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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 FORM 10-Q (Mark One) [X]
    
    Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the quarterly period ended March 31, 2004 or [   ]
    
    Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the transition period from      to Commission File Number: 0-29583 Loudeye Corp.  Delaware
    
    91-1908833(State or other jurisdiction of
    
    (I.R.S. Employer Identification No.)incorporation or organization)
 1130 Rainier Avenue South, Seattle, WA 98144
(Address of principal executive offices) (Zip Code) 206-832-4000
(Registrants telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes  [X]  
No  [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2)
Yes  [   ]  
No  [X] Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date. Common
    
    
    
    69,924,886(Class)
    
    
    
    (Outstanding at May 11, 2004)




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Loudeye Corp. Form 10-Q Quarterly Report
For the Quarter Ended March 31, 2004  
 TABLE OF CONTENTS PagePART
    
    I.
    
    Financial Information (unaudited)Item
    
    1
    
    Financial Statements
    
    
    3Consolidated Balance Sheets
    
    
    4Consolidated Statements of OperationsConsolidated
Statement of Stockholders Equity
    
    
    5Consolidated Statements of Cash Flows
    
    
    6Notes to Consolidated Financial Statements
    
    
    7Item
    
    2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item
    
    3
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    38Item
    
    4
    
    Disclosure Controls and Procedures
    
    
    38PART
    
    II.
    
    Other InformationItem
    
    1
    
    Legal Proceedings
    
    
    39Item
    
    2
    
    Changes in Securities and Use of Proceeds
    
    
    39Item
    
    3
    
    Defaults Upon Senior Securities
    
    
    40Item
    
    4
    
    Submission of Matters to a Vote of Security Holders
    
    
    40Item
    
    5
    
    Other Information
    
    
    40Item
    
    6
    
    Exhibits and Reports on Form 8-K
    
    
    40EXHIBIT 10.2EXHIBIT 10.3EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I  FINANCIAL INFORMATION 
 ITEM I            FINANCIAL STATEMENTS LOUDEYE CORP. 
 CONSOLIDATED BALANCE SHEETS
 (Unaudited, in thousands)
 March 31,
    
    December 31,2004
    
    2003ASSETSCash and cash equivalents
    
    $
    20,348
    
    
    $
    12,480Marketable securities
    
    
    14,114
    
    
    
    9,460Accounts receivable, net of allowances of $180 and $235
    
    
    1,776
    
    
    
    1,781Prepaid expenses and other
    
    
    574
    
    
    
    345Assets held for sale
    
    
    
    
    
    
    363Net assets transferred under contractual arrangement
    
    
    863
    
    
    
    Total current assets
    
    
    37,675
    
    
    
    24,429Restricted investments
    
    
    316
    
    
    
    316Property and equipment, net
    
    
    2,876
    
    
    
    1,123Goodwill
    
    
    2,434
    
    
    
    Intangible assets, net
    
    
    1,389
    
    
    
    86Other assets, net
    
    
    281
    
    
    
    360Assets held for sale
    
    
    90
    
    
    
    730Total assets
    
    $
    45,061
    
    
    $
    27,044LIABILITIES AND STOCKHOLDERS EQUITYAccounts payable
    
    $
    1,611
    
    
    $
    1,229Line of credit
    
    
    
    
    
    
    1,285Accrued compensation and benefits
    
    
    321
    
    
    
    378Other accrued expenses
    
    
    1,233
    
    
    
    1,155Accrued special charges
    
    
    521
    
    
    
    1,670Deferred revenue
    
    
    718
    
    
    
    485Current portion of long-term debt
    
    
    1,323
    
    
    
    1,348Liabilities related to assets held for sale
    
    
    
    
    
    
    98Total current liabilities
    
    
    5,727
    
    
    
    7,648Deferred revenue
    
    
    78
    
    
    
    228Long-term debt, net of current portion
    
    
    1,843
    
    
    
    2,135Total liabilities
    
    
    7,648
    
    
    
    10,011Commitments and contingenciesSTOCKHOLDERS EQUITYPreferred stock, $0.001 par value, 5,000 shares
authorized, none outstanding
    
    
    
    
    
    
    Common stock and additional paid-in capital; for
common stock, $0.001 par value, 100,000 shares
authorized; 69,788 shares issued and outstanding in
2004 and 56,974 issued and outstanding in 2003
    
    
    233,442
    
    
    
    210,134Deferred stock-based compensation
    
    
    (361
    )
    
    
    (214
    )Accumulated deficit
    
    
    (195,708
    )
    
    
    (192,887
    )Accumulated other comprehensive income
    
    
    40
    
    
    
    Total stockholders equity
    
    
    37,413
    
    
    
    17,033Total liabilities and stockholders equity
    
    $
    45,061
    
    
    $
    27,044
 The accompanying notes are an integral part of these consolidated financial statements. 3




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LOUDEYE CORP. 
 CONSOLIDATED STATEMENTS OF OPERATIONS
  Three Months Ended March 31,2004
    
    2003REVENUES
    
    $
    1,991
    
    
    $
    3,310COST OF REVENUESOther cost of revenues
    
    
    1,407
    
    
    
    2,541Non-cash stock-based compensation
    
    
    19
    
    
    
    4Total cost of revenues
    
    
    1,426
    
    
    
    2,545Gross profit
    
    
    565
    
    
    
    765OPERATING EXPENSESResearch and development (excluding
non-cash stock-based compensation of $27
in 2004 and $2 in 2003)
    
    
    590
    
    
    
    577Sales and marketing (excluding non-cash
stock-based compensation of $32 in 2004
and $6 in 2003)
    
    
    635
    
    
    
    1,547General and administrative (excluding
non-cash stock-based compensation of $63
in 2004 and $30 in 2003)
    
    
    1,960
    
    
    
    2,753Amortization of intangible assets
    
    
    140
    
    
    
    525Stock-based compensation
    
    
    122
    
    
    
    38Special charges  goodwill impairments
    
    
    
    
    
    
    5,307Special charges (credits)  other
    
    
    (50
    )
    
    
    3,130Total operating expenses
    
    
    3,397
    
    
    
    13,877OPERATING LOSS
    
    
    (2,832
    )
    
    
    (13,112
    )OTHER INCOME (EXPENSE)Investment income
    
    
    79
    
    
    
    85Interest expense
    
    
    (71
    )
    
    
    (50
    )Other
    
    
    3
    
    
    
    18Total other income (expense)
    
    
    11
    
    
    
    53Net loss
    
    $
    (2,821
    )
    
    $
    (13,059
    )Basic and diluted net loss per share
    
    $
    (0.04
    )
    
    $
    (0.28
    )Weighted average shares   basic and diluted
    
    
    63,286
    
    
    
    46,487
 The accompanying notes are an integral part of these consolidated financial statements. 4




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LOUDEYE CORP. 
 CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY
  Common Stock andAdditional Paid-in CapitalAccumulatedDeferred Stock-
    
    
    
    
    
    Other
    
    Totalbased
    
    Accumulated
    
    Comprehensive
    
    StockholdersShares
    
    Amount
    
    Compensation
    
    Deficit
    
    Income
    
    EquityBALANCES, December 31, 2003
    
    
    56,974
    
    
    $
    210,134
    
    
    $
    (214
    )
    
    $
    (192,887
    )
    
    $
    
    
    
    $
    17,033Stock option exercises
    
    
    250
    
    
    
    133
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    133Shares issued in private placement
    
    
    10,811
    
    
    
    18,901
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,901Shares issued for acquisition
    
    
    1,753
    
    
    
    3,961
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,961Deferred stock compensation
    
    
    
    
    
    
    286
    
    
    
    (286
    )
    
    
    
    
    
    
    
    
    
    
    --Amortization of deferred stock
compensation, net of
cancellations
    
    
    
    
    
    
    
    
    
    
    139
    
    
    
    
    
    
    
    
    
    
    
    139Stock-based compensation
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2Issuance of common stock warrant
    
    
    
    
    
    
    25
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    25Unrealized gains on marketable
securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    40
    
    
    
    40Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,821
    )
    
    
    
    
    
    
    (2,821
    )Comprehensive
loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,781
    )BALANCES, March 31, 2004
    
    
    69,788
    
    
    $
    233,442
    
    
    $
    (361
    )
    
    $
    (195,708
    )
    
    $
    40
    
    
    $
    37,413
 The accompanying notes are an integral part of these consolidated financial statements. 5




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LOUDEYE CORP. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
  Three Months EndedMarch 31,2004
    
    2003Operating ActivitiesNet loss
    
    $
    (2,821
    )
    
    $
    (13,059
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    481
    
    
    
    812Special charges and other non-cash items
    
    
    (3
    )
    
    
    6,593Stock-based compensation
    
    
    141
    
    
    
    42Changes in operating assets and liabilities, net of
amounts acquired in purchase of business:Accounts receivable
    
    
    278
    
    
    
    (389
    )Prepaid expenses and other assets
    
    
    (170
    )
    
    
    1,195Accounts payable
    
    
    (87
    )
    
    
    784Accrued compensation, benefits and other expenses
    
    
    (16
    )
    
    
    351Accrued special charges
    
    
    (1,099
    )
    
    
    (206
    )Deposits and deferred revenues
    
    
    44
    
    
    
    759Assets and liabilities transferred under contractual
arrangement and held for sale
    
    
    42
    
    
    
    109Net cash used in operating activities
    
    
    (3,210
    )
    
    
    (3,009
    )Investing ActivitiesPurchases of property and equipment
    
    
    (1,813
    )
    
    
    (43
    )Cash paid for acquisition of business and technology, net
    
    
    
    
    
    
    (82
    )Payments received on loans made to related party and
related interest
    
    
    
    
    
    
    238Purchases of marketable securities
    
    
    (8,096
    )
    
    
    Sales of marketable securities
    
    
    3,460
    
    
    
    5,280Net cash (used in) provided by investing activities
    
    
    (6,449
    )
    
    
    5,393Financing ActivitiesProceeds from exercise of stock options
    
    
    133
    
    
    
    Proceeds from private equity placement financing, net
    
    
    18,996
    
    
    
    Principal payments on line of credit, long-term debt and
capital lease obligations
    
    
    (1,602
    )
    
    
    (294
    )Repurchase of common stock
    
    
    
    
    
    
    (227
    )Net cash provided by (used in) financing activities
    
    
    17,527
    
    
    
    (521
    )Net increase in cash and cash equivalents
    
    
    7,868
    
    
    
    1,863Cash and cash equivalents, beginning of period
    
    
    12,480
    
    
    
    1,780Cash and cash equivalents, end of period
    
    $
    20,348
    
    
    $
    3,643Supplemental disclosures:Cash paid for interest
    
    $
    65
    
    
    $
    60Assets acquired under capital lease obligations
    
    
    
    
    
    
    112Issuance of common stock for acquisitions of businesses
    
    
    3,961
    
    
    
    708Issuance
of common stock warrant
    
    
    25
    
    
    
    
 The accompanying notes are an integral part of these consolidated financial statements. 6




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LOUDEYE CORP. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 March 31, 2004
(Unaudited)
  1.
    
    ORGANIZATION and RISKS The Company Loudeye Corp. (the Company or Loudeye) provides digital media services
and media restoration services. The Company is headquartered in Seattle,
Washington and to date conducts business in the United States in two
business segments, digital media services and media restoration services. As
discussed in Note 5, the Company transferred the assets and certain liabilities
of its media restoration services business in January 2004. Risks The Company is subject to a number of risks similar to other companies in
a comparable stage of development, including, but not limited to, reliance on
key personnel, successful marketing of its services in an emerging market,
competition from other companies with greater technical, financial, management
and marketing resources, successful development of new services, successful
integration of acquired businesses and technology, the enhancement of existing
services and the ability to secure adequate financing to support future
operations. Basis of Consolidation The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany transactions
and balances have been eliminated in consolidation. Unaudited Interim Financial Data The interim consolidated financial statements are unaudited and have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted pursuant to such rules and
regulations. These consolidated financial statements should be read in
conjunction with the audited consolidated financial statements and notes
thereto included in the Companys Annual Report on Form 10-K as filed with the
Securities and Exchange Commission on March 22, 2004. The interim financial
information included herein reflects all adjustments (consisting only of normal
recurring adjustments) that are, in the opinion of management, necessary for a
fair presentation of the results for interim periods. The unaudited results of
operations for the three months ended March 31, 2004 and 2003 are not
necessarily indicative of the results to be expected for the full years. Use of Estimates The preparation of the financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates. Managements assessments of the impairment of property and equipment,
goodwill and intangible assets are sensitive accounting estimates that could
result in additional impairment charges in the near term. Factors that impact
these estimates include, but are not limited to, possible changes in business
plans, decreases in the market price of the Companys common stock and
declining financial results. Management evaluates the potential loss exposure on various claims and
lawsuits arising in the normal course of business. An accrual is made if the
amount of a particular claim or lawsuit is probable and reasonably estimable. 7




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2.
    
