**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

**(MARK ONE)**

| **ý**                                                                                                                                                                                              |   | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
| **For  the fiscal year ended June 30, 2003**                                                                                                                                                            |
|                                                                                                                                                                                                    |
| **OR**                                                                                                                                                                                                  |
|                                                                                                                                                                                                    |   |                                                                                          |
| **o**                                                                                                                                                                                                   |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For  the transition period from                 to               ** |

 

**Commission file number 1-07115**

 

**K-TEL INTERNATIONAL, INC.**

(Exact name of registrantas specified in its charter)

 

| **Minnesota**                                                    |   | **41-0946588**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                             |   |                                  |
| **2655  Cheshire Lane North, Suite 100, Plymouth, Minnesota**    |   | **55447**                             |
| (Address of principal  executive offices)                        |   | (Zip Code)                            |

 

Registrant’s telephonenumber, including area code: **(763) 559-5566**

 

Securities registeredpursuant to Section 12(b) of the Act:

**None**

 

Securities registeredpursuant to Section 12(g) of the Act:

**CommonStock, par value $0.01**

(Title of class)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes ý    No o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

 

Indicate by check mark whether or not the registrant is an acceleratedfiler (as defined in Exchange Act Rule 12b-2)

 

Yes o    No ý

 

As of December 31,2002, the aggregate market value of voting stock held by non-affiliates of theregistrant based on the last sale price as reported by the Over-the-CounterBulletin Board on such date was $292,706.

 

As of September 22, 2003, the registrant had 13,653,738 shares ofCommon Stock outstanding.

 

DOCUMENTS INCORPORATED BYREFERENCE

None.

 

 

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**TABLE OF CONTENTS**

 
| PART I                                      |                                                                                             |
|---------------------------------------------|--------------------------------------------------------------------------------------------------|
|                                        |                                                                                             |
| Item  1.                                    | Business                                                                                         |
| Item  2.                                    | Properties                                                                                       |
| Item  3.                                    | Legal  Proceedings                                                                               |
| Item  4.                                    | Submission  of Matters to a Vote of Security Holders                                             |
| Item  4a.                                   | Executive  Officers of the Registrant                                                            |
|                                        |                                                                                             |
| PART  II                                    |                                                                                             |
|                                        |                                                                                             |
| Item  5.                                    | Market  for Registrant’s Common Equity and Related Stockholder Matters                      |
| Item  6.                                    | Selected  Financial Data                                                                         |
| Item  7.                                    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations      |
| Item  7a.                                   | Quantitative  and Qualitative Disclosures about Market Risk                                      |
| Item  8.                                    | Financial  Statements and Supplementary Data                                                     |
| Item  9.                                    | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure            |
| Item  9a.                                   | Controls  and Procedures                                                                         |
|                                        |                                                                                             |
| PART  III                                   |                                                                                             |
|                                        |                                                                                             |
| Item  10.                                   | Directors  and Executive Officers of the Registrant                                              |
| Item  11.                                   | Executive  Compensation                                                                          |
| Item  12.                                   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters |
| Item  13.                                   | Certain  Relationships and Related Transactions                                                  |
| Item  14.                                   | Principal  Accountant Fees and Services                                                          |
|                                        |                                                                                             |
| PART  IV                                    |                                                                                             |
|                                        |                                                                                             |
| Item  15.                                   | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                                 |
|                                        |
| Signatures                                  |
| Index  to Consolidated Financial Statements |
| Exhibit Index                               |

 

**SAFE HARBOR STATEMENT UNDER THEPRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

 

Certain statements of a non-historical nature under the caption“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and elsewhere in this Form 10-K constitute “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995. Such forward-looking statements may be identified by the use ofterminology such as “may,” “will,” “expect,” “anticipate,” “estimate,”“should,” or “continue” or the negative thereof or other variations thereon orcomparable terminology. Such forward-looking statements are subject to certainrisks and uncertainties that could cause actual results to differ materiallyfrom historical results or from those results currently anticipated orprojected. Such factors include, among other things, the following: changes inconsumer purchasing; demand for and market acceptance of new and existing products;the impact from competition for recorded music; the outcome of legalproceedings; dependence on suppliers and distributors; the outcome of oursubsidiaries’ bankruptcy and liquidation; success of marketing and promotionefforts; technological changes and difficulties; availability of financing;foreign currency variations; general economic, political and businessconditions; and other matters. We undertake no obligation to release publiclythe result of any revisions to these forward-looking statements, except asrequired by law.

 

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**PART I**

 

**ITEM 1****:  BUSINESS**

 

K-tel International, Inc. (the “Company,” “K-tel,” or the “registrant”)was incorporated in 1968. Its corporate offices are located at 2655 CheshireLane North, Suite 100, Plymouth, Minnesota, and its phone number is (763)559-5566. Through its operating subsidiaries, K-tel licenses its music cataloginternationally and markets entertainment products mainly derived from itscatalog through retail and direct response marketing channels in the UnitedStates and Europe. The Company has a focused method of distribution thattargets the strengths of fewer individual retailers and supplies productssuited to each retailer’s needs. These new products are derived mainly from theCompany’s master recordings music catalog with the objective of realizing morecompetitive profit margins. K-tel purchases inventory from its duplicators tomeet customer orders. Most customers purchase on a guaranteed sale basis whereunsold merchandise can be returned for credit. Historically, K-tel subsidiarieshad also distributed consumer products through operations that have beendiscontinued, and operated an Internet e-commerce site which has been suspendeddue to continuing losses. K-tel seeks to license its trademarks to othercompanies in businesses unrelated to K-tel’s current operations. Licenses aregranted for a royalty or fee, with no cost to the Company. The Company haslicensed certain marks to K-tel Drug Mart Ltd., a Canadian direct marketer ofprescription drugs beneficially owned by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel. K-tel Drug Mart, whichrecently began operations, offers prescription drugs from its pharmacy inCanada to persons in the United States. K-tel is merely a licensor of its markto K-tel Drug Mart. To date, K-tel Drug Mart’s operations have not generatedany significant licensing revenues for the Company.

 

Description of Current Businesses

 

Music Licensing and Sales

 

Currently K-tel’sprimary activity is the licensing of music to other record companies and toother segments of the entertainment industry. K-tel owns a proprietary mastermusic catalog of approximately 6,000 titles consisting of original recordingsand re-recordings of music from the 1950’s through today. Supplementing thismajor asset, K-tel has a non-exclusive worldwide license for a catalog of over30,000 music titles. The Company also licenses the rights to master recordingsto third parties worldwide for use in albums, films, television programs andcommercials for either a flat fee or a royalty based on the number of unitssold. K-tel continuously adds to its music master catalog to ensure growth andproduct diversity. Licensing of its proprietary music rights to third partieshas historically been an important revenue source for K-tel.

 

The Company alsomarkets and sells pre-recorded compact discs utilizing the master recordings inits music catalog, and DVD’s from its developing catalog of musicalperformances. Customers include retailers, wholesalers and rack servicedistributors. These products are also sold through subsidiaries and licenseesin the United Kingdom and elsewhere in Europe. The principal entertainmentproducts that K-tel markets and sells consist primarily of pre-recordedthematic music packages in a compilation format featuring various artists.These thematic music selections, which cover nearly all music genres, aretargeted to a variety of age groups. K-tel provides marketing support for itsmusic sales through cooperative advertising with retailers, print media, radioand television advertising, and in-store promotions and displays.

 

For the year endedJune 30, 2003, K-tel’s net sales included $902,000 recovered from an audit oflicensing income related to prior years. This is not expected to be a recurringsource of income.

 

Two customers,Anderson Merchandising, Inc. and Handleman Company accounted for approximately17.0% and 13.1% respectively of K-tel’s revenue for the year ended June 30,2003. The loss of, or a substantial reduction in, business from any of thesecustomers would have a material adverse effect on the Company.

 

K-tel currently delivers music products (CDs and DVDs) throughtraditional wholesale and retail distribution channels. Prior to April 2001,the Company was distributing its music products in the United States to mostmajor music retailers (Transworld Entertainment, Musicland, Best Buy, CircuitCity, Tower Records) and to major distributors (Handelman, AndersonMerchandising, Valley Media). The Company now has a customer base that includesonly a few selected retailers and distributors, and offers products that are ofmore interest to these individual customers. This focused approach is intendedto improve product sell-through, minimize returns of unsold inventory and allowthe Company to realize more competitive profit margins. This existing method ofdistributing music could be materially altered by new technologies that willenable users and customers of pre-recorded music to electronically downloadpre-recorded music at home to various personal computer media formats. Thetechnology is developing and a number of competing companies are seeking tohave the industry and the public embrace their technologies. Participants inthis technology competition include Microsoft

 

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Corporation, Liquid Audio, Inc., Apple Computer, Inc., MP3.com, Inc.and others. Digital music distribution provides both significant risks andopportunities for K-tel. The risks include K-tel’s uncertain ability to competewith other music companies from a marketing and a technological standpoint. TheCompany believes there are opportunities to enhance its current distribution methodsas well as increase opportunities to license its owned library of masterrecordings. K-tel’s music sales and licensing subsidiaries are pursuing thesealternative distribution channels.

 

In March 2001, theCompany’s music distribution subsidiary in the United States, K-telInternational (USA), Inc. (K-tel (USA)) ceased operations and filed forprotection under Chapter 7 of the United States bankruptcy code. This eventended the Company’s traditional method of distributing music products throughmost retailers. The Company now distributes its music products through anothersubsidiary, K-tel Entertainment, Inc.

 

The Company’s ability to continue its present operations and implementfuture expansion plans successfully is contingent mainly upon its ability tomaintain its line of credit arrangements with K-5 Leisure Products, Inc., theCompany’s largest shareholder controlled by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel. (See Note 3 to theconsolidated financial statements), increase its revenues and profit margins,and ultimately attain and sustain profitable operations. Without increasedrevenues and sustained profitability, the cash generated from the Company’scurrent operations will likely be inadequate to fund operations and service itsindebtedness on an ongoing basis. Management is focusing its efforts on musiclicensing and limited music distribution. However, there can be no assurancethat the Company will achieve profitable operations through these efforts or beable to continue operations. The financial statements do not include anyadjustments that might result from the outcome of these uncertainties. Thereport of the Company’s independent certified public accountants as of June 30,2003 and 2002 and for the three years in the period ended June 30, 2003included an explanatory paragraph expressing doubt about our ability tocontinue as a going concern.

 

# E-Commerce

 

K-tel ceasedoperating its K-tel.com website, which marketed its own and other suppliers’products to retail customers, in the fourth quarter of 2001 because thisbusiness segment was not cost effective. The web site has since beenredeveloped to support the Company’s sale of proprietary brand-namecompilations and newly developed CD and DVD products to customers in the UnitedStates and United Kingdom.

 

Competition

 

The music business is highly competitive and dominated by majorcompanies. K-tel faces competition for discretionary consumer purchases of itsproducts from other record companies and other entertainment sources, such asfilm and video companies. Several major record companies in the United Statesincluding Bertelsmann AG, Sony Corp., Time Warner, Inc. and Universal MusicGroup dominate the market for pre-recorded music. K-tel does not have thefinancial resources, nor does it have the depth or breadth of catalog,distribution capabilities or current repertoire of these companies. Its abilityto compete in this market depends upon:

 

•                  theskill and creativity of its employees to expand and utilize its music catalogto create compilation packages;

 

•                  itsability to distribute its products effectively and efficiently; and

 

•                  itsability to build upon and maintain its reputation for producing, licensing,marketing and distributing high quality music.

 

The core of K-tel’s music business involves the licensing of thirdparty rights and the utilization of its own catalog to create musiccompilations for retail distribution. The major pre-recorded music companies,either directly or through subsidiaries, now manufacture or distributepre-recorded music compilations in direct competition with K-tel’s musiccompilation products. With this new competition, it is far more difficult forK-tel to access pre-recorded music from these major companies at acceptablerates. Therefore, the Company relies heavily on its own Dominion catalog andhas accelerated the rate at which it produces new master recordings.

 

Another form ofcompetition for the Company is the increasing ability for users and customersof pre-recorded music to download pre-recorded music electronically at home tovarious personal computer media formats. Although the technology and therelated legal issues are still emerging, and although K-tel is pursuingopportunities offered by this technology, the Company is uncertain how this newtechnology will impact its current operations.

 

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Intellectual Property

 

The Company believes that the K-tel® name andmark are well recognized and are therefore valuable assets of the Company. TheCompany pursues the registration of its trademarks and service marks in theU.S. and internationally. Effective trademark, service mark and copyrightprotection may not be available in every country in which its products andservices are made available on-line. The Company has registered the trade markK-tel®, variations of that mark and other marks relating to its products in theU.S. and internationally in various product and service categories. K-tel alsoclaims rights in trademarks licensed by the Company in two pending U.S.trademark applications covering the marks “K-TEL DRUG MART,” and “K-TEL MEDS.”Federal and state trademark registrations continue indefinitely, so long as thetrademarks are in use and periodic renewals and other required filings aremade.

 

The Company regards its copyrights, servicemarks, trademarks, trade dress, trade secrets and similar intellectual propertyas critical to its success, and relies on trademark and copyright law, tradesecret protection and confidentiality and/or license agreements with itsemployees, customers, partners and others to protect its proprietary rights.K-tel believes strongly in protecting its intellectual property and will seekprotection for new products and marks whenever the Company believes it isadvisable.K-tel cannot assure you that any trademarks held by it will bevalid, enforceable or otherwise of value to the Company in relation to itscompetitors or the market in general, or that any trademark for which it hasapplied or may apply will be granted.

 

Inaddition to trademark protection, the Company generally obtains copyrights inmusic works, compilations and sound recordings.

 

Employees

 

On June 30, 2003, K-tel employed 21 full time people worldwide.

#  

Financial and Geographic Information 

 

For financial informationabout the Company’s business segment and geographic area operations for each ofthe three fiscal years ended June 30, 2003 see Note 8 to the consolidatedfinancial statements.

 

**ITEM 2****:  PROPERTIES**

 

K-tel’s corporate offices and U.S. operations are located in leasedfacilities in Plymouth, a suburb of Minneapolis, Minnesota, consisting ofapproximately 4,000 square feet of office space and approximately 6,000 squarefeet of warehouse. K-tel’s foreign subsidiaries lease a total of approximately9,500 square feet of office and warehouse facilities. See Note 6 to theconsolidated financial statements for a summary of the lease agreements. TheCompany believes that these facilities are adequate for its current needs.

 

**ITEM 3****:  LEGAL PROCEEDINGS**

 

Class Action Lawsuit

 

K-tel and certain of its current and former officers and directors werenamed as defendants in *In re K-telInternational, Inc. Securities Litigation*, No. 98-CV-2480. Thisaction consolidated twenty-three purported class actions that were initiallyfiled in various United States District Courts in November 1998, and weresubsequently transferred to, and consolidated in, the United States DistrictCourt for the District of Minnesota. On July 19, 1999, the plaintiffs filed anamended consolidated class action complaint that challenged the accuracy ofcertain public disclosures made by K-tel regarding its financial conditionduring the period from May 1998 through November 1998. The plaintiffs assertedclaims under the federal securities laws and sought damages in an unspecifiedamount as well as costs, including attorneys’ fees and any other relief theCourt deemed just and proper. K-tel moved to dismiss the complaint, and on July31, 2000, the United States District Court granted the Company’s motion todismiss. The Court also barred further actions by the plaintiffs and deniedplaintiffs’ request to amend the complaint in order to refile the complaint inthe future. The plaintiffs appealed to the United States Court of Appeals forthe Eighth Circuit, and the Court of Appeals heard the matter in October 2001.On August 7, 2002 the Court of Appeals, in a two to one decision, denied theplaintiffs’ appeal. On August 20, 2002, the plaintiffs applied for a rehearingby the full Court of Appeals. K-tel filed a response on September 15, 2002 tothe plaintiffs’ petition for rehearing at the request of the Court. On October2, 2002, the Court denied the petition for rehearing. The plaintiffs had untilJanuary 1, 2003 to seek a writ of certiorari (a petition asking the Court for adiscretionary review of a lower court decision) from the United States SupremeCourt, but did not seek this writ. There having been no appeal filed,

 

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the case has been dismissed with no further recourse available.

