UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

(Mark One)

 

 

K-TEL INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

 

 

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 ý     No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).

 

Yes o     No ý

 

As of May 17, 2004, there were 13,653,738 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

 

 

 

K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES

FORM 10-Q

 

FOR THE THREE AND NINE MONTH PERIODS

ENDED MARCH 31, 2004

 

INDEX

 

PART I. Financial Information (Unaudited):
	Item 1.	Financial Statements
		Condensed Consolidated Balance Sheets as of March 31, 2004 and June 30, 2003
		Condensed Consolidated Statements of Operations for the Three and Nine Month Periods Ended March 31, 2004 and 2003
		Condensed Consolidated Statements of Cash Flows for the Nine Month Periods Ended March 31, 2004 and 2003
		Notes to Condensed Consolidated Financial Statements
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk
	Item 4.	Controls and Procedures
PART II. Other Information:
	Item 1.	Legal Proceedings
	Item 6.	Exhibits and Reports on Form 8-K
SIGNATURES
INDEX TO EXHIBITS

 

Important Factors Relating to Forward Looking Statements

 

Certain statements of a non-historical nature under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Form 10-Q constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be identified by the use of terminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” “should,” or “continue” or the negative thereof or other variations thereon or comparable terminology. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or from those results currently anticipated or projected. Such factors include, among other things, the following: changes in consumer purchasing; demand for and market acceptance of new and existing products; the impact from competition for recorded music; the outcome of legal proceedings; dependence on suppliers and distributors; the outcome of our subsidiaries’ bankruptcy and liquidation; success of marketing and promotion efforts; technological changes and difficulties; availability of financing; foreign currency variations; general economic, political and business conditions; and other matters. We undertake no obligation to release publicly the result of any revisions to these forward-looking statements, except as required by law.

 

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K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS - UNAUDITED

(in thousands)

 

		March 31, 2004			June 30, 2003
ASSETS
Current Assets:
Cash and equivalents		$	113		$	1,219
Accounts receivable, net of allowance for doubtful accounts of $15 and $25		1,558			1,559
Inventories		626			520
Royalty advances		177			235
Prepaid expenses and other		366			304
Total Current Assets		2,840			3,837
Property and equipment, net of accumulated depreciation and amortization of $1,496 and $1,506		100			101
Owned catalog masters, net of accumulated amortization of $2,898 and $2,755		690			819
		$	3,630		$	4,757
LIABILITIES AND SHAREHOLDERS’ DEFICIT
Current Liabilities:
Notes payable to affiliate and other		$	11,250		$	11,515
Accounts payable		980			1,162
Accrued royalties		2,272			2,333
Reserve for returns		133			213
Net liabilities of discontinued operations		63			116
Total Current Liabilities		14,698			15,339
Shareholders’ Deficit:
Common stock – 50,000,000 shares authorized; par value $.01; 13,653,738 issued and outstanding		136			136
Additional paid-in capital		21,292			21,292
Accumulated deficit		(32,311		)	(31,759		)
Accumulated other comprehensive loss		(185		)	(251		)
Total Shareholders’ Deficit		(11,068		)	(10,582		)
		$	3,630		$	4,757

 

The accompanying notes are an integral part of these financial statements.

 

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K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS - UNAUDITED

(in thousands - except per share data)

 

		Three Months Ended March 31,						Nine Months Ended March 31,
		2004			2003			2004			2003
Net Sales		$	1,647		$	1,923		$	5,024		$	5,295
Costs and Expenses:
Cost of goods sold		798			990			2,327			2,486
Advertising		13			81			88			146
Selling, general and administrative		1,027			1,026			2,847			2,936
Total Costs and Expenses		1,838			2,097			5,262			5,568
Operating Loss		(191		)	(174		)	(238		)	(273		)
Other Expense:
Interest expense		(129		)	(130		)	(366		)	(399		)
Other		(8		)	(75		)	(19		)	(190		)
Total Other Expense		(137		)	(205		)	(385		)	(589		)
Loss from Continuing Operations		(328		)	(379		)	(623		)	(862		)
Loss from Discontinued Operations		(6		)	(60		)	(67		)	(474		)
Loss before Extraordinary Item		(334		)	(439		)	(690		)	(1,336		)
Extraordinary Item - Gain on Liquidation		138			—			138			—
Net Loss		$	(196	)	$	(439	)	$	(552	)	$	(1,336	)
Loss per Share – Basic and Diluted:
Continuing Operations		$	(.02	)	$	(.03	)	$	(.05	)	$	(.06	)
Discontinued Operations		—			—			—			(.04		)
Extraordinary Item		.01			—			.01			—
Net Loss		$	(.01	)	$	(.03	)	$	(.04	)	$	(.10	)
Shares used in the calculation of loss per share - Basic and Diluted		13,654			13,654			13,654			13,654
Comprehensive Loss:
Net loss		$	(196	)	$	(439	)	$	(552	)	$	(1,336	)
Translation adjustment		31			(17		)	72			(63		)
Other Loss		(2		)	—			(6		)	—
Comprehensive Loss		$	(167	)	$	(456	)	$	(486	)	$	(1,399	)

 

The accompanying notes are an integral part of these financial statements.

