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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

         (Mark One)

OR

Commission file number 000-30063

ARTISTDIRECT, INC.

(323) 634-4000
(Registrant’s telephone number, including area code)

N/A
(Former name, former address and former fiscal year, if changed since last report)

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

Yes [X]   No [   ]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Number of shares of Common Stock, par value $0.01 per share, outstanding as of September 30, 2002: 3,461,130 shares.

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INDEX

         In this Report, the words “ARTISTdirect,” the “Company,” “we,” “us” and “our” collectively refer to ARTISTdirect, Inc.

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PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS.

ARTISTdirect, Inc. and Subsidiaries
Consolidated Balance Sheets
(amounts in thousands)

See accompanying notes to consolidated financial statements.

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ARTISTdirect, Inc. and Subsidiaries
Consolidated Statements of Operations
(amounts in thousands, except for share data)

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ARTISTdirect, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(amounts in thousands)

See accompanying notes to consolidated financial statements.

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ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1 – THE COMPANY

ARTISTdirect, Inc. (the “Company”) was formed on October 6, 1999 upon its merger with ARTISTdirect, LLC (the “Capital Reorganization”). The Capital Reorganization was only a change in the form of ownership of the Company. ARTISTdirect, LLC was organized as a California limited liability company and commenced operations on August 8, 1996.

NOTE 2 – REVERSE STOCK SPLIT

On July 5, 2001, the Company declared a 1 for 10 reverse stock split (the “Reverse Stock Split”). The outstanding common stock, redeemable common securities, options and warrants have been retroactively adjusted to reflect the Reverse Stock Split.

NOTE 3 – CRITICAL ACCOUNTING POLICIES

Principles of Consolidation

The accompanying financial statements include the consolidated accounts of the Company and its subsidiaries in which it has controlling interests in the form of voting and operating control. All significant intercompany accounts and transactions have been eliminated for all periods presented.

Unaudited Interim Financial Information

The unaudited interim financial statements of the Company included herein have been prepared in accordance with the instructions for Form 10-Q under the Securities Exchange Act of 1934, as amended, and Article 10 of Regulation S-X under the Securities Act of 1933, as amended. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements.

In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company at September 30, 2002 and results of its operations for the three and nine months ended September 30, 2002 and 2001 and cash flows for the nine months ended September 30, 2002 and 2001. The results for the three and nine months ended September 30, 2002 are not necessarily indicative of the expected results for the full year or any future period. These financial statements should be read in conjunction with the consolidated financial statements and footnotes included in the Company’s documents filed with the Securities and Exchange Commission (“SEC”) including its Form 10-K and Registration Statements on Form S-1, and all amendments thereto.

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Loss Per Common Share

The Company computes net loss per share in accordance with Statement of Financial Accounting Standards (“SFAS”) No.128, “Earnings Per Share,” and Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) No. 98. SFAS No.128 requires companies with complex capital structures to present basic and diluted earnings per share (“EPS”). Basic EPS is measured as the income or loss available to common shareholders divided by the weighted average outstanding common shares for the period. Diluted EPS is similar to basic EPS but presents the dilutive effect on a per-share basis of potential common shares (e.g., convertible securities, options, and the like) as if they had been converted at the beginning of the periods presented. Potential common shares that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from diluted EPS. The number of potentially dilutive common share equivalents outstanding as of September 30, 2002 and 2001 and excluded from diluted EPS because their effect is anti-dilutive, was approximately 750,000 and 1.3 million respectively.

Revenue Recognition

E-Commerce revenue includes the sale of music and related merchandise, such as apparel, collectibles and accessories, through the ARTISTdirect shopping mall of the Company’s network. The Company recognizes the gross amount of product sales and shipping revenue upon shipment of the item and records appropriate reserves for product returns. The Company has experienced seasonality with respect to its online product sales. In particular, the Company’s e-commerce sales in the fourth quarter have, on average, been higher than in other quarters. The Company believes that this trend may continue for the foreseeable future.