 

RTL Shopping S.A.

 

The Company has been named in a lawsuit filed in France brought byRTL9, a French cable TV station. The action seeks damages in the approximateamount 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-telMarketing Ltd. alleging that RTL9 ran a commercial for K-tel Marketing whichpresented a product under brand names alleged to infringe on the competitor’sown trademarks and also translated an English language script indicating thatthe product was “just like” or “as good as” others into “better than” inFrench, contrary to French law. The suit alleged trademark infringement, unfaircompetition, illicit comparative advertising and passing off. RTL9 then suedK-tel Marketing on October 4, 2000, pursuant to an indemnification provisionthe parties had entered into. Subsequently, K-tel Marketing went into liquidationand RTL9 filed a suit in December 2000 against K-tel International, Inc. underits 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 documentsdisputing the claim and advising the court of K-tel (USA)’s Chapter 7bankruptcy filing.

 

The Company believes that RTL9 has no basis for a complaint against theCompany. As the result of information supplied by the parties to the Court,RTL9 has proposed to drop the lawsuit.

 

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

 

On March 14, 2000, K-tel and its subsidiary in Germany commenced anaction for breach of express and implied warranties against Defendant TristarProducts, Inc. This action is venued in the United States District Court forthe District of Minnesota. This action arises out of Tristar’s sale to K-tel ofa defective home exercise product called the “BunBlaster” for resale in Germany,Austria and Switzerland. By written contract, Tristar has agreed to indemnifyK-tel for injuries and damages arising out of the resale of those goods. K-telis seeking approximately $2 million in consequential damages. Tristar isvigorously defending this claim. Discovery has been completed. Tristar hasfiled a Motion for Summary Judgment, to which the Company filed a Memorandum inOpposition. This motion was heard in U.S. District Court in Minneapolis onAugust 25, 2003. The Court has yet to rule on this motion.

 

On April 30, 2001, Tristar also asserted a patent and trademark/trade-dress counterclaim against K-tel for allegedly passing off a productcalled the “K-tel Hook and Hang” while allegedly a distributor of the originalpatented Tristar Hook and Hang product. The Company denies the allegationbecause it never was a distributor of this or any similar product and intendsto defend this action vigorously. Tristar has not identified the amount ofdamages it seeks with respect to this counterclaim. The United States DistrictCourt for the District of Minnesota issued an order on August 14, 2001 severingthis action from the Company’s action. This action is at an early stage and nodiscovery or other actions have occurred.

 

#### Other Litigation and Disputes

 

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

 

Subsidiaries’ Bankruptcy and Liquidation

 

In March 2001, the Company’s music distribution subsidiary in theUnited States, K-tel International (USA), Inc. ceased operations and filed forprotection under Chapter 7 of the United States Bankruptcy Code. Pursuant to anagreement between the bankruptcy trustee and K-5 Leisure Products, Inc.(K-tel’s secured creditor and controlling shareholder) entered into on March 3,2003, the trustee released K-5 Leisure Products, Inc., K-tel and itssubsidiaries and affiliates from any claims and actions with respect to thebankruptcy filing. The trustee filed a Limited Notice of Abandonment relativeto K-5’s security interest in K-tel’s assets. The Bankruptcy Court approved theabandonment as of June 13, 2003.

 

In November 2000, the Company’s consumer products subsidiary in theUnited Kingdom, K-tel Marketing Ltd., ceased operations and began voluntaryliquidation proceedings. At the initial meeting of the creditors on November24, 2000, the creditors voted for the liquidation to become a creditors’liquidation under English law. The Company has not been informed by theliquidators or their counsel of any plan to attempt to hold it or any of itssubsidiaries liable for any of the

 

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commitments of K-tel Marketing Ltd. Management believes the Companywill have no ongoing material liability related to K-tel Marketing Ltd. as aresult of the liquidation proceeding.

 

**ITEM 4****:  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

No matters were submitted to a vote of K-tel’s security holders duringthe fourth quarter of fiscal 2003.

 

**ITEM 4A****.  EXECUTIVE OFFICERS OF THE REGISTRANT**

 

The following table sets forth certain information with respect to theexecutive officers of K-tel at June 30, 2003.

 
| **Name of Officer** |   | **Age** |   | **Positions  and Offices Held**                                         |
|---------------------|--------|---------|--------|-------------------------------------------------------------------------|
|                |   |    |   |                                                                    |
| Philip Kives        |   | 74      |   | Chairman of the Board, Chief Executive Officer,  President and Director |
| Dennis Ward         |   | 57      |   | Chief Financial Officer, Secretary and Director                         |

 

The officers of K-tel are elected annually and serve at the discretionof the Board of Directors.

 

**Philip Kives** has held various offices and/ormanagerial positions with K-tel for more than thirty-five years. Mr. Kives iscurrently the Company’s Chairman, Chief Executive Officer and President.

 

**DennisW. Ward** was appointed Chief Financial Officer and Secretaryof K-tel on December 29, 2000and has served as Controller of K-5 Leisure Products, Inc. (K-tel’s largestshareholder) for more than twelve years.

 

**PART II**

 

**ITEM 5****:  MARKET FOR REGISTRANT’S COMMON STOCK ANDRELATED STOCKHOLDER MATTERS**

 

On September 22, 2003, there were 1,391 record holders of K-tel’scommon stock and 13,653,738 shares outstanding. The Company’s common stock istraded on the Over-the-Counter Bulletin Board under the symbol “KTEL”.

 

The following table shows the range of high and low closing prices pershare of K-tel’s common stock for the fiscal year periods indicated. Suchover-the-counter market quotations reflect inter-dealer prices, without retailmark-up, mark-down or commission, and may not necessarily represent actualtransactions.

 
|        |   | **2003** |   | **2002** |   |
|-------------|--------|----------|--------|----------|--------|
|        |   | **High** |   | **Low**  |   | **High** |   | **Low** |   |
| 1st Quarter |   | $        | .10    |     | $      | .05 |   | $ | .14 |   | $ | .10 |   |
| 2nd Quarter |   | $        | .10    |     | $      | .04 |   | $ | .39 |   | $ | .12 |   |
| 3rd Quarter |   | $        | .06    |     | $      | .04 |   | $ | .40 |   | $ | .13 |   |
| 4th Quarter |   | $        | .18    |     | $      | .04 |   | $ | .15 |   | $ | .09 |   |

 

No cash dividends have been declared on K-tel’s common stock during thepast two fiscal years and K-tel does not expect to pay cash dividends in theforeseeable future. Management plans to use cash generated from operations forexpansion of its business. The declaration or payment by K-tel of dividends, ifany, on its common stock in the future is subject to the discretion of theBoard of Directors and will depend on K-tel’s earnings, financial condition,capital requirements and other relevant factors. The declaration or payment byK-tel of dividends is also subject to the terms of its credit facility.

 

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**EquityCompensation Plan Information**

 

The following table provides information as of June 30, 2003 withrespect to compensation plans under which the Company’s equity securities areauthorized for issuance.

 
|                                                        |   | **Number of  securities to be  issued upon exercise of  outstanding options,  warrants and rights  (a)** |   | **Weighted-average  exercise price of  outstanding options,  warrants and rights  (b)** |   | **Number of  securities remaining  available for future issuance  under equity compensation plans  (excluding securities reflected in  column (a))  (c)** |      |
|-------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|-----------|
| Equity compensation  plans approved by security holders     |   | 142,900                                                                                                  | (1)    | $                                                                                       | 5.93   |                                                                                                                                                      | 2,387,989 | (2) |
| Equity compensation  plans not approved by security holders |   | 300,000                                                                                                  | (3)    | $                                                                                       | 0.05   |                                                                                                                                                      | NA        |   |
| Total                                                       |   | 442,900                                                                                                  |   | $                                                                                       | 1.95   |                                                                                                                                                      | 2,387,989 |   |

 

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(1)                                  Consistsof 140,900 shares issuable pursuant to options granted under the Company’s 1997Stock Option Plan and 2,000 shares of common stock issuable pursuant to optionsgranted under the Company’s 1987 Stock Incentive Plan.

 

(2)                                  Representsshares of common stock remaining available for future issuance under theCompany’s 1997 Stock Option Plan, as amended.

 

(3)                                  Includesnon-qualified stock options to purchase 95,000 shares of our common stockissued outside of the Company’s 1997 Stock Option Plan to each of Jay WilliamSmalley, Richard R. Marklund and Wesley C. Hayne in connection with suchnon-employee directors’ appointment to the Company’s Compensation/ Stock OptionCommittee and a non-qualified stock option to purchase 15,000 shares of ourcommon stock issued outside the Company’s 1997 Stock Option Plan to Jay WilliamSmalley in consideration of his past and continued service on the Company’s boardof directors. (See Director Compensation on page 18.) Does not include anaggregate of 2,137,939 shares of common stock issuable pursuant to a stockoption exchange program approved on March 18, 2003 by a committee of theCompany’s board of directors comprised solely of independent directors. Underthe program, four optionees agreed to cancellation of previously awardedoptions under the Company’s 1997 Stock Option Plan and the Company agreed toissue options to purchase an equal number of shares outside the Company’s stockoption plan not earlier than six months and one day after the date ofcancellation of the previously awarded options. The replacement options will beissued at an exercise price per share equal to the fair market value of theCompany’s common stock on the date of grant and will expire ten years after thedate of grant. The options previously awarded were cancelled on March 18, 2003and replacement options had not yet been granted as of the date of the table.

 

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**ITEM 6****:  SELECTED FINANCIAL DATA**

 

The followingsummary of consolidated operations and certain balance sheet informationincludes the consolidated results of operations of K-tel and its subsidiariesas of and for the five years ended June 30, 2003. This summary should be readin conjunction with the consolidated financial statements and notes theretoappearing elsewhere in this filing. All share and per share amounts are basedon the weighted average shares issued. All amounts are in thousands of dollars,except per share data.

 
|                               |   | **2003** |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
|                               |   |     |   |     |   |     |   |     |   |     |   |
| Net sales                          |   | $        | 7,234  |     | $      | 6,875    |   | $        | 17,514 |     | $      | 29,092 |   | $ | 44,650 |   |
| Operating income  (loss)           |   | $        | 53     |     | $      | (332     | )      | $        | (9,480 | )        | $      | (12,980 | ) | $ | (8,356 | ) |
| Loss from  discontinued operations |   | $        | (581   | )        | $      | (180     | )      | $        | (4,315 | )        | $      | (5,541 | ) | $ | (2,260 | ) |
| Extraordinary  item:               |   |     |   |     |   |     |   |     |   |     |   |
| Gain on  bankruptcies              |   | $        | — |     | $      | 894      |   | $        | 16,185 |     | $      | — |   | $ | — |   |
| Net income  (loss)                 |   | $        | (988   | )        | $      | 14       |   | $        | 1,369  |     | $      | (15,738 | ) | $ | (11,547 | ) |
| Net loss per  share:               |   |     |   |     |   |     |   |     |   |     |   |
| Continuing  operations             |   | $        | (.03   | )        | $      | (.05     | )      | $        | (.77   | )        | $      | (1.02 | ) | $ | (1.01 | ) |
| Total assets                       |   | $        | 4,757  |     | $      | 4,250    |   | $        | 3,832  |     | $      | 17,941 |   | $ | 32,249 |   |
| Long-term debt                     |   | $        | — |     | $      | —   |   | $        | 4,000  |     | $      | 4,000 |   | $ | 4,000 |   |

 

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**I****TEM 7****:  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**General**

 

Through its operating subsidiaries, K-tel licenses its music cataloginternationally and markets entertainment products mainly derived from itscatalog in the United States and Europe through retail and direct responsemarketing channels.

 

For this analysis, the following changes in the Company’s businessshould be considered: K-tel closed the operations of its German subsidiary,Dominion Vertriebs GmbH, in June 2000; one of its subsidiaries in the UnitedKingdom, K-tel Marketing Ltd., in November 2000; and a United Statessubsidiary, K-tel Consumer Products, Inc., in February 2001. These threeclosings represent the discontinuation of the Company’s consumer productsdivision and accordingly have been presented in the accompanying financialstatements as discontinued operations. In addition, in March 2001, theCompany’s music distribution subsidiary in the United States, K-tel (USA)ceased operations and filed for protection under Chapter 7 of the United StatesBankruptcy Code.

 

Through anothersubsidiary, K-tel Entertainment, Inc., K-tel has a focused method ofdistribution that targets the strengths of fewer individual retailers andsupplies products suited to each retailer’s specific needs. These new productsare derived from the Company’s master recordings music catalog with theobjective of realizing more competitive profit margins. As well, the Companyseeks to license its name and marks to other businesses for a royalty or fee.

 

**A.  RESULTS OF OPERATIONS**

 

The following sections discuss the results of operations by businesssegment. See Note 8 to the consolidated financial statements for additionalsegment information. General corporate expenses of $860,000 in the year endedJune 30, 2003, $1,049,000 in the year ended June 30, 2002 and $2,689,000 in theyear ended June 30, 2001 have been allocated to the segments.

 

**FISCAL2003 VERSUS FISCAL 2002**

 

Net sales for the year ended June 30, 2003 were $7,234,000, an increaseof 5.2% from fiscal 2002 sales of $6,875,000. This sales increase wasattributed to increased domestic music sales partially offset by a decrease inlicensing revenue. The net loss for fiscal 2003 was $988,000, or $.07 pershare, compared to a net income of $14,000, or $.00 per share (after anextraordinary gain of $894,000 related to the K-tel Marketing liquidation), infiscal 2002.

 

The following sections discuss the results of continuing operations bybusiness segment.

 

**BUSINESSSEGMENT RESULTS**

 

**Music**

 

Sales in the music segment were $4,454,000 for the year ended June 30,2003 compared to $3,757,000 for the year ended June 30, 2002, an increase of18.6%. The increase was primarily related to increased sales to Handleman whobecame a customer late in the prior year and to an increased number of productsavailable for sale during the most recently completed year.

 

Cost of goods sold in the music segment increased to 63.2% of sales forthe year ended June 30, 2003 compared to 54.2% of sales for the year ended June30, 2002. Advertising expenses within the segment, which consists primarily ofco-operative advertising payments, trade advertising and promotions, increasedto $200,000 for the year ended June 30, 2003 compared to $172,000 for the yearended June 30, 2002.

 

Selling, general and administrative expenses for the segment decreased$669,000, or 20.5%, to $2,600,000 for the year ended June 30, 2003 compared to$3,269,000 for the year ended June 30, 2002. The primary reasons for thedecrease were related the closing of the Company’s office in Germany in 2002and efforts to reduce overhead costs in the Company’s office in England. As aresult, the music segment incurred an operating loss of $1,106,000 for the yearended June 30, 2003 compared to an operating loss of $1,725,000 for the yearended June 30, 2002.

