**UNITED STATES****SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**(MarkOne)**

 

| **ý** |   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934**                                                                                                                                                                                                                                  |   |
|------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|       |   |                                                                                                                                                                                                                                                                                                                            |   |
|       |   | **For the quarterly period ended December 31, 2003**                                                                                                                                                                                                                                                                            |   |
|       |   |                                                                                                                                                                                                                                                                                                                            |   |
| **or**     |   |
|       |   |                                                                                                                                                                                                                                                                                                                            |   |
| **o**      |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934**                                                                                                                                                                                                                                 |   |
|       |   |                                                                                                                                                                                                                                                                                                                            |   |
|       |   | **For  the transition period from                        to                            ** |   |
|       |   |                                                                                                                                                                                                                                                                                                                            |   |
|       |   | **Commission File Number:  1-07115**                                                                                                                                                                                                                                                                                       |   |
|       |   |                                                                                                                                                                                                                                                                                                                            |   |
|       |   | **K-TEL  INTERNATIONAL, INC.**                                                                                                                                                                                                                                                                                                  |   |
|       |   | (Exact name of 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 by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.

 

Yes  ý           Noo

 

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

 

Yes  o           Noý

 

As of February 13, 2004, therewere 13,653,738 shares of the registrant’s common stock, par value $0.01 pershare, outstanding.

 

 

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

**FORM 10-Q**

 

**FOR THE THREE AND SIX MONTH PERIODS**

**ENDED DECEMBER 31, 2003**

 

INDEX

 
| PART I.            | Financial  Information (Unaudited): |                |
|--------------------|-------------------------------------|---------------------|
|               |                                |
|               |                                | Item 1.             | Financial  Statements |   |
|               |                                |
|               |                                |                | Condensed Consolidated Balance Sheets as of  December 31, 2003 and June 30, 2003 |   |
|               |                                |
|               |                                |                | Condensed Consolidated Statements of  Operations  for the Three and Six Month Periods Ended  December 31, 2003 and 2002 |   |
|               |                                |
|               |                                |                | Condensed Consolidated Statements of Cash  Flows  for the Six Month Periods Ended  December 31, 2003 and 2002 |   |
|               |                                |
|               |                                |                | 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 Factors Relating to Forward LookingStatements**

 

Certain statements of anon-historical nature under the caption “Management’s Discussion and Analysisof Financial Condition and Results of Operations” and elsewhere in this Form10-Q constitute “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 forrecorded music; the outcome of legal proceedings; dependence on suppliers anddistributors; the outcome of our subsidiaries’ bankruptcy and liquidation;success of marketing and promotion efforts; technological changes anddifficulties; availability of financing; foreign currency variations; generaleconomic, political and business conditions; and other matters. We undertake noobligation to release publicly the result of any revisions to theseforward-looking statements, except as required by law.

 

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

**CONDENSED CONSOLIDATED BALANCE SHEETS -UNAUDITED**

*(in thousands*)

 
|                                                                                                        |   | **December  31,  2003** |   | **June 30,  2003** |   |
|-------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|--------------------|--------|
|                                                                                                        |   |                    |   |               |   |
| ASSETS                                                                                                      |   |                    |   |               |   |
|                                                                                                        |   |                    |   |               |   |
| Current Assets:                                                                                             |   |                    |   |               |   |
| Cash and equivalents                                                                                        |   | $                       | 49     |               | $      | 1,219 |   |
| Accounts receivable, net of allowance for  doubtful  accounts of $27 and $25                           |   | 1,833                   |   | 1,559              |   |
| Inventories                                                                                                 |   | 588                     |   | 520                |   |
| Royalty advances                                                                                            |   | 243                     |   | 235                |   |
| Prepaid expenses and other                                                                                  |   | 511                     |   | 304                |   |
| Total Current Assets                                                                                        |   | 3,224                   |   | 3,837              |   |
|                                                                                                        |   |                    |   |               |   |
| Property and equipment, net of accumulated  depreciation and amortization of $1,466 and $1,506              |   | 103                     |   | 101                |   |
|                                                                                                        |   |                    |   |               |   |
| Owned catalog masters, net of accumulated  amortization of $2,852 and $2,755                                |   | 733                     |   | 819                |   |
|                                                                                                        |   |                    |   |               |   |
|                                                                                                        |   | $                       | 4,060  |               | $      | 4,757 |   |
|                                                                                                        |   |                    |   |               |   |
| LIABILITIES AND SHAREHOLDERS’ DEFICIT                                                                  |   |                    |   |               |   |
|                                                                                                        |   |                    |   |               |   |
| Current Liabilities:                                                                                        |   |                    |   |               |   |
| Notes payable to affiliate and other                                                                        |   | $                       | 11,198 |               | $      | 11,515 |   |
| Accounts payable                                                                                            |   | 974                     |   | 1,162              |   |
| Accrued royalties                                                                                           |   | 2,467                   |   | 2,333              |   |
| Reserve for returns                                                                                         |   | 204                     |   | 213                |   |
| Net liabilities of discontinued operations                                                                  |   | 118                     |   | 116                |   |
| Total Current Liabilities                                                                                   |   | 14,961                  |   | 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                                                                                         |   | (32,115                 | )      | (31,759            | )      |
| Accumulated other comprehensive loss                                                                        |   | (214                    | )      | (251               | )      |
| Total Shareholders’ Deficit                                                                            |   | (10,901                 | )      | (10,582            | )      |
|                                                                                                        |   |                    |   |               |   |
|                                                                                                        |   | $                       | 4,060  |               | $      | 4,757 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

