**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

 

**FORM 10-Q**

 

 

(MarkOne)

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**Forthe quarterly period ended September 30, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**Forthe 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                                                   |       | (I.RS. Employer  Identification No.) |
| incorporation or  organization)                                                    |       |                                 |
|                                                                               |       |                                 |
| **2491  Xenium Lane North, Plymouth, Minnesota**                                   | ** ** | **55441**                            |
| (Address of  principal executive offices)                                          |       | (Zip Code)                           |
|                                                                               |       |                                 |
| Registrant’s telephone number, including area code:  **(763)  559-5566** |
|                                                                               |       |                                 |
|                                                                               |       |                                 |
| Securities  registered pursuant to Section 12(b) of the Act:                       |
| **None**                                                                           |
|                                                                               |       |                                 |
| Securities  registered pursuant to Section 12(g) of the Act:                       |
| **Common  Stock, par value $0.01**                                                 |
| (Title of class)                                                                   |

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.   Yes x      No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

| Large Accelerated  Filer o |   | Accelerated  Filer o |   | Non-Accelerated  Filer x |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).   Yes o      No x

As of November 22, 2006, the registrant had 13,653,738 shares of CommonStock outstanding.

 

 

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIESFORM 10-Q**

**FOR THE THREEMONTH PERIODENDED SEPTEMBER 30, 2006**

INDEX
| PART I.   Financial Information  (Unaudited): |
|--------------------------------------------------------------|
|                                                         |   |   |
|                                                         | Item 1. | Financial Statements |
|                                                         |   |   |
|                                                         |   | Condensed Consolidated Balance Sheets as of  September 30, 2006 and June 30, 2006 |
|                                                         |   |   |
|                                                         |   | Condensed Consolidated Statements of Operations for  the Three Months Ended September 30, 2006 and 2005 |
|                                                         |   |   |
|                                                         |   | Condensed Consolidated Statements of Cash Flows for  the Three Months Ended September 30, 2006 and 2005 |
|                                                         |   |   |
|                                                         |   | 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 |
|                                                         |   |   |
| Signatures                                                   |
|                                                         |   |   |
| Index to Exhibits                                            |
|                                                              |  |  |  |

** **

**SAFE HARBORSTATEMENT UNDER THEPRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

Certainstatements of a non-historical nature under the caption “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andelsewhere in this Form 10-Q constitute “forward-looking statements” within themeaning of the Private Securities Litigation Reform Act of 1995. Suchforward-looking statements may be identified by the use of terminology such as “may,”“will,” “expect,” “anticipate,” “estimate,” “should,” or “continue” or thenegative thereof or other variations thereon or comparable terminology. Suchforward-looking statements are subject to certain risks and uncertainties thatcould cause actual results to differ materially from historical results or fromthose results currently anticipated or projected. Such factors include, amongother things, the following: changes in consumer purchasing; demand for andmarket acceptance of new and existing products; the impact from competition forrecorded music; dependence on suppliers and distributors; success of marketingand promotion efforts; technological changes and difficulties; availability offinancing; foreign currency variations; general economic, political andbusiness conditions; and other matters. We undertake no obligation to releasepublicly the result of any revisions to these forward-looking statements,except as required by law.

 

2

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS — UNAUDITED*(in thousands — except share data*)**

