UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

☑

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2019

☐

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From to

Commission file number 001-35810

QUALSTAR CORPORATION

(Exact name of registrant as specified in its charter)

CALIFORNIA

95-3927330

(State or other jurisdiction of incorporation or organization)

1267 Flynn Road, Camarillo, CA

(Address of principal executive offices)

(I.R.S. Employer Identification No.)

93012

(Zip Code)

Registrant’s telephone number, including area code: (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 ☑ No☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☑ No☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and emerging growth company in Rule 12b-2 of the Exchange Act.

Large accelerated filer ☐	Accelerated filer ☐
Non-accelerated filer ☑	Smaller reporting company ☑
	Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

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

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

Title of each class:	Trading Symbol	Name of each exchange on which registered:
Common Stock	QBAK	The NASDAQ Capital Market

At November 1, 2019 the issuer had 1,907,252 shares of common stock, no par value, issued and outstanding.

QUALSTAR CORPORATION

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2019

INDEX

PART I — FINANCIAL INFORMATION

Item 1.	Financial Statements

		●	Condensed Consolidated Balance Sheets — September 30, 2019 (unaudited) and December 31, 2018	1

		●	Unaudited Condensed Consolidated Statements of Operations — Three and nine months ended September 30, 2019 and 2018	2

		●	Unaudited Condensed Consolidated Statements of Shareholders’ Equity — Three and nine months ended September 30, 2019 and 2018	3

		●	Unaudited Condensed Consolidated Statements of Cash Flows — Nine months ended September 30, 2019 and 2018	4

		●	Notes to unaudited Condensed Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations			17

Item 3.	Qualitative and Quantitative Disclosures About Market Risk			22

Item 4.	Controls and Procedures			22

PART II — OTHER INFORMATION

Item 1.	Legal Proceedings	23

Item 1A.	Risk Factors	23

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	24

Item 3.	Defaults Upon Senior Securities	24

Item 4.	Mine Safety Disclosures	24

Item 5.	Other Information	24

Item 6.	Exhibits	25

	Signatures	26

PART I — FINANCIAL INFORMATION

ITEM 1. Financial Statements

QUALSTAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

	September 30, 2019			December 31, 2018
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	4,271		$	4,781
Restricted cash		100			100
Accounts receivables, net		2,177			1,809
Inventories, net		2,728			2,897
Prepaid expenses and other current assets		250			180
Total current assets		9,526			9,767
Non-current assets:
Property and equipment, net		132			112
Right-of-use		734			-
Other assets		133			119
Total non-current assets		999			231
Total assets	$	10,525		$	9,998

Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	1,325		$	1,023
Accrued payroll and related liabilities		177			185
Deferred service revenue, short-term		671			736
Lease liabilities, current		272			-
Other accrued liabilities		405			559
Total current liabilities		2,850			2,503
Long-term liabilities:
Other long-term liabilities		53			40
Lease liabilities, long term		494			-
Deferred service revenue		257			127
Total long-term liabilities		804			167
Total liabilities		3,654			2,670

Shareholders’ equity:
Preferred stock, no par value; 5,000,000 shares authorized; no shares issued		-			-
Common stock, no par value; 50,000,000 shares authorized, shares issued and outstanding 1,914,852 at September 30, 2019 and 2,030,017 shares at December 31, 2018		18,790			19,426
Accumulated deficit		(11,919	)		(12,098	)
Total shareholders’ equity		6,871			7,328
Total liabilities and shareholders’ equity	$	10,525		$	9,998

See notes to condensed consolidated financial statements.

QUALSTAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
Net revenues	$	3,703	$	3,154	$	9,998	$	9,320
Cost of goods sold		2,749		1,901		7,319		5,217
Gross profit		954		1,253		2,679		4,103
Operating expenses:
Engineering		122		123		473		372
Sales and marketing		368		351		982		1,000
General and administrative		427		374		1,078		1,262
Total operating expenses		917		848		2,533		2,634
Income from operations		37		405		146		1,469
Other income		12		-		33		-
Income before income taxes		49		405		179		1,469
Provision for income taxes		-		-		-		-
Net income	$	49	$	405	$	179	$	1,469
Earnings per share:
Basic	$	0.03	$	0.20	$	0.09	$	0.72
Diluted	$	0.03	$	0.20	$	0.09	$	0.70
Shares used in per share calculation:
Basic		1,922		2,048		1,967		2,048
Diluted		1,922		2,065		1,967		2,088

See notes to condensed consolidated financial statements.

QUALSTAR CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(In thousands)

	Three Months Ended September 30, 2019
	Common Stock						Accumulated Other Comprehensive Income		Accumulated
	Shares			Amount			(Loss)		Deficit			Total
Balances at June 30, 2019		1,937		$	18,907		$	—	$	(11,968	)	$	6,939
Stock repurchase		(22	)		(117	)		—		—			(117	)
Net income		—			—			—		49			49
Balances at September 30, 2019		1,915		$	18,790		$	—	$	(11,919	)	$	6,871

	Three Months Ended September 30, 2018
	Common Stock				Accumulated Other Comprehensive Income		Accumulated
	Shares		Amount		(Loss)		Deficit			Total
Balances at June 30, 2018		2,048	$	19,519	$	—	$	(12,520	)	$	6,999
Exercise of stock options		—		—		—		—			—
Net income		—		—		—		405			405
Balances at September 30, 2018		2,048	$	19,519	$	—	$	(12,115	)	$	7,404

	Nine Months Ended September 30, 2019
	Common Stock						Accumulated Other Comprehensive Income		Accumulated
	Shares			Amount			(Loss)		Deficit			Total
Balances at December 31, 2018		2,030		$	19,426		$	—	$	(12,098	)	$	7,328
Stock repurchase		(115	)		(636	)		—		—			(636	)
Net income		—			—			—		179			179
Balances at September 30, 2019		1,915		$	18,790		$	—	$	(11,919	)	$	6,871

	Nine Months Ended September 30, 2018
	Common Stock				Accumulated Other Comprehensive Income		Accumulated
	Shares		Amount		(Loss)		Deficit			Total
Balances at December 31, 2017		2,043	$	19,480	$	—	$	(13,584	)	$	5,896
Exercise of stock options		5		39		—		—			39
Net income		—		—		—		1,469			1,469
Balances at September 30, 2018		2,048	$	19,519	$	—	$	(12,115	)	$	7,404

See notes to condensed consolidated financial statements.

