K TEL INTERNATIONAL INC - 10-K Annual Report

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K-tel International, Inc.
2605 Fernbrook Lane N.
Minneapolis, MN 55427

October 12, 1998

Securities and Exchange Commission
450 Fifth Street, NW
Attn: Filing Desk, Stop 1-4
Washington, D.C. 20549-1004

Gentlemen:

Enclosed is K-tel International, Inc.'s Form 10K for the fiscal year ended June
30, 1998, pursuant to the applicable provisions of the Securities Exchange Act
of 1934.

Questions can be directed to the undersigned at 818-225-6160 or faxed to
818-223-4200.

Sincerely,

/S/ Corey Fischer
Chief Financial Officer
K-tel International, Inc.

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended June 30, 1998

OR

[ ] 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 (I.R.S. employer identification no.)
incorporation or organization)

2605 Fernbrook Lane North, Minneapolis, Minnesota 55447-4736
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (612) 559-6888

Securities registered pursuant to Section 12(b) of the Act:
None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.01 The Nasdaq Stock Market
(Title of class) (Name of exchange on which registered)

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
of1934 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 by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

As of September 11, 1998 the aggregate market value of voting stock held
by non-affiliates of the registrant based on the last sales price as reported by
the Nasdaq Stock Market on such date was $34,235,000.

As of June 30, 1998 the registrant had 8,316,668 shares of Common Stock
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Company's Notice of Meeting of Shareholders and Proxy Statement
for the Annual Shareholders Meeting, which are expected to be filed with the
Security and Exchange Commission in the next 30 days, are incorporated into Part
III of this Form by amendment.

1

PART I

ITEM 1: BUSINESS

K-tel International, Inc. (the "Company", "K-tel" or the "Registrant") was
incorporated in 1968 with its current corporate offices located at 2605
Fernbrook Lane North, Minneapolis, Minnesota. The Company is an international
marketer and distributor of entertainment and consumer products and is a leader
in the market niche for pre-recorded music compilations. With more than thirty
years of marketing experience in the United States ("U.S."), Canada and Europe,
the Company has developed the resources, knowledgeable personnel, information
systems, and distribution capabilities to launch music, video, and consumer
products quickly in the North American and European markets through traditional
retail and direct-response marketing channels. On May 1, 1998 the Company
launched its new Internet service, K-tel Express (www.ktel.com), featuring a
wide spectrum of music products for purchase by the public around the globe.
Open for commerce 24 hours a day, 365 days a year, K-tel Express features more
than 250,000 music titles, at value prices, through this on-line shopping
service.

Development of Business

The Company's core business for many years has been the marketing and sale of
(i) pre-recorded music from both the Company's owned music master catalog and
under licenses from third party record companies, and (ii) consumer products.
Sales of music products, including albums, cassettes and compact discs are made
to rackjobbers (distributors which stock and manage inventory within certain
music and video departments for certain retail stores), wholesalers and
retailers in the U.S. and through subsidiaries and licensees in the United
Kingdom and elsewhere in Europe. The Company has also used television
direct-response marketing for many years in marketing pre-recorded music. Sales
of consumer products, including housewares, automotive accessories and exercise
equipment, are made to retailers in the U.S., Europe and directly to the
consumer in targeted direct response marketing campaigns through the use of
short and long form television advertising, print and other media.

In 1997 the Company formed a U.S. media buying and infomercial-marketing
subsidiary which performed media buying services for third parties and also
marketed products through infomercials produced by third parties. As of June 30,
1998, due to accumulated losses of $2,300,000, the Company had curtailed most of
these media buying operations. In March of 1998 the Company acquired certain
media and other assets of United Kingdom based Regal Shop International Ltd.
Acquisition of this operation now enables the Company to reach consumers in
France, Switzerland, Belgium, Austria and Luxembourg. On May 1, 1998 the Company
launched its new Internet service K-tel Express.

Description of Current Business

K-tel is currently a vertically-integrated marketer and distributor of
entertainment and consumer products and is a leader in the market niche for
pre-recorded music compilations. On May 1, 1998 the Company launched K-tel
Express, its on-line music retailing business that features a wide spectrum of
music products for purchase by the public over the Internet. Open 24 hours a
day, 365 days a year, K-tel Express is a virtual music store that enables
customers to choose from the proprietary brand-name compilations that have made
the K-tel name synonymous with quality music for over 30 years. K-tel Express
offers customers more than 250,000 other music titles at value prices and the
opportunity to create their own custom CD compilations from the Company's master
music catalog. The website features audio sampling, user-friendly navigation and
search capabilities, a high level of customer service and competitive pricing.
Revenues from K-tel Express sales are not yet a significant part of the
Company's business, but the Company believes the prospects for K-tel Express and
electronic commerce, in general, are encouraging.

The Company's music operations consist of the sale of pre-recorded music through
traditional retail distribution and over the Internet. The Company's proprietary
entertainment products consist primarily of pre-recorded thematic music packages
in a compilation format featuring various artists. These thematic music
selections cover nearly all music genres and are targeted toward all age groups.
The Company has two sources for music, its proprietary music master catalog,
which consists of 3,500 "Top 100" titles, and songs licensed from third party
record music companies. One of the Company's major assets is its music master
catalog consisting of original recordings and re-recordings of music from the
1950s through the 1980s ("Master Recordings"). The Master Recordings are
utilized in the Company's proprietary compilation products and are also licensed
to third parties world-wide for use in albums, films, television programs, and
commercials for either a flat fee or a royalty based on the number or units
sold. The Company is constantly adding to its music master catalog to ensure
growth and product diversity. Licensing of the Company's proprietary music
rights to third parties has historically been an

2

important revenue source for the Company. The Company provides marketing support
for its music sales through television and print media advertising, cooperative
advertising with retailers, and in-store promotions and displays.

Music products are sold over the Internet through the Company's K-tel Express
website. The Company believes that the emergence of electronic commerce
("e-commerce") presents K-tel with a significant opportunity to capture market
share in the burgeoning e-commerce area by capitalizing on K-tel's high name
recognition, extensive catalog of proprietary music content and existing
capabilities and expertise in niche marketing, which the Company believes will
be critical to success in Internet retailing. The Company intends to use the
same combination of resources that has made it a leader in the direct marketing
arena that it pioneered and will rely heavily on its brand identity with
consumers. A number of characteristics of online music retailing such as audio
sampling, search capabilities, availability of deep catalog content, and at home
convenience shopping make the sale of pre-recorded music via the Internet
particularly attractive relative to traditional retail outlets. Although
Internet sales are not yet a significant part of K-tel's business revenues, the
Company believes the prospects of K-tel Express and e-commerce in general are
encouraging. However, the success of on-line marketing cannot be currently
determined, and further penetration in this market will require substantial
additional financial resources, development and acquisition of technology,
investments in marketing and contractual relationships with third parties.
Results will also be affected by existing competition, which the Company
anticipates will intensify, and by additional entrants to the market who may
already have the necessary technology and expertise, many of whom may have
substantially greater resources than the Company.