    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash and Cash Equivalents The Company considers all highly liquid investments with a remaining
maturity of three months or less at the date of acquisition to be cash
equivalents. Cash and cash equivalents consist of demand deposits and money
market accounts maintained with financial institutions and certain other
investment grade instruments, which at times exceed federally insured limits.
The Company has not experienced any losses on its cash and cash equivalents. Marketable Securities The Company has invested amounts in investment-grade government
obligations, institutional money market funds and other obligations with FDIC
insured U.S. banks. Marketable securities are accounted for as available for
sale. Marketable securities are classified in current assets as they are
considered by management as available to support current operations. Restricted Cash and Investments The Company has approximately $316,000 of short-term investments which are
utilized as collateral for certain irrevocable standby letters of credit.
Accordingly, these investments are classified as restricted investments in the
consolidated balance sheets. These securities all mature within one year and
reported amounts approximate fair value due to the relatively short maturities
of these investments. These investments are related to standby letters of
credit required for certain lease agreements which expire through 2005.
Accordingly, the restricted investments have been classified in long-term
assets in the accompanying consolidated balance sheets. Fair Value of Financial Instruments and Concentrations of Credit Risk Financial instruments that potentially subject the Company to
concentrations of credit risk consist of cash and cash equivalents, marketable
securities, and long-term obligations. Fair values of cash and cash equivalents
approximate their carrying value due to the short period of time to maturity.
Short-term investments are reported at their market value. The carrying value
of the Companys line of credit and long-term obligations approximate fair
value because the interest rates of the obligations are variable. The Company is exposed to credit risk because it extends credit to its
customers. The Company performs initial and ongoing evaluations of its
customers financial condition and generally extends credit on open account,
requiring collateral as deemed necessary. The Company had sales to certain significant customers, as a percentage of
revenues, as follows: Three Months EndedMarch 31,2004
    
    2003Customer A
    
    
    11
    %
    
    
    7
    %Customer B
    
    
    4
    %
    
    
    13
    %15
    %
    
    
    20
    %
 Revenues from Customer A were reported primarily in the Digital Media
Services segment and revenues from Customer B were reported primarily in the
Media Restoration Services segment. Impairment of Long-lived Assets The Company assesses the recoverability of long-lived assets whenever
events or changes in business circumstances indicate that the carrying value of
an asset may not be recoverable. An impairment loss is considered when the sum
of the expected undiscounted future net cash flows over the remaining useful
life is less than the carrying amount of the asset. Goodwill and Intangible Assets 8




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The Company accounts for goodwill and intangible assets in accordance with
Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets (FAS 142). Under FAS 142, goodwill and intangible assets
deemed to have indefinite lives are not amortized, but are subject to, at a
minimum, annual impairment tests. The Company completes its annual impairment
test as of November 30 of each year. As disclosed in Note 7, the Company has
recorded goodwill and intangible assets in connection with its acquisition of
Overpeer, Inc. in March 2004. Revenue Recognition The Company recognizes revenue in accordance with Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements, (SAB 101) as
amended by Staff Accounting Bulletin No. 104 (SAB 104), and EITF 00-21,
Revenue Arrangements with Multiple Deliverables. The Company recognizes
revenue associated with the license of software in accordance with Statement of
Position 97-2, Software Revenue Recognition (SOP 97-2), as amended by SOP
98-4, SOP 98-9 and related interpretations and Technical Practice Aids. The Company recognizes revenues from encoding services, digital music
samples services, digital distribution services, Internet radio services, live
and on-demand webcasting services, software licensing, content
protection services,
and media restoration services. The Company recognizes these revenues when
persuasive evidence of an arrangement exists, the product and/or service has
been delivered, the price is fixed and determinable, and collectibility is
reasonably assured. In arrangements that include rights to multiple products and/or services,
the Company allocates the total arrangement consideration among each of the
deliverables using the residual method, under which revenue is allocated to
undelivered elements based on verifiable and objective evidence of the fair
value of the undelivered elements. Multiple element arrangements may consist
of implementation services, development services, encoding services, digital
music samples services, digital distribution services, Internet radio services,
and on-demand webcasting services. Verifiable and objective evidence is based
upon the price charged when an element is sold separately. Under the provisions of SOP 97-2, in software arrangements that involve
rights to multiple products and services, the Company allocates the total
arrangement consideration among each of the deliverables using the residual
method, under which revenue is allocated to the undelivered elements based on
vendor-specific objective evidence of the fair value of such undelivered
elements. Elements included in multiple element arrangements consist of
software, intellectual property, implementation services, maintenance and
consulting services. Vendor-specific objective evidence is based on the price
charged when an element is sold separately or, in the case of an element not
sold separately, the price established by management, if it is probable that
the price, once established, will not change before market introduction. Deferred revenue arises from payments received in advance of the
culmination of the earnings process. Deferred revenue expected to be realized
within the next twelve months is classified as current. Encoding services consist of the conversion of audio and video content
into digital media formats. Sales of encoding services are generally under
nonrefundable time and materials or per unit contracts. Under the provisions of
SAB 101, as amended by SAB 104, and EITF 00-21, the Company recognizes revenues
as the encoding services are rendered and the Company has no continuing
involvement in the goods and services delivered, which is the date
the finished media is shipped to the customer. Digital music samples services are provided to customers using the
Companys proprietary streaming media software, tools, and processes. Music
samples are streamed files containing selected portions, or samples, of a full
music track and are typically 30 to 60 seconds in length. Customer billings
are based on the volume of data streamed at rates agreed upon in the customer
contract, subject to a nonrefundable monthly minimum fee. Under the provisions
of SAB 101, as amended by SAB 104, and EITF 00-21, the Company recognizes
revenue in the period in which the samples are delivered. Digital distribution services consist primarily of rights clearing
services, ringtune services and the hosting of digital media content for the
Companys customers for download by the end user. Customer billings for
digital distribution services are generally based on a combination of a set-up
fee, a fixed montly fee and a fee per download. Under the provisions of SAB
101, as amended by SAB 104, and EITF 00-21, the Company recognizes revenue in
the period in which the services are provided. Similar to the digital music samples services, Internet radio and video
services are provided to customers using the Companys proprietary media
software, tools and processes. Internet radio and video services can consist
of the rebroadcasting over the Internet 9




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of a customers over-the-air radio programming. Services provided may
also include playlist selection and programming services for online radio
channels and may include related video content, such as music videos. Under
the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, revenue from
the sale of Internet radio and video services is recognized on a monthly basis
as the services are provided and customers are typically billed monthly in
arrears. Webcasting services are provided to customers using the Companys
proprietary streaming media software, tools and processes. Services for live
webcast events may be sold separately or combined with on-demand webcasting
services in which the Company may host an archive of the webcast event for
future use on an on-demand basis. In addition, on-demand webcasting services
are often sold separately without the live event component. As a result, the
Company has verifiable and objective evidence of the fair value for both the
live and on-demand services. Under the provisions of SAB 101, as amended by
SAB 104, and EITF 00-21, the Company recognizes revenue for live webcasting in
the period in which the webcast event occurs. Revenue for on-demand webcasting
services are deferred and recognized ratably over the period in which the
services are provided. Customer billings are typically based on the volume of
data streamed at rates agreed upon in the customer contract or a set monthly
fee. Content
protection services consist primarily of anti-piracy, data mining, and
content promotion solutions related to peer-to-peer file sharing networks.
Customer billings for content protection services are generally based on a
fixed monthly fee, but may also contain a volume-based component and, for
content promotion services, a fee based on customer sales volume. Under the
provisions of SAB 101, as amended by SAB 104, and EITF 00-21, the Company
recognizes revenue in the period in which the services are provided. Media restoration services consist of services provided by our VidiPax
subsidiary to restore and upgrade old or damaged archives of traditional media.
Under the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, the
Company recognizes revenues as these services are rendered and the Company has
no continuing involvement in the goods and services delivered, which generally
is the date the finished media is shipped to the customer. As discussed in
Note 5, the Company sold its Vidipax subsidiary on January 30, 2004 pursuant to
an agreement dated October 31, 2003. Stock-based Compensation The Company accounts for stock-based employee compensation plans under the
recognition and measurement principles of Accounting Principles Board Opinion
No. 25, Accounting for Stock Issues to Employees, (APB 25), as interpreted by
Financial Accounting Standards Board Interpretation No. 44, Accounting for
Certain Transactions Involving Stock Compensation, an Interpretation of APB 25
(FIN 44), and related interpretations. Under APB 25, compensation expense is
based on the difference between the exercise price of employee stock options
granted and the fair value of the Companys common stock at the date of grant.
Deferred compensation, if any, is amortized over the vesting period of the
related options, which is three to four years. Equity instruments issued to non-employees are accounted for in accordance
with the provisions of Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation (FAS 123) and Emerging Issues Task
Force Issue No. 96-18, Accounting for Equity Investments that are Issued to
Other than Employees for Acquiring or in Conjunction with Selling Goods or
Services (EITF 96-18), and related interpretations. Stock-based compensation for the quarter ended March 31, 2004 totaled
$141,000, consisting of the amortization of deferred stock compensation of
$139,000, of which $19,000 is included in cost of revenues, stock-based
compensation expense of $14,000 related to options granted to a consultant, and
a credit of $12,000 for variable stock compensation related to stock options
that were repriced in 2001. Stock-based compensation was $42,000 for the
quarter ended March 31, 2003, of which $4,000 is included in cost of revenues,
consisting of the amortization of deferred stock compensation. 10




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The following table illustrates the effect on net loss and net loss per
share if the Company had applied the fair value recognition provisions of FAS
123 to stock-based employee compensation (in thousands): Three Months EndedMarch 31,2004
    
    2003Net loss, as reported
    
    $
    (2,821
    )
    
    $
    (13,059
    )Add: stock-based employee compensation
expense under APB 25 included in reported
net loss
    
    
    127
    
    
    
    42Deduct: total stock-based employee
compensation expense determined under fair
value method for all awards
    
    
    (442
    )
    
    
    (589
    )Pro forma net loss
    
    $
    (3,136
    )
    
    $
    (13,606
    )Net loss per share:Basic and diluted  as reported
    
    $
    (0.04
    )
    
    $
    (0.28
    )Basic and diluted  pro-forma
    
    $
    (0.05
    )
    
    $
    (0.29
    )
 To determine compensation expense under FAS 123, the Company used the following
assumptions: 2004
    
    2003  Risk-free interest rates
    
    
    2.33 - 5.71
    %
    
    
    3.00 - 5.71
    %  Expected lives
    
    3 years
    
    5 years  Expected dividend yields
    
    
    0
    %
    
    
    0
    %  Expected volatility
    
    
    115
    %
    
    
    75
    %
 Reclassifications Certain information reported in previous periods has been reclassified to
conform to the current period presentation. These reclassifications had no
impact on previously reported net loss, stockholders equity or cash flows.  3.
    
    SPECIAL CHARGES The Company has recorded Special Charges related to corporate
restructurings, facilities consolidations and the impairment of assets in
accordance with its long-lived asset policy (see Note 2). The following table
summarizes such charges recorded in the consolidated statements of operations
(in thousands): Three Months Ended March 31,2004
    
    2003Goodwill impairment
    
    $
    
    
    
    $
    5,307Intangible assets impairment
    
    
    
    
    
    
    685Property and equipment impairment
    
    
    
    
    
    
    601Employee severance and termination benefits
    
    
    
    
    
    
    501Facilities
related charges (credits)
    
    
    (50
    )
    
    
    465Other restructuring charges
    
    
    
    
    
    
    878$
    (50
    )
    
    $
    8,437
 The following table summarizes the activity in accrued special charges during
the three months ended March 31, 2004 (in thousands): Facilities RelatedChargesBalance, December 31, 2003
    
    $
    1,670Additional accruals
    
    
    Payments
    
    
    (1,099
    )Adjustments
    
    
    (50
    )Balance, March 31, 2004
    
    $
    521
 During the fourth quarter of 2002, management committed to a plan to exit
certain of the Companys leased facilities, including the Companys unoccupied
facility at 414 Olive Way, Seattle, WA. Under the provisions of EITF 94-3, the
Company recorded the estimated lease termination costs in accrued special
charges. As discussed in Note 9, the landlord of the Companys unoccupied
facility at 414 Olive Way, Seattle, WA filed suit against the Company in April
2003 for breach of its lease. In January 2004, the Court 11




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entered a judgment in favor of the plaintiff for rents due through January
2004 of $438,000, which the Company accrued in a prior period and paid in the first quarter of 2004. At December 31, 2003, the Company had accrued special charges under the
provisions of Statement of Financial Accounting Standards No. 146, Accounting
for Costs Associated with Exit or Disposal Activities (FAS 146) related to its
Vidipax facility in New York, New York. The lease agreement was originally
entered into in December 2002 and the Company had never occupied the facility.
During 2003, the Company informed the landlord of its decision to release its
rights under the lease agreement and had been in ongoing discussions with the
landlord to negotiate a lease termination agreement. Accordingly, under the
requirements of FAS 146, the Company had accrued $562,000 in accrued special
charges through the third quarter of 2003 representing the estimated fair value
of future rental payments, net of estimated sublease rentals and related costs
with respect to the termination of this lease. In December 2003, the Company
accrued an additional $150,000, for a total accrual of $712,000, to adjust its
estimate of the fair value of the liability based on further negotiations with
the landlord. In February 2004, the Company entered into a lease settlement
agreement with the landlord pursuant to which the Company paid the landlord
$450,000 and allowed the landlord to retain its security deposit of $212,000,
for a total settlement of $662,000. The $50,000 difference between the amount
recorded in accrued special charges and the final settlement amount has been
reflected as a credit to special charges in the consolidated statement of
operations. In February 2003, the Companys Chairman and Chief Executive Officer, John
T. Baker, resigned and the Company engaged Regent Pacific Management
Corporation to provide management services to the Company. In March 2003,
Regent Pacific resigned from the engagement and Jeffrey M. Cavins was elected
President and Chief Executive Officer. These events are described more fully in
the Companys Annual Report on Form 10-K for the year ended December 31, 2003.
During and subsequent to Regent Pacifics engagement, the Company undertook a
strategic and operational analysis of its business and product lines. This
analysis resulted in the development of a new strategic and operational plan,
under which the Company restructured itself to focus on its core competencies
in digital media services and on core strategic customers and markets for its
enterprise communications services. A revised corporate forecast was developed
in connection with this plan. The revised forecast also considered that the
Company had learned that revenue from a significant customer in its Media
Restoration Services segment would be less than originally anticipated. Using
the revised forecast, the Company performed a reassessment of the carrying
value of all of its assets, both tangible and intangible. The revised forecast
demonstrated that certain tangible and intangible assets related
to its media restoration services and enterprise communications services
businesses were impaired, as the projected undiscounted discernible cash flows
did not exceed the carrying value of the assets over their estimated useful
lives. The fair values of each of these assets were estimated using primarily a
discounted cash flow method. The fair value of goodwill was estimated under the
two-step process required by FAS 142. The estimated fair values of each of the
assets were then compared to their carrying values to measure the impairments.
As a result of this analysis, the Company recorded impairment charges for
goodwill, intangible assets, and property and equipment related to its
enterprise communication services and media restoration services businesses of
$5.3 million, $685,000, and $601,000, respectively. In addition to the impairment charges above, the Company recorded
severance and termination benefits of $204,000 associated with a reduction in
force announced in March 2003 of approximately 35% of its consolidated
staffing. The Company also recorded $297,000 of severance and termination
benefits with respect to certain changes in senior management in the first
quarter of 2003. The Company incurred costs of approximately $465,000 related
to the termination of certain facilities leases in connection with its
facilities consolidation. The other restructuring charges of $878,000 represent
fees and costs paid to Regent Pacific Management Corporation with respect to
interim management services provided to the Company in connection with its
management and operational restructuring.  4.
    
    NET LOSS PER SHARE Basic earnings per share is computed by dividing net loss by the weighted
average number of shares of common stock outstanding during the period. Diluted
earnings per share is computed by dividing net loss by the weighted average
number of common and dilutive common equivalent shares outstanding during the
period. Common equivalent shares consist of shares of common stock issuable
upon the exercise of stock options and warrants (using the treasury stock
method). For all periods presented, common equivalent shares are excluded from
the calculation because their effect is antidilutive as a result of the
Companys net losses. The Company has excluded the following numbers of shares
using this method (in thousands): 12




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Three-Months Ended March 312004
    
    2003Options
    
    
    7,419
    
    
    
    7,273Warrants
    
    
    1,041
    
    
    
    2638,460
    

    
    
    7,536
  5.
    
