<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 JUNE 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 August 18, 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 - June 30, 2006 (unaudited) and
               December 31, 2005...........................................    3

           Consolidated Statements of Income - for the three and six
               months ended June 30, 2006 and 2005 (unaudited).............    5

           Consolidated Statements of Cash Flows - for the six months
               ended June 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........................................   16

Item 3.    Quantitative and Qualitative Disclosures About Market Risk......   38

Item 4.    Controls and Procedures.........................................   38

                                  PART II
                             OTHER INFORMATION

Item 1.    Legal Proceedings...............................................   40

Item 1A.   Risk Factors....................................................   41

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds.....   41

Item 3.    Defaults Upon Senior Securities.................................   41

Item 4.    Submission of Matters to a Vote of Security Holders.............   42

Item 5.    Other Information...............................................   42

Item 6.    Exhibits........................................................   42

Signatures ................................................................   43

Exhibits Filed with This Report............................................   44



<PAGE>

                         PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

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

                                     ASSETS

                                                             JUNE 30,     DECEMBER 31,
                                                               2006          2005
                                                            -----------   -----------
                                                            (unaudited)
CURRENT ASSETS
<S>                                                         <C>           <C>
       Cash and cash equivalents                            $ 1,363,054   $ 4,056,541
       Restricted cash                                           12,307        30,864
       Accounts receivable, net of allowance for doubtful
          accounts of $39,287 (unaudited) and $3,145          9,031,657    13,091,546
       Inventory, net of allowance for obsolete inventory
          of $43,772 (unaudited) and $29,690                  8,519,079     6,917,878
       Inventory in transit                                     895,982        66,478
       Prepaid expenses and other current assets                149,160     1,484,084
                                                            -----------   -----------

                  Total current assets                       19,971,239    25,647,391

PROPERTY AND EQUIPMENT, net of accumulated depreciation
    of $1,479,400 (unaudited) and $1,422,943                    130,866       172,005
TRADEMARKS, net of accumulated amortization
    of $5,553,172 (unaudited) and $5,518,708                    396,408       430,872
OTHER ASSETS                                                     38,366        27,032
                                                            -----------   -----------

                  TOTAL ASSETS                              $20,536,879   $26,277,300
                                                            ===========   ===========

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

                                       3


<PAGE>

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

                      LIABILITIES AND STOCKHOLDERS' EQUITY

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

CURRENT LIABILITIES
   Line of credit                                           $  3,767,104    $  5,053,582
   Accounts payable and accrued expenses                       3,515,835       5,925,668
   Accounts payable - related parties                          6,510,561       8,222,078
   Reserves for customer returns and sales incentives            401,944         494,289
                                                            ------------    ------------

     Total current liabilities                                14,195,444      19,695,617
                                                            ------------    ------------

STOCKHOLDERS' EQUITY
   Preferred Stock
      10,000,000 shares authorized, $0.001 par value
   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                                    31,617,025      31,595,952
Treasury stock, 0 (unaudited) and 13,493 shares, at cost              --        (126,014)
Accumulated deficit                                          (25,280,131)    (24,892,787)
                                                            ------------    ------------

     Total stockholders' equity                                6,341,435       6,581,683
                                                            ------------    ------------

         TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY         $ 20,536,879    $ 26,277,300
                                                            ============    ============

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


                                       4


<PAGE>

                                      I/OMAGIC CORPORATION
                                         AND SUBSIDIARY
                                CONSOLIDATED STATEMENTS OF INCOME
                    FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2006 AND 2005
                                           (UNAUDITED)

                                            THREE MONTHS ENDED JUNE 30,      SIX MONTHS ENDED JUNE 30,
                                               2006             2005           2006             2005
                                            ------------    ------------    ------------    ------------
                                            (unaudited)      (unaudited)     (unaudited)     (unaudited)

NET SALES                                   $  9,881,740    $  9,557,611    $ 18,875,639    $ 18,594,423
COST OF SALES                                  8,471,864       8,040,306      16,712,375      16,495,186
                                            ------------    ------------    ------------    ------------

GROSS PROFIT                                   1,409,876       1,517,305       2,163,264       2,099,237
                                            ------------    ------------    ------------    ------------

OPERATING EXPENSES
     Selling, marketing, and advertising         223,637         123,224         455,692         297,425
     General and administrative                2,718,339       1,042,376       4,152,428       2,459,841
     Depreciation and amortization                44,062          60,728          90,922         139,301
                                            ------------    ------------    ------------    ------------

       Total operating expenses                2,986,038       1,226,328       4,699,042       2,896,567
                                            ------------    ------------    ------------    ------------

PROFIT (LOSS) FROM OPERATIONS                 (1,576,162)        290,977      (2,535,778)       (797,330)
                                            ------------    ------------    ------------    ------------

OTHER INCOME (EXPENSE)
     Interest income                                  14             245             106             282
     Interest expense                            (91,582)        (64,798)       (171,722)       (142,151)
     Other income                              2,378,500           2,948       2,320,850          11,280
                                            ------------    ------------    ------------    ------------

          Total other income (expense)         2,286,932         (61,605)      2,149,234        (130,589)
                                            ------------    ------------    ------------    ------------

INCOME (LOSS) BEFORE INCOME TAXES                710,770         229,372        (386,544)       (927,919)

