company executed a sub-lease for approximately 30% of its facility to a sub-tenant for a period of 18 months with an option to renew for an additional 22 months. The total amount of minimum rentals to be received under the sub-lease for the initial 18 month period is $160,578. In addition to the base rent, the sub-tenant also pays its proportionate share of the monthly operating expenses related to the facilities.




Capital Lease Obligations




The Company entered into various lease agreements during 2007 to acquire certain equipment. The lease agreements expired during the first quarter of 2010 and the Company exercised its right to purchase the equipment for the amounts provided in the lease agreements.




Other Contractual Obligations




During its normal course of business, the Company has made commitments under which it will or may be required to make payments in relation to certain transactions. These include lease, service and retail agreements and employment contracts. See “Note 12—Commitments and Contingencies” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.




Financial Agreements




On October 29, 2008, the Company entered into a Sale of Accounts and Security Agreement dated as of October 24, 2008 with Rexford Funding, LLC which provides for an accounts receivable-based credit facility. There was no outstanding balance owed to Rexford Funding, LLC as of September 30, 2010. See Note 8—Credit Facility.




Service Agreements




The Company periodically enters into various agreements for services including, but not limited to, public relations, financial consulting, sales consulting and manufacturing consulting. The agreements generally are ongoing until such time as they are terminated. Compensation for services is paid either on a fixed monthly rate or based on a percentage, as specified. These expenses are included in operating expenses in the accompanying consolidated statements of operations.


10




Legal Matters




The Company may be involved in certain legal proceedings and claims which arise in the normal course of business. Management does not believe that the outcome of these matters will have a material effect on the Company’s financial position, results of operations or cash flows.




NOTE 12 – STOCK-BASED COMPENSATION




The Company has a 2002 Stock Option Plan and a 2003 Stock Option Plan, which are collectively referred to as the “Plans.”  The total number of shares of the Company’s common stock authorized for issuance under the 2002 Stock Option Plan and the 2003 Stock Option Plan are 133,334, and 400,000, respectively.




Under the Plans, options granted may be either “incentive stock options,” within the meaning of Section 422 of the Internal Revenue Code, or “nonqualified options.” Incentive stock options granted under the Plans must have an exercise price of not less than the fair market value of a share of common stock on the date of grant unless the optionee owns more than 10% of the total voting securities of the Company. In this case, the exercise price will not be less than 110% of the fair market value of a share of common stock on the date of grant. Incentive stock options may not be granted to an optionee under the Plans if the aggregate fair market value, as determined on the date of grant, of the stock with respect to which incentive stock options are exercisable by such optionee in any calendar year under the Plans, exceeds $100,000. Nonqualified options granted under the Plans must have an exercise price of not less than the fair market value of a share of common stock on the date of grant. Nonqualified options granted under the Plans must have an exercise price of not less than 85% of the fair market value of a share of common stock on the date of grant.




Under the Plans, options may be exercised during a period of time fixed by the committee administering the Plans (which could include the entire Board of Directors of the Company). Options granted under the Plans must vest at a rate not less than 20% per year over a consecutive five-year period. No option granted under either Plan may be exercised more than 10 years after the date of grant. Incentive stock options granted to an optionee who owns more than 10% of the voting securities of the Company may not be exercised more than five years after the date of grant.




The weighted-average exercise prices, remaining contractual lives and aggregate intrinsic values for options and warrants granted, exercisable, and expected to vest under the Plans as of September 30, 2010 were as follows (unaudited):





Options

Number of

Shares

Weighted-

Average

Exercise

Price Per Share

Weighted-

Average

Remaining

Contractual

Life (Years)

Aggregate

Intrinsic

Value(1)Outstanding


9,300


$
3.50



3.5


$
−Expected to vest


9,300


$
3.50



3.5


$
−Exercisable


9,300


$
3.50



3.5


$
−





(1) Awards that are expected to vest take into consideration estimated forfeitures for awards not yet vested.


11




There were no options granted during the nine months ended September 30, 2010 and 2009. No cash was received from the exercise of stock options for the nine months ended September 30, 2010 and 2009. As of September 30, 2010, there was no unrecognized compensation costs related to non-vested share-based compensation arrangements.




Share-based compensation expense was $0 and $16,084 for the nine months ended September 30, 2010 and 2009, respectively. There was no tax deduction for share-based compensation expense during those periods. When options are exercised, the Company’s policy is to issue new shares to satisfy share option exercises.




The Company expenses share-based compensation in cost of goods sold or operating expenses, depending on the job function of the employee.




NOTE 13 – INCOME TAXES




The Company is required to file federal and state income tax returns in the United States. The preparation of these tax returns requires the Company to interpret the applicable tax laws and regulations in effect in such jurisdictions, which could affect the amount of tax paid by the Company. The Company, in consultation with its tax advisors, bases its tax returns on interpretations that are believed to be reasonable under the circumstances. The tax returns, however, are subject to routine reviews by the various federal and state taxing authorities in the jurisdictions in which the Company files its returns. As part of these reviews, a taxing authority may disagree with respect to the tax positions taken by the Company (“uncertain tax positions”) and therefore require the Company to pay additional taxes. The Company prepares an accrual for uncertain tax positions as more definitive information becomes available from taxing authorities, completion of tax audits, expiration of statute of limitations, or upon occurrence of other events. With few exceptions, the Company is no longer subject to United States federal, state or local, or non-United States income tax examination by tax authorities for tax years before 2001.