    TRANSFER OF MEDIA RESTORATION ASSETS AND LIABILITIES On January 30, 2004 (Transfer Date), the Companys wholly-owned media
restoration services subsidiary, VMRLE Co., Inc. (formerly Vidipax, Inc.),
transferred substantially all of its assets and certain liabilities to a
company controlled by the former general manager of VMRLE Co., Inc. pursuant to an
asset purchase agreement signed on October 31, 2003 and amended on January 30,
2004. The total purchase price of $1.2 million was placed in escrow when the
asset purchase agreement was signed. Based on the January 30, 2004 amendment,
$900,000 of the $1.2 million purchase price was to be released from escrow upon
the assignment to the purchaser of contracts with the General Services
Administration of the United States (GSA Contracts). If the GSA Contracts
were not assigned within a certain time period after the Transfer Date, the
purchaser had the option to unwind the transfer and reclaim the $1.2 million
held in escrow. Accordingly, consistent with the provisions of SEC Staff
Accounting Bulletin Topic 5E, the assets and liabilities transferred were
recorded on the consolidated balance sheet as assets and liabilities
transferred under contractual arrangement at their carrying value as of the
Transfer Date. As of December 31, 2003, these assets and
liabilities were classified as held for sale. On May 10, 2004,
(Accounting Closing Date), the GSA contracts were
assigned to the purchaser, resulting in the subsequent release of the $900,000
from escrow to VMRLE Co., Inc. For the period from the Transfer Date to the
Accounting Closing Date, VMRLE Co., Inc. continued to be the contracting party with the
GSA. The media restoration services provided under the GSA contracts during
that period were provided by the purchaser as agent for VMRLE Co., Inc. and the
purchaser retained the profits or losses earned from such services.
Because VMRLE Co., Inc. continued to be the primary obligor under the
GSA contracts until their assignment, revenues and costs of revenues
in the consolidated statement of operations of Loudeye reflect the
revenues from services provided under the GSA contracts of $95,000
for the period from the Transfer Date through March 31, 2004.
All other revenues and costs of VMRLE, Co., Inc.s operations
have been appropriately excluded from the Companys Statement of
Operations subsequent to the Transfer Date. Results from
services provided under the GSA contracts from March 31, 2004 to
the Accounting Closing
Date will be recorded as revenues and cost of revenues in the Companys
consolidated statement of operations in the second quarter of 2004. The
difference between the proceeds and the carrying value of the assets and
liabilities transferred as of the Accounting Closing Date will be recorded as a gain or
loss on the sale of assets and liabilities transferred in the second quarter of
2004. With the GSA Contract assigned to the purchaser, the remaining $300,000 of
the $1.2 million held in escrow will be released upon the execution of an
agreement relating to certain rights associated with certain equipment owned by
a third party. If such agreement is not executed by October 31, 2004, the
purchaser may reclaim the $300,000 held in escrow. Due to this uncertainty,
the $300,000 will be recorded as a gain at the time the agreement is executed. The Company may receive up to an additional $500,000 based on the
purchaser achieving certain performance targets over a period of two years from
the Transfer Date. At transfer, the Company also entered into a co-marketing
and reseller agreement with the purchaser pursuant to which the Company will
sell, for a fee, media restoration services on behalf of the purchaser for a
two-year period. The co-marketing and earn-out provisions constitute
continuing involvement by the Company under FAS 144. Consequently, VMRLE Co.
Inc. has not been reported as a discontinued operation.  6.
    
    PRIVATE EQUITY FINANCING In February 2004, the Company sold 10,810,811 shares of common stock at
$1.85 per share to a limited number of accredited investors. The gross proceeds
received from the financing were $20,000,000. The Company paid a placement fee
equal to 5% of the gross proceeds. The net proceeds of the offering, after
commissions and expenses, will be used for working capital and general
corporate purposes, including expansion of the Companys business-to-business
digital music solutions in the U.S. and internationally. The Company filed a
registration statement in March 2004 covering the resale of the shares sold in
the financing and has agreed to use its reasonable efforts to have the
registration statement declared effective by the SEC as soon thereafter as
practicable.  7.
    
    ACQUISITION OF OVERPEER, INC. In March 2004, the Company completed the acquisition of Overpeer, Inc.
(Overpeer), a privately held company based in New York. Pursuant to the
Agreement and Plan of Merger and Reorganization (Merger Agreement), among
Loudeye, Privateer Acquisition Corp., a wholly owned subsidiary of the Company,
Overpeer and certain of Overpeers stockholders, Privateer Acquisition Corp.
was merged with and into Overpeer, with Overpeer continuing as the surviving
company and a wholly-owned subsidiary of the Company (the Merger). 13




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##### Table of Contents



As a result of the Merger, all of the outstanding capital
stock of Overpeer was exchanged for a total of 1,752,772 shares of Loudeyes
common stock. The number of shares issued in the Merger was calculated by
dividing $4,000,000 by the volume weighted average closing sales price of
Loudeyes common stock on each of the thirty consecutive trading days preceding
the closing of the Merger, or $2.2821 per share. 262,916 of the shares issued
in the Merger will be held in escrow for one year and will be available during
that time to satisfy indemnity claims under the Merger Agreement. The Company
filed a registration statement in March 2004 for the resale of the securities
issued to the Overpeer shareholders, which registration statement has not yet
been declared effective. Overpeer is a provider of digital media data mining, anti-piracy and
promotional solutions, which are complimentary to Loudeyes current and planned
future digital media solutions. The acquisition is intended to allow the
Company to provide a more complete suite of digital media solutions to its
customers. The Company accounted for the acquisition in accordance with Statement of
Financial Accounting Standards No. 141, Business Combinations. In accordance
with EITF Issue No. 99-12 Determination of the Measurement Date for the Market
Price of Acquirer Securities Issued in a Purchase Business Combination, the
fair value of the shares issued was determined to be $2.26 per share based on
the closing price of the Companys common stock on February 29, 2004, which was
the date on which the number of shares issued could be determined. The
following table summarizes the preliminary estimated fair values of the assets acquired and
liabilities assumed, along with the preliminary estimated useful lives of property and
equipment and intangible assets, which have been recorded in the Companys
digital media services segment (in thousands): PurchasePriceAllocation
    
    Useful lifeCurrent assets
    
    $
    277Property and equipment
    
    
    278
    
    
    1 - 3 yearsGoodwill
    
    
    2,434Trademark
    
    
    42
    
    
    IndefiniteAcquired technology
    
    
    682
    
    
    5 yearsCustomer relationships
    
    
    317
    
    
    7 yearsNon-compete agreements
    
    
    373
    
    
    3 yearsOther long-term assets
    
    
    8Current liabilities
    
    
    (321
    )Total purchase price
    
    $
    4,090
 The purchase price allocation
set forth above includes acquisition costs of $129,000 is preliminary and subject to
change in future periods pending the completion of an independent
valuation report. The following table presents the unaudited pro forma results of the
Company for the three months ended March 31, 2004 and 2003 assuming the Company
had acquired Overpeer at the beginning of each period (in thousands): Three Months EndedMarch 31,2004
    
    2003Total revenues
    
    $
    2,168
    
    
    $
    3,608Net loss
    
    $
    (2,956
    )
    
    $
    (13,381
    )Basic and diluted net loss per share
    
    $
    (0.05
    )
    
    $
    (0.29
    )
  8.
    
    SEGMENT INFORMATION The Company operates in two business segments, Digital Media Services and
Media Restoration Services. As described in Note 5, the Company transferred
the assets and certain liabilities of its media restoration services business
on January 30, 2004. The following information summarizes the Companys
segments (in thousands): 14




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##### Table of Contents



Three Months EndedMarch 31,2004
    
    2003RevenuesDigital Media Services
    
    $
    1,812
    
    
    $
    2,660Media Restoration Services
    
    
    179
    
    
    
    650$
    1,991
    
    
    $
    3,310Net LossDigital Media Services
    
    $
    (2,768
    )
    
    $
    (12,349
    )Media Restoration Services
    
    
    (53
    )
    
    
    (710
    )$
    (2,821
    )
    
    $
    (13,059
    )
 December 31,March 31, 2004
    
    2003Total AssetsDigital Media Services
    
    $
    44,198
    
    
    $
    25,829Media Restoration Services
    
    
    863
    
    
    
    1,215$
    45,061
    
    
    $
    27,044
  9.
    
    CONTINGENCIES In July and August 2001, four substantially similar class action
complaints were filed in the Untied States District Court for the Southern
District of New York against the Company and certain of its former officers and
directors, as well as against certain underwriters who handled its initial
public offering of common stock in March 2000. The various complaints were
filed purportedly on behalf of a class of persons who purchased the Companys
common stock during the time period beginning on March 15, 2000 and ending on
December 6, 2000. The complaints together allege violations of the Securities
Act of 1933 and the Securities Exchange Act of 1934, primarily based on the
allegation that there was undisclosed compensation received by the Companys
underwriters in connection with its initial public offering and the allegation
that the underwriters entered into undisclosed arrangements with some investors
that were designed to distort and/or inflate the market price for the Companys
common stock in the aftermarket following the initial public offering. These
actions have all been consolidated before the same judge for pretrial purposes.
No specific amount of damages has been claimed. The Company and the individual
defendants have demanded to be indemnified by the underwriter defendants
pursuant to the underwriting agreement entered into at the time of the initial
public offering. Presently, all claims against the former officers have been
withdrawn without prejudice. The Company, along with the other issuer
defendants, moved to dismiss the claims in the complaint. In February 2003 the
court denied the Companys motion. A proposed settlement and release of claims
against the issuer defendants was approved by the court and is scheduled to be
completed in June 2004. Management does not anticipate that the
Company will be required to pay any amounts under this settlement. In February 2003, the Company entered into an agreement with Regent
Pacific Management Corporation pursuant to which Regent Pacific would provide
management services. The agreement was for a term of 26 weeks, with an option
to renegotiate certain terms of the agreement after 13 weeks, and was
terminable by either party under certain circumstances. Under the agreement,
the Company paid certain fees to Regent Pacific. In addition, Regent Pacific
was to receive stock options to purchase up to 4,000,000 shares of Loudeye
common stock based on Regent Pacifics length of service. These options were
to be granted at various times throughout their engagement at exercise prices
based on the closing market price on each grant date. In March 2003, Regent
Pacific resigned from the engagement. In July 2003, Regent Pacific filed suit
against the Company in the United States District Court for the Northern
District of California for breach of the agreement. In this complaint, Regent
Pacific is seeking unspecified damages and specific performance of the alleged
obligation to grant the stock options due to them under the contract. The
Company answered the complaint in September 2003 denying all allegations and
asserting counterclaims. In March 2004, the court granted the Companys motion
to transfer the case to the United States District Court for the Western
District of Washington. The Company intends to defend vigorously this action
and to pursue vigorously its counterclaims. The likelihood of loss is
not considered probable and the amount of loss, if any, is not
estimable at this time. In April 2003, the landlord of the Companys unoccupied facility at 414
Olive Way, Seattle, WA filed suit against the Company in the Superior Court of
Washington, King County, for breach of its lease and is seeking damages of $2.0
million. In January 2004, the court entered a judgment in favor of the
plaintiff for rents due through January 2004 of $438,000, which
the Company had accrued in a prior period and
paid in the first quarter of 2004. The Court reserved the other issues in the
suit, including mitigation, interest and attorneys fees, for trial. The
Company has appealed the judgment and management believes that the Company has
meritorious defenses to the claims made in the suit and intends to defend this
suit vigorously and the Company may also bring certain counterclaims against
the landlord. If the Company does not prevail on its appeal or its
counterclaims, the Company may be held liable for additional amounts beyond the 15




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##### Table of Contents



amount of the judgment. As of December 31, 2003 and March 31, 2004, the
Company has recorded in accrued special charges an estimate of the additional
amounts the Company may ultimately be required to pay with respect to this
matter. The Company becomes involved from time to time in various other claims and
lawsuits incidental to the ordinary course of its operations, including such
matters as contract and lease disputes and complaints alleging employment
discrimination. The Company believes that the outcome of any such pending
claims or proceedings individually or in the aggregate, will not have a
material adverse effect upon its business or financial condition, cash flows,
or results of operations. In
the normal course of business, the Company indemnifies other parties,
including business partners, lessors and parties to other transactions
with the Company. The Company has agreed to hold the other parties
harmless against losses arising from the breach of representation or
covenants, or out of intellectual property infringement or other
claims made by third parties. These agreements may limit the time
within which an indemnification claim can be made. In addition, the
Company has entered into indemnification agreements with certain of
its officers and directors and the Companys by-laws contain similar
indemnification obligations to the Companys officers and directors.
It is not possible to determine the maximum potential amount under
these indemnification  agreements since the Company has not had any
prior indemnification claim upon which to base an estimate and each
claim would be based on the unique facts and circumstances of the
claim and the particular provisions of each agreement. 16




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS Forward-Looking Statements The following discussion of our financial condition and results of
operations contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended, and are made under the safe harbor
provisions thereof. In some cases, you can identify forward-looking statements
by terminology such as may, will, should, expect, plan, anticipate,
believe, estimate, predict, potential or continue, the negative of
terms like these or other comparable terminology. These forward-looking
statements are only predictions and actual events or results may differ
materially from those projected. Specific factors that could cause actual
results to differ materially from those projected include, but are not limited
to the Risk Factors set for the below in this Managements Discussion and
Analysis of Financial Condition and Results of Operations. All
forward-looking statements included in this document are based on information
available to us on the date hereof, and we assume no obligation to publicly
release any revisions of the forward-looking statements contained herein to
reflect events or circumstances after the date hereof. Readers are cautioned
not to place undue reliance on these forward-looking statements, as our
business and financial performance are subject to substantial risks and
uncertainties. Overview We are an innovative business-to-business provider of services that
facilitate the distribution and promotion of digital media content to media &
entertainment, retail and enterprise customers. Our services enable our
customers to outsource the management and distribution of audio and video
digital media content over the Internet and on other digital distribution

platforms. Our technical infrastructure and back-end solutions, combined with
our proprietary applications, comprise an end-to-end solution, from basic
digital media services, such as the hosting, storage, encoding, management and
protection of media assets for content owners, to complex, fully-outsourced
digital media distribution and promotional services, such as private-labeled
digital music download stores and streaming Internet radio and music sample
services. Our solutions reduce the complexity and cost of internal solutions,
and enable our customers to provide branded digital media offerings to their
users while supporting a variety of digital media technologies and consumer
business models. The Loudeye Solution During the first quarter of 2004, we provided our services via two primary
business segments, Digital Media Services and Media Restoration Services. As
discussed in Note 5 to the consolidated financial statements, in January 2004
we transferred substantially all of the assets of our media restoration
services subsidiary, Vidipax, Inc., to a company controlled by the general
manager of that subsidiary. While we will have ongoing rights to co-market and
resell media restoration services for two years after the sale, we anticipate
media restoration services will represent a significantly smaller portion of
our operations for the remainder of 2004 and beyond. Digital Media Services.We provide a full service business-to-business
digital media solution that allows our customers to deploy, rapidly and cost
effectively, their own privately branded digital media service. Our solution
is the culmination of our significant investments in our systems and
infrastructure. Some of the key features of our solution include:  
    
