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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,
    2003                                                 
| 
|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).     o Yes          þ No

As of September 24, 2003, the aggregate
market value of the common equity held by non-affiliates of the
registrant was approximately $37,091,000.

The total shares of common stock without par
value outstanding at September 24, 2003 is 12,639,609.

DOCUMENTS INCORPORATED BY REFERENCE

Items 10, 11, 12 and 13 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, 2003.



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TABLE OF CONTENTS



|                                                  |                                                                                               |  |  |  |  |  |  | 
|------------------------------------------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|FORWARD-LOOKING STATEMENTS                       
|PART I                                           
|                                                  | Item 1. Business                                                                             
|RISK FACTORS                                     
|                                                  | Item 2. Properties                                                                           
|                                                  | Item 3. Legal Proceedings                                                                    
|                                                  | Item 4. Submission of Matters to a Vote of Shareholders                                      
|MANAGEMENT                                       
|PART II                                          
|                                                  | Item 5. Market for Registrants Common Stock and Related Stockholder Matters                 
|                                                  | Item 6. Selected Financial Data                                                              
|                                                  | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                                                  | Item 7A. Qualitative and Quantitative Disclosures about Market Risk                          
|                                                  | Item 8. Financial Statements and Supplementary Data                                          
|                                                  | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 
|                                                  | Item 9A. Controls and Procedures                                                             
|PART III                                         
|                                                  | Item 14. Principal Accountant Fees and Services                                              
|PART IV                                          
|                                                  | Item 15. Exhibits, Financials Statement Schedules and Reports on Form 8-K                    
|                                                  | Item 8. Financial Statements and Supplementary Data                                          
|INDEX TO CONSOLIDATED FINANCIAL STATEMENTS       
|REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
|CONSOLIDATED BALANCE SHEETS                      
|CONSOLIDATED STATEMENTS OF INCOME                
|CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY  
|CONSOLIDATED STATEMENTS OF CASH FLOWS            
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS       
|                                                  | SCHEDULE II                                                                                  
|SIGNATURES                                       
|EXHIBIT INDEX                                    
|EXHIBIT 21.1                                     
|EXHIBIT 21.1                                     
|EXHIBIT 31.1                                     
|EXHIBIT 31.2                                     
|EXHIBIT 32.1                                     
|EXHIBIT 32.2                                     



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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,
storage arrays of tape cartridges and robotics to move the tape
cartridges from their storage locations to the tape drives under
software control. Our tape libraries provide storage solutions
for organizations requiring backup, recovery and archival
storage of critical electronic information. Our tape libraries
also can provide near-online storage as an alternative to disk
drives. Our products are compatible with commonly used network
operating systems, including UNIX, Windows NT, NetWare and
Linux. Our tape libraries also are compatible with a wide range
of storage management software packages, such as those supplied
by Computer Associates, Legato, Tivioli and Veritas. We offer
tape libraries for multiple tape drive technologies, including
those using Advanced Intelligent Tape(AIT), Super Advanced
Intelligent Tape(SAIT), Super Digital Linear Tape(SDLT), and
Linear Tape Open(LTO) tape drives and media.

We sell our tape libraries worldwide, primarily
to value added resellers, system integrators, and original
equipment manufacturers. These customers integrate our products
with software from third party vendors to provide storage
solutions, and in turn resell to end users. We custom configure
each of our libraries based on each customers individual
requirements, with a typical 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.
The 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 8mm and other tape drive
technologies and tape media formats. Automated tape libraries
and related products, such as tape drives and tape media,
represented approximately 89.3% of revenues for fiscal 2001,
approximately 82.9% of revenues for fiscal 2002, and
approximately 79.8% of revenues for fiscal 2003. 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 N2
Power, Incorporated, a supplier of ultra small high efficiency
open-frame switching power supplies. Power supplies provided by
N2 Power are utilized within our tape library products as well
as sold to other original equipment manufacturers for
incorporation into their products. N2Power products are sold
under the N2Power brand name through outside sales
representatives and distributors to original equipment
manufacturers.

1



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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 need for
data storage is growing in response to the increase in the
amount of data that is generated and 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, 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 information. 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

The following factors are contributing to the
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 and archival storage of data. We believe that
    the need to utilize databases 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.The growth in data is being
    fueled not only by the increase in information but also in the
    types of stored data. For example, storage of 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.                                                                                                                                                                                                                                                                   
|
| |  | Growth in 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.                                                                
|
| |  | Growth in network server computing
    applications and data.The use of
    server-based computer networks has shifted critical information
    and applications to network servers in order 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 increasingly are 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.
    Decreases in costs not only encourage the storage of more data,
    but also make it more cost effective to add storage capacity
    rather than to remove old data, contributing to greater storage
    demand for data which in the past may have been purged
    periodically.                                                                                                                                            



| |                                                
| | -----------------------------------------------
| | Advances in Storage Management
    Technologies

The growth in data and need for storage is
contributing to an evolution in traditional storage solutions.
New open standard technologies are designed to provide
high-speed connectivity for data-intensive applications across
multiple operating systems, including UNIX, Windows NT, NetWare
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,

2



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | 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 currently exists
    with traditional technologies. Additionally, SANs are able to
    provide these benefits across multiple operating systems.                                                                                                                                                                                                                                                                                                                                                        
|
| |  | Advanced storage management
    software.The development of advanced
    storage management software has led to the use of tape as a
    lower-cost alternative to disk drives for on-line storage. 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 and put it back on
    the disk file for user access. This sometimes is referred to as
    near-online storage. This process reduces the overall storage
    cost by using the least expensive storage medium to save data
    that is not expected to be needed on a frequent basis. Advances
    in storage management software have increased the ability of
    businesses to 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 library
    directly into a network without increasing demands on the file
    server or 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 three technologies: magnetic disk, optical disk and
magnetic tape. Each of these solutions represents 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 and optical disks provide quicker access to
stored data and generally are used when speed is important. Less
frequently used data often is migrated from magnetic or optical
disks to tape storage. Tape libraries provide a near-online
solution, where less frequently used data files are stored on
tapes instead of on disks.



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

Automated tape libraries speed 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 also are capable of being
operated from a remote location or during off-hours when no
attendant is on duty. Automated tape libraries are a key
component of a network administrators overall storage
solution.

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.

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 recovery in the event the original data 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 physical or natural disaster
    at the primary site.

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Archiving.Archiving
    is the storage of data for historical purposes. When important
    information is stored on tape, automated tape libraries, in
    conjunction with storage management software, 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 for other purposes. Tape libraries
    also are used for archiving because of the 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 and tape drives.                                                                                                                                                                                               
|
| |  | Digital video.Digital recording of camera images for surveillance and security
    purposes is beginning to replace traditional analog VHS
    recording in mid-size to large 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 vast number of tapes created in these facilities.
    Library based systems index, store and play back the video
    images on demand, thereby reducing the recall time and cost of
    operation significantly when compared to VHS recording and
    playback devices. Digital recording technology provides enhanced
    resolution and accommodates the recording of transactional data
    such as cash register transaction 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. Tape library storage of a digitized
    image costs considerably less than storing a film copy, and can
    be recalled years later with considerably less effort.
    Additionally, there is a trend to require that these records be
    kept available for longer periods of time.                                                                                                                                                                                                                                                                                                                                                                             



| |                                          
| | -----------------------------------------
| | 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 original equipment manufacturers. Many
organizations, however, do not have sufficient in-house
resources but often 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 storage management
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 storage management 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 reseller
distribution channels and to serve select 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.

4



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Our Solution

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 product 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, assembly and testing of
our products which reduces the potential for product failures
and results in products that require little maintenance.

The technology utilized within 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 in order to prevent our product lines from
becoming obsolete. To give a few examples, this year we
completed development of 5 new models in our RLS rack-mount
series of tape libraries, of which, all 5 models were
shipping as of the date of this report. Furthermore, we
introduced 4 models of our new TLS 5000 Series Tape
Library which incorporates SAIT tape technology. SAIT tapes have
the highest density available on the market at 500 gigabytes per
tape (native), making the TLS 5000 Series Tape Library the
lowest cost per gigabyte tape library on the market.

Our tape libraries are compatible with over fifty
third-party storage management software packages, such as those
supplied by Computer Associates, Legato, Tivoli and Veritas.
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 the lack of
compatibility is a significant barrier to entry for new tape
library competitors. To ensure compatibility, our engineers work
closely with the application software vendors during 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 evaluation 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 as to current and contemplated changes to
our products and by referring business to them when value added
resellers or end users inquire about software sources.

We have focused our business primarily on
supporting value added resellers and original equipment
manufacturers as the most effective and profitable distribution
channels for our tape libraries. Our solution is to offer our
resellers reliable tape libraries, multiple tape format choices,
and more attractive profit opportunities than do other tape
library manufacturers. We custom configure each of our libraries
based on the resellers requirements, with a typical
delivery time of one to three working days. Our solution for
original equipment manufacturers is to offer them control over
product design changes, qualification testing, and private
labeling. We believe these factors enhance the resellers
and original equipment manufacturers ability to sell our
products and encourage them to remain loyal to Qualstar.

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 Advanced
    Intelligent Tape (AIT), Super Advanced Intelligent Tape (SAIT),
    Super Digital Linear Tape (SDLT), and Linear Tape Open (LTO)
    tape media formats. 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 their end-user customers.

5



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Focus distribution 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
    increase the likelihood of closing a sale and to increase the
    resellers profit margins. We intend to maintain our
    marketing presence in support of this distribution channel. We
    conduct business with our value added resellers on an individual
    purchase order basis and no long-term commitments are involved.
    Additionally, there are no exclusive territories assigned to our
    value added resellers.
|
| |  | Maintain and strengthen original equipment
    manufacturer relationships.We sell
    our products to several companies under private label or
    original equipment manufacturer relationships. Original
    equipment manufacturer sales enable us to reach some end users
    not served by our value added 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 commitments
    are in place.                                                                                                                                                                                                                             
|
| |  | Develop libraries for new tape technologies.The tape drive industry is
    continuously advancing the state of technology. We will continue
    to monitor new product releases and design new libraries for
    those technologies that appear promising and meet our standards
    for capacity, quality and reliability.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  | Maintain our rate of innovation.We plan to maintain our high level of
    research and development efforts in order 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 manufacturing 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 |    |            |  |               |              | Maximum     
|               |  | Product   |    | Tape Drive |  | Range of Tape |              | Capacity in 
|Product Family |  | Family    |    | Technology |  | Cartridges    |              | Terabytes(1)
|               |  |           |    |            |  |               |              |             
|TLS-4000       |  |           | 11 |            |  |               | Sony AIT     |              |  |  | 12 to 600 |  |  |  | 60.0  | 
|TLS-5000       |  |           | 4  |            |  |               | Sony SAIT    |              |  |  | 33 - 264  |  |  |  | 132.0 | 
|TLS-6000       |  |           | 7  |            |  |               | Quantum SDLT |              |  |  | 10 to 240 |  |  |  | 38.4  | 
|TLS-8000       |  |           | 7  |            |  |               | LTO          |              |  |  | 11 to 264 |  |  |  | 52.8  | 
|RLS-4000       |  |           | 3  |            |  |               | Sony AIT     |              |  |  | 22 - 70   |  |  |  | 7.0   | 
|RLS-5000       |  |           | 1  |            |  |               | Sony SAIT    |              |  |  | 44        |  |  |  | 22.0  | 
|RLS-6000       |  |           | 1  |            |  |               | Quantum SDLT |              |  |  | 27        |  |  |  | 4.3   | 
|RLS-8000       |  |           | 1  |            |  |               | LTO          |              |  |  | 36        |  |  |  | 7.2   | 



---



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

6



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##### Table of Contents



Some of our tape library product 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 middle segment range of 12 to 600
tapes. We design our tape libraries for 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
sometimes are stored in removable magazines, allowing for bulk
removal of the tapes. Our libraries also offer key features such
as barcode readers to scan cartridge labels, and an input/output
port for importing and exporting individual tapes under system
control. Many of our library models are expandable after
installation 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 develop enhancements and improvements
for our existing products in order 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
    most of our models to meet the needs of 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.We
    use only brushless electric motors in our tape libraries. Motors
    are a key component in any robotic system. 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 I/ O Port.Our VIOP feature allows IT
    administrators the ability to select the number of cartridge
    slots that can 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 placed off-site in various regions but
    must be administered from a single location. With our Q-Link
    remote manager, our customers have the ability to put our
    products anywhere in the world and manage them from a single
    administrative hub using a standard web browser.