Prior to January 1, 2007, the Company analyzed and determined no accrual was required for uncertain tax positions based upon ASC 450, Accounting for Contingencies, which requires the Company to accrue for the estimated additional amount of taxes for the uncertain tax positions if it was probable the Company would be required to pay such additional taxes. Effective January 1, 2007, the Company adopted and implemented the provisions of ASC 740-10,Accounting for Uncertainty in Income Taxes, which requires the Company to accrue for the estimated additional amount of taxes for the uncertain tax positions if it is more likely than not that the Company would be required to pay such additional taxes. As a result of the implementation of ASC 740-10, the Company recognized no charge for uncertain tax positions.




ASC 740, Income Taxes, requires that a valuation allowance be established when it is more likely than not that its recorded net deferred tax asset will not be realized. In determining whether a valuation allowance is required, a company must take into account all positive and negative evidence with regard to the utilization of a deferred tax asset. ASC 740 further states that it is difficult to conclude that a valuation allowance is not needed when there is negative evidence such as cumulative losses in recent years. As of September 30, 2010 and December 31, 2009, the valuation allowance for deferred tax assets totaled approximately $16,329,000 and $16,376,000, respectively. For the nine months ended September 30, 2010 and September 30, 2009, the net change in the valuation allowance was a decrease of approximately $47,000 and a decrease of approximately $100,000, respectively.




The Company plans to continue to provide a full valuation allowance on future tax benefits until it can sustain an appropriate level of profitability and until such time, the Company would not expect to recognize any significant tax benefits in its future results of operations.


12




As of September 30, 2010, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $39,486,000 and $28,669,000, respectively, that expire through 2029 and 2019, respectively. The utilization of net operating loss carryforwards may be limited under the provisions of Internal Revenue Code Section 382 and similar state provisions due to the change in ownership.




ASC 740-10 not only impacts the amount of the Company’s accrual for uncertain tax positions but it also impacts the manner in which such accruals should be classified in the Company’s financial statements. In connection with the implementation of FIN 48, and if an accrual is recorded, the Company will record the aggregate accrual for uncertain tax positions as a component of current or non-current income tax payable and the offsetting amounts as a component of the Company’s net deferred tax assets and liabilities.




The Company’s continuing practice is to recognize interest and penalties related to income tax matters in income tax expense. As of September 30, 2010 and December 31, 2009, the Company had no accrual for the payment of interest and penalties.




NOTE 14 – SEGMENT INFORMATION




The Company currently operates in one business segment, consumer electronics. All fixed assets are located at the Company’s headquarters in the United States. All sales for the nine months ended September 30, 2010 were in the United States.




NOTE 15 – RECENT ACCOUNTING PRONOUNCEMENTS




In September 2009, the FASB issued ASC 605-25, Revenue Recognition – Multiple-Deliverable Revenue Arrangements. This guidance addresses how to separate deliverables and how to measure and allocate consideration to one or more units of accounting. Specifically, the guidance requires that consideration be allocated among multiple deliverables based on relative selling prices. The guidance establishes a selling price hierarchy of (1) vendor-specific objective evidence, (2) third-party evidence, and (3) estimated selling price. This guidance is effective for annual periods beginning after December 15, 2009 but may be adopted early as of the beginning of an annual period. The adoption of this statement did not have a material effect on the Company’s financial statements and results of operations.




In June 2009, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162, now referred to as ASC 105-10, Generally Accepted Accounting Principles. The FASB Accounting Standards Codification, or the Codification, has become the source of authoritative United States generally accepted accounting principles recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission under authority of federal securities laws are also sources of authoritative United States generally accepted accounting principles for Securities and Exchange Commission registrants. On the effective date of this statement, the Codification will supersede all then-existing non-Securities and Exchange Commission accounting and reporting standards. All other non-grandfathered non-Securities and Exchange Commission accounting literature not included in the Codification will become non-authoritative. This statement is effective for financial statements issued for interim and annual periods ending after September 30, 2009. The adoption of this statement did not have a material effect on the Company’s financial statements.




In June 2009, the FASB issued SFAS No. 165, later codified in ASC 855-10, Subsequent Events. ASC 855-10 establishes general standards for the evaluation, recognition and disclosure of events and transactions that occur after the balance sheet date. Although there is new terminology, the standard is based on the same principles as those that currently exist in the auditing standards. The standard, which includes a new required disclosure of the date through which an entity has evaluated subsequent events, is effective for interim or annual periods ending after June 15, 2009. The adoption of ASC 855-10 did not have a material effect on the Company’s financial statements.


13




In April 2009, the FASB issued FASB Staff Position (“FSP) No. 107-1 and Accounting Principles Board (“APB”) Opinion No. 28-1, later codified in ASC 825-10-65-1, Interim Disclosures about Fair Value of Financial Instruments. FSP 107-1 and APB 28-1 require fair value disclosures in both interim, as well as annual, financial statements in order to provide more timely information about the effects of current market conditions on financial instruments. FSP 107-1 and APB 28-1 and their adoption did not have a material impact on the Company’s financial statements.




In August 2009, FASB issued Accounting Standards Update (“ASU”) No. 2009-05, Fair Value Measurements and Disclosures (ASC Topic 820) — Measuring Liabilities at Fair Value. This update requires clarification for circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the following techniques: 1) a valuation technique that uses either the quoted price of the identical liability when traded as an asset or quoted prices for similar liabilities or similar liabilities when traded as an asset; or 2) another valuation technique that is consistent with the principles in ASC Topic 820 such as the income and market approach to valuation. The amendments in this update also clarify that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability. This update further clarifies that if the fair value of a liability is determined by reference to a quoted price in an active market for an identical liability, that price would be considered a Level 1 measurement in the fair value hierarchy. Similarly, if the identical liability has a quoted price when traded as an asset in an active market, it is also a Level 1 fair value measurement if no adjustments to the quoted price of the asset are required. This update was effective for the Company’s second quarter of fiscal year 2010. The adoption of ASU No. 2009-05 did not have a material impact on the Company’s consolidated results of operations and financial position.