    Web enabled architecture;
    
    Archive of 4.5 million music tracks in uncompressed, digital master format;
    
    Highly scalable and reliable operations;
    
    Support for multiple media players, digital media formats and codecs;
    
    Support for multiple bit rates; and
    
    Extensive, transferable content rights and experience working with major and independent record labels. Although our customers may choose any combination of services we offer, our
management views our solutions in three tiers of service. These tiers are
summarized as follows: Tier 1:
    
    These services consist primarily of content management, encoding and
fulfillment, and metadata services. Revenues from these services tend to
consist of repeat, rather than recurring, business. Tier 1 services
currently account for a substantial portion of our digital media services
revenue. However, over the next several years we expect the proportion of
revenues from Tier 1 services to decline relative to revenues from Tier 2
and Tier 3 services.
 17




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##### Table of Contents



Sales of our Tier 1 digital media services are generally under
nonrefundable time and materials or per unit contracts. Under these
contracts, we recognize revenues as services are rendered and we have no
continuing involvement in the goods and services delivered, which
generally is the date the finished media is shipped to the customer.Tier 2:
    
    These services consist primarily of hosted media and delivery as well
as rights administration and settlement. Revenues from these services
tend to consist of recurring business and may include scalable
economics. Revenues for Tier 2 services may include monthly minimum fees,
setup and license fees, professional services fees, ongoing maintenance
fees and a share of our customers transactional revenues.We sell our music samples service in application service provider
(ASP) arrangements. We are required to host the applications and the
customer does not have the ability to have the application hosted by
another entity without an additional charge. Billings are generally made
based upon volumes of data delivered or minutes of content streamed, and
revenue is recognized as the services are delivered.Our enhanced enterprise communication services include highly
scalable, live and on-demand audio and video webcasting services,
supported by proprietary applications such as synchronized streaming slide
presentation capabilities. Revenue from live webcasts is recognized when
the webcasts are delivered. Revenue from on-demand webcasts is recognized
over the period of time they are made available.Tier 3:
    
    These services consist primarily of custom application development,
ASP services, commerce engine, analytics and full operational outsourcing.
Revenues from Tier 3 services will consist of recurring business and may
include setup and licensing fees, professional services fees, ongoing
maintenance fees and a share of our customers transactional revenues. We expect that
over the next several years Tier 3 services will account for the majority
of our revenues.
 Media Restoration Services.Our media restoration services segment has
performed services to restore and migrate legacy media archives to current
media formats. We recognized revenues as services were rendered and we had no
continuing involvement in the goods and services delivered, which generally was
the date the finished media was shipped to the customer. Highlights of First Quarter 2004 Operating Results The following is a summary description of our operating results for the
three months ended March 31, 2004. A more detailed discussion of our operating
results is included below under the heading Results of Operations. Our first quarter of 2004 represents a continuation of the business and
strategic initiatives implemented in 2003. Highlights include: Organization:  
    
    We expanded our management team with the hiring of Lawrence J.
Madden, executive vice president and chief financial officer, and
William P. Fasig, executive vice president of business development,
sales and marketing. Digital Media Solutions Initiatives:  
    
    We upgraded our Media Operations Center and increased its archive
storage, throughput and encoding capacities.
    
    We launched IndieSource, an extension of our music label program that
enables companies that build a digital music business to license hundreds
of thousands of non-major label, independent music tracks from around
the world through a single program. We have signed several independent
labels to the program, including Saregama, Indias largest music
company.
    
    We developed a complete solution for Universal Music Publishing Groups SYNCHExpress.com Website.
    
    We powered the first Web-enabled and wireless in-store media kiosks with enhanced features and digital media content. 18




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$20 million Equity Financing:  
    
    We sold 10,810,811 shares of common stock at $1.85 per share to a
limited number of accredited investors in a private placement. The net
proceeds received from this financing were $18.9 million. We had cash,
short-term investments and restricted investments of $34.8 million at
March 31, 2004, compared to $22.3 million at December 31, 2003. Acquisitions and Divestitures:  
    
    As discussed in Note 7 to the consolidated financial statements, we
acquired Overpeer, Inc., a leading provider of digital media data
mining, anti-piracy and promotional solutions. Following this
acquisition, we made significant investments in the Overpeer service
line including doubling its capacity, expanding capabilities, and adding
dedicated sales staff.
    
    As discussed in Note 5 to the consolidated financial statements, we
sold our Vidipax subsidiary to increase our focus on digital media
services. We believe our first quarter shows positive results deriving from these
initiatives. Our first quarter 2004 revenues were $2.0 million, compared to
$3.3 million in the prior year quarter. The results for the 2004 quarter
include $155,000 of revenue attributable to our acquisition of Overpeer, and an
increase of $157,000 in revenue from our core digital media services business.
These increases were offset by a decrease in our webcasting business resulting
from a restructuring in 2003 (representing $1.2 million of the decrease) and
the sale of our Vidipax subsidiary in January 2004 (representing
$471,000 of
the decrease). Our first quarter gross profit as a percentage of revenues was 28%,
compared to 23% in the prior year quarter, principally due to restructuring
activities and other cost management initiatives. We reported a net loss of $2.8 million or $0.04 per share in the first
quarter of 2004, compared to a net loss of $13.1 million or $0.28 per share in
the prior year quarter. Results of Operations Revenues.Revenues totaled $2.0 million and $3.3 million for the first
quarter of 2004 and 2003 and consisted of the following (in thousands): Three Months Ended March 31,$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Encoding services
    
    $
    339
    
    
    $
    377
    
    
    $
    (38
    )
    
    
    (10
    %)Samples services
    
    
    474
    
    
    
    459
    
    
    
    15
    
    
    
    3
    %Webcasting
    
    
    362
    
    
    
    1,522
    
    
    
    (1,160
    )
    
    
    (76
    %)Internet radio and hosting
services
    
    
    374
    
    
    
    297
    
    
    
    77
    
    
    
    26
    %Content
protection services
    
    
    155
    
    
    
    
    
    
    
    155
    
    
    
    100
    %Digital distribution services
    
    
    108
    
    
    
    5
    
    
    
    103
    
    
    
    2,060
    %Media restoration services
    
    
    179
    
    
    
    650
    
    
    
    (471
    )
    
    
    (72
    )%Total Revenue
    
    $
    1,991
    
    
    $
    3,310
    
    
    $
    (1,319
    )
    
    
    (40
    )%
 Our product mix changed significantly over the course of 2003 after we
restructured our management team and operations and changed our strategic
direction at the end of the first quarter of 2003. We shifted marketing
emphasis away from webcasting and more toward digital media services, primarily
digital music solutions. Our current webcasting services are focused on
customer relationships that provide higher margins. As a result, revenue from
webcasting services decreased significantly for the first quarter of 2004
compared to the first quarter of 2003. Revenues from encoding services, samples services, and radio and hosting
services generally fluctuate based on the volume of content delivered (for
encoding services) and volume of content streamed (for samples and radio and
hosting services). Such volume is driven primarily by our customers content
needs and the level of activity on their websites. Consequently, a certain
amount of fluctuation in these revenue sources is common. 19




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Content
protection services are provided by our Overpeer subsidiary which we
acquired in March 2004. Accordingly, there were no revenues from such services
in 2003. Revenues from digital distribution services consist principally of
ringtunes and rights clearing services. We began providing these services
following our restructuring in the first quarter of 2003, so there were
limited revenues from such services in the first quarter of 2003. Media restoration services revenue for the first quarter of 2004 does not
include a full three months of revenue due to the transfer of our media
restoration business on January 30, 2004 as discussed in
Note 5 to the consolidated financial statements. Cost
of Revenues.Cost of revenues decreased to $1.4 million for the first
quarter of 2004 from $2.5 million for the first quarter of 2003.
Cost of revenues decreased from 77% of revenue in 2003 to 72% of
revenue in 2004, and consisted
of the following (in thousands): Three Months Ended March 31,$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Digital Media services
    
    $
    1,260
    
    
    $
    2,044
    
    
    $
    (784
    )
    
    
    (38
    )%Media Restoration services
    
    
    166
    
    
    
    501
    
    
    
    (335
    )
    
    
    (67
    )%Total Cost of Revenues
    
    $
    1,426
    
    
    $
    2,545
    
    
    $
    (1,119
    )
    
    
    (44
    )%
 Cost of revenues include the cost of production, including personnel, an
allocated portion of facilities and equipment, and other supporting functions
related to the delivery of our digital media and media restoration services.
The decrease is due primarily to cost reduction initiatives implemented in
March 2003, which included reductions in our workforce and the renegotiation or
termination of several facilities leases. We have begun to expand our
production work force in order to meet the demands of anticipated growth and
new initiatives. Accordingly, we expect cost of revenues to increase
moderately over the remainder of 2004 compared to the same periods in 2003. Depreciation included in cost of revenues increased to approximately
$292,000 in 2004 from $216,000 in 2003. This increase is due primarily to
equipment purchased in the first quarter of 2004 of $1.5 million to upgrade the
storage and access systems for our digital music archive. Accordingly, we
expect depreciation included in cost of revenues to increase moderately in 2004
compared to 2003. Operating Expenses.Our operating expenses were as follows for the first
quarter of 2004 and 2003 (in thousands): Three Months Ended March 31,$ Increase
    
    % Increase2004
    
    2003
    
    (Decrease)
    
    (Decrease)Research and development
    
    $
    590
    
    
    $
    577
    
    
    $
    13
    
    
    
    2
    %Sales and marketing
    
    
    635
    
    
    
    1,547
    
    
    
    (912
    )
    
    
    (59
    )%General and administrative
    
    
    1,960
    
    
    
    2,753
    
    
    
    (793
    )
    
    
    (29
    )%Amortization of intangible and other
assets
    
    
    140
    
    
    
    525
    
    
    
    (385
    )
    
    
    (73
    )%Stock-based compensation
    
    
    122
    
    
    
    38
    
    
    
    84
    
    
    
    221
    %Special charges  goodwill impairments
    
    
    
    
    
    
    5,307
    
    
    
    (5,307
    )
    
    
    (100
    )%Special
charges (credits)  other
    
    
    (50
    )
    
    
    3,130
    
    
    
    (3,180
    )
    
    
    (102
    )%Total Operating Expenses
    
    $
    3,397
    
    
    $
    13,877
    
    
    $
    (10,480
    )
    
    
    (76
    )%
 Research and Development.Research and development expenses totaled
$590,000 and $577,000 for the first quarter of 2004 and 2003. Research and
development expenses include labor and other related costs of the continued
development and support of our digital media services. We expect research and
development expense to increase moderately through the remainder of 2004
compared to the same period in 2003 as we invest in the development of our
digital media service offerings, particularly our Loudeye Digital
MusicStore and iRadio products, as well as our content
protection services. 20




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Sales and Marketing.Sales and marketing expenses totaled $635,000 and
$1.5 million for the first quarters of 2004 and 2003. Sales and marketing
expenses consist primarily of salaries, commissions, product branding costs,
advertising, public relations costs, trade show expenses, and cost of marketing
collateral. The decrease in sales and marketing expenses is due to the
decreased personnel and cost reduction initiatives related to our reductions in
force in the first quarter of 2003. We expect sales and marketing expenses to
increase moderately through the remainder of 2004 compared to the same period
in 2003 as we expand our sales force and marketing personnel to market and sell
our new Tier 3 application level products and services. General and Administrative.General and administrative expenses decreased
to $2.0 million in the first quarter of 2004 from $2.8 million in the first
quarter 2003. This decrease was due to the decrease in personnel related to our
reductions in force in the first quarter of 2003, and related cost reduction
initiatives. General and administrative expenses consist primarily of rent,
facilities and information technology charges, salaries, legal expenses,
investor relations costs and other costs associated with being a public
company. We anticipate that general and administrative expenses for the
remainder of 2004 will increase moderately compared to the same period of 2003
as we increase our personnel and other resources to support our growth. In
addition, we will incur additional professional fees in order to comply with
the new requirements under the Sarbanes-Oxley Act of 2002. Amortization of Intangible and Other Assets.Amortization of intangible
and other assets totaled $140,000 and $525,000 for the first quarters of 2004
and 2003, and includes amortization of identified intangible assets related to
acquisitions. The decrease was due to the impairment charges recorded in the
first quarter of 2003, which resulted in lower amortization charges starting
with the second quarter of 2003. We will incur additional amortization expense
in 2004 related to our acquisition of Overpeer, Inc. However, based on our
intangible assets as of March 31, 2004, amortization expense for the remainder
of 2004 will continue to be less than 2003. Stock-Based Compensation.Stock-based compensation included in operating
expenses for the first quarter of 2004 totaled $122,000, consisting of the
amortization of deferred stock compensation of $120,000, stock-based
compensation expense of $14,000 related to options granted to a consultant, and
a credit of $12,000 for variable stock compensation related to stock options
that were repriced in 2001. Stock-based compensation included in operating
expenses was $38,000 for the first quarter of 2003, consisting of the
amortization of deferred stock compensation. The increase in amortization of
deferred stock-based compensation is due to options granted to employees at
below fair value in July 2003 and February 2004. Special Charges.We have recorded special charges related to corporate
restructurings, facilities consolidations and the impairment of assets in
accordance with our long-lived asset policy. Following is a summary of special
charges for the first quarters of 2004 and 2003 (in thousands): 2004
    
    2003Goodwill impairment
    
    $
    
    
    
    $
    5,307Intangible and other asset impairments
    
    
    
    
    
    
    685Property and equipment impairments
    
    
    
    
    
    
    601Facilities
related charges (credits)
    
    
    (50
    )
    
    
    465Employee severance and termination benefits
    
    
    
    
    
    
    501Other restructuring charges
    
    
    
    
    
    
    878$
    (50
    )
    
    $
    8,437
 In February 2004, we entered into a lease settlement agreement with the
landlord or our Vidipax facility in New York, New York, pursuant to which we
paid $450,000 and allowed the landlord to retain its security deposit of
$212,000, for a total settlement of $662,000. This total settlement was $50,000
less than we had recorded in accrued special charges at December 31, 2003.
Accordingly, this $50,000 difference has been reflected as a credit to special
charges in the consolidated statement of operations. Impairments during the
first quarter of 2003 are explained in Note 3 to the consolidated financial
statements. Investment Income.Investment income consists of interest income and
realized gains and losses on sales of our investments. Investment income
totaled $79,000 and $85,000 for the first quarters of 2004 and 2003. The
decrease was due primarily to realized gains on sales of investments in the
first quarter of 2003. For 2004, we expect interest income will increase due
to higher average investment balance resulting from the proceeds received from
the private equity financings completed in August 2003 and February 2004. 21




