QUALSTAR CORP - Quarter Report: 2005 September (Form 10-Q)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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 þ          No o

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

      Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes o          No þ

      Total shares of common stock without par value outstanding at September 30, 2005 is 12,253,117.

Qualstar Corporation

FORM 10-Q

For The Quarterly Period Ended September 30, 2005

INDEX

PART I — FINANCIAL INFORMATION

QUALSTAR CORPORATION

CONSOLIDATED CONDENSED BALANCE SHEETS

SEPTEMBER 30, 2005 AND JUNE 30, 2005

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

QUALSTAR CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004

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

QUALSTAR CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004

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

QUALSTAR CORPORATION

CONSOLIDATED CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

THREE MONTHS ENDED SEPTEMBER 30, 2005

See the accompanying notes to these condensed consolidated financial statements.

QUALSTAR CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

SEPTEMBER 30, 2005

(Unaudited)

(In thousands, except per share data)

      The accompanying condensed consolidated financial statements are unaudited, except for the balance sheet at June 30, 2005 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 for the fiscal year ended June 30, 2005, filed with the Securities and Exchange Commission (SEC) on September 26, 2005. In the opinion of management, these unaudited condensed consolidated 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 September 30, 2005, consolidated results of operations for the three months ended September 30, 2005, and consolidated cash flows for the three months ended September 30, 2005. Operating results for the three month period ended September 30, 2005 are not necessarily indicative of results to be expected for a full year.

      The following table sets forth the computation of basic and diluted net loss per share for the three months ended September 30, 2005 and 2004:

      All shares related to stock options are excluded for the three months ended September 30, 2005, and 2004, respectively, from the computation of diluted loss per share as the effect would have been antidilutive.

      Effective July 1, 2005, we adopted Statement of Financial Accounting Standard (“SFAS”) No. 123(R), share-based payment, using the modified prospective application transition method. The adoption of SFAS No. 123(R) did not have a significant impact on our loss from operations, loss before income taxes, net loss, cash flows from operations, cash flows from financing activities, or our basic and diluted earnings per share, and the amounts recognized as stock based compensation expense are similar to the amounts reported historically in the Company’s footnotes under the pro forma disclosure provisions of SFAS 123.

      Our net loss for the three months ended September 30, 2005 includes $35,000 of compensation costs and $0 income tax benefits related to our stock based compensation arrangement as we have fully reserved our

QUALSTAR CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

deferred tax assets. For the three months ended September 30, 2004, 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 loss and loss per share for the three months ended September 30, 2004 would have been reduced to the pro forma amounts indicated below:

      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 September 30, 2005 and June 30, 2005.

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

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

QUALSTAR CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

      For the three months ended September 30, 2005 and 2004, comprehensive loss amounted to approximately $315,000 and $226,000, respectively. The difference between net loss and comprehensive loss relates to the changes in the unrealized losses or gains the Company recorded for its available-for-sale securities.

      We are from time to time involved in various lawsuits and legal proceedings that arise in the ordinary course of business. At this time, we are not aware of any pending or threatened litigation against us that we expect will have a material adverse effect on our business, financial condition, liquidity or operating results. Legal claims are inherently uncertain, however. We cannot assure you that we will not be adversely affected in the future by legal proceedings.

      The Company has a full valuation allowance against it’s net deferred tax assets due to the uncertainty regarding the realization of these net deferred tax assets in future periods.

      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, 2005 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. We offer tape libraries for multiple tape drive technologies including AIT, Super AIT, SuperDLT, and LTO tape drives and media.

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

      In July 2002, we purchased the assets of N2Power, Incorporated, a supplier of ultra small high efficiency open-frame switching power supplies. Power supplies provided by N2Power are utilized within our tape library products as well as sold to original equipment manufacturers for incorporation into their products. N2Power products are sold under the N2Power brand name as well as under a private label brand name through independent sales representatives and distributors. Revenues from N2Power products were not material as a percentage of total revenues for fiscal 2005 and fiscal 2004, but represented 8.8% of revenues in the first quarter of fiscal 2006.

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 principles 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 product to our customers. Title and risk of loss transfer to the customer when the product leaves our dock in Simi Valley, California, or another shipping location designated

by us. In general, these customers are allowed to return the product, free of penalty, within thirty days of shipment, if the product does not meet the end user’s requirements. Revenues from technical support services and other services are recognized at the time services are performed.

      We record an allowance for estimated sales returns based on past experience and current knowledge of our customer base. Our experience has been such that only a very small percentage of libraries are returned. Should our experience change, however, we may require additional allowances for sales returns.

      We estimate our allowance for doubtful accounts based on an assessment of the collectibility of specific accounts and the overall condition of accounts receivable. In evaluating the adequacy of the allowance for doubtful accounts, we analyze specific trade receivables, historical bad debts, customer credits, customer credit-worthiness and changes in customers’ payment terms and patterns. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make additional payments, then we may need to make additional allowances. Likewise, if we determine that we could realize more of our receivables in the future than previously estimated, we would adjust the allowance to increase income in the period we made this determination.