 

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**Licensing**

 

Licensing revenues were $2,780,000 for fiscal 2003 compared to$3,118,000 for fiscal 2002, a decrease of 10.8%. While European revenuedecreased $405,000, domestic revenue from licensing activity increased $67,000.The decrease in Europe reflected a reduced level of licensing in the musicindustry. While domestic licensing experienced this as well, licensing revenue fromthe Company’s main licensee increased significantly. In mid-2002, the Companyundertook a program to audit licensees of the music catalog in order to verifycompliance with the terms of license agreements. One of the audits undertakendetermined that a significant amount of revenue had not been reported to theCompany. During the year ended June 30, 2003 the licensee subject to this auditmade the royalty payments that are required under the license, and theCompany’s revenue has increased accordingly. While the Company expects otherlicensing activity to continue at a reduced level into the next fiscal year,the Company is hopeful that current efforts will help reverse this trend forthe Company during the year. Operating income in the licensing segment was$1,159,000 for the year ended June 30, 2003 and $1,393,000 for the year endedJune 30, 2002, a decrease of 16.8%.

 

**FISCAL2002 VERSUS FISCAL 2001**

 

Net sales for the year ended June 30, 2002 were $6,875,000, a decreaseof 61% from the year ended June 30, 2001 sales of $17,514,000. The salesdecrease was primarily attributed to the cessation of operations of theCompany’s domestic music distribution subsidiary, K-tel (USA), which had salesof $11,948,000 during 2001. For the fiscal year ended June 30, 2002,approximately 43% of the Company’s net sales were derived in Europe. Net incomefor the year ended June 30, 2002 was $14,000, or $.00 per share (after anextraordinary gain of $894,000 related to the K-tel Marketing liquidation),compared to a net income of $1,369,000, or $.10 per share (after anextraordinary gain of $16,185,000 related to the K-tel (USA) bankruptcy filing)in the year ended June 30, 2001.

 

The following sections discuss the results of continuing operations bybusiness segment.

 

**BUSINESSSEGMENT RESULTS**

 

**Music**

 

Sales in the music segment were $3,757,000 for the year ended June 30,2002 compared to $14,202,000 for the year ended June 30, 2001, a declineof 74%. European sales decreased $674,000 and domestic music sales decreased$9,965,000. The domestic business had been comprised primarily of sales ofmusic compilations produced by K-tel and the sales and distribution of otherrecord labels. Sales declined as K-tel (USA) ceased operations and filed forbankruptcy in March 2001. Sales during the year ended June 30, 2002 were inanother domestic subsidiary (K-tel Entertainment, Inc.) that markets productsderived from the Company’s proprietary master music catalog.

 

Cost of goods sold in the music segment decreased to 55% of sales forthe year ended June 30, 2002 compared to 106.9% of sales for the year endedJune 30, 2001. The cost of goods in excess of net sales for the year ended June30, 2001 reflected the disposal of slow-moving and obsolete inventory at pricesless than cost during the period. Advertising expenses within the segment,which consist primarily of co-operative advertising payments, trade advertisingand promotions, decreased to $183,000 for the year ended June 30, 2002 comparedto $513,000 for the year ended June 30, 2001. The decrease in advertisingspending was primarily the result of reduced levels of advertising during theyear ended June 30, 2002.

 

Selling, general and administrative expenses for the segment decreased$3,070,000, or 49%, to $3,269,000 for the year ended June 30, 2002 compared to$6,261,000 for the year ended June 30, 2001. The primary reasons for thedecrease were related to general overall spending reductions and nine months ofoperations of the domestic music distribution subsidiary in the year ended June30, 2001. As a result, the music segment incurred an operating loss of$1,725,000 for the year ended June 30, 2002 compared to an operating loss of$7,749,000 for the year ended June 30, 2001.

 

In connection with the K-tel Marketing Ltd. creditors’ liquidation inthe year ended June 30, 2002, the assets and liabilities of the subsidiary havebeen removed from the books of the Company and the remaining net liability hasbeen shown as a gain on liquidation. During the fiscal year ended June 30,2002, this subsidiary was not operating. During the fiscal year ended June 30,2001, this subsidiary had net sales of $3,179,000 and sustained an operatingloss of $3,220,000. Management believes the Company will have no ongoingliability related to this subsidiary as a result of the filing and the outcomeof the liquidation proceeding.

 

In connection with the K-tel (USA) bankruptcy filing in the year endedJune 30, 2001, the assets and liabilities of the subsidiary were removed fromthe books of the Company and the remaining net liability has been shown as again on liquidation. During the fiscal year ended June 30, 2002, thissubsidiary was not operating. During the fiscal year ended June 30, 2001, thissubsidiary had net sales of $11,948,000 and sustained an operating loss$5,229,000. Management believes

 

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the Company will have no ongoing liability related to this subsidiaryas a result of the filing and the outcome of the bankruptcy proceeding.

 

**Licensing**

 

Licensing revenues were $3,118,000 for the year ended June 30, 2002compared to $3,710,000 for the year ended June 30, 2001, a decrease of 15.9%.Included in the segment revenue in the year ended June 30, 2001 wasapproximately $763,000 of inter-company revenue, which was eliminated on theaccompanying consolidated financial statements. Operating income in thelicensing segment was $1,393,000 for the year ended June 30, 2002 and $425,000for the year ended June 30, 2001, an increase of 228%, which was a result ofoperational productivity improvements.

 

**Other**

 

The “Other” segment of the business was comprised of the e-commercebusiness, which was closed in the fourth quarter of 2001. The Company hadneither revenue nor losses from this segment in the years ended June 30, 2002and 2003. Revenue from this segment was $365,000 in the year ended June 30,2001. Operating losses from this segment were $2,156,000 in the year ended June30, 2001.

 

**Critical Accounting Policies**

 

Revenue Recognition – The Companyderives its revenue mainly from two sources: the sale of music compilations(predominately compact discs) produced by the Company, and license revenue fromthe licensing of Company-owned masters. Revenue from music sales is recognizedat the time of shipment to the customer, while license revenue is recognizedwhen payment is received from customers or when known amounts are receivable,as prior to that date collection is not considered probable. Most music salesare made with a right of return of unsold goods. Estimated reserves for returnsare established by management based upon historical experience and product mixand are subject to ongoing review and adjustment by the Company. These reservesare recorded at the time of sale and are reflected as a reduction in revenues.The Company’s reserve for returns was $213,000 at June 30, 2003 and $40,000 atJune 30, 2002.

 

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

 

Royalties - The Company has enteredinto license agreements with various record companies and publishers underwhich it pays royalties on units sold. The Company accrues royalties usingcontractual rates and certain estimated rates on applicable units sold. Thecontractual royalty liability is computed quarterly and the accrued royaltybalance is adjusted accordingly. The royalty agreements are subject to audit bylicensors.

 

**Recent Accounting Pronouncements**

 

In June 2002, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards No. 146 (SFAS 146), *Accounting for Costs Associated with Exit or DisposalActivities*. SFAS 146 provides financial accounting and reportingguidance for costs associated with exit or disposal activities, includingone-time termination benefits, contract termination costs other than for acapital lease, and costs to consolidate facilities or relocate employees. Thisstatement is effective for exit or disposal activities that are initiated afterDecember 31, 2002. Management does not believe this pronouncement will have amaterial effect on the Company’s consolidated financial position and results ofoperations.

 

In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others.*FIN45 addresses the disclosure requirements of a guarantor in its interim andannual financial statements about its obligations under certain guarantees thatis has issued. FIN 45 also requires a guarantor to recognize, at the inceptionof a guarantee, a liability for the fair value of the obligation undertaken inissuing the guarantee. The disclosure requirements of FIN 45 were effective forthe Company for its quarter ended December 31, 2002. The liability recognitionrequirement is applicable prospectively to all guarantees issued or modifiedafter December 31, 2002. This pronouncement is not anticipated to have amaterial effect on the Company’s consolidated financial position or results ofoperations.

 

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In December 2002, the FASB issued Statement 148 (FAS 148), *Accounting for Stock-Based Compensation Transitionand Disclosure.* FAS 148 amends the disclosure and certain transitionprovisions of Statement 123, *Accounting forStock-Based Compensation.* Its disclosure provisions, which apply toall entities with employee stock-based compensation, are effective for fiscalyears ending after December 15, 2002. New interim period disclosures wererequired in financial statements for interim periods beginning after December15, 2002. This pronouncement is not anticipated to have a material effect onthe Company’s consolidated financial position or results of operations.

 

In January 2003, the FASB issued Interpretation (FIN 46), *Consolidation of Variable Interest Entities.*FIN 46 is an interpretation of Accounting Research Bulletin No. 51, *Consolidated Financial Statements,* andaddresses consolidation by business enterprises of variable interest entities.FIN 46 applies immediately to variable interest entities created or obtainedafter January 31, 2003 and it applies in the first fiscal year or interimperiod beginning after June 15, 2003, to variable interest entities in which anenterprise holds a variable interest that is acquired before February 1, 2003.This pronouncement is not anticipated to have a material effect on theCompany’s consolidated financial position or results of operations.

#  

# In May 2003, the FASB issuedStatement 150, *Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity*.Statement 150 changes the classifications in the statement of financialposition of certain common financial instruments from either equity ormezzanine presentation to liabilities and requires an issuer of those financialstatements to recognize changes in fair value or redemption amount, asapplicable, in earnings. SFAS 150 is effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003. Adoptionof Statement 150 is not anticipated to have an impact on the Company’sconsolidated financial position or results of operations.

 

## **B. 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, theChairman of the Board, President and Chief Executive Officer of K-tel. Underthe terms of the agreement (the “K-5 Facility”), K-5 has agreed to makeavailable up to $8,000,000 to K-tel on a revolving basis. The loan bearsinterest at a variable rate based upon the “base rate” of a nationallyrecognized lending institution (4.0% at June 30, 2003), expires July 20, 2005,and is subordinated to the Foothill loan (see below). The K-5 Facility containsthe same covenants as the Foothill loan agreement. K-tel has pledged the stockof its foreign subsidiaries as collateral for the loan, and the loan carries asubordinated position to the Foothill loan on all other assets of the Company.K-tel had outstanding balances of $7,282,000 and $6,026,000 as of June 30, 2003and 2002 respectively under the K-5 Facility. At June 30, 2003, K-tel obtaineda waiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

 

In addition, K-tel has a second loan agreement with K-5, under whichK-5 assumed rights and obligations under a loan from the Company’s formerbanker (Foothill Capital Corporation) pursuant to an Assignment and AcceptanceAgreement dated February 27, 2001. This Foothill loan, which has been extendedthrough July 20, 2005, provides for a $10,000,000 credit facility consisting ofa $4,000,000 term loan due upon expiration, and a $6,000,000 revolving facilityunder which borrowings are limited to a percent of eligible receivables.Borrowings under the facility bear interest at a variable rate based on a “baserate” of a nationally recognized lending institution plus 1% (5.0% at June 30,2003) and are collateralized by the assets of certain Company subsidiaries inthe United States, including accounts receivable, inventories, equipment, musiclibrary and general intangibles. The loan agreement contains certain financialand other covenants or restrictions, including the maintenance of a minimumshareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of June 30, 2003 and 2002,$4,000,000 was outstanding under the term loan and there were no borrowingsunder the revolving facility. At June 30, 2003, K-tel obtained a waiver fromK-5 for its non-compliance under the covenants, limitations and restrictions ofthe credit agreement.

 

K-tel has an overdraft privilege borrowing facility with The Royal Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2.0% per annum over the baserate (a total of 5.75% at June 30, 2003) but are subject to a minimum of 6% perannum. K-tel had outstanding balances of $233,000 and $227,000 as of June 30,2003 and 2002 respectively.

 

K-tel hasprimarily funded its operations to date through internally generated capital,proceeds from stock option exercises and secured loans from K-5. Managementcurrently believes that K-tel has sufficient cash and borrowing capacity to ensurethe Company will continue operations in the near term. In part, this is aresult of improvement in operating results in fiscal 2003 as well as the twoexisting lines of credit with K-5. Although K-5 continues to advance fundssufficient to meet the

 

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Company’s needs atthis time, there can be no assurance that this will be adequate or continue inthe future or that K-tel will be able to obtain additional financing uponfavorable terms when required.

 

The Company’s ability to continue its present operations and implementfuture expansion plans successfully is contingent mainly upon its ability tomaintain its line of credit arrangements with K-5, increase its revenues andprofit margins, and ultimately attain and sustain profitable operations.Without increased revenues and sustained profitability beyond the near term,the cash generated from the Company’s current operations will likely beinadequate to fund operations and service its indebtedness on an ongoing basis.Management is focusing its efforts on music licensing and limited musicdistribution. However, there can be no assurance that the Company will achieveprofitable operations through these efforts. In the event the Company is unableto fund its operations and implement its current business plan properly, it maybe unable to continue operations. The financial statements do not include anyadjustments that might result from the outcome of these uncertainties. Thereport of the Company’s independent certified public accountants as of June 30,2003 and 2002 and for the three years in the period ended June 30, 2003included an explanatory paragraph expressing doubt about our ability tocontinue as a going concern.

 

**CAUTIONARY STATEMENT**

 

Certaininformation of a non-historical nature contained in Items 1, 2, 3 and 7 of thisForm 10-K include forward-looking statements. Words such as “anticipates”,“believes”, “expects”, “intends”, “future”, and similar expressions identifyforward-looking statements. Any such forward-looking statements reflect theCompany’s current views with respect to future events and financialperformance, and are subject to a variety of factors that could cause theactual results or performance to differ materially from historical results orfrom the anticipated results or performance expressed or implied by suchforward-looking statements. Because of such factors, the Company cannot assureyou that the actual results or developments that it anticipates will berealized or, even if substantially realized, that they will have theanticipated results.

 

Therisks and uncertainties that may affect the Company’s business include, but arenot limited to, those set forth below. The risks and uncertainties set forthbelow incorporate both historical and “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended, and Section21E of the Securities Exchange Act of 1934, as amended. You should not placeundue reliance on such forward-looking statements, which speak only as of thedate hereof. You should also be aware that, except as the law may otherwiserequire, the Company undertakes no obligation to publicly revise any suchforward-looking statements to reflect events or circumstances that may ariseafter the date of this report. The following information is not intended tolimit in any way the characterization of other statements or information underother captions as cautionary statements for such purpose. The order in whichsuch factors appear below should not be construed to indicate their relativeimportance or priority.

 

•                                          The Company incurred lossesin the fiscal years ended June 30, 2003 and June 30, 2002 and expects tocontinue incurring losses in the near future.

 

•                                          Continuation and expansionof the Company’s operations will require additional working capital andcontinued access to financing to meet working capital requirements and developnew business opportunities.

 

•                                          The Company has primarilyfunded its operations to date through internally generated capital, proceedsfrom stock option exercises and secured loans from K-5 Leisure Products, Inc.(“K-5”), the Company’s largest shareholder controlled by Philip Kives, theChairman of the Board, President and Chief Executive Officer of K-tel, andthere can be no assurance that K-5 will continue to advance funds sufficient tomeet the Company’s needs or that the Company will be able to obtain additionalfinancing upon favorable terms when required.

 

•                                          Approximately 30.1% of theCompany’s revenue for the year ended June 30, 2003, was derived from two majorcustomers, and the loss of any such customer could have a material adverseeffect on the Company.

 

•                                          The music business is highly competitive anddominated by several major record companies that dominate the market forpre-recorded music, have greater financial resources than the Company and havea larger depth and breadth of catalog, distribution capabilities and currentrepertoire than the Company, making it difficult to compete in this market.

 

•                                          The major pre-recorded music companies,either directly or through subsidiaries, now manufacture or distributepre-recorded music compilations in direct competition with the Company’s musiccompilation products.

 

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**ITEM 7A****:  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

K-tel is exposed to various market risks, including changes in interestrates and foreign currency exchange rates. Market risk is the potential lossarising from adverse changes in market rates and prices, such as interest ratesand foreign currency exchange rates. K-tel does not enter into derivatives orother financial instruments for trading or speculative purposes.