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

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS - UNAUDITED**

*(in thousands -except per share data)*

 
|                                                                        |   | **Three  Months Ended  December 31,** |   | **Six Months  Ended  December 31,** |   |
|-----------------------------------------------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                                                        |   | **2003**                              |   | **2002**                            |   | **2003** |   | **2002** |   |
|                                                                        |   |                                  |   |                                |   |   |   |   |   |
| Net Sales                                                                   |   | $                                     | 1,759  |                                | $      | 1,874 |   | $ | 3,377 |   | $ | 3,372 |   |
|                                                                        |   |                                  |   |                                |   |   |   |   |   |
| Costs and Expenses:                                                         |   |                                  |   |                                |   |   |   |   |   |
| Cost of goods sold                                                          |   | 860                                   |   | 897                                 |   | 1,529 |   | 1,496 |   |
| Advertising                                                                 |   | 32                                    |   | 19                                  |   | 75 |   | 65 |   |
| Selling, general and administrative                                         |   | 954                                   |   | 959                                 |   | 1,820 |   | 1,910 |   |
| Total Costs and Expenses                                                    |   | 1,846                                 |   | 1,876                               |   | 3,424 |   | 3,472 |   |
| Operating Loss                                                              |   | (87                                   | )      | (2                                  | )      | (47 | ) | (100 | ) |
|                                                                        |   |                                  |   |                                |   |   |   |   |   |
| Other Expense:                                                              |   |                                  |   |                                |   |   |   |   |   |
| Interest expense                                                            |   | (120                                  | )      | (133                                | )      | (237 | ) | (269 | ) |
| Other                                                                       |   | —                                |   | (51                                 | )      | (11 | ) | (115 | ) |
| Total Other Expense                                                         |   | (120                                  | )      | (184                                | )      | (248 | ) | (384 | ) |
|                                                                        |   |                                  |   |                                |   |   |   |   |   |
| Loss from Continuing Operations                                             |   | (207                                  | )      | (186                                | )      | (295 | ) | (484 | ) |
|                                                                        |   |                                  |   |                                |   |   |   |   |   |
| Loss from Discontinued Operations                                           |   | (20                                   | )      | (204                                | )      | (61 | ) | (414 | ) |
|                                                                        |   |                                  |   |                                |   |   |   |   |   |
| Net Loss                                                                    |   | $                                     | (227   | )                                   | $      | (390 | ) | $ | (356 | ) | $ | (898 | ) |
|                                                                        |   |                                  |   |                                |   |   |   |   |   |
| Loss per Share – Basic and Diluted:                                    |   |                                  |   |                                |   |   |   |   |   |
| Continuing Operations                                                       |   | $                                     | (.02   | )                                   | $      | (.01 | ) | $ | (.02 | ) | $ | (.04 | ) |
| Discontinued Operations                                                     |   | —                                |   | (.02                                | )      | (.01 | ) | (.03 | ) |
| Net Loss                                                                    |   | $                                     | (.02   | )                                   | $      | (.03 | ) | $ | (.03 | ) | $ | (.07 | ) |
|                                                                        |   |                                  |   |                                |   |   |   |   |   |
| Shares used in the calculation of loss per  share  - Basic and Diluted |   | 13,654                                |   | 13,654                              |   | 13,654 |   | 13,654 |   |
|                                                                        |   |                                  |   |                                |   |   |   |   |   |
| Comprehensive Loss:                                                         |   |                                  |   |                                |   |   |   |   |   |
| Net loss                                                                    |   | $                                     | (227   | )                                   | $      | (390 | ) | $ | (356 | ) | $ | (898 | ) |
| Translation adjustment                                                      |   | —                                |   | 15                                  |   | 37 |   | (46 | ) |
| Comprehensive Loss                                                          |   | $                                     | (227   | )                                   | $      | (375 | ) | $ | (319 | ) | $ | (944 | ) |

 

The accompanying notes are an integral part of these financialstatements.

 

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

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS - UNAUDITED**

*(in thousands)*

 
|                                                                     |   | **Six Months  Ended  December 31,** |   |
|--------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                     |   | **2003**                            |   | **2002** |   |
| Cash flows  from Operating Activities:                                   |   |                                |   |   |   |
| Net loss                                                                 |   | $                                   | (356   | ) | $ | (898 | ) |
| Adjustments to reconcile net loss to cash  used in operating activities: |   |                                |   |   |   |
| Depreciation and amortization                                            |   | 132                                 |   | 172 |   |
| Other                                                                    |   | (5                                  | )      | (9 | ) |
| Changes in operating assets and liabilities:                             |   |                                |   |   |   |
| Accounts receivable, net                                                 |   | 68                                  |   | (378 | ) |
| Inventories                                                              |   | (54                                 | )      | 60 |   |
| Royalty advances                                                         |   | 8                                   |   | 32 |   |
| Prepaid expenses                                                         |   | (197                                | )      | (167 | ) |
| Accounts payable                                                         |   | (558                                | )      | 271 |   |
| Accrued royalties                                                        |   | 138                                 |   | 12 |   |
| Reserve for returns                                                      |   | (8                                  | )      | 122 |   |
| Income taxes, net                                                        |   | 24                                  |   | — |   |
| Cash used in operating activities                                        |   | (808                                | )      | (783 | ) |
|                                                                     |   |                                |   |   |   |
| Cash flows from Investing Activities:                                    |   |                                |   |   |   |
| Purchases of property and equipment                                      |   | (41                                 | )      | (13 | ) |
| Other                                                                    |   | (6                                  | )      | — |   |
| Cash used in investing activities                                        |   | (47                                 | )      | (13 | ) |
|                                                                     |   |                                |   |   |   |
| Cash flows from Financing Activities:                                    |   |                                |   |   |   |
| Borrowings on notes payable                                              |   | 1,483                               |   | 1,665 |   |
| Payments on notes payable                                                |   | (1,819                              | )      | (713 | ) |
| Cash provided by (used in) financing  activities                         |   | (336                                | )      | 952 |   |
|                                                                     |   |                                |   |   |   |
| Effect of exchange rates on cash                                         |   | 21                                  |   | (96 | ) |
|                                                                     |   |                                |   |   |   |
| Net increase (decrease) in cash and  equivalents                         |   | (1,170                              | )      | 60 |   |
|                                                                     |   |                                |   |   |   |
| Cash and equivalents at beginning of period                              |   | 1,219                               |   | 75 |   |
|                                                                     |   |                                |   |   |   |
| Cash and equivalents at end of period                                    |   | $                                   | 49     |   | $ | 135 |   |

 

The accompanying notes are an integral part of these financial statements.