Media revenue consists primarily of sales of banner advertisements and sponsorships. In sales of banner advertisements, the Company principally earns revenue based on the number of impressions or times an advertisement appears on pages viewed within its Web sites. The Company’s banner advertising commitments generally range from one to six months. Banner advertising revenue is generally recognized as the impressions are served during the period in which the advertisement is displayed, provided that no significant obligations of ARTISTdirect remain and collection of the resulting receivable is reasonably assured. The Company typically guarantees a minimum number of impressions to the advertiser. To the extent that minimum guaranteed page deliveries are not met, the Company defers recognition of the corresponding revenue until the guaranteed impressions are delivered. There were no such instances as of September 30, 2002 and 2001. The Company also sells to advertisers sponsorship of a Web page or event for a specified period of time. The Company recognizes sponsorship revenue over the period in which the sponsored page or event is displayed. To the extent that committed obligations under sponsorship agreements are not met, revenue recognition is deferred until the obligations are met.

iMusic record label revenue consists primarily of the sale of compact discs by artists signed to the iMusic record label. The Company recognizes revenues upon the shipment of compact discs to retailers and independent wholesalers and records appropriate reserves for product returns. iMusic is the brand name used by the Company for the record label operated by its wholly-owned subsidiary ARTISTdirect Digital, Inc.

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Stock-Based Compensation

Stock-based compensation included in cost of revenue represents the amortization of non-cash compensation expense related to vendor warrants and stock options granted to artists and their advisors in connection with entering into contractual commitments to operate their online commerce activities, as well as compensation amounts resulting from the rescission offer completed in December 2001. The Company records the fair value of options and warrants granted to non-employees as compensation expense over the period of service. The Company determines the fair value of these options and warrants based on the Black-Scholes option pricing model.

Stock-based compensation included in operating expenses represents the amortization of non-cash compensation expense related to equity instruments granted to employees, directors, professional firms, artists and artist advisors, as well as compensation amounts resulting from the rescission offer completed in December 2001. Compensation for equity grants to non-employees is recorded in the same manner as described above. The Company records stock compensation for employee option grants equal to the excess of the fair value of its common stock over the exercise price on the grant date. The Company records the compensation over the vesting period.

Please see Note 5 below for more information on stock-based compensation.

Impairment of Long-Lived Assets and Goodwill

Prior to 2002, the Company followed the provisions of SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of,” which required it to periodically review the carrying amounts of long-lived assets (which consist primarily of fixed assets) and goodwill to determine whether current events or circumstances warrant adjustments to such carrying amounts. An impairment adjustment is necessary in the event that the net book value of such long-lived assets and related goodwill exceeds the future undiscounted cash flows attributable to such assets. In such an event, the loss is measured by the amount that the carrying value of such assets exceeds their fair value. Considerable management judgment is necessary to estimate the fair value of assets; accordingly, actual results could vary significantly from such estimates. As of January 1, 2002, the Company follows the provisions of SFAS No. 142 and No. 144, as more fully described below.

Estimates

In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Such estimates for the Company include the allowance for doubtful accounts, the valuation allowance on deferred tax assets, useful lives of intangible assets and the valuation of long-lived assets and goodwill. Such estimates for the ARTISTdirect Records record label joint venture include the allowance for returns and the reserve on artist advances. Actual results could differ from those estimates.

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Reclassifications

Certain reclassifications have been made to the 2001 Financial Statements to conform to the 2002 presentation.

Recently Issued Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141, “Business Combinations” (“SFAS No. 141”) and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). SFAS No. 141 requires that the purchase method of accounting be used for all business combinations and specifies criteria that intangible assets acquired in a business combination must meet to be recognized and reported separately from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 142.

Following is a reconciliation of the reported net loss for the three and nine months ended September 30, 2002 and 2001 to the net loss, as it would have been if SFAS No. 142 had been effective on January 1, 2001:

As of June 30, 2002, the Company determined that the remaining goodwill was impaired due to the continued downturn in the online advertising market combined with the decline in the market place values for advertising-based Internet businesses. As a result, the Company recorded a loss from impairment of the goodwill in the amount of $788,000 in the second quarter of 2002. The loss from impairment of goodwill was recorded as a then current period operating expense as the events that caused the reduction in value transpired subsequent to the transition date of January 1, 2002.