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

NET INCOME (LOSS)                           $    709,970    $    226,972    $   (387,344)   $   (930,319)
                                            ============    ============    ============    ============


BASIC AND DILUTED INCOME (LOSS) PER SHARE   $       0.16    $       0.05    $      (0.09)   $      (0.21)
                                            ============    ============    ============    ============

BASIC AND DILUTED WEIGHTED-AVERAGE
   SHARES OUTSTANDING                          4,539,896       4,529,672       4,534,458       4,529,672
                                            ============    ============    ============    ============


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

                                                5


<PAGE>

                              I/OMAGIC CORPORATION
                                 AND SUBSIDIARY
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                 FOR THE SIX MONTHS ENDED JUNE 30, 2006 AND 2005
                                   (UNAUDITED)

                                                            SIX MONTHS ENDED JUNE 30,
                                                              2006           2005
                                                           -----------    -----------
                                                           (unaudited)    (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
   Net loss                                                $  (387,344)   $  (930,319)
   Adjustments to reconcile net loss to net cash
     used in operating activities
       Depreciation and amortization                            56,458        104,837
       Amortization of trademarks                               34,464         34,464
       Allowance for doubtful accounts                          36,142         91,581
       Reserve for customer returns and sales incentives       (92,345)      (102,931)
       Reserve for obsolete inventory                          220,815        536,566
       Stock based compensation expense                         84,664             --
       (Increase) decrease in
         Accounts receivable                                 4,023,748      2,051,188
         Inventory                                          (1,822,016)    (2,601,550)
         Inventory in transit                                 (829,504)       461,261
         Prepaid expenses and other current assets           1,334,925       (518,317)
         Other assets                                          (11,334)            --
       Decrease in
         Accounts payable and accrued expenses              (2,409,836)      (458,796)
         Accounts payable - related parties                 (1,711,517)       396,262
                                                           -----------    -----------

   Net cash used in operating activities                    (1,472,680)      (935,754)
                                                           -----------    -----------

CASH FLOWS FROM INVESTING ACTIVITIES
   Purchase of property and equipment                          (15,318)        (1,255)
   Restricted cash                                              18,557        825,685
                                                           -----------    -----------

   Net cash provided by investing activities                     3,239        824,430
                                                           -----------    -----------

CASH FLOWS FROM FINANCING ACTIVITIES
    Net payments on line of credit                          (1,286,478)    (1,771,612)
    Exercise of stock options                                   62,432             --
                                                           -----------    -----------

Net cash used in financing activities                       (1,224,046)    (1,771,612)
                                                           -----------    -----------

Net decrease in cash and cash equivalents                   (2,693,487)    (1,882,936)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD               4,056,541      3,587,807
                                                           -----------    -----------

CASH AND CASH EQUIVALENTS, END OF PERIOD                   $ 1,363,054    $ 1,704,871
                                                           ===========    ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
    INTEREST PAID                                          $   168,175    $   141,816
                                                           ===========    ===========
    INCOME TAXES PAID                                      $        --    $     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 SEC 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 June 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 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 six months ended
June 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 employee and directors for the three and six months ended June 30,
2006 was $45,104 and $84,664, respectively, and are included in general and
administrative expenses. Income (loss) from operations for the three and six
months ended June 30, 2006 would have been $(1,531,058) and $(2,451,114),
respectively, if the Company had not adopted SFAS 123(R). Income (loss) before
income taxes for the three and six months ended June 30, 2006 would have been


                                       7


<PAGE>

$755,874 and $(301,880), respectively, if the Company had not adopted SFAS
123(R). Net income (loss) for the three and six months ended June 30, 2006 would
have been $755,074 and $(302,680), respectively, if the Company had not adopted
SFAS 123(R). For the three and six months ended June 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 six
months ended June 30, 2006 would have been $0.17 and $(0.07), respectively, if
the Company had not adopted SFAS 123(R), compared to reported basic income
(loss) per share of $0.16 and $(0.09), respectively. Diluted income (loss) per
share for the three and six months ended June 30, 2006 would have been $0.16 and
$(0.07), respectively, if the Company had not adopted SFAS 123(R), compared to
reported diluted income (loss) per share of $0.16 and $(0.09), 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 six months ended June 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).

                                                    THREE MONTHS    SIX MONTHS
                                                        ENDED          ENDED
                                                   JUNE 30, 2005   JUNE 30, 2005
                                                      ---------     -----------

Net income (loss), as reported                        $ 226,972     $  (930,319)

   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                                          (21,711)        (43,788)
                                                      ---------     -----------
   Pro forma net income (loss)                        $ 205,261     $  (974,107)
                                                      =========     ===========
Net income (loss) per common share:
   Basic and diluted, as reported                     $    0.05     $     (0.21)
                                                      =========     ===========
   Basic and diluted, pro forma                       $    0.04     $     (0.22)
                                                      =========     ===========

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 six months ended June
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 six months
ended June 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 six months
ended June 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.
Forfeitures were recognized as incurred. During the three and six months ended
June 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.

                                       8


<PAGE>

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 six 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 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 expected effect of FIN 48 on its results of operations
and financial position.

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 position, 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 that this new standard will not have a material impact
on its financial position, results of operations, or cash flows.

                                       9


<PAGE>

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.

