##### ** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

| **(Mark One)** |
|----------------|
|           |   |   |   |   |
| **ý**     |   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|           |   |   |   |   |
|           |   | **For the quarterly period ended March 31, 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:  0-6664** |

 

 

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

 

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

Yes  ý       No o

 

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

Yes  o       No ý

 

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

 

 

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

** FORM 10-Q**

 

**FORTHE THREE AND NINE MONTH PERIODS**

**ENDEDMARCH 31, 2003**

 

INDEX

 
| PART I.           |   | Financial Information (Unaudited): |
|-------------------|--------|------------------------------------|
|              |   |                               |   |   |
|              |   | Item 1.                            |   | Condensed Consolidated Balance Sheets as of  March 31, 2003 and June 30, 2002 |
|              |   |                               |   |   |
|              |   |                               |   | Condensed Consolidated Statements of  Operations  for the Three and Nine Month Periods Ended  March 31, 2003 and 2002 |
|              |   |                               |   |   |
|              |   |                               |   | Condensed Consolidated Statements of Cash  Flows  for the Nine Month Periods Ended  March 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 2.                            |   | Changes in Securities and Use of Proceeds |
|              |   |                               |   |   |
|              |   | Item 6.                            |   | Exhibits and Reports on Form 8-K |
|              |   |                               |   |   |
| Signatures        |
|              |   |                               |   |   |
| Certifications    |
|              |   |                               |   |   |
| Index to Exhibits |
|                   |        |                                    |  |  |  |  |

 

**Important FactorsRelating to Forward Looking Statements**

 

Certain statements of a non-historical nature under the caption“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and elsewhere in this Form 10-Q constitute “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995. Such forward-looking statements may be identified by the use ofterminology such as “may,” “will,” “expect,” “anticipate,” “estimate,”“should,” or “continue” or the negative thereof or other variations thereon orcomparable terminology. Such forward-looking statements are subject to certainrisks and uncertainties that could cause actual results to differ materiallyfrom historical results or from those results currently anticipated orprojected. Such factors include, among other things, the following: changes inconsumer purchasing; demand for and market acceptance of new and existingproducts; the impact from competition for recorded music; the outcome of legalproceedings; dependence on suppliers and distributors; the outcome of the twosubsidiaries’ bankruptcy and liquidation; success of marketing and promotionefforts; technological changes and difficulties; availability of financing;foreign currency variations; general economic, political and businessconditions; and other matters. The Company undertakes 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 SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS -UNAUDITED**

*(in thousands*)

 
|                                                                                                 |   | **March 31,  2003** |   | **June 30,  2002** |   |
|------------------------------------------------------------------------------------------------------|--------|---------------------|--------|--------------------|--------|
|                                                                                                 |   |                |   |               |   |
| ASSETS                                                                                               |   |                |   |               |   |
|                                                                                                 |   |                |   |               |   |
| Current Assets:                                                                                      |   |                |   |               |   |
| Cash and equivalents                                                                                 |   | $                   | 83     |               | $      | 75 |   |
| Accounts receivable, net                                                                             |   | 2,076               |   | 1,656              |   |
| Inventories                                                                                          |   | 583                 |   | 637                |   |
| Royalty advances                                                                                     |   | 245                 |   | 282                |   |
| Prepaid expenses and other                                                                           |   | 451                 |   | 378                |   |
| Total Current Assets                                                                                 |   | 3,438               |   | 3,028              |   |
|                                                                                                 |   |                |   |               |   |
| Property and equipment, net of accumulated  depreciation and amortization of $1,472 and $1,418       |   | 110                 |   | 162                |   |
|                                                                                                 |   |                |   |               |   |
| Owned catalog masters, net of accumulated  amortization of $2,701 and $2,829                         |   | 869                 |   | 1,060              |   |
|                                                                                                 |   |                |   |               |   |
|                                                                                                 |   | $                   | 4,417  |               | $      | 4,250 |   |
|                                                                                                 |   |                |   |               |   |
| LIABILITIES AND SHAREHOLDERS’ DEFICIT                                                           |   |                |   |               |   |
|                                                                                                 |   |                |   |               |   |
| Current Liabilities:                                                                                 |   |                |   |               |   |
| Loans payable to affiliate and other                                                                 |   | $                   | 11,359 |               | $      | 10,253 |   |
| Accounts payable                                                                                     |   | 1,525               |   | 1,264              |   |
| Accrued royalties                                                                                    |   | 2,256               |   | 2,245              |   |
| Reserve for returns                                                                                  |   | 216                 |   | 40                 |   |
| Net liabilities of discontinued operations                                                           |   | 104                 |   | 92                 |   |
| Total Current Liabilities                                                                            |   | 15,460              |   | 13,894             |   |
|                                                                                                 |   |                |   |               |   |
| Shareholders’ Deficit:                                                                          |   |                |   |               |   |
| Common stock – 50,000,000 shares  authorized; par value $.01; 13,653,738 issued and outstanding |   | 136                 |   | 136                |   |
| Additional paid-in capital                                                                           |   | 21,292              |   | 21,292             |   |
| Accumulated deficit                                                                                  |   | (32,107             | )      | (30,771            | )      |
| Cumulative translation adjustment                                                                    |   | (364                | )      | (301               | )      |
| Total Shareholders’ Deficit                                                                     |   | (11,043             | )      | (9,644             | )      |
|                                                                                                 |   |                |   |               |   |
|                                                                                                 |   | $                   | 4,417  |               | $      | 4,250 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