Our TLS Series product line is specifically
designed to be placed on the floor or on a table top, without
the need for a special equipment rack. If requested, we provide
our customers with an adapter kit for mounting some models in a
rack. Other manufacturers design libraries primarily for
rack-mounting, and supply an adapter for table-top use. We chose
the opposite approach to distinguish ourselves from many of our

7



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##### Table of Contents



competitors. We believe that this approach
provides the most convenient and lowest cost solution for the
largest segment of our customer base.


During Fiscal 2003 we commenced shipments of our
RLS Series of tape libraries. These products are designed to fit
conveniently in equipment racks utilizing only five standard
units, or a total of 8.75 inches of rack space. In
addition, the RLS can provide all of the high-availability
features needed in the most demanding applications such as
dual-redundant power supplies and hot-swappable power supplies
and tape drives. We believe these features give the RLS Series
of tape libraries a competitive advantage over other compact
rack-mount tape libraries that do not offer as robust a
combination of features. We believe this product line will
provide a cost effective solution for a large portion of our
customer base.

Other
Products

We have manufactured 9-track auto-loading
reel-to-reel tape drives since 1990. Demand for 9-track tape
drives has been declining for many years, and we expect overall
demand for 9-track tape drives to continue to decline in the
future. Therefore, we announced the end of the life for 9-track
tape drives. In addition to our tape libraries and 9-track tape
drives, we sell ancillary products such as tape media, tape
magazines, cables, bar code labels and adapters for rack
mounting our tape libraries.

In July of 2002, we purchased the assets and
intellectual property of N2Power, Incorporated, a privately held
company located in Newbury Park, California. N2Power designs,
develops, manufactures, and sells ultra small high-efficiency
open-frame switching power supplies based upon its patented
technology. Since the purchase, N2Power has been relocated to
our facility in Simi Valley, California. N2Power products are
utilized within our tape libraries as well as sold on the open
market primarily through outside sales representatives and
distributors to original equipment manufacturers.

Sales and Marketing

Sales

We sell our tape library products primarily
through value added resellers. Our direct sales force usually
will initiate contact with value added resellers who might be
likely 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 force
resellers to purchase through distributors and who sometimes
sell directly to end users, thereby competing with their own
resellers. Some of the advantages of our strategy include the
following:



| |   |                                                                                                                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Higher profit
    margins.By avoiding the extra
    distribution markup, higher profit margins are available to be
    shared by both us and the reseller.                                                                                                                                                                                                       
|
| |  | Custom
    configurations.By circumventing the
    distribution step, we are able to offer custom configurations of
    our products, such as special paint, private branding and
    non-standard interface options, on very short notice.                                                                                                                      
|
| |  | Channel conflicts
    avoided.We refer all end-user
    inquiries to our reseller partners. Because they know that we
    typically do not sell directly to the end user, there is an
    attitude of cooperation between the reseller and us. Frequently,
    our sales representatives make end-user visits with the reseller
    to help close a pending sale.
|
| |  | Credit.We typically
    extend credit to resellers if they meet our credit requirements.                                                                                                                                                                                                                                                                         
|
| |  | Rapid delivery.We
    generally ship a product to the reseller 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. We
strive to work with original equipment manufacturers early in
the product development cycle so that we can obtain valuable
product development

8



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##### Table of Contents



feedback. 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.


Our sales are spread across a broad customer
base. For the year ended June 30, 2003, no single customer
accounted for more than 10% of our revenue.

Our international sales efforts are currently
directed from our headquarters 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 customers outside of North America were
$13.9 million, or 26.9% of revenues in fiscal 2001,
$12.1 million or 32.2% of revenues in fiscal 2002, and
$9.9 million or 29.4% of revenues in fiscal 2003.



| |          
| | ---------
| | 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 including the COMDEX Fall trade
show, 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.

Another element of our marketing plan is our lead
registration program. This program awards value added resellers
that uncover sales opportunities and promote our products to the
end user. In exchange for this effort, the reseller is rewarded
with a higher profit margin on that particular sale. The lead
registration program gives our reseller partners an advantage
over their competitors who purchase from distribution channels.
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 Support

We believe that strong customer service and
support is an essential aspect of our business. Our customer
service and 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, which are fulfilled by IBM.
|
| |  | 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, in certain situations, visit the
    customers site.                                                                                                                                                                        
|
| |  | Training.We offer a
    product maintenance training program for end users, value added
    reseller and original equipment manufacturer maintenance
    personnel. We conduct our training classes at our headquarters,
    as well as on-site at the locations of our value added resellers
    or original equipment manufacturers.                                                                                                                                                                                                                                                                                    

9



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Warranty.The
    standard warranty period on our tape libraries is three years.
    During the first year for our TLS libraries and the first three
    years for our RLS libraries, we offer immediate replacement of
    defective products at no charge, subject to availability and
    credit approval of the purchaser. The purchaser is responsible
    for returning the defective product to us in a timely manner
    without damage. After the first year, the customer must first
    ship the tape library to our factory, where we will service the
    product during the warranty period at no charge. We offer
    out-of-warranty factory service at a flat fee plus applicable
    taxes, duties and transportation costs. For tape drives, we pass
    the warranty provided by the drive manufacturer on to our
    customer. On-site service for library products is available
    within the United States and some foreign countries for an extra
    charge. We contract with outside service providers to supply
    on-site service.

Manufacturing and Suppliers

We manufacture our products at our facility in
Simi Valley, California. We currently operate four 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.

In order to respond rapidly to sales orders, we
build our tape libraries to a semi-finished state in advance of
receipt of an order, 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.

The manufacturing cycle to bring the tape
libraries to a semi-finished state is approximately five working
days. We believe that this capability represents an effective
way to control our inventory levels while maintaining the
ability to fill specific customer 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 a product order, we generally ship the product to the
customer 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 sales.

We select our suppliers carefully 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
standard 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 recording 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. We have experienced only one
situation involving a limited supply of components. Between
January 1999 and January 2000, Sony Electronics, Inc., our
sole-source supplier of Advanced Intelligent Tape drives and
tape media, was unable to provide us with sufficient quantities
of 50 gigabyte tape media to meet our order volume. During this
period, our customers generally did not delay purchases of
Advanced Intelligent Tape libraries from us because of this
shortage, but accepted delivery of tape libraries with a partial
shipment of 50 gigabyte tape media or accepted 36 gigabyte
tape media, which was available during that period.

N2Power products are currently produced in China
by a contract-manufacturing firm. We provide complete production
documentation specifying each component and assembly techniques.
We also specify performance criteria used to test the power
supplies after they complete a burn-in cycle at elevated
temperatures. Finished power supplies are shipped to our Simi
Valley facility where they undergo further quality control
inspections and tests prior to shipping to our OEM customers.

10



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##### Table of Contents



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 StorageTek,
Quantum/ATL Products, Advanced Digital Information Corporation
(ADIC), Overland Storage, and Spectra Logic.

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, 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
affected our sales to date.

As a greater number of competitors introduce
products in a particular tape drive technology, the increased
competition normally results in price erosion, a reduction in
gross margins and a loss of market share 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;                 
|
| |  | purchase price;                                                                           
|
| |  | storage capacity;                                                                         
|
| |  | speed of data transfer;                                                                   
|
| |  | compatibility with existing network operating
    systems and storage management software;
|
| |  | after-sale expandability of a tape library to
    meet increasing storage requirements;   
|
| |  | expected product life and cost of maintenance; and                                        
|
| |  | the availability of optional features                                                     
|
| |  | physical configuration and power requirements of
    the library.                         

We believe our tape libraries compete favorably
with respect to these factors.

Research and Development

Our research and development group of 29 people
consists of two teams. Our original team located in Simi Valley,
California, has developed over 40 separate tape library
models for eleven different tape formats over the last eight
years. In fiscal 2002 we established our Advanced Development
Group in Boulder, Colorado. They are responsible for the design
and development of a new generation of tape libraries. Our
engineers are a diverse and robust group who have the capability
to meet the needs of a complex and demanding 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

11



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##### Table of Contents



thorough knowledge of each of the different tape
drive technologies, as well as SCSI, iSCSI, and Fibre Channel
and other interface technologies.


We frequently develop new products in response to
the availability of 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 various 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 giving us
the ability 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 and 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
$1.3 million in fiscal 2001, $2.1 million in fiscal
2002, and $4.0 million the year ended June 30, 2003.
We anticipate spending at our current level, or slightly higher,
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 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 Inventions and Confidentiality
agreements with our development engineers 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 21, 2003, we had 111
full-time employees, including 35 in manufacturing, 29 in
research and development, 6 in customer service, 18 in sales and
marketing, and 23 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



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RISK FACTORS

Our principal competitors devote greater
financial and marketing resources to developing 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 recent years several of 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 many 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, 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
89.3% of our revenues for fiscal year 2001, approximately 82.9%
of our revenues for fiscal 2002, and approximately 79.8% of our
revenues for the year ended June 30, 2003. 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



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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 8 millimeter Advanced Intelligent Tape drives and
    media, and Super Advanced Intelligent tape drives and media.
    Sony has allocated some of their products in the past and may
    allocate them again in the future. In fiscal 2001, we derived
    $39.8 million, or 77.1%, of our revenues, in fiscal 2002 we
    derived $24.6 million, or 65.3% of revenues, and in fiscal
    2003, we derived $18.9 million, or 56.2% of our revenues
    from the sale of libraries, tape drives and tape media based on
    Sony Advanced Intelligent Tape 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 SDLT 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 SDLT tape drive requirements.                                                                                                                                                                                                                                                                                                                                                                     
|
| |  | The Linear Tape Open standard was developed by an
    industry consortium consisting of IBM, Hewlett Packard and
    Seagate. LTO competes with 8mm 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 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 or that it refrain from purchasing competing
products.

We do not have any exclusive or long-term
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 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 may fluctuate in the future due to
several factors, including:



| |   |                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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;
|
| |  | the rate of growth in the data storage market and
    the various segments within it;                                                                            
|
| |  | timing and levels of our operating expenses; and                                                                                                                 
|
| |  | availability of tape media.                                                                                                                                      

15



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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. Our products are facing increasing
competition from automated tape library products 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.

We depend upon independent software vendors to
provide software that integrates our libraries with computer
operating systems.