In October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (ASC Topic 605) - Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force. This guidance modifies the fair value requirements of ASC subtopic 605-25, Revenue Recognition-Multiple Element Arrangementsby allowing the use of the “best estimate of selling price” in addition to vendor-specific objective evidence (“VSOE”) and verifiable objective evidence (VOE) (now referred to as “TPE” standing for third-party evidence) for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted. This update requires expanded qualitative and quantitative disclosures and is effective for the Company’s first quarter of fiscal year 2011. However, early adoption is allowed. The Company is currently evaluating the impact of adopting this update on its consolidated results of operations and financial position.




In October 2009, the FASB issued ASU No. 2009-14, Certain Revenue Arrangements That Include Software Elements. This ASU changes the accounting model for revenue arrangements that include both tangible products and software elements that are “essential to the functionality,” and scopes these products out of current software revenue guidance. The new guidance will include factors to help companies determine what software elements are considered “essential to the functionality.” The amendments will now subject software-enabled products to other revenue guidance and disclosure requirements, such as guidance surrounding revenue arrangements with multiple-deliverables. The amendments in this ASU are effective prospectively for revenue arrangements entered into or materially modified in the fiscal years beginning on or after June 15, 2010. Early application is permitted. The Company is currently evaluating this new ASU.


14




In January 2010, FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (ASC Topic 820) — Improving Disclosures About Fair Value Measurements. The ASU requires new disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. It also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. The new disclosures and clarifications of existing disclosures are effective for the Company’s third quarter of fiscal year 2010, except for the disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements, which are effective for the Company’s first quarter of fiscal year 2012. Other than requiring additional disclosures, the adoption of this new guidance will not have a material impact on the Company’s consolidated results of operations and financial position.




In February 2010, the FASB issued ASU 2010-09, Subsequent Events – Amendments to Certain Recognition and Disclosure Requirements, that amends ASC Subtopic 855-10, Subsequent Events – Overall. ASU 2010-09 requires an SEC filer to evaluate subsequent events through the date that the financial statements are issued but removed the requirement to disclose this date in the notes to the entity’s financial statements. The amendments are effective upon issuance of the final update and accordingly, the Company has adopted the provisions of ASU 2010-09. The adoption of these provisions did not have a material impact on the Company’s consolidated financial statements.




In March 2010, the FASB ratified the Emerging Issues Task Force final consensus on Issue No. 08-9, Milestone Method of Revenue Recognition. The guidance in this consensus allows milestone method as an acceptable revenue recognition methodology when an arrangement includes substantive milestones. The guidance provides a definition of substantive milestone and should be applied regardless of whether the arrangement includes single or multiple deliverables or units of accounting. The scope of this consensus is limited to the transactions involving milestones relating to research and development deliverables. The guidance includes enhanced disclosure requirements about each arrangement, individual milestones and related contingent consideration, information about substantive milestones and factors considered in the determination. The consensus is effective prospectively to milestones achieved in fiscal years, and interim periods within those years, after June 15, 2010. Early application and retrospective application are permitted. The Company is currently evaluating this new consensus.


15




NOTE 16 – INCOME (LOSS) PER COMMON SHARE




The Company computes basic income (loss) per common share using net income (loss) and the weighted-average number of common shares outstanding during the period. Diluted income (loss) per common shares is computed using net income (loss) and the weighted-average number of common shares and potentially dilutive common shares outstanding during the period.




The following table sets forth the changes to the computation of basic and diluted income (loss) per share for the three and nine months ended September 30, 2010 and 2009:




Three Months Ended September 30


Nine Months Ended September 302010


2009


2010


2009(unaudited)


(unaudited)


(unaudited)


(unaudited)Net income (loss) available to shareholders

$
(99,002
)

$
58,650


$
(268,544
)

$
244,163Basic income (loss) per share:Basic weighted average shares outstanding


4,540,292



4,540,292



4,540,292



4,540,292Basic income (loss) per share

$
(0.02
)

$
0.01


$
(0.06
)

$
0.05Diluted income (loss) per share:Basic weighted average shares outstanding


4,540,292



4,540,292



4,540,292



4,540,292Effective of dilutive stock options*


-



-



-



-Diluted weighted average shares outstanding


4,540,292



4,540,292



4,540,292



4,540,292Diluted income (loss) per share

$
(0.02
)

$
0.01


$
(0.06
)

$
0.05


*            Diluted income (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Options with an exercise price in excess of the average market value of the Company’s common stock during the period have been excluded from the calculation as their effect would be anti-dilutive. Additionally, potentially dilutive securities are excluded from the computation of income (loss) per share in periods in which a net loss is reported as their effect would be anti-dilutive. Thus, both basic and diluted weighted-average shares outstanding are the same in all periods presented.




16


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS




The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2010 and the related notes and the other financial information included elsewhere in this report. This discussion contains forward-looking statements regarding the data storage and digital entertainment industries and our expectations regarding our future performance, liquidity and financial resources. Our actual results could differ materially from those expressed in these forward-looking statements as a result of any number of factors, including those set forth under the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2009 and elsewhere in this report.




Overview




Business Overview




We sell data storage products and other consumer electronics products. Our data storage products collectively accounted for approximately 99% of our net sales for the first nine months of 2010 and our other consumer electronics products collectively accounted for approximately 1% of our net sales in the first nine months of 2010.




