<PAGE>

================================================================================
                          U. S. SECURITIES AND EXCHANGE
                        COMMISSION WASHINGTON, D.C. 20549

                                    FORM 10-Q

(Mark One)
|X|  QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
     OF 1934
                For the quarterly period ended SEPTEMBER 30, 2006

| |  TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
     OF 1934
                For the transition period from ______ to _______

                         Commission File Number: 0-27267

                              I/OMAGIC CORPORATION
           (Name of small business issuer as specified in its charter)

                    NEVADA                            33-0773180
         (State or other jurisdiction              (I.R.S. Employer
      of incorporation or organization)           Identification No.)

                                    4 MARCONI
                            IRVINE, CALIFORNIA 92618
                    (Address of principal executive offices)

                          (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 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 whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Check one:

 Large accelerated filer | |  Accelerated filer | |  Non-accelerated filer |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 14, 2006, there were 4,540,292 shares of the issuer's common
stock issued and outstanding.

================================================================================


<PAGE>

                       I/OMAGIC CORPORATION AND SUBSIDIARY

                                TABLE OF CONTENTS

                                     PART I
                              FINANCIAL INFORMATION

                                                                            PAGE
                                                                            ----

Item 1.   Financial Statements

          Consolidated Balance Sheets - September 30, 2006 (unaudited)
              and December 31, 2005.........................................  3

          Consolidated Statements of Income - for the Three and Nine
              Months Ended September 30, 2006 and 2005 (unaudited)..........  5

          Consolidated Statements of Cash Flows - for the Nine Months
              Ended September 30, 2006 and 2005 (unaudited).................  6

          Notes to Consolidated Financial Statements........................  7

Item 2.   Management's Discussion and Analysis of Financial Condition
          and Results of Operation.......................................... 17

Item 3.   Quantitative and Qualitative Disclosures About Market Risk........ 40

Item 4.   Controls and Procedures........................................... 41

                                     PART II
                                OTHER INFORMATION

Item 1.   Legal Proceedings................................................. 42

Item 1A.  Risk Factors...................................................... 43

Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds....... 44

Item 3.   Defaults Upon Senior Securities................................... 44

Item 4.   Submission of Matters to a Vote of Security Holders............... 44

Item 5.   Other Information................................................. 44

Item 6.   Exhibits.......................................................... 44

Signatures.................................................................. 45

Exhibits Filed with This Report



<PAGE>
<TABLE>
<S>     <C>
                                    PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                                         I/OMAGIC CORPORATION
                                            AND SUBSIDIARY
                                      CONSOLIDATED BALANCE SHEETS
                         SEPTEMBER 30, 2006 (UNAUDITED) AND DECEMBER 31, 2005

                                                ASSETS

                                                                           SEPTEMBER 30,  DECEMBER 31,
                                                                               2006           2005
                                                                           ------------   ------------
                                                                           (unaudited)
CURRENT ASSETS
       Cash and cash equivalents                                           $  1,244,812   $  4,056,541
       Restricted cash                                                          542,273         30,864
       Accounts receivable, net of allowance for doubtful
          accounts of $173,171 (unaudited) and $3,145                        10,089,511     13,091,546
       Inventory, net of allowance for obsolete inventory of $93,052
          (unaudited) and $29,690                                             8,370,073      6,917,878
       Inventory in transit                                                     174,201         66,478
       Prepaid expenses and other current assets                                 13,711      1,484,084
                                                                           ------------   ------------

                  Total current assets                                       20,434,581     25,647,391

PROPERTY AND EQUIPMENT, net of accumulated depreciation of
    $1,505,105 (unaudited) and $1,422,943                                       117,451        172,005
TRADEMARKS, net of accumulated amortization
    of $5,570,404 (unaudited) and $5,518,708                                    379,176        430,872
OTHER ASSETS                                                                     48,836         27,032
                                                                           ------------   ------------

                  TOTAL ASSETS                                             $ 20,980,044   $ 26,277,300
                                                                           ============   ============

        The accompanying notes are an integral part of these consolidated financial statements.


                                                  3
</TABLE>


<PAGE>
<TABLE>
<S>     <C>
                                          I/OMAGIC CORPORATION
                                             AND SUBSIDIARY
                                      CONSOLIDATED BALANCE SHEETS
                          SEPTEMBER 30, 2006 (UNAUDITED) AND DECEMBER 31, 2005

                                  LIABILITIES AND STOCKHOLDERS' EQUITY

                                                                           SEPTEMBER 30,   DECEMBER 31,
                                                                               2006           2005
                                                                           ------------    ------------
                                                                            (unaudited)

CURRENT LIABILITIES
   Line of credit                                                          $  3,998,793    $  5,053,582
   Accounts payable and accrued expenses                                      4,337,799       5,925,668
   Accounts payable - related parties                                         5,675,992       8,222,078
   Reserves for customer returns and sales incentives                           508,703         494,289
                                                                           ------------    ------------

     Total current liabilities                                               14,521,287      19,695,617
                                                                           ------------    ------------

STOCKHOLDERS' EQUITY
   Preferred Stock, $0.001 par value;
       10,000,000 shares authorized
      Series A, 1,000,000 shares authorized, 0 and 0 shares
        issued and outstanding                                                       --              --
      Series B, 1,000,000 shares authorized, 0 and 0 shares
        issued and outstanding                                                       --              --
   Common stock, $0.001 par value;
     100,000,000 shares authorized
     4,540,292 (unaudited) and 4,529,672 shares issued and outstanding            4,541           4,532
Additional paid-in capital                                                   31,651,348      31,595,952
Treasury stock, 0 (unaudited) and 13,493 shares, at cost                              -        (126,014)
Accumulated deficit                                                         (25,197,132)    (24,892,787)
                                                                           ------------    ------------

     Total stockholders' equity                                               6,458,757       6,581,683
                                                                           ------------    ------------

         TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                        $ 20,980,044    $ 26,277,300
                                                                           ============    ============

        The accompanying notes are an integral part of these consolidated financial statements.


                                                   4
</TABLE>


<PAGE>
<TABLE>
<S>     <C>
                                           I/OMAGIC CORPORATION
                                              AND SUBSIDIARY
                                     CONSOLIDATED STATEMENTS OF INCOME
                      FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
                                                (UNAUDITED)

                                                   THREE MONTHS ENDED              NINE MONTHS ENDED
                                                      SEPTEMBER 30,                  SEPTEMBER 30,
                                                  2006            2005            2006            2005
                                              ------------    ------------    ------------    ------------
                                               (unaudited)     (unaudited)     (unaudited)     (unaudited)

NET SALES                                     $ 11,458,674    $  8,423,756    $ 30,334,312    $ 27,018,179
COST OF SALES                                    9,374,588       7,074,310      26,086,963      23,569,496
                                              ------------    ------------    ------------    ------------

GROSS PROFIT                                     2,084,086       1,349,446       4,247,349       3,448,683
                                              ------------    ------------    ------------    ------------

OPERATING EXPENSES
     Selling, marketing, and advertising           190,030         182,265         645,725         479,690
     General and administrative                  1,713,809       1,254,080       5,922,866       3,713,921
     Depreciation and amortization                  42,936          49,148         133,857         188,449
                                              ------------    ------------    ------------    ------------

       Total operating expenses                  1,946,775       1,485,493       6,702,448       4,382,060
                                              ------------    ------------    ------------    ------------

PROFIT (LOSS) FROM OPERATIONS                      137,311        (136,047)     (2,455,099)       (933,377)
                                              ------------    ------------    ------------    ------------

OTHER INCOME (EXPENSE)
     Interest income                                     1              64             107             346
     Interest expense                              (63,016)        (76,543)       (234,738)       (218,694)
     Other income                                    8,701              52       2,386,185          11,332
                                              ------------    ------------    ------------    ------------

          Total other income (expense)             (54,314)        (76,427)      2,151,554        (207,016)
                                              ------------    ------------    ------------    ------------

INCOME (LOSS) BEFORE PROVISION FOR
INCOME TAXES                                        82,997        (212,474)       (303,545)     (1,140,393)

PROVISION FOR INCOME TAXES                               -               -             800           2,400
                                              ------------    ------------    ------------    ------------

NET INCOME (LOSS)                             $     82,997    $   (212,474)   $   (304,345)   $ (1,142,793)
                                              ============    ============    ============    ============


BASIC AND DILUTED INCOME (LOSS) PER SHARE     $       0.02    $      (0.05)   $      (0.07)   $      (0.25)
                                              ============    ============    ============    ============

BASIC AND DILUTED WEIGHTED-AVERAGE
   SHARES OUTSTANDING                            4,540,292       4,530,581       4,536,424       4,529,978
                                              ============    ============    ============    ============

          The accompanying notes are an integral part of these consolidated financial statements.


                                                    5
</TABLE>


<PAGE>
<TABLE>
<S>     <C>
                                   I/OMAGIC CORPORATION
                                      AND SUBSIDIARY
                           CONSOLIDATED STATEMENTS OF CASH FLOWS
                   FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
                                        (UNAUDITED)

                                                             NINE MONTHS ENDED SEPTEMBER 30,
                                                                  2006            2005
                                                              ------------    ------------
                                                               (unaudited)     (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
   Net loss                                                   $   (304,345)   $ (1,142,793)
   Adjustments to reconcile net loss to net cash
     used in operating activities
       Depreciation and amortization                                82,162         136,753
       Amortization of trademarks                                   51,696          51,696
       Allowance for doubtful accounts                             173,171         179,183
       Reserve for customer returns and sales incentives            14,414         (72,929)
       Allowance for obsolete inventory                            270,815         705,426
       Stock based compensation expense                            118,987              --
       (Increase) decrease in
         Accounts receivable                                     2,828,864       2,329,027
         Inventory                                              (1,723,010)     (1,738,502)
         Inventory in transit                                     (107,724)        435,066
         Prepaid expenses and other current assets               1,470,371        (783,383)
         Other assets                                              (21,804)             --
       Decrease in
         Accounts payable and accrued expenses                  (1,587,866)        289,024
         Accounts payable - related parties                     (2,546,087)     (1,729,369)
                                                              ------------    ------------

   Net cash used in operating activities                        (1,280,356)     (1,340,801)
                                                              ------------    ------------

CASH FLOWS FROM INVESTING ACTIVITIES
   Purchase of property and equipment                              (27,607)        (24,193)
   Restricted cash                                                (511,409)      1,006,044
                                                              ------------    ------------

   Net cash provided by (used in) investing activities            (539,016)        981,851
                                                              ------------    ------------

CASH FLOWS FROM FINANCING ACTIVITIES
    Net payments on line of credit                              (1,054,789)       (453,587)
    Proceeds from exercise of warrants                                  --           6,650
    Exercise of stock options                                       62,432              --
                                                              ------------    ------------

Net cash used in financing activities                             (992,357)       (446,937)
                                                              ------------    ------------

Net decrease in cash and cash equivalents                       (2,811,729)       (805,887)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                   4,056,541       3,587,807
                                                              ------------    ------------

CASH AND CASH EQUIVALENTS, END OF PERIOD                      $  1,244,812    $  2,781,920
                                                              ============    ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
    INTEREST PAID                                             $    235,333    $    211,658
                                                              ============    ============
    INCOME TAXES PAID                                         $      1,600    $      2,400
                                                              ============    ============

  The accompanying notes are an integral part of these consolidated financial statements.


                                            6
</TABLE>


<PAGE>

                              I/OMAGIC CORPORATION
                                 AND SUBSIDIARY
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION AND BUSINESS

I/OMagic Corporation ("I/OMagic"), a Nevada corporation, and its subsidiary
(collectively, the "Company") develop, manufacture through subcontractors,
market, and distribute optical and mobile data storage products to the consumer
electronics marketplace.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements of I/OMagic
Corporation have been prepared pursuant to the rules and regulations of the
Securities and Exchange Commission ("SEC") 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, 2005, and notes thereto included in
the Company's Annual Report on Form 10-K, filed with the Securities and Exchange
Commission on March 31, 2006. In the opinion of management, the accompanying
unaudited 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, 2006, and
its results of operations for the periods presented. These unaudited
consolidated financial statements are not necessarily indicative of the results
to be expected for the entire year.

The unaudited consolidated financial statements include IOM Holdings, Inc. (the
"Subsidiary") Intercompany transactions and balances have been eliminated in
consolidation.

USE OF ESTIMATES

The preparation of financial statements 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 revenue and expenses during the reporting
period. Actual results could differ from those estimates.

STOCK-BASED COMPENSATION

On January 1, 2006, the Company adopted Statements of Financial Accounting
Standards ("SFAS") No. 123 (revised 2004), "Share-Based Payment," ("SFAS
123(R)") which requires the measurement and recognition of compensation expense
for all share-based payment awards made to employees and directors based on
estimated fair values. SFAS 123(R) supersedes the Company's previous accounting
under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued
to Employees" ("APB 25") for periods beginning in fiscal 2006. In March 2005,
the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
("SAB 107") relating to SFAS 123(R). The Company has applied the provisions of
SAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective transition
method, which requires the application of the accounting standard as of January
1, 2006, the first day of the Company's fiscal year 2006. The Company's
consolidated financial statements as of and for the three and nine months ended
September 30, 2006 reflect the impact of SFAS 123(R). In accordance with the
modified prospective transition method, the Company's consolidated financial
statements for prior periods have not been restated to reflect, and do not
include, the impact of SFAS 123(R). Stock-based compensation expense recognized
under SFAS 123(R) for employees and directors for the three and nine months
ended September 30, 2006 was $34,323 and $118,987, respectively, and are
included in general and administrative expenses. Income (loss) from operations
for the three and nine months ended September 30, 2006 would have been $171,634
and $(2,336,112), respectively, if the Company had not adopted SFAS 123(R).


                                       7


<PAGE>

Income (loss) before income taxes for the three and nine months ended September
30, 2006 would have been $117,320 and $(184,558), respectively, if the Company
had not adopted SFAS 123(R). Net income (loss) for the three and nine months
ended September 30, 2006 would have been $117,320 and $(185,358), respectively,
if the Company had not adopted SFAS 123(R). For the three and nine months ended
September 30, 2006, cash flow from operations and cash flow from financing
activities were not effected by the adoption of SFAS 123(R). Basic income (loss)
per share for the three and nine months ended September 30, 2006 would have been
$0.03 and $(0.04), respectively, if the Company had not adopted SFAS 123(R),
compared to reported basic income (loss) per share of $0.02 and $(0.07),
respectively. Diluted income (loss) per share for the three and nine months
ended September 30, 2006 would have been $0.03 and $(0.04), respectively, if the
Company had not adopted SFAS 123(R), compared to reported diluted income (loss)
per share of $0.02 and $(0.07), respectively.

The following table illustrates the effect on net loss and loss per share if the
Company had applied the fair value recognition provisions of SFAS 123 to
stock-based awards granted under the Company's stock option plans for the three
and nine months ended September 30, 2005. For purposes of this pro-forma
disclosure, the fair value of the options is estimated using the
Black-Scholes-Merton option-pricing formula ("Black-Scholes model") and
amortized to expense generally over the options' requisite service periods
(vesting periods).

