| ” We believe that the risks described below are the most important factors which may cause our actual future results of operations to differ materially from the results projected in the forward-looking statements |
| RISKS RELATED TO OUR BUSINESS The principal risks applicable to our business in general are described below |
| Specific risks applicable to our tape library and power supply operating segments are described in the following subsections of Item 1A We have a limited number of executives |
| The loss of any single executive or the failure to hire and integrate capable new executives could harm our business |
| The success of our business is tied closely to the managerial, engineering and business acumen of our existing executives |
| William J Gervais, our President, has been largely responsible for the development of most of our tape libraries, has overseen our operations and growth, and established and maintained our strategic relationships |
| We expect that he will continue these efforts for the foreseeable future |
| Our future success will also depend on our ability to attract, retain and motivate key executives and other key personnel, many of whom have been instrumental in developing new technologies and strategic plans |
| We may not be able to retain our existing personnel or attract additional qualified personnel in the future |
| However, our current dependence on a limited number of executives and other key personnel, for whom replacements may be difficult to find, entails a risk that we may not be able to supervise and manage our ongoing operations |
| Our 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 result 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 |
| Our research and development spending may not yield results that justify the costs incurred |
| In recent fiscal years we have spent substantial amounts for research and development |
| Our products and markets are technologically advanced and rapidly evolving, and we cannot be assured that these efforts will successfully provide us with new or upgraded products that will be competitive |
| If these 13 _________________________________________________________________ [70]Table of Contents programs are not successful, our investment in research and development will not yield corresponding benefits to us |
| Our customers have the right to return our products in certain circumstances |
| An excessive number of returns may reduce our revenues |
| Our customers have 30 days from the date of purchase to return products that do not conform to an end user’s requirements |
| Distributors have additional return privileges that extend well beyond 30 days |
| We may otherwise allow product returns if we think that doing so maximizes the effectiveness of our sales channels and promotes our reputation for quality and service |
| Although we estimate and reserve for potential returns in our reported financial results, actual returns could exceed our estimates |
| If the number of returns exceeds our estimates, our financial results could be adversely impacted for the periods during which returns are made |
| We may spend money pursuing sales that do not occur when anticipated or at all |
| Original equipment manufacturer customers typically conduct significant evaluation, testing, implementation and acceptance procedures before they begin to market and sell new products |
| This evaluation process is lengthy and may range from six months to one year or more |
| This process is complex and may require significant sales, marketing, engineering and management resources on our part |
| The process becomes more complex as we simultaneously qualify our products with multiple customers or pursue large orders with a single customer |
| As a result, we may expend resources to develop customer relationships before we recognize any revenue from these relationships, if at all |
| We sell a significant portion of our products to customers located outside the United States |
| Currency fluctuations and increased costs associated with international sales could make our products unaffordable in foreign markets, which would reduce our revenue or profitability |
| Revenues from shipments to customers outside of North America accounted for approximately 26dtta1prca of revenues in fiscal 2006, approximately 27dtta3prca of revenues in fiscal 2005 and approximately 32dtta4prca of revenues in fiscal 2004 |
| We believe that international sales will continue to represent a significant portion of our revenues |
| Our international sales subject us to a number of risks, including: • political and economic instability may reduce demand for our products or our ability to market our products in foreign countries; • although we denominate our international sales in US 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 operations, may reduce sales |
| These risks may increase our costs of doing business internationally and reduce our revenues or profitability |
| 14 _________________________________________________________________ [71]Table of Contents A failure to develop and maintain proprietary technology may negatively affect our business |
| We rely on copyright protection of electronic circuits and our firmware, as well as patent protection for some of our designs and products |
| We also rely on a combination of trademark, trade secret, and other intellectual property laws and various contract rights to protect our proprietary rights |
| However, we do not believe our intellectual property rights provide significant protection from competition |
| As a consequence, these rights may not preclude competitors from developing products that are substantially equivalent or superior to our products |
| In addition, many aspects of our products are not subject to intellectual property protection and therefore can be reproduced by our competitors |
| Intellectual property infringement claims brought against us could be time consuming and expensive to defend |
| In recent years, there has been an increasing amount of litigation in the United States involving patents and other intellectual property rights |
| Qualstar is not currently directly involved in any intellectual property litigation or proceedings |