 

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K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - UNAUDITED

(in thousands)

 

		Nine Months Ended March 31,
		2004			2003
Cash flows from Operating Activities:
Net loss		$	(552	)	$	(1,336	)
Adjustments to reconcile net loss to cash provided by (used in) operating activities:
Depreciation and amortization		191			246
Discontinued Operations		(6		)	4
Changes in operating assets and liabilities:
Accounts receivable, net		355			(400		)
Inventories		(85		)	63
Royalty advances		83			46
Prepaid expenses		(47		)	(66		)
Accounts payable		(534		)	250
Accrued royalties		(57		)	14
Reserve for returns		(76		)	177
Cash used in operating activities		(728		)	(1,002		)
Cash flows provided by (used in) Investing Activities:
Purchases of property and equipment		(54		)	(14		)
Proceeds from sale of property and equipment		8			15
Cash provided by (used in) investing activities		(46		)	1
Cash flows from Financing Activities:
Borrowings on notes payable		2,070			2,016
Payments on notes payable		(2,359		)	(917		)
Cash provided by (used in) financing activities		(289		)	1,099
Effect of exchange rates on cash		(43		)	(90		)
Net increase (decrease) in cash and equivalents		(1,106		)	8
Cash and equivalents at beginning of period		1,219			75
Cash and equivalents at end of period		$	113		$	83

 

The accompanying notes are an integral part of these financial statements.

 

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K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

1.             BUSINESS AND LIQUIDITY

 

K-tel International, Inc. (the “Company” or “K-tel”) was incorporated in 1968 and currently has its corporate offices located in Plymouth, Minnesota. Through its operating subsidiaries, K-tel licenses its music catalog internationally and markets entertainment products mainly derived from its catalog through retail and direct response marketing channels in the United States and Europe. The Company has a focused method of distribution that targets the strengths of selected individual retailers and supplies products suited to each retailer’s needs. These products are derived mainly from the Company’s master recordings music catalog with the objective of realizing more competitive profit margins. K-tel seeks to license its trademarks to other companies in businesses unrelated to K-tel’s current operations. Licenses are granted for a royalty or fee, with no cost to the Company. The Company has licensed certain marks to K-tel Drug Mart Ltd., a Canadian direct marketer of prescription drugs beneficially owned by Philip Kives, the Chairman of the Board, President and Chief Executive Officer of K-tel.  K-tel is merely a licensor of its mark to K-tel Drug Mart. To date, K-tel Drug Mart’s operations have not generated any significant licensing revenues for the Company.

 

Discontinued Operations

 

The Company’s consumer products business, which was concentrated in Europe, consisted primarily of housewares, consumer convenience items and exercise equipment. The Company discontinued its consumer products operations in Germany, the United Kingdom and the United States in June 2000, November 2000 and January 2001 respectively. Accordingly, these activities have been presented in the accompanying financial statements as discontinued operations. The accompanying condensed consolidated financial statements have been prepared to reflect the consumer products division as a discontinued operation. The net liabilities of discontinued operations at March 31, 2004 and 2003 and ongoing current expenses relate to legal matters and completion of statutory reporting requirements for the former operations in Germany.

 

Going Concern

 

During the nine months ended March 31, 2004 and 2003, the Company incurred net losses from continuing operations of $623,000 and $862,000 respectively. Operating activities used $728,000 and $1,002,000 of cash during the nine months ended March 31, 2004 and 2003 respectively. Additionally, the Company had a working capital deficit of $11,858,000 at March 31, 2004.

 

The Company’s ability to continue its present operations and implement future expansion plans successfully is contingent mainly upon its ability to maintain its line of credit arrangements with K-5 Leisure Products, Inc. (See Note 3), increase its revenues and profit margins, and ultimately attain and sustain profitable operations. Without increased revenues and sustained profitability, the cash generated from the Company’s current operations will likely be inadequate to fund operations and service its indebtedness on an ongoing basis. Management is focusing its efforts on music licensing and limited music distribution. However, there can be no assurance that the Company will achieve profitable operations through these efforts. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.

 

2.             BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation - The accompanying condensed consolidated unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by US GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year as a whole. The unaudited condensed consolidated balance sheet for June 30, 2003 has been derived from audited consolidated

 

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financial statements as of that date. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended June 30, 2003.

 

Principles of Consolidation - The accompanying condensed consolidated financial statements include the accounts of K-tel International, Inc. and its domestic and foreign subsidiaries, all of which are wholly owned. All significant intercompany accounts and transactions have been eliminated.

 

Revenue Recognition – The Company derives its revenue mainly from two sources: the sale of music compilations (predominately compact discs) produced by the Company, and license revenue from the licensing of Company-owned masters. Revenue from music sales is recognized at the time of shipment to the customer, while license revenue is recognized when payment is received from customers or when known amounts are receivable, as prior to that date collection is not considered probable. Most music sales are made with a right of return of unsold goods. Estimated reserves for returns are established by management based upon historical experience and product mix and are subject to ongoing review and adjustment by the Company. These reserves are recorded at the time of sale and are reflected as a reduction in revenues. The Company’s reserve for returns was $133,000 at March 31, 2004 and $213,000 at June 30, 2003.

 

Cost of Goods Sold – The Company expenses all product manufacturing, distribution and royalty costs associated with music sales as cost of goods sold. The Company also expenses royalties, commissions and amortization of its owned master recordings associated with its license revenue as costs of goods sold.