3

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

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS - UNAUDITED**

*(in thousands - except per share data)*

 
|                                                 |   | **Three  Months Ended  March 31,** |   | **Nine  Months Ended  March 31,** |   |
|------------------------------------------------------|--------|------------------------------------|--------|-----------------------------------|--------|
|                                                 |   | **2003**                           |   | **2002**                          |   | **2003** |   | **2002** |   |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Net Sales                                            |   | $                                  | 1,923  |                              | $      | 1,766 |   | $ | 5,295 |   | $ | 5,251 |   |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Costs and Expenses:                                  |   |                               |   |                              |   |   |   |   |   |
| Cost of goods sold                                   |   | 990                                |   | 719                               |   | 2,486 |   | 2,135 |   |
| Advertising                                          |   | 81                                 |   | 18                                |   | 146 |   | 69 |   |
| Selling, general and administrative                  |   | 1,026                              |   | 1,157                             |   | 2,936 |   | 3,425 |   |
| Total Costs and Expenses                             |   | 2,097                              |   | 1,894                             |   | 5,568 |   | 5,629 |   |
| Operating Loss                                       |   | (174                               | )      | (128                              | )      | (273 | ) | (378 | ) |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Other Income (Expense):                              |   |                               |   |                              |   |   |   |   |   |
| Interest expense                                     |   | (130                               | )      | (177                              | )      | (399 | ) | (346 | ) |
| Other income (expense)                               |   | (75                                | )      | 2                                 |   | (190 | ) | (48 | ) |
| Total Other Income (Expense)                         |   | (205                               | )      | (175                              | )      | (589 | ) | (394 | ) |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Loss from Continuing Operations Before  Income Taxes |   | (379                               | )      | (303                              | )      | (862 | ) | (772 | ) |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Income Taxes                                         |   | —                             |   | —                            |   | — |   | — |   |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Loss from Continuing Operations                      |   | (379                               | )      | (303                              | )      | (862 | ) | (772 | ) |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Discontinued Operations:                             |   |                               |   |                              |   |   |   |   |   |
| Loss from Discontinued Operations                    |   | (60                                | )      | (4                                | )      | (474 | ) | (146 | ) |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Net Loss                                             |   | $                                  | (439   | )                                 | $      | (307 | ) | $ | (1,336 | ) | $ | (918 | ) |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Loss per Share – Basic and Diluted:             |   |                               |   |                              |   |   |   |   |   |
| Continuing Operations                                |   | $                                  | (.03   | )                                 | $      | (.02 | ) | $ | (.06 | ) | $ | (.06 | ) |
| Discontinued Operations                              |   | —                             |   | —                            |   | (.04 | ) | (.01 | ) |
| Net Loss                                             |   | $                                  | (.03   | )                                 | $      | (.02 | ) | $ | (.10 | ) | $ | (.07 | ) |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Weighted Average Shares Outstanding –           |   | 13,654                             |   | 13,654                            |   | 13,654 |   | 13,654 |   |
| Basic and Diluted:                                   |   |                               |   |                              |   |   |   |   |   |
|                                                 |   |                               |   |                              |   |   |   |   |   |
| Comprehensive Loss:                                  |   |                               |   |                              |   |   |   |   |   |
| Net Loss                                             |   | $                                  | (439   | )                                 | $      | (307 | ) | $ | (1,336 | ) | $ | (918 | ) |
| Foreign Currency Gain (Loss)                         |   | (17                                | )      | 43                                |   | (63 | ) | (2 | ) |
| Comprehensive Loss                                   |   | $                                  | (456   | )                                 | $      | (264 | ) | $ | (1,399 | ) | $ | (920 | ) |

 

 

See accompanying notes to condensedconsolidated financial statements.

 

4

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

##### **CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS - UNAUDITED**

*(in thousands)*

 
|                                                                     |   | **Nine  Months Ended  March 31** |   |
|--------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                     |   | **2003**                         |   | **2002** |   |
|                                                                     |   |                             |   |   |   |
| Cash flows from Operating Activities:                                    |   |                             |   |   |   |
| Net loss                                                                 |   | $                                | (1,336 | ) | $ | (918 | ) |
| Adjustments to reconcile net loss to cash  used in operating activities: |   |                             |   |   |   |
| Depreciation and amortization                                            |   | 246                              |   | 296 |   |
| Loss on disposal of property and equipment                               |   | 1                                |   | 4 |   |
| Discontinued operations                                                  |   | 3                                |   | (180 | ) |
| Changes in operating assets and  liabilities:                            |   |                             |   |   |   |
| Accounts receivable                                                      |   | (400                             | )      | (566 | ) |
| Inventories                                                              |   | 63                               |   | (28 | ) |
| Royalty and other advances                                               |   | 46                               |   | (90 | ) |
| Prepaid expenses and other                                               |   | (66                              | )      | 234 |   |
| Accounts payable and other                                               |   | 250                              |   | (259 | ) |
| Accrued royalties                                                        |   | 14                               |   | 189 |   |
| Reserve for returns                                                      |   | 177                              |   | (2 | ) |
| Income taxes, net                                                        |   | —                           |   | 7 |   |
| Cash used in operating activities                                        |   | (1,002                           | )      | (1,313 | ) |
|                                                                     |   |                             |   |   |   |
| Cash flows provided by (used in) Investing  Activities:                  |   |                             |   |   |   |
| Proceeds from sale of property and  equipment                            |   | 15                               |   | 27 |   |
| Purchases of property and equipment                                      |   | (14                              | )      | — |   |
| Music catalog additions                                                  |   | —                           |   | (114 | ) |
| Cash used in investing activities                                        |   | 1                                |   | (87 | ) |
|                                                                     |   |                             |   |   |   |
| Cash flows from Financing Activities:                                    |   |                             |   |   |   |
| Borrowings on loans payable                                              |   | 2,016                            |   | 2,039 |   |
| Payments on loans payable                                                |   | (917                             | )      | (702 | ) |
| Cash provided by financing activities                                    |   | 1,099                            |   | 1,337 |   |
|                                                                     |   |                             |   |   |   |
| Effect of exchange rates on cash                                         |   | (90                              | )      | 37 |   |
|                                                                     |   |                             |   |   |   |
| Net increase (decrease) in cash and  equivalents                         |   | 8                                |   | (26 | ) |
|                                                                     |   |                             |   |   |   |
| Cash and equivalents at beginning of period                              |   | 75                               |   | 173 |   |
|                                                                     |   |                             |   |   |   |
| Cash and equivalents at end of period                                    |   | $                                | 83     |   | $ | 147 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