K-tel's marketing strategy for K-tel Express is to leverage its proprietary
music content and its worldwide television expenditures to drive traffic to the
site and gain market share. The Company's brand name recognition, along with its
international presence and direct access to consumers through alternative media
channels, all serve to create strong synergies between the existing core
operations of K-tel and its expansion into the e-commerce arena. The Company's
objective is to continue its focus on developing K-tel Express as a synergistic
asset to its music business and related marketing operations. During fiscal 1999
K-tel expects to introduce a custom compilation system that will offer on line
shoppers the ability to create compilations from any of our 3,500 "Top 100"
titles from our master music catalog. This is an example of how these synergies
create new opportunities to expand K-tel product breadth and consumer reach.
Over the coming year K-tel will continue to analyze and explore the best
strategy for the exploitation of our new e-commerce market place.

K-tel has provided additional enhancements to K-tel Express since the launch of
its online service. These actions include entering into a partnership agreement
with RealNetworks, Inc. to develop user friendly technology enabling consumers
to create customized CD compilations and artwork on-line. As an additional
enhancement the Company has licensed digital music delivery technology from
Liquid Audio which will allow K-tel Express customers to download up to 3,500
songs from K-tel's music master catalog in Liquid Track format. K-tel Express
also posts BILLBOARD MAGAZINE's industry music charts. Expanding its products
and service offerings on the site, the Company has signed an agreement to
integrate Muze Inc.'s home video content of 35,000 titles, as well as its music
and movie reviews. In order to provide a secure and convenient shopping
environment for K-tel Express customers, the Company entered into an agreement
with CyberSource to integrate its scalable payment processing infrastructure. In
addition, the Company also entered into a comprehensive Internet marketing and
services agreement with @Home Network.

The Company's consumer products consist primarily of housewares, automotive
accessories, and exercise equipment. The Company concentrates on products that
have the potential for worldwide appeal and that are innovative, readily
demonstrated and inexpensive (generally retailing for less than $100). In
Europe, the Company engages in an extensive amount of direct response marketing.
European direct response business is solicited through national and local
television and radio advertising and print media. The Company also utilizes
limited direct response advertising campaigns to test consumer acceptance of new
products within specific demographic or geographic markets allowing the Company
to assess a product's potential before having to make a significant capital
commitment. The Company's strategy in its direct response campaigns is to
generate revenues and profits from both the direct response campaigns and
subsequent retail demand.

With more than 30 successive years of marketing experience in the United States,
Canada and Europe, the Company has developed the resources, including
knowledgeable personnel, information systems, distribution systems and media
buying capabilities, to launch music and consumer products quickly in the North
American and European markets through the Internet, by traditional retail
(direct-to-retailers or through rackjobbers (i.e., distributors who stock and
manage inventory within music and video departments for certain retail stores))
and through direct response (direct-to-consumer). The Company, through its
subsidiaries, maintains active operations in the United States, Canada, the
United Kingdom, Germany, France, Switzerland, Belgium, Austria and Finland.

3

Sales of pre-recorded music products to Handleman Company represented 7%, 8%,
and 12% of the Company's consolidated net sales for the years ended June 30,
1998, 1997 and 1996. Loss of business with the Handleman Company would have a
material adverse effect on the Company's operating results.

Competition

The online commerce market, particularly over the Internet, is new, rapidly
evolving and intensely competitive, which competition the Company expects to
intensify in the future. Barriers to entry are minimal, and current and new
competitors can launch new websites at a relatively low cost. In addition, the
retail music industry is intensely competitive. Through its K-Tel Express
business, the Company currently competes with a variety of companies, including
(i) online vendors of music, music videos and other related products, (ii)
online vendors of movies, books and other related products, (iii) online service
providers which offer music products directly or cooperation with other
retailers, (iv) traditional retailers of music products, including specialty
music retailers, (v) other retailers that offer music products, including mass
merchandisers, superstores and consumer electronic stores; and (vi) non-store
retailers such as music clubs. Many of these traditional retailers also support
dedicated Web sites which compete directly with the Company. Competitive
pressures created by any one of these companies, or by the Company's competitors
collectively, could have a material adverse affect on the Company.

The Company's music and consumer products compete for the disposable income
spent by consumers on discretionary purchases. As such, K-tel's products must be
attractively priced and meet the specific interests or needs of consumers.
K-tel's products sold in retail stores compete with other entertainment products
for shelf and display space. Because most retail purchases are impulse buys by
consumers, location and size of the shelf space devoted to the Company's music
products are important factors in determining the volume of retail sales.

The market for pre-recorded music is dominated by six major recorded music
companies in the U.S. (Thorne EMI, Bertelsmann AG, Sony Corp., MCA, Inc., Time
Warner, Inc., and Polygram Holding, Inc.). K-tel primarily operates in the niche
market of music compilations. K-tel believes there are a number of competitors,
including special market divisions of the six major record companies, as well as
Simitar Entertaiment, Inc., Rhino Records (which is owned by Time Warner's
wholly-owned subsidiary, Atlantic Records) and Priority Records, an independent
record company, which are engaged in developing and marketing music
compilations. K-tel's ability to compete in this market is largely dependent on
the expansion and utilization of its catalog and the acquisition of licenses
that enable it to create compilation packages.

Employees

On June 30, 1998 the Company employed 189 full time people worldwide.

Financial Information

For financial information about the Company's foreign and domestic operations
for each of the last three fiscal years ended June 30, 1998 see Note 9 to the
consolidated financial statements.

Year 2000 Disclosure

The Company has developed a plan to ensure its systems are compliant with the
requirements to process transactions in the year 2000. The majority of the
Company's internal information systems have been upgraded or are in the process
of being upgraded or replaced with fully compliant new systems. The Company's
European subsidiaries have upgraded or are in the process of replacing or
upgrading their information systems to comply with Year 2000 requirements. The
total cost of the software and implementation is estimated to be approximately
$150,000. The new system implementation is expected to be completed by July 31,
1999. Some of the Company's customers utilize equipment to capture and transmit
financial transactions. The Company is in the process of making the necessary
updates to this equipment to ensure it will be effective in the year 2000. The
Company is also working with its processing banks and network providers to
ensure their systems are year 2000 compliant. All of these costs will be or have
been borne by the processors and network companies. Should the Company, its
customers, its vendors or the processing banks fail to resolve year 2000 issues,
the Company may lose certain financial and operating data. The Company is in the
process of developing a contingency plan, which it expects to be completed by
the end of the fiscal year.

