**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

| **ý** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|------------|-----------------------------------------------------------------------------------------------|
|       |                                                                                          |
|       | **For the quarterly period ended December 31,  2002**                                         |

 

**or**

 

| **o**  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                          |
|   | **For the transition period  from                      to                      ** |

 

**CommissionFile Number:  0-6664**

 

| **K-TEL  INTERNATIONAL, INC.**                                  |
|-----------------------------------------------------------------|
| (Exact name of registrant as specified in  its charter)         |
|                                                            |   |   |
| **Minnesota**                                                   |   | **41****-0946588** |
| (State or other jurisdiction of  incorporation or organization) |   | (I.RS. Employer  Identification No.) |
|                                                            |   |   |
| **2655 Cheshire Lane North, Suite  100, Plymouth, Minnesota**   |   | **55447** |
| (Address of principal executive offices)                        |   | (Zip Code) |
|                                                            |   |   |
| **(763) 559-5566**                                              |
| (Registrant’s telephone number, including  area code)      |

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes  ý      No  o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined by Rule12b-2 of the Exchange Act).

Yes  o      No  ý

 

As of February13, 2003, there were 13,653,738 shares of the registrant’s common stock, parvalue $0.01 per share, outstanding.

 

 

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

**FORM10-Q**

 

**FORTHE THREE AND SIX MONTH PERIODS**

**ENDEDDECEMBER 31, 2002**

 

INDEX

 
| PART I.   | Financial Statements (Unaudited): |
|-----------|-----------------------------------|
|      |                              |
|      | Item 1.                           | Condensed Consolidated Balance Sheets as of  December 31, 2002 and June 30, 2002 |
|      |                              |   |
|      |                              | Condensed Consolidated Statements of  Operations  for the Three and Six Month Periods Ended  December 31, 2002 and 2001 |
|      |                              |   |
|      |                              | Condensed  Consolidated Statements of Cash Flows  for the Six Month Periods Ended  December 31, 2002 and 2001 |
|      |                              |   |
|      |                              | Notes to Condensed Consolidated Financial  Statements |
|      |                              |   |
|      | Item 2.                           | Management’s Discussion and Analysis of  Financial  Condition and Results of Operations |
|      |                              |   |
|      | Item  3.                          | Quantitative and Qualitative Disclosures About Market Risk |
|      |                              |   |
|      | Item 4.                           | Controls  and Procedures |
|      |                              |   |
| PART  II. | Other  Information                |
|      |                              |   |
|      | Item 1.                           | Legal Proceedings |
|      |                              |   |
|      | Item 6.                           | Exhibits  and Reports on Form 8-K |
|      |
|      | Signatures                        |
|      |                              |
|      | Certifications                    |
|           |                                   |  |  |

 

2

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**K-TEL INTERNATIONAL, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCESHEETS - UNAUDITED**

*(in thousands*)

 
|                                                                                                 |   | **December  31,  2002** |   | **June 30,  2002** |   |
|------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|--------------------|--------|
|                                                                                                 |   |                    |   |               |   |
| ASSETS                                                                                               |   |                    |   |               |   |
|                                                                                                 |   |                    |   |               |   |
| Current Assets:                                                                                      |   |                    |   |               |   |
| Cash and equivalents                                                                                 |   | $                       | 135    |               | $      | 75 |   |
| Accounts receivable, net                                                                             |   | 2,069                   |   | 1,656              |   |
| Inventories                                                                                          |   | 591                     |   | 637                |   |
| Royalty advances                                                                                     |   | 264                     |   | 282                |   |
| Prepaid expenses and other                                                                           |   | 555                     |   | 378                |   |
| Total Current Assets                                                                                 |   | 3,614                   |   | 3,028              |   |
|                                                                                                 |   |                    |   |               |   |
| Property and equipment, net of accumulated  depreciation and amortization of $1,471 and $1,418       |   | 147                     |   | 162                |   |
|                                                                                                 |   |                    |   |               |   |
| Owned catalog masters, net of accumulated  amortization of $2,649 and $2,829                         |   | 922                     |   | 1,060              |   |
|                                                                                                 |   |                    |   |               |   |
|                                                                                                 |   | $                       | 4,683  |               | $      | 4,250 |   |
|                                                                                                 |   |                    |   |               |   |
| LIABILITIES AND SHAREHOLDERS’ DEFICIT                                                           |   |                    |   |               |   |
|                                                                                                 |   |                    |   |               |   |
| Current Liabilities:                                                                                 |   |                    |   |               |   |
| Loans payable to affiliate and other                                                                 |   | $                       | 11,217 |               | $      | 10,253 |   |
| Accounts payable                                                                                     |   | 1,560                   |   | 1,264              |   |
| Accrued royalties                                                                                    |   | 2,255                   |   | 2,245              |   |
| Reserve for returns                                                                                  |   | 161                     |   | 40                 |   |
| Net liabilities of discontinued operations                                                           |   | 78                      |   | 92                 |   |
| Total Current Liabilities                                                                            |   | 15,271                  |   | 13,894             |   |
|                                                                                                 |   |                    |   |               |   |
| Shareholders’ Deficit:                                                                          |   |                    |   |               |   |
| Common stock – 50,000,000 shares  authorized; par value $.01; 13,653,738 issued and outstanding |   | 136                     |   | 136                |   |
| Additional paid-in capital                                                                           |   | 21,292                  |   | 21,292             |   |
| Accumulated deficit                                                                                  |   | (31,669                 | )      | (30,771            | )      |
| Cumulative translation adjustment                                                                    |   | (347                    | )      | (301               | )      |
| Total Shareholders’ Deficit                                                                     |   | (10,588                 | )      | (9,644             | )      |
|                                                                                                 |   |                    |   |               |   |
|                                                                                                 |   | $                       | 4,683  |               | $      | 4,250 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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**K-TEL INTERNATIONAL, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS - UNAUDITED***(in thousands - except per share data)*