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Interest Expense.Interest expense relates to our debt instruments,
consisting of our line of credit, term loan and capital lease obligations.
Interest expense totaled $71,000 and $50,000 for the first quarters of 2004 and
2003. The increase was due primarily to higher average debt balances in 2004
resulting from borrowings under the $3 million term loan facility that we put
in place at the end of 2003. Other Income.Other income was $3,000 and $18,000 for the first quarters
of 2004 and 2003 and consists principally of gains on sales of excess
equipment. Liquidity and Capital Resources As of March 31, 2004, we had approximately $34.8 million of cash, cash
equivalents, marketable securities, and restricted investments. These funds
reflect net proceeds of $18.9 million from our sale of common stock in a
private placement in February 2004. Of these funds, $316,000 is held in
investment accounts that serve as collateral for standby letters of credit for
certain of our capital lease and other obligations. Net cash used in operating activities was $3.2 million and $3.0 million
for first quarters of 2004 and 2003. For 2004, cash used in operating
activities resulted primarily from a net loss of $2.8 million and payments of
accrued special charges of $1.1 million, offset partially by non-cash charges
for depreciation and amortization and stock-based compensation aggregating
$622,000. The payment of accrued special charges relates to the
settlement of our lease obligation with respect to our Vidipax facility in New
York, New York and payment of a judgement related to an unoccupied facility in
Seattle, Washington as described in Note 3 to the consolidated financial
statements. Net cash used in investing activities was $6.4 million in the first
quarter of 2004, consisting principally of the net purchases of short-term
investments of $4.6 million to invest a portion of the proceeds from our
private equity financing in February 2004 and purchases of property and
equipment of $1.8 million, consisting principally of equipment to upgrade the
storage and access systems for our digital music archive. Net cash provided by financing activities was $17.5 million for the first
quarter of 2004, consisting primarily of proceeds from the private equity
financing in February 2004 of $19.0 million, as described below, and proceeds
from the exercise of stock options of $133,000, offset partially by principal
payments on our debt and capital lease obligations of $300,000 and the
repayment in full of our line of credit for $1.3 million. Other Recent Developments As more fully described in Note 5 to the consolidated financial
statements, in May 2004, $900,000 in proceeds from the sale of our Vidipax
subsidiary were released from escrow. The remaining $300,000 held in escrow
will be released upon our conveyance to the purchaser of rights we have
to use certain equipment owned by a third party. If we do not convey such
rights by October 31, 2004, the purchaser will have the right to reclaim the
$300,000 held in escrow. We believe that our existing cash, cash equivalents, and short-term
investments will be sufficient to fund our operations and meet our working
capital and capital expenditure requirements for the next year. Since we have
incurred net losses since inception, we have relied on sales of equity
securities, proceeds from the exercises of stock options and warrants and
borrowings under our credit facilities to fund our working capital needs.
Such capital may not be available in the future if it is needed. The
availability of such capital will depend on a number of factors, some of which
are outside our control. These include general market conditions, conditions in
the private equity and public markets, the then-current market price of our
common stock, and our historical financial performance and future prospects.
Our ability to raise capital could also be affected by any of the risks
affecting our business discussed below under the heading Risk Factors. Critical Accounting Policies and Estimates We have identified the most critical accounting policies and estimates
used in the preparation of our financial statements by considering accounting
policies and estimates that involve the most complex or subjective decisions or
assessments. Revenue recognition.We recognize revenue in accordance with Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, as
amended by Staff Accounting Bulletin No. 104, and EITF 00-21. We recognize
revenue associated with the 22




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license of software in accordance with Statement of Position 97-2,
Software Revenue Recognition (SOP 97-2), as amended by SOP 98-4, SOP 98-9 and
related interpretations and Technical Practice Aids. We recognize revenues from encoding services, digital music samples
services, digital distribution services, Internet radio services, live and
on-demand webcasting services, software licensing, peer-to-peer services and
media restoration services. We recognize these revenues when persuasive
evidence of an arrangement exists, the product and/or service has been
delivered, the price is fixed and determinable, and collectibility is
reasonably assured. In arrangements that include rights to multiple products and/or services,
we allocate the total arrangement consideration among each of the deliverables
using the residual method, under which revenue is allocated to undelivered
elements based on verifiable and objective evidence of the fair value of the
undelivered elements. Multiple element arrangements may consist of
implementation services, development services, encoding services, digital music
samples services, digital distribution services, Internet radio services, and
live and on-demand webcasting services. Verifiable objective evidence is based
upon the price charged when an element is sold separately. Under the provisions of SOP 97-2, in software arrangements that involve
rights to multiple products and services, we allocate the total arrangement
consideration among each of the deliverables using the residual method, under
which revenue is allocated to the undelivered elements based on vendor-specific
objective evidence of the fair value of such undelivered elements. Elements
included in multiple element arrangements consist of software, intellectual
property, implementation services, maintenance and consulting services.
Vendor-specific objective evidence is based on the price charged when an
element is sold separately or, in the case of an element not sold separately,
the price established by management, if it is probable that the price, once
established, will not change before market introduction. Deferred revenue arises from payments received in advance of the
culmination of the earnings process. Deferred revenue expected to be realized
within the next twelve months is classified as current liability Long-lived assets.Management periodically evaluates the recoverability
of our long-lived assets in accordance with SFAS No. 144. When doing so,
management is required evaluate the recoverability of an assets (or group of
assets) carrying value through estimates of undiscounted future cash flows. If
the assets are deemed impaired, the assets are written down to estimated fair
value. Estimates of fair value may differ from the actual amount that could be
realized if we were to sell our assets. Managements
assessments of the impairment of property and equipment are sensitive accounting estimates that could
result in additional impairment charges in the near term. Factors that impact
these estimates include, but are not limited to, possible changes in business
plans, market price of our common stock and declining financial results. Net
long-term assets subject to impairment review in the future totaled $7.1
million at March 31, 2004. We will continue to review the carrying value of our
long-lived assets and goodwill for impairments. Future adverse developments in
our business may result in additional charges. Goodwill and Intangible Assets.We account for goodwill and intangible
assets in accordance with Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets (FAS 142). Under FAS 142, goodwill and
intangible assets deemed to have indefinite lives are not amortized, but are
subject to, at a minimum, annual impairment tests. The Company completes its
annual impairment test as of November 30 of each year. As disclosed in Note 7,
we have recorded goodwill and intangible assets in connection with our
acquisition of Overpeer, Inc. in March 2004. Exit costs.We have followed the provisions of EITF 94-3 to record the
costs associated with exit activities through December 31, 2002 and FAS 146 for
exit activities after December 31, 2003. Management is required to make its
best estimates of exit costs such as remaining lease obligations and/or
termination fees, these estimates may be different than the actual amounts that
will be paid under existing lease arrangements. Future adverse changes in our
business could result in additional exit activities and charges. Litigation.We become involved from time to time in various claims and
lawsuits incidental to the ordinary course of our operations, including such
matters as contract and lease disputes and complaints alleging employment
discrimination. We believe that the outcome of any such pending claims or
proceedings individually or in the aggregate, will not have a material adverse
effect upon our business or financial condition, cash flows, or results of
operations. Income tax valuation allowance.Deferred tax assets and liabilities are
determined based on the differences between the financial statement and tax
bases of assets and liabilities using the enacted tax rates in effect for the
periods in which the differences are 23




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expected to reverse. The Companys net deferred tax asset has been
reduced by a full valuation allowance based upon managements determination
that it is more likely than not that the net deferred tax asset will
not be realized. 24




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RISK FACTORS Our company has a short operating history and our industry is new and
rapidly evolving, which makes it difficult to evaluate our business. We were formed as a limited liability company in August 1997 and
incorporated in March 1998. Our limited operating history makes it difficult to
evaluate us or our prospects and performance, due to our:  
    
    unproven ability to generate profits;
    
    limited historical financial data; and
    
    limited experience in addressing emerging trends that may affect our business. We have recently shifted our marketing emphasis to application level
services, which we have only recently begun to deliver. You should consider
our prospects in light of the risk, expenses and difficulties we may encounter
as an early stage company in the new and rapidly evolving market segments we
serve. As a result of such risks, expenses and difficulties, we may have
difficulty:  
    
    Establishing and maintaining broad market acceptance of our
products and services and converting that acceptance into direct and
indirect sources of revenue;
    
    Establishing and maintaining our brand name;
    
    Successfully developing new products, product features and
services on a timely basis and increasing the functionality and
features of existing products and services;
    
    Successfully responding to our current competition including,
competition from emerging technologies and solutions;
    
    Developing and maintaining strategic relationships to enhance
the distribution, features, content and utility of our products and
services; and
    
    Attracting, training and retaining qualified sales, technical
and customer support personnel. Our quarterly financial results will continue to fluctuate making it
difficult to forecast our operating results. Our quarterly operating results have fluctuated in the past and we expect
our revenues and operating results may vary significantly from quarter to
quarter due to a number of factors, many of which are beyond our control,
including:  
    
    Market acceptance of our turn-key application level services;
    
    Variability in demand for our digital media services and applications;
    
    Market acceptance of digital media and components offered by us and our competitors;
    
    Ability of our customers and ourselves to procure necessary intellectual property rights for digital media content;
    
    Willingness of our customers to enter into longer-term volume
or recurring revenue digital media and applications service
agreements and purchase orders in light of the economic and legal
uncertainties related to their business models;
    
    Governmental regulations affecting use of the Internet,
including regulations concerning intellectual property rights and
security measures; or 25




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
    
    Competition from other companies entering our markets. Our limited operating history and unproven business model further
contribute to the difficulty of making meaningful quarterly comparisons and
forecasts. Our current and future levels of operating expenses and capital
expenditures are based largely on our growth plans and estimates of expected
future revenues. These expenditure levels are, to a large extent, fixed in the
short term and our sales cycle can be lengthy. Thus, we may not be able to
adjust spending or generate new revenue sources in a timely manner to
compensate for any shortfall in revenues, and any significant shortfall in
revenues relative to planned expenditures could have an immediate adverse
effect on our business and results of operations. If our operating results fall
below the expectations of securities analysts and investors in some future
periods, our stock price could decline significantly. We may need to raise additional capital in the future, and if we are
unable to secure adequate funds on terms acceptable to us, we may be unable to
execute our business plan. If we raise additional capital, current stockholders
may experience significant dilution. As of March 31, 2004, we had approximately $34.8 million in cash and cash
equivalents, marketable securities, and restricted investments. In the first
quarter of 2004, we completed a private placement that resulted in net proceeds
of $18.9 million. We have, however, experienced net losses from operations and
net losses are expected to continue into future periods. If our existing cash
reserves prove insufficient to fund operating and other expenses, we may find
it necessary to secure additional financing, sell assets or reduce expenditures
further. In the event additional financing is required, we may not be able to
obtain such financing on acceptable terms, or at all. If adequate funds are not
available or are not available on acceptable terms, we may not be able to
pursue our business objectives. This inability could seriously harm our
business, results of operations and financial condition. If additional funds are raised through the issuance of equity or
convertible debt securities, the percentage ownership of our current
stockholders will be reduced and these securities may have rights and
preferences superior to those of our current stockholders. If we raise capital
through debt financing, we may be forced to accept restrictions affecting our
liquidity, including restrictions on our ability to incur additional
indebtedness or pay dividends. Because we expect to continue to incur net losses, we may not be able to
implement our business strategy and the price of our stock may decline. As of March 31, 2004, we had an accumulated deficit of $195.7 million. We
have incurred net losses from inception, and we expect to continue to incur net
losses in future periods. Accordingly, our ability to operate our business and implement our
business strategy may be hampered by negative cash flows in the future, and the
value of our stock may decline as a result. Our capital requirements may vary
materially from those currently planned if, for example, we incur unforeseen
capital expenditures, unforeseen operating expenses or make investments to
maintain our competitive position. If we lack necessary capital, we may have to
delay or abandon some or all of our development plans or otherwise forego
market opportunities. We will need to generate significant additional revenues
to be profitable in the future and we may not generate sufficient revenues to
be profitable on either a quarterly or annual basis in the future. We might not be successful in implementing our business strategy in a
cost-effective manner, if at all, and the implementation may require
significant additional expenditures on our part. The capital requirements of
our business strategy combined with the expectation that we will incur net
losses in future periods could have a serious adverse impact on our business,
results of operations and financial position. Even if we ultimately do achieve
profitability, we may not be able to sustain or increase profitability on a
quarterly or annual basis. Our success is dependent on the performance and retention of our executive
officers and key employees. Our business and operations are substantially dependent on the performance
of our executive officers and key employees who have worked together for only a
relatively short period of time. We do not maintain key person life insurance
on any of our executive officers. The loss of one or several key employees
could seriously harm our business. Any reorganization or reduction in the size
of our employee base could harm our ability to attract and retain other
valuable employees critical to the success of our business. We must integrate our recent acquisition of Overpeer, Inc. and we may need
to make additional future acquisitions to remain competitive. The process of
identifying, acquiring and integrating future acquisitions may constrain
valuable management 26




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resources, and our failure to effectively integrate future acquisitions
may result in the loss of key employees and the dilution of stockholder value
and have an adverse effect on our operating results. We have completed a number of acquisitions during the past three fiscal
years, and we expect to continue to pursue strategic acquisitions in the
future. In March 2004, we completed the acquisition of Overpeer, Inc. Integrating the Overpeer acquisition and completing any potential future
acquisitions could cause significant diversions of management time and
resources. Financing for future acquisitions may not be available on favorable
terms, if at all. If we identify an appropriate acquisition candidate for any
of our businesses, we may not be able to negotiate the terms of the
acquisition successfully, finance the acquisition or integrate the acquired
business, products, technologies or employees into our existing business and
operations. Future acquisitions may not be well-received by the investment
community, which may cause our stock price to fall. We cannot ensure that we
will be able to identify or complete any acquisition in the future. If we acquire businesses, new products or technologies in the future, we
may be required to amortize significant amounts of identifiable intangible
assets and we may record significant amounts of goodwill that will be subject
to at least annual testing for impairment. For example, we recorded in our
first quarter of fiscal 2003 impairments of $5.3 million, $685,000 and $601,000
to goodwill, intangible assets, and property and equipment related to our
enterprise communication services and media restoration services business. A
significant portion of those impairments related to assets acquired in our
acquisition of TT Holding Corp. in November 2002. If we consummate one or more
significant future acquisitions in which the consideration consists of stock or
other securities, our existing stockholders ownership could be diluted
significantly. If we were to proceed with one or more significant future
acquisitions in which the consideration included cash, we could be required to
use a substantial portion of our available cash. The anticipated benefits of
any acquisition may not be realized. If any of the negative events occur, our
operations and financial position could be harmed. We face competition from free peer-to-peer services such as KaZaA and
Morpheus, from emerging paid online music services delivered electronically,
and from traditional retail music distributors. The online music services of our customers face significant competition
from free peer-to-peer services, such as KaZaA, Morpheus, Grokster and a
variety of other similar services that allow computer users to connect with
each other and to copy many types of program files, including music and other
media, from one anothers hard drives, all without securing licenses from
content providers. The legal status of these free services is uncertain,
because although some courts have found that these services violate copyright
laws, other services have been found to not violate any copyright laws,
particularly in the case of Grokster. Additionally, enforcement efforts against
those in violation have not effectively shut down these services, and there can
be no assurance that these services will ever be shut down. The ongoing
presence of these free services substantially impairs the marketability of
legitimate services, regardless of the ultimate resolution of their legal
status. Because digital recorded music formats, such as MP3, do not always contain
mechanisms for tracking the source or ownership of digital recordings, users
are able to download and distribute unauthorized or pirated copies of
copyrighted recorded music over the Internet. This piracy is a significant
concern to record companies and artists, and is a primary reason many record
companies and artists are reluctant to digitally deliver their recorded music
over the Internet. As long as pirated recordings are available, many consumers
will choose free pirated recordings rather than paying for legitimate
recordings. Accordingly, if this issue is not addressed, our business might be
harmed. Many of our competitors have substantially greater capital resources than
we do. Many of our competitors have significantly more resources than we do,
including access to content, and some of our competitors may be able to
leverage their experience in providing online music distribution services or
similar services to their customers in other businesses. Some of these
competitors may be able to offer services at a lower price than we can. In
addition, competing services may be able to obtain more or better music content
or may be able to license such content on more favorable terms than we can,
which could harm the ability of our online music services to compete
effectively in the marketplace. Online music distribution services in general are new and rapidly evolving
and may not prove to be viable business models. 27