 

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

 

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**1.             BUSINESS AND LIQUIDITY**

 

K-tel International, Inc. (the“Company” or “K-tel”) was incorporated in 1968 and currently has its corporateoffices 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 new products are derived mainly from theCompany’s master recordings music catalog with the objective of realizing morecompetitive profit margins. K-tel seeks to license its trademarks to othercompanies in businesses unrelated to K-tel’s current operations. Licenses aregranted for a royalty or fee, with no cost to the Company. The Company haslicensed certain marks to K-tel Drug Mart Ltd., a Canadian direct marketer ofprescription drugs beneficially owned by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel.  K-tel 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 productsbusiness, which was concentrated in Europe, consisted primarily of housewares,consumer convenience items and exercise equipment. The Company discontinued itsconsumer products operations in Germany, the United Kingdom and the UnitedStates in June 2000, November 2000 and January 2001 respectively. Accordingly,these activities have been presented in the accompanying financial statementsas discontinued operations. The accompanying condensed consolidated financialstatements have been prepared to reflect the consumer products division as adiscontinued operation. The net liabilities of discontinued operations atDecember 31, 2003 and 2002 consist of assets of $0 and $326,000 and liabilitiesof $118,000 and $404,000. The ongoing current expenses relate to legal mattersand completion of statutory reporting requirements for the former operations inGermany.

 

Going Concern

 

During the six months endedDecember 31, 2003 and 2002, the Company incurred net losses from continuingoperations of $295,000 and $484,000 respectively. Operating activities used$808,000 and $783,000 of cash during the six months ended December 31, 2003 and2002 respectively. Additionally, the Company had a working capital deficit of$11,737,000 at December 31, 2003.

 

The Company’s ability tocontinue its present operations and implement future expansion planssuccessfully is contingent mainly upon its ability to maintain its line ofcredit arrangements with K-5 Leisure Products, Inc. (See Note 3), increase itsrevenues and profit margins, 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 ofPresentation - The accompanying condensed consolidatedunaudited financial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“US GAAP”) forinterim financial information and with the instructions to Form 10-Q and Rule10-01 of Regulation S-X. Accordingly, they do not include all of the informationand footnotes required by US GAAP for complete financial statements. In theopinion of management, all adjustments (consisting of normal recurringadjustments) considered necessary for a fair presentation have been included.Operating results for the three and six month periods ended December 31, 2003are not necessarily indicative of the results that may be expected for the yearas a whole. The unaudited condensed consolidated balance sheet for June 30,2003 has been derived from audited consolidated

 

6

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financial statements as of thatdate. For further information, refer to the consolidated financial statementsand footnotes thereto included in the Company’s annual report on Form 10-K forthe year ended June 30, 2003.

 

Principles ofConsolidation - The accompanying condensedconsolidated 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.

 

RevenueRecognition – The Company derives its revenue mainlyfrom two sources: the sale of music compilations (predominately compact discs)produced by the Company, and license revenue from the licensing ofCompany-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 $204,000 at December 31, 2003 and $213,000 at June 30,2003.

 

Cost of GoodsSold – The Company expenses all product manufacturing,distribution and royalty costs associated with music sales as cost of goodssold. The Company also expenses royalties, commissions and amortization of itsowned master recordings associated with its license revenue as costs of goods sold.

 

Shipping andHandling Costs – The Company expenses within cost ofgoods sold all shipping and handling costs incurred in the shipment of goods.

 

Cash and CashEquivalents – Cash and cash equivalents consistprincipally of cash and short-term, highly liquid investments with originalmaturities 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 CatalogMasters – The Company capitalizes the costs topurchase owned master recordings at the time of acquisition. These costs areamortized over the estimated useful life of these master recordings, which isgenerally seven years, and represents management’s best estimate of the averageperiod of value.

 

Rights to UseMusic Product - Certain of the Company’s compilationproducts are master recordings under license from record companies andpublishers. In most instances, minimum guarantees or non-refundable advancesare required to obtain the licenses and are realized through future sales ofthe product. The amounts paid for minimum guarantees or non-refundable advancesare capitalized and charged to expense as sales are made. The unrealizedportion of guarantees and advances is included in royalty advances in theaccompanying consolidated balance sheets. Licenses are subject to audit bylicensors. When anticipated sales appear to be insufficient to fully recoverthe minimum guarantees or non-refundable advances, a provision against currentoperations is made for anticipated losses.

 

Property andEquipment - Property and equipment are stated at cost.Depreciation and amortization is provided using straight line or decliningbalance methods over the estimated useful lives of the assets, which range fromthree to nine years.

 

LongLived-Assets – The Company evaluates its long-livedassets quarterly, or earlier if a triggering event occurs, to determinepotential impairment by comparing the carrying value of those assets to therelated undiscounted future cash flows of the assets. If an asset is determinedto be impaired, it is written down to its estimated fair value.

 

Royalties- The Company has entered into license agreements with various record companiesand publishers under which it pays royalties on units sold. The Company accruesroyalties using contractual rates and certain estimated rates on applicableunits sold. The contractual royalty liability is computed quarterly and theaccrued royalty balance is adjusted accordingly. The royalty agreements aresubject to audit by licensors.

 

Advertising- The Company expenses the costs of advertising when the advertising takesplace. Advertising expenses were $75,000 and $65,000 for the six month periodsended December 31, 2003 and 2002 respectively.

 

7

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ForeignCurrency - The operations of foreign subsidiaries aremeasured in local currencies. Assets and liabilities are translated into U.S.dollars at period-end exchange rates. Revenues and expenses are translated atthe average exchange rates prevailing during the period. Adjustments resultingfrom translating the financial statements of foreign entities into U.S. dollarsare recorded as a component of accumulated other comprehensive income or loss.

 

Stock-basedCompensation – The Company accounts for stock-basedawards to employees using the intrinsic value method prescribed in APB No. 25,“Accounting for Stock Issued to Employees,” whereby the options are granted atmarket price, and therefore no compensation costs are recognized. The Companyhas elected to retain its current method of accounting as described above andhas adopted the SFAS Nos. 123 and 148 disclosure requirements. If compensationexpense for the Company’s various stock option plans had been determined basedupon the projected fair values at the grant dates for awards under those plansin accordance with SFAS No. 123, the Company’s pro-forma net earnings, basicand diluted earnings per common share would have been as follows:

 
|                     |   | **Three  Months Ended  December 31,** |   | **Six Months  Ended  December 31,** |   |
|--------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                     |   | **2003**                              |   | **2002**                            |   | **2003** |   | **2002** |   |
|                     |   |                                  |   |                                |   |   |   |   |   |
| Net Loss (in  thousands) |   |                                  |   |                                |   |   |   |   |   |
| As reported              |   | $                                     | (227   | )                                   | $      | (390 | ) | $ | (356 | ) | $ | (898 | ) |
| Pro forma                |   | $                                     | (334   | )                                   | $      | (405 | ) | $ | (463 | ) | $ | (913 | ) |
|                     |   |                                  |   |                                |   |   |   |   |   |
| Basic and Diluted EPS    |   |                                  |   |                                |   |   |   |   |   |
| As reported              |   | $                                     | (.02   | )                                   | $      | (.03 | ) | $ | (.03 | ) | $ | (.07 | ) |
| Pro forma                |   | $                                     | (.04   | )                                   | $      | (.03 | ) | $ | (.03 | ) | $ | (.07 | ) |

