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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 SEPTEMBER 30, 2003

OR

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

COMMISSION FILE NUMBER 1-13402

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

At October 31, 2003 there were 51,245,334 shares of common stock, par value $0.01 per share, outstanding.

INPUT/OUTPUT, INC. AND SUBSIDIARIES

INDEX TO FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003

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INPUT/OUTPUT, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)

See accompanying Notes to Unaudited Consolidated Financial Statements.

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INPUT/OUTPUT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)

See accompanying Notes to Unaudited Consolidated Financial Statements.

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INPUT/OUTPUT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

See accompanying Notes to Unaudited Consolidated Financial Statements.

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INPUT/OUTPUT, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

(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, 2002 has been derived from the Company’s audited consolidated financial statements at that date. The consolidated balance sheet at September 30, 2003, the consolidated statements of operations for the three and nine months ended September 30, 2003 and 2002, and the consolidated statements of cash flows for the nine months ended September 30, 2003 and 2002 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 and nine months ended September 30, 2003 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. 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, 2002. Certain amounts previously reported in the consolidated financial statements have been reclassified to conform to the current period’s presentation.

(2)

Restructuring Activities

     In 2002, the Company initiated a restructuring program which included reducing its full-time headcount by approximately 300 positions and closing certain of its facilities and relocating those operations to other existing Company facilities or outsourcing those operations to contract manufacturers. In July 2003, the Company completed the move out of its Alvin, Texas manufacturing facility. See further discussion at Note 3 of Notes to Unaudited Consolidated Financial Statements. Additionally, in the first quarter of 2003, the Company relocated a majority of its geophone stringing operations from a leased facility in Norwich, U.K. to a leased facility in the United Arab Emirates.

     The Company has continued to evaluate its staffing needs and has eliminated approximately 60 positions from its full-time staff during the third quarter of 2003. The Company’s full-time headcount was 472 at September 30, 2003, down from 799 at January 1, 2002. The additional headcount reductions primarily related to manufacturing and research and development positions and resulted in additional severance charges of approximately $0.5 million in the third quarter of 2003. A summary of restructuring activities is as follows (in thousands):

     Of the total severance expense of $0.5 million for the three months ended September 30, 2003, $0.1 million was included in costs of sales and $0.4 million in research and development expenses. Of the total severance expense of $2.0 million for the nine months ended September 30, 2003, $0.7 million was included in costs of sales, $0.8 million in general and administrative expenses and $0.5 million in research and development expenses. The impact of severance costs on general and administrative expenses was partially offset by credits of $0.7 million for the cancellation of unvested restricted stock. Approximately $0.6 million of the severance expense included in the general and administrative expenses for the nine months ended September 30, 2003 was related to severance costs associated with the Company’s former President and Chief Operating Officer and the former Vice President of Business Development. These executive severance costs will be paid over a period of one year from the date of their departure.

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(3)

Net Assets Held for Sale

     In July 2003, the Company completed the move out of its Alvin, Texas manufacturing facility and is currently marketing the facility for sale. The facility and related land had a net carrying value of $2.4 million at September 30, 2003. In addition, during the third quarter of 2003, the Company listed for sale 16.75 acres of land which is located across from the Company’s headquarters in Stafford, Texas. The carrying value of the land is $0.9 million. These assets have been reclassified as “Held for Sale” under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

(4)

Impairment of Long-lived Assets

     During the quarter ended June 30 2003, the Company incurred a $2.5 million charge to cost of sales related to the write-down of rental equipment associated with the Company’s first generation radio-based VectorSeis® land acquisition systems. This equipment was being utilized in North America as part of the strategic marketing alliance between the Company and Veritas DGC Inc. In May 2003, the strategic marketing alliance was terminated, leading the Company to reassess the net realizable value of this equipment. As this equipment was an older generation of the Company’s technology, the Company determined that a write-down was appropriate.

     During the quarter ended March 31, 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 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 the first quarter of 2003. In addition, inventory associated with this project of $0.2 million was written off and included within research and development expenses at March 31, 2003.

     During the quarter ended September 30, 2002, the Company began the process of vacating its Alvin, Texas manufacturing facility. Due to the planned closure, the Company performed impairment test in accordance with SFAS No. 144. As a result of the impairment test, the facility and certain related manufacturing equipment were considered impaired and the Company recorded an impairment charge of approximately $5.3 million in the third quarter of 2002. The method of determining fair value was primarily based upon quoted market prices for the facility and forecasted negative cash flows during the interim period prior to closure. In addition, the Company recorded a charge of $0.6 million for the closure of its Louisville, Colorado facility, which primarily related to the future non-cancelable lease obligation.

(5)

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 11% 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 is accounted for under the cost method basis for investment accounting. Robert P. Peebler, the Company’s President and Chief Executive Officer, founded EVP in April 2001 and served as the President and Chief Executive Officer until joining I/O in March 2003. Mr. Peebler is currently the Chairman of EVP and holds a 23% ownership interest in EVP.