Our data storage products consist of a range of products that store traditional personal computer data as well as movies, music, photos, video games and other multi-media content. Our other consumer electronics products consist of a range of products that focus on digital movies, music and photos.




We sell our products through computer, consumer electronics and office supply superstores, wholesale clubs, distributors, and other major North American retailers. Our network of retailers enables us to offer products to consumers across North America, including every major metropolitan market in the United States. We had no sales outside the United States in the first nine months of 2010. During the first nine months of 2010, our most significant retailer and distributors were Staples, Tech Data and D&H Distributing. Collectively, this retailer and these distributors accounted for 92.3% of our net sales for the first nine months of 2010, or 64.1%, 15.3% and 12.9%, respectively. During the first nine months of 2009, our most significant retailer and distributors were Staples, D&H Distributing and Tech Data. Collectively, this retailer and these distributors accounted for 86.7% of our net sales for the first nine months of 2009, or 45.7%, 31.8% and 9.2%, respectively.




We market our products primarily under our I/OMagic® brand name, but from time to time, we also market products under our Digital Research Technologies® and Hi-Val® brand names. We sell our data storage products primarily under our I/OMagic® brand name, bundling various hardware devices with different software applications to meet a range of consumer needs.




We do not directly manufacture any of the components incorporated into our products. We subcontract the manufacturing of the majority of our products or source our products from suppliers in Asia, predominantly from China and Taiwan, which allows us to offer products at highly competitive prices. Most of our subcontract manufacturers and suppliers have substantial product development resources and facilities, and are among the major component manufacturers and suppliers in their product categories, which we believe affords us substantial flexibility in offering new and enhanced products.


17




Liquidity Overview




As of November 8, 2010, we had $696,246 of cash and cash equivalents and significant long-term liabilities.  We may have insufficient capital to fund our operations for the next twelve months or less.  These factors, among others, raise substantial doubt about our ability to continue as a going concern and our independent registered public accounting firm has issued a report expressing substantial doubt about our ability to continue as a going concern.




Our plans for improving our financial condition include ongoing efforts to bring new products to market and explore other products with our customers, subcontract manufacturers and suppliers to sell through our sales channels, negotiating suitable repayment terms for outstanding obligations owed to a related-party supplier, seeking new equity capital and new vendor partnerships, timely collection of existing accounts receivable, and sell-through of inventory currently in our sales channels. If our capital requirements or cash flow vary materially from our current projections, if we are unable to further successfully negotiate suitable repayment terms for outstanding obligations owed to a related-party supplier, if we are unable to timely collect our accounts receivable or unable to sell-through inventory currently in our sales channels as anticipated, or if unforeseen circumstances occur, we may have insufficient liquidity and may require additional financing to sustain our operations. In addition, if we are unable to bring successful new products to market soon, we may be forced to substantially curtail our operations. See “—Liquidity and Capital Resources” below.




Critical Accounting Policies and Estimates




The preparation of our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, requires us to make judgments and estimates that may have a significant impact upon the portrayal of our financial condition and results of operations. We believe that of our significant accounting policies, the following require estimates and assumptions that require complex, subjective judgments by management that can materially impact the portrayal of our financial condition and results of operations: going concern assumption, revenue recognition; sales incentives; market development funds and cooperative advertising costs, rebate promotion costs and slotting fees; inventory obsolescence allowance; lower-of-cost-or-market reserve; accounts receivable and allowance for doubtful accounts; and product returns. These significant accounting policies are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” in our Annual Report on Form 10-K for the year ended December 31, 2009.


18




Results of Operations


The tables presented below, which compare our results of operations from one period to another, present the results for each period, the change in those results from one period to another in both dollars and percentage change and the results for each period as a percentage of net sales. The columns present the following:




·
The first two data columns in each table show the dollar results for each period presented.




·
The columns entitled “Dollar Variance” and “Percentage Variance” show the change in results, both in dollars and percentages. These two columns show favorable changes as positive and unfavorable changes as negative. For example, when our net sales increase from one period to the next, that change is shown as a positive number in both columns. Conversely, when expenses increase from one period to the next, that change is shown as a negative in both columns.




·
The last two columns in each table show the results for each period as a percentage of net sales.




Three Months Ended September 30, 2010 Compared to Three Months Ended September 30, 2009 (Unaudited)




Three Months Ended

September 30,



Dollar Variance Favorable



Percentage

Variance

Favorable



Results as a Percentage of

Net Sales2010



2009



(Unfavorable)



(Unfavorable)



2010



2009(in thousands)Net sales

$
1,311


$
2,342


$
(1,031
)


(44.0%
)


100.0%



100.0%Cost of sales


841



1,653



812



49.1%



64.1%



70.6%Gross profit


470



689



(219
)


(31.8%
)


35.9%



29.4%Selling, marketing and advertising expenses


94



154



60



39.0%



7.2%



6.6%General and administrative expenses


462



462



—



—%



35.2%



19.7%Depreciation and amortization


13



13



—



—%



1.0%



0.6%Operating income (loss)


(99
)


60



(159
)


(265.0%
)


(7.6%
)


2.6%Other income (expense)


—



(1
)


1



(100.0%
)


—%



—%Net income (loss)

$
(99
)

$
59


$
(158
)


(267.8%
)


(7.6%
)


2.5%





Net Sales. Net sales decreased by $1,031,000, or 44%, to $1,311,000 in the third quarter of 2010 as compared to $2,342,000 in the third quarter of 2009. The decrease in our net sales was primarily caused by a $955,000, or 43%, decrease in sales of our optical data storage products. Sales of our optical data storage products totaled $1,249,000, or 95% of our net sales for the third quarter of 2010, as compared to $2,204,000, or 94% of our net sales for the third quarter of 2009. Sales of our magnetic data storage products totaled $60,000, or 4% of our net sales for the third quarter of 2010, as compared to $137,000, or 6% of our net sales for the third quarter of 2009.  Sales of our other consumer electronics products totaled $3,000, or 1% of our net sales for the third quarter of 2010 as compared to $1,000, or 1% of our net sales for the third quarter of 2009.