<TABLE>
<S>     <C>
                                                               THREE MONTHS     NINE MONTHS
                                                                   ENDED           ENDED
                                                               SEPTEMBER 30,   SEPTEMBER 30,
                                                                   2005            2005
                                                               ------------    ------------

Net loss, as reported                                          $   (212,474)   $ (1,142,793)

   Stock-based employee compensation expense included in
   reported net income (loss), net of related tax effects                --              --

   Total stock-based employee compensation expense
   determined under fair value based method for all
   awards, net of related tax effects                              (388,555)       (432,708)
                                                               ------------    ------------
   Pro forma net loss                                          $   (601,029)   $ (1,575,501)
                                                               ============    ============
Net loss per common share:
   Basic and diluted, as reported                              $      (0.05)   $      (0.25)
                                                               ============    ============
   Basic and diluted, pro forma                                $      (0.13)   $      (0.35)
                                                               ============    ============
</TABLE>

SFAS 123(R) requires companies to estimate the fair value of share-based payment
awards to employees and directors on the date of grant using an option-pricing
model. The value of the portion of the award that is ultimately expected to vest
is recognized as expense over the requisite service periods in the Company's
Consolidated Statements of Income. Stock-based compensation expense recognized
in the Consolidated Statements of Income for the three and nine months ended
September 30, 2006 included compensation expense for share-based payment awards
granted prior to, but not yet vested as of January 1, 2006 based on the grant
date fair value estimated in accordance with the pro-forma provisions of SFAS
123 and compensation expense for the share-based payment awards granted
subsequent to January 1, 2006, for which there was none granted in the three and
nine months ended September 30, 2006, based on the grant date fair value
estimated in accordance with the provisions of SFAS 123(R). For stock-based
awards issued to employees and directors, stock-based compensation is attributed
to expense using the straight-line single option method, which is consistent
with how the prior-period pro formas were provided. As stock-based compensation
expense recognized in the Consolidated Statements of Income for the three and
nine months ended September 30, 2006 is based on awards ultimately expected to
vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires
forfeitures to be estimated at the time of grant and revised, if necessary, in
subsequent periods if actual forfeitures differ from those estimates. In its
pro-forma information required under SFAS 123 for the periods prior to fiscal
2006, the Company accounted for forfeitures as they occurred.

Prior to the adoption of SFAS 123(R), the Company accounted for stock-based
awards to employees and directors using the intrinsic value method in accordance
with APB 25. Under the intrinsic value method, the Company recognized
share-based compensation equal to the award's intrinsic value at the time of
grant over the requisite service periods using the straight-line method.


                                       8


<PAGE>

Forfeitures were recognized as incurred. During the three and nine months ended
September 30, 2005, there was no stock-based compensation expense recognized in
the Consolidated Statements of Income for awards issued to employees and
directors as the awards had no intrinsic value at the time of grant because
their exercise prices equaled the fair values of the common stock at the time of
grant.

The Company's determination of fair value of share-based payment awards to
employees and directors on the date of grant using the Black-Scholes model,
which is affected by the Company's stock price as well as assumptions regarding
a number of highly complex and subjective variables. These variables include,
but are not limited to the Company's expected stock price volatility over the
expected term of the awards, and actual and projected employee stock option
exercise behaviors. Prior to 2006, when valuing awards, the Company used the
awards' contractual term as a proxy for the expected life of the award and
historical volatility to approximate expected volatility. There were no new
awards during the first nine months of 2006.

The Company has elected to adopt the detailed method provided in SFAS 123(R) for
calculating the beginning balance of the additional paid-in capital pool ("APIC
pool") related to the tax effects of employee stock-based compensation, and to
determine the subsequent impact on the APIC pool and Consolidated Statements of
Cash Flows of the tax effects of employee stock-based compensation awards that
are outstanding upon adoption of SFAS 123(R).

RECENT ACCOUNTING PRONOUNCEMENTS

In October 2006, the Emerging Issues Task Force ("EITF") issued EITF 06-3, "How
Taxes Collected from Customers and Remitted to Governmental Authorities Should
Be Presented in the Income Statement (That is, Gross versus Net Presentation)"
to clarify diversity in practice on the presentation of different types of taxes
in the financial statements. The Task Force concluded that, for taxes within the
scope of the issue, a company may adopt a policy of presenting taxes either
gross within revenue or net. That is, it may include charges to customers for
taxes within revenues and the charge for the taxes from the taxing authority
within cost of sales, or, alternatively, it may net the charge to the customer
and the charge from the taxing authority. If taxes subject to EITF 06-3 are
significant, a company is required to disclose its accounting policy for
presenting taxes and the amounts of such taxes that are recognized on a gross
basis. The guidance in this consensus is effective for the first interim
reporting period beginning after December 15, 2006 (the first quarter of our
fiscal year 2007). The Company does not expect the adoption of EITF 06-3 to have
a material impact on its financial condition, results of operations or cash
flows.

In September 2006, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 158, "Employer's accounting for Defined Benefit Pension and Other Post
Retirement Plans". SFAS No. 158 requires employers to recognize in its statement
of financial position an asset or liability based on the retirement plan's over
or under funded status. SFAS No. 158 is effective for fiscal years ending after
December 15, 2006. The Company is currently evaluating the effect that the
application of SFAS No. 158 will have on its financial condition, results of
operations and cash flows.

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements"
("SFAS 157"), which defines the fair value, establishes a framework for
measuring fair value and expands disclosures about fair value measurements. This
statement is effective for financial statements issued for fiscal years
beginning after November 15, 2007, and interim periods within those fiscal
years. Early adoption is encouraged, provided that the Company has not yet
issued financial statements for that fiscal year, including any financial
statements for an interim period within that fiscal year. The Company is
currently evaluating the impact SFAS 157 may have on the Company's financial
condition, results of operations and cash flows.

In September 2006, the United States Securities and Exchange Commission issued
Staff Accounting Bulletin ("SAB") No. 108, "Considering the Effects of Prior
Year Misstatements when Quantifying Misstatements in Current Year Financial
Statements" ("SAB 108"). SAB 108 provides guidance on the consideration of the
effects of prior year misstatements in quantifying current year misstatements
for the purpose of a materiality assessment. SAB 108 establishes an approach
that requires quantification of financial statement errors based on the effects
of each of the Company's balance sheet and statement of operations and the
related financial statement disclosures. SAB 108 permits existing public
companies to record the cumulative effect of initially applying this approach in
the first year ending after November 15, 2006 by recording the necessary
correcting adjustments to the carrying values of assets and liabilities as of
the beginning of that year with the offsetting adjustment recorded to the


                                       9


<PAGE>

opening balance of retained earnings. Additionally, the use of the cumulative
effect transition method requires detailed disclosure of the nature and amount
of each individual error being corrected through the cumulative adjustment and
how and when it arose. The Company is currently evaluating the impact SAB 108
may have to the Company's financial condition, results of operations and cash
flows.

In July 2006, the FASB released FASB Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes," an interpretation of FASB Statement No. 109 ("FIN
48"). FIN 48 clarifies the accounting and reporting for uncertainties in income
tax law. This interpretation prescribes a comprehensive model for the financial
statement recognition, measurement, presentation and disclosure of uncertain tax
positions taken or expected to be taken in income tax returns. This statement is
effective for fiscal years beginning after December 15, 2006. The Company is
currently evaluating the effect of FIN 48 on its financial condition, results of
operations and cash flows.

In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets," which provides an approach to simplify efforts to obtain
hedge-like (offset) accounting. This Statement amends FASB SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities", with respect to the accounting for separately recognized
servicing assets and servicing liabilities. The Statement (1) requires an entity
to recognize a servicing asset or servicing liability each time it undertakes an
obligation to service a financial asset by entering into a servicing contract in
certain situations; (2) requires that a separately recognized servicing asset or
servicing liability be initially measured at fair value, if practicable; (3)
permits an entity to choose either the amortization method or the fair value
method for subsequent measurement for each class of separately recognized
servicing assets or servicing liabilities; (4) permits at initial adoption a
one-time reclassification of available-for-sale securities to trading securities
by an entity with recognized servicing rights, provided the securities
reclassified offset the entity's exposure to changes in the fair value of the
servicing assets or liabilities; and (5) requires separate presentation of
servicing assets and servicing liabilities subsequently measured at fair value
in the balance sheet and additional disclosures for all separately recognized
servicing assets and servicing liabilities. SFAS No. 156 is effective for all
separately recognized servicing assets and liabilities as of the beginning of an
entity's fiscal year that begins after September 15, 2006, with earlier adoption
permitted in certain circumstances. The Statement also describes the manner in
which it should be initially applied. The Company does not believe that SFAS No.
156 will have a material impact on its financial condition, results of
operations or cash flows.

In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments", which amends SFAS No. 133, "Accounting for Derivatives
Instruments and Hedging Activities" and SFAS No. 140, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities." SFAS No.
155 amends SFAS No. 133 to narrow the scope exception for interest-only and
principal-only strips on debt instruments to include only such strips
representing rights to receive a specified portion of the contractual interest
or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow
qualifying special-purpose entities to hold a passive derivative financial
instrument pertaining to beneficial interests that itself is a derivative
instrument. The Company is currently evaluating the impact of this new standard,
but the Company believes this new standard will not have a material impact on
its financial condition, results of operations or cash flows.

INCOME (LOSS) PER SHARE

The Company calculates income (loss) per share in accordance with SFAS No. 128,
"Earnings Per Share." Basic income (loss) per share is computed by dividing the
net income (loss) available to common stockholders by the weighted-average
number of common shares outstanding. Diluted income (loss) per share is computed
similar to basic income (loss) per share, except that the denominator is
increased to include the number of additional common shares that would have been
outstanding if the potential common shares had been issued and if the additional
common shares were dilutive.


                                       10


<PAGE>

The following potential common shares have been excluded from the computation of
diluted income per share for the nine months ended September 30, 2006 and 2005,
and the three months ended September 30, 2005 since their effect would have been
anti-dilutive, and for the three months ended September 30, 2006 due to the
exercise price being greater than the Company's weighted-average stock price for
the period.

                                  SEPTEMBER 30,  SEPTEMBER 30,
                                      2006           2005
                                  ------------   ------------
Stock options outstanding              346,500        478,950
Warrants outstanding                   180,000        150,000
                                  ------------   ------------
  TOTAL                                526,500        628,950
                                  ============   ============

NOTE 3 - INVENTORY

Inventory consisted of the following:

                                                   SEPTEMBER 30,   DECEMBER 31,
                                                       2006            2005
                                                   ------------    ------------
                                                   (unaudited)
Component parts                                    $  2,314,903    $  2,491,594
Finished goods - warehouse                            1,650,463       1,034,877
Finished goods - consigned                            4,497,759       3,421,097
Allowance for obsolete and slow moving inventory        (93,052)        (29,690)
                                                   ------------    ------------
  TOTAL                                            $  8,370,073    $  6,917,878
                                                   ============    ============

NOTE 4 - PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:

                                                   SEPTEMBER 30,  DECEMBER 31,
                                                       2006           2005
                                                   ------------   ------------
                                                   (unaudited)
Computer equipment and software                    $  1,072,988   $  1,059,799
Warehouse equipment                                      69,013         55,238
Office furniture and equipment                          282,618        281,974
Vehicles                                                 91,304         91,304
Leasehold improvements                                  106,633        106,633
                                                   ------------   ------------
                                                      1,622,556      1,594,948
Less accumulated depreciation and amortization        1,505,105      1,422,943
                                                   ------------   ------------
  TOTAL                                            $    117,451   $    172,005
                                                   ============   ============

For the nine months ended September 30, 2006 and 2005, depreciation and
amortization expense was $133,857 (unaudited) and $188,449 (unaudited),
respectively. For the three months ended September 30, 2006 and 2005,
depreciation and amortization expense was $42,936 (unaudited) and $49,148
(unaudited), respectively.

NOTE 5 - LINE OF CREDIT

On August 15, 2003, the Company entered into an agreement for an asset-based
line of credit with United National Bank, effective August 18, 2003. The line
allowed the Company to borrow up to a maximum of $6.0 million. The line of
credit was initially used to pay off the outstanding balance with ChinaTrust
Bank (USA) as of September 2, 2003, which was $3,379,827. On March 9, 2005, the
Company entered into a Loan and Security Agreement for an asset-based line of
credit with GMAC Commercial Finance LLC ("GMAC"). The line of credit allows the
Company to borrow up to a maximum of $10.0 million. The line of credit is to be
used for general operations. The new credit facility was initially used to pay
off the Company's outstanding balance with United National Bank as of March 10,
2005, which balance was $3,809,320, and was also used to pay $25,000 of the
Company's closing fees for the GMAC line of credit.


                                       11


<PAGE>

The line of credit initially expired on March 9, 2008 and is secured by
substantially all of the Company's assets. The line of credit allows for a
sublimit of $2.0 million for outstanding letters of credit. The Company
currently is not using letters of credit. Advances on the line of credit bear
interest at the floating commercial loan rate initially equal to the prime rate
plus 0.75%. The Company also has the option to use the LIBOR rate plus an
initial amount of 3.50%. The prime rate as of September 30, 2006 was 8.25%.
These rates are applicable if the average amount available for borrowing for the
prior six month period is between $1.0 million and $3.5 million. If the average
amount available for borrowing is less than $1.0 million, then the rates
applicable to all amounts borrowed increase by 0.25%. If the average amount
available for borrowing is greater than $3.5 million, then the rates applicable
to all amounts borrowed decrease by 0.25%. For the unused portion of the line,
the Company is to pay on a monthly basis, an unused line fee in the amount of
0.25% of the average unused portion of the line for the preceding month.

The Loan Agreement contains one financial covenant--that the Company maintain at
the end of each measurement period a fixed charge coverage ratio of at least 1.5
to 1.0. A measurement period is defined in the Loan Agreement as the three month
period ended March 31, 2005, the six month period ended June 30, 2005, the nine
month period ended September 30, 2005, the 12 month period ended December 31,
2005, and thereafter the twelve month period ending on March 31, June 30,
September 30, and December 31 of each year during the term of the credit
facility. As of September 30, 2006, the Company was in breach of the financial
covenant. GMAC declined to provide a waiver for this covenant default.

On October 18, 2006, the Company and GMAC entered into a Forbearance Agreement
that provides for the forbearance by GMAC from enforcing its rights and remedies
under that certain Loan and Security Agreement dated March 9, 2005 by and
between the Company and GMAC as a result of the Company failing to satisfy a
financial covenant contained in the Loan Agreement. The Agreement is effective
through January 15, 2007, at which time all obligations to GMAC will be due and
payable in full. GMAC's agreement to forbear from enforcing its rights under the
Loan Agreement and related documents is subject to the following conditions: (i)
there are no further events of default under the Loan Agreement; (ii) the
Company complies with all terms and conditions of the Agreement and the Loan
Agreement (as amended by the Agreement); (iii) the Company maintains EBITDA of
at least the following: (a) $160,000 for the quarter ended September 30, 2006,
(b) $150,000 for the four months ended October 31, 2006, (c) $250,000 for the
five months ended November 30, 2006, and (d) $360,000 for the six months ended
December 31, 2006; (d) the Company must hire a permanent Chief Financial Officer
by no later than December 15, 2006; and (e) as soon as available, the Company
must deliver to GMAC a copy of it semi-annual audited financial statements. The
Agreement also amends the Loan Agreement to (1) delete the Company's inventory
from the calculation of the borrowing base, (2) reduce the maximum amount that
may be borrowed under the Loan Agreement from $10 million to $5 million, (3)
increase the static reserve from $1,000,000 to $1,350,000, and (4) increase the
fixed charge coverage ratio from 1.2:1.0 to 1.5:1.0. Under the Agreement, the
Company also reaffirmed all its obligations under the Loan Agreement and related
documents and released GMAC from any liability related to facts in existence as
of the date of the Agreement. The Agreement also provides that the Company must
pay GMAC a non-refundable forbearance fee of $25,000 and that from and after the
date of the Agreement, advances under the credit facility will bear interest at
the post-default rate of prime plus 2.75% per annum. On October 18, 2006, the
prime rate was 8.25%.

The obligations of the Company under the Loan Agreement are secured by
substantially all of the Company's assets and guaranteed by the Company's
Subsidiary. The obligations of the Company and the guarantee obligations of its
Subsidiary are secured pursuant to a Pledge and Security Agreement executed by
the Company, a Collateral Assignment Agreement executed by the Company, a
Guaranty Agreement executed by its Subsidiary, a General Security Agreement
executed by its Subsidiary, an Intellectual Property Security Agreement and
Collateral Assignment executed by the Company, and an Intellectual Property
Security Agreement and Collateral Assignment executed by its Subsidiary.

The outstanding balance with GMAC as of September 30, 2006 was $3,998,793
(unaudited). As of September 30, 2006, no additional borrowings were available
to the Company.


