QUALSTAR CORP - Quarter Report: 2003 December (Form 10-Q)

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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended December 31, 2003

For the transition period from _______ to _______

Commission file number 000-30083

QUALSTAR CORPORATION

3990-B Heritage Oak Court
Simi Valley, CA 93063
(805) 583-7744

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 [X]   No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes [  ]    No [X]

Total shares of common stock without par value outstanding at February 6, 2004 is 12,576,699.

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QUALSTAR CORPORATION
FORM 10-Q
For the quarterly period ended December 31, 2003

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PART I — FINANCIAL INFORMATION

ITEM 1. Financial Statements

QUALSTAR CORPORATION
CONSOLIDATED CONDENSED BALANCE SHEETS
DECEMBER 31, 2003 AND JUNE 30, 2003
(in thousands)

See the accompanying notes to these interim consolidated condensed financial statements.

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QUALSTAR CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
THREE MONTHS AND SIX MONTHS ENDED DECEMBER 31, 2003 AND 2002
(UNAUDITED)
(in thousands, except per share data)

See the accompanying notes to these interim consolidated condensed financial statements.

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QUALSTAR CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED DECEMBER 31, 2003 AND 2002
(UNAUDITED)
(in thousands)

See the accompanying notes to these interim consolidated condensed financial statements.

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QUALSTAR CORPORATION
CONSOLIDATED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
SIX MONTHS ENDED DECEMBER 31, 2003
(UNAUDITED)
(in thousands)

See the accompanying notes to these interim consolidated condensed financial statements.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
DECEMBER 31, 2003
(in thousands, except per share data)
(UNAUDITED)

NOTE 1. BASIS OF PRESENTATION

     The accompanying consolidated condensed financial statements are unaudited, except for the balance sheet at June 30, 2003 which is derived from our audited financial statements, and should be read in conjunction with the consolidated financial statements and related notes included in Qualstar Corporation’s (“Qualstar,” “us,” “we,” or “our”) Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC) on September 26, 2003. In the opinion of management, these unaudited consolidated condensed financial statements include all adjustments, consisting primarily of normal recurring items, which are necessary for the fair presentation of Qualstar’s consolidated financial position as of December 31, 2003, consolidated results of operations for the three months and six months ended December 31, 2003 and 2002, and consolidated cash flows for the six months ended December 31, 2003 and 2002. Operating results for the three and six month periods ended December 31, 2003 are not necessarily indicative of results to be expected for a full year.

NOTE 2. EARNINGS PER SHARE

     The following table sets forth the computation of basic and diluted net income per share for the three months and six months ended December 31, 2003 and 2002:

Shares issuable under stock options of 317,000 and 616,500 for the three month and six month period ended December 31, 2003, respectively, have been excluded from the computation of diluted earnings per share as the effect would have been antidilutive.

NOTE 3. MARKETABLE SECURITIES

     Marketable securities consist primarily of high-quality corporate, federal and state government 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 the Company 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 the Company’s marketable securities were classified as available-for-sale at December 31, 2003 and June 30, 2003.

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

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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.

NOTE 4. INVENTORIES

     Inventories are stated at the lower of cost (first-in, first-out basis) or market. Inventory is comprised as follows:

NOTE 5. COMPREHENSIVE INCOME (LOSS)

     For the six months ended December 31, 2003 and 2002, comprehensive income (loss) amounted to approximately $(0.45) million and $0.6 million, respectively. The difference between net income (loss) and comprehensive income (loss) relates to the changes in the unrealized losses or gains the Company recorded for its available-for-sale securities.

NOTE 6. 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 recognition of expense when the option price is less than the fair value of the stock at the date of grant. The Company generally awards options for a fixed number of shares at an option price equal to the fair value of the stock at the date of grant. The Company has adopted the disclosure only provisions of the Financial Accounting Standards Board’s Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” (SFAS 123).

     If the Company 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:

Shares issuable under stock options of 317,000 and 616,500 for the three month and six month period ended December 31, 2003, respectively, have been excluded from the computation of diluted earnings per share as the effect would have been antidilutive.

NOTE 7. BUSINESS ACQUISITIONS

     On July 11, 2002, the Company acquired the assets and intellectual properties of N2Power, Incorporated (N2Power), a privately held company which designs and produces small and efficient open-frame switching power supplies. The consideration for this acquisition was $250,000 plus acquisition expenses of $38,000. The purchase price was primarily allocated to a patent which will be

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amortized over 5 years. The accompanying consolidated financial statements include the operations of N2Power from the date of acquisition.

