##### **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 March 31, 2004**                                                                                                                                                                                                            |
|                                       |
| **or**                                     |
|                                       |
| o                                          | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                |
|                                       |
|                                       | **For the transition period from                      to                    ** |
|                                       |
| **Commission  File Number:  1-07115** |

 

**K-TELINTERNATIONAL, INC.**

(Exact name of registrant as specified in itscharter)

 

| **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 by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes ý     No o

 

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

 

Yes o     No ý

 

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

 

 

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

**FORM10-Q**

 

**FORTHE THREE AND NINE MONTH PERIODS**

**ENDEDMARCH 31, 2004**

 

INDEX

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

 

**Important FactorsRelating to Forward Looking Statements**

 

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

 

2

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

**CONDENSEDCONSOLIDATED BALANCE SHEETS -UNAUDITED**

*(in thousands*)

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

 

The accompanying notes are an integral partof these financial statements.

 

3

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

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS- UNAUDITED**

*(in thousands - except per share data)*

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

 

The accompanying notes are an integral partof these financial statements.

 

4

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

##### **CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS- UNAUDITED**

*(in thousands)*

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

 

The accompanying notes are an integral partof these financial statements.

 

5

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

 

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**1.****             BUSINESS ANDLIQUIDITY**

 

K-tel International, Inc. (the “Company” or “K-tel”) was incorporatedin 1968 and currently has its corporate offices located in Plymouth, Minnesota.Through its operating subsidiaries, K-tel licenses its music cataloginternationally and markets entertainment products mainly derived from itscatalog through retail and direct response marketing channels in the UnitedStates and Europe. The Company has a focused method of distribution thattargets the strengths of selected individual retailers and supplies productssuited to each retailer’s needs. These products are derived mainly from theCompany’s master recordings music catalog with the objective of realizing morecompetitive profit margins. K-tel seeks to license its trademarks to othercompanies in businesses unrelated to K-tel’s current operations. Licenses aregranted for a royalty or fee, with no cost to the Company. The Company haslicensed certain marks to K-tel Drug Mart Ltd., a Canadian direct marketer ofprescription drugs beneficially owned by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel.  K-tel is merely a licensor of its mark toK-tel Drug Mart. To date, K-tel Drug Mart’s operations have not generated anysignificant 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,November 2000 and January 2001 respectively. Accordingly, theseactivities have been presented in the accompanying financial statements asdiscontinued operations. The accompanying condensed consolidated financialstatements have been prepared to reflect the consumer products division as adiscontinued operation. The net liabilities of discontinued operations atMarch 31, 2004 and 2003 and ongoing current expenses relate to legalmatters and completion of statutory reporting requirements for the formeroperations in Germany.

 

Going Concern

 

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

 

The Company’s ability to continue its present operations and implementfuture expansion plans successfully is contingent mainly upon its ability tomaintain its line of credit arrangements with K-5 Leisure Products, Inc. (SeeNote 3), increase its revenues and profit margins, and ultimately attain andsustain profitable operations. Without increased revenues and sustainedprofitability, the cash generated from the Company’s current operations willlikely be inadequate to fund operations and service its indebtedness on anongoing basis. Management is focusing its efforts on music licensing andlimited music distribution. However, there can be no assurance that the Companywill achieve profitable operations through these efforts. The financialstatements do not include any adjustments that might result from the outcome ofthese uncertainties.

 

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

 

Basis of Presentation - The accompanying condensedconsolidated unaudited financial statements have been prepared in accordancewith accounting principles generally accepted in the United States of America(“US GAAP”) for interim financial information and with the instructions to Form10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all ofthe information and footnotes required by US GAAP for complete financialstatements. In the opinion of management, all adjustments (consisting of normalrecurring adjustments) considered necessary for a fair presentation have beenincluded. Operating results for the three and nine month periods endedMarch 31, 2004 are not necessarily indicative of the results that may beexpected for the year as a whole. The unaudited condensed consolidated balancesheet for June 30, 2003 has been derived from audited consolidated

 

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, 2003.

 

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

 

Revenue Recognition – The Company derives itsrevenue mainly from two sources: the sale of music compilations (predominatelycompact discs) produced by the Company, and license revenue from the licensingof Company-owned masters. Revenue from music sales is recognized at the time ofshipment to the customer, while license revenue is recognized when payment isreceived from customers or when known amounts are receivable, as prior to thatdate collection is not considered probable. Most music sales are made with aright of return of unsold goods. Estimated reserves for returns are establishedby management based upon historical experience and product mix and are subjectto ongoing review and adjustment by the Company. These reserves are recorded atthe time of sale and are reflected as a reduction in revenues. The Company’sreserve for returns was $133,000 at March 31, 2004 and $213,000 atJune 30, 2003.