| However, in April 2004 we settled litigation that Raytheon Company had filed alleging that Qualstar and eight other named defendants infringed on a patent owned by Raytheon Company entitled “Mass Data Storage Library |
| ” 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 |
| Our warranty reserves may not adequately cover our warranty obligations |
| We have established reserves for the estimated liability associated with our product warranties |
| However, we could experience unforeseen circumstances where these or future reserves may not adequately cover our warranty obligations |
| Our revenues and operating results may fluctuate unexpectedly from quarter to quarter, which may cause our stock price to decline |
| Our quarterly revenues and operating results have fluctuated in the past, and are likely to vary significantly in the future due to several factors, including: • general economic conditions affecting spending for information technology; • increased competition and pricing pressures; • reductions in the size, delays in the timing, or cancellation of significant customer orders; • shifts in product or distribution channel mix; • the timing of the introduction or enhancement of products by us, our original equipment manufacturer customers or our competitors; • expansions or reductions in our relationships with value added reseller and original equipment manufacturer customers; 15 _________________________________________________________________ [72]Table of Contents • financial difficulties affecting our value added reseller or original equipment manufacturer customers that render them unable to pay amounts owed to us; • market acceptance of new and enhanced versions of our products; • new product developments by storage device manufacturers, such as disk drives, that could render our products less cost effective or less competitive; • 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 key components and performance of key suppliers |
| We believe that period to period comparisons of our operating results may not necessarily be reliable indicators of our future performance |
| It is likely that in some future period our operating results will not meet your expectations or those of public market analysts |
| Any unanticipated change in revenues or operating results is likely to cause our stock price to fluctuate since such changes reflect new information available to investors and analysts |
| New information may cause investors and analysts to revalue our stock and this, in the aggregate, may cause fluctuations in our stock price |
| Our 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 43prca of our outstanding common stock as of June 30, 2006 |
| 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 5cmam000cmam000 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 currently intend to pay dividends and therefore you will only be able to recover your investment in our common stock, if at all, by selling the shares of the stock that you own |
| We historically have pursued a policy of reinvesting our earnings in research and development, expanding our value added reseller and original equipment manufacturer relationships, and expanding our 16 _________________________________________________________________ [73]Table of Contents manufacturing capabilities |
| Consequently, we have never paid dividends on our shares of capital stock |
| We currently intend to continue this policy for the foreseeable future to strengthen our financial and competitive position in the markets in which we operate |
| Consequently, it may be difficult to sell your shares |
| This, as well as the factors listed below, has caused the price of our stock to be volatile |
| Consequently, it may be difficult to sell your shares of our stock at the price you paid for them or at a price equal to that quoted on The Nasdaq Stock Market |
| Factors that may cause our stock price to fluctuate in the future include: • quarterly variations in operating results, especially if they differ from our previously announced forecasts or forecasts made by analysts; • our announcements of anticipated future revenues or operating results; • announcements concerning us, our competitors, our customers, or our industry; • the introduction of new technology or products by us or our competitors; • comments regarding us and the data storage market made by industry analysts or on Internet bulletin boards; • changes in earnings estimates by analysts or changes in accounting policies; • changes in product pricing policies by us or our competitors; and • changes in general economic conditions |
| In addition, stock markets have experienced extreme price and volume volatility in recent years |
| This volatility has had a substantial effect on the market prices of securities of many smaller public companies for reasons frequently unrelated or disproportionate to the operating performance of the specific companies |
| These market fluctuations may adversely affect the market price of our common stock |
| RISKS RELATED TO OUR TAPE LIBRARY BUSINESS The principal risks applicable specifically to our tape library operating segment are described below |
| Our principal competitors devote greater financial resources to developing, marketing and selling automated tape libraries |
| Consequently, we may be unable to maintain or increase our market share |
| We face significant competition in developing and selling automated tape libraries |
| Rapid and ongoing changes in technology and product standards could quickly render our products less competitive, or even obsolete |
| We have significantly fewer financial, technical, manufacturing, marketing and other resources than many of our competitors and these limited resources may harm our business in many ways |
| For example, in the past several years our competitors have: • acquired other tape library companies; • increased the geographic scope of their market; • offered a wider range of tape library products; and • developed and acquired proprietary software and disk based products that operate in conjunction with their products and the products of their competitors |
| 17 _________________________________________________________________ [74]Table of Contents 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 |