                                       12


<PAGE>

NOTE 6 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES

Accounts payable and accrued expenses consisted of the following:

                                               SEPTEMBER 30,  DECEMBER 31,
                                                   2006           2005
                                               ------------   ------------
                                               (unaudited)
Accounts payable                               $  1,530,421   $  1,477,459
Accrued rebates and marketing                     2,233,290      3,848,545
Accrued compensation and related benefits           181,017        187,771
Other                                               393,071        411,893
                                               ------------   ------------
  TOTAL                                        $  4,337,799   $  5,925,668
                                               ============   ============

NOTE 7 - TRADE CREDIT FACILITIES WITH RELATED PARTIES

In January 2003, the Company entered into a trade credit facility with a related
party, whereby the related party agreed to purchase inventory on behalf of the
Company. The agreement allowed the Company to purchase up to $10.0 million, with
payment terms of 120 days following the date of invoice. The third party was to
charge the Company a 5% handling fee on the supplier's unit price. A 2% discount
to the handling fee applied if the Company reached an average running monthly
purchasing volume of $750,000. Returns made by the Company, which were agreed by
the supplier, resulted in a credit to the Company for the handling charge. As
security for the trade credit facility, the Company paid the related party a
security deposit of $1.5 million, of which $750,000 could be applied against
outstanding accounts payables to the related party after six months. As of
December 31, 2004, $1.5 million had been applied against outstanding accounts
payables to the related party. The agreement was for 12 months. At the end of
the 12-month period, either party was entitled to terminate the agreement upon
30 days' written notice. Otherwise, the agreement would remain continuously
valid without requiring a newly signed agreement. Both parties had the right to
terminate the agreement one year following the inception date by giving the
other party 30 days written notice of termination. During 2004, the Company
purchased $2.5 million of inventory under this arrangement. As of December 31,
2004, there were $0 in trade payables under this arrangement. This trade line of
credit was terminated on June 6, 2005 and a new trade facility agreement was
entered into, which was subsequently amended and restated on July 21, 2005 to
provide that the new facility would be retroactive to April 29, 2005.

Under the terms of the facility, the related party agreed to purchase and
manufacture inventory on behalf of the Company. The Company could purchase up to
$15.0 million of inventory either (i) through the related party as an
international purchasing office, or (ii) manufactured by the related party. For
inventory purchased through the related party, the payment terms were 120 days
following the date of invoice by the related party and the related party charges
the Company a 5% handling fee on the supplier's unit price. A 2% discount of the
handling fee would be applied if the Company reached an average running monthly
purchasing volume of $750,000. Returns made by the Company, which are agreed to
by the supplier, would result in a credit to the Company for the handling
charge. For inventory manufactured by the related party, the payment terms were
90 days following the date of the invoice by the related party. The Company was
to pay the related party 10% of the purchase price on any purchase orders issued
to the related party, as a down-payment for the order, within one week of the
purchase order. The agreement had an initial term of one year after which the
agreement would continue indefinitely if not terminated at the end of the
initial term. At the end of the initial term and at any time thereafter, either
party had the right to terminate the facility upon 30 days' prior written notice
to the other party.

A second amended and restated trade facility agreement was entered into with
this related party on May 3, 2006 and was effective as of April 1, 2006. The
terms of the second amended and restated trade facility agreement are
substantially the same as those of the initial amended and restated trade
facility agreement, except that (i) the related party charges the Company a 4%
handling fee on the supplier's unit price instead of the 5% handling fee
previously charged, (ii) the 2% discount of the handling fee would no longer
apply regardless of purchasing volume, and (iii) the 10% down-payment of the
purchase price on any purchase orders is due within ten days instead of one
week. During the first nine months of 2006, the Company purchased $13.8 million
(unaudited) of inventory under this arrangement. As of September 30, 2006, there
was $5,357,668 (unaudited) in trade payables under this arrangement.


                                       13


<PAGE>

In February 2003, the Company entered into an agreement with a related party,
whereby the related party agreed to supply and store at the Company's warehouse
up to $10.0 million of inventory on a consignment basis. Under the agreement,
the Company would insure the consignment inventory, store the consignment
inventory for no charge, and furnish the related party with weekly statements
indicating all products received and sold and the current consignment inventory
level. The agreement could be terminated by either party with 60 days written
notice. In addition, this agreement provides for a trade line of credit of up to
$10.0 million with payment terms of net 60 days, non-interest bearing. During
the nine months ended September 30, 2006, the Company purchased $1,558,000
(unaudited) of inventory under this arrangement. As of September 30, 2006, there
was $318,324 (unaudited) in trade payables outstanding under this arrangement.

NOTE 8 - TREASURY STOCK

The Company retired 13,493 shares of treasury stock valued at $126,014 in the
nine months ended September 30, 2006.

NOTE 9 - COMMITMENTS AND CONTINGENCIES

LEASES

The Company leases its facilities and certain equipment under non-cancelable
operating lease agreements that expire through August 2009. On August 1, 2006,
the Company amended its original facility lease to extend its term to August 31,
2009.

Rent expense was $320,608 (unaudited) and $282,486 (unaudited) for the nine
months ended September 30, 2006 and 2005, respectively, and is included in
general and administrative expenses in the accompanying Consolidated Statements
of Income. Rent expense was $128,372 (unaudited) and $94,882 (unaudited) for the
quarter ended September 30, 2006 and 2005, respectively.

LITIGATION

On or about May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for
breach of contract and legal malpractice against Lawrence W. Horwitz, Gregory B.
Beam, Horwitz & Beam, Inc., Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and
Senn Palumbo Meulemans, LLP, the Company's former attorneys and their respective
law firms, in the Superior Court of the State of California for the County of
Orange. The complaint sought damages of $15.0 million arising out of the
defendants' representation of I/OMagic and IOM Holdings, Inc. in an acquisition
transaction and in a separate arbitration matter. On or about November 6, 2003,
the Company filed its First Amended Complaint against all defendants. Defendants
responded to the Company's First Amended Complaint denying the Company's
allegations. Defendants Lawrence W. Horwitz and Lawrence M. Cron also filed a
Cross-Complaint against the Company for attorneys' fees in the approximate
amount of $79,000. The Company denied the allegations in the Cross-Complaint.
Trial began on February 6, 2006 and on March 10, 2006, the jury ruled in the
Company's favor against Lawrence W. Horwitz, Horwitz & Beam, Inc., Lawrence M.
Cron, Horwitz & Cron and Senn Palumbo Meulemans, LLP, and awarded the Company
$3.0 million in damages. The Company has not collected any of this amount.
Judgment was entered on or about April 5, 2006. However, defendants have since
filed a motion for new trial and a motion for judgment notwithstanding the
verdict. On May 31, 2006, the Court denied the motion for new trial in its
entirety, denied the motion for judgment notwithstanding the verdict as to
Lawrence W. Horwitz, Horwitz & Beam, Inc. and Lawrence M. Cron, but granted the
motion for judgment notwithstanding the verdict as to Horwitz & Cron and Senn
Palumbo Meulemans, LLP. An Amended Judgment Notwithstanding the Verdict based
upon the Court's ruling on the motion for judgment notwithstanding the verdict
was entered on or about July 7, 2006. Appeals have since been filed as to both
the original Judgment and the Amended Judgment. These appeals remain pending.

On May 20, 2005, the Company filed a complaint for breach of contract, breach of
implied covenant of good faith and fair dealing, and common counts against
OfficeMax North America, Inc., or defendant, in the Superior Court of the State
of California for the County of Orange, Case No. 05CC06433. The complaint sought
damages of in excess of $22 million arising out of the defendants' alleged
breach of contract under an agreement entered into in May 2001. On or about June
20, 2005, OfficeMax removed the case to the United States District Court for the
Central District of California, Case No. SA CV05-0592 DOC(MLGx). On August 1,
2005, OfficeMax filed its Answer and Counter-Claim against the Company. The
Counter-Claim against the Company alleged four causes of action against the


                                       14


<PAGE>

Company: breach of contract, unjust enrichment, quantum valebant, and an action
for declaratory relief. The Counter-Claim alleged, among other things, that the
Company was liable to OfficeMax in the amount of no less than $138,000 under the
terms of a vendor agreement executed between the Company and OfficeMax in
connection with the return of computer peripheral products to the Company for
which OfficeMax alleged it was never reimbursed. The Counter-Claim sought, among
other things, at least $138,000 from the Company, along with pre-judgment
interest, attorneys' fees and costs of suit. The Company filed a response
denying all of the affirmative claims set forth in the Counter-Claim, denying
any wrongdoing or liability, and denying that OfficeMax was entitled to obtain
any relief.

In April 2006, the Company's case against OfficeMax North America, Inc. was
settled in its entirety. In settling the matter, each party denied liability and
wrongdoing and the settlement was entered into solely for the purpose of
compromising and settling the litigation and in order to avoid the risk, cost,
and burden of litigation and participation therein. Pursuant to the settlement,
OfficeMax paid $2,375,000 (unaudited) to the Company.

In addition, the Company is 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 affect on the Company's
financial condition, results of operations or cash flows.

NOTE 10 - RELATED PARTY TRANSACTIONS

During the nine months ended September 30, 2006 and 2005, the Company made
purchases from related parties totaling approximately $15,261,443 (unaudited)
and $18,073,816 (unaudited), respectively.

As of September 30, 2006 and December 31, 2005, the Company had trade payables
to related parties totaling approximately $5,675,992 (unaudited) and $8,222,078,
respectively.

NOTE 11 - STOCK OPTIONS AND WARRANTS

The Company has the following two stock option plans:

     o    2002 Stock Option Plan (the "2002 Plan")
     o    2003 Stock Option Plan (the "2003 Plan")

The total number of shares of the Company's common stock authorized for issuance
under the 2002 Plan and the 2003 Plan are 133,334, and 400,000, respectively.
The plans are collectively referred to as the "Plans," which are more fully
described in the Company's annual report on Form 10-K for the year ended
December 31, 2005. As of December 31, 2005, there were options to acquire
478,550 shares of common stock issued to employees and directors that were
outstanding under the Plans, and warrants issued to consultants to acquire
180,000 shares of common stock that were outstanding.

The weighted average exercise prices, remaining contractual lives and aggregate
intrinsic values for options granted, exercisable, and expected to vest under
the Plans as of December 31, 2005 were as follows:

                                                   Weighted-
                                    Weighted-      Average
                                     Average      Remaining
                        Number of   Exercise      Contractual
                         Shares       Price       Life (Years)  Intrinsic Value
                         ------       -----       ------------  ---------------
As of December 31, 2005:
Outstanding             478,550       $   2.84        4.72        $ 1,105,408
Expected to Vest        465,000       $   2.84        4.71        $ 1,076,000
Exercisable             287,493       $   2.91        4.77        $   644,054

Aggregate intrinsic value excludes those options that are not "in-the-money" as
of December 31, 2005. Awards that are expected to vest take into consideration
estimated forfeitures for awards not yet vested.


                                       15


<PAGE>

The weighted average exercise prices, remaining contractual lives and aggregate
intrinsic values for warrants granted, exercisable, and expected to vest as of
December 31, 2005 were as follows:

                                                   Weighted-
                                    Weighted-      Average
                                     Average      Remaining
                        Number of   Exercise      Contractual
                         Shares       Price       Life (Years)  Intrinsic Value
                         ------       -----       ------------  ---------------
As of December 31, 2005:
Outstanding             180,000       $   4.83        0.97        $   172,500
Expected to Vest        180,000       $   4.83        0.97        $   172,500
Exercisable             180,000       $   4.83        0.97        $   172,500

Aggregate intrinsic value excludes those warrants that are not "in-the-money" as
of December 31, 2005. Awards that are expected to vest take into consideration
estimated forfeitures for awards not yet vested.

Prior to 2005, there were no options exercised. Options exercised in 2005 were
immaterial. The total fair value of shares vested during the years ended
December 31, 2003, 2004 and 2005, were $0, $12,275 and $463,781, respectively.

As of December 31, 2005, there was $377,000 of total unrecognized compensation
costs related to non-vested share-based compensation arrangements granted,
including warrants. That cost is expected to be recognized over the
weighted-average period of 4.5 years.

When options are exercised, the Company's policy is to issue new shares to
satisfy share option exercises.

NOTE 12 - GEOGRAPHIC INFORMATION

The Company currently operates in one business segment. All fixed assets are
located in the Company's headquarters in the United States. Net sales by
geographical area for the three and nine months ended September 30, 2006 and
September 30, 2005 were:

<TABLE>
<S>     <C>
                      Three Months Ended                  Nine Months Ended
                -----------------------------    -----------------------------
                September 30,   September 30,    September 30,   September 30,
                     2006            2005             2006            2005
                -------------   -------------    -------------   -------------
United States   $   8,862,774   $   8,436,444    $  27,814,031   $  26,822,623

Canada              2,595,900         (12,688)       2,520,281         195,556
                -------------   -------------    -------------   -------------
Total           $  11,458,674   $   8,423,756    $  30,334,312   $  27,018,179
                =============   =============    =============   =============
</TABLE>


                                       16


<PAGE>

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

     THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR
CONSOLIDATED AUDITED FINANCIAL STATEMENTS AND THE RELATED NOTES AND THE OTHER
FINANCIAL INFORMATION IN OUR MOST RECENT ANNUAL REPORT ON FORM 10-K AND OUR
CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS AND THE RELATED NOTES AND OTHER
FINANCIAL INFORMATION INCLUDED ELSEWHERE IN THIS REPORT. THIS DISCUSSION
CONTAINS FORWARD-LOOKING STATEMENTS REGARDING THE DATA STORAGE INDUSTRY AND OUR
EXPECTATIONS REGARDING OUR FUTURE PERFORMANCE, LIQUIDITY AND CAPITAL 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 MOST RECENT ANNUAL REPORT ON
FORM 10-K AND UNDER OTHER CAPTIONS CONTAINED ELSEWHERE IN THIS REPORT.

OVERVIEW

     We are a leading provider of optical and mobile data storage products. Our
data storage products consist of a range of products that store traditional
personal computer data as well as music, photos, movies, games and other
multi-media content. These products are designed principally for general data
storage purposes. Our optical data storage products include both internal and
external DVD drives and internal and external CD drives. Our line of mobile data
storage products, which we call our GigaBankTM, DataBankTM and Data-to-GoTM
products, are compact and portable hard disk drives with a built-in USB
connector with data storage capacities ranging from 4 gigabytes to 750
gigabytes. In the third quarter, we launched a new product featuring our 3.5"
GigaBankTM external hard disk drives and we also expanded our sales efforts in
Canada by featuring bilingual packaging.

     We sell our products through computer, consumer electronics, office supply
superstores, membership warehouses and other retailers in over 8,000 retail
locations throughout North America. Our network of retailers enables us to offer
products to consumers across North America, including every major metropolitan
market in the United States. In the past three years, our major retailers have
included Best Buy, Best Buy Canada, Circuit City, CompUSA, Costco, Office Depot,
OfficeMax and Staples. Our principle brand is I/OMagic(R), however, from time to
time, we also sell products under our Hi-Val(R) and Digital Research
Technologies(R) brand names.

     Our optical data storage products collectively accounted for approximately
45% of our net sales in the first nine months of 2006 while our mobile data
storage products collectively accounted for approximately 52% of our net sales
in the first nine months of 2006. Our optical data storage products accounted
for approximately 60% of our net sales in the first nine months of 2005 and our
mobile data storage products accounted for approximately 36% of our net sales in
the first nine months of 2005. This sales mix reflects our continued and
increasing focus on mobile data storage products.