QUALSTAR CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

	Nine months Ended September 30,
	2019			2018
Cash flows from operating activities:
Net income	$	179		$	1,469
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		35			69
Loss on disposal of assets		30			-
Provision for recovery of bad debts and returns, net		-			1
Provision for inventory obsolescence		237			227
Amortization of right of use		(338	)		-
Changes in operating assets and liabilities:
Accounts receivable		(368	)		(245	)
Inventories		(68	)		(1,381	)
Prepaid expenses and other current assets		(84	)		(75	)
Accounts payable		302			17
Accrued payroll and related liabilities		(8	)		153
Deferred service revenue		65			(109	)
Lease liabilities		349			-
Other accrued liabilities		(120	)		(14	)
Total adjustments		32			(1,357	)
Net cash provided by operating activities		211			112

Cash flows from investing activities:
Purchases of equipment		(85	)		(18	)
Net cash used in investing activities		(85	)		(18	)

Cash flows from financing activities:
Proceeds from the exercise of stock options		-			39
Purchase of common stock		(636	)		-
Net cash provided by (used in) financing activities		(636	)		39

Net increase (decrease) in cash, restricted cash and cash equivalents		(510	)		133

Cash, restricted cash and cash equivalents at beginning of period		4,881			4,798

Cash, restricted cash and cash equivalents at end of period	$	4,371		$	4,931

Supplemental cash flow disclosures:

Income taxes paid	$	10		$	32

See notes to condensed consolidated financial statements.

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying condensed consolidated balance sheet as of December 31, 2018, has been derived from audited consolidated financial statements. The accompanying unaudited interim condensed consolidated financial statements have been prepared on the same basis as our annual audited consolidated financial statements and in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial statements.

Preparing condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Examples include estimates of loss contingencies, product life cycles and inventory obsolescence, bad debts, sales returns, share-based compensation, forfeiture rates, the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.

Qualstar has established two additional subsidiaries to aid in the Company’s global expansion. On July 4, 2018, a wholly-owned subsidiary of Qualstar Corporation, Qualstar Limited, was created to operate the Company’s data storage business in Europe and Africa. On September 5, 2018, a wholly-owned subsidiary of Qualstar Corporation, Q-Smart Data Private Limited, was created to operate the Company’s data storage business in Asia.

We design our products at our facilities in California and Singapore. We sell our products globally through authorized resellers and directly to OEMs. N2Power utilizes contract manufacturers in Asia to produce our power solutions products. Our storage products are manufactured by us at our factory in Camarillo, California and by our OEM suppliers in other parts of the world.

The Company's significant accounting policies are disclosed in Note 1 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on March 7, 2019 (the “Annual Report”). There were no material changes to the significant accounting policies during the nine months ended September 30, 2019, apart from the Company's accounting policy related to the accounting for leases, as discussed below.

Principles of Consolidation

The condensed consolidated financial statements include our accounts and the accounts of each of our wholly owned subsidiaries that were in existence during the periods presented: Qualstar Corporation Singapore Private Limited, N2Power, Inc., Qualstar Limited and Q-Smart Data Private Limited. All significant intercompany accounts and transactions have been eliminated in consolidation.

Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Company’s Annual Report.

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

Revenue Recognition

The Company recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine revenue recognition for arrangements that the Company determines are within the scope of ASC 606, we perform the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) we satisfy a performance obligation. The five-step model is applied to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods or services transferred to the customer. At contract inception, once the contract is determined to be within the scope of ASC 606, we assess the goods or services promised within each contract and determine those that are performance obligations and assess whether each promised good or service is distinct. We then recognize revenue in the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied.

Title and risk of loss generally pass to our customers upon shipment. In limited circumstances where either title or risk of loss pass upon destination, we defer revenue recognition until such events occur. We derive revenues from two primary sources: products and services. Product revenue includes the shipment of product according to the agreement with our customers for data storage products and power supplies. Services include customer support (technical support), installations, consulting, and design services. A contract may include both product and services. Rarely, contracts with customers contain multiple performance obligations. For these contracts, the Company accounts for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices are typically estimated based on observable transactions when these services are sold on a standalone basis.

A variety of technical services can be contracted by our customers for a designated period of time. The service contracts allow customers to call Qualstar for technical support, replace defective parts and to have onsite service provided by Qualstar’s third party contract service provider. We record revenue for contract services at the amount of the service contract, but such amount is deferred at the beginning of the service term and amortized ratably over the life of the contract.

Deferred service revenue is shown separately in the condensed consolidated balance sheets as current and long term. At September 30, 2019 we had deferred service revenue of approximately $928,000. At December 31, 2018, we had deferred service revenue of approximately $863,000.

Legal and Other Contingencies

The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. When legal costs that the entity expects to incur in defending itself in connection with a loss contingency accrual are expected to be material, the loss should factor in all costs and, if the legal costs are reasonably estimable, they should be accrued in accordance with ASC 450, regardless of whether a liability can be estimated for the contingency itself. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. Changes in these factors could materially impact our condensed consolidated financial statements. No loss contingency was reported as of September 30, 2019. At December 31, 2018, we had a loss contingency reserve of $100,000.

Fair Value of Financial Instruments

The carrying amounts of the Company's financial instruments, which include cash equivalents, accounts receivable, accounts payable, related party, and other long-term liabilities, approximate their fair values.

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

Accounting for Income Taxes

We estimate our tax liabilities based on current tax laws in the statutory jurisdictions in which we operate in accordance with ASC 740, “Income Taxes.” 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 may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. ASC 740 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures.

We maintain a valuation allowance to reduce our deferred tax assets due to the uncertainty surrounding the timing of realizing the benefits of net 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. No provision for taxes have been made, as the Company has net operating loss carryforwards available to offset taxable income.

Leases

Effective January 1, 2019, the Company accounts for its leases under ASC 842, Leases. Under this guidance, arrangements meeting the definition of a lease are classified as operating or financing leases, and are recorded on the consolidated balance sheet as both a right of use asset and lease liability, calculated by discounting fixed lease payments over the lease term at the rate implicit in the lease or the Company’s incremental borrowing rate. Lease liabilities are increased by interest and reduced by payments each period, and the right of use asset is amortized over the lease term. For operating leases, interest on the lease liability and the amortization of the right of use asset result in straight-line rent expense over the lease term. For finance leases, interest on the lease liability and the amortization of the right of use asset results in front-loaded expense over the lease term. Variable lease expenses are recorded when incurred.