 

Shipping and Handling Costs – The Company expenses within cost of goods sold all shipping and handling costs incurred in the shipment of goods.

 

Cash and Cash Equivalents – Cash and cash equivalents consist principally of cash and short-term, highly liquid investments with original maturities of less than ninety days.

 

Inventories – Inventories, which consists of finished goods that include all direct product costs, are valued at the lower of cost, determined on a first-in, first-out basis, or net realizable value.

 

Owned Catalog Masters – The Company capitalizes the costs to purchase owned master recordings at the time of acquisition. These costs are amortized over the estimated useful life of these master recordings, which is generally seven years, and represents management’s best estimate of the average period of value.

 

Rights to Use Music Product - Certain of the Company’s compilation products are master recordings under license from record companies and publishers. In most instances, minimum guarantees or non-refundable advances are required to obtain the licenses and are realized through future sales of the product. The amounts paid for minimum guarantees or non-refundable advances are capitalized and charged to expense as sales are made. The unrealized portion of guarantees and advances is included in royalty advances in the accompanying consolidated balance sheets. Licenses are subject to audit by licensors. When anticipated sales appear to be insufficient to fully recover the minimum guarantees or non-refundable advances, a provision against current operations is made for anticipated losses.

 

Property and Equipment - Property and equipment are stated at cost. Depreciation and amortization is provided using straight line or declining balance methods over the estimated useful lives of the assets, which range from three to nine years.

 

Long Lived-Assets – The Company evaluates its long-lived assets quarterly, or earlier if a triggering event occurs, to determine potential impairment by comparing the carrying value of those assets to the related undiscounted future cash flows of the assets. If an asset is determined to be impaired, it is written down to its estimated fair value.

 

Royalties - The Company has entered into license agreements with various record companies and publishers under which it pays royalties on units sold. The Company accrues royalties using contractual rates and certain estimated rates on applicable units sold. The contractual royalty liability is computed quarterly and the accrued royalty balance is adjusted accordingly. The royalty agreements are subject to audit by licensors.

 

Advertising - The Company expenses the costs of advertising when the advertising takes place. Advertising expenses were $88,000 and $146,000 for the nine month periods ended March 31, 2004 and 2003 respectively.

 

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Foreign Currency - The operations of foreign subsidiaries are measured in local currencies. Assets and liabilities are translated into U.S. dollars at period-end exchange rates. Revenues and expenses are translated at the average exchange rates prevailing during the period. Adjustments resulting from translating the financial statements of foreign entities into U.S. dollars are recorded as a component of accumulated other comprehensive income or loss.

 

Stock-based Compensation – The Company accounts for stock-based awards to employees using the intrinsic value method prescribed in APB No. 25, “Accounting for Stock Issued to Employees,” whereby the options are granted at market price, and therefore no compensation costs are recognized. The Company has elected to retain its current method of accounting as described above and has adopted the SFAS Nos. 123 and 148 disclosure requirements. If compensation expense for the Company’s various stock option plans had been determined based upon the projected fair values at the grant dates for awards under those plans in accordance with SFAS No. 123, the Company’s pro-forma net earnings, basic and diluted earnings per common share would have been as follows:

 

		Three Months Ended March 31,						Nine Months Ended March 31,
		2004			2003			2004			2003
Net Loss (in thousands)
As reported		$	(196	)	$	(439	)	$	(552	)	$	(1,336	)
Pro forma		$	(196	)	$	(472	)	$	(659	)	$	(1,435	)
Basic and Diluted EPS
As reported		$	(.01	)	$	(.03	)	$	(.04	)	$	(.10	)
Pro forma		$	(.01	)	$	(.03	)	$	(.05	)	$	(.11	)

 

Stock Option Exchange – On March 18, 2003, a committee of the Company’s board of directors comprised solely of independent directors, approved a “Stock Option Exchange Program.” The Program provided for a small number of optionees who were previously awarded options to purchase shares of common stock under the Company’s 1997 Stock Option Plan to exchange them voluntarily for options to purchase an equal number of shares outside the Company’s Stock Option Plan. Options to purchase an aggregate of 2,137,939 shares of common stock, with a weighted average price per share of $5.95, were submitted for cancellation. Replacement options were proposed to be issued six months and one day after the date of cancellation of the existing options and were to be at an exercise price per share equal to the fair market value of the Company’s common stock as quoted on the OTC Bulletin Board on the date of grant and expire ten years after the date of grant. On November 18, 2003, the replacement options were issued at a price per share of $.08. There will be no compensation expense recognized as a result of this exchange.

 

Income Taxes - Deferred income taxes are provided for temporary differences between the financial reporting basis and tax basis of the Company’s assets and liabilities at currently enacted tax rates. A valuation allowance equal to the aggregate amount of deferred tax assets is established when realization is not likely.

 

Net Income (Loss) Per Share - The Company’s basic net earnings (loss) per share amounts have been computed by dividing net earnings (loss) by the weighted average number of outstanding common shares. Diluted net earnings (loss) per share amounts have been computed by dividing net earnings (loss) by the weighted average number of outstanding common shares and common share equivalents relating to the stock options, when dilutive.