 

Stock OptionExchange – On March 18, 2003, a committee of theCompany’s board of directors comprised solely of independent directors,approved a “Stock Option Exchange Program.” The Program provides for a smallnumber of optionees who were previously awarded options to purchase shares ofcommon stock under the Company’s 1997 Stock Option Plan to exchange themvoluntarily for options to purchase an equal number of shares outside theCompany’s Stock Option Plan. Options to purchase an aggregate of 2,137,939shares of common stock, with a weighted average price per share of $5.95, were submittedfor cancellation. Replacement options were proposed to be issued six months andone day after the date of cancellation of the existing options and would be atan exercise price per share equal to the fair market value of the Company’scommon stock as quoted on the OTC Bulletin Board on the date of grant andexpire ten years after the date of grant. On November 18, 2003, thereplacements options were issued at a price per share of $.08. There will be nocompensation expense recognized as a result of this exchange.

 

Income Taxes- Deferred income taxes are provided for temporary differences between thefinancial reporting basis and tax basis of the Company’s assets and liabilitiesat currently enacted tax rates. A valuation allowance equal to the aggregateamount of deferred tax assets is established when realization is not likely.

 

Net Income(Loss) Per Share - Basic and diluted net income (loss)per share have been computed by dividing net income (loss) by the weightedaverage number of shares outstanding during the period. For all periodspresented, common stock equivalents were excluded from the per sharecalculation as the net effect would be antidilutive. For the six month periodsended December 31, 2003 and 2002, weighted average options to purchase 953,630and 2,332,395 shares of common stock, with weighted average exercise prices of$0.95 and $5.74 were excluded from the computation of common share equivalentsfor the respective periods as they were antidilutive. For the three monthperiods ended December 31, 2003 and 2002, weighted average options to purchase1,464,360 and 2,390,950 shares of common stock, with weighted average exerciseprices of $0.64 and $5.60 were excluded from the computation of common shareequivalents for the respective periods as they were antidilutive.

 

Use ofEstimates - Preparing consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America (US GAAP) requires management to make estimates andassumptions 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.

 

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**3.             LOANSPAYABLE TO AFFILIATE**

 

K-tel has a Line of CreditAgreement with K-5 Leisure Products, Inc. (“K-5”), the Company’s largestshareholder controlled by Philip Kives, the Chairman of the Board, Presidentand Chief Executive Officer of K-tel. Under the terms of the agreement (the“K-5 Facility”), K-5 has agreed to make available up to $8,000,000 to K-tel ona revolving basis. The loan bears interest at a variable rate based upon the“base rate” of a nationally recognized lending institution (4.0% at December31, 2003), expires July 20, 2005, and is subordinated to the Foothill loan (seebelow). The K-5 Facility contains the same covenants as the Foothill loanagreement. K-tel has pledged the stock of its foreign subsidiaries ascollateral for the loan, and the loan carries a subordinated position to theFoothill loan on all other assets of the Company. K-tel had outstandingbalances of $6,947,000 and $7,282,000 as of December 31, 2003 and June 30, 2003respectively under the K-5 Facility. At December 31, 2003, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

 

In addition, K-tel has a secondloan agreement with K-5, under which K-5 assumed rights and obligations under aloan from the Company’s former banker (Foothill Capital Corporation) pursuantto an Assignment and Acceptance Agreement dated February 27, 2001. ThisFoothill loan, which has been extended through July 20, 2005, provides for a$10,000,000 credit facility consisting of a $4,000,000 term loan due uponexpiration, and a $6,000,000 revolving facility under which borrowings arelimited to a percent of eligible receivables. Borrowings under the facilitybear interest at a variable rate based on a “base rate” of a nationallyrecognized lending institution plus 1% (5.0% at December 31, 2003) and arecollateralized by the assets of certain Company subsidiaries in the UnitedStates, including accounts receivable, inventories, equipment, music libraryand general intangibles. The loan agreement contains certain financial andother covenants or restrictions, including the maintenance of a minimumshareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of December 31, 2003 and June30, 2003, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At December 31, 2003, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

 

K-tel has an overdraftprivilege borrowing facility with The Royal Bank of Scotland in the UnitedKingdom. This facility is secured by a standby letter of credit for $260,000provided by K-tel International Ltd., a Canadian company controlled by PhilipKives and is payable on demand in accordance with normal banking practices.Borrowings bear interest of 2.0% per annum over the base rate (a total of 5.75%at December 31, 2003) but are subject to a minimum of 6.0% per annum. K-tel hadoutstanding balances of $234,000 and $233,000 as of December 31, 2003 and June30, 2003 respectively.

 

**4.             COMMITMENTSAND CONTINGENCIES**

 

RTL Shopping S. A.

 

The Company has been named in alawsuit filed in France brought by RTL9, a French cable TV station. The actionseeks damages in the approximate amount of 20 million French Francs, orapproximately $2.8 million. Initially, RTL9 was named as a defendant in a suitbrought 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 theclaim and advising the court of K-tel (USA)’s Chapter 7 bankruptcy filing.

 

After the Company advised theCourt that RTL9 had no basis for a complaint against the Company, RTL9 proposedto drop their lawsuit. On September 23, 2003, RTL9 and the Company signed anagreement terminating the suit. The final disposition of the lawsuit will beconfirmed by the Court at a trial hearing. A date has not been set by theCourt.

 

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K-telInternational, Inc. vs. Tristar Products, Inc.