     During the second quarter, EVP failed to close two anticipated asset management agreements. Since that time, EVP has re-evaluated its business model and adequacy of capital. In August 2003, the Board of EVP voted to liquidate EVP as it was unable to present a clear and feasible business strategy. Therefore, in the second quarter the Company wrote its investment down to its approximate liquidation value of $1.0 million, resulting in a charge against earnings of $2.0 million. The Company’s share of the final liquidation payment is expected to be distributed in the fourth quarter of 2003. In order to avoid any potential conflict of interest concerns, Mr. Peebler has suggested and the Company has agreed that all proceeds he receives from the liquidation of EVP will be paid to the Company. This amount has been included in the Company’s estimate of liquidation value.

(6)

Stock-Based Compensation

     If the Company had elected to recognize compensation expense for equity incentives awarded to employees using a fair value approach, net loss, basic loss per share and diluted loss per share for the periods presented would have increased as follows (in thousands, except per share amounts):

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     Effective March 31, 2003, the Company granted its President and Chief Executive Officer stock options to purchase 1,325,000 shares of common stock of the Company at an exercise price of $6.00 per share under the Company’s 2003 Stock Option Plan (the “Plan”). The options vest in equal monthly installments over a three-year period beginning on the anniversary of the date of grant and have a term of ten years. The Plan was approved by the Company’s shareholders at the Company’s 2003 annual meeting of shareholders in June 2003.

(7)

Segment Information

     The Company evaluates and reviews results based on two segments, Land and Marine, 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 earnings (loss) from operations. A summary of segment information for the three and nine months ended September 30, 2003 and 2002 is as follows (in thousands):

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     Intersegment sales are insignificant for all periods presented. Corporate assets include all assets specifically related to corporate personnel and operations 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 destination is not known, it is based on the geographical location of initial shipment.

(8)

Inventories

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

     During the quarter 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 segment. See further discussion at Note 4 of Notes to Unaudited Consolidated Financial Statements. In addition, an unrelated inventory obsolescence charge of $0.3 million was reflected in cost of sales for the quarter ended March 31, 2003 related to the closure of the Company’s Alvin, Texas manufacturing facility. For the quarter ended September 30, 2003, the Company recorded an inventory obsolescence charge of approximately $0.3 million primarily related to inventory determined to be in excess of the Company’s near-term requirements. For the quarter ended September 30, 2002, the Company recorded an inventory obsolescence charge of approximately $3.8 million primarily related to the discontinuance of certain analog land seismic and marine positioning products.

     As part of the Company’s strategic direction, the Company is increasing the use of contract manufacturers as an alternative to in-house manufacturing. Under many of the Company’s outsourcing arrangements, its manufacturing partners first utilize the Company’s on-hand inventory, then directly purchase inventory at agreed-upon levels to meet the Company’s forecasted demand. If demand proves to be less than the Company originally forecasted, its manufacturing partners have the right to require the Company to purchase any excess or obsolete inventory that its partners purchased on their behalf. Should the Company be required to purchase

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inventory pursuant to these provisions, the Company may be required to expend large sums of cash for inventory that it may never utilize. Such purchases could materially and adversely effect the Company’s financial position and results of operations.

     At September 30, 2003, the Company had a commitment to purchase certain marine equipment for $3.0 million, which was subsequently purchased in October 2003. The non-cancelable purchase commitment was entered into for an anticipated sale. However, the potential customer ceased negotiations to purchase this inventory after that customer failed to be awarded an expected survey. The Company currently expects to sell a portion of this inventory in the fourth quarter of 2003, with the remainder of this inventory being sold throughout 2004.

(9)

Accounts and Notes Receivable

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

     A summary of notes receivable, accrued interest and allowance for loan loss is as follows (in thousands):

(10)

Goodwill

     In August 2003, the Company paid $1.3 million in additional consideration to the former shareholders of AXIS Geophysics, Inc. (“AXIS”) to settle all future contingent obligations. This additional consideration was recorded as an increase to goodwill. See further discussion at Note 16 of Notes to Unaudited Consolidated Financial Statements.

     During the quarter ended September 30, 2002, the Company performed an interim impairment test on the Company’s analog land products reporting unit. This reporting unit represents the Company’s traditional analog geophones, vehicles and vibrators, cables and connectors. The need for an interim impairment test was predicated upon the continuing weakness in the traditional analog land seismic markets and the precarious financial condition of many of the seismic contractors, coupled with an anticipated decrease in demand for analog products due to the success of the Company’s new VectorSeis digital sensor technology. The results of the impairment test indicated that all of the goodwill associated with the Company’s analog land products reporting unit was impaired. Therefore an impairment charge of $15.1 million was recorded for the quarter ended September 30, 2002. The Company determined the fair value of the reporting unit using a discounted future returns valuation method.

(11)

Non-Cash Activity

     During the nine months ended September 30, 2003, the Company transferred $1.9 million of inventory at cost to rental equipment in connection with leasing arrangements with marine customers and sold previously leased marine rental equipment to a customer via a note agreement for $1.4 million. In addition, the Company financed $1.9 million of insurance costs through the execution of short-term notes payable. See further discussion at Note 13 of Notes to Unaudited Consolidated Financial Statements.