     Our net sales increased by $3.3 million, or 12.2%, to $30.3 million in the
first nine months of 2006 from $27.0 million in the first nine months of 2005.
Our net loss decreased by $838,000 to $304,000 in the first nine months of 2006
from a net loss of $1.1 million in the first nine months of 2005. Our improved
operating results were due, in large part, to the following factors:

     o    NET SALES. Our increase in net sales in the first nine months of 2006
          as compared to the first nine months of 2005 was primarily due to the
          following combination of factors:


                                       17


<PAGE>

          o    a continued and substantial increase in sales of our mobile data
               storage products combined with a lower rate of returns and less
               sales incentives associated with these products; sales of our
               mobile data storage products increased by 61% in the first nine
               months of 2006 as compared to the same period in 2005, which was
               partially offset by a continued decline in sales of our optical
               data storage products; sales of our optical data storage products
               decreased by 14% in the first nine months of 2006 as compared to
               the same period in 2005; and

          o    the launch of our 3.5" GigaBankTM external hard disk drives which
               resulted in $2.5 million of net sales for the first nine months
               of 2006.

     o    GROSS PROFIT. Our gross profit margins increased to 14.0% of net sales
          in the first nine months of 2006 as compared to gross profit margins
          of 12.8% of net sales in the first nine months of 2005. This increase
          was primarily due to increased sales of our mobile data storage
          products, which generally have higher gross profit margins, and
          decreased sales of our optical data storage products, which generally
          have lower gross profit margins. Also, our mobile data storage
          products have lower rates of return and less market pressure for sales
          incentives as compared to our optical data storage products. In
          addition, the launch of our 3.5" GigaBankTM external hard disk drives
          had a positive impact on our gross profit margins.

     o    OPERATING EXPENSES. Our operating expenses increased to 22.1% of net
          sales in the first nine months of 2006 as compared to 16.2% of net
          sales in the first nine months of 2005. This increase was primarily
          due to increased general and administrative expenses, including
          approximately $1.2 million of offering cost expensed in the second
          quarter of 2006 in connection with a registered public offering that
          had not yet been completed as of June 30, 2006, is not now completed
          and may never be completed. In addition, our operating expenses
          increased due to higher legal fees, audit fees and product assembly
          fees in the first nine months of 2006 as compared to the same period
          in 2005.

     o    OTHER INCOME. Our other income increased by over approximately $2.4
          million. This increase was due to the receipt of approximately $2.4
          million upon the settlement of a litigation matter with OfficeMax.

     A combination of factors affected our net sales, including the continued
decline in sales of our optical data storage products. We continue to
de-emphasize CD- and DVD-based products because we believe that they are
included as a standard component in most new computer systems. In addition, the
market for DVD-based products in the first nine months of 2006 continued to be
extremely competitive and was characterized by abundant product supplies. The
market for DVD-based data storage products continued to experience intense
competition and downward pricing pressures resulting in lower than expected
overall dollar sales. The effects of these factors on sales of our DVD-based
products were substantially similar in this regard to that of the data storage
industry. Sales of our optical data storage products decreased by 14% to $13.8
million, or 45% of our net sales, in the first nine months of 2006 as compared
to $16.1 million, or 60% of our net sales, in the first nine months of 2005.

     In addition to the factors described above, we believe that mobile data
storage devices, including our GigaBankTM, DataBankTM and Data-to-GoTM products,
and our competitors' flash memory devices, thumbdrives and other mobile data
storage devices, which are an alternative to optical data storage products, have
caused a decline in the relative market share of optical data storage products
and likewise caused a decline in our sales of optical data storage products in
the first nine months of 2006. We expect to continue to broaden our range of
products by expanding our mobile data storage product line and we anticipate
that sales of these devices will continue to increase as a percentage of our
total net sales over the next twelve months.


                                       18


<PAGE>

     Sales of our mobile data storage products increased by 61% to $15.8
million, or 52% of our net sales, in the first nine months of 2006 as compared
to $9.8 million, or 36% of our net sales, in the first nine months of 2005.

     One of our core strategies is to be among the first-to-market with new and
enhanced product offerings based on established technologies. We expect to
continue to apply this strategy, as we have done in the contexts of optical data
storage products and for our mobile data storage products, to next-generation
super-high capacity storage devices. This strategy extends not only to new
products, but also to enhancements of existing products. We believe that by
employing this strategy, we will be able to maintain relatively high average
selling prices and gross profit margins and avoid relying on the highly
competitive market of last-generation and older devices.

     Our business faces the significant risk that certain of our retailers will
implement a private label or direct import program, or expand their existing
programs, especially for higher margin products. Our retailers may believe that
higher profit margins can be achieved if they implement a direct import or
private label program, excluding us from the sales channel. One of our
challenges will be to deliver products and provide services to our retailers in
a manner and at a level that makes private label or direct importation of
products less attractive to our retailers, while maintaining product margins at
levels sufficient to allow for profitability that meets or exceeds our goals.

   OPERATING PERFORMANCE AND FINANCIAL CONDITION

     We focus on numerous factors in evaluating our operating performance and
our financial condition. In particular, in evaluating our operating performance,
we focus primarily on net sales, net product margins, net retailer margins,
rebates and sales incentives, and inventory turnover as well as operating
expenses and net income.

     NET SALES. Net sales is a key indicator of our operating performance. We
closely monitor overall net sales, as well as net sales to individual retailers,
and seek to increase net sales by expanding sales to additional retailers and
expanding sales to existing retailers both by increasing sales of existing
products and introducing new products. Management monitors net sales on a weekly
basis, but also considers sales seasonality, promotional programs and product
life-cycles in evaluating weekly sales performance. As net sales increase or
decrease from period to period, it is critical for management to understand and
react to the various causes of these fluctuations, such as successes or failures
of particular products, promotional programs, product pricing, retailer
decisions, seasonality and other causes. Where possible, management attempts to
anticipate potential changes in net sales and seeks to prevent adverse changes
and stimulate positive changes by addressing the expected causes of adverse and
positive changes. We believe that our good working relationships with our
retailers enable us to monitor closely consumer acceptance of particular
products and promotional programs which in turn enable us to better anticipate
changes in market conditions.

     NET PRODUCT MARGINS. Net product margins, from product-to-product and
across all of our products as a whole, is an important measurement of our
operating performance. We monitor margins on a product-by-product basis to
ascertain whether particular products are profitable or should be phased out as
unprofitable products. In evaluating particular levels of product margins on a
product-by-product basis, we focus on attaining a level of net product margin
sufficient to contribute to normal operating expenses and to provide a profit.
The level of acceptable net product margin for a particular product depends on
our expected product sales mix. However, we occasionally sell products for
certain strategic reasons to, for example, complete a product line or for
promotional purposes, without a rigid focus on historical product margins or
contribution to operating expenses or profitability.


                                       19


<PAGE>

     NET RETAILER MARGINS. We seek to manage profitability on a retailer level,
not solely on a product level. Although we focus on net product margins on a
product-by-product basis and across all of our products as a whole, our primary
focus is on attaining and building profitability on a retailer-by-retailer
level. For this reason, our mix of products is likely to differ among our
various retailers. These differences result from a number of factors, including
retailer-to-retailer differences, products offered for sale and promotional
programs.

     REBATES AND SALES INCENTIVES. Rebates and sales incentives offered to
customers and retailers are an important aspect of our business and are
instrumental in obtaining and maintaining market leadership through competitive
pricing in generating sales on a regular basis as well as stimulating sales of
slow-moving products. We focus on rebates and sales incentives costs as a
proportion of our total net sales to ensure that we meet our expectations of the
costs of these programs and to understand how these programs contribute to our
profitability or result in unexpected losses.

     INVENTORY TURNOVER. Our products' life-cycles typically range from 3-12
months, generating lower average selling prices as the cycles mature. We attempt
to keep our inventory levels at amounts adequate to meet our retailers' needs
while minimizing the danger of rapidly declining average selling prices and
inventory financing costs. By focusing on inventory turnover cycles, we seek to
identify slow-moving products and take appropriate actions such as
implementation of rebates and sales incentives to increase inventory turnover.

     Our use of a consignment sales model with certain retailers results in
increased amounts of inventory that we must carry and finance and results in
greater exposure to the danger of declining average selling prices. However, our
consignment sales model allows us to more quickly and efficiently implement
promotional programs and pricing adjustments to sell off slow-moving inventory
and prevent further price erosion.

     Our targeted inventory turnover cycle for our combined sales models is 6 to
8 weeks of inventory, which equates to an annual inventory turnover cycle of
approximately 6.5 to 8.7. For the first nine months of 2006, our annualized
inventory turnover cycle was 4.8 as compared to 5.0 for the first nine months of
2005, primarily as a result of a 17% increase in inventory. The increase in
inventory turnover for the first nine months of 2006 included $271,000 of
expenses for slow-moving and obsolete inventory as compared to $705,000 of
expenses for slow-moving and obsolete inventory in the first nine months of
2005.

     OPERATING EXPENSES. We focus on operating expenses to keep these expenses
within budgeted amounts to achieve or exceed our targeted profitability. We
budget certain of our operating expenses in proportion to our projected net
sales, including operating expenses related to production, shipping, technical
support, and inside and outside commissions and bonuses. However, most of our
expenses related to general and administrative costs, product design and sales
personnel are essentially fixed over large sales ranges. Deviations that result
in operating expenses in greater proportion than budgeted signal to management
that it must ascertain the reasons for the unexpected increase and take
appropriate action to bring operating expenses back into the budgeted
proportion.

     NET INCOME. Net income is the ultimate goal of our business. By managing
the above factors, among others, and monitoring our actual results of
operations, our goal is to generate net income at levels that meet or exceed our
targets.

     In evaluating our financial condition, we focus primarily on cash on hand,
available trade lines of credit, available bank line of credit, anticipated
near-term cash receipts, and accounts receivable as compared to accounts
payable. Cash on hand, together with our other sources of liquidity, is critical


                                       20


<PAGE>

to funding our day-to-day operations. Funds available under our line of credit
with GMAC Commercial Finance are also an important source of liquidity and a
measure of our financial condition. We use our line of credit on a regular basis
as a standard cash management procedure to purchase inventory and to fund our
day-to-day operations without interruption during periods of slow collection of
accounts receivable. Anticipated near-term cash receipts are also regarded as a
short-term source of liquidity, but are not regarded as immediately available
for use until receipt of funds actually occurs.

     The proportion of our accounts receivable to our accounts payable and the
expected maturity of these balance sheet items is an important measure of our
financial condition. We attempt to manage our accounts receivable and accounts
payable to focus on cash flows in order to generate cash sufficient to fund our
day-to-day operations and satisfy our liabilities. Typically, we prefer that
accounts receivable are matched in duration to, or collected earlier than, when
accounts payable are paid. If accounts payable are either out of proportion to,
or due far in advance of, the expected collection of accounts receivable, we
will likely have to use our cash on hand or our line of credit to satisfy our
accounts payable obligations, without relying on additional cash receipts, which
will reduce our ability to purchase and sell inventory and may impact our
ability, at least in the short-term, to fund other parts of our business.

   SALES MODELS

     We employ three primary sales models: a standard terms sales model, a
consignment sales model and a special terms sales model. We generally use one of
these three primary sales models, or some combination of these sales models,
with each of our retailers.

     STANDARD TERMS

     Currently, the majority of our net sales are on a terms basis. Under our
standard terms sales model, a retailer is obligated to pay us for products sold
to it within a specified number of days from the date of sale of products to the
retailer. Our standard terms are typically net 60 days. We typically collect
payment from a retailer within 60 to 75 days following the sale of products to a
retailer.

     CONSIGNMENT

     Under our consignment sales model, a retailer is obligated to pay us for
products sold to it within a specified number of days following our notification
by the retailer of the resale of those products. Retailers notify us of their
resale of consigned products by delivering weekly or monthly sell-through
reports. A sell-through report discloses sales of products sold in the prior
period covered by the report - that is, a weekly or monthly sell-through report
covers sales of consigned products in the prior week or month, respectively. The
period for payment to us by retailers relating to their sale of consigned
products corresponding to these sell-through reports varies from retailer to
retailer. For sell-through reports generated weekly, we typically collect
payment from a retailer within 30 days of the receipt of those reports. For
sell-through reports generated monthly, we typically collect payment from a
retailer within 15 days of the receipt of those reports. Products held by a
retailer under our consignment sales model are recorded as our inventory at
offsite locations until their resale by the retailer.

     Consignment sales represented a growing percentage of our net sales from
2001 through 2003. However, during 2004, our consignment sales model accounted
for 31% of our total net sales as compared to 37% of our total net sales in
2003, primarily as a result of consigning fewer products to Best Buy, which was
our largest consignment retailer, which was partially offset by an increase in
consigning more products to Staples. In 2005, our consignment sales model
accounted for 33% of our total net sales as compared to 31% of our total net
sales in 2004. During the first nine months of 2006 our consignment sales model
accounted for 45% of our total net sales as compared to 35% of our total net
sales in the first nine months of 2005, representing a 29% increase, primarily


                                       21


<PAGE>

as a result of consigning more products to both Office Depot and Staples.
Although consignment sales increased as a percentage of our net sales in 2005 as
compared to 2004 and increased as a percentage of our net sales in the first
nine months of 2006 as compared to the first nine months of 2005, it is not
clear whether consignment sales as a percentage of our total net sales will grow
or decline in the future.

     We have increased the use of our consignment sales model based in part on
the preferences of some of our retailers. Our retailers often prefer the
benefits resulting from our consignment sales model over our standard terms
sales model. These benefits include payment by a retailer only in the event of
resale of a consigned product, resulting in less risk borne by the retailer of
price erosion due to competition and technological obsolescence. Deferring
payment until following the sale of a consigned product also enables a retailer
to avoid having to finance the purchase of that product by using cash on hand or
by borrowing funds and incurring borrowing costs. In addition, retailers also
often operate under budgetary constraints on purchases of certain products or
product categories. As a result of these budgetary constraints, the purchase by
a retailer of certain products typically will cause reduced purchasing power for
other products. Products consigned to a retailer ordinarily fall outside of
these budgetary constraints and do not cause reduced purchasing power for other
products. As a result of these benefits, we believe that we are able to sell
more products by using our consignment sales model than by using only our
standard terms sales model.

     Managing an appropriate level of consignment sales is an important
challenge. As noted above, the payment period for products sold on consignment
is based on the day consigned products are resold by a retailer, and the payment
period for products sold on a standard terms basis is based on the day the
product is sold initially to the retailer, independent of the date of resale of
the product. Accordingly, we generally prefer that higher-turnover inventory is
sold on a consignment basis while lower-turnover inventory is sold on a
traditional terms basis. Management focuses closely on consignment sales to
manage our cash flow to maximize liquidity as well as net sales. Close attention
is directed toward our inventory turnover cycles to ensure that they are
sufficiently frequent to maintain appropriate liquidity. Our consignment sales
model enables us to have more pricing control over inventory sold through our
retailers as compared to our standard terms sales model. If we identify a
decline in inventory turnover cycles for products in our consignment sales
channels, we can implement price modifications more quickly and efficiently as
compared to the implementation of sales incentives in connection with our
standard terms sales model. This affords us more flexibility to take action to
attain our targeted inventory turnover cycles.

     We retain most risks of ownership of products in our consignment sales
channels. These products remain as our inventory until their resale by our
retailers. 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 cycles 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 sales channels, our sales,
profitability and financial resources may decline.

     SPECIAL TERMS

     We occasionally employ a special terms sales model. Under our special terms
sales model, the payment terms for the purchase of our products are negotiated
on a case-by-case basis and typically cover a specified quantity of a particular
product. We ordinarily do not offer any rights of return or rebates for products
sold under our special terms sales model. Our payment terms are ordinarily
shorter under our special terms sales model than under our standard terms or
consignment sales models and we typically require payment in advance, at the
time of sale, or shortly following the sale of products to a retailer.


                                       22


<PAGE>

RETAILERS

     Historically, a limited number of retailers have accounted for a
significant percentage of our net sales. During the first nine months of 2006
and during the year 2005, our seven largest retailers accounted for
approximately 90% and 89%, respectively, of our total net sales. We expect that
sales of our products to a limited number of retailers will continue to account
for a majority of our sales in the foreseeable future. We do not have long-term
purchase agreements with any of our retailers. If we were to lose any of our
major retailers or experience any material reduction in orders from any of them,
and were unable to replace our sales to those retailers, it could have a
material adverse effect on our business and results of operations.

SEASONALITY

     Our products have historically been affected by seasonal purchasing
patterns. The seasonality of our sales is in direct correlation to the
seasonality experienced by our retailers and the seasonality of the consumer
electronics industry. After adjusting for the addition of new retailers, our
fourth quarter has historically generated the strongest sales, which correlates
to well-established consumer buying patterns during the Thanksgiving through
Christmas holiday season. Our first and third quarters have historically shown
some strength from time to time based on post-holiday season sales in the first
quarter and back-to-school sales in the third quarter. Our second quarter has
historically been our weakest quarter for sales, again following
well-established consumer buying patterns. The impact of seasonality on our
future results will be affected by our product mix, which will vary from quarter
to quarter.

