FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004

OR

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

COMMISSION FILE NUMBER 1-12691

INPUT/OUTPUT, INC.

     REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (281) 933-3339

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes: [X] No: [ ]

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

At April 30, 2004, there were 53,126,054 shares of common stock, par value $0.01 per share, outstanding.

INPUT/OUTPUT, INC. AND SUBSIDIARIES

TABLE OF CONTENTS FOR FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2004

INPUT/OUTPUT, INC. AND SUBSIDIARIES

See accompanying Notes to Unaudited Consolidated Financial Statements.

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INPUT/OUTPUT, INC. AND SUBSIDIARIES

See accompanying Notes to Unaudited Consolidated Financial Statements.

4

INPUT/OUTPUT, INC. AND SUBSIDIARIES

See accompanying Notes to Unaudited Consolidated Financial Statements.

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INPUT/OUTPUT, INC. AND SUBSIDIARIES

(1)

Basis of Presentation

     The consolidated balance sheet of Input/Output, Inc. and its subsidiaries (collectively referred to as the “Company” or “I/O”) at December 31, 2003 has been derived from the Company’s audited consolidated financial statements at that date. The consolidated balance sheet at March 31, 2004, the consolidated statements of operations for the three months ended March 31, 2004 and 2003, and the consolidated statements of cash flows for the three months ended March 31, 2004 and 2003, have been prepared by the Company without audit. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the three months ended March 31, 2004 are not necessarily indicative of the operating results for a full year or of future operations.

     These consolidated financial statements have been prepared using accounting principles generally accepted in the United States for interim financial information and the instructions to Form 10-Q and applicable rules of Regulation S-X of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements presented in accordance with accounting principles generally accepted in the United States have been omitted. The accompanying consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 (as amended by Forms 10-K/A). Certain amounts previously reported in the consolidated financial statements have been reclassified to conform to the current period’s presentation.

(2)

Stock-Based Compensation

     The Company has elected to continue to follow the intrinsic value method of accounting for equity-based compensation as prescribed by APB Opinion No. 25. If the Company had adopted Statement of Accounting Standards (SFAS) No. 123, net loss, basic loss per share and diluted loss per share for the periods presented would have been increased as follows (in thousands, except per share amounts):

     The above amounts are based on Black-Scholes’ valuation model. The key variables used in valuing the options were as follows: average risk-free interest rate based on 5-year Treasury bonds, an estimated option term of five years, no dividends and expected stock price volatility of 60% during the three months ended March 31, 2004 and 2003.

(3)

Segment and Geographic Information

     The Company evaluates and reviews results based on three segments (Land Imaging, Marine Imaging, and Processing and Software) to allow for increased visibility and accountability of costs and more focused customer service and product development. The Company measures segment operating results based on income (loss) from operations.

     Prior to December 31, 2003, the Company included Processing and Software (formerly referred to as Processing) within the Land Imaging segment due to its relatively low contribution to the Company’s operations. However, during 2003, as the Company re-evaluated its business strategies, concluding that Processing and Software will be an increasing portion of its business and should be reported as a separate segment. In February 2004, the Company purchased Concept Systems Holdings Limited (Concept) and has included Concept within the Processing and Software segment. See further discussion of the Concept acquisition at Note 14 of Notes to Unaudited Consolidated Financial Statements.

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     A summary of segment information for the three months ended March 31, 2004 and 2003, restated for three months ended March 31, 2003 to reflect the Processing and Software segment, is as follows (in thousands):

     Intersegment sales are insignificant for all periods presented. Corporate assets include all assets specifically related to corporate personnel and operations, a majority of cash and cash equivalents and all facilities that are jointly utilized by segments. Depreciation and amortization expense is allocated to segments based upon use of the underlying assets.

     A summary of net sales by geographic area is as follows (in thousands):

     Net sales are attributed to individual countries on the basis of the ultimate destination of the equipment, if known. If the ultimate

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destination of such equipment is not known, net sales are attributed to the geographical location of initial shipment.