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). SFAS No. 143 requires the Company to record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development and/or normal use of the assets. The Company also records a corresponding asset that is depreciated over the life of the asset. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the end of each period to reflect the

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passage of time and changes in the estimated future cash flows underlying the obligation. The Company is required to adopt SFAS No. 143 on January 1, 2003. The adoption of this pronouncement is not expected to have a material impact on the Company’s consolidated financial statements.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”). SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. SFAS No. 144 requires companies to separately report discontinued operations and extends that reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. The Company adopted the provisions of SFAS No. 144 effective January 1, 2002. The adoption has not had any effect on the Company’s financial statements.

In July 2002, the issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3 (EITF 94-3), “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The Statement is based on the general principle that a liability for a cost associated with an exit or disposal activity should be recorded when it is incurred, that is, when it meets the definition of a liability.

NOTE 4 – ARTIST DIRECT RECORDS, LLC

In May 2001, the Company entered into an agreement with veteran entertainment executive Frederick W. “Ted” Field to become Chairman and Chief Executive Officer of ARTISTdirect and form a new record label, ARTISTdirect Records, LLC, in partnership with ARTISTdirect. On June 29, 2001, ARTISTdirect stockholders approved the employment of Mr. Field and the formation of the ARTISTdirect Records record label. ARTISTdirect Records was formed as a 50/50 co-venture between ARTISTdirect and Mr. Field, with the Company providing a significant financial commitment.

In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North American distribution agreement and worldwide license agreement with BMG, the global music division of Bertelsmann AG. Under the terms of the agreement, BMG Distribution will distribute ARTISTdirect Records’ releases in North America, and BMG will license ARTISTdirect Records’ repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Records from the Company. As part of this transaction, BMG agreed to assume $5.0 million of the Company’s funding commitment to ARTISTdirect Records.

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The Company initially committed to the venture a total of $50 million over five years with the Company committing to fund up to $15.0 million per year, subject to a limit of $33 million in any three year period. Any funding in excess of these amounts would require the approval of the Company’s Board of Directors. As a result of the BMG equity purchase, the Company’s funding commitment has been reduced to $45 million.

In August 2002, the Company’s Board of Directors approved an agreement (the “Bridge Loan Agreement”) to accelerate up to $10 million of its funding commitment to ARTISTdirect Records. This funding is in addition to $15 million that the Company is obligated to advance to ARTISTdirect Records in 2002 as part of the $50 million funding commitment entered into between the Company and ARTISTdirect Records in April 2001 and approved by the Company’s stockholders in June 2001. Any and all advances made pursuant to the Bridge Loan Agreement will be credited toward satisfaction of the Company’s overall commitment and toward satisfaction of its funding obligation for 2003.

Under the terms of the Bridge Loan Agreement, the Company will make up to $10 million available to ARTISTdirect Records during the remainder of 2002 in four-week tranches approved by the Board. The Company’s Board has approved the initial tranche of funding for the four-week period ended September 30, 2002. As consideration for entering into the Bridge Loan Agreement, the Company will receive a 2.0% interest in ARTISTdirect Records from Radar Records Holdings, L.L.C. (“FieldCo,” the entity through which Mr. Field owns his interest in ARTISTdirect Records) and, as consideration for the funding of each four-week tranche, the Company will receive an additional 4.5% interest in ARTISTdirect Records from FieldCo (collectively, the “Equity Transfer”). Assuming funding of the entire $10 million, the Company’s interest in ARTISTdirect Records would increase to 65% from 45% and Mr. Field’s interest in ARTISTdirect Records would decrease to 30% from 50%. The Bridge Loan Agreement also provides that any dilution from the issuance of equity interests in ARTISTdirect Records that would have been borne solely by the Company will be borne both by FieldCo and the Company pro rata with their then respective ownership interests. Furthermore, the Bridge Loan Agreement contains a provision designed to provide the Company with a minimum compound annual rate of return of 25% based upon the realized value of the Bridge Loan Agreement and the Equity Transfer, however, there can be no assurance that such rate of return will be realized.

