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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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Form 10-K



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|  |  |                                                                                             
|- |  | --------------------------------------------------------------------------------------------
|þ |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
| 
|  |  | For the fiscal year ended June 30,
    2004                                                 
| 
|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



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Qualstar Corporation

|                                                             |  |                                                   
|------------------------------------------------------------ |  | --------------------------------------------------
|(Incorporated under the laws
    of the State of California) |  | 95-3927330(I.R.S. Employer
    Identification No.)

3990-B Heritage Oak Court

Simi Valley, CA 93063


(805) 583-7744




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Securities registered pursuant to
Section 12(b) of the Act:

None


Securities registered pursuant to
Section 12(g) of the Act:

Common Stock




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Indicate by check mark whether the registrant
(1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the
past
90 days.     Yes þ          No o

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be
contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any
amendment to this
Form 10-K.     þ

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Act).     Yes o          No þ

As of December 31, 2003, the aggregate
market value of the common equity held by non-affiliates of the
registrant was approximately $34,037,000.

The total shares of common stock without par
value outstanding at September 16, 2004 is 12,608,199.

DOCUMENTS INCORPORATED BY REFERENCE

Items 10, 11, 12, 13 and 14 of
Part III of this Form 10-K are incorporated by
reference from the registrants definitive proxy statement
for its annual meeting of shareholders, which will be filed with
the Commission on or before October 28, 2004.



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FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains
forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934.
Forward-looking statements inherently are subject to risks and
uncertainties, some of which we cannot predict or quantify. Our
actual results may differ materially from the results projected
in the forward-looking statements. Factors that might cause such
a difference include, but are not limited 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 Condition and Results of Operations.
You generally can identify forward-looking statements by the use
of forward-looking terminology such as believes,
may, will, expects,
intends, estimates,
anticipates, plans, seeks,
or continues, or the negative thereof or variations
thereon or similar terminology. Forward looking statements also
include the assumptions underlying or relating to any such
statements. Forward looking statements contained within this
document represent a good-faith assessment of Qualstars
future performance for which management believes there is a
reasonable basis. Qualstar disclaims any obligation to update
the forward looking statements contained herein, except as may
be required by law.

PART I



|        |         
|------- | --------
|Item 1. | Business

Introduction

We design, develop, manufacture and sell
automated magnetic tape libraries used to store, retrieve and
manage electronic data primarily in network computing
environments. Tape libraries consist of cartridge tape drives,
tape cartridges and robotics to move the cartridges from their
storage locations to the tape drives under software control. Our
tape libraries provide data storage solutions for organizations
requiring backup, recovery and archival storage of critical
electronic information. Our products are compatible with
commonly used operating systems, including UNIX, Windows,
NetWare, MAC and Linux. Our tape libraries are also compatible
with a wide range of storage management software packages, such
as those supplied by Computer Associates, EMC/ Legato, Tivoli,
Veritas, CommVault and BakBone Software. We offer tape libraries
for multiple tape drive technologies, including AIT, Super AIT,
SuperDLT and LTO.

We sell our tape libraries worldwide, primarily
to value added resellers, system integrators and original
equipment manufacturers. These customers typically integrate our
tape libraries with software from third party vendors and
related hardware such as servers and network components to
provide storage solutions, which are then sold to end users. We
configure our libraries based on each customers individual
requirements, with a normal delivery time of one to three
working days. This rapid fulfillment of customer orders allows
our resellers to minimize their inventory levels and allows us
to compete effectively with distribution channels used by our
competitors.

Qualstar was incorporated in California in 1984.
Our initial products were IBM compatible 9-track reel-to-reel
tape drives. In 1995, we entered the tape automation market with
a series of tape libraries incorporating 8mm tape drives. Since
that time, we have introduced a succession of tape library
models designed to work with the leading automation capable tape
drive technologies. Automated tape libraries and related
products, such as tape drives and tape media, represented
approximately 81.4% of revenues for fiscal 2004, approximately
79.8% of revenues for fiscal 2003, and approximately 82.9% of
revenues for fiscal 2002. Sales of 9-track tape drives, services
and other products 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 switching power supplies. Power supplies provided by
N2Power are utilized within our tape library products as well as
sold to original equipment manufacturers for incorporation into
their products. N2Power products are sold under the N2Power
brand name as well as under a private label brand name through
independent sales representatives and distributors. Revenues
from N2Power products have not been material as a percentage of
total revenues for fiscal 2004 and fiscal 2003.

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Industry Background

Storing, managing and protecting data has become
critical to the operation of many enterprises as the world
economy becomes increasingly information dependent. The data
storage industry is growing in response to the increase in the
amount of data that is generated and that must be preserved. The
amount of data has been increasing due to the growth in the
number of computers, the number, size and complexity of computer
networks and software applications, and the emergence of new
applications such as image processing, e-commerce, internet
services, medical image storage, video and motion picture image
storage, and other multi-media applications. In addition,
businesses continue to generate increasing amounts of
traditional business information with respect to their products,
customers and financial data. This increase in the amount of
data that is generated stimulates increases in the demand for
data 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
    virtually every corporate data disaster protection plan.                                                                           
|
| |  | 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, e-mail and voicemail, 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 costs 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 in traditional storage solutions. New technologies are
designed to provide high-speed connectivity for data-intensive
applications across multiple operating systems, including UNIX,
Windows, NetWare, MAC and Linux. These new methods of storage
and data management technologies 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
    important 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 on two technologies: magnetic disk and magnetic tape.
These technologies represent a compromise among a variety of
competing factors including capacity, cost, speed, portability
and data reliability. Magnetic tapes are removable, which allows
them to be transported easily to an off-site location for
security or protection from natural disasters. Magnetic disks
provide quicker access to stored data and generally are used
when speed is important. Less frequently used data is often
migrated from magnetic disks to tape storage. Tape libraries
provide a near-online solution, where less frequently used data
files are stored on tape at substantially lower cost compared to
disk while still providing automated access.



| |                                    
| | -----------------------------------
| | Tape Libraries and
    Applications

Tape libraries automate the tape loading process,
eliminate errors induced by human operators, and enhance
security compared to tapes that must be retrieved and loaded
manually. Tape libraries can also be operated from remote
locations around the clock, thus, eliminating the need for an
operator. Automated tape libraries are a key component in a
companys overall storage solution and data protection
strategy.

Tape drives and tape media are two key components
of tape libraries. The costs of tape drives and tape media have
declined with advances in technology, and we expect this trend
to continue. As prices decline, new applications for automated
storage become justified, further increasing the number of
applications that can benefit from the use of tape libraries. We
believe that continued technological improvements in tape drives
and tape media will further reduce overall storage costs in the
future.

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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 enhanced resolution and
    accommodates the recording of transaction information such as
    cash register data and credit card data alongside the video
    image, which is not possible with 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 the size of an enterprise, the type of data
generated and the amount of data to be stored. With the
increased dependence on stored data, most organizations,
regardless of their size, have a heightened need for storage
solutions that integrate devices such as tape drives, tape
libraries and storage management software. Those organizations
with sufficient in-house information technology resources can
rely on their internal infrastructure and expertise to design,
purchase and implement their own storage solutions. These
organizations may elect to purchase equipment from distributors
or directly from the original equipment manufacturers. Many
organizations, however, do not have sufficient in-house
resources but have the same need for data storage solutions.
These organizations often look to value added resellers to
design, supply and install their storage solutions.

Value added resellers develop and install storage
solutions for enterprises that face complex storage needs but
lack the in-house capability of designing and implementing the
proper solution or have chosen to outsource these functions.
Typically, the value added reseller will select among a variety
of different hardware technologies and software options, as well
as provide installation and other services, to deliver a
complete storage solution for the end user. Value added
resellers require rapid turnaround of orders, custom
configuration of tape libraries, drop shipment to their
customers site, compatibility with multiple tape formats
and software, and marketing and technical support.

Original equipment manufacturers generally resell
products made by others under their own brand name and typically
assume responsibility for product sales, service and support.
Original equipment manufacturers enable manufacturers, such as
Qualstar, to reach end users not served by other channels and to
serve select

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vertical markets where specific original
equipment manufacturers have exceptional strength. Original
equipment manufacturers require special services such as product
configuration control, extensive qualification testing, custom
colors and private labeling.


Our Solutions

We offer storage solutions that respond to the
growing data management challenges facing businesses today,
while addressing the unique needs of value added resellers and
original equipment manufacturers.

We believe that high reliability is important to
the end users of our products due to the critical nature of the
data that is being stored, shorter time periods available for
the back-up operations, and the operation of backup systems
during hours when personnel may not be available to respond to
problems. To address these concerns, we emphasize quality and
reliability in the design, manufacturing and testing of our
products which reduces the potential for product failures and
results in products that require little maintenance.

The technology utilized in automated tape
libraries is continuously evolving due to advances in data
recording methods, component cost reductions, advances in
semiconductor and microprocessor technologies, and a general
trend toward miniaturization in the electronics industry. This
changing technology requires that we continuously develop and
market new products to prevent our product lines from becoming
obsolete.

Our tape libraries are compatible with over
forty-five(45) third-party storage management software packages,
including those supplied by Computer Associates, EMC/ Legato,
Tivoli, Veritas, CommVault and BakBone Software. Storage
management software enables network administrators to allocate
the use of storage technologies among user groups or tasks, to
manage data from a central location, and to retrieve, transfer
and backup data between multiple workstations. We believe that
storage management software is a crucial component of any
automated storage installation, and lack of compatibility is a
significant barrier to entry for new tape library competitors.
To ensure compatibility, our engineers work with the application
software vendors during the product development cycles. We do
not have contracts with any application software vendors, nor do
we need access to their software code to design our products. We
maintain relationships with them by supplying tape libraries so
they can qualify their software to work with our tape libraries
and by evaluating their software for compatibility with our tape
libraries. We also support our relationships with them by
keeping them informed about current and anticipated changes to
our products and by referring business to them when value added
resellers or end users inquire about storage management software
sources.

Strategy

Our goals are to enhance our position as a
supplier of automated tape libraries and to increase our market
share in each of the tape formats in which we compete. To
achieve these goals, we intend to:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Offer libraries for multiple tape drive
    technologies.We offer tape libraries
    for a range of tape drive technologies, including AIT, Super
    AIT, SuperDLT, and LTO. 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                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | equipment manufacturer sales enable us to reach
    some end users not served by our value added resellers. The same
    product characteristics that make our tape libraries attractive
    to value added resellers also are important to original
    equipment manufacturers. We will continue to pursue and develop
    opportunities with 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 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 control over the development and manufacture of new
products are key factors in the successful execution of our
strategy. We design our tape libraries with a high percentage of
common parts, use quality components and minimize the number of
moving parts. We utilize proprietary techniques in the design,
production and testing of our libraries in order to simplify the
manufacturing process and reduce our costs. We produce all of
our products at a single facility and control our inventory
closely to provide rapid delivery to our customers. These steps
allow us to design and bring to market new products rapidly in
response to changing technology.

Products



| |               
| | --------------
| | Tape Libraries

We offer a number of tape library families, each
capable of incorporating one or more tape drive technologies, as
summarized in the following table:

|               |  |                |    |            |  |               |  |                  |           |  |  |  |       | 
|-------------- |  | -------------- | -- | ---------- |  | ------------- |  | ---------------- | --------- |  |  |  | ----- | 
|               |  | Models in      |    | Tape Drive |  | Range of Tape |  | Maximum Capacity
|Product Family |  | Product Family |    | Technology |  | Cartridges    |  | in Terabytes(1) 
|               |  |                |    |            |  |               |  |                 
|TLS-4000       |  |                | 10 |            |  | Sony AIT      |  |                  | 12 to 600 |  |  |  | 120.0 | 
|TLS-5000       |  |                | 4  |            |  | Sony SAIT     |  |                  | 33 to 264 |  |  |  | 132.0 | 
|TLS-6000       |  |                | 6  |            |  | Quantum SDLT  |  |                  | 10 to 240 |  |  |  | 72.0  | 
|TLS-8000       |  |                | 6  |            |  | LTO           |  |                  | 11 to 264 |  |  |  | 52.8  | 
|RLS-4000       |  |                | 4  |            |  | Sony AIT      |  |                  | 22 to 70  |  |  |  | 14.0  | 
|RLS-5000       |  |                | 2  |            |  | Sony SAIT     |  |                  | 16 to 44  |  |  |  | 22.0  | 
|RLS-6000       |  |                | 1  |            |  | Quantum SDLT  |  |                  | 27        |  |  |  | 8.1   | 
|RLS-8000       |  |                | 3  |            |  | LTO           |  |                  | 16 to 44  |  |  |  | 8.8   | 



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|    |                                                                                                                                                                                                     
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(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%.

Some of our tape library families include a
number of models that differ in storage capacity, price and
features. Our libraries are installed in network computing
environments ranging from small departmental networks to
enterprise-wide networks supporting hundreds of users. We
believe that selling products for multiple tape drive
technologies insulates us somewhat from the dynamics of the
marketplace as various tape standards compete for market share.
This helps our products appeal to the broadest possible range of
end user market segments. This wide range of products makes us a
one-stop supplier for our value added reseller and original
equipment manufacturer customers, enabling them to meet most end
user requirements for a specific tape format. Our wide range of
products for competing tape drive technologies also helps to
insulate us from the occasional supply shortages from tape drive
or tape media manufacturers.

Tape libraries generally contain two or more tape
drives and from several to thousands of tapes. We concentrate
our product offerings in the mid-range of 10 to 600 tapes. We
design our tape libraries for

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continuous, unattended operation. Multiple tape
drives allow simultaneous access to different data files by
different users on the network, and increase the rate at which
data can move on to, out of, or within the network. A library
with multiple tape drives can back up data using all drives
simultaneously, significantly speeding up the recording process.
Within the library, tape cartridges are stored in removable
magazines, allowing for easy bulk removal of the tapes. Our
libraries also offer features such as barcode readers to scan
cartridge labels and an input/output port for importing and
exporting individual tapes under system control. Several of our
library models are expandable in the field by increasing the
number of tape storage positions. This feature provides the end
user with the ability to increase data capacity as storage needs
grow.


We offer automated tape libraries with different
data storage capacities and data transfer rates. We continue to
develop and release new libraries to expand our product
offerings to meet the changing demands of the marketplace. In
addition, we continue to enhance and improve our existing
products to maintain our competitive position in the marketplace.

Our tape libraries incorporate a number of
specialized features that we believe improve reliability,
serviceability and performance, 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 all 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 robotic 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 specifically designed to be placed on the floor or on a
tabletop, without the need for a special equipment rack. If
requested, we provide our customers with an adapter kit for rack
mounting some models. Other manufacturers design libraries
primarily for rack mounting, and supply an adapter for tabletop
use.

Our RLS Series of tape libraries are designed to
fit efficiently in equipment racks and provide back-up capacity
in only five standard units, or a total of 8.75 inches of
rack space. In addition, the RLS was designed to support
dual-redundant power supplies and hot-swappable tape drives.



| |               
| | --------------
| | Other Products

We manufactured 9-track auto-loading reel-to-reel
tape drives since 1990. Demand for 9-track tape drives had been
declining for many years. Therefore, we announced the end of the
life for 9-track tape drives in September 2002 with final
revenue shipments in the second quarter of fiscal 2004. In
addition to our tape libraries, we sell ancillary products such
as tape media, tape magazines, cables, bar code labels and
adapters for rack mounting our TLS Series tape libraries.

7



---



##### 



In July 2002, we purchased the assets and
intellectual property of N2Power, Incorporated, a privately held
company located in Newbury Park, California. Our N2Power
division designs, manufactures, and sells ultra small
high-efficiency open-frame switching power supplies based on its
patented technology. N2Power products are used in our tape
libraries and sold to original equipment manufacturers and a
private label distributor.

Sales and Marketing



| |      
| | -----
| | Sales

We sell our tape library products primarily
through value added resellers. Our sales force will initiate
contact with value added resellers who are candidates to sell
our tape libraries. We strive to develop relationships with
resellers who have expertise in storage management applications,
established relationships with end users and the experience to
understand and satisfy their customers needs.

We believe that by selling directly to value
added resellers, we have an advantage over competitors who will
often sell directly to end users, thereby competing with their
resellers. Some of the 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 all end user
    inquiries to our reseller partners. Because they know that we
    will not sell directly to the end user, there is an attitude of
    cooperation between the reseller and us. Frequently, our sales
    force will make end user visits with resellers to help close a
    pending sale.
|
| |  | Credit.We extend
    credit 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 added resellers, we believe that original equipment
manufacturers are an important element of our business. The
sales cycle for original equipment manufacturers generally
encompasses six months to one year and involves extensive
product and system qualification testing, evaluation,
integration and verification. Most of our sales of automated
tape libraries to original equipment manufacturers are for use
in video surveillance and medical imaging applications. Original
equipment manufacturers typically assume responsibility for
product sales, service and support.

In May 2004 we entered into a non-exclusive
agreement with Ingram Micro, Inc. to sell our products to
smaller VARs who in turn sell to end users. Under the agreement,
select RLS Series models called TeraLoaders are available
through Ingram Micro. Commercial distribution is a new sales
channel for us and there were no revenues from this channel in
fiscal 2004.

Our international sales are currently directed
from our corporate offices in Simi Valley, California. European
sales are coordinated through our European sales office in the
United Kingdom. We intend to continue to develop our
international markets to create additional outlets for our
products. All of our international sales are denominated in
U.S. dollars. Revenues from customers outside of North
America were approximately $10.2 million or 32.4% of
revenues in fiscal 2004, approximately $9.9 million or
29.4% of revenues in fiscal 2003, and approximately
$12.1 million or 32.2% of revenues in fiscal 2002.