 

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

 

Inventories – Inventories, which consists offinished goods that include all direct product costs, are valued at the lowerof cost, determined on a first-in, first-out basis, 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. The unrealized portion of guarantees and advances is included in royaltyadvances in the accompanying consolidated balance sheets. Licenses are subjectto audit by licensors. When anticipated sales appear to be insufficient tofully recover the minimum guarantees or non-refundable advances, a provisionagainst current operations is made for anticipated losses.

 

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. Advertising expenses were$88,000 and $146,000 for the nine month periods ended March 31, 2004 and2003 respectively.

 

7

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Foreign Currency - The operations of foreignsubsidiaries 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 component of accumulatedother comprehensive income or loss.

 

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

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

 

Stock Option Exchange – On March 18,2003, a committee of the Company’s board of directors comprised solely ofindependent directors, approved a “Stock Option Exchange Program.” The Programprovided for a small number of optionees who were previously awarded options topurchase shares of common stock under the Company’s 1997 Stock Option Plan toexchange them voluntarily for options to purchase an equal number of sharesoutside the Company’s Stock Option Plan. Options to purchase an aggregate of2,137,939 shares of common stock, with a weighted average price per share of$5.95, were submitted for cancellation. Replacement options were proposed to beissued six months and one day after the date of cancellation of the existingoptions and were to be at an exercise price per share equal to the fair marketvalue of the Company’s common stock as quoted on the OTC Bulletin Board on thedate of grant and expire ten years after the date of grant. OnNovember 18, 2003, the replacement options were issued at a price pershare of $.08. There will be no compensation expense recognized as a result ofthis exchange.

 

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 taxrates. A valuation allowance equal to the aggregate amount of deferred taxassets is established when realization is not likely.

 

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

 

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

 

8

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

 

**3.****             LOANSPAYABLE TO AFFILIATE**

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc.(“K-5”), the Company’s largest shareholder controlled by Philip Kives, theChairman of the Board, President and Chief Executive Officer of K-tel. Underthe terms of the agreement (the “K-5 Facility”), K-5 has agreed to makeavailable up to $8,000,000 to K-tel on a revolving basis. The loan bearsinterest at a variable rate based upon the “base rate” of a nationallyrecognized lending institution (4.0% at March 31, 2004), expiresJuly 20, 2005, and is subordinated to the Foothill loan (see below). TheK-5 Facility contains the same covenants as the Foothill loan agreement. K-telhas pledged the stock of its foreign subsidiaries as collateral for the loan,and the loan carries a subordinated position to the Foothill loan on all otherassets of the Company. K-tel had outstanding balances of $7,156,000 and$7,282,000 as of March 31, 2004 and June 30, 2003 respectively underthe K-5 Facility. At March 31, 2004, K-tel obtained a waiver from K-5 forits non-compliance under the covenants, limitations and restrictions of thecredit 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 beenextended through July 20, 2005, provides for a $10,000,000 credit facilityconsisting of a $4,000,000 term loan due upon expiration, and a $6,000,000revolving facility under which borrowings are limited to a percent of eligiblereceivables. Borrowings under the facility bear interest at a variable ratebased on a “base rate” of a nationally recognized lending institution plus 1%(5.0% at March 31, 2004) and are collateralized by the assets of certainCompany subsidiaries in the United States, including accounts receivable,inventories, equipment, music library and general intangibles. The loanagreement contains certain financial and other covenants or restrictions,including the maintenance of a minimum shareholders’ equity by K-tel,limitations on capital expenditures, restrictions on music libraryacquisitions, limitations on other indebtedness and restrictions on dividendspaid by K-tel. As of March 31, 2004 and June 30, 2003, $4,000,000 wasoutstanding under the term loan and there were no borrowings under therevolving facility. At March 31, 2004, K-tel obtained a waiver from K-5for its non-compliance under the covenants, limitations and restrictions of thecredit 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 $125,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2.0% per annum over the baserate (a total of 6.0% at March 31, 2004) but are subject to a minimum of6.0% per annum. K-tel had outstanding balances of $94,000 and $233,000 as ofMarch 31, 2004 and June 30, 2003 respectively.

 

**4.****             COMMITMENTSAND CONTINGENCIES**

 

RTL Shopping S. A.