 

K-tel’s exposure to market risk for changes in interest rates relatesto K-tel’s short-term borrowings. K-tel’s short-term credit facilities carry avariable interest rate that does have an impact on future earnings and cashflows. At June 30, 2003, K-tel had variable rate debt of $11,515,000. If theinterest rate were to change 100 basis points or 1% while K-tel was borrowingunder the credit facilities, interest expense would change by $115,000.

 

Approximately 32% of K-tel’s revenues during the year ended June 30,2003 were derived from operations in Europe. The results of operations andfinancial position of K-tel’s operations in Europe were principally measured intheir respective currencies and translated into U.S. dollars. The effect offoreign currency fluctuations in these European countries is somewhat mitigatedby the fact that expenses are generally incurred in the same currencies inwhich the revenue is generated. The reported income of these subsidiaries willbe higher or lower depending on the weakening or strengthening of the U.S.dollar against the respective foreign currency. If the U.S. dollar foreigncurrency rate were to change by 1%, the effect on income would be $4,000.Additionally, approximately 18% of K-tel’s assets at June 30, 2003 were basedin its foreign operations and were translated into U.S. dollars at foreigncurrency exchange rate in effect as of the end of each accounting period, withthe effect of such translation reflected as a separate component ofconsolidated shareholders’ equity (deficit). Accordingly, K-tel’s consolidated shareholders’equity (deficit) will fluctuate depending on the weakening or strengthening ofthe U.S. dollar against the respective foreign currency.

 

**ITEM 8****:  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

The consolidated financial statements and related notes and schedulesrequired by this Item are set forth in Part IV, Item 15, and identified inthe index on page 23.

 

**ITEM 9****:  CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

There were no changes in or disagreementswith accountants during the years ended June 30, 2003 and June 30, 2002.

#  

# **ITEM 9A****:  CONTROLS AND PROCEDURES**

 

# Under thesupervision and with the participation of the Company’s management, includingthe Company’s Chief Executive Officer and Chief Financial Officer, the Companyevaluated the effectiveness of the design and operation of its disclosurecontrols and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under theExchange Act). Based upon that evaluation, the Chief Executive Officer andChief Financial Officer concluded that, as of the end of the period covered bythis report, the Company’s disclosure controls and procedures are adequatelydesigned to ensure that information required to be disclosed by the Company inthe reports it files or submits under the Exchange Act is recorded, processed,summarized and reported, within the time periods specified in applicable rulesand forms.

 

# During theCompany’s most recent fiscal quarter, there has been no change in the Company’sinternal control over financial reporting (as defined in Rule 13a-15(f) or15d-15(f) under the Exchange Act) that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

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**PART III**

 

**ITEM 10****:  DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

 

The following describes the business, the business experience andbackground of each director and executive officer of K-tel.

 

**WesleyC. Hayne**, age 56, waselected a director in November 2002. Since 2000, Mr. Hayne has been ChiefExecutive Officer of Biorefining, Inc., a company that develops, commercializesand licenses patented technologies capable of converting residual plantmaterial into high-end, value-added products. From 1999 to 2000, Mr. Hayne wasPresident of Cybrix Corporation, Inc., a company that provides solutions andleases staffing for computer security and disaster planning. From 1997 to 2000,Mr. Hayne was Chief Executive Officer of International Concept Development,Inc., a company that develops fast food restaurants in Europe. Mr. Hayne fileda petition under Chapter 7 of the Bankruptcy Code before the U.S. BankruptcyCourt for the District of Minnesota on February 16, 1999, resulting in thedischarge of personal debts effective May 10, 1999.

 

**PhilipKives**, age 74,founded K-tel in 1968 and has served as its Chairman of the Board since K-tel’sinception. In addition, Mr. Kives has been the Chief Executive Officer for morethan five years.

 

**Richard Marklund**, age58, was elected a director in November 2002. Since 2002, Mr. Marklund has beenChairman and Chief Executive Officer of Phoenix Newcastle Holdings, Inc., amanagement consulting company. From 2000 until 2002, Mr. Marklund served asExecutive Vice President of Wamnet Inc., a data communication company. From1998 until 2000, Mr. Marklund served as Chief Executive Officer of HyperportInternational, Inc., a real estate development company.

 

**JayWilliam Smalley**, age69, was elected a director in January 1999. Since 1970, Mr. Smalley hasbeen Chief Executive Officer of JWS, Inc., a privately owned real estatedevelopment and sales company specializing in hotel, motel, industrial andresidential properties.

 

**DennisW. Ward**, age 57,was elected a director in January 1999 and the Company’s Secretary and ChiefFinancial Officer in December 2000. Since 1990, Mr. Ward has been theController of K-tel International, Ltd., a Canadian corporation owned by PhilipKives and engaged in the marketing and distribution of consumer products, andof K-5 Leisure Products, Inc. (K-tel’s largest shareholder).

 

**Section 16(a) Beneficial OwnershipReporting Compliance**

 

Section 16(a) of theSecurities Exchange Act of 1934, as amended, requires K-tel’s officers,directors and persons who own more than 10% of a registered class of K-tel’sequity securities to file reports of ownership on Form 3 and changes inownership on Form 4 or 5 with the Securities and Exchange Commission. Suchofficers, directors and 10% shareholders also are required by Securities andExchange Commission’s rules to furnish K-tel with copies of all Section 16(a)reports they file. Based solely on its review of the copies of such formsreceived by it, or written representations from certain reporting persons, theCompany believes that during the last fiscal year, its officers, directors and10% shareholders filed all reports on a timely basis, except as set forthherein.

 

Reports on Form 3 for Richard Marklund and Wesley Hayne due followingtheir election to the board of directors effective November 27, 2002 werenot filed on a timely basis. A report on Form 4 relating to the grant ofoptions to purchase an aggregate of 110,000 shares of common stock outside our1997 Stock Option Plan to Jay William Smalley on November 27, 2002 was notfiled on a timely basis. A report on Form 4 disclosing the cancellation ofoptions to purchase common stock pursuant to the Company’s Stock OptionExchange Program effective March 18, 2003 was not filed in a timely manner byeach of Philip Kives and Dennis Ward.

 

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**ITEM 11****:  EXECUTIVE COMPENSATION**

 

The following table sets forth the aggregate cash compensation paid toor accrued by each of K-tel’s executive officers for services rendered to K-telduring the fiscal years ended June 30, 2003, 2002 and 2001. K-tel has nowritten employment agreements with its executive officers.

 

**Summary Compensation Table**

 
|                            |   | **Annual  Compensation** |   | **Long-Term  Compensation  Awards** |   |      |   |
|---------------------------------|--------|--------------------------|--------|-------------------------------------|--------|-----------|--------|
| **Name and Principal Position** |   | **Fiscal  Year**         |   | **Salary**                          |   | **Bonus** |   | **Securities  Underlying  Options** |   | **All Other  Compensation** |   |
|                            |   |                     |   |                                |   |      |   |   |   |   |   |
| Philip Kives                    |   | 2003                     |   | $                                   | — |      | $      | — |   | — |   | $ | — |   |
| Chief Executive  Officer        |   | 2002                     |   | $                                   | — |      | $      | — |   | — |   | $ | — |   |
|                            |   | 2001                     |   | $                                   | — |      | $      | — |   | 80,000 |   | $ | — |   |
|                            |   |                     |   |                                |   |      |   |   |   |   |   |
| Dennis Ward                     |   | 2003                     |   | $                                   | — |      | $      | — |   | — |   | $ | — |   |
| Chief Financial  Officer        |   | 2002                     |   | $                                   | — |      | $      | — |   | — |   | $ | — |   |
|                            |   | 2001                     |   | $                                   | — |      | $      | — |   | 190,000 |   | $ | — |   |

 

No options were grantedduring the fiscal year ended June 30, 2003, to any of K-tel’s executiveofficers.

 

No options were exercised by the executive officers during the lastfiscal year and no unexercised options were held by the executive officers asof the end of the last fiscal year.

 

**DirectorCompensation**

 

Directors who areemployees of our Company receive no compensation for their services asdirector. Non-employee directors receive cash compensation of $10,000 per year(paid quarterly) and are entitled to receive non-qualified stock options forthe purchase of 5,000 shares of our common stock at an exercise price equal tothe fair market value of our common stock on the date of initial election andupon each re-election by the shareholders at an annual or special meeting. Inconnection with their appointment to the Company’s Compensation/Stock OptionCommittee during the fiscal year ended June 30, 2003, Jay William Smalley,Richard R. Marklund and Wesley C. Hayne each also received a non-qualifiedstock option to purchase 95,000 shares of our common stock issued outside theCompany’s 1997 Stock Option Plan. During the fiscal year ended June 30, 2003,Mr. Smalley also received a non-qualified stock option to purchase 15,000shares of common stock outside the Company’s 1997 Stock Option Plan inconsideration of his past and continued service on the Company’s board ofdirectors. All stock options issued to non-employee directors during the fiscalyear ended June 30, 2003 are exercisable for a period of ten years from thedate of grant and bear an exercise price equal to the last sale price of ourcommon stock as quoted by the OTC Bulletin Board for the five trading daysimmediately ending after the close of the market on November 27, 2002, the datethe board of directors resolved to grant such options.

 

**ITEM 12****:  SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

The following table contains certain information as of September 22,2003, regarding the beneficial ownership of the Common Stock by (i) each personknown to K-tel to own beneficially five percent or more of the Common Stock,(ii) each director of K-tel, (iii) each executive officer of K-tel and (iv) thedirectors and executive officers as a group. The percentage of beneficialownership is based on 13,653,738 shares outstanding as of September 22, 2003.Any shares which are subject to an option or a warrant exercisable within 60days are reflected in the following table and are deemed to be outstanding forthe purpose of computing the percentage of Common Stock owned by the option orwarrant holder but are not deemed to be outstanding for the purpose ofcomputing the percentage of Common Stock owned by any other person. Unlessotherwise indicated, each person in the table has sole voting and investmentpower as to the shares shown. Unless otherwise indicated, the address for eachlisted shareholder is c/o K-tel International, Inc., 2655 Cheshire LaneNorth,  Suite 100, Plymouth, Minnesota55447.

 

17

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|                                                                     |   | **Amount and  Nature  of Beneficial Ownership(1)** |   | **Percentage  of  Outstanding Stock** |   |
|--------------------------------------------------------------------------|--------|----------------------------------------------------|--------|---------------------------------------|--------|
|                                                                     |   |                                               |   |                                  |   |
| Philip Kives  220 Saulteaux Crescent  Winnipeg, Manitoba R3J 3W3  Canada |   | 7,799,614                                          | (2)    | 57.1                                  | %      |
| Dennis Ward                                                              |   | —                                             | (3)    | —                                |   |
| Jay William  Smalley                                                     |   | 120,000                                            | (4)    | *                                     |   |
| Wesley C. Hayne                                                          |   | 100,000                                            | (4)    | *                                     |   |
| Richard Marklund                                                         |   | 100,000                                            | (4)    | *                                     |   |
| All directors  and officers as a group  (5 persons)                      |   | 8,119,614                                          | (5)    | 59.5                                  | %      |

 

----

*                                         Indicatesownership of less than 1% of the outstanding shares of Common Stock.

(1)                                  Thesecurities “beneficially owned” by a person are determined in accordance withthe definition of “beneficial ownership” set forth in the regulations of theSecurities and Exchange Commission and accordingly, may include securitiesowned by or for, among others, the spouse, children or certain other relativesof such person as well as other securities as to which the person has or sharesvoting or investment power or has the right to acquire within 60 days. Morethan one person may beneficially own the same shares.

(2)                                  Consistsof 7,474,278 shares held directly by K-5 Leisure Products Inc. (an affiliate ofthe Company controlled by Mr. Kives), and 325,336 shares held by a wholly-ownedsubsidiary of K-5. Does not include 1,702,939 shares purchasable upon theexercise of options proposed to be granted pursuant to the terms of a “StockOption Exchange Program”. (See footnote 2 to Equity Compensation PlanInformation table on page 8.)

(3)                                  Doesnot include 255,000 shares purchasable upon exercise of options proposed to begranted pursuant to the terms of a “Stock Option Exchanage Program”. (Seefootnote 2 to Equity Compensation Plan Information table on page 8.)

(4)                                  Representsshares purchasable upon the exercise of options.

(5)                                  Includes320,000 shares purchasable upon the exercise of options.

 

**ITEM 13****:  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

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, theChairman of the Board, President and Chief Executive Officer of K-tel. Underthe terms of the agreement (the “K-5 Facility”), K-5 has agreed to makeavailable up to $8,000,000 to K-tel on a revolving basis. The loan bearsinterest at a variable rate based upon the “base rate” of a nationallyrecognized lending institution (4.0% at June 30, 2003), expires July 20, 2005,and is subordinated to the Foothill loan (see below). The K-5 Facility containsthe same covenants as the Foothill loan agreement. K-tel has pledged the stockof its foreign subsidiaries as collateral for the loan, and the loan carries asubordinated position to the Foothill loan on all other assets of the Company.K-tel had outstanding balances of $7,282,000 and $6,026,000 as of June 30, 2003and 2002 respectively under the K-5 Facility. At June 30, 2003, K-tel obtaineda waiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

 

In addition, K-tel has a second loan agreementwith K-5, under which K-5 assumed rights and obligations under a loan from theCompany’s former banker (Foothill Capital Corporation) pursuant to anAssignment and Acceptance Agreement dated February 27, 2001. ThisFoothill 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 uponexpiration, and a $6,000,000 revolving facility under which borrowings arelimited to a percent of eligible receivables. Borrowings under the facilitybear interest at a variable rate based on a “base rate” of a nationallyrecognized lending institution plus 1% (5.0% at June 30, 2003) and arecollateralized by the assets of certain Company subsidiaries in the UnitedStates, including accounts receivable, inventories, equipment, music libraryand general intangibles. The loan agreement contains certain financial andother covenants or restrictions, including the maintenance of a minimumshareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of June 30, 2003 and 2002,$4,000,000 was outstanding under the term loan and there were no borrowingsunder the revolving facility.

 

18

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At June 30, 2003, K-telobtained 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 Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2.0% per annum over the baserate (a total of 5.75% at June 30, 2003) but are subject to a minimum of 6.0%per annum. K-tel had outstanding balances of $233,000 and $227,000 as of June30, 2003 and 2002 respectively.

 

The Company purchased approximately $463,000 in the year ended June 30,2003, $366,000 in the year ended June 30, 2002 and $574,000 in the year endedJune 30, 2001 of music entertainment and consumer convenience products fromK-5, which represented 14.6%, 14.7% and 3.7% of cost of goods sold,respectively. There were trade payables to K-5 of $371,000 at June 30, 2003, $291,000 at June 30, 2002 and $285,000 at June 30, 2001, or 31.9%, 23.0% and22.2% of total trade payables, respectively.

 

The Company had no sales of consumer convenience products to K-5 duringfiscal years 2003 and 2002 and sales of $13,000 during fiscal 2001. There was abalance receivable from K-5 at June 30, 2003 of $73,000, June 30, 2002 of$129,000 and June 30, 2001 of $109,000. No interest was charged on the relatedoutstanding balances during fiscal years 2003, 2002 and 2001.

 

During the fiscal year ended June 30, 2003, the Company licensedcertain marks to K-tel Drug Mart Ltd., a Canadian direct marketer ofprescription drugs owned by Philip Kives, the Chairman of the Board, Presidentand Chief Executive Officer of K-tel. The terms of the license agreementbetween the Company and K-tel Drug Mart have not been finalized, but willinvolve payment of a royalty to the Company by K-tel Drug Mart for use of thetrademark. The agreement is currently under consideration by the Company, andwill be subject to approval by the Company’s independent directors.