INFORMATION CONTAINED IN THIS ITEM CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN
THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995, WHICH CAN
BE IDENTIFIED BY THE USE OF FORWARD-LOOKING TERMINOLOGY SUCH AS "MAY," "WILL,"
"WOULD," "COULD," "INTEND," "PLAN," "EXPECT," "ANTICIPATE," "ESTIMATE," OR
"CONTINUE," OR NEGATIVE VARIATIONS THEREOF OR OTHER VARIATIONS THEREON OR
COMPARABLE TERMINOLOGY. MANY FACTORS COULD CAUSE ACTUAL RESULTS TO DIFFER
MATERIALLY FROM THOSE

4

IN THE FORWARD-LOOKING STATEMENTS, INCLUDING OVERALL ECONOMIC CONDITIONS,
CONSUMER PURCHASING, CUSTOMER ACCEPTANCE OF PRODUCTS, MARKETING AND PROMOTION
EFFORTS, FOREIGN CURRENCY VARIATIONS AND CHANGES IN INTEREST RATES.

ITEM 2: PROPERTIES

K-tel's corporate offices and U.S. operations are located in leased facilities
in a suburb of Minneapolis, Minnesota, consisting of approximately 21,985 square
feet of office space and approximately 69,653 square feet of warehouse. In
September 1997 the Company's California operations relocated to a new leased
facility in Calabasas, California, which consists of approximately 6,758 square
feet of office space.

K-tel's foreign subsidiaries lease a total of 46,776 square feet of office and
warehouse facilities.

See Note 8 to the consolidated financial statements for a summary of lease
agreements.

ITEM 3: LEGAL PROCEEDINGS

The Company is involved in legal actions in the ordinary course of its business.
Although the outcomes of any such legal actions cannot be predicted, in the
opinion of management, there is no legal proceeding pending or asserted against
or involving the Company for which the outcome is likely to have a material
adverse effect upon the consolidated financial position or results of operations
of the Company.

K-tel International Inc. v. Platinum Entertainment Inc. In September 1997 the
Company commenced a declaratory judgment action against Platinum Entertainment,
Inc. ("Platinum") in Minnesota state court. The Company alleged that it was
entitled to $1.75 million which Platinum deposited in an earnest money escrow
account pursuant to Platinum's agreement to purchase two of the Company's
subsidiaries, K-tel International (USA), Inc. and Dominion Entertainment,
memorialized in the March 1997 Purchase and Sale Agreement. The Company further
alleged claims of breach of the March 1997 Purchase and Sale Agreement and
related confidentiality agreement, defamation, fraud, and promissory estoppel.

Platinum removed the action to federal court and asserted a counterclaim against
the Company seeking a declaration that Platinum was entitled to the earnest
money and alleging claims of breach of contract and fraudulent inducement. While
still engaged in the discovery process the parties settled the action between
themselves, agreeing to a payment to K-tel of $875,000 of the earnest money
escrow and reimbursement by Platinum of certain accounting fees paid by the
Company, along with an exchange of releases. The parties also stipulated to the
dismissal of the action with prejudice and the Court dismissed the action with
prejudice by Order dated July 7, 1998.

Early v. K-tel International Inc. On March 10, 1997 Mr. Christopher Early filed
a class action Complaint against K-tel International, Inc. ("the Company"),
Dominion Entertainment, Inc., and certain retailers in the Circuit Court of Cook
County, Illinois. The defendants removed the action to the United States
District Court for the Northern District of Illinois on April 3, 1997. On March
30, 1998 Mr. Early obtained leave to file an Amended Complaint adding K-tel
International (USA), Inc. and one additional retailer as defendants purporting
to allege class actions under (1) the Illinois Consumer Fraud and Deceptive
Trade Practices Act and (2) the Racketeer Influenced and Corrupt Organizations
Act for allegedly deceptive packaging of certain tapes and compact discs which
packaging allegedly defrauded consumers into believing that certain recordings
thereon were original rather than new recordings. On behalf of the class, Early
purports to seek (1) treble damages; (2) compensatory damages; (3) punitive
damages; (4) an injunction prohibiting "the further sale of mislabeled tapes and
CD's;" and (5) attorneys' fees and costs. The defendants have moved to dismiss
the Amended Complaint and in the alternative for a partial summary judgment on
one aspect thereof. This motion has been fully briefed but not ruled upon and
discovery has not commenced. The Company has indemnified the retailer defendants
in this matter. The Company believes the case is without merit and intends to
contest the case vigorously.

5

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of the Company's security holders during the
fourth quarter of fiscal 1998.

EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth certain information with respect to the executive
officers of the Company at September 28, 1998.

Name of Officer Age Positions and Offices Held
- ---------------- --- ---------------------------------------------------

Philip Kives 69 Chairman of the Board and Chief Executive Officer

Jeffrey Koblick 51 Executive Vice President, Purchasing and Operations

Corey Fischer 41 Vice President-Finance, Chief Financial Officer,
Treasurer

Business Experience

Messrs. Kives and Koblick have held various offices and/or managerial positions
with the Company for more than the past five years.

Mr. Fischer joined K-tel in July 1997 and became Chief Financial Officer in
October, 1997. Prior to joining K-tel, Mr. Fischer was the Director of Finance
at Las Vegas Entertainment Network, Inc. from 1995-1997, and at Hemsdale
Communications, Inc. from 1994-1995, both NASDAQ traded companies. Prior to
that, Mr. Fischer was a Senior Manager in the corporate entertainment group of
Deloitte & Touche.

6

PART II

ITEM 5: MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

On September 11, 1998 there were 1,468 record owners of the Company's common
stock and approximately 8,316,668 shares outstanding. The Company's common stock
trades on the NASDAQ National Market System under the symbol "KTEL".

The following table shows the range of high and low closing sales prices per
share, accounting for the stock split on May 1, 1998, of the Company's Common
Stock as reported by the NASDAQ Stock Market for the fiscal year periods
indicated:

1998 1997
--------------------- ---------------------
High Low High Low
--------- --------- --------- ---------
First Quarter 3 15/16 3 1/16 1 15/16 1 3/4
Second Quarter 3 3/4 3 1/16 3 13/16 1 3/4
Third Quarter 2 3 1/16 4 3/8 3 3/8
Fourth Quarter 39 15/16 3 1/4 4 1/8 3 3/4

On April 21, 1998 the Board of Directors declared a two for one stock split of
the Company's common stock in the form of a stock dividend paid to shareholders
of record on May 1, 1998. Prices have been adjusted to reflect the two for one
stock split.

No cash dividends have been declared on the Company's common stock during the
past two fiscal years and the Company does not expect to pay cash dividends in
the foreseeable future. Management plans to use cash generated from operations
for expansion of its business.

ITEM 6: SELECTED FINANCIAL DATA

The following summary of consolidated operations and certain balance sheet
information includes the consolidated results of operations of K-tel
International, Inc. and its subsidiaries as of and for the five years ended June
30, 1998. This summary should be read in conjunction with the consolidated
financial statements and notes thereto appearing elsewhere in this filing. All
share and per share amounts are based on the weighted average shares issued. All
amounts are in thousands of dollars, except per share data.