PRICING PRESSURES

     We face downward pricing pressures within our industry that arise from a
number of factors. The products we sell are subject to rapid technological
change and obsolescence. Companies within the data storage industry are
continuously developing new products with heightened performance and
functionality. This puts downward pricing pressures on existing products and
constantly threatens to make them, or causes them to be, obsolete. Our typical
product life-cycle is extremely short and ranges from three to twelve months,
generating lower average selling prices as the cycle matures.

     In addition, the data storage industry is extremely competitive. Numerous
competitors such as BenQ, Hewlett-Packard, Lite-On, Memorex, Philips
Electronics, Samsung Electronics, Sony, and TDK, compete with us in the optical
data storage industry. Competitors such as Iomega, LaCie, Maxtor, PNY
Technologies, SimpleTech, Sony, Seagate Technology and Western Digital offer
products similar to our GigaBankTM, DataBankTM and Data-to-GoTM mobile data
storage products. Intense competition within our industry exerts downward
pricing pressures on products that we offer. Also, one of our core strategies is
to offer our products as affordable alternatives to higher-priced products
offered by our larger competitors. The effective execution of this business
strategy results in downward pricing pressure on products that we offer because
our products must appeal to consumers partially based on their attractive prices
relative to products offered by our large competitors. As a result, we are
unable to rely as heavily on other non-price factors such as brand recognition
and must consistently maintain lower prices.

     Finally, the actions of our retailers often exert downward pricing
pressures on products that we offer. Our retailers pressure us to offer products
to them at attractive prices. In doing this, we do not believe that the overall
goal of our retailers is to increase their margins on these products. Instead,


                                       23


<PAGE>

we believe that our retailers pressure us to offer products to them at
attractive prices in order to increase sales volume and consumer traffic, as
well as to compete more effectively with other retailers of similar products.
Additional downward pricing pressure also results from the continuing threat
that our retailers may begin to directly import or private-label products that
are identical or very similar to our products. Our pricing decisions with regard
to certain products are influenced by the ability of retailers to directly
import or private-label identical or similar products. Therefore, we constantly
seek to maintain prices that are highly attractive to our retailers and that
offer less incentive to our retailers to commence or maintain direct import or
private-label programs.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

     Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these consolidated financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the consolidated financial statements and the reported amount of net
sales and expenses for each period. The following represents a summary of our
critical accounting policies, defined as those policies that we believe are the
most important to the portrayal of our financial condition and results of
operations and that require management's most difficult, subjective or complex
judgments, often as a result of the need to make estimates about the effects of
matters that are inherently uncertain.

     REVENUE RECOGNITION

     We recognize revenue under three primary sales models: a standard terms
sales model, a consignment sales model and a special terms sales model. We
generally use one of these three primary sales models, or some combination of
these sales models, with each of our retailers.

     STANDARD TERMS

     Under our standard terms sales model, a retailer is obligated to pay us for
products sold to it within a specified number of days from the date that title
to the products is transferred to the retailer. Our standard terms are typically
net 60 days from the transfer of title to the products to a retailer. We
typically collect payment from a retailer within 60 to 75 days from the transfer
of title to the products to a retailer. Transfer of title occurs and risk of
ownership passes to a retailer at the time of shipment or delivery, depending on
the terms of our agreement with a particular retailer. The sale price of our
products is substantially fixed or determinable at the date of sale based on
purchase orders generated by a retailer and accepted by us. A retailer's
obligation to pay us for products sold to it under our standard terms sales
model is not contingent upon the resale of those products. We recognize revenue
for standard terms sales at the time title to products is transferred to a
retailer.

     CONSIGNMENT

     Under our consignment sales model, a retailer is obligated to pay us for
products sold to it within a specified number of days following our notification
by the retailer of the resale of those products. Retailers notify us of their
resale of consigned products by delivering weekly or monthly sell-through
reports. A sell-through report discloses sales of products sold in the prior
period covered by the report - that is, a weekly or monthly sell-through report
covers sales of consigned products in the prior week or month, respectively. The
period for payment to us by retailers relating to their resale of consigned
products corresponding to these sell-through reports varies from retailer to
retailer. For sell-through reports generated weekly, we typically collect


                                       24


<PAGE>

payment from a retailer within 30 days of the receipt of those reports. For
sell-through reports generated monthly, we typically collect payment from a
retailer within 15 days of the receipt of those reports. At the time of a
retailer's resale of a product, title is transferred directly to the consumer.
Risk of theft or damage of a product, however, passes to a retailer upon
delivery of that product to the retailer. The sale price of our products is
substantially fixed or determinable at the date of sale based on a product
sell-through report generated by a retailer and delivered to us. Except in the
case of theft or damage, a retailer's obligation to pay us for products
transferred under our consignment sales model is entirely contingent upon the
resale of those products. Products held by a retailer under our consignment
sales model are recorded as our inventory at offsite locations until their
resale by the retailer. Because we retain title to products in our consignment
sales channels until their resale by a retailer, revenue is not recognized until
the time of resale. Accordingly, price modifications to inventory maintained in
our consignment sales channels do not have an effect on the timing of revenue
recognition. We recognize revenue for consignment sales in the period during
which resale occurs.

     SPECIAL TERMS

     Under our special terms sales model, the payment terms for the purchase of
our products are negotiated on a case-by-case basis and typically cover a
specified quantity of a particular product. The result of our negotiations is a
special agreement with a retailer that defines how and when transfer of title
occurs and risk of ownership shifts to the retailer. We ordinarily do not offer
any rights of return or rebates for products sold under our special terms sales
model. A retailer is obligated to pay us for products sold to it within a
specified number of days from the date that title to the products is transferred
to the retailer, or as otherwise agreed to by us. Our payment terms are
ordinarily shorter under our special terms sales model than under our standard
terms or consignment sales models and we typically require payment in advance,
at the time of transfer of title to the products or shortly following the
transfer of title to the products to a retailer. Transfer of title occurs and
risk of ownership passes to a retailer at the time of shipment, delivery,
receipt of payment or the date of invoice, depending on the terms of our
agreement with the retailer. The sale price of our products is substantially
fixed or determinable at the date of sale based on our agreement with a
retailer. A retailer's obligation to pay us for products sold to it under our
special terms sales model is not contingent upon the resale of those products.
We recognize revenue for special terms sales at the time title to products is
transferred to a retailer.

     SALES INCENTIVES

     From time to time, we enter into agreements with certain retailers
regarding price decreases that are determined by us in our sole discretion.
These agreements allow those retailers (subject to limitations) a credit equal
to the difference between our current price and our new reduced price on units
in the retailers' inventories or in transit to the retailers on the date of the
price decrease.

     We record an estimate of sales incentives based on our actual sales
incentive rates over a trailing twelve-month period, adjusted for any known
variations, which are charged to operations and offset against gross sales at
the time products are sold with a corresponding accrual for our estimated sales
incentive liability. This accrual--our sales incentive reserve--is reduced by
deductions on future payments taken by our retailers relating to actual sales
incentives.

     At the end of each quarterly period, we analyze our existing sales
incentive reserve and apply any necessary adjustments based upon actual or
expected deviations in sales incentive rates from our applicable historical
sales incentive rates. The amount of any necessary adjustment is based upon the
amount of our remaining field inventory, which is calculated by reference to our
actual field inventory last conducted, plus inventory-in-transit and less
estimated product sell-through. The amount of our sales incentive liability for


                                       25


<PAGE>

each product is equal to the amount of remaining field inventory for that
product multiplied by the difference between our current price and our new
reduced price to our retailers for that product. This data, together with all
data relating to all sales incentives granted on products in the applicable
period, is used to adjust our sales incentive reserve established for the
applicable period.

     In the first nine months of 2006, our sales incentives were $497,000, or
1.3% of gross sales, all of which was offset against gross sales, as compared to
$1.1 million, or 2.8% of gross sales, in the first nine months of 2005, all of
which was offset against gross sales. This 54% decrease in sales incentives as a
percentage of gross sales reflects our shift in product mix towards mobile data
storage products, which experience less market pressure for sales incentives,
and away from optical data storage products.

   MARKET DEVELOPMENT FUND AND COOPERATIVE ADVERTISING COSTS, REBATE PROMOTION
   COSTS AND SLOTTING FEES

     Market development fund and cooperative advertising costs, rebate promotion
costs and slotting fees are charged to operations and offset against gross sales
in accordance with Emerging Issues Task Force, or EITF, Issue No. 01-9. Market
development fund and cooperative advertising costs and rebate promotion costs
are each promotional costs. Slotting fees are fees paid directly to retailers
for allocation of shelf-space in retail locations. In the first nine months of
2006, our market development fund and cooperative advertising costs, rebate
promotion costs and slotting fees were $4.8 million, or 12.2% of gross sales,
all of which was offset against gross sales, as compared to market development
fund and cooperative advertising costs, rebate promotion costs and slotting fees
of $4.5 million, or 12.1% of gross sales, in the first nine months of 2005, all
of which was offset against gross sales.

     Consideration generally given by us to a retailer is presumed to be a
reduction of selling price, and therefore, a reduction of gross sales. However,
if we receive an identifiable benefit that is sufficiently separable from our
sales to that retailer, such that we could have paid an independent company to
receive that benefit and we can reasonably estimate the fair value of that
benefit, then the consideration is characterized as an expense. We estimate the
fair value of the benefits we receive by tracking the advertising done by our
retailers on our behalf and calculating the value of that advertising using a
comparable rate for similar publications.

   ALLOWANCE FOR OBSOLETE AND SLOW MOVING INVENTORY

     Our warehouse supervisor, production supervisor and production manager
physically review our warehouse inventory for slow-moving and obsolete products.
All products of a material amount are reviewed quarterly and all products of an
immaterial amount are reviewed annually. We consider products that have not been
sold within six months to be slow-moving. Products that are no longer compatible
with current hardware or software are considered obsolete. The potential for
re-sale of slow-moving and obsolete inventories is considered through market
research, analysis of our retailers' current needs, and assumptions about future
demand and market conditions. The recorded cost of both slow-moving and obsolete
inventories is then reduced to its estimated market value based on current
market pricing for similar products. We utilize the Internet to provide
indications of market value from competitors' pricing, third party inventory
liquidators and auction websites. The recorded costs of our slow-moving and
obsolete products are reduced to current market prices when the recorded costs
exceed those market prices. For the first nine months of 2006 we increased our
inventory reserve and recorded a corresponding increase in cost of goods sold of
$271,000 for inventory for which recorded cost exceeded the current market price
of this inventory on hand. For the first nine months of 2005, we increased our
inventory reserve and recorded a corresponding increase in cost of goods sold of
$705,000 for inventory for which recorded cost exceeded the current market price
of this inventory on hand. All adjustments establish a new cost basis for
inventory as we believe such reductions are permanent declines in the market
price of our products. Generally, obsolete inventory is sold to companies that


                                       26


<PAGE>

specialize in the liquidation of these items while we continue to market
slow-moving inventories until they are sold or become obsolete. We reduce our
inventory reserve as we reduce the values of specific products in our detailed
inventory report based upon our lower-of-cost-or-market analysis. During the
first nine months of 2006 and 2005, we reduced the values of specific products
and accordingly reduced the reserve by $207,000 and $134,000, respectively. For
the first nine months of 2006 and 2005, gains recorded as a result of sales of
obsolete inventory above the reserved amount were not significant to our results
of operations and accounted for less than 1% of our total net sales. Although we
have no specific statistical data on this matter, we believe that our practices
are reasonable and consistent with those of our industry.

   INVENTORY ADJUSTMENTS

     Our warehouse supervisor, production supervisor and production manager
physically review our warehouse inventory for obsolete or damaged
inventory-related items on a monthly basis. Inventory-related items (such as
sleeves, manuals or broken products no longer under warranty from our
subcontract manufacturers or suppliers) which are considered obsolete or damaged
are reviewed by these personnel together with our Controller or Chief Financial
Officer. At the discretion of our Controller or Chief Financial Officer, these
items are physically disposed of and we make corresponding accounting
adjustments resulting in inventory adjustments. In addition, on a monthly basis,
our detail inventory report and our general ledger are reconciled by our
Controller and any variances result in a corresponding inventory adjustment.
Although we have no specific statistical data on this matter, we believe that
our practices are reasonable and consistent with those of our industry.

   ALLOWANCE FOR DOUBTFUL ACCOUNTS

     We maintain allowances for doubtful accounts for estimated losses resulting
from the inability of our retailers to make required payments. Our current
retailers consist of either large national or regional retailers with good
payment histories with us. Since we have not experienced any previous payment
defaults with any of our current retailers, our allowance for doubtful accounts
is minimal. We perform periodic credit evaluations of our retailers and maintain
allowances for potential credit losses based on management's evaluation of
historical experience and current industry trends. If the financial condition of
our retailers were to deteriorate, resulting in the impairment of their ability
to make payments, additional allowances may be required. New retailers are
evaluated through Dunn & Bradstreet before terms are established. Although we
expect to collect all amounts due, actual collections may differ.

   PRODUCT RETURNS

     We have a limited 90-day to one year time period for product returns from
end-users; however, our retailers generally have return policies that allow
their customers to return products within only fourteen to thirty days after
purchase. We allow our retailers to return damaged or defective products to us
following a customary return merchandise authorization process. We utilize
actual historical return rates to determine our allowance for returns in each
period. Gross sales are reduced by estimated returns and cost of sales is
reduced by the estimated cost of those sales. We record a corresponding accrual
for the estimated liability associated with the estimated returns. This
estimated liability is based on the gross margin of the products corresponding
to the estimated returns. This accrual is offset each period by actual product
returns.

     Our current estimated weighted average future product return rate is
approximately 7.6%. As noted above, our return rate is based upon our past
history of actual returns and we estimate amounts for product returns for a
given period by applying this historical return rate and reducing actual gross
sales for that period by a corresponding amount. Our historical return rate for
a particular product is the life-to-date return rate of similar products. This


                                       27


<PAGE>

life-to-date return rate is updated monthly. We also compare this life-to-date
return rate to our trailing 18-month return rate to determine whether any
material changes in our return rate have occurred that may not be reflected in
the life-to-date return rate. We believe that using a trailing 18-month return
rate takes two key factors into consideration, specifically, an 18-month return
rate provides us with a sufficient period of time to establish recent historical
trends in product returns for each product category, and provides us with a
period of time that is short enough to account for recent technological shifts
in our product offerings in each product category. If an unusual circumstance
exists, such as a product category that has begun to show materially different
actual return rates as compared to life-to-date return rates, we will make
appropriate adjustments to our estimated return rates. Factors that could cause
materially different actual return rates as compared to life-to-date return
rates include product modifications that simplify installation, a new product
line, within a product category, that needs time to better reflect its return
performance and other factors.

     Although we have no specific statistical data on this matter, we believe
that our practices are reasonable and consistent with those of our industry.

     Our warranty terms under our arrangements with our suppliers are that any
product that is returned by a retailer or retail customer as defective can be
returned by us to the supplier for full credit against the original purchase
price. We incur only minimal shipping costs to our suppliers in connection with
the satisfaction of our warranty obligations.

   STOCK-BASED COMPENSATION

     On January 1, 2006, we adopted Statements of Financial Accounting Standards
("SFAS") No. 123 (revised 2004), "Share-Based Payment," or SFAS 123(R), which
requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors based on estimated
fair values. SFAS 123(R) supersedes our previous accounting under Accounting
Principles Board Opinion No. 25, or APB 25, "Accounting for Stock Issued to
Employees" for periods beginning in fiscal 2006. In March 2005, the Securities
and Exchange Commission issued Staff Accounting Bulletin No. 107, or SAB 107,
relating to SFAS 123(R). We have applied the provisions of SAB 107 in our
adoption of SFAS 123(R).

