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  **SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549** **Form 10-K**    þ     **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE    SECURITIES EXCHANGE ACT OF 1934**   **FOR THE FISCAL YEAR ENDED JUNE 30, 2005** **o** **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE    SECURITIES EXCHANGE ACT OF 1934**   **FOR THE TRANSITION PERIOD    FROM           TO****COMMISSION FILE NUMBER 000-30083** **QUALSTAR CORPORATION**   **CALIFORNIA** **95-3927330***(STATE OF INCORPORATION)* *(I.R.S. EMPLOYER IDENTIFICATION NO.)***3990-B HERITAGE OAK COURT, SIMI VALLEY, CA 93063****(805) 583-7744** **Securities registered pursuant to Section 12(b) of theAct:****NONE****Securities registered pursuant to Section 12(g) of theAct:****COMMON STOCK**      Indicate by check mark whether the registrant (1) has filedall reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has beensubject to such filing requirements for the past90 days.     Yes þ          No o     Indicate by check mark if disclosure of delinquent filerspursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best ofregistrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of thisForm 10-K or any amendment to thisForm 10-K.     þ     Indicate by check mark whether the registrant is an acceleratedfiler (as defined in Rule 12b-2 of the ExchangeAct).     Yes o          No þ     Indicate by check mark whether the registrant is a shell company(as defined in Rule 12b-2 of the ExchangeAct).     Yes o          No þ     As of December 31, 2004, the aggregate market value of thecommon equity held by non-affiliates of the registrant wasapproximately $32,071,000.     The total shares of common stock without par value outstandingat September 16, 2005 is 12,253,117.**DOCUMENTS INCORPORATED BY REFERENCE**     Items 10, 11, 12, 13 and 14 of Part III of thisForm 10-K are incorporated by reference from theregistrant’s definitive proxy statement for its annualmeeting of shareholders, which will be filed with the Commissionon or before October 28, 2005.  

**Qualstar Corporation****FORM 10-K****For The Fiscal Year Ended June 30, 2005****INDEX**            **PART I**     Item 1.      Business  1        Risk Factors  12        Executive Officers of the Registrant  20      Item 2.      Properties  21      Item 3.      Legal Proceedings  21      Item 4.      Submission of Matters to a Vote of Security    Holders  21      **PART II**     Item 5.      Market for Registrant’s Common Equity,    Related Stockholder Matters, and Issuer Purchases of Equity    Securities  21      Item 6.      Selected Financial Data  22      Item 7.      Management’s Discussion and Analysis    of Financial Condition and Results of Operations  23      Item 7A.      Quantitative and Qualitative Disclosures    about Market Risk  29      Item 8.      Financial Statements and Supplementary    Data  30      Item 9.      Changes in and Disagreements with    Accountants on Accounting and Financial Disclosure  48      Item 9A.      Controls and Procedures  48      Item 9B.      Other Information  48      **PART III**     Item 10.      Directors and Executive Officers of the    Registrant  48      Item 11.      Executive Compensation  48      Item 12.      Security Ownership of Certain Beneficial    Owners and Management  48      Item 13.      Certain Relationships and Related    Transactions  48      Item 14.      Principal Accountant Fees and Services  49      **PART IV**     Item 15.      Financial Statement Schedules and    Exhibits  49        Signatures  50        Exhibit Index  51  EX-10.4 EX-10.5 EX-21.1 EX-23.1 EX-31.1 EX-31.2 EX-32.1 EX-32.2

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**FORWARD-LOOKING STATEMENTS**     This Annual Report on Form 10-K contains forward-lookingstatements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the SecuritiesExchange Act of 1934. Forward-looking statements inherently aresubject to risks and uncertainties, some of which we cannotpredict or quantify. Our actual results may differ materiallyfrom the results projected in the forward-looking statements.Factors that might cause such a difference include, but are notlimited to, those discussed in “ITEM 1 —Business,” including the section therein entitled“Risk Factors,” and in “ITEM 7 —Management’s Discussion and Analysis of Financial Conditionand Results of Operations.” You generally can identifyforward-looking statements by the use of forward-lookingterminology such as “believes,” “may,”“will,” “expects,” “intends,”“estimates,” “anticipates,”“plans,” “seeks,” or “continues,”or the negative thereof or variations thereon or similarterminology. Forward looking statements also include theassumptions underlying or relating to any such statements.Forward looking statements contained within this documentrepresent a good-faith assessment of Qualstar’s futureperformance for which management believes there is a reasonablebasis. Qualstar disclaims any obligation to update the forwardlooking statements contained herein, except as may be requiredby law.**PART I****Item 1.*****Business*****Introduction**     We design, develop, manufacture and sell automated magnetic tapelibraries used to store, retrieve and manage electronic dataprimarily in network computing environments. Tape librariesconsist of cartridge tape drives, tape cartridges and roboticsto move the cartridges from their storage locations to the tapedrives under software control. Our tape libraries provide datastorage solutions for organizations requiring backup, recoveryand archival storage of critical data. Our products arecompatible with commonly used operating systems, including UNIX,Windows, and Linux. Our tape libraries are also compatible witha wide range of storage management software packages, such asthose supplied by Computer Associates, EMC/ Legato, Tivoli,Symantec/ Veritas, CommVault and BakBone Software. We offer tapelibraries for multiple tape drive technologies, including LTO,AIT, Super AIT, and SuperDLT.     We sell our tape libraries worldwide, primarily to value addedresellers, system integrators and original equipmentmanufacturers. These customers typically integrate our tapelibraries with software from third party vendors and relatedhardware such as servers and network components to providestorage solutions, which are then sold to end users. Weconfigure our libraries based on each customer’s individualrequirements, with a normal delivery time of one to threeworking days. This rapid fulfillment of customer orders allowsour resellers to minimize their inventory levels and allows usto compete effectively with distribution channels used by ourcompetitors.     Qualstar was incorporated in California in 1984. Our initialproducts were IBM compatible 9-track reel-to-reel tape drives.In 1995, we entered the tape automation market with a series oftape libraries incorporating 8mm tape drives. Since that time,we have introduced a succession of tape library models designedto work with the leading automation-capable tape drivetechnologies. Automated tape libraries and related products,such as tape drives and tape media, represented approximately75.1% of revenues for fiscal 2005, approximately 81.4% ofrevenues for fiscal 2004, and approximately 79.8% of revenuesfor fiscal 2003. Sales of power supplies, services and otherproducts accounted for the balance of our revenues.     In July 2002, we purchased the assets of N2Power, Incorporated,a supplier of ultra small high efficiency open-frame switchingpower supplies. Power supplies provided by N2Power are utilizedwithin our tape library products as well as sold to originalequipment manufacturers for incorporation into their products.N2Power products are sold under the N2Power brand name as wellas under a private label brand name through independent salesrepresentatives and distributors. Revenues from N2Power productstotaled 5.0% of total revenues for fiscal 2005 and 1.8% of totalrevenues for fiscal 2004.
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**Industry Background**     Storing, managing and protecting data has become critical to theoperation of many enterprises and governments as the worldeconomy becomes increasingly information dependent. The datastorage industry is growing in response to the increase in theamount of data that is generated and that must be preserved. Theamount of data has been increasing due to the growth in thenumber of computers, the number, size and complexity of computernetworks and software applications, and the emergence of newapplications such as image processing, e-commerce, internetservices, medical image storage, video and motion picture imagestorage, and other multi-media applications. In addition,businesses continue to generate increasing amounts oftraditional business information with respect to their products,customers and financial data. This increase in the amount ofdata that is generated stimulates increases in the demand fordata storage and the management of this data.***Factors Driving Growth in Data Storage*** • *Increased demand from Internet and e-commerce businesses.*    The growth in the Internet and e-commerce has created businesses    that depend on the creation, access to and archival storage of    data. We believe this demand will continue to grow as    individuals and businesses increase their reliance on the    Internet for communications, commerce and data retrieval.  • *Growth in new types of data.* New types of data are also    fueling the growth in data storage. For example, graphics, audio    and MP3, video, medical and security images, and multi-media    uses such as video on demand, require far greater storage    capacity than text and financial data.  • *Recognition of the critical importance of data.* Corporate    databases contain useful information about customer records,    order patterns and other factors that can be analyzed and    transformed into a valuable asset and a competitive advantage.    The ability to efficiently store, manage and protect this    information is important to the value and success of many    businesses. The usefulness of past and present data is further    enhanced by new sophisticated data mining software applications    that can access and analyze large databases.  • *Growing awareness of the need for disaster protection.*    Companies are recognizing that without their data they may not    survive. Natural disasters, as well as overt and covert actions    targeted at individual companies, classes of users or whole    countries, can destroy data and entire data centers, threatening    a company’s very existence. Systematic replication and    secure off-site storage of corporate data is recognized as the    best defense against catastrophic data loss. Tape libraries are    a key technology in most corporate data disaster protection    plans.  • *Compliance with new regulatory requirements for records    retention.* Many businesses now have to deal with new    regulatory requirements from various governmental agencies that    require businesses to retain data for longer periods of time.    The regulations that have received the most visibility include    HIPAA requirements covering medical records; Sarbanes-Oxley,    which addresses corporate governance; and Rule 17a under    the Securities Exchange Act of 1934, regarding recordkeeping    requirements for the securities industry. These regulations and    others are projected to increase demand for long-term storage    capacity over the next few years.  • *Growth in network computing applications and data.* The    use of computer networks has shifted critical information and    applications to network servers to allow more people to gain    access to stored data as well as to create new data. As the    speed of network computing has increased, numerous new    applications have become feasible such as computer fax and    e-mail, all of which generate progressively more data.    Organizations are increasingly aware of the need to protect this    data, as networks become a mission-critical element of many    operations.  • *Decrease in the costs of storing data.* The costs of data    storage have decreased with advances in technology and improved    manufacturing processes. We expect these costs to continue to    decrease. The decrease in the cost of data storage encourages    the storage of more data and makes it more cost effective to add    storage capacity than to remove old data, which in the past may    have been purged periodically.
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***Advances in Storage Management Technologies***     The growth in data is contributing to an evolution intraditional storage solutions. New technologies are designed toprovide high-speed connectivity for data-intensive applicationsacross multiple operating systems, including UNIX, Windows, andLinux. These new methods of storage and data managementtechnologies include the following: • *Fibre Channel.* Fibre Channel is an interface technology    based on industry standards for the connection of storage    devices to networks. Interface is the term used to describe the    electronics, cabling and software used to facilitate    communications between devices. With Fibre Channel, users are    better able to share stored information with other storage    devices and servers over longer distances, with data transfer    speeds significantly faster than the most common interface    technology in use today, thereby increasing the importance of    storage area networks.  • *Storage Area Networks.* Storage Area Network, or SAN,    architecture applies the inherent benefits of a networked    approach to data storage applications, which allows data to move    efficiently and reliably between multiple storage devices and    servers. The benefits of SAN architecture also include    increasing the expandability of existing storage solutions and    providing a higher level of connectivity than exists with    traditional technologies. Additionally, SANs are able to provide    these benefits across multiple operating systems.  • *Advanced storage management software.* This software    automatically migrates infrequently accessed data to the lower    cost storage medium such as a tape library. A user’s    request for this data at some later date will recall the data    automatically from the tape library. This process reduces the    overall storage cost by using the least expensive storage medium    to store data that is not expected to be needed on a frequent    basis. Advances in storage management software have increased    the ability of businesses to more cost-effectively store, manage    and retrieve data, which in turn allows businesses to operate    more efficiently.  • *Network Attached Storage.* Current storage devices are    dependent on a file server for all commands and control. Network    attached storage devices give storage devices file server    functionality, which allow users to plug a storage device    directly into a network without requiring a separate file    server. This allows users to maintain, or even enhance, system    performance while saving on both time and cost.***Types of Data Storage***     Current non-volatile storage solutions are based primarily ontwo technologies: magnetic disk and magnetic tape. Thesetechnologies represent a compromise among a variety of competingfactors including capacity, cost, speed, portability and datareliability. Magnetic tapes are removable, which allows them tobe transported easily to an off-site location for security orprotection from physical harm. Magnetic disks provide quickeraccess to stored data and generally are used when speed isimportant. Less frequently used data is often migrated frommagnetic disks to tape storage. Tape libraries provide anear-online solution, where less frequently used data files arestored on tape at substantially lower cost compared to diskwhile still providing automated access.***Tape Libraries and Applications***     Tape libraries automate the tape loading process, eliminateerrors induced by human operators, and enhance security comparedto tapes that must be retrieved and loaded manually. Tapelibraries can also be operated from remote locations around theclock, thus, eliminating the need for an operator. Automatedtape libraries are a key component in a company’s overallstorage solution and data protection strategy.     Tape drives and tape media are two key components of tapelibraries. The costs of tape drives and tape media have declinedwith advances in technology, and we expect this trend tocontinue. As prices decline, new applications for automatedstorage become justified, further increasing the number ofapplications that can benefit from the use of tape libraries. Webelieve that continued technological improvements in tape drivesand tape media will further reduce overall storage costs in thefuture.