19


The average unit net sales price of our optical data storage products for the third quarter of 2010 increased by 4% to $58.48 compared to $56.27 for the third quarter of 2009. We sold approximately 21,000 optical data storage units in the third quarter of 2010 as compared to approximately 39,000 units in the third quarter of 2009, representing a decrease of approximately 46%.




Our overall product return rate was 2.8% in the third quarter of 2010 compared to 13.7% in the third quarter of 2009.  The decrease in our overall product return rate resulted from a decrease in returns of our optical data storage products during the third quarter of 2010 as compared to the third quarter of 2009.




Our sales incentives, point-of-sale rebates, market development funds, cooperative advertising costs and cross-dock fees, rebate promotion costs and slotting fees, collectively as a percentage of gross sales, increased to 10%, all of which were offset against gross sales, in the third quarter of 2010, as compared to 7% in the third quarter of 2009. The increase in our overall rate of sales incentives, point-of-sale rebates, market development funds, cooperative advertising costs and cross-dock fees, rebate promotion costs and slotting fees resulted primarily from point-of-sale rebates associated with our optical data storage products in the third quarter of 2010 as compared to the third quarter of 2009.  We believe that our overall strategy for stimulating sales through sales incentives has not been effective and we are reviewing our promotions strategy to increase sales.




Gross Profit. Gross profit decreased by $219,000, or 32%, to $470,000 in the third quarter of 2010 as compared to gross profit of $689,000 in the third quarter of 2009. The decrease in gross profit primarily resulted from decreased net sales but was partially offset by increased operating margins on our optical data storage products due to higher average unit net sales prices as well as changes in our product mix that shifted sales to products with lower material costs. Our gross profit margin as a percentage of net sales increased to 36% in the third quarter of 2010 as compared 29% in the third quarter of 2009 as a result of higher average unit net sales prices as well as changes in our product mix that shifted sales to products with lower material costs.




Selling, Marketing and Advertising Expenses. Selling, marketing and advertising expenses decreased by $60,000, or 39%, to $94,000 in the third quarter of 2010 as compared to $154,000 in the third quarter of 2009. This decrease was primarily due to decreases of $37,000 in shipping and handling costs which resulted from reduced sales, $21,000 in outside commissions related to lower sales, $8,000 in trade shows expenses, $1,000 in sales expenses, $1,000 in customer refunds, $1,000 in supplies, $1,000 in support services and $1,000 in sales expenses, all of which were partially offset by increases of $10,000 in personnel costs, and $1,000 in travel and entertainment expenses.




General and Administrative Expenses. General and administrative expenses remained the same for both periods. However, there were decreases of $10,000 in facilities costs, $6,000 in finance charges, $3,000 in taxes, $3,000 in insurance costs, $2,000 in audit fees, $2,000 in outside services costs and $1,000 in bank charges, all of which were offset by increases of $10,000 in rent, $9,000 in personnel costs, $2,000 in supplies expenses, $2,000 in legal fees, $2,000 in system support expenses, $1,000 in travel and entertainment expenses and $1,000 in miscellaneous expenses.




Depreciation and Amortization. Depreciation and amortization remained the same for both periods.




Net Interest Expense. There was no interest expense for either period as financing charges related to our credit facility with Bay View Funding are included in general and administrative expenses.


20




Other Income. Other income decreased by $1,000, or 100%, in the third quarter of 2010 as compared to the third quarter of 2009 primarily as a result of miscellaneous income recognized in the third quarter of 2009 that did not recur in the same period in 2010.




Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009 (Unaudited)




Nine Months Ended

September 30,



Dollar Variance Favorable



Percentage Variance Favorable



Results as a

Percentage of

Net Sales2010



2009



(Unfavorable)



(Unfavorable)



2010



2009(in thousands)Net sales

$
4,935


$
7,932


$
(2,997
)


(37.8%
)


100.0%



100.0%Cost of sales


3,455



5,338



1,883



35.3%



70.0%



67.3%Gross profit


1,480



2,594



(1,114
)


(42.9%
)


30.0%



32.7%Selling, marketing and advertising expenses


320



515



195



37.9%



6.5%



6.5%General and administrative expenses


1,388



1,799



411



22.8%



28.1%



22.7%Depreciation and amortization


39



40



1



2.5%



0.8%



0.5%Operating income (loss)


(267
)


240



(507
)


(211.3%
)


(5.4%
)


3.0%Net interest expense


—



(1
)


1



100.0%



—%



—Other income (expense)


(1
)


6



(7
)


116.7%



—%



0.1%Income (loss) from operations before income taxes


(268
)


245



(513
)


(209.4%
)


(5.4%
)


3.1%Income tax provision


1



1



—



—%



—%



—%Net income (loss)

$
(269
)

$
244


$
(513
)


(210.2%
)


(5.5%
)


3.1%




Net Sales.  Net sales decreased by $2,997,000, or 38%, to $4,935,000 in the first nine months of 2010 as compared to $7,932,000 in the first nine months of 2009. The decrease in our net sales was primarily caused by a decrease of $2,609,000, or 36%, in sales of our optical data storage products. Sales of our optical data storage products totaled $4,717,000, or 96% of our net sales for the first nine months of 2010 as compared to $7,326,000, or 92% of our net sales in the first nine months of 2009. Also, sales of our magnetic data storage products decreased by $390,000, or 65%, to $212,000, or 4% of our net sales for the first nine months of 2010, as compared to $602,000, or 8% of our net sales, for the first nine months of 2009.  Sales of our other consumer electronics products totaled $5,000, or 1% of our net sales for first nine months of 2010 as compared to $6,000, or 1% of our net sales for the first nine months of 2009.