     We adopted SFAS 123(R) using the modified prospective transition method,
which requires the application of the accounting standard as of January 1, 2006,
the first day of our fiscal year 2006. Our consolidated financial statements as
of and for the three and nine months ended September 30, 2006 reflect the impact
of SFAS 123(R). In accordance with the modified prospective transition method,
our consolidated financial statements for prior periods have not been restated
to reflect, and do not include, the impact of SFAS 123(R). Stock-based
compensation expense recognized under SFAS 123(R) for employee and directors for
the three and nine months ended September 30, 2006 was $34,323 and $118,987,
respectively, and are included in general and administrative expenses. Income
(loss) from operations for the three and nine months ended September 30, 2006
would have been $171,634 and $(2,336,112), respectively, if we had not adopted
SFAS 123(R). Income (loss) before income taxes for the three and nine months
ended September 30, 2006 would have been $117,320 and $(184,558), respectively,
if we had not adopted SFAS 123(R). Net income (loss) for the three and nine
months ended September 30, 2006 would have been $117,320 and $(185,358),
respectively, if we had not adopted SFAS 123(R). For the three and nine months
ended September 30, 2006, cash flow from operations and cash flow from financing
activities were not effected by the adoption of SFAS 123(R). Basic income (loss)
per share for the three and nine months ended September 30, 2006 would have been
$0.03 and $(0.04), respectively, if we had not adopted SFAS 123(R), compared to
reported basic income (loss) per share of $0.02 and $(0.07), respectively.
Diluted income (loss) per share for the three and nine months ended September
30, 2006 would have been $0.03 and $(0.04), respectively, if we had not adopted
SFAS 123(R), compared to reported diluted income (loss) per share of $0.02 and
$(0.07), respectively.


                                       28


<PAGE>

     The following table illustrates the effect on net loss and loss per share
if we had applied the fair value recognition provisions of SFAS 123 to
stock-based awards granted under our stock option plans for the nine months
ended September 30, 2005. For purposes of this pro-forma disclosure, the fair
value of the options is estimated using the Black-Scholes-Merton option-pricing
formula, or the Black-Scholes model, and amortized to expense generally over the
options' requisite service periods (vesting periods).

<TABLE>
<S>     <C>
                                                        THREE MONTHS     NINE MONTHS
                                                            ENDED           ENDED
                                                        SEPTEMBER 30,   SEPTEMBER 30,
                                                            2005            2005
                                                        ------------    ------------
Net loss, as reported                                   $   (212,474)   $ (1,142,793)

   Stock-based employee compensation expense included
   in reported net loss, net of related tax effects               --              --

   Total stock-based employee compensation expense
   determined under fair value based method for all
   awards, net of related tax effects                       (388,555)       (432,708)
                                                        ------------    ------------
Pro forma net loss                                      $   (601,029)   $ (1,575,501)
                                                        ============    ============
Net loss per common share:
   Basic and diluted, as reported                       $      (0.05)   $      (0.25)
                                                        ============    ============
   Basic and diluted, pro forma                         $      (0.13)   $      (0.35)
                                                        ============    ============
</TABLE>

     SFAS 123(R) requires companies to estimate the fair value of share-based
payment awards to employees and directors on the date of grant using an
option-pricing model. The value of the portion of the award that is ultimately
expected to vest is recognized as expense over the requisite service periods in
our Consolidated Statements of Income. Stock-based compensation expense
recognized in the Consolidated Statements of Income for the three and nine
months ended September 30, 2006 included compensation expense for share-based
payment awards granted prior to, but not yet vested as of January 1, 2006 based
on the grant date fair value estimated in accordance with the pro-forma
provisions of SFAS 123 and compensation expense for the share-based payment
awards granted subsequent to January 1, 2006, for which there were no grants
during the three and nine months ended September 30, 2006, based on the grant
date fair value estimated in accordance with the provisions of SFAS 123(R). For
stock-based awards issued to employees and directors, stock-based compensation
is attributed to expense using the straight-line single option method, which is
consistent with how the prior-period pro formas were provided. As stock-based
compensation expense recognized in the Consolidated Statements of Income for the
three and nine months ended September 30, 2006 is based on awards ultimately
expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R)
requires forfeitures to be estimated at the time of grant and revised, if
necessary, in subsequent periods if actual forfeitures differ from those
estimates. In its pro-forma information required under SFAS 123 for the periods
prior to fiscal 2006, we accounted for forfeitures as they occurred.

     Prior to the adoption of SFAS 123(R), we accounted for stock-based awards
to employees and directors using the intrinsic value method in accordance with
APB 25. Under the intrinsic value method, we recognized share-based compensation
equal to the award's intrinsic value at the time of grant over the requisite
service periods using the straight-line method. Forfeitures were recognized as
incurred. During the three and nine months ended September 30, 2005, there was


                                       29


<PAGE>

no stock-based compensation expense recognized in the Consolidated Statements of
Income for awards issued to employees and directors as the awards had no
intrinsic value at the time of grant because their exercise prices equaled the
fair values of the common stock at the time of grant.

     Our determination of fair value of share-based payment awards to employees
and directors on the date of grant using the Black-Scholes model, which is
affected by our stock price as well as assumptions regarding a number of highly
complex and subjective variables. These variables include, but are not limited
to our expected stock price volatility over the expected term of the awards, and
actual and projected employee stock option exercise behaviors. Prior to 2006,
when valuing awards, we used the awards' contractual term as a proxy for the
expected life of the award and historical volatility to approximate expected
volatility. There were no new awards during the first nine months of 2006.

     We have elected to adopt the detailed method provided in SFAS 123(R) for
calculating the beginning balance of the additional paid-in capital pool, or
APIC pool, related to the tax effects of employee stock-based compensation, and
to determine the subsequent impact on the APIC pool and Consolidated Statements
of Cash Flows of the tax effects of employee stock-based compensation awards
that are outstanding upon adoption of SFAS 123(R).

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:

     o    The first two data columns in each table show the absolute results for
          each period presented.

     o    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 a 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.

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


                                       30


<PAGE>

THREE MONTHS ENDED SEPTEMBER 30, 2006 (UNAUDITED) COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 2005 (UNAUDITED)
<TABLE>
<S>     <C>
                                                                                                         RESULTS AS A PERCENTAGE
                                                                          DOLLAR       PERCENTAGE         OF NET SALES FOR THE
                                            THREE MONTHS ENDED           VARIANCE       VARIANCE           THREE MONTHS ENDED
                                              SEPTEMBER 30,           ------------    ------------            SEPTEMBER 30,
                                       ---------------------------      FAVORABLE       FAVORABLE      ----------------------------
                                           2006           2005        (UNFAVORABLE)   (UNFAVORABLE)        2006            2005
                                       ------------   ------------    ------------    ------------     ------------    ------------
                                                                             (in thousands)
Net sales ............................ $     11,459   $      8,424    $      3,035            36.0%           100.0%          100.0%
Cost of sales ........................        9,375          7,074          (2,301)          (32.5)            81.8            84.0
                                       ------------   ------------    ------------    ------------     ------------    ------------
Gross profit .........................        2,084          1,350             734            54.4             18.2            16.0
Selling, marketing and advertising
  expenses ...........................          190            183              (7)           (3.8)             1.7             2.2
General and administrative expenses ..        1,714          1,254            (460)          (36.7)            15.0            14.9
Depreciation and amortization ........           43             50               7            14.0              0.4             0.6
                                       ------------   ------------    ------------    ------------     ------------    ------------
Operating income (loss) ..............          137           (137)            274           200.0              1.2             1.6
Net interest expense .................           63             76              13            17.1              0.5             0.9
Other income .........................            9             --               9              --              0.1              --
                                       ------------   ------------    ------------    ------------     ------------    ------------
Income (loss) from operations before
  provision for income taxes .........           83           (213)            296           139.0              0.7              --
Provision for income taxes............           --             --              --              --               --              --
                                       ------------   ------------    ------------    ------------     ------------    ------------
Net Income (loss) .................... $         83   $       (213)   $        296           139.0%             0.7%            2.5%
                                       ============   ============    ============    ============     ============    ============
</TABLE>

     NET SALES. We believe that the increase in the amount of $3.0 million in
net sales from $8.4 million for the quarter ended September 30, 2005 to $11.5
million for the quarter ended September 30, 2006 is primarily due to the
substantial increase in sales of our mobile data storage products and the launch
of our new 3.5" GigaBankTM external hard disk drives, which was partially offset
by the continued decline in sales of our optical data storage products.

     A combination of factors affected our net sales. We continued to
de-emphasize CD- and DVD-based products because we believe that they are
included as a standard component in most new computer systems. In addition, the
market for DVD-based products in the third quarter of 2006 continued to be
extremely competitive and was characterized by abundant product supplies. The
market for DVD-based data storage products continued to experience intense
competition and downward pricing pressures resulting in lower than expected
overall dollar sales. The effects of these factors on sales of our DVD-based
products were substantially similar in this regard to that of the data storage
industry. Sales of our optical data storage products decreased by 16% to $4.1
million, or 36% of our net sales, in the third quarter of 2006 as compared to
$4.9 million, or 59% of our net sales, in the third quarter of 2005.

     In addition to the factors described above, we believe that mobile data
storage devices, including our GigaBankTM, DataBankTM and Data-to-GoTM products,
and our competitors' flash memory devices, thumbdrives and other mobile data
storage devices, which are an alternative to optical data storage products, have
caused a decline in the relative market share of optical data storage products
and likewise caused a decline in our sales of optical data storage products in
the quarter ended September 30, 2006. We expect to continue to broaden our range
of products by expanding our mobile data storage product line and we anticipate
that sales of these devices will continue to increase as a percentage of our
total net sales over the next twelve months. Sales of our mobile data storage
products increased by 109% to $6.9 million, or 60% of our net sales, in the
third quarter of 2006 as compared to $3.3 million, or 39% of our net sales, in
the third quarter of 2005. In addition, we launched a 3.5" GigaBankTM external
hard disk drive product in the Canadian marketplace in the third quarter of
2006, which resulted in net sales of $2.4 million, or 21% of our net sales, in
the third quarter of 2006.


                                       31


<PAGE>

     Two other items also had an important impact on the increase in net sales
in the quarter ended September 30, 2006 as compared to the quarter ended
September 30, 2005. For the quarter ended September 30, 2006, our product return
rate was 8% of gross sales, or $1.1 million, compared to 13% of gross sales, or
$1.4 million, for the quarter ended September 30, 2005. The decline in our
product return rate was caused by an increase in sales of our mobile data
storage products, which generally have lower rates of return, and a decrease in
sales of our optical data storage products, which generally have higher rates of
return. In addition, for the quarter ended September 30, 2006, our sales
incentives were 1% of gross sales, or $124,000, compared to 2% of gross sales,
or $221,000, for the quarter ended September 30, 2005. The decline in our sales
incentive rates was also caused by an increase in sales of our mobile data
storage products, which generally experience less market pressure for sales
incentives, and a decrease in sales of our optical data storage products, which
generally experience higher market pressure for sales incentives.

     GROSS PROFIT. The increase in gross profit of $734,000 from $1.3 million
for the quarter ended September 30, 2005 to $2.1 million for the quarter ended
September 30, 2006 is primarily due to an increase in gross margins as a
percentage of net sales. Our gross profit margins increased to 18.2% of net
sales in the third quarter of 2006 as compared to gross profit margins of 16.0%
of net sales in the third quarter of 2005. The increase in gross profit margins
is primarily due to higher margins generated by increased sales of our mobile
data storage products. In addition, we had less inventory obsolescence in the
third quarter of 2006 as compared to the third quarter of 2005.

     SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses increased marginally by $7,000 in the quarter ended
September 30, 2006 as compared to the quarter ended September 30, 2005. However,
our selling marketing and advertising expenses decreased as a percentage of our
net sales to 1.7% in the quarter ended September 30, 2006 from 2.2% in the
quarter ended September 30, 2005. The decline in our selling, marketing and
advertising expenses as a percentage of our net sales was primarily due to
electing not to attend one trade show in the quarter ended September 20, 2006
that we attended in the same period in 2005.

     GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased by $460,000 in the quarter ended September 30, 2006 as compared to the
quarter ended September 30, 2005. This increase was primarily due to $30,000 in
legal fees mainly in relation to trial expenses associated with ongoing
litigation matters; a $115,000 increase in audit fees due to more costly
year-end and semi-annual audits; an increase of over $100,000 in outside
financial consulting services during our search for a new Chief Financial
Officer and a new Controller, and including costs associated with the engagement
of a public relations contractor; and a $100,000 increase in product assembly
costs. We believe that the additional product assembly costs will enable us to
more efficiently deliver our products and improve our cash flow. In addition,
$35,000 of stock-based compensation expenses are included in general and
administrative expenses.

     DEPRECIATION AND AMORTIZATION EXPENSES. The $7,000 decrease in depreciation
and amortization expenses resulted from certain of our fixed assets becoming
fully depreciated since the quarter ended September 30, 2005.


                                       32


<PAGE>

NINE MONTHS ENDED SEPTEMBER 30, 2006 (UNAUDITED) COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 2005 (UNAUDITED)
<TABLE>
<S>     <C>
                                                                                                         RESULTS AS A PERCENTAGE
                                                                          DOLLAR       PERCENTAGE         OF NET SALES FOR THE
                                            NINE MONTHS ENDED            VARIANCE       VARIANCE            NINE MONTHS ENDED
                                              SEPTEMBER 30,           ------------    ------------            SEPTEMBER 30,
                                       ---------------------------      FAVORABLE       FAVORABLE      ----------------------------
                                           2006           2005        (UNFAVORABLE)   (UNFAVORABLE)        2006            2005
                                       ------------   ------------    ------------    ------------     ------------    ------------
                                                                             (in thousands)
Net sales ............................ $     30,334   $     27,018    $      3,316            12.3%           100.0%          100.0%
Cost of sales ........................       26,087         23,569          (2,517)          (10.7)            86.0            87.2
                                       ------------   ------------    ------------    ------------     ------------    ------------
Gross profit .........................        4,247          3,449             799            23.2             14.0            12.8
Selling, marketing and advertising
  expenses ...........................          646            480            (166)          (34.6)             2.1             1.8
General and administrative expenses ..        5,923          3,714          (2,209)          (59.5)            19.5            13.7
Depreciation and amortization ........          134            189              55            29.1              0.4             0.7
                                       ------------   ------------    ------------    ------------     ------------    ------------
Operating loss .......................       (2,456)          (934)         (1,522)         (163.0)             8.1             3.5
Net interest expense .................          235            218             (16)           (7.3)             0.8             0.8
Other income .........................        2,386             11           2,375        21,590.9              7.9              --
                                       ------------   ------------    ------------    ------------     ------------    ------------
Loss from operations before
  provision for income taxes .........         (305)        (1,141)            837            73.4              1.0             4.2
Provision for income taxes ...........            1              2               1            50.0               --              --
                                       ------------   ------------    ------------    ------------     ------------    ------------
Net loss ............................. $       (304)  $     (1,143)   $        838            73.3%             1.0%            4.2%
                                       ============   ============    ============    ============     ============    ============
</TABLE>

     NET SALES. As discussed above, we believe that the increase in the amount
of $3.3 million in net sales from $27.0 million for the nine months ended
September 30, 2005 to $30.3 million for the nine months ended September 30, 2006
is primarily due to the substantial increase in sales of our mobile data storage
products and the launch of our new 3.5" GigaBankTM external hard disk drives,
which was partially offset by the continued decline in sales of our optical data
storage products.

     As also discussed above, a combination of factors affected our net sales.
We continued to de-emphasize CD- and DVD-based products because we believe that
they are included as a standard component in most new computer systems. In
addition, the market for DVD-based products in the first nine months of 2006
continued to be extremely competitive and was characterized by abundant product
supplies. The market for DVD-based data storage products continued to experience
intense competition and downward pricing pressures resulting in lower than
expected overall dollar sales. The effects of these factors on sales of our
DVD-based products were substantially similar in this regard to that of the data
storage industry. Sales of our optical data storage products decreased by 14% to
$13.8 million, or 45% of our net sales, in the first nine months of 2006 as
compared to $16.1 million, or 60% of our net sales, in the first nine months of
2005.