5

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

 

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

## **1.             BUSINESSAND LIQUIDITY**

 

K-tel International, Inc. (the “Company,” “K-tel,” or the “registrant”)was incorporated in 1968. Its corporate offices are located at 2655 CheshireLane North, Suite 100, Plymouth, Minnesota, and its phone number is (763)559-5566. Through its operating subsidiaries, K-tel licenses its music cataloginternationally and markets entertainment products mainly derived from itscatalog through retail and direct response marketing channels in the UnitedStates and Europe. The Company is implementing a more focused method ofdistribution that targets the strengths of fewer individual retailers andsupplies products suited to each retailer’s needs. These new products arederived mainly from the Company’s master recordings music catalog with the objectiveof realizing more competitive profit margins. Historically, K-tel subsidiarieshad also distributed consumer products through operations which have beendiscontinued, and operated an Internet e-commerce site which has been suspendeddue to continuing losses. 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 Drug Mart, which recently beganoperations, offers prescription drugs from its pharmacy in Canada to persons inthe United States. K-tel is merely a licensor of its mark to K-tel Drug Mart.To date, K-tel Drug Mart’s operations have not generated any significantlicensing revenues for the Company.

 

Discontinued Operations

 

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

 

Going Concern

 

During the nine months ended March 31, 2003, the Company continued tosustain losses from continuing operations, amounting to $862,000 during theperiod. Additionally, the Company had a working capital deficit of $11,983,000at March 31, 2003.

 

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

 

**2.             BASIS OF PRESENTATION AND SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

 

Basis of Presentation - The accompanyingcondensed consolidated unaudited financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (“US GAAP”) for interim financial information and with the instructionsto Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not includeall of the information and footnotes required by US GAAP for complete financialstatements. In the opinion of management, all adjustments (consisting of normalrecurring adjustments) considered necessary for a fair presentation have beenincluded. Operating results for the three and nine month periods ended March31, 2003 are not necessarily indicative of the results that may be expected forthe year as a whole. The unaudited condensed consolidated balance sheet forJune 30, 2002 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, 2002.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Rights to Use Music Product - Certain of theCompany’s compilation products are master recordings under license from recordcompanies and publishers. In most instances, minimum guarantees or non-refundableadvances are required to obtain the licenses and are realized through futuresales of the product. The amounts paid for minimum guarantees or non-refundableadvances are capitalized and charged to expense as sales are made. Whenanticipated sales appear to be insufficient to fully recover the minimumguarantees or non-refundable advances, a provision against current operationsis made for anticipated losses. The unrealized portion of guarantees andadvances is included in royalty advances in the accompanying condensedconsolidated balance sheets. Licenses are subject to audit by licensors.

 

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

 

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

 

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

 

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

 

7

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

 

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

 
|                     |   | **Three  Months Ended  March 31** |   | **Nine  Months Ended  March 31,** |   |
|--------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|
|                     |   | **2003**                          |   | **2002**                          |   | **2003** |   | **2002** |   |
| Net loss (in thousands): |   |                              |   |                              |   |   |   |   |   |
| As reported              |   | $                                 | (439   | )                                 | $      | (307 | ) | $ | (1,336 | ) | $ | (918 | ) |
| Pro forma                |   | (472                              | )      | (425                              | )      | (1,435 | ) | (1,272 | ) |
|                     |   |                              |   |                              |   |   |   |   |   |
| Basic and Diluted EPS:   |   |                              |   |                              |   |   |   |   |   |
| As reported              |   | (.03                              | )      | (.02                              | )      | (.10 | ) | (.07 | ) |
| Pro forma                |   | (.03                              | )      | (.03                              | )      | (.11 | ) | (.09 | ) |
|                          |        |                                   |        |                                   |        |  |  |  |  |  |  |  |  |

 

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

 

Net Income (Loss) Per Share - Basic anddiluted net income (loss) per share have been computed by dividing net income(loss) by the weighted average number of shares outstanding during the period.For all periods presented, common stock equivalents were excluded from the pershare calculation as the effect would be antidilutive. For the nine monthsended March 31, 2003 and 2002, weighted average options to purchase 2,312,876and 2,330,906 shares of common stock, with weighted average exercise prices of$5.79 and $5.88 were excluded from the computation of common share equivalentsfor the respective periods as they were antidilutive. For the three monthsended March 31, 2003 and 2002, options to purchase 2,583,839 and 2,330,906shares of common stock, with weighted average exercise prices of $5.19 and$5.88 were excluded from the computation of common share equivalents for therespective periods as they were antidilutive.

 

Stock Option Exchange – On March 18, 2003, acommittee of the Company’s board of directors comprised solely of independentdirectors, approved a “Stock Option Exchange Program.” The Program provides fora small number of optionees who were previously awarded options to purchaseshares of common stock under the Company’s 1997 Stock Option Plan to exchangethem for options to purchase an equal number of shares outside the Company’sStock Option Plan. The options to purchase an aggregate 2,137,939 shares ofcommon stock have a weighted average price per share of $5.95. Replacementoptions are proposed to be issued six months and one day after the date ofcancellation of the existing options and shall be at an exercise price per shareequal to the fair market value of the Company’s common stock as quoted on theNasdaq OTC Bulletin Board on the date of grant and shall expire ten years afterthe date of grant. It is anticipated that there will be no compensation expenserecognized as a result of this exchange.