Our sales are spread across a broad customer
base. For the year ended June 30, 2004, no single customer
accounted for more than 10% of our revenue.

8



---



##### 





| |          
| | ---------
| | Marketing

We support our sales efforts with a broad array
of marketing programs designed to generate brand awareness,
attract and retain qualified value added resellers and inform
end users about the advantages of our products. We provide our
resellers with a full range of marketing materials, including
product specifications, sales literature, software connectivity
information and product application notes.

We train our resellers to sell our products and
to answer customers questions. We advertise in key
publications, and participate in trade shows. We display our
products under the Qualstar brand name at various trade shows
and participate in other trade shows in partnership with our
principal suppliers and resellers. We support our marketing and
customer support with a website that features comprehensive
marketing and product information.

We conduct sales and technical training classes
for our resellers. We also conduct various promotional
activities for resellers and end users, including
product-specific rebates and co-operative advertising.

Customer Service and Technical
Support

We believe that strong customer service and
technical support is an essential aspect of our business. Our
customer service and technical 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, distributors and
    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 most countries within Europe.                                                                                                                                                          

Manufacturing and Suppliers

We manufacture all products at our facility in
Simi Valley, California. We currently operate five assembly
lines during one daily eight-hour shift. As needs require, we
have the ability to add a second or third shift to increase our
capacity.

To respond rapidly to orders, we build our tape
libraries to a semi-finished state, perform full testing and
then place the tape libraries in a holding area until an order
is received. Once an order is confirmed, we remove the unit from
the holding area, install tape drives and configure the unit to
meet the specific requirements of the order, retest and then
ship.

9



---



##### 



The manufacturing cycle to bring the libraries to
a semi-finished state is approximately five working days. We
believe that this process represents an effective way to control
our inventory levels while maintaining the ability to fill
specific orders in short lead times. We coordinate inventory
planning and management with suppliers and customers to match
our production to market demand. Once we confirm an order, we
generally ship the product within one to three working days. We
believe this response time is among the fastest in the industry
and gives us a competitive edge. Because we fill the majority of
our orders as they are received, our backlog generally is small
and is not indicative of future revenues.

We carefully select our suppliers based on their
ability to provide quality parts that meet our specifications
and volume requirements. Inventory planning and management is
coordinated closely with suppliers to match our production
needs. Many of the components assembled into our libraries are
off-the-shelf parts, which reduces the risk of part shortages
and allows us to maintain inventory of these parts at a minimum.
A number of our component parts are not available off the shelf,
but are designed to our specifications for integration into our
products.

Tape drives and tape media are available only
from a limited number of suppliers, some of which are
sole-source providers. Some of our suppliers compete with us by
selling their own tape libraries. The risk of allocation is
greater upon the introduction of a new tape drive technology.
Any disruption in supplies of tape drives or tape media could
delay shipments of our products.

Competition

The market for automated tape libraries is
intensely competitive and characterized by rapidly changing
technology and evolving standards. Because we offer a broad
range of libraries for different tape drive technologies, we
tend to have a large number of competitors that differ depending
on the particular format and performance level. We compete in a
segment of the overall tape library market that focuses on small
to mid-range network computing environments. Our principal
competitors in this market segment include Storage Technology
Corporation, Quantum Corporation, Advanced Digital Information
Corporation, Overland Storage, Inc., and Spectra Logic
Corporation.

Many of our competitors have substantially
greater financial and other resources, better name recognition,
larger research and development staffs, and more capabilities in
manufacturing, marketing and distributing products than we do.
Our competitors may develop new technologies and products that
are more effective than our products. We are not ISO-9000
certified, unlike some of our competitors, which may limit some
customers ability to purchase our products. However, we do
not believe that our current determination not to seek ISO-9000
certification has significantly affected our revenues to date.

As competitors introduce products in a particular
tape drive technology, the increased competition normally
results in price erosion and a reduction in gross margins for
all competitors. We cannot assure you that we will be able to
compete successfully against either current or potential
competitors or that competition will not cause a reduction in
our revenues or profit margins. We believe that our ability to
compete depends on a number of factors, including the success
and timing of new product developments by us and by our
competitors, compatibility of our products with a broad range of
computing systems, product performance, reliability, price,
marketing and sales execution and customer support.
Specifically, we believe that the principal competitive factors
in the selection of a tape library include:



| |   |                                                                                        
| | - | ---------------------------------------------------------------------------------------
| |  | 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;

10



---



##### 





| |   |                                                                                   
| | - | ----------------------------------------------------------------------------------
| |  | expected product life and 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 with respect to these factors.

Research and Development

Our research and development group of 27 people
consists of two engineering teams who have data storage and
related industry experience. Our original team located in Simi
Valley, California, has developed over 40 separate tape library
models for eleven different tape formats over the last nine
years. In fiscal 2002 we began our Advanced Development Group in
Boulder, Colorado. They are responsible for the design and
development of our next generation of large-scale tape
libraries. Our engineers are a diverse and robust group who have
the capability to meet the needs of a complex and dynamic data
storage market.

Our research and development efforts rely on the
integration of multiple engineering disciplines to generate
products that meet market needs in a competitive and timely
fashion. Successful development of automated tape libraries
requires the integration of mechanical design, electronic design
packaging, software design, and firmware design into a single
product. Product success also relies on the engineering
groups thorough knowledge of each of the different tape
drive technologies, as well as SCSI and Fibre Channel interface
technologies.

We frequently develop new products in response to
the availability of a new tape drive technology. As tape drive
manufacturers compete in the marketplace, they continually
invest in research and development to gain performance
leadership either by offering increasingly enhanced versions of
their current tape drive products or by introducing an entirely
new tape drive technology. We benefit from these industry
developments by utilizing the new technology in our products.
Our engineers work closely with the tape drive manufacturers
through the drive development cycle to assure that reliable tape
library and tape drive combinations are brought to market.

The design architecture of our tape libraries
makes use of common parts across most product families, allowing
us to develop and introduce new products quickly. If a new tape
drive is an advanced version of one already incorporated in one
or more of our products, our time and dollar investment to
incorporate the new drive can be relatively small, with the
primary focus being on verification testing. When the form
factors differ, the time and investment requirements can grow
substantially, and may require development of a new product
family altogether.

We also develop new products as we identify
emerging market needs. Our sales, marketing, product development
and engineering groups identify products to fulfill customer and
marketplace needs. Our research and development group
concentrates on leveraging previous engineering investments into
new products. For example, our firmware is based on successive
generations of the operating system developed for our first
library. We also use common parts in our different library
series and leverage our electro-mechanical and electronic
hardware technology from previous products into next generation
designs. In some cases, entire subassemblies are transferable,
leveraging not only engineering time but also materials
purchasing, inventory stocking and manufacturing efforts.

Our research and development expenses were
approximately $4.3 million in fiscal 2004, approximately
$4.0 million in fiscal 2003, and approximately
$2.1 million for the year ended June 30, 2002. We
anticipate spending approximately at our current level on
research and development in the future.

Intellectual Property

We rely on copyright protection of our firmware,
as well as patent protection for some of our designs and
products. We also rely on a combination of trademark, trade
secret and other intellectual property laws to protect our
proprietary rights. However, we do not believe our intellectual
property provides significant protection from competition. We
believe that, because of the rapid pace of technological change
in the tape

11



---



##### 



storage industry, patent, copyright, trademark
and trade secret protection are less significant than factors
such as the knowledge, ability and experience of our personnel
and timely new product introductions.


We enter into Employee Proprietary Information
and Inventions Agreements with our engineers along with all
employees and consultants to protect our technology and designs.
However, we do not believe that such protection can preclude
competitors from developing substantially equivalent products.

Employees

As of September 24, 2004, we had
104 full-time employees, including 38 in operations and
manufacturing, 27 in research and development, 6 in customer
service and technical support, 19 in sales and marketing, and 14
in finance and administration. We also employ a small number of
temporary employees and consultants as needed. We are not a
party to any collective bargaining agreement or other similar
agreement. We believe that we have a good relationship with our
employees.

12



---



##### 



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
selling automated tape libraries. Rapid and ongoing changes in
technology and product standards could quickly render our
products less competitive, or even obsolete. We have
significantly fewer financial, technical, manufacturing,
marketing and other resources than many of our competitors and
these limited resources may harm our business in many ways. For
example, 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                                                                              
|
| |  | acquired proprietary software products that
    operate in conjunction with their products and the products of
    their competitors.

In the future, our competitors may leverage their
greater resources 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. We cannot guarantee that our resources will be
sufficient to address this competition or that we will manage
costs and adopt strategies capable of effectively utilizing our
resources. If we are unable to respond to competitive pressures
successfully, our prices and profit margins may fall and our
market share may decrease.

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
responsible for the development of most of our tape libraries,
has overseen our operations and growth, and established and
maintained our strategic relationships. We expect that he will
continue these efforts for the foreseeable future. Our future
success will also depend on our ability to attract, retain and
motivate key executives and other key personnel, many of whom
have been instrumental in developing new technologies and
strategic plans. However, our current dependence on a limited
number of executives and other key personnel, for whom
replacements may be difficult to find, entails a risk that we
may not be able to supervise and manage our 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 tape drives and tape media, represented approximately
81.4% of our revenues for fiscal year 2004, approximately 79.8%
of our revenues for fiscal 2003, and approximately 82.9% of our
revenues for the year ended June 30, 2002. We depend on a
limited number of third-party manufacturers to supply us with
the tape drives and tape media that we incorporate into our
automated tape libraries. Some tape drive manufacturers,
including Sony Corporation and Quantum Corporation, compete with
us by also manufacturing tape libraries. There can be no
assurance that other tape drive manufacturers will not also
begin to manufacture libraries.

13



---



##### 



Historically, some of these suppliers have been
unable to meet demand for their products and have allocated
their limited supply among customers. If suppliers limit our
supply of tape drives or tape media, we may be forced to delay
or cancel shipments of our tape libraries. The major supplier
risks we face 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 2004 we derived approximately
    $16.1 million, or 51.1%, of our revenues, in fiscal 2003 we
    derived approximately $18.9 million, or 56.2% of revenues,
    and in fiscal 2002, we derived approximately $24.6 million,
    or 65.3% of our revenues from the sale of libraries, tape drives
    and tape media based on Sony AIT technology. 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 Seagate. LTO
    competes with AIT and other half-inch tape drives and media. IBM
    and Hewlett Packard both 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 future be, unable to meet our demand, including our
needs for timely delivery, adequate quantity and high quality.
We do not have long-term supply contracts with any of our
significant suppliers. The partial or complete loss of any of
our suppliers could result in lost revenue, added costs and
production delays or 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 primarily through value added resellers and original
equipment manufacturers, and intend to continue this strategy
for the foreseeable future. Value added resellers integrate our
tape libraries with products of other manufacturers and sell the
combined products to their own customers. Original equipment
manufacturers combine our tape libraries with their own products
and sell the combined product under their own brand. We
currently devote, and intend to continue to devote, significant
resources to develop these relationships. A failure to initiate,
manage and expand our relationships with value added resellers
or original equipment manufacturers could limit our ability to
grow or sustain our current level of revenues.

Our focus on the distribution of our products
through value added 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 by value added
    resellers and, consequently, tape libraries for these customers
    will be increasingly sold through distribution channels rather
    than through value added resellers.

14



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##### 



We depend upon our original equipment
manufacturer customers ability to develop new products,
applications and product enhancements that incorporate our
products in a timely, cost-effective and customer-friendly
manner. We cannot guarantee that our original equipment
manufacturer customers will meet these challenges effectively.
Original equipment manufacturers typically conduct substantial
and lengthy evaluation programs before certifying a new product
for inclusion in their product line. We may be required to
devote significant financial and human resources to these
evaluation programs with no assurance that our products will
ever be selected. In addition, even if selected by the original
equipment manufacturer, there generally is no requirement that
the original equipment manufacturer purchase any particular
amount of product from us or that it refrain from purchasing
competing products.

We do not have any exclusive agreements with our
value added resellers or original equipment manufacturers, who
purchase our products on an individual purchase order basis. If
we lose important value added resellers or original equipment
manufacturer customers, if they reduce their focus on our
products or if we are unable to obtain additional value added
reseller or original equipment manufacturer customers, our
business 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 that incorporate some form of tape technology. We
expect to derive substantially all of our revenues from these
products for the foreseeable future. As a result, we will
continue to be subject to the risk of a decrease in revenues if
demand for these products declines or if rising prices make it
more difficult to obtain them. If storage products incorporating
technologies other than tape gain comparable or superior market
acceptance, our business could be harmed.

We depend upon the AIT tape format supplied by
Sony Electronics Inc. for a large 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
tape drives and tape media. If Sony should discontinue
manufacturing AIT tape products or fail to advance AIT
technology to keep pace with the industry trend of increasing
tape capacity, our revenues or operating results could be
significantly 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 in the past, and are likely to vary significantly in
the future due to several factors, including:



| |   |                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | general economic conditions affecting enterprise
    spending for information technology;                                                                        
|
| |  | increased competition and pricing pressures;                                                                                                                     
|
| |  | reductions in the size, delays in the timing, or
    cancellation of significant customer orders;                                                                
|
| |  | fluctuations in product 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;                                   
|
| |  | financial difficulties affecting our value added
    reseller or original equipment manufacturer customers that
    render them unable to pay amounts owed to us;
|
| |  | new product developments by storage device
    manufacturers;                                                                                                    
|
| |  | the rate of growth in the data storage market and
    the various segments within it;                                                                            

15



---



##### 





| |   |                                                                                    
| | - | -----------------------------------------------------------------------------------
| |  | 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 operating results may not necessarily be reliable indicators
of our future performance. It is likely that in some future
period our operating results will not meet your expectations or
those of public market analysts.

Any unanticipated change in revenues or operating
results is likely to cause our stock price to fluctuate since
such changes reflect new information available to investors and
analysts. New information may cause investors and analysts to
revalue our stock and this, in the aggregate, may cause
fluctuations in our stock 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 are received. Consequently, we do not have significant
order backlog and a large portion of our revenues in each
quarter results from orders placed during that quarter. Because
backlog can be an important indicator of future revenues, our
lack of backlog makes it more difficult to forecast our future
revenues. Since our operating expenses are relatively fixed in
the short term, unexpected fluctuations in revenues could
negatively impact our quarterly operating results.

If we fail to develop and introduce new tape
libraries 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 changing technology and evolving industry standards. The
future success of Qualstar will depend on our ability to
anticipate changes in technology, to develop new and enhanced
products on a timely and cost-effective basis, and to introduce,
manufacture and achieve market acceptance of these new and
enhanced products. In particular, our success will depend on the
market acceptance of our soon to be introduced XLS family of
automated tape libraries, our next generation of automated
tape libraries designed for the enterprise automated tape
library marketplace. Our RLS and TLS families of tape libraries
are facing increasing competition from automated tape library
products manufactured by our competitors and likely will face
competition from other types of storage devices that may be
developed in the future.

Development schedules for high technology
products are inherently subject to uncertainty and there can be
no assurance we will be able to meet our product development
schedules or that our development costs will be within budgeted
amounts. If the products or product enhancements developed are
not deliverable due to technical problems, quality issues or
component shortages, or if such products or product enhancements
are not accepted by the marketplace or are unreliable, then our
business, financial condition and results of operations may be
materially adversely affected.

The introduction of new storage technologies or
the adoption of an industry standard different than our current
product standards could render our existing products obsolete.

Our increased research and development
spending may not yield results that justify the costs
incurred.

In recent fiscal years we have substantially
increased our research and development spending over that of
prior periods. Our products and markets are technologically
advanced and rapidly evolving, and we cannot be assured that
these efforts will successfully provide us with new or upgraded
products that will be competitive. If these programs are not
successful, our increased investment in research and development
will not yield corresponding 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 the storage management software, which supports the
library and integrates it into the users computing
environment to provide a complete storage

16



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##### 



solution. We do not develop and have no control
over the development of this storage management software.
Instead we rely on third party independent software vendors to
develop and support this software. Accordingly, the continued
development and future growth of the market for our products
will depend partly upon the success of software vendors to meet
the overall data storage and management needs of tape library
purchasers and our ability to maintain relationships with these
firms. Although we do not have contracts with any third party
independent software vendors, we maintain relationships 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 to return products that do not conform to the end
users specifications. We may otherwise allow product
returns if we think that doing so maximizes the effectiveness of
our sales channels and promotes our reputation for quality and
service.

Although we estimate and reserve for potential
returns in our reported financial results, actual returns could
exceed our estimates. If the number of returns exceeds our
estimates, our financial results could be adversely impacted for
the periods during which returns are made.

We may spend money pursuing sales that do not
occur when anticipated or at all.

Original equipment manufacturer customers
typically conduct significant evaluation, testing,
implementation and acceptance procedures before they begin to
market and sell new models of tape libraries. This evaluation
process is lengthy and may range from six months to one year or
more. This process is complex and may require significant sales,
marketing, engineering and management resources on our part. The
process becomes more complex as we simultaneously qualify our
products with multiple customers or pursue large orders with a
single customer. As a result, we may expend resources to develop
customer relationships before we recognize any revenue from
these relationships, 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 America accounted for approximately 32.4% of revenues in
fiscal 2004, approximately 29.4% of revenues in fiscal 2003, and
approximately 32.2% of revenues in fiscal 2002. We believe that
international sales will continue to represent a significant
portion of our revenues. Our international 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;                                                                                                
|
| |  | 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;                                                                                                                                             

17



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##### 





| |   |                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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 products, may
    reduce sales.  