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     Current and emerging applications for tape libraries include: • *Automated backup.* Backup is the creation of a duplicate    copy of current data for the purpose of recovering the data in    the event the original is lost or damaged. An automated tape    library, in conjunction with storage management software, can    backup network data at any time without human intervention. A    library with multiple tape drives can backup data using all of    its drives simultaneously, thus significantly speeding up the    recording process. Backup tapes can be removed from the library    and stored in an off-site location for protection against a loss    of the primary site.  • *Archiving.* Archiving is the storage of data for    historical purposes. When information is stored on tape,    automated tape libraries, under application control, can catalog    tapes for future retrieval and prevent unauthorized removal or    corruption of data by using password or key lock protection.    Archival tapes provide a historic record for use in fraud    detection, audit, legal and other processes. Tape libraries are    also used for archiving due to benefits offered by the tape    medium, such as long-term data integrity, resistance to    environmental contamination, ease of relocation, low cost, and    the availability of “Write Once Read Many” or WORM    tapes.  • *Digital video.* Digital recording of camera images for    surveillance and security purposes is an alternative to    traditional analog VHS recording in installations such as    airports, retail stores, government facilities and gaming    operations. This is an important market opportunity because tape    libraries eliminate the need for operators to load, unload,    store and retrieve the large number of tapes created in these    facilities. Library based systems index, store and play back the    video images on demand, significantly reducing the retrieval    time and cost of operation when compared to VHS recording    and playback devices. Digital recording technology provides    higher resolution than analog VHS recording technology.  • *Image management.* Storage-intensive applications such as    satellite mapping and medical image management systems are    turning to tape libraries because of the cost advantage over    traditional storage methods. X-ray images or MRI results, for    instance, must frequently be kept on file for years. Storing a    digitized image in a tape library costs considerably less than    storing a film copy, and can be retrieved years later with the    click of a mouse.***Distribution of Tape Library Products***     The requirements for storage solutions vary depending on thesize of an enterprise, the type of data generated and the amountof data to be stored. With the increased dependence on storeddata, most organizations, regardless of their size, have aheightened need for storage solutions that integrate devicessuch as tape drives, tape libraries and storage managementsoftware. Those organizations with sufficient in-houseinformation technology resources can rely on their internalinfrastructure and expertise to design, purchase and implementtheir own storage solutions. These organizations may elect topurchase equipment from distributors or directly from theoriginal equipment manufacturers. Many organizations, however,do not have sufficient in-house resources but have the same needfor data storage solutions. These organizations often look tovalue added resellers to design, supply and install theirstorage solutions.     Value added resellers develop and install storage solutions forenterprises that face complex storage needs but lack thein-house capability of designing and implementing the propersolution or have chosen to outsource these functions. Typically,the value added reseller will select among a variety ofdifferent hardware technologies and software options, as well asprovide installation and other services, to deliver a completestorage solution for the end user. Value added resellers requirerapid turnaround of orders, custom configuration of tapelibraries, drop shipment to their customer’s site,compatibility with multiple tape formats and software, andmarketing and technical support.     Original equipment manufacturers generally resell products madeby others under their own brand name and typically assumeresponsibility for product sales, service and support. Originalequipment manufacturers enable manufacturers, such as Qualstar,to reach end users not served by other channels and to serveselect vertical markets where specific original equipmentmanufacturers have exceptional strength. Original
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equipment manufacturers require special services such as productconfiguration control, extensive qualification testing, customcolors and private labeling.**Our Solutions**     We offer storage solutions that respond to the growing datamanagement challenges facing businesses today, while addressingthe unique needs of value added resellers and original equipmentmanufacturers.     We believe that high reliability is important to the end usersof our products due to the critical nature of the data that isbeing stored, shorter time periods available for the back-upoperations, and the operation of backup systems during hourswhen personnel may not be available to respond to problems. Toaddress these concerns, we emphasize quality and reliability inthe design, manufacturing and testing of our products whichreduces the potential for product failures and results inproducts that require little maintenance.     The technology utilized in automated tape libraries iscontinuously evolving due to advances in data recording methods,component cost reductions, advances in semiconductor andmicroprocessor technologies, and a general trend towardminiaturization in the electronics industry. This changingtechnology requires that we continuously develop and market newproducts to prevent our product lines from becoming obsolete.     Our tape libraries are compatible with over forty-five(45)third-party storage management software packages, includingthose supplied by Computer Associates, EMC/ Legato, Tivoli,Symantec/ Veritas, CommVault and BakBone Software. Storagemanagement software enables network administrators to allocatethe use of storage technologies among user groups or tasks, tomanage data from a central location, and to retrieve, transferand backup data between multiple workstations. We believe thatstorage management software is a crucial component of anyautomated storage installation, and lack of compatibility is asignificant barrier to entry for new tape library competitors.To ensure compatibility, our engineers work with independentsoftware vendors during the product development cycles. We donot have contracts with any independent software vendors, nor dowe need access to their software code to design our products. Wemaintain relationships with them by supplying tape libraries sothey can qualify their software to work with our tape librariesand by evaluating their software for compatibility with our tapelibraries. We also support our relationships with them bykeeping them informed about current and anticipated changes toour products and by referring business to them when value addedresellers or end users inquire about storage management softwaresources.**Strategy**     Our goals are to enhance our position as a supplier of automatedtape libraries and to maintain or increase our market share ineach of the tape formats in which we compete. To achieve thesegoals, we intend to: • *Offer libraries for multiple tape drive technologies.* We    offer tape libraries for a range of tape drive technologies,    including LTO, AIT, Super AIT, and SuperDLT. By offering    products based on multiple tape drive technologies, we reduce    our dependence on the success of any single technology and can    offer products that target the specific preferences of resellers    and original equipment manufacturers and their end user    customers.  • *Focus on value added reseller channels.* We sell our    products primarily through selected value added resellers who    have a strong market presence, have demonstrated the ability to    work directly with end users, and who maintain relationships    with major vendors of storage management software. Because we    market our products primarily through this channel, we have    implemented a variety of programs to support and enhance our    relationships with our reseller partners. These programs are    designed to benefit the reseller and increase the likelihood of    selling our products. We intend to maintain our marketing    presence in support of this channel. We conduct business with    our value added resellers on an individual purchase order basis    and no long-term purchase commitments are involved.  • *Maintain and strengthen original equipment manufacturer    relationships.* We sell our products to several companies    under private label or original equipment manufacturer    relationships. Original equipment manufacturer sales enable us    to reach some end users not served by our value added
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     resellers. The same product characteristics that make our tape    libraries attractive to value added resellers also are important    to original equipment manufacturers. We conduct business with    our original equipment manufacturer customers on an individual    purchase order basis and no long-term purchase commitments are    involved.  • *Develop libraries for new tape technologies.* The tape    drive industry is continuously advancing the state of    technology. We will continue to design new libraries for those    technologies that appear promising and that meet our standards    for capacity, quality and reliability.  • *Maintain our rate of innovation.* We plan to maintain our    high level of investment in research and development to exploit    emerging technologies and product opportunities. We intend to    continue the expansion of our product lines to incorporate    higher capacities and new technologies.     We believe that our experience, efficiency and strict controlover the development and manufacture of new products are keyfactors in the successful execution of our strategy. We designour tape libraries with a high percentage of common parts, usequality components and minimize the number of moving parts. Weutilize proprietary techniques in the design, production andtesting of our libraries in order to simplify the manufacturingprocess and reduce our costs. We manufacture all of our productsat a single facility and we control our inventory closely toprovide rapid delivery to our customers. These steps allow us todesign and bring to market new products rapidly in response tochanging technology.**Products*****Tape Libraries***     We offer a number of tape library families, each capable ofincorporating one or more tape drive technologies, as summarizedin the following table:               **Tape Drive** **Range of Tape** **Maximum Capacity****Product Family** **Technology** **Cartridges** **in Terabytes(1)**           TLS-4000  Sony AIT   12 to 600   120.0     TLS-5000  Sony SAIT   33 to 264   132.0     TLS-6000  Quantum SDLT   10 to 240   72.0     TLS-8000  LTO   11 to 264   105.6     RLS-4000  Sony AIT   22 to 70   14.0     RLS-5000  Sony SAIT   16 to 44   22.0     RLS-6000  Quantum SDLT   27   8.1     RLS-8000  LTO   12 to 44   17.6  (1)     A Terabyte is one million megabytes, or one thousand gigabytes.    The table shows native capacity and excludes gains from data    compression, which can increase capacity by more than 100%.     Our tape library families include a number of models that differin storage capacity, price and features. Our libraries areinstalled in network computing environments ranging from smalldepartmental networks to enterprise-wide networks supportinghundreds of users. We believe that selling products for multipletape drive technologies insulates us somewhat from the dynamicsof the marketplace as various tape standards compete for marketshare. This helps our products appeal to the broadest possiblerange of end user market segments. This wide range of productsmakes us a one-stop supplier for our value added reseller andoriginal equipment manufacturer customers, enabling them to meetmost end user requirements for a specific tape format. Our widerange of products for competing tape drive technologies alsohelps to insulate us from the occasional supply shortages fromtape drive or tape media manufacturers.     Tape libraries generally contain two or more tape drives andfrom several to thousands of tapes. We concentrate our productofferings in the mid-range of 10 to 600 tapes. We design ourtape libraries for continuous, unattended operation. Multipletape drives allow simultaneous access to different data files bydifferent users on the network, and increase the rate at whichdata can move on to, out of, or within the
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network. A library with multiple tape drives can back up datausing all drives simultaneously, significantly speeding up therecording process. In some of our libraries, tape cartridges arestored in removable magazines, allowing for easy bulk removal ofthe tapes. Our libraries also offer features such as barcodereaders to scan cartridge labels and an input/output port forimporting and exporting tapes under system control. Several ofour library models are expandable in the field by increasing thenumber of tape storage positions. This feature provides the enduser with the ability to increase data capacity as storage needsgrow.     We continue to develop and release new libraries to expand ourproduct offerings to meet the changing demands of themarketplace. In addition, we continue to enhance and improve ourexisting products to maintain our competitive position.     Some of our tape libraries incorporate a number of specializedfeatures that we believe improve reliability, serviceability andperformance, including: • *Rapid tape drive replacement.* We design our libraries so    that a tape drive can be replaced quickly without special tools.    This feature minimizes the off-line time required when a tape    drive must be replaced, and frequently avoids the high cost and    delays of a service call.  • *Fibre Channel connectivity.* We offer a Fibre Channel    option on many of our models for connection to Storage Area    Networks and other high performance applications.  • *Closed-loop servo control.* Our tape libraries use digital    closed-loop servo control for robotic motion to provide precise    tape handling. This yields motion that is smooth, repeatable and    highly reliable.  • *Brushless motors.* Motors are a key component in any    robotic system. We use only brushless electric motors in our    tape libraries. Brushless motors provide longer life and less    electrical noise compared to conventional brush-type motors. We    build many of our own motors in order to obtain optimum    performance and reliability.  • *Variable Input/ Output Port.* Our VIOP feature allows    users to select the number of cartridge slots to be dedicated to    bulk import or export of media to or from the library.  • *Remote management.* Many larger companies with global    back-up solutions or disaster management programs require tape    libraries that can be put off-site in various regions, but that    must be administered from a single location. With Q-Link, our    remote library manager, customers can put libraries anywhere in    the world and manage them from a single administrative hub using    a standard web browser.     Our flagship product line, the TLS Series, is specificallydesigned to be placed on the floor or on a tabletop, without theneed for a special equipment rack. If requested, we provide ourcustomers with an adapter kit for rack mounting some models.Other manufacturers design libraries primarily for rackmounting, and supply an adapter for tabletop use.     Our RLS Series of tape libraries are designed to fit efficientlyin equipment racks and provide back-up capacity in only fivestandard units, or a total of 8.75 inches of rack space. Inaddition, some models in the RLS series were designed to supportdual-redundant power supplies and hot-swappable tape drives.***Other Products***     In addition to our tape libraries, we sell ancillary productssuch as tape media, tape magazines, cables, bar code labels andadapters for rack mounting.     In July 2002, we purchased the assets and intellectual propertyof N2Power, Incorporated, a privately held company located inNewbury Park, California. Our N2Power division designs,manufactures, and sells ultra small high-efficiency open-frameswitching power supplies based on its patented technology.N2Power products are used in our tape libraries as well as soldto original equipment manufacturers and a private labeldistributor.
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**Sales and Marketing*****Sales***     We sell our tape library products primarily through value addedresellers. Our sales force will initiate contact with valueadded resellers who are candidates to sell our tape libraries.We strive to develop relationships with resellers who haveexpertise in storage management applications, establishedrelationships with end users and the experience to understandand satisfy their customers’ needs.     We believe that by selling directly to value added resellers, wehave an advantage over competitors who will often sell directlyto end users, thereby competing with their resellers. Some ofthe advantages of our strategy include the following: • *Higher profit margins.* Focusing on this channel, we    achieve economies that result in higher profit margins to be    shared by both the reseller and us.  • *Custom configurations.* We offer custom configurations of    our products, such as special paint, private branding and    non-standard options, on very short notice.  • *Channel conflicts avoided.* We refer substantially all end    user inquiries to our reseller partners. Frequently, our sales    force will make end user visits with resellers to help close a    pending sale.  • *Credit.* We extend credit terms to resellers who meet our    credit requirements.  • *Rapid delivery.* We generally ship a product within one to    three working days of confirming an order, rivaling the delivery    time of many distributors.     Although we sell our tape libraries primarily to value addedresellers, we believe that original equipment manufacturers arean important element of our business. The sales cycle fororiginal equipment manufacturers generally encompasses sixmonths to one year and may involve extensive product and systemqualification testing, evaluation, integration and verification.Original equipment manufacturers typically assume responsibilityfor product sales, service and support.     Our international sales are currently directed from ourcorporate offices in Simi Valley, California. European sales arecoordinated through our European sales office in the UnitedKingdom. All of our international sales are denominated inU.S. dollars. Revenues from customers outside of NorthAmerica were approximately $6.9 million, or 27.3% ofrevenues in fiscal 2005, approximately $10.2 million or32.4% of revenues in fiscal 2004, and approximately$9.9 million or 29.4% of revenues in fiscal 2003.     Our sales are spread across a broad customer base. For the yearended June 30, 2005, no single customer accounted for morethan 10% of our revenue.***Marketing***     We support our sales efforts with a broad array of marketingprograms designed to generate brand awareness, attract andretain qualified value added resellers and inform end usersabout the advantages of our products. We provide our resellerswith a full range of marketing materials, including productspecifications, sales literature, software connectivityinformation and product application notes.     We train our resellers to sell our products and to answercustomers’ questions. We advertise in key publications andparticipate in trade shows. We display our products under theQualstar brand name at some trade shows and participate in othertrade shows in partnership with our principal suppliers andresellers. We support our marketing and customer support with awebsite that features comprehensive marketing and productinformation.     We conduct sales and technical training classes for ourresellers. We also conduct various promotional activities forresellers and end users, including product-specific rebates andco-operative advertising.
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**Customer Service and Technical Support**     We believe that strong customer service and technical support isan essential aspect of our business. Our customer service andtechnical support efforts consist of the following components: • *Technical support.* Our technical support personnel are    available twenty-four hours per day, Monday through Friday.    Technical support personnel are available to all customers at no    charge by telephone, facsimile and e-mail to answer questions    and solve problems relating to our products. Our technical    support personnel are trained in all aspects of our products.    Our support staff is located at our headquarters in Simi Valley,    California. We sell service contracts for on-site service of our    tape libraries installed within the United States and Canada,    which are fulfilled by IBM Corporation and on-site service    contracts sold in Europe are fulfilled by Eastman Kodak S.A.    Commercial Imaging Group.  • *Sales engineering.* Our engineers provide both pre-and    post-sales support to our resellers. Engineers typically become    involved in more complex problem-solving situations involving    interactions between our products, third-party software, network    server hardware and the network operating systems. Engineers    work with resellers and end users over the telephone and at an    end user site as required.  • *Training.* We offer a product maintenance training program    for end users, value added resellers, original equipment    manufacturers, customer service and technical support personnel.    We conduct training classes at our headquarters and on-site as    appropriate.  • *Warranty.* The warranty period on our tape libraries is    three years. Some TLS and all RLS models have three year advance    replacement warranty coverage that provides for replacement of    components or, if necessary, complete libraries. All other TLS    models have a one year advance replacement warranty with the    second and third year being return-to-factory for service at no    charge. Customers may purchase extended advance replacement    service coverage and on-site service if they are located in the    United States, Canada and some countries within Europe.**Manufacturing and Suppliers**     We manufacture all of our tape libraries at our facility in SimiValley, California. We currently operate five assembly linesduring one daily eight-hour shift. As needs require, we have theability to add a second or third shift to increase our capacity.     To respond rapidly to orders, we build our tape libraries to asemi-finished state, perform full testing and then place thetape libraries in a holding area until an order is received.Once an order is confirmed, we remove the unit from the holdingarea, install tape drives and configure the unit to meet thespecific requirements of the order, retest and then ship.     The manufacturing cycle to bring the libraries to asemi-finished state is approximately five working days. Webelieve that this process represents an effective way to controlour inventory levels while maintaining the ability to fillspecific orders in short lead times. We coordinate inventoryplanning and management with suppliers and customers to matchour production to market demand. Once we confirm an order, wegenerally ship the product within one to three working days. Webelieve this response time is among the fastest in the industryand gives us a competitive edge. Because we fill the majority ofour orders as they are received, our backlog generally is smalland is not indicative of future revenues.     We carefully select our suppliers based on their ability toprovide quality parts that meet our specifications and volumerequirements. Inventory planning and management is coordinatedclosely with suppliers to match our production needs. Many ofthe components assembled into our libraries are off-the-shelfparts, which reduces the risk of part shortages and allows us tomaintain inventory of these parts at a minimum. A number of ourcomponent parts are not available off the shelf, but aredesigned to our specifications for integration into our products.     Tape drives and tape media are available only from a limitednumber of suppliers, some of which are sole-source providers.Some of our suppliers compete with us by selling their own tapelibraries. The risk of
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allocation is greater upon the introduction of a new tape drivetechnology. Any disruption in supplies of tape drives or tapemedia could delay shipments of our products.**Competition**     The market for automated tape libraries is intensely competitiveand characterized by rapidly changing technology and evolvingstandards. Because we offer a broad range of libraries fordifferent tape drive technologies, we tend to have a largenumber of competitors that differ depending on the particularformat and performance level. We compete in a segment of theoverall tape library market that focuses on small to mid- rangenetwork computing environments. Our principal competitors inthis market segment include Sun/ StorageTek, QuantumCorporation, Advanced Digital Information Corporation, OverlandStorage, Inc., and Spectra Logic Corporation.     Many of our competitors have substantially greater financial andother resources, better name recognition, larger research anddevelopment staffs, and more capabilities in manufacturing,marketing and distributing products than we do. Our competitorsmay develop new technologies and products that are moreeffective than our products. We are not ISO-9000 certified,unlike some of our competitors, which may limit somecustomers’ ability to purchase our products.     As competitors introduce products in a particular tape drivetechnology, the increased competition normally results in priceerosion and a reduction in gross margins for all competitors. Wecannot assure you that we will be able to compete successfullyagainst either current or potential competitors or thatcompetition will not cause a reduction in our revenues or profitmargins. We believe that our ability to compete depends on anumber of factors, including the success and timing of newproduct developments by us and by our competitors, compatibilityof our products with a broad range of computing systems, productperformance, reliability, price, marketing and sales executionand customer support. Specifically, we believe that theprincipal competitive factors in the selection of a tape libraryinclude: •     reliability of the robotic assembly that handles the tape    cartridges;  •     initial purchase price;  •     storage capacity;  •     speed of data transfer;  •     compatibility with existing operating systems and storage    management software;  •     after-sale expandability of a tape library to meet increasing    storage requirements;  •     expected product life, cost of maintenance and total cost of    ownership; and  •     physical configuration and power requirements of the library.     We believe our tape libraries compete favorably overall withrespect to many of these factors.**Research and Development**     Our research and development group of 21 people consists ofengineers and technicians who have data storage and relatedindustry experience. We have developed over 40 separate tapelibrary models for eleven different tape formats over the lastten years.     Our research and development efforts rely on the integration ofmultiple engineering disciplines to generate products that meetmarket needs in a competitive and timely fashion. Successfuldevelopment of automated tape libraries requires the integrationof mechanical design, electronic design packaging, softwaredesign, and firmware design into a single product. Productsuccess also relies on the engineering group’s thoroughknowledge of each of the different tape drive technologies.     We frequently develop new products in response to theavailability of a new tape drive technology. As tape drivemanufacturers compete in the marketplace, they continuallyinvest in research and development to
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gain performance leadership either by offering increasinglyenhanced versions of their current tape drive products or byintroducing an entirely new tape drive technology. We benefitfrom these industry developments by utilizing the new technologyin our products. Our engineers work closely with the tape drivemanufacturers through the drive development cycle to assure thatreliable tape library and tape drive combinations are brought tomarket.     The design architecture of our tape libraries makes use ofcommon parts across most product families, allowing us todevelop and introduce new products quickly. If a new tape driveis an advanced version of one already incorporated in one ormore of our products, our time and dollar investment toincorporate the new drive can be relatively small, with theprimary focus being on verification testing. When the formfactors differ, the time and investment requirements can growsubstantially, and may require development of a new productfamily altogether.     We also develop new products as we identify emerging marketneeds. Our sales, marketing, product development and engineeringgroups identify products to fulfill customer and marketplaceneeds. Our research and development group concentrates onleveraging previous engineering investments into new products.For example, our firmware is based on successive generations ofthe operating system developed for our first library. We alsouse common parts in our different library series and leverageour electro-mechanical and electronic hardware technology fromprevious products into next generation designs. In some cases,entire subassemblies are transferable, leveraging not onlyengineering time but also materials purchasing, inventorystocking and manufacturing efforts.     Our research and development expenses were approximately$3.8 million in fiscal 2005, approximately$4.3 million in fiscal 2004, and approximately$4.0 million in fiscal 2003. We anticipate research anddevelopment costs to be slightly lower in fiscal 2006.**Intellectual Property**     We rely on copyright protection of our firmware, as well aspatent protection for some of our designs and products. We alsorely on a combination of trademark, trade secret and otherintellectual property laws to protect our proprietary rights.However, we do not believe our intellectual property providessignificant protection from competition. We believe that,because of the rapid pace of technological change in the tapestorage industry, patent, copyright, trademark and trade secretprotection are less significant than factors such as theknowledge, ability and experience of our personnel and timelynew product introductions.     We enter into Employee Proprietary Information and InventionsAgreements with our engineers along with all employees andconsultants to protect our technology and designs. However, wedo not believe that such protection can preclude competitorsfrom developing substantially equivalent products.**Employees**     As of September 26, 2005, we had 95 full-timeemployees, including 35 in operations and manufacturing, 22 inresearch and development, 6 in customer service and technicalsupport, 17 in sales and marketing, and 15 in administration andfinance. We also employ a small number of temporary employeesand consultants as needed. We are not a party to any collectivebargaining agreement or other similar agreement. We believe thatwe have a good relationship with our employees.