1998 1997 1996 1995 1994
---------- ---------- ---------- ---------- ----------

Net Sales $ 85,626 $ 75,501 $ 71,987 $ 65,917 $ 54,270
========== ========== ========== ========== ==========
Operating Income (loss) $ (2,535) $ 3,582 $ 4 $ (2,188) $ 223
========== ========== ========== ========== ==========
Net Income (loss) $ (2,407) $ 3,204 $ (745) $ (2,483) $ 376
========== ========== ========== ========== ==========
Net Income (Loss) Per Share

Basic $ (.31) $ .43 $ (.10) $ (.33) $ .05
========== ========== ========== ========== ==========
Diluted $ (.31) $ .41 $ (.10) $ (.33) $ .05
========== ========== ========== ========== ==========
Total Assets $ 39,035 $ 30,492 $ 27,795 $ 28,637 $ 26,874
========== ========== ========== ========== ==========
Long-Term Debt $ 4,174 $ -- $ -- $ -- $ --
========== ========== ========== ========== ==========
Cash Dividends Declared and Paid $ -- $ -- $ -- $ -- $ --
========== ========== ========== ========== ==========

7

ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS:

RESULTS OF OPERATIONS

The following tables set forth, for the periods indicated, results of operations
by geographic region as a percentage of net sales. All amounts are in thousands
of dollars.

Year ended June 30, 1998

North Corporate
America Europe Expenses Total
-------- -------- -------- --------

Net Sales $ 55,883 100% $ 29,743 100% $ -- $ 85,626 100%

Costs and expenses
Cost of goods sold 34,873 63 12,797 43 -- 47,670 55
Advertising 10,161 18 6,647 22 -- 16,808 20
Selling, general & administrative 12,923 23 8,493 29 2,267 23,683 28
-------- -------- -------- -------- -------- -------- --------

Operating income (loss) (2,074) (4) 1,806 6 (2,267) (2,535) (3)
-------- -------- -------- -------- -------- -------- --------

Interest (expense) income, net (233) -- 48 -- (257) (442) --
Foreign translation adjustment, net (9) -- 32 -- (39) (16) --
Other -- -- -- -- 614 614 --
Benefit (provision) for taxes, net 22 -- (147) -- 97 (28) --
-------- -------- -------- -------- -------- -------- --------
Net income (loss) $ (2,294) -- $ 1,739 -- $ (1,852) $ (2,407) --
======== ======== ======== ======== ======== ======== ========

Year ended June 30, 1997

North Corporate
America Europe Expenses Total
-------- -------- -------- --------

Net Sales $ 47,786 100% $ 27,715 100% $ -- $ 75,501 100%

Costs and expenses
Cost of goods sold 28,985 61 12,402 45 -- 41,387 55
Advertising 5,820 12 5,700 21 -- 11,520 15
Selling, general & administrative 10,309 21 7,270 26 1,433 19,012 25
-------- -------- -------- -------- -------- -------- --------

Operating income (loss) 2,672 6 2,343 8 (1,433) 3,582 5
-------- -------- -------- -------- -------- -------- --------

Interest (expense) income, net 29 -- 11 -- (38) 2 --
Foreign translation adjustment, net (16) -- (63) -- (83) (162) --
Benefit (provision) for taxes, net (181) -- (107) -- 70 (218) --
-------- -------- -------- -------- -------- -------- --------
Net income (loss) $ 2,504 -- $ 2,184 -- $ (1,484) $ 3,204 --
======== ======== ======== ======== ======== ======== ========

Year ended June 30, 1996

North Corporate
America Europe Expenses Total
-------- -------- -------- --------

Net Sales $ 48,605 100% $ 23,382 100% $ -- $ 71,987 100%

Costs and expenses
Cost of goods sold 27,690 57 10,975 47 -- 38,665 54
Advertising 7,495 15 5,025 21 -- 12,520 17
Selling, general & administrative 11,423 24 7,420 32 1,955 20,798 29
-------- -------- -------- -------- -------- -------- --------

Operating income (loss) 1,997 4 (38) 0 (1,955) 4 0
-------- -------- -------- -------- -------- -------- --------

Interest (expense) income, net (282) -- 17 -- (14) (279) --
Foreign translation adjustment, net 4 -- (125) -- 2 (119) --
Benefit (provision) for taxes, net (210) -- (141) -- -- (351) --
-------- -------- -------- -------- -------- -------- --------
Net income (loss) $ 1,509 -- $ (287) -- $ (1,967) $ (745) --
======== ======== ======== ======== ======== ======== ========

8

FISCAL 1998 COMPARED WITH FISCAL 1997

Consolidated net sales for the year ended June 30, 1998 were $85,626,000
with an operating loss of $2,535,000 and a net loss of $2,407,000, or $.31
per basic and diluted share. Consolidated net sales for the prior year
were $75,501,000 with operating income of $3,582,000 and net income of
$3,204,000 or $.43 per basic and $.41 per diluted share. Contributing to
the 1998 loss was a $2.300,000 loss related to the Company's recently
curtailed U.S. third-party media buying operation, $1,200,000 fourth
quarter loss resulting from both soft sales and an overall decrease in
gross margins on sales of the Company's domestic mid-line and budget
priced music compilations, $400,000 in start up costs incurred by the
launch of the Company's new online service, K-tel Express (www.ktel.com),
as well as a non-cash loss of $514,000 recognized on the revaluation of
certain securities received in connection with a previous settlement.

CONSOLIDATED NET SALES for the year ended June 30, 1998 increased
$10,125,000 or 13% from the comparable period in 1997. North American
sales for the year ended June 30, 1998 increased $8,097,000 or 17% from
the comparable period in 1997. This increase was mainly due to a
$7,582,000 increase in sales derived from the Company's U.S. media buying
and infomercial subsidiary which was not in existence for most of the
comparable period in 1997. Revenue from the Company's Internet business,
K-tel Express, was not significant. European sales for the year ended June
30, 1998 increased $2,028,000 or 7% from the comparable period in 1997.
This increase was mainly due to sales from K-tel Marketing (UK) Limited,
the Company's new subsidiary that commenced operations in March 1998 with
the acquisition of certain media and other assets from Regal Shop
International Ltd.

CONSOLIDATED COST OF GOODS SOLD AS A PERCENTAGE OF NET SALES for the year
ended June 30, 1998 was consistent with the comparable period in 1997.
Costs of goods sold as a percentage of net sales for North America for the
year ended June 30, 1998 was 63% as compared to 61% in the comparable
period in 1997. The increase is mainly due to the Company experiencing
soft sales and overall decrease in gross margins on sales of the company's
domestic mid-line and budget priced music compilations and a high level of
returns of consumer products, the majority of which are no longer being
distributed by the Company. European costs of goods sold as a percentage
of net sales was 43% as compared to 45% in the comparable period in 1997
as the gross margins were slightly higher on merchandise sold via direct
response as compared to the merchandise sold in the prior period.