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Online music distribution services are a relatively new business model for
delivering digital media over the Internet. It is too early to predict whether
consumers will accept in significant numbers, online music services and
accordingly whether the services will be financially viable. If online music
distribution services do not prove to be popular with consumers, or if these
services cannot sustain any such popularity, our business and prospects would
be harmed. We must provide digital rights management solutions that are acceptable to
both content providers and consumers. We must also provide digital rights management solutions and other
security mechanisms in order to address concerns of content providers and
artists, and we cannot be certain that we can develop, license or acquire such
solutions, or that content licensors or consumers will accept them. Consumers
may be unwilling to accept the use of digital rights management technologies
that limit their use of content, especially with large amounts of free content
readily available. No assurance can be given that such solutions will be
available to us upon reasonable terms, if at all. If we are unable to acquire
these solutions on reasonable or any terms, or if customers are unwilling to
accept these solutions, our business and prospects could be harmed. Our business could be harmed by a lack of availability of popular content. Our digital media services business is affected by the release of hit
music titles, which can create cyclical trends in sales distinctive to the
music industry. It is not possible to determine the timing of these cycles or
the future availability of hit titles. Hit products are important because they
generate consumer interest. We depend upon the music content providers to
continue to produce hit products. To the extent that new hits are not
available, or not available at prices attractive to consumers, our sales and
margins may be adversely affected. The growth of our business depends on the increased use of the Internet
for communications, electronic commerce and advertising. The growth of our business depends on the continued growth of the Internet
as a medium for media consumption, communications, electronic commerce and
advertising. Our business will be harmed if Internet usage does not continue to
grow, particularly as a source of media information and entertainment and as a
vehicle for commerce in goods and services. Our success also depends on the
efforts of third parties to develop the infrastructure and complementary
products and services necessary to maintain and expand the Internet as a viable
commercial medium, and identifying additional viable revenue models for digital
media-based businesses. We believe that other Internet-related issues, such as
security, privacy, reliability, cost, speed, ease of use and access, quality of
service, and necessary increases in bandwidth availability and access on an
affordable basis, remain largely unresolved and may affect the amount and type
of business that is conducted over the Internet, and may adversely affect our
ability to sell our products and services and ultimately impact our business
results and prospects. If Internet usage grows, the Internet infrastructure may not be able to
support the demands placed on it by such growth, specifically the demands of
delivering high-quality media content. As a result, the performance and
reliability of the Internet may decline. In addition, Websites have experienced
interruptions in service as a result of outages, system attacks and other
delays occurring throughout the Internet network infrastructure. If these
outages, attacks or delays occur frequently or on a broad scale in the future,
Internet usage, as well as the usage of our products, services and Websites,
could grow more slowly or decline. If broadband technologies do not become widely available or widely
adopted, our online media distribution services may not achieve broad market
acceptance, and our business may be harmed. We believe that increased Internet use and especially the increased use of
media over the Internet may depend on the availability of greater bandwidth or
data transmission speeds (also known as broadband transmission). If broadband
technologies do not become widely available or widely adopted, our online media
distribution services may not achieve broad market acceptance and our business
and prospects could be harmed. Congestion over the Internet and data loss may
interrupt audio and video streams, resulting in unsatisfying user experiences.
The success of digital media distribution over the Internet depends on the
continued rollout of broadband access to consumers on an affordable basis. To
date, we believe that broadband technologies have been adopted at a slower rate
than expected, which we believe has delayed broader-based adoption of the
Internet as a media distribution medium. Our business and prospects may be
harmed if the rate of adoption does not increase. More consumers are utilizing non-PC devices to access digital content, and
we may not be successful in developing versions of our products and services
that will gain widespread adoption by users of such devices. 28




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In the coming years, the number of individuals who access digital content
through devices other than a personal computer, such as personal digital
assistants, cellular telephones, television set-top devices, game consoles and
Internet appliances, may increase dramatically. Manufacturers of these types of
products are increasingly investing in media-related applications, but these
devices are in an early stage of development and business models are new and
unproven. If we are unable to offer our services on these alternative non-PC
devices, we may fail to capture a sufficient share of an increasingly important
portion of the market for digital media services or our costs may increase
significantly. We depend on a limited number of customers for a majority of our revenues
so the loss of, or delay in payment from, one or a small number of customers
could have a significant impact on our revenues and operating results. A limited number of customers have accounted for a majority of our
revenues and may continue to do so for the foreseeable future. During 2003 and
2002, one customer accounted for approximately 11% and 13% of our revenues and
another customer accounted for 5% and 10% of our revenues. During the first
quarter of 2004, one customer accounted for 11% of our revenues. We believe
that a small number of customers may continue to account for a significant
percentage of our revenues for the foreseeable future. Due to high revenue
concentration among a limited number of customers, the cancellation, reduction
or delay of a large customer order or our failure to complete or deliver a
project on a timely basis during a given quarter is likely to significantly
reduce revenues. In addition, if any significant customer fails to pay amounts
it owes us, or does not pay those amounts on time, our revenues and operating
results could suffer. If we are unsuccessful in increasing and broadening our
customer base, our business could be harmed. Average selling prices of our products and services may decrease, which
may harm our gross margins. The average selling prices of our products and services may be lower than
expected as a result of competitive pricing pressures, promotional programs and
customers who negotiate price reductions in exchange for longer term purchase
commitments or otherwise. The pricing of services sold to our customers depends
on the duration of the agreement, the specific requirements of the order,
purchase volumes, the sales and service support and other contractual
agreements. We have experienced and expect to continue to experience pricing
pressure and anticipate that the average selling prices and gross margins for
our products will decrease over product life cycles. We may not be successful
in developing and introducing on a timely basis new products with enhanced
features that can be sold at higher gross margins. We may be liable or alleged to be liable to third parties for music,
software, and other content that we encode, distribute, or make available on to
our customers. We may be liable or alleged to be liable to third parties for the content
that we encode, distribute or make available to our customers:  
    
    If the content or the performance of our services violates
third party copyright, trademark, or other intellectual property
rights;
    
    If our customers violate the intellectual property rights of
others by providing content to us or by having us perform digital
media services; or
    
    If content that we encode or otherwise handle for our customers
is deemed obscene, indecent, or defamatory. Any alleged liability could harm our business by damaging our reputation,
requiring us to incur legal costs in defense, exposing us to awards of damages
and costs and diverting managements attention which could have an adverse
effect on our business, results of operations and financial condition. Our
customers for encoding services generally agree to hold us harmless from claims
arising from their failure to have the right to encode the content given to us
for that purpose. However, customers may contest this responsibility or not
have sufficient resources to defend claims and we have limited insurance
coverage for claims of this nature. Because we host, stream and Webcast audio and video content on or from our
Website and on other Websites for customers and provide services related to
digital media content, we face potential liability or alleged liability for
negligence, infringement of copyright, patent, or trademark rights, defamation,
indecency and other claims based on the nature and content of the materials we
host. Claims of this nature have been brought, and sometimes successfully
prosecuted, against content distributors. In addition, we could be exposed to
liability with respect to the unauthorized duplication of content or
unauthorized use of other parties proprietary 29




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technology. Any imposition of liability that is not covered by insurance
or is in excess of insurance coverage or any alleged liability could harm our
business. We cannot assure you that third parties will not claim infringement by us
with respect to past, current, or future technologies. The music industry in
particular has recently been the focus of infringement claims. We expect that
participants in our markets will be increasingly subject to infringement claims
as the number of services and competitors in our industry segment grows. In
addition, these risks are difficult to quantify in light of the continuously
evolving nature of laws and regulations governing the Internet. Any claim
relating to proprietary rights, whether meritorious or not, could be
time-consuming, result in costly litigation, cause service upgrade delays or
require us to enter into royalty or licensing agreements, and we can not assure
you that we will have adequate insurance coverage or that royalty or licensing
agreements will be available on terms acceptable to us or at all. If we do not continue to add customers for our services, our revenues and
business will be harmed. In order to achieve return on our investments in new products and
services, we must continue to add new customers while minimizing the rate of
loss of existing customers. If our other marketing and promotional activities
fail to add new customers at a rate significantly higher than our rate of loss,
our business will suffer. In addition, if the costs of such marketing and
promotional activities increase in order to add new customers, our margins and
operating results will suffer. We cannot be certain that we will be able to protect our intellectual
property, and we may be found to infringe on proprietary rights of others,
which could harm our business. Our intellectual property is important to our business, and we seek to
protect our intellectual property through copyrights, trademarks, patents,
trade secrets, confidentiality provisions in our customer, supplier and
strategic relationship agreements, nondisclosure agreements with third parties,
and invention assignment agreements with our employees and contractors. We
cannot assure you that measures we take to protect our intellectual property
will be successful or that third parties will not develop alternative solutions
that do not infringe upon our intellectual property. In addition, we could be subject to intellectual property infringement
claims by others. Potential customers may be deterred from distributing content
over the Internet for fear of infringement claims. The music industry in
particular has recently been the focus of heightened concern with respect to
copyright infringement and other misappropriation claims, and the outcome of
developing legal standards in that industry is expected to affect music, video
and other content being distributed over the Internet. If, as a result,
potential customers forego distributing traditional media content over the
Internet, demand for our digital media services and applications could be
reduced which would harm our business. The music industry in the U.S. is
generally regarded as extremely litigious in nature compared to other
industries and we could become engaged in litigation with others in the music
industry. Claims against us, and any resultant litigation, should they occur in
regard to any of our digital media services and applications, could subject us
to significant liability for damages including treble damages for willful
infringement. In addition, even if we prevail, litigation could be
time-consuming and expensive to defend and could result in the diversion of our
time and attention. Any claims from third parties may also result in
limitations on our ability to use the intellectual property subject to these
claims. Further, we plan to offer our digital media services and applications
to customers worldwide including customers in foreign countries that may offer
less protection for our intellectual property than the United States. Our
failure to protect against misappropriation of our intellectual property, or
claims that we are infringing the intellectual property of third parties could
have a negative effect on our business, revenues, financial condition and
results of operations. We rely on strategic relationships to promote our services and for access
to licensed technology; if we fail to maintain or enhance these relationships,
our ability to serve our customers and develop new services and applications
could be harmed. Our ability to provide our services to users of multiple technologies and
platforms depends significantly on our ability to develop and maintain our
strategic relationships with key streaming media technology companies and
content providers. We rely on these relationships for licensed technology and
content. We also rely on relationships with major recording labels for our
music content licensing strategy. Obtaining comprehensive music content
licenses is challenging, as doing so may require us to obtain copyright
licenses with various third parties in the fragmented music recording and
publishing industries. These copyrights often address differing activities
related to the delivery of digital media, including reproduction and
performance, some of which may require separate licensing arrangements from
various rights holders such as publishers, artists and record labels. The
effort to obtain the necessary rights by such third parties is often
significant, and could disrupt, delay, or prevent us from executing our
business plans. Because of the large number of potential parties from which we
must obtain licenses, we may never be able to obtain a sufficient number of
licenses to allow us to provide services that will meet our customers
expectations. 30




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Due to the evolving nature of our industry, we will need to develop
additional relationships to adapt to changing technologies and standards and to
work with newly emerging companies with whom we do not have pre-existing
relationships. We cannot be certain that we will be successful in developing
new relationships or that our partners will view these relationships as
significant to their own business or that they will continue their commitment
to us in the future. If we are unable to maintain or enhance these
relationships, we may have difficulty strengthening our technology development
and increasing the adoption of our brand and services. Our business will suffer if we do not anticipate and meet specific
customer requirements or respond to technological change. The market for digital media services is characterized by rapid
technological change, frequent new product introductions and changes in
customer requirements, some of which are unique or on a customer by customer
basis. We may be unable to respond quickly or effectively to these developments
or requirements. Our future success will depend to a substantial degree on our
ability to offer services that incorporate leading technology, address the
increasingly sophisticated, varied or individual needs of our current and
prospective customers and respond to technological advances and emerging
industry standards and practices on a timely and cost-effective basis. You
should be aware that:  
    
    Our technology or systems may become obsolete upon the
introduction of alternative technologies;
    
    We may not have sufficient resources to develop or acquire new
technologies or the ability to introduce new services capable of
competing with future technologies or service offerings; and
    
    The price of our services is likely to decline as rapidly as
the cost of any competitive alternatives. The development of new or enhanced services through technology development
activities is a complex and uncertain process that requires the accurate
anticipation of technological and market trends. We may experience design,
manufacturing, marketing and other difficulties that could delay or prevent the
development, introduction or marketing of new services and enhancements. In
addition, our inability to effectively manage the transition from older
services to newer services could cause disruptions to customer orders and harm
our business and prospects. Our music content licenses could result in operational complexity that may
divert resources or make our business more expensive to conduct. The large number of licenses that we need to maintain in order to expand
our music-related services creates operational difficulties in connection with
tracking the rights that we have acquired and the complex royalty structures
under which we must pay. In addition, our licensing agreements typically allow
the third party to audit our royalty tracking and payment mechanisms to ensure
that we are accurately reporting and paying the royalties owed. If we are
unable to accurately track the numerous parties that we must pay in connection
with each delivery of digital music services and deliver the appropriate
payment in a timely fashion, we may risk penalties up to and including
termination of certain licenses. Competition may decrease our market share, revenues, and gross margins. We face intense and increasing competition in the digital media services
market. If we do not compete effectively or if we experience reduced market
share from increased competition, our business will be harmed. In addition, the
more successful we are in the emerging market for digital media services, the
more competitors are likely to emerge. We believe that the principal
competitive factors in our market include:  
    