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**RISK FACTORS*****Our principal competitors devote greater financial    resources to developing, marketing and selling automated tape    libraries. Consequently, we may be unable to maintain or    increase our market share.***     We face significant competition in developing and sellingautomated tape libraries. Rapid and ongoing changes intechnology and product standards could quickly render ourproducts less competitive, or even obsolete. We havesignificantly fewer financial, technical, manufacturing,marketing and other resources than many of our competitors andthese limited resources may harm our business in many ways. Forexample, in the past several years our competitors have: •     acquired other tape library companies;  •     increased the geographic scope of their market;  •     offered a wider range of tape library products; and  •     developed and acquired proprietary software and disk based    products that operate in conjunction with their products and the    products of their competitors.     In the future, our competitors may leverage their greaterresources to: •     develop, manufacture and market products that are less expensive    or technologically superior to our products;  •     attend more trade shows and spend more on advertising and    marketing;  •     reach a wider array of potential customers through a broader    range of distribution channels;  •     respond more quickly to new or changing technologies, customer    requirements and standards; or  •     reduce prices in order to preserve or gain market share.     We believe competitive pressures are likely to continue. Wecannot guarantee that our resources will be sufficient toaddress this competition or that we will manage costs and adoptstrategies capable of effectively utilizing our resources. If weare unable to respond to competitive pressures successfully, ourprices and profit margins may fall and our market share maydecrease.***We have a limited number of executives. The loss of any    single executive or the failure to hire and integrate capable    new executives could harm our business.***     The success of our business is tied closely to the managerial,engineering and business acumen of our existing executives.William J. Gervais, our President, has been largely responsiblefor the development of most of our tape libraries, has overseenour operations and growth, and established and maintained ourstrategic relationships. We expect that he will continue theseefforts for the foreseeable future. Our future success will alsodepend on our ability to attract, retain and motivate keyexecutives and other key personnel, many of whom have beeninstrumental in developing new technologies and strategic plans.We may not be able to retain our existing personnel or attractadditional qualified personnel in the future. However, ourcurrent dependence on a limited number of executives and otherkey personnel, for whom replacements may be difficult to find,entails a risk that we may not be able to supervise and manageour ongoing operations.***Our suppliers could reduce shipments of tape drives and    tape media. If this occurs, we would be forced to curtail    production, our revenues could fall and our market share could    decline.***     Automated tape libraries and related products, such as tapedrives and tape media, represented approximately 75.1% of ourrevenues for fiscal 2005, approximately 81.4% of our revenuesfor fiscal 2004, and approximately 79.8% of our revenues forfiscal 2003. We depend on a limited number of third-partymanufacturers to supply us with the tape drives and tape mediathat we incorporate into our automated tape libraries. Some tapedrive manufacturers, including Sony Corporation and QuantumCorporation, compete
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with us by also manufacturing tape libraries. There can be noassurance that other tape drive manufacturers will not alsobegin to manufacture libraries.     Historically, some of these suppliers have been unable to meetdemand for their products and have allocated their limitedsupply among customers. If suppliers limit our supply of tapedrives or tape media, we may be forced to delay or cancelshipments of our tape libraries. The major supplier risks weface include the following: •     Sony Electronics, Inc. is our sole-source supplier of AIT and    Super AIT drives and media. In the past, Sony has allocated some    of their products and may allocate them again in the future. In    fiscal 2005 we derived approximately $12.0 million or 47.8%    of our revenues, in fiscal 2004 we derived approximately    $16.1 million, or 51.1%, of our revenues, and in fiscal    2003 we derived approximately $18.9 million, or 56.2% of    revenues from the sale of libraries, tape drives and tape media    based on Sony AIT and Super AIT technologies. If Sony reduces    its sales to us or raises its prices, we could lose revenues and    our margins could decline.  •     Quantum Corporation is our sole-source supplier of SuperDLT tape    drives and competes with us as a manufacturer of automated tape    libraries. In the past, Quantum has allocated quantities of tape    drives among its customers. It is possible that Quantum will    allocate again, and as a result, may be unable to meet our    future SuperDLT tape drive requirements.  •     The LTO standard was developed by an industry consortium    consisting of IBM, Hewlett Packard and Quantum/ Certance. LTO    competes with AIT and other half-inch tape drives and media. All    three drive suppliers also sell automated tape libraries that    utilize LTO tape drives and compete with our products.    Therefore, even if we receive adequate allocation, it may be at    a price that renders our products uncompetitive.     Our other suppliers have in the past been, and may in the futurebe, unable to meet our demand, including our needs for timelydelivery, adequate quantity and high quality. We do not havelong-term supply contracts with any of our significantsuppliers. The partial or complete loss of any of our supplierscould result in lost revenue, added costs and production delaysor could otherwise harm our business and customer relationships.***Our revenues could decline if we fail to execute our    distribution strategy successfully.***     We distribute and sell our automated tape libraries primarilythrough value added resellers and original equipmentmanufacturers, and intend to continue this strategy for theforeseeable future. Value added resellers integrate our tapelibraries with products of other manufacturers and sell thecombined products to their own customers. Original equipmentmanufacturers combine our tape libraries with their own productsand sell the combined product under their own brand. Wecurrently devote, and intend to continue to devote, significantresources to develop these relationships. A failure to initiate,manage and expand our relationships with value added resellersor original equipment manufacturers could limit our ability togrow or sustain our current level of revenues.     Our focus on the distribution of our products through valueadded resellers poses the following risks: •     we may reach fewer customers because we depend on value added    resellers to market to end users and these value added resellers    may fail to market effectively or fail to devote sufficient or    effective sales, marketing and technical support to the sales of    our products;  •     we may lose sales because many of our value added resellers sell    products that compete with our products. These value added    resellers may reduce their marketing efforts for our products in    favor of products manufactured by our competitors;  •     our costs may increase as value added resellers generally    require a higher level of customer support than do original    equipment manufacturers; and  •     as the market for tape libraries matures, we expect that tape    libraries designed for small and medium size businesses will not    require the level of sales, marketing and technical support    traditionally provided
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     by value added resellers and, consequently, tape libraries for    these customers will be increasingly sold through distribution    channels rather than through value added resellers.     We depend upon our original equipment manufacturercustomers’ ability to develop new products, applicationsand product enhancements that incorporate our products in atimely, cost-effective and customer-friendly manner. We cannotguarantee that our original equipment manufacturer customerswill meet these challenges effectively. Original equipmentmanufacturers typically conduct substantial and lengthyevaluation programs before certifying a new product forinclusion in their product line. We may be required to devotesignificant financial and human resources to these evaluationprograms with no assurance that our products will ever beselected. In addition, even if selected by the originalequipment manufacturer, there generally is no requirement thatthe original equipment manufacturer purchase any particularamount of product from us or that it refrain from purchasingcompeting products.     We do not have any exclusive agreements with our value addedresellers or original equipment manufacturers, who purchase ourproducts on an individual purchase order basis. If we loseimportant value added resellers or original equipmentmanufacturer customers, if they reduce their focus on ourproducts or if we are unable to obtain additional value addedreseller or original equipment manufacturer customers, ourbusiness could suffer.***We rely on tape technology for substantially all of our    revenues. Our business will be harmed if demand for storage    solutions using tape technology declines or fails to develop as    we expect.***     We derive substantially all of our revenues from products thatincorporate some form of tape technology. We expect to derivesubstantially all of our revenues from these products for theforeseeable future. As a result, we will continue to be subjectto the risk of a decrease in revenues if demand for theseproducts declines or if rising prices make it more difficult toobtain them. If products incorporating other technologies gaincomparable or superior market acceptance and competitive priceadvantage, our business, financial condition and operatingresults could be adversely and materially affected unless wesuccessfully develop and market products incorporating the newtechnology.***We depend upon the AIT and Super AIT tape formats supplied    by Sony Electronics Inc. for a significant portion of our    revenues. Should Sony abandon or fail to advance this tape    format, future revenues or operating results could    suffer.***     Sony Electronics Inc. is our sole supplier of AIT and Super AITtape drives and tape media. If Sony should discontinuemanufacturing these products or fail to advance the technologyto keep pace with the industry trend of increasing tapecapacity, our revenues or operating results could besignificantly impacted.***Our revenues and operating results may fluctuate    unexpectedly from quarter to quarter, which may cause our stock    price to decline.***     Our quarterly revenues and operating results have fluctuated inthe past, and are likely to vary significantly in the future dueto several factors, including: •     general economic conditions affecting spending for information    technology;  •     increased competition and pricing pressures;  •     reductions in the size, delays in the timing, or cancellation of    significant customer orders;  •     shifts in product or distribution channel mix;  •     the timing of the introduction or enhancement of products by us,    our original equipment manufacturer customers or our competitors;  •     expansions or reductions in our relationships with value added    reseller and original equipment manufacturer customers;
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 •     financial difficulties affecting our value added reseller or    original equipment manufacturer customers that render them    unable to pay amounts owed to us;  •     increased number and diversity of available data back-up and    archive storage alternatives resulting in delays to customer    decision-making cycles;  •     market acceptance of new and enhanced versions of our products;  •     new product developments by storage device manufacturers,    including cost and performance of disk drive products;  •     the rate of growth in the data storage market and the various    segments within it;  •     timing and levels of our operating expenses; and  •     availability of tape media and key components and performance of    key suppliers.     We believe that period to period comparisons of our operatingresults may not necessarily be reliable indicators of our futureperformance. It is likely that in some future period ouroperating results will not meet your expectations or those ofpublic market analysts.     Any unanticipated change in revenues or operating results islikely to cause our stock price to fluctuate since such changesreflect new information available to investors and analysts. Newinformation may cause investors and analysts to revalue ourstock and this, in the aggregate, may cause fluctuations in ourstock price.***Our lack of significant order backlog makes it difficult    to forecast future revenues and operating results.***     We normally ship products within a few days after orders arereceived. Consequently, we do not have significant order backlogand a large portion of our revenues in each quarter results fromorders placed during that quarter. Because backlog can be animportant indicator of future revenues, our lack of backlogmakes it more difficult to forecast our future revenues. Sinceour operating expenses are relatively fixed in the short term,unexpected fluctuations in revenues could negatively impact ourquarterly operating results.***If we fail to develop and introduce new products on a    timely and cost-effective basis, or if our products do not    contain the features required by the marketplace, we will    eventually lose market share and sales to more innovative    competitors.***     The market for our products is characterized by rapidly changingtechnology and evolving industry standards. The future successof Qualstar will depend on our ability to anticipate changes intechnology, to develop new and enhanced products on a timely andcost-effective basis, and to introduce, manufacture and achievemarket acceptance of these new and enhanced products. Inparticular, our success will depend on the market acceptance ofour soon to be introduced XLS family of automated tapelibraries, our “next generation of automated tapelibraries” designed for the enterprise marketplace. Our RLSand TLS families of tape libraries are facing increasingcompetition from products manufactured by our competitors andmay face competition from other types of storage devices thatmay be developed in the future.     Development schedules for high technology products areinherently subject to uncertainty and there can be no assurancewe will be able to meet our product development schedules orthat our development costs will be within budgeted amounts. Ifthe products or product enhancements developed are notdeliverable due to technical problems, quality issues orcomponent shortages, or if such products or product enhancementsare not accepted by the marketplace or are unreliable, then ourbusiness, financial condition and results of operations may bematerially adversely affected.     The introduction of new storage technologies or the adoption ofan industry standard different than our current productstandards could render our existing products obsolete.