 

# **ITEM 14****. ****PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

# Pursuant to SECRelease No. 33-8183 (as amended by Release No. 33-8183A), the disclosurerequirements of this Item are not effective until the Annual Report on Form10-K for the first fiscal year ending after December 15, 2003.

 

19

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**PART IV**

 

**ITEM 15****:  EXHIBITS, FINANCIAL STATEMENT SCHEDULES ANDREPORTS ON FORM 8-K**

 

(a)                                  FinancialStatements and Schedules

 

The consolidated statements and schedules listed inthe accompanying Index to Consolidated Financial Statements and Schedules onpage 23 hereof are filed as part of this report.

 

(b)                                 Reportson 8-K

 

There were no reports filed under Form 8-K by theCompany for the quarter ended June 30, 2003.

 

(c)                                  Exhibits

 

Reference is made to the Exhibit Index on Page 41.

 

(d)           ExcludedFinancial Statements

 

Not applicable.

 

20

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the Company has duly caused this report to be signed onits behalf on October 14, 2003, by the undersigned, thereunto duly authorized.

 
|   | K-TEL INTERNATIONAL, INC.              |
|--------|----------------------------------------|
|   |                                   |
|   | By                                     |  /s/ Philip Kives |   |
|   | (Philip Kives - Chairman of the Board, |
|   | Chief Executive Officer and President) |

 

 

Pursuant to the requirements of the Securities and Exchange Act of1934, this report has been signed below by the following persons on behalf of theregistrant and in the capacities indicated and on the dates indicated.

 
| **Signatures**          |   | **Title**                                              |                                | **Date** |
|-------------------------|--------|--------------------------------------------------------|-------------------------------------|----------|
|                    |   |                                                   |                                |     |
| /s/ Philip Kives        |   |                                                   | Chairman, Chief Executive  Officer, |     | October 14, 2003 |
| Philip Kives            |   | (Principal Executive  Officer)  President and Director |                                |     |
|                    |   |                                                   |                                |     |
| /s/ Dennis Ward         |   |                                                   | Chief Financial Officer             |     | October 14, 2003 |
| Dennis Ward             |   | (Principal Accounting  Office  Director                |                                |     |
|                    |   |                                                   |                                |     |
| /s/ Jay William Smalley |   |                                                   | Director                            |     | October 14, 2003 |
| Jay William Smalley     |   |                                                   |                                |     |
|                    |   |                                                   |                                |     |
| /s/ Wesley C. Hayne     |   |                                                   | Director                            |     | October 14, 2003 |
| Wesley C. Hayne         |   |                                                   |                                |     |
|                    |   |                                                   |                                |     |
| /s/ Richard Marklund    |   |                                                   | Director                            |     | October 14, 2003 |
| Richard Marklund        |   |                                                   |                                |     |

 

21

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## **K-TEL INTERNATIONAL, INC.AND SUBSIDIARIES**

**INDEX****TOCONSOLIDATED FINANCIAL STATEMENTS**

 
| Report  of Independent Certified Public Accountants                                                                            |
|--------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                           |
| Consolidated Balance Sheets as of June  30, 2003 and 2002                                                                      |
|                                                                                                                           |
| Consolidated Statements of  Operations for each of the three years in the period ended June 30, 2003                           |
|                                                                                                                           |
| Consolidated Statements of  Shareholders’ Equity (Deficit) for each of the three years in the period  ended June 30, 2003 |
|                                                                                                                           |
| Consolidated  Statements of Cash Flows for each of the three years in the period ended June  30, 2003                          |
|                                                                                                                           |
| Notes  to Consolidated Financial Statements                                                                                    |
|                                                                                                                           |
| Supplemental Schedule to Consolidated Financial  Statements:                                                                   |
|                                                                                                                           |
| Schedule II - Valuation and Qualifying  Accounts for each of the three years in the period ended June 30, 2003                 |

 

All other schedules for which provision is made in the applicableaccounting regulations of the Securities and Exchange Commission have beenomitted as not required, not applicable or the information required has beenincluded elsewhere in the consolidated financial statements and notes thereto.

 

22

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**REPORTOF****INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS**

 

 

To the Board of Directors and Shareholders of K-tel International, Inc.

 

We have audited the accompanying consolidated balance sheets of K-telInternational, Inc. (a Minnesota corporation) and subsidiaries as ofJune 30, 2003 and 2002 and the related consolidated statements ofoperations, shareholders’ equity (deficit), and cash flows for each of thethree years in the period ended June 30, 2003. These financial statements arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we planand perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall financial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of K-telInternational, Inc. and subsidiaries as of June 30, 2003 and 2002 and theresults of their operations and their cash flows for the each of the threeyears in the period ended June 30, 2003 in conformity with accountingprinciples generally accepted in the United States of America.

 

The accompanying financial statements have been prepared assuming thatthe Company will continue as a going concern. As discussed in Note 1 to thefinancial statements, the Company has incurred significant recurring lossesfrom operations and has a net working capital deficit that raises substantialdoubt about the Company’s ability to continue as a going concern. Management’splans in regard to these matters are also described in Note 1. The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 

We have also audited Schedule II for each of the three years in theperiod ended June 30, 2003. In our opinion, this schedule, when considered inrelation to the basic financial statements taken as a whole, presents fairly,in all material respects, the information therein.

 

 
|                    |   | /S/ GRANT THORNTON LLP |   |
|-------------------------|--------|------------------------|--------|
|                    |   |                   |
| Minneapolis, Minnesota, |   |                   |
| August 7, 2003          |   |                   |

 

23

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**K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES**

## **CONSOLIDATED BALANCE SHEETS**

**JUNE 30,**

*(in thousands - except share data)*

 
|                                                                                                  |   | **2003** |   | **2002** |   |
|-------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                                                                  |   |     |   |     |   |
| ASSETS                                                                                                |   |     |   |     |   |
|                                                                                                  |   |     |   |     |   |
| Current Assets:                                                                                       |   |     |   |     |   |
| Cash and cash  equivalents                                                                            |   | $        | 1,219  |     | $      | 75 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $25 and $68                           |   | 1,559    |   | 1,656    |   |
| Inventories                                                                                           |   | 520      |   | 637      |   |
| Royalty advances                                                                                      |   | 235      |   | 282      |   |
| Prepaid expenses  and other                                                                           |   | 304      |   | 378      |   |
| Total Current  Assets                                                                                 |   | 3,837    |   | 3,028    |   |
|                                                                                                  |   |     |   |     |   |
| Property and  equipment, net of accumulated depreciation and amortization of $1,506 and  $1,418       |   | 101      |   | 162      |   |
|                                                                                                  |   |     |   |     |   |
| Owned catalog  masters, net of accumulated amortization of $2,755 and $2,829                          |   | 819      |   | 1,060    |   |
|                                                                                                  |   |     |   |     |   |
|                                                                                                  |   | $        | 4,757  |     | $      | 4,250 |   |
|                                                                                                  |   |     |   |     |   |
| LIABILITIES AND  SHAREHOLDERS’ DEFICIT                                                           |   |     |   |     |   |
|                                                                                                  |   |     |   |     |   |
| Current  Liabilities:                                                                                 |   |     |   |     |   |
| Notes payable to  affiliate and other                                                                 |   | $        | 11,515 |     | $      | 10,253 |   |
| Accounts payable                                                                                      |   | 1,162    |   | 1,264    |   |
| Accrued  royalties                                                                                    |   | 2,333    |   | 2,245    |   |
| Reserve for  returns                                                                                  |   | 213      |   | 40       |   |
| Net liabilities  of discontinued operations                                                           |   | 116      |   | 92       |   |
| Total Current  Liabilities                                                                            |   | 15,339   |   | 13,894   |   |
|                                                                                                  |   |     |   |     |   |
| 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                                                                                  |   | (31,759  | )      | (30,771  | )      |
| Accumulated  other comprehensive loss                                                                 |   | (251     | )      | (301     | )      |
| Total  Shareholders’ Deficit                                                                     |   | (10,582  | )      | (9,644   | )      |
|                                                                                                  |   |     |   |     |   |
|                                                                                                  |   | $        | 4,757  |     | $      | 4,250 |   |

 

*Theaccompanying notes are an integral part of these financial statements.*

 

24

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

## **YEARSENDED JUNE 30,**

*(inthousands - except per share data)*

 

 
|                                                                       |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                       |   |     |   |     |   |     |   |
| Net Sales                                                                  |   | $        | 7,234  |     | $      | 6,875    |   | $ | 17,514 |   |
|                                                                       |   |     |   |     |   |     |   |
| Costs and  Expenses:                                                       |   |     |   |     |   |     |   |
| Cost of goods  sold                                                        |   | 3,181    |   | 2,485    |   | 15,658   |   |
| Advertising                                                                |   | 200      |   | 172      |   | 618      |   |
| Selling, general  and administrative                                       |   | 3,800    |   | 4,550    |   | 10,718   |   |
| Total Costs and  Expenses                                                  |   | 7,181    |   | 7,207    |   | 26,994   |   |
| Operating Income  (Loss)                                                   |   | 53       |   | (332     | )      | (9,480   | )      |
|                                                                       |   |     |   |     |   |     |   |
| Other Income  (Expense):                                                   |   |     |   |     |   |     |   |
| Interest income                                                            |   | —   |   | —   |   | 155      |   |
| Interest expense                                                           |   | (534     | )      | (472     | )      | (912     | )      |
| Foreign currency  transaction loss                                         |   | —   |   | —   |   | (360     | )      |
| Other income  (expense)                                                    |   | 74       |   | (37      | )      | —   |   |
| Total Other  Income (Expense)                                              |   | (460     | )      | (509     | )      | (1,117   | )      |
|                                                                       |   |     |   |     |   |     |   |
| Loss from  Continuing Operations Before Income Taxes                       |   | (407     | )      | (841     | )      | (10,597  | )      |
|                                                                       |   |     |   |     |   |     |   |
| Benefit for  Income Taxes                                                  |   | —   |   | 141      |   | 96       |   |
|                                                                       |   |     |   |     |   |     |   |
| Loss from  Continuing Operations                                           |   | (407     | )      | (700     | )      | (10,501  | )      |
|                                                                       |   |     |   |     |   |     |   |
| Discontinued  Operations:                                                  |   |     |   |     |   |     |   |
| Loss from  Discontinued Operations                                         |   | (581     | )      | (180     | )      | (4,315   | )      |
|                                                                       |   |     |   |     |   |     |   |
| Loss before  Extraordinary Item                                            |   | (988     | )      | (880     | )      | (14,816  | )      |
|                                                                       |   |     |   |     |   |     |   |
| Extraordinary  Item:                                                       |   |     |   |     |   |     |   |
| Gain on  Subsidiary Liquidations                                           |   | —   |   | 894      |   | 16,185   |   |
|                                                                       |   |     |   |     |   |     |   |
| Net Income  (Loss)                                                         |   | $        | (988   | )        | $      | 14       |   | $ | 1,369 |   |
|                                                                       |   |     |   |     |   |     |   |
| Income (Loss)  per Share – Basic and Diluted:                         |   |     |   |     |   |     |   |
| Continuing  Operations                                                     |   | $        | (.03   | )        | $      | (.05     | )      | $ | (.77 | ) |
| Discontinued  Operations                                                   |   | (.04     | )      | (.01     | )      | (.32     | )      |
| Extraordinary  Item                                                        |   | —   |   | .06      |   | 1.19     |   |
| Net Income  (Loss)                                                         |   | $        | (.07   | )        | $      | .00      |   | $ | .10 |   |
|                                                                       |   |     |   |     |   |     |   |
| Shares used in  the calculation of loss per share– Basic and Diluted: |   | 13,654   |   | 13,654   |   | 13,654   |   |
|                                                                       |   |     |   |     |   |     |   |
| Comprehensive  Income (Loss)                                               |   |     |   |     |   |     |   |
| Net income  (loss)                                                         |   | $        | (988   | )        | $      | 14       |   | $ | 1,369 |   |
| Unrealized  pension cost                                                   |   | (55      | )      | —   |   | —   |   |
| Translation  adjustment                                                    |   | 105      |   | (18      | )      | 476      |   |
| Comprehensive  Income (Loss)                                               |   | $        | (938   | )        | $      | (4       | )      | $ | 1,845 |   |

 

*The accompanying notes are an integral part of thesefinancial statements.*

 

25

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**K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT)**

**YEARS ENDED JUNE 30, 2003, 2002 AND 2001**

*(in thousands)*

 
|                                     |       | **Common  Stock** |       | **Additional    Paid-In   Capital** |   | **Accumulated    Deficit** |   | **Accumulated  Other  Comprehensive  (Loss)** |   | **Total** |    |
|------------------------------------------|------------|-------------------|------------|-------------------------------------|--------|----------------------------|--------|-----------------------------------------------|--------|-----------|---------|
|                                     |       |              |       |                                |   |
|                                     |       |              |       |                                |   |
|                                     | **Shares** |              | **Amount** |                                |   |                       |   |                                          |
|                                     |       |              |       |                                |   |                       |   |                                          |   |      |    |   |   |
| Balance at June  30, 2000                |       | 10,321            |       | $                                   | 103    |                       | $      | 20,213                                        |   | $         | (32,154 | ) | $ | (759 | ) | $ | (12,597 | ) |
|                                     |       |              |       |                                |   |                       |   |                                          |   |      |    |   |   |
| Net income                               |       | —            |       | —                              |   | —                     |   | 1,369                                         |   | —    |    | 1,369 |   |
| Conversion of  debt to equity            |       | 3,333             |       | 33                                  |   | 467                        |   | —                                        |   | —    |    | 500 |   |
| Translation  adjustment                  |       | —            |       | —                              |   | —                     |   | —                                        |   | 476       |    | 476 |   |
|                                     |       |              |       |                                |   |                       |   |                                          |   |      |    |   |   |
| Balance at June  30, 2001                |       | 13,654            |       | 136                                 |   | 20,680                     |   | (30,785                                       | )      | (283      | )       | (10,252 | ) |
|                                     |       |              |       |                                |   |                       |   |                                          |   |      |    |   |   |
| Net income                               |       | —            |       | —                              |   | —                     |   | 14                                            |   | —    |    | 14 |   |
| Reduction of  notes payable to affiliate |       | —            |       | —                              |   | 612                        |   | —                                        |   | —    |    | 612 |   |
| Translation  adjustment                  |       | —            |       | —                              |   | —                     |   | —                                        |   | (18       | )       | (18 | ) |
|                                     |       |              |       |                                |   |                       |   |                                          |   |      |    |   |   |
| Balance at June  30, 2002                |       | 13,654            |       | 136                                 |   | 21,292                     |   | (30,771                                       | )      | (301      | )       | (9,644 | ) |
|                                     |       |              |       |                                |   |                       |   |                                          |   |      |    |   |   |
| Net income                               |       | —            |       | —                              |   | —                     |   | (988                                          | )      | —    |    | (988 | ) |
| Unrealized  pension cost                 |       | —            |       | —                              |   | —                     |   | —                                        |   | (55       | )       | (55 | ) |
| Translation  adjustment                  |       | —            |       | —                              |   | —                     |   | —                                        |   | 105       |    | 105 |   |
|                                     |       |              |       |                                |   |                       |   |                                          |   |      |    |   |   |
| Balance at June  30, 2003                |       | 13,654            |       | $                                   | 136    |                       | $      | 21,292                                        |   | $         | (31,759 | ) | $ | (251 | ) | $ | (10,582 | ) |

 