NOTE 8. STOCK REPURCHASE

     On February 12, 2003, the Company announced that the Board of Directors authorized a stock repurchase program of up to 500,000 shares of the Company’s common stock. The stock repurchase is funded by available working capital. There is no time limit for the completion of the stock repurchase program and it may be discontinued at any time. During the three month and six month periods ended December 31, 2003, the Company repurchased a total of 62,910 shares of its common stock at a total cost of $314,000. From February 12, 2003 through December 31, 2003, the Company had repurchased a total of 139,477 shares of its common stock at a total cost of approximately $658,084, or an average price of approximately $4.72 per share.

NOTE 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 in the process of pre-trial discovery. On January 14, 2004, the Court held a hearing to construe the terms of the claim and we are currently awaiting the Court’s claim construction ruling. The trial has been rescheduled from June 7, 2004 to September 7, 2004 and will be located in Marshall, Texas. Qualstar and our legal counsel continue 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.

     Qualstar may be involved in litigation or other legal proceedings from time to time in the normal course of business. Other than the Raytheon lawsuit discussed above, however, there are no material actions currently pending.

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Statements in this Quarterly Report on Form 10-Q concerning the future business, operating results and financial condition of Qualstar are 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. These 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 our Annual Report on Form 10-K for the fiscal year ended June 30, 2003 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,” “expects,” “intends,” “estimates,” “anticipates,” “plans,” “seeks,” or “continues,” or the negative thereof or variations thereon or similar terminology. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statements to reflect the occurrence of events or circumstances in the future.

OVERVIEW

     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. These tape drive technologies compete with each other in terms of their native storage capacity as well as their ability to quickly and efficiently read and write data. Since all models of our tape libraries are required to have tape drives to operate, the overall performance of our tape libraries is associated with the performance of the tape drive it contains. Historically, our business has been focused on selling tape libraries that incorporate AIT technology, as the majority of our revenue has been generated from this product line. The current generation of AIT tape drives (AIT3) contain a maximum native capacity of 100 gigabytes per tape. In the past year, the capacity of tape drives using the LTO (Linear Tape Open) half-inch tape format was increased to a maximum of 200 gigabytes, native, surpassing that of AIT tape drives. In recent quarters, we have noticed a downward trend in the amount of library shipments which incorporate AIT technology and an upward trend in shipments of libraries which incorporate tape drive technology based upon a half-inch form factor such as LTO, SDLT, and SAIT.

     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, which they in turn resell to end users. We custom configure each of our libraries based on each customer’s individual requirements, with a normal delivery time of one to three working days. This rapid fulfillment of customer orders allows our resellers to minimize their inventory levels and allows us to compete effectively with distribution channels used by our competitors.

     Qualstar was incorporated in California in 1984. 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.

     In July 2002, we purchased the assets of N2Power, Incorporated, a supplier of ultra small high efficiency open-frame switching power supplies. Power supplies provided by N2Power are utilized within our tape library products as well as sold to other OEM customers for incorporation into their products. N2Power products are sold under the N2Power brand name through outside sales representatives and distributors to OEM’s.

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

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financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to customer promotional offers, sales returns, bad debts, inventories, warranty costs, investments, and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

     Revenue Recognition

     Revenue is recognized upon shipment of products to our customers. Title and risk of loss transfer to the customer when the product leaves our 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 specification. 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 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.

     Allowance for Doubtful Accounts

     We maintain an allowance for doubtful accounts and returns 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.

     Inventory Reserves

     We write down our inventory for estimated obsolescence, potential shrinkage, or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand 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.

     Warranty Costs

     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. Historically our warranty costs have not been significant.

     Accounting for Income Taxes

     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.

RESULTS OF OPERATIONS

The following table sets forth items in our statement of operations as a percentage of net revenues for the periods presented. The data has been derived from our unaudited consolidated condensed financial statements.

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Three Months Ended December 31, 2003 Compared to Three Months Ended December 31, 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 sale. Net revenues for the three months ended December 31, 2003 were $9.6 million, compared with net revenues of $8.4 million for the three months ended December 31, 2002, an increase of $1.2 million. Revenue was higher in the second quarter of fiscal 2004 primarily due to a $1.4 million shipment to a video surveillance OEM which accounted for approximately 14.5% of our net revenues for the quarter. Although we don’t believe such a large order is a one time event, we do not anticipate receiving another order of this magnitude in the short term.

     GROSS PROFIT. Cost of goods sold consists primarily of direct labor, purchased parts, depreciation of plant and equipment, rent, utilities, and packaging costs. Gross profit was $3.6 million, or 37.6% of net revenues, for the three months ended December 31, 2003, compared to $3.1 million, or 37.4% of net revenues, for the three months ended December 31, 2002. The increase in our gross profit as a percentage of net revenues was primarily due to a shift in our product mix compounded with a higher unit shipment volume for the quarter ended December 31, 2003 as compared to the same quarter a year ago. The majority of our net revenue comes from the sale of tape libraries and drives. Other products such as tape media and service contracts can influence our overall gross profit margin, since they are different in nature than tape libraries and drives. Tape media, which is available through general distribution channels, historically has had lower gross margins when compared to the tape libraries and drives in which it is used. Furthermore, service revenues generally have higher gross margins as a percentage of net revenues than do tape libraries and drives. During the three month period ended December 31, 2003, we generated a larger percentage of our net revenue from service than in the same period last year. In addition to product mix, our gross margin was positively impacted since shipment volume was up approximately 24% and our fixed overhead costs were spread over a larger unit sales base. We expect gross margin to be consistent with historical trends for the third quarter of fiscal 2004.