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***Our increased research and development spending may not    yield results that justify the costs incurred.***     In recent fiscal years we have substantially increased ourresearch and development spending over that of prior periods.Our products and markets are technologically advanced andrapidly evolving, and we cannot be assured that these effortswill successfully provide us with new or upgraded products thatwill be competitive. If these programs are not successful, ourincreased investment in research and development will not yieldcorresponding benefits to us.***We depend upon independent software vendors to provide    management software that makes our tape libraries    functional.***     The utility of an automated tape library depends partly upon thestorage management software, which supports the library andintegrates it into the user’s computing environment toprovide a complete storage solution. We do not develop and haveno control over the development of this storage managementsoftware. Instead we rely on third party independent softwarevendors to develop and support this software. Accordingly, thecontinued development and future growth of the market for ourproducts will depend partly upon the success of software vendorsto meet the overall data storage and management needs of tapelibrary purchasers and our ability to maintain relationshipswith these firms. Although we do not have contracts with anythird party independent software vendors, we maintainrelationships with them by: •     supplying tape libraries so they can qualify their software to    work with our tape libraries;  •     evaluating their software for compatibility with our tape    libraries;  •     keeping them informed as to current and contemplated changes to    our products; and  •     referring business to them when value added resellers or end    users inquire about software sources.***Our customers have the right to return our products in    certain circumstances. An excessive number of returns may reduce    our revenues.***     Our customers have 30 days from the date of purchase toreturn products that do not conform to an end user’srequirements. We may otherwise allow product returns if we thinkthat doing so maximizes the effectiveness of our sales channelsand promotes our reputation for quality and service.     Although we estimate and reserve for potential returns in ourreported financial results, actual returns could exceed ourestimates. If the number of returns exceeds our estimates, ourfinancial results could be adversely impacted for the periodsduring which returns are made.***We may spend money pursuing sales that do not occur when    anticipated or at all.***     Original equipment manufacturer customers typically conductsignificant evaluation, testing, implementation and acceptanceprocedures before they begin to market and sell new models oftape libraries. This evaluation process is lengthy and may rangefrom six months to one year or more. This process is complex andmay require significant sales, marketing, engineering andmanagement resources on our part. The process becomes morecomplex as we simultaneously qualify our products with multiplecustomers or pursue large orders with a single customer. As aresult, we may expend resources to develop customerrelationships before we recognize any revenue from theserelationships, if at all.***We sell a significant portion of our products to customers    located outside the United States. Currency fluctuations and    increased costs associated with international sales could make    our products unaffordable in foreign markets, which would reduce    our revenue or profitability.***     Revenues from shipments to customers outside of North Americaaccounted for approximately 27.3% of revenues in fiscal 2005,approximately 32.4% of revenues in fiscal 2004, andapproximately 29.4% of revenues
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in fiscal 2003. We believe that international sales willcontinue to represent a significant portion of our revenues. Ourinternational sales subject us to a number of risks, including: •     political and economic instability may reduce demand for our    products or our ability to market our products in foreign    countries;  •     although we denominate our international sales in    U.S. dollars, currency fluctuations could make our products    unaffordable to foreign purchasers or more expensive compared to    those of foreign manufacturers;  •     restrictions on the export or import of technology may reduce or    eliminate our ability to sell in certain markets;  •     the need to comply with a wide variety of foreign laws and    regulations;  •     greater difficulty of administering business overseas may    increase the costs of foreign sales and support;  •     foreign governments may impose tariffs, quotas and taxes on our    products;  •     longer payment cycles typically associated with international    sales and potential difficulties in collecting accounts    receivable may reduce the profitability of foreign    sales; and  •     our current determination not to seek ISO-9000 certification, a    widely accepted method of establishing and certifying the    quality of a manufacturer’s operations, may reduce sales.     These risks may increase our costs of doing businessinternationally and reduce our revenues or profitability.***We may have to expend significant amounts of time and    money defending or settling product liability claims arising    from failures of our tape libraries.***     Because our tape library customers use our products to store andbackup their important data, we face potential liability if ourproducts fail to perform. Although we maintain general liabilityinsurance, our insurance may not cover potential claims of thistype or may not be adequate to indemnify us for all liabilitythat may be imposed. Any imposition of liability that is notcovered by insurance or that exceeds our insurance coveragecould reduce our profitability or cause us to discontinueoperations.***A failure to develop and maintain proprietary technology    may negatively affect our business.***     We rely on copyright protection of electronic circuits and ourfirmware, as well as patent protection for some of our designsand products. We also rely on a combination of trademark, tradesecret, and other intellectual property laws and variouscontract rights to protect our proprietary rights. However, wedo not believe our intellectual property rights providesignificant protection from competition. As a consequence, theserights may not preclude competitors from developing productsthat are substantially equivalent or superior to our products.In addition, many aspects of our products are not subject tointellectual property protection and therefore can be reproducedby our competitors.***Intellectual property infringement claims brought against    us could be time consuming and expensive to defend.***     In recent years, there has been an increasing amount oflitigation in the United States involving patents and otherintellectual property rights. Qualstar is not currently directlyinvolved in any intellectual property litigation or proceedings.However, in April 2004 we settled litigation that RaytheonCompany had filed alleging that Qualstar and eight other nameddefendants infringed on a patent owned by Raytheon Companyentitled “Mass Data Storage Library.” In the future,we may become subject to other claims or inquiries
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regarding our alleged unauthorized use of a third party’sintellectual property. An adverse outcome in litigation couldforce us to do one or more of the following: •     stop selling, incorporating or using our products or services    that use the challenged intellectual property;  •     subject us to significant liabilities to third parties;  •     obtain from the owners of the infringed intellectual property    right a license to sell or use the relevant technology, which    license may not be available on reasonable terms, or at    all; or  •     redesign those products or services that use the infringed    technology, which redesign may be either economically or    technologically infeasible.     Whether or not an intellectual property litigation claim isvalid, the cost of responding to it, in terms of legal fees andexpenses and the diversion of management resources, could harmour business.***Undetected software or hardware flaws could increase our    costs, reduce our revenues and divert resources from our core    business needs.***     Our tape libraries are complex. Despite our efforts to reviseand update our manufacturing and test processes to addressengineering and component changes, we may not be able to controland eliminate manufacturing flaws adequately. These flaws mayinclude undetected software or hardware defects associated with: •     a newly introduced product;  •     a new version of an existing product; or  •     a product that has been integrated into a network storage    solution with the products of other vendors.     The variety of contexts in which errors may arise may make itdifficult to identify the source of a problem. These problemsmay: •     cause us to incur significant warranty, repair and replacement    costs;  •     divert the attention of our engineering personnel from our    product development efforts;  •     cause significant customer relations problems; or  •     damage our reputation.     To address these risks, we frequently revise and updatemanufacturing and test procedures to address engineering andcomponent changes to our products. If we fail to adequatelymonitor, develop and implement appropriate test andmanufacturing processes we could experience a rate of productfailure that results in substantial shipment delays, repair orreplacement costs or damage to our reputation. Product flaws mayalso consume our limited engineering resources and interrupt ourdevelopment efforts. Significant product failures would increaseour costs and result in the loss of future sales and be harmfulto our business.***Our warranty reserves may not adequately cover our    warranty obligations.***     We have established reserves for the estimated liabilityassociated with our product warranties. However, we couldexperience unforeseen circumstances where these or futurereserves may not adequately cover our warranty obligations.***Our officers and directors could implement corporate    actions that are not in the best interests of our shareholders    as a whole.***     Our executive officers and directors own beneficially, in theaggregate, approximately 45% of our outstanding common stock asof June 30, 2005. As a result, these shareholders will beable to exercise significant control over all matters requiringshareholder approval, including the election of directors and
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approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us. Theinterests of our officers and directors, when acting in theircapacity as shareholders, may lead them to: •     vote for the election of directors who agree with the incumbent    officers’ or directors’ preferred corporate    policy; or  •     oppose or support significant corporate transactions when these    transactions further their interests as incumbent officers or    directors, even if these interests diverge from their interests    as shareholders per se and thus from the interests of other    shareholders.***Some provisions of our charter documents may make takeover    attempts difficult, which could depress the price of our stock    and inhibit your ability to receive a premium price for your    shares.***     Our board of directors has the authority, without any action bythe shareholders, to issue up to 5,000,000 shares ofpreferred stock and to fix the rights and preferences of suchshares. In addition, our articles of incorporation and bylawscontain provisions that eliminate cumulative voting in theelection of directors and require shareholders to give advancenotice if they wish to nominate directors or submit proposalsfor shareholder approval. These provisions may have the effectof delaying, deferring or preventing a change in control, maydiscourage bids for our common stock at a premium over itsmarket price and may adversely affect the market price, and thevoting and other rights of the holders of our common stock.***We do not currently intend to pay dividends and therefore    you will only be able to recover your investment in our common    stock, if at all, by selling the shares of the stock that you    own.***     We historically have pursued a policy of reinvesting ourearnings in research and development, expanding our value addedreseller and original equipment manufacturer relationships, andexpanding our manufacturing capabilities. Consequently, we havenever paid dividends on our shares of capital stock. Wecurrently intend to continue this policy for the foreseeablefuture to strengthen our financial and competitive position inthe tape library market.***Trading in our stock has been limited and our stock price    has been volatile. Consequently, it may be difficult to sell    your shares.***     There has been very little trading in shares of our stock andsome days it does not trade at all. This, as well as the factorslisted below, has caused the price of our stock to be veryvolatile. Consequently, it may be difficult to sell your sharesof our stock at the price you paid for them or at a price equalto that quoted in the Nasdaq National Market. Factors that maycause our stock price to fluctuate in the future include: •     quarterly variations in operating results, especially if they    differ from our previously announced forecasts or forecasts made    by analysts;  •     our announcements of anticipated future revenues or operating    results;  •     announcements concerning us, our competitors, our customers, or    our industry;  •     the introduction of new technology or products by us or our    competitors;  •     comments regarding us and the data storage market made by    industry analysts or on Internet bulletin boards;  •     changes in earnings estimates by analysts or changes in    accounting policies;  •     changes in product pricing policies by us or our    competitors; and  •     changes in general economic conditions.In addition, stock markets have experienced extreme price andvolume volatility in recent years. This volatility has had asubstantial effect on the market prices of securities of manysmaller public companies for reasons frequently unrelated ordisproportionate to the operating performance of the specificcompanies. These market fluctuations may adversely affect themarket price of our common stock.
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**EXECUTIVE OFFICERS OF THE REGISTRANT****Executive Officers**     Officers are elected by and serve at the discretion of the boardof directors. The executive officers of Qualstar as ofSeptember 26, 2005 are:       **Name** **Age** **Position**         William J. Gervais  62      Chief Executive Officer, President and Director    Richard A. Nelson  62      Vice President of Engineering, Secretary and Director    Frederic T. Boyer  61      Vice President and Chief Financial Officer    David L. Griffith  49      Vice President of Operations    Robert K. Covey  58      Vice President of Marketing    Robert C. King  61      Vice President of Sales**Background**     *William J. Gervais* is a founder of Qualstar and has beenour President and a director since our inception in 1984, andwas elected Chief Executive Officer in January 2000. From 1984until January 2000, Mr. Gervais also served as our ChiefFinancial Officer. From 1981 until 1984, Mr. Gervais wasPresident of Northridge Design Associates, Inc., an engineeringconsulting firm. Mr. Gervais was a co-founder, and servedas Engineering Manager from 1976 until 1981, of MicropolisCorporation. Mr. Gervais earned a B.S. degree in MechanicalEngineering from California State Polytechnic University, Pomonain 1967.     *Richard A. Nelson* is a founder of Qualstar and has beenour Vice President of Engineering, Secretary and a directorsince our inception in 1984. From 1974 to 1984, Mr. Nelsonwas self employed as an engineering consultant specializing inmicroprocessor technology. Mr. Nelson earned a B.S. inElectronic Engineering from California State PolytechnicUniversity, Pomona in 1966.     *Frederic T. Boyer* has been our Vice President and ChiefFinancial Officer since October, 2002. Prior to joining us,Mr. Boyer was Vice President and Chief Financial Officer ofAccelerated Networks from 1998 to 2001. From May 1997 to October1998, Mr. Boyer was the Senior Vice President, Finance andAdministration and Chief Financial Officer of Software Dynamics.From January 1996 to May 1997, Mr. Boyer was a consultantto several technology companies. From March 1990 to January1996, Mr. Boyer was Vice President and Chief FinancialOfficer of Fibermux Corporation, a networking company lateracquired by ADC Telecommunications. Mr. Boyer holds anM.B.A. from Loyola University, a B.S. in Accounting fromCalifornia State University, Los Angeles, and a B.S. inEconomics from California State Polytechnic University, Pomona.     *David L. Griffith*, currently our Vice President ofOperations, joined the company in October of 2001. From 1999 to2001, Mr. Griffith served as the President and ChiefExecutive Officer of Stardrive Solutions Inc., a softwaresolutions provider for the broadcast automation industry. From1998 to 1999, Mr. Griffith was the Corporate Vice Presidentof Business Development at Tandberg Data ASA where he wasresponsible for the development of worldwide business plans andcorporate expansion activities. From 1994 to 1998,Mr. Griffith was the President and Chief Executive Officerof Tandberg Data, Inc. located in Simi Valley, California. From1990 to 1994, Mr. Griffith was the Vice President of Salesand Marketing for Tandberg Data, Inc. From 1987 to 1990,Mr. Griffith acted as Marketing Manager and Program Managerfor the Memory Products Group of Siemens Information Systems.Mr. Griffith received a degree in Mechanical Engineeringfrom California State Polytechnic University in 1980.     *Robert K. Covey* has been our Vice President of Marketingsince 1994. From 1986 to 1993 Mr. Covey was regionalmanager of ATG Cygnet, an optical disk library firm. From 1982to 1985, Mr. Covey served as national sales manager atMicropolis Corporation, a former disk drive manufacturer.Mr. Covey attended Butler University and Bentley Collegefrom 1965 to 1968.     *Robert C. King* was appointed our Vice President of Salesin June 2005. From 1999 until it was acquired by JDS Uniphase in2004, Mr. King was Vice President, Sales for E2OCommunications, a manufacturer of optical transceivers. From1995 to 1998 Mr. King was Vice President, Sales andMarketing for Advanced
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Photonix. From 1992 to 1995, Mr. King served as VicePresident, Sales and Marketing for Performance MaterialsCorporation. From 1989 to 1992, Mr. King served as VicePresident, Market and Business Development for PCO, a subsidiaryof Corning Incorporated. Mr. King holds a B.S.M.E. degreefrom Ohio University in Athens, Ohio.**Item 2.*****Properties***     Our headquarters, located in Simi Valley, California, consistsof a single building containing approximately 57,000 square feethousing our manufacturing, sales and marketing, finance andadministration and approximately half of our engineering. Ourlease on this facility expires in February 2011, with an earlytermination option becoming available in February of 2007. Renton this facility is $39,000 per month, with step-upsranging from $2,400 to $2,800 per month every two years.     We also lease approximately 4,300 square feet of officespace in Boulder, Colorado, that houses our Advanced DevelopmentGroup. The lease of the Boulder, Colorado facility expires in2007. Additionally, we have a sales office in Surrey,United Kingdom.**Item 3.*****Legal Proceedings***     We are from time to time involved in various lawsuits and legalproceedings that arise in the ordinary course of business. Atthis time, we are not aware of any pending or threatenedlitigation against us that we expect will have a materialadverse effect on our business, financial condition, liquidityor operating results. Legal claims are inherently uncertain,however. We cannot assure you that we will not be adverselyaffected in the future by legal proceedings.**Item 4.*****Submission of Matters to a Vote of Shareholders***     No matters were submitted to a vote of security holders duringthe fourth quarter of the fiscal year ended June 30, 2005.**PART II****Item 5.*****Market for Registrant’s Common Equity, Related    Stockholder Matters and Issuer Purchases of Equity    Securities***     Qualstar’s common stock is quoted on the NASDAQ StockMarket’s National Market (NASDAQ Symbol — QBAK).The following table sets forth the high and low closing saleprices of our common stock as reported by NASDAQ, during theperiods indicated:              **Period** **Date Range** **High** **Low**           Fiscal 2005:                 First Quarter  July 1 — September, 30, 2004  $6.44  $5.00      Second Quarter  October 1 — December 31, 2004  $6.94  $4.33      Third Quarter  January 1 — March 31, 2005  $5.00  $4.00      Fourth Quarter  April 1 — June 30, 2005  $4.55  $3.53     Fiscal 2004:                 First Quarter  July 1 — September, 30, 2003  $6.23  $4.75      Second Quarter  October 1 — December 31, 2003  $5.40  $4.25      Third Quarter  January 1 — March 31, 2004  $6.10  $4.56      Fourth Quarter  April 1 — June 30, 2004  $6.88  $5.25      There were approximately 49 owners of record of Qualstar’scommon stock as of September 16, 2005.     Qualstar has declared no cash dividends during the periodsreported. Qualstar does not currently anticipate paying cashdividends in the foreseeable future, but intends to retain anyfuture earnings for reinvestment in its business. Any futuredetermination to pay cash dividends will be at the discretion ofour Board of Directors and will be dependent uponQualstar’s financial condition, results of operations,capital requirements, terms of any debt instruments then ineffect and such other factors as our Board of Directors may deemrelevant at the time.