*The accompanying notes are an integral part of thesefinancial statements.*

 

26

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**K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YEARS ENDED JUNE 30,**

*(in thousands)*

 
|                                                                                                   |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Operating  Activities:                                                                                 |   |     |   |     |   |     |   |
| Net income  (loss)                                                                                     |   | $        | (988   | )        | $      | 14       |   | $ | 1,369 |   |
| Adjustment to  reconcile net income (loss) to cash used in operating activities:                       |   |     |   |     |   |     |   |
| Depreciation and  amortization                                                                         |   | 315      |   | 380      |   | 408      |   |
| Loss on disposal  of property and equipment                                                            |   | 1        |   | 3        |   | 349      |   |
| Gain on  liquidation                                                                                   |   | —   |   | (894     | )      | (16,185  | )      |
| Discontinued  operations                                                                               |   | 7        |   | (109     | )      | 3,630    |   |
| Write down of  long lived asset                                                                        |   | —   |   | —   |   | 417      |   |
| Changes in  operating assets and liabilities:                                                          |   |     |   |     |   |     |   |
| Accounts  receivable, net                                                                              |   | 10       |   | (689     | )      | 3,217    |   |
| Inventories                                                                                            |   | 137      |   | (199     | )      | 2,378    |   |
| Royalty advances                                                                                       |   | 68       |   | (84      | )      | (82      | )      |
| Prepaid expenses  and other current assets                                                             |   | 89       |   | 295      |   | (225     | )      |
| Accounts payable                                                                                       |   | (62      | )      | (699     | )      | 2,421    |   |
| Accrued  royalties                                                                                     |   | 87       |   | 157      |   | 230      |   |
| Income taxes                                                                                           |   | —   |   | (130     | )      | —   |   |
| Reserve for  returns                                                                                   |   | 173      |   | (12      | )      | (370     | )      |
| Cash used in  operating activities                                                                     |   | (163     | )      | (1,967   | )      | (2,443   | )      |
|                                                                                                   |   |     |   |     |   |     |   |
| Investing  Activities:                                                                                 |   |     |   |     |   |     |   |
| Purchases of  property and equipment                                                                   |   | (18      | )      | (124     | )      | (62      | )      |
| Music catalog additions                                                                                |   | —   |   | —   |   | (63      | )      |
| Other                                                                                                  |   | 15       |   | 27       |   | 27       |   |
| Cash used in  investing activities                                                                     |   | (3       | )      | (97      | )      | (98      | )      |
|                                                                                                   |   |     |   |     |   |     |   |
| Financing  Activities:                                                                                 |   |     |   |     |   |     |   |
| Borrowings on  notes payable                                                                           |   | 2,278    |   | 3,676    |   | 13,946   |   |
| Payments on  notes payable                                                                             |   | (1,033   | )      | (1,629   | )      | (12,508  | )      |
| Cash provided by  financing activities                                                                 |   | 1,245    |   | 2,047    |   | 1,438    |   |
|                                                                                                   |   |     |   |     |   |     |   |
| Effect of  exchange rates on cash                                                                      |   | 65       |   | (81      | )      | 478      |   |
|                                                                                                   |   |     |   |     |   |     |   |
| Net increase  (decrease) in cash equivalents                                                           |   | 1,144    |   | (98      | )      | (625     | )      |
|                                                                                                   |   |     |   |     |   |     |   |
| Cash and  equivalents at beginning of period                                                           |   | 75       |   | 173      |   | 798      |   |
|                                                                                                   |   |     |   |     |   |     |   |
| Cash and  equivalents at end of period                                                                 |   | $        | 1,219  |     | $      | 75       |   | $ | 173 |   |
|                                                                                                   |   |     |   |     |   |     |   |
| Supplemental  Cash Flow Information                                                                    |   |     |   |     |   |     |   |
| Cash Paid For -                                                                                        |   |     |   |     |   |     |   |
| Interest                                                                                               |   | $        | 396    |     | $      | 598      |   | $ | 483 |   |
| Income Taxes                                                                                           |   | $        | — |     | $      | —   |   | $ | 4 |   |
| Non-cash  Information                                                                                  |   |     |   |     |   |     |   |
| Reduction of  notes payable to affiliate through debt forgiveness, recorded as a capital  contribution |   | $        | — |     | $      | 612      |   | $ | — |   |
| Music Catalogs  reclassified to prepaid assets                                                         |   | $        | — |     | $      | 173      |   | $ | — |   |

 

*The accompanying notes are an integral part of thesefinancial statements.*

 

27

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**K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES**

**NOTES****TOCONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30, 2003, 2002 AND 2001**

 

**1.             BUSINESS AND LIQUIDITY**

 

K-tel International, Inc. (the “Company” or “K-tel”) was incorporatedin 1968 and currently has its corporate offices located in Plymouth, Minnesota.Through its operating subsidiaries, K-tel licenses its music cataloginternationally and markets entertainment products mainly derived from itscatalog through retail and direct response marketing channels in the UnitedStates and Europe. The Company has a focused method of distribution thattargets the strengths of fewer individual retailers and supplies productssuited to each retailer’s needs. These new products are derived mainly from theCompany’s master recordings music catalog with the objective of realizing morecompetitive profit margins. K-tel seeks to license its trademarks to othercompanies in businesses unrelated to K-tel’s current operations. Licenses aregranted for a royalty or fee, with no cost to the Company. The Company haslicensed certain marks to K-tel Drug Mart Ltd., a Canadian direct marketer ofprescription drugs beneficially owned by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel. K-tel Drug Mart, whichrecently began operations, offers prescription drugs from its pharmacy inCanada to persons in the United States. K-tel is merely a licensor of its markto K-tel Drug Mart. To date, K-tel Drug Mart’s operations have not generatedany significant licensing revenues for the Company.

 

Subsidiaries’ Bankruptcy and Liquidation

 

In March 2001, the Company’s music distribution subsidiary in theUnited States, K-tel International (USA), Inc. ceased operations and filed forprotection under Chapter 7 of the U. S. bankruptcy code. In connection withthis filing, the assets and liabilities of this subsidiary were removed fromthe books of the Company as control of the subsidiary was transferred to thebankruptcy trustee. The net liability at the time of this filing was shown as again on the Chapter 7 liquidation. Management believes the Company will have noongoing liability related to this subsidiary as a result of the filing and theoutcome of the bankruptcy proceeding. During the fiscal year ended June 30,2001, this subsidiary had net sales of $11,948,000 and an operating loss of$5,299,000.

 

In November 2000, the Company’s consumer products subsidiary in theUnited Kingdom, K-tel Marketing Ltd., ceased operations and began voluntaryliquidation proceedings. At the initial meeting of the creditors on November24, 2000, the creditors voted for the liquidation to become a creditors’liquidation under English law. The Company has not been informed by theliquidators or their counsel of any plan to attempt to hold it or any of itssubsidiaries liable for any of the commitments of K-tel Marketing Ltd.Management believes the Company will have no ongoing material liability relatedto K-tel Marketing Ltd. as a result of the liquidation proceeding. K-telMarketing Ltd. had no operations during the fiscal years ended June 30, 2003and 2002. During fiscal 2001, this subsidiary had net sales of $3,179,000 andan operating loss of $3,220,000. Losses in the year ended June 30, 2003 of$581,000 and $180,000 in the year ended June 30, 2002 related mainly to legalfees incurred in the Tristar litigation (See Note 6.)

 

Discontinued Operations

 

The Company’s consumer products business, which was concentrated inEurope, consisted primarily of housewares, consumer convenience items andexercise equipment. The Company discontinued its consumer products operationsin Germany, the United Kingdom and the United States in June 2000, November2000 and January 2001, respectively. Accordingly, these activities have beenpresented in the accompanying financial statements as discontinued operations.Net sales for these operations were $3,818,000 for the fiscal year ended June30, 2001. The accompanying consolidated financial statements have been preparedto reflect the consumer products division as a discontinued operation. The netliabilities of discontinued operations at June 30, 2003 and 2002 consist ofassets of $19,000 and $14,000 and liabilities of $135,000 and $106,000.

 

Going Concern

 

During the years ended June 30, 2003, 2002 and 2001, the Companyincurred net losses from continuing operations of $407,000, $700,000 and$10,501,000, respectively, and used $163,000, $1,967,000, and $2,443,000 ofcash in operating activities. Additionally, the Company had a working capitaldeficit of $11,502,000 at June 30, 2003.

 

The Company’s ability to continue its present operations and implementfuture expansion plans successfully is contingent mainly upon its ability tomaintain its line of credit arrangements with K-5 Leisure Products, Inc. (SeeNote 3), increase its revenues and profit margins, and ultimately attain andsustain profitable operations. Without increased revenues and

 

28

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sustained profitability,the cash generated from the Company’s current operations will likely beinadequate to fund operations and service its indebtedness on an ongoing basis.Management is focusing its efforts on music licensing and limited musicdistribution. However, there can be no assurance that the Company will achieveprofitable operations through these efforts. The financial statements do notinclude any adjustments that might result from the outcome of theseuncertainties.

 

**2.             SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

Principles of Consolidation - Theaccompanying consolidated financial statements include the accounts of K-telInternational, Inc. and its domestic and foreign subsidiaries, all of which arewholly owned. All significant intercompany accounts and transactions have beeneliminated.

 

Revenue Recognition – The Companyderives its revenue mainly from two sources: the sale of music compilations(predominately compact discs) produced by the Company, and license revenue fromthe licensing of Company-owned masters. Revenue from music sales is recognizedat the time of shipment to the customer, while license revenue is recognizedwhen payment is received from customers or when known amounts are receivable,as prior to that date collection is not considered probable. Most music salesare made with a right of return of unsold goods. Estimated reserves for returnsare established by management based upon historical experience and product mixand are subject to ongoing review and adjustment by the Company. These reservesare recorded at the time of sale and are reflected as a reduction in revenues.The Company’s reserve for returns was $213,000 at June 30, 2003 and $40,000 atJune 30, 2002.

 

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

 

Shipping and Handling Costs – TheCompany expenses within cost of goods sold all shipping and handling costsincurred in the shipment of goods.

 

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

 

Inventories – Inventories, whichconsists of finished goods that include all direct product costs, are valued atthe lower of cost, determined on a first-in, first-out basis, or net realizablevalue.

 

Owned Catalog Masters – The Companycapitalizes the costs to purchase owned master recordings at the time ofacquisition. These costs are amortized over the estimated useful life of thesemaster recordings, which is generally seven years and represents management’sbest estimate of the average period of value.

 

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

 

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

 

Long Lived-Assets – The Companyevaluates its long-lived assets quarterly, or earlier if a triggering eventoccurs, to determine potential impairment by comparing the carrying value ofthose assets to the related undiscounted future cash flows of the assets. If anasset is determined to be impaired, it is written down to its estimated fairvalue. During the quarter ended March 31, 2001, the Company suspended itsonline business to relocate these operations to the Company’s offices inMinnesota and update the website to reflect the Company’s continuingoperations. The Company wrote down the assets of that business to its estimatedfair value, resulting in a charge during the quarter ended March 31, 2001 ofapproximately $240,000. In addition, during the quarter ended June 30, 2001,the Company wrote down approximately $177,000 of trademarks related to itsEuropean operations, which were determined to have no remaining value as theCompany is no longer marketing the products benefited by those trademarks.These charges were included within general 

 

29

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and administrative expense.

 

Royalties - The Company has enteredinto license agreements with various record companies and publishers underwhich it pays royalties on units sold. The Company accrues royalties usingcontractual rates and certain estimated rates on applicable units sold. Thecontractual royalty liability is computed quarterly and the accrued royaltybalance is adjusted accordingly. The royalty agreements are subject to audit bylicensors.

 

Advertising - The Company expensesthe costs of advertising when the advertising takes place, except for directresponse advertising, which is capitalized and amortized over its expectedperiod of future benefits (usually the period remaining under a relatedcontract, which is generally less than one year). Direct response advertisingconsists primarily of television advertising whereby customers respondspecifically to the advertising and where the Company can identify theadvertising that elicited the response. Advertising expenses were $200,000,$172,000, and $618,000 for the years ended June 30, 2003, 2002 and 2001,respectively.

 

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

 

Stock-based Compensation – TheCompany accounts for stock-based awards to employees using the intrinsic valuemethod prescribed in APB No. 25, “Accounting for Stock Issued to Employees,”whereby the options are granted at market price, and therefore no compensationcosts are recognized. The Company has elected to retain its current method ofaccounting as described above and has adopted the SFAS Nos. 123 and 148disclosure requirements. If compensation expense for the Company’s variousstock option plans had been determined based upon the projected fair values atthe 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 commonshare would have been as follows:

 

|                               |   | **Fiscal Year Ended  June 30,** |   |
|------------------------------------|--------|---------------------------------|--------|
|                               |   | **2003**                        |   | **2002** |   | **2001** |   |
| Net income (loss)  (in thousands): |   |                            |   |   |   |   |   |
| As reported                        |   | $                               | (988   | ) | $ | 14 |   | $ | 1,369 |   |
| Pro forma                          |   | $                               | (1,003 | ) | $ | (458 | ) | $ | (496 | ) |
|                               |   |                            |   |   |   |   |   |
| Basic and  Diluted EPS:            |   |                            |   |   |   |   |   |
| As reported                        |   | $                               | (.07   | ) | $ | (.00 | ) | $ | .10 |   |
| Pro forma                          |   | $                               | (.07   | ) | $ | (.04 | ) | $ | (.04 | ) |

 

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

 

Net Income (Loss) Per Share - Basicand diluted net income (loss) per share have been computed by dividing netincome (loss) by the weighted average number of shares outstanding during theperiod. For all periods presented, common stock equivalents were excluded fromthe per share calculation as the net effect would be antidilutive. For thefiscal years ended June 30, 2003, 2002 and 2001, weighted average options topurchase 442,900, 2,273,839, and 2,336,889 shares of common stock, withweighted average exercise prices of $1.95, $5.89, and $5.77 were excluded fromthe computation of common share equivalents for the respective periods as theywere antidilutive.

 

Use of Estimates - Preparingconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America (“US GAAP”) requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, and disclosure of contingent assets and liabilities atthe date of the financial statements and the reported amounts of revenues andexpenses during the reporting period. Principal estimates include allowancesfor bad debt, inventory valuation, return reserves, royalty obligations, purchasecommitments and product replacement costs. Actual results could differ fromthose estimates used by management.

 

30

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**3.            ****LOANSPAYABLE 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, theChairman of the Board, President and Chief Executive Officer of K-tel. Underthe terms of the agreement (the “K-5 Facility”), K-5 has agreed to makeavailable up to $8,000,000 to K-tel on a revolving basis. The loan bearsinterest at a variable rate based upon the “base rate” of a nationallyrecognized lending institution (4.0% at June 30, 2003), expires July 20, 2005,and is subordinated to the Foothill loan (see below). The K-5 Facility containsthe same covenants as the Foothill loan agreement. K-tel has pledged the stockof its foreign subsidiaries as collateral for the loan, and the loan carries asubordinated position to the Foothill loan on all other assets of the Company.K-tel had outstanding balances of $7,282,000 and $6,026,000 as of June 30, 2003and 2002 respectively under the K-5 Facility. At June 30, 2003, K-telobtained 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 agreementwith K-5, under which K-5 assumed rights and obligations under a loan from theCompany’s former banker (Foothill Capital Corporation) pursuant to anAssignment and Acceptance Agreement dated February 27, 2001. ThisFoothill 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 uponexpiration, and a $6,000,000 revolving facility under which borrowings arelimited to a percent of eligible receivables. Borrowings under the facilitybear interest at a variable rate based on a “base rate” of a nationallyrecognized lending institution plus 1% (5.0% at June 30, 2003) andare collateralized by the assets of certain Company subsidiaries in the UnitedStates, including accounts receivable, inventories, equipment, music libraryand general intangibles. The loan agreement contains certain financial andother covenants or restrictions, including the maintenance of a minimumshareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of June 30, 2003 and 2002,$4,000,000 was outstanding under the term loan and there were no borrowingsunder the revolving facility. At June 30, 2003, K-tel obtained a waiver fromK-5 for its non-compliance under the covenants, limitations and restrictions ofthe credit agreement.