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 solution. We do not
develop and have no control over the development of this storage
management software. Instead we rely on independent third party
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 independent software vendors, we maintain
relationships with them by:



| |   |                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------
| |  | supplying evaluation tape libraries so they can
    qualify their software to work with our tape libraries;
|
| |  | evaluating their software for compatibility with
    our tape libraries;                                   

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| |   |                                                                                                       
| | - | ------------------------------------------------------------------------------------------------------
| |  | 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 with 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 harmed 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 of North America. 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
North America accounted for approximately 26.9% in fiscal 2001,
32.2% in fiscal 2002, and 29.4% in fiscal 2003. We believe that
international sales will continue to represent a significant
portion of our revenues. Our foreign 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;                                                                                                                                             
|
| |  | 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 sales 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

17



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##### Table of Contents



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. We currently are defending a
lawsuit brought against us by Raytheon Company
(Raytheon), which alleges that some of our tape
library products infringe a patent owned by Raytheon. 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 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;

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##### Table of Contents





| |   |                                                  
| | - | -------------------------------------------------
| |  | 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 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 44.5% of our
outstanding common stock. 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.

We do not 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 intend to continue this policy for the
foreseeable future to strengthen our financial and competitive
position in the tape library market.






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

Qualstar leases 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.

Qualstar also leases 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,

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Qualstar maintains small sales offices in Kenyon,
Rhode Island; San Diego, California; Atlanta, Georgia; Stafford
Virginia; and Surrey, United Kingdom.







|        |                  
|------- | -----------------
|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 infringe a patent
owned by Raytheon entitled Mass Data Storage
Library. Raytheon filed an amended complaint on or about
February 6, 2003, which includes an allegation that
Qualstars tape libraries infringe Raytheons patent.
The complaint seeks an injunction against all defendants and an
unspecified amount of damages. Qualstar responded to the
complaint on March 7, 2003 and denied Raytheons
allegations of infringement. The parties are currently in the
process of pre-trial discovery. A patent claims construction
hearing is presently scheduled for January 14, 2004 and a
trial is scheduled for June 7, 2004, both of which will be
located in Marshall, Texas. Qualstar and our legal counsel
continues to analyze Raytheons patent and available
defenses to the claims of infringement. Based on this analysis,
we believe that Raytheons claims against us are without
merit and we intend to vigorously defend against this complaint.
We do not believe the ultimate outcome of this matter will have
a material impact on our financial position or results of
operations.

From time to time, we may be involved in other
litigation or legal matters in the normal course of business.
However, other than the Raytheon matter discussed above, there
are currently no other material proceedings, pending or, to the
knowledge of management, threatened against Qualstar.






|        |                                                    
|------- | ---------------------------------------------------
|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, 2003.

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##### Table of Contents






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 26, 2003 are:

|                     |  |     |    |          |  |                                                          
|-------------------- |  | --- | -- | -------- |  | ---------------------------------------------------------
|Name                 |  | Age |    | Position
|                     |  |     |    |         
|William J. Gervais   |  |     | 60 |          |  | Chief Executive Officer, President and Director          
|Richard A. Nelson    |  |     | 60 |          |  | Vice President of Engineering, Secretary and
    Director
|Thomas J. Studebaker |  |     | 61 |          |  | Vice President of Advanced Development                   
|Frederic T. Boyer    |  |     | 59 |          |  | Vice President and Chief Financial Officer               
|David L. Griffith    |  |     | 47 |          |  | Vice President of Operations                             
|Mark R. Gilmore      |  |     | 53 |          |  | Vice President of Sales                                  
|Robert K. Covey      |  |     | 55 |          |  | Vice President of Marketing                              

Background

William J. Gervaisis 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 in 1967.

Richard A. Nelsonis
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 in 1966.

Thomas J. Studebakerhas 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 Packaging and
Robotic Development Manager 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. Boyerhas 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, Incorporated. 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
Marymount 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,

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##### Table of Contents



Inc. From 1987 to 1990, Mr. Griffith acted
as Marketing Manager and Program Manager for the Memory Products
Group of Siemens Information Systems. From 1985 to 1987,
Mr. Griffith was Director of Disk Operations for Ibis
Systems Inc. From 1982 to 1985, Mr. Griffith acted as a
Principle Engineer for Ibis Systems Inc. Mr. Griffith
received a degree in Mechanical Engineering from California
State Polytechnic University in 1980.


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

Robert K. Coveyhas
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 from 1965 to 1968.

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##### Table of Contents






PART II






|        |                                                                         
|------- | ------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Stock
    and Related Stockholder Matters

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 2001: |                |            |  |                               |  |     |   |       |  |  |   |     
|             | First Quarter  |            |  | July 1  September 30, 2000   |  |     | $ | 13.50 |  |  | $ | 7.00 | 
|             | Second Quarter |            |  | October 1  December 31, 2000 |  |     | $ | 14.75 |  |  | $ | 6.00 | 
|             | Third Quarter  |            |  | January 1  March 31, 2001    |  |     | $ | 9.13  |  |  | $ | 5.31 | 
|             | Fourth Quarter |            |  | April 1  June 30, 2001       |  |     | $ | 8.00  |  |  | $ | 5.94 | 
|Fiscal 2002: |                |            |  |                               |  |     |   |       |  |  |   |     
|             | First Quarter  |            |  | July 1  September 30, 2001   |  |     | $ | 6.92  |  |  | $ | 4.45 | 
|             | Second Quarter |            |  | October 1  December 31, 2001 |  |     | $ | 6.05  |  |  | $ | 4.37 | 
|             | Third Quarter  |            |  | January 1  March 31, 2002    |  |     | $ | 7.61  |  |  | $ | 5.94 | 
|             | Fourth Quarter |            |  | April 1  June 30, 2002       |  |     | $ | 7.40  |  |  | $ | 5.58 | 
|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 19, 2003.

Qualstar has declared no cash dividends during
the periods reported. Qualstar does not 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 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.

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|        |                        
|------- | -----------------------
|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,                    
|                                           |                            |                                         
|                                           |                            | 1999                                     |        | 2000  |       | 2001 |        | 2002  |       | 2003
|                                           |                            |                                          |        |       |       |      |        |       |       |     
|                                           |                            |                                         
|                                           |                            | (In thousands, expect per share amounts)
|Statements of Income Data:                 |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|Net revenues                               |                            | $                                        | 29,698 |       |       | $    | 49,352 |       |       | $    | 51,572 |        |       | $ | 37,631 |        |        | $ | 33,557 |       
|Cost of goods sold                         |                            |                                          | 19,058 |       |       |      | 30,915 |       |       |      | 33,216 |        |       |   | 23,753 |        |        |   | 21,171 |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|Gross profit                               |                            |                                          | 10,640 |       |       |      | 18,437 |       |       |      | 18,356 |        |       |   | 13,878 |        |        |   | 12,386 |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|Operating expenses:                        |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|                                           | Research and development   |                                          |        | 925   |       |      |        | 1,027 |       |      |        | 1,279  |       |   |        | 2,136  |        |   |        | 3,994  |       
|                                           | Sales and marketing        |                                          |        | 1,941 |       |      |        | 2,643 |       |      |        | 3,399  |       |   |        | 3,048  |        |   |        | 3,834  |       
|                                           | General and administrative |                                          |        | 1,267 |       |      |        | 2,057 |       |      |        | 3,301  |       |   |        | 5,222  |        |   |        | 4,428  |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|                                           |                            | Total operating expenses                 |        |       | 4,133 |      |        |       | 5,727 |      |        |        | 7,979 |   |        |        | 10,406 |   |        |        | 12,256 | 
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|Income from operations                     |                            |                                          | 6,507  |       |       |      | 12,710 |       |       |      | 10,377 |        |       |   | 3,472  |        |        |   | 130    |       
|Investment income                          |                            |                                          | 41     |       |       |      | 54     |       |       |      | 1,225  |        |       |   | 1,133  |        |        |   | 693    |       
|Impairment of investment                   |                            |                                          |       |       |       |      |       |       |       |      | (1,050 | )      |       |   |       |        |        |   |       |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|Income before income taxes                 |                            |                                          | 6,548  |       |       |      | 12,764 |       |       |      | 10,552 |        |       |   | 4,605  |        |        |   | 823    |       
|Provision for income taxes                 |                            |                                          | 2,562  |       |       |      | 4,968  |       |       |      | 3,824  |        |       |   | 1,845  |        |        |   | 274    |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|Net income                                 |                            | $                                        | 3,986  |       |       | $    | 7,796  |       |       | $    | 6,728  |        |       | $ | 2,760  |        |        | $ | 549    |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|Earnings per share:                        |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|                                           | Basic                      |                                          | $      | 0.60  |       |      | $      | 1.10  |       |      | $      | 0.54   |       |   | $      | 0.22   |        |   | $      | 0.04   |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|                                           | Diluted                    |                                          | $      | 0.42  |       |      | $      | 0.80  |       |      | $      | 0.53   |       |   | $      | 0.22   |        |   | $      | 0.04   |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|Shares used to compute earnings per share: |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|                                           | Basic                      |                                          |        | 6,629 |       |      |        | 7,119 |       |      |        | 12,372 |       |   |        | 12,475 |        |   |        | 12,579 |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       
|                                           | Diluted                    |                                          |        | 9,467 |       |      |        | 9,742 |       |      |        | 12,668 |       |   |        | 12,664 |        |   |        | 12,666 |       
|                                           |                            |                                          |        |       |       |      |        |       |       |      |        |        |       |   |        |        |        |   |        |       

|                          |  |                |        |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|------------------------- |  | -------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ |  |  | - | ------ | 
|                          |  |               
|                          |  | June 30,      
|                          |  |               
|                          |  | 1999           |        | 2000 |  | 2001 |        | 2002 |  | 2003
|                          |  |                |        |      |  |      |        |      |  |     
|                          |  |               
|                          |  | (In thousands)
|Balance Sheet Data:       |  |                |        |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|Cash and cash equivalents |  | $              | 2,134  |      |  | $    | 3,081  |      |  | $    | 11,509 |  |  | $ | 4,859  |  |  | $ | 6,236  | 
|Marketable securities     |  |                |       |      |  |      | 15,895 |      |  |      | 15,578 |  |  |   | 25,987 |  |  |   | 29,857 | 
|Working capital           |  |                | 11,205 |      |  |      | 33,620 |      |  |      | 43,382 |  |  |   | 46,507 |  |  |   | 47,191 | 
|Total assets              |  |                | 12,950 |      |  |      | 37,984 |      |  |      | 47,878 |  |  |   | 50,758 |  |  |   | 52,096 | 
|Total debt                |  |                |       |      |  |      |       |      |  |      |       |  |  |   |       |  |  |   |       | 
|Shareholders equity      |  |                | 11,640 |      |  |      | 35,032 |      |  |      | 44,689 |  |  |   | 47,973 |  |  |   | 48,868 | 

24



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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 those using Advanced Intelligent Tape
(AIT), Super Advanced Intelligent Tape (SAIT), Super Digital
Linear Tape (SDLT), and Linear Tape Open (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 large libraries, we have developed a family
of tape libraries over the last eight years spanning a broad
range of tape formats, prices, capacity and performance. Our
product mix has changed over the last six fiscal years as we
introduced new products to address additional tape formats and
changing customer preferences. For example, during fiscal year
2003, we introduced a new series of rack-mount libraries
compatible with the popular LTO and SDLT technologies.
Furthermore, we were the first manufacturer to introduce tape
libraries compatible with the new SAIT technology. We expect our
product mix 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 storage solutions to end
users that are installed complete and ready to operate. 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 typically 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 headquarters 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 customers outside of North America were
$13.9 million, or 26.9% of revenues in fiscal 2001,
$12.1 million, or 32.2% of revenues in fiscal 2002, and
$9.8 million, or 29.4% of revenues in fiscal 2003.