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

                                                        JUNE 30,        JUNE 30,
                                                         2006            2005
                                                        -------         -------
Stock options outstanding                               424,500         121,950
Warrants outstanding                                    180,000          20,000
                                                        -------         -------
  TOTAL                                                 604,500         141,950
                                                        =======         =======

NOTE 3 - INVENTORY

Inventory consisted of the following:

                                                       JUNE 30,     DECEMBER 31,
                                                        2006           2005
                                                     -----------    -----------
                                                     (unaudited)
Component parts                                      $ 2,245,694    $ 2,491,594
Finished goods - warehouse                             1,729,028      1,034,877
Finished goods - consigned                             4,588,129      3,421,097
Reserves for obsolete and slow moving inventory          (43,772)       (29,690)
                                                     -----------    -----------
  TOTAL                                              $ 8,519,079    $ 6,917,878
                                                     ===========    ===========

NOTE 4 - PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:

                                                      JUNE 30,      DECEMBER 31,
                                                        2006           2005
                                                     -----------    ------------
                                                     (unaudited)
Computer equipment and software                      $ 1,060,698    $  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
                                                     -----------    ------------
                                                       1,610,266       1,594,948
Less accumulated depreciation and amortization         1,479,400       1,422,943
                                                     -----------    ------------
  TOTAL                                              $   130,866    $    172,005
                                                     ===========    ============

For the six months ended June 30, 2006 (unaudited) and 2005 (unaudited),
depreciation and amortization expense was $90,922 and $139,301, respectively.
For the three months ended June 30, 2006 (unaudited) and June 30, 2005
(unaudited), depreciation and amortization expense was $44,062 and $60,728,
respectively.

                                       10


<PAGE>

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.

The line of credit expires 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 June 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 June 30, 2006, the Company was in breach of the financial
covenant. GMAC has declined to provide a waiver for this covenant default.
However, the Company is currently in discussions with GMAC regarding entering
into a forbearance agreement addressing this covenant default. The Company
believes that GMAC will review possible parameters for this forbearance
agreement during the remainder of August 2006.

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 June 30, 2006 was $3,767,104
(unaudited). The amount available to the Company for borrowing as of June 30,
2006 was $475,011 (unaudited).


NOTE 6 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES

Accounts payable and accrued expenses consisted of the following:

                                                     JUNE 30,       DECEMBER 31,
                                                       2006            2005
                                                    -----------     ------------
                                                    (unaudited)
Accounts payable                                    $ 1,038,268     $  1,477,459
Accrued rebates and marketing                         1,994,542        3,848,545
Accrued compensation and related benefits               124,881          187,771
Other                                                   358,144          411,893
                                                    -----------     ------------
  TOTAL                                             $ 3,515,835     $  5,925,668
                                                    ===========     ============

                                       11


<PAGE>

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 a 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 a 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 a 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 six months of 2006, the Company purchased $10.8 million
(unaudited) of inventory under this arrangement. As of June 30, 2006, there were
$6,266,134 (unaudited) in trade payables under this arrangement.

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 will 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 may 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 six months ended June 30, 2006, the Company purchased $1,183,000 (unaudited)
of inventory under this arrangement. As of June 30, 2006, there were $244,427
(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
six months ended June 30, 2006.

                                       12


<PAGE>

NOTE 9 - COMMITMENTS AND CONTINGENCIES

LEASES

The Company leases its facilities and certain equipment under non-cancelable
operating lease agreements that expire through December 2008. The Company moved
to its current facilities in September 2003.

Rent expense was $192,236 (unaudited) and $187,604 (unaudited) for the six
months ended June 30, 2006 and 2005, respectively, and is included in general
and administrative expenses in the accompanying Consolidated Statements of
Income. Rent expense was $96,118 (unaudited) and $95,271 (unaudited) for the
quarter ended June 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
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.

                                       13


<PAGE>

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 position or results of operations.


NOTE 10 - RELATED PARTY TRANSACTIONS

During the six months ended June 30, 2006 and 2005, the Company made purchases
from related parties totaling approximately $11,975,223 (unaudited) and
$13,332,465 (unaudited), respectively.

As of June 30, 2006 and December 31, 2005, the Company had trade payables to
related parties totaling approximately $6,510,561 (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    Intrinsic
                             Shares        Price       Life (Years)     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
estimate forfeitures for awards not yet vested.

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    Intrinsic
                             Shares        Price       Life (Years)     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

                                       14


<PAGE>

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
estimate 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.

                                       15


<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. In addition to optical
data storage products, we also focus on and sell a line of mobile data storage
products, which we call our GigaBankTM, DataBankTM and Data-to-GoTM products,
and which are compact and portable hard disk drives with a built-in USB
connector with data storage capacities ranging from 4 gigabytes to 750
gigabytes.

         We sell our products through computer, consumer electronics, office
supply superstores, warehouse 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 in every major metropolitan market
in the United States. In the past three years, our major retailers have included
Best Buy, 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 48% of our net sales in the first six months of 2006 and our
mobile data storage products collectively accounted for approximately 52% of our
net sales in the first six months of 2006. Our optical data storage products
accounted for approximately 63% of our net sales in the first six months of 2005
and our mobile data storage products accounted for approximately 37% of our net
sales in the first six months of 2005. This sales mix reflects our continued and
increasing focus on mobile data storage products.