 

The Company has been named in a lawsuit filed in France brought byRTL9, a French cable TV station. The action seeks damages in the approximateamount of 20 million French Francs, or approximately $2.8 million. Initially,RTL9 was named as a defendant in a suit brought by a competitor of K-telMarketing Ltd. alleging that RTL9 ran a commercial for K-tel Marketing whichpresented a product under brand names alleged to infringe on the competitor’sown trademarks and also translated an English language script indicating thatthe product was “just like” or “as good as” others into “better than” inFrench, contrary to French law. The suit alleged trademark infringement, unfaircompetition, illicit comparative advertising and passing off. RTL9 then sued K-telMarketing on October 4, 2000, pursuant to an indemnification provision theparties had entered into. Subsequently, K-tel Marketing went into liquidationand RTL9 filed a suit in March 2000 against K-tel International, Inc.under its agreement to guarantee payment for the commercial time. On May 28,2001, RTL9 presented documents in court identifying K-tel International (USA),Inc. as a target of its claim. On September 3, 2001, the Company fileddocuments disputing the claim and advising the court of K-tel (USA)’s Chapter 7bankruptcy filing.

 

9

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

 

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

 

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

 

On April 30, 2001, Tristar also asserted a patent and trademark/trade-dress counterclaim against K-tel for allegedly passing off a 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, 2001severing this action from the Company’s action. This action is at an earlystage and no discovery or other actions have occurred.

 

#### **Other Litigation and Disputes**

 

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

 

Subsidiary’s Liquidation

 

In November 2000, the Company’s consumer products subsidiary inthe United Kingdom, K-tel Marketing Ltd., ceased operations and began voluntaryliquidation proceedings. At the initial meeting of the creditors onNovember 24, 2000, the creditors voted for the liquidation to become acreditors’ liquidation under English law. The Company has not been informed bythe liquidators or their counsel of any plan to attempt to hold it or any ofits subsidiaries 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. As the onlysecured creditor, the Company received a preliminary distribution ofapproximately $138,000 on March 1, 2004.

 

**5.****             BUSINESSSEGMENT AND GEOGRAPHIC AREA DATA**

 

The Company markets and distributes entertainment productsinternationally and through its operating subsidiaries. K-tel’s businesses areorganized, managed and internally reported as two segments: retail music salesand music licensing. These segments are based on differences in products,customer type and sales and distribution methods. The Company’s consumerproduct and e-commerce operations have been discontinued, are presented in theaccompanying financial statements as discontinued operations and are thereforenot included in the segment information.

 

The retail music segment consists primarily of the sales ofpre-recorded music both from the Company’s master music 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.

 

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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 the presentation.

 

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

 

BUSINESS SEGMENT INFORMATION

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

 

GEOGRAPHIC INFORMATION

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

 

11

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**ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSISOF 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.

 

Through a subsidiary, K-tel Entertainment, Inc., K-tel has a focusedmethod of distribution that targets the strengths of selected individualretailers and supplies products suited to each retailer’s specific needs. Theseproducts are primarily derived from the Company’s master recordings musiccatalog with the objective of realizing more competitive profit margins. Aswell, the Company seeks to license its name and marks to other businesses for aroyalty or fee.

 

#### **THREE MONTHS ENDEDMARCH 31, 2004 VERSUS MARCH 31, 2003**

 

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

 

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

 

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

 

#### **BUSINESS SEGMENTRESULTS**

 

#### **Music**

 

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

 

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

 

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

 

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

 

**Licensing**

 

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

 

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#### **NINE MONTHS ENDEDMARCH 31, 2004 VERSUS MARCH 31, 2003**

 

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

 

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

 

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

 

#### **BUSINESS SEGMENTRESULTS**

 

#### **Music**

 

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

 

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

 

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

 

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

 

**Licensing**

 

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

 

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

 

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

 