 

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

 

**3.**             **LOANS PAYABLE TO AFFILIATE**

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc.(“K-5”), the Company’s largest shareholder controlled by Philip Kives, theChairman of the Board, President and Chief Executive Officer of K-tel. Underthe terms of the agreement (the “K-5 Facility”), K-5 has agreed to makeavailable up to $8,000,000 to K-tel on a revolving basis. The loan bearsinterest at a variable rate based upon the “base rate” of a nationallyrecognized

 

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lending institution (4.25% atMarch 31, 2003), expires July 20, 2005, and is subordinated to the Foothillloan (see below). The K-5 Facility contains the same covenants as the Foothillloan agreement. 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 $7,102,000 and $6,026,000 as of March 31, 2003 and June 30, 2002respectively under the K-5 Facility. At March 31, 2003, K-tel obtained a waiverfrom K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

 

In addition, K-tel has a second loan agreement with K-5, under whichK-5 assumed rights and obligations under a loan from the Company’s formerbanker (Foothill Capital Corporation) pursuant to an Assignment and AcceptanceAgreement dated February 27, 2001. This Foothill loan, which has been extendedthrough July 20, 2005, provides for a $10,000,000 credit facility consisting ofa $4,000,000 term loan due upon expiration, and a $6,000,000 revolving facilityunder which borrowings are limited to a percent of eligible receivables.Borrowings under the facility bear interest at a variable rate based on a “baserate” of a nationally recognized lending institution plus 1% (5.25% at March31, 2003) and are collateralized by the assets of certain Company subsidiariesin the United States, including accounts receivable, inventories, equipment,music library and general intangibles. The loan agreement contains certainfinancial and other covenants or restrictions, including the maintenance of aminimum shareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of March 31, 2003 and June 30,2002, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At March 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 overdraft privilege borrowing facility with The Royal Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2% per annum over the base rate(a total of 6% at March 31, 2003) and are subject to a minimum of 6% per annum.K-tel had outstanding balances of $218,000 and $227,000 as of March 31, 2003and June 30, 2002 respectively.

 

**4.**             **COMMITMENTS AND CONTINGENCIES**

 

Class Action Suit

 

K-tel and certain of its current and former officers and directors werenamed as defendants in *In re K-telInternational, Inc. Securities Litigation*, No. 98-CV-2480. Thisaction consolidated twenty-three purported class actions that were initiallyfiled in various United States District Courts in November 1998, and weresubsequently transferred to, and consolidated in, the United States DistrictCourt for the District of Minnesota. On July 19, 1999, the plaintiffs filed anamended consolidated class action complaint that challenged the accuracy ofcertain public disclosures made by K-tel regarding its financial conditionduring the period from May 1998 through November 1998. The plaintiffs assertedclaims under the federal securities laws and sought damages in an unspecifiedamount as well as costs, including attorneys’ fees and any other relief theCourt deemed just and proper. K-tel moved to dismiss the complaint, and on July31, 2000, the United States District Court granted the Company’s motion todismiss. The Court also barred further actions by the plaintiffs and deniedplaintiffs’ request to amend the complaint in order to refile the complaint inthe future. The plaintiffs appealed to the United States Court of Appeals forthe Eighth Circuit, and the Court of Appeals heard the matter in October 2001.On August 7, 2002 the Court of Appeals, in a two to one decision, denied the plaintiffs’appeal. On August 20, 2002 the plaintiffs applied for a rehearing by the fullCourt of Appeals. K-tel filed a response on September 15, 2002 to theplaintiffs’ petition for rehearing at the request of the Court. On October 2,2002, the Court denied the petition for rehearing. The plaintiffs had untilJanuary 1, 2003 to seek a writ of certiorari (a petition asking the Court for adiscretionary review of a lower court decision) from the United States SupremeCourt, but did not seek this writ. There having been no appeal filed, the casehas been dismissed with prejudice on the merits.

 

RTL Shopping S. A.

 

The Company has been named in a lawsuit filed in France brought byRTL9, a French cable TV station. Initially, RTL9 was named as a defendant in 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,

 

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pursuant to an indemnification provision the parties had entered into.Subsequently, K-tel Marketing went into liquidation and RTL9 filed a suit inDecember 2000 against K-tel International, Inc. under its agreement toguarantee payment for the commercial time. On May 28, 2001, RTL9 presenteddocuments in court identifying K-tel International (USA), Inc. as a target ofits claim. On September 3, 2001 the Company filed documents disputing the claimand advising the court of K-tel (USA)’s Chapter 7 bankruptcy filing.

 

The initial lawsuit against RTL9 and the RTL9 claim against K-tel areproceeding together through the French courts, and the parties involved in theinitial lawsuit continue to submit new briefs to the Court related to thataction. The action seeks damages in the approximate amount of 20 million FrenchFrancs, or approximately $2.8 million. The Company believes that RTL9 has nobasis for a complaint against the Company. As the result of informationsupplied by the parties to the Court, RTL9 has proposed to drop the lawsuit.

 

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

 

On March 14, 2000, K-tel and its subsidiary in Germany commenced anaction for breach of express and implied warranties against Defendant TristarProducts, Inc. This action is venued in the United States District Court forthe District of Minnesota. This action arises out of Tristar’s sale to K-tel ofa defective home exercise product called the “BunBlaster” for resale inGermany, Austria and Switzerland. By written contract, Tristar has agreed toindemnify   K-tel for injuries anddamages arising out of the resale of those goods. K-tel is seeking approximately$2 million in consequential damages. Tristar is vigorously defending thisclaim. Discovery has been completed. The Court has ordered that the action beready for trial by June 2, 2003, after which the Court will schedule a trialdate.