These risks may increase our costs of doing
business internationally 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 and backup their important data, we face
potential liability if our products fail to perform. Although we
maintain general liability insurance, our insurance may not
cover potential claims of this type or may not be adequate to
indemnify us for all liability that may be imposed. Any
imposition of liability that is not covered by insurance or that
exceeds our insurance coverage could reduce our profitability or
cause us to discontinue operations.

A failure to develop and maintain proprietary
technology may negatively affect our business.

We rely on copyright protection of our firmware,
as well as patent protection for some of our designs and
products. We also rely on a combination of trademark, trade
secret, and other intellectual property laws and various
contract rights to protect our proprietary rights. However, we
do not believe our intellectual property rights provide
significant protection from competition. As a consequence, these
rights may not preclude competitors from developing products
that are substantially equivalent or superior to our products.
In addition, many aspects of our products are not subject to
intellectual property protection and therefore can be reproduced
by 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 of litigation in the United States involving patents and
other intellectual property rights. Qualstar is not currently
directly involved in any intellectual property litigation or
proceedings. However, in April 2004 we settled litigation that
Raytheon Company had filed alleging that Qualstar and eight
other named defendants infringed on a patent owned by Raytheon
Company entitled Mass Data Storage Library. This
lawsuit is described in Item 3 of this report. In the
future, we may become subject to other claims or inquiries
regarding our alleged unauthorized use of a third partys
intellectual property. An adverse outcome in litigation could
force 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 is valid, the cost of responding to it, in
terms of legal fees and expenses and the diversion of management
resources, could harm our business.

Undetected software or hardware flaws could
increase our costs, reduce our revenues and divert our resources
from our core business needs.

Our tape libraries are complex. Despite our
efforts to revise and update our manufacturing and test
processes to address engineering and component changes, we may
not be able to control and eliminate

18



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##### 



manufacturing flaws adequately. These flaws may
include 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 it difficult to identify the source of a problem. These
problems may:



| |   |                                                                                            
| | - | -------------------------------------------------------------------------------------------
| |  | 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
update manufacturing and test procedures to address engineering
and component changes to our products. If we fail to adequately
monitor, develop and implement appropriate test and
manufacturing processes we could experience a rate of product
failure that results in substantial shipment delays, repair or
replacement costs or damage to our reputation. Product flaws may
also consume our limited engineering resources and interrupt our
development efforts. Significant product failures would increase
our costs and result in the loss of future sales and be harmful
to our business.

Our warranty reserves may not adequately cover
our warranty obligations.

We have established reserves for the estimated
liability associated with our product warranties. However, we
could experience unforeseen circumstances where these or future
reserves 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 the aggregate, approximately 44% of our
outstanding common stock as of December 31, 2003. As a
result, these shareholders will be able to exercise significant
control over all matters requiring shareholder approval,
including the election of directors and approval of significant
corporate transactions, which could delay or prevent someone
from acquiring or merging with us. The interests of our officers
and directors, when acting in their capacity 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 by the shareholders, to issue up to
5,000,000 shares of preferred stock and to fix the rights
and preferences of such shares. In addition, our articles of
incorporation and bylaws contain provisions that eliminate
cumulative voting in the election of directors and require
shareholders to give advance notice if they wish to nominate
directors or submit proposals for shareholder approval. These
provisions may have the effect of delaying, deferring or
preventing a change in control, may discourage bids for our
common stock at a premium over its market price and may
adversely affect the market price, and the voting and other
rights of the holders of our common stock.

19



---



##### 



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 our earnings in research and development, expanding
our value added reseller and original equipment manufacturer
relationships, and expanding our manufacturing capabilities.
Consequently, we have never paid dividends on our shares of
capital stock. We currently intend to continue this policy for
the foreseeable future to strengthen our financial and
competitive position in the tape library market.



|        |           
|------- | ----------
|Item 2. | Properties

We lease all of the facilities used in our
business. Our headquarters, manufacturing and TLS and RLS
engineering are located in a single building containing
approximately 57,000 square feet located in Simi Valley,
California. Our lease on this facility expires in February 2011,
with an early termination option becoming available in February
of 2007. Rent on this facility is $39,000 per month, with
step-ups ranging from $2,400 to $2,800 per month every two
years.

We also lease approximately 4,300 square
feet of office space in Boulder, Colorado, that houses our
Advanced Development Group. The lease of the Boulder, Colorado
facility expires in 2007. Additionally, we maintain small sales
offices in Kenyon, Rhode Island; Atlanta, Georgia; Stafford,
Virginia; Surrey, United Kingdom; Dallas, Texas; and, Chicago,
Illinois.



|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

On January 10, 2003, Raytheon Company
(Raytheon) filed a complaint in the United States
District Court for the Eastern District of Texas alleging that
Qualstar and eight other named defendants infringed on a patent
owned by Raytheon entitled Mass Data Storage
Library. Raytheon filed an amended complaint on or about
February 6, 2003, which included an allegation that
Qualstars tape libraries infringe Raytheons patent.
On April 2, 2004, Raytheon and Qualstar entered into a
written settlement agreement pursuant to which all claims
between the parties alleged in the litigation were dismissed
with prejudice. The costs to settle this dispute have been
included in our results of operations in general and
administrative expenses in the year ended June 30, 2004 and
have not had a material adverse effect on our financial position.

Qualstar may be involved in other litigation or
legal matters from time to time in the normal course of business.



|        |                                                    
|------- | ---------------------------------------------------
|Item 4. | Submission of Matters to a Vote of
    Shareholders

No matters were submitted to a vote of security
holders during the fourth quarter of the fiscal year ended
June 30, 2004.

20



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##### 



MANAGEMENT

Executive Officers

Officers are elected by and serve at the
discretion of the board of directors. The executive officers of
Qualstar as of September 24, 2004 are:

|                     |  |     |    |          |  |                                                          
|-------------------- |  | --- | -- | -------- |  | ---------------------------------------------------------
|Name                 |  | Age |    | Position
|                     |  |     |    |         
|William J. Gervais   |  |     | 61 |          |  | Chief Executive Officer, President and Director          
|Richard A. Nelson    |  |     | 61 |          |  | Vice President of Engineering, Secretary and
    Director
|Thomas J. Studebaker |  |     | 62 |          |  | Vice President of Advanced Development                   
|Frederic T. Boyer    |  |     | 60 |          |  | Vice President and Chief Financial Officer               
|David L. Griffith    |  |     | 48 |          |  | Vice President of Operations                             
|Mark R. Gilmore      |  |     | 54 |          |  | Vice President of Sales                                  
|Robert K. Covey      |  |     | 57 |          |  | Vice President of Marketing                              

Background

William J. Gervais is a founder of Qualstar and
has been our President and a director since our inception in
1984, and was elected Chief Executive Officer in January 2000.
From 1984 until January 2000, Mr. Gervais also served as
our Chief Financial Officer. From 1981 until 1984,
Mr. Gervais was President of Northridge Design Associates,
Inc., an engineering consulting firm. Mr. Gervais was a
co-founder, and served as Engineering Manager from 1976 until
1981, of Micropolis Corporation. Mr. Gervais earned a B.S.
degree in Mechanical Engineering from California State
Polytechnic University, Pomona in 1967.

Richard A. Nelson is a founder of Qualstar and
has been our Vice President of Engineering, Secretary and a
director since our inception in 1984. From 1974 to 1984,
Mr. Nelson was self employed as an engineering consultant
specializing in microprocessor technology. Mr. Nelson
earned a B.S. in Electronic Engineering from California State
Polytechnic University, Pomona in 1966.

Thomas J. Studebaker has been our Vice President
of Advanced Development since April of 2002. From 1997 to 2002,
Mr. Studebaker was Vice President of Engineering, Storage
Automation & Solutions Division of Exabyte Corporation.
From 1991 to 1997, Mr. Studebaker was Director of New
Product Development for Exabyte Corporation. Mr. Studebaker
acted as Manager, Packaging and Robotic Development of Storage
Technology Corporation from 1977 to 1991. In 1966,
Mr. Studebaker received a B.S. in Mechanical Engineering
from the University of Colorado. Mr. Studebaker received
his Post Graduate Certificate from the U.S. Army Management
Engineering Training Agency in 1966.

Frederic T. Boyer has been our Vice President and
Chief Financial Officer since October, 2002. Prior to joining
us, Mr. Boyer was Vice President and Chief Financial
Officer of Accelerated Networks from 1998 to 2001. From May 1997
to October 1998, Mr. Boyer was the Senior Vice President,
Finance and Administration and Chief Financial Officer of
Software Dynamics. From January 1996 to May 1997, Mr. Boyer
was a consultant to several technology companies. From March
1990 to January 1996, Mr. Boyer was Vice President and
Chief Financial Officer of Fibermux Corporation, a networking
company later acquired by ADC Telecommunications. Mr. Boyer
holds an M.B.A. from Loyola University, a B.S. in Accounting
from California State University, Los Angeles, and a B.S. in
Economics from California State Polytechnic University, Pomona.

David L. Griffith, currently our Vice President
of Operations, joined the company in October of 2001. From 1999
to 2001, Mr. Griffith served as the President and Chief
Executive Officer of Stardrive Solutions Inc., a software
solutions provider for the broadcast automation industry. From
1998 to 1999, Mr. Griffith was the Corporate Vice President
of Business Development at Tandberg Data ASA where he was
responsible for the development of worldwide business plans and
corporate expansion activities. From 1994 to 1998,
Mr. Griffith was the President and Chief Executive Officer
of Tandberg Data, Inc. located in Simi Valley, California. From
1990 to 1994, Mr. Griffith was the Vice President of Sales
and Marketing for Tandberg Data,

21



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##### 



Inc. From 1987 to 1990, Mr. Griffith acted
as Marketing Manager and Program Manager for the Memory Products
Group of Siemens Information Systems. Mr. Griffith received
a degree in Mechanical Engineering from California State
Polytechnic University in 1980.


Mark R. Gilmore has been our Vice President of
Sales since January of 2002. From August of 1974 through January
of 2002, Mark held various positions in Sales, Marketing and
Project Management on a global basis with the Eastman Kodak
Company. Most recently Mark was the Worldwide General Manager of
OEM Products for the Document Imaging Division and US National
Sales Manager for Imagelink Archive Products. In 1985, Mark
obtained an M.B.A. from Marquette University. In 1972, Mark
graduated from Grove City College where he received a B.A.
degree in Accounting.

Robert K. Covey has been our Vice President of
Marketing since 1994. From 1986 to 1993 Mr. Covey was
regional manager of ATG Cygnet, an optical disk library firm.
From 1982 to 1985, Mr. Covey served as national sales
manager at Micropolis Corporation, a former disk drive
manufacturer. Mr. Covey attended Butler University and
Bentley College from 1965 to 1968.

Supplemental Information  Code of
Business Conduct and Ethics

The Company has adopted a Code of Business
Conduct and Ethics for all of its employees, officers and
directors that contains portions specifically applicable to
executives and officers of the Company, including the Chief
Executive Officer, the Chief Financial Officer, the Controller
and employees performing financial functions for individual
business units of the Company. A copy of the Code of Business
Conduct and Ethics is posted on the Companys website and
is also available, without charge, to any shareholder who sends
a written request to the Chief Financial Officer at 3990-B
Heritage Oak Court, Simi Valley, California 93063.

22



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##### 



PART II



|        |                                                                                                                     
|------- | --------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity,
    Related Stockholder Matters and Issuer Purchases of Equity
    Securities

Qualstar commenced its initial public offering of
common stock on June 23, 2000. Qualstars common stock
is quoted on the NASDAQ Stock Markets National Market
(NASDAQ Symbol  QBAK). The following table sets forth
the high and low closing sale prices of our common stock as
reported by NASDAQ, during the periods indicated:

|             |                |            |                               |      |   |      |  |  |   |      | 
|------------ | -------------- | ---------- | ----------------------------- | ---- | - | ---- |  |  | - | ---- | 
|Period       |                | Date Range |                               | High |   | Low 
|             |                |            |                               |      |   |     
|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 | 
|Fiscal 2003: |                |            |                               |      |   |      |  |  |   |     
|             | First Quarter  |            | July 1  September, 30, 2002  |      | $ | 6.21 |  |  | $ | 4.21 | 
|             | Second Quarter |            | October 1  December 31, 2002 |      | $ | 5.78 |  |  | $ | 3.65 | 
|             | Third Quarter  |            | January 1  March 31, 2003    |      | $ | 5.51 |  |  | $ | 3.89 | 
|             | Fourth Quarter |            | April 1  June 30, 2003       |      | $ | 6.25 |  |  | $ | 4.04 | 

There were approximately 54 owners of record of
Qualstars common stock as of September 16, 2004.

Qualstar has declared no cash dividends during
the periods reported. Qualstar does not currently anticipate
paying cash dividends in the foreseeable future, but intends to
retain any future earnings for reinvestment in its business. Any
future determination to pay cash dividends will be at the
discretion of our Board of Directors and will be dependent upon
Qualstars financial condition, results of operations,
capital requirements, terms of any debt instruments then in
effect and such other factors as our Board of Directors may deem
relevant at the time.

23



---



##### 





|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

The following selected financial data is
qualified in its entirety by and should be read in conjunction
with Managements Discussion and Analysis of
Financial Condition and Results of Operations and the
financial statements and notes thereto included elsewhere in
this 10-K. Our historical financial results are not necessarily
indicative of results to be expected for any future period.

|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |       |       | 
|------------------------------------------------------------------- | -------------------------- | ---------------------------------------- | ------ | ------ | ------ | ---- | ------ | ------ | ------ | ---- | ------ | ------ | ------ | - | ------ | ------ | ----- | - | ------ | ----- | ----- | 
|                                                                    |                            |                                         
|                                                                    |                            | Years Ended June 30,                    
|                                                                    |                            |                                         
|                                                                    |                            | 2004                                     |        | 2003   |        | 2002 |        | 2001   |        | 2000
|                                                                    |                            |                                          |        |        |        |      |        |        |        |     
|                                                                    |                            |                                         
|                                                                    |                            | (In thousands, expect per share amounts)
|Statements of Income Data:                                          |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|Net revenues                                                        |                            | $                                        | 31,530 |        |        | $    | 33,557 |        |        | $    | 37,631 |        |        | $ | 51,572 |        |       | $ | 49,352 |      
|Cost of goods sold                                                  |                            |                                          | 19,575 |        |        |      | 21,171 |        |        |      | 23,753 |        |        |   | 33,216 |        |       |   | 30,915 |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|Gross profit                                                        |                            |                                          | 11,955 |        |        |      | 12,386 |        |        |      | 13,878 |        |        |   | 18,356 |        |       |   | 18,437 |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|Operating expenses:                                                 |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|                                                                    | Research and development   |                                          |        | 4,268  |        |      |        | 3,994  |        |      |        | 2,136  |        |   |        | 1,279  |       |   |        | 1,027 |      
|                                                                    | Sales and marketing        |                                          |        | 3,607  |        |      |        | 3,834  |        |      |        | 3,048  |        |   |        | 3,399  |       |   |        | 2,643 |      
|                                                                    | General and administrative |                                          |        | 5,420  |        |      |        | 4,428  |        |      |        | 5,222  |        |   |        | 3,301  |       |   |        | 2,057 |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|                                                                    |                            | Total operating expenses                 |        |        | 13,295 |      |        |        | 12,256 |      |        |        | 10,406 |   |        |        | 7,979 |   |        |       | 5,727 | 
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|Income (loss) from operations                                       |                            |                                          | (1,340 | )      |        |      | 130    |        |        |      | 3,472  |        |        |   | 10,377 |        |       |   | 12,710 |      
|Investment income                                                   |                            |                                          | 624    |        |        |      | 693    |        |        |      | 1,133  |        |        |   | 1,225  |        |       |   | 54     |      
|Impairment loss for other-than-temporary decline
    in investments |                            |                                          | (160   | )      |        |      |       |        |        |      |       |        |        |   |       |        |       |   |       |      
|Impairment of investment                                            |                            |                                          |       |        |        |      |       |        |        |      |       |        |        |   | (1,050 | )      |       |   |       |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|Income (loss) before income taxes                                   |                            |                                          | (876   | )      |        |      | 823    |        |        |      | 4,605  |        |        |   | 10,552 |        |       |   | 12,764 |      
|Provision (benefit) for income taxes                                |                            |                                          | (145   | )      |        |      | 274    |        |        |      | 1,845  |        |        |   | 3,824  |        |       |   | 4,968  |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|Net income (loss)                                                   |                            | $                                        | (731   | )      |        | $    | 549    |        |        | $    | 2,760  |        |        | $ | 6,728  |        |       | $ | 7,796  |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|Earnings (loss) per share:                                          |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|                                                                    | Basic                      |                                          | $      | (0.06  | )      |      | $      | 0.04   |        |      | $      | 0.22   |        |   | $      | 0.54   |       |   | $      | 1.10  |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|                                                                    | Diluted                    |                                          | $      | (0.06  | )      |      | $      | 0.04   |        |      | $      | 0.22   |        |   | $      | 0.53   |       |   | $      | 0.80  |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|Shares used to compute earnings (loss) per share:                   |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|                                                                    | Basic                      |                                          |        | 12,577 |        |      |        | 12,579 |        |      |        | 12,475 |        |   |        | 12,372 |       |   |        | 7,119 |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      
|                                                                    | Diluted                    |                                          |        | 12,577 |        |      |        | 12,666 |        |      |        | 12,664 |        |   |        | 12,668 |       |   |        | 9,742 |      
|                                                                    |                            |                                          |        |        |        |      |        |        |        |      |        |        |        |   |        |        |       |   |        |      

|                          |  |                |        |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|------------------------- |  | -------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ |  |  | - | ------ | 
|                          |  |               
|                          |  | June 30,      
|                          |  |               
|                          |  | 2004           |        | 2003 |  | 2002 |        | 2001 |  | 2000
|                          |  |                |        |      |  |      |        |      |  |     
|                          |  |               
|                          |  | (In thousands)
|Balance Sheet Data:       |  |                |        |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|Cash and cash equivalents |  | $              | 6,401  |      |  | $    | 6,236  |      |  | $    | 4,859  |  |  | $ | 11,509 |  |  | $ | 3,081  | 
|Marketable securities     |  |                | 29,376 |      |  |      | 29,857 |      |  |      | 25,987 |  |  |   | 15,578 |  |  |   | 15,895 | 
|Working capital           |  |                | 46,534 |      |  |      | 47,191 |      |  |      | 46,507 |  |  |   | 43,382 |  |  |   | 33,620 | 
|Total assets              |  |                | 51,647 |      |  |      | 52,096 |      |  |      | 50,758 |  |  |   | 47,878 |  |  |   | 37,984 | 
|Total debt                |  |                |       |      |  |      |       |      |  |      |       |  |  |   |       |  |  |   |       | 
|Shareholders equity      |  |                | 48,064 |      |  |      | 48,868 |      |  |      | 47,973 |  |  |   | 44,689 |  |  |   | 35,032 | 

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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 in conjunction with our financial statements and notes
thereto.