(4)

Accounts and Notes Receivable

     A summary of accounts receivable is as follows (in thousands):

     Approximately $4.5 million of the Company’s total accounts receivable at March 31, 2004 related to a July 2003 sale of an Image™ land data acquisition system to a customer located in China. This customer had experienced certain reliability issues with the system that the Company is currently working to resolve. The Company expects to be paid in full once all reliability issues have been resolved. Therefore, no allowance has been established for this receivable.

     Notes receivable are collateralized by the products sold, bear interest at contractual rates of up to 12.7% per year and are due at various dates through 2006. The weighted average interest rate at March 31, 2004 was 7.7%. A summary of notes receivable, accrued interest and allowance for loan-loss is as follows (in thousands):

     Approximately $10.6 million of the Company’s total notes receivable at March 31, 2004 related to one customer, a subsidiary of a major Russian energy company. During 2003, this customer became delinquent on approximately $0.8 million of its scheduled principal and interest payments, in addition to becoming delinquent on $1.8 million of its trade receivables. In January 2004, the Company refinanced the delinquent portion of its notes and trade receivables into a new note totaling $2.6 million, with payments due in equal installments over a twelve-month period. Based on the Company’s internal credit review and meetings with the customer and its parent company, the Company expects the customer will pay all of its obligations in full and, therefore, no allowance has been established for these receivables.

(5)

Inventories

     A summary of inventories, net of reserves, is as follows (in thousands):

     For the three months ended March 31, 2003, inventory of approximately $0.2 million was written off and included within research and development expenses. This write-off relates to the cancellation of the solid streamer project within the Marine Imaging segment. See further discussion at Note 10 of Notes to Unaudited Consolidated Financial Statements. In addition, an unrelated inventory obsolescence charge of $0.3 million was reflected in cost of sales related to the closure of the Company’s Alvin, Texas manufacturing facility.

     In October 2003, the Company purchased certain marine equipment for $3.2 million for an anticipated sale to one customer. However, this potential customer ceased negotiations after it failed to be awarded an expected survey. For the three months ended March 31, 2004, the Company entered into a lease agreement for approximately $0.6 million of costs for this equipment. As of March

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31, 2004, approximately $1.8 million of this equipment remained available for sale by the Company, and the Company expects to sell the equipment in 2004.

     As part of the Company’s business plan, the Company is increasing the use of contract manufacturers as an alternative to in-house manufacturing. Under a few of the Company’s outsourcing arrangements, its manufacturing outsourcers first utilize the Company’s on-hand inventory, then directly purchase inventory at agreed-upon quantities and lead times in order to meet the Company’s scheduled deliveries. If demand proves to be less than the Company originally forecasted, the Company’s outsourcer has the right to require the Company to purchase inventory which the outsourcer had purchased on the Company’s behalf. However, since the Company now typically issues purchase orders to the Company’s outsourcers based upon its short-term forecast (usually three months or less), the Company has reduced the risk that it may be required to purchase inventory that it may never utilize.

(6)

Net Assets Held For Sale

     In July 2003, the Company completed the closure of its Alvin, Texas manufacturing facility and is currently marketing the facility for sale. At March 31, 2004, the facility and related land had a net carrying value of $2.4 million and has been reclassified as “Held for Sale” under the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. In January 2004, the Company completed the sale of 16.75 acres of land owned by it located across from its headquarters in Stafford, Texas, receiving net proceeds of $1.5 million, resulting in a gain on the sale of $0.6 million.

(7)

Non-Cash Activity

     During the first quarter of 2004, the Company acquired Concept. As part of the consideration, the Company issued 1,680,000 of its common shares. See further discussion at Note 14 of Notes to Unaudited Consolidated Financial Statements. During the three months ended March 31, 2004 and 2003, the Company transferred $2.6 million and $1.9 million, respectively, of inventory at cost to rental equipment in connection with certain leasing arrangements.