In calculating the right of use asset and lease liability, the Company has elected to combine lease and non-lease components. The Company excludes short-term leases having initial terms of 12 months or less from the new guidance as an accounting policy election, and recognizes rent expense on a straight-line basis over the lease term.

The Company continues to account for leases in the prior period financial statements under ASC Topic 840.

Operating Segments

The Company operates in two segments, Data Storage and Power Supplies. Operating segments are identified as functional groups within an enterprise in which discrete financial information is utilized by the chief operating decision maker in allocating resources and assessing performance. In the case of Qualstar, the chief operating decision maker is its President and Chief Executive Officer. This position maintains decision-making control over, and assesses the performance of, the two divisional levels of the Company.

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

NOTE 2 – RECENT ACCOUNTING PRONOUNCEMENTS

Recent accounting guidance adopted

FASB issued ASU 2016-02, ASU 2018-09, ASU 2018-10, 2018-11, and 2019-01 to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements and to provide guidance related to accounting for leases, such as the application of an implicit rate, lessee reassessment of lease classification and certain transition adjustments. The Company elected ASU-11’s alternative transition approach of recording lease liabilities and right-of-use assets via a cumulative effect adjustment to retained earnings at the date of adoption. Effective January 1, 2019, the Company adopted ASU 2016-02, ASU 2018-09, ASU 2018-10, 2018-11 and 2019-0. The result is the recording of the lease liability and the right-of-use asset to the balance sheet and it did not have a material effect on our consolidated results of operations or consolidated cash flows.

In June 2018, the FASB issued ASU 2018-07 as a simplification for the accounting for non-employee share-based payment transactions resulting from expanding the scope of Topic 718, Compensation-Stock Compensation. This standard is effective for fiscal years beginning after December 15, 2018. Effective January 1, 2019, the Company adopted ASU 2018-07 and it did not have a material effect on our consolidated financial statements.

In February 2018, the FASB issued ASU 2018-02 to provide guidance related to adjustments for deferred tax assets and liabilities based on the changes created by the U.S. federal government tax bill enacted December 22, 2017. This standard is effective for fiscal years beginning after December 15, 2018. Effective January 1, 2019, the Company adopted ASU 2018-02 and it did not have a material effect on our consolidated financial statements.

NOTE 3 - BALANCE SHEET DETAILS

The following tables provide details of selected balance sheet accounts (in thousands):

Inventories

Inventories are stated at the lower of cost (first-in, first-out basis) or net realizable value. Inventories are comprised as follows (in thousands):

	September 30, 2019		December 31, 2018
	(unaudited)
Raw materials	$	163	$	136
Finished goods		2,565		2,761
Net inventory balance	$	2,728	$	2,897

Property and equipment, net

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

	September 30, 2019			December 31, 2018
	(unaudited)
Leasehold improvements	$	162		$	114
Furniture and fixtures		268			286
Machinery and equipment		610			844
		1,040			1,244
Less accumulated depreciation and amortization		(908	)		(1,132	)
Property and equipment, net	$	132		$	112

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

Depreciation and amortization expense for the three months ended September 30, 2019 and 2018 was $11,000 and $17,000 (unaudited), respectively, and for the nine months ended September 30, 2019 and 2018 was $35,000 and $69,000 (unaudited), respectively.

Other Accrued Liabilities

The components of other liabilities are as follows (in thousands):

	September 30, 2019		December 31, 2018
	(unaudited)
Accrued warranty	$	341	$	365
Accrued outside commissions		46		41
Accrued contingent legal fees		-		100
Deferred rent		-		22
Other accrued liabilities		18		31
Total other accrued liabilities	$	405	$	559

NOTE 4 –CONTINGENCIES

Accrued Warranty

We provide a three-year advance replacement warranty on all XLS and RLS libraries and a two-year warranty on our Q-Series libraries. This includes replacement of components, or if necessary, complete libraries. XLS libraries sold in North America also include one year of on-site service. Customers may purchase on-site service if they are located in the United States, Canada, and selected countries in Europe, Asia Pacific and Latin America. All customers may purchase extended warranty service coverage upon expiration of the standard warranty.

We provide a three-year warranty on all power supplies that includes repair or if necessary, replacement of the power supply.

A provision for costs related to warranty expense is recorded when revenue is recognized, which is estimated based on historical warranty costs incurred.

Activity in the liability for product warranty (included in other accrued liabilities) for the periods presented is as follows (in thousands):

	Nine months Ended September 30, 2019			Year Ended December 31, 2018
	(unaudited)
Beginning balance	$	365		$	322
Cost of warranty claims		(13	)		(15	)
Accruals for product warranties		(11	)		58
Ending balance	$	341		$	365

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

NOTE 5 – NET EARNINGS PER SHARE

Basic net earnings per share has been computed by dividing net income by the weighted average number of common shares outstanding. Diluted net earnings per share has been computed by dividing net earnings by the weighted average common shares outstanding plus dilutive securities or other contracts to issue common stock as if these securities were exercised or converted to common stock.

The following table sets forth the computation of basic and diluted net income per share for the periods indicated, in thousands, except per share amounts.

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
In thousands (except per share amounts):
Net income	$	49	$	405	$	179	$	1,469
Weighted average outstanding shares of common stock		1,922		2,048		1,967		2,048
Dilutive potential common shares from employee stock options		-		17		-		40
Common stock and common stock equivalents		1,922		2,065		1,967		2,088
Income per share:
Basic net income per share	$	0.03	$	0.20	$	0.09	$	0.72
Diluted net income per share	$	0.03	$	0.20	$	0.09	$	0.70

Outstanding stock options that were excluded from the calculation of diluted net income per share, as their inclusion would have been anti-dilutive, were 161,333 and 1,333 stock options for the three months ended September 30, 2019 and 2018, respectively, and were 176,000 and 1,333 stock options for the nine months ended September 30, 2019 and 2018, respectively.