Overview

We design, develop, manufacture and sell
automated magnetic tape libraries used to store, retrieve and
manage electronic data primarily in network computing
environments. We offer tape libraries for multiple tape drive
technologies, including AIT, Super AIT, SuperDLT, and LTO
tape drives and media.

Many enterprises now routinely manage very large
databases, in addition to storing information on local desktop
computers. This, coupled with the growth in the amount of data
from new sources and applications, is increasing the need for
managing and storing data efficiently. Anticipating the
increased demand for tape libraries, we have developed tape
libraries spanning a broad range of tape formats, prices,
capacity and performance. We expect our products to continue to
evolve in the future in response to emerging tape technologies
and changing customer preferences.

We have developed a network of value added
resellers who specialize in delivering complete storage
solutions to end users. End users of our products range from
small businesses requiring simple automated backup solutions to
large organizations needing complex storage management
solutions. We also sell our products to original equipment
manufacturers who incorporate our products with theirs, which
they sell as a complete system or solution. We assist our
customers with marketing and technical support.

Our international sales efforts are currently
directed from our corporate offices in Simi Valley, California.
European sales are coordinated through our European sales office
in the United Kingdom. We intend to continue to develop our
international markets and create additional outlets for our
products. All of our international sales are denominated in
U.S. dollars. Revenues from sales outside North America
were approximately $10.2 million, or 32.4% of revenues in
fiscal 2004, approximately $9.9 million, or 29.4% of
revenues in fiscal 2003, and approximately $12.1 million,
or 32.2% of revenues in fiscal 2002.

We also design, develop, manufacture and sell
ultra small high-efficiency open-frame switching power supplies
for original equipment manufacturers of telecommunications
equipment, servers, routers, switches, RAIDs, and other
processor based equipment. Our power supplies are sold under the
N2Power brand name through independent sales representatives and
distributors.

Net revenues include revenues from the sale of
tape libraries, library tape drives, tape cartridges, and
ancillary products. Ancillary revenues include service, repair,
and on-site service agreements, net of the cost of any third
party service contracts, and power supplies. Automated tape
libraries and related products, such as tape drives and tape
media, represented approximately 81.4% of revenues in fiscal
2004, approximately 79.8% of revenues in fiscal 2003, and
approximately 82.9% of revenues in fiscal 2002. Sales of
ancillary products and services accounted for the balance of our
revenues.

Gross margins depend on several factors,
including the cost of manufacturing, product mix, customer
demand and the level of competition. Larger tape libraries
provide higher gross margins than do smaller tape libraries
primarily because there is less competition in this market
segment.

Research and development activities include the
design and development of new products, as well as enhancements
to existing products. Our core group of engineers, located in
Simi Valley, California, continues to work on new products and
make enhancements to our existing products. Our Advanced
Development Group, located in Boulder, Colorado, continues to
work on our next generation of automated tape libraries. We
expect research and development expenses to remain comparable in
the next fiscal year as both engineering groups are expected to
be operating at their current level throughout fiscal 2005.

We expect general and administrative expenses to
decrease in fiscal 2005 due to decreases in deferred
compensation expense and legal fees as fiscal 2004 included
legal expenses in defense of a patent infringement lawsuit with
Raytheon, which was settled in fiscal 2004. We expect sales and
marketing expenses to be higher in fiscal 2005 due to additional
expenses to bring our next generation tape library to market.

25



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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 prices of
stock options and restricted stock granted to employees and
directors during fiscal 2000 and the deemed fair value for
accounting purposes of our common stock on the grant dates.
Amortization of deferred compensation was approximately $140,000
during fiscal 2004, approximately $301,000 in fiscal 2003, and
approximately $430,000 during fiscal 2002, which was recorded as
general and administrative expenses in the statements of
operations. The deferred compensation related to these stock
options and restricted stock is fully amortized at June 30,
2004.

Critical Accounting Policies and
Estimates

Our discussion and analysis of our financial
condition and results of operations is based upon our financial
statements, which have been prepared in accordance with
accounting principals generally accepted in the United States.
The preparation of these financial statements requires us to
make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses and related
disclosure of contingent assets and liabilities. On an on-going
basis, we evaluate our estimates, including those related to
customer promotional offers, sales returns, bad debts,
inventories, warranty costs, investments, and income taxes. We
base our estimates on historical experience and on various other
assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or
conditions.

We believe the following critical accounting
policies affect our more significant judgments and estimates
used in the preparation of 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 product leaves our dock in Simi Valley, California, or
another shipping location designated by us. In general, these
customers are allowed to return the product, free of penalty,
within thirty days of shipment, if the product does not meet
specifications. Revenues from technical support services and
other services are recognized at the time services are performed.

We record an allowance for estimated sales
returns based on past experience and current knowledge of our
customer base. Our experience has been such that only a very
small percentage of libraries 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 an assessment of the collectibility of specific
accounts and the overall condition of accounts receivable. In
evaluating the adequacy of the allowance for doubtful accounts,
we analyze specific trade receivables, historical bad debts,
customer credits, customer credit-worthiness and changes in
customers payment terms and patterns. If the financial
condition of our customers were to deteriorate, resulting in an
impairment of their ability to make additional payments, then we
may need to make additional allowances. Likewise, if we
determine that we could realize more of our receivables in the
future than previously estimated, we would adjust the allowance
to increase income in the period we made this determination.

Inventory
Valuation

We record inventories at the lower of cost or
market value. We assess the value of our inventories
periodically based upon numerous factors including expected
product or material demand, current market conditions,
technological obsolescence, current cost and net realizable
value. If necessary, we write down our inventory for estimated
obsolescence, potential shrinkage, or unmarketable inventory
equal to the difference between the cost of inventory and the
estimated market value based upon assumptions about future demand

26



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and market conditions. If technology changes more
rapidly than expected, or market conditions become less
favorable than those projected by management, additional
inventory write-downs may be required.


Warranty
Obligations

We provide for the estimated cost of product
warranties at the time revenue is recognized. We engage in
extensive product quality programs and processes, including
active monitoring and evaluation of product failure rates,
material usage and estimation of service delivery costs incurred
in correcting a product failure. However, should actual product
failure rates, material usage, or service delivery costs differ
from our estimates, revisions to the estimated warranty
liability would be required. Historically our warranty costs
have not been significant.

Accounting
for Income Taxes

We estimate our tax liability based on current
tax laws in the statutory jurisdictions in which we operate.
These estimates include judgements about deferred tax assets and
liabilities resulting from temporary differences between assets
and liabilities recognized for financial reporting purposes and
such amounts recognized for tax purposes, as well as about the
realization of deferred tax assets.

We maintain a valuation allowance to reduce our
deferred tax assets due to the uncertainty surrounding the
timing of realizing the benefits of specific deferred tax assets
in future years. We have considered future taxable income and
ongoing prudent and feasible tax planning strategies in
assessing the need for such a valuation allowance. In the event
we were to determine that we would be able to realize all or
part of our net deferred tax asset in the future, an adjustment
to the deferred tax asset would be charged to income in the
period such determination was made.

We may periodically undergo examinations by the
federal and state regulatory authorities and the Internal
Revenue Service. We may be assessed additional taxes and or
penalties contingent on the outcome of these examinations. Our
previous examinations have not resulted in any unfavorable or
significant assessments.

We currently have a prior fiscal year under audit
by the Internal Revenue Service (IRS). The IRS has
proposed an adjustment which we believe will ultimately not
result in any significant adjustments to the previously filed
return. If the proposed adjustment requires an amendment of the
prior year tax return, we believe that any additional taxes that
we may be required to pay will not have a significant effect on
our financial position or results of operations.

27



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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,
|                                                                    |                            |                     
|                                                                    |                            | 2004                 |       | 2003 |  | 2002
|                                                                    |                            |                      |       |      |  |     
|Net revenues                                                        |                            |                      | 100.0 | %    |  |      | 100.0 | %    |  |  | 100.0 | %   
|                                                                    | Cost of goods sold         |                      |       | 62.1 |  |      |       | 63.1 |  |  |       | 63.1 | 
|                                                                    |                            |                      |       |      |  |      |       |      |  |  |       |     
|                                                                    | Gross margin               |                      |       | 37.9 |  |      |       | 36.9 |  |  |       | 36.9 | 
|Operating expenses:                                                 |                            |                      |       |      |  |      |       |      |  |  |       |     
|                                                                    | Research and development   |                      |       | 13.5 |  |      |       | 11.9 |  |  |       | 5.7  | 
|                                                                    | Sales and marketing        |                      |       | 11.4 |  |      |       | 11.4 |  |  |       | 8.1  | 
|                                                                    | General and administrative |                      |       | 17.2 |  |      |       | 13.2 |  |  |       | 13.9 | 
|                                                                    |                            |                      |       |      |  |      |       |      |  |  |       |     
|Income (loss) from operations                                       |                            |                      | (4.2  | )    |  |      | 0.4   |      |  |  | 9.2   |     
|Investment income                                                   |                            |                      | 2.0   |      |  |      | 2.0   |      |  |  | 3.0   |     
|Impairment loss for other-than-temporary decline
    in investments |                            |                      | (0.6  | )    |  |      |      |      |  |  |      |     
|                                                                    |                            |                      |       |      |  |      |       |      |  |  |       |     
|Income (loss) before provision (benefit) for
    income taxes       |                            |                      | (2.8  | )    |  |      | 2.4   |      |  |  | 12.2  |     
|Provision (benefit) for income taxes                                |                            |                      | (0.5  | )    |  |      | 0.8   |      |  |  | 4.9   |     
|                                                                    |                            |                      |       |      |  |      |       |      |  |  |       |     
|Net income (loss)                                                   |                            |                      | (2.3  | )%   |  |      | 1.6   | %    |  |  | 7.3   | %   
|                                                                    |                            |                      |       |      |  |      |       |      |  |  |       |     

Revenues are recognized upon shipment of the
product to the customer, less estimated returns, for which
provision is made at the time of sale. The following table
summarizes our revenue by major product line:

|                       |                                           |                      |       |      |   |      |       |      |   |  |       |      |  
|---------------------- | ----------------------------------------- | -------------------- | ----- | ---- | - | ---- | ----- | ---- | - |  | ----- | ---- | -
|                       |                                           |                     
|                       |                                           | Years Ended June 30,
|                       |                                           |                     
|                       |                                           | 2004                 |       | 2003 |   | 2002
|                       |                                           |                      |       |      |   |     
|Tape Library revenues: |                                           |                      |       |      |   |      |       |      |   |  |       |     
|                       | TLS                                       |                      |       | 56.4 | % |      |       | 67.7 | % |  |       | 74.1 | %
|                       | RLS                                       |                      |       | 15.5 |   |      |       | 4.0  |   |  |       | 0.0  |  
|                       |                                           |                      |       |      |   |      |       |      |   |  |       |     
|                       |                                           |                      | 71.9  |      |   |      | 71.7  |      |   |  | 74.1  |     
|                       |                                           |                      |       |      |   |      |       |      |   |  |       |     
|Other revenues:        |                                           |                      |       |      |   |      |       |      |   |  |       |     
|                       | Service                                   |                      |       | 7.6  |   |      |       | 6.2  |   |  |       | 6.7  |  
|                       | Media                                     |                      |       | 9.5  |   |      |       | 8.1  |   |  |       | 10.3 |  
|                       | 9 Track, Spares, Upgrades, Power Supplies |                      |       | 11.0 |   |      |       | 14.0 |   |  |       | 8.9  |  
|                       |                                           |                      |       |      |   |      |       |      |   |  |       |     
|                       |                                           |                      | 100.0 | %    |   |      | 100.0 | %    |   |  | 100.0 | %   
|                       |                                           |                      |       |      |   |      |       |      |   |  |       |     

Fiscal 2004 Compared to Fiscal 2003

Net Revenues.Revenues are recognized upon shipment of the product to the
customer, less estimated returns, for which provision is made at
the time of the sale. Revenues for the year ended June 30,
2004 were $31.5 million, a decrease of 6.0% compared to net
revenues of $33.6 million for the year ended June 30,
2003.

The decrease in revenues was due primarily to a
decline in the demand for our tape libraries using 8mm AIT tape
technology. This decrease was substantially offset by an
increase in revenues from our libraries using half inch
technology, such as LTO-2 and Super AIT. The most recent AIT
tape technology has only half the native storage capacity of the
most recent LTO-2 and other half inch tape technologies. We have
been successful at incorporating half inch tape drives into our
TLS libraries as well as the newer rack-mountable RLS libraries
and shifting customer preferences to the half inch tape format.
This resulted in revenues being divided about evenly between 8mm
and half inch tape technologies in absolute dollars in fiscal
2004. In fiscal

28



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2003, by comparison, revenues attributed to AIT
tape technology in 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 ended
June 30, 2004 from $24.1 million, or 71.7% of
revenues, in the year ended June 30, 2003. Selling prices
of our libraries remained relatively stable during fiscal 2004.
Average selling prices of library tape drives increased during
fiscal 2004 due to a change in product mix.

Gross Profit.Gross
profit was $12.0 million, or 37.9% of revenues, for the
year ended June 30, 2004, compared to $12.4 million,
or 36.9% of revenues, for fiscal 2003. Cost of goods sold
consists primarily of direct labor, purchased parts,
depreciation of plant and equipment, rent, utilities, and
packaging costs. The increase in gross margin as a percentage of
revenues was attributed to efficiencies achieved in material
management; a more favorable product mix caused by the
discontinuation of several lower margin libraries; and, sales of
media with higher than normal margins.

Research and
Development.Research and development
expenses consist of engineering salaries, benefits, outside
consultant fees, purchased parts and supplies used in
development activities. Research and development expenses 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 year ended
June 30, 2003. This increase was due primarily to costs
incurred in the continuing operating activities of our Advanced
Development Group in Boulder, Colorado, established in late
fiscal 2002 to design and develop our next generation of tape
libraries. We anticipate research and development costs to
remain approximately at the same level in fiscal 2005.

Sales and Marketing.Sales and marketing expenses consist primarily of employee
salaries, benefits, sales commissions, trade show costs,
advertising and travel related expenses. Sales and marketing
expenses decreased by 5.9% to $3.6 million, or 11.4% of
revenues for the year ended June 30, 2004, as compared to
$3.8 million, or 11.4% of revenues, for the year ended
June 30, 2003. Although the percent decrease is consistent
with the decrease in revenues, in absolute dollars, the decrease
can be attributed to a reduction in advertising costs due to a
shift to the lower cost electronic advertising versus print
advertising and lower co-operative advertising as well as a
reduction in travel related expenditures.

General and
Administrative.General and
administrative expenses include employee salaries and benefits,
deferred compensation related to stock options and restricted
stock, provision for doubtful accounts, and professional service
fees. General and administrative expenses increased to
$5.4 million for fiscal 2004 as compared to
$4.4 million for fiscal 2003. As a percentage of revenues,
general and administrative expenses increased to 17.2% for the
year ended June 30, 2004 as compared to 13.2% for the year
ended June 30, 2003. The increase in general and
administrative expenses was due primarily to legal fees and
settlement costs associated with our defense of the Raytheon
lawsuit.

Investment Income and Impairment Loss for
Other-than-Temporary Decline in
Investments.Investment income, net of
an impairment loss for other-than-temporary decline in
investments of $160,000, decreased to $464,000 in the year ended
June 30, 2004 as compared to $693,000 in the year ended
June 30, 2003. This decrease was due primarily to the
adoption of Emerging Issues Task Force No. 03-1, which
resulted in recognizing an impairment loss for
other-than-temporary decline in investments of $160,000 in
earnings. In addition, the economy continues to experience low
interest rates, which has had a negative impact on our
portfolios overall performance.

Provision for Income
Taxes.The benefit for income taxes
was $145,000, or 16.6% of pre-tax loss, for fiscal 2004 compared
to a provision of $274,000, or 33.3% of pre-tax income, for
fiscal 2003. The low effective tax benefit rate in fiscal 2004
can be primarily attributed to valuation allowances established
for capital losses realized on a tax basis in fiscal 2004 and
net operating loss carryforwards based on our assessment
regarding the realizability of these benefits in future years.

Fiscal 2003 Compared to Fiscal 2002

Net Revenues.Revenues for the year ended June 30, 2003 were
$33.6 million, a decrease of 10.8% compared to net revenues
of $37.6 million for the year ended June 30, 2002.