| 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 66dtta2prca of our revenues for fiscal 2006, approximately 75dtta1prca of our revenues for fiscal 2005 and approximately 81dtta4prca of our revenues for fiscal 2004 |
| 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 |
| Historically, some of these suppliers have been unable to meet demand for their products and have allocated their limited supply among customers |
| If suppliers limit our supply of tape drives or tape media, we may be forced to delay or cancel shipments of our tape libraries |
| The major supplier risks we face include the following: • Sony Electronics, Inc |
| is our sole-source supplier of AIT and Super AIT drives and media |
| In the past, Sony has allocated some of their products and may allocate them again in the future |
| In fiscal 2006 we derived approximately dlra7dtta9 million or 36dtta4prca of our revenues, in fiscal 2005 we derived approximately dlra12dtta0 million, or 47dtta8prca, of our revenues, and in fiscal 2004 we derived approximately dlra16dtta1 million, or 51dtta1prca of revenues from the sale of libraries, tape drives and tape media based on Sony AIT and Super AIT technologies |
| If Sony reduces its sales to us or raises its prices, we could lose revenues and our margins could decline |
| • Quantum Corporation is our sole-source supplier of SuperDLT tape drives and competes with us as a manufacturer of automated tape libraries |
| In the past, Quantum has allocated quantities of tape drives among its customers |
| It is possible that Quantum will allocate again, and as a result, may be unable to meet our future SuperDLT tape drive requirements |
| • The LTO standard was developed by an industry consortium consisting of IBM, Hewlett Packard and Quantum/Certance |
| LTO competes with AIT and other half-inch tape drives and media |
| All three drive suppliers also sell automated tape libraries that utilize LTO tape drives and compete with our products |
| Therefore, even if we receive adequate allocation, it may be at a price that renders our products uncompetitive |
| Our other suppliers have in the past been, and may in the 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 |
| 18 _________________________________________________________________ [75]Table of Contents Our revenues could decline if we fail to execute our distribution strategy successfully |
| We distribute and sell our automated tape libraries primarily through value added resellers and original equipment manufacturers, and intend to continue this strategy for the foreseeable future |
| Value added resellers integrate our tape libraries with products of other manufacturers and sell the combined products to their own customers |
| Original equipment manufacturers combine our tape libraries with their own products and sell the combined product under their own brand |
| We currently devote, and intend to continue to devote, significant resources to develop these relationships |
| A failure to initiate, manage and expand our relationships with value added resellers or original equipment manufacturers could limit our ability to grow or sustain our current level of revenues |
| Our focus on the distribution of our products through value added resellers poses the following risks: • we may reach fewer customers because we depend on value added resellers to market to end users and these value added resellers may fail to market effectively or fail to devote sufficient or effective sales, marketing and technical support to the sales of our products; • we may lose sales because many of our value added resellers sell products that compete with our products |
| These value added resellers may reduce their marketing efforts for our products in favor of products manufactured by our competitors; • our costs may increase as value added resellers generally require a higher level of customer support than do original equipment manufacturers; and • as the market for tape libraries matures, we expect that tape libraries designed for small and medium size businesses will not require the level of sales, marketing and technical support traditionally provided by value added resellers and, consequently, tape libraries for these customers will be increasingly sold through distribution channels rather than through value added resellers |
| We depend upon our original equipment manufacturer customers’ ability to develop new products, applications and product enhancements that incorporate our products in a timely, cost-effective and customer-friendly manner |
| We cannot guarantee that our original equipment manufacturer customers will meet these challenges effectively |
| Original equipment manufacturers typically conduct substantial and lengthy evaluation programs before certifying a new product for inclusion in their product line |
| We may be required to devote significant financial and human resources to these evaluation programs with no assurance that our products will ever be selected |
| In addition, even if selected by the original equipment manufacturer, there generally is no requirement that the original equipment manufacturer purchase any particular amount of product from us or that it refrain from purchasing competing products |
| We do not have any exclusive agreements with our value added resellers or original equipment manufacturers, who purchase our products on an individual purchase order basis |
| If we lose important value added resellers or original equipment manufacturer customers, if they reduce their focus on our products or if we are unable to obtain additional value added reseller or original equipment manufacturer customers, our business could suffer |
| We rely on tape technology for a substantial part 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 a high percentage of our revenues from products that incorporate some form of tape technology |
| We expect to derive a high percentage 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 products incorporating other technologies gain comparable or superior market acceptance and competitive price advantage, our business, financial condition and operating results could be adversely and materially affected unless we successfully develop and market products incorporating the new technology |