         Our net sales increased by $281,000, or 1.5%, to $18.9 million in the
first six months of 2006 from $18.6 million in the first six months of 2005. Our
net loss decreased by $543,000 to $387,000 in the first six months of 2006 from
a net loss of $930,000 in the first six months of 2005. Our operating results
were due, in large part, to the following factors:

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

              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 49% in
                   the first six months of 2006 as compared to the same period
                   in 2005; which was partially offset by

                                       16


<PAGE>

              o    a continued decline in sales of our optical data storage
                   products combined with a higher rate of returns and greater
                   sales incentives associated with these products; sales of our
                   optical data storage products decreased by 19% in the first
                   six months of 2006 as compared to the same period in 2005;

         o    GROSS PROFIT. Our gross profit margins increased to 11.5% in the
              first six months of 2006 as compared to gross profit margins of
              11.3% in the first six 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. In addition, 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.
              The increase in gross profit margins was partially offset by an
              increase in freight costs due to shipping more product via air to
              expedite sales of our mobile data storage products combined with a
              general increase in fuel prices.

         o    OPERATING EXPENSES. Our operating expenses increased by 62.2% to
              24.9% of net sales in the first six months of 2006 as compared to
              15.6% of net sales in the first six months of 2005. This increase
              was primarily due to increased general and administrative
              expenses, including approximately $1.2 million of offering
              expenses realized in the second quarter of 2006 in connection with
              a registered public offering that had not yet been completed as of
              June 30, 2006 and 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 six 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 six 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 19% to $9.0
million, or 48% of our net sales, in the first six months of 2006 as compared to
$11.1 million, or 63% of our net sales, in the first six 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 six 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 49% to $9.7 million, or 52% of our net sales, in the first
six months of 2006 as compared to $6.5 million, or 37% of our net sales, in the
first six months of 2005.

                                       17


<PAGE>

         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.

                                       18


<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 levels, 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 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 levels for our combined sales models is
6 to 8 weeks of inventory, which equates to an annual inventory turnover level
of approximately 6.5 to 8.5. For the first six months of 2006, our annualized
inventory turnover level was 4.4 as compared to 4.5 for the first six months of
2005, primarily as a result of a 4% increase in inventory. The increase in
inventory turnover for the first six months of 2006 included $221,000 of
expenses for slow-moving and obsolete inventory as compared to $537,000 of
expenses for slow-moving and obsolete inventory in the first six months of 2005.
For the year 2005, our annualized inventory turnover level was 4.8 as compared
to 7.5 in 2004, primarily as a result of a 42% decrease in net sales, which was
partially offset by a 10% decrease in inventory.

         OPERATING EXPENSES. We focus on operating expenses to keep these
expenses within budgeted amounts in order to achieve or exceed our targeted
profitability. We budget certain of our operating expenses in proportion to our
projected net sales, including operating expenses relating to production,
shipping, technical support, and inside and outside commissions and bonuses.
However, most of our expenses relating 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.

                                       19


<PAGE>

         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 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,
accounts payable. 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 six months of 2006 our consignment sales


                                       20


<PAGE>

model accounted for 42% of our total net sales as compared to 34% of our total
net sales in the first six months of 2005, representing a 24% increase,
primarily 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 six months of 2006 as compared to the first six 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.

            During 2002 and 2003, we 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 levels 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 levels 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 levels.

         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 levels may force us to
reduce prices and accept lower margins to sell consigned products. If we fail to
select high turnover products for our consignment sales channels, our sales,
profitability and financial resources may decline.

                                       21


<PAGE>

         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.

RETAILERS

         Historically, a limited number of retailers have accounted for a
significant percentage of our net sales. During the first six months of 2006 and
during the year 2005, our six largest retailers accounted for approximately 89%
and 99%, 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 only 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.

                                       22


<PAGE>

         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,
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.

                                       23


<PAGE>

         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 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.

                                       24


<PAGE>

         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
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 six months of 2006, our sales incentives were $372,000, or
1.5% of gross sales, all of which was offset against gross sales, as compared to
$832,000, or 3.2% of gross sales, in the first six months of 2005, all of which
was offset against gross sales. This 53% 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. In 2005, our sales incentives were
$1.3 million, or 2.6% of gross sales, all of which was offset against gross
sales.

   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 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 six months of
2006, our market development fund and cooperative advertising costs, rebate
promotion costs and slotting fees were $3.5 million, or 13.7% 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 $3.6 million, or 13.6% of gross sales, in the first six 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.

   INVENTORY OBSOLESCENCE ALLOWANCE

         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


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<PAGE>

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 six months of 2006 we increased our
inventory reserve and recorded a corresponding increase in cost of goods sold of
$221,000 for inventory for which recorded cost exceeded the current market price
of this inventory on hand. For the first six months of 2005, we increased our
inventory reserve and recorded a corresponding increase in cost of goods sold of
$537,000 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
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 six months of 2006 and 2005, we reduced the values of specific products
and accordingly reduced the reserve by $207,000 and $0, respectively. For the
first six 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 have no
informal return policies. We utilize actual historical return rates to determine
our allowance for returns in each period. Gross sales is 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.

                                       26


<PAGE>

         Our current estimated weighted average future product return rate is
approximately 8.0%. 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
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 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 six months ended June 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 six months ended June 30, 2006 was $45,104 and
$84,664, respectively, and are included in general and administrative expenses.