 

For the nine month period ended March 31, 2004 and 2003, weighted average options to purchase 132,900 and 2,312,876 shares of common stock, with weighted average exercise prices of $6.37 and $5.79 were excluded from the computation of common share equivalents for the respective periods as their exercise prices were higher than the average fair market value of the common shares during the reporting period. For the three month periods ended March 31, 2004 and 2003, weighted average options to purchase 132,900 and 2,583,839 shares of common stock, with weighted average exercise prices of $6.37 and $5.19 were excluded from the computation of common share equivalents for the respective periods as their exercise prices were higher than the average fair market value of the common shares during the reporting period. Had net income been achieved, approximately 1,282,095 and 367,211 of common stock equivalents would have been included in the computation of diluted net income per share for the three and nine months ended March 31, 2004.

 

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Use of Estimates - Preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (US GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Principal estimates include allowances for bad debt, inventory valuation, return reserves, royalty obligations, purchase commitments and product replacement costs. Actual results could differ from those estimates used by management.

 

3.             LOANS PAYABLE TO AFFILIATE

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc. (“K-5”), the Company’s largest shareholder controlled by Philip Kives, the Chairman of the Board, President and Chief Executive Officer of K-tel. Under the terms of the agreement (the “K-5 Facility”), K-5 has agreed to make available up to $8,000,000 to K-tel on a revolving basis. The loan bears interest at a variable rate based upon the “base rate” of a nationally recognized lending institution (4.0% at March 31, 2004), expires July 20, 2005, and is subordinated to the Foothill loan (see below). The K-5 Facility contains the same covenants as the Foothill loan agreement. K-tel has pledged the stock of its foreign subsidiaries as collateral for the loan, and the loan carries a subordinated position to the Foothill loan on all other assets of the Company. K-tel had outstanding balances of $7,156,000 and $7,282,000 as of March 31, 2004 and June 30, 2003 respectively under the K-5 Facility. At March 31, 2004, K-tel obtained a waiver from K-5 for its non-compliance under the covenants, limitations and restrictions of the credit agreement.

 

In addition, K-tel has a second loan agreement with K-5, under which K-5 assumed rights and obligations under a loan from the Company’s former banker (Foothill Capital Corporation) pursuant to an Assignment and Acceptance Agreement dated February 27, 2001. This Foothill loan, which has been extended through July 20, 2005, provides for a $10,000,000 credit facility consisting of a $4,000,000 term loan due upon expiration, and a $6,000,000 revolving facility under which borrowings are limited to a percent of eligible receivables. Borrowings under the facility bear interest at a variable rate based on a “base rate” of a nationally recognized lending institution plus 1% (5.0% at March 31, 2004) and are collateralized by the assets of certain Company subsidiaries in the United States, including accounts receivable, inventories, equipment, music library and general intangibles. The loan agreement contains certain financial and other covenants or restrictions, including the maintenance of a minimum shareholders’ equity by K-tel, limitations on capital expenditures, restrictions on music library acquisitions, limitations on other indebtedness and restrictions on dividends paid by K-tel. As of March 31, 2004 and June 30, 2003, $4,000,000 was outstanding under the term loan and there were no borrowings under the revolving facility. At March 31, 2004, K-tel obtained a waiver from K-5 for its non-compliance under the covenants, limitations and restrictions of the credit agreement.

 

K-tel has an overdraft privilege borrowing facility with The Royal Bank of Scotland in the United Kingdom. This facility is secured by a standby letter of credit for $125,000 provided by K-tel International Ltd., a Canadian company controlled by Philip Kives and is payable on demand in accordance with normal banking practices. Borrowings bear interest of 2.0% per annum over the base rate (a total of 6.0% at March 31, 2004) but are subject to a minimum of 6.0% per annum. K-tel had outstanding balances of $94,000 and $233,000 as of March 31, 2004 and June 30, 2003 respectively.

 

4.             COMMITMENTS AND CONTINGENCIES

 

RTL Shopping  S. A.

 

The Company has been named in a lawsuit filed in France brought by RTL9, a French cable TV station. The action seeks damages in the approximate amount of 20 million French Francs, or approximately $2.8 million. Initially, RTL9 was named as a defendant in a suit brought by a competitor of K-tel Marketing Ltd. alleging that RTL9 ran a commercial for K-tel Marketing which presented a product under brand names alleged to infringe on the competitor’s own trademarks and also translated an English language script indicating that the product was “just like” or “as good as” others into “better than” in French, contrary to French law. The suit alleged trademark infringement, unfair competition, illicit comparative advertising and passing off. RTL9 then sued K-tel Marketing on October 4, 2000, pursuant to an indemnification provision the parties had entered into. Subsequently, K-tel Marketing went into liquidation and RTL9 filed a suit in March 2000 against K-tel International, Inc. under its agreement to guarantee payment for the commercial time. On May 28, 2001, RTL9 presented documents in court identifying K-tel International (USA), Inc. as a target of its claim. On September 3, 2001, the Company filed documents disputing the claim and advising the court of K-tel (USA)’s Chapter 7 bankruptcy filing.

 

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After the Company advised the Court that RTL9 had no basis for a complaint against the Company, RTL9 proposed to drop their lawsuit. On September 23, 2003, RTL9 and the Company signed an agreement terminating the suit. The final disposition of the lawsuit will be confirmed by the Court at a trial hearing involving only the two remaining parties to the lawsuit. A trial date has not been set by the Court.