 

K-tel has an overdraft privilege borrowing facility with The Royal Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2.0% per annum over the baserate (a total of 5.75% at June 30, 2003) but are subject to a minimum of 6.0%per annum. K-tel had outstanding balances of $233,000 and $227,000 as of June30, 2003 and 2002 respectively.

 

**4.****                                      INCOMETAXES**

 

The Company operates in several countries and is subject to various taxregulations and tax rates. The provisions for income taxes are computed basedon income reported for financial statement purposes in accordance with the taxrules and regulations of the taxing authorities where the income is earned.

 

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The provision (benefit)for income taxes consists of the following for the years ended June 30 (inthousands):

 
|                                                        |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                        |   |     |   |     |   |     |   |
| Income (loss)  before provision (benefit) for income taxes: |   |     |   |     |   |     |   |
| United States                                               |   | $        | 196    |     | $      | (295     | )      | $ | 2,871 |   |
| Foreign                                                     |   | (1,184   | )      | 168      |   | (1,598   | )      |
| Total                                                       |   | $        | (988   | )        | $      | (127     | )      | $ | 1,273 |   |
|                                                        |   |     |   |     |   |     |   |
| Provision (benefit)  for income taxes:                      |   |     |   |     |   |     |   |
| Current                                                     |   |     |   |     |   |     |   |
| United States                                               |   | $        | — |     | $      | (141     | )      | $ | (100 | ) |
| Foreign                                                     |   | —   |   | —   |   | 4        |   |
|                                                        |   |     |   |     |   |     |   |
| Total provision  (benefit) for income taxes                 |   | $        | — |     | $      | (141     | )      | $ | (96 | ) |

 

A reconciliation of theU.S. Federal statutory rate to the effective tax rate for the years ended June30 was as follows:

 
|                                 |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                 |   |     |   |     |   |     |   |
| Federal  statutory rate              |   | 34       | %      | 34       | %      | 34       | %      |
| State Taxes, net  of Federal benefit |   | 0        |   | 2        |   | 2        |   |
| Valuation  allowance                 |   | (34      | )      | (36      | )      | (36      | )      |
|                                 |   | —   |   | —   |   | —   |   |

 

Deferred income taxes are provided for the temporary differencesbetween the financial reporting basis and the tax basis of the Company’s assetsand liabilities. Temporary differences, which are all deferred tax assets, wereas follows (in thousands):

 
|                             |   | **June 30,  2003** |   | **June 30,  2002** |   |
|----------------------------------|--------|--------------------|--------|--------------------|--------|
|                             |   |               |   |               |   |
| Net operating  loss carryfowards |   | $                  | 20,875 |               | $      | 17,661 |   |
| Alternative  minimum tax credits |   | 432                |   | 432                |   |
| Foreign tax  credit              |   | 325                |   | 325                |   |
| Reserve for  returns             |   | 852                |   | 761                |   |
| Depreciation and  amortization   |   | 199                |   | 238                |   |
| Royalty reserves                 |   | 145                |   | 105                |   |
| Inventory  reserves              |   | 36                 |   | 40                 |   |
| Nondeductible  accruals          |   | 286                |   | 310                |   |
| Allowance for  bad debts         |   | 19                 |   | 29                 |   |
| Valuation  allowance             |   | (23,169            | )      | (19,901            | )      |
|                             |   | $                  | — |               | $      | — |   |

 

A valuation allowance equal to the aggregate amount of deferred taxassets has been established until such time as realizability is more likelythan not.

 

For U.S. tax reporting purposes, the Company has net operating losscarryforwards (“NOL”) of approximately $58,000,000. However, of the amountavailable through 2013 and 2020, $20,100,000 of the NOL relates to deductionsassociated with the exercise of stock options. The tax benefit of approximately$7,236,000 associated with this stock option deduction will be recorded asadditional paid-in capital when realized. The NOL carryforwards may be reducedin future years, without financial statement benefit, to the extent ofintercompany dividends received from foreign subsidiaries. Also, the NOLcarryforwards are subject to review and possible adjustment by taxingauthorities. In addition, the Company has approximately $432,000 in U.S.federal alternative minimum tax credits and $325,000 in foreign tax credits,which may be utilized in the future to offset any regular corporate income taxliability.

 

32

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**5.****                                      CAPITALTRANSACTIONS**

 

Stock Option Plan

 

The Company has a Stock Option Plan for officers, directors, andemployees of the Company. Under the terms of this plan the Board of Directorshas the sole authority to determine the employees to whom options and awardsare granted, the type, size and terms of the awards, the timing of the grants,the duration of the exercise period and any other matters arising under theplan. The common stock incentives may take the form of incentive stock options andnonqualified stock options. The Company’s 1987 plan, which has expired, covereda maximum of 700,000 shares of common stock, of which options for the purchaseof 2,000 shares remain outstanding and exercisable. In February 1997, theCompany’s Board of Directors approved a new stock option plan covering amaximum of 600,000 shares of common stock, which was subsequently amended to5,000,000 through shareholder amendments in February 1999, January 2000 andNovember 2000. There were options on 2,613,011 net shares granted under thisplan as of June 30, 2003. Of these options granted, 2,472,111 have beenexercised. Any options cancelled are available for future grants. No optionsgranted have expired.

 

Stock Option Exchange

 

On March 18, 2003, a committee of the Company’s board of directorscomprised solely of independent directors, approved a “Stock Option ExchangeProgram.” The program provides for a small number of optionees who werepreviously awarded options to purchase shares of common stock under the Company’s1997 Stock Option Plan to exchange them for options to purchase an equal numberof shares outside the Company’s Stock Option Plan. The options to purchase anaggregate 2,137,939 shares of common stock have a weighted average price pershare of $5.95. Replacement options are proposed to be issued six months andone day after the date of cancellation of the existing options and shall be atan exercise price per share equal to the fair market value of the Company’scommon stock as quoted on the OTC Bulletin Board on the date of grant and shallexpire ten years after the date of grant. It is anticipated that there will beno compensation expense recognized as a result of this exchange.

 

Restricted and Non-Qualified Stock Options

 

In addition to stock options granted under the terms of the StockOption Plan, the Board of Directors has the sole authority to grant employees,officers and directors incentive stock options and non-qualified stock optionsoutside the Stock Option Plan. The Board of Directors determines the type, sizeand terms of the grants, timing of the grants, the duration of the exerciseperiod and any other matters pertaining to options or awards granted outside ofthe Stock Option Plan. There were options on 355,000 net shares granted outsidethe Stock Option Plan as of June 30, 2003.

 

The share information forall plans is summarized below:

 
|                       |   | **Incentive Stock  Options** |   | **Non-Qualified  Stock Options** |   | **Weighted  Average  Exercise Price** |   |
|----------------------------|--------|------------------------------|--------|----------------------------------|--------|---------------------------------------|--------|
|                       |   |                         |   |                             |   |                                  |   |
| Outstanding June  30, 2000 |   | 2,210,556                    |   | 497,000                          |   | $                                     | 6.72   |   |
|                       |   |                         |   |                             |   |                                  |   |
| Granted                    |   | 310,000                      |   | 75,000                           |   | 1.06                                  |   |
| Cancelled                  |   | (228,167                     | )      | (527,500                         | )      | 6.49                                  |   |
| Outstanding June  30, 2001 |   | 2,292,389                    |   | 44,500                           |   | $                                     | 5.77   |   |
|                       |   |                         |   |                             |   |                                  |   |
| Adjustment (1)             |   | (2,105,045                   | )      | 2,105,045                        |   |                                  |   |
|                       |   |                         |   |                             |   |                                  |   |
| Cancelled                  |   | (36,050                      | )      | (27,000                          | )      | 5.86                                  |   |
| Outstanding June  30, 2002 |   | 151,294                      |   | 2,122,545                        |   | $                                     | 5.89   |   |
|                       |   |                         |   |                             |   |                                  |   |   |
| Granted                    |   | 10,000                       |   | 300,000                          |   | .05                                   |   |
| Cancelled                  |   | (73,394                      | )      | (2,067,545                       | )      | 5.86                                  |   |
| Outstanding June  30, 2003 |   | 87,900                       |   | 355,000                          |   | $                                     | 1.95   |   |

 

----

(1)                                  Adjustmentreflects options disclosed previously as incentive that should have beenrecorded as non-qualified.

 

33

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The following tables summarize information concerning currentlyoutstanding and exercisable stock options at June 30, 2003:

 

| **Options  Outstanding** |        |
|--------------------------|-------------|
| **Exercise  Prices**     |        | **Number  of Shares** |   | **Weighted  Average  Remaining  Contractual Life** |   |
| **Range**                |        | **Weighted  Average** |
| $                        | 0.05        |   | $ | 0.05 |   | 310,000 |   | 9.4 years |   |
| $                        | 1.75        |   | $ | 1.75 |   | 1,000 |   | 3.3 years |   |
| $                        | 3.06 - 3.38 |   | $ | 3.29 |   | 1,400 |   | 3.6 years |   |
| $                        | 5.51 - 6.00 |   | $ | 5.66 |   | 97,500 |   | 6.6 years |   |
| $                        | 8.73        |   | $ | 8.73 |   | 33,000 |   | 5.7 years |   |
|                     |        |   |   | 442,900 |   |   |   |

 

| **Options Exercisable** |        |                  |   |
|-------------------------|-------------|-----------------------|--------|
| **Exercise Prices**     |        |                  |   |   |   |
| **Range**               |        | **Weighted  Average** |   | **Number  of Shares** |   |   |   |
| $                       | 0.05        |                  | $      | 0.05 |   | 310,000 |   |   |   |
| $                       | 1.75        |                  | $      | 1.75 |   | 1,000 |   |   |   |
| $                       | 3.06 - 3.38 |                  | $      | 3.29 |   | 1,400 |   |   |   |
| $                       | 5.51 - 6.00 |                  | $      | 5.66 |   | 97,500 |   |   |   |
| $                       | 8.73        |                  | $      | 8.73 |   | 33,000 |   |   |   |
|                    |        |                  |   | 442,900 |   |   |   |

 

The weighted average fair value of options granted in fiscal 2003 was$.05 and fiscal 2001 was $1.06. No options were granted in fiscal 2002. Becausethe fair value provisions have not been applied to options granted prior toJune 30, 1995, the resulting pro forma compensation cost (See Note 1) may notbe representative of that to be expected in future years.

 

The fair value of eachoption is estimated on the date of grant using the Black-Scholes option pricingmodel. The following assumptions were used to estimate the fair value ofoptions:

 
|                     |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------|--------|----------|--------|----------|--------|----------|--------|
|                     |   |     |   |     |   |     |   |
| Risk-free  interest rate |   | 4.00%    |   | 5.00%    |   | 5.00%    |   |
| Expected life            |   | 10 years |   | 5 years  |   | 5 years  |   |
| Expected  volatility     |   | 220%     |   | 150%     |   | 150%     |   |
| Expected  dividend yield |   | None     |   | None     |   | None     |   |

 

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**6.****                                      COMMITMENTSAND CONTINGENCIES**

 

Class Action Lawsuit

 

K-tel and certain of its current and former officers and directors werenamed as defendants in *In re K-telInternational, Inc. Securities Litigation*, No. 98-CV-2480. Thisaction consolidated twenty-three purported class actions that were initiallyfiled in various United States District Courts in November 1998, and weresubsequently transferred to, and consolidated in, the United States DistrictCourt for the District of Minnesota. On July 19, 1999, the plaintiffs filed anamended consolidated class action complaint that challenged the accuracy ofcertain public disclosures made by K-tel regarding its financial conditionduring the period from May 1998 through November 1998. The plaintiffs assertedclaims under the federal securities laws and sought damages in an unspecifiedamount as well as costs, including attorneys’ fees and any other relief theCourt deemed just and proper. K-tel moved to dismiss the complaint, and on July31, 2000, the United States District Court granted the Company’s motion todismiss. The Court also barred further actions by the plaintiffs and deniedplaintiffs’ request to amend the complaint in order to refile the complaint inthe future. The plaintiffs appealed to the United States Court of Appeals forthe Eighth Circuit, and the Court of Appeals heard the matter in October 2001.On August 7, 2002 the Court of Appeals, in a two to one decision, denied theplaintiffs’ appeal. On August 20, 2002 the plaintiffs applied for a rehearingby the full Court of Appeals. K-tel filed a response on September 15, 2002 tothe plaintiffs’ petition for rehearing at the request of the Court. On October2, 2002, the Court denied the petition for rehearing. The plaintiffs had untilJanuary 1, 2003 to seek a writ of certiorari (a petition asking the Court for adiscretionary review of a lower court decision) from the United States SupremeCourt, but did not seek this writ. There having been no appeal filed, the casehas been dismissed with no further recourse available.

 

RTL Shopping S.A.

 

The Company has been named in a lawsuit filed in France brought byRTL9, a French cable TV station. The action seeks damages in the approximateamount 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-telMarketing Ltd. alleging that RTL9 ran a commercial for K-tel Marketing whichpresented a product under brand names alleged to infringe on the competitor’sown trademarks and also translated an English language script indicating thatthe product was “just like” or “as good as” others into “better than” inFrench, contrary to French law. The suit alleged trademark infringement, unfaircompetition, illicit comparative advertising and passing off. RTL9 then suedK-tel Marketing on October 4, 2000, pursuant to an indemnification provisionthe parties had entered into. Subsequently, K-tel Marketing went intoliquidation and RTL9 filed a suit in December 2000 against K-tel International,Inc. under its agreement to guarantee payment for the commercial time. On May28, 2001, RTL9 presented documents in court identifying K-tel International(USA), Inc. as a target of its claim. On September 3, 2001, the Company fileddocuments disputing the claim and advising the court of K-tel (USA)’s Chapter 7bankruptcy filing.

 

The Company believes that RTL9 has no basis for a complaint against theCompany. As the result of information supplied by the parties to the Court,RTL9 has proposed to drop the lawsuit.

 

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

 

On March 14, 2000, K-tel and its subsidiary in Germany commenced anaction for breach of express and implied warranties against Defendant TristarProducts, Inc. This action is venued in the United States District Court forthe District of Minnesota. This action arises out of Tristar’s sale to K-tel ofa defective home exercise product called the “BunBlaster” for resale inGermany, Austria and Switzerland. By written contract, Tristar has agreed toindemnify K-tel for injuries and damages arising out of the resale of thosegoods. K-tel is seeking approximately $2 million in consequential damages.Tristar is vigorously defending this claim. Discovery has been completed.Tristar has filed a Motion for Summary Judgment, to which the Company filed aMemorandum in Opposition. This motion was heard in U.S. District Court inMinneapolis on August 25, 2003. The Court has yet to rule on this motion.

 

On April 30, 2001, Tristar also asserted a patent and trademark/trade-dress counterclaim against K-tel for allegedly passing off a productcalled the “K-tel Hook and Hang” while allegedly a distributor of the originalpatented Tristar Hook and Hang product. The Company denies the allegationbecause it never was a distributor of this or any similar product and intendsto defend this action vigorously. Tristar has not identified the amount ofdamages it seeks with respect to this counterclaim. The United States DistrictCourt for the District of Minnesota issued an order on August 14, 2001 severingthis action from the Company’s action. This action is at an early stage and nodiscovery or other actions have occurred.