CONSOLIDATED ADVERTISING COSTS for the year ended June 30, 1998 increased
$5,288,000 or 46% from the comparable period in 1997. North American
advertising costs for the year ended June 30, 1998 increased $4,341,000 or
75% from the comparable period in 1997. This increase was mainly due to a
$5,600,000 increase in the advertising and media costs incurred by the
Company's U.S. media-buying and infomercial subsidiary that was not in
existence for most of the comparable period of 1997. This increase was
offset by a decrease of $1,500,000 in advertising by the Company's U.S.
music operations that directly related to a decrease in television
promotion for its products. European advertising costs for the year ended
June 30, 1998 increased $947,000 or 17% from the comparable period in
1997. This increase was mainly due to advertising costs from K-tel
Marketing (UK) Limited, the Company's new subsidiary that commenced
operations in March 1998.

CONSOLIDATED SELLING, GENERAL AND ADMINISTRATIVE EXPENSES for the year
ended June 30, 1998 increased $4,671,000 or 25% from the comparable period
in 1997. North American selling, general and administrative expenses for
the year ended June 30, 1998 increased $2,614,000 or 25% from the
comparable period in 1997. The difference in part relates to a reduction
of $850,000 in 1997 of general and administrative costs that resulted from
the recovery of certain legal and other costs related to a dispute with a
third party over certain music licensing rights. Excluding the settlement
amount, general and administration expenses for the year ended June 30,
1998 as compared to same period in 1997 increased by $1,764,000. This
remaining increase relates to costs incurred by the Company's U.S.
media-buying and infomercial subsidiary that was not in existence for most
of the comparable period in 1997. European selling, general and
administrative expenses for the year ended June 30, 1998 increased by
$1,223,000 or 17% from the comparable period in 1997. This increase was
mainly due to costs from K-tel Marketing (UK) Limited, the Company's new
subsidiary that commenced operations in March 1998. Additionally,
corporate expenses increased by $834,000 from the comparable period in
1997. The increase mostly to related a non cash loss of $514,000 relating
to the revaluation of certain securities received in connection with a
previous settlement.

OPERATING INCOME for the year ended June 30, 1998 decreased $6,117,000
from the comparable period in 1997. North American operating income
decreased $4,746,000 from the comparable period in 1997. The decrease in
part relates to a reduction of $850,000 in 1997 of general and
administrative costs that resulted from the recovery of

9

certain legal and other costs related to a dispute with a third party over
certain music licensing rights. Excluding the settlement amount operating
income for year ended June 30, 1998, as compared to same period in 1997,
decreased by $3,317,000. This decrease relates to $2,300,000 of losses
incurred by the Company's U.S. third-party media buying subsidiary the
operations of which have since been curtailed; $400,000 of startup costs
incurred with the May 1, 1998 launch of K-tel Express, the Company's
Internet music business; a non cash loss of $514,000 relating to the
revaluation of certain securities received in connection with a previous
settlement and a $700,000 difference in operations from the Company's U.S.
music and consumer product divisions (this difference resulted mainly from
soft sales and an overall decrease in gross margins on sales of the
Company's domestic mid-line and budget priced music compilations and a
high level of returns of consumer products, the majority of which are no
longer being distributed by the Company). European operating income for
the year ended June 30, 1998 decreased by approximately $537,000 from the
comparable period in 1997. This decrease relates mostly to a decrease in
operating results from the Company's United Kingdom music operation, whose
European export business decreased due to the strength of the British
currency against other European currencies.

INTEREST EXPENSE for the year ended June 30, 1998, increased $368,000 to
$490,000, as compared to $122,000 in the same period in 1997. The increase
in interest expense corresponds with the increased borrowings made by the
Company during these periods under its existing credit facilities.

OTHER INCOME of $614,000 for the fiscal year ended 1998 relates to a
settlement with Platinum Entertainment, Inc. over the disbursement of
funds from an earnest money escrow account.

FISCAL 1997 COMPARED WITH FISCAL 1996

Consolidated net sales for the fiscal year ended June 30, 1997 were
$75,501,000 with operating income of $3,582,000 and net income of
$3,204,000 or $.43 per basic and .41 per diluted share. Consolidated net
sales for the fiscal year ended June 30, 1996 were $71,987,000 with an
operating income of $4,000 and net loss of $745,000 or $.10 per basic and
diluted share.

CONSOLIDATED NET SALES increased $3,514,000 or 5% for the fiscal year
ended June 30, 1997. North American net sales decreased 2% from the prior
fiscal year due primarily to prior year fourth quarter divestitures of
unprofitable businesses/divisions, lower U.S. consumer convenience product
retail sales resulting from less new product promotions and lower U.S.
direct response television sales resulting from fewer promotions. The
decrease in U.S. sales more than offset the increase in sales derived from
the Company's new U.S. media buying and infomercial company. European
sales increased from the prior fiscal year due mainly to stronger German
and United Kingdom sales in the current year. Foreign currency conditions
were less favorable than in the comparable prior year period and caused
sales to be $1,250,000 lower for the year ended June 30, 1997 than they
would have been had exchange rates remained consistent with the prior
year.

CONSOLIDATED COST OF GOODS SOLD for the year ended June 30, 1997 were 55%
of sales compared to 54% for the prior year ended. North American cost of
goods sold, as a percentage of sales, was 61% compared to 57% for the
prior year comparable period due primarily to the start up of a U.S. media
buying and infomercial business which generated mainly media buying
revenue in fiscal 1997 (media buying revenues carry small margins
consisting only of media buying fees charged to third parties) and to
slightly higher cost of goods sold in the U.S. retail music business.
European cost of goods sold as a percent of net sales were 45% compared to
47% in the prior year period due mainly to overall higher music and
consumer product margins resulting from a stronger margin product mix in
the current period.

ADVERTISING COSTS as a percentage of net sales for the fiscal year ended
June 30, 1997 was 15% compared to 17% for the previous year. North
American advertising costs as a percent of net sales was 12% compared to
15% for the prior year comparable period due to higher prior year levels
of direct response television advertising in the U.S.. This decrease more
than offset an increase in U.S. retail music current year advertising
expenditures. Direct response sales carry higher advertising requirements
than normal retail sales. European advertising costs as a percentage of
net sales for the year ended June 30, 1997 were the same as the prior
year.

SELLING, GENERAL AND ADMINISTRATIVE expenses for the fiscal year ended
June 30, 1997 were $19,012,000 or 25% of net sales compared to $20,798,000
or 29% of net sales in the prior fiscal year. North American selling,
general and administrative expenses were down $1,114,000 for the year
ended June 30, 1997 due mainly to the second quarter settlement of a long
outstanding legal dispute with a United Kingdom entertainment company
regarding infringement of a number of the Company's owned music master
recordings. The settlement resulted in a second

10

quarter net benefit (recovery of legal expenses) to the Company of
$850,000. European selling, general and administrative expenses for the
year ended June 30, 1997 were lower as a percent of sales compared to the
prior year due mainly to better overall European sales performance in the
current fiscal year.