NOTE 6 – STOCKHOLDERS’ EQUITY

On December 5, 2018, the board of directors approved a stock repurchase program (the “Stock Repurchase Program”) to repurchase shares of the Company’s common stock. The program permitted repurchases of up to a maximum aggregate purchase price of $2,400,000 and the number of shares of Common Stock repurchased shall not exceed 409,000. Under the Stock Repurchase Program, during the three and nine months ended September 30, 2019 a total of 22,458 and 115,164 shares were repurchased, with a total of 133,266 shares having been repurchased since the program began. The program expires December 5, 2019.

NOTE 7 –STOCK INCENTIVE PLANS AND SHARE-BASED COMPENSATION

Share-Based Compensation

The Company did not incur an expense for share-based compensation associated with outstanding stock options for the three and nine months ended September 30, 2019 and 2018. No income tax benefit was recognized in the condensed consolidated statements of operations for share-based arrangements in any period presented. At September 30, 2019, the Company did not have any unrecognized compensation costs related to share-based compensation.

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

Stock Option Plan

The Company has two share-based compensation plans as described below.

Qualstar adopted the 2008 Stock Incentive Plan (the “2008 Plan”) under which incentive and nonqualified stock options and restricted stock could be granted for shares of common stock. The 2008 Plan has expired and no additional options may be granted under that plan. However, 20,000 options that were previously granted under the 2008 Plan will continue under their terms.

The 2017 Stock Incentive Plan (the “2017 Plan”) permits the award of stock options (both incentive and non-qualified options), stock appreciation rights, restricted stock, restricted stock units, unrestricted stock, performance shares, dividend equivalent rights and cash-based awards to employees (including executive officers), directors and consultants of the Company and its subsidiaries. The 2017 Plan authorizes the issuance of an aggregate of 300,000 shares of common stock and the plan is administered by the Compensation Committee of the Company’s Board of Directors.

With respect to options, the fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that uses various assumptions, such as volatility, expected term and risk-free interest rate. Expected volatilities are based on the historical volatility of the Company’s stock. The Company uses historical data to estimate option exercise and employee termination in determining forfeiture rates. The expected term of options granted is estimated based on the vesting term of the award, historical employee exercise behavior, expected volatility of the Company’s stock and an employee’s average length of service. The risk-free interest rate used in this model correlates to a U.S. constant rate Treasury security with a contractual life that approximates the expected term of the option award.

The following table summarizes stock option activity:

Options	Shares			Weighted Average Exercise Price per Share		Weighted Average Remaining Contractual Term (years)		Aggregate Intrinsic Value
Outstanding at December 31, 2018		178,000		$	7.19		8.63		—
Granted		—			—		—		—
Exercised		—			—		—		—
Forfeited, canceled or expired		(16,667	)		7.38		—		—
Outstanding at September 30, 2019		161,333			7.17		7.74		—


Exercisable at September 30, 2019		161,333		$	7.17		7.74	$	—

NOTE 8 – INCOME TAXES

We did not record a provision or benefit for income taxes for the three and nine months ended September 30, 2019 and 2018, as the Company has net operating loss carryforwards available to offset taxable income. The Company has recorded a full valuation allowance against its net deferred tax assets based on the Company’s assessment regarding the realizable nature of these net deferred tax assets in future periods. The 2017 federal tax return was examined and provided a no change notice by the Internal Revenue Service.

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

NOTE 9 – SIGNIFICANT CUSTOMERS, CONCENTRATION OF CREDIT RISK, AND GEOGRAPHIC INFORMATION

We have no outstanding debt nor do we utilize auction rate securities or derivative financial instruments in our investment portfolio. Cash and other investments may be in excess of FDIC insurance limits.

Our financial results could be affected by changes in foreign currency exchange rates or weak economic conditions in foreign markets. As all sales are currently made in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets.

	Three Months Ended September 30,										Nine Months Ended September 30,
	2019					2018					2019					2018
Revenue – geographic activity (in thousands):	(unaudited)					(unaudited)					(unaudited)					(unaudited)
		$	%				$	%				$	%				$	%
North America	$	2,267		61.2	%	$	1,723		54.6	%	$	6,184		61.9	%	$	5,082		54.5	%
Europe		418		11.3	%		545		17.3	%		1,195		11.9	%		1,427		15.3	%
Asia Pacific		1,016		27.4	%		883		28.0	%		2,576		25.8	%		2,769		29.7	%
Other		2		0.1	%		3		0.1	%		43		0.4	%		42		0.5	%
	$	3,703		100.0	%	$	3,154		100.0	%	$	9,998		100.0	%	$	9,320		100.0	%

Two customers accounted for 20.7% and 11.0% of the Company’s net revenue for the three-month period ended September 30, 2019. At September 30, 2019, the same two customers were 36.7% of the accounts receivable balance. The accounts receivable balances totaled 6.3% of net accounts receivable for the same two customers as of December 31, 2018.

Two customers accounted for 23.5% and 11.0% of the Company’s net revenue for the nine-month period ended September 30, 2019. At September 30, 2019, the same two customers were 31.9% of the accounts receivable balance.

NOTE 10 – COMMITMENTS

Lease Agreements

The Company has entered into a new lease in Camarillo, California for its headquarters beginning June 1, 2019. The facility is 9,910 square feet and is a 5 year and two-month lease, expiring July 31, 2024. The rent on this facility is $9,910 per month with a 3% step-up annually. Qualstar subleases a portion of the warehouse space to Interlink Electronics, Inc. (“Interlink”) and BKF Capital Group, Inc. (“BKF”) and is reimbursed for the space and other related expenses on a monthly basis. As described in Note 12, Interlink and BKF are related parties.

Qualstar leases a 15,160 square foot facility located in Simi Valley, California. The three-year lease began December 15, 2014 and has been renewed for an additional three years, expiring February 28, 2021. Rent on this facility is $11,000 per month with a step-up of 3% annually. On May 22, 2019, Qualstar entered into a Standard Sublease Multi-Tenant (the “Sublease”), with Stillwater Agency, Inc., a California corporation (“Stillwater”), for the Simi Valley location, which previously served as Qualstar’s head office location and principal executive office. The term of the Sublease commenced on July 15, 2019 and ends on February 28, 2021 (the “Term”). The base rent under the Sublease is approximately $12,886.00 per month. Stillwater is also responsible for approximately nine percent (9%) of certain operating expenses and taxes associated with the office building in which the leased premises are located. Prior to entering the Sublease, Qualstar subleased a portion of the warehouse space to Interlink and was reimbursed for the space and other related expenses on a monthly basis.