 

On March 14, 2000, K-tel andits subsidiary in Germany commenced an action for breach of express and impliedwarranties against Defendant Tristar Products, Inc. This action is venued inthe United States District Court for the District of Minnesota. This actionarises out of Tristar’s sale to K-tel of a defective home exercise productcalled the “BunBlaster” for resale in Germany, Austria and Switzerland. Bywritten contract, Tristar has agreed to indemnify K-tel for injuries anddamages arising out of the resale of those goods. K-tel is seekingapproximately $2 million in consequential damages. Tristar is vigorouslydefending this claim. Discovery has been completed. Tristar filed a Motion forSummary Judgment, to which the Company filed a Memorandum in Opposition. Thismotion was heard in U.S. District Court in Minneapolis on August 25, 2003. TheCourt issued its order denying the motion on January 29, 2004. The parties arenow waiting for a trial date to be set by the Court.

 

On April 30, 2001, Tristar alsoasserted a patent and trademark/ trade-dress counterclaim against K-tel forallegedly passing off a product called the “K-tel Hook and Hang” whileallegedly a distributor of the original patented Tristar Hook and Hang product.The Company denies the allegation because it never was a distributor of this orany similar product and intends to defend this action vigorously. Tristar hasnot identified the amount of damages it seeks with respect to thiscounterclaim. The United States District Court for the District of Minnesotaissued an order on August 14, 2001 severing this action from the Company’saction. This action is at an early stage and no discovery or other actions haveoccurred.

 

OtherLitigation and Disputes

 

K-tel and its subsidiaries arealso involved in other legal actions in the ordinary course of their business.With all litigation matters, management considers the likelihood of loss basedon the facts and circumstances. If management determines that a loss isprobable and the amount of loss can be reasonably estimated, such amount isrecorded as a liability. Although the outcome of any such legal actions cannotbe predicted, in the opinion of management there is currently no legalproceeding pending or asserted against or involving K-tel for which the outcomeis likely to have a material adverse effect upon the consolidated financialposition or results of operations of K-tel.

 

Subsidiaries’Bankruptcy and Liquidation

 

In March 2001, the Company’smusic distribution subsidiary in the United States, K-tel International (USA),Inc. ceased operations and filed for protection under Chapter 7 of the UnitedStates Bankruptcy Code. Pursuant to an agreement between the bankruptcy trusteeand K-5 Leisure Products, Inc. (K-tel’s secured creditor and controllingshareholder) entered into on March 3, 2003, the trustee released K-5 LeisureProducts, Inc., K-tel and its subsidiaries and affiliates from any claims andactions with respect to the bankruptcy filing. The trustee filed a LimitedNotice of Abandonment relative to K-5’s security interest in K-tel’s assets.The Bankruptcy Court approved the abandonment as of June 13, 2003.

 

In November 2000, the Company’sconsumer products subsidiary in the United Kingdom, K-tel Marketing Ltd.,ceased operations and began voluntary liquidation proceedings. At the initialmeeting of the creditors on November 24, 2000, the creditors voted for theliquidation to become a creditors’ liquidation under English law. The Companyhas not been informed by the liquidators or their counsel of any plan toattempt to hold it or any of its subsidiaries liable for any of the commitmentsof K-tel Marketing Ltd. Management believes the Company will have no ongoingmaterial liability related to K-tel Marketing Ltd. as a result of theliquidation proceeding.

 

**5.             BUSINESSSEGMENT AND GEOGRAPHIC AREA DATA**

 

The Company markets anddistributes entertainment products internationally and through its operatingsubsidiaries. K-tel’s businesses are organized, managed and internally reportedas two segments: retail music sales and music licensing. These segments arebased on differences in products, customer type and sales and distributionmethods. The Company’s consumer product and e-commerce operations have beendiscontinued, are presented in the accompanying financial statements as discontinuedoperations and are therefore not included in the segment information.

 

The retail music segmentconsists primarily of the sales of pre-recorded music both from the Company’smaster music catalog and under licenses obtained from other record companies.The Company sells compact discs and

 

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DVD’s directly to retailers,wholesalers and rack service distributors which stock and manage inventorywithin music departments for retail stores.

 

In the licensing segment, theCompany licenses the rights to its master music catalog, consisting of originalrecordings and re-recordings of music from the 1950’s through today, to thirdparties world-wide for use in albums, films, television programs, andcommercials for either a flat fee or a royalty based on the number of unitssold.

 

Operating profits or losses ofthese segments include an allocation of general corporate expenses.Depreciation and amortization and capital additions are not significant andhave therefore been excluded from the presentation.

 

Certain financial informationon the Company’s continuing operating segments is as follows:

 

BUSINESS SEGMENT INFORMATION

 
| **(in  thousands)**              |   | **Music** |       | **Licensing** |       | **Other** |       | **Corporate  Elimination** |       | **Total  Company** |       |
|----------------------------------|--------|-----------|------------|---------------|------------|-----------|------------|----------------------------|------------|--------------------|------------|
|                             |   |      | ** ** |          | ** ** |      | ** ** |                       | ** ** |               | ** ** |
| Six Months  Ended December 31,   |   |      |       |          |       |      |       |                       |       |               |       |   |
|                             |   |      |       |          |       |      |       |                       |       |               |       |   |
| Net Sales                        | 2003   |      | $          | 2,497         |       | $         | 880        |                       | $          | —             |       | $ | — |   | $ | 3,377 |   |
|                             | 2002   |      | 2,184      |          | 1,188      |      | —     |                       | —     |               | 3,372      |   |
|                             |   |      |       |          |       |      |       |                       |       |               |       |   |
| Operating Income (Loss)          | 2003   |      | $          | (146          | )          | $         | 99         |                       | $          | —             |       | — |   | $ | (47 | ) |
|                             | 2002   |      | (400       | )             | 300        |      | —     |                       | —     |               | (100       | ) |
|                             |   |      |       |          |       |      |       |                       |       |               |       |   |
| Assets                           | 2003   |      | $          | 3,080         |       | $         | 783        |                       | $          | 197                |       | $ | — |   | $ | 4,060 |   |
|                             | 2002   |      | 2,944      |          | 1,229      |      | 510        |                       | —     |               | 4,683      |   |
|                             |   |      |       |          |       |      |       |                       |       |               |       |   |
| Three Months  Ended December 31, |   |      |       |          |       |      |       |                       |       |               |       |   |
|                             |   |      |       |          |       |      |       |                       |       |               |       |   |
| Net Sales                        | 2003   |      | $          | 1,398         |       | $         | 361        |                       | $          | —             |       | $ | — |   | $ | 1,759 |   |
|                             | 2002   |      | 1,241      |          | 633        |      | —     |                       | —     |               | 1,874      |   |
|                             |   |      |       |          |       |      |       |                       |       |               |       |   |
| Operating Income (Loss)          | 2003   |      | $          | (39           | )          | $         | (48        | )                          | $          | —             |       | $ | — |   | $ | (87 | ) |
|                             | 2002   |      | (233       | )             | 231        |      | —     |                       | —     |               | (2         | ) |