29



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The decrease in revenues was primarily due to an
overall decline in the demand for our tape libraries using AIT
tape technology. Revenues from our TLS tape library series are
dominated by the AIT tape format. Due to competing factors in
the marketplace, some customers migrated towards higher density
tape formats, which were introduced in fiscal 2003, such as
LTO2, rather than choosing AIT. Partially offsetting the decline
in revenues from our AIT tape libraries, were revenues generated
from the introduction of new models in the RLS Series of
rack-mountable tape libraries.

Revenues from tape libraries and related media
decreased to $26.8 million, or 79.8% of revenues in the
year ended June 30, 2003, from $31.2 million, or 82.9%
of revenues in the year ended June 30, 2002. Selling prices
of our libraries remained relatively stable during fiscal 2003.
Average selling prices of library tape drives increased during
fiscal 2003 due to a change in product mix. During the year, we
sold more half-inch tape drives as a percentage of total tape
drives sold. In general, half inch tape drives are sold at a
higher price than 8mm tape drives. Average selling prices of
half-inch tape drives increased during the year due to the
introduction of the LTO2 tape format.

Gross Profit.Gross
profit was $12.4 million, or 36.9% of revenues, for the
year ended June 30, 2003, compared to $13.9 million,
or 36.9% of revenues, for fiscal 2002. During fiscal 2003, we
were able to keep our gross margin stable compared to fiscal
2002.

Research and
Development.Research and development
expenses for the year ended June 30, 2003 increased 87.0%
to $4.0 million as compared to $2.1 million for the
year ended June 30, 2002. This increase was due primarily
to costs associated in bringing our new rack-mount libraries to
market, the continuing operating activities of our Advanced
Development Group in Boulder, Colorado, and to the development
of higher watt power supplies. The Advanced Development Group
was established in late fiscal 2002 to design and develop our
next generation of tape libraries. During fiscal 2003, the
Advanced Development Group became fully staffed.

Sales and Marketing.Sales and marketing expenses increased by 25.8% to
$3.8 million, or 11.4% of revenues for the year ended
June 30, 2003, as compared to $3.0 million, or 8.1% of
revenues, for the year ended June 30, 2002. This increase
was primarily due to higher advertising and promotional costs
for the launch of the RLS product line and a decrease in
marketing development funds from our key suppliers.

General and
Administrative.General and
administrative expenses decreased to $4.4 million for
fiscal 2003 as compared to $5.2 million for fiscal 2002. As
a percentage of revenues, general and administrative expenses
decreased to 13.2% for the year ended June 30, 2003 as
compared to 13.9% for the year ended June 30, 2002. The
decrease in general and administrative expenses was due
primarily to the fact that fiscal 2002 included an increase in
the reserve for doubtful accounts of $1.6 million, while no
similar reserve was established in fiscal 2003. Partially
offsetting the decrease in general and administrative expenses
were higher expenses for professional services and legal fees
associated with our defense of the Raytheon lawsuit.

Investment Income.Investment income decreased to $693,000 in the year ended
June 30, 2003 as compared to $1.1 million in the year
ended June 30, 2002. This decrease was due primarily to an
overall shift in our investment strategy, which places more
emphasis on principal preservation that it does on income
generation. In addition to this, the economy continues to
experience low interest rates, which has had a negative impact
on our portfolios overall performance.

Provision for Income
Taxes.The provision for income taxes
was $274,000, or 33.3% of pre-tax income, for fiscal 2003
compared to $1.8 million, or 40.1% of pre-tax income, for
fiscal 2002. The decrease in the percentage of the provision for
income taxes to pre-tax income was primarily due to allocation
changes made to our investment portfolio to be more heavily
weighted towards non-taxable investment income.

Liquidity and Capital Resources

Historically, we have funded our capital
requirements with cash provided by operations. Cash provided by
operating activities was $0.3 million in fiscal 2004,
$6.0 million in fiscal 2003, and $4.1 million in
fiscal 2002. In fiscal 2004, operating cash was primarily
provided by a refund of fiscal 2003 income taxes paid and
increases in accounts payable and accrued liabilities, offset
partially by increases in accounts receivable and

30



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##### 



inventories. In fiscal 2003, operating cash was
primarily provided by reductions in accounts receivable and
inventory. In fiscal 2002, operating cash was provided primarily
by net income. In fiscal 2004, cash flow from operating
activities was primarily used for repurchasing shares of our
common stock and in fiscal 2003 and 2002, cash flow from
operating activities was primarily used to purchase marketable
securities.


Cash used in investing activities was $15,000 in
fiscal 2004, $4.7 million in fiscal 2003, and
$11.0 million in fiscal 2002. Cash used in investing
activities for fiscal 2004, 2003, and 2002 related primarily to
purchases of marketable securities as well as equipment and
leasehold improvements.

On July 11, 2002, we purchased the assets
and intellectual property of N2Power, Incorporated, a privately
held company that designed and produced small and efficient
open-frame switching power supplies. In consideration for the
assets and intellectual properties, we paid $250,000, in cash,
and incurred additional acquisition costs of $38,000.

As of June 30, 2004, we had
$6.4 million in cash and cash equivalents and
$29.4 million in marketable securities. We believe that our
existing cash and cash equivalents and anticipated cash flows
from our operating activities, plus funds available from the
sale of our marketable securities, will be sufficient to fund
our working capital and capital expenditure needs for at least
the next 12 months. We may utilize cash to invest in
businesses, products or technologies that we believe are
strategic. We regularly evaluate other companies and
technologies for possible investment by us. In addition, we have
made and may in the future make investments in companies with
whom we have identified potential synergies. However, we have no
present commitments or agreements with respect to any material
acquisition of other businesses or technologies.

Summary of Contractual Obligations and
Commitments

The following is a summary of our future payments
due under contractual obligations as of June 30, 2004 (in
thousands):

|                   |  |           |       |             |  |       |       |  |  |   |       | 
|------------------ |  | --------- | ----- | ----------- |  | ----- | ----- |  |  | - | ----- | 
|                   |  | Operating |       | Purchase    |  |      
|Year Ended June 30 |  | Leases    |       | Obligations |  | Total
|                   |  |           |       |             |  |      
|2005               |  | $         | 562   |             |  | $     | 2,446 |  |  | $ | 3,008 | 
|2006               |  |           | 581   |             |  |       |      |  |  |   | 581   | 
|2007               |  |           | 590   |             |  |       |      |  |  |   | 590   | 
|2008               |  |           | 554   |             |  |       |      |  |  |   | 554   | 
|2009               |  |           | 568   |             |  |       |      |  |  |   | 568   | 
|Thereafter         |  |           | 931   |             |  |       |      |  |  |   | 931   | 
|                   |  |           |       |             |  |       |       |  |  |   |       | 
|                   |  | $         | 3,786 |             |  | $     | 2,446 |  |  | $ | 6,232 | 
|                   |  |           |       |             |  |       |       |  |  |   |       | 

Purchase obligations in the table above represent
the value of open purchase orders as of June 30, 2004. We
believe that some of these obligations could be canceled for
payment of a nominal penalty or no penalty; however, the amount
of open purchase orders that could be canceled under such terms
is difficult 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
them worldwide. As a result, our financial results could be
affected by factors such as changes in foreign currency exchange
rates or weak economic conditions in foreign markets. As all
sales are currently made in U.S. dollars, a strengthening
of the dollar could make our products less competitive in
foreign markets. Our interest income is sensitive to changes in
the general level of U.S. interest rates, particularly
since the majority of our investments are in short-term
instruments. We have

31



---



##### 



no outstanding debt nor do we utilize derivative
financial instruments. Therefore, no quantitative tabular
disclosures are required.




|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

See Index to Financial Statements at page F-1 of
this report.



|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|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 the participation of our management,
including our Chief Executive Officer and our Chief Financial
Officer, of the effectiveness of the design and operation of
Qualstars disclosure controls and procedures as of
June 30, 2004, pursuant to Rule 13a-15 under the
Securities Exchange Act of 1934. Based upon that evaluation, our
Chief Executive Officer and Chief Financial Officer concluded
that those disclosure controls and procedures were adequate to
ensure that information required to be disclosed in this report
is recorded, processed, summarized and reported in a timely
basis.

We did not make any changes in our internal
control over financial reporting during the fourth quarter of
fiscal 2004 that materially affected, or are reasonably likely
to materially affect, our internal control over financial
reporting.



|         |                  
|-------- | -----------------
|Item 9B. | Other Information

None.



PART III


The information called for by Items 10,
11, 12, 13 and 14 of Part III of Form 10-K
(except information as to Qualstars executive officers,
which information follows Item 4 in Part I of this
Report) will be included in Qualstars Proxy Statement
which management intends to file with the Securities and
Exchange Commission within 120 days after the close of its
fiscal year ended June 30, 2004, and is hereby incorporated
by reference to such Proxy Statement.



PART IV




|         |                                                
|-------- | -----------------------------------------------
|Item 15. | Exhibits and Financials Statement
    Schedules

(a) (1) The following documents are
filed as part of this Report:



| |                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------
| | Consolidated Financial Statements  See
    Index to Financial Statements in Item 8 commencing at
    page F-1 of this Report.

(2) Supplemental Schedule:



| |                                                                                     
| | ------------------------------------------------------------------------------------
| | Schedule II  Valuation and
    Qualifying Accounts; Allowance for Doubtful Accounts

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.

32



---



##### 



(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.
|            | 14 | .1          |  | 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.                                                           



| |   |                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | 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.

33



---



##### 





|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                            |  |      |     | 
|----------------------------------------------------------- |  | ---- | --- | 
|                                                            |  | Page
|                                                            |  |     
|Report of Independent Registered Public
    Accounting Firm |  |      | F-2 | 
|Consolidated Balance Sheets                                 |  |      | F-3 | 
|Consolidated Statements of Operations                       |  |      | F-4 | 
|Consolidated Statements of Shareholders
    Equity         |  |      | F-5 | 
|Consolidated Statements of Cash Flows                       |  |      | F-6 | 
|Notes to Consolidated Financial Statements                  |  |      | F-7 | 

F-1



---



##### 



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

The Board of Directors and Shareholders of

Qualstar Corporation


We have audited the accompanying consolidated
balance sheets of Qualstar Corporation as of June 30, 2004
and 2003, and the related consolidated statements of operations,
shareholders equity, and cash flows for each of the three
years in the period ended June 30, 2004. Our audits also
included the financial statement schedule listed at the index in
Item 15(a). These financial statements and schedule are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements and schedule based on our audits.

We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred
to above present fairly, in all material respects, the
consolidated financial position of Qualstar Corporation at
June 30, 2004 and 2003, and the consolidated results of its
operations and its cash flows for the three years in the period
ended June 30, 2004, in conformity with U.S. generally
accepted accounting principles. Also, in our opinion, the
related financial statement schedule, when considered in
relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information set
forth therein.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Woodland Hills, California

August 13, 2004


F-2



---



##### 



QUALSTAR CORPORATION

CONSOLIDATED BALANCE SHEETS

|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |        |        | 
|---------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | ------ | ------ |  | ----- | ------ | ------ | 
|                                         |                                                                                                                                                                   |                                           
|                                         |                                                                                                                                                                   | June 30,                                  
|                                         |                                                                                                                                                                   |                                           
|                                         |                                                                                                                                                                   | 2004                                       |       | 2003  
|                                         |                                                                                                                                                                   |                                            |       |       
|                                         |                                                                                                                                                                   |                                           
|                                         |                                                                                                                                                                   | (In thousands, except                     
|                                         |                                                                                                                                                                   | per share amounts)                        
|ASSETS                                  
|Current assets:                          |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|                                         | Cash and cash equivalents                                                                                                                                         |                                            | $     | 6,401  |        |  | $     | 6,236  |       
|                                         | Marketable securities                                                                                                                                             |                                            |       | 29,376 |        |  |       | 29,857 |       
|                                         | Accounts receivable, net of allowances of $217 as
    of June 30, 2004 and $260 as of June 30, 2003                                                               |                                            |       | 4,628  |        |  |       | 4,535  |       
|                                         | Inventories                                                                                                                                                       |                                            |       | 7,418  |        |  |       | 7,091  |       
|                                         | Prepaid expenses and other current assets                                                                                                                         |                                            |       | 470    |        |  |       | 234    |       
|                                         | Prepaid income taxes                                                                                                                                              |                                            |       | 1,072  |        |  |       | 1,336  |       
|                                         | Deferred income taxes                                                                                                                                             |                                            |       | 594    |        |  |       | 939    |       
|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|                                         |                                                                                                                                                                   | Total current assets                       |       |        | 49,959 |  |       |        | 50,228 | 
|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|Property and equipment, net              |                                                                                                                                                                   |                                            | 1,439 |        |        |  | 1,557 |       
|Other assets                             |                                                                                                                                                                   |                                            | 249   |        |        |  | 311   |       
|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|                                         |                                                                                                                                                                   | Total assets                               |       | $      | 51,647 |  |       | $      | 52,096 | 
|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|LIABILITIES AND SHAREHOLDERS
    EQUITY
|Current liabilities:                     |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|                                         | Accounts payable                                                                                                                                                  |                                            | $     | 1,171  |        |  | $     | 1,136  |       
|                                         | Accrued payroll and related liabilities                                                                                                                           |                                            |       | 500    |        |  |       | 432    |       
|                                         | Other accrued liabilities                                                                                                                                         |                                            |       | 1,754  |        |  |       | 1,469  |       
|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|                                         |                                                                                                                                                                   | Total current liabilities                  |       |        | 3,425  |  |       |        | 3,037  | 
|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|Deferred income taxes                    |                                                                                                                                                                   |                                            | 158   |        |        |  | 191   |       
|Shareholders equity:                    |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|                                         | Preferred stock, no par value; 5,000 shares
    authorized; no shares issued                                                                                      |                                            |       |       |        |  |       |       |       
|                                         | Common stock, no par value; 50,000 shares
    authorized, 12,596 and 12,640 shares issued and outstanding
    as of June 30, 2004 and June 30, 2003, respectively |                                            |       | 20,121 |        |  |       | 20,366 |       
|                                         | Deferred compensation                                                                                                                                             |                                            |       |       |        |  |       | (140   | )     
|                                         | Notes from directors                                                                                                                                              |                                            |       | (45    | )      |  |       | (156   | )     
|                                         | Accumulated other comprehensive income (loss)                                                                                                                     |                                            |       | (101   | )      |  |       | (22    | )     
|                                         | Retained earnings                                                                                                                                                 |                                            |       | 28,089 |        |  |       | 28,820 |       
|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|                                         |                                                                                                                                                                   | Total shareholders equity                 |       |        | 48,064 |  |       |        | 48,868 | 
|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |       
|                                         |                                                                                                                                                                   | Total liabilities and shareholders equity |       | $      | 51,647 |  |       | $      | 52,096 | 
|                                         |                                                                                                                                                                   |                                            |       |        |        |  |       |       

See accompanying notes

F-3



---



##### 



QUALSTAR CORPORATION

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |        |        | 
|------------------------------------------------------------------- | -------------------------- | ------------------------ | ------ | ------ | ------ | ---- | ------ | ------ | ------ | - | ------ | ------ | ------ | 
|                                                                    |                            |                         
|                                                                    |                            | Years Ended June 30,    
|                                                                    |                            |                         
|                                                                    |                            | 2004                     |        | 2003   |        | 2002
|                                                                    |                            |                          |        |        |        |     
|                                                                    |                            |                         
|                                                                    |                            | (In thousands, except   
|                                                                    |                            | per share amounts)      
|Net revenues                                                        |                            | $                        | 31,530 |        |        | $    | 33,557 |        |        | $ | 37,631 |       
|Cost of goods sold                                                  |                            |                          | 19,575 |        |        |      | 21,171 |        |        |   | 23,753 |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|Gross profit                                                        |                            |                          | 11,955 |        |        |      | 12,386 |        |        |   | 13,878 |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|Operating expenses:                                                 |                            |                          |        |        |        |      |        |        |        |   |        |       
|                                                                    | Research and development   |                          |        | 4,268  |        |      |        | 3,994  |        |   |        | 2,136  |       
|                                                                    | Sales and marketing        |                          |        | 3,607  |        |      |        | 3,834  |        |   |        | 3,048  |       
|                                                                    | General and administrative |                          |        | 5,420  |        |      |        | 4,428  |        |   |        | 5,222  |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|                                                                    |                            | Total operating expenses |        |        | 13,295 |      |        |        | 12,256 |   |        |        | 10,406 | 
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|Income (loss) from operations                                       |                            |                          | (1,340 | )      |        |      | 130    |        |        |   | 3,472  |       
|Investment income                                                   |                            |                          | 624    |        |        |      | 693    |        |        |   | 1,133  |       
|Impairment loss for other-than-temporary decline
    in investments |                            |                          | (160   | )      |        |      |       |        |        |   |       |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|Income (loss) before income taxes                                   |                            |                          | (876   | )      |        |      | 823    |        |        |   | 4,605  |       
|Provision (benefit) for income taxes                                |                            |                          | (145   | )      |        |      | 274    |        |        |   | 1,845  |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|Net income (loss)                                                   |                            | $                        | (731   | )      |        | $    | 549    |        |        | $ | 2,760  |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|Earnings (loss) per share:                                          |                            |                          |        |        |        |      |        |        |        |   |        |       
|                                                                    | Basic                      |                          | $      | (0.06  | )      |      | $      | 0.04   |        |   | $      | 0.22   |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|                                                                    | Diluted                    |                          | $      | (0.06  | )      |      | $      | 0.04   |        |   | $      | 0.22   |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|Shares used to compute earnings (loss) per share:                   |                            |                          |        |        |        |      |        |        |        |   |        |       
|                                                                    | Basic                      |                          |        | 12,577 |        |      |        | 12,579 |        |   |        | 12,475 |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       
|                                                                    | Diluted                    |                          |        | 12,577 |        |      |        | 12,666 |        |   |        | 12,664 |       
|                                                                    |                            |                          |        |        |        |      |        |        |        |   |        |       