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, RAIDs, and other
processor based equipment. Our power supplies are sold under the
N2Power brand name through outside sales representatives and
distributors. Revenues in fiscal 2003 were not significant and
totaled approximately $216,000.

Net revenues include revenues from the sale of
tape libraries, library tape drives, storage media, and
ancillary products. Ancillary revenues include service, repair,
and on-site service warranties, net of the cost of any third
party service contracts, and 9-track tape drives, which we
announced as end-of-life in fiscal year 2002, and power
supplies. Automated tape libraries and related products, such as
tape drives and tape media, represented approximately 89.3% of
revenues in fiscal 2001, 82.9% of revenues in fiscal 2002, and
79.8% of revenues in fiscal 2003. Sales of services and other
products 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 of strong customer demand and less
competition. Our gross margins have benefited from a shift in
demand towards our larger tape libraries. However, some
customers of larger tape libraries desire significant quantities
of tape media. Sales of large quantities of tape media partially
offset the higher gross margins associated with sales of larger
tape libraries because tape media provide significantly lower
gross margins than tape libraries. From time to time, we have
been unable to meet demand for tape media because

25



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of supply constraints. We may experience higher
gross margins in quarters when sales of tape media decrease due
to supply constraints and lower gross margins in quarters when
sales of tape media increase due to greater availability. We
expect that our markets growth in revenues and attractive
gross margins will encourage new competitors to enter our
marketplace, which may affect our gross margins.


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
enhancements to our existing products. Our Advanced Development
Group, located in Boulder, Colorado, will continue work on a new
generation of automated tape libraries. We expect research and
development expenses to hold steady or slightly increase in the
next fiscal year as the Advanced Development Group, which was
expanding its staff and level of activity during fiscal 2003,
should be operating at its target level throughout fiscal 2004.

We expect selling, general and administrative
expenses to increase slightly in fiscal 2003, due to the
increasing cost of employee benefits, the increasing costs of
being a public company, and legal fees associated with our
defense of the Raytheon lawsuit.

We recorded deferred compensation of
approximately $1.7 million in the third quarter of fiscal
2000, representing the difference between the exercise price of
options and restricted stock awards 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 the deferred compensation was approximately
$437,000 during fiscal 2001, $430,000 during fiscal 2002, and
$301,000 in fiscal 2003, which was recorded as general and
administrative expenses in the statements of income. Total
deferred compensation amortization will be approximately
$140,000 in fiscal 2004.

Results of Operations

The following table reflects, as a percentage of
net revenues, statements of income data for the periods
indicated:

|                                         |                            |                      |       |      |  |      |       |      |  |  |       |      | 
|---------------------------------------- | -------------------------- | -------------------- | ----- | ---- |  | ---- | ----- | ---- |  |  | ----- | ---- | 
|                                         |                            |                     
|                                         |                            | Years Ended June 30,
|                                         |                            |                     
|                                         |                            | 2001                 |       | 2002 |  | 2003
|                                         |                            |                      |       |      |  |     
|Net revenues                             |                            |                      | 100.0 | %    |  |      | 100.0 | %    |  |  | 100.0 | %   
|                                         | Cost of goods sold         |                      |       | 64.4 |  |      |       | 63.1 |  |  |       | 63.1 | 
|                                         |                            |                      |       |      |  |      |       |      |  |  |       |     
|                                         | Gross margin               |                      |       | 35.6 |  |      |       | 36.9 |  |  |       | 36.9 | 
|Operating expenses:                      |                            |                      |       |      |  |      |       |      |  |  |       |     
|                                         | Research and development   |                      |       | 2.5  |  |      |       | 5.7  |  |  |       | 11.9 | 
|                                         | Sales and marketing        |                      |       | 6.6  |  |      |       | 8.1  |  |  |       | 11.4 | 
|                                         | General and administrative |                      |       | 6.4  |  |      |       | 13.9 |  |  |       | 13.2 | 
|                                         |                            |                      |       |      |  |      |       |      |  |  |       |     
|Income from operations                   |                            |                      | 20.1  |      |  |      | 9.2   |      |  |  | 0.4   |     
|Investment income                        |                            |                      | 2.4   |      |  |      | 3.0   |      |  |  | 2.0   |     
|Impairment of investment                 |                            |                      | (2.0  | )    |  |      |      |      |  |  |      |     
|                                         |                            |                      |       |      |  |      |       |      |  |  |       |     
|Income before provision for income taxes |                            |                      | 20.5  |      |  |      | 12.2  |      |  |  | 2.4   |     
|Provision for income taxes               |                            |                      | 7.4   |      |  |      | 4.9   |      |  |  | 0.8   |     
|                                         |                            |                      |       |      |  |      |       |      |  |  |       |     
|Net income                               |                            |                      | 13.1  | %    |  |      | 7.3   | %    |  |  | 1.6   | %   
|                                         |                            |                      |       |      |  |      |       |      |  |  |       |     

Fiscal 2003 Compared to Fiscal 2002

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,
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.

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##### Table of Contents



The decrease in revenues was primarily due to an
overall decline in the demand for our tape libraries using AIT
tape technology and the significant decline in revenues from two
of our largest customers. 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 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. Cost of goods sold
consists primarily of direct labor, purchased parts,
depreciation of plant and equipment, rent, utilities, and
packaging costs. During fiscal year 2003, we were able to keep
our margins stable.

Research and
Development.Research and development
expenses consist of engineering salaries, benefits, purchased
parts and supplies used in development activities. 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 Advance Development Group
became fully staffed. We anticipate research and development
costs to increase slightly in fiscal 2004.

Sales and Marketing.Sales and marketing expenses consist primarily of employee
salaries, benefits, sales commissions, trade show costs,
advertising, technical support and travel related expenses.
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 include employee salaries and benefits,
deferred compensation related to stock options and restricted
stock awards, provision for doubtful accounts, and professional
service fees. 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 than 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

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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.


Fiscal 2002 Compared to Fiscal 2001

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,
2002 were $37.6 million, a decrease of 27.0% compared to
net revenues of $51.6 million for the year ended
June 30, 2001. The decrease in revenues was primarily due
to an overall decline in the market for tape libraries and the
decline of revenue from two major customers. Revenues from tape
libraries and related media decreased to $31.2 million, or 82.9%
of revenues, in the year ended June 30, 2002 from $46.0
million, or 89.3% of revenues, in the year ended June 30,
2001. Selling prices of our libraries remained relatively stable
during fiscal 2002. However, selling prices of 8mm library tape
drives declined during fiscal 2002, whereas half-inch library
tape drives increased in overall selling price. The decline in
selling prices of 8mm tape drives was attributable to reduced
costs for these drives from our suppliers, which were passed
through to our customers in the form of lower selling prices.
Half-inch library tape drives increased in selling price due to
introduction of the new, more expensive LTO and SDLT tape drives.

Gross Profit.Gross
profit was $13.9 million, or 36.9% of revenues, for the
year ended June 30, 2002, compared to $18.4 million,
or 35.6% of revenues, for fiscal 2001. 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 primarily caused by product mix.

Research and
Development.Research and development
expenses consist of engineering salaries, benefits, purchased
parts and supplies used in development activities. Research and
development expenses for the year ended June 30, 2002
increased 67.0% to $2.1 million as compared to
$1.3 million for the year ended June 30, 2001. This
increase was due primarily to costs associated in bringing our
new rack-mount library to market. In addition, we opened an
Advanced Development office in Boulder, Colorado. Although not
fully operational at June 30, 2002, there were nominal
costs incurred in establishing this research and development
facility during fiscal 2002.

Sales and Marketing.Sales and marketing expenses consist primarily of employee
salaries, benefits, sales commissions, trade show costs,
advertising, technical support and travel related expenses.
Sales and marketing expenses decreased 10.3% to
$3.0 million, or 8.1% of revenues for the year ended June
30, 2002, as compared to $3.4 million, or 6.6% of revenues,
for the year ended June 30, 2001. This decrease was due
primarily to the decrease of commissions paid to our sales force
as a result of lower sales.

General and
Administrative.General and
administrative expenses include employee salaries and benefits,
deferred compensation related to stock options and restricted
stock awards, provision for doubtful accounts, and professional
service fees. General and administrative expenses increased to
$5.2 million for fiscal 2002 as compared to
$3.3 million for fiscal 2001. As a percentage of revenue,
general and administrative expenses increased to 13.9% for the
year ended June 30, 2002 as compared to 6.4% for the year
ended June 30, 2001. The increase in general and
administrative expenses was caused primarily by an increase in
our allowance for doubtful accounts of approximately
$1.6 million primarily reflecting a single, insolvent
customer.

Investment income.Investment income decreased to $1.1 million in the year
ended June 30, 2002 as compared to $1.2 in the year ended
June 30, 2001. This decrease was due to primarily to a poor
performing economy in which overall interest rates were low
partially offset by an increase in funds available for
investment.

Provision for Income
Taxes.The provision for income taxes
was $1.8 million, or 40.1% of pre-tax income, for fiscal 2002
compared to $3.8 million, or 36.2% of pre-tax income, for
fiscal 2001. The increase in the percentage of the provision for
income taxes to pre-tax income was primarily due to a higher
than anticipated state apportionment factor for California
income taxes.

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##### Table of Contents



Liquidity and Capital Resources

Historically, we have funded our capital
requirements with cash provided by operations. Cash provided by
operating activities were $6.6 million in fiscal 2001,
$4.1 million in fiscal 2002, and $6.0 million in
fiscal 2003. In fiscal 2001 and 2002, operating cash was
provided primarily by net income. In fiscal 2003, operating cash
was primarily provided by reductions in accounts receivable and
inventory. In fiscal 2001, cash flow from operating activities
was primarily used to fund increases in inventories and the
purchase of marketable securities. In fiscal 2002 and 2003, cash
flow from operating activities was primarily used to purchase
marketable securities.

Cash used in investing activities was $609,000 in
fiscal 2001, $11.0 million in fiscal 2002, and $4.7 million
in fiscal 2003. Cash used in investing activities for fiscal
2001, 2002, and 2003 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 designs and produces 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.

Our contractual obligations as of June 30,
2003 are as follows (in thousands):

|                            |  |        |     |             |  |             |       |            |  |       |       |  |  |   |       |  |  |   |       | 
|--------------------------- |  | ------ | --- | ----------- |  | ----------- | ----- | ---------- |  | ----- | ----- |  |  | - | ----- |  |  | - | ----- | 
|                            |  | Due in |     | Due in 2005 |  | Due in 2007 |       | Due        |  |      
|                            |  | 2004   |     | and 2006    |  | and 2008    |       | Thereafter |  | Total
|                            |  |        |     |             |  |             |       |            |  |      
|Operating lease obligations |  | $      | 549 |             |  | $           | 1,143 |            |  | $     | 1,144 |  |  | $ | 1,499 |  |  | $ | 4,335 | 
|                            |  |        |     |             |  |             |       |            |  |       |       |  |  |   |       |  |  |   |       | 
|Total                       |  | $      | 549 |             |  | $           | 1,143 |            |  | $     | 1,144 |  |  | $ | 1,499 |  |  | $ | 4,335 | 
|                            |  |        |     |             |  |             |       |            |  |       |       |  |  |   |       |  |  |   |       | 

As of June 30, 2003, we had
$6.2 million in cash and cash equivalents and
$29.9 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 expect to 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.