 
| ** **                                                                                                                        | ** ** | **September 30,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                                                                        | ** ** | **2006**               | ** ** | **2006**          | ** ** |
| ASSETS                                                                                                                            |       |                   |       |              |       |
|                                                                                                                              |       |                   |       |              |       |
| Current assets:                                                                                                                   |       |                   |       |              |       |
| Cash and cash  equivalents                                                                                                        |       | $                      | 1,470      |              | $          | 1,689 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $2 at September 30 and  June 30                                   |       | 632                    |       | 601               |       |
| Inventories                                                                                                                       |       | 452                    |       | 390               |       |
| Royalty advances                                                                                                                  |       | 7                      |       | 7                 |       |
| Prepaid expenses  and other                                                                                                       |       | 157                    |       | 194               |       |
| Total current  assets                                                                                                             |       | 2,718                  |       | 2,881             |       |
|                                                                                                                              |       |                   |       |              |       |
| Property and equipment,  net of accumulated depreciation and amortization of $317 at September 30 and  $306 at June 30            |       | 53                     |       | 55                |       |
|                                                                                                                              |       |                   |       |              |       |
| Owned catalog masters,  net of accumulated amortization of  $3,317 at September 30 and $3,277 at June 30                     |       | 299                    |       | 336               |       |
|                                                                                                                              |       | $                      | 3,070      |              | $          | 3,272 |   |
|                                                                                                                              |       |                   |       |              |       |
| LIABILITIES AND  SHAREHOLDERS’ DEFICIT                                                                                       |       |                   |       |              |       |
| Current liabilities:                                                                                                              |       |                   |       |              |       |
| Notes payable to  affiliate and other                                                                                             |       | $                      | 12,399     |              | $          | 12,098 |   |
| Accounts payable                                                                                                                  |       | 967                    |       | 1,206             |       |
| Accrued  royalties                                                                                                                |       | 1,872                  |       | 1,793             |       |
| Reserve for  returns                                                                                                              |       | 109                    |       | 126               |       |
| Net liabilities  of discontinued operations                                                                                       |       | 31                     |       | 31                |       |
| Total current  liabilities                                                                                                        |       | 15,378                 |       | 15,254            |       |
|                                                                                                                              |       |                   |       |              |       |
| Shareholders’ deficit:                                                                                                       |       |                   |       |              |       |
| Common stock —  50,000,000 shares authorized; par value $.01; 13,653,738 issued and  outstanding at September 30 and June 30 |       | 136                    |       | 136               |       |
| Additional  paid-in capital                                                                                                       |       | 21,292                 |       | 21,292            |       |
| Accumulated  deficit                                                                                                              |       | (33,489                | )          | (33,134           | )          |
| Accumulated  other comprehensive loss                                                                                             |       | (247                   | )          | (276              | )          |
| Total  shareholders’ deficit                                                                                                 |       | (12,308                | )          | (11,982           | )          |
|                                                                                                                              |       | $                      | 3,070      |              | $          | 3,272 |   |

 

The accompanyingnotes are an integral part of these financial statements.

3

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS — UNAUDITED*(in thousands - except per share data)***
| ** **                                                             | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                             | ** ** | **September 30,**           | ** ** |
| ** **                                                             | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Net sales                                                              |       | $                                | 888        |   | $ | 1,196 |   |
|                                                                   |       |                             |       |   |   |
| Costs and  expenses:                                                   |       |                             |       |   |   |
| Cost of goods sold                                                     |       | 287                              |       | 505 |   |
| Advertising                                                            |       | 63                               |       | 20 |   |
| Selling, general and administrative                                    |       | 650                              |       | 743 |   |
| Total costs and expenses                                               |       | 1,000                            |       | 1,268 |   |
| Operating loss                                                         |       | (112                             | )          | (72 | ) |
|                                                                   |       |                             |       |   |   |
| Other expense:                                                         |       |                             |       |   |   |
| Interest expense                                                       |       | (239                             | )          | (187 | ) |
| Other                                                                  |       | (4                               | )          | (2 | ) |
| Total other expense                                                    |       | (243                             | )          | (189 | ) |
|                                                                   |       |                             |       |   |   |
| Loss from  continuing operations                                       |       | (355                             | )          | (261 | ) |
|                                                                   |       |                             |       |   |   |
| Loss from  discontinued operations                                     |       | —                           |       | (3 | ) |
|                                                                   |       |                             |       |   |   |
| Net loss                                                               |       | $                                | (355       | ) | $ | (264 | ) |
|                                                                   |       |                             |       |   |   |
| Loss per share -  basic and diluted:                                   |       |                             |       |   |   |
| Continuing operations                                                  |       | $                                | (.03       | ) | $ | (.02 | ) |
| Discontinued operations                                                |       | —                           |       | — |   |
| Net loss                                                               |       | $                                | (.03       | ) | $ | (.02 | ) |
|                                                                   |       |                             |       |   |   |
| Shares used in  the calculation of loss per share - Basic and Diluted: |       | 13,654                           |       | 13,654 |   |
|                                                                   |       |                             |       |   |   |
| Comprehensive  loss:                                                   |       |                             |       |   |   |
| Net loss                                                               |       | $                                | (355       | ) | $ | (264 | ) |
| Translation adjustment                                                 |       | 29                               |       | (20 | ) |
| Comprehensive loss                                                     |       | $                                | (326       | ) | $ | (284 | ) |

 

The accompanyingnotes are an integral part of these financial statements.