 
|                                                           |   | **Three  Months Ended  December 31,** |   | **Six Months  Ended  December 31,** |   |
|----------------------------------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                                           |   | **2002**                              |   | **2001**                            |   | **2002** |   | **2001** |   |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Net Sales                                                      |   | $                                     | 1,874  |                                | $      | 2,104 |   | $ | 3,372 |   | $ | 3,485 |   |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Costs and Expenses:                                            |   |                                  |   |                                |   |   |   |   |   |
| Cost of goods sold                                             |   | 897                                   |   | 894                                 |   | 1,496 |   | 1,416 |   |
| Advertising                                                    |   | 19                                    |   | 28                                  |   | 65 |   | 51 |   |
| Selling, general and administrative                            |   | 959                                   |   | 1,035                               |   | 1,910 |   | 2,268 |   |
| Total Costs and Expenses                                       |   | 1,876                                 |   | 1,956                               |   | 3,472 |   | 3,735 |   |
| Operating Income (Loss)                                        |   | (2                                    | )      | 148                                 |   | (100 | ) | (250 | ) |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Other Income (Expense):                                        |   |                                  |   |                                |   |   |   |   |   |
| Interest expense                                               |   | (133                                  | )      | (88                                 | )      | (269 | ) | (169 | ) |
| Other expense                                                  |   | (51                                   | )      | (50                                 | )      | (115 | ) | (50 | ) |
| Total Other Income (Expense)                                   |   | (184                                  | )      | (138                                | )      | (384 | ) | (219 | ) |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Income (Loss) from Continuing Operations  Before Taxes         |   | (186                                  | )      | 10                                  |   | (484 | ) | (469 | ) |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Income Taxes                                                   |   | —                                |   | —                              |   | — |   | — |   |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Income (Loss) from Continuing Operations                       |   | (186                                  | )      | 10                                  |   | (484 | ) | (469 | ) |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Discontinued Operations:                                       |   |                                  |   |                                |   |   |   |   |   |
| Loss from Discontinued Operations                              |   | (204                                  | )      | (117                                | )      | (414 | ) | (142 | ) |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Net Loss                                                       |   | $                                     | (390   | )                                   | $      | (107 | ) | $ | (898 | ) | $ | (611 | ) |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Loss per Share – Basic and Diluted:                       |   |                                  |   |                                |   |   |   |   |   |
| Continuing Operations                                          |   | $                                     | (.01   | )                                   | $      | .00 |   | $ | (.04 | ) | $ | (.03 | ) |
| Discontinued Operations                                        |   | (.02                                  | )      | (.01                                | )      | (.03 | ) | (.01 | ) |
| Net Loss                                                       |   | $                                     | (.03   | )                                   | $      | (.01 | ) | $ | (.07 | ) | $ | (.04 | ) |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Weighted Average Shares Outstanding – Basic  and Diluted: |   | 13,654                                |   | 13,654                              |   | 13,654 |   | 13,654 |   |
|                                                           |   |                                  |   |                                |   |   |   |   |   |
| Comprehensive Loss:                                            |   |                                  |   |                                |   |   |   |   |   |
| Net Loss                                                       |   | $                                     | (390   | )                                   | $      | (107 | ) | $ | (898 | ) | $ | (611 | ) |
| Foreign Currency Gain (Loss)                                   |   | 15                                    |   | 47                                  |   | (46 | ) | (45 | ) |
| Comprehensive Loss                                             |   | $                                     | (375   | )                                   | $      | (60 | ) | $ | (944 | ) | $ | (656 | ) |

 

See accompanying notes to condensedconsolidated financial statements.

 

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS -UNAUDITED***(in thousands)*

 
|                                                                     |   | **Six Months  Ended  December 31,** |   |
|--------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                     |   | **2002**                            |   | **2001** |   |
| Cash flows from Operating Activities:                                    |   |                                |   |   |   |
| Net loss                                                                 |   | $                                   | (898   | ) | $ | (611 | ) |
| Adjustments to reconcile net loss to cash  used in operating activities: |   |                                |   |   |   |
| Depreciation and amortization                                            |   | 172                                 |   | 230 |   |
| Loss on disposal of property and equipment                               |   | —                              |   | 4 |   |
| Discontinued operations                                                  |   | (9                                  | )      | 93 |   |
| Changes in operating assets and  liabilities:                            |   |                                |   |   |   |
| Accounts receivable                                                      |   | (378                                | )      | (901 | ) |
| Inventories                                                              |   | 60                                  |   | 62 |   |
| Royalty and other advances                                               |   | 32                                  |   | 105 |   |
| Prepaid expenses and other                                               |   | (167                                | )      | 203 |   |
| Accounts payable and other                                               |   | 271                                 |   | (114 | ) |
| Accrued royalties                                                        |   | 12                                  |   | 370 |   |
| Reserve for returns                                                      |   | 122                                 |   | 1 |   |
| Income taxes, net                                                        |   | —                              |   | 4 |   |
| Cash used in operating activities                                        |   | (783                                | )      | (554 | ) |
|                                                                     |   |                                |   |   |   |
| Cash flows from Investing Activities:                                    |   |                                |   |   |   |
| Proceeds from sale of property and  equipment                            |   | —                              |   | 27 |   |
| Purchases of property and equipment                                      |   | (13                                 | )      | — |   |
| Music catalog additions                                                  |   | —                              |   | (114 | ) |
| Cash used in investing activities                                        |   | (13                                 | )      | (87 | ) |
|                                                                     |   |                                |   |   |   |
| Cash flows from Financing Activities:                                    |   |                                |   |   |   |
| Borrowings on loans payable                                              |   | 1,665                               |   | 1,312 |   |
| Payments on loans payable                                                |   | (713                                | )      | (629 | ) |
| Cash provided by financing activities                                    |   | 952                                 |   | 683 |   |
|                                                                     |   |                                |   |   |   |
| Effect of exchange rates on cash                                         |   | (96                                 | )      | (71 | ) |
|                                                                     |   |                                |   |   |   |
| Net increase (decrease) in cash and  equivalents                         |   | 60                                  |   | (29 | ) |
|                                                                     |   |                                |   |   |   |
| Cash and equivalents at beginning of period                              |   | 75                                  |   | 173 |   |
|                                                                     |   |                                |   |   |   |
| Cash and equivalents at end of period                                    |   | $                                   | 135    |   | $ | 144 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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

 

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**1.             BUSINESSAND LIQUIDITY**

 

K-tel International, Inc. (the “Company,” “K-tel,” or the “Registrant”)was incorporated in 1968. Its corporate offices are located at 2655 CheshireLane North, Suite 100, Plymouth, Minnesota, and its phone number is (763)559-5566. Through its operating subsidiaries, K-tel licenses its music cataloginternationally and markets entertainment products mainly derived from itscatalog through retail and direct response marketing channels in the UnitedStates and Europe. The Company is implementing a more focused method ofdistribution that targets the strengths of fewer individual retailers andsupplies products suited to each retailer’s needs. These new products arederived mainly from the Company’s master recordings music catalog with theobjective of realizing more competitive profit margins. Historically, K-telsubsidiaries had also distributed consumer products through operations whichhave been discontinued, and operated an Internet e-commerce site which has beensuspended due to continuing losses. K-tel has begun a program of licensing itstrademarks to other companies in businesses unrelated to K-tel’s currentoperations. Licenses are granted for a royalty or fee, with no cost to theCompany. The Company has licensed certain marks to K-tel Drug Mart Ltd., aCanadian direct marketer of prescription drugs beneficially owned by PhilipKives, the Chairman of the Board, President and Chief Executive Officer ofK-tel. . K-tel Drug Mart, which recently began operations, offers prescriptiondrugs from its pharmacy in Canada to persons in the United States. K-tel ismerely a licensor of its mark to K-tel Drug Mart. To date, K-tel Drug Mart’soperations have not generated any significant licensing revenues for the Company.