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 is recognized upon shipment of products
to our customers. Title and risk of loss transfer to the
customer when the product leaves our shipping dock in Simi
Valley, California. In general, these customers are allowed to
return the product, free of penalty, within 30 days of
shipment if the product does not meet the required
specifications. After 30 days, customers generally are not
allowed to return product to us without a restocking fee. We
record an allowance for estimated sales returns based on past
experience and current

29



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##### Table of Contents



knowledge of our customer base. Our experience
has been such that only a very small percentage of libraries are
ever returned. Should our experience change, however, we may
require additional allowances for sales returns.


We maintain an allowance for doubtful accounts
for estimated losses resulting from the inability of our
customers to make required payments. If the financial condition
of our customers were to deteriorate, resulting in an impairment
of their ability to make payments, additional allowances may be
required. In addition, if the financial condition of our
customers for which we have already established allowances were
to improve, then their ability to make payments to us would be
less impaired, potentially making such allowances unnecessary.

We write down our inventory for estimated
obsolescence or unmarketable inventory equal to the difference
between the cost of inventory and the estimated market value
based upon assumptions about future demand 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.
Likewise, if technology changes more slowly than expected, or
market conditions become more favorable than those projected by
management, inventory write-downs may become unnecessary.

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
actively 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.

We do not currently record a valuation allowance
to reduce our deferred tax assets because we believe that the
assets are more likely than not to be realized. While we have
considered future taxable income and ongoing prudent and
feasible tax planning strategies in assessing the need for a
valuation allowance, in the event we were to determine that we
would not 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.




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 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.

30



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##### Table of Contents








|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

Not applicable.






|         |                        
|-------- | -----------------------
|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, 2003, 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.




PART III

The information called for by Items 10, 11,
12 and 13 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, 2003, and is hereby incorporated by reference to
such Proxy Statement.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services

The disclosure requirements of this Item are not
applicable to Qualstar until the Annual Report on Form 10-K
for the fiscal year ending June 30, 2004.




PART IV






|         |                                                                     
|-------- | --------------------------------------------------------------------
|Item 15. | Exhibits, Financials Statement Schedules
    and Reports on Form 8-K

(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 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.

(b) Reports on Form 8-K. On
May 1, 2003, Qualstar filed a report on Form 8-K to
furnish information pursuant to Item 12 relating to
Qualstars results of operations for the fiscal third
quarter and nine months ended March 31, 2003.

31



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##### Table of Contents



(c) 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.
|        | 21 | .1          |  | Subsidiaries of Qualstar Corporation                                                                                   
|        | 23 | .1          |  | Consent of Ernst & Young LLP, Independent
    Auditors.                                                                
|        | 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(c) of this
    report.

32



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##### Table of Contents






Item 8.     Financial
Statements and Supplementary Data




INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                      |  |      |     | 
|----------------------------------------------------- |  | ---- | --- | 
|                                                      |  | Page
|                                                      |  |     
|Report of Ernst & Young LLP, Independent
    Auditors |  |      | F-2 | 
|Consolidated Balance Sheets                           |  |      | F-3 | 
|Consolidated Statements of Income                     |  |      | 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



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##### Table of Contents






REPORT OF ERNST & YOUNG LLP, INDEPENDENT
AUDITORS

The Board of Directors and Shareholders of

Qualstar Corporation


We have audited the accompanying consolidated
balance sheets of Qualstar Corporation as of June 30, 2002
and 2003, and the related consolidated statements of income,
shareholders equity, and cash flows for each of the three
years in the period ended June 30, 2003. 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
auditing standards generally accepted in the 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, 2002 and 2003, and the consolidated results of its
operations and its cash flows for the three years in the period
ended June 30, 2003, in conformity with accounting
principles generally accepted in the United States. 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, 2003


F-2



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QUALSTAR CORPORATION






CONSOLIDATED BALANCE SHEETS


|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |        |        | 
|---------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | ------ | ------ |  | ----- | ------ | ------ | 
|                                         |                                                                                                                                                          |                                           
|                                         |                                                                                                                                                          | June 30,                                  
|                                         |                                                                                                                                                          |                                           
|                                         |                                                                                                                                                          | 2002                                       |       | 2003  
|                                         |                                                                                                                                                          |                                            |       |       
|                                         |                                                                                                                                                          |                                           
|                                         |                                                                                                                                                          | (In thousands)                            
|ASSETS                                  
|Current assets:                          |                                                                                                                                                          |                                            |       |        |        |  |       |       
|                                         | Cash and cash equivalents                                                                                                                                |                                            | $     | 4,859  |        |  | $     | 6,236  |       
|                                         | Marketable securities                                                                                                                                    |                                            |       | 25,986 |        |  |       | 29,857 |       
|                                         | Accounts receivable, net of allowances of $2,100
    in 2002 and $260 in 2003.                                                                           |                                            |       | 6,695  |        |  |       | 4,535  |       
|                                         | Inventories                                                                                                                                              |                                            |       | 9,652  |        |  |       | 7,091  |       
|                                         | Prepaid expenses and other current assets                                                                                                                |                                            |       | 355    |        |  |       | 234    |       
|                                         | Prepaid income taxes                                                                                                                                     |                                            |       | 148    |        |  |       | 1,336  |       
|                                         | Deferred income taxes                                                                                                                                    |                                            |       | 1,501  |        |  |       | 939    |       
|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |       
|                                         |                                                                                                                                                          | Total current assets                       |       |        | 49,196 |  |       |        | 50,228 | 
|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |       
|Property and equipment, net              |                                                                                                                                                          |                                            | 1,324 |        |        |  | 1,557 |       
|Other assets                             |                                                                                                                                                          |                                            | 238   |        |        |  | 311   |       
|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |       
|                                         | Total assets                                                                                                                                             |                                            | $     | 50,758 |        |  | $     | 52,096 |       
|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |       
|                                        
|LIABILITIES AND SHAREHOLDERS
    EQUITY
|Current liabilities:                     |                                                                                                                                                          |                                            |       |        |        |  |       |       
|                                         | Accounts payable                                                                                                                                         |                                            | $     | 1,590  |        |  | $     | 1,136  |       
|                                         | Accrued payroll and related liabilities                                                                                                                  |                                            |       | 308    |        |  |       | 432    |       
|                                         | Other accrued liabilities                                                                                                                                |                                            |       | 693    |        |  |       | 1,469  |       
|                                         | Income taxes payable                                                                                                                                     |                                            |       | 98     |        |  |       |       |       
|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |       
|                                         |                                                                                                                                                          | Total current liabilities                  |       |        | 2,689  |  |       |        | 3,037  | 
|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |       
|Deferred income taxes                    |                                                                                                                                                          |                                            | 96    |        |        |  | 191   |       
|Commitments and contingencies            |                                                                                                                                                          |                                            |       |        |        |  |       |       
|Shareholders equity:                    |                                                                                                                                                          |                                            |       |        |        |  |       |       
|                                         | Preferred stock, no par value; 5,000 shares
    authorized; no shares issued                                                                             |                                            |       |       |        |  |       |       |       
|                                         | Common stock, no par value; 50,000 shares
    authorized, 12,656 and 12,640 shares issued and outstanding as
    of June 30, 2002 and 2003, respectively |                                            |       | 20,751 |        |  |       | 20,366 |       
|                                         | Deferred compensation                                                                                                                                    |                                            |       | (631   | )      |  |       | (140   | )     
|                                         | Notes from directors                                                                                                                                     |                                            |       | (387   | )      |  |       | (156   | )     
|                                         | Accumulated other comprehensive income(loss)                                                                                                             |                                            |       | (31    | )      |  |       | (22    | )     
|                                         | Retained earnings                                                                                                                                        |                                            |       | 28,271 |        |  |       | 28,820 |       
|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |       
|                                         |                                                                                                                                                          | Total shareholders equity                 |       |        | 47,973 |  |       |        | 48,868 | 
|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |       
|                                         |                                                                                                                                                          | Total liabilities and shareholders equity |       | $      | 50,758 |  |       | $      | 52,096 | 
|                                         |                                                                                                                                                          |                                            |       |        |        |  |       |       

See accompanying notes

F-3



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QUALSTAR CORPORATION






CONSOLIDATED STATEMENTS OF INCOME


|                                           |                            |                          |        |        |       |      |        |        |        |   |        |        |        | 
|------------------------------------------ | -------------------------- | ------------------------ | ------ | ------ | ----- | ---- | ------ | ------ | ------ | - | ------ | ------ | ------ | 
|                                           |                            |                         
|                                           |                            | Years Ended June 30,    
|                                           |                            |                         
|                                           |                            | 2001                     |        | 2002   |       | 2003
|                                           |                            |                          |        |        |       |     
|                                           |                            |                         
|                                           |                            | (In thousands, except   
|                                           |                            | per share amounts)      
|Net revenues                               |                            | $                        | 51,572 |        |       | $    | 37,631 |        |        | $ | 33,557 |       
|Cost of goods sold                         |                            |                          | 33,216 |        |       |      | 23,753 |        |        |   | 21,171 |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|Gross profit                               |                            |                          | 18,356 |        |       |      | 13,878 |        |        |   | 12,386 |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|Operating expenses:                        |                            |                          |        |        |       |      |        |        |        |   |        |       
|                                           | Research and development   |                          |        | 1,279  |       |      |        | 2,136  |        |   |        | 3,994  |       
|                                           | Sales and marketing        |                          |        | 3,399  |       |      |        | 3,048  |        |   |        | 3,834  |       
|                                           | General and administrative |                          |        | 3,301  |       |      |        | 5,222  |        |   |        | 4,428  |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|                                           |                            | Total operating expenses |        |        | 7,979 |      |        |        | 10,406 |   |        |        | 12,256 | 
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|Income from operations                     |                            |                          | 10,377 |        |       |      | 3,472  |        |        |   | 130    |       
|Investment income                          |                            |                          | 1,225  |        |       |      | 1,133  |        |        |   | 693    |       
|Impairment of investment                   |                            |                          | (1,050 | )      |       |      |       |        |        |   |       |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|Income before provision for income taxes   |                            |                          | 10,552 |        |       |      | 4,605  |        |        |   | 823    |       
|Provision for income taxes                 |                            |                          | 3,824  |        |       |      | 1,845  |        |        |   | 274    |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|Net income                                 |                            | $                        | 6,728  |        |       | $    | 2,760  |        |        | $ | 549    |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|Earnings per share:                        |                            |                          |        |        |       |      |        |        |        |   |        |       
|                                           | Basic                      |                          | $      | 0.54   |       |      | $      | 0.22   |        |   | $      | 0.04   |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|                                           | Diluted                    |                          | $      | 0.53   |       |      | $      | 0.22   |        |   | $      | 0.04   |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|Shares used to compute earnings per share: |                            |                          |        |        |       |      |        |        |        |   |        |       
|                                           | Basic                      |                          |        | 12,372 |       |      |        | 12,475 |        |   |        | 12,579 |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       
|                                           | Diluted                    |                          |        | 12,668 |       |      |        | 12,664 |        |   |        | 12,666 |       
|                                           |                            |                          |        |        |       |      |        |        |        |   |        |       