The average unit net sales price of our optical data storage products for the first nine months of 2010 increased by 10% to $61.73 compared to $56.06 for the first nine months of 2009.  We sold approximately 76,000 optical data storage units in the first nine months of 2010 as compared to approximately 131,000 units in the first nine months of 2009, representing a decrease of approximately 42%.




Our overall product return rate was 8.3% in the first nine months of 2010 as compared to 14.2% in the first nine months of 2009. The decrease in our overall product return rate resulted from a decrease in returns of our optical data storage products during the first nine months of 2010 as compared to the first nine months of 2009.


21




Our sales incentives, market development funds and cooperative advertising costs, rebate promotion costs and slotting fees, collectively as a percentage of gross sales, increased to 9.1% of gross sales, all of which were offset against gross sales, in the first nine months of 2010, as compared to 8.0% in the first nine months of 2009.  The increase in our overall rate of sales incentives, point-of-sale rebates, market development funds, cooperative advertising costs and cross-dock fees, rebate promotion costs and slotting fees resulted primarily from point-of-sale rebates associated with our optical data storage products in the third quarter of 2010 as compared to the third quarter of 2009.  We believe that our overall strategy for stimulating sales through sales incentives has not been effective and we are reviewing our promotions strategy to increase sales.




Gross Profit. Gross profit decreased by $1,114,000, or 43%, to $1,480,000 in the first nine months of 2010 as compared to gross profit of $2,594,000 in the first nine months of 2009. The decrease in gross profit primarily resulted from lower sales and decreased operating margins on our optical data storage products. Our gross profit margin as a percentage of net sales decreased to 30% in the first nine months of 2010 as compared to gross profit margin of 33% in the first nine months of 2009, as a result of decreased market demand that shifted sales to products with higher costs.




Selling, Marketing and Advertising Expenses. Selling, marketing and advertising expenses decreased by $195,000, or 38%, to $320,000 in the first nine months of 2010 as compared to $515,000 in the first nine months of 2009. This decrease was primarily due to decreases of $100,000 in shipping and handling costs related to lower sales volumes, $45,000 in outside commissions related to lower sales, $32,000 in personnel costs, 9,000 in sales expenses, $5,000 in customer refunds and $5,000 in trade show expenses, all of which were partially offset by an increase of $1,000 in supplies costs.




General and Administrative Expenses. General and administrative expenses decreased by $411,000, or 23%, to $1,388,000 in the first nine months of 2010 as compared to $1,799,000 in the first nine months of 2009. This decrease was primarily due to decreases of $111,000 in legal fees, $88,000 in finance charges, $78,000 in audit fees, $65,000 in facilities costs, $30,000 in insurance costs, $24,000 in outside services costs, $14,000 in taxes, $12,000 in travel and entertainment expenses, $5,000 in supplies expenses, $2,000 in product design expenses, and $2,000 in financial relations expenses, all of which were partially offset by increases of $6,000 in bad debt expense, $6,000 in personnel costs, $5,000 in bank charges, and $3,000 in system support expenses.




Depreciation and Amortization. Depreciation and amortization expense decreased in the first nine months of 2010 as compared to the first nine months of 2009 as a result of some assets becoming fully depreciated during the first nine months of 2009.




Net Interest Expense. Net interest expense decreased by $1,000.  Financing charges related to our credit facility with Bay View Funding are included in general and administrative expenses.




Other Income. Other income decreased by $7,000, or 117%, in the first nine months of 2010 as compared to the first nine months of 2009 primarily as a result of miscellaneous income recognized in the first nine months of 2009 that did not recur in the same period in 2010.


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Liquidity and Capital Resources




Overview




Our principal sources of liquidity have been cash provided by operations and borrowings under our credit facilities. Our principal uses of cash have been to provide working capital to finance our operations and to satisfy our debt service requirements. We anticipate that these sources and uses will continue to be our principal sources and uses of cash for the foreseeable future. As of September 30, 2010, we had working capital of $1,921,000, an accumulated deficit of $33,962,000, cash and cash equivalents of $707,000 and net accounts receivable of $163,000. This compares to a working capital deficit of $1,997,000, an accumulated deficit of $33,693,000, cash and cash equivalents of $446,000 and net accounts receivable of $655,000 as of December 31, 2009. For the nine months ended September 30, 2010, our cash and cash equivalents increased by $262,000.  The change to positive working capital as of September 30, 2010 compared to a working capital deficit as of December 31, 2009 is primarily a result of reclassifying a portion of accounts payable – related party to a long-term liability based on the repayment schedule agreed to with the related party in July 2010. See “—Trade Credit Facility” below.




As of November 8, 2010, we had approximately $696,246 of cash and cash equivalents and significant long-term liabilities. We may have insufficient liquidity to fund our operations for the next twelve months or less.