 

Discontinued Operations

 

The Company’s consumer products business, which was concentrated inEurope, consisted primarily of housewares, consumer convenience items andexercise equipment. The Company discontinued its consumer products operationsin Germany, the United Kingdom and the United States in June 2000, November2000 and January 2001, respectively although the Company continues to pursueits claim against a former supplier of defective goods to its Germansubsidiary. Accordingly, these activities have been presented in theaccompanying financial statements as discontinued operations. The accompanyingconsolidated financial statements have been prepared to reflect the consumerproducts division as a discontinued operation. The Company’s Loss from DiscontinuedOperations represents legal fees related to the Tristar Products, Inc. lawsuitdescribed in Note 4.

 

Going Concern

 

During the six months ended December 31, 2002, the Company continued tosustain losses from continuing operations, losing $484,000 during the period.Additionally, the Company had a working capital deficit of $11,657,000at December 31, 2002.

 

The Company’s ability to continue its present operations and implementfuture expansion plans successfully is contingent mainly upon its ability tomaintain its line of credit arrangements with K-5 Leisure Products, Inc. (SeeNote 3.), increase its revenues, and ultimately attain and sustain profitableoperations. Without increased revenues and sustained profitability, the cashgenerated from the Company’s current operations will likely be inadequate tofund operations and service its indebtedness on an ongoing basis. Management isfocusing its efforts on music licensing and limited music distribution.However, there can be no assurance that the Company will achieve profitableoperations through these efforts. The financial statements do not include anyadjustments that might result from the outcome of these uncertainties.

 

**2.****                                      BASISOF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

Basis of Presentation - The accompanyingcondensed consolidated unaudited financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (“US GAAP”) for interim financial information and with theinstructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, theydo not include all of the information and footnotes required by US GAAP forcomplete financial statements. In the opinion of management, all adjustments(consisting of normal recurring adjustments) considered necessary for a fairpresentation have been included. Operating results for the three and six monthperiods ended December 31, 2002 are not necessarily indicative of the resultsthat may be expected for the year as a whole. The unaudited condensedconsolidated balance sheet for June 30, 2002 has been derived from auditedconsolidated 

 

6

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financial statements as of that date. For further information, refer tothe consolidated financial statements and footnotes thereto included in theCompany’s annual report on Form 10-K for the year ended June 30, 2002.

 

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

 

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

 

Cost of Goods Sold – The Company expenses allproduct manufacturing, distribution and royalty costs associated with musicsales as cost of goods sold. The Company also expenses royalties, commissionsand amortization of its owned master recordings associated with its licenserevenue as costs of goods sold.

 

Shipping and Handling Costs – The Companyexpenses within cost of goods sold all shipping and handling costs incurred inthe shipment of goods.

 

Cash and Equivalents – Cash and equivalentsconsist principally of cash and short-term, highly liquid investments withoriginal maturities of less than ninety days.

 

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

 

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

 

Rights to Use Music Product - Certain of theCompany’s compilation products are master recordings under license from recordcompanies and publishers. In most instances, minimum guarantees ornon-refundable advances are required to obtain the licenses and are realizedthrough future sales of the product. The amounts paid for minimum guarantees ornon-refundable advances are capitalized and charged to expense as sales aremade. When anticipated sales appear to be insufficient to fully recover theminimum guarantees or non–refundable advances, a provision againstcurrent operations is made for anticipated losses. The unrealized portion ofguarantees and advances is included in royalty advances in the accompanyingcondensed consolidated balance sheets. Licenses are subject to audit bylicensors.

 

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

 

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

 

Royalties - The Company has entered intolicense agreements with various record companies and publishers under which itpays royalties on units sold. The Company accrues royalties using contractualrates and certain estimated rates on applicable units sold. The contractualroyalty liability is computed quarterly and the accrued royalty balance isadjusted accordingly. The royalty agreements are subject to audit by licensors.

 

Advertising - The Company expenses the costsof advertising when the advertising takes place, except for direct responseadvertising, which is capitalized and amortized over its expected period offuture benefits (usually the period remaining under a related contract, whichis generally less than one year). Direct response advertising consistsprimarily of television advertising whereby customers respond specifically tothe advertising and where the Company can identify the advertising thatelicited the response.

 

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Foreign Currency - The operations of allforeign entities are measured in local currencies. Assets and liabilities aretranslated into U.S. dollars at period-end exchange rates. Revenues andexpenses are translated at the average exchange rates prevailing during theperiod. Adjustments resulting from translating the financial statements offoreign entities into U.S. dollars are recorded as a separate component ofshareholders’ deficit.

 

Stock–based Compensation - The Companyaccounts for stock-based awards to employees using the intrinsic value methodand recognizes compensation expense for certain stock based awards granted toemployees.

 

Income Taxes - Deferred income taxes areprovided for temporary differences between the financial reporting basis andtax basis of the Company’s assets and liabilities at currently enacted tax rates.

 

Net Income (Loss) Per Share - Basic anddiluted net income (loss) per share have been computed by dividing net income(loss) by the weighted average number of shares outstanding during the period.For all periods presented, common stock equivalents were excluded from the pershare calculation as the effect would be antidilutive. For the six months endedDecember 31, 2002 and 2001, weighted average options to purchase 2,332,395 and2,331,445 shares of common stock, with weighted average exercise prices of$5.74 and $5.88 were excluded from the computation of common share equivalentsfor the respective periods as they were antidilutive. For the three monthsended December 31, 2002 and 2001, options to purchase 2,390,950 and 2,331,673shares of common stock, with weighted average exercise prices of $5.60 and$5.88 were excluded from the computation of common share equivalents for therespective periods as they were antidilutive.

 

Use of Estimates - Preparing consolidatedfinancial statements in conformity with US GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets,liabilities, and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Principal estimates include allowances for baddebt, inventory valuation, return reserves, royalty obligations, purchasecommitments and product replacement costs. Actual results could differ fromthose estimates used by management.

 

**3.             LOANS PAYABLE TO AFFILIATE**

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc.,the Company’s largest shareholder controlled by Philip Kives, the Chairman ofthe Board, President and Chief Executive Officer of K-tel. Under the terms ofthe agreement (the “K-5 Facility”), K-5 has agreed to make available up to$8,000,000 to K-tel on a revolving basis. The loan bears interest at a variablerate based upon the “base rate” of a nationally recognized lending institution(4.25% at December 31, 2002), expires July 20, 2005, and is subordinated to theFoothill loan (see below). The K-5 Facility contains the same covenants as theFoothill loan agreement. K-tel has pledged the stock of its foreignsubsidiaries as collateral for the loan, and the loan carries a subordinatedposition to the Foothill loan on all other assets of the Company. K-tel hadoutstanding balances of $6,959,000 and $6,026,000 as of December 31, 2002 andJune 30, 2002 respectively under the K-5 Facility. At December 31, 2002, K-telobtained a waiver from K-5 for its default under the covenants, limitations andrestrictions of the credit agreement.