 

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

#### ** **

#### **OtherLitigation and Disputes**

 

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

 

Subsidiaries’ Bankruptcy and Liquidation

 

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

 

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

 

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**5.             BUSINESSSEGMENT AND GEOGRAPHIC AREA DATA**

 

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

 

The retail music segment consists primarily of the sales of pre-recordedmusic both from the Company’s music master catalog and under licenses obtainedfrom other record companies. The Company sells compact discs and DVD’s directlyto retailers, wholesalers and rack service distributors which stock and manageinventory within music departments for retail stores.

 

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

 

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

 

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

 

BUSINESS SEGMENT INFORMATION

 
| **Nine Months Ended  March 31,** |   | **Music** |       | **Licensing** |       | **Other** |       | **Total**Company |       |
|----------------------------------|--------|-----------|------------|---------------|------------|-----------|------------|------------------|------------|
| **(in thousands)**               |   |      | ** ** |          | ** ** |      | ** ** |             | ** ** |
|                             |   |      |       |          |       |      |       |             |       |
| Net Sales                        | 2003   |      | $          | 3,569         |       | $         | 1,726      |             | $          | — |   | $ | 5,295 |   |
|                             | 2002   |      | 3,264      |          | 1,987      |      | —     |             | 5,251      |   |
|                             |   |      |       |          |       |      |       |             |       |   |
| Operating Income (Loss)          | 2003   |      | $          | (588          | )          | $         | 315        |             | $          | — |   | $ | (273 | ) |
|                             | 2002   |      | (1,167     | )             | 789        |      | —     |             | (378       | ) |
|                             |   |      |       |          |       |      |       |             |       |   |
| Assets                           | 2003   |      | $          | 3,045         |       | $         | 1,014      |             | $          | 358 |   | $ | 4,417 |   |
|                             | 2002   |      | 2,201      |          | 1,480      |      | 323        |             | 4,004      |   |

 
| **Three Months  Ended March 31,** |   |   |   |   |   |   |   |   |   |   |
|-----------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| **(in thousands)**                |   |   |   |   |   |   |   |   |   |   |
|                              |   |   |   |   |   |   |   |   |   |   |
| Net Sales                         | 2003   |   | $      | 1,385  |   | $      | 538    |   | $      | — |   | $ | 1,923 |   |
|                              | 2002   |   | 962    |   | 804    |   | — |   | 1,766  |   |
|                              |   |   |   |   |   |   |   |   |   |   |
| Operating Income (Loss)           | 2003   |   | $      | (183   | )      | $      | 9      |   | $      | — |   | $ | (174 | ) |
|                              | 2002   |   | (537   | )      | 409    |   | — |   | (128   | )      |

 

GEOGRAPHIC INFORMATION

 
| **Nine  Months Ended  March 31,** |   | **United States** |       | **Europe** |       | **Total** |       |
|-----------------------------------|--------|-------------------|------------|------------|------------|-----------|------------|
| **(in thousands)**                |   |              | ** ** |       | ** ** |      | ** ** |
|                              |   |              |       |       |       |      |       |
| Net Sales                         | 2003   |              | $          | 3,320      |       | $         | 1,975      |   | $ | 5,295 |   |
|                              | 2002   |              | 2,686      |       | 2,565      |      | 5,251      |   |
|                              |   |              |       |       |       |      |       |   |
| Assets                            | 2003   |              | $          | 3,015      |       | $         | 1,402      |   | $ | 4,417 |   |
|                              | 2002   |              | 2,376      |       | 1,628      |      | 4,004      |   |

 
| **Three Months Ended  March 31,** |   |   | **United States** |   | **Europe** |   | **Total** | ** ** |
|-----------------------------------|--------|--------|-------------------|--------|------------|--------|-----------|------------|
| **(in thousands)**                |   |   |              |   |       |   |      |       |
|                              |   |   |              |   |       |   |      |       |
| Net Sales                         | 2003   |   | $                 | 1,240  |       | $      | 683       |       | $ | 1,923 |   |
|                              | 2002   |   | 902               |   | 864        |   | 1,766     |       |
|                                   |        |        |                   |        |            |        |           |            |  |  |  |

 

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**6.             RECENTLYISSUED ACCOUNTING STANDARDS**

 

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

 

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

 

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

 

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

 

**7.            RECENTLY PASSED LEGISLATION**

 

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Actof 2002 (the “Act”), which immediately impacts Securities and ExchangeCommission registrants, public accounting firms, lawyers and securitiesanalysts. This legislation is the most comprehensive since the passage of theSecurities Act of 1933 and the Securities Exchange Act of 1934. It has farreaching effects on the standards of integrity for corporate management, boardof directors, and executive management. Additional disclosures, certificationsand procedures will be required of the Company. Management does not anticipateany material adverse effect on the Company as a result of the passage of thislegislation; however, the full scope of the Act has not yet been determined.

 

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

 

**General**

 

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

 

For this analysis, the following changes in the Company’s businessshould be considered:  K-tel closed theoperations of its German subsidiary, Dominion Vertriebs GmbH, in June 2000; oneof its subsidiaries in the United Kingdom, K-tel Marketing Ltd., in November2000; and a United States subsidiary, K-tel Consumer Products, Inc., inFebruary 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 is implementing a more-focused methodof distribution that targets the strengths of fewer individual retailers andsupplies products suited to each retailer’s specific needs. These new productsare derived from the Company’s master recordings music catalog with theobjective of realizing more competitive profit margins. As well, the Companyseeks to license its name and marks to other businesses for a royalty or fee.

 

#### **THREE MONTHS ENDED MARCH 31, 2003 VERSUS MARCH31, 2002**

 

Net sales for the three months ended March 31, 2003 were $1,923,000, anincrease of 8.9% from sales of $1,766,000 for the quarter ended March 31, 2002.This increase resulted primarily from a significant increase in the number oftitles available for sale to U.S. retail music stores.