     In August 2002, the Company repurchased all of the 40,000 outstanding shares of its Series B Convertible Preferred Stock and all of the 15,000 outstanding shares of its Series C Convertible Preferred Stock (the “Preferred Stock”). In exchange for the Preferred Stock, the Company paid $30.0 million in cash at closing, issued a $31.0 million unsecured promissory note due May 7, 2004 and granted warrants to purchase 2,673,517 shares of the Company’s common stock at $8.00 per share through August 5, 2005. See further discussion at Note 18 of Notes to Unaudited Consolidated Financial Statements.

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(12)

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. Basic and diluted loss per share are the same for the three months and nine months ended September 30, 2003 and 2002, as all potential common shares were anti-dilutive. In August 2002, the Company repurchased all the outstanding shares of Preferred Stock. As part of the repurchase the Company granted warrants to purchase 2,673,517 shares of the Company’s common stock at $8.00 per share through August 5, 2005. The warrants are considered anti-dilutive for all periods and are not included in the calculation of diluted loss per common share.

(13)

Long Term Debt and Lease Obligations

     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 are due on a monthly basis bearing an interest rate of 5.75%, with final payment due 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 these notes payable at September 30, 2003 was $1.5 million.

     In August 2002, in connection with the repurchase of 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%. Interest is payable in quarterly payments, with all principal and unpaid interest due on May 7, 2004. The Company records 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, recording the excess accrued interest of $0.3 million as an adjustment of interest expense in the second quarter of 2003. The excess accrued interest represents the recorded but unpaid interest on the note at its effective rate of approximately 11%, compared to the note’s initial stated rate of 8%. The note restricts cash dividends in excess of $5.0 million per year while the note is 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 is payable in quarterly payments of $0.2 million plus interest, with final payment due in July 2005. The unpaid balance at September 30, 2003 was $1.7 million.

     In August 2001, the Company sold its corporate headquarters and manufacturing facility located in Stafford, Texas for $21.0 million. Simultaneous to 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 pursuant to 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%. The unpaid balance at September 30, 2003 was $19.1 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 obligation. The Company failed to meet the tangible net worth requirements of 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. The deposit has been reflected as a long-term other asset.

     In January 2001, in connection with the acquisition of Pelton Company, Inc. (“Pelton”), the Company entered into a $3.0 million two-year unsecured promissory note payable to a former shareholder of Pelton, bearing interest at 8.5% per year. The note was paid in full in February 2003.

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

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(14)

Deferred Income Tax

     During the quarter ended September 30, 2002, the Company established an additional valuation allowance to fully reserve its net deferred tax assets and has continued to maintain a full valuation allowance. The Company’s net deferred assets 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. Income tax (benefit) expense of $(0.1) million and $0.2 million for the three months and nine months ended September 30, 2003, respectively, includes federal tax refunds of $0.6 million and $1.2 million, respectively, and state and foreign taxes as the Company continues to maintain a full valuation allowance for its net deferred tax assets. Additionally, the Company received foreign tax refunds of $1.7 million during the nine months ended September 30, 2003, which had been accrued as of December 31, 2002.

     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. Although management believes the Company’s results for those periods were heavily affected by both 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 technology, the Company’s cumulative loss in the most recent three-year period and the nine months ended September 30, 2003 represented sufficient negative evidence to establish an additional valuation allowance under the provisions of SFAS No. 109. The Company will maintain a full valuation allowance for its net deferred tax assets and net operating loss carryforwards until sufficient positive evidence exists to support reversal of the allowance.

(15)

Comprehensive Loss

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

(16)

Acquisitions

     In July 2002, the Company acquired all of the outstanding capital stock of AXIS for $2.5 million of cash and issued a $2.5 million three-year unsecured promissory note. Under the terms of the agreement the Company was obligated to pay additional consideration to the former shareholders of AXIS at an amount equal to 33.33% of AXIS’ adjusted EBITDA for the years ended December 31, 2003, 2004 and 2005, exceeding a minimum threshold of $1.0 million. In August 2003, the Company paid $1.3 million in additional consideration to the former shareholders of AXIS to settle all future contingent obligations. This additional consideration was recorded as an increase to goodwill. AXIS is a seismic data service company based in Denver, Colorado, which provides specialized seismic data processing and integration services to major and independent exploration and production companies. The AXIS Interpretation-Ready Process™ (“IRP”) integrates seismic and subsurface geological data to provide customers more accurate and higher quality data that can result in improved reservoir characterizations.

     In May 2002, the Company acquired certain assets of S/N Technologies (“S/N”) for $0.7 million of cash. The assets acquired from S/N included proprietary technology applicable to solid streamer products used to acquire 2D, 3D and high-resolution marine seismic data. However, in May 2003 the Company determined that it would no longer continue the internal development of the solid streamer project. As such, the acquired assets of S/N were impaired and other assets associated with this project were written off as of March 31, 2003. See further discussion of this impairment at Note 4 of Notes to Unaudited Consolidated Financial Statements.

     The acquisitions were accounted for by the purchase method, with the purchase price allocated to the fair value of assets purchased and liabilities assumed. The allocation of the purchase price, including related direct costs, for the acquisition of AXIS and S/N are as follows (in thousands):

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