 

35

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Litigation and Disputes

 

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

 

Subsidiaries’ Bankruptcy and Liquidation

 

In March 2001, the Company’s music distribution subsidiary in theUnited States, K-tel International (USA), Inc. ceased operations and filed forprotection under Chapter 7 of the United States Bankruptcy Code. Pursuant to anagreement between the bankruptcy trustee and K-5 Leisure Products, Inc.(K-tel’s secured creditor and controlling shareholder) entered into on March 3,2003, the trustee released K-5 Leisure Products, Inc., K-tel and itssubsidiaries and affiliates from any claims and actions with respect to thebankruptcy filing. The trustee filed a Limited Notice of Abandonment relativeto K-5’s security interest in K-tel’s assets. The Bankruptcy Court approved theabandonment as of June 13, 2003.

 

In November 2000, the Company’s consumer products subsidiary in theUnited Kingdom, K-tel Marketing Ltd., ceased operations and began voluntaryliquidation proceedings. At the initial meeting of the creditors on November24, 2000, the creditors voted for the liquidation to become a creditors’liquidation under English law. The Company has not been informed by theliquidators or their counsel of any plan to attempt to hold it or any of itssubsidiaries liable for any of the commitments of K-tel Marketing Ltd.Management believes the Company will have no ongoing material liability relatedto K-tel Marketing Ltd. as a result of the liquidation proceeding.

 

Leases

 

The Company has entered into several office and warehouse leases whichexpire through 2005. Commitments under these leases are $210,576 in 2004, and$46,490 in 2005. Rental expense was $253,523 in 2003, $216,327 in 2002, and$654,000 in 2001.

 

**7.****                                      SIGNIFICANTCUSTOMERS AND RELATED PARTY TRANSACTIONS**

 

Two customers, Anderson Merchandisers and Handleman Company accountedfor approximately 17.0% and 13.1% respectively of K-tel’s revenue for the yearended June 30, 2003. The loss of, or a substantial reduction in, business fromany of these customers would have a material adverse effect on the Company.

 

See Note 3 forinformation regarding debt transactions with related parties.

 

The Company purchased approximately $463,000 in the year ended June 30,2003, $366,000 in the year ended June 30, 2002 and $574,000 in the year endedJune 30, 2001 of music entertainment and consumer convenience products fromK-5, the Company’s largest shareholder controlled by Philip Kives, Chairman ofthe Board, President and Chief Executive Officer of K-tel. There were tradepayables to K-5 of $371,000 at June 30, 2003, $291,000 at June 30, 2002 and$285,000 at June 30, 2001.

 

The Company had no sales of consumer convenience products to K-5 duringthe years ended June 30, 2003 and 2002, and sales of $13,000 during the yearended June 30, 2001. There was a balance receivable from K-5 at June 30, 2003of $73,000, June 30, 2002 of $129,000, and June 30, 2001 of $109,000. Nointerest was charged on the related outstanding balances during fiscal years2003, 2002 and 2001.

 

**8.****                                      BUSINESSSEGMENT AND GEOGRAPHIC AREA DATA**

 

The Company markets and distributes entertainment productsinternationally and through its operating subsidiaries. K-tel’s businesses areorganized, managed and internally reported as three segments: retail musicsales, music licensing and other, which consists primarily of e-commerce (whichwas closed in the fourth quarter of fiscal 2002). These segments are based ondifferences in products, customer type and sales and distribution methods. TheCompany’s consumer product operations have been discontinued and are presentedin the accompanying financial statements as discontinued operations and aretherefore not included in the segment information.

 

36

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

 

In the licensing segment, the Company licenses the rights to its mastermusic catalog, consisting of original recordings and re-recordings of musicfrom 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 royaltybased on the number of units sold.

 

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

 

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

 

BUSINESS SEGMENTINFORMATION

 
| **Fiscal Years Ended  June 30,** |   | **Music** |   | **Licensing** |   | **Other** |   | **Corporate  Eliminations** |   | **Total**Company |   |
|----------------------------------|--------|-----------|--------|---------------|--------|-----------|--------|-----------------------------|--------|------------------|--------|
| **(in thousands)**               |   |      |   |          |   |      |   |                        |   |             |   |
|                             |   |      |   |          |   |      |   |                        |   |             |   |
| Net Sales                        |   | 2003      |   | $             | 4,454  |      | $      | 2,780                       |   | $                | — |   | — |   | $ | 7,234 |   |
|                             |   | 2002      |   | 3,757         |   | 3,118     |   | —                      |   | —           |   | 6,875 |   |
|                             |   | 2001      |   | 14,202        |   | 3,710     |   | 365                         |   | (763             | )      | 17,514 |   |
|                             |   |      |   |          |   |      |   |                        |   |             |   |   |   |
| Operating Income  (Loss)         |   | 2003      |   | $             | (1,106 | )         | $      | 1,159                       |   | $                | — |   | — |   | $ | 53 |   |
|                             |   | 2002      |   | (1,725        | )      | 1,393     |   | —                      |   |             |   | (332 | ) |
|                             |   | 2001      |   | (7,749        | )      | 425       |   | (2,156                      | )      | —           |   | (9,480 | ) |
|                             |   |      |   |          |   |      |   |                        |   |             |   |   |   |
| Assets                           |   | 2003      |   | $             | 2,356  |      | $      | 2,128                       |   | $                | 273    |   | — |   | $ | 4,757 |   |
|                             |   | 2002      |   | 2,319         |   | 1,668     |   | 121                         |   | 142              |   | 4,250 |   |
|                             |   | 2001      |   | 1,501         |   | 1,650     |   | 443                         |   | 238              |   | 3,832 |   |

 

GEOGRAPHIC INFORMATION

 
| **Fiscal Years Ended  June 30,** |   | **United States** |   | **Europe** |   | **Total** |   |
|----------------------------------|--------|-------------------|--------|------------|--------|-----------|--------|
| **(in thousands)**               |   |              |   |       |   |      |   |   |   |
|                             |   |              |   |       |   |      |   |   |   |   |   |   |
| Net Sales                        |   | 2003              |   | $          | 4,949  |      | $      | 2,285 |   | $ | 7,234 |   |
|                             |   | 2002              |   | 3,949      |   | 2,926     |   | 6,875 |   |
|                             |   | 2001              |   | 13,914     |   | 3,600     |   | 17,514 |   |
|                             |   |              |   |       |   |      |   |   |   |
| Assets                           |   | 2003              |   | $          | 3,889  |      | $      | 868 |   | $ | 4,757 |   |
|                             |   | 2002              |   | 2,792      |   | 1,458     |   | 4,250 |   |
|                             |   | 2001              |   | 2,042      |   | 1,790     |   | 3,832 |   |

 

**9.****                                      RECENTACCOUNTING PRONOUNCEMENTS**

 

In January 2003, the FASB issued Interpretation (FIN 46), *Consolidation of Variable Interest Entities.*FIN 46 is an interpretation of Accounting Research Bulletin No. 51, *Consolidated Financial Statements,* andaddresses consolidation by business enterprises of variable interest entities.FIN 46 applies immediately to variable interest entities created or obtainedafter January 31, 2003 and it applies in the first fiscal year or interimperiod beginning after June 15, 2003, to variable interest entities in which anenterprise holds a variable interest that is acquired before February 1, 2003.This pronouncement is not anticipated to have a material effect on theCompany’s consolidated financial position or results of operations.

 

In December 2002, the FASB issued Statement 148 (FAS 148), *Accounting for Stock-Based Compensation Transitionand Disclosure.* FAS 148 amends the disclosure and certain transitionprovisions of Statement 123, *Accounting forStock-Based Compensation.* Its disclosure provisions, which apply toall entities with employee stock-based compensation, are effective for fiscalyears ending after December 15, 2002. New interim period disclosures arerequired in financial statements for interim periods beginning afterDecember 15, 2002. This pronouncement is not anticipated to have amaterial effect on the Company’s consolidated financial position or results ofoperations.

 

37

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In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others.*FIN45 addresses the disclosure requirements of a guarantor in its interim andannual financial statements about its obligations under certain guarantees thatis has issued. FIN 45 also requires a guarantor to recognize, at the inceptionof a guarantee, a liability for the fair value of the obligation undertaken inissuing the guarantee. The disclosure requirements of FIN 45 are effective forthe Company for its quarter ended December 31, 2002. The liability recognitionrequirement is applicable prospectively to all guarantees issued or modifiedafter December 31, 2002. This pronouncement is not anticipated to have amaterial effect on the Company’s consolidated financial position or results ofoperations.

 

In June 2002, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards No. 146 (SFAS 146), *Accounting for Costs Associated with Exit or DisposalActivities*. SFAS 146 provides financial accounting and reportingguidance for costs associated with exit or disposal activities, includingone-time termination benefits, contract termination costs other than for acapital lease, and costs to consolidate facilities or relocate employees. Thisstatement is effective for exit or disposal activities that are initiated afterDecember 31, 2002. Management does not believe this pronouncement will have amaterial effect on the Company’s consolidated financial position and results ofoperations.

 

In May 2003, the FASB issuedStatement 150, *Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity*.Statement 150 changes the classifications in the statement of financialposition of certain common financial instruments from either equity ormezzanine presentation to liabilities and requires an issuer of those financialstatements to recognize changes in fair value or redemption amount, asapplicable, in earnings. SFAS 150 is effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003. Adoptionof Statement 150 is not anticipated to have an impact on the Company’s consolidatedfinancial position or results of operations.

 

38

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**SCHEDULEII**

 

**K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES**

 

**VALUATION AND QUALIFYING ACCOUNTS**

 

Years ended June 30,

(In thousands)

 
|                             |   | **Balance at  Beginning of  Period** |   | **Charged to Costs  and Expenses or  Net Sales** |   | **Charged to  Other  Accounts (1)** |   | **Deductions** |   | **Balance at  End of Period** |   |
|----------------------------------|--------|--------------------------------------|--------|--------------------------------------------------|--------|-------------------------------------|--------|----------------|--------|-------------------------------|--------|
| Allowance for  Doubtful Accounts |   |                                 |   |                                             |   |                                |   |           |   |                          |   |
|                             |   |                                 |   |                                             |   |                                |   |           |   |                          |   |
| 2003                             |   | $                                    | 68     |                                             | $      | 62                                  |   | $              | 9      |                          | $      | (114 | )(2) | $ | 25 |   |
| 2002                             |   | $                                    | 33     |                                             | $      | 50                                  |   | $              | 5      |                          | $      | (20 | )(2) | $ | 68 |   |
| 2001                             |   | $                                    | 1,416  |                                             | $      | (41                                 | )      | $              | (4     | )                             | $      | (1,338 | )(2) | $ | 33 |   |
|                             |   |                                 |   |                                             |   |                                |   |           |   |                          |   |
| Reserve for Returns              |   |                                 |   |                                             |   |                                |   |           |   |                          |   |
|                             |   |                                 |   |                                             |   |                                |   |           |   |                          |   |
| 2003                             |   | $                                    | 40     |                                             | $      | 446                                 |   | $              | — |                          | $      | (273 | ) | $ | 213 |   |
| 2002                             |   | $                                    | 50     |                                             | $      | 49                                  |   | $              | 6      |                          | $      | (65 | ) | $ | 40 |   |
| 2001                             |   | $                                    | 4,623  |                                             | $      | 45                                  |   | $              | (3     | )                             | $      | (4,615 | ) | $ | 50 |   |

 

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(1) Exchange rate change

(2) Uncollectible accounts written off, net ofrecoveries

 

39

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**EXHIBITINDEX**

 
| **Exhibit  No.** |   | **Description of Exhibit**                                                                                                                                                                                                                                                                                                        |
|------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 3.1              |   | Restated Articles of Incorporation, as amended.                                                                                                                                                                                                                                                                                   |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 3.2              |   | Restated By-Laws (incorporated by reference to the  Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1985  (File No. 1-07115)).                                                                                                                                                                       |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 4                |   | See Exhibits 3.1 and 3.2.                                                                                                                                                                                                                                                                                                         |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.1             |   | 1987 Stock Incentive Plan (incorporated by reference  to the Company’s Annual Report on Form 10-K for the fiscal year ended June  30, 1987 (File No. 1-07115)).                                                                                                                                                              |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.2             |   | 1997 Stock Option Plan (incorporated by reference to  the Company’s Annual Report on Form 10-K for the fiscal year ended June 30,  1997 (File No. 1-07115)).                                                                                                                                                                 |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.3             |   | Form of Incentive Stock Option Agreement under the  Company’s 1997 Stock Option Plan (incorporated by reference to the Company’s  Annual Report on Form 10-K for the fiscal year ended June 30, 2000 (File No.  1-07115)).                                                                                              |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.4             |   | Form of Non-Qualified Stock Option Agreement under  the Company’s 1997 Stock Option Plan (incorporated by reference to the  Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2000  (File No. 1-07115)).                                                                                          |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.5             |   | Form of Non-Qualified  Stock Option Agreement between the registrant and certain non-employee  directors of the registrant, authorized effective November 27, 2002  (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for  the fiscal quarter ended March 31, 2003 (File No. 1-07115)).              |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.6             |   | Loan and Security Agreement between the Company and  Foothill Capital Corporation dated November 19, 1997 (incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the fiscal  quarter ended December 31, 1997 (File No. 1-07115)).                                                          |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.7             |   | Amendment Number One to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated March  30, 1998 (incorporated by reference to the Company’s Annual Report on Form  10-K for the fiscal year ended June 30, 1998 (File No. 1-07115)).                                                     |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.8             |   | Amendment Number Two to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated  September 23, 1998 (incorporated by reference to the Company’s Annual Report  on Form 10-K for the fiscal year ended June 30, 1998 (File No. 1-07115)).                                                 |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.9             |   | Restated Amendment Number Two to the Loan and  Security Agreement between the Company and Foothill Capital Corporation dated  September 30, 1998 (incorporated by reference to the Company’s Annual Report  on Form 10-K for the fiscal year ended June 30, 1998 (File No. 1-07115)).                                        |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.10            |   | Amendment Number Three to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated  September 22, 1999 (incorporated by reference to the Company’s Annual Report  on Form 10-K for the fiscal year ended June 30, 2000 (File No. 1-07115)).                                               |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.11            |   | Amendment Number Four to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated May 15,  2000(incorporated by reference to the Company’s Annual Report on Form 10-K  for the fiscal year ended June 30, 2000 (File No. 1-07115)).                                                       |
|             |   |                                                                                                                                                                                                                                                                                                                              |
| 10.12            |   | Amendment to Loan Agreement and Security Agreement  between the Company and K-5 Leisure Products, Inc., as assignee of Foothill  Capital Corporation dated February 12, 2002 (incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended December  31, 2001 (File No. 1-07115)). |

 

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| 10.13  |   | Credit Agreement between the Company and K-5 Leisure  Products, Inc. dated September 27, 1999.                                                                                                                                                                                    |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                              |
| 10.14  |   | $8,000,000 principal amount Note between the Company  and K-5 Leisure Products, Inc. dated September 27, 1999.                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                              |
| 10.15  |   | Amendment to Credit Agreement and Note between the  Company and K-5 Leisure Products, Inc. dated February 12, 2002  (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for  the fiscal quarter ended December 31, 2001 (File No. 1-07115)). |
|   |   |                                                                                                                                                                                                                                                                              |
| 21     |   | Subsidiaries of the Registrant.                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                              |
| 23.1   |   | Consent of Independent Certified Public Accountants.                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                              |
| 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 to  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 to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                              |

 

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