Qualstar also leases approximately 5,400 square feet of office space in Westlake Village, California, that expires January 31, 2020. Rent on this facility is $11,000 per month, with a step-up of 3% annually. Effective March 21, 2016, Qualstar entered into a sublease agreement for the Westlake Village facility. The term of the sublease expires at the same time as the term of the master lease and the tenant pays Qualstar $12,000 per month with a step-up of 3% annually.

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

Effective April 1, 2016, a two-year lease was signed for 1,359 square feet for $2,500 per month in Singapore, which has been renewed until March 31, 2020.

Such leases do not require any contingent rental payments, impose any financial restrictions, or contain any residual value guarantees. Variable expenses generally represent the Company’s share of the landlord’s operating expenses. The Company does not have any leases classified as financing leases.

The rate implicit in each lease is not readily determinable, and we therefore use our incremental borrowing rate to determine the present value of the lease payments. The weighted average incremental borrowing rate used to determine the initial value of right of use (ROU) assets and lease liabilities during the three months ended September 30, 2019 was 6.75%, derived from borrowing rate quotes as obtained from the Company’s business bank. We have certain contracts for real estate which may contain lease and non-lease components which we have elected to treat as a single lease component.

Right of use assets for operating leases are periodically reduced by impairment losses. We use the long-lived assets impairment guidance in ASC Subtopic 360-10, Property, Plant, and Equipment – Overall, to determine whether a ROU asset is impaired, and if so, the amount of the impairment loss to recognize. As of September 30, 2019, we have not recognized any impairment losses for our ROU assets.

We monitor for events or changes in circumstances that require a reassessment of one of our leases. When a reassessment results in the remeasurement of a lease liability, a corresponding adjustment is made to the carrying amount of the corresponding ROU asset unless doing so would reduce the carrying amount of the ROU asset to an amount less than zero. In that case, the amount of the adjustment that would result in a negative ROU asset balance is recorded in profit or loss.

At September 30, 2019, the Company had current and long-term operating lease liabilities of $272,000 and $495,000, respectively, and right of use assets of $734,000.

Future minimum lease payments under these leases are as follows, in thousands, (unaudited):

							Net
	Minimum						Minimum
	Lease			Sublease			Lease
Years Ending December 31,	Payment			Revenue			Payment
Remainder of 2019	$	105		$	(81	)	$	24
2020		277			(167	)		110
2021		148			(26	)		122
2022		129			-			129
2023		133			-			133
After		79			-			79
Total undiscounted future non-cancelable minimum lease payments		871			(274	)		597
Less: Imputed interest		(104	)		-			(104	)
Present value of lease liabilities	$	767		$	(274	)	$	493

In the Company's financial statements for periods prior to January 1, 2019, the Company accounts for leases under ASC 840, and provides for rent expense on a straight-line basis over the lease terms. Net rent expense for the three and nine months ended September 30, 2019 was $45,000 and $129,000, respectively.

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

Other information related to our operating leases is as follows:

	Nine Months Ended September 30, 2019
Weighted average remaining lease term in years		1.77
Weighted average discount rate		6.75	%

Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases	$	243
Operating cash flows from finance leases		-
Financing cash flows from finance leases		-

NOTE 11 – SEGMENT INFORMATION

In its operation of the business, management reviews certain financial information, including segmented internal profit and loss statements prepared on a basis consistent with U.S. GAAP. Our two segments are Power Supplies and Data Storage. The two segments discussed in this analysis are presented in the way we internally manage and monitor performance for the three and nine months ended September 30, 2019 and 2018. Our allocations of internal resources were made to the two business segments for the three and nine months ended September 30, 2019 and 2018. The types of products and services provided by each segment are summarized below:

Power Supplies — The Company designs and markets high-efficiency switching power supplies. We utilize contract manufacturers in Asia to produce the power supply products. These power supplies are used to convert AC line voltage to DC voltages, or DC voltages to other DC voltages for use in a wide variety of electronic equipment such as communications equipment, industrial machine tools, wireless systems, as well as medical and gaming devices. We sell our products globally through authorized resellers and directly to original equipment manufacturers (“OEMs”).

Storage — The data storage industry is experiencing a tremendous increase in newly generated digital data due to Rich Media Content, Internet of Things, Data Mining and the Cloud. Tape based storage solution providers enable businesses to manage the massive growth of digital data assets in a cost-effective manner. Our tape-based data storage product lines address long-term archive, backup and recovery of electronic data. These products consist of networked libraries that store and move high-density tape cartridges and high-speed tape drives that stream data to and from the tape cartridges. These optimized solutions allow the video centric markets such as media and entertainment, oil and gas, surveillance, digital security and medical imaging to achieve targeted data workflows.

Segment revenue, income before taxes and total assets were as follows (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
Revenue
Power Supplies	$	1,450	$	1,612	$	4,117	$	4,598
Storage:
Product		1,148		789		3,060		1,973
Service		1,105		753		2,821		2,749
Total storage	$	2,253	$	1,542	$	5,881	$	4,722
Revenue	$	3,703	$	3,154	$	9,998	$	9,320

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2019			2018		2019			2018
Income (Loss) before Taxes
Power Supplies	$	(141	)	$	164	$	(497	)	$	181
Storage		190			241		676			1,288
Income (loss) before taxes	$	49		$	405	$	179		$	1,469

	September 30, 2019		December 31, 2018
Total Assets	(unaudited)
Power Supplies
Cash and cash equivalents	$	285	$	381
Accounts receivable, net		948		1,048
Inventories, net		1,261		1,576
Property and equipment, net		12		47
Other assets		115		102
Total power supply assets		2,621		3,154
Storage
Cash and cash equivalents	$	3,986	$	4,400
Restricted cash		100		100
Accounts receivable, net		1,229		761
Inventories, net		1,467		1,321
Prepaid expenses and other current assets		240		168
Property and equipment, net		120		65
Other assets		762		29
Total storage assets		7,904		6,844
Total Assets	$	10,525	$	9,998

NOTE 12 – RELATED PARTY TRANSACTIONS

Steven N. Bronson is the Company’s CEO and is also the President and CEO and a majority shareholder of Interlink Electronics, Inc. (“Interlink”) and BKF Capital Group, Inc. (“BKF”). Interlink reimburses Qualstar for leased space at the Camarillo facility and prior to the Company’s entry into the Sublease, described in Note 10, for leased space at the Simi Valley facility. Interlink also reimburses the Company for other administrative expenses paid by or on behalf of the Company. The total amount charged to Interlink for the three months ended September 30, 2019 and 2018 was $15,000 and $4,000, respectively and $25,000 and $12,000 for the nine months ended September 30, 2019 and 2018. Interlink owed Qualstar $7,000 and $2,000 at September 30, 2019 and December 31, 2018, respectively.