See accompanying notes

F-4



---



##### 



QUALSTAR CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY

|                                                        |                                                                     |                      |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |      |      |   |   |        |       |   |   |        |       |       |  
|------------------------------------------------------- | ------------------------------------------------------------------- | -------------------- | ------ | -------- |  | ------------ | ------ | ------------- |  | ----------- | ------ | -------- |  | ----- | ---- | - |  | - | ---- | ---- | - | - | ------ | ----- | - | - | ------ | ----- | ----- | -
|                                                        |                                                                     |                      |        |          |  |              |        |               |  | Accumulated |        |          |  |      
|                                                        |                                                                     |                      |        |          |  |              |        | Other         |  |             |        |         
|                                                        |                                                                     | Common Stock         |        |          |  | Notes        |        | Comprehensive |  |             |        |         
|                                                        |                                                                     |                      |        | Deferred |  | From         |        | Income        |  | Retained    |        |         
|                                                        |                                                                     | Shares               |        | Amount   |  | Compensation |        | Directors     |  | (Loss)      |        | Earnings |  | Total
|                                                        |                                                                     |                      |        |          |  |              |        |               |  |             |        |          |  |      
|                                                        |                                                                     |                     
|                                                        |                                                                     | (In thousands)      
|Balances at July 1, 2001                                |                                                                     |                      | 12,601 |          |  |              | 20,691 |               |  |             | (1,061 | )        |  |       | (512 | ) |  |   | 60   |      |   |   | 25,511 |       |   |   | 44,689 |      
|                                                        |                                                                     |                      |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |      |      |   |   |        |       |   |   |        |      
|Exercise of stock options                               |                                                                     |                      | 55     |          |  |              | 35     |               |  |             |       |          |  |       |     |   |  |   |     |      |   |   |       |       |   |   | 35     |      
|Amortization of deferred compensation                   |                                                                     |                      |       |          |  |              |       |               |  |             | 430    |          |  |       |     |   |  |   |     |      |   |   |       |       |   |   | 430    |      
|Settlement of IPO expenses                              |                                                                     |                      |       |          |  |              | 25     |               |  |             |       |          |  |       |     |   |  |   |     |      |   |   |       |       |   |   | 25     |      
|Accrued interest on directors notes                    |                                                                     |                      |       |          |  |              |       |               |  |             |       |          |  |       | (27  | ) |  |   |     |      |   |   |       |       |   |   | (27    | )    
|Principal payments on directors notes                  |                                                                     |                      |       |          |  |              |       |               |  |             |       |          |  |       | 152  |   |  |   |     |      |   |   |       |       |   |   | 152    |      
|Comprehensive income:                                   |                                                                     |                      |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |      |      |   |   |        |       |   |   |        |      
|                                                        | Net income                                                          |                      |        |         |  |              |        |              |  |             |        |         |  |       |      |  |  |   |      |     |   |   |        | 2,760 |   |   |        | 2,760 |      
|                                                        | Change in unrealized gains (losses) on investments                  |                      |        |         |  |              |        |              |  |             |        |         |  |       |      |  |  |   |      | (91  | ) |   |        |      |   |   |        | (91   | )    
|                                                        |                                                                     |                      |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |      |      |   |   |        |       |   |   |        |      
|                                                        |                                                                     | Comprehensive income |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |      |      |   |   |        |       |   |   |        |       | 2,669 |  
|                                                        |                                                                     |                      |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |      |      |   |   |        |       |   |   |        |      
|Balances at June 30, 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 and interest 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 |      
|                                                        |                                                                     |                      |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |      |      |   |   |        |       |   |   |        |      

See accompanying notes

F-5



---



##### 



QUALSTAR CORPORATION

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                         |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |         |       |        |  
|-------------------------------------------------------- | -------------------------------------------------------------------------------------------- | ------------------------------------------------------------------- | --------------------------------------------- | ------- | --- | ---- | ------ | ------- | --- | ------ | ------- | ------- | ----- | ------ | -
|                                                         |                                                                                              |                                                                    
|                                                         |                                                                                              | Years Ended June 30,                                               
|                                                         |                                                                                              |                                                                    
|                                                         |                                                                                              | 2004                                                                |                                               | 2003    |     | 2002
|                                                         |                                                                                              |                                                                     |                                               |         |     |     
|                                                         |                                                                                              |                                                                    
|                                                         |                                                                                              | (In thousands)                                                     
|OPERATING ACTIVITIES:                                    |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        
|                                                         | Net income (loss)                                                                            |                                                                     | $                                             | (731    | )   |      | $      | 549     |     |        | $       | 2,760   |      
|                                                         | Adjustments to reconcile net income (loss) to net
    cash provided by operating activities: |                                                                     |                                               |         |     |      |        |         |     |        |         |         |      
|                                                         |                                                                                              | Depreciation and amortization                                       |                                               |         | 423 |      |        |         | 380 |        |         |         | 272   |       
|                                                         |                                                                                              | Deferred income taxes                                               |                                               |         | 312 |      |        |         | 657 |        |         |         | (469  | )     
|                                                         |                                                                                              | Provision for (recovery of) bad debts and returns                   |                                               |         | 186 |      |        |         | (53 | )      |         |         | 1,679 |       
|                                                         |                                                                                              | Amortization of deferred compensation                               |                                               |         | 140 |      |        |         | 301 |        |         |         | 430   |       
|                                                         |                                                                                              | Impairment loss for other-than-temporary decline
    in investments |                                               |         | 160 |      |        |         |    |        |         |         |      |       
|                                                         |                                                                                              | Accrued interest on directors notes                                |                                               |         | (6  | )    |        |         | (17 | )      |         |         | (27   | )     
|                                                         |                                                                                              | Changes in operating assets and liabilities:                        |                                               |         |     |      |        |         |     |        |         |         |       |       
|                                                         |                                                                                              |                                                                     | Accounts receivable                           |         |     | (279 | )      |         |     | 2,213  |         |         |       | (1,995 | )
|                                                         |                                                                                              |                                                                     | Inventories                                   |         |     | (327 | )      |         |     | 2,609  |         |         |       | 980    |  
|                                                         |                                                                                              |                                                                     | Prepaid expenses and other assets             |         |     | (222 | )      |         |     | 236    |         |         |       | 93     |  
|                                                         |                                                                                              |                                                                     | Prepaid income taxes and income taxes payable |         |     | 264  |        |         |     | (1,167 | )       |         |       | 877    |  
|                                                         |                                                                                              |                                                                     | Accounts payable                              |         |     | 35   |        |         |     | (454   | )       |         |       | (784   | )
|                                                         |                                                                                              |                                                                     | Accrued payroll and related liabilities       |         |     | 68   |        |         |     | 124    |         |         |       | 81     |  
|                                                         |                                                                                              |                                                                     | Other accrued liabilities                     |         |     | 285  |        |         |     | 657    |         |         |       | 235    |  
|                                                         |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        
|Net cash provided by operating activities                |                                                                                              |                                                                     | 308                                           |         |     |      | 6,035  |         |     |        | 4,132   |        
|INVESTING ACTIVITIES:                                    |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        
|                                                         | Purchases of equipment and leasehold improvements                                            |                                                                     |                                               | (257    | )   |      |        | (561    | )   |        |         | (470    | )    
|                                                         | Purchases of marketable securities                                                           |                                                                     |                                               | (41,123 | )   |      |        | (34,375 | )   |        |         | (19,435 | )    
|                                                         | Proceeds from the sale of marketable securities                                              |                                                                     |                                               | 41,365  |     |      |        | 30,513  |     |        |         | 8,936   |      
|                                                         | Purchase of assets of N2Power, Incorporated                                                  |                                                                     |                                               |        |     |      |        | (288    | )   |        |         |        |      
|                                                         |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        
|Net cash used in investing activities                    |                                                                                              |                                                                     | (15                                           | )       |     |      | (4,711 | )       |     |        | (10,969 | )      
|FINANCING ACTIVITIES:                                    |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        
|                                                         | Principal and interest payments on
    directors notes                                      |                                                                     |                                               | 117     |     |      |        | 248     |     |        |         | 152     |      
|                                                         | Proceeds from exercise of stock options                                                      |                                                                     |                                               | 69      |     |      |        | 149     |     |        |         | 35      |      
|                                                         | Repurchase of common stock                                                                   |                                                                     |                                               | (314    | )   |      |        | (344    | )   |        |         |        |      
|                                                         |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        
|Net cash provided by (used in) financing
    activities  |                                                                                              |                                                                     | (128                                          | )       |     |      | 53     |         |     |        | 187     |        
|NET INCREASE (DECREASE) IN CASH AND CASH
    EQUIVALENTS |                                                                                              |                                                                     | 165                                           |         |     |      | 1,377  |         |     |        | (6,650  | )      
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD           |                                                                                              |                                                                     | 6,236                                         |         |     |      | 4,859  |         |     |        | 11,509  |        
|                                                         |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        
|CASH AND CASH EQUIVALENTS, END OF PERIOD                 |                                                                                              | $                                                                   | 6,401                                         |         |     | $    | 6,236  |         |     | $      | 4,859   |        
|                                                         |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        
|SUPPLEMENTAL CASH FLOW DISCLOSURES:                      |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        
|                                                         | Income taxes paid                                                                            |                                                                     | $                                             | 12      |     |      | $      | 904     |     |        | $       | 1,436   |      
|                                                         |                                                                                              |                                                                     |                                               |         |     |      |        |         |     |        |         |        

See accompanying notes

F-6



---



##### 



QUALSTAR CORPORATION

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS



|   |                                               
|-- | ----------------------------------------------
|1. | Summary of Significant Accounting
    Policies



| |         
| | --------
| | Business

Qualstar Corporation (Qualstar) was
incorporated in California in 1984 to develop and manufacture
IBM compatible 9-track reel-to-reel tape drives for the personal
computer and workstation marketplaces. Since 1995, Qualstar has
focused its efforts on designing, developing, manufacturing and
selling automated magnetic tape libraries used to store,
retrieve and manage electronic data primarily in the network
computing environment. Tape libraries consist of cartridge tape
drives, tape cartridges and robotics to move the tape cartridges
from their storage locations to the tape drives under software
control. Qualstars libraries provide storage solutions for
organizations requiring backup, recovery, and archival storage
of critical electronic information. Qualstars tape
libraries are compatible with commonly used operating systems,
including UNIX, Windows, NetWare, MAC and Linux and a wide range
of storage management software. Qualstar offers tape libraries
for multiple tape drive technologies, including those using AIT,
Super AIT, SuperDLT and LTO.



| |                            
| | ---------------------------
| | Principles in Consolidation

The consolidated financial statements include the
accounts and operations of Qualstar and its wholly owned
subsidiary. All significant intercompany accounts have been
eliminated.



| |                          
| | -------------------------
| | Cash and Cash Equivalents

Qualstar classifies as cash equivalents only cash
and those investments that are short term, highly liquid,
readily convertible to cash, and so near their maturity that
they present insignificant risk of changes in value because of
changes in interest rates.



| |                                                                        
| | -----------------------------------------------------------------------
| | Concentration of Credit Risk, Other Risks
    and Significant Customers

Qualstar sells its products primarily through a
variety of market channels including original equipment
manufacturers (OEM) and value added resellers
(VAR) located worldwide. Ongoing credit evaluations of
customers financial condition are performed by Qualstar
and generally collateral is not required. Potential
uncollectible accounts have been provided for in the financial
statements.

Sales outside of North America represented
approximately 32.4% of net revenues in 2004, approximately 29.4%
of net revenues in 2003 and approximately 32.2% of net revenues
in 2002. Revenues from Qualstars two largest customers
combined were approximately 14.6%, 15.4%, and 17.6% for the
years ended June 30, 2004, 2003, and 2002, respectively. At
June 30, 2004 and 2003, the two largest customers
accounts receivable, net of specific allowances, totaled
approximately 22.4% and 30.1% of net accounts receivable,
respectively.



| |                      
| | ---------------------
| | Marketable Securities

Marketable securities consist primarily of
high-quality U.S. corporate securities and
U.S. federal government and state government debt
securities. These securities are classified in one of three
categories: trading, available-for-sale, or held-to-maturity.
Trading securities are bought and held principally for the
purpose of selling them in the near term. Held-to-maturity
securities are those securities which Qualstar has the ability
and intent to hold until maturity. All other securities not
included in trading or held-to-maturity are classified as
available-for-sale. All of Qualstars marketable securities
were classified as available-for-sale at June 30, 2004 and
2003.

Available-for-sale securities are recorded at
market value. Unrealized holding gains and losses, net of the
related income tax effect, on available-for-sale securities are
excluded from earnings and are reported as a separate component
of shareholders equity until realized. Dividend and
interest income are recognized when earned. Realized gains and
losses for securities classified as available-for-sale are
included in earnings when

F-7



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

the underlying securities are sold and are
derived using the specific identification method for determining
the cost of securities sold.

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 Its
Application to Certain Investments, (EIFT 03-1)
effective for annual financial statements with fiscal years
ending after June 15, 2004. EITF 03-1 provides
guidance for determining when an investment is
other-than-temporarily impaired, and states that an investment
is considered other-than-temporarily impaired when its fair
value is less than its amortized cost basis and is deemed other
than temporary. The application of EITF 03-1 to the
Companys marketable securities portfolio resulted in the
identification of an other-than-temporarily impaired investment
as of June 30, 2004. In accordance with EITF 03-1, the
Company has recognized an impairment loss for
other-than-temporary decline in investments of $160,000 in
earnings equal to the difference between the amortized cost
basis and its fair value as of June 30, 2004.



| |            
| | -----------
| | Inventories

Inventories are stated at the lower of cost
(first-in, first-out basis) or market.



| |          
| | ---------
| | Suppliers

Sales and costs of goods sold related to products
purchased from one supplier totaled approximately 51.1% and
41.3%, respectively, of total sales and cost of goods sold for
the year ended June 30, 2004. Sales and costs of goods sold
related to products purchased from one large supplier totaled
approximately 56.2% and 57.3%, respectively, of total sales and
cost of goods sold for the year ended June 30, 2003. Sales
and costs of goods sold related to products purchased from one
supplier totaled approximately 65.3% and 54.2%, respectively, of
total sales and cost of goods sold for the year ended
June 30, 2002.



| |                       
| | ----------------------
| | Property and Equipment

Property and equipment is depreciated using the
straight-line method over the estimated useful lives (3 to
7 years) of the individual assets. Leasehold improvements
are amortized over the estimated useful lives, or the term of
the related leases, whichever is shorter, using the
straight-line method.



| |                           
| | --------------------------
| | Investment in Common Stock

In November 1999, Qualstar purchased an
approximate 1% interest in Chaparral Network Storage, Inc.
(Chaparral) for an aggregate purchase price of $1,050,000. This
investment was accounted for under the cost method. During the
fourth quarter of fiscal year 2001, management determined the
carrying value of the investment in Chaparral exceeded its net
realizable value as a result of rapid changes in technology and
the availability of capital for further development of
Chaparrals family of products. Accordingly, management
determined an allowance in the amount of $1,050,000 was
necessary to reduce the carrying value of the investment in
Chaparral to its estimated net realizable value. The related
charge was included in the statement of operations as an
impairment of investment in the year ended June 30, 2001.
In the third quarter of fiscal year 2004, Chaparral merged with
DHSA Corporation, a wholly owned subsidiary of Dot Hill Systems
Corporation, from which Qualstar received approximately $20,000
as a return on principal from the original investment in
Chaparral.



| |                  
| | -----------------
| | Long-Lived Assets

Qualstar reviews for the impairment of long-lived
assets whenever events or changes in circumstances indicate the
carrying amount of any asset may not be recoverable. An
impairment loss would be recognized when the estimated
undiscounted future cash flows expected to result from the use
of the asset and its

F-8



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

eventual disposition is less than the carrying
amount. If an impairment is indicated, the amount of the loss to
be recorded is based upon an estimate of the difference between
the carrying amount and the fair value of the asset. Fair value
is based upon discounted cash flows expected to result from the
use of the asset and its eventual disposition and other
valuation methods. Qualstar has identified no impairment loss of
long-lived assets during the periods presented.



| |                    
| | -------------------
| | Revenue Recognition

Revenues are recognized upon shipment of the
product to the customer and when collectibility is reasonably
assured, less estimated returns for which provisions are made at
the time of sale. The provision for estimated returns is made
based on known claims and estimates of additional returns based
on historical data. Revenues from technical support services and
other services are recognized at the time the services are
performed.



| |                            
| | ---------------------------
| | Shipping and Handling Costs

Qualstar generally records all charges for
outbound shipping and handling as revenue. All inbound shipping
and fulfillment costs are classified as costs of goods sold.



| |                     
| | --------------------
| | Warranty Obligations

Qualstar provides a three year warranty period on
its tape libraries. 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 most countries
within Europe. A provision for costs related to warranty expense
is recorded when revenue is recognized, which is estimated based
on historical warranty costs incurred.