 

In addition, K-tel has a second loan agreement with K-5, under whichK-5 assumed rights and obligations under a loan from the Company’s formerbanker (Foothill Capital Corporation) pursuant to an Assignment and AcceptanceAgreement dated February 27, 2001. This Foothill loan, which has been extendedthrough July 20, 2005, provides for a $10,000,000 credit facility consisting ofa $4,000,000 term loan due upon expiration, and a $6,000,000 revolving facilityunder which borrowings are limited to a percent of eligible receivables.Borrowings under the facility bear interest at a variable rate based on a “baserate” of a nationally recognized lending institution plus 1% (5.25% at December31, 2002) and are collateralized by the assets of certain Company subsidiariesin the United States, including accounts receivable, inventories, equipment,music library and general intangibles. The loan agreement contains certainfinancial and other covenants or restrictions, including the maintenance of aminimum shareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of December 31, 2002 and June30, 2002, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At December 31, 2002, K-tel obtained awaiver from K-5 for its default under the covenants, limitations andrestrictions of the credit agreement.

 

K-tel has an overdraft privilege borrowing facility with The Royal Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian 

 

8

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company controlled by Philip Kives and is payable on demand inaccordance with normal banking practices. Borrowings bear interest of 2% perannum over the base rate (a total of 6% at December 31, 2002) and are subjectto a minimum of 6% per annum. K-tel had outstanding balances of $258,000 and$227,000 as of December 31, 2002 and June 30, 2002 respectively.

 

**4.             COMMITMENTS AND CONTINGENCIES**

#### ** **

Class Action Lawsuit

 

K-tel and certain of its current and former officers and directors werenamed as defendants in *In re K-telInternational, Inc. Securities Litigation*, No. 98-CV-2480. Thisaction consolidates twenty-three purported class actions that were initiallyfiled in various United States District Courts in November 1998, and weresubsequently transferred to, and consolidated in, the United States DistrictCourt for the District of Minnesota. On July 19, 1999, the plaintiffs filed anamended consolidated class action complaint that challenges the accuracy ofcertain public disclosures made by K-tel regarding its financial conditionduring the period from May 1998 through November 1998. The plaintiffs assertedclaims under the federal securities laws and seek damages in an unspecifiedamount as well as costs, including attorneys’ fees and any other relief theCourt deems just and proper. K-tel moved to dismiss the complaint, and on July31, 2000, the United States District Court granted the Company’s motion todismiss. The Court also barred further actions by the plaintiffs and deniedplaintiffs’ request to amend the complaint in order to refile the complaint inthe future. The plaintiffs appealed to the United States Court of Appeals forthe Eighth Circuit, and the Court of Appeals heard the matter in October 2001.On August 7, 2002 the Court of Appeals, in a two to one decision, denied theplaintiffs’ appeal. On August 20, 2002 the plaintiffs applied for a rehearingby the full Court of Appeals. K-tel filed a response on September 15, 2002 tothe plaintiffs’ petition for rehearing at the request of the Court. On October2, 2002, the Court denied the petition for rehearing. The plaintiffs had untilJanuary 1, 2003 to seek a writ of certiorari (a petition asking the Court for adiscretionary review of a lower court decision) from the United States SupremeCourt, but did not seek this writ. K-tel has two insurance policies under whichthe insurers provide the defense of the claims on behalf of the Company. Thepolicies provide coverage of up to $20 million, which is subject to theinsurers’ reservations of legal rights under the applicable policies. Undertheir reservations of rights, the insurers could contest their obligations toindemnify the Company and its directors and officers. K-tel may have anobligation to indemnify the officers and directors named in this lawsuit.

 

RTL Shopping S. A.

 

The Company has been named in a lawsuit filed in France brought byRTL9, a French cable TV station. Initially, RTL9 was named as a defendant in asuit brought by a competitor of K-tel Marketing Ltd. alleging that RTL9 ran acommercial for K-tel Marketing which presented a product under brand namesalleged to infringe on the competitor’s own trademarks and also translated anEnglish language script indicating that the product was “just like” or “as goodas” others into “better than” in French, contrary to French law. The suitalleged trademark infringement, unfair competition, illicit comparativeadvertising and passing off. RTL9 then sued K-tel Marketing on October 4, 2000,pursuant to an indemnification provision the parties had entered into.Subsequently, K-tel Marketing went into liquidation and RTL9 filed a suit inDecember 2000 against K-tel International, Inc. under its agreement toguarantee payment for the commercial time. On May 28, 2001, RTL9 presenteddocuments in court identifying K-tel International (USA), Inc. as a target ofits claim. On September 3, 2001 the Company filed documents disputing the claimand advising the court of K-tel (USA)’s Chapter 7 bankruptcy filing.

 

The initial lawsuit against RTL9 and the RTL9 claim against K-tel areproceeding together through the French courts, and the parties involved in theinitial lawsuit continue to submit new briefs to the Court related to thataction. The Court has scheduled a case conference on February 24, 2003, afterwhich the parties may not file any further evidence or submissions with theCourt. The Court has scheduled oral arguments for March 31, 2003. The actionseeks damages in the approximate amount of 20 million French Francs, orapproximately $2.8 million. The Company believes that RTL9 has no basis for acomplaint against the Company. 

 

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

 

On March 14, 2000, K-tel and its subsidiary in Germany commenced anaction for breach of express and implied warranties against Defendant TristarProducts, Inc. This action is venued in the United States District Court forthe District of Minnesota. This action arises out of Tristar’s sale toPlaintiffs of a defective home exercise product called the “BunBlaster” forresale in Germany, Austria and Switzerland. By written contract, Tristar hasagreed to indemnify Plantiffs for injuries and damages arising out of theresale of those goods. Plaintiffs are seeking 

 

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approximately $2 million in consequential damages. Tristar isvigorously defending this claim and the action is currently in discovery. TheCourt has scheduled trial for June 2, 2003.

 

On April 30, 2001, Tristar also asserted a patent and trademark/trade-dress counter-claim against K-tel for allegedly passing off a productcalled the “K-tel Hook and Hang” while allegedly a distributor of the original patentedTristar Hook and Hang product. The Company denies the allegation because itnever was a distributor of this or any similar product and intends to defendthis action vigorously. Tristar has not identified the amount of damages itseeks with respect to this counterclaim. The United States District Court forthe District of Minnesota issued an order on August 14, 2001 severing thisaction from the Company’s action. This action is at an early stage and nodiscovery or other actions have occurred.

 

#### **OtherLitigation and Disputes**

 

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

 

Subsidiaries’ Bankruptcy and Liquidation

 

In March 2001, the Company’s music distribution subsidiary in theUnited States, K-tel International (USA), Inc. ceased operations and filed forprotection under Chapter 7 of the United States Bankruptcy Code. Although thebankruptcy court has not yet confirmed the formal plan of liquidation, theCompany has not been informed by the trustee or its counsel of any plan by thecourt to attempt to hold it or any of its subsidiaries liable for any of thecommitments of K-tel (USA).  Managementbelieves the Company will have no ongoing material liability related to K-tel(USA) as a result of the filing and the outcome of the bankruptcy proceeding.