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<PAGE>

Income (loss) from operations for the three and six months ended June 30, 2006
would have been $(1,531,058) and $(2,451,114), respectively, if we had not
adopted SFAS 123(R). Income (loss) before income taxes for the three and six
months ended June 30, 2006 would have been $755,874 and $(301,880),
respectively, if we had not adopted SFAS 123(R). Net income (loss) for the three
and six months ended June 30, 2006 would have been $755,074 and $(302,680),
respectively, if we had not adopted SFAS 123(R). For the three and six months
ended June 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 six months ended June 30, 2006 would have been $0.17
and $(0.07), respectively, if we had not adopted SFAS 123(R), compared to
reported basic income (loss) per share of $0.16 and $(0.09), respectively.
Diluted income (loss) per share for the three and six months ended June 30, 2006
would have been $0.16 and $(0.07), respectively, if we had not adopted SFAS
123(R), compared to reported diluted income (loss) per share of $0.16 and
$(0.09), respectively.

         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 six months ended
June 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).

                                                      THREE MONTHS   SIX MONTHS
                                                         ENDED         ENDED
                                                        JUNE 30,      JUNE 30,
                                                          2005          2005
                                                       ---------    -----------

        Net income (loss), as reported                 $ 226,972    $  (930,319)

           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                           (21,711)       (43,788)
                                                       ---------    -----------
        Pro forma net income (loss)                    $ 205,261    $  (974,107)
                                                       =========    ===========
        Net income (loss) per common share:
           Basic and diluted, as reported              $    0.05    $     (0.21)
                                                       =========    ===========
           Basic and diluted, pro forma                $    0.04    $     (0.22)
                                                       =========    ===========

         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
six months ended June 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 six months ended June 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 six months ended June 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.

                                       28


<PAGE>

         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 six months ended June 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.

         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 six 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.

                                       29


<PAGE>

THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) COMPARED TO THREE MONTHS ENDED JUNE
30, 2005 (UNAUDITED)

<TABLE>
                                                                                                 RESULTS AS A PERCENTAGE
                                                                      DOLLAR       PERCENTAGE      OF NET SALES FOR THE
                                              THREE MONTHS ENDED     VARIANCE       VARIANCE       THREE MONTHS ENDED
                                                   JUNE 30,         ----------    ------------           JUNE 30,
                                              ------------------     FAVORABLE       FAVORABLE     -------------------
                                               2006       2005     (UNFAVORABLE)   (UNFAVORABLE)    2006         2005
                                              -------    -------    ----------    ------------     -------     -------
                                                      (in thousands)

<S>                                           <C>        <C>        <C>               <C>            <C>         <C>
Net sales .................................   $ 9,882    $ 9,558    $      324             3.4%      100.0%      100.0%
Cost of sales .............................     8,472      8,041          (431)           (5.4)       85.7        84.1
                                              -------    -------    ----------    ------------     -------     -------
Gross profit ..............................     1,410      1,517          (107)           (7.1)       14.3        15.9
Selling, marketing and advertising
  expenses ................................       224        123          (101)          (82.1)        2.3         1.3
General and administrative expenses .......     2,718      1,042        (1,676)         (160.8)       27.5        10.9
Depreciation and amortization .............        44         61            17            27.9         0.4         0.6
                                              -------    -------    ----------    ------------     -------     -------
Operating income (loss) ...................    (1,576)       291        (1,867)         (641.6)      (16.0)        3.0
Net interest expense ......................       (91)       (65)          (26)          (40.0)       (0.9)       (0.7)
Other income ..............................     2,378          3         2,375        79,166.7        24.1          --
                                              -------    -------    ----------    ------------     -------     -------
Income from operations before provision
  for income taxes ........................       711        229           482           210.5         7.2         2.4
Income tax provision ......................         1          2             1            50.0          --          --
                                              -------    -------    ----------    ------------     -------     -------
Net Income ................................   $   710    $   227    $      483           212.8%        7.2%        2.4%
                                              =======    =======    =========    =============     =======     =======
</TABLE>

         NET SALES. As discussed above, we believe that the increase in the
amount of $324,000 in net sales from $9.6 million for the quarter ended June 30,
2005 to $9.9 million for the quarter ended June 30, 2006 is primarily due to the
substantial increase in the sale of our mobile data storage products, 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 six 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 20% to
$4.8 million, or 48% of our net sales, in the second quarter of 2006 as compared
to $6.0 million, or 62% of our net sales, in the second 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 June 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 50% to $5.1 million, or 52% of our net sales, in the
second quarter of 2006 as compared to $3.4 million, or 35% of our net sales, in
the second quarter of 2005.

                                       30


<PAGE>

         Two other items also had an important impact on the increase in net
sales in the quarter ended June 30, 2006 as compared to the quarter ended June
30, 2005. For the quarter ended June 30, 2006 our product return rate was 10% of
gross sales, or $1.2 million, compared to 13% of gross sales, or $1.7 million,
for the quarter ended June 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 June 30, 2006, our sales incentives were 1% of gross
sales, or $152,000, compared to 3% of gross sales, or $378,000, for the quarter
ended June 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 decrease in gross profit of $107,000 from $1.5
million for the quarter ended June 30, 2005 to $1.4 million for the quarter
ended June 30, 2006 is primarily due to two factors: an increase in freight
costs and a decline in gross margins. Freight costs as a percentage of net sales
increased from 3% for the quarter ended June 30, 2005 to 6% for the quarter
ended June 30, 2006. The increase in freight costs is primarily due to shipping
more product via air to expedite sales of our mobile data storage products
combined with a general increase in fuel prices. Our gross profit margins
decreased to 14.3% in the second quarter of 2006 as compared to gross profit
margins of 15.9% in the second quarter of 2005. The decrease in gross profit
margins was primarily due to the increase in freight costs.

         SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses increased by $100,000 in the quarter ending June 30, 2006
as compared to the quarter ending June 30, 2005. This increase was primarily due
to display expenses, which we generally do not incur, but which were incurred to
better position our mobile data storage products at retailer locations.

         GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative
expenses increased by $1.7 million in the quarter ended June 30, 2006 as
compared to the quarter ended June 30, 2005. This increase was primarily due to
approximately $1.2 million of offering expenses realized in the second quarter
of 2006 in connection with a registered public offering that had not yet been
completed as of June 30, 2006 and is not now completed and may never be
completed. This increase was also due to $200,000 in legal fees mainly in
relation to trial expenses associated with ongoing litigation matters, $100,000
in audit fees and a $150,000 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, $45,000 of stock-based
compensation expenses are included in general and administrative expenses.

         DEPRECIATION AND AMORTIZATION EXPENSES. The $17,000 decrease in
depreciation and amortization expenses resulted from certain of our fixed assets
becoming fully depreciated since the quarter ended June 30, 2005.

         OTHER INCOME. Other income increased by $2.4 million in the quarter
ended June 30, 2006 as compared to the quarter ended June 30, 2005. This
increase was primarily due to the receipt of approximately $2.4 million upon the
settlement of a litigation matter with OfficeMax. The settlement funds were
partially offset by an increase in net interest expense of $26,000 due to higher
interest rates in the quarter ended June 30, 2006 as compared to the quarter
ended June 30, 2005.

                                       31


<PAGE>

SIX MONTHS ENDED JUNE 30, 2006 (UNAUDITED) COMPARED TO SIX MONTHS ENDED
   JUNE 30, 2005 (UNAUDITED)
<TABLE>
                                                                                                       RESULTS AS A PERCENTAGE
                                                                            DOLLAR       PERCENTAGE     OF NET SALES FOR THE
                                                   SIX MONTHS ENDED        VARIANCE       VARIANCE         SIX MONTHS ENDED
                                                       JUNE 30,           ----------    ------------           JUNE 30,
                                                 ---------------------     FAVORABLE      FAVORABLE      -------------------
                                                    2006        2005     (UNFAVORABLE)  (UNFAVORABLE)     2006         2005
                                                 ---------    --------    ----------    ------------     -------     -------
                                                         (in thousands)

<S>                                              <C>          <C>         <C>               <C>            <C>         <C>
Net sales ....................................   $  18,876    $ 18,594    $      282             1.5%      100.0%      100.0%
Cost of sales ................................      16,712      16,495          (217)           (1.3)       88.5        88.7
                                                 ---------    --------    ----------    ------------     -------     -------
Gross profit .................................       2,164       2,099            65             3.1        11.5        11.3
Selling, marketing and advertising expenses...         456         297          (159)          (53.5)        2.4         1.6
General and administrative expenses ..........       4,152       2,460        (1,692)          (68.8)       22.0        13.2
Depreciation and amortization ................          91         139            48            34.5         0.5         0.8
                                                 ---------    --------    ----------    ------------     -------     -------
Operating loss ...............................      (2,535)       (797)       (1,738)         (218.1)      (13.4)       (4.3)
Net interest expense .........................        (172)       (142)          (30)          (21.1)       (0.9)       (0.8)
Other income .................................       2,321          11         2,310        21,000.0        12.3         0.1
                                                 ---------    --------    ----------    ------------     -------     -------
Loss from operations before provision for
  income taxes ...............................        (386)       (928)          542           (58.4)       (2.0)       (5.0)
Income tax provision .........................           1           2             1            50.0        --          --
                                                 ---------    --------    ----------    ------------     -------     -------
Net Loss .....................................   $    (387)   $   (930)   $      543           (58.4)%      (2.1)%      (5.0)%
                                                 =========    ========    ==========    ============     =======     =======
</TABLE>

         NET SALES. As discussed above, we believe that the increase in the
amount of $282,000 in net sales from $18.6 million for the six months ended June
30, 2005 to $18.9 million for the six months ended June 30, 2006 is primarily
due to the substantial increase in the sale of our mobile data storage products,
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 six 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 19% to
$9.0 million, or 48% of our net sales, in the first six months of 2006 as
compared to $11.1 million, or 63% of our net sales, in the first six 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 quarter ended June 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 49% to $9.7 million, or 52% of our net sales, in the first
six months of 2006 as compared to $6.5 million, or 37% of our net sales, in the
first six months of 2005.

         Two other items also had an important impact on the increase in net
sales in the six months ended June 30, 2006 as compared to the six months ended
June 30, 2005. For the six months ended June 30, 2006 our product return rate
was 10% of gross sales, or $2.5 million, compared to 13% of gross sales, or $3.4
million, for the six months ended June 30, 2005. The decline in our product
return rate was caused by an increase in sales of our mobile data storage


                                       32


<PAGE>

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 six months ended June 30, 2006, our sales incentives were
2% of gross sales, or $373,000, compared to 4% of gross sales, or $832,000, for
the six months ended June 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 slight increase in gross profit of $65,000 from $2.1
million for the first six months of 2005 to $2.2 million for the first six
months of 2006 is primarily due to a decrease in charges to our inventory
reserve from $537,000, or 2% of gross sales, during the first six months of 2005
to $221,000, or 1% of gross sales, during the first six months of 2006. The
large adjustment in 2005 was due to the adjustment of the value of our
slow-moving and obsolete inventory.