4

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

 

 
| ** **                                                               | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                               | ** ** | **September 30,**           | ** ** |
| ** **                                                               | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Operating  activities:                                                   |       |                             |       |   |   |
| Net loss                                                                 |       | $                                | (355       | ) | $ | (264 | ) |
| Adjustments to  reconcile net loss to cash used in operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                            |       | 45                               |       | 53 |   |
| Changes in  operating assets and liabilities:                            |       |                             |       |   |   |
| Accounts receivable, net                                                 |       | (12                              | )          | 495 |   |
| Inventories                                                              |       | (53                              | )          | 30 |   |
| Royalty advances                                                         |       | 2                                |       | — |   |
| Prepaid expenses                                                         |       | 38                               |       | 13 |   |
| Accounts payable                                                         |       | (251                             | )          | (718 | ) |
| Accrued royalties                                                        |       | 68                               |       | 127 |   |
| Reserve for returns                                                      |       | (17                              | )          | 3 |   |
| Cash used in operating activities                                        |       | (535                             | )          | (261 | ) |
|                                                                     |       |                             |       |   |   |
| Investing  activities:                                                   |       |                             |       |   |   |
| Purchases of property and equipment                                      |       | (3                               | )          | — |   |
| Cash used in investing activities                                        |       | (3                               | )          | — |   |
|                                                                     |       |                             |       |   |   |
| Financing  activities:                                                   |       |                             |       |   |   |
| Borrowings on notes payable                                              |       | 915                              |       | 1,031 |   |
| Payments on notes payable                                                |       | (614                             | )          | (782 | ) |
| Cash provided by financing activities                                    |       | 301                              |       | 249 |   |
|                                                                     |       |                             |       |   |   |
| Effect of  exchange rates on cash                                        |       | 18                               |       | (1 | ) |
|                                                                     |       |                             |       |   |   |
| Net decrease in  cash and cash equivalents                               |       | (219                             | )          | (13 | ) |
|                                                                     |       |                             |       |   |   |
| Cash and cash  equivalents at beginning of period                        |       | 1,689                            |       | 1,272 |   |
|                                                                     |       |                             |       |   |   |
| Cash and cash  equivalents at end of period                              |       | $                                | 1,470      |   | $ | 1,259 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

5

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)**

**1.            BUSINESS AND LIQUIDITY**

K-tel International, Inc.(the “Company”, “K-tel” or the “registrant”) was incorporated in 1968 andcurrently has its corporate offices located in Plymouth, Minnesota. Through itsoperating subsidiaries, K-tel licenses its music catalog internationally andmarkets entertainment products mainly derived from its catalog through retailand direct response marketing channels in the United States and Europe. TheCompany has a focused method of distribution that targets the strengths ofselected individual retailers and supplies products suited to each retailer’sneeds. These products are derived mainly from the Company’s master recordingsmusic catalog with the objective of realizing more competitive profit margins.K-tel seeks to license its name and trademarks to other companies. Licenses aregranted for a royalty or fee, with no cost to the Company.

DiscontinuedOperations

The Company’sconsumer products business, which was concentrated in Europe, consistedprimarily of house wares, consumer convenience items and exercise equipment.The Company discontinued its consumer products operations in Germany, theUnited Kingdom and the United States in June 2000, November 2000 and January2001, respectively. Accordingly, these activities have been presented in theaccompanying financial statements as discontinued operations. The accompanyingcondensed consolidated financial statements have been prepared to reflect theconsumer products division as a discontinued operation. The net liabilities ofdiscontinued operations at September 30, 2006 and June 30, 2006, and resultsfrom discontinued operations for the three months ended September 30, 2006 and2005, relate primarily to legal matters and completion of statutory reportingrequirements for the former operations in Germany.

Going Concern

During the threemonths ended September 30, 2006 and 2005, the Company incurred net losses fromcontinuing operations of $355,000 and $261,000, respectively. Operatingactivities used $535,000 and $261,000 of cash during the three months endedSeptember 30, 2006 and 2005, respectively. Additionally, the Company had aworking capital deficit of $12,660,000 at September 30, 2006.