 

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

** **

**5.             BUSINESS SEGMENT AND GEOGRAPHICAREA DATA**

 

The Company markets and distributes entertainment productsinternationally and through its operating subsidiaries. K–tel’sbusinesses are organized, managed and internally reported as three segments:retail music sales, music licensing and other, which consists primarily ofe-commerce (which was closed in the fourth quarter of fiscal 2002). Thesesegments are based on differences in products, customer type and sales anddistribution methods. The Company’s consumer product operations have beendiscontinued and are presented in the accompanying financial statements asdiscontinued operations and are therefore not included in the segmentinformation.

 

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

 

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

 

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

 

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

 

BUSINESS SEGMENT INFORMATION

 
| **Six Months  Ended  December 31,** |   | **Music** |   | **Licensing** |   | **Other** |   | **Corporate  Elimination** |   | **Total Company** |   |
|-------------------------------------|--------|-----------|--------|---------------|--------|-----------|--------|----------------------------|--------|-------------------|--------|
| ***(in thousands)***                |   |      |   |          |   |      |   |                       |   |              |   |   |   |
|                                |   |      |   |          |   |      |   |                       |   |              |   |   |   |
| Net Sales                           |   | 2002      |   | $             | 2,184  |      | $      | 1,188                      |   | $                 | — |   | $ | — |   | $ | 3,372 |   |
|                                |   | 2001      |   | 2,303         |   | 1,548     |   | —                     |   | (366              | )      | 3,485 |   |
|                                |   |      |   |          |   |      |   |                       |   |              |   |   |   |
| Operating Income (Loss)             |   | 2002      |   | $             | (400   | )         | $      | 299                        |   | $                 | — |   | — |   | $ | (100 | ) |
|                                |   | 2001      |   | (630          | )      | 380       |   | —                     |   | —            |   | (250 | ) |
|                                |   |      |   |          |   |      |   |                       |   |              |   |   |   |
| Assets                              |   | 2002      |   | $             | 2,944  |      | $      | 1,229                      |   | $                 | 510    |   | $ | — |   | $ | 4,683 |   |
|                                |   | 2001      |   | 2,750         |   | 1,248     |   | 231                        |   | —            |   | 4,229 |   |

 
| **Three  Months Ended  December 31,** |   |   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
|---------------------------------------|--------|--------|------------|--------|------------|--------|------------|--------|------------|--------|------------|
|                                  |   |   |       |   |       |   |       |   |       |   |       |   |   |
| Net Sales                             |   | 2002   |       | $      | 1,241      |   | $          | 633    |       | $      | —     |   | $ | — |   | $ | 1,874 |   |
|                                  |   | 2001   |       | 1,547  |       | 764    |       | — |       | (207   | )          | 2,104 |   |
|                                  |   |   |       |   |       |   |       |   |       |   |       |   |   |
| Operating Income (Loss)               |   | 2002   |       | $      | (233       | )      | $          | 231    |       | $      | —     |   | $ | — |   | $ | (2 | ) |
|                                  |   | 2001   |       | (57    | )          | 205    |       | — |       | — |       | 148 |   |

 

GEOGRAPHIC INFORMATION

 
| **Six Months  Ended  December 31,** |   | **United States** |   | **Europe** |   | **Total** |   |
|-------------------------------------|--------|-------------------|--------|------------|--------|-----------|--------|
| ***(in thousands)***                |   |              |   |       |   |      |   |   |   |
|                                |   |              |   |       |   |      |   |   |   |
| Net Sales                           |   | 2002              |   | $          | 2,080  |      | $      | 1,292 |   | $ | 3,372 |   |
|                                |   | 2001              |   | 1,783      |   | 1,702     |   | 3,485 |   |
|                                |   |              |   |       |   |      |   |   |   |
| Assets                              |   | 2002              |   | $          | 3,177  |      | $      | 1,506 |   | $ | 4,683 |   |
|                                |   | 2001              |   | 2,344      |   | 1,885     |   | 4,229 |   |

 
| **Three Months Ended  December 31,** |   |   |   |   |   |   |   |
|--------------------------------------|--------|--------|--------|--------|--------|--------|--------|
|                                 |   |   |   |   |   |   |   |   |   |
| Net Sales                            |   | 2002   |   | $      | 1,100  |   | $      | 774 |   | $ | 1,874 |   |
|                                 |   | 2001   |   | 1,403  |   | 701    |   | 2,104 |   |
|                                      |        |        |        |        |        |        |        |  |  |  |  |  |

 

**6.             NEWACCOUNTING PRONOUNCEMENTS**

 

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

 

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

 

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In December 2002 the FASB issued Statement 148 (FAS 48), *Accounting for Stock-Based Compensation Transitionand Disclosure.* FAS 148 amends the disclosure and certain transitionprovisions of Statement 123, *Accounting forStock-Based Compensation.* Its disclosure provisions, which apply toall entities with employee stock-based compensation, are effective for fiscalyears ending after December 15, 2002. New interim period disclosures arerequired in financial statements for interim periods beginning after December15, 2002. This pronouncement is not anticipated to have a material effect onthe Company’s consolidated financial position or results of operations.

 

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

 

**7.             RECENTLYPASSED LEGISLATION**

 

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Actof 2002 (the “Act”), which immediately impacts Securities and ExchangeCommission registrants, public accounting firms, lawyers and securitiesanalysts. This legislation is the most comprehensive since the passage of theSecurities Acts of 1933 and 1934. It has far reaching effects on the standardsof integrity for corporate management, board of directors, and executivemanagement. Additional disclosures, certifications and procedures will berequired of the Company. We do not expect any material adverse effect on theCompany as a result of the passage of this legislation; however, the full scopeof the Act has not yet been determined.

 

Refer to management’s certifications contained elsewhere in this reportregarding the Company’s compliance with Sections 302 and 906 of theSarbanes-Oxley Act of 2002.

 

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**ITEM 2: ****MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**General**

 

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

 

For this analysis, the following changes in the Company’s businessshould be considered: K-tel closed the operations of its German subsidiary,Dominion Vertriebs GmbH, in June 2000, one of its subsidiaries in the UnitedKingdom, K-tel Marketing Ltd., in November 2000 and a U.S. subsidiary, K-telConsumer Products, Inc. in February 2001. These three closings represent thediscontinuation of the Company’s consumer products division and accordinglyhave been presented in the accompanying financial statements as discontinuedoperations. In addition, in March 2001, the Company’s music distributionsubsidiary in the United States, K-tel International (USA), Inc., ceasedoperations and filed for protection under Chapter 7 of the U.S. bankruptcycode.

 

Through another subsidiary, K-tel Entertainment, Inc., K-tel isimplementing a more focused method of distribution that targets the strengthsof fewer individual retailers and supplies products suited to each retailer’sspecific needs. These new products are derived mainly from the Company’s masterrecordings music catalog with the objective of realizing more competitiveprofit margins. As well, the Company has begun licensing its name and marks to otherbusinesses for a royalty or fee.