(8)

Loss per Common Share

     Basic loss per common share is computed by dividing net loss applicable to common shares by the weighted average number of common shares outstanding during the period. Diluted loss per common share is determined on the assumption that outstanding dilutive stock options have been exercised and the aggregate proceeds were used to reacquire common stock using the average price of such common stock for the period. The total number of options outstanding at March 31, 2004 and 2003 were 5,719,131 and 4,488,325, respectively. In December 2003, the Company issued $60.0 million of notes convertible into its common stock at a conversion rate 231.4815 shares per $1,000 principal amount of notes (a conversion price of $4.32), which represents 13,888,888 total common shares. Basic and diluted loss per share are the same for the three months ended March 31, 2004 and 2003, as all potential common shares were anti-dilutive.

(9)

Notes Payable, Long Term Debt and Lease Obligations

     In December 2003, the Company issued $60.0 million of convertible senior notes, which mature on December 15, 2008. The notes bear interest at an annual rate per annum of 5.5%, payable semi-annually. The notes, which are not redeemable prior to their maturity, are convertible into the Company’s common stock at an initial conversion rate of 231.4815 shares per $1,000 principal amount of notes (a conversion price of $4.32), which represents 13,888,888 total common shares. The Company paid $3.5 million in underwriting and professional fees, which have been recorded as deferred financing costs and are being amortized over the term of the notes.

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     In May 2003, the Company financed $0.5 million of insurance costs through the execution of a short-term note payable. The principal and interest on the note were due on a monthly basis and bore interest at a rate of 5.75% per annum with final payment made in February 2004. In August 2003, the Company financed an additional $1.4 million of insurance costs with similar terms except final payment is due in May 2004. The unpaid balance under this note payable at March 31, 2004 was $0.3 million.

      In August 2002, in connection with the repurchase of its Series B Preferred Stock, the Company issued a $31.0 million unsecured promissory note due May 7, 2004, which bore interest at 8% per year until May 7, 2003, at which time the interest rate increased to 13% per annum. Interest was payable in quarterly payments, with all principal and unpaid interest due on May 7, 2004. The Company recorded interest on this note at an effective rate of approximately 11% per year over the life of the note. In May 2003, the Company repaid $15.0 million of the note and in December 2003, the Company repaid, in full, the remaining outstanding principal balance of $16.0 million plus accrued interest. The note terms had restricted cash dividends on shares of Company common stock in excess of $5.0 million per year while the note was outstanding.

     In July 2002, in connection with the acquisition of AXIS, the Company entered into a $2.5 million three-year unsecured promissory note payable to the former shareholders of AXIS, bearing interest at 4.34% per year. Principal was payable in quarterly payments of $0.2 million plus interest, with final payment due in July 2005. The unpaid balance at March 31, 2004 was $1.3 million.

     In August 2001, the Company sold its corporate headquarters and manufacturing facility located in Stafford, Texas for $21.0 million. Simultaneously with the sale, the Company entered into a non-cancelable lease with the purchaser of the property. The lease has a twelve-year term with three consecutive options to extend the lease for five years each. The Company has no purchase option under the lease. As a result of the lease terms, the commitment was recorded as a twelve-year, $21.0 million lease obligation with an implicit interest rate of 9.1% per annum. The unpaid balance at March 31, 2004 was $18.6 million. The Company paid $1.7 million in commissions and professional fees, which have been recorded as deferred financing costs and are being amortized over the twelve-year term of the lease obligation. At June 30, 2003, the Company failed to meet the tangible net worth requirement under this lease. Therefore, in the third quarter of 2003, the Company provided a letter of credit to the landlord of the property in the amount of $1.5 million. To secure the issuance of the letter of credit, the Company was required to deposit $1.5 million with the issuing bank. This letter of credit will remain outstanding until the Company is back in compliance with the tangible net worth requirement for eight consecutive quarters, or until the expiration of the eighth year of the lease in 2009. The deposit has been classified as a long-term other asset.

     A summary of future principal obligations under the notes payable and lease obligations is as follows (in thousands):

(10)

Impairment of Long-Lived Assets

     During the first quarter of 2003, the Company initiated an evaluation of its solid streamer project and concluded it would no longer internally pursue this product for commercial development. In conjunction with this evaluation, certain fixed assets and patented technology within the Marine Imaging segment were deemed impaired in accordance with SFAS No. 144. As a result, fixed assets of $0.5 million and intangible assets of $0.6 million were considered impaired and written off as a charge against earnings. In addition, inventory associated with this project of approximately $0.2 million was written off and included within research and development expenses at March 31, 2003.