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.            BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANTACCOUNTING 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 (“USGAAP”) for interim financial information and with the instructions to Form 10-Qand Rule 10-01 of Regulation S-X. Accordingly, they do not include all of theinformation 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 month period ended September 30, 2006are not necessarily indicative of the results that may be expected for the yearas a whole. The unaudited condensed consolidated balance sheet for June 30,2006 has been derived from audited consolidated 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, 2006.

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Principles ofConsolidation — The accompanying condensed consolidatedfinancial statements include the accounts of K-tel International, Inc. and itsdomestic and foreign subsidiaries, all of which are wholly owned. Allsignificant intercompany accounts and transactions have been eliminated.

Revenue Recognition— The Company derives its revenue mainly from two sources: license revenue fromthe licensing of Company-owned masters and the sale of music compilations(predominately compact discs) produced by the Company. License revenue isrecognized when payment is received from customers or when known amounts arereceivable, as prior to that date collection is not considered probable.Revenue from music sales is recognized at the time of shipment to the customer.Most music sales are made with a right of return of unsold goods. Estimatedreserves for returns are established by management based upon historicalexperience and product mix and are subject to ongoing review and adjustment bythe Company. These reserves are recorded at the time of sale and are reflectedas a reduction in revenues. The Company’s reserve for returns was $109,000 atSeptember 30, 2006 and $126,000 at June 30, 2006.

Cost of Goods Sold— The Company expenses all product manufacturing, distribution and royaltycosts associated with music sales as cost of goods sold. The Company alsoexpenses royalties, commissions and amortization of its owned master recordingsassociated with its license revenue as cost of goods sold.

Shipping and Handling Costs— The Company expenses within cost of goods sold all shipping and handlingcosts incurred in the shipment of goods.

Cash and Cash Equivalents— Cash and cash equivalents consist principally of cash and short-term, highlyliquid investments with original maturities of less than ninety days.

Accounts Receivable— Accounts receivable balances are presented net of allowances. The Companydetermines its allowances by considering a number of factors, including thelength of time trade receivables are past due, the Company’s previous history,and the customer’s current ability to pay obligations to the Company. TheCompany writes off accounts receivable when they become uncollectible.

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

Owned Catalog Masters— The Company capitalizes the costs to purchase owned master recordings at thetime of acquisition. These costs are amortized over the estimated useful lifeof these master recordings, which is generally seven years, and representsmanagement’s best estimate of the average period of value.

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.

Long Lived-Assets— The Company evaluates its long-lived assets quarterly, or earlier if atriggering event occurs, to determine potential impairment by comparing thecarrying value of those assets to the related undiscounted future cash flows ofthe assets. If an asset is determined to be impaired, it is written down to itsestimated 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, except for direct response advertising, which is capitalized andamortized over its expected period of future benefits (usually the periodremaining under a related contract, which is generally less than one year).Direct response advertising consists primarily of television advertisingwhereby customers respond specifically to the advertising and where the Companycan identify the advertising that elicited the response. Advertising expenseswere $63,000 and $20,000 for the three month periods ended September 30, 2006and 2005, respectively.

Foreign Currency— The operations of foreign subsidiaries are measured in local currencies.Assets and liabilities are translated into U.S. dollars at period-end exchangerates. Revenue and expenses are translated at the average exchange ratesprevailing during the period. Adjustments resulting from translating thefinancial statements of foreign entities into U.S. dollars are recorded as acomponent of accumulated other comprehensive income or loss.

7

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Stock-basedCompensation — The Company accounts for stock-based awards toemployees using the intrinsic value method prescribed in APB No. 25, “Accountingfor Stock Issued to Employees,” whereby the options are granted at marketprice, and therefore no compensation costs are recognized. The Company haselected to retain its current method of accounting as described above and hasadopted 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, andbasic and diluted earnings per common share would have been unchanged from asreported.