QUALSTAR CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)-(Continued)

The Company reimburses Interlink for expenses paid on the Company’s behalf. Interlink occasionally pays travel, consulting and other expenses incurred by Qualstar. The Company reimbursed Interlink $45,000 and $50,000 for the three months ended September 30, 2019 and 2018, respectively and $103,000 and $180,000 for the nine months ended September 30, 2019 and 2018, respectively. Qualstar did not owe Interlink as of September 30, 2019. At December 31, 2018, Qualstar owed Interlink $2,000.

The Company reimburses BKF for expenses paid on the Company’s behalf. BKF occasionally pays consulting expenses incurred by Qualstar. BKF did not incur any expenses on behalf of Qualstar during the three months ended September 30, 2019 and no expenses were reimbursed by the Company to BKF during such period. The Company did reimburse BKF $2,000 for the nine months ended September 30, 2018 for expenses incurred on the Company’s behalf. Qualstar did not owe BKF any monies at September 30, 2019 and owed $2,000 as of December 31, 2018.

NOTE 13 – SUBSEQUENT EVENTS

On October 29, the Company granted to Steven N. Bronson, the Company’s President and Chief Executive Officer, 50,000 restricted stock units (the “Restricted Stock Units”) for shares of the Company’s common stock under the terms of the Company’s 2017 Stock Option and Incentive Plan and an associated Restricted Stock Unit Agreement with Mr. Bronson (the “Restricted Stock Unit Agreement”). The Restricted Stock Units were awarded pursuant to that certain employment agreement entered into between the Company and Mr. Bronson on April 13, 2019. For each of the fiscal years ended December 31, 2019 and December 31, 2020, Restricted Stock Units for 25,000 shares of the Company’s common stock shall vest and the underlying common stock shall become issuable subject to the Company’s achievement of financial and performance objectives for the applicable fiscal year established by the Company’s Compensation Committee. Subject to the satisfaction of certain conditions, unvested Restricted Stock Units shall also vest and the underlying common stock shall become issuable upon Mr. Bronson’s death or disability, in the event the Company terminates Mr. Bronson’s employment without cause or if Mr. Bronson terminates his employment with the Company for good reason, and in the event of a change in control of the Company.

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 the Company including estimates, projections, statements relating to our business plans, objectives and operating results, and the assumptions upon which those statements are based, 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 Part II, Item 1A of this report and in our Annual Report on Form 10-K for the year ended December 31, 2018 in “Item 1 Business,” “Item 1A Risk Factors,” and in “Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements are generally identified 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

Qualstar Corporation and its Subsidiaries (“Qualstar”, the “Company”, “we”, “us” or “our”) manufactures and markets data storage system products and compact, high efficiency power solutions. Our data storage devices include highly scalable automated magnetic tape libraries used to store, retrieve and manage electronic data primarily in the network computing environment. Our data storage devices include models ranging from entry level to enterprise and are a cost-effective solution for organizations requiring backup, recovery and archival storage of critical electronic information. The distribution channels for our data storage devices include resellers, system integrators, and original equipment manufacturers (“OEMs”). In addition, the Company is a leading provider of standard, semi-custom and custom power solutions marketed under the N2Power brand. Our power solution products provide OEM designers increased functionality while reducing thermal loads and cooling requirements and lowering operating costs. Our power solution products are currently sold to OEMs in a wide range of markets, including telecom/networking equipment, audio/visual, industrial, gaming and now medical with our new product offerings.

The Company is focused on expanding sales in both business units in two key areas: adding key customers and expanding its product portfolio. The data storage business is adding more strategic partners that will expand our geographic footprint and increase our reach to additional industries. The power supply business unit is expanding its customer base in specific market verticals, such as the gaming industry. In addition to adding new internally designed and private label products, the power supply business is focusing on providing value add services in establishing itself as an optimized product development manufacturer (OPDM) for current and future new customers. This will allow N2Power to act as a one-stop shop providing solutions for more complex power assembly units and chassis solutions for their OEM customers.

The Company continues to expand its product portfolio through internal development, private labeling and establishing worldwide partnerships with other power supply and data storage related companies. These new relationships will increase our product development engineering capabilities and help us stay at the forefront of both the data storage and power supply industries.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

We describe our significant accounting policies in Note 1, “Summary of Significant Accounting Policies” of the accompanying Notes to Condensed Consolidated Financial Statements.

RESULTS OF OPERATIONS - (Unaudited)

The following table is presented in thousands, except for percentages. The percentages in the table are based on net revenues.

	Three Months Ended September 30,										Nine Months Ended September 30,
	2019					2018					2019					2018
	$		%			$		%			$		%			$		%
Power supply revenues	$	1,450		39.2	%	$	1,612		51.1	%	$	4,117		41.2	%	$	4,598		49.3	%
Storage revenues		2,253		60.8	%		1,542		48.9	%		5,881		58.8	%		4,722		50.7	%
Net revenues		3,703		100.0	%		3,154		100.0	%		9,998		100.0	%		9,320		100.0	%
Cost of goods sold		2,749		74.2	%		1,901		60.3	%		7,319		73.2	%		5,217		56.0	%
Gross profit		954		25.8	%		1,253		39.7	%		2,679		26.8	%		4,103		44.0	%
Operating expenses:
Engineering		122		3.3	%		123		3.9	%		473		4.7	%		372		4.0	%
Sales and marketing		368		9.9	%		351		11.1	%		982		9.8	%		1,000		10.7	%
General and administrative		427		11.5	%		374		11.9	%		1,078		10.8	%		1,262		13.5	%
Total operating expenses		917		24.7	%		848		26.9	%		2,533		25.3	%		2,634		28.3	%
Income from operations		37		1.0	%		405		12.8	%		146		1.5	%		1,469		15.8	%
Other income		12		0.3	%		-		-	%		33		0.3	%		-		-	%
Net income	$	49		1.3	%	$	405		12.8	%	$	179		1.8	%	$	1,469		15.8	%

Comparison of the Three Months Ended September 30, 2019 and 2018 (unaudited)

Change in Net Revenues:

	Three months Ended September 30,
	2019					2018					Change
	Amount		% of net revenue			Amount		% of net revenue			Amount			%
Power supply revenues	$	1,450		39.2	%	$	1,612		51.1	%	$	(162	)	$	(10.0	)%
Storage revenues		2,253		60.8	%		1,542		48.9	%		711			46.1	%
Net revenues	$	3,703		100.0	%	$	3,154		100.0	%	$	549			17.4	%

The increase in net revenues for the three months ended September 30, 2019 compared to the prior year period is attributable to the segment-specific factors described below.