         In addition, our gross profit margins increased to 11.5% in the first
six months of 2006 as compared to gross profit margins of 11.3% in the first six
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. In addition, 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.

         The decrease in charges to our inventory reserve and our increased
gross profit margins were partially offset by an increase in freight costs.
Freight costs as a percentage of net sales increased from 3% for the six months
ended June 30, 2005 to 5% for the six months ended June 30, 2006. The increase
in freight costs is primarily due to shipping more product via air to expedite
sales of our mobile data storage products combined with a general increase in
fuel prices.

         SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses increased by $159,000 in the first six months of 2006 as
compared to the first six months of 2005. This increase was primarily due to
display expenses, which we generally do not incur, but which were incurred to
better position our mobile data storage products at retailer locations.

         GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative
expenses increased by $1.7 million in the first six months of 2006 as compared
to the first six months of 2005. This increase was primarily due to
approximately $1.2 million of offering expenses realized in the second quarter
of 2006 in connection with a registered public offering that had not yet been
completed as of June 30, 2006 and is not now completed and may never be
completed. This increase was also due to $200,000 in legal fees mainly in
relation to trial expenses associated with ongoing litigation matters, $100,000
in audit fees and a $150,000 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, $85,000 of stock-based
compensation expenses are included in general and administrative expenses.

         DEPRECIATION AND AMORTIZATION EXPENSES. The $48,000 decrease in
depreciation and amortization expenses primarily resulted from certain of our
fixed assets becoming fully depreciated following the six months ended June 30,
2005.

         OTHER INCOME. Other income increased by $2.3 million in the first six
months of 2006 as compared to the first six 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. The settlement funds were partially
offset by an increase in net interest expense of $30,000 due to higher interest
rates in the six months ended June 30, 2006 as compared to the six months ended
June 30, 2005.

                                       33


<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 June 30, 2006, we had working capital of $5.8
million, an accumulated deficit of $25.2 million, $1.4 million in cash and cash
equivalents and $9.0 million in net accounts receivable. This compares with
working capital of $6.0 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 six months ended June 30, 2006, our cash decreased $2.7
million, or 65.9%, from $4.1 million to $1.4 million as compared to a decrease
of $1.9 million, or 52.8%, for the quarter ended June 30, 2005 from $3.6 million
to $1.7 million.

         Cash used in our operating activities totaled $1.5 million during the
first six months of 2006 as compared to cash used in our operating activities of
$900,000 during the first six months of 2005. This $600,000 increase in cash
used in our operating activities in the first six months of 2006 as compared to
the same period in 2005 primarily resulted from:

         o    a $2.1 million decrease in accounts payable - related parties,
              caused by the payment of outstanding invoices;
         o    a $2.0 million decrease in accounts payable caused by the payment
              of outstanding invoices;
         o    a $1.3 million increase in inventory in transit as a result of
              large shipments to a major retailer at June 30, 2006; and
         o    a $315,000 decrease in our reserve for slow-moving and obsolete
              inventory.

         These decreases in cash were partially offset by:

         o    a $2.0 million increase in accounts receivable comprised of a $4.0
              million increase in the first six months of 2006 as compared to a
              $2.0 million increase in the first six months of 2005 resulting
              from decreases due to faster collections;

         o    a $1.8 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 and
              is not now completed and may never be completed;

         o    a $780,000 decrease in inventory; and

         o    a $543,000 decrease in net loss.

         Cash provided by our investing activities totaled $3,000 during the
first six months of 2006 as compared to cash provided by our investing
activities of $824,000 during the first six months of 2005. Our investing
activities during the first six months of 2006 consisted of restricted cash
related to our GMAC Commercial Finance line of credit and nominal purchases of
property and equipment. Our investing activities during the first six months of
2005 consisted of restricted cash related to our United National Bank loan and
nominal purchases of property and equipment.

                                       34


<PAGE>

         Cash used in our financing activities totaled $1.2 million during the
first six months of 2006 as compared to cash used in our financing activities of
$1.8 million for the first six months of 2005. We had $1.3 million in net
borrowings on our GMAC Commercial Finance line of credit and received $62,000
upon the exercise of employee stock options in the first six 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 Commercial Finance and we borrowed an additional $375,000 under our
GMAC Commercial Finance line of credit during the first six 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 Commercial
Finance.

         Our asset-based line of credit with GMAC Commercial Finance expires on
March 9, 2008 and allows us to borrow up to $10.0 million. The line of credit
bears interest at a floating interest rate equal to the prime rate of interest
plus 0.75%. 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 Commercial Finance are secured by
substantially all of our assets and guaranteed by our wholly-owned subsidiary,
IOM Holdings, Inc. The loan agreement has one financial covenant which requires
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 have been in violation of this financial covenant in the past and
may be in violation of this financial covenant in the future. If we are unable
to attain the financial covenant ratios, then GMAC Commercial Finance has the
option to immediately terminate the line of credit and the unpaid principal
balance and all accrued interest on the unpaid balance will then be immediately
due and payable. If the loan were to be called and we were 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 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 June 30, 2006, we owed
GMAC Commercial Finance approximately $3.8 million and had available to us
approximately $475,000 of additional borrowings. As of that date, we were in
breach of the financial covenant. GMAC has declined to provide a waiver for this
covenant default. However, we are currently in discussions with GMAC regarding
entering into a forbearance agreement addressing this covenant default. We
believe that GMAC will review possible parameters for this forbearance agreement
during the remainder of August 2006.