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 Loss Per Share— Basic and diluted net loss per share have been computed by dividing net lossby the weighted average number of shares outstanding during the period. For allperiods presented, common stock equivalents were excluded from the per sharecalculation as the net effect would be antidilutive. For the three monthperiods ended September 30, 2006 and 2005, weighted average options to purchase2,228,939 shares of common stock, with weighted average exercise price of $.19were excluded from the computation of common share equivalents for therespective periods as they were antidilutive.

Use of Estimates— Preparing consolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America (US GAAP) requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, and disclosure of contingent assets and liabilities atthe date of the financial statements and the reported amounts of revenue andexpenses during the reporting period. Principal estimates include allowancesfor bad debt, inventory valuation, return reserves, royalty obligations,purchase commitments and product replacement costs. Actual results could differfrom those estimates used by management.

**3.            LOANS PAYABLE TO AFFILIATE**

K-tel has a Line of Credit Agreement with K-5Leisure Products, Inc. (“K-5”), the Company’s largest shareholder and an entitycontrolled by Philip Kives, the Chairman of the Board, President and ChiefExecutive 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 on a revolvingbasis. The loan bears interest at a variable rate based upon the “base rate” ofa nationally recognized lending institution (8.25% at September 30, 2006),expires July 20, 2008, and is subordinated to the Foothill loan (see below).The K-5 Facility contains the same covenants as the Foothill loan agreement.K-tel has pledged the stock of its foreign subsidiaries as collateral for theloan, and the loan carries a subordinated position to the Foothill loan on allother assets of the Company. K-tel had outstanding balances of $8,399,000 and$8,098,000 as of September 30, 2006 and June 30, 2006, respectively, under theK-5 Facility. At September 30, 2006, K-tel obtained a waiver from K-5 for itsnon-compliance under the covenants, limitations and restrictions of the creditagreement.

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In addition, K-tel has a second loan agreement with K-5, under whichK-5 assumed rights and obligations under a loan from the Company’s formerbanker (Foothill Capital Corporation) pursuant to an Assignment and AcceptanceAgreement dated February 27, 2001. This Foothill loan, which has been extendedthrough July 20, 2008, provides for a $10,000,000 credit facility consisting ofa $4,000,000 term loan due upon expiration, and a $6,000,000 revolving facilityunder which borrowings are limited to a percent of eligible receivables. Borrowingsunder the facility bear interest at a variable rate based on a “base rate” of a nationallyrecognized lending institution plus 1% (9.25% at September 30, 2006) 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 September 30, 2006 and June30, 2006, K-tel had $4,000,000 outstanding under the term loan and there wereno borrowings under the revolving facility. At September 30, 2006, K-telobtained a waiver from K-5 for its non-compliance under the covenants,limitations and restrictions of the credit agreement.

**4.            COMMITMENTS AND CONTINGENCIES**

K-tel and its subsidiariesare involved in legal proceedings 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 proceedingscannot be 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.

**5.            BUSINESS SEGMENT AND GEOGRAPHIC AREADATA**

K-tel’s businessesare organized, managed and internally reported as two segments: music licensingand retail music sales. These segments are based on differences in products,customer type and sales and distribution methods.

The Companylicenses the rights to its master music catalog, consisting of original recordingsand re-recordings of music from the 1950’s through today, to third partiesworld-wide for use in albums, films, television programs, commercials andelectronic downloads to various media formats, for either a flat fee or aroyalty based on the number of units sold.

The retail musicsegment of the Company markets and distributes entertainment productsinternationally and through its operating subsidiaries. The retail musicsegment consists primarily of the sales of pre-recorded music from the Company’smaster music catalog. The Company sells compact discs and DVD’s directly toretailers, wholesalers and rack service distributors which stock and manageinventory within music departments for retail stores.

The Company’sconsumer product and e-commerce operations have been discontinued, arepresented in the accompanying financial statements as discontinued operationsand are therefore not included in the segment information.

Operating profitsor losses of these segments include an allocation of general corporateexpenses. Depreciation and amortization and capital additions are notsignificant and have therefore been excluded from the presentation.