 

K-tel International, Inc. vs. Tristar Products, Inc.

 

On March 14, 2000, K-tel and its subsidiary in Germany commenced an action for breach of express and implied warranties against Defendant Tristar Products, Inc. This action is venued in the United States District Court for the District of Minnesota. This action arises out of Tristar’s sale to K-tel of a defective home exercise product called the “BunBlaster” for resale in Germany, Austria and Switzerland. By written contract, Tristar has agreed to indemnify K-tel for injuries and damages arising out of the resale of those goods. K-tel is seeking approximately $2 million in consequential damages. Tristar is vigorously defending this claim. Discovery has been completed. Tristar filed a Motion for Summary Judgment, to which the Company filed a Memorandum in Opposition. This motion was heard in U.S. District Court in Minneapolis on August 25, 2003. The Court issued its order denying the motion on January 29, 2004. The parties are now waiting for a trial date to be set by the Court.

 

On April 30, 2001, Tristar also asserted a patent and trademark/ trade-dress counterclaim against K-tel for allegedly passing off a product called the “K-tel Hook and Hang” while allegedly a distributor of the original patented Tristar Hook and Hang product. The Company denies the allegation because it never was a distributor of this or any similar product and intends to defend this action vigorously. Tristar has not identified the amount of damages it seeks with respect to this counterclaim. The United States District Court for the District of Minnesota issued an order on August 14, 2001 severing this action from the Company’s action. This action is at an early stage and no discovery or other actions have occurred.

 

Other Litigation and Disputes

 

K-tel and its subsidiaries are also involved in other legal actions in the ordinary course of their business. With all litigation matters, management considers the likelihood of loss based on the facts and circumstances. If management determines that a loss is probable and the amount of loss can be reasonably estimated, such amount is recorded as a liability. Although the outcome of any such legal actions cannot be predicted, in the opinion of management there is currently no legal proceeding pending or asserted against or involving K-tel for which the outcome is likely to have a material adverse effect upon the consolidated financial position or results of operations of K-tel.

 

Subsidiary’s Liquidation

 

In November 2000, the Company’s consumer products subsidiary in the United Kingdom, K-tel Marketing Ltd., ceased operations and began voluntary liquidation proceedings. At the initial meeting of the creditors on November 24, 2000, the creditors voted for the liquidation to become a creditors’ liquidation under English law. The Company has not been informed by the liquidators or their counsel of any plan to attempt to hold it or any of its subsidiaries liable for any of the commitments of K-tel Marketing Ltd. Management believes the Company will have no ongoing material liability related to K-tel Marketing Ltd. as a result of the liquidation proceeding. As the only secured creditor, the Company received a preliminary distribution of approximately $138,000 on March 1, 2004.

 

5.             BUSINESS SEGMENT AND GEOGRAPHIC AREA DATA

 

The Company markets and distributes entertainment products internationally and through its operating subsidiaries. K-tel’s businesses are organized, managed and internally reported as two segments: retail music sales and music licensing. These segments are based on differences in products, customer type and sales and distribution methods. The Company’s consumer product and e-commerce operations have been discontinued, are presented in the accompanying financial statements as discontinued operations and are therefore not included in the segment information.

 

The retail music segment consists primarily of the sales of pre-recorded music both from the Company’s master music catalog and under licenses obtained from other record companies. The Company sells compact discs and DVD’s directly to retailers, wholesalers and rack service distributors which stock and manage inventory within music departments for retail stores.

 

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In the licensing segment, the Company licenses the rights to its master music catalog, consisting of original recordings and re-recordings of music from the 1950’s through today, to third parties world-wide for use in albums, films, television programs, and commercials for either a flat fee or a royalty based on the number of units sold.

 

Operating profits or losses of these segments include an allocation of general corporate expenses. Depreciation and amortization and capital additions are not significant and have therefore been excluded from the presentation.

 

Certain financial information on the Company’s continuing operating segments is as follows:

 

BUSINESS SEGMENT INFORMATION

 

(in thousands)			Music			Licensing			Other			Corporate Elimination			Total Company
Nine Months Ended March 31,
Net Sales	2004		$	3,694		$	1,330		$	—		$	—		$	5,024
	2003		3,569			1,726			—			—			5,295
Operating Income (Loss)	2004		$	(369	)	$	131		$	—		—			$	(238	)
	2003		(588		)	315			—			—			(273		)
Assets	2004		$	2,749		$	726		$	155		$	—		$	3,630
	2003		3,045			1,014			358			—			4,417
Three Months Ended March 31,
Net Sales	2004		$	1,197		$	450		$	—		$	—		$	1,647
	2003		1,385			538			—			—			1,923
Operating Income (Loss)	2004		$	(223	)	$	32		$	—		$	—		$	(191	)
	2003		(183		)	9			—			—			(174		)

 

GEOGRAPHIC INFORMATION

 

(in thousands)			United States			Europe			Total
Nine Months Ended March 31,
Net Sales	2004		$	2,887		$	2,137		$	5,024
	2003		3,320			1,975			5,295
Assets	2004		$	2,239		$	1,391		$	3,630
	2003		3,015			1,402			4,417
Three Months Ended March 31,
Net Sales	2004		$	865		$	782		$	1,647
	2003		1,240			683			1,923

 

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ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

GENERAL

 

Through its operating subsidiaries, K-tel licenses its music catalog internationally and markets entertainment products mainly derived from its catalog in the United States and Europe through retail and direct response marketing channels.