| 19 _________________________________________________________________ [76]Table of Contents If we fail to develop and introduce new products on a timely and cost-effective basis, or if our products do not contain the features required by the marketplace, we will eventually lose market share and sales to more innovative competitors |
| The market for our products is characterized by rapidly changing technology and evolving industry standards |
| The future success of Qualstar will depend on our ability to anticipate changes in technology, to develop new and enhanced products on a timely and cost-effective basis, and to introduce, manufacture and achieve market acceptance of these new and enhanced products |
| In particular, our success will depend on the market acceptance of our new XLS family of automated tape libraries |
| Our RLS and TLS families of tape libraries are facing increasing competition from products manufactured by our competitors and may 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 management software that makes our tape libraries functional |
| The utility of an automated tape library depends 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 third party independent software vendors to develop and support this software |
| Accordingly, the continued development and future growth of the market for our products will depend partly upon the success of software vendors to meet the overall data storage and management needs of tape library purchasers and our ability to maintain relationships with these firms |
| Although we do not have contracts with any third party independent software vendors, we maintain relationships with them by: • supplying tape libraries so they can qualify their software to work with our tape libraries; • evaluating their software for compatibility with our tape libraries; • keeping them informed as to current and contemplated changes to our products; and • referring business to them when value added resellers or end users inquire about software sources |
| We may have to expend significant amounts of time and money defending or settling product liability claims arising from failures of our tape libraries |
| Because our tape library customers use our products to store and backup their important data, we face potential liability if our products fail to perform |
| Although we maintain general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed |
| Any imposition of liability that is not covered by insurance or that exceeds our insurance coverage could reduce our profitability or cause us to discontinue operations |
| Undetected flaws could increase our costs, reduce our revenues and divert resources from our core business needs |
| Our tape libraries are complex |
| Despite our efforts to revise and update our manufacturing and test processes to address engineering and component changes, we may not be able to control and eliminate 20 _________________________________________________________________ [77]Table of Contents manufacturing flaws adequately |
| These flaws may include undetected software or hardware defects associated with: • a newly introduced product; • a new version of an existing product; or • a product that has been integrated into a network storage solution with the products of other vendors |
| The variety of contexts in which errors may arise may make it difficult to identify the source of a problem |
| These problems may: • cause us to incur significant warranty, repair and replacement costs; • divert the attention of our engineering personnel from our product development efforts; • cause significant customer relations problems; or • damage our reputation |
| To address these risks, we frequently revise and update manufacturing and test procedures to address engineering and component changes to our products |
| If we fail to adequately monitor, develop and implement appropriate test and manufacturing processes we could experience a rate of product failure that results in substantial shipment delays, repair or replacement costs or damage to our reputation |
| Product flaws may also consume our limited engineering resources and interrupt our development efforts |
| Significant product failures would increase our costs and result in the loss of future sales and be harmful to our business |
| RISKS RELATED TO OUR POWER SUPPLY BUSINESS The principal risks applicable specifically to our power supply operating segment are described below |
| We depend on a single contract manufacturer for the majority of our power supplies |
| The primary supplier of our N2 Power power supplies is located in China |
| If this manufacturer should be unable to deliver products to us on a timely basis or at all, our power supply business could be adversely affected |
| Though we have four years of favorable experience with this supplier, there can be no assurance that circumstances might not change and compel this supplier to curtail or terminate deliveries to us |
| Environmental health and safety laws may restrict our operations |
| We are subject to local laws and regulations in various regions in which we sell our power supplies, including the European Union (“EU”) in particular |
| A new EU directive may have a material impact on our business |
| The Restriction of Certain Hazardous Substances Directive (RoHS), which restricts the distribution of certain substances, including lead, within the EU, became effective July 1, 2006 |
| We are in the process of transitioning our power supply manufacturing to a RoHS compliant process |
| During the transition, there is risk that some of our inventory manufactured before the transition may become unmarketable in the EU, resulting in inventory write downs that could adversely affect our operating results |
| Price erosion may have a material adverse effect on our margins and profitability |
| The majority of the power supply manufactures that we compete with have substantially more resources and more models available than we do |
| Additionally the power supply business is generally characterized by intense competition |
| There can be no assurances that a competitor will not choose to use such resources to underprice our products in the market, thereby adversely affecting our sales or margins |