(11)

Investment in Energy Virtual Partners, Inc.

     In April 2003, the Company invested $3.0 million in Series B Preferred securities of Energy Virtual Partners, Inc. (EVP) for 22% of the outstanding ownership interests and 12% of the outstanding voting interests. EVP provided asset management services to large oil and gas companies to enhance the value of their oil and gas properties. This investment was accounted for under the cost method for

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investment accounting. Robert P. Peebler, the Company’s President and Chief Executive Officer, founded EVP in April 2001 and served as EVP’s President and Chief Executive Officer until joining I/O in March 2003.

     During the second quarter of 2003, EVP failed to close two anticipated asset management agreements, which resulted in EVP’s management re-evaluating its business model and adequacy of capital. During August 2003, the board of directors of EVP voted to liquidate EVP. For that reason, in the second quarter of 2003, the Company wrote its investment down to its approximate liquidation value of $1.0 million. Mr. Peebler offered, and the Company agreed, that all proceeds Mr. Peebler received from the liquidation of EVP were to be paid to the Company. In December 2003, the Company received a portion of its final liquidation payment of $0.7 million from EVP and $0.1 million from Mr. Peebler. In March 2004, the Company received final liquidation payments of $0.1 million from EVP and $0.01 million from Mr. Peebler.

(12)

Deferred Income Tax

     In 2002, the Company established an additional valuation allowance to reserve for substantially all of its net deferred tax assets. Subsequent to that date the Company has continued to record a valuation allowance for its net deferred assets, which are primarily net operating loss carryforwards. The establishment of this valuation allowance does not affect the Company’s ability to reduce future tax expense through utilization of prior years’ net operating losses. At March 31, 2004 and 2003, the unreserved deferred income tax asset of $1.1 million represents the Company’s prior alternative minimum tax payments that are recoverable through the carryback of net operating losses. Income tax expense of $0.6 million and $0.6 million for the three months ended March 31, 2004 and 2003, respectively, reflects state and foreign taxes.

     The valuation allowance was calculated in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes,” which places primary importance on the Company’s cumulative operating results in the most recent three-year period when assessing the need for a valuation allowance. The Company’s results for those periods were heavily affected by industry conditions, and deliberate and planned business restructuring activities in response to the prolonged downturn in the seismic equipment market, as well as heavy expenditures on research and development. Nevertheless, recent losses represented sufficient negative evidence to establish an additional valuation allowance. The Company has continued to reserve substantially all of its net deferred tax assets and will continue until there is sufficient positive evidence to warrant reversal.

(13)

Comprehensive Loss

     The components of comprehensive loss are as follows (in thousands):

(14)

Acquisitions

     In February 2004, the Company purchased all the share capital of Concept. Concept is a provider of software, systems and services for towed streamer, seabed and land seismic operations based in Edinburgh, Scotland. The purchase price was approximately $38.4 million in cash, including acquisition costs, and 1,680,000 shares of the Company’s common stock, valued at $10.8 million. The Company issued to certain key employees options to purchase up to 365,000 shares of its common stock for an exercise price of $6.42 per share. The options vest over a four-year period. The Company acquired Concept as part of its strategy to develop solutions that integrate complex data streams from multiple seismic sub-systems, including source, source control, positioning, and recording in all environments, including land, towed streamer, and seabed acquisition.

     The acquisition was accounted for by the purchase method, with the purchase price allocated to the fair value of assets purchased and liabilities assumed. As of March 31, 2004, the allocation of the purchase price was based upon a preliminary fair value study, which will be finalized in the second quarter of 2004. The allocation of the purchase price, including related direct costs, for the acquisition of Concept is as follows (in thousands):

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     The consolidated results of operations of the Company include the results of Concept from the date of acquisition. Pro forma results prior to the acquisition date were not material to the Company’s consolidated results of operations.

(15)

Restructuring Activities

     A summary of the Company’s restructuring programs is as follows (in thousands):