Our condensed consolidated financial statements as of and for the three and nine months ended September 30, 2010 have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. As discussed in this report and in Note 1 to our condensed consolidated financial statements included elsewhere in this report, we have incurred significant recurring losses, have working capital and stockholders’ deficits, have serious liquidity concerns and may require additional financing in the foreseeable future. These factors, among others, raise substantial doubt about our ability to continue as a going concern. The condensed consolidated financial statements included in this report do not include any adjustments that might result from the outcome of this uncertainty.




Our plans for improving our financial condition include ongoing efforts to bring new products to market and explore other products with our customers, subcontract manufacturers and suppliers to sell through our sales channels, negotiating suitable repayment terms for outstanding obligations owed to a related-party supplier, seeking new equity capital and new vendor partnerships, timely collection of existing accounts receivable, and sell-through of inventory currently in our sales channels. If our capital requirements or cash flow vary materially from our current projections, if we are unable to further successfully negotiate suitable repayment terms for outstanding obligations owed to a related-party supplier, if we are unable to timely collect our accounts receivable or unable to sell-through inventory currently in our sales channels as anticipated, or if unforeseen circumstances occur, we may have insufficient liquidity and may require additional financing to sustain our operations. In addition, if we are unable to bring successful new products to market soon, we may be forced to substantially curtail our operations.




If we incur future losses, we could experience significant additional shortages of liquidity and our ability to purchase inventory and to operate our business may be significantly impaired, which could lead to further declines in our results of operations and financial condition.




Cash Flows




The following table summarizes our cash flows for the periods presented (unaudited):




Nine Months EndedSeptember30,2010


2009Net cash provided by:Operating activities

$
261,635


$
225,201Net increase in cash and cash equivalents

$
261,635


$
225,201




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The $261,635 in cash provided by our operating activities for the nine months ended September 30, 2010, including when compared to the same period in 2009, does not accurately reflect the underlying weakness we experienced in our business during 2010 caused by decreased demand for our products.




Our business activity continued to weaken in the third quarter of 2010 as demand for our products continued to decline.  Although our average unit net sales price increased in both the first nine months and third quarter of 2010 as compared to the same periods in 2009, we anticipate that additional promotions and sales incentives will be necessary to increase sales for the fourth quarter of 2010.  The $261,635 in cash provided by our operating activities in the first nine months of 2010 was generated in large part from collections of accounts receivable and the continued effects of our operational initiatives to improve inventory management, reduce overall inventory levels and reduce operating costs. Also, we continued the successful collection of outstanding accounts receivable in accordance with our normal sales and collection cycles and we made limited payments to our related party supplier in 2010. As of September 30, 2010, we owed the related party $4,208,553. The $179,700 reduction from the $4,388,253 owed to the related party as of December 31, 2009 arose as a result of $124,700 due to offsets from products we returned to the related party in 2010 and two payments totaling $55,000 made in accordance with the repayment schedule agreed to in July 2010.  See “—Trade Credit Facility” below.




Credit Facility — Bay View Funding




On October 29, 2008, we entered into a Sale of Accounts and Security Agreement, or the Agreement, dated as of October 24, 2008 with Rexford Funding, LLC, which was subsequently acquired by Bay View Funding on November 11, 2009. The Agreement provides for an accounts receivable-based credit facility.




The credit facility allows us to sell accounts receivable to Bay View Funding subject to a maximum amount equal to $1,500,000. The purchase price for each purchased account is to equal the net invoice amount less Bay View Funding’s commission. Bay View Funding is entitled to a factoring commission equal to 0.033% of the gross invoice amount of each purchased account receivable and an additional 0.033% for each day the account receivable remains outstanding and unpaid.




Bay View Funding, in its sole and absolute discretion, may from time to time advance us funds against the purchase price of the accounts receivable in an amount of up to 75% (except as to accounts receivable of Staples which shall be up to 60%) of the aggregate purchase price of the purchased accounts receivable, subject to customary reductions, including those based on (i) disputed accounts receivable, (ii) any accounts receivable from a customer whom Bay View Funding deems not credit worthy, (iii) any accounts receivable unpaid in excess of 60 days, (iv) any accounts receivable from a past-due customer when 25% or more accounts receivable from that customer are unpaid in excess of 60 days, (v) any accounts receivable which Bay View Funding deems, in its sole and absolute discretion, are ineligible, and (vi) any fees, actual or estimated, that are chargeable to our reserve account as to the credit facility. Bay View Funding is entitled to interest charges on all advances at a rate equal to the Prime Rate plus 1.00%, but in no case less than 5.50%.




The Agreement had an initial term through April 30, 2009 with automatic six month extensions unless either party terminated the Agreement at least 60 but not more than 90 days prior to the end of the initial term or any renewal term.  In August 2009, we modified the Agreement to include a month-to-month term. At all times Bay View Funding has the right to terminate the Agreement upon 30 days prior notice.


24




If we terminate the Agreement prior to the end of any renewal term, we will be subject to an early termination fee equal to Bay View Funding’s average monthly commission and/or deficiency charges for the preceding six month period, or the entire period from the date of the Agreement if the preceding period is less than six months, multiplied by the number of months remaining in the applicable renewal term.




Our obligations under the Agreement are secured by our accounts receivable and all proceeds thereof and, with respect thereto, all chattel paper, commercial tort claims, deposit accounts, documents, general intangibles, goods, letters of credit, letter of credit rights and all supporting obligations.




There was no outstanding balance under the credit facility as of September 30, 2010 or as of the filing of this report.