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**Item 6.*****Selected Financial Data***     The following selected financial data is qualified in itsentirety by and should be read in conjunction with“Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and the financialstatements and notes thereto included elsewhere inthis 10-K. Our historical financial results are notnecessarily indicative of results to be expected for any futureperiod.                         **Years Ended June 30,**     **2005** **2004** **2003** **2002** **2001**             **(In thousands, expect per share amounts)****Statements of Income Data:**                        Net revenues $25,144  $31,530  $33,557  $37,631  $51,572     Cost of goods sold  16,529   19,575   21,171   23,753   33,216                     Gross profit  8,615   11,955   12,386   13,878   18,356                     Operating expenses:                         Research and development  3,750   4,268   3,994   2,136   1,279      Sales and marketing  3,350   3,607   3,834   3,048   3,399      General and administrative  3,955   5,420   4,428   5,222   3,301                       Total operating expenses  11,055   13,295   12,256   10,406   7,979                     Income (loss) from operations  (2,440)  (1,340)  130   3,472   10,377     Investment income  858   624   693   1,133   1,225     Impairment loss for other-than-temporary decline in investments  —   (160)  —   —   —     Impairment of investment  —   —   —   —   (1,050)                    Income (loss) before income taxes  (1,582)  (876)  823   4,605   10,552     Provision (benefit) for income taxes  65   (145)  274   1,845   3,824                     Net income (loss) $(1,647) $(731) $549  $2,760  $6,728                     Earnings (loss) per share:                         Basic $(0.13) $(0.06) $0.04  $0.22  $0.54                      Diluted $(0.13) $(0.06) $0.04  $0.22  $0.53                     Shares used to compute earnings (loss) per share:                         Basic  12,398   12,577   12,579   12,475   12,372                      Diluted  12,398   12,577   12,666   12,664   12,668                                        **June 30,**     **2005** **2004** **2003** **2002** **2001**             **(In thousands)****Balance Sheet Data:**                        Cash and cash equivalents $12,210  $6,401  $6,236  $4,859  $11,509     Marketable securities  21,854   29,376   29,857   25,987   15,578     Working capital  43,275   46,534   47,191   46,507   43,382     Total assets  47,223   51,647   52,096   50,758   47,878     Total debt  —   —   —   —   —     Shareholders’ equity  44,653   48,064   48,868   47,973   44,689 
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**Item 7.*****Management’s Discussion and Analysis of Financial    Condition and Results of Operations***     The following discussion and analysis should be read inconjunction with our financial statements and notes thereto.**Overview**     We design, develop, manufacture and sell automated magnetic tapelibraries used to store, retrieve and manage electronic dataprimarily in network computing environments. We offer tapelibraries for multiple tape drive technologies, including LTO,AIT, Super AIT, and SuperDLT tape drives and media.     Many enterprises now routinely manage very large databases, inaddition to storing information on local desktop computers.This, coupled with the growth in the amount of data from newsources and applications, is increasing the need for managingand storing data efficiently. Anticipating the increased demandfor tape libraries, we have developed tape libraries spanning abroad range of tape formats, prices, capacity and performance.We expect our products to continue to evolve in the future inresponse to emerging tape technologies and changing customerpreferences.     We have developed a network of value added resellers whospecialize in delivering complete storage solutions to endusers. End users of our products range from small businessesrequiring simple automated backup solutions to largeorganizations needing complex storage management solutions. Wealso sell our products to original equipment manufacturers whobundle our products with their own and sell them as part of acomplete system or solution. We assist our customers withmarketing, sales and technical support.     Our international sales efforts are currently directed from ourcorporate offices in Simi Valley, California. European sales arecoordinated through our European sales office in the UnitedKingdom. All of our international sales are denominated inU.S. dollars. Revenues from sales outside North Americawere approximately $6.9 million, or 27.3% of revenues infiscal 2005, approximately $10.2 million, or 32.4% ofrevenues in fiscal 2004, and approximately $9.9 million, or29.4% of revenues in fiscal 2003.     We also design, develop, manufacture and sell ultra smallhigh-efficiency open-frame switching power supplies for originalequipment manufacturers of telecommunications equipment,servers, routers, switches, RAIDs, and other equipment. Ourpower supplies are sold under the N2Power brand name throughindependent sales representatives and a private distributor. Theprimary customers are original equipment manufacturers andcontract manufacturers.     Net revenues include revenues from the sale of tape libraries,library tape drives, tape cartridges, and ancillary products.Ancillary revenues include service, repair, on-site serviceagreements net of the cost of any third party service contracts,and power supplies. Automated tape libraries and relatedproducts, such as tape drives and tape media, representedapproximately 75.1% of revenues in fiscal 2005, approximately81.4% of revenues in fiscal 2004, and approximately 79.8% ofrevenues in fiscal 2003. Sales of ancillary products andservices accounted for the balance of our revenues.     Gross margins depend on several factors, including the cost ofmanufacturing, product mix, customer demand and the level ofcompetition. Larger tape libraries provide higher gross marginsthan do smaller tape libraries primarily because the competitionis less intense in this market segment.     Research and development activities include the design anddevelopment of new products, as well as enhancements to existingproducts. Our engineering group is developing our nextgeneration of automated tape libraries, currently in transitionfrom the development phase to the pilot production phase, withmanufacturing lines planned for our Simi Valley facility. Weexpect research and development expenses to decrease slightly inabsolute dollars in the next fiscal year.     We expect general and administrative expenses to increase infiscal 2006 due to expensing stock options underSFAS 123(R). We expect sales and marketing expenses toincrease in fiscal 2006 due to additional expenses associatedwith bringing our next generation tape libraries to market.
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     We recorded deferred compensation of approximately$1.7 million in the third quarter of fiscal 2000,representing the difference between the exercise price of stockoptions and restricted stock granted to employees and directorsduring fiscal 2000 and the deemed fair value for accountingpurposes of our common stock on the grant dates. Amortization ofdeferred compensation, which was recorded as general andadministrative expense in the statement of operations, was $0 infiscal 2005, approximately $140,000 during fiscal 2004, andapproximately $301,000 in fiscal 2003. The deferred compensationrelated to these stock options and restricted stock was fullyamortized as of June 30, 2004.**Critical Accounting Policies and Estimates**     Our discussion and analysis of our financial condition andresults of operations is based upon our financial statements,which have been prepared in accordance with accountingprincipals generally accepted in the United States. Thepreparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses and relateddisclosure of contingent assets and liabilities. On an on-goingbasis, we evaluate our estimates, including those related tocustomer promotional offers, sales returns, bad debts,inventories, warranty costs, investments, and income taxes. Webase our estimates on historical experience and on various otherassumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions orconditions.     We believe the following critical accounting policies affect ourmore significant judgments and estimates used in the preparationof our consolidated financial statements.***Revenue Recognition***     Revenue is recognized upon shipment of product to our customers.Title and risk of loss transfer to the customer when the productleaves our dock in Simi Valley, California, or another shippinglocation designated by us. In general, these customers areallowed to return the product, free of penalty, within thirtydays of shipment, if the product does not meet the enduser’s requirements. Revenues from technical supportservices and other services are recognized at the time servicesare performed.     We record an allowance for estimated sales returns based on pastexperience and current knowledge of our customer base. Ourexperience has been such that only a very small percentage oflibraries are returned. Should our experience change, however,we may require additional allowances for sales returns.***Allowance for Doubtful Accounts***     We estimate our allowance for doubtful accounts based on anassessment of the collectibility of specific accounts and theoverall condition of accounts receivable. In evaluating theadequacy of the allowance for doubtful accounts, we analyzespecific trade receivables, historical bad debts, customercredits, customer credit-worthiness and changes incustomers’ payment terms and patterns. If the financialcondition of our customers were to deteriorate, resulting in animpairment of their ability to make additional payments, then wemay need to make additional allowances. Likewise, if wedetermine that we could realize more of our receivables in thefuture than previously estimated, we would adjust the allowanceto increase income in the period we made this determination.***Inventory Valuation***     We record inventories at the lower of cost or market value. Weassess the value of our inventories periodically based uponnumerous factors including expected product or material demand,current market conditions, technological obsolescence, currentcost and net realizable value. If necessary, we write down ourinventory for estimated obsolescence, potential shrinkage, orunmarketable inventory equal to the difference between the costof inventory and the estimated market value based uponassumptions about future demand and market conditions. Iftechnology changes more rapidly than expected, or marketconditions become less favorable than those projected bymanagement, additional inventory write-downs may be required.
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***Warranty Obligations***     We provide for the estimated cost of product warranties at thetime revenue is recognized. We engage in extensive productquality programs and processes, including active monitoring andevaluation of product failure rates, material usage andestimation of service delivery costs incurred in correcting aproduct failure. However, should actual product failure rates,material usage, or service delivery costs differ from ourestimates, revisions to the estimated warranty liability wouldbe required. Historically our warranty costs have not beensignificant.***Accounting for Income Taxes***     We estimate our tax liability based on current tax laws in thestatutory jurisdictions in which we operate. These estimatesinclude judgments about deferred tax assets and liabilitiesresulting from temporary differences between assets andliabilities recognized for financial reporting purposes and suchamounts recognized for tax purposes, as well as about therealization of deferred tax assets.     We maintain a valuation allowance to reduce our deferred taxassets due to the uncertainty surrounding the timing ofrealizing the benefits of net deferred tax assets in futureyears. We have considered future taxable income and ongoingprudent and feasible tax planning strategies in assessing theneed for such a valuation allowance. In the event we were todetermine that we would be able to realize all or part of ournet deferred tax asset in the future, the valuation allowancewould be decreased accordingly.     We may periodically undergo examinations by the federal andstate regulatory authorities and the Internal Revenue Service.We may be assessed additional taxes and or penalties contingenton the outcome of these examinations. Our previous examinationshave not resulted in any unfavorable or significant assessments.     The Company had fiscal 2002 under audit by the Internal RevenueService (“IRS”) for which the IRS issued a no changeopinion in the quarter ended March 31, 2005.**Results of Operations**     The following table reflects, as a percentage of net revenues,statements of operations data for the periods indicated:                **Years Ended June 30,**     **2005** **2004** **2003**           Net revenues  100.0%  100.0%  100.0%     Cost of goods sold  65.7   62.1   63.1                Gross margin  34.3   37.9   36.9     Operating expenses:                 Research and development  14.9   13.5   11.9      Sales and marketing  13.4   11.4   11.4      General and administrative  15.7   17.2   13.2               Income (loss) from operations  (9.7)  (4.2)  0.4     Investment income  3.4   2.0   2.0     Impairment loss for other-than-temporary decline in investments  —   (0.6)  —               Income (loss) before provision (benefit) for income taxes  (6.3)  (2.8)  2.4     Provision (benefit) for income taxes  0.3   (0.5)  0.8               Net income (loss)  (6.6)%  (2.3)%  1.6%          
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     Revenues are recognized upon shipment of the product to thecustomer, less estimated returns, for which provision is made atthe time of sale. The following table summarizes our revenue bymajor product line:                **Years Ended June 30,**     **2005** **2004** **2003**           Tape Library revenues:                 TLS  51.7%  56.4%  67.7%     RLS  13.1   15.5   4.0              64.8   71.9   71.7               Other revenues:                 Service  10.5   7.6   6.2      Media  10.3   9.5   8.1      Power Supplies  5.1   1.8   0.6      Upgrades, Spares, 9 Track  9.3   9.2   13.4              100.0%  100.0%  100.0%          **Fiscal 2005 Compared to Fiscal 2004**     *Net Revenues.* Revenues are recognized upon shipment ofthe product to the customer, less estimated returns, for whichprovision is made at the time of the sale. Revenues for the yearended June 30, 2005 were $25.1 million, a decrease of20.3% compared to net revenues of $31.5 million for theyear ended June 30, 2004.     The decrease in revenues was due primarily to a decline in thedemand for our tape libraries using 8mm AIT tape technology andto a lesser extent, half inch tape technology. Revenues fromlibraries incorporating AIT tape technology were lower due tocustomer preferences shifting to the higher capacity half inchtechnology tape drives, caused, in part, by the delayedavailability of AIT4 tape drives. Moreover, when AIT4 tapedrives did become available, they were not backward read-writecompatible with earlier generations of AIT tape drives. Both ofthese factors negatively impacted our upgrade business in ourlarge AIT customer base. Revenues incorporating half inchtechnology exceeded revenues incorporating 8mm technology inabsolute dollars in fiscal 2005. In fiscal 2004, by comparison,revenues were divided about evenly between 8mm and half inchtape technologies in absolute dollars. However, revenues fromlibraries incorporating half inch technology decreased fromfiscal 2004 as the second and third quarters of fiscal 2004benefited from a large non-recurring library order ofapproximately $2.5 million.     Revenues from tape libraries and drives decreased to$16.3 million, or 64.8% of revenues, in the year endedJune 30, 2005 from $22.7 million, or 71.9% ofrevenues, in the year ended June 30, 2004. Although sellingprices of our libraries dropped during fiscal 2005, averageselling prices of libraries increased during fiscal 2005 due toa change in product mix.     *Gross Profit.* Gross profit was $8.6 million, or34.3% of revenues, for the year ended June 30, 2005,compared to $12.0 million, or 37.9% of revenues, for fiscal2004. Cost of goods sold consists primarily of direct labor,purchased parts, depreciation of plant and equipment, rent,utilities, and packaging costs. The decrease in gross margin asa percentage of revenues was attributed to lower manufacturingoverhead absorption due to lower revenues as well as to lowerselling prices due to greater competitive pricing pressures.     *Research and Development.* Research and developmentexpenses consist of engineering salaries, benefits, outsideconsultant fees, purchased parts, and supplies used indevelopment activities. Research and development expenses forthe year ended June 30, 2005 decreased to $3.8 millionor 14.9% of revenues as compared to $4.3 million or 13.5%of revenues for the year ended June 30, 2004. This decreasein absolute dollars was due primarily to lower prototypematerial costs and salaries, partly offset by higher consultingcosts, as the next generation of tape libraries transitions fromthe development phase to the pilot production phase.