In November 2002, the Financial Accounting
Standards Board (FASB) issued Interpretation No. 45
(FIN 45), Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of
the Indebtedness of Others, which clarifies the
requirements of Statement of Financial Accounting Standards
(SFAS) No. 5, Accounting for
Contingencies, relating to a guarantors accounting
for and disclosures for certain guarantees. FIN 45 requires
enhanced disclosures, among other things, for certain
guarantees, including warranty accruals. Qualstar does not issue
third party guarantees, as defined, and therefore only the
disclosure provisions of FIN 45 apply. Qualstar adopted
FIN 45 for the year ended June 30, 2003, and the
adoption has had no impact on Qualstars financial position
or results of operations. Additional disclosures have not been
provided as the Companys warranty accrual and warranty
expense is not material in any of the periods presented.



| |                         
| | ------------------------
| | Research and Development

All research and development costs are charged to
expense as incurred. These costs consist primarily of
engineering salaries, benefits, outside consultant fees, and
purchased parts and supplies of personnel directly involved in
the design and development of new products.



| |            
| | -----------
| | Advertising

Qualstar expenses all costs of advertising and
promotion as incurred. Advertising and promotion expenses for
the years ended June 30, 2004, 2003 and 2002 were
approximately $601,000, $984,000, and $211,000, respectively.

F-9



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                            
| | -------------------------------------------
| | Accounting for Stock Based
    Compensation

Employee stock options are accounted for under
Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, as amended
and interpreted, which requires the recognition of expense when
the option price is less than the fair value of the stock at the
date of grant. Qualstar generally awards options for a fixed
number of shares at an option price equal to the fair value at
the date of grant. Qualstar has adopted the disclosure-only
provisions of SFAS No. 123, Accounting for
Stock-Based Compensation (SFAS 123).

If Qualstar recognized employee stock
option-related compensation expense in accordance with
SFAS 123 and used the minimum value method for grants prior
to the Companys initial public offering and the
Black-Scholes method model afterward for determining the
weighted average fair value of options granted, the
Companys net income (loss) and earnings (loss) per share
would have been reduced to the pro forma amounts indicated below:

|                                                                           |                       |                            |        |       |   |      |      |      |  |   |       |      | 
|-------------------------------------------------------------------------- | --------------------- | -------------------------- | ------ | ----- | - | ---- | ---- | ---- |  | - | ----- | ---- | 
|                                                                           |                       |                           
|                                                                           |                       | Fiscal Year Ended June 30,
|                                                                           |                       |                           
|                                                                           |                       | 2004                       |        | 2003  |   | 2002
|                                                                           |                       |                            |        |       |   |     
|Net income (loss) as reported                                              |                       | $                          | (731   | )     |   | $    | 549  |      |  | $ | 2,760 |     
|Stock-based employee compensation cost included
    in reported net income |                       |                            | 140    |       |   |      | 301  |      |  |   | 430   |     
|Pro forma stock-based employee compensation cost
    under SFAS 123        |                       |                            | (505   | )     |   |      | (591 | )    |  |   | (590  | )   
|                                                                           |                       |                            |        |       |   |      |      |      |  |   |       |     
|Pro forma net income (loss)                                                |                       | $                          | (1,096 | )     |   | $    | 259  |      |  | $ | 2,600 |     
|                                                                           |                       |                            |        |       |   |      |      |      |  |   |       |     
|Earnings (loss) per share:                                                 |                       |                            |        |       |   |      |      |      |  |   |       |     
|                                                                           | Basic  as reported   |                            | $      | (0.06 | ) |      | $    | 0.04 |  |   | $     | 0.22 | 
|                                                                           |                       |                            |        |       |   |      |      |      |  |   |       |     
|                                                                           | Basic  pro forma     |                            | $      | (0.09 | ) |      | $    | 0.02 |  |   | $     | 0.21 | 
|                                                                           |                       |                            |        |       |   |      |      |      |  |   |       |     
|                                                                           | Diluted  as reported |                            | $      | (0.06 | ) |      | $    | 0.04 |  |   | $     | 0.22 | 
|                                                                           |                       |                            |        |       |   |      |      |      |  |   |       |     
|                                                                           | Diluted  pro forma   |                            | $      | (0.09 | ) |      | $    | 0.02 |  |   | $     | 0.21 | 
|                                                                           |                       |                            |        |       |   |      |      |      |  |   |       |     

For purposes of pro forma disclosures, the
estimated fair value of the options is amortized over the
options vesting periods. The pro forma effect on net
income or loss for 2004, 2003 and 2002 is not representative of
the pro forma effect on net income or loss in future years
because compensation expense in future years will reflect the
amortization of a larger number of stock options granted in
several succeeding years.

In computing the pro forma compensation expense
under SFAS 123, a weighted-average fair value of $3.59 for
2004, $4.29 for 2003, and $1.97 for 2002 stock option grants was
estimated at the date of grant using the minimum value option
pricing model before Qualstars initial public offering and
the Black Scholes model afterward with the following assumptions:

|                         |  |      |          |      |  |      |          |   |  |  |          |  
|------------------------ |  | ---- | -------- | ---- |  | ---- | -------- | - |  |  | -------- | -
|                         |  | 2004 |          | 2003 |  | 2002
|                         |  |      |          |      |  |     
|Expected dividend yield  |  |      | 0        | %    |  |      | 0        | % |  |  | 0        | %
|Risk-free interest rate  |  |      | 2.9      | %    |  |      | 2.7      | % |  |  | 4.5      | %
|Expected life of options |  |      | 4  years |      |  |      | 5  years |   |  |  | 5  years |  
|Volatility               |  |      | 100.8    | %    |  |      | 54.0     | % |  |  | 38.0     | %

F-10



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |             
| | ------------
| | Income Taxes

Income taxes are accounted for using the
liability method in accordance with SFAS 109,
Accounting for Income Taxes. Under this method,
deferred tax liabilities and assets are recognized for the
expected future tax consequences of temporary differences
between the financial statement and tax bases of assets and
liabilities, and for the expected future tax benefit to be
derived from tax credits and loss carryforwards. Current income
tax expense or benefit represents the amount of income taxes
expected to be payable or refundable for the current year. A
valuation allowance is established when, in the opinion of
management, it is more likely than not that some portion or all
of the deferred tax assets will not be realized.



| |                            
| | ---------------------------
| | Comprehensive Income (Loss)

Comprehensive income (loss) is accounted for
according to SFAS No. 130, Reporting
Comprehensive Income (SFAS 130). Comprehensive income
(loss) includes unrealized gains and losses on debt and equity
securities classified as available-for-sale and included as a
component of shareholders equity.



| |                          
| | -------------------------
| | Earnings (Loss) Per Share

Qualstar calculates earnings (loss) per share in
accordance with SFAS No. 128, Earnings per
Share. Basic earnings per share has been computed by
dividing net income (loss) by the weighted average number of
common shares outstanding. Diluted earnings (loss) per share has
been computed by dividing net income (loss) by the weighted
average common shares outstanding plus dilutive securities or
other contracts to issue common stock as if these securities
were exercised or converted to common stock.

The following table sets forth the calculation
for basic and diluted earnings per share for the periods
indicated:

|          |                                                                   |                     |   |        |   |      |   |        |  |  |   |        | 
|--------- | ----------------------------------------------------------------- | ------------------- | - | ------ | - | ---- | - | ------ |  |  | - | ------ | 
|          |                                                                   |                    
|          |                                                                   | Year Ended June 30,
|          |                                                                   |                    
|          |                                                                   | 2004                |   | 2003   |   | 2002
|          |                                                                   |                     |   |        |   |     
|          |                                                                   |                    
|          |                                                                   | (In thousands)     
|Earnings: |                                                                   |                     |   |        |   |      |   |        |  |  |   |       
|          | Net income (loss)                                                 |                     | $ | (731   | ) |      | $ | 549    |  |  | $ | 2,760  | 
|          |                                                                   |                     |   |        |   |      |   |        |  |  |   |       
|Shares:   |                                                                   |                     |   |        |   |      |   |        |  |  |   |       
|          | Weighted average shares for basic earnings (loss)
    per share   |                     |   | 12,577 |   |      |   | 12,579 |  |  |   | 12,475 | 
|          | Stock options                                                     |                     |   |       |   |      |   | 87     |  |  |   | 189    | 
|          |                                                                   |                     |   |        |   |      |   |        |  |  |   |       
|          | Weighted average shares for diluted earnings
    (loss) per share |                     |   | 12,577 |   |      |   | 12,666 |  |  |   | 12,664 | 
|          |                                                                   |                     |   |        |   |      |   |        |  |  |   |       

Shares issuable under stock options of 511,000,
152,000 and 68,000 for the years ended June 30, 2004, 2003
and 2002, respectively, have been excluded from the computation
of diluted earnings (loss) per share because the effect would be
antidilutive.



| |                    
| | -------------------
| | Segment Information

Based on the provisions of
SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information and the manner in which
the Chief Operating Decision Maker analyzes the business,
Qualstar has determined that it does not have separately
reportable operating segments.



| |                                        
| | ---------------------------------------
| | Fair Value of Financial
    Instruments

The carrying amounts reported in the balance
sheets for cash and cash equivalents, accounts receivable and
accounts payable approximate their fair values due to the short
term nature of these financial instruments.

F-11



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                          
| | -------------------------
| | Estimates and Assumptions

The preparation of financial statements in
conformity with accounting principles generally accepted in the
United States requires management to make estimates and
assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ
materially from those estimates.



| |                 
| | ----------------
| | Reclassification

Certain prior year amounts have been reclassified
to conform to the current year presentation.



|   |                      
|-- | ---------------------
|2. | Marketable Securities

The following table shows the gross unrealized
losses and fair value of the Companys investments with
unrealized losses that are not deemed to be
other-than-temporarily impaired, aggregated by investment
category and length of time that individual securities have been
in a continuous unrealized loss position, at June 30, 2004.

|                                                                               |  |                     |        |              |  |                |      |            |  |       |   |            |  |   |   |  |  |   |        |  |  |   |      |  
|------------------------------------------------------------------------------ |  | ------------------- | ------ | ------------ |  | -------------- | ---- | ---------- |  | ----- | - | ---------- |  | - | - |  |  | - | ------ |  |  | - | ---- | -
|                                                                               |  |                     |        |              |  |                |      |            |  |      
|                                                                               |  |                     |        | 12 Months or |  |               
|                                                                               |  | Less Than 12 Months |        | 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 |  | $                   | 9,623  |              |  | $              | (81  | )          |  | $     |  |            |  | $ |  |  |  | $ | 9,623  |  |  | $ | (81  | )
|Government Sponsored Enterprise collateralized
    mortgage obligations        |  |                     | 1,244  |              |  |                | (17  | )          |  |       |  |            |  |   |  |  |  |   | 1,244  |  |  |   | (17  | )
|Corporate bonds                                                                |  |                     | 1,018  |              |  |                | (5   | )          |  |       |  |            |  |   |  |  |  |   | 1,018  |  |  |   | (5   | )
|                                                                               |  |                     |        |              |  |                |      |            |  |       |   |            |  |   |   |  |  |   |        |  |  |   |      |  
|Total                                                                          |  | $                   | 11,885 |              |  | $              | (103 | )          |  | $     |  |            |  | $ |  |  |  | $ | 11,885 |  |  | $ | (103 | )
|                                                                               |  |                     |        |              |  |                |      |            |  |       |   |            |  |   |   |  |  |   |        |  |  |   |      |  

U.S. Treasury
Obligations.The unrealized losses on
the Companys investments in U.S. Treasury obligations
and direct obligations of U.S. Government agencies were
caused by interest rate increases. The contractual terms of
these investments do not permit the issuer to settle the
securities at a price less than the amortized cost of the
investment. Because the Company has the ability and intent to
hold these investments until a recovery of fair value, which may
be maturity, the Company does not consider these investments to
be other-than-temporarily impaired at June 30, 2004.

Government Sponsored Enterprise (GSE)
Collateralized Mortgage Obligations.Freddie Mac and Fannie Mae are identified as GSEs. The
unrealized losses on the Companys investment in GSE
collateralized mortgage obligations were caused by interest rate
increases. The cash flows of these investments are guaranteed by
the GSE. Because the decline in market value is attributable to
changes in interest rates and not credit quality and because the
Company has the ability and intent to hold these investments
until a recovery of fair value, which may be maturity, the
Company does not consider these investments to be
other-than-temporarily impaired at June 30, 2004.

Corporate Bonds.The
Companys unrealized loss on investments in corporate bonds
relates to an investment in International Lease Finance Corp, a
bond with a credit rating of AA- (S&P). The unrealized loss
was primarily caused by fluctuations in the interest rate
environment. The contractual terms of this investment does not
permit International Lease Finance Corp to settle the security
at a price less than par. Because the Company has the ability
and intent to hold this investment until a recovery of fair
value, which may be maturity, it does not consider the
investment in International Lease Finance Corps bond to be
other-than-temporarily impaired at June 30, 2004.

F-12



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |            
|-- | -----------
|3. | Inventories

Inventories consist of the following (in
thousands):

|               |  |          |       |      |  |   |       | 
|-------------- |  | -------- | ----- | ---- |  | - | ----- | 
|               |  |         
|               |  | June 30,
|               |  |         
|               |  | 2004     |       | 2003
|               |  |          |       |     
|Raw materials  |  | $        | 6,370 |      |  | $ | 6,454 | 
|Finished goods |  |          | 1,048 |      |  |   | 637   | 
|               |  |          |       |      |  |   |       | 
|               |  | $        | 7,418 |      |  | $ | 7,091 | 
|               |  |          |       |      |  |   |       | 



|   |                       
|-- | ----------------------
|4. | Property and Equipment

The components of property and equipment are as
follows (in thousands):

|                        |                                                |          |       |        |   |   |       |        |  
|----------------------- | ---------------------------------------------- | -------- | ----- | ------ | - | - | ----- | ------ | -
|                        |                                                |         
|                        |                                                | June 30,
|                        |                                                |         
|                        |                                                | 2004     |       | 2003  
|                        |                                                |          |       |       
|Leasehold improvements  |                                                | $        | 546   |        |   | $ | 541   |       
|Furniture and fixtures  |                                                |          | 970   |        |   |   | 890   |       
|Machinery and equipment |                                                |          | 2,340 |        |   |   | 2,276 |       
|                        |                                                |          |       |        |   |   |       |       
|                        |                                                |          | 3,856 |        |   |   | 3,707 |       
|                        | Less accumulated depreciation and amortization |          |       | (2,417 | ) |   |       | (2,150 | )
|                        |                                                |          |       |        |   |   |       |       
|                        |                                                | $        | 1,439 |        |   | $ | 1,557 |       
|                        |                                                |          |       |        |   |   |       |       



|   |             
|-- | ------------
|5. | Income Taxes

The provision (benefit) for income taxes is
comprised of the following (in thousands):

|          |         |                     |      |      |   |      |      |      |   |   |       |       |  
|--------- | ------- | ------------------- | ---- | ---- | - | ---- | ---- | ---- | - | - | ----- | ----- | -
|          |         |                    
|          |         | Year Ended June 30,
|          |         |                    
|          |         | 2004                |      | 2003 |   | 2002
|          |         |                     |      |      |   |     
|Current:  |         |                     |      |      |   |      |      |      |   |   |       |      
|          | Federal |                     | $    | (451 | ) |      | $    | (332 | ) |   | $     | 1,775 |  
|          | State   |                     |      | (6   | ) |      |      | (51  | ) |   |       | 539   |  
|          |         |                     |      |      |   |      |      |      |   |   |       |      
|          |         |                     | (457 | )    |   |      | (383 | )    |   |   | 2,314 |      
|Deferred: |         |                     |      |      |   |      |      |      |   |   |       |      
|          | Federal |                     |      | 257  |   |      |      | 579  |   |   |       | (391  | )
|          | State   |                     |      | 55   |   |      |      | 78   |   |   |       | (78   | )
|          |         |                     |      |      |   |      |      |      |   |   |       |      
|          |         |                     | 312  |      |   |      | 657  |      |   |   | (469  | )    
|          |         |                     |      |      |   |      |      |      |   |   |       |      
|          |         | $                   | (145 | )    |   | $    | 274  |      |   | $ | 1,845 |      
|          |         |                     |      |      |   |      |      |      |   |   |       |      

F-13



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following is a reconciliation of the
statutory federal income tax rate to Qualstars effective
income tax rate:

|                                                          |  |                     |       |      |  |      |       |   |  |  |      |  
|--------------------------------------------------------- |  | ------------------- | ----- | ---- |  | ---- | ----- | - |  |  | ---- | -
|                                                          |  |                    
|                                                          |  | Year Ended June 30,
|                                                          |  |                    
|                                                          |  | 2004                |       | 2003 |  | 2002
|                                                          |  |                     |       |      |  |     
|Statutory federal income tax expense (benefit)            |  |                     | (34.0 | )%   |  |      | 34.0  | % |  |  | 34.0 | %
|State income taxes, net of federal income tax
    benefit |  |                     | (4.2  | )    |  |      | 2.6   |   |  |  | 4.5  |  
|Non-taxable investment income                             |  |                     | (16.0 | )    |  |      | (16.6 | ) |  |  | (7.2 | )
|Research and development credits                          |  |                     | (22.8 | )    |  |      |      |   |  |  |     |  
|Valuation allowance                                       |  |                     | 55.2  |      |  |      |      |   |  |  |     |  
|Amortization of deferred compensation                     |  |                     | 5.4   |      |  |      | 12.5  |   |  |  | 9.3  |  
|Other                                                     |  |                     | (0.2  | )    |  |      | 0.8   |   |  |  | (0.5 | )
|                                                          |  |                     |       |      |  |      |       |   |  |  |      |  
|                                                          |  |                     | (16.6 | )%   |  |      | 33.3  | % |  |  | 40.1 | %
|                                                          |  |                     |       |      |  |      |       |   |  |  |      |  

The tax effect of temporary differences resulted
in deferred income tax assets (liabilities) as follows
(in thousands):

|                        |                                                   |                                 |     |        |       |   |     |      |      |  
|----------------------- | ------------------------------------------------- | ------------------------------- | --- | ------ | ----- | - | --- | ---- | ---- | -
|                        |                                                   |                                
|                        |                                                   | June 30,                       
|                        |                                                   |                                
|                        |                                                   | 2004                            |     | 2003  
|                        |                                                   |                                 |     |       
|Deferred tax assets:    |                                                   |                                 |     |        |       |   |     |     
|                        | Net operating loss and other credit carryforwards |                                 | $   | 555    |       |   | $   |     |     
|                        | Capital loss carryforwards                        |                                 |     | 487    |       |   |     |     |     
|                        | Allowance for bad debts and returns               |                                 |     | 89     |       |   |     | 107  |     
|                        | Inventory reserves                                |                                 |     | 146    |       |   |     | 130  |     
|                        | Reserve for Chaparral investment                  |                                 |     |       |       |   |     | 430  |     
|                        | Capitalized inventory costs                       |                                 |     | 33     |       |   |     | 32   |     
|                        | Other accruals                                    |                                 |     | 326    |       |   |     | 240  |     
|                        |                                                   |                                 |     |        |       |   |     |     
|                        |                                                   | Total gross deferred tax assets |     |        | 1,636 |   |     |      | 939  |  
|                        | Valuation allowance                               |                                 |     | (1,042 | )     |   |     |     |     
|                        |                                                   |                                 |     |        |       |   |     |     
|                        |                                                   | Net deferred tax asset          |     |        | 594   |   |     |      | 939  |  
|Deferred tax liability: |                                                   |                                 |     |        |       |   |     |     
|                        | Depreciation and other                            |                                 |     | (158   | )     |   |     | (191 | )   
|                        |                                                   |                                 |     |        |       |   |     |     
|                        |                                                   | Total deferred tax liability    |     |        | (158  | ) |     |      | (191 | )
|                        |                                                   |                                 |     |        |       |   |     |     
|                        |                                                   | $                               | 436 |        |       | $ | 748 |     
|                        |                                                   |                                 |     |        |       |   |     |     

A valuation reserve has been established at
June 30, 2004 for $1,042 based on the Companys
assessment regarding the realizability of certain deferred tax
assets in future years. The Company has net operating losses,
capital losses and other carryforwards for tax purposes of
$2,368 at June 30, 2004 expiring between fiscal years 2009
and 2024.