See accompanying notes

F-4



---



##### Table of Contents



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, 2000                                |                                  |                | 12,164 |          |  | $            | 18,400 |               |  | $           | (1,534 | )        |  | $     | (617 | ) |  |   |    |     |   | $ | 18,783 |       |  | $ | 35,032 |      
|                                                        |                                  |                |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |     |     |   |   |        |       |  |   |        |      
|Exercise of stock options                               |                                  |                | 62     |          |  |              | 43     |               |  |             |       |          |  |       |     |   |  |   |    |     |   |   |       |       |  |   | 43     |      
|Issuance of common stock                                |                                  |                | 375    |          |  |              | 2,284  |               |  |             |       |          |  |       |     |   |  |   |    |     |   |   |       |       |  |   | 2,284  |      
|Amortization of deferred compensation                   |                                  |                |       |          |  |              |       |               |  |             | 437    |          |  |       |     |   |  |   |    |     |   |   |       |       |  |   | 437    |      
|Forfeiture of unvested stock options                    |                                  |                |       |          |  |              | (36    | )             |  |             | 36     |          |  |       |     |   |  |   |    |     |   |   |       |       |  |   |       |      
|Accrued interest on directors notes                    |                                  |                |       |          |  |              |       |               |  |             |       |          |  |       | (35  | ) |  |   |    |     |   |   |       |       |  |   | (35    | )    
|Principal payments on directors notes                  |                                  |                |       |          |  |              |       |               |  |             |       |          |  |       | 140  |   |  |   |    |     |   |   |       |       |  |   | 140    |      
|Comprehensive income:                                   |                                  |                |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |     |     |   |   |        |       |  |   |        |      
|                                                        | Net income                       |                |        |         |  |              |        |              |  |             |        |         |  |       |      |  |  |   |     |    |   |   |        | 6,728 |  |   |        | 6,728 |  
|                                                        | Unrealized gains on investments  |                |        |         |  |              |        |              |  |             |        |         |  |       |      |  |  |   | $   | 60  |   |   |        |      |  |   |        | 60    |  
|                                                        |                                  |                |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |     |     |   |   |        |       |  |   |        |      
|                                                        | Comprehensive income             |                |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |     |     |   |   |        |       |  |   |        | 6,788 |  
|                                                        |                                  |                |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |     |     |   |   |        |       |  |   |        |      
|Balances at June 30, 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 |  
|                                                        | Unrealized 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   |  
|                                                        | Unrealized gains on investments  |                |        |         |  |              |        |              |  |             |        |         |  |       |      |  |  |   |     | 9   |   |   |        |      |  |   |        | 9     |  
|                                                        |                                  |                |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |     |     |   |   |        |       |  |   |        |      
|                                                        | Comprehensive income             |                |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |     |     |   |   |        |       |  |   |        | 558   |  
|                                                        |                                  |                |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |     |     |   |   |        |       |  |   |        |      
|Balances at June 30, 2003                               |                                  |                | 12,640 |          |  | $            | 20,366 |               |  | $           | (140   | )        |  | $     | (156 | ) |  | $ | (22 | )   |   | $ | 28,820 |       |  | $ | 48,868 |      
|                                                        |                                  |                |        |          |  |              |        |               |  |             |        |          |  |       |      |   |  |   |     |     |   |   |        |       |  |   |        |      

See accompanying notes

F-5



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##### Table of Contents



QUALSTAR CORPORATION






CONSOLIDATED STATEMENTS OF CASH
FLOWS


|                                                        |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |         |     |        |  
|------------------------------------------------------- | ------------------------------------------------------------------------------------- | -------------------------------------------- | --------------------------------------------- | ------ | ----- | ------ | ------- | ------- | ----- | ------ | ------ | ------- | --- | ------ | -
|                                                        |                                                                                       |                                             
|                                                        |                                                                                       | Years Ended June 30,                        
|                                                        |                                                                                       |                                             
|                                                        |                                                                                       | 2001                                         |                                               | 2002   |       | 2003  
|                                                        |                                                                                       |                                              |                                               |        |       |       
|                                                        |                                                                                       |                                             
|                                                        |                                                                                       | (In thousands)                              
|OPERATING ACTIVITIES:                                   |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        
|                                                        | Net income                                                                            |                                              | $                                             | 6,728  |       |        | $       | 2,760   |       |        | $      | 549     |    
|                                                        | Adjustments to reconcile net income to net cash
    provided by operating activities: |                                              |                                               |        |       |        |         |         |       |        |        |         |    
|                                                        |                                                                                       | Depreciation and amortization                |                                               |        | 237   |        |         |         | 272   |        |        |         | 380 |       
|                                                        |                                                                                       | Deferred income taxes                        |                                               |        | (344  | )      |         |         | (469  | )      |        |         | 657 |       
|                                                        |                                                                                       | Provision for bad debts and returns          |                                               |        | 118   |        |         |         | 1,679 |        |        |         | (53 | )     
|                                                        |                                                                                       | Amortization of deferred compensation        |                                               |        | 437   |        |         |         | 430   |        |        |         | 301 |       
|                                                        |                                                                                       | Impairment of investment                     |                                               |        | 1,050 |        |         |         |      |        |        |         |    |       
|                                                        |                                                                                       | Accrued interest on directors notes         |                                               |        | (35   | )      |         |         | (27   | )      |        |         | (17 | )     
|                                                        |                                                                                       | Changes in operating assets and liabilities: |                                               |        |       |        |         |         |       |        |        |         |     |       
|                                                        |                                                                                       |                                              | Accounts receivable                           |        |       | 779    |         |         |       | (1,995 | )      |         |     | 2,213  |  
|                                                        |                                                                                       |                                              | Inventories                                   |        |       | (1,975 | )       |         |       | 980    |        |         |     | 2,609  |  
|                                                        |                                                                                       |                                              | Prepaid expenses and other assets             |        |       | (455   | )       |         |       | 93     |        |         |     | 236    |  
|                                                        |                                                                                       |                                              | Prepaid income taxes and income taxes payable |        |       | (162   | )       |         |       | 877    |        |         |     | (1,167 | )
|                                                        |                                                                                       |                                              | Accounts payable                              |        |       | 33     |         |         |       | (784   | )      |         |     | (454   | )
|                                                        |                                                                                       |                                              | Accrued payroll and related liabilities       |        |       | (166   | )       |         |       | 81     |        |         |     | 124    |  
|                                                        |                                                                                       |                                              | Other accrued liabilities                     |        |       | 325    |         |         |       | 235    |        |         |     | 657    |  
|                                                        |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        
|Net cash provided by operating activities               |                                                                                       |                                              | 6,570                                         |        |       |        | 4,132   |         |       |        | 6,035  |        
|INVESTING ACTIVITIES:                                   |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        
|                                                        | Purchases of equipment and leasehold improvements                                     |                                              |                                               | (986   | )     |        |         | (470    | )     |        |        | (561    | )  
|                                                        | Purchases of marketable securities                                                    |                                              |                                               | (7,232 | )     |        |         | (19,435 | )     |        |        | (34,375 | )  
|                                                        | Proceeds from the sale of marketable securities                                       |                                              |                                               | 7,609  |       |        |         | 8,936   |       |        |        | 30,513  |    
|                                                        | Purchase of assets of N2 Power, Incorporated                                          |                                              |                                               |       |       |        |         |        |       |        |        | (288    | )  
|                                                        |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        
|Net cash used in investing activities                   |                                                                                       |                                              | (609                                          | )      |       |        | (10,969 | )       |       |        | (4,711 | )      
|FINANCING ACTIVITIES:                                   |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        
|                                                        | Principal and interest payments on
    directors notes                               |                                              |                                               | 140    |       |        |         | 152     |       |        |        | 248     |    
|                                                        | Proceeds from issuance of common stock, net of
    offering costs                     |                                              |                                               | 2,284  |       |        |         |        |       |        |        |        |    
|                                                        | Proceeds from exercise of stock options                                               |                                              |                                               | 43     |       |        |         | 35      |       |        |        | 149     |    
|                                                        | Repurchase of common stock                                                            |                                              |                                               |       |       |        |         |        |       |        |        | (344    | )  
|                                                        |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        
|Net cash provided by financing activities               |                                                                                       |                                              | 2,467                                         |        |       |        | 187     |         |       |        | 53     |        
|NET INCREASE(DECREASE) IN CASH AND CASH
    EQUIVALENTS |                                                                                       |                                              | 8,428                                         |        |       |        | (6,650  | )       |       |        | 1,377  |        
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD          |                                                                                       |                                              | 3,081                                         |        |       |        | 11,509  |         |       |        | 4,859  |        
|                                                        |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        
|CASH AND CASH EQUIVALENTS, END OF PERIOD                |                                                                                       | $                                            | 11,509                                        |        |       | $      | 4,859   |         |       |        | 6,236  |        
|                                                        |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        
|SUPPLEMENTAL CASH FLOW DISCLOSURES:                     |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        
|                                                        | Income taxes paid                                                                     |                                              | $                                             | 4,330  |       |        | $       | 1,436   |       |        | $      | 904     |    
|                                                        |                                                                                       |                                              |                                               |        |       |        |         |         |       |        |        |        

See accompanying notes

F-6



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##### Table of Contents



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
high-performance cartridge tape drives, storage arrays of 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 network operating
systems, including UNIX, Windows NT, NetWare, and Linux and a
wide range of storage management software. Qualstar offers tape
libraries for multiple tape drive technologies, including those
using Linear Tape Open, Advanced Intelligent Tape, Super Digital
Linear Tape, and Super Advanced Intelligent Tape.



| |                            
| | ---------------------------
| | 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 uncollectable accounts
have been provided for in the financial statements.

Revenue to customers outside of North America
represented 26.9% of net revenues in 2001, 32.2% of net revenues
in 2002 and 29.4% of revenues in 2003. Revenues from
Qualstars two largest customers were 29.2%, 17.6%, and
15.4% for the years ended June 30, 2001, 2002, and 2003,
respectively. At June 30, 2002 and 2003, the two largest
customers accounts receivable, net of specific allowances,
totaled 8.5% and 30.1% of total 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, 2002 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

F-7



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##### Table of Contents



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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



| |            
| | -----------
| | 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 77.1% and
71.6%, respectively, of total sales and cost of goods sold for
the year ended June 30, 2001. Sales and costs of goods sold
related to products purchased from one large supplier totaled
approximately 65.3% and 54.2%, respectively, of total sales and
cost of goods sold for the year ended June 30, 2002. Sales
and costs of goods sold related to products purchased from one
supplier totaled approximately 56.2% and 57.3%, respectively, of
total sales and cost of goods sold for the year ended
June 30, 2003.



| |                       
| | ----------------------
| | 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 is accounted for under the cost method. Chaparral
designs and manufactures RAID controllers and intelligent
storage routers for tape library applications.