OPERATING INCOME for the year ended June 30, 1997 increased to $3,582,000
compared to operating income of $4,000 for the fiscal year ended June 30,
1996. North American operating income increased from the prior year mainly
due to the positive profit impact from the above mentioned settlement with
a U.K. entertainment company regarding infringement of a number of the
Company's owned music master recordings, stronger profit from third party
licensing of the Company's owned music master catalog and lower current
year losses from the U.S. consumer convenience product business. These
increases more than offset decreases in operating income in the Company's
U.S. retail music business resulting mainly from slightly higher cost of
goods sold, higher current year advertising expenditures and increased
selling, general and administrative expenses from the prior year in
anticipation of future sales growth. European operating income improved
over fiscal 1996 due mainly to strong current year profit in the Company's
German operation versus a minor prior year profit and current profit from
the Company's United Kingdom operation compared to prior year comparable
period loss as a result of restructuring those operations.

INTEREST EXPENSE was $122,000 for the fiscal year ended June 30, 1997,
compared to $409,000 for the fiscal year ended June 30, 1996. The decrease
in interest expense was due to less current year usage of the Company's
asset based line of credit.

Liquidity and Capital Resources

During the year ended June 30, 1998 the Company experienced negative cash
flow from operations of $2,378,000, which mostly related to funding of
losses from the Company's U.S. third-party media buying subsidiary, the
operations of which have been curtailed as of June 30, 1998. Also during
the year ended June 30, 1998, the Company utilized another $3,246,000 for
investing activities. These funds were used for music catalog additions
and for the development and acquisition of system hardware and software
used by K-tel Express, the Company's Internet retailing site. To finance
the above, the Company increased its borrowings under its credit
facilities during the year by $6,500,000, and also received $1,644,000 in
proceeds from the exercise of employee stock options.

Until November 20, 1997 the Company had a revolving credit agreement with
a U.S. bank that provided borrowings of up to $2,500,000 based upon a
monthly borrowing base derived from certain of the Company's U.S.
Subsidiaries' accounts receivable. The loan was secured by assets of the
Company's U.S. Subsidiaries, including accounts receivable, inventories,
equipment and owned music master recordings and was guaranteed by the
Company.

On November 20, 1997 certain of the Company's U.S. Subsidiaries entered
into a new four-year $10 million credit facility with another lending
institution. The credit facility consists of a $4 million term loan due in
full November 20, 2001 and a $6 million revolving credit facility, limited
to a percent of eligible receivables and inventory, that expires November
20, 2001. Borrowings under the facility bear interest at a variable rate
based on a "base rate" announced by a banking affiliate associated with
the lending institution (8.5% at June 30, 1998) and are secured by the
assets of certain U.S. Subsidiaries, including accounts receivable,
inventories, equipment, music library and general intangibles. The loan
agreement contains certain financial and other covenants or restrictions,
including the maintenance of a minimum tangible net worth by the Company,
limitations on capital expenditures, restrictions on music library
acquisitions, limitations on the incurrence of indebtedness and
restrictions on dividends paid by the Company. The Company has guaranteed
the obligations of its subsidiaries under the credit facility and has
pledged the stock of those subsidiaries and its assets to secure the
Company's obligations under its guaranty. On November 20, 1997 a portion
of the proceeds from the funding of the credit facility were used to repay
in full the bank revolving credit agreement discussed in the preceding
paragraph and such agreement was terminated. As of June 30, 1998 the
amount outstanding under the revolving credit facility was $3,738,000 and
the maximum additional available under the borrowing limitations at June
30, 1998 was $148,000. The maximum amount outstanding under the line of
credit was $4,417,000 during fiscal 1998. The Company was either in
compliance with or had obtained waivers for all covenants, limitations and
restrictions. The Company has amended and further amended certain
financial covenants with the lender for fiscal 1999 and beyond, assuming
an equity placement in the quarter ending December 31, 1999, and expects
to be in compliance with the revised covenants. Future losses from
businesses such as K-tel Express or the inability to complete an equity
placement may result in further renegotiations of such covenants or the
need to seek replacement financing. There can be no assurances that such
financing will be available on terms satisfactory to the Company.

11

K-5 Leisure Products, Inc. ("K-5"), an affiliate controlled by the
Company's Chairman of the Board and Chief Executive Officer, has from time
to time made advances to the Company. Advances on this facility reached
$1,500,000 as of November 20, 1997 when the debt was repaid in full from
the borrowings under the Company's new credit facility. As of June 30,
1998 K-5 had advanced an additional $1,000,000 to the Company and an
additional $3,000,000 subsequent to June 30, 1998 through October 9, 1998.
The Company pays interest on the unpaid principal amount of financing at
the same rate as the Company pays on its credit facility, until repayment
of the loan, which is due on demand.

The Company has primarily funded its operations to date through internally
generated capital, bank financing or advances made by an affiliate of the
Chairman of the Board and Chief Executive Officer. However, the Company
anticipates that it will require additional cash in order to further
develop and promote its Internet retail music site, K-tel Express.
Although the Company has made no material commitments for capital
expenditures, it anticipates a substantial increase in funding
requirements for development and acquisition of technology, marketing and
promotion, and for capital expenditures to develop the infrastructure
necessary for the anticipated growth in operations. To date the Company
has no commitments for any additional financing and there can be no
assurance that such commitments can be obtained on favorable terms, if at
all. The Company has available to it funding from a company owned by the
Company's Chairman of the Board and Chief Executive Officer. Although
management does not have access to the financial statements of the
Chairman's other companies, he has committed to the Company that he will
fund its operations through fiscal 1999, and the Company is in the process
of formalizing the commitment in the form a credit agreement.

During the fiscal year ended June 30, 1998 the Company purchased
approximately $334,000 of consumer convenience product from K-5. The
Company owed approximately $9,000 to the affiliate at June 30, 1998. This
same affiliate purchased approximately $39,000 of consumer convenience
products from the Company during the year ended June 30, 1998, and owed
the Company $4,000 at June 30, 1998. Outstanding balances are settled on a
timely basis. No interest was charged on the related outstanding balances
during fiscal 1998.

INFORMATION CONTAINED IN THIS ITEM CONTAINS "FORWARD-LOOKING STATEMENTS"
WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995, WHICH CAN BE IDENTIFIED BY THE USE OF FORWARD-LOOKING TERMINOLOGY
SUCH AS "MAY," "WILL," "WOULD," "COULD," "INTEND," "PLAN," "EXPECT,"
"ANTICIPATE," "ESTIMATE," OR "CONTINUE," OR NEGATIVE VARIATIONS THEREOF OR
OTHER VARIATIONS THEREON OR COMPARABLE TERMINOLOGY. MANY FACTORS COULD
CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN THE
FORWARD-LOOKING STATEMENTS, INCLUDING OVERALL ECONOMIC CONDITIONS,
CONSUMER PURCHASING, CUSTOMER ACCEPTANCE OF PRODUCTS, MARKETING AND
PROMOTION EFFORTS, FOREIGN CURRENCY VARIATIONS AND CHANGES IN INTEREST
RATES.

ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The consolidated financial statements and related notes and schedules
required by this Item are set forth in Part IV, Item 14, and identified in
the index on page 18.