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     *Sales and Marketing.* Sales and marketing expenses consistprimarily of employee salaries, benefits, sales commissions,trade show costs, advertising and travel related expenses. Salesand marketing expenses decreased to $3.4 million, or 13.3%of revenues for the year ended June 30, 2005, as comparedto $3.6 million, or 11.4% of revenues, for the year endedJune 30, 2004. The decrease in absolute dollars can beattributed primarily to a reduction in advertising and outsidecommission expenses.     *General and Administrative.* General and administrativeexpenses include employee salaries and benefits, deferredcompensation related to stock options and restricted stock,provision for doubtful accounts, and professional service fees.General and administrative expenses decreased to$4.0 million, or 15.7% of revenues for the year endedJune 30, 2005 as compared to $5.4 million, or 17.2% ofrevenues for the year ended June 30, 2004. The decrease ingeneral and administrative expenses was due to lower legalexpenses attributed to the settlement of the Raytheon lawsuit inApril 2004, lower bad debt expense and the absence of deferredstock compensation.     *Investment Income and Impairment Loss forOther-than-Temporary Decline in Investments.* Investmentincome increased to $858,000 for the year ended June 30,2005 as compared to net investment income of $464,000 in fiscal2004. The increase is attributed to lowering the averageduration of our portfolio to capture the higher short-termyields available in the current higher interest rateenvironment. In addition, an impairment loss forother-than-temporary decline in investments of $160,000 wasrecognized in fiscal 2004 earnings due to the adoption ofEmerging Issues Task Force No. 03-1.     *Provision for Income Taxes.* The provision for incometaxes was $65,000, or –4.1% of pre-tax loss, for fiscal2005 compared to a benefit of $145,000, or 16.6% of pre-taxloss, for fiscal 2004. The provision for income taxes in fiscal2005 can be primarily attributed to establishing full valuationallowances against net deferred tax assets based on ourassessment regarding the realizability of these benefits infuture years offset by the recognition of research anddevelopment credits to be received. In fiscal 2004, the loweffective tax benefit rate was primarily attributed toestablishing valuation allowances for capital losses realized ona tax basis in fiscal 2004 and net operating loss carryforwards.**Fiscal 2004 Compared to Fiscal 2003**     *Net Revenues.* Revenues for the year ended June 30,2004 were $31.5 million, a decrease of 6.0% compared to netrevenues of $33.6 million for the year ended June 30,2003.     The decrease in revenues was due primarily to a decline in thedemand for our tape libraries using 8mm AIT tape technology.This decrease was substantially offset by an increase inrevenues from our libraries using half inch technology, such asLTO-2 and Super AIT. The most recent AIT tape technology hasonly half the native storage capacity of the most recent LTO-2and other half inch tape technologies. We have been successfulat incorporating half inch tape drives into our TLS libraries aswell as the newer rack-mountable RLS libraries and shiftingcustomer preferences to the half inch tape format. This resultedin revenues being divided about evenly between 8mm and half inchtape technologies in absolute dollars in fiscal 2004. In fiscal2003, by comparison, revenues attributed to AIT tape technologyin absolute dollars exceeded half inch technology by 44%.     Revenues from tape libraries and drives decreased to$22.7 million, or 71.9% of revenues, in the year endedJune 30, 2004 from $24.1 million, or 71.7% ofrevenues, in the year ended June 30, 2003. Selling pricesof our libraries remained relatively stable during fiscal 2004.Average selling prices of library tape drives increased duringfiscal 2004 due to a change in product mix.     *Gross Profit.* Gross profit was $12.0 million, or37.9% of revenues, for the year ended June 30, 2004,compared to $12.4 million, or 36.9% of revenues, for fiscal2003. The increase in gross margin as a percentage of revenueswas attributed to efficiencies achieved in material management;a more favorable product mix caused by the discontinuation ofseveral lower margin libraries; and sales of media with higherthan normal margins.     *Research and Development.* Research and developmentexpenses for the year ended June 30, 2004 increased 6.9% to$4.3 million or 13.5% of revenues as compared to$4.0 million or 11.9% of revenues for the
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year ended June 30, 2003. This increase was due primarilyto costs incurred in the continuing operating activities of ourAdvanced Development Group in Boulder, Colorado, established inlate fiscal 2002 to design and develop our next generation oftape libraries.     *Sales and Marketing.* Sales and marketing expensesdecreased by 5.9% to $3.6 million, or 11.4% of revenues forthe year ended June 30, 2004, as compared to$3.8 million, or 11.4% of revenues, for the year endedJune 30, 2003. Although the percent decrease is consistentwith the decrease in revenues, in absolute dollars, the decreasecan be attributed to a reduction in advertising costs due to ashift to the lower cost electronic advertising versus printadvertising and lower co-operative advertising as well as areduction in travel related expenditures.     *General and Administrative.* General and administrativeexpenses increased to $5.4 million for fiscal 2004 ascompared to $4.4 million for fiscal 2003. As a percentageof revenues, general and administrative expenses increased to17.2% for the year ended June 30, 2004 as compared to 13.2%for the year ended June 30, 2003. The increase in generaland administrative expenses was due primarily to legal fees andsettlement costs associated with our defense of the Raytheonlawsuit.     *Investment Income and Impairment Loss forOther-than-Temporary Decline in Investments.* Investmentincome, net of an impairment loss for other-than-temporarydecline in investments of $160,000, decreased to $464,000 in theyear ended June 30, 2004 as compared to $693,000 in theyear ended June 30, 2003. This decrease was due primarilyto the adoption of Emerging Issues Task Force No. 03-1,which resulted in recognizing an impairment loss forother-than-temporary decline in investments of $160,000 inearnings. In addition, the economy continues to experience lowinterest rates, which has had a negative impact on ourportfolio’s overall performance.     *Provision for Income Taxes.* The benefit for income taxeswas $145,000, or 16.6% of pre-tax loss, for fiscal 2004 comparedto a provision of $274,000, or 33.3% of pre-tax income, forfiscal 2003. The low effective tax benefit rate in fiscal 2004can be primarily attributed to valuation allowances establishedfor capital losses realized on a tax basis in fiscal 2004 andnet operating loss carryforwards based on our assessmentregarding the realizability of these benefits in future years.**Liquidity and Capital Resources**     Historically, we have funded our capital requirements with cashprovided by operations. Cash provided by operating activitieswas $.2 million in fiscal 2005, $.3 million in fiscal2004, and $6.0 million in fiscal 2003. In fiscal 2005,operating cash was primarily provided by refunds of fiscal 2002federal and state income taxes paid and a decrease in accountsreceivable, offset partially by decreases in accounts payableand other accrued liabilities. In fiscal 2004, operating cashwas primarily provided by a refund of fiscal 2003 income taxespaid and increases in accounts payable and other accruedliabilities, offset partially by increases in accountsreceivable and inventories. In fiscal 2003, operating cash wasprimarily provided by reductions in accounts receivable andinventory.     Cash provided by investing activities was $7.3 million infiscal 2005, and cash used in investing activities was $15,000in fiscal 2004, and $4.7 million in fiscal 2003. Cashprovided by investing activities in fiscal 2005 relatedprimarily to sales of marketable securities partially offset bypurchases of equipment. Cash used in investing activities forfiscal 2004 and 2003 related primarily to purchases ofmarketable securities as well as equipment and leaseholdimprovements.     Cash used in financing activities was $1.7 million infiscal 2005, $.1 million in fiscal 2004 and cash providedby financing activities was $.05 million in fiscal 2003.Cash used in financing activities for fiscal 2005 and 2004,related primarily to repurchasing shares of the Company’scommon stock. Cash provided by financing activities in fiscal2003 related primarily to principal and interest payments ondirectors’ notes and proceeds from the exercise of stockoptions, partially offset by the repurchase of theCompany’s common stock.     As of June 30, 2005, we had $12.2 million in cash andcash equivalents and $21.9 million in marketablesecurities. We believe that our existing cash and cashequivalents and funds available from the sale of our
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marketable securities, will be sufficient to fund our workingcapital and capital expenditure needs for at least the next12 months. We may utilize cash to invest in businesses,products or technologies that we believe are strategic. Weregularly evaluate other companies and technologies for possibleinvestment by us. In addition, we have made and may in thefuture make investments in companies with whom we haveidentified potential synergies. However, we have no presentcommitments or agreements with respect to any materialacquisition of other businesses or technologies.**Summary of Contractual Obligations and Commitments**     The following is a summary of our future payments due undercontractual obligations as of June 30, 2005:               **Operating** **Purchase**  **Year Ended June 30** **Leases** **Obligations** **Total**         **(in thousands)**    2006 $581  $2,035  $2,616     2007  592   —   592     2008  554   —   554     2009  570   —   570     Thereafter  895   —   895             $3,192  $2,035  $5,227                Purchase obligations in the table above represent the value ofopen purchase orders as of June 30, 2005. We believe thatsome of these obligations could be canceled for payment of anominal penalty or no penalty; however, the amount of openpurchase orders that could be canceled under such terms isdifficult to quantify.**Off-Balance Sheet Arrangements**     We do not have any off-balance sheet arrangements.**Item 7A.*****Qualitative and Quantitative Disclosures About Market    Risk***     We develop products in the United States and sell themworldwide. As a result, our financial results could be affectedby factors such as changes in foreign currency exchange rates orweak economic conditions in foreign markets. As all sales arecurrently made in U.S. dollars, a strengthening of thedollar could make our products less competitive in foreignmarkets. Our interest income is sensitive to changes in thegeneral level of U.S. interest rates, particularly sincethe majority of our investments are in shorter durationsecurities. We have no outstanding debt nor do we utilizederivative financial instruments. Therefore, no quantitativetabular disclosures are required.**Item 8.*****Financial Statements and Supplementary Data***        **Page**       (1) Consolidated Financial Statements         Report of Independent Registered Public Accounting Firm  30      Consolidated Balance Sheets  31      Consolidated Statements of Operations  32      Consolidated Statements of Shareholders’ Equity  33      Consolidated Statements of Cash Flows  34      Notes to Consolidated Financial Statements  35      (2) Supplemental Schedule:         Schedule II — Valuation and Qualifying Accounts;    Allowance for Doubtful Accounts  47 
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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**The Board of Directors and Shareholders ofQualstar Corporation     We have audited the accompanying consolidated balance sheets ofQualstar Corporation as of June 30, 2005 and 2004, and therelated consolidated statements of operations,shareholders’ equity, and cash flows for each of the threeyears in the period ended June 30, 2005. Our audits alsoincluded the financial statement schedule listed in the Index atItem 15(a). These financial statements and schedule are theresponsibility of the Company’s management. Ourresponsibility is to express an opinion on these financialstatements and schedule based on our audits.     We conducted our audits in accordance with the standards of thePublic Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements arefree of material misstatement. We were not engaged to perform anaudit of the Company’s internal control over financialreporting. Our audit included consideration of internal controlover financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness ofthe Company’s internal control over financial reporting.Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing theaccounting principles used and significant estimates made bymanagement, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonablebasis for our opinion.     In our opinion, the financial statements referred to abovepresent fairly, in all material respects, the consolidatedfinancial position of Qualstar Corporation at June 30, 2005and 2004, and the consolidated results of its operations and itscash flows for each of the three years in the period endedJune 30, 2005, in conformity with U.S. generallyaccepted accounting principles. Also, in our opinion, therelated financial statement schedules, when considered inrelation to the basic financial statements taken as a whole,present fairly in all material respects the information setforth therein.     /s/ ERNST & YOUNG LLPWoodland Hills, CaliforniaAugust 10, 2005
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**QUALSTAR CORPORATION****CONSOLIDATED BALANCE SHEETS****(In thousands)**             **June 30,**     **2005** **2004**     **ASSETS**    Current assets:             Cash and cash equivalents $12,210  $6,401      Marketable securities  21,854   29,376      Accounts receivable, net of allowances of $248 at June 30,    2005 and $217 at June 30, 2004  3,532   4,628      Inventories  7,157   7,418      Prepaid expenses and other current assets  452   470      Prepaid income taxes  640   1,072      Deferred income taxes  —   594              Total current assets  45,845   49,959            Property and equipment, net  1,188   1,439     Other assets  190   249              Total assets $47,223  $51,647         **LIABILITIES AND SHAREHOLDERS’ EQUITY**    Current liabilities:             Accounts payable $763  $1,171      Accrued payroll and related liabilities  496   500      Other accrued liabilities  1,311   1,754              Total current liabilities  2,570   3,425            Deferred income taxes  —   158     Shareholders’ equity:             Preferred stock, no par value; 5,000 shares authorized; no    shares issued  —   —      Common stock, no par value; 50,000 shares authorized,    12,253 and 12,596 shares issued and outstanding as of    June 30, 2005 and June 30, 2004, respectively  18,370   20,121      Notes from directors  —   (45)     Accumulated other comprehensive income (loss)  (159)  (101)     Retained earnings  26,442   28,089              Total shareholders’ equity  44,653   48,064              Total liabilities and shareholders’ equity $47,223  $51,647        See accompanying notes
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**QUALSTAR CORPORATION****CONSOLIDATED STATEMENTS OF OPERATIONS****(In thousands, except per share amounts)**                 **Years Ended June 30,**     **2005** **2004** **2003**           Net revenues $25,144  $31,530  $33,557     Cost of goods sold  16,529   19,575   21,171               Gross profit  8,615   11,955   12,386               Operating expenses:                 Research and development  3,750   4,268   3,994      Sales and marketing  3,350   3,607   3,834      General and administrative  3,955   5,420   4,428                 Total operating expenses  11,055   13,295   12,256               Income (loss) from operations  (2,440)  (1,340)  130     Investment income  858   624   693     Impairment loss for other-than-temporary decline in investments  —   (160)  —               Income (loss) before income taxes  (1,582)  (876)  823     Provision (benefit) for income taxes  65   (145)  274               Net income (loss) $(1,647) $(731) $549               Earnings (loss) per share:                 Basic $(0.13) $(0.06) $0.04                Diluted $(0.13) $(0.06) $0.04               Shares used to compute earnings (loss) per share:                 Basic  12,398   12,577   12,579                Diluted  12,398   12,577   12,666           See accompanying notes
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**QUALSTAR CORPORATION****CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY****(In thousands)**                                         **Accumulated**            **Other**      **Common Stock**   **Notes** **Comprehensive**        **Deferred** **from** **Income** **Retained**    **Shares** **Amount** **Compensation** **Directors** **(Loss)** **Earnings** **Total**                   Balances at July 1, 2002  12,656   20,751   (631)  (387)  (31)  28,271   47,973                           Exercise of stock options  60   149   —   —   —   —   149     Forfeiture of unvested stock options  —   (190)  190   —   —   —   —     Retirement of shares pursuant to stock repurchase  (76)  (344)  —   —   —   —   (344)    Amortization of deferred compensation  —   —   301   —   —   —   301     Accrued interest on directors’ notes  —   —   —   (17)  —   —   (17)    Principal payments on directors’ notes  —   —   —   248   —   —   248     Comprehensive income:                                 Net income  —   —   —   —   —   549   549      Change in unrealized gains (losses) on investments  —   —   —   —   9   —   9                             Comprehensive income                          558                           Balances at June 30, 2003  12,640  $20,366  $(140) $(156) $(22) $28,820  $48,868                           Exercise of stock options  19   69   —   —   —   —   69     Retirement of shares pursuant to stock repurchase  (63)  (314)  —   —   —   —   (314)    Amortization of deferred compensation  —   —   140   —   —   —   140     Accrued interest on directors’ notes  —   —   —   (6)  —   —   (6)    Principal and interest payments on directors’ notes  —   —   —   117   —   —   117     Comprehensive loss:                                 Net loss  —   —   —   —   —   (731)  (731)     Change in unrealized gains (losses) on investments  —   —   —   —   (239)  —   (239)     Impairment loss for other-than-temporary decline in investments  —   —   —   —   160   —   160                             Comprehensive loss                          (810)                          Balances at June 30, 2004  12,596  $20,121  $—  $(45) $(101) $28,089  $48,064                           Exercise of stock options  16   76   —   —   —   —   76     Retirement of shares pursuant to stock repurchase  (359)  (1,827)  —   —   —   —   (1,827)    Principal and interest payments on directors’ notes  —   —   —   45   —   —   45     Comprehensive loss:                                 Net loss  —   —   —   —   —   (1,647)  (1,647)     Change in unrealized gains (losses) on investments  —   —   —   —   (58)  —   (58)                            Comprehensive loss                          (1,705)                          Balances at June 30, 2005  12,253  $18,370  $—  $ —  $(159) $26,442  $44,653                       See accompanying notes
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**QUALSTAR CORPORATION****CONSOLIDATED STATEMENTS OF CASH FLOWS****(In thousands)**                  **Years Ended June 30,**     **2005** **2004** **2003**           OPERATING ACTIVITIES:                 Net income (loss) $(1,647) $(731) $549      Adjustments to reconcile net income (loss) to net cash provided    by operating activities:                  Depreciation and amortization  463   423   380       Deferred income taxes  436   312   657       Provision for (recovery of) bad debts and returns  38   186   (53)      Amortization of deferred compensation  —   140   301       Impairment loss for other-than-temporary decline in investments  —   160   —       Accrued interest on directors’ notes  —   (6)  (17)      Gain on sale of securities  (11)  —   —       Changes in operating assets and liabilities:                   Accounts receivable  1,058   (279)  2,213        Inventories  261   (327)  2,609        Prepaid expenses and other assets  29   (222)  236        Prepaid income taxes and income taxes payable  432   264   (1,167)       Accounts payable  (408)  35   (454)       Accrued payroll and related liabilities  (4)  68   124        Other accrued liabilities  (443)  285   657               Net cash provided by operating activities  204   308   6,035     INVESTING ACTIVITIES:                 Purchases of equipment and leasehold improvements  (164)  (257)  (561)     Purchases of marketable securities  (22,277)  (41,123)  (34,375)     Proceeds from the sale of marketable securities  29,752   41,365   30,513      Purchase of assets of N2Power, Incorporated  —   —   (288)              Net cash provided by (used in) investing activities  7,311   (15)  (4,711)    FINANCING ACTIVITIES:                 Principal and interest payments on directors’ notes  45   117   248      Proceeds from exercise of stock options  76   69   149      Repurchase of common stock  (1,827)  (314)  (344)              Net cash provided by (used in) financing activities  (1,706)  (128)  53     NET INCREASE IN CASH AND CASH EQUIVALENTS  5,809   165   1,377     CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD  6,401   6,236   4,859               CASH AND CASH EQUIVALENTS, END OF PERIOD $12,210  $6,401  $6,236               SUPPLEMENTAL CASH FLOW DISCLOSURES:                 Income taxes paid $5  $12  $904           See accompanying notes
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS****1.****Summary of Significant Accounting Policies*****Business***     Qualstar Corporation (“Qualstar”) was incorporated inCalifornia in 1984 to develop and manufacture IBM compatible9-track reel-to-reel tape drives for the personal computer andworkstation marketplaces. Since 1995, Qualstar has focused itsefforts on designing, developing, manufacturing and sellingautomated magnetic tape libraries used to store, retrieve andmanage electronic data primarily in the network computingenvironment. Tape libraries consist of cartridge tape drives,tape cartridges and robotics to move the tape cartridges fromtheir storage locations to the tape drives under softwarecontrol. Qualstar’s libraries provide storage solutions fororganizations requiring backup, recovery, and archival storageof critical electronic information. Qualstar’s tapelibraries are compatible with commonly used operating systems,including UNIX, Windows and Linux and a wide range of storagemanagement software. Qualstar offers tape libraries for multipletape drive technologies, including those using LTO, AIT, SuperAIT, and SuperDLT.     In July 2002, Qualstar purchased the assets of N2Power,Incorporated, a supplier of ultra small high efficiency openframe switching power supplies. Power supplies are sold with theN2Power brand name as well as under a private label brand nameto original equipment manufacturers. In addition, they areutilized in Qualstar’s tape library products.***Principles in Consolidation***     The consolidated financial statements include the accounts andoperations of Qualstar and its wholly owned subsidiary. Allsignificant intercompany accounts have been eliminated.***Cash and Cash Equivalents***     Qualstar classifies as cash equivalents only cash and thoseinvestments that are short term, highly liquid, readilyconvertible to cash, and so near their maturity that theypresent an insignificant risk of change in value due to changesin interest rates.***Concentration of Credit Risk, Other Risks and Significant    Customers***     Qualstar sells its products primarily through a variety ofmarket channels including original equipment manufacturers(OEM) and value added resellers (VAR) locatedworldwide. Ongoing credit evaluations of customers’financial condition are performed by Qualstar, and generally,collateral is not required. Potential uncollectible accountshave been provided for in the financial statements.     Sales outside of North America represented approximately 27.3%of net revenues in fiscal 2005, approximately 32.4% of netrevenues in fiscal 2004 and approximately 29.4% of net revenuesin fiscal 2003. Revenues from Qualstar’s two largestcustomers combined were approximately 13.9%, 14.6%, and 15.4%for the years ended June 30, 2005, 2004, and 2003,respectively. At June 30, 2005, 2004 and 2003, the twolargest customer’s accounts receivable, net of specificallowances, totaled approximately 18.7%, 22.4% and 30.1% of netaccounts receivable, respectively.***Marketable Securities***     Marketable securities consist primarily of high-qualityU.S. corporate securities and U.S. federal governmentand state government debt securities. These securities areclassified in one of three categories: trading,available-for-sale, or held-to-maturity. Trading securities arebought and held principally for the purpose of selling them inthe near term. Held-to-maturity securities are those securitieswhich Qualstar has the ability and intent to hold untilmaturity. All other securities not included in trading orheld-to-maturity are
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**classified as available-for-sale. All of Qualstar’smarketable securities were classified as available-for-sale atJune 30, 2005 and 2004.     Available-for-sale securities are recorded at market value.Unrealized holding gains and losses, net of the related incometax effect, on available-for-sale securities are excluded fromearnings and are reported as a separate component ofshareholders’ equity until realized. Dividend and interestincome are recognized when earned.     Realized gains and losses for securities classified asavailable-for-sale are included in earnings when the underlyingsecurities are sold and are derived using the specificidentification method for determining the cost of securitiessold.     On March 31, 2004, the Emerging Issues Task Force(EITF) reached a consensus on Issue No. 03-1,“The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments”, (EIFT 03-1)effective for annual financial statements with fiscal yearsending after June 15, 2004. EITF 03-1 providesguidance for determining when an investment isother-than-temporarily impaired, and states that an investmentis considered other-than-temporarily impaired when its fairvalue is less than its amortized cost basis and is deemed otherthan temporary. The application of EITF 03-1 to theCompany’s marketable securities portfolio resulted in theidentification of an other-than-temporarily impaired investmentas of June 30, 2004. In accordance with EITF 03-1, theCompany recognized an impairment loss for other-than-temporarydecline in investments of $160,000 in earnings equal to thedifference between the amortized cost basis and its fair valueas of June 30, 2004.***Inventories***     Inventories are stated at the lower of cost (first-in, first-outbasis) or market.***Suppliers***     Sales and costs of goods sold related to products purchased fromone supplier totaled approximately 47.8% and 41.0%,respectively, of total sales and cost of goods sold for the yearended June 30, 2005. Sales and costs of goods sold relatedto products purchased from one large supplier totaledapproximately 51.1% and 41.3%, respectively, of total sales andcost of goods sold for the year ended June 30, 2004. Salesand costs of goods sold related to products purchased from onesupplier totaled approximately 56.2% and 57.3%, respectively, oftotal sales and cost of goods sold for the year endedJune 30, 2003.***Property and Equipment***     Property and equipment is depreciated using the straight-linemethod over the estimated useful lives (3 to 7 years) ofthe individual assets. Leasehold improvements are amortized overthe estimated useful lives, or the term of the related leases,whichever is shorter, using the straight-line method.***Long-Lived Assets***     Qualstar reviews for the impairment of long-lived assetswhenever events or changes in circumstances indicate thecarrying amount of any asset may not be recoverable. Animpairment loss would be recognized when the estimatedundiscounted future cash flows expected to result from the useof the asset and its eventual disposition is less than thecarrying amount. If an impairment is indicated, the amount ofthe loss to be recorded is based upon an estimate of thedifference between the carrying amount and the fair value of theasset. Fair value is based upon discounted cash flows expectedto result from the use of the asset and its eventual dispositionand other valuation methods. There were no impairment losses oflong-lived assets recognized during the periods presented.