         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


                                       35


<PAGE>

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 June 30, 2006, we owed Lung Hwa Electronics $6.3 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 June
30, 2006, we owed BTC USA $244,000 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.

         Our net loss decreased 58.4% to $387,000 for the first six months of
2006 from $930,000 for the first six 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 expenses realized in the second quarter of 2006 in
connection with a registered public offering that had not yet been completed as
of June 30, 2006 and is not now completed and may never be completed. 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


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<PAGE>

additional inventory to meet the demand for other products. In addition, as a
result of our products' short life-cycles, which generate lower average selling
prices as the cycles mature, low inventory turnover levels may force us to
reduce prices and accept lower margins to sell consigned products. If we fail to
select high turnover products for our consignment 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 Commercial Finance
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 June 30, 2006 was $8.2 million as compared to a backlog
at June 30, 2005 of $4.8 million. Based on historical trends, we anticipate that
our June 30, 2006 backlog may be reduced by approximately 25%, or $2.0 million,
to a net sales amount of $6.2 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
non-consigned retailers or the sell-through of our products by consigned
retailers causes 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 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 results of
operations and financial position.

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<PAGE>

         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 position, 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
believes that this new standard will not have a material impact on our financial
position, 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 six months of 2006. Our sales to a foreign country (Canada) were less than
1% of our total sales for the first six 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 with GMAC
Commercial Finance in the amount of up to $10.0 million. The line of credit
provides for an interest rate equal to the prime lending rate as reported in THE
WALL STREET JOURNAL plus 0.75%. 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 the GMAC
Commercial Finance 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 June 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


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<PAGE>

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 June 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
June 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 and
we have not yet located a suitable candidate to fill that position. Although we
were able to timely file 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 recent departure of our former Chief Financial Officer in June
2006, on our assessment of our disclosure controls and procedures and has
concluded, in the third quarter of 2006 and as of June 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 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 six 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.


                                       39


<PAGE>

         We expect to locate a suitable candidate to fill the position of Chief
Financial Officer who has expertise in public company financial reporting
compliance by September 30, 2006, which we believe will contribute to our
ability to handle the matters necessary to properly prepare and to timely file
our periodic reports. In the interim, we have hired a financial consultant to
assist us in preparing our periodic reports.

         Management expects that the remediation described above will remediate
the corresponding material weakness also described above by December 31, 2006.
As noted above, management estimates that we have 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. Management believes that a suitable candidate for
the position of Chief Financial Officer will have an annual base salary of at
least $100,000, not including benefits and other costs of employment.

   CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

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

                           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
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.

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<PAGE>

   OFFICEMAX NORTH AMERICA, INC.

         On May 6, 2005, OfficeMax North America, Inc., or plaintiff, filed a
Complaint for Declaratory Judgment in the United States District Court of the
Northern District of Ohio against I/OMagic. The complaint seeks declaratory
relief regarding whether plaintiff is still obligated to us under certain
previous agreements between the parties. The complaint also seeks plaintiff's
costs as well as reasonable attorneys' fees. The complaint arises out of our
contentions that plaintiff is still obligated to us under an agreement entered
into in May 2001 and plaintiff's contention that it has been released from such
obligation. As of the date of this report, we have filed a motion to dismiss, or
in the alternative, a motion to stay the plaintiff's action against us. The
claims relating to this action were settled in connection with the settlement of
the litigation described immediately below.

         On May 20, 2005, we 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 us. The Counter-Claim
against us alleged four causes of action: breach of contract, unjust enrichment,
quantum valebant, and an action for declaratory relief. The Counter-Claim
alleged, among other things, that the we were liable to OfficeMax in the amount
of no less than $138,000 under the terms of a vendor agreement executed between
us and OfficeMax in connection with the return of computer peripheral products
to us for which OfficeMax alleged it was never reimbursed. The Counter-Claim
sought, among other things, at least $138,000 from us, along with pre-judgment
interest, attorneys' fees and costs of suit. We 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 of 2006, the case 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 us $2,375,000.

         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
position 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.

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

         None.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

         None.

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<PAGE>

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

         None.

ITEM 5.  OTHER INFORMATION

         None.

ITEM 6.  EXHIBITS

         Exhibit
         Number        Description
         ------        -----------

         10.1          Second Amended and Restated Agreement dated May 3, 2006
                       and effective as of April 1, 2006 between Lung Hwa
                       Electronics Co., Ltd. and I/OMagic Corporation*

         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.


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<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:  August 18, 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)


                                       43


<PAGE>

                         EXHIBITS FILED WITH THIS REPORT

Exhibit
Number        Description
------        -----------

10.1          Second Amended and Restated Agreement dated May 3, 2006 and
              effective as of April 1, 2006 between Lung Hwa Electronics Co.,
              Ltd. and I/OMagic Corporation

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


                                       44