 

Through a subsidiary, K-tel Entertainment, Inc., K-tel has a focused method of distribution that targets the strengths of selected individual retailers and supplies products suited to each retailer’s specific needs. These products are primarily derived from the Company’s master recordings music catalog with the objective of realizing more competitive profit margins. As well, the Company seeks to license its name and marks to other businesses for a royalty or fee.

 

THREE MONTHS ENDED MARCH 31, 2004 VERSUS MARCH 31, 2003

 

Net sales for the three month period ended March 31, 2004 were $1,647,000 a decrease of 14.4% from net sales of $1,923,000 for the three month period ended March 31, 2003. This decrease reflected lower sales of both music and licensing. The net loss for the three month period ended March 31, 2004 was $196,000, or $.01 per share, compared to a net loss of $439,000, or $.03 per share, for the three month period ended March 31, 2003.

 

General corporate expenses of $242,000 and $179,000 for the three month periods ended March 31, 2004 and 2003 respectively have been allocated to the segments.

 

The following sections discuss the results of continuing operations by business segment.

 

BUSINESS SEGMENT RESULTS

 

Music

 

Sales in the music segment were $1,197,000 for the three month period ended March 31, 2004 compared to $1,385,000 for the three month period ended March 31, 2003, a decrease of $188,000, or 13.6%. The overall decrease resulted mainly from reduced sales to our UK-based exporters whose sales have been affected by the increased strength of the British pound.

 

Cost of goods sold in the music segment decreased to 61.6% of sales for the three month period ended March 31, 2004 compared to 64.6% of sales for the three month period ended March 31, 2003 reflecting increased margins on UK sales. Advertising expenses within the segment, which consists primarily of co-operative advertising payments, trade advertising and promotions, decreased to $13,000 for the three month period ended March 31, 2004 compared to $81,000 for the three month period ended March 31, 2003.

 

Selling, general and administrative expenses were $669,000, or 55.9% of sales for the three month period ended March 31, 2004 compared to $590,000, or 42.6% of sales for the three month period ended March 31, 2003. The increase was mainly a result of income tax and information services reviews completed during the quarter.

 

As a result, the music segment incurred an operating loss of $223,000 for the three month period ended March 31, 2004 compared to an operating loss of $183,000 for the three month period ended March 31, 2003.

 

Licensing

 

Licensing revenue was $450,000 for the three month period ended March 31, 2004 compared to $538,000 for the three month period ended March 31, 2003, a decrease of 16.4% reflecting reduced licensing activity. Operating income in the licensing segment was $32,000 for the three month period ended March 31, 2004 compared to operating income of $9,000 for the three month period ended March 31, 2003, an increase of 255.6%, reflecting costs incurred in the previous year related to audits of the licensees of the Company’s music catalog.

 

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NINE MONTHS ENDED MARCH 31, 2004 VERSUS MARCH 31, 2003

 

Net sales for the nine month period ended March 31, 2004 were $5,024,000 a decrease of 5.1% from net sales of $5,295,000 for the nine month period ended March 31, 2003. This decrease was attributed to a decrease in licensing revenue. The net loss for the nine month period ended March 31, 2004 was $552,000, or $.04 per share, compared to a net loss of 1,336,000, or $.10 per share, for the nine month period ended March 31, 2003.

 

General corporate expenses of $673,000 and $631,000 for the nine month periods ended March 31, 2004 and 2003 respectively have been allocated to the segments.

 

The following sections discuss the results of continuing operations by business segment.

 

BUSINESS SEGMENT RESULTS

 

Music

 

Sales in the music segment were $3,694,000 for the nine month period ended March 31, 2004 compared to $3,569,000 for the nine month period ended March 31, 2003, an increase of $125,000, or 3.5%. This increase was primarily attributed to an increase in DVD sales.

 

Cost of goods sold in the music segment decreased to 57.0% of sales for the nine month period ended March 31, 2004 compared to 60.4% of sales for the nine month period ended March 31, 2003 reflecting cost containment efforts in the English operations. Advertising expenses within the segment, which consists primarily of co-operative advertising payments, trade advertising and promotions, decreased to $73,000 for the nine month period ended March 31, 2004 compared to $166,000 for the nine month period ended March 31, 2003.

 

Selling, general and administrative expenses were $1,868,000 or 50.6% of sales for the nine month period ended March 31, 2004 compared to $1,898,000, or 53.2% of sales for the nine month period ended March 31, 2003. The primary reason for the decrease was the discontinuation of unprofitable product lines in England along with continued staff and cost reductions in the U.S. and England.

 

As a result, the music segment incurred an operating loss of $369,000 for the nine month period ended March 31, 2004 compared to an operating loss of $588,000 for the nine month period ended March 31, 2003.

 

Licensing

 

Licensing revenue was $1,330,000 for the nine month period ended March 31, 2004 compared to $1,726,000 for the nine month period ended March 31, 2003, a decrease of 22.9% reflecting reduced domestic licensing activity that was partially offset by increased licensing in England. The Company is concentrating its efforts on developing licensing arrangements in several other segments of the entertainment industry.