 

GEOGRAPHIC INFORMATION

 
| **(in thousands)**                    |   | **United States** |   | **Europe** |   | **Total** |   |
|---------------------------------------|--------|-------------------|--------|------------|--------|-----------|--------|
|                                  |   |              |   |       |   |      |   |
| Six Months  Ended  December 31,  |   |              |   |       |   |      |   |
|                                  |   |              |   |       |   |      |   |
| Net Sales                             | 2003   |              | $      | 2,022      |   | $         | 1,355  |   | $ | 3,377 |   |
|                                  | 2002   |              | 2,080  |       | 1,292  |      | 3,372  |   |
|                                  |   |              |   |       |   |      |   |   |
| Assets                                | 2003   |              | $      | 2,660      |   | $         | 1,400  |   | $ | 4,060 |   |
|                                  | 2002   |              | 3,177  |       | 1,506  |      | 4,683  |   |
|                                  |   |              |   |       |   |      |   |   |
| Three Months Ended  December 31, |   |              |   |       |   |      |   |   |
|                                  |   |              |   |       |   |      |   |   |
| Net Sales                             | 2003   |              | $      | 1,058      |   | $         | 701    |   | $ | 1,759 |   |
|                                  | 2002   |              | 1,100  |       | 774    |      | 1,874  |   |

 

**6.             NEW ACCOUNTING PRONOUNCEMENTS**

 

In January 2003, the FinancialAccounting Standards Board (FASB) issued FASB 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 in the first fiscal year or interim period beginning afterDecember 15, 2003, to variable interest entities in which an enterprise holds avariable interest that is acquired before February 1, 2003. This pronouncementis not anticipated to have a material effect on the Company’s consolidatedfinancial position or results of operations.

 

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**ITEM2: MANAGEMENT’S****DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**General**

 

Through its operating subsidiaries,K-tel licenses its music catalog internationally and markets entertainmentproducts mainly derived from its catalog in the United States and Europethrough retail and direct response marketing channels.

 

For this analysis, thefollowing changes in the Company’s business should be considered: K-tel closedthe operations of its German subsidiary, Dominion Vertriebs GmbH, in June 2000;one of its subsidiaries in the United Kingdom, K-tel Marketing Ltd., inNovember 2000; and a United States subsidiary, K-tel Consumer Products, Inc.,in February 2001. These three closings represent the discontinuation of theCompany’s consumer products division and accordingly have been presented in theaccompanying financial statements as discontinued operations. In addition, inMarch 2001, the Company’s music distribution subsidiary in the United States,K-tel (USA) ceased operations and filed for protection under Chapter 7 of theUnited States Bankruptcy Code.

 

Through another subsidiary,K-tel Entertainment, Inc., K-tel has a focused method of distribution thattargets the strengths of selected individual retailers and supplies productssuited to each retailer’s specific needs. These new products are primarilyderived from the Company’s master recordings music catalog with the objectiveof realizing more competitive profit margins. As well, the Company seeks tolicense its name and marks to other businesses for a royalty or fee.

 

**THREE MONTHS ENDED DECEMBER 31, 2003 VERSUSDECEMBER 31, 2002**

 

Net sales for the three month periodended December 31, 2003 were $1,759,000 a decrease of 6.1% from net sales of$1,874,000 for the three month period ended December 31, 2002. This decreasewas attributed to decreased licensing revenue partially offset by an increasein music sales. The net loss for the three month period ended December 31, 2003was $227,000, or $.02 per share, compared to a net loss of $390,000, or $.03per share, for the three month period ended December 31, 2002.

 

General corporate expenses of$237,000 and $338,000 for the three month periods ended December 31, 2003 and2002 respectively have been allocated to the segments.

 

The following sections discussthe results of continuing operations by business segment.

 

**BUSINESSSEGMENT RESULTS**

 

**Music**

 

Sales in the music segment were$1,398,000 for the three month period ended December 31, 2003 compared to$1,241,000 for the three month period ended December 31, 2002, an increase of$157,000, or 12.7%. The overall increase was primarily due to an increase inmusic DVD sales.

 

Cost of goods sold in the musicsegment decreased to 55.7% of sales for the three month period ended December31, 2003 compared to 64.7% of sales for the three month period ended December31, 2002 reflecting cost containment on new product offerings. Advertisingexpenses within the segment, which consists primarily of co-operativeadvertising payments, trade advertising and promotions, decreased to $37,000for the three month period ended December 31, 2003 compared to $39,000 for thethree month period ended December 31, 2002.

 

Selling, general andadministrative expenses were $627,000, or 44.8% of sales for the three monthperiod ended December 31, 2003 compared to $700,000, or 56.4% of sales for thethree month period ended December 31, 2002. The primary reason for the decreasewas the discontinuation of unprofitable product lines in England along with thecontinued staff and cost reductions in the U.S. and English operations. As aresult, the music segment incurred an operating loss of $39,000 for the threemonth period ended December 31, 2003 compared to an operating loss of $233,000for the three month period ended December 31, 2002.

 

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**Licensing**

 

Licensing revenue was $361,000for the three month period ended December 31, 2003 compared to $633,000 for thethree month period ended December 31, 2002, a decrease of 43.0% reflectingreduced licensing activity. As a result, the licensing segment incurred anoperating loss of $48,000 for the three month period ended December 31, 2003compared to operating income of $231,000 for the three month period endedDecember 31, 2002, a decrease of 120.8%.

 

**SIX MONTHS ENDED DECEMBER 31, 2003 VERSUSDECEMBER 31, 2002**

 

Net sales for the six monthperiod ended December 31, 2003 were $3,377,000 a marginal increase from netsales of $3,372,000 for the six month period ended December 31, 2002. Thisincrease was attributed to increased music sales offset by a decrease inlicensing revenue. The net loss for the six month period ended December 31,2003 was $356,000, or $.03 per share, compared to a net loss of $898,000, or$.07 per share, for the six month period ended December 31, 2002.