 

The loss for the three months ended March 31, 2003 was $439,000, or$.03 per share, compared to a loss of $307,000, or $.02 per share, for thethree months ended March 31, 2002.

 

General corporate expenses of $179,000 and $404,000 for the threemonths ended March 31, 2003 and March 31, 2002 respectively have been allocatedto the business segments.

 

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

 

#### **BUSINESS SEGMENT RESULTS**

 

#### **Music**

 

Sales in the music segment were $1,385,000 for the three months endedMarch 31, 2003 compared to $962,000 for the three months ended March 31, 2002,an increase of $423,000, or 44%. Sales to retailers increased both in the U.S.and England because of increased and improved product offerings and additionalcustomers, but sales decreased marginally in the English shopping channel andexport markets.

 

Cost of goods sold in the music segment decreased to 64.6% of sales forthe three months ended March 31, 2003 compared to 70.0% of sales for the threemonths ended March 31, 2002. This decrease reflected slight improvements inprofit margins in both the U.S. and England, even though the remaining U.S.inventory of DVD products was sold for less than cost. Advertising expenseswithin the segment, which consist primarily of co-operative advertisingpayments, trade advertising and promotions, increased to $81,000 and wereapproximately 5.8% of sales for the three months ended March 31, 2003 comparedto $29,000, or 3.0% of sales for the three months ended March 31, 2002. Thisincrease was related to increased promotional programs with customers. Selling,general and administrative expenses were $590,000, or 42.6% of sales for the threemonths ended March 31, 2003 compared to $834,000, or 86.7% of sales for thethree months ended March 31, 2002. The decrease of $244,000 resulted mainlyfrom cost reductions in Europe achieved by closing down the Company’s musicsales branch office in Germany and terminating an agreement to administer acatalog owned by Marathon Music.

 

As a result, the music segment incurred an operating loss of $183,000for the three months ended March 31, 2003 compared to an operating loss of$537,000 for the three months ended March 31, 2002.

 

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**Licensing**

 

Licensing revenue was $538,000 for the three months ended March 31,2003 compared to $804,000 for the three months ended March 31, 2002, a decreaseof 33%. This reflected a general reduction in licensing activity in the musicindustry. Selling, general and administrative expenses were $434,000 for thethree months ended March 31, 2003 compared to $348,000 for the three monthsended March 31, 2002, an increase of $86,000, or 24.7%. While the Companycontinued to achieve operating cost reductions, new costs were incurred relatedto audits of the licensees of the Company’s music catalog. Operating income inthe licensing segment was $9,000 for the three months ended March 31, 2003 and$409,000 for the three months ended March 31, 2002, a decrease of 97.8%.

 

#### **NINE MONTHS ENDED MARCH 31, 2003 VERSUS MARCH31, 2002**

 

Net sales for the nine months ended March 31, 2003 were $5,295,000, anincrease of .8% from sales of $5,251,000 for the nine months ended March 31,2002. The loss for the nine months ended March 31, 2003 was $1,336,000, or $.10per share, compared to a loss of $918,000, or $.07 per share, for the ninemonths ended March 31, 2002.

 

General corporate expenses of $631,000 and $881,000 for the nine monthsended March 31, 2003 and 2002 have been allocated to the business segments.

 

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

#### ** **

#### **BUSINESS SEGMENT RESULTS**

 

#### **Music**

 

Sales in the music segment were $3,569,000 for the nine months endedMarch 31, 2003 compared to $3,264,000 for the nine months ended March 31, 2002,an increase of $305,000, or 9.3%. While domestic sales increased $615,000,European music sales decreased $310,000 primarily because of significantfragmentation in the shopping channel market in England as well as lower salesoutside England. The Company does not expect sales to the shopping channelmarket to increase. Sales outside England were adversely affected by the strengthof the British pound.

 

Cost of goods sold in the music segment increased to 60.4% of sales forthe nine months ended March 31, 2003 compared to 55.7% of sales for the ninemonths ended March 31, 2002. This increase reflected reduced domestic grossprofit margins that resulted from adverse currency fluctuations on productspurchased for resale in the budget music market. Advertising expenses withinthe segment, which consist primarily of co-operative advertising payments,trade advertising and promotions, increased to $166,000 and was approximately4.7% of sales for the nine months ended March 31, 2003 compared to $80,000, or2.5% of sales for the nine months ended March 31, 2002. This cost increase wasrelated to the increased levels of advertising and customer promotions duringthe period. Selling, general and administrative expenses were $1,898,000, or53.2% of sales for the nine months ended March 31, 2003 compared to $2,560,000,or 78.4% of sales for the nine months ended March 31, 2002. The reduction of$662,000, or 25.9%, was mainly due to continuing efforts to achieve costreductions particularly in Europe where the Company closed its music salesbranch office in Germany and terminated an agreement to administer a catalogowned by Marathon Music.

 

As a result, the music segment incurred an operating loss of $588,000for the nine months ended March 31, 2003 compared to an operating loss of$1,167,000 for the nine months ended March 31, 2002.

 

**Licensing**

 

Licensing revenue was $1,726,000 for the nine months ended March 31,2003 compared to $1,987,000 for the nine months ended March 31, 2002, adecrease of $261,000, or 13%. While European revenue decreased $280,000,domestic revenue from licensing activity increased $19,000. The decrease inEurope reflected a reduced level of licensing in the music industry. Whiledomestic licensing experienced this as well, licensing revenue from theCompany’s main license increased significantly. In mid-2002, the Companyundertook a program to audit licensees of the music catalog in order to verifycompliance with the terms of license agreements. The first audit was undertakenat Madacy Entertainment (“Madacy”) and determined that a significant amount ofrevenue had not been reported to the Company. During the nine months endedMarch 31, 2002 Madacy has made royalty payments that are more appropriate underthe license, and the Company’s revenue has increased accordingly during theyear. While the Company expects other licensing activity to continue at areduced level at least through the remainder of the fiscal

 

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year, the Company is hopeful that current efforts will help reversethis trend for the Company in the next fiscal year. Madacy has made interimpayments to the Company while the audit results are finalized. Selling, generaland administrative expenses were $1,079,000 for the nine months ended March 31,2003 compared to $880,000 for the nine months ended March 31, 2002, an increaseof $199,000, or 22.6%. This increase was attributable to costs associated withthe Madacy audit. Operating income in the licensing segment was $315,000 forthe nine months ended March 31, 2003 and $789,000 for the nine months endedMarch 31, 2002, a decrease of 60%.