     RESEARCH AND DEVELOPMENT. Research and development expenses consist primarily of engineering salaries, benefits, purchased parts and supplies used in development activities of our Advanced Development Group located in Boulder, Colorado, as well as our engineering group located in Simi Valley, California. Research and development expenses for the three months ended December 31, 2003 were $1.1 million, or 11.1% of net revenues, as compared to $0.9 million, or 11.1% of net revenues, for the three months ended December 31, 2002. The increase in research and development expenses in absolute dollars was primarily due to our multi-year research and development initiative at our Advanced Development Group, which we established in late fiscal 2002 to develop a new line of enterprise-class tape libraries. We expect research and development expenses to remain at approximately the current level in absolute terms in the third quarter of fiscal 2004.

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     SALES AND MARKETING. Sales and marketing expenses consist primarily of employee salaries and benefits, sales commissions, trade show costs, advertising, technical support and travel related expenses. Sales and marketing expenses for the three months ended December 31, 2003 were $1.0 million or 10.9% of net revenues, compared to $1.0 million, or 12.5% of net revenues, for the three months ended December 31, 2002.

     GENERAL AND ADMINISTRATIVE. General and administrative expenses consist of employee salaries and benefits, deferred compensation related to stock options and restricted stock awards, provision for doubtful accounts and returns, and professional service fees. General and administrative expenses for the three months ended December 31, 2003 were $1.4 million, or 14.9% of net revenues, compared with $1.0 million, or 12.4% of net revenues, for the three months ended December 31, 2002. The increase in general and administrative expenses was due primarily to an increase in legal fees associated with our defense of a patent infringement lawsuit brought by Raytheon Company against nine defendants, including Qualstar, and additions to our reserve for doubtful accounts. We expect these litigation expenses to continue at the current level for the next several quarters. Consequently, we expect general and administrative expenses to remain at approximately the current level during the third quarter of fiscal 2004.

     INVESTMENT INCOME. Investment income was $192,000 in the quarter ended December 31, 2003 compared with investment income of $102,000 in the quarter ended December 31, 2002. The increase in the current quarter is due to a realized loss of approximately $90,000 recognized in the quarter ended December 31, 2002 attributed to the liquidation of an investment with a market value below its carrying value.

     PROVISION (BENEFIT) FOR INCOME TAXES. We recorded a provision for income taxes of $49,000 equal to 19.1% of our pre-tax income, for the three months ended December 31, 2003. This compares with a provision for income taxes of $145,000, or 64.7% of pre-tax income for the three months ended December 31, 2002. The decrease in the percentage of the provision for income taxes to pre-tax income was primarily due to $60,000 of additional provision, net of certain items, taken during the three months ended December 31, 2002 for items relating to prior years. The percentage of the provision for income taxes to pre-tax income, for the three months ended December 31, 2003, was recorded to yield an annualized effective tax rate of 34.8% based on a year to date tax provision, and is comparable to our fiscal year 2003 rate of 33.3%. Future operating results may change this estimate.

Six Months Ended December 31, 2003 Compared to Six Months Ended December 31, 2002.

     NET REVENUES. Net revenues for the six months ended December 31, 2003 were $15.5 million, compared with net revenues of $17.2 million for the six months ended December 31, 2002, a decrease of $1.7 million. Revenue was lower for the six months ended December 31, 2003 due to reduced demand for our tape libraries which incorporate AIT (Advanced Intelligent Tape) technology. Although we offer all major tape formats in our libraries, historically we have sold mostly AIT-based tape libraries. Recently, sales of our libraries incorporating half-inch tape technologies, such as LTO, SDLT (Super Digital Linear Tape) and, more recently, SAIT (Super Advanced Intelligent Tape), have been increasing, but these increases have not been sufficient to offset the decline in sales of our libraries using AIT tape technology.

     GROSS PROFIT. Gross profit was $5.8 million or 37.6% of net revenues, for the six months ended December 31, 2003, compared to $6.3 million, or 36.8% of net revenues, for the six months ended December 31, 2002. The increase in our gross profit as a percentage of net revenues was primarily due to a more favorable shift in our product mix. Generally, larger tape libraries and newer tape drive technologies have higher gross margins than do smaller tape libraries and older tape drive technologies. In addition, service revenues generally have higher gross margins than do tape libraries and drives. Media, which is available through general distribution channels, historically has had a lower gross margin when compared to the tape libraries and drives in which it is used. During the six month period ended December 31, 2003, we generated a larger portion of our net revenues from service and less from media than the same period one year ago.