ITEM 9: DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

12

PART III

ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT

The information concerning Directors required under this Item will be included
in the Company's Notice of Meeting of Shareholders and Proxy Statement to be
filed with the Securities and Exchange Commission and is incorporated herein by
reference. The information concerning Executive Officers of the Registrant is
furnished as an unnumbered item in Part I following Item 4.

ITEM 11: MANAGEMENT REMUNERATION

The information required under this Item will be included in the Company's
Notice of Meeting of Shareholders and Proxy Statement for the Annual Meeting of
Shareholders to be filed with the Securities and Exchange Commission and is
incorporated herein by reference.

ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required under this Item will be included in the Company's
Notice of Meeting of Shareholders and Proxy Statement to be filed with the
Securities and Exchange Commission and is incorporated herein by reference.

ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required under this Item will be included in the Company's
Notice of Meeting of Shareholders and Proxy Statement for the Annual Meeting of
Shareholders to be filed with the Securities Exchange Commission and is
incorporated herein by reference.

13

PART IV

ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) Financial Statements and Schedules

The consolidated statements and schedules listed in the accompanying Index
to Consolidated Financial Statements and Schedules on Page 25 hereof are
filed as part of this report.

(b) Reports on 8-K

No reports on Form 8-K were filed during the fourth quarter ended June 30,
1998.

(c) Exhibits

The Exhibits listed below, which are numbered corresponding to Item 601 of
Regulation S-K, are filed as a part of this report.

Exhibit Item
- ------- ----

3 Restated Article and Restated By-Laws incorporated herein by reference to Exhibit 3
of the Registrant's Annual Report on Form 10-K
for the year ended June 30, 1985

3.1 Amendment to Articles of Incorporation incorporated herein by reference to Exhibit
3.1 of the Registrant's Annual Report on Form
10-K for the year ended March 31, 1998

10.13 1987 Stock Incentive Plan incorporated herein by reference to Exhibit
10.13 of the Registrant's Annual Report on
Form 10-K for the year ended June 30, 1987

10.47 Non-Qualified Stock Option Agreement - incorporated herein by reference to Exhibit
Philip Kives 10.47 of the Registrant's Quarterly Report on
Form 10-Q for the quarter ended March 31, 1997

10.52 1997 Stock Option Plan incorporated herein by reference to Exhibit
10.52 of the Registrant's Quarterly Report on
Form 10-K for the quarter ended June 30, 1997

10.53 Loan and Security Agreement - incorporated herein by reference to Exhibit
Foothill Capital Corporation 10.53 of the Registrant's Quarterly Report on
Form 10-Q for the quarter ended December 31,
1997

10.54 Non-Qualified Stock Option Agreement - Attached to this report as Exhibit 10.54
Philip Kives

10.55 Amendment Number One - Loan and Security Attached to this report as Exhibit 10.55
Agreement- Foothill Capital Corporation

10.56 Amendment Number Two - Loan and Security Attached to this report as Exhibit 10.56
Agreement- Foothill Capital Corporation

10.57 Restated Amendment Number Two- Loan and Attached to this report as Exhibit 10.57
Security Agreement-Foothill Capital
Corporation

21 Subsidiaries of the Registrant Attached to this report as Exhibit 21

23 Consent of Independent Public Accountants Attached to this report as Exhibit 23

27 Financial Data Schedule (SEC use)

14

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Company has duly caused this report to be signed on its behalf
on September 18, 1998 by the undersigned, there unto duly authorized.

K-TEL INTERNATIONAL, INC.

By /S/ Philip Kives
---------------------------------------
(Philip Kives - Chairman of the Board
and Chief Executive Officer)

Pursuant to the requirements of the Securities and Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated and on the dates indicated.

Signatures Title Date
- ---------- ----- ----

/S/ Philip Kives Chairman, Chief Executive Officer (Principal October 12, 1998
- --------------------------- Executive Officer) and Director
Philip Kives

/S/ Corey Fischer Vice President-Finance, Director, October 12, 1998
- --------------------------- Chief Financial Officer and Treasurer
Corey Fischer (Principal Accounting Officer)

/S/ Jeffrey Koblick Executive Vice President, Purchasing and October 12, 1998
- --------------------------- Operations and Director
Jeffrey Koblick

/S/ Garry Kieves Director October 12, 1998
- ---------------------------
Garry Kieves

/S/ Louis Scheimer Director October 12, 1998
- ---------------------------
Louis Scheimer

15

(ITEM 14(A))
K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Public Accountants.................................. 17

Consolidated Balance Sheets as of June 30, 1998 and 1997.................. 18

Consolidated Statements of Operations for each of the three years ended
June 30, 1998............................................................. 19

Consolidated Statements of Shareholders' Equity for each of the three
years ended June 30, 1998................................................. 20

Consolidated Statements of Cash Flows for each of the three years ended
June 30, 1998............................................................. 21

Notes to Consolidated Financial Statements................................ 22-30

Supplemental Schedule to Consolidated Financial Statements:

Schedule II - Valuation and Qualifying Accounts for each of the
three years ended June 30, 1998..................................... 31

All other schedules for which provision is made in the applicable accounting
regulations of the Securities and Exchange Commission have been omitted as not
required, not applicable or the information required has been included elsewhere
in the consolidated financial statements and notes thereto.

16

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To K-tel International, Inc.:

We have audited the accompanying consolidated balance sheets of K-tel
International, Inc. (a Minnesota corporation) and subsidiaries as of June 30,
1998 and 1997, and the related consolidated statements of operations,
shareholders' equity and cash flows for each of the three years in the period
ended June 30, 1998. These financial statements and the schedule referred to
below are the responsibility of the Company's management. Our responsibility is
to express an opinion on these financial statements and schedule based on our
audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of K-tel International, Inc. and
subsidiaries as of June 30, 1998 and 1997, and the results of their operations
and their cash flows for each of the three years in the period ended June 30,
1998, in conformity with generally accepted accounting principles.

Our audit was made for the purpose of forming an opinion on the basic financial
statements taken as a whole. The schedule listed in the index to consolidated
financial statements is presented for purposes of complying with the Securities
and Exchange Commissions rules and is not part of the basic financial
statements. This schedule has been subjected to the auditing procedures applied
in the audit of the basic financial statements and, in our opinion, fairly
states in all material respects the financial data required to be set forth
therein in relation to the basic financial statements taken as a whole.