The Company has advanced a total of $18.75 million for the nine months ended September 30, 2002, of which $3.75 million represented advances approved by the Company’s Board under the Bridge Loan Agreement. As a result, the Company’s interest in ARTISTdirect Records as of September 30, 2002 has increased from 45% to 53.75% and Mr. Field’s interest has decreased from 50% to 41.25%. From inception, the Company has advanced a total of $24.0 million of its $45.0 million commitment as of September 30, 2002.

As of September 30, 2002, the Company had unrestricted cash and short-term investments totaling $16.3 million. Pro forma for advances made subsequent to September 30, 2002 and assuming funding of the entire $10 million under the Bridge Loan Agreement, the Company’s advances to ARTISTdirect Records would total $30.25 million and the Company’s unrestricted cash and short-term investments would be $10.0 million.

In addition, the Company has a commitment to advance to ARTISTdirect Records approximately $2.75 million in 2003 (assuming the full $10 million provided under the Bridge Loan Agreement is advanced by the Company in 2002, as expected) and approximately $12.0 million in 2004.

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The Company’s commitment to fund ARTISTdirect Records is subject to a guaranty for the benefit of BMG. Should the Company fail to meet its commitment, BMG may choose to enforce the guaranty or provide substitute financing that could result in dilution of the Company’s interest in ARTISTdirect Records.

Assuming payment of the $2.75 million advance to ARTISTdirect Records in 2003, the Company currently anticipates that available cash resources, including short-term investments, may not be sufficient to meet anticipated needs for working capital and capital expenditures for at least twelve months without additional capital. Furthermore, ARTISTdirect Records will require capital in addition to that to be provided by the Company to continue its operations.

The Company is currently pursuing alternatives to raise additional capital in order to continue funding of the Company and ARTISTdirect Records. There can be no assurance that additional capital can be obtained by either the Company or by ARTISTdirect Records on reasonable terms, in a timely manner or at all. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records and the Company, and impair the value of the Company’s investment in ARTISTdirect Records. If additional funds are raised through the issuance of equity securities of either the Company or ARTISTdirect Records, the percentage ownership of current stockholders in the Company and/or ARTISTdirect Records will be reduced.

Because the Company is not deemed to have voting or operating control of ARTISTdirect Records, it does not consolidate the results of ARTISTdirect Records and it records its share of losses based on the equity method of accounting as income (loss) from equity investments in its consolidated statements of operations. Prior to the completion of BMG’s purchase of a 5% interest in ARTISTdirect Records in April 2002 and BMG’s assumption of 10% of the Company’s total funding commitment, the Company had committed to fund 100% of the operations of ARTISTdirect Records and has recorded 100% of the losses attributable to that venture from inception to April 30, 2002. From May 1, 2002, the Company has recorded only its proportionate share, on the basis of relative funding commitments, of any future losses of ARTISTdirect Records. The Company recognized $23.6 million of equity loss from the record label for the nine months ended September 30, 2002 and has recognized $32.3 million of losses from inception to September 30, 2002.

The carrying amount of the Company’s investment in ARTISTdirect Records represents the difference between the Company’s investment and advances and the Company’s share of profit or loss from ARTISTdirect Records. As of September 30, 2002, the Company’s share of losses exceeded the amount of the Company’s investment and advances to date, resulting in a credit balance of approximately $8.3 million. Therefore, the carrying amount has been classified as a liability on the Company’s balance sheet.

A roll forward of the Company’s net investment balance for the nine months ended September 30, 2002 is as follows:

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A summary income statement for ARTISTdirect Records for the three and nine months ended September 30, 2002 is as follows (amounts in thousands):

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A summary balance sheet for ARTISTdirect Records as of September 30, 2002 is as follows (amounts in thousands):

As of September 30, 2002, ARTISTdirect Records had entered into recording agreements with fourteen artists and advanced a total of $10.1 million in artist and producer advances and recording costs. The amount of these advances is recoupable against royalties to be earned by the artists and producers based on sales. However, given that the artists signed by ARTISTdirect Records have no previous track record, the venture has accrued a provision for 100% of the advances expended, in accordance with generally accepted accounting principles.