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)*****Revenue Recognition***     Revenues are recognized upon shipment of the product to thecustomer and when collectibility is reasonably assured, lessestimated returns for which provisions are made at the time ofsale. The provision for estimated returns is made based on knownclaims and estimates of additional returns based on historicaldata. Revenues from technical support services and otherservices are recognized at the time the services are performed.***Shipping and Handling Costs***     Qualstar generally records all charges for outbound shipping andhandling as revenue. All inbound shipping and fulfillment costsare classified as costs of goods sold.***Warranty Obligations***     Qualstar provides a three year warranty period on its tapelibraries. Some TLS and all RLS models have three year advancereplacement warranty coverage that provides for replacement ofcomponents, or if necessary, complete libraries. All other TLSmodels have a one year advance replacement warranty with thesecond and third year being return-to-factory for service at nocharge. Customers may purchase extended advance replacementservice coverage and on-site service if they are located in theUnited States, Canada and most countries within Europe. Aprovision for costs related to warranty expense is recorded whenrevenue is recognized, which is estimated based on historicalwarranty costs incurred.     In November 2002, the Financial Accounting Standards Board(FASB) issued Interpretation No. 45 (FIN 45),“Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of theIndebtedness of Others,” which clarifies the requirementsof Statement of Financial Accounting Standards(SFAS) No. 5, “Accounting forContingencies,” relating to a guarantor’s accountingfor and disclosures for certain guarantees. FIN 45 requiresenhanced disclosures, among other things, for certainguarantees, including warranty accruals. Qualstar does not issuethird party guarantees, as defined, and therefore only thedisclosure provisions of FIN 45 apply. Qualstar adoptedFIN 45 for the year ended June 30, 2003, and theadoption has had no impact on Qualstar’s financial positionor results of operations. Additional disclosures have not beenprovided as the Company’s warranty accrual and warrantyexpense is not material in any of the periods presented.***Research and Development***     All research and development costs are charged to expense asincurred. These costs consist primarily of engineering salaries,benefits, outside consultant fees, and purchased parts andsupplies of personnel directly involved in the design anddevelopment of new products.***Advertising***     Qualstar expenses all costs of advertising and promotion asincurred. Advertising and promotion expenses for the years endedJune 30, 2005, 2004 and 2003 were approximately $520,000,$601,000, and $984,000, respectively.***Accounting for Stock Based Compensation***     Employee stock options are accounted for under AccountingPrinciples Board Opinion No. 25, “Accounting for StockIssued to Employees,” as amended and interpreted, whichrequires the recognition of expense when the option price isless than the fair value of the stock at the date of grant.Qualstar generally awards options for a fixed number of sharesat an option price equal to the fair value at the date of grant.
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**Qualstar has adopted the disclosure-only provisions ofSFAS No. 123, “Accounting for Stock-BasedCompensation” (SFAS 123).     If Qualstar recognized employee stock option-relatedcompensation expense in accordance with SFAS 123 and usedthe minimum value method for grants prior to the Company’sinitial public offering and the Black-Scholes method modelafterward for determining the weighted average fair value ofoptions granted, the Company’s net income (loss) andearnings (loss) per share would have been reduced to the proforma amounts indicated below:                **Fiscal Year Ended June 30,**     **2005** **2004** **2003**         **(in thousands, except per share amounts)**    Net income (loss) as reported $(1,647) $(731) $549     Stock-based employee compensation cost included in reported net    income  —   140   301     Pro forma stock-based employee compensation cost under    SFAS 123  (118)  (505)  (591)              Pro forma net income (loss) $(1,765) $(1,096) $259               Earnings (loss) per share:                 Basic — as reported $(0.13) $(0.06) $0.04                Basic — pro forma $(0.14) $(0.09) $0.02                Diluted — as reported $(0.13) $(0.06) $0.04                Diluted — pro forma $(0.14) $(0.09) $0.02                For purposes of pro forma disclosures, the estimated fair valueof the options is amortized over the options’ vestingperiods. The pro forma effect on net income or loss for 2005,2004 and 2003 is not representative of the pro forma effect onnet income or loss in future years because compensation expensein future years may reflect the amortization of a larger numberof stock options granted in several succeeding years.     In computing the pro forma compensation expense underSFAS 123, a weighted-average fair value of $1.27 for 2005,$3.59 for 2004, and $4.29 for 2003 stock option grants wasestimated at the date of grant using the minimum value optionpricing model before Qualstar’s initial public offering andthe Black Scholes model afterward with the following assumptions:               **2005** **2004** **2003**           Expected dividend yield  0%  0%  0%    Risk-free interest rate  3.8%  2.9%  2.7%    Expected life of options  4 years   4 years   5 years     Volatility  36.9%  100.8%  54.0%***Income Taxes***     Income taxes are accounted for using the liability method inaccordance with SFAS 109, “Accounting for IncomeTaxes.” Under this method, deferred tax liabilities andassets are recognized for the expected future tax consequencesof temporary differences between the financial statement and taxbases of assets and liabilities, and for the expected future taxbenefit to be derived from tax credits and loss carryforwards.Current income tax expense or benefit represents the amount ofincome taxes expected to be payable or
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**refundable for the current year. A valuation allowance isestablished when, in the opinion of management, it is morelikely than not that some portion or all of the deferred taxassets will not be realized.***Comprehensive Income (Loss)***     Comprehensive income (loss) is accounted for according toSFAS No. 130, “Reporting ComprehensiveIncome” (SFAS 130). Comprehensive income (loss)includes unrealized gains and losses on debt and equitysecurities classified as available-for-sale and included as acomponent of shareholders’ equity.***Earnings (Loss) Per Share***     Qualstar calculates earnings (loss) per share in accordance withSFAS No. 128, “Earnings per Share.” Basicearnings per share has been computed by dividing net income(loss) by the weighted average number of common sharesoutstanding. Diluted earnings (loss) per share has been computedby dividing net income (loss) by the weighted average commonshares outstanding plus dilutive securities or other contractsto issue common stock as if these securities were exercised orconverted to common stock.     The following table sets forth the calculation for basic anddiluted earnings per share for the periods indicated:                **Year Ended June 30,**     **2005** **2004** **2003**         **(In thousands)**    Earnings:                 Net income (loss) $(1,647) $(731) $549               Shares:                 Weighted average shares for basic earnings (loss) per share  12,398   12,577   12,579      Stock options  —   —   87                Weighted average shares for diluted earnings (loss) per share  12,398   12,577   12,666                Shares issuable under stock options of 455,000, 511,000 and152,000 for the years ended June 30, 2005, 2004 and 2003,respectively, have been excluded from the computation of dilutedearnings (loss) per share because the effect would beantidilutive.***Segment Information***     Based on the provisions of SFAS No. 131,“Disclosures about Segments of an Enterprise and RelatedInformation” and the manner in which the Chief OperatingDecision Maker analyzes the business, Qualstar has determinedthat it does not have separately reportable operating segments.***Fair Value of Financial Instruments***     The carrying amounts reported in the balance sheets for cash andcash equivalents, accounts receivable and accounts payableapproximate their fair values due to the short term nature ofthese financial instruments.***Estimates and Assumptions***     The preparation of financial statements in conformity withaccounting principles generally accepted in the United Statesrequires management to make estimates and assumptions thataffect the amounts reported in the financial statements andaccompanying notes. Actual results could differ materially fromthose estimates. Management believes that the estimates arereasonable.
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)*****Reclassification***     Certain prior year amounts have been reclassified to conform tothe current year presentation.**2.****Marketable Securities**     The following table shows the gross unrealized losses and fairvalue of the Company’s investments with unrealized lossesthat are not deemed to be other-than-temporarily impaired,aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized lossposition, at June 30, 2005.                           **Less Than 12 Months** **12 Months or Greater** **Total**         **Fair** **Unrealized** **Fair** **Unrealized** **Fair** **Unrealized**  **Value** **Loss** **Value** **Loss** **Value** **Loss**               **(In thousands)**    US Treasury obligations and direct obligations of    U.S. Government agencies $3,973  $(27) $8,645  $(58) $12,618  $(85)    Government Sponsored Enterprise collateralized mortgage    obligations  934   (3)  1,538   (17)  2,472   (20)    Corporate bonds  4,054   (41)  1,708   (13)  5,762   (54)                       Total $8,961  $(71) $11,891  $(88) $20,852  $(159)                        *U.S. Treasury Obligations.* The unrealized losses onthe Company’s investments in U.S. Treasury obligationsand direct obligations of U.S. Government agencies werecaused by interest rate increases. The contractual terms ofthese investments do not permit the issuer to settle thesecurities at a price less than the amortized cost of theinvestment. Because the Company has the ability and intent tohold these investments until a recovery of fair value, which maybe maturity, the Company does not consider these investments tobe other-than-temporarily impaired at June 30, 2005.     *Government Sponsored Enterprise (GSE) CollateralizedMortgage Obligations.* Freddie Mac and Fannie Mae areidentified as GSEs. The unrealized losses on the Company’sinvestment in GSE collateralized mortgage obligations werecaused by interest rate increases. The cash flows of theseinvestments are guaranteed by the GSE. Because the decline inmarket value is attributable to changes in interest rates andnot credit quality and because the Company has the ability andintent to hold these investments until a recovery of fair value,which may be maturity, the Company does not consider theseinvestments to be other-than-temporarily impaired atJune 30, 2005.     *Corporate Bonds.* The unrealized losses on theCompany’s investments in corporate bonds were caused byinterest rate increases. The contractual terms of theseinvestments do not permit the issuer to settle the securities ata price less than the amortized cost of the investment. Becausethe Company has the ability and intent to hold these investmentsuntil a recovery of fair value, which may be maturity, theCompany does not consider these investments to beother-than-temporarily impaired at June 30, 2005.