Certain financialinformation on the Company’s continuing operating segments is as follows:

BUSINESS SEGMENTINFORMATION *(in thousands)*

| Three Months Ended  September 30, | ** ** | ** ** | **Licensing** | ** ** | **Music** | ** ** | **Other** | ** ** | **Total  Company** | ** ** |
|--------------------------------------------------|------------|------------|---------------|------------|-----------|------------|-----------|------------|--------------------|------------|
| Net sales                                        | 2006       |       | $             | 469        |      | $          | 419       |       | $                  | —     |   | $ | 888 |   |
|                                             | 2005       |       | 515           |       | 681       |       | —    |       | 1,196              |       |
|                                             |       |       |          |       |      |       |      |       |               |
| Operating income  (loss)                         | 2006       |       | $             | 101        |      | $          | (213      | )          | $                  | —     |   | $ | (112 | ) |
|                                             | 2005       |       | 164           |       | (236      | )          | —    |       | (72                | )          |
|                                             |       |       |          |       |      |       |      |       |               |
| Assets                                           | 2006       |       | $             | 344        |      | $          | 2,701     |       | $                  | 25         |   | $ | 3,070 |   |
|                                             | 2005       |       | 482           |       | 3,468     |       | 131       |       | 4,081              |       |
|                                                  |            |            |               |            |           |            |           |            |                    |            |  |  |  |  |  |

 

GEOGRAPHIC INFORMATION *(in thousands)*

| Three Months Ended  September 30, | ** ** | ** ** | **United States** | ** ** | **Europe** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|------------|------------------------|------------|------------|------------|-----------|------------|
| Net sales                                        | 2006       |       | $                      | 529        |       | $          | 359       |       | $ | 888 |   |
|                                             | 2005       |       | 772                    |       | 424        |       | 1,196     |       |
|                                             |       |       |                   |       |       |       |      |
| Assets                                           | 2006       |       | $                      | 747        |       | $          | 2,323     |       | $ | 3,070 |   |
|                                             | 2005       |       | 2,051                  |       | 2,030      |       | 4,081     |       |
|                                                  |            |            |                        |            |            |            |           |            |  |  |  |  |

** **

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

**General**

Through its operatingsubsidiary, Dominion Entertainment, Inc. (“Dominion”), K-tel licenses itsmaster music catalog internationally and has entered into licensing agreementswith several companies that offer electronic downloads via their internet sitesof many of Dominion’s owned masters. K-tel and Dominion have also entered intoagreements with BCI Eclipse Company, LLC (“BCI”) to market and sellentertainment products derived from Dominion’s master music catalog under theK-tel logo in the United States and Canada.

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

**A.            RESULTS OF OPERATIONS**

Net sales for the threemonths ended September 30, 2006 were $888,000, a decrease of 25.8% from salesof $1,196,000 for the three month period ended September 30, 2005. This salesdecrease was primarily attributed to reduced domestic music revenue. The net lossfor the three month period ended September 30, 2006 was $355,000, or $.03 pershare, compared to a loss of $264,000, or $.02 per share, for the three monthperiod ended September 30, 2005.

General corporateexpenses of $98,000 and $105,000 for the three months periods ended September30, 2006 and 2005, respectively, have been allocated to the segments.

The following sectionsdiscuss the results of continuing operations by business segment.

#### **BUSINESS SEGMENT RESULTS**

**Licensing**

Licensing revenue was$469,000 for the three month period ended September 30, 2006 compared to$515,000 for the three month period ended September 30, 2005, a decrease of8.9%. This decrease was due to decreased third party licensing activity in theUnited Kingdom. The Company continues to concentrate its efforts on expandingthe customer base for the Company’s master music catalog for electronicdownloads and with independent music labels and manufacturers.

Royalty costs within thesegment decreased to $87,000 for the three month period ended September 30,2006 compared to $108,000 for the three month period ended September 30, 2005due to decreased third party licensing sales in the United Kingdom. Selling,general and administrative expenses for the segment increased $38,000 for the threemonth period ended September 30, 2006 to $281,000 compared to $243,000 for thethree month period ended September 30, 2005. The primary reason for theincrease in general and administrative expenses was the additional overheadcosts related to the German operation of the Company’s subsidiary in the UnitedKingdom.

There was operatingincome in the licensing segment of $101,000 for the three month period endedSeptember 30, 2006 compared to operating income of $164,000 for the three monthperiod ended September 30, 2005, a decrease of $63,000.