    Ability to offer a private branded solution;
    
    Service functionality, quality and performance;
    
    Ease of use, reliability, scalability and security of services;
    
    Establishing a significant base of customers and distribution partners; 31




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
    
    Ability to introduce new services to the market in a timely manner;
    
    Customer service and support;
    
    Attracting third-party web developers; and
    
    Pricing. Many of our competitors have substantially more capital, longer operating
histories, greater brand recognition, larger customer bases and significantly
greater financial, technical and marketing resources than we do. These
competitors may also engage in more extensive development of their
technologies, adopt more aggressive pricing policies and establish more
comprehensive marketing and advertising campaigns than we can. Our competitors
may develop products and service offerings that we do not offer or that are
more sophisticated or more cost effective than our own. For these and other
reasons, our competitors products and services may achieve greater acceptance
in the marketplace than our own, limiting our ability to gain market share and
customer loyalty and to generate sufficient revenues to achieve a profitable
level of operations. Our failure to adequately address any of the above factors
could harm our business and operating results. Our industry is experiencing consolidation that may intensify competition. The Internet and digital media services industries are undergoing
substantial change that has resulted in increasing consolidation and a
proliferation of strategic transactions. Many companies in these industries
have failed or are being acquired by larger entities. As a result, we are
increasingly competing with larger competitors which have substantially greater
resources than we do. We expect this consolidation and strategic partnering to
continue. Acquisitions or strategic relationships could harm us in a number of
ways. For example:  
    
    Competitors could acquire or enter into relationships with
companies with which we have strategic relationships and discontinue
our relationship, resulting in the loss of distribution opportunities
for our products and services or the loss of certain enhancements or
value-added features to our products and services;
    
    Competitors could obtain exclusive access to desirable
multimedia content and prevent that content from being available in
certain formats, thus impairing our content selection and our ability
to attract customers;
    
    Suppliers of important or emerging technologies could be
acquired by a competitor or other company which could prevent us from
being able to utilize such technologies in our offerings, and
disadvantage our offerings relative to those of competitors;
    
    A competitor could be acquired by a party with significant
resources and experience that could increase the ability of the
competitor to compete with our products and services; and
    
    Other companies with related interests could combine to form
new, formidable competition, which could preclude us from obtaining
access to certain markets or content; or which could significantly
change the market for our products and services. Any of these results could put us at a competitive disadvantage that could
cause us to lose customers, revenue and market share. They could also force us
to expend greater resources to meet the competitive threat, which could also
harm our operating results. We must enhance our existing digital media services and applications, and
develop and introduce new services and applications to remain competitive in
that segment. Any failure to do so in a timely manner will cause our results of
operations in that segment to suffer. The market for digital media service solutions is characterized by rapidly
changing technologies and short product life cycles. These market
characteristics are heightened by the emerging nature of the Internet and the
continuing trend of companies from many industries to offer Internet-based
applications and services. The widespread adoption of the new Internet,
networking, streaming 32




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media, or telecommunications technologies or other technological changes
could require us to incur substantial expenditures to modify or adapt our
operating practices or infrastructure. Our future success will depend in large
part upon our ability to:  
    
    Identify and respond to emerging technological trends in the
market;
    
    Enhance our products by adding innovative features that
differentiate our digital media services and applications from those
of our competitors;
    
    Acquire and license leading technologies;
    
    Bring digital media services and applications to market and
scale our business and operations on a timely basis at competitive
prices; and
    
    Respond effectively to new technological changes or new product
announcements by others. We will not be competitive unless we continually introduce new services
and applications or enhancements to existing services and applications that
meet evolving industry standards and customer needs. In the future, we may not
be able to address effectively the compatibility and interoperability issues
that arise as a result of technological changes and evolving industry
standards. The technical innovations required for us to remain competitive are
inherently complex, require long development schedules and are dependent in
some cases on sole source suppliers. We will be required to continue to invest
in research and development in order to attempt to maintain and enhance our
existing technologies and products, but we may not have the funds available to
do so. Even if we have sufficient funds, these investments may not serve the
needs of customers or be compatible with changing technological requirements or
standards. Most development expenses must be incurred before the technical
feasibility or commercial viability of new or enhanced services and
applications can be ascertained. Revenue from future services and applications
or enhancements to services and applications may not be sufficient to recover
the associated development costs. The technology underlying our services and applications is complex and may
contain unknown defects that could harm our reputation, result in product
liability or decrease market acceptance of our services and applications. The technology underlying our digital media services and applications is
complex and includes software that is internally developed and software
licensed from third parties. These software products may contain errors or
defects, particularly when first introduced or when new versions or
enhancements are released. We may not discover software defects that affect our
current or new services and applications or enhancements until after they are
sold. Furthermore, because our digital media services are designed to work in
conjunction with various platforms and applications, we are susceptible to
errors or defects in third-party applications that can result in a lower
quality product for our customers. Because our customers depend on us for
digital media management, any interruptions could:  
    
    Damage our reputation;
    
    Cause our customers to initiate product liability suits against us;
    
    Increase our product development resources;
    
    Cause us to lose sales; and
    
    Delay market acceptance of our digital media services and applications. We do not possess product liability insurance, and our errors and
omissions coverage is not likely to be sufficient to cover our complete
liability exposure. Our network is subject to security and stability risks that could harm our
business and reputation and expose us to litigation or liability. Online commerce and communications depend on the ability to transmit
confidential information and licensed intellectual property securely over
private and public networks. Any compromise of our ability to transmit such
information and data securely or 33




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reliably, and any costs associated with preventing or eliminating such
problems, could harm our business. Our systems and operations are susceptible
to, and could be damaged or interrupted by a number of security and stability
risks, including: outages caused by fire, flood, power loss, telecommunications
failure, Internet breakdown, earthquake and similar events. We do not have
complete redundancy in our webcasting facilities and therefore any damage or
destruction to these would significantly harm our webcasting business. Our
systems are also subject to human error, security breaches, power losses,
computer viruses, break-ins, denial of service attacks, sabotage, intentional
acts of vandalism and tampering designed to disrupt our computer systems,
Websites and network communications. A sudden and significant increase in
traffic on our Websites could strain the capacity of the software, hardware and
telecommunications systems that we deploy or use. This could lead to slower
response times or system failures. Our operations also depend on receipt of timely feeds from our content
providers, and any failure or delay in the transmission or receipt of such
feeds could disrupt our operations. We also depend on Web browsers, ISPs and
online service providers to provide access over the Internet to our product and
service offerings. Many of these providers have experienced significant outages
or interruptions in the past, and could experience outages, delays and other
difficulties due to system failures unrelated to our systems. These types of
interruptions could continue or increase in the future. The occurrence of any of these or similar events could damage our
business, hurt our ability to distribute products and services and collect
revenue, threaten the proprietary or confidential nature of our technology,
harm our reputation, and expose us to litigation or liability. We may be
required to expend significant capital or other resources to protect against
the threat of security breaches, hacker attacks or system malfunctions or to
alleviate problems caused by such breaches, attacks or failures. Our services are complex and are deployed in complex environments and
therefore may have errors or defects that could seriously harm our business. Our services are highly complex and are designed to be deployed in and
across numerous large complex networks. Our digital distribution activities are
managed by sophisticated software and computer systems. From time to time, we
have needed to correct errors and defects. In addition, we must continually
develop and update these systems over time as our business and business needs
grow and change, and these systems may not adequately reflect the current needs
of our business. We may encounter delays in developing these systems, and the
systems may contain undetected errors and defects that could cause system
failures. Any system error or failure that causes interruption in availability
of products or content or an increase in response time could result in a loss
of potential or existing business services customers, users, advertisers or
content providers. If we suffer sustained or repeated interruptions, our
products, services and Websites could be less attractive to such entities or
individuals and our business could be harmed. Our transmission capacity is not entirely in our control, as we rely in
part on transmission capacity provided by third parties. Insufficient
transmission capacity could result in interruptions in our services and loss of
revenues. Significant portions of our business are dependent on providing customers
with efficient and reliable services to enable customers to broadcast content
to large audiences on a live or on-demand basis. Our operations are dependent
in part upon transmission capacity provided by third-party telecommunications
network providers. Any failure of such network providers to provide the
capacity we require may result in a reduction in, or interruption of, service
to our customers. If we do not have access to third-party transmission
capacity, we could lose customers and if we are unable to obtain such capacity
on terms commercially acceptable to us, our business and operating results
could suffer. Our business and operations may be especially subject to the risks of
earthquakes and other natural catastrophes. Our computer and communications infrastructure is located at a single
leased facility in Seattle, Washington, an area that is at heightened risk of
earthquake and volcanic events. We do not have fully redundant systems, and we
may not have adequate business interruption insurance to compensate us for
losses that may occur from a system outage. Despite our efforts, our network
infrastructure and systems could be subject to service interruptions or damage
and any resulting interruption of services could harm our business, operating
results and reputation. Government regulation could adversely affect our business prospects. Few existing laws or regulations specifically apply to the Internet, other
than laws and regulations generally applicable to businesses. Certain U.S.
export controls and import controls of other countries, including controls on
the use of encryption 34




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technologies, may apply to our products. Many laws and regulations,
however, are pending and may be adopted in the United States, individual states
and local jurisdictions and other countries with respect to the Internet. These
laws may relate to many areas that impact our business, including content
issues (such as obscenity, indecency and defamation), copyright and other
intellectual property rights, digital rights management, encryption, caching of
content by server products, personal privacy, taxation, e-mail, sweepstakes,
promotions, network and information security and the convergence of traditional
communication services with Internet communications, including the future
availability of broadband transmission capability and wireless networks. These
types of regulations are likely to differ between countries and other political
and geographic divisions. Other countries and political organizations are
likely to impose or favor more and different regulation than that which has
been proposed in the United States, thus furthering the complexity of
regulation. In addition, state and local governments may impose regulations in
addition to, inconsistent with, or stricter than federal regulations. The
adoption of such laws or regulations, and uncertainties associated with their
validity, interpretation, applicability and enforcement, may affect the
available distribution channels for and costs associated with our products and
services, and may affect the growth of the Internet. Such laws or regulations
may harm our business. Our products and services may also become subject to
investigation and regulation of foreign data protection and e-commerce
authorities, including those in the European Union. Such activities could
result in additional product and distribution costs for us in order to comply
with such regulation. There is uncertainty regarding how existing laws governing issues such as
property ownership, copyright and other intellectual property issues, digital
rights management, taxation, gambling, security, illegal or obscene content,
retransmission of media, and personal privacy and data protection apply to the
Internet. The vast majority of such laws was adopted before the advent of the
Internet and related technologies and does not address the unique issues
associated with the Internet and related technologies. Most of the laws that
relate to the Internet have not yet been interpreted. In addition to potential
legislation from local, state and federal governments, labor guild agreements
and other laws and regulations that impose fees, royalties or unanticipated
payments regarding the distribution of media over the Internet may directly or
indirectly affect our business. While we and our customers may be directly
affected by such agreements, we are not a party to such agreements and have
little ability to influence the degree such agreements favor or disfavor
Internet distribution or our business models. Changes to or the interpretation
of these laws and the entry into such industry agreements could:  
    
    Limit the growth of the Internet;
    
    Create uncertainty in the marketplace that could reduce demand for our products and services;
    
    Increase our cost of doing business;
    
    Expose us to increased litigation risk, substantial defense
costs and significant liabilities associated with content available
on our Websites or distributed or accessed through our products or
services, with our provision of products and services, and with the
features or performance of our products and Websites;
    
    Lead to increased product development costs or otherwise harm
our business; or
    
    Decrease the rate of growth of our user base and limit our
ability to effectively communicate with and market to our user base. The Digital Millennium Copyright Act (DMCA) includes statutory licenses
for the performance of sound recordings and for the making of recordings to
facilitate transmissions. Under these statutory licenses, we and our broadcast
customers may be required to pay licensing fees for digital sound recordings we
deliver in original and archived programming and through retransmissions of
radio broadcasts. The DMCA does not specify the rate and terms of the licenses,
which are determined by arbitration proceedings, known as CARP proceedings,
supervised by the United States Copyright Office. Past CARP proceedings have
resulted in proposed rates for statutory webcasting that were significantly in
excess of rates requested by webcasters. CARP proceedings relating to music
subscription and non-subscription services offering music programming that
qualify for various licenses under U.S. copyright law are pending. We cannot
predict the outcome of these CARP proceedings and may elect instead to directly
license music content for our subscription and/or non-subscription services,
either alone or in concert with other affected companies. Such licenses may apply only to music performed in the United States, and
the availability of corresponding licenses for international performances is
unclear. Therefore, our ability to find rights holders and negotiate
appropriate licenses is uncertain. Many of our customers may be affected by
these rates, which may negatively affect our revenue. Several CARP proceedings
are 35




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pending for subscription music services and services that deliver digital
downloads of music, and the outcome of these CARPs will also likely affect our
business in ways that we cannot predict. Depending on the rates and terms
adopted for the statutory licenses, our business could be harmed both by
increasing our own cost of doing business, as well as by increasing the cost of
doing business for our customers. We anticipate future CARPs relating to music
subscription delivery services, which may also adversely affect the online
distribution of music. The Child Online Protection Act and the Child Online Privacy Protection
Act impose civil and criminal penalties on persons distributing material
harmful to minors over the Internet to persons under the age of 17, or
collecting personal information from children under the age of 13. We do not
knowingly distribute harmful materials to minors or collect personal
information from children under the age of 13. The manner in which these Acts
may be interpreted and enforced cannot be fully determined, and future
legislation similar to these Acts could subject us to potential liability if we
were deemed to be non-compliant with such rules and regulations, which in turn
could harm our business. There are a large number of legislative proposals before the United States
Congress and various state legislatures regarding intellectual property,
digital rights management, copy protection requirements, privacy, email
marketing and security issues related to our business. It is not possible to
predict whether or when such legislation may be adopted, and certain proposals,
if adopted, could materially and adversely affect our business through a
decrease in user registration and revenue, and influence how and whether we can
communicate with our customers. We may be subject to market risk and legal liability in connection with
the data collection capabilities of our products and services. Many of our products are interactive Internet applications that by their
very nature require communication between a client and server to operate. To
provide better consumer experiences and to operate effectively, our products
send information to servers. Many of the services we provide also require that
a user provide certain information to us. We post an extensive privacy policy
concerning the collection, use and disclosure of user data involved in
interactions between our client and server products. Any failure by us to
comply with our posted privacy policy and existing or new legislation regarding
privacy issues could impact the market for our products and services, subject
us to litigation and harm our business. A class action lawsuit has been filed against us that may result in
litigation that is costly to defend and the outcome of which is uncertain and
may harm our business. We, and various underwriters for our initial public offering are
defendants in a putative shareholder class action. The complaint alleges
undisclosed improper underwriting practices concerning the allocation of shares
for our IPO, in violation of the federal securities laws. Similar complaints
have been filed concerning the IPOs of more than 300 companies, and the
litigation has been coordinated in federal court for the Southern District of
New York as In re Initial Public Offering Securities Litigation, 21 MC 92. A
proposal has been made for the settlement and release of claims against the
issuer defendants. The settlement is subject to a number of conditions,
including approval of other proposed settling parties and the court. If the
settlement does not occur, and litigation against us continues, we believe we
have meritorious defenses and intend to defend this case vigorously. In
addition, because class action litigation has often been brought against
companies with periods of volatility in their stock prices, we could become
involved in additional litigation. Our stock price is volatile and may continue to be volatile in the future. Our common stock trades on the Nasdaq SmallCap Market. The market price
of our common stock has fluctuated significantly to date. In the future, the
market price of our common stock could be subject to significant fluctuations
due to general market conditions and in response to quarter-to-quarter
variations in:  
    