Segment Revenue

Power Supplies – The decrease in power supply sales in the three months ended September 30, 2019 compared to the prior year period is primarily attributable to the decreased orders from existing customers. Key customers that incorporate our power supplies have variable life cycles and production demands. Revenues generated from one key customer decreased significantly during the period, as their demand for our product fell. As some projects reach end - of - life, the timing of new production creates a fluctuation in sales.

Storage – For the three months ended September 30, 2019 compared to the prior year period we experienced growth in our storage product sales as we attracted new customers. Some of the new customers target industries that have larger data storage needs which drive sales of our larger storage solutions. Service revenue also increased as a result of an increase in revenue received from our partnership with Sony Imaging Products & Solutions Inc. for the development of an enterprise class optical disk archive (“ODA”) library, which revenue was offset with a slight decline in technical support revenue. The service revenue from our relationship with Sony will fluctuate during various phases of the project.

Gross Profit:

	Three months Ended September 30,
	2019					2018					Change
	Amount		% of net revenue			Amount		% of net revenue			$Amount			%
Gross profit	$	954		25.8	%	$	1,253		39.7	%	$	(299	)		(23.9	)%

The gross profit decrease for the three months ended September 30, 2019 compared to the prior year period is primarily attributed to our power supply business. The reduced revenue did not contribute the same margins to apply to the fixed costs of the business as in the prior year. Gross profit also decreased as a result of the Company’s project development service contract with Sony, which arrangement mandates different levels of gross profit during various phases of the project. The current phase allows a gross profit limit of 10% with a maximum profit of $250,000.

Operating Expenses:

	Three months Ended September 30,
	2019					2018					Change
	Amount		% of net revenue			Amount		% of net revenue			Amount			%
Engineering	$	122		3.3	%	$	123		3.9	%	$	(1	)		(0.8	)%
Sales and marketing	$	368		9.9	%	$	351		11.1	%	$	17			4.8	%
General and administrative	$	427		11.5	%	$	374		11.9	%	$	53			14.2	%

Engineering

Engineering expenses were relatively consistent for the three months ended September 30, 2019 compared to the prior year.

Sales and Marketing

Sales and marketing expenses increased during the three months ended September 30, 2019 from the prior year period, primarily from an increase in marketing expenses and sales commissions offset by a reduction in personnel costs.

General and Administrative

General and administrative costs increased during the three months ended September 30, 2019 from the prior year period as a result of an increase in legal fees and costs associated with our move to our new facility in Camarillo, California, offset by decline in bonus expenses.

Other income

Other income increased as a result of interest earned during the three months ended September 30, 2019.

Provision for Income Taxes

We did not record a provision or benefit for income taxes for each of the three months ended September 30, 2019 and 2018, due to our net operating loss carryforwards (NOL’s). There were no changes to the valuation allowance during the three months ended September 30, 2019.

Comparison of the Nine Months Ended September 30, 2019 and 2018 (unaudited)

Change in Net Revenues:

	Nine months Ended September 30,
	2019					2018					Change
	Amount		% of net revenue			Amount		% of net revenue			Amount			%
Power supply revenues	$	4,117		41.2	%	$	4,598		49.3	%	$	(481	)		(10.5	)%
Storage revenues		5,881		58.8	%		4,722		50.7	%		1,159			24.5	%
Net revenues	$	9,998		100.0	%	$	9,320		100.0	%	$	678			7.3	%

The increase in net revenues for the nine months ended September 30, 2019 compared to the prior year period is attributable to the segment-specific factors described below.

Segment Revenue

Power Supplies – The decrease in power supply sales in the nine months ended September 30, 2019 compared to the prior year period is primarily attributable to the decreased orders from existing customers. Key customers that incorporate our power supplies have variable life cycles and production demands. Revenues generated from one key customer decreased significantly during the period, as their demand for our product fell. As some projects reach end - of - life, the timing of new production creates a fluctuation in sales.

Storage – For the nine months ended September 30, 2019 compared to the prior year period we experienced revenue growth from data storage product sales, offset by a decline in services revenues relating to storage products. The increase in product revenues is attributed to new reseller relationships focused on media and entertainment and other industries, which resellers have a high demand for tape technology. Our service revenue decreased compared to the prior year period, primarily due to a decrease in our technical support revenue.

Gross Profit:

	Nine months Ended September 30,
	2019					2018					Change
	Amount		% of net revenue			Amount		% of net revenue			Amount			%
Gross profit	$	2,679		26.8	%	$	4,103		44.0	%	$	(1,424	)		(34.7	)%

The gross profit decrease for the nine months ended September 30, 2019 compared to the prior year period is primarily attributed to the decreased gross profit of power supplies and data storage service. Power supply gross profit declined due to a decrease in sales in our power supply segment and a $190,000 one-time charge for the write down of raw material inventory repurchased from a terminated contract manufacturer. Gross profit in our data storage segment declined during the period as a result of reduced revenue from service contracts. In addition, gross profit in our data storage segment decreased during the period as a result of our contract with Sony, which arrangement mandates different levels of gross profit during various phases of the project. The current phase allows a gross profit limit of 10% with a maximum profit of $250,000.

Operating Expenses:

	Nine months Ended September 30,
	2019					2018					Change
	Amount		% of net revenue			Amount		% of net revenue			Amount			%
Engineering	$	473		4.7	%	$	372		4.0	%	$	101			27.2	%
Sales and marketing	$	982		9.8	%	$	1,000		10.7	%	$	(18	)		(1.8	)%
General and administrative	$	1,078		10.8	%	$	1,262		13.5	%	$	(184	)		(14.6	)%

Engineering

Engineering expenses increased in the nine months ended September 30, 2019 from the prior year period as a result of an increase in compliance testing expense as we certified our power supplies to the new UL safety standards.