 

Royalty costs within the segment increased to $539,000 for the nine month period ended March 31, 2004 compared to $467,000 for the nine month period ended March 31, 2003. Decreased royalty costs resulting from the decrease in licensing revenue were more than offset by increased costs related to a significant increase in the use of the Company’s catalog by the English operation.

 

Selling, general and administrative expenses decreased to $978,000 for the nine month period ended March 31, 2004 compared to $1,079,000 for the nine month period ended March 31, 2003, a decrease of 9.4% reflecting audit costs incurred in the previous period and reduced amortization of owned master recordings as the masters become fully amortized.

 

Operating income in the licensing segment was $131,000 for the nine month period ended March 31, 2004 compared to $315,000 for the nine month period ended March 31, 2003, a decrease of 58.4%.

 

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LIQUIDITY AND CAPITAL RESOURCES

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc. (“K-5”), the Company’s largest shareholder controlled by Philip Kives, the Chairman of the Board, President and Chief Executive Officer of K-tel. Under the terms of the agreement (the “K-5 Facility”), K-5 has agreed to make available up to $8,000,000 to K-tel on a revolving basis. The loan bears interest at a variable rate based upon the “base rate” of a nationally recognized lending institution (4.0% at March 31, 2004), expires July 20, 2005, and is subordinated to the Foothill loan (see below). The K-5 Facility contains the same covenants as the Foothill loan agreement. K-tel has pledged the stock of its foreign subsidiaries as collateral for the loan, and the loan carries a subordinated position to the Foothill loan on all other assets of the Company. K-tel had outstanding balances of $7,156,000 and $7,282,000 as of March 31, 2004 and June 30, 2003 respectively under the K-5 Facility. At March 31, 2004, K-tel obtained a waiver from K-5 for its non-compliance under the covenants, limitations and restrictions of the credit agreement.

 

In addition, K-tel has a second loan agreement with K-5, under which K-5 assumed rights and obligations under a loan from the Company’s former banker (Foothill Capital Corporation) pursuant to an Assignment and Acceptance Agreement dated February 27, 2001. This Foothill loan, which has been extended through July 20, 2005, provides for a $10,000,000 credit facility consisting of a $4,000,000 term loan due upon expiration, and a $6,000,000 revolving facility under which borrowings are limited to a percent of eligible receivables. Borrowings under the facility bear interest at a variable rate based on a “base rate” of a nationally recognized lending institution plus 1% (5.0% at March 31, 2004) and are collateralized by the assets of certain Company subsidiaries in the United States, including accounts receivable, inventories, equipment, music library and general intangibles. The loan agreement contains certain financial and other covenants or restrictions, including the maintenance of a minimum shareholders’ equity by K-tel, limitations on capital expenditures, restrictions on music library acquisitions, limitations on other indebtedness and restrictions on dividends paid by K-tel. As of March 31, 2004 and June 30, 2003, $4,000,000 was outstanding under the term loan and there were no borrowings under the revolving facility. At March 31, 2004, K-tel obtained a waiver from K-5 for its non-compliance under the covenants, limitations and restrictions of the credit agreement.

 

K-tel has an overdraft privilege borrowing facility with The Royal Bank of Scotland in the United Kingdom. This facility is secured by a standby letter of credit for $125,000 provided by K-tel International Ltd., a Canadian company controlled by Philip Kives and is payable on demand in accordance with normal banking practices. Borrowings bear interest of 2.0% per annum over the base rate (a total of 6.0% at March 31, 2004) but are subject to a minimum of 6.0% per annum. K-tel had outstanding balances of $94,000 and $233,000 as of March 31, 2004 and June 30, 2003 respectively.

 

K-tel has primarily funded its operations to date through internally generated capital, proceeds from stock option exercises and secured loans from K-5. Management currently believes that K-tel has sufficient cash and borrowing capacity to ensure the Company will continue operations in the near term. In part, this is a result of improvement in operating results in fiscal 2003 as well as the two existing lines of credit with K-5. Although K-5 continues to advance funds sufficient to meet the Company’s needs at this time, there can be no assurance that this will be adequate or continue in the future or that K-tel will be able to obtain additional financing upon favorable terms when required.

 

The Company’s ability to continue its present operations and implement future expansion plans successfully is contingent mainly upon its ability to maintain its line of credit arrangements with K-5, increase its revenues and profit margins, and ultimately attain and sustain profitable operations. Without increased revenues and sustained profitability, the cash generated from the Company’s current operations will likely be inadequate to fund operations and service its indebtedness on an ongoing basis. Management is focusing its efforts on music licensing and limited music distribution. However, there can be no assurance that the Company will achieve profitable operations through these efforts. In the event the Company is unable to fund its operations and implement its current business plan properly, it may be unable to continue operations. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.

 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

There have been no material changes in the Company’s market risk during the nine month period ended March 31, 2004. For additional information, refer to page 15 of the Company’s annual report on Form 10-K for the fiscal year ended June 30, 2003.

 

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ITEM 4.  CONTROLS AND PROCEDURES

 

Under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Chief Financial Officer, the Company evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are adequately designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms.

 

During the Company’s most recent fiscal quarter, there has been no change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II

 

ITEM 1. LEGAL PROCEEDINGS

 

RTL Shopping  S. A.