 

#### **THREE MONTHS ENDED DECEMBER 31, 2002 VERSUSDECEMBER 31, 2001**

 

Net sales for the three months ended December 31, 2002 were $1,874,000a decrease of 10.9% from sales of $2,104,000 for the quarter ended December 31,2001. This decrease can be mainly attributed to a decrease in sales to theshopping channel market in England. The loss for the three months endedDecember 31, 2002 was $390,000, or $.03 per share, compared to a loss of$107,000, or $.01 per share, for the three months ended December 31, 2001.

 

General corporate expenses of $338,000 and $113,000 for the threemonths ended December 31, 2002 and 2001 respectively have been allocated to thebusiness segments.

 

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

 

#### **BUSINESS SEGMENT RESULTS**

 

#### **Music**

 

Sales in the music segment were $1,241,000 for the three months endedDecember 31, 2002 compared to $1,547,000 for the three months ended December31, 2001, a decrease of $306,000, or 19.8%. European sales decreased $350,000primarily because of significant fragmentation in the English shopping channelmarket which until this year has been dominated by one channel – Shop! TheCompany does not expect sales to this market to increase.

 

Cost of goods sold in the music segment increased to 64.7% of sales forthe three months ended December 31, 2002 compared to 41.6% of sales for thethree months ended December 31, 2001. This reflected adverse foreign currencyfluctuation on products purchased for resale in the budget music market as wellas an increase in anticipated returns of product sold earlier in the calendaryear. Advertising expenses within the segment, which consist primarily ofco-operative advertising payments, trade advertising and promotions, increasedto $39,000 and were approximately 3.2% of sales for the three months endedDecember 31, 2002 compared to $28,000, or 1.8% of sales for the three monthsended December 31, 2001. This increase was related to the increased levels ofadvertising done during the current period. Selling, general and administrativeexpenses were $700,000, or 56.4% of sales for the three months ended December31, 2002 compared to $934,000, or 60.4% of sales for the three months endedDecember 31, 2001. The reduction of $234,000 was mainly because of continuingefforts to achieve cost reductions. As a result, the music segment incurred anoperating loss of $233,000 for the three months ended December 31, 2002compared to an operating loss of $57,000 for the three months ended December31, 2001.

 

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**Licensing**

 

Licensing revenue was $633,000 for the three months ended December 31,2002 compared to $764,000 for the three months ended December 31, 2001, adecrease of 17.1% reflecting a general reduction in licensing activity in themusic industry. The Company expects this reduced level of licensing activity tocontinue at least through the remainder of this fiscal year. Included in thesegment revenue for the three months ended December 31, 2001 was approximately$207,000 of intercompany revenues which is eliminated on the accompanyingfinancial statements. Operating income in the licensing segment was $231,000for the three months ended December 31, 2002 compared to $205,000 for the threemonths ended December 31, 2001, an increase of 12.7%.

 

#### **SIX MONTHS ENDED DECEMBER 31, 2002 VERSUSDECEMBER 31, 2001**

 

Net sales for the six months ended December 31, 2002 were $3,372,000, adecline of 3.3% from sales of $3,485,000 for the six months ended December 31,2001. While sales to retail music outlets increased modestly, sales to the TVshopping channels in England decreased significantly. The loss for the sixmonths ended December 31, 2002 was $913,000, or $.07 per share, compared to aloss of $611,000, or $.04 per share, for the six months ended December 31,2001.

 

General corporate expenses of $452,000 and $477,000 for the six monthsended December 31, 2002 and 2001 respectively have been allocated to thebusiness segments.

 

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

 

#### **BUSINESS SEGMENT RESULTS**

 

#### **Music**

 

Sales in the music segment were $2,184,000 for the six months endedDecember 31, 2002 compared to $2,303,000 for the six months ended December 31,2001, a decrease of 5.2%. While domestic sales increased $177,000, Europeanmusic sales decreased $296,000 primarily because of significant fragmentationin the shopping channel market in England as well as lower sales outsideEngland. The Company does not expect sales to the shopping channel market toincrease. Sales outside England were adversely affected by the strength of theBritish pound.

 

Cost of goods sold in the music segment increased to 57.8% of sales forthe six months ended December 31, 2002 compared to 49.7% of sales for the sixmonths ended December 31, 2001. This increase reflected reduced domestic grossprofit margins that resulted from adverse currency fluctuations on productspurchased for resale in the budget music market. Advertising expenses withinthe segment, which consist primarily of co-operative advertising payments,trade advertising and promotions, increased to $85,000 and were approximately3.9% of sales for the six months ended December 31, 2002 compared to $51,000, or2.2% of sales for the six months ended December 31, 2001. This cost increasewas related to the increased levels of advertising done during the period.Selling, general and administrative expenses were $1,302,000, or 59.9% of salesfor the six months ended December 31, 2002 compared to $1,737,000, or 75.4% ofsales for the six months ended December 31, 2001. The reduction of $435,000, or25.0%, was mainly due to continuing efforts to achieve cost reductions. As aresult, the music segment incurred an operating loss of $400,000 for the sixmonths ended December 31, 2002 compared to an operating loss of $630,000 forthe six months ended December 31, 2001.

 

**Licensing**

 

Licensing revenue was $1,188,000 for the six months ended December 31,2002 compared to $1,548,000 for the six months ended December 31, 2001, adecrease of 23.3%. Domestic revenue decreased $306,000 reflecting a reducedlevel of licensing activity in the music industry. The Company expects thisreduced level of licensing activity to continue at least through the remainderof this fiscal year. Included in the segment revenue for the six months endedDecember 31, 2001 was approximately $366,000 of intercompany revenues which iseliminated on the accompanying financial statements. Operating income in thelicensing segment was $299,000 for the six months ended December 31, 2002 and$380,000 for the six months ended December 31, 2001, a decrease of 21.3%.

 

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**New Accounting Pronouncements**

 

The notes to the condensed consolidated financial statements includedwith this Form 10-Q include disclosures regarding recently issued accountingpronouncements, none of which are expected to have a material effect on theCompany’s financial position or results of operations.

 

**B. LIQUIDITY AND CAPITAL RESOURCES**

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc.,an affiliate of the Company controlled by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel. Under the terms of theagreement (the “K-5 Facility”), K-5 has agreed to make available up to$8,000,000 to K-tel on a revolving basis. The loan bears interest at a variablerate based upon the “base rate” of a nationally recognized lending institution(4.25% at December 31, 2002), expires July 20, 2005, and is subordinated to theFoothill loan (see below). The K-5 Facility contains the same covenants as theFoothill loan agreement. K-tel has pledged the stock of its foreignsubsidiaries as collateral for the loan, and the loan carries a subordinatedposition to the Foothill loan on all other assets of the Company. K-tel hadoutstanding balances of $6,959,000 and $6,026,000 as of December 31, 2002 andJune 30, 2002 respectively under the K-5 Facility. At December 31, 2002, K-telobtained a waiver from K-5 for its default under the covenants, limitations andrestrictions of the credit agreement.