ARTHUR ANDERSEN LLP

Minneapolis, Minnesota,
October 9, 1998

17

K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF JUNE 30
(IN THOUSANDS - EXCEPT SHARE DATA)

ASSETS 1998 1997
- ------------------------------------------------------- ---------- ----------

Current Assets:
Cash and cash equivalents $ 5,941 $ 3,341
Accounts receivable, less allowances of $661 and $952 15,341 16,667
Inventories 6,430 4,287
Royalty advances 1,475 1,552
Prepaid expenses and other 3,043 2,587
---------- ----------
Total Current Assets 32,230 28,434

Property and Equipment, net of
accumulated depreciation and amortization
of $2,671 and $2,172 2,131 982
Other Assets 4,674 1,076
---------- ----------
$ 39,035 $ 30,492
========== ==========

LIABILITIES AND SHAREHOLDERS' EQUITY
- -------------------------------------------------------
Current Liabilities:
Current portion of Notes Payable $ 3,738 $ 836
Note payable to affiliate 1,000 1,500
Accounts payable 7,390 3,708
Accrued royalties 8,465 11,296
Reserve for returns 4,758 4,930
Other current liabilities 5,736 3,642
---------- ----------
Total Current Liabilities 31,087 25,912
---------- ----------

Notes Payable, net of current portion 4,174 --

Commitments and Contingencies (Note 8)

Shareholders' Equity:
Common stock - 15,000,000 shares authorized;
par value $.01; 8,316,668 and 7,567,568
issued and outstanding 41 37
Additional Paid In Capital 9,609 7,969
Accumulated Deficit (4,869) (2,462)
Cumulative translation adjustment (1,007) (964)
---------- ----------
Total Shareholders' Equity 3,774 4,580
---------- ----------
$ 39,035 $ 30,492
========== ==========

THE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE AN INTEGRAL PART
OF THESE BALANCE SHEETS.

18

K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED JUNE 30
(IN THOUSANDS - EXCEPT SHARE AND PER SHARE DATA)

1998 1997 1996
---------- ---------- ----------

NET SALES $ 85,626 $ 75,501 $ 71,987
---------- ---------- ----------

COSTS AND EXPENSES:
Cost of goods sold 47,670 41,387 38,665
Advertising 16,808 11,520 12,520
Selling, general & administrative 23,683 19,012 20,798

---------- ---------- ----------
Total Costs and Expenses 88,161 71,919 71,983
---------- ---------- ----------

OPERATING INCOME (LOSS) (2,535) 3,582 4
---------- ---------- ----------

NON-OPERATING INCOME (EXPENSE):
Interest income 48 124 130
Interest expense (490) (122) (409)
Other income 614 -- --
Foreign currency transaction loss (16) (162) (119)
---------- ---------- ----------
Total Non-operating Income (Expense) 156 (160) (398)
---------- ---------- ----------

INCOME (LOSS) BEFORE PROVISION
FOR INCOME TAXES (2,379) 3,422 (394)

PROVISION FOR INCOME TAXES (Note 6) 28 218 351
---------- ---------- ----------

NET INCOME (LOSS) $ (2,407) $ 3,204 $ (745)
========== ========== ==========

NET INCOME (LOSS) PER SHARE;
BASIC $ (.31) $ .43 $ (.10)
DILUTED $ (.31) $ .41 $ (.10)
SHARES USED IN THE CALCULATION OF
INCOME (LOSS) PER SHARE;
BASIC 7,736 7,527 7,460
DILUTED 7,736 7,908 7,460

THE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE AN INTEGRAL PART
OF THESE STATEMENTS.

19

K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED JUNE 30
(IN THOUSANDS)

Common Stock Additional Cumulative
------------------------ Paid In Accumulated Translation
Shares Amount Capital Deficit Adjustment Total
---------- ---------- ---------- ---------- ---------- ----------

Balance, July 1, 1995 $ 7,428 $ 37 $ 7,816 $ (4,921) $ (479) $ 2,453

Net loss -- -- -- (745) -- (745)
Proceeds from exercise of stock options 56 -- 54 -- -- 54
Translation adjustment -- -- -- -- (198) (198)
---------- ---------- ---------- ---------- ---------- ----------

Balance, June 30, 1996 7,484 37 7,870 (5,666) (677) 1,564

Net income -- -- -- 3,204 -- 3,204
Proceeds from exercise of stock options 84 -- 99 -- -- 99
Translation adjustment -- -- -- -- (287) (287)
---------- ---------- ---------- ---------- ---------- ----------

Balance, June 30, 1997 7,568 37 7,969 (2,462) (964) 4,580

Net loss -- -- -- (2,407) -- (2,407)
Proceeds from exercise of stock options 749 4 1,640 -- -- 1,644
Translation adjustment -- -- -- -- (43) (43)
---------- ---------- ---------- ---------- ---------- ----------

Balance, June 30, 1998 $ 8,317 $ 41 $ 9,609 $ (4,869) $ (1,007) $ 3,774
========== ========== ========== ========== ========== ==========

THE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE AN INTEGRAL PART
OF THESE STATEMENTS.

20

K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED JUNE 30
(IN THOUSANDS)

1998 1997 1996
---------- ---------- ----------

Cash Flows From Operating Activities:
Net income (loss) $ (2,407) $ 3,204 $ (745)
Adjustments to reconcile net income (loss) to cash provided by (used for)
operating activities:
Depreciation and amortization 1,060 630 805
Loss on valuation of marketable securities 514 -- --
Changes in current operating items:
Restricted cash -- -- 536
Accounts receivable 1,427 (1,927) (3,216)
Inventories (1,997) 1,461 1,458
Royalty advances 75 (347) 966
Prepaid expenses and other (936) (1,955) 1,395
Accounts payable 2,981 1,039 (842)
Accrued royalties (2,809) 412 1,885
Return reserve (348) (1,863) 66
Income taxes, net 62 (89) 313
---------- ---------- ----------
Cash provided by (used for) operating activities (2,378) 565 2,621
---------- ---------- ----------

Investing Activities:
Property and equipment purchases (1,620) (740) (240)
Proceeds from sale of property and equipment 4 141 215
Music catalog additions (932) (200) (781)
Acquisition of Regal Shop International (Note 3) (350) -- --
Other (348) (114) (42)
---------- ---------- ----------
Cash used for investing activities (3,246) (913) (848)
---------- ---------- ----------

Financing Activities:
Issuance of long term debt 4,178 -- --
Line of Credit, Foothill Capital, net 3,738 -- --
Repayments on line of credit (836) (1,028) (652)
Borrowings(repayment)on note payable to affiliate (500) 1,500 --
Proceeds from exercise of stock options 1,644 99 54
---------- ---------- ----------
Cash provided by (used for) financing activities 8,224 571 (598)
Effect of Exchange Rate Changes on Cash and Cash Equivalents -- (137) (74)
---------- ---------- ----------
Net Increase in Cash and Cash Equivalents 2,600 86 1,101
Cash and Cash Equivalents at Beginning of Year 3,341 3,255 2,154
---------- ---------- ----------
Cash and Cash Equivalents at End of Year $ 5,941 $ 3,341 $ 3,255
========== ========== ==========

Supplemental Cash Flow Information
Cash Paid For -
Interest $ 476 $ 67 $ 220
========== ========== ==========
Income Taxes $ 60 $ 268 $ 494
========== ========== ==========

THE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE AN INTEGRAL PART
OF THESE STATEMENTS.

21

K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1998, 1997 AND 1996

1. BUSINESS AND LIQUIDITY

K-tel International, Inc. (the "Company", "K-tel", the "Registrant") is an
international marketer and distributor of entertainment and consumer
products and is a leader in the market niche for pre-recorded music