 

General corporate expenses of$449,000 and $452,000 for the six month periods ended December 31, 2003 and2002 respectively have been allocated to the segments.

 

The following sections discussthe results of continuing operations by business segment.

 

**BUSINESSSEGMENT RESULTS**

 

**Music**

 

Sales in the music segment were$2,497,000 for the six month period ended December 31, 2003 compared to$2,184,000 for the six month period ended December 31, 2002, an increase of$313,000, or 14.3%. Domestic sales of CD and DVD music products accounted forthis increase. K-tel anticipates continuing increased sales of music-relatedDVD products by exploiting its owned and licensed master recordings.

 

Cost of goods sold in the musicsegment decreased to 54.8% of sales for the six month period ended December 31,2003 compared to 57.8% of sales for the six month period ended December 31,2002 reflecting cost containment efforts in the English operations. Advertisingexpenses within the segment, which consists primarily of co-operativeadvertising payments, trade advertising and promotions, decreased to $60,000for the six month period ended December 31, 2003 compared to $85,000 for thesix month period ended December 31, 2002.

 

Selling, general andadministrative expenses were $1,199,000, or 48.0% of sales for the six monthperiod ended December 31, 2003 compared to $1,302,000, or 59.9% of sales forthe six month period ended December 31, 2002. The primary reason for thedecrease was the discontinuation of unprofitable product lines in England alongwith continued staff and cost reductions in the U.S. and England.

 

As a result, the music segmentincurred an operating loss of $146,000 for the six month period ended December31, 2003 compared to an operating loss of $400,000 for the six month periodended December 31, 2002.

 

**Licensing**

 

Licensing revenue was $880,000for the six month period ended December 31, 2003 compared to $1,188,000 for thesix month period ended December 31, 2002, a decrease of 25.9% reflectingreduced domestic licensing activity that was partially offset by increasedlicensing in England. The Company is concentrating its efforts on buildinglicensing arrangements in several other segments of the entertainment industry.

 

Royalty costs within thesegment decreased to $160,000 for the six month period ended December 31, 2003compared to $237,000 for the six month period ended December 31, 2002 primarilybecause of the decrease in licensing revenue.

 

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Selling, general andadministrative expenses decreased to $432,000 for the six month period endedDecember 31, 2003 compared to $541,000 for the six month period ended December31, 2002, a decrease of 20.1% reflecting audit costs incurred in the previousperiod and reduced amortization expense of owned master recordings as themasters became fully amortized.

 

Operating income in thelicensing segment was $99,000 for the six month period ended December 31, 2003compared to $300,000 for the six month period ended December 31, 2002, adecrease of 67.0%.

 

**NewAccounting Pronouncements**

 

In January 2003, the FinancialAccounting Standards Board (FASB) issued FASB 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 in the first fiscal year or interim period beginning afterDecember 15, 2003, to variable interest entities in which an enterprise holds avariable interest that is acquired before February 1, 2003. This pronouncementis not anticipated to have a material effect on the Company’s consolidatedfinancial position or results of operations.

 

**B. LIQUIDITY AND CAPITAL RESOURCES**

 

K-tel has a Line of CreditAgreement with K-5 Leisure Products, Inc. (“K-5”), the Company’s largestshareholder controlled by Philip Kives, the Chairman of the Board, Presidentand Chief Executive Officer of K-tel. Under the terms of the agreement (the“K-5 Facility”), K-5 has agreed to make available up to $8,000,000 to K-tel ona revolving basis. The loan bears interest at a variable rate based upon the“base rate” of a nationally recognized lending institution (4.0% at December31, 2003), expires July 20, 2005, and is subordinated to the Foothill loan (seebelow). The K-5 Facility contains the same covenants as the Foothill loanagreement. K-tel has pledged the stock of its foreign subsidiaries ascollateral for the loan, and the loan carries a subordinated position to theFoothill loan on all other assets of the Company. K-tel had outstandingbalances of $6,947,000 and $7,282,000 as of December 31, 2003 and June 30, 2003respectively under the K-5 Facility. At December 31, 2003, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

 

In addition, K-tel has a secondloan agreement with K-5, under which K-5 assumed rights and obligations under aloan from the Company’s former banker (Foothill Capital Corporation) pursuantto an Assignment and Acceptance Agreement dated February 27, 2001. ThisFoothill loan, which has been extended through July 20, 2005, provides for a$10,000,000 credit facility consisting of a $4,000,000 term loan due uponexpiration, and a $6,000,000 revolving facility under which borrowings arelimited to a percent of eligible receivables. Borrowings under the facilitybear interest at a variable rate based on a “base rate” of a nationallyrecognized lending institution plus 1% (5.0% at December 31, 2003) and arecollateralized by the assets of certain Company subsidiaries in the UnitedStates, including accounts receivable, inventories, equipment, music libraryand general intangibles. The loan agreement contains certain financial andother covenants or restrictions, including the maintenance of a minimumshareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of December 31, 2003 and June30, 2003, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At December 31, 2003, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

 

K-tel has an overdraftprivilege borrowing facility with The Royal Bank of Scotland in the UnitedKingdom. This facility is secured by a standby letter of credit for $260,000provided by K-tel International Ltd., a Canadian company controlled by PhilipKives and is payable on demand in accordance with normal banking practices.Borrowings bear interest of 2.0% per annum over the base rate (a total of 5.75%at December 31, 2003) but are subject to a minimum of 6.0% per annum. K-tel hadoutstanding balances of $234,000 and $233,000 as of December 31, 2003 and June30, 2003 respectively.

 

K-tel has primarily funded itsoperations to date through internally generated capital, proceeds from stockoption exercises and secured loans from K-5. Management currently believes thatK-tel has sufficient cash and borrowing capacity to ensure the Company willcontinue operations in the near term. In part, this is a result of improvementin operating results in fiscal 2003 as well as the two existing lines of creditwith K-5. Although K-5 continues to advance funds sufficient to meet theCompany’s needs at this time, there can be no assurance that this will be

 

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adequate or continue in thefuture or that K-tel will be able to obtain additional financing upon favorableterms when required.