 

The Company has been named in a lawsuit filed in France brought by RTL9, a French cable TV station. The action seeks damages in the approximate amount of 20 million French Francs, or approximately $2.8 million. Initially, RTL9 was named as a defendant in a suit brought by a competitor of K-tel Marketing Ltd. alleging that RTL9 ran a commercial for K-tel Marketing which presented a product under brand names alleged to infringe on the competitor’s own trademarks and also translated an English language script indicating that the product was “just like” or “as good as” others into “better than” in French, contrary to French law. The suit alleged trademark infringement, unfair competition, illicit comparative advertising and passing off. RTL9 then sued K-tel Marketing on October 4, 2000, pursuant to an indemnification provision the parties had entered into. Subsequently, K-tel Marketing went into liquidation and RTL9 filed a suit in March 2000 against K-tel International, Inc. under its agreement to guarantee payment for the commercial time. On May 28, 2001, RTL9 presented documents in court identifying K-tel International (USA), Inc. as a target of its claim. On September 3, 2001, the Company filed documents disputing the claim and advising the court of K-tel (USA)’s Chapter 7 bankruptcy filing.

 

After the Company advised the Court that RTL9 had no basis for a complaint against the Company, RTL9 proposed to drop their lawsuit. On September 23, 2003, RTL9 and the Company signed an agreement terminating the suit. The final disposition of the lawsuit will be confirmed by the Court at a trial hearing involving only the two remaining parties to the lawsuit. A trial date has not been set by the Court.

 

K-tel International, Inc. vs. Tristar Products, Inc.

 

On March 14, 2000, K-tel and its subsidiary in Germany commenced an action for breach of express and implied warranties against Defendant Tristar Products, Inc. This action is venued in the United States District Court for the District of Minnesota. This action arises out of Tristar’s sale to K-tel of a defective home exercise product called the “BunBlaster” for resale in Germany, Austria and Switzerland. By written contract, Tristar has agreed to indemnify K-tel for injuries and damages arising out of the resale of those goods. K-tel is seeking approximately $2 million in consequential damages. Tristar is vigorously defending this claim. Discovery has been completed. Tristar filed a Motion for Summary Judgment, to which the Company filed a Memorandum in Opposition. This motion was heard in U.S. District Court in Minneapolis on August 25, 2003. The Court issued its order denying the motion on January 29, 2004. The parties are now waiting for a trial date to be set by the Court.

 

On April 30, 2001, Tristar also asserted a patent and trademark/ trade-dress counterclaim against K-tel for allegedly passing off a product called the “K-tel Hook and Hang” while allegedly a distributor of the original patented Tristar Hook and Hang product. The Company denies the allegation because it never was a distributor of this or any similar product and intends to defend this action vigorously. Tristar has not identified the amount of damages it seeks with respect to this counterclaim. The United States District Court for the District of Minnesota issued an order on

 

15

 

August 14, 2001 severing this action from the Company’s action. This action is at an early stage and no discovery or other actions have occurred.

 

Other Litigation and Disputes

 

K-tel and its subsidiaries are also involved in other legal actions in the ordinary course of their business. With all litigation matters, management considers the likelihood of loss based on the facts and circumstances. If management determines that a loss is probable and the amount of loss can be reasonably estimated, such amount is recorded as a liability. Although the outcome of any such legal actions cannot be predicted, in the opinion of management there is currently no legal proceeding pending or asserted against or involving K-tel for which the outcome is likely to have a material adverse effect upon the consolidated financial position or results of operations of K-tel.

 

Subsidiary’s Liquidation

 

In November 2000, the Company’s consumer products subsidiary in the United Kingdom, K-tel Marketing Ltd., ceased operations and began voluntary liquidation proceedings. At the initial meeting of the creditors on November 24, 2000, the creditors voted for the liquidation to become a creditors’ liquidation under English law. The Company has not been informed by the liquidators or their counsel of any plan to attempt to hold it or any of its subsidiaries liable for any of the commitments of K-tel Marketing Ltd. Management believes the Company will have no ongoing material liability related to K-tel Marketing Ltd. as a result of the liquidation proceeding. As the only secured creditor, the Company received a preliminary distribution of approximately $138,000 on March 1, 2004.

 

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

 

(a)           EXHIBITS

 

See “Index to Exhibits.”

 

(b)           REPORTS ON FORM 8-K

 

There were no reports filed under Form 8-K by the Company during the three month period ended March 31, 2004.

 

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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.

 

 

	K-TEL INTERNATIONAL, INC.
	REGISTRANT
Dated: May 17, 2004	/S/ PHILIP KIVES
	PHILIP KIVES
	CHAIRMAN AND CHIEF EXECUTIVE OFFICER
Dated: May 17, 2004	/S/ DENNIS WARD
	DENNIS WARD
	CHIEF FINANCIAL OFFICER
	(principal accounting officer)

 

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INDEX TO EXHIBITS

 

Exhibit No.		Description of Exhibit
31.1		Certification by Chief Executive Officer pursuant to Rule 13a-14.
31.2		Certification by Chief Financial Officer pursuant to Rule 13a-14.
32.1		Certification by Chief Executive Officer pursuant 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification by Chief Financial Officer pursuant 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

18