K TEL INTERNATIONAL INC (KTEL) Quarterly Report (SEC form 10-Q)
November 20, 1998
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
GENERAL - K-tel International, Inc. is an international marketer and distributor of entertainment and
consumer products and is a leader in the market niche for pre-recorded music compilations. With more than
thirty years of marketing experience in the United States ("U.S."), Canada and Europe, the Company has
developed the resources, knowledgeable personnel, information systems, and distribution capabilities to launch
music, video, and consumer products quickly in the North American and European markets through traditional
retail and direct-response marketing channels. On May 1, 1998, the Company launched its new Internet service,
K-tel Express (www.ktel.com), featuring a wide spectrum of music products for purchase by the public around
the globe. Open for commerce 24 hours a day, 365 days a year, K-tel Express features more than 250,000
music titles at value prices through this on-line shopping service. Revenue generated from K-tel Express
through September 30, 1998 has not been material.
The Company markets and sells pre-recorded music both from the Company's owned music master catalog and
under licenses from third party record companies. Sales of albums, cassettes and compact discs are made to
rackjobbers (distributors which stock and manage inventory within certain music and video departments for
certain retail stores), wholesalers and retailers in the U.S. and through subsidiaries and licensees in the United
Kingdom and elsewhere in Europe. Television direct-response marketing of pre-recorded music and consumer
convenience product is a significant source of revenue for the Company, specifically in Europe.
In 1997, the Company formed a U.S. media buying and infomercial-marketing subsidiary, which performed
media buying services for third parties and also marketed products through infomercials produced by third
parties. As of June 30, 1998, due to accumulated losses of $2,300,000 the Company curtailed most of these
media buying operations.
In March of 1998, the Company acquired certain media and other assets of United Kingdom based Regal Shop
International Ltd. and began operating these assets as K-tel Marketing (UK) Limited. In September 1998, the
Company discontinued its K-tel home video product line.
A. RESULTS OF OPERATIONS
Consolidated net sales for the three months ended September 30, 1998 were $18,792,000 with an operating
loss of $3,161,000 and a net loss of $3,077,000, or $.37 per basic and diluted share. Consolidated net sales
for the same period in the prior year were $25,135,000 with operating income of $1,393,000 and net income
of $1,207,000, or $.16 per basic and $.15 per diluted share. The following tables set forth, for the periods
indicated, results of operations by geographic region as a percentage of net sales. All amounts are in thousands
of dollars.
Three Months Ended September 30, 1998
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North Corporate
America Europe Expenses Total
-------- -------- -------- --------
Net Sales $ 9,677 100% $ 9,115 100% -- $ 18,792 100%
Costs and expenses
Cost of goods sold 6,462 67 3,972 44 -- 10,434 55
Advertising 1,956 20 2,474 27 -- 4,430 24
Selling, general & administrative 3,085 32 3,368 37 636 7,089 38
-------- -------- -------- -------- -------- -------- --------
Operating income (loss) (1,826) (19) (699) (8) (636) (3,161) (17)
-------- -------- -------- -------- -------- -------- --------
Interest (expense) income, net (62) -- 12 -- (94) (144) --
Foreign translation adjustment, net 130 -- 28 -- 16 174 --
Benefit (provision) for taxes, net 76 -- (65) -- 43 54 --
-------- -------- -------- -------- -------- -------- --------
Net income (loss) $ (1,682) -- $ (724) -- $ (671) $ (3,077) --
======== ======== ======== ======== ======== ======== ========
Three Months Ended September 30, 1997
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North Corporate
America Europe Expenses Total
-------- -------- -------- --------
Net Sales $ 17,818 100% $ 7,317 100% -- $ 25,135 100%
Costs and expenses
Cost of goods sold 11,472 64 3,332 46 -- 14,804 59
Advertising 2,258 13 1,468 20 -- 3,726 15
Selling, general & administrative 2,943 17 1,720 23 549 5,212 21
-------- -------- -------- -------- -------- -------- --------
Operating income (loss) 1,145 6 797 11 (549) 1,393 5
-------- -------- -------- -------- -------- -------- --------
Interest (expense) income, net (36) -- 9 -- (27) (54) --
Foreign translation adjustment, net (76) -- 45 -- 1 (30) --
Benefit (provision) for taxes, net (80) -- (59) -- 37 (102) --
-------- -------- -------- -------- -------- -------- --------
Net income (loss) $ 953 -- $ 792 -- % (538) $ 1,207 --
======== ======== ======== ======== ======== ======== ========
CONSOLIDATED NET SALES for the three months ended September 30, 1998 decreased $6,343,000, or
25%, from the comparable period in 1997. North American sales for the three months ended September 30,
1998 decreased $8,141,000, or 46%, from the comparable period in 1997. This decrease was mainly due to a
$5,800,000 decrease in sales that resulted from the curtailment of the Company's U.S. media buying and
infomercial operations from the comparable period in 1997, and from a $2,500,000 decrease in music and
consumer product sales from the comparable period in 1997. European sales for the three months ended
September 30, 1998 increased $1,798,000, or 25%, from the comparable period in 1997. The increase relates
to $2,700,000 of sales generated from the Company's new marketing operation (K-tel Marketing (UK) Limited)
that began operations in April 1998 concurrent with the Company's acquisition of assets of Regal Shop
International. This increase was offset by a decrease in sales from the comparable period in 1997 of
approximately $1,500,000 from the Company's German operations.