 

In addition, K-tel has a second loan agreement with K-5, under whichK-5 assumed rights and obligations under a loan from the Company’s formerbanker (Foothill Capital Corporation) pursuant to an Assignment and AcceptanceAgreement dated February 27, 2001. This Foothill loan, which has been extendedthrough July 20, 2005, provides for a $10,000,000 credit facility consisting ofa $4,000,000 term loan due upon expiration, and a $6,000,000 revolving facilityunder which borrowings are limited to a percent of eligible receivables.Borrowings under the facility bear interest at a variable rate based on a “baserate” of a nationally recognized lending institution plus 1% (5.25% at December31, 2002) and are collateralized by the assets of certain Company subsidiariesin the United States, including accounts receivable, inventories, equipment,music library and general intangibles. The loan agreement contains certainfinancial and other covenants or restrictions, including the maintenance of aminimum shareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of December 31, 2002 and June30, 2002, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At December 31, 2002, K-tel obtained awaiver from K-5 for its default under the covenants, limitations andrestrictions of the credit agreement.

 

K-tel has an overdraft privilege borrowing facility with The Royal Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives, and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2% per annum over the base rate(a total of 6% at December 31, 2002) and are subject to a minimum of 6% perannum. K-tel had outstanding balances of $258,000 and $227,000 as of December31, 2002 and June 30, 2002 respectively.

 

K-tel has primarily funded its operations to date through internallygenerated capital, proceeds from stock option exercises and secured loans fromK-5. Management currently believes that K-tel has sufficient cash and borrowingcapacity to ensure the Company will continue operations in the near term.Although K-5 continues to advance funds sufficient to meet the Company’s needsat this time, there can be no assurance that this will be adequate or continuein the future or that K-tel will be able to obtain additional financing uponfavorable terms when required.

 

The Company’s ability to continue its present operations and implementfuture expansion plans successfully is contingent mainly upon its ability tomaintain its line of credit arrangements with K-5 Leisure Products, Inc. (SeeNote 3.), increase its revenues, and ultimately attain and sustain profitableoperations. Without increased revenues and sustained profitability, the cashgenerated from the Company’s current operations will likely be inadequate tofund operations and service its indebtedness on an ongoing basis. Management isfocusing its efforts on music licensing and limited music distribution.However, there can be no assurance that the Company will achieve profitableoperations through these efforts. The financial statements do not include anyadjustments that might result from the outcome of these uncertainties.

 

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**Important FactorsRelating to Forward Looking Statements**

 

Certain statements of a non-historical nature under the captions“Business,” “Legal Proceedings,” “Market for Registrant’s Common Equity andRelated Stockholder Matters,” “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations,” and elsewhere in this Form 10-Qconstitute “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995. Such forward-looking statements maybe identified by the use of terminology such as “may,” “will,” “expect,”“anticipate,” “estimate,” “should,” or “continue” or the negative thereof orother variations thereon or comparable terminology. Such forward-lookingstatements are subject to certain risks and uncertainties that could causeactual results to differ materially from historical results or from thoseresults currently anticipated or projected. Such factors include, among otherthings, the following: changes in consumer purchasing; demand for and marketacceptance of new and existing products; the impact from competition formerchandise and recorded music; the outcome of securities laws claims by apurported class action lawsuit; dependence on suppliers and distributors; theoutcome of  the two subsidiaries’bankruptcy and liquidation; success of marketing and promotion efforts;technological changes and difficulties; availability of financing; foreigncurrency variations; general economic, political and business conditions; andother matters. The Company undertakes no obligation to release publicly theresult of any revisions to these forward-looking statements, except as requiredby law.

 

**ITEM 3.****QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

There have been no material changes in the Company’s market risk duringthe six months ended December 31, 2002. For additional information, refer topage 14 of the Company’s annual report on Form 10-K for the fiscal year endedJune 30, 2002.

 

**ITEM 4.****CONTROLSAND PROCEDURES**

 

Within the 90 days prior to the date of thisreport, K-tel carried out an evaluation, under the supervision and with theparticipation of K-tel’s management, including K-tel’s Chief Executive Officerand the Chief Financial Officer, of the effectiveness of the design andoperation of K-tel’s disclosure controls and procedures as defined in ExchangeAct Rules 13a-14(c) and 15d-14(c). Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that K-tel’s disclosurecontrols and procedures are effective in alerting them in a timely manner tomaterial information relating to the Company (including its consolidatedsubsidiaries) required to be included in the Company’s periodic SEC filings.There were no significant changes in K-tel’s internal controls or in otherfactors that could significantly affect these controls subsequent to the dateof their evaluation.

 

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**PARTII**

 

#### **ITEM1. LEGAL PROCEEDINGS**

#### ** **

Class Action Lawsuit

 

K-tel and certain of its current and former officers and directors werenamed as defendants in *In re K-telInternational, Inc. Securities Litigation*, No. 98-CV-2480. Thisaction consolidates twenty-three purported class actions that were initiallyfiled in various United States District Courts in November 1998, and weresubsequently transferred to, and consolidated in, the United States DistrictCourt for the District of Minnesota. On July 19, 1999, the plaintiffs filed anamended consolidated class action complaint that challenges the accuracy ofcertain public disclosures made by K-tel regarding its financial conditionduring the period from May 1998 through November 1998. The plaintiffs asserted claimsunder the federal securities laws and seek damages in an unspecified amount aswell as costs, including attorneys’ fees and any other relief the Court deemsjust and proper. K-tel moved to dismiss the complaint, and on July 31, 2000,the United States District Court granted the Company’s motion to dismiss. TheCourt also barred further actions by the plaintiffs and denied plaintiffs’request to amend the complaint in order to refile the complaint in the future.The plaintiffs appealed to the United States Court of Appeals for the EighthCircuit, and the Court of Appeals heard the matter in October 2001. On August7, 2002 the Court of Appeals, in a two to one decision, denied the plaintiffs’appeal. On August 20, 2002 the plaintiffs applied for a rehearing by the fullCourt of Appeals. K-tel filed a response on September 15, 2002 to theplaintiffs’ petition for rehearing at the request of the Court. On October 2,2002, the Court denied the petition for rehearing. The plaintiffs had untilJanuary 1, 2003 to seek a writ of certiorari (a petition asking the Court for adiscretionary review of a lower court decision) from the United States SupremeCourt, but did not seek this writ. K-tel has two insurance policies under whichthe insurers provide the defense of the claims on behalf of the Company. Thepolicies provide coverage of up to $20 million, which is subject to theinsurers’ reservations of legal rights under the applicable policies. Undertheir reservations of rights, the insurers could contest their obligations toindemnify the Company and its directors and officers. K-tel may have anobligation to indemnify the officers and directors named in this lawsuit.

 

RTL Shopping S. A.