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****3.****Inventories**     Inventories consist of the following:           **June 30,**     **2005** **2004**       **(in thousands)**    Raw materials $6,196  $6,370     Finished goods  961   1,048          $7,157  $7,418        **4.****Property and Equipment**     The components of property and equipment are as follows:            **June 30,**     **2005** **2004**       **(in thousands)**    Leasehold improvements $546  $546     Furniture and fixtures  994   970     Machinery and equipment  2,320   2,340           3,860   3,856      Less accumulated depreciation and amortization  (2,672)  (2,417)         $1,188  $1,439        **5.****Income Taxes**     The provision (benefit) for income taxes is comprised of thefollowing:                **Year Ended June 30,**     **2005** **2004** **2003**         **(in thousands)**    Current:                 Federal $(156) $(451) $(332)     State  (215)  (6)  (51)             (371)  (457)  (383)    Deferred:                 Federal  342   257   579      State  94   55   78              436   312   657             $65  $(145) $274           
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The following is a reconciliation of the statutory federalincome tax rate to Qualstar’s effective income tax rate:               **Year Ended June 30,**     **2005** **2004** **2003**           Statutory federal income tax expense (benefit)  (34.0)%  (34.0)%  34.0%    State income taxes, net of federal income tax benefit  (3.7)  (4.2)  2.6     Non-taxable investment income  (3.4)  (16.0)  (16.6)    Research and development credits  (15.5)  (22.8)  —     Valuation allowance  60.9   55.2   —     Amortization of deferred compensation  0.0   5.4   12.5     Other  (0.2)  (0.2)  0.8              4.1%  (16.6)%  33.3%               The tax effect of temporary differences resulted in deferredincome tax assets (liabilities) as follows:             **June 30,**     **2005** **2004**       **(in thousands)**    Deferred tax assets:             Net operating loss carryforwards $610  $26      Capital loss and other credit carryforwards  501   513      Research and development credit carryforwards  471   503      Allowance for bad debts and returns  102   89      Inventory reserves  167   146      Capitalized inventory costs  40   33      Other accruals  331   326              Total gross deferred tax assets  2,222   1,636            Deferred tax liabilities:             Depreciation and other  (215)  (158)             Total gross deferred tax liabilities  (215)  (158)           Valuation allowance  (2,007)  (1,042)             Net deferred tax assets $—  $436             The Company placed a valuation allowance on net deferred taxassets during the fiscal year ended June 30, 2005 based onthe Company’s assessment regarding the realizability ofsuch assets in future years. The Company has net operatinglosses, capital losses, research and development credit andother carryforwards for tax purposes of $1,582 at June 30,2005 expiring between fiscal years 2009 and 2025, except for thestate research and development credit, which has no limit on thecarryforward period.     The Company had fiscal 2002 under audit by the Internal RevenueService (“IRS”) for which the IRS issued a no changeopinion in the quarter ended March 31, 2005.**6.****Preferred Stock**     Qualstar’s capital structure allows for the Board ofDirectors to authorize 5,000,000 shares of preferred stock.The Board of Directors has authority to fix the rights,preferences, privileges and restrictions, including
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**voting rights, of these shares of preferred stock without anyfuture vote or action by the shareholders. At June 30, 2005and 2004, there were no outstanding shares of preferred stock.**7.****Stock Option Plans**     Qualstar adopted a stock option plan (1998 Stock Incentive Plan)under which incentive and nonqualified stock options could begranted for an aggregate of no more than 1,215,000 sharesof common stock. Under the terms of the plan, options could beissued at an exercise price of not less than 100% of the fairmarket value of common stock as determined by the board ofdirectors (or board appointed administrator) on the date ofgrant. If an incentive stock option is granted to an individualowning more than 10% of the total combined voting power of allstock, the exercise price of the option may not be less than110% of the fair market value of the underlying shares on thedate of grant. Options are exercisable in annual installmentsand terminate as specified in each option agreement, butterminate no later than ten years after the date of grant.     The following table summarizes all stock option activity:                    **Weighted**  **Stock** **Exercise Price** **Average**  **Options** **per Share** **Exercise Price**         **(in thousands, except per share amounts)**    Outstanding at June 30, 2003  480  $2.78 - $9.38  $5.27      Granted  104   5.10   5.10      Exercised  (19)  2.78 - 5.25   3.54      Cancelled  (54)  4.89 - 9.38   5.90               Outstanding at June 30, 2004  511  $4.23 - $9.38  $5.24      Granted  90   3.71   3.71      Exercised  (16)  4.23 - 5.25   4.74      Cancelled  (130)  4.23 - 9.38   5.79               Outstanding at June 30, 2005  455  $3.71 - $9.38  $4.80                                    **Options Exercisable at**  **Options Outstanding at June 30, 2005** **June 30, 2005**         **Weighted**   **Weighted**  **Number of** **Weighted Average** **Average** **Number of** **Average**  **Shares** **Remaining** **Exercise** **Shares** **Exercise****Exercise Price Range** **Outstanding** **Contractual Life** **Price** **Exercisable** **Price**               $3.71  90   10.0  $3.71   —  $—     $4.23 - 5.94  333   7.2  $4.65   181  $4.63     $9.38  32   5.1  $9.38   32  $9.38      On January 14, 2000, each of Qualstar’s fournon-employee directors were granted and purchased54,000 shares of restricted stock pursuant to the 1998Stock Incentive Plan at a price of $2.78 per share. Eachdirector paid for the shares with a promissory note in theamount of $150,000 secured by the purchased shares. Interest onthe notes accrued at the rate of 6.21% and was payable annually.Payments of principal on the notes were due in four equal annualinstallments beginning in January 2002. Qualstar, solely at itsdiscretion, had the right to repurchase each director’srestricted shares at the original purchase price upontermination of service for any reason. Qualstar’srepurchase right lapsed and the shares vested ratably over fouryears based upon each year of service as a director. All ofthese shares were fully vested as of January 14, 2004.     Upon issuance of the restricted stock and granting of stockoptions in January 2000, Qualstar recorded a deferredcompensation charge of $1.7 million related to both stockoptions and restricted stock for the difference between theexercise price and the deemed fair market value for accountingpurposes on the date of
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**the grant. The deferred compensation recorded was amortized overa four-year vesting period, which resulted in compensationexpense of $140,000 in fiscal 2004, $301,000 in fiscal 2003, and$430,000 in fiscal 2002. During the year ended June 30,2003, approximately 52,000 of unvested stock options related tothese grants were forfeited. The forfeitures resulted in adecrease in common stock paid-in-capital and deferredcompensation of $190,000 during the year ended June 30,2003.**8.****Purchase of N2Power**     On July 11, 2002, Qualstar acquired the assets andintellectual properties of N2Power, Incorporated, a privatelyheld company which designed and produced small and efficientopen-frame switching power supplies. The consideration for thisacquisition amounted to $250,000 plus acquisition expenses of$38,000. The purchase price was primarily allocated to a patent,in the amount of $240,000, which is being amortized over5 years. At June 30, 2005, accumulated amortization ofthe patent was $144,000. Amortization expense for the yearsended June 30, 2005, 2004 and 2003 was $48,000 in eachyear. Amortization expense is estimated to be $48,000 in each ofthe fiscal years 2006 and 2007.**9.****Commitments**     Qualstar’s lease agreement for its facility located in SimiValley, California, expires in February of 2011, with an earlytermination option becoming available in February of 2007. Theannual rent for the lease is $468,000, with step-ups rangingfrom $28,000 to $34,000 every two years.     Qualstar’s lease agreement for its facility located inBoulder, Colorado, expires in May of 2007. The annual rent forthe lease is $55,000, with a nominal step-up of approximately 2%annually.     Future minimum lease payments under these leases are as follows:       **Minimum****Year Ending** **Lease Payment**       2006 $581,000     2007  592,000     2008  554,000     2009  570,000     Thereafter  895,000       $3,192,000          Rent expense (including equipment rental) for the years endedJune 30, 2005, 2004, and 2003, was $671,000, $679,000, and$589,000, respectively.**10.****Legal Proceedings**     On January 10, 2003, Raytheon Company(“Raytheon”) filed a complaint in the United StatesDistrict Court for the Eastern District of Texas alleging thatQualstar and eight other named defendants infringed on a patentowned by Raytheon entitled “Mass Data StorageLibrary.” Raytheon filed an amended complaint on or aboutFebruary 6, 2003, which included an allegation thatQualstar’s tape libraries infringe Raytheon’s patent.On April 2, 2004, Raytheon and Qualstar entered into awritten settlement agreement pursuant to which all claimsbetween the parties alleged in the litigation were dismissedwith prejudice. The costs to settle this dispute have beenincluded in our results of operations in general andadministrative expenses in the year ended June 30, 2004 andhave not had a material adverse effect on our financial position.     We are from time to time involved in various lawsuits and legalproceedings that arise in the ordinary course of business. Atthis time, we are not aware of any pending or threatenedlitigation against us that we
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**expect will have a material adverse effect on our business,financial condition, liquidity or operating results. Legalclaims are inherently uncertain, however. We cannot assure youthat we will not be adversely affected in the future by legalproceedings.**11.****Geographic Information**     Information regarding revenues attributable to theQualstar’s primary geographic operating regions is asfollows:                **Year Ended June 30,**     **2005** **2004** **2003**         **(in thousands)**    Revenues:                 North America $18,281  $21,312  $23,678      Europe  4,933   4,842   7,349      Asia  1,264   4,279   1,837      Other  666   1,097   693             $25,144  $31,530  $33,557                The geographic classification of revenues is based upon thelocation to which the product is shipped. Qualstar does not haveany significant long-lived assets outside of the United States.**12.****Benefit Plans**     Qualstar has a voluntary deferred compensation plan (the Plan)qualifying for treatment under Internal Revenue CodeSection 401(k). All employees are eligible to participatein the Plan following three months of service of employment andmay contribute up to 100% of their compensation on a pre-taxbasis, not to exceed the annual IRS maximum. Qualstar, at thediscretion of management, may make matching contributions in anamount equal to 25% of the first 6% of compensation contributedby eligible participants. Qualstar’s contributions underthe Plan totaled $67,000, $76,000, and $58,000 for the yearsended June 30, 2005, 2004, and 2003 respectively.**13.****Related Party Transactions**     Qualstar’s outside counsel is a member of its board ofdirectors. During the years ended June 30, 2005, 2004, and2003 Qualstar paid $105,000, $131,000, and $149,000,respectively to the law firm in which the director is ashareholder for general business purposes.**14.****Recent Accounting Pronouncements**     On December 16, 2004, the FASB issued FASB StatementNo. 123 (revised 2004), Share-Based Payment(SFAS 123(R), which is a revision of FASB StatementNo. 123, Accounting for Stock-Based Compensation.SFAS 123(R) supersedes APB Opinion No. 25, Accountingfor Stock Issued to Employees, and amends FASB StatementNo. 95, Statement of Cash Flows. Generally, the approach inSFAS 123(R) is similar to the approach described inStatement 123. However, SFAS 123(R) requires allshare-based payments to employees, including grants of employeestock options, be recognized in the income statement based ontheir fair values. Pro forma disclosure is no longer analternative.     SFAS 123(R) must be adopted as of the first interim orannual reporting period that begins after June 15, 2005. Wewill adopt SFAS 123(R) on July 1, 2005.     SFAS 123(R) permits public companies to adopt itsrequirements using one of two methods. The first method is amodified prospective transition method whereby a company wouldrecognize share-based
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**QUALSTAR CORPORATION****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**employee costs from the beginning of the fiscal period in whichthe recognition provisions are first applied as if thefair-value-based accounting method had been used to account forall employee awards granted, modified, or settled after theeffective date and to any awards that were not fully vested asof the effective date. Measurement and attribution ofcompensation cost for awards that are nonvested as of theeffective date of SFAS 123(R) would be based on the sameestimate of the grant-date fair value and the same attributionmethod used previously under SFAS 123. For those awardsthat are granted, modified, or settled afterStatement 123(R) is adopted, compensation cost will bemeasured and recognized in the financial statements inaccordance with the provisions of Statement 123(R). Priorperiods would not be restated.     The second adoption method is a modified retrospectivetransition method whereby a company would recognize employeecompensation cost for periods presented prior to the adoption ofSFAS 123(R) in accordance with the original provisions ofSFAS 123; that is, an entity would recognize employeecompensation cost in the amounts reported in the pro formadisclosures provided in accordance with SFAS 123. A companywould not be permitted to make any changes to those amounts uponadoption of SFAS 123(R) unless those changes represent acorrection of an error. For periods after the date of adoptionof SFAS 123(R), the modified prospective transition methoddescribed above would be applied.     The Company currently expects to adopt SFAS 123(R) usingthe modified prospective transition method, and expects theadoption to have an effect on Qualstar’s results ofoperations similar to the amounts reported historically in theCompany’s footnotes under the pro forma disclosureprovisions of SFAS 123.**15.****Quarterly Results of Operations (Unaudited)**                    **Three Months Ended**     **June 30,** **March 31,** **December 31,** **September 30,**           **(In thousands, except per share amounts)****Fiscal 2005:**                    Net sales $6,706  $5,742  $6,392  $6,305     Gross profit  2,110   1,861   2,311   2,333     Net income (loss)  (429)  (635)  (347)  (236)    Net earnings (loss) per share:                     Basic $(0.04) $(0.05) $(0.03) $(0.02)     Diluted  (0.04)  (0.05)  (0.03)  (0.02)**Fiscal 2004:**                    Net sales $7,696  $8,302  $9,556  $5,976     Gross profit  3,114   3,007   3,594   2,240     Net income (loss)  (16)  (346)  207   (576)    Net earnings (loss) per share:                     Basic $0.00  $(0.03) $0.02  $(0.05)     Diluted  0.00   (0.03)  0.02   (0.05)
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**SCHEDULE II****QUALSTAR CORPORATION****VALUATION AND QUALIFYING ACCOUNTS****ALLOWANCE FOR DOUBTFUL ACCOUNTS****For the Years Ended June 30, 2005, 2004, and 2003**                     **Column A** **Column B** **Column C** **Column D** **Column E**             **Charged**        **Balance at** **to Costs** **Charged**   **Balance at**  **Beginning of** **and** **to Other**   **End of****Description** **Period** **Expenses** **Accounts** **Deductions(1)** **Period**               Year Ended June 30, 2005 $217,000  $172,000  $—  $141,000  $248,000     Year Ended June 30, 2004 $260,000  $208,000  $—  $251,000  $217,000     Year Ended June 30, 2003 $2,100,000  $(53,000) $—  $1,787,000  $260,000  (1)     Uncollectible accounts written off, net of recoveries.
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**Item 9.*****Changes in and Disagreements with Accountants on    Accounting and Financial Disclosure***     None.**Item 9A.*****Controls and Procedures***     We carried out an evaluation, under the supervision and with theparticipation of our management, including our Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of thedesign and operation of Qualstar’s disclosure controls andprocedures as of June 30, 2005, pursuant toRule 13a-15 under the Securities Exchange Act of 1934.Based upon that evaluation, our Chief Executive Officer andChief Financial Officer concluded that our disclosure controlsand procedures are effective to ensure that information requiredto be disclosed by us in reports that we file or submit underthe Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Commission’s rulesand forms, and to ensure that the information required to bedisclosed by us in reports that we file or submit under theExchange Act is accumulated and communicated to our management,including our Chief Executive Officer and Chief FinancialOfficer, as appropriate, to allow timely decisions regardingrequired disclosure.     We did not make any changes in our internal control overfinancial reporting during the fourth quarter of fiscal 2005that materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.**Item 9B.     *****Other Information***     None.**PART III**     The information called for by Items 10, 11, 12, 13 and14 of Part III of Form 10-K (except information as toQualstar’s executive officers, which is included underPart I, Item 1 of this Report) will be included inQualstar’s Proxy Statement which management intends to filewith the Securities and Exchange Commission within 120 daysafter the close of its fiscal year ended June 30, 2005, andis hereby incorporated by reference to such Proxy Statement.**Item 10.     *****Directors and Executive Officers of the Registrant***     A list of our executive officers and biographical informationappears in Part I, Item 1 of this report. Informationabout our Directors may be found under the caption“Election of Directors” of our Proxy Statement (the“Proxy Statement”). That information is incorporatedherein by reference.     The information in the Proxy Statement set forth under thecaption “Section 16(a) Beneficial Ownership ReportingCompliance” is incorporated herein by reference.**Item 11.     *****Executive Compensation***     The information in the Proxy Statement set forth under thecaptions “Executive Compensation” and“Information Regarding the Board and its Committees”is incorporated herein by reference.**Item 12.     *****Security Ownership of Certain Beneficial Owners and    Management***     The information in the Proxy Statement set forth under thecaption “Security Ownership of Certain Beneficial Ownersand Management” is incorporated herein by reference.**Item 13.     *****Certain Relationships and Related Transactions***     The information set forth under the captions “CertainRelationships and Related Transactions” of the ProxyStatement is incorporated herein by reference.
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**Item 14.     *****Principal Accountant Fees and Services***     Information concerning principal accountant fees and servicesappears in the Proxy Statement “Independent RegisteredPublic Accounting Firm” and is incorporated herein byreference.**PART IV****Item 15.*****Financial Statement Schedules and Exhibits*** (a)     The financial statements and supplemental schedules are set    forth under Item 8 of this Annual Report on Form 10-K.     All other schedules have been omitted since the required    information is not present in amounts sufficient to require    submission of the schedule, or because the required information    is included in the consolidated financial statements or notes    thereto.     (b) *Exhibits:*     **Exhibit**  **No.** **Description**    3.1(1)     Restated Articles of Incorporation. 3.2(1)     Amended and Restated Bylaws.  10.1(1)*     1998 Stock Incentive Plan, as amended and restated.  10.2(1)     Form of Indemnification Agreement.  10.3(2)     Lease agreement between Strategic Performance Fund-II, Inc. and    Qualstar Corporation, dated September 20, 2000.  10.4*     Base salaries payable to executive officers during the fiscal    year ending June 30, 2006.  10.5*     Cash bonus plan for executive officers for fiscal year ending    June 30, 2006.  14.1(3)     Code of Business Conduct and Ethics  21.1     Subsidiaries of Qualstar Corporation  23.1     Consent of Independent Registered Public Accounting Firm.  31.1     Certification of Principal Executive Officer pursuant to    Section 302 of the Sarbanes-Oxley Act of 2002.  31.2     Certification of Principal Financial Officer pursuant to    Section 302 of the Sarbanes-Oxley Act of 2002.  32.1     Certification of Principal Executive Officer pursuant to    Section 906 of the Sarbanes-Oxley Act of 2002. 32.2     Certification of Principal Financial Officer pursuant to    Section 906 of the Sarbanes-Oxley Act of 2002. (1)     Incorporated by reference to the designated exhibits to    Qualstar’s registration statement on Form S-1    (Commission File No. 333-96009), declared effective by the    Commission on June 22, 2000. (2)     Incorporated by reference to the designated exhibit to    Qualstar’s Report on Form 10-Q for the fiscal quarter    ended September 30, 2000. (3)     Incorporated by reference to the designated exhibit to    Qualstar’s Report on Form 10-K for the fiscal year    ended June 30, 2004 *    Each of these exhibits constitutes a management contract,    compensatory plan or arrangement required to be filed as an    exhibit to this report pursuant to Item 15(b) of this    report.
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**SIGNATURES**     Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly causedthis report to be signed on its behalf by the undersignedthereunto duly authorized. Qualstar Corporation     By:     /s/ William J.    Gervais       William J. Gervais, *Chief Executive Officer and President*Date: September 26, 2005     Pursuant to the requirements of the Securities Exchange Act of1934, this report has been signed below by the following personson behalf of the registrant and in the capacities and on thedates indicated.       **Signature** **Title** **Date**          /s/ William J. Gervais