     In addition to the factors described above, we believe that mobile data
storage devices, including our GigaBankTM, DataBankTM and Data-to-GoTM products,
and our competitors' flash memory devices, thumbdrives and other mobile data
storage devices, which are an alternative to optical data storage products, have
caused a decline in the relative market share of optical data storage products
and likewise caused a decline in our sales of optical data storage products in
the first nine months of 2006. We expect to continue to broaden our range of
products by expanding our mobile data storage product line and we anticipate
that sales of these devices will continue to increase as a percentage of our
total net sales over the next twelve months. Sales of our mobile data storage
products increased by 61% to $15.8 million, or 52% of our net sales, in the
first nine months of 2006 as compared to $9.8 million, or 36% of our net sales,
in the first nine months of 2005.

     Two other items also had an important impact on the increase in net sales
in the nine months ended September 30, 2006 as compared to the nine months ended
September 30, 2005. For the nine months ended September 30, 2006 our product
return rate was 9% of gross sales, or $3.5 million, compared to 13% of gross


                                       33


<PAGE>

sales, or $4.8 million, for the nine months ended September 30, 2005. The
decline in our product return rate was caused by an increase in sales of our
mobile data storage products, which generally have lower rates of return, and a
decrease in sales of our optical data storage products, which generally have
higher rates of return. In addition, for the nine months ended September 30,
2006, our sales incentives were less than 1% of gross sales, or $497,000,
compared to 3% of gross sales, or $1,053,000, for the nine months ended
September 30, 2005. The decline in our sales incentive rates was also caused by
an increase in sales of our mobile data storage products, which generally
experience less market pressure for sales incentives, and a decrease in sales of
our optical data storage products, which generally experience higher market
pressure for sales incentives.

     GROSS PROFIT. The increase in gross profit of $799,000 from $3.4 million
for the first nine months of 2005 to $4.2 million for the first nine months of
2006 is primarily due to increased sales of our mobile data storage products,
which generally have higher gross profit margins, and decreased sales of our
optical data storage products which generally have lower gross profit margins.
Also, our mobile data storage products have lower rates of return and less
market pressure for sales incentives as compared to our optical data storage
products. Our gross profit margins increased to 14.0% of net sales in the first
nine months of 2006 as compared to gross profit margins of 12.8% of net sales
in the first nine months of 2005.

     In addition, we had a decline in inventory obsolescence for the first nine
months of 2006 of $434,000 from $705,000 in the first nine months of 2005 to
$271,000 in the same period of 2006. This decline was due to a large adjustment
of the value of slow-moving and obsolete inventory in 2005.

     SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses increased by $166,000 in the first nine months of 2006 as
compared to the first nine months of 2005. Our selling marketing and advertising
expenses increased as a percentage of our net sales to 2.1% in the first nine
months of 2006 from 1.8% in the first nine months of 2005. The increase in our
selling, marketing and advertising expenses as a percentage of our net sales was
primarily due to display expenses, which we generally do not incur, but that
were incurred to better position our mobile data storage products at retailer
locations.

     GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased by $2.2 million in the first nine months of 2006 as compared to the
first nine months of 2005. This increase was primarily due to approximately $1.2
million of offering cost expensed in the second quarter of 2006 in connection
with a registered public offering that had not yet been completed as of June 30,
2006, is not now completed and may never be completed. This increase was also
due to $285,000 in legal fees mainly in relation to trial expenses associated
with ongoing litigation matters; $235,000 in audit fees for annual and
semi-annual audits; $140,000 in outside financial consulting services during our
search for a new Chief Financial Officer and a new Controller, and including
costs associated with the engagement of a public relations contractor; and a
$280,000 increase in product assembly costs. We believe that the additional
product assembly costs will enable us to more efficiently deliver our products
and improve our cash flow. In addition, $119,000 of stock-based compensation
expenses are included in general and administrative expenses.

     DEPRECIATION AND AMORTIZATION EXPENSES. The $55,000 decrease in
depreciation and amortization expenses primarily resulted from certain of our
fixed assets becoming fully depreciated following the nine months ended
September 30, 2005.

     OTHER INCOME. Other income increased by $2.4 million in the first nine
months of 2006 as compared to the first nine months of 2005. This increase was
primarily due to the receipt of approximately $2.4 million upon the settlement
of a litigation matter with OfficeMax.


                                       34


<PAGE>

LIQUIDITY AND CAPITAL RESOURCES

     Our principal sources of liquidity have been cash provided by operations
and borrowings under our bank and trade credit facilities. Our principal uses of
cash have been to provide working capital, finance capital expenditures and
satisfy our debt service requirements. We anticipate that these sources and uses
will continue to be our principal sources and uses of cash in the foreseeable
future. As of September 30, 2006, we had working capital of $5.9 million, an
accumulated deficit of $25.2 million, $1.2 million in cash and cash equivalents
and $10.1 million in net accounts receivable. This compares with working capital
of $5.9 million, an accumulated deficit of $24.9 million, $4.1 million in cash
and cash equivalents and $13.1 million in net accounts receivable as of December
31, 2005.

     For the nine months ended September 30, 2006, our cash decreased $2.9
million, or 71%, from $4.1 million to $1.2 million as compared to a decrease of
$800,000 or 22%, for the nine months ended September 30, 2005 from $3.6 million
to $2.8 million.

     Cash used in our operating activities totaled $1.3 million during the first
nine months of 2006 as compared to cash used in our operating activities of $1.3
million during the first nine months of 2005. Cash used in our operating
activities in the first nine months of 2006 as compared to the same period in
2005 resulted from the following combination of factors:

     o    a $1.9 million decrease in accounts payable caused by the payment of
          outstanding invoices;

     o    an $800,000 decrease in accounts payable - related parties, caused by
          the payment of outstanding invoices

     o    a $500,000 increase in inventory in transit; and

     o    a $400,000 decrease in our reserve for slow-moving and obsolete
          inventory.

     These decreases in cash were partially offset by:

     o    a $2.3 million decrease in prepaid expenses primarily due to
          approximately $1.2 million of offering costs expensed in the second
          quarter of 2006 in connection with a registered public offering that
          had not yet been completed as of June 30, 2006, is not now completed
          and may never be completed;

     o    an $800,000 decrease in net loss; and

     o    a $500,000 increase in accounts receivable comprised of a $2.8 million
          increase in the first nine months of 2006 as compared to a $2.3
          million increase in the first nine months of 2005 resulting from
          decreases due to faster collections.

     Cash used in our investing activities totaled $539,000 during the first
nine months of 2006 as compared to cash provided by our investing activities of
$982,000 during the first nine months of 2005. Our investing activities during
the first nine months of 2006 consisted of restricted cash related to our GMAC
Commercial Finance, or GMAC, line of credit and nominal purchases of property
and equipment. Over $500,000 in our lockbox account as of September 30, 2006
could not be transferred to GMAC as a result of our bank's policy to hold
deposits for 2 days, which resulted in the usage in restricted cash. Our
investing activities during the first nine months of 2005 consisted of
restricted cash related to our United National Bank loan and nominal purchases
of property and equipment.

     Cash used in our financing activities totaled $992,000 during the first
nine months of 2006 as compared to cash used in our financing activities of
$447,000 for the first nine months of 2005. We had $1.1 million in net
borrowings on our GMAC line of credit and received $62,000 upon the exercise of


                                       35


<PAGE>

employee stock options in the first nine months of 2006. We paid down $2.2
million of our United National Bank loan through funds generated by our
operations during the first quarter of 2005. We paid down the balance of $3.8
million of our United National Bank loan through our new line of credit with
GMAC and we borrowed an additional $1.7 million under our GMAC line of credit
during the first nine months of 2005.

     On August 15, 2003, we entered into an asset-based business loan agreement
with United National Bank. The agreement provided for a revolving loan of up to
$6.0 million secured by substantially all of our assets and initially was to
expire on September 1, 2004 and which, on numerous occasions in 2004 and 2005,
was extended to its final expiration date on March 11, 2005. Advances of up to
65% of eligible accounts receivable bore interest at a floating interest rate
equal to the prime rate of interest as reported in THE WALL STREET JOURNAL plus
0.75%. On March 9, 2005, we replaced our asset-based line of credit with United
National Bank with an asset-based line of credit with GMAC.

     Our asset-based line of credit with GMAC expires on January 15, 2007 and
allows us to borrow up to $5.0 million. The line of credit bears interest at a
floating interest rate equal to the prime rate of interest plus 2.75%. This
interest rate is adjustable upon each movement in the prime lending rate. If the
prime lending rate increases, our interest rate expense will increase on an
annualized basis by the amount of the increase multiplied by the principal
amount outstanding under our credit facility. Our obligations under our loan
agreement with GMAC are secured by substantially all of our assets and
guaranteed by our wholly-owned subsidiary, IOM Holdings, Inc. Until our entry
into a forbearance agreement with GMAC, as discussed below, the loan agreement
had one financial covenant which required us to maintain a fixed charge coverage
ratio of at least 1.5 to 1.0 for the three months ended June 30, 2005, the six
months ended September 30, 2005, the nine months ended December 31, 2005, the
twelve months ended March 31, 2006 and for each twelve month period ending on
the end of each calendar quarter thereafter. We were in violation of this
financial covenant as of September 30, 2006.

     On October 18, 2006, we entered into a forbearance agreement with GMAC that
provides for the forbearance by GMAC from enforcing its rights and remedies
under the loan agreement as a result of our failure to satisfy a financial
covenant contained in the loan agreement. The forbearance agreement is effective
through January 15, 2007, at which time all obligations to GMAC will be due and
payable in full. GMAC's agreement to forbear from enforcing its rights under the
loan agreement and related documents is subject to the following conditions: (i)
there are no further events of default under the loan agreement; (ii) we comply
with all terms and conditions of the forbearance agreement and the loan
agreement (as amended by the forbearance agreement); (iii) we maintain EBITDA of
at least the following: (a) $160,000 for the quarter ended September 30, 2006,
(b) $150,000 for the four months ended October 31, 2006, (c) $250,000 for the
five months ended November 30, 2006, and (d) $360,000 for the six months ended
December 31, 2006; (d) we must hire a permanent Chief Financial Officer by no
later than December 15, 2006; and (e) as soon as available, we must deliver to
GMAC a copy of our semi-annual audited financial statements. The forbearance
agreement also amends the loan agreement to (1) delete our inventory from the
calculation of the borrowing base, (2) reduce the maximum amount that may be
borrowed under the loan agreement from $10.0 million to $5.0 million, (3)
increase the static reserve from $1,000,000 to $1,350,000, and (4) increase the
fixed charge coverage ratio from 1.2:1.0 to 1.5:1.0. The forbearance agreement
also provides that from and after the date of the agreement, advances under the
credit facility will bear interest at the post-default rate of prime plus 2.75%
per annum. On October 18, 2006, the prime rate was 8.25%.

     If we are unable to comply with the forbearance agreement and the loan
agreement, then GMAC has the option to immediately terminate the line of credit
and demand payment of the unpaid principal balance and all accrued interest on
the unpaid balance then outstanding. If the loan were to be called and we were


                                       36


<PAGE>

unable to obtain alternative financing, we would lack adequate funds to acquire
inventory in amounts sufficient to sustain or expand our current sales
operation. In addition, we would be unable to fund our day-to-day operations.

     Our new credit facility with GMAC was initially used to pay off our
outstanding loan balance as of March 10, 2005 with United National Bank, which
balance was approximately $3.8 million, and was also used to pay $25,000 of our
closing fees in connection with securing the credit facility. As of September
30, 2006, we owed GMAC approximately $4.0 million and did not have available any
additional borrowings.

     On May 3, 2006, and effective as of April 1, 2006, we entered into a new
trade credit facility with Lung Hwa Electronics, which is one of our
stockholders, that replaced our previous $15.0 million trade credit facility.
Under the terms of the new facility, Lung Hwa Electronics has agreed to purchase
and manufacture inventory on our behalf. We can purchase an aggregate of up to
$15.0 million of inventory manufactured by Lung Hwa Electronics or manufactured
by third parties, in which case we use Lung Hwa Electronics as an international
purchasing office. For inventory manufactured by third parties and purchased
through Lung Hwa Electronics, the payment terms are 120 days following the date
of invoice by Lung Hwa Electronics. Lung Hwa Electronics charges us a 4%
handling fee on a supplier's unit price. Returns made by us, which are agreed to
by a supplier, result in a credit to us for the handling charge. For inventory
manufactured by Lung Hwa Electronics, the payment terms are 90 days following
the date of invoice by Lung Hwa Electronics. We are to pay Lung Hwa Electronics,
within ten days of the purchase order, 10% of the purchase price on any purchase
orders issued to Lung Hwa Electronics as a down-payment for the order. The trade
credit facility has an initial term of one year after which the facility will
continue indefinitely if not terminated at the end of the initial term. At the
end of the initial term and at any time thereafter, either party has the right
to terminate the facility upon 30 days' prior written notice to the other party.
As of September 30, 2006, we owed Lung Hwa Electronics $5.4 million in trade
payables.

     In February 2003, we entered into a Warehouse Services and Bailment
Agreement with Behavior Tech Computer (USA) Corp., or BTC USA. Under the terms
of the agreement, BTC USA has agreed to supply and store at our warehouse up to
$10.0 million of inventory on a consignment basis. We are 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
provides us with a trade line of credit of up to $10.0 million 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. As of
September 30, 2006, we owed BTC USA $318,000 under this arrangement. BTC USA is
a subsidiary of Behavior Tech Computer Corp., one of our significant
stockholders. Mr. Steel Su, a director of I/OMagic, is the Chief Executive
Officer of Behavior Tech Computer Corp.

     Lung Hwa Electronics and BTC USA provide us with significantly preferential
trade credit terms. These terms include extended payment terms, substantial
trade lines of credit and other preferential buying arrangements. We believe
that these terms are substantially better terms than we could likely obtain from
other subcontract manufacturers or suppliers. In fact, we believe that our trade
credit facility with Lung Hwa Electronics is likely unique and could not be
replaced through a relationship with an unrelated third party. If either of Lung
Hwa Electronics or BTC USA does not continue to offer us substantially the same
preferential trade credit terms, our ability to finance inventory purchases
would be harmed, resulting in significantly reduced sales and profitability. In
addition, we would incur additional financing costs associated with shorter
payment terms which would also cause our profitability to decline.


                                       37


<PAGE>

     Our net loss decreased 73% to $304,000 for the first nine months of 2006
from $1.1 million for the first nine months of 2005, primarily resulting from
the receipt of approximately $2.4 million upon the settlement of a litigation
matter with OfficeMax, which amount was partially offset by approximately $1.2
million of offering cost expensed in the second quarter of 2006 in connection
with a registered public offering that had not yet been completed as of June 30,
2006, is not now completed and may never be completed. In addition, our shift in
focus in 2006 away from optical data storage products to mobile data storage
products with higher margins has helped generate profitable quarters and we are
hopeful that we can generate net income in future quarters. However, if either
the absolute level or the downward trend of our net loss continues or increases,
we could experience significant 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 operating performance and financial
condition.

     We retain most risks of ownership of products in our consignment sales
channels. These products remain our inventory until their resale by our
retailers. 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 cycles 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 sales channels, our sales,
profitability and financial resources may decline.

     If any of our major retailers, or a significant number of our smaller
retailers, implement or expand private label programs covering products that
compete with our products, our net sales will likely decline and our net losses
are likely to increase, which in turn could have a material and adverse impact
on our liquidity, financial condition and capital resources. However, management
intends to use its best efforts to insure that we retain our current retailers
and try to expand sales to those major retailers to which we currently do not
sell our products. We cannot assure you that our existing retailers will remain
our customers or that we will successfully sell any products to other retailers.

     Despite our continued losses, we believe that current and future available
capital resources, revenues generated from operations, and other existing
sources of liquidity, including our trade credit facilities with Lung Hwa
Electronics and BTC USA and our credit facility with GMAC will be sufficient to
fund our anticipated working capital and capital expenditure requirements for at
least the next twelve months. If, however, our capital requirements or cash flow
vary materially from our current projections or if unforeseen circumstances
occur, we may require additional financing. Our failure to raise capital, if
needed, could restrict our growth, limit our development of new products or
hinder our ability to compete.

BACKLOG

     Our backlog at September 30, 2006 was $4.1 million as compared to a backlog
at September 30, 2005 of $4.4 million. Based on historical trends, we anticipate
that our September 30, 2006 backlog may be reduced by approximately 25%, or $1.0
million to a net sales amount of $3.1 million as a result of returns, sales
incentives, market development funds, cooperative advertising costs and rebate
promotion costs.