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 is included in the statement of income as an
impairment of investment.



| |                  
| | -----------------
| | 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 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 losses 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

F-8



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##### Table of Contents



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 Costs

Qualstar generally provides warranties for its
products ranging from one to three years. With respect to drives
and tapes used in Qualstars products, but manufactured by
a third party, Qualstar passes on to the customer the warranty
on such drives and tapes provided by the manufacturer. 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, outside consultant fees, prototype
materials and applicable overhead expenses 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, 2001, 2002 and 2003 were $426,000,
$211,000, and $984,000, respectively.



| |                                            
| | -------------------------------------------
| | 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).



| |             
| | ------------
| | 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

F-9



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##### Table of Contents



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

tax consequences of temporary differences between
the carrying amounts and the tax bases of assets and liabilities.



| |                     
| | --------------------
| | Comprehensive Income

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



| |                   
| | ------------------
| | Earnings Per Share

Qualstar calculates earnings per share in
accordance with SFAS No. 128, Earnings per
Share. Basic earnings per share has been computed by
dividing net income by the weighted average number of common
shares outstanding. Diluted earnings per share has been computed
by dividing net income 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,
|          |                                                            |                    
|          |                                                            | 2001                |   | 2002   |  | 2003
|          |                                                            |                     |   |        |  |     
|          |                                                            |                    
|          |                                                            | (In thousands)     
|Earnings: |                                                            |                     |   |        |  |      |   |        |  |  |   |       
|          | Net income                                                 |                     | $ | 6,728  |  |      | $ | 2,760  |  |  | $ | 549    | 
|          |                                                            |                     |   |        |  |      |   |        |  |  |   |       
|Shares:   |                                                            |                     |   |        |  |      |   |        |  |  |   |       
|          | Weighted average shares for basic earnings per
    share   |                     |   | 12,372 |  |      |   | 12,475 |  |  |   | 12,579 | 
|          | Stock options                                              |                     |   | 296    |  |      |   | 189    |  |  |   | 87     | 
|          |                                                            |                     |   |        |  |      |   |        |  |  |   |       
|          | Weighted average shares for diluted earnings per
    share |                     |   | 12,668 |  |      |   | 12,664 |  |  |   | 12,666 | 
|          |                                                            |                     |   |        |  |      |   |        |  |  |   |       

Shares issuable under stock options of 68,000,
68,000 and 152,000 for the years ended June 30, 2001, 2002
and 2003, respectively, have been excluded from the computation
of diluted earnings 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.



| |                          
| | -------------------------
| | 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.

F-10



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##### Table of Contents



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



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

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

2.     Inventories

Inventories consist of the following (in
thousands):

|               |  |          |       |      |  |   |       | 
|-------------- |  | -------- | ----- | ---- |  | - | ----- | 
|               |  |         
|               |  | June 30,
|               |  |         
|               |  | 2002     |       | 2003
|               |  |          |       |     
|Raw materials  |  | $        | 7,980 |      |  | $ | 6,454 | 
|Finished goods |  |          | 1,672 |      |  |   | 637   | 
|               |  |          |       |      |  |   |       | 
|               |  | $        | 9,652 |      |  | $ | 7,091 | 
|               |  |          |       |      |  |   |       | 

3.     Property and
Equipment

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

|                        |                                                |          |       |        |   |   |       |        |  
|----------------------- | ---------------------------------------------- | -------- | ----- | ------ | - | - | ----- | ------ | -
|                        |                                                |         
|                        |                                                | June 30,
|                        |                                                |         
|                        |                                                | 2002     |       | 2003  
|                        |                                                |          |       |       
|Leasehold improvements  |                                                | $        | 541   |        |   | $ | 541   |       
|Furniture and fixtures  |                                                |          | 907   |        |   |   | 890   |       
|Machinery and equipment |                                                |          | 2,050 |        |   |   | 2,276 |       
|                        |                                                |          |       |        |   |   |       |       
|                        |                                                |          | 3,498 |        |   |   | 3,707 |       
|                        | Less accumulated depreciation and amortization |          |       | (2,174 | ) |   |       | (2,150 | )
|                        |                                                |          |       |        |   |   |       |       
|                        |                                                | $        | 1,324 |        |   | $ | 1,557 |       
|                        |                                                |          |       |        |   |   |       |       

4.     Income
Taxes

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

|          |         |                     |       |       |   |      |       |       |   |   |      |      |  
|--------- | ------- | ------------------- | ----- | ----- | - | ---- | ----- | ----- | - | - | ---- | ---- | -
|          |         |                    
|          |         | Year Ended June 30,
|          |         |                    
|          |         | 2001                |       | 2002  |   | 2003
|          |         |                     |       |       |   |     
|Current:  |         |                     |       |       |   |      |       |       |   |   |      |     
|          | Federal |                     | $     | 3,414 |   |      | $     | 1,775 |   |   | $    | (332 | )
|          | State   |                     |       | 754   |   |      |       | 539   |   |   |      | (51  | )
|          |         |                     |       |       |   |      |       |       |   |   |      |     
|          |         |                     | 4,168 |       |   |      | 2,314 |       |   |   | (383 | )   
|Deferred: |         |                     |       |       |   |      |       |       |   |   |      |     
|          | Federal |                     |       | (256  | ) |      |       | (391  | ) |   |      | 579  |  
|          | State   |                     |       | (88   | ) |      |       | (78   | ) |   |      | 78   |  
|          |         |                     |       |       |   |      |       |       |   |   |      |     
|          |         |                     | (344  | )     |   |      | (469  | )     |   |   | 657  |     
|          |         |                     |       |       |   |      |       |       |   |   |      |     
|          |         | $                   | 3,824 |       |   | $    | 1,845 |       |   | $ | 274  |     
|          |         |                     |       |       |   |      |       |       |   |   |      |     

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##### Table of Contents



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,
|                                                          |  |                    
|                                                          |  | 2001                |      | 2002 |  | 2003
|                                                          |  |                     |      |      |  |     
|Statutory federal income tax expense                      |  |                     | 34.0 | %    |  |      | 34.0 | % |  |  | 34.0 | %
|State income taxes, net of federal income tax
    benefit |  |                     | 4.3  |      |  |      | 4.5  |   |  |  | 2.6  |  
|Other                                                     |  |                     | (2.1 | )    |  |      | 1.6  |   |  |  | (3.3 | )
|                                                          |  |                     |      |      |  |      |      |   |  |  |      |  
|                                                          |  |                     | 36.2 | %    |  |      | 40.1 | % |  |  | 33.3 | %
|                                                          |  |                     |      |      |  |      |      |   |  |  |      |  

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

|                        |                                     |                           |       |      |       |   |     |      |     | 
|----------------------- | ----------------------------------- | ------------------------- | ----- | ---- | ----- | - | --- | ---- | --- | 
|                        |                                     |                          
|                        |                                     | June 30,                 
|                        |                                     |                          
|                        |                                     | 2002                      |       | 2003
|                        |                                     |                           |       |     
|Deferred tax assets:    |                                     |                           |       |      |       |   |     |     
|                        | Allowance for bad debts and returns |                           | $     | 861  |       |   | $   | 107  |    
|                        | Inventory reserves                  |                           |       |     |       |   |     | 130  |    
|                        | Reserve for Chaparral investment    |                           |       | 430  |       |   |     | 430  |    
|                        | Capitalized inventory costs         |                           |       | 31   |       |   |     | 32   |    
|                        | State income taxes                  |                           |       | 140  |       |   |     |     |    
|                        | Other accruals                      |                           |       | 39   |       |   |     | 240  |    
|                        |                                     |                           |       |      |       |   |     |     
|                        |                                     | Total deferred tax assets |       |      | 1,501 |   |     |      | 939 | 
|Deferred tax liability: |                                     |                           |       |      |       |   |     |     
|                        | Depreciation                        |                           |       | (96  | )     |   |     | (191 | )  
|                        |                                     |                           |       |      |       |   |     |     
|                        |                                     | $                         | 1,405 |      |       | $ | 748 |     
|                        |                                     |                           |       |      |       |   |     |     

No valuation reserve was established at
June 30, 2002 and 2003, based on the Companys
expectations to be able to realize the benefit from the deferred
tax assets.

5.     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, 2002
and 2003, there were no outstanding shares of preferred stock.

6.     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

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QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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):

|                             |           |         |     |                |   |                |              |              |  |   |      |      | 
|---------------------------- | --------- | ------- | --- | -------------- | - | -------------- | ------------ | ------------ |  | - | ---- | ---- | 
|                             |           |         |     |                |   | Weighted      
|                             |           | Stock   |     | Exercise Price |   | Average       
|                             |           | Options |     | Per Share      |   | Exercise Price
|                             |           |         |     |                |   |               
|Outstanding at July 1, 2000  |           |         | 286 |                |   | $              | 0.22 - $2.78 |              |  | $ | 1.60 |     
|                             | Granted   |         |     | 84             |   |                |              | 9.38         |  |   |      | 9.38 | 
|                             | Exercised |         |     | (62            | ) |                |              | 0.22 -  2.78 |  |   |      | 0.68 | 
|                             | Cancelled |         |     | (52            | ) |                |              | 0.56 -  9.38 |  |   |      | 3.46 | 
|                             |           |         |     |                |   |                |              |              |  |   |      |     
|Outstanding at June 30, 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 |     
|                             |           |         |     |                |   |                |              |              |  |   |      |     

|                     |  |                                      |     |                     |  |          |     |             |  |          |      |  |  |  |    |  |  |   |      | 
|-------------------- |  | ------------------------------------ | --- | ------------------- |  | -------- | --- | ----------- |  | -------- | ---- |  |  |  | -- |  |  | - | ---- | 
|                     |  |                                      |     |                     |  |          |     |            
|                     |  |                                      |     | Options Exercisable
|                     |  | Options Outstanding at June 30, 2003 |     | at June 30, 2003   
|                     |  |                                      |     |                    
|                     |  |                                      |     | Weighted            |  |          |     | Weighted   
|                     |  | Number of                            |     | Weighted Average    |  | Average  |     | Number of   |  | Average 
|                     |  | Shares                               |     | Remaining           |  | Exercise |     | Shares      |  | Exercise
|Exercise Price Range |  | Outstanding                          |     | Contractual Life    |  | Price    |     | Exercisable |  | Price   
|                     |  |                                      |     |                     |  |          |     |             |  |         
|$2.78                |  |                                      | 14  |                     |  |          | 6.5 |             |  | $        | 2.78 |  |  |  | 10 |  |  | $ | 2.78 | 
|$4.23 - 5.94         |  |                                      | 414 |                     |  |          | 8.8 |             |  | $        | 5.21 |  |  |  | 62 |  |  | $ | 4.84 | 
|$9.38                |  |                                      | 52  |                     |  |          | 7.1 |             |  | $        | 9.38 |  |  |  | 34 |  |  | $ | 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
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.

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 the option and restricted stock awards 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 is being amortized over the four-year
vesting period, which resulted in compensation expense of
$437,000 in fiscal 2001, $430,000 in fiscal 2002, and $301,000
in fiscal 2003. During the years ended June 30, 2001 and
2003, approximately 36,000 and 52,000, respectively, 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 $36,000 and
$190,000 during the years ended June 30, 2001 and 2003,
respectively.