 

The Company has been named in a lawsuit filed in France brought byRTL9, a French cable TV station. Initially, RTL9 was named as a defendant in asuit brought by a competitor of K-tel Marketing Ltd. alleging that RTL9 ran acommercial for K-tel Marketing which presented a product under brand namesalleged to infringe on the competitor’s own trademarks and also translated anEnglish language script indicating that the product was “just like” or “as goodas” others into “better than” in French, contrary to French law. The suitalleged trademark infringement, unfair competition, illicit comparativeadvertising and passing off. RTL9 then sued K-tel Marketing on October 4, 2000,pursuant to an indemnification provision the parties had entered into.Subsequently, K-tel Marketing went into liquidation and RTL9 filed a suit inDecember 2000 against K-tel International, Inc. under its agreement toguarantee payment for the commercial time. On May 28, 2001, RTL9 presenteddocuments in court identifying K-tel International (USA), Inc. as a target ofits claim. On September 3, 2001 the Company filed documents disputing the claimand advising the court of K-tel (USA)’s Chapter 7 bankruptcy filing.

 

The initial lawsuit against RTL9 and the RTL9 claim against K-tel areproceeding together through the French courts, and the parties involved in theinitial lawsuit continue to submit new briefs to the Court related to thataction. The Court has scheduled a case conference on February 24, 2003, afterwhich the parties may not file any further evidence or submissions with theCourt. The Court has scheduled oral arguments for March 31, 2003. The actionseeks damages in the approximate amount of 20 million French Francs, orapproximately $2.8 million. The Company believes that RTL9 has no basis for acomplaint against the Company. 

 

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

 

On March 14, 2000, K-tel and its subsidiary in Germany commenced anaction for breach of express and implied warranties against Defendant TristarProducts, Inc. This action is venued in the United States District Court forthe District of Minnesota. This action arises out of Tristar’s sale toPlaintiffs of a defective home exercise product called the “BunBlaster” forresale in Germany, Austria and Switzerland. By written contract, Tristar hasagreed to indemnify Plantiffs for injuries and damages arising out of theresale of those goods. Plaintiffs are seeking approximately $2 million inconsequential damages. Tristar is vigorously defending this claim and theaction is currently in discovery. The Court has scheduled trial for June 2,2003.

 

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

 

#### **OtherLitigation and Disputes**

 

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

 

Subsidiaries’ Bankruptcy and Liquidation

 

In March 2001, the Company’s music distribution subsidiary in theUnited States, K-tel International (USA), Inc. ceased operations and filed forprotection under Chapter 7 of the United States Bankruptcy Code. Although thebankruptcy court has not yet confirmed the formal plan of liquidation, theCompany has not been informed by the trustee or its counsel of any plan by thecourt to attempt to hold it or any of its subsidiaries liable for any of thecommitments of K-tel (USA). Management believes the Company will have noongoing material liability related to K-tel (USA) as a result of the filing andthe outcome of the bankruptcy proceeding.

 

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

 

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## **ITEM6.** EXHIBITS AND REPORTS ON FORM 8-K

 
| (a)    |   | EXHIBITS INDEX                                                                                                    |
|--------|--------|-------------------------------------------------------------------------------------------------------------------|
|   |   | None.                                                                                                             |
|   |   |                                                                                                              |
| (b)    |   | REPORTS ON FORM 8-K                                                                                               |
|   |   |                                                                                                              |
|   |   | There were no reports filed under Form 8-K by the Company during the  three month period ended December 31, 2002. |

 

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##### **SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                     | K-TEL INTERNATIONAL, INC.                                            |   |
|--------------------------|----------------------------------------------------------------------|--------|
|                     | REGISTRANT                                                           |
|                     |                                                                 |
|                     |                                                                 |
| Dated: February 13, 2003 | /s/ PHILIP KIVES                                                     |   |
|                     | PHILIP KIVES  CHAIRMAN AND CHIEF EXECUTIVE OFFICER                   |
|                     |                                                                 |
|                     |                                                                 |
| Dated: February 13, 2003 | /s/ DENNIS WARD                                                      |   |
|                     | DENNIS WARD  CHIEF FINANCIAL OFFICER  (principal accounting officer) |

 

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**CERTIFICATIONS**

 

CHIEF EXECUTIVE OFFICERCERTIFICATION PURSUANT TO RULE 13a-14

 

I, Philip Kives, President and Chief Executive Officer of K-telInternational, Inc., certify that:

 

1.                                       I have reviewedthis quarterly report on Form 10-Q of K-tel International, Inc.;

 

2.                                       Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.                                       Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.                                       The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

a)                                      designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b)                                     evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.                                       The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a)                                      all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     any fraud, whetheror not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.                                       The registrant’sother certifying officer and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

 
| Dated:  February 13, 2003 | By     |   | /s/ Philip Kives                                    |   |
|-------------------------------------|--------|--------|-----------------------------------------------------|--------|
|                                |   |   | Philip Kives  President and Chief Executive Officer |

 

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CHIEF FINANCIAL OFFICERCERTIFICATION PURSUANT TO RULE 13a-14

 

I, Dennis Ward, Chief Financial Officer of K-tel International, Inc.,certify that:

 

1.                                       I have reviewedthis quarterly report on Form 10-Q of K-tel International, Inc.;

 

2.                                       Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.                                       Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.                                       The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

a)                                      designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b)                                     evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.                                       The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a)                                      all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     any fraud, whetheror not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.                                       The registrant’sother certifying officer and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

 
| Dated:  February 13, 2003 | By     |   | /s/ Dennis Ward                      |   |
|-------------------------------------|--------|--------|--------------------------------------|--------|
|                                |   |   | Dennis Ward  Chief Financial Officer |

 

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CHIEF EXECUTIVE OFFICERCERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350

 

In connection with the Quarterly Report of K-tel International, Inc.(the “Company”) on Form 10-Q for the quarterly period ended December 31, 2002,as filed with the Securities and Exchange Commission on the date hereof (the“Report”), I, Philip Kives, President and Chief Executive Officer of theCompany, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002, that:

 

1.                                       the Report fullycomplies with the requirements of Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934; and

 

2.                                       the informationcontained in the Report fairly presents, in all material respects, thefinancial condition and results of operations of the Company.

 

 
| Dated:  February 13, 2003 | By     |   | /s/ Philip Kives                                    |   |
|-------------------------------------|--------|--------|-----------------------------------------------------|--------|
|                                |   |   | Philip Kives  President and Chief Executive Officer |

 

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CHIEF FINANCIAL OFFICERCERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350

 

 

In connection with the Quarterly Report of K-tel International, Inc.(the “Company”) on Form 10-Q for the quarterly period ended December 31, 2002,as filed with the Securities and Exchange Commission on the date hereof (the“Report”), I, Dennis Ward, Chief Financial Officer of the Company, certify,pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002, that:

 

1.                                       the Report fullycomplies with the requirements of Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934; and

 

2.                                       the informationcontained in the Report fairly presents, in all material respects, thefinancial condition and results of operations of the Company.

 

 
| Dated:  February 13, 2003 | By     |   | /s/ Dennis Ward                      |   |
|-------------------------------------|--------|--------|--------------------------------------|--------|
|                                |   |   | Dennis Ward  Chief Financial Officer |

 

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