 

**New Accounting Pronouncements**

 

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

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc.(“K-5”), the Company’s largest shareholder controlled by Philip Kives, theChairman of the Board, President and Chief Executive Officer of K-tel. Underthe terms of the agreement (the “K-5 Facility”), K-5 has agreed to makeavailable up to $8,000,000 to K-tel on a revolving basis. The loan bearsinterest at a variable rate based upon the “base rate” of a nationallyrecognized lending institution (4.25% at March 31, 2003), expires July 20,2005, and is subordinated to the Foothill loan (see below). The K-5 Facilitycontains the same covenants as the Foothill loan agreement. K-tel has pledgedthe stock of its foreign subsidiaries as collateral for the loan, and the loancarries a subordinated position to the Foothill loan on all other assets of theCompany. K-tel had outstanding balances of $7,102,000 and $6,026,000 as ofMarch 31, 2003 and June 30, 2002 respectively under the K-5 Facility. At March31, 2003, K-tel obtained a waiver from K-5 for its non-compliance under thecovenants, limitations and restrictions of the credit agreement.

 

In addition, K-tel has a second loan agreement with K-5, under whichK-5 assumed rights and obligations under a loan from the Company’s formerbanker (Foothill Capital Corporation) pursuant to an Assignment and AcceptanceAgreement dated February 27, 2001. This Foothill loan, which has been extendedthrough July 20, 2005, provides for a $10,000,000 credit facility consisting ofa $4,000,000 term loan due upon expiration, and a $6,000,000 revolving facilityunder which borrowings are limited to a percent of eligible receivables.Borrowings under the facility bear interest at a variable rate based on a “baserate” of a nationally recognized lending institution plus 1% (5.25% at March31, 2003) and are collateralized by the assets of certain Company subsidiariesin the United States, including accounts receivable, inventories, equipment,music library and general intangibles. The loan agreement contains certainfinancial and other covenants or restrictions, including the maintenance of aminimum shareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of March 31, 2003 and June 30,2002, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At March 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 overdraft privilege borrowing facility with The Royal Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2% per annum over the base rate(a total of 6% at March 31, 2003) and are subject to a minimum of 6% per annum.K-tel had outstanding balances of $218,000 and $227,000 as of March 31, 2003and June 30, 2002 respectively.

 

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

 

The Company’s ability to continue its present operations and implementfuture expansion plans successfully is contingent mainly upon its ability tomaintain its line of credit arrangements with K-5 Leisure Products, Inc. (SeeNote 3.), increase its revenues, and ultimately attain and sustain profitableoperations. Without increased revenues and sustained profitability, the cashgenerated from the Company’s current operations will likely be inadequate tofund operations and service its indebtedness on an ongoing basis. Management isfocusing its efforts on music licensing and limited music distribution.However, there can be no assurance that the Company will achieve

 

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profitable operations through these efforts. The financial statementsdo not include any adjustments that might result from the outcome of theseuncertainties.

 

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

 

There have been no material changes in the Company’s market risk duringthe nine months ended March 31, 2003. For additional information, refer to page14 of the Company’s annual report on Form 10-K for the fiscal year ended June30, 2002.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

The Company maintains a system of disclosurecontrols and procedures that is designed to provide reasonable assurance thatinformation, which is required to be disclosed, is accumulated and communicatedto management timely. Within the 90 days prior to the date of this report,K-tel carried out an evaluation, under the supervision and with theparticipation of K-tel’s management, including K-tel’s Chief Executive Officerand the Chief Financial Officer, of the effectiveness of the design andoperation of K-tel’s disclosure controls and procedures as defined in ExchangeAct Rules 13a-14(c) and 15d-14(c). Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that K-tel’s disclosurecontrols and procedures are effective in alerting them in a timely manner tomaterial information relating to the Company (including its consolidatedsubsidiaries) required to be included in the Company’s periodic SEC filings.

 

There were no significant changes in K-tel’sinternal controls or in other factors that could significantly affect thesecontrols subsequent to the date of their evaluation.

 

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**PART II**

 

 

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

 

Class Action Suit

 

K-tel and certain of its current and former officers and directors werenamed as defendants in *In re K-telInternational, Inc. Securities Litigation*, No. 98-CV-2480. Thisaction consolidated twenty-three purported class actions that were initiallyfiled in various United States District Courts in November 1998, and weresubsequently transferred to, and consolidated in, the United States DistrictCourt for the District of Minnesota. On July 19, 1999, the plaintiffs filed anamended consolidated class action complaint that challenged the accuracy ofcertain public disclosures made by K-tel regarding its financial conditionduring the period from May 1998 through November 1998. The plaintiffs assertedclaims under the federal securities laws and sought damages in an unspecifiedamount as well as costs, including attorneys’ fees and any other relief the Courtdeemed just and proper. K-tel moved to dismiss the complaint, and on July 31,2000, the United States District Court granted the Company’s motion to dismiss.The Court also barred further actions by the plaintiffs and denied plaintiffs’request to amend the complaint in order to refile the complaint in the future.The plaintiffs appealed to the United States Court of Appeals for the EighthCircuit, and the Court of Appeals heard the matter in October 2001. On August7, 2002 the Court of Appeals, in a two to one decision, denied the plaintiffs’appeal. On August 20, 2002 the plaintiffs applied for a rehearing by the fullCourt of Appeals. K-tel filed a response on September 15, 2002 to theplaintiffs’ petition for rehearing at the request of the Court. On October 2,2002, the Court denied the petition for rehearing. The plaintiffs had untilJanuary 1, 2003 to seek a writ of certiorari (a petition asking the Court for adiscretionary review of a lower court decision) from the United States SupremeCourt, but did not seek this writ. There having been no appeals filed, the casehas been dismissed with prejudice on the merits.