#### **Music**

Sales in the musicsegment were $419,000 for the three month period ended September 30, 2006compared to $681,000 for the three month period ended September 30, 2005, adecrease of $262,000, or 38.5%. The decrease was primarily due to decreaseddomestic music sales related to the Company’s transition from primarily adistributions business to a licensing business.

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Cost of goods sold in themusic segment decreased to 47.7% of sales for the three month period endedSeptember 30, 2006 compared to 58.3% of sales for the three month period endedSeptember 30, 2005 reflecting the decrease in domestic retail music sales thathad lower margins. The segment’s advertising expenses, which consist primarilyof co-operative advertising payments, trade advertising and promotions,increased to $63,000 for the three month period ended September 30, 2006compared to $20,000 for the three month period ended September 30, 2005. Thisincrease was due to increased advertising expense in the Company’s subsidiaryin the United Kingdom.

Selling, general andadministrative expenses were $369,000, or 88.0% of sales for the three monthperiod ended September 30, 2006 compared to $500,000, or 73.5% of sales for thethree month period ended September 30, 2005. The primary reason for thedecrease in general and administrative expenses was the reduced overhead costsat the Company’s office in the United States relating to retail music sales.

The music segmentincurred an operating loss of $213,000 for the three month period endedSeptember 30, 2006 compared to operating loss of $236,000 for the three monthperiod ended September 30, 2005.

**B.            LIQUIDITYAND CAPITAL RESOURCES**

K-tel has a Line of Credit Agreement with K-5Leisure Products, Inc. (“K-5”), the Company’s largest shareholder and an entitycontrolled by Philip Kives, the Chairman of the Board, President and ChiefExecutive 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 on a revolvingbasis. The loan bears interest at a variable rate based upon the “base rate” ofa nationally recognized lending institution (8.25% at September 30, 2006),expires July 20, 2008, and is subordinated to the Foothill loan (see below).The K-5 Facility contains the same covenants as the Foothill loan agreement.K-tel has pledged the stock of its foreign subsidiaries as collateral for theloan, and the loan carries a subordinated position to the Foothill loan on allother assets of the Company. K-tel had outstanding balances of $8,399,000 and$8,098,000 as of September 30, 2006 and June 30, 2006, respectively, under theK-5 Facility. At September 30, 2006, K-tel obtained a waiver from K-5 for itsnon-compliance under the covenants, limitations and restrictions of the creditagreement.

In addition, K-tel has a second loan agreement with K-5, under whichK-5 assumed rights and obligations under a loan from the Company’s formerbanker (Foothill Capital Corporation) pursuant to an Assignment and AcceptanceAgreement dated February 27, 2001. This Foothill loan, which has been extendedthrough July 20, 2008, provides for a $10,000,000 credit facility consisting ofa $4,000,000 term loan due upon expiration, and a $6,000,000 revolving facilityunder which borrowings are limited to a percent of eligible receivables.Borrowings under the facility bear interest at a variable rate based on a “baserate” of a nationally recognized lending institution plus 1% (9.25% at September 30, 2006)and are collateralized by the assets of certain Company subsidiaries in theUnited States, including accounts receivable, inventories, equipment, musiclibrary and general intangibles. The loan agreement contains certain financialand other covenants or restrictions, including the maintenance of a minimumshareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of September 30, 2006 and June30, 2006, K-tel had $4,000,000 outstanding under the term loan and there wereno borrowings under the revolving facility. At September 30, 2006, K-telobtained a waiver from K-5 for its non-compliance under the covenants,limitations and restrictions of the credit agreement.

K-tel has primarilyfunded its recent operations through secured loans from K-5. Assuming K-5continues to advance funds sufficient to meet the Company’s needs, managementcurrently believes that K-tel has sufficient cash and borrowing capacity toensure the Company will continue operations for the foreseeable future.Although K-5 continues to advance funds sufficient to meet the Company’s needsat this time, there can be no assurance that this will be adequate or continuein the future or that K-tel will be able to obtain additional financing uponfavorable terms when required.

The Company’s ability tocontinue its present operations 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 Company’s currentoperations will likely not generate cash sufficient to fund operations andservice 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.

 

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

There has been nomaterial changes in the Company’s market risk during the three month periodended September 30, 2006. For additional information, refer to the Company’sannual report on Form 10-K for the fiscal year ended June 30, 2006.