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

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc.(“K-5”), the Company’s largest shareholder controlled by Philip Kives, theChairman of the Board, President and Chief Executive Officer of K-tel. Underthe terms of the agreement (the “K-5 Facility”), K-5 has agreed to makeavailable up to $8,000,000 to K-tel on a revolving basis. The loan bearsinterest at a variable rate based upon the “base rate” of a nationallyrecognized lending institution (4.0% at March 31, 2004), expiresJuly 20, 2005, and is subordinated to the Foothill loan (see below). TheK-5 Facility contains the same covenants as the Foothill loan agreement. K-telhas pledged the stock of its foreign subsidiaries as collateral for the loan,and the loan carries a subordinated position to the Foothill loan on all otherassets of the Company. K-tel had outstanding balances of $7,156,000 and$7,282,000 as of March 31, 2004 and June 30, 2003 respectively underthe K-5 Facility. At March 31, 2004, K-tel obtained a waiver from K-5 forits non-compliance under the covenants, limitations and restrictions of thecredit 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 beenextended through July 20, 2005, provides for a $10,000,000 credit facilityconsisting of a $4,000,000 term loan due upon expiration, and a $6,000,000revolving facility under which borrowings are limited to a percent of eligiblereceivables. Borrowings under the facility bear interest at a variable ratebased on a “base rate” of a nationally recognized lending institution plus 1%(5.0% at March 31, 2004) and are collateralized by the assets of certainCompany subsidiaries in the United States, including accounts receivable,inventories, equipment, music library and general intangibles. The loanagreement contains certain financial and other covenants or restrictions,including the maintenance of a minimum shareholders’ equity by K-tel,limitations on capital expenditures, restrictions on music libraryacquisitions, limitations on other indebtedness and restrictions on dividendspaid by K-tel. As of March 31, 2004 and June 30, 2003, $4,000,000 wasoutstanding under the term loan and there were no borrowings under therevolving facility. At March 31, 2004, K-tel obtained a waiver from K-5for its non-compliance under the covenants, limitations and restrictions of thecredit 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 $125,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2.0% per annum over the baserate (a total of 6.0% at March 31, 2004) but are subject to a minimum of6.0% per annum. K-tel had outstanding balances of $94,000 and $233,000 as ofMarch 31, 2004 and June 30, 2003 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. Inpart, this is a result of improvement in operating results in fiscal 2003 aswell as the two existing lines of credit with K-5. Although K-5 continues toadvance funds sufficient to meet the Company’s needs at this time, there can beno assurance that this will be adequate or continue in the future or that K-telwill be able to obtain additional financing upon favorable terms when required.

 

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

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

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

 

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**ITEM4.  CONTROLS AND PROCEDURES**

 

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

 

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

 

**PART II**

 

#### **ITEM 1. LEGAL PROCEEDINGS**

 

RTL Shopping S. A.

 

The Company has been named in a lawsuit filed in France brought byRTL9, a French cable TV station. The action seeks damages in the approximateamount of 20 million French Francs, or approximately $2.8 million. Initially,RTL9 was named as a defendant in a suit brought by a competitor of K-telMarketing Ltd. alleging that RTL9 ran a commercial for K-tel Marketing whichpresented a product under brand names alleged to infringe on the competitor’sown trademarks and also translated an English language script indicating thatthe product was “just like” or “as good as” others into “better than” inFrench, contrary to French law. The suit alleged trademark infringement, unfaircompetition, illicit comparative advertising and passing off. RTL9 then suedK-tel Marketing on October 4, 2000, pursuant to an indemnification provisionthe parties had entered into. Subsequently, K-tel Marketing went intoliquidation and RTL9 filed a suit in March 2000 against K-telInternational, Inc. under its agreement to guarantee payment for the commercialtime. On May 28, 2001, RTL9 presented documents in court identifying K-telInternational (USA), Inc. as a target of its claim. On September 3, 2001,the Company filed documents disputing the claim and advising the court of K-tel(USA)’s Chapter 7 bankruptcy filing.

 

After the Company advised the Court that RTL9 had no basis for acomplaint against the Company, RTL9 proposed to drop their lawsuit. OnSeptember 23, 2003, RTL9 and the Company signed an agreement terminatingthe suit. The final disposition of the lawsuit will be confirmed by the Court ata trial hearing involving only the two remaining parties to the lawsuit. Atrial date has not been set by the Court.

 

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

 

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

 

On April 30, 2001, Tristar also asserted a patent and trademark/trade-dress counterclaim against K-tel for allegedly passing off a 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

 

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

 

#### **Other Litigation and Disputes**

 

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

 

Subsidiary’s Liquidation

 

In November 2000, the Company’s consumer products subsidiary inthe United Kingdom, K-tel Marketing Ltd., ceased operations and began voluntaryliquidation proceedings. At the initial meeting of the creditors onNovember 24, 2000, the creditors voted for the liquidation to become acreditors’ liquidation under English law. The Company has not been informed bythe liquidators or their counsel of any plan to attempt to hold it or any ofits subsidiaries 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. As the onlysecured creditor, the Company received a preliminary distribution ofapproximately $138,000 on March 1, 2004.

 

## **ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K**

 

(a)           EXHIBITS

 

See “Index to Exhibits.”

 

(b)           REPORTS ON FORM 8-K

 

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

 

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##### **SIGNATURES**

 

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

 

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

 

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**INDEX TO EXHIBITS**

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

 

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