 

RTL Shopping S. A.

 

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

 

The initial lawsuit against RTL9 and the RTL9 claim against K-tel areproceeding together through the French courts, and the parties involved in theinitial lawsuit continue to submit new briefs to the Court related to thataction. The action seeks damages in the approximate amount of 20 million FrenchFrancs, or approximately $2.8 million. The Company believes that RTL9 has nobasis for a complaint against the Company. As the result of informationsupplied by the parties to the Court, RTL9 has proposed to drop the lawsuit.

 

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

 

On March 14, 2000, K-tel and its subsidiary in Germany commenced anaction for breach of express and implied warranties against Defendant TristarProducts, Inc. This action is venued in the United States District Court forthe District of Minnesota. This action arises out of Tristar’s sale to K-tel ofa defective home exercise product called the “BunBlaster” for resale inGermany, Austria and Switzerland. By written contract, Tristar has agreed toindemnify  K-tel for injuries anddamages arising out of the resale of those goods. K-tel is seekingapproximately $2 million in consequential damages. Tristar is vigorously defendingthis. Discovery has been completed. The Court has ordered that the action beready for trial by June 2, 2003, after which the Court will schedule a trialdate.

 

 

On April 30, 2001, Tristar also asserted a patent and trademark/trade-dress counter-claim against K-tel for allegedly passing off a productcalled the “K-tel Hook and Hang” while allegedly a distributor of the originalpatented Tristar Hook and Hang product. The Company denies the allegationbecause it never was a distributor of this or any similar

 

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product and intends to defend this action vigorously. Tristar has notidentified the amount of damages it seeks with respect to this counterclaim.The United States District Court for the District of Minnesota issued an orderon August 14, 2001 severing this action from the Company’s action. This actionis at an early stage and no discovery or other actions have occurred.

 

#### **OtherLitigation and Disputes**

 

K-tel and its subsidiaries are also involved in other legal actions inthe ordinary course of its business. With all litigation matters, managementconsiders the likelihood of loss based on the facts and circumstances. Ifmanagement determines that a loss is probable and the amount of loss can be reasonablyestimated, such amount is recorded as a liability. Although the outcome of anysuch legal actions cannot be predicted, in the opinion of management there iscurrently no legal proceeding pending or asserted against or involving K-telfor which the outcome is likely to have a material adverse effect upon theconsolidated financial position or results of operations of K-tel.

 

Subsidiaries’ Bankruptcy and Liquidation

 

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

 

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

 

**ITEM2.  CHANGES IN SECURITIES AND USE OFPROCEEDS**

 

On January 13, 2003, the Company issued non-qualified stock options topurchase 95,000 shares of common stock to each of Jay William Smalley, RichardR. Marklund and Wesley C. Hayne, in consideration of their agreements to serveon the Company’s Audit Committee and Compensation/Stock Option Committee. OnJanuary 13, 2003, the Company also issued to Mr. Smalley a non-qualified stockoption to purchase 15,000 shares of common stock in consideration of past andcontinued service on the Company’s board of directors. The foregoing optionswere authorized by the Company’s board of directors effective November 27, 2002and were granted outside the Company’s 1997 Stock Option Plan in transactionsnot involving any public offering pursuant to the exemption from registrationin Section 4(2) of the Securities Act of 1933. Such securities are restrictedas to sale or transfer, unless registered under the Securities Act, andinstruments representing such securities contain restrictive legends preventingsale, transfer or other disposition unless registered under the Securities Act.In addition, the recipients of such securities received, or had access to,material information concerning the Company including, but not limited to,reports on Form 10-K, Form 10-Q and Form 8-K, as filed with the SEC. Theoptions were vested in full upon grant and are exercisable at $0.05 per sharefor a period of ten years from the date of grant.

 

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

 

 

(a)                                  EXHIBITS

 

See “Index to Exhibits.”

 

(b)                                 REPORTS ON FORM 8-K

 

There were no reports filed under Form 8-K by the Company during thethree month period ended March 31, 2003.

 

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##### **SIGNATURES**

 

 

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

 

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

 

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**CERTIFICATIONS**

 

 

CHIEF EXECUTIVE OFFICERCERTIFICATION PURSUANT TO RULE 13a-14

 

 

I, PhilipKives, President and Chief Executive Officer of K-tel International, Inc.,certify that:

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

6.                                       The othercertifying officer and I have indicated in this quarterly report whether or notthere were significant changes in internal controls or in other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

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

 

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CHIEF FINANCIAL OFFICERCERTIFICATION PURSUANT TO RULE 13a-14

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

6.                                       The othercertifying officer and I have indicated in this quarterly report whether or notthere were significant changes in internal controls or in other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

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

 

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**INDEX TOEXHIBITS**

 

 
| **Exhibit Number** |   | **Description**                                                                                                                                       |
|--------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |   |                                                                                                                                                  |
| 10                 |   | Form of Non-Qualified Stock  Option Agreement between the registrant and certain directors of the  registrant, authorized effective November 27, 2002 |
|               |   |                                                                                                                                                  |
| 99.1               |   | Certification Pursuant to 18  U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                              |
|               |   |                                                                                                                                                  |
| 99.2               |   | Certification Pursuant to 18  U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                              |

 

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