Sales and Marketing

Sales and marketing expenses slightly decreased during the nine months ended September 30, 2019 from the prior year period, primarily as a result of decreased sales commissions and promotional expenses.

General and Administrative

General and administrative costs decreased during the nine months ended September 30, 2019 from the prior year period. General and administrative costs decreased primarily due to a decrease in bonus expense, travel expenses, and professional services and legal fees offset by expenses incurred in connection with our move to our new facility in Camarillo, California.

Provision for Income Taxes: We did not record a provision or benefit for income taxes for each of the nine months ended September 30, 2019 and 2018, due to our prior year operating losses. There were no changes to the valuation allowance during the nine months ended September 30, 2019.

CONTRACTUAL OBLIGATIONS

On March 15, 2019, we entered into a Standard Industrial/Commercial Multi-Tenant Lease – Gross dated February 14, 2019 (the “Lease”), with Flynn-Adolfo Associates, LP, a California limited partnership, for approximately 9,910 square feet of office and warehouse space at 1267 Flynn Road in Camarillo, California (the “Premises”). As of June 1, 2019, the Premises serves as our head office location and is used for research and development, manufacturing, storage and other ancillary business purposes. The initial base rent under the Lease is approximately $9,910 per month and is subject to escalation over the term of the Lease. We are also responsible for our pro-rata share of certain operating expenses and taxes associated with the office building in which the Premises are located. The term of the Lease commenced on June 1, 2019 and will expire on July 31, 2024. We have an option to renew the Lease for two (2) additional thirty-nine (39) month terms.

OFF-BALANCE SHEET ARRANGEMENTS

As of the date of this Quarterly Report on Form 10-Q, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

LIQUIDITY AND CAPITAL RESOURCES

Operating Activities

Our principal source of liquidity is cash generated from operations. Net cash provided by operating activities was $211,000 for the nine months ended September 30, 2019 compared to the net cash provided by operating activities of $112,000 for the nine months ended September 30, 2018.

The cash provided by operating activities for the nine months ended September 30, 2019 of $211,000 consisted of the operating income for the period of $179,000, decreased by non-cash adjustments of $36,000 and an increase in the changes of operating assets and liabilities of $68,000.

Investing Activities

Cash used for investing activities for the nine months ended September 30, 2019 was $85,000 relating to the upgrade of computer equipment, leasehold improvements and the installation of new warehouse fixtures. Cash used for investing activities for the nine months ended September 30, 2018 of $18,000 related to the purchase of computer equipment.

Financing Activities

Cash used by financing activities during the nine months ended September 30, 2019 was $636,000 relating to the purchase of common stock under the Company’s buy-back program.

As of September 30, 2019, cash, restricted cash and cash equivalents decreased $510,000 to $4,371,000 from $4,881,000 at December 31, 2018.

We believe that our existing cash and cash equivalents and cash flows from our operating activities will be sufficient to fund our working capital and capital expenditure needs for at least twelve months from the date of this report. We may utilize cash to invest in or acquire businesses, products or technologies that we believe are additive to the strategic expansion of the Company. We periodically evaluate other companies and technologies for possible investment or acquisition. 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 investment in or acquisition of other businesses or technologies. In the event that we require additional capital to meet our business needs, there can be no assurance that additional funding will be available to us when needed or, if available, that it can be obtained on commercially reasonable terms.

ITEM 3. Qualitative and Quantitative Disclosures about Market Risk

Not applicable.

ITEM 4. Controls and Procedures

We maintain "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, that are designed to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and our principal financial officer, as applicable, to allow timely decisions regarding required disclosure.

Evaluation of disclosure and controls and procedures

As of the end of the period covered by this report, 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 disclosure controls and procedures. Based on the evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and that our disclosure controls and procedures are operating in an effective manner to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms.

Changes in internal controls over financial reporting

There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during our most recent quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there is only reasonable assurance that our controls will succeed in achieving their stated goals under all potential future conditions.

PART II — OTHER INFORMATION

ITEM 1. Legal Proceedings

Qualstar is subject to a variety of claims and legal proceedings that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in the aggregate, will not have a material adverse impact on our financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. We accrue loss contingencies in connection with our commitments and contingencies, including litigation, when it is probable that a loss has occurred and the amount of the loss can be reasonably estimated.

ITEM 1A. Risk Factors

During the three months ended September 30, 2019, there have been no significant changes to the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

We initiated a Stock Repurchase Program on December 5, 2018 (see Note 6 for further information). The following table presents the information about purchases by us of our common stock for the three months ended September 30, 2019:

Period:	Total number of shares purchased		Average price paid per share		Total number of shares purchased as a result of publicly announced plans or programs		Maximum or approximate dollar value of shares yet to be purchased under the plans or programs

July 1 – July 31, 2019		9,544	$	5.585		120,352	$	1,734,748

August 1 – August 31, 2019		12,914	$	4.924		133,266	$	1,671,499

September 1 – September 30, 2019		-	$	-		133,266	$	1,671,499

ITEM 3. Defaults upon Senior Securities

None.

ITEM 4. Mine Safety Disclosures

Not applicable.

ITEM 5. Other Information

None.

ITEM 6. Exhibits

Incorporated by Reference

Exhibit
Number

Exhibit Description

Form

File Number

Exhibit

Filing Date

Filed
Herewith

10.1+

Amendment to Qualstar Corporation 2017 Stock Option and Incentive Plan

10-Q

001-35810

10.1

August 13, 2019

31.1

Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2

Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1

Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2

Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS

XBRL Instance Document

101.SCH

XBRL Taxonomy Extension Schema Document

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document

101.DEF

XBRL Taxonomy Extension Definition Linkbase Document

101.LAB

XBRL Taxonomy Extension Label Linkbase Document

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document

**Furnished herewith

+Each a management contract or compensatory plan or arrangement.

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.

	QUALSTAR CORPORATION



Dated: November 7, 2019	By:	/s/STEVEN N. BRONSON
		Steven. N. Bronson
		Chief Executive Officer and President
		(Principal Executive Officer)

QUALSTAR CORP 10-Q