We currently have a prior fiscal year under audit
by the Internal Revenue Service (IRS). The IRS has
proposed an adjustment which we believe will ultimately not
result in any significant adjustments to the previously filed
return. If the proposed adjustment requires an amendment of the
prior year tax return, we believe that any additional taxes that
we may be required to pay will not have a significant effect on
our financial position or results of operations.

F-14



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                
|-- | ---------------
|6. | Preferred Stock

Qualstars capital structure allows for the
Board of Directors to authorize 5,000,000 shares of
preferred stock. The Board of Directors has authority to fix the
rights, preferences, privileges and restrictions, including
voting rights, of these shares of preferred stock without any
future vote or action by the shareholders. At June 30, 2004
and 2003, there were no outstanding shares of preferred stock.



|   |                   
|-- | ------------------
|7. | Stock Option Plans

Qualstar adopted a stock option plan in 1998
(1998 Stock Incentive Plan) under which incentive and
nonqualified stock options could be granted for an aggregate of
no more than 270,000 shares of common stock. During fiscal
2000, Qualstar amended and restated the 1998 stock option plan
to increase the pool of options and shares of restricted stock
that could be granted for an aggregate of no more than
1,215,000 shares of common stock. Under the terms of the
plan, options could be issued at an exercise price of not less
than 100% of the fair market value of common stock as determined
by the board of directors (or board appointed administrator) on
the date of grant. If an incentive stock option is granted to an
individual owning more than 10% of the total combined voting
power of all stock, the exercise price of the option may not be
less than 110% of the fair market value of the underlying shares
on the date of grant. Options are exercisable in annual
installments and terminate as specified in each option
agreement, but terminate no later than ten years after the date
of grant.

The following table summarizes all stock option
activity (in thousands, except per share amounts):

|                             |           |         |     |           |   |                |              |             |  |   |      |      | 
|---------------------------- | --------- | ------- | --- | --------- | - | -------------- | ------------ | ----------- |  | - | ---- | ---- | 
|                             |           |         |     | Exercise  |   | Weighted      
|                             |           | Stock   |     | Price Per |   | Average       
|                             |           | Options |     | Share     |   | Exercise Price
|                             |           |         |     |           |   |               
|Outstanding at July 1, 2001  |           |         | 256 |           |   | $              | 0.22 - $9.38 |             |  | $ | 4.00 |     
|                             | Granted   |         |     | 248       |   |                |              | 4.37 - 5.94 |  |   |      | 5.21 | 
|                             | Exercised |         |     | (55       | ) |                |              | 0.22 - 2.78 |  |   |      | 0.63 | 
|                             | Cancelled |         |     | (8        | ) |                |              | 2.78        |  |   |      | 2.78 | 
|                             |           |         |     |           |   |                |              |             |  |   |      |     
|Outstanding at June 30, 2002 |           |         | 441 |           |   | $              | 0.56 - $9.38 |             |  | $ | 5.12 |     
|                             | Granted   |         |     | 167       |   |                |              | 4.23 - 4.89 |  |   |      | 4.29 | 
|                             | Exercised |         |     | (60       | ) |                |              | 0.56 - 2.78 |  |   |      | 2.48 | 
|                             | Cancelled |         |     | (68       | ) |                |              | 2.78 - 9.38 |  |   |      | 4.33 | 
|                             |           |         |     |           |   |                |              |             |  |   |      |     
|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 |     
|                             |           |         |     |           |   |                |              |             |  |   |      |     

|             |  |                                      |     |                     |  |          |     |             |  |          |      |  |  |  |     |  |  |   |      | 
|------------ |  | ------------------------------------ | --- | ------------------- |  | -------- | --- | ----------- |  | -------- | ---- |  |  |  | --- |  |  | - | ---- | 
|             |  |                                      |     |                     |  |          |     |            
|             |  |                                      |     | Options Exercisable
|             |  | Options Outstanding at June 30, 2004 |     | at June 30, 2004   
|             |  |                                      |     |                    
|             |  |                                      |     | Weighted            |  |          |     | Weighted   
|             |  | Number of                            |     | Weighted Average    |  | Average  |     | Number of   |  | Average 
|Exercise     |  | Shares                               |     | Remaining           |  | Exercise |     | Shares      |  | Exercise
|Price Range  |  | Outstanding                          |     | Contractual Life    |  | Price    |     | Exercisable |  | Price   
|             |  |                                      |     |                     |  |          |     |             |  |         
|$4.23 - 5.94 |  |                                      | 469 |                     |  |          | 8.3 |             |  | $        | 4.87 |  |  |  | 141 |  |  | $ | 4.90 | 
|$9.38        |  |                                      | 42  |                     |  |          | 6.1 |             |  | $        | 9.38 |  |  |  | 32  |  |  | $ | 9.38 | 

On January 14, 2000, each of Qualstars
four non-employee directors were granted and purchased
54,000 shares of restricted stock pursuant to the 1998
Stock Incentive Plan at a price of $2.78 per share. Each

F-15



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

director paid for the shares with a promissory
note in the amount of $150,000 secured by the purchased shares.
Interest on the notes accrues at the rate of 6.21% and is
payable annually. Payments of principal on the notes are due in
four equal annual installments beginning in January 2002.
Qualstar, solely at its discretion, has the right to repurchase
each directors restricted shares at the original purchase
price upon termination of service for any reason.
Qualstars repurchase right lapses and the shares vest
ratably over four years based upon each year of service as a
director. All of these shares were fully vested as of
January 14, 2004.

Upon issuance of the restricted stock and
granting of stock options in January 2000, Qualstar recorded a
deferred compensation charge of $1.7 million related to
both stock options and restricted stock for the difference
between the exercise price and the deemed fair market value for
accounting purposes on the date of the grant. The deferred
compensation recorded was amortized over a four-year vesting
period, which resulted in compensation expense 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 to these grants were
forfeited. The forfeitures resulted in a decrease in common
stock paid-in-capital and deferred compensation of $190,000
during the year ended June 30, 2003.



|   |                    
|-- | -------------------
|8. | Purchase of N2Power

On July 11, 2002, Qualstar acquired the
assets and intellectual properties of N2Power, Incorporated, a
privately held company which designed and produced small and
efficient open-frame switching power supplies. The consideration
for this acquisition 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
over 5 years. The accompanying consolidated financial
statements include the operations of N2Power from the date of
acquisition. At June 30, 2004, accumulated amortization of
the patent was $96,000. Amortization expense for the years ended
June 30, 2004 and 2003 was $48,000 in each year.
Amortization expense is estimated to be $48,000 in each of the
fiscal years 2005, 2006, and 2007.



|   |            
|-- | -----------
|9. | Commitments

Qualstars lease agreement for its facility
located in Simi Valley, California, expires in February of 2011,
with an early termination option becoming available in February
of 2007. The annual rent for the lease is $468,000, with
step-ups ranging from $28,000 to $34,000 every two years.

Qualstars lease agreement for its facility
located in Boulder, Colorado, expires in May of 2007 with an
initial annual rent in the amount of $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
|            |  |              
|2005        |  | $             | 562,000   | 
|2006        |  |               | 581,000   | 
|2007        |  |               | 590,000   | 
|2008        |  |               | 554,000   | 
|2009        |  |               | 568,000   | 
|Thereafter  |  |               | 931,000   | 
|            |  |               |           | 
|            |  | $             | 3,786,000 | 
|            |  |               |           | 

Rent expense (including equipment rental) for the
years ended June 30, 2004, 2003, and 2002, was $679,000,
$589,000, and $594,000, respectively.

F-16



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |                  
|--- | -----------------
|10. | Legal Proceedings

On January 10, 2003, Raytheon Company
(Raytheon) filed a complaint in the United States
District Court for the Eastern District of Texas alleging that
Qualstar and eight other named defendants infringed on a patent
owned by Raytheon entitled Mass Data Storage
Library. Raytheon filed an amended complaint on or about
February 6, 2003, which included an allegation that
Qualstars tape libraries infringe Raytheons patent.
On April 2, 2004, Raytheon and Qualstar entered into a
written settlement agreement pursuant to which all claims
between the parties alleged in the litigation were dismissed
with prejudice. The costs to settle this dispute have been
included in our results of operations in general and
administrative expenses in the year ended June 30, 2004 and
have not had a material adverse effect on our financial position.

Qualstar may be involved in other litigation or
legal matters from time to time in the normal course of business.



|    |                       
|--- | ----------------------
|11. | Geographic Information

Information regarding revenues attributable to
the Qualstars primary geographic operating regions is as
follows (in thousands):

|          |               |                     |        |        |  |      |        |        |  |   |        |        | 
|--------- | ------------- | ------------------- | ------ | ------ |  | ---- | ------ | ------ |  | - | ------ | ------ | 
|          |               |                    
|          |               | Year Ended June 30,
|          |               |                    
|          |               | 2004                |        | 2003   |  | 2002
|          |               |                     |        |        |  |     
|Revenues: |               |                     |        |        |  |      |        |        |  |   |        |       
|          | North America |                     | $      | 21,312 |  |      | $      | 23,678 |  |   | $      | 25,550 | 
|          | Europe        |                     |        | 4,842  |  |      |        | 7,349  |  |   |        | 9,811  | 
|          | Asia          |                     |        | 4,279  |  |      |        | 1,837  |  |   |        | 1,758  | 
|          | Other         |                     |        | 1,097  |  |      |        | 693    |  |   |        | 512    | 
|          |               |                     |        |        |  |      |        |        |  |   |        |       
|          |               | $                   | 31,530 |        |  | $    | 33,557 |        |  | $ | 37,631 |       
|          |               |                     |        |        |  |      |        |        |  |   |        |       

The geographic classification of revenues is
based upon the location to which the product is shipped.
Qualstar does not have any 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
Code Section 401(k). All employees are eligible to
participate in the Plan following three months of service of
employment and may contribute up to 100% of their compensation
on a pre-tax basis, not to exceed the annual IRS maximum.
Qualstar, at the discretion of management, may make matching
contributions in an amount equal to 25% of the first 6% of
compensation contributed by eligible participants.
Qualstars contributions under the Plan totaled $76,000,
$58,000, and $51,000 for the years ended June 30, 2004,
2003, and 2002 respectively.



|    |                           
|--- | --------------------------
|13. | Related Party Transactions

Qualstars outside counsel is a member of
its board of directors. During the years ended June 30,
2004, 2003 and 2002 Qualstar paid $131,000, $149,000 and
$132,000, respectively to the law firm in which the director is
a shareholder for general business purposes.

F-17



---



##### 



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |                                                
|--- | -----------------------------------------------
|14. | Quarterly Results of Operations
    (Unaudited)

|                               |         |                                          |       |           |   |              |       |               |   |   |       |      |  |   |       |       |  
|------------------------------ | ------- | ---------------------------------------- | ----- | --------- | - | ------------ | ----- | ------------- | - | - | ----- | ---- |  | - | ----- | ----- | -
|                               |         |                                         
|                               |         | Three Months Ended                      
|                               |         |                                         
|                               |         | June 30,                                 |       | March 31, |   | December 31, |       | September 30,
|                               |         |                                          |       |           |   |              |       |              
|                               |         |                                         
|                               |         | (In thousands, except per share amounts)
|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 | )
|                              
|Fiscal 2003:                   |         |                                          |       |           |   |              |       |               |   |   |       |      |  |   |       |      
|Net sales                      |         | $                                        | 8,168 |           |   | $            | 8,189 |               |   | $ | 8,408 |      |  | $ | 8,792 |      
|Gross profit                   |         |                                          | 2,956 |           |   |              | 3,104 |               |   |   | 3,148 |      |  |   | 3,178 |      
|Net income (loss)              |         |                                          | (43   | )         |   |              | 11    |               |   |   | 79    |      |  |   | 502   |      
|                              
|Net earnings (loss) per share: |         |                                          |       |           |   |              |       |               |   |   |       |      |  |   |       |      
|                               | Basic   |                                          | $     | 0.00      |   |              | $     | 0.00          |   |   | $     | 0.01 |  |   | $     | 0.04  |  
|                               | Diluted |                                          |       | 0.00      |   |              |       | 0.00          |   |   |       | 0.01 |  |   |       | 0.04  |  

F-18



---



##### 



SCHEDULE II

QUALSTAR CORPORATION

VALUATION AND QUALIFYING ACCOUNTS

ALLOWANCE FOR DOUBTFUL ACCOUNTS


For the Years Ended June 30, 2004, 2003,
and 2002


|                         |  |            |           |          |  |          |           |               |  |            |   |  |  |   |           |  |  |   |           | 
|------------------------ |  | ---------- | --------- | -------- |  | -------- | --------- | ------------- |  | ---------- | - |  |  | - | --------- |  |  | - | --------- | 
|Column A                 |  | Column B   |           | Column C |  |          |           | Column D      |  | Column E  
|                         |  |            |           |          |  |          |           |               |  |           
|                         |  |            |           | Charged  |  |          |           |               |  |           
|                         |  | Balance at |           | to Costs |  | Charged  |           |               |  | Balance at
|                         |  | Beginning  |           | and      |  | to Other |           |               |  | End of    
|Description              |  | of Period  |           | Expenses |  | Accounts |           | Deductions(1) |  | Period    
|                         |  |            |           |          |  |          |           |               |  |           
|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   | 
|Year Ended June 30, 2002 |  | $          | 470,000   |          |  | $        | 1,679,000 |               |  | $          |  |  |  | $ | 49,000    |  |  | $ | 2,100,000 | 



---



|    |                                                           
|--- | ----------------------------------------------------------
|(1) | Uncollectible accounts written off, net of
    recoveries.



---



##### 



SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.



| |                     
| | --------------------
| | QUALSTAR CORPORATION



| |     |                       
| | --- | ----------------------
| | By: | /s/ WILLIAM J. GERVAIS

| |                                          
| | -----------------------------------------
| |                                          
| | William J. Gervais,                      
| | Chief Executive Officer and
    President

Date: September 24, 2004

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the
capacities and on the dates indicated.

|                                         |  |                                                                                                     |  |                    |  | 
|---------------------------------------- |  | --------------------------------------------------------------------------------------------------- |  | ------------------ |  | 
|                                         |  |                                                                                                     |  |                   
|Signature                                |  | Title                                                                                               |  | Date              
|                                         |  |                                                                                                     |  |                   
|                                        
|/s/ WILLIAM J. GERVAISWilliam J. Gervais |  | Chief Executive Officer,
    President and Director
    (principal executive officer)               |  | September 24, 2004
|                                        
|/s/ RICHARD A. NELSONRichard A. Nelson   |  | Vice President, Engineering
    Secretary and Director                                              |  | September 24, 2004
|                                        
|/s/ FREDERIC T. BOYERFrederic T. Boyer   |  | Vice President and Chief
    Financial Officer
    (principal financial
    and accounting officer) |  | September 24, 2004
|                                        
|/s/ BRUCE E. GLADSTONEBruce E. Gladstone |  | Director                                                                                            |  | September 24, 2004
|                                        
|/s/ TRUDE C. TAYLORTrude C. Taylor       |  | Director                                                                                            |  | September 24, 2004
|                                        
|/s/ ROBERT E. RICHRobert E. Rich         |  | Director                                                                                            |  | September 24, 2004
|                                        
|/s/ ROBERT T. WEBBERRobert T. Webber     |  | Director                                                                                            |  | September 24, 2004



---



##### 



EXHIBIT INDEX

|            |    |             |  |                                                                                                                        
|----------- | -- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------
|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.
|            | 14 | .1          |  | 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.                                                           



| |   |                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | 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.