From July 16, 2002, Mr. Field has elected to defer his salary that he was due to receive under his employment agreements with ARTISTdirect Records and ARTISTdirect. As of September 30, 2002, a total of $208,333 and $104,667, respectively, had been expensed and accrued by ARTISTdirect Records and ARTISTdirect.

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NOTE 5 – STOCK-BASED COMPENSATION

Stock-based compensation represents the amortization of non-cash compensation expense related to equity instruments granted to employees, directors, professional firms, artists and advisors and is recorded in both cost of revenue and operating expenses. Stock-based compensation recorded in cost of revenue represents compensation in connection with artists entering into contractual commitments to operate their online commerce activities.

Stock-based compensation in cost of revenue for the three and nine months ended September 30, 2002 was $792,000 and $2.7 million, respectively. Stock-based compensation expense for the three and nine months ended September 30, 2001 was $1.5 million and $4.6 million, respectively.

Stock-based compensation in operating expenses for the three and nine months ended September 30, 2002 was $399,000 and $1.9 million, respectively. Stock-based compensation expense for the three and nine months ended September 30, 2001 was $1.6 million and $4.9 million, respectively.

In December 2001, the Company completed a rescission offer in which it rescinded the purchase of 83,403 shares of its common stock purchased upon the exercise of options and the issuance of vested and unvested unexercised options to purchase 636,740 shares of its common stock. The shares of common stock were repurchased at prices ranging from $12.40 to $40.00 per share and the unexercised options that were rescinded had exercise prices ranging from $12.40 to $140.00 per share. In aggregate, the Company paid $10.2 million to rescind the shares and options. During 2001, the Company recorded stock-based compensation related to the rescission offer of approximately $6.9 million. An additional approximate $1.8 million is being expensed during 2002, of which approximately $370,000 was recorded for the three months ended September 30, 2002 and $1.7 million was recorded for the nine months ended September 30, 2002. We did not record any compensation expense related to the shares and options of those holders who chose not to accept the rescission offer.

NOTE 6 – SEGMENT INFORMATION

As of September 30, 2002, the Company operates primarily through three reportable segments: E-commerce operations (“E-commerce”), Media operations (“Media”) and iMusic record label operations (“iMusic record label”). iMusic is the brand name used by the Company for the record label operated by its wholly-owned subsidiary ARTISTdirect Digital, Inc. Because ARTISTdirect Records’ results are not consolidated due to the fact that the Company does not exert voting and operating control over it, ARTISTdirect Records’ activity is not included in the same segment data as the iMusic record label..

In prior years, the Company also considered its talent agency business to be a segment, but the Company decided, in December 2001, to exit this business and as a result it has been shown as a discontinued operation in the consolidated statements of operations. The Company also previously considered digital music to be a separate segment; however, this business has not developed as quickly as initially anticipated and is no longer considered a separate reportable segment. The segment data below has been restated for all periods to reflect the current segment structure.

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E-commerce revenue is generated from the sale of recorded music and music-related merchandise. Media revenue is generated from the sale of advertising and sponsorships, both online and offline. iMusic record label revenue is generated from the sale of recorded music performed by Artists signed to the iMusic record label, which is wholly-owned by the Company.

The factors for determining reportable segments were based on service and products. Each segment is responsible for executing a unique marketing and business strategy. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on EBITDA (earnings or loss before interest, taxes, depreciation and amortization, stock based compensation, loss from impairment of goodwill, and income (loss) from discontinued operations). Included in EBITDA loss are direct operating expenses for the segment. The following table summarizes the revenue and EBITDA loss by segment for the three months ended September 30, 2002 and 2001, respectively. Corporate expenses consist of general operating expenses that are not directly related to the operations of the segments.