Credit Facility — BTC USA




In February 2003, we entered into a Warehouse Services and Bailment Agreement with BTC USA. Under the terms of the agreement, BTC USA agreed to supply and store at our warehouse up to $10,000,000 of inventory on a consignment basis. We were responsible for insuring the consigned inventory, storing the consigned inventory for no charge, and furnishing BTC USA with weekly statements indicating all products received and sold and the current level of consigned inventory. The agreement also provided us with a trade line of credit of up to $10,000,000 with payment terms of net 60 days, without interest. The agreement may be terminated by either party upon 60 days’ prior written notice to the other party. BTC USA is a subsidiary of Behavior Tech Computer Corp., one of our significant stockholders. Mr. Steel Su, who is the Chief Executive Officer of Behavior Tech Computer Corp., is one of our former directors.  We did not make any purchases under this arrangement during the nine months ended September 30, 2010 and 2009. As of September 30, 2010, there were $4,208,553 in trade payables outstanding under this arrangement. On July 20, 2010, we agreed to make a payment of $50,000 and monthly payments each in the amount of $5,000 over the next 23 months to BTC USA.  I/OMagic and BTC USA are to reach agreement on or before September 1, 2011 on repayment of the balance owed.




BTC USA provided us with significantly preferential trade credit terms. These terms included extended payment terms, substantial trade lines of credit and other preferential buying arrangements. We believe that these terms were substantially better terms than we could likely obtain from other subcontract manufacturers or suppliers. We do not currently utilize this trade credit facility as BTC USA is either not able to supply certain products we currently sell, or in some cases, we are able to source certain products at better prices directly from other third-party manufacturers. Additionally, due to substantial outstanding obligations owed to BTC USA, it is highly unlikely that we will be able to obtain additional inventory supplies from BTC USA unless, and at least until, our trade payables owed to BTC USA are repaid.  Even if we are able to repay our trade payables owed to BTC USA, we may be unable to obtain additional inventory supplies from BTC USA on the same terms as before, on satisfactory terms, or at all.




Liquidity Impact of Consignment Inventory Model




We retain most risks of ownership of our consignment inventory. These products remain our inventory until their sale by our customers. For example, both Office Depot and OfficeMax returned substantial consigned inventory in the fourth quarter of 2007 and the first quarter of 2008, respectively, each in anticipation of discontinuing sales of our products. The return of this inventory resulted in significant inventory valuation adjustments caused by the declining value of the inventory, principally, our magnetic data storage products. For the three and nine months ended September 30, 2010 and 2009, no lower-of-cost-or-market adjustments were made. In addition, the turnover frequency of our inventory on consignment is critical to generating regular cash flow in amounts necessary to keep financing costs to targeted levels and to purchase additional inventory. If this inventory turnover is not sufficiently frequent, our financing costs may exceed targeted levels and we may be unable to generate regular cash flow in amounts necessary to purchase additional inventory to meet the demand for other products. In addition, as a result of our products’ short life-cycles, which generate lower average selling prices as the cycles mature, low inventory turnover levels may force us to reduce prices and accept lower margins to sell consigned products. If we fail to select high turnover products for our consignment inventory model, our sales, profitability and financial resources will likely decline.


25




Impact of New Accounting Pronouncements




The disclosure requirements and impacts of new accounting pronouncements are described in “Note 15—Recent Accounting Pronouncements” of the notes to condensed consolidated financial statements contained elsewhere in this report.




ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK




Not applicable.




ITEM 4.
CONTROLS AND PROCEDURES




Evaluation of Disclosure Controls and Procedures




We conducted an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Acting Chief Financial Officer of the effectiveness of the design and operation of our disclosure controls and procedures. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934, as amended (“Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures also include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure. Based on this evaluation, our Chief Executive Officer and Acting Chief Financial Officer concluded as of September 30, 2010 that our disclosure controls and procedures were effective at the reasonable assurance level.




Changes in Internal Control over Financial Reporting




There has been no change during our most recently completed fiscal quarter that has materially affected or is reasonably likely to materially affect, our internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.




PART II – OTHER INFORMATION




ITEM 1.
LEGAL PROCEEDINGS




We are subject to legal proceedings, claims and litigation arising in the ordinary course of business. While the amounts claimed may be substantial, the ultimate liability cannot presently be determined because of considerable uncertainties that exist. Therefore, it is possible that the outcome of those legal proceedings, claims and litigation could adversely affect our quarterly or annual operating results or cash flows when resolved in a future period. However, based on facts currently available, management believes such matters will not adversely affect our financial position, results of operations or cash flows.


26




ITEM 1A.
RISK FACTORS




In addition to the other information set forth in this report, you should carefully consider the factors discussed under “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009, which could materially and adversely affect our business, financial condition and results of operations. The risks described in our Annual Report on Form 10-K for the year ended December 31, 2009 are not the only risks we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition and results of operations.




ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS




None.




ITEM 3.
DEFAULTS UPON SENIOR SECURITIES




None.




ITEM 4.
(REMOVED AND RESERVED)




Not applicable.




ITEM 5.
OTHER INFORMATION




None.




ITEM 6.
EXHIBITS




ExhibitNumber
Description




31.1
Certification Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (*)





31.2
Certification Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes–Oxley Act of 2002 (*)




32.1
Certification of President and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (*)





(*)                 Filed herewith.





27




SIGNATURES




Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.




I/OMAGIC CORPORATIONDated:  November 9, 2010
By:
/s/ TONY SHAHBAZTony ShahbazActing Chief Financial Officer(principal financial and accounting officer)











28


EXHIBITS FILED WITH THIS REPORT





ExhibitNumber
Description
 
 31.1
Certification Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (*)
 
 31.2
Certification Required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as Adopted Pursuant to Section 302 of the Sarbanes–Oxley Act of 2002 (*)
 
 32.1
Certification of President and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (*)