 

The Company’s ability tocontinue its present operations and implement future expansion planssuccessfully is contingent mainly upon its ability to maintain its line ofcredit arrangements with K-5, increase its revenues and profit margins, andultimately attain and sustain profitable operations. Without increased revenuesand sustained profitability, the cash generated from the Company’s currentoperations will likely be inadequate to fund operations and service itsindebtedness on an ongoing basis. Management is focusing its efforts on musiclicensing and limited music distribution. However, there can be no assurancethat the Company will achieve profitable operations through these efforts. In theevent the Company is unable to fund its operations and implement its currentbusiness plan properly, it may be unable to continue operations. The financialstatements do not include any adjustments that might result from the outcome ofthese uncertainties.

 

**ITEM3.  QUANTITATIVE****ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

There have been no materialchanges in the Company’s market risk during the six month period ended December31, 2003. For additional information, refer to page 15 of the Company’s annualreport on Form 10-K for the fiscal year ended June 30, 2003.

 

**ITEM4.  CONTROLS AND****PROCEDURES**

 

Under the supervision and withthe participation of the Company’s management, including the Company’s ChiefExecutive Officer and 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 Financial Officerconcluded 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 mostrecent fiscal quarter, there has been no change in the Company’s internalcontrol over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f)under the Exchange Act) that has materially affected, or is reasonably likelyto materially 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 alawsuit filed in France brought by RTL9, a French cable TV station. The actionseeks damages in the approximate amount of 20 million French Francs, orapproximately $2.8 million. Initially, RTL9 was named as a defendant in a suitbrought 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 to guaranteepayment for the commercial time. On May 28, 2001, RTL9 presented documents incourt identifying K-tel International (USA), Inc. as a target of its claim. OnSeptember 3, 2001, the Company filed documents disputing the claim and advisingthe court of K-tel (USA)’s Chapter 7 bankruptcy filing.

 

After the Company advised theCourt that RTL9 had no basis for a complaint against the Company, RTL9 proposedto drop their lawsuit. On September 23, 2003, RTL9 and the Company signed anagreement terminating the suit. The final disposition of the lawsuit will beconfirmed by the Court at a trial hearing. A date has not been set by theCourt.

 

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K-telInternational, Inc. vs. Tristar Products, Inc.

 

On March 14, 2000, K-tel andits subsidiary in Germany commenced an action for breach of express and impliedwarranties against Defendant Tristar Products, Inc. This action is venued inthe United States District Court for the District of Minnesota. This actionarises out of Tristar’s sale to K-tel of a defective home exercise productcalled the “BunBlaster” for resale in Germany, Austria and Switzerland. Bywritten contract, Tristar has agreed to indemnify K-tel for injuries anddamages arising out of the resale of those goods. K-tel is seekingapproximately $2 million in consequential damages. Tristar is vigorouslydefending this claim. Discovery has been completed. Tristar filed a Motion forSummary Judgment, to which the Company filed a Memorandum in Opposition. Thismotion was heard in U.S. District Court in Minneapolis on August 25, 2003. TheCourt issued its order denying the motion on January 29, 2004. The parties arenow waiting for a trial date to be set by the Court.

 

On April 30, 2001, Tristar alsoasserted a patent and trademark/ trade-dress counterclaim against K-tel forallegedly passing off a product called the “K-tel Hook and Hang” whileallegedly a distributor of the original patented Tristar Hook and Hang product.The Company denies the allegation because it never was a distributor of this orany similar product and intends to defend this action vigorously. Tristar hasnot identified the amount of damages it seeks with respect to thiscounterclaim. The United States District Court for the District of Minnesotaissued an order on August 14, 2001 severing this action from the Company’saction. This action is at an early stage and no discovery or other actions haveoccurred.

 

OtherLitigation and Disputes

 

K-tel and its subsidiaries arealso involved in other legal actions in the ordinary course of their business.With all litigation matters, management considers the likelihood of loss basedon the facts and circumstances. If management determines that a loss isprobable and the amount of loss can be reasonably estimated, such amount isrecorded as a liability. Although the outcome of any such legal actions cannotbe predicted, in the opinion of management there is currently no legalproceeding pending or asserted against or involving K-tel for which the outcomeis likely to have a material adverse effect upon the consolidated financialposition or results of operations of K-tel.

 

Subsidiaries’Bankruptcy and Liquidation

 

In March 2001, the Company’smusic distribution subsidiary in the United States, K-tel International (USA),Inc. ceased operations and filed for protection under Chapter 7 of the UnitedStates Bankruptcy Code. Pursuant to an agreement between the bankruptcy trusteeand K-5 Leisure Products, Inc. (K-tel’s secured creditor and controlling shareholder)entered into on March 3, 2003, the trustee released K-5 Leisure Products, Inc.,K-tel and its subsidiaries and affiliates from any claims and actions withrespect to the bankruptcy filing. The trustee filed a Limited Notice ofAbandonment relative to K-5’s security interest in K-tel’s assets. TheBankruptcy Court approved the abandonment as of June 13, 2003.

 

In November 2000, the Company’sconsumer products subsidiary in the United Kingdom, K-tel Marketing Ltd.,ceased operations and began voluntary liquidation proceedings. At the initialmeeting of the creditors on November 24, 2000, the creditors voted for theliquidation to become a creditors’ liquidation under English law. The Companyhas not been informed by the liquidators or their counsel of any plan toattempt to hold it or any of its subsidiaries liable for any of the commitmentsof K-tel Marketing Ltd. Management believes the Company will have no ongoingmaterial liability related to K-tel Marketing Ltd. as a result of theliquidation proceeding.

 

**ITEM 6. ****EXHIBITSAND 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 the three month period  ended December 31, 2003. |

 

 

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**SIGNATURES**

 

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

 

 
|                      | K-TEL  INTERNATIONAL, INC.            |   |
|---------------------------|---------------------------------------|--------|
|                      | REGISTRANT                            |
|                      |                                  |
|                      |                                  |
| Dated:  February 13, 2004 | /S/ PHILIP  KIVES                     |   |
|                      | PHILIP KIVES                          |
|                      | CHAIRMAN AND  CHIEF EXECUTIVE OFFICER |
|                      |                                  |
|                      |                                  |
| Dated:  February 13, 2004 | /S/ DENNIS  WARD                      |   |
|                      | DENNIS WARD                           |
|                      | CHIEF  FINANCIAL OFFICER              |
|                      | (principal  accounting officer)       |

 

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**INDEXTO 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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