**ITEM 4.**                    CONTROLS ANDPROCEDURES

Under thesupervision and with the participation of the Company’s management, includingthe Company’s Chief Executive Officer and Chief Financial Officer, the Companyevaluated the effectiveness of the design and operation of its disclosurecontrols and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under theExchange Act). Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that, as of the end of the period covered by thisreport, the Company’s disclosure controls and procedures were not effectivebecause of the continued inability of the Company to file its reporting on atimely basis.  The untimely filings haveresulted in part from the follow up necessary to address the materialweaknesses in internal control over financial reporting that had been noted infiscal year 2004.

The Company did notmaintain effective controls over cash disbursements and payroll transactions atits UK subsidiary. In September 2004, the Company discovered that the formerChief Financial Officer of its UK subsidiary misappropriated funds from thesubsidiary and one of its customers. Adjustments related to the reversal ofoverstated expenses and recovery of amounts misappropriated were included inthe restatement of the Company’s consolidated financial statements for periodsprior to June 30, 2004 and for the years ended June 30, 2005 and 2004 andresulted in the Company reporting a material weakness in internal control overfinancial reporting.

*In response to this materialweakness, the Company terminated the employee, undertook a full-scaleinvestigation of the matter, retained a forensic auditing firm and dismissedthe accounting firm in the UK that audited the UK subsidiary’s financial booksand records. In addition, the Company hired a new Financial Controller andstringent internal control procedures were created and implemented for theCompany’s purchasing, accounts payable, check signing, payroll, petty cash andfinancial reporting policies. Management believes that these procedures,implemented upon the discovery of the misappropriation of funds, have allowedthe Company to remediate this material weakness and to improve its internalcontrol over financial reporting.*

*In fiscal 2005 and 2004, it was alsodetermined that the segregation of duties in the U.S. office was limited due tothe small number of employees. This segregation of duties became furtherlimited by vacancies that occurred in the Company’s finance department. Inparticular, customer orders were recorded by the same person who initiatedshipments, checks were deposited by the accounts receivable clerk, and employeepayroll and changes were entered by the Operations Manager, who also distributedthe payroll checks.*

*In response to this materialweakness in the U.S. office, the former Controller was rehired in the periodcovered by this report and duties and responsibilities were revised to allowfor improved segregation of duties and to increase the level of approvals andreviews.  The foregoing remedial stepshave allowed the Company to remediate its material weakness and to improve its internalcontrol over financial reporting.*

# During the fiscal quarterended September 30, 2006, there was no change in the Company’s internal controlover financial 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.

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**PART II**

**ITEM 1.**                    LEGALPROCEEDINGS

#### Litigation and Disputes

K-tel and itssubsidiaries are involved in legal proceedings in the ordinary course of theirbusiness. With all litigation matters, management considers the likelihood ofloss based on the facts and circumstances. If management determines that a lossis probable and the amount of loss can be reasonably estimated, such amount isrecorded as a liability. Although the outcome of any such legal proceedingscannot be 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.

**ITEM 6.**                    EXHIBITS

See “Index to Exhibits.”

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                          |   | K-TEL INTERNATIONAL, INC.            |
|--------------------------|--------|--------------------------------------|
|                     |   | REGISTRANT                           |
|                     |   |                                 |
|                     |   |                                 |
| Dated: November 22, 2006 |   | /S/ PHILIP KIVES                     |
|                     |   | PHILIP KIVES                         |
|                     |   | CHAIRMAN AND CHIEF EXECUTIVE OFFICER |
|                     |   |                                 |
|                     |   |                                 |
| Dated: November 22, 2006 |   | /s/ KIMMY LOCKWOOD                   |
|                     |   | KIMMY LOCKWOOD                       |
|                     |   | PRINCIPAL FINANCIAL 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(a).                                                                                   |       |
|             |       |                                                                                                                                                    |       |
| 31.2             |       | Certification by  Principal Financial Officer pursuant to Rule 13a-14(a).                                                                               |       |
|             |       |                                                                                                                                                    |       |
| 32.1             |       | Certification by Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sabanes-Oxley Act of 2002.     |       |
|             |       |                                                                                                                                                    |       |
| 32.2             |       | Certification by Principal Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sabanes-Oxley Act of  2002. |       |

 

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