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QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 and earnings per share would have been
reduced to the pro forma amounts indicated below:

|                                                                           |                       |                            |       |      |  |      |       |      |  |   |      |      | 
|-------------------------------------------------------------------------- | --------------------- | -------------------------- | ----- | ---- |  | ---- | ----- | ---- |  | - | ---- | ---- | 
|                                                                           |                       |                           
|                                                                           |                       | Fiscal Year Ended June 30,
|                                                                           |                       |                           
|                                                                           |                       | 2001                       |       | 2002 |  | 2003
|                                                                           |                       |                            |       |      |  |     
|Net income as reported                                                     |                       | $                          | 6,728 |      |  | $    | 2,760 |      |  | $ | 549  |     
|Stock-based employee compensation cost included
    in reported net income |                       |                            | 437   |      |  |      | 430   |      |  |   | 301  |     
|Pro forma stock-based employee compensation cost
    under SFAS 123.       |                       |                            | (558  | )    |  |      | (590  | )    |  |   | (591 | )   
|                                                                           |                       |                            |       |      |  |      |       |      |  |   |      |     
|Pro forma net income                                                       |                       | $                          | 6,607 |      |  | $    | 2,600 |      |  | $ | 259  |     
|                                                                           |                       |                            |       |      |  |      |       |      |  |   |      |     
|Earnings per share:                                                        |                       |                            |       |      |  |      |       |      |  |   |      |     
|                                                                           | Basic  as reported   |                            | $     | 0.54 |  |      | $     | 0.22 |  |   | $    | 0.04 | 
|                                                                           |                       |                            |       |      |  |      |       |      |  |   |      |     
|                                                                           | Basic  pro forma     |                            | $     | 0.53 |  |      | $     | 0.21 |  |   | $    | 0.02 | 
|                                                                           |                       |                            |       |      |  |      |       |      |  |   |      |     
|                                                                           | Diluted  as reported |                            | $     | 0.53 |  |      | $     | 0.22 |  |   | $    | 0.04 | 
|                                                                           |                       |                            |       |      |  |      |       |      |  |   |      |     
|                                                                           | Diluted  pro forma   |                            | $     | 0.52 |  |      | $     | 0.21 |  |   | $    | 0.02 | 
|                                                                           |                       |                            |       |      |  |      |       |      |  |   |      |     

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 for 2001, 2002 and 2003 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 $5.88 for
2001, $1.97 for 2002, and $4.29 for 2003 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:

|                         |  |      |         |      |  |      |         |   |  |  |         |  
|------------------------ |  | ---- | ------- | ---- |  | ---- | ------- | - |  |  | ------- | -
|                         |  | 2001 |         | 2002 |  | 2003
|                         |  |      |         |      |  |     
|Expected dividend yield  |  |      | 0       | %    |  |      | 0       | % |  |  | 0       | %
|Risk-free interest rate  |  |      | 6.5     | %    |  |      | 4.5     | % |  |  | 2.7     | %
|Expected life of options |  |      | 5 years |      |  |      | 5 years |   |  |  | 5 years |  
|Volatility               |  |      | 69.0    | %    |  |      | 38.0    | % |  |  | 54.0    | %

7.     Purchase of N2
Power

On July 11, 2002, Qualstar acquired the
assets and intellectual properties of N2Power, Incorporated, a
privately held company which designs and produces 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, 2003, accumulated amortization of
the patent was $48,000. Amortization expense for the year ended
June 30, 2003 was $48,000. Amortization expense is
estimated to be $48,000 in each of fiscal years 2004, 2005,
2006, and 2007.

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QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

8.     Commitments

During fiscal year 2001, Qualstar entered into a
new lease agreement for a facility located in Simi Valley,
California. The lease agreement 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.

During fiscal year 2002, Qualstar entered into a
new lease agreement for a facility located in Boulder, Colorado.
The lease agreement 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
|            |  |              
|2004        |  | $             | 549,000   | 
|2005        |  |               | 562,000   | 
|2006        |  |               | 581,000   | 
|2007        |  |               | 590,000   | 
|2008        |  |               | 554,000   | 
|Thereafter  |  |               | 1,499,000 | 
|            |  |               |           | 
|            |  | $             | 4,335,000 | 
|            |  |               |           | 

Rent expense (including equipment rental) for the
years ended June 30, 2001, 2002, and 2003, was $366,000,
$594,000, and $589,000 respectively.

9.     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 infringe a patent
owned by Raytheon entitled Mass Data Storage
Library. Raytheon filed an amended complaint on or about
February 6, 2003, which includes an allegation that
Qualstars tape libraries infringe Raytheons patent.
The complaint seeks an injunction against all defendants and an
unspecified amount of damages. Qualstar responded to the
complaint on March 7, 2003 and denied Raytheons
allegations of infringement. The parties are currently engaged
in pre-trial discovery. A patent claims construction hearing is
presently scheduled for January 14, 2004 and a trial is
scheduled for June 7, 2004, both of which will be located
in Marshall, Texas. Qualstar and its legal counsel continue to
analyze Raytheons patent and available defenses to the
claims of infringement. Based on this analysis, Qualstar
believes that Raytheons claims against Qualstar are
without merit and Qualstar intends to vigorously defend against
this complaint. Management does not believe the ultimate outcome
of this matter will have a material effect on Qualstars
financial position or results of operations.

Qualstar may be involved in other litigation or
legal matters from time to time in the normal course of
business. However, other than the Raytheon matter discussed
above, there are currently no other material proceedings,
pending or, to the knowledge of management, threatened against
Qualstar.

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QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

10.     Geographic
Information

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

|          |               |                     |        |        |  |      |        |        |  |   |        |        | 
|--------- | ------------- | ------------------- | ------ | ------ |  | ---- | ------ | ------ |  | - | ------ | ------ | 
|          |               |                    
|          |               | Year Ended June 30,
|          |               |                    
|          |               | 2001                |        | 2002   |  | 2003
|          |               |                     |        |        |  |     
|Revenues: |               |                     |        |        |  |      |        |        |  |   |        |       
|          | North America |                     | $      | 37,700 |  |      | $      | 25,550 |  |   | $      | 23,678 | 
|          | Europe        |                     |        | 9,850  |  |      |        | 9,811  |  |   |        | 7,349  | 
|          | Asia          |                     |        | 3,754  |  |      |        | 1,758  |  |   |        | 1,837  | 
|          | Other         |                     |        | 268    |  |      |        | 512    |  |   |        | 693    | 
|          |               |                     |        |        |  |      |        |        |  |   |        |       
|          |               | $                   | 51,572 |        |  | $    | 37,631 |        |  | $ | 33,557 |       
|          |               |                     |        |        |  |      |        |        |  |   |        |       

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.

11.     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 90 days of employment and
may contribute up to 25% of their compensation. 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 $44,000, $51,000, and $58,000 for the years
ended June 30, 2001, 2002, and 2003 respectively.

12.     Related Party
Transactions

Qualstars outside counsel became a member
of its board of directors, in January 2000. During the year
ended June 30, 2001, Qualstar paid $175,000 to the law firm
in which the director is a shareholder, of which $70,000 related
to the initial public offering with the remainder for general
business purposes. During the year ended June 30, 2002,
Qualstar paid $132,000 for general business purposes to the law
firm in which the director is a shareholder. During the year
ended June 20, 2003, Qualstar paid $149,000 for general
business purposes to the law firm in which the director is a
shareholder.

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##### Table of Contents



QUALSTAR CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

13.     Quarterly
Results of Operations (unaudited)

|                              |         |                                          |       |              |  |           |        |          |  |   |       |      |  |   |        |       |  
|----------------------------- | ------- | ---------------------------------------- | ----- | ------------ |  | --------- | ------ | -------- |  | - | ----- | ---- |  | - | ------ | ----- | -
|                              |         |                                         
|                              |         | Three Months Ended                      
|                              |         |                                         
|                              |         | September 30,                            |       | December 31, |  | March 31, |        | June 30,
|                              |         |                                          |       |              |  |           |        |         
|                              |         |                                         
|                              |         | (In thousands, except per share amounts)
|Fiscal 2002:                  |         |                                          |       |              |  |           |        |          |  |   |       |      |  |   |        |      
|Net sales                     |         | $                                        | 8,797 |              |  | $         | 10,031 |          |  | $ | 8,603 |      |  | $ | 10,200 |      
|Gross profit                  |         |                                          | 3,330 |              |  |           | 3,798  |          |  |   | 3,191 |      |  |   | 3,559  |      
|Net income(loss)              |         |                                          | 1,167 |              |  |           | 1,208  |          |  |   | 695   |      |  |   | (310   | )    
|Net earnings(loss) per share: |         |                                          |       |              |  |           |        |          |  |   |       |      |  |   |        |      
|                              | Basic   |                                          | $     | 0.09         |  |           | $      | 0.10     |  |   | $     | 0.06 |  |   | $      | (0.02 | )
|                              | Diluted |                                          |       | 0.09         |  |           |        | 0.10     |  |   |       | 0.05 |  |   |        | (0.02 | )
|Fiscal 2003:                  |         |                                          |       |              |  |           |        |          |  |   |       |      |  |   |        |      
|Net sales                     |         | $                                        | 8,792 |              |  | $         | 8,408  |          |  | $ | 8,189 |      |  | $ | 8,168  |      
|Gross profit                  |         |                                          | 3,178 |              |  |           | 3,148  |          |  |   | 3,104 |      |  |   | 2,956  |      
|Net income(loss)              |         |                                          | 502   |              |  |           | 79     |          |  |   | 11    |      |  |   | (43    | )    
|Net earnings(loss) per share: |         |                                          |       |              |  |           |        |          |  |   |       |      |  |   |        |      
|                              | Basic   |                                          | $     | 0.04         |  |           | $      | 0.01     |  |   | $     | 0.00 |  |   | $      | 0.00  |  
|                              | Diluted |                                          |       | 0.04         |  |           |        | 0.01     |  |   |       | 0.00 |  |   |        | 0.00  |  

F-17



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##### Table of Contents






SCHEDULE II

QUALSTAR CORPORATION

VALUATION AND QUALIFYING ACCOUNTS

ALLOWANCE FOR DOUBTFUL ACCOUNTS


For the Years Ended June 30, 2001, 2002,
and 2003


|                         |  |            |           |            |  |          |           |               |  |            |   |  |  |   |           |  |  |   |           | 
|------------------------ |  | ---------- | --------- | ---------- |  | -------- | --------- | ------------- |  | ---------- | - |  |  | - | --------- |  |  | - | --------- | 
|Column A                 |  | Column B   |           | Column C   |  |          |           | Column D      |  | Column E  
|                         |  |            |           |            |  |          |           |               |  |           
|                         |  | Balance at |           | Charged to |  | Charged  |           |               |  | Balance at
|                         |  | Beginning  |           | Costs and  |  | to Other |           |               |  | End of    
|Description              |  | of Period  |           | Expenses   |  | Accounts |           | Deductions(1) |  | Period    
|                         |  |            |           |            |  |          |           |               |  |           
|Year Ended June 30, 2001 |  | $          | 470,000   |            |  | $        | 118,000   |               |  | $          |  |  |  | $ | 118,000   |  |  | $ | 470,000   | 
|Year Ended June 30, 2002 |  | $          | 470,000   |            |  | $        | 1,679,000 |               |  | $          |  |  |  | $ | 49,000    |  |  | $ | 2,100,000 | 
|Year Ended June 30, 2003 |  | $          | 2,100,000 |            |  | $        | (53,000   | )             |  | $          |  |  |  | $ | 1,787,000 |  |  | $ | 260,000   | 



---



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

F-18



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##### Table of Contents






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 26, 2003

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 26, 2003
|                                        
|/s/ RICHARD A. NELSONRichard A. Nelson   |  | Vice President, Engineering Secretary and Director                                              |  | September 26, 2003
|                                        
|/s/ FREDERIC T. BOYERFrederic T. Boyer   |  | Vice President and Chief
    Financial Officer
    (principal financial and accounting officer) |  | September 26, 2003
|                                        
|/s/ BRUCE E. GLADSTONEBruce E. Gladstone |  | Director                                                                                        |  | September 26, 2003
|                                        
|/s/ TRUDE C. TAYLORTrude C. Taylor       |  | Director                                                                                        |  | September 26, 2003
|                                        
|/s/ ROBERT E. RICHRobert E. Rich         |  | Director                                                                                        |  | September 26, 2003
|                                        
|/s/ ROBERT T. WEBBERRobert T. Webber     |  | Director                                                                                        |  | September 26, 2003

F-19



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##### Table of Contents






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.
|            | 21.1     |             |  | Subsidiaries of Qualstar Corporation                                                                                   
|            | 23.1     |             |  | Consent of Ernst & Young LLP, Independent
    Auditors.                                                                
|            | 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(c) of this
    report.

F-20