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

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

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

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

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

RESULTS OF OPERATIONS

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

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

      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 September 30, 2005 were $6.1 million, compared with net revenues of $6.3 million for the three months ended September 30, 2004, a decrease of $.2 million. The decrease in revenues is attributed to lower revenues from tape libraries incorporating AIT, SAIT, and SDLT tape drives, partially offset by higher revenues from libraries incorporating LTO tape drives and revenues from power supplies. We derived approximately 12% of

our revenues from one customer for the three months ended September 30, 2005, and approximately 10% of our revenues from one customer for the three months ended September 30, 2004.

      Gross Profit. Gross profit represents the difference between our net revenues and cost of goods sold. Cost of goods sold consists primarily of purchased parts, direct and indirect labor costs, rent, technical support costs, depreciation of plant and equipment, utilities, and packaging costs. Gross profit was $1.9 million, or 31.2% of net revenues, for the three months ended September 30, 2005, compared to $2.3 million, or 37.0% of net revenues, for the three months ended September 30, 2004. The decline in gross profit was primarily the result of competitive pricing pressures, increased labor and material costs partially due to a change in product mix and increased media sales, which have a lower gross profit margin, as a percentage of total revenue.

      Research and Development. Research and development expenses consist of engineering salaries, benefits, outside consultant fees, and purchased parts and supplies used in development activities. Research and development expenses for the three months ended September 30, 2005 were $719,000, or 11.8% of net revenues, as compared to $954,000 or 15.1% of net revenues, for the three months ended September 30, 2004. The decrease in research and development expenses was due to lower compensation expense resulting from fewer employees, lower prototype material costs incurred by our Advanced Development Group, as the multi-year development initiative that was established to develop a new line of enterprise-class tape libraries moves towards completion, and lower expense associated with libraries shipped to independent software vendors.

      Sales and Marketing. Sales and marketing expenses consist primarily of employee salaries and benefits, sales commissions, trade show costs, advertising and travel related expenses. Sales and marketing expenses for the three months ended September 30, 2005 were $757,000, or 12.4% of net revenues, compared to $847,000, or 13.4% of net revenues, for the three months ended September 30, 2004. The decrease in sales and marketing expenses was primarily due to lower promotion expenses partially offset by lower rebate credits from certain vendors.

      General and Administrative. General and administrative expenses include employee salaries and benefits, provision for doubtful accounts and professional service fees. General and administrative expenses for the three months ended September 30, 2005 were $910,000, or 14.9% of net revenues, compared with $932,000 or 14.8% of net revenues, for the three months ended September 30, 2004. The decrease in general and administrative expenses in absolute dollars was due to a decrease in compensation expense.

      Investment Income. Investment income was $271,000 in the three months ended September 30, 2005, compared to $164,000 for the three months ended September 30, 2004. The increase is attributed to lowering the average duration of our portfolio to capture the higher short term yields available in the current higher interest rate environment.

      Provision (Benefit) for Income Taxes. We did not record a provision or benefit for income taxes for either the three months ended September 30, 2005 or for the three months ended September 30, 2004. We have recorded a full valuation allowance against our net deferred tax assets due to the uncertainty regarding the realization of these net deferred tax assets in future periods.

LIQUIDITY AND CAPITAL RESOURCES

      Historically, we have funded our capital requirements with cash provided by operations. Cash provided by operating activities was $25,000 in the three months ended September 30, 2005, primarily attributed to a reduction in accounts receivable and an increase in accounts payable, partially offset by an increase in prepaid expenses and other assets and a decrease in other accrued liabilities. Cash provided by operating activities was $369,000 in the three months ended September 30, 2004, primarily attributed to a reduction in accounts receivable partially offset by a decrease in accounts payable.

      Cash used in investing activities was $637,000 in the three months ended September 30, 2005, primarily attributed to the purchase of marketable securities. Cash used in investing activities was $2.7 million in the three months ended September 30, 2004, primarily attributed to the purchase of marketable securities, partially offset by the sale of marketable securities.

      Cash was not used in financing activities during the three months ended September 30, 2005. Cash provided by financing activities during the three months ended September 30, 2004 was $100,000, primarily attributed to proceeds from the exercise of stock options and principal and interest repayments of a director’s note.

      As of September 30, 2005, we had $11.6 million in cash and cash equivalents and $22.3 million in marketable securities. We believe that our existing cash and cash equivalents, plus funds available from the sale of our marketable securities, will be sufficient to fund our working capital and capital expenditure needs for at least the next 12 months. We may utilize cash to invest in businesses, products or technologies that we believe are strategic. We regularly evaluate other companies and technologies for possible investment by us. In addition, we have made and may in the future make investments in companies with whom we have identified potential synergies. However, we have no present commitments or agreements with respect to any material acquisition of other businesses or technologies.

      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 U.S. 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.

      We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of Qualstar’s disclosure controls and procedures as of September 30, 2005, 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 our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and to ensure that the information required to be disclosed by us in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

      We did not make any changes in our internal control over financial reporting during the first quarter of fiscal 2006 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

      (a) Exhibits:

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.

Dated: November 11, 2005

Dated: November 11, 2005

EXHIBIT INDEX