     Our backlog may not be indicative of our actual sales beyond a rotating
six-week cycle. The amount of backlog orders represents revenue that we
anticipate recognizing in the future, as evidenced by purchase orders and other
purchase commitments received from retailers. The shipment of these orders for


                                       38


<PAGE>

non-consigned retailers or the sell-through of our products by consigned
retailers creates recognition of the purchase commitments as revenue. However,
there can be no assurance that we will be successful in fulfilling such orders
and commitments in a timely manner, that retailers will not cancel purchase
orders, or that we will ultimately recognize as revenue the amounts reflected as
backlog based upon industry trends, historical sales information, returns and
sales incentives.

IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS

     In October 2006, the Emerging Issues Task Force ("EITF") issued EITF 06-3,
"How Taxes Collected from Customers and Remitted to Governmental Authorities
Should Be Presented in the Income Statement (That is, Gross versus Net
Presentation)" to clarify diversity in practice on the presentation of different
types of taxes in the financial statements. The Task Force concluded that, for
taxes within the scope of the issue, a company may adopt a policy of presenting
taxes either gross within revenue or net. That is, it may include charges to
customers for taxes within revenues and the charge for the taxes from the taxing
authority within cost of sales, or, alternatively, it may net the charge to the
customer and the charge from the taxing authority. If taxes subject to EITF 06-3
are significant, a company is required to disclose its accounting policy for
presenting taxes and the amounts of such taxes that are recognized on a gross
basis. The guidance in this consensus is effective for the first interim
reporting period beginning after December 15, 2006 (the first quarter of our
fiscal year 2007). We do not expect the adoption of EITF 06-3 to have a material
impact on our financial condition, results of operations or cash flows.

     In September 2006, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 158, "Employer's accounting for Defined Benefit Pension and Other Post
Retirement Plans". SFAS No. 158 requires employers to recognize in its statement
of financial position an asset or liability based on the retirement plan's over
or under funded status. SFAS No. 158 is effective for fiscal years ending after
December 15, 2006. We are currently evaluating the effect that the application
of SFAS No. 158 will have on our financial condition, results of operations and
cash flows.

     In September 2006, the Financial Accounting Standards Board (FASB) issued
SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), which defines the fair
value, establishes a framework for measuring fair value and expands disclosures
about fair value measurements. This statement is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and
interim periods within those fiscal years. Early adoption is encouraged,
provided that we have not yet issued financial statements for that fiscal year,
including any financial statements for an interim period within that fiscal
year. We are currently evaluating the impact SFAS 157 may have on our financial
condition, results of operations and cash flows.

     In September 2006, the United States Securities and Exchange Commission
issued Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements" ("SAB 108"). SAB 108 provides guidance on the consideration of the
effects of prior year misstatements in quantifying current year misstatements
for the purpose of a materiality assessment. SAB 108 establishes an approach
that requires quantification of financial statement errors based on the effects
of each of our balance sheet and statement of operations and the related
financial statement disclosures. SAB 108 permits existing public companies to
record the cumulative effect of initially applying this approach in the first
year ending after November 15, 2006 by recording the necessary correcting
adjustments to the carrying values of assets and liabilities as of the beginning
of that year with the offsetting adjustment recorded to the opening balance of
retained earnings. Additionally, the use of the cumulative effect transition
method requires detailed disclosure of the nature and amount of each individual
error being corrected through the cumulative adjustment and how and when it
arose. We are currently evaluating the impact SAB 108 may have to our financial
condition, results of operations and cash flows.


                                       39


<PAGE>

     In July 2006, the FASB released FASB Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes," an interpretation of FASB Statement No. 109 (FIN
48). FIN 48 clarifies the accounting and reporting for uncertainties in income
tax law. This interpretation prescribes a comprehensive model for the financial
statement recognition, measurement, presentation and disclosure of uncertain tax
positions taken or expected to be taken in income tax returns. This statement is
effective for fiscal years beginning after December 15, 2006. We are currently
evaluating the expected effect of FIN 48 on our financial condition, results of
operations and cash flows.

     In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets," which provides an approach to simplify efforts to obtain
hedge-like (offset) accounting. This Statement amends FASB SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities", with respect to the accounting for separately recognized
servicing assets and servicing liabilities. The Statement (1) requires an entity
to recognize a servicing asset or servicing liability each time it undertakes an
obligation to service a financial asset by entering into a servicing contract in
certain situations; (2) requires that a separately recognized servicing asset or
servicing liability be initially measured at fair value, if practicable; (3)
permits an entity to choose either the amortization method or the fair value
method for subsequent measurement for each class of separately recognized
servicing assets or servicing liabilities; (4) permits at initial adoption a
one-time reclassification of available-for-sale securities to trading securities
by an entity with recognized servicing rights, provided the securities
reclassified offset the entity's exposure to changes in the fair value of the
servicing assets or liabilities; and (5) requires separate presentation of
servicing assets and servicing liabilities subsequently measured at fair value
in the balance sheet and additional disclosures for all separately recognized
servicing assets and servicing liabilities. SFAS No. 156 is effective for all
separately recognized servicing assets and liabilities as of the beginning of an
entity's fiscal year that begins after September 15, 2006, with earlier adoption
permitted in certain circumstances. The Statement also describes the manner in
which it should be initially applied. We do not believe that SFAS No. 156 will
have a material impact on our financial condition, results of operations or cash
flows.

     In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments", which amends SFAS No. 133, "Accounting for
Derivatives Instruments and Hedging Activities" and SFAS No. 140, "Accounting
for Transfers and Servicing of Financial Assets and Extinguishment of
Liabilities." SFAS No. 155 amends SFAS No. 133 to narrow the scope exception for
interest-only and principal-only strips on debt instruments to include only such
strips representing rights to receive a specified portion of the contractual
interest or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow
qualifying special-purpose entities to hold a passive derivative financial
instrument pertaining to beneficial interests that itself is a derivative
instrument. We are currently evaluating the impact of this new standard but we
believe this new standard will not have a material impact on our financial
condition, results of operations, or cash flows.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Our operations were not subject to commodity price risk during the first
nine months of 2006. Our sales to a foreign country (Canada) were only 7% of our
total sales for the first nine months of 2006, and thus we experienced
negligible foreign currency exchange rate risk. We do not hedge against this
risk.

     We currently have an asset-based business loan agreement in the amount of
up to $5.0 million. The line of credit provides for an interest rate equal to
the prime lending rate as reported in THE WALL STREET JOURNAL plus 2.75%. This


                                       40


<PAGE>

interest rate is adjustable upon each movement in the prime lending rate. If the
prime lending rate increases, our interest rate expense will increase on an
annualized basis by the amount of the increase multiplied by the principal
amount outstanding under the business loan agreement.

ITEM 4. CONTROLS AND PROCEDURES

   EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

     We conducted an evaluation, with the participation of our Chief Executive
Officer and Interim Chief Financial Officer, of the effectiveness of the design
and operation of our disclosure controls and procedures, as defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended,
or the Exchange Act, as of September 30, 2006, to ensure that information
required to be disclosed by us in the reports filed or submitted by us under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the Securities Exchange Commission's rules and forms,
including to ensure that information required to be disclosed by us in the
reports filed or submitted by us under the Exchange Act is accumulated and
communicated to our management, including our principal executive and principal
financial officer, or persons performing similar functions, as appropriate to
allow timely decisions regarding required disclosure. Based on that evaluation,
our Chief Executive Officer and Interim Chief Financial Officer has concluded
that as of September 30, 2006, our disclosure controls and procedures were not
effective at the reasonable assurance level due to the material weakness
described below.

     A material weakness is a control deficiency (within the meaning of the
Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or
combination of control deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim financial
statements will not be prevented or detected. Management has identified the
following material weakness which has caused management to conclude that, as of
September 30, 2006, our disclosure controls and procedures were not effective at
the reasonable assurance level:

     We did not maintain a sufficient complement of finance and accounting
personnel to handle the matters necessary to timely file our Form 10-K for the
year ended December 31, 2004 and our Form 10-Q for the quarter ended March 31,
2005. In addition, our former Chief Financial Officer resigned in June 2006.
Although we timely filed our Forms 10-Q for the quarters ended June 30, 2005 and
September 30, 2005, our Form 10-K for the year ended December 31, 2005 and our
Forms 10-Q for the quarters ended March 31, 2006 and June 30, 2006, management
evaluated the impact of our lack of sufficient finance and accounting personnel,
including the departure of our former Chief Financial Officer in June 2006, on
our assessment of our disclosure controls and procedures and has concluded as of
September 30, 2006, that the control deficiency that resulted in our lack of
sufficient personnel represented a material weakness.

   REMEDIATION OF MATERIAL WEAKNESS

     To remediate the material weakness in our disclosure controls and
procedures identified above, we have done the following, in the periods
specified below:

     In addition to working with our independent auditors, in the fourth quarter
of 2004, we retained a third-party consultant, who is an experienced partner of
a registered public accounting firm specializing in public company financial
reporting, to advise us and our Audit Committee regarding our financial
reporting processes. We also engaged, in the fourth quarter of 2004, another
third-party accounting firm, other than our independent auditors, to assist us
with our financial reporting processes. These third-parties have assisted us in
altering our financial reporting processes, which we expect will better enable


                                       41


<PAGE>

us to timely file our periodic reports. In the third quarter of 2005, we further
improved our ability to timely make required filings by implementing additional
automated reporting procedures with respect to product returns and sales
incentives through enhancements to our MIS financial reporting system that
expedite our internal reporting processes and our periodic reviews by our
independent auditors. In addition, we allocated and continue to allocate part of
the time of certain company personnel with accounting experience to assist us in
generating reports and schedules necessary to timely file our periodic reports
and we believe that this has assisted us, and will continue to assist us, in
timely filing our periodic reports. Prior to this time, these personnel focused
their time on other matters. During the first nine months of 2006, we continued
to implement enhancements to our financial reporting processes, including
increased training of our finance and accounting staff regarding financial
reporting requirements and the evaluation and further implementation of
automated procedures within our MIS financial reporting system.

     We have hired an individual who we expect will become our new Chief
Financial Officer effective November 15, 2006 and who has substantial expertise
in public company financial reporting compliance and who we believe will
contribute to our ability to handle the matters necessary to properly prepare
and to timely file our periodic reports. Following the departure of our former
Chief Financial Officer and prior to hiring the individual who we expect will
become our new Chief Financial Officer, we engaged the services of financial
consultants to assist us in preparing our periodic reports.

     Management expects that the actions described above will remediate the
corresponding material weakness also described above by December 31, 2006.
Management estimates that we paid the third-party consultant approximately
$37,000 in connection with his services and estimates that we have paid the
third-party accounting firm approximately $63,000 in connection with its
services. Management is unable to estimate our capital or other expenditures
associated with the allocation of time of certain company personnel to assist us
in generating reports and schedules necessary to timely file our periodic
reports or our additional capital or other expenditures related to higher fees
paid to our independent auditors in connection with their review of this
remediation. In addition, since May 2006, management estimates that we have paid
financial consultants who assisted us in preparing our periodic reports during
our search for a new Chief Financial Officer approximately $150,000. Our new
Chief Financial Officer will have an annual base salary of $150,000, not
including benefits and other costs of employment.

   CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

     The changes noted above, specifically, the changes relating to our
engagement of the services of financial consultants to assist us in preparing
our periodic reports during our search for a new Chief Financial Officer are the
only changes during our most recently completed fiscal quarter that have
materially affected or are 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

   HORWITZ AND BEAM

     On May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for
breach of contract and legal malpractice against Lawrence W. Horwitz, Gregory B.
Beam, Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and Senn
Palumbo Meulemans, LLP, our former attorneys and their respective law firms, in
the Superior Court of the State of California for the County of Orange. The
complaint seeks damages of $15 million arising out of the defendants'
representation of I/OMagic and IOM Holdings, Inc. in an acquisition transaction


                                       42


<PAGE>

and in a separate arbitration matter. On November 6, 2003, we filed our First
Amended Complaint against all defendants. Defendants have responded to our First
Amended Complaint denying our allegations. Defendants Lawrence W. Horwitz and
Lawrence M. Cron have also filed a Cross-Complaint against us for attorneys'
fees in the approximate amount of $79,000. We denied the allegations in the
Cross-Complaint. Trial began on February 6, 2006 and on March 10, 2006, the jury
ruled in our favor against Lawrence W. Horwitz, Horwitz & Beam, Inc., Lawrence
M. Cron, Horwitz & Cron and Senn Palumbo Meulemans, LLP, and awarded us $3.0
million in damages. We have not collected any of this amount. Judgment was
entered on or about April 5, 2006. However, defendants have since filed a motion
for new trial and a motion for judgment notwithstanding the verdict. On May 31,
2006, the Court denied the motion for new trial in its entirety, denied the
motion for judgment notwithstanding the verdict as to Lawrence W. Horwitz,
Horwitz & Beam, Inc. and Lawrence M. Cron, but granted the motion for judgment
notwithstanding the verdict as to Horwitz & Cron and Senn Palumbo Meulemans,
LLP. An Amended Judgment Notwithstanding the Verdict based upon the Court's
ruling on the motion for judgment notwithstanding the verdict was entered on or
about July 7, 2006. Appeals have since been filed as to both the original
Judgment and the Amended Judgment. These appeals remain pending.

     In addition, we are 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 our financial condition
or results of operations.

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, 2005, which could materially
affect our business, financial condition and results of operations. The risks
described in our Annual Report on Form 10-K 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 adversely affect our
business, financial condition and results of operations. The factors discussed
under "Risk Factors" in our Annual Report on Form 10-K for the year ended
December 31, 2005 have not materially changed other than as set forth below:

   WE MAY BE UNABLE TO MEET OUR FINANCIAL COVENANTS WITH GMAC COMMERCIAL
   FINANCE. IN ADDITION, OUR CREDIT FACILITY WITH GMAC COMMERCIAL FINANCE
   EXPIRES IN JANUARY 2007. IF WE ARE UNABLE TO MEET THESE COVENANTS, OR IF OUR
   CREDIT FACILITY IS NOT TIMELY REPLACED WITH A NEW FACILITY, IT IS LIKELY THAT
   WE WILL BE UNABLE TO BORROW FUNDS TO PURCHASE INVENTORY, TO SUSTAIN OR EXPAND
   OUR CURRENT SALES VOLUME AND TO FUND OUR DAY-TO-DAY OPERATIONS.

     We have been in violation of our financial covenants with GMAC Commercial
Finance, or GMAC, in the past and may be in violation of our financial covenants
in the future. On October 18, 2006, we entered into a forbearance agreement with
GMAC that provides for the forbearance by GMAC from enforcing its rights and
remedies under a loan agreement as a result of our failure to satisfy a
financial covenant contained in the loan agreement. The forbearance agreement is
effective through January 15, 2007, at which time all obligations to GMAC will
be due and payable in full. If we are unable to comply with these forbearance or
loan agreements, GMAC will have the option to immediately terminate the credit
facility and demand payment of the unpaid principal balance and all accrued
interest on the unpaid balance then outstanding. If the loan were to be called
and if we are unable to obtain alternative financing, we would lack adequate
funds to acquire inventory in amounts sufficient to sustain or expand our
current sales operation. In addition, we would be unable to fund our day-to-day
operations.


                                       43


<PAGE>

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

     None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

     None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None.

ITEM 5. OTHER INFORMATION

     None.

ITEM 6. EXHIBITS

   Exhibit
   Number        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          Certifications of Chief Executive Officer 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.


                                       44


<PAGE>

                                   SIGNATURES

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

                                       I/OMAGIC CORPORATION


Dated:  November 14, 2006              By: /s/ Tony Shahbaz
                                          -------------------------------------
                                          Tony Shahbaz, President, Chief
                                          Executive Officer and Interim
                                          Chief Financial Officer
                                          (principal executive officer and
                                          principal financial and
                                          accounting officer)


                                       45


<PAGE>

                         EXHIBITS FILED WITH THIS REPORT

Exhibit
Number         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           Certifications of Chief Executive Officer 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



                                       46