     RESEARCH AND DEVELOPMENT. Research and development expenses for the six months ended December 31, 2003 were $2.2 million, or 14.3% of net revenues, as compared to $1.8 million, or 10.3% of net revenues, for the six months ended December 31, 2002. The increase in research and development costs are primarily due to our multi-year research and development initiative at our Advanced Development Group, which we established in late fiscal 2002 in Boulder, Colorado. The Advanced Development Group is developing a new line of enterprise-class tape libraries.

     SALES AND MARKETING. Sales and marketing expenses for the six months ended December 31, 2003 were $1.7 million, or 11.2% of net revenues, compared to $1.9 million, or 11.1% of net revenues, for the six months ended December 31, 2002.

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     GENERAL AND ADMINISTRATIVE. General and administrative expenses for the six months ended December 31, 2003 were $2.8 million, or 17.9% of net revenues, compared with $1.9 million, or 11.3% of net revenues, for the six months ended December 31, 2002. The increase in general and administrative expenses was due primarily to an increase in legal fees associated with our defense of a patent infringement lawsuit brought by Raytheon Company against nine defendants, including Qualstar, and additions to our reserve for doubtful accounts.

     INVESTMENT INCOME. Investment income for the six months ended December 31, 2003 was $346,000 comparable with investment income of $386,000 for the six months ended December 31, 2002.

     PROVISION (BENEFIT) FOR INCOME TAXES. The benefit for income taxes was $(197,000), or 34.8% of pre-tax loss, for the six months ended December 31, 2003, compared to a provision for income taxes of $519,000, or 47.2% of pre-tax income, for the six months ended December 31, 2002. The decrease in the percentage of the provision (benefit) for income taxes to pre-tax income (loss) was primarily due to $60,000 of additional provision, net of certain items, taken during the three months ended December 31, 2002 for items relating to prior years.

LIQUIDITY AND CAPITAL RESOURCES

     Historically, we have funded our capital requirements with net cash provided by operating activities. Net cash provided by operating activities was $0.2 million in the six months ended December 31, 2003 and $5.5 million in the six months ended December 31, 2002. For the six months ended December 31, 2003, cash provided by operating activities was primarily provided by a reduction in inventories and the receipt of a cash tax refund from the Internal Revenue Service, partially offset by a decrease in accounts payable. For the six months ended December 31, 2002, cash provided by operating activities was primarily provided by collection of accounts receivable and reductions in inventory levels, partially offset by a decrease in accounts payable.

     Net cash used in investing activities was $3.3 million during the first six months of fiscal year 2004, primarily attributed to purchases of marketable securities. Net cash used in investing activities was $1.3 million during the first six months of fiscal year 2003, attributed to the purchase of marketable securities, property and equipment, and the assets of N2Power.

     There was no significant cash used or provided by financing activities during the six month period ended December 31, 2003, or December 31, 2002.

     On February 12, 2003, we announced that our Board of Directors had authorized a program to repurchase up to 500,000 shares of our common stock in open market transactions, block purchases or private transactions. These stock repurchases will be funded by available working capital and are not expected to negatively impact our liquidity. There is no time limit for the completion of the stock repurchase program and it may be discontinued at any time. We used $314,000 to repurchase common stock during the six months ended December 31, 2003.

     As of December 31, 2003, we had $2.9 million in cash and cash equivalents and $33.0 million in marketable securities. We believe our existing cash and cash equivalents, plus anticipated cash flows from our operating activities, and 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 we believe are strategic. We periodically 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.

ITEM 3. Quantitative and Qualitative 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. Since all sales are currently made in U.S. dollars, a strengthening of the US dollar could make our products less competitive in foreign markets. Our investment income is sensitive to changes in the general level of US 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.

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ITEM 4. 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 December 31, 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.

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PART II — OTHER INFORMATION

ITEM 1. 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. On January 14, 2004, the Court held a hearing to construe the terms of the claim and we are currently awaiting the Court’s claim construction ruling. The trial has been rescheduled from June 7, 2004 to September 7, 2004 and will be located in Marshall, Texas. Qualstar and our legal counsel continue 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.

     Qualstar may be involved in litigation or other legal proceedings from time to time in the normal course of business. Other than the Raytheon lawsuit discussed above, however, there are no material actions currently pending.

ITEM 6. Exhibits and Reports on Form 8-K.

(a)  Exhibits:

(b)  Reports on Form 8-K. We filed or furnished the following current reports on Form 8-K during the second quarter of fiscal 2004:

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SIGNATURES

     Pursuant to the requirements 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.

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EXHIBIT INDEX

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