    Our anticipated or actual operating results;
    
    Developments concerning our technologies and market offerings;
    
    Technological innovations or setbacks by us or our competitors;
    
    Conditions in the digital media and Internet markets; 36




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
    
    Announcements of merger or acquisition transactions; and
    
    Other events or factors and general economic and market conditions. The stock market in recent years has experienced extreme price and volume
fluctuations that have affected the market price of many technology companies,
and that have often been unrelated or disproportionate to the operating
performance of companies. Future sales of our common stock or the perception that future sales could
occur, may adversely affect our common stock price. If a large number of shares of our common stock are sold in the open
market or if there is a perception that such sales could occur, the trading
price of our common stock could decline materially. In addition, the sale of
these shares, or possibility of such sale, could impair our ability to raise
capital through the sale of additional shares of common stock. In 2003, we registered 17,358,553 shares for resale by selling
stockholders, representing 30.5% of our common shares then outstanding. In
addition, we have filed a registration statement for resale by selling
stockholder of up to 12,593,570 shares, representing 18.0% of our common stock
outstanding on May 4, 2004, which registration statement has not yet been
declared effective. The selling stockholders under effective registration
statements will be permitted to sell their registered shares in the open market
from time to time without advance notice to us or to the market and without
limitations on volume. Sales of shares pursuant to exercisable options and warrants could also
lead to subsequent sales of the shares in the public market. These sales,
together with sales of shares by the selling stockholders, could depress the
market price of our stock by creating an excess in supply of shares for sale.
Availability of these shares for sale in the public market could also impair
our ability to raise capital by selling equity securities. Securities analysts may not continue to cover our common stock or may
issue negative reports, and this may have a negative impact on our common
stocks market price. There is no guarantee that securities analysts will continue to cover our
common stock. If securities analysts do not cover our common stock, the lack of
research coverage may adversely affect our common stocks market price. The
trading market for our common stock relies in part on the research and reports
that industry or financial analysts publish about our business or us. If one or
more of the analysts who cover us downgrades our stock, our stock price may
decline rapidly. If one or more of these analysts ceases coverage of our
company, we could lose visibility in the market, which in turn could cause our
stock price to decline. In addition, recently adopted rules mandated by the
Sarbanes-Oxley Act of 2002, and a global settlement reached between the SEC,
other regulatory analysts and a number of investment banks in April 2003, may
lead to a number of fundamental changes in how analysts are reviewed and
compensated. In particular, many investment banking firms will now be required
to contract with independent financial analysts for their stock research. It
may be difficult for companies with smaller market capitalizations, such as our
company, to attract independent financial analysts that will cover our common
stock, which could have a negative effect on our market price. If proposed accounting regulations that require companies to expense stock
options are adopted, our earnings will decrease and our stock price may
decline. A number of publicly-traded companies have recently announced that they
will begin expensing stock option grants to employees. In addition, the
Financial Accounting Standards Board (FASB) has indicated that possible rule
changes requiring expensing of stock options may be adopted in the near future.
Currently, we include such expenses on a pro forma basis in the notes to our
annual financial statements in accordance with accounting principles generally
accepted in the United States, but do not include stock option expense for
employee options in our reported financial statements. If accounting standards
are changed to require us to expense stock options, our reported earnings will
decrease significantly and our stock price could decline. Some provisions of our certificate of incorporation and bylaws and of
Delaware law may deter takeover attempts, which may limit the opportunity of
our stockholders to sell their shares at a favorable price. Some of the provisions of our certificate of incorporation and bylaws
could make it more difficult for a third party to acquire us, even if doing so
might be beneficial to our stockholders by providing them with the opportunity
to sell their shares possibly at a premium over the then market price. 37




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For example, our board of directors is divided into three classes. At each
annual meeting of stockholders, the terms of approximately one-third of the
directors will expire, and new directors will be elected to serve for three
years. It will take at least two annual meetings to effect a change in control
of our board of directors because a majority of the directors cannot be elected
at a single meeting, which may discourage hostile takeover bids. In addition, our certificate of incorporation authorizes the board of
directors to issue up to 5,000,000 shares of preferred stock. The preferred
stock may be issued in one or more series, the terms of which may be determined
at the time of issuance by our board of directors without further action by the
stockholders. These terms may include voting rights including the right to vote
as a series on particular matters, preferences as to dividends and liquidation,
conversion rights, redemption rights and sinking fund provisions. No shares of

preferred stock are currently outstanding and we have no present plans for the
issuance of any preferred stock. The issuance of any preferred stock, however,
could diminish the rights of holders of our common stock, and therefore could
reduce the value of our common stock. In addition, specific rights granted to
future holders of preferred stock could be used to restrict our ability to
merge with, or sell assets to, a third party. The ability of our board of
directors to issue preferred stock could make it more difficult, delay,
discourage, prevent or make it more costly to acquire or effect a change in
control, thereby preserving the current stockholders control. Our bylaws contain provisions that require stockholders to act only at a
duly-called meeting and make it difficult for any person other than management
to introduce business at a duly-called meeting by requiring such other person
to follow certain notice procedures. Finally, we are also subject to Section 203 of the Delaware General
Corporation Law which, subject to certain exceptions, prohibits a Delaware
corporation from engaging in any business combination with any interested
stockholder for a period of three years following the date that the stockholder
became an interested stockholder. The preceding provisions of our certificate
of incorporation and bylaws, as well as Section 203 of the Delaware General
Corporation Law, could discourage potential acquisition proposals, delay or
prevent a change of control and prevent changes in our management, even if such
things would be in the best interests of our stockholders. We have not, and currently do not anticipate, paying dividends on our common
stock. We have never paid any dividends on our common stock and do not plan to pay
dividends on our common stock for the foreseeable future. We currently intend
to retain future earnings, if any, to finance operations, capital expenditures
and the expansion of our business. 
 Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our financial results could be affected by factors such as changes in
interest rates and fluctuations in the stock market. As substantially all sales
are currently made in U.S. dollars, a strengthening of the dollar could make
our services less competitive in foreign markets. We do not use derivative
instruments to hedge our risks. Our interest income is sensitive to changes in
the general level of U.S. interest rates. Based on our cash and investment
balances of $34.8 million at March 31, 2004, a one percent change in interest
rates would cause a change in interest income of $348,000 per year. Due to the
investment grade level of our investments, we anticipate no material market
risk exposure. In addition, interest on our term loan is based on the prime
rate. Based on the $2.8 million balance outstanding at March 31, 2004, a one
percent increase in the prime rate would increase our interest expense by
$28,000 per year. We invest in investment-grade government obligations, institutional money
market funds and other obligations with FDIC insured US banks. Our primary
investment focus is to preserve capital and earn a market rate of return on our
investments. We do not speculate nor invest in publicly traded equity
securities and, therefore, do not believe that our capital is subject to
significant market risk. 
 Item 4 DISCLOSURE CONTROLS AND PROCEDURES We maintain a set of disclosure controls and procedures designed to ensure
that information required to be disclosed by us in the reports filed under the
Securities Exchange Act, is recorded, processed, summarized and reported within
the time periods specified by 38




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the SECs rules and forms. Disclosure controls are also designed with the
objective of ensuring that this information is accumulated and communicated to
our management, including our Chief Executive Officer and Chief Financial
Officer, as appropriate to allow timely decisions regarding required
disclosure. Based upon their evaluation as of the end of the period covered by this
report, the Chief Executive Officer and the Chief Financial Officer concluded
that our disclosure controls and procedures are effective to ensure that
information required to be included in our periodic SEC filings is recorded,
processed, summarized, and reported within the time periods specified in the
SEC rules and forms. There have been no changes in our internal controls during the
period covered by this report that significantly affect our control
environment. Limitations of Disclosure Controls and Procedures.Our management,
including our Chief Executive Officer and Chief Financial Officer, does not
expect that our disclosure controls or internal controls over financial
reporting will prevent all errors or all instances of fraud. A control system,
no matter how well designed and operated, can provide only reasonable, not
absolute, assurance that the control systems objectives will be met. Further,
the design of a control system must reflect the fact that there are resource
constraints, and the benefits of controls must be considered relative to their
costs. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within our company have been detected. These
inherent limitations include the realities that judgments in decision-making
can be faulty, and that breakdowns can occur because of simple error or
mistake. Controls can also be circumvented by the individual acts of some
persons, by collusion of two or more people, or by management override of the
controls. The design of any system of controls is based in part upon certain
assumptions about the likelihood of future events, and any design may not
succeed in achieving its stated goals under all potential future conditions.
Over time, controls may become inadequate because of changes in conditions or
deterioration in the degree of compliance with policies or procedures. Because
of the inherent limitation of a cost-effective control system, misstatements
due to error or fraud may occur and not be detected. 
 PART II. OTHER INFORMATION 
 ITEM 1: LEGAL PROCEEDINGS See
Note 9 to the consolidated unaudited financial statements for information
concerning legal proceedings. We become involved from time to time in various other claims and lawsuits
incidental to the ordinary course of our operations, including such matters as
contract and lease disputes and complaints alleging employment discrimination.
We believe that it is likely that the outcome of any such pending claims or
proceedings individually or in the aggregate, will not have a material adverse
effect upon our business or financial condition, results of operations, or cash
flows. 
 ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS In December 2003, we entered into a term loan facility with a bank. In
connection with this transaction we issued a warrant to the lender to purchase
25,000 shares of our common stock at $1.75 per share. The warrant expires on
December 31, 2010. The warrant was issued without registration under the
Securities Act of 1933 (the Act) to an accredited investor in reliance on the
exemption provided by Section 4(2) of the Act. An appropriate legend was placed
on the warrant and will be placed on the shares issuable upon exercise of the
warrant. In January 2004, we issued to an executive search firm a five-year warrant
exercisable for 12,820 shares of common stock with an exercise price of $1.95
per share. The search firm is a sophisticated investor which had access to all
material information concerning our company, and we relied on Section 4(2) of
the Securities Act in issuing such warrant. An appropriate legend was placed on
the warrant and will be placed on the shares issuable upon exercise of the
warrant. In February 2004, we entered into a Securities Purchase Agreement with
certain institutional investors pursuant to which the we issued and sold
10,810,811 shares of our common stock at a price of $1.85 per share. We also
paid to the placement agent, Allen & Company, a placement fee of 5% of the
gross proceeds. The shares were issued and sold without registration under the
Securities Act of 1933 to accredited investors in reliance on the exemption
provided by Regulation D, Rule 506 under the Securities Act. An appropriate
legend was placed on the shares. The shares purchased are included in a
registration statement on Form S-3 which has been filed but has not yet been
declared effective. We have agreed to use our reasonable efforts to have the
registration statement declared effective by the SEC as soon as practicable. 39




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In March 2004, we completed the acquisition of Overpeer, Inc., a privately
held company based in New York. In the acquisition, all of the outstanding
capital stock of Overpeer was exchanged for a total of 1,752,772 shares of our
common stock. The number of shares issued was calculated by dividing $4,000,000
by the volume weighted average closing sales price of one share of our common
stock as quoted on the Nasdaq SmallCap Market on each of the thirty consecutive
trading days preceding the closing of the acquisition, or $2.2821 per share.
262,916 of the shares issued in the acquisition were placed into an escrow
account that will remain open for one year to satisfy indemnity claims we may
have. The shares of common stock issued in the acquisition were offered and
sold to Overpeers former stockholders without registration under the
Securities Act of 1933 in reliance upon the exemption provided by Regulation D,
Rule 506 under the Securities Act. An appropriate legend was placed on the
shares. The shares purchased are included in a registration statement on Form
S-3 which has been filed but has not yet been declared effective. 
 ITEM 3: DEFAULTS UPON SENIOR SECURITIES None. 
 ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 
 ITEM 5: OTHER INFORMATION None. 
 ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits.  2.1
    (1)

    Agreement and Plan of Merger and Reorganization10.1
    (2)

    Form of Subscription Agreement.10.2
    

    Offer letter dated February 21, 2004 between William P. Fasig and Loudeye Corp., filed herewith.10.3
    

    Offer letter dated March 12, 2004 between Lawrence J. Madden and Loudeye Corp., filed herewith.31.1
    

    Certification of Jeffrey M. Cavins, President and Chief Executive
Officer of Loudeye Corp., Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2
    

    Certification of Lawrence J. Madden., Executive Vice President and
Chief Financial Officer of Loudeye Corp., Pursuant to 18 U.S.C. Section
1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of
200232.1
    

    Certification of Jeffrey M. Cavins, President and Chief Executive
Officer of Loudeye Corp., Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
    

    Certification of Lawrence J. Madden., Executive Vice President and
Chief Financial Officer of Loudeye Corp., Pursuant to 18 U.S.C. Section
1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002   (1)
    
    Incorporated by reference to Loudeye Corp.s Form 8-K filed on
March 5, 2004.(2)
    
    Incorporated by reference to Loudeye Corp.s Form 8-K filed on
February 13, 2004.  (b)
    
    Reports on Form 8-K  On January 9, 2004, we filed a Report on Form 8-K containing disclosure in
Items 5 and 7.On February 17, 2004, we filed a Report on Form 8-K containing disclosure
in Items 5 and 7. 40




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On February 24, 2004, we furnished a Report on Form 8-K containing
disclosure for Item 12.On March 5, 2004 we filed a Report on Form 8-K containing disclosure in
Items 2 and 7.On March 11, 2004 we filed a Report on Form 8-K containing disclosure in
Item 5. 41




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report on Form 10-Q to be signed on its behalf
by the undersigned, thereunto duly authorized, in the City of Seattle, State of
Washington, May 17, 2004. LOUDEYE CORP.BY:
    
    /s/ JEFFREY M. CAVINSJeffrey M. CavinsPresident and Chief Executive Officer(Principal Executive Officer)BY:
    
    /s/ LAWRENCE J. MADDENLawrence J. MaddenExecutive Vice President and Chief Financial officer(Principal Financial and Accounting Officer)
 42