CONSOLIDATED COST OF GOODS SOLD AS A PERCENTAGE OF NET SALES for the nine months ended
September 30, 1998 were 55% as compared to 59% in the comparable period in 1997. Cost of goods sold as a
percentage of net sales for North America for the three months ended September 30, 1998 were 67% as
compared to 64% in the comparable period in 1997. The increase is mainly due to a loss of $650,000 incurred
by the Company when it discontinued marketing and distribution of its home video product line. European cost
of goods sold were 44% as compared to 46% in the comparable period in 1997 as the gross margins were
slightly higher on merchandise sold via direct response during the three months ended September 30, 1998 as
compared to the merchandise sold in the comparable period in 1997.
CONSOLIDATED ADVERTISING COSTS for the three months ended September 30, 1998 increased
$704,000, or 19%, from the comparable period in 1997. North American advertising costs for the three
months ended September 30, 1998, decreased $302,000, or 13%, from the comparable period in 1997. The
majority of this decrease related to advertising costs incurred by the Company's U.S. media buying and
infomercial operations which were $1,200,000 for the three months ended September 30, 1997. There were no
such costs in the comparable period in 1998. This decrease was offset by an increase in advertising costs for
the three month period ended September 30, 1998 that resulted from write offs and charges of approximately
$800,000 of infomercials and deferred advertising costs incurred by the Company on products no longer
marketed. European advertising costs for the three months ended September 30, 1998 increased $1,006,000,
or 69%, from the comparable period in 1997. This increase specifically relates to a dvertising costs incurred
by K-tel Marketing (UK) Limited, the Company's United Kingdom marketing operation that was not in existence
for the comparable period in 1997.
CONSOLIDATED SELLING, GENERAL AND ADMINISTRATIVE EXPENSES for the three months ended
September 30, 1998, increased $1,877,000, or 36%, from the comparable period in 1997. North American
selling, general and administrative expenses for the three months ended September 30, 1998 increased
$142,000, or 5% from the comparable period in 1997. The majority of the increase related to $600,000 of
K-tel Express expenses which was not in existence in the prior year comparable period in 1997. This increase
was partially offset by lower selling, general and administrative expense due to discontinued operations in the
Company's media buying business. European selling, general and administrative expenses for the three months
ended September 30, 1998 increased $1,680,000, or 96%, from the comparable period in 1997. This increase
relates primarily to $1,100,000 of
costs incurred by K-tel Marketing (UK) Limited, the Company's United Kingdom marketing operation that was
not in existence in the comparable period in 1997 and a $250,000 loss incurred when the Company discontinued
a catalog operation in its German subsidiary.
OPERATING INCOME for the three months ended September 30, 1998 decreased $4,554,000 to a loss of
$3,161,000 from the comparable period in 1997. North American operating income for the three months ended
September 30, 1998 decreased $2,971,000 to a loss of $1,826,000, from the comparable period in 1997. The
majority of the decrease relates to write-offs of approximately $1,450,000 of certain non-music related
assets and curtailments of marginal business lines, a difference in earnings of $1,100,00 that resulted from
decreased music and consumer product sales, and $600,000 from the Company's continued investment in its
e-commerce operations. European operating income for the three months ended September 30, 1998 decreased
$1,496,000 to a loss of $699,000 from the comparable period in 1997. The decrease related mostly to losses
from the Company's operation in Germany caused by a decrease in sales volume, including a loss of $250,000
when the Company discontinued its catalog operation in Germany.
INTEREST EXPENSE for the three months ended September 30, 1998, increased $89,000 to $159,000, as
compared to $70,000 in the same period in 1997. The increase in interest expense corresponds with the
increased borrowings made by the Company during these periods under its existing credit facilities. During the
three months ended September 30, 1998, the Company experienced a foreign currency transaction gain of
$174,000, compared to a loss of $30,000 experienced during the comparable period in the prior year. Most of
the Company's foreign currency transaction exposure is due to its European subsidiaries' liabilities, which are
payable to the Company's U.S. parent or U.S. subsidiaries. In accordance with generally accepted accounting
principles the payable balances are adjusted quarterly to the local currency equivalent of the U.S. dollar. The
majority of the translation losses for the three-month period ended September 30, 1998 were the result of
these intercompany liabilities. Gains or losses resulting from these intercompany liabilities remain unrealized
until such time as the underlying liabilities are settled.
INCOME TAXES for the three months ended September 30, 1998, were a benefit of $54,000 compared to a
provision of $102,000 in the comparable period in 1997. Variations in the Company's tax provision are a
factor of the country of origin of profits and the availability of net operating loss carryforwards.
Operating results for the three month period is not necessarily indicative of the results that may be expected
for the full year.
B. LIQUIDITY AND CAPITAL RESOURCES
During the three months ended September 30, 1998, the Company experienced negative cash flow from
operations of $4,881,000, and utilized another $498,000 for investing activities. To finance the above, the
Company borrowed an additional $1,407,000 under its existing credit facilities, and borrowed $2,000,000
from an affiliate of its Chairman of the Board and Chief Executive Officer.
The Company has an existing $10 million credit facility with a lending institution. The credit facility consists
of a $4 million term loan due in full on November 20, 2001 and a $6 million revolving credit facility, limited to
a percent of eligible receivables and inventory, that expires November 20, 2001. Borrowings under the facility
bear interest at a variable rate based on a "base rate" announced by a banking affiliate associated with the
lending institution (8.5% at September 30, 1998) and are secured by the assets of certain U.S. subsidiaries,
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 tangible
net worth by the Company, limitations on capital expenditures, restrictions on music library acquisitions,
limitations on the incurrence of indebtedness and restrictions on dividends paid by the Company. The Company
has guaranteed the obligations of its subsidiaries under the credit facility and has pledged the stock of those
subsidiaries and its assets to secure the Company's obligations under its guaranty. As of September 30, 1998,
$4,000,000 was outstanding under the term loan and $5,146,000 was outstanding under the line of credit and
the maximum additional available under the borrowing limitations at that date was $72,742. The Company was
either in compliance with or had obtained waivers for all covenants, limitations and restrictions. The Company
has amended certain financial covenants with the lender for fiscal 1999 and beyond, and expects to be out of
compliance with the tangible net requirement until the Company achieves the necessary level of profitable
operations, obtains an equity placement infusion or further modifies the covenants. As such, the Company has
reclassified its $4 million term loan to current as of September 30, 1998.
chairman has agreed to fund any capital requirements, if necessary, through September 30, 1999. Future losses
from businesses such as K-tel Express or the inability to complete an equity placement may result in further
renegotiations of such covenants or the need to seek replacement financing. There can be no assurances that
such financing will be available on terms satisfactory to the Company.
K-5 Leisure Products, Inc. ("K-5"), an affiliate controlled by the Company's Chairman of the Board and Chief
Executive Officer, has from time to time made advances to the Company. As of September 30, 1998 K-5 had
advanced $3,000,000 to the Company and advanced an additional $440,000 subsequent to September 30,
1998. The Company pays interest on the unpaid principal amount of financing at the same rate as the Company
pays on its credit facility, until repayment of the loan, which is due on demand.
The Company has primarily funded its operations to date through internally generated capital, bank financing
or advances made by an affiliate of the Chairman of the Board and Chief Executive Officer. However, the
Company anticipates that it will require additional cash in order to further develop and promote its Internet
retail music site, K-tel Express. Although the Company has made no material commitments for capital
expenditures, it anticipates a substantial increase in funding requirements for development and acquisition of
technology, marketing and promotion, payment of $900,000 over two years to Playboy Enterprises, Inc. and
for capital expenditures to develop the infrastructure necessary for the anticipated growth in operations. To
date, the Company has no commitments for any additional financing and there can be no assurance that such
commitments can be obtained on favorable terms, if at all. The Company has available to it funding from a
company owned by the Company's Chairman of the Board and Chief Executive Officer. Although management
does not have access to the financial statements of the Chairman's other companies, he has committed to the
Company that he will fund its operations through fiscal 1999 and the Company is in the process of formalizing
the commitment in the form a credit agreement.
During the first three months of fiscal 1999, the Company purchased approximately $25,000 of consumer
convenience product from an affiliate controlled by the Company's Chairman of the Board and Chief Executive
Officer. The Company owed approximately $37,000 to the affiliate at September 30, 1998. This same
affiliate purchased approximately $2,000 of consumer convenience products from the Company during the
three months ended September 30, 1998 and owed the Company $35,000 at September 30, 1998. No interest
will be charged on the related outstanding balances during fiscal 1998.
The Company has been notified by the Nasdaq Stock Market that the Company failed to meet the minimum
tangible net asset requirement necessary for continued listing on the Nasdaq National Market. The Company
has requested a hearing to the de-listing procedures before the Nasdaq Listing Qualifications Panel to obtain a
temporary extension to these requirements and an opportunity to raise additional capital to satisfy the
requirements. There is no assurance that the Company will be successful in its attempt to remain listed on the
Nasdaq National Market. If the Company is de-listed from the National Market, the Company may apply to the
Nasdaq Small Cap Market.
Year 2000 Disclosure
The Company has developed a plan to ensure its systems are compliant with the requirements to process
transactions in the year 2000. The majority of the Company's internal information systems have been upgraded
or are in the process of being upgraded or replaced with fully compliant new systems. The Company's European
subsidiaries have upgraded or are in the process of replacing or upgrading their information systems to comply
with Year 2000 requirements. The total cost of the software and implementation is estimated to be
approximately $150,000. The new system implementation is expected to be completed by July 31, 1999. Some
of the Company's customers utilize equipment to capture and transmit financial transactions. The Company is in
the process of making the necessary updates to this equipment to ensure it will be effective in the year 2000.
The Company is also working with its processing banks and network providers to ensure their systems are year
2000 compliant. All of these costs will be or have been borne by the processors and network companies. Should
the Company, its customers, its vendors or the processing banks fail to resolve year 2000 issues, the Company
may lose certain financial and operating data. The Company is in the process of developing a contingency plan,
which it expects to be completed by the end of the fiscal year.
Euro Conversion Disclosure
On January 1, 1999, eleven of the fifteen member countries of the European Union are scheduled to establish
fixed conversion rates between their existing sovereign currencies and the euro. The participating countries
have agreed to adopt the euro as their common legal currency on that date. At this point, the Company can not
yet predict the anticipated impact of the euro conversion on the Company.
Important Factors Relating to Forward Looking Statements - Information in this form 10Q may contain
forward-looking statements relating to future results of the Company (including certain projections and
business trends) that are "forward-looking statements" as defined in the Private Securities Litigation Reform
Act of 1995. Actual results and performance may differ materially from the forward-looking statements as a
result of certain risks and uncertainties, including but not limited to, changes in political and economic
conditions, demand for and market acceptance of new and existing products, the impact from competition for
Internet content, merchandise and recorded music, dependence on strategic alliance partners, suppliers and
distributors, market acceptance of the Internet for commerce and as a medium for advertising, technological
changes and difficulties, and availability of financing.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBIT INDEX
(b) REPORTS ON FORM 8-K
The Company did not file any reports on Form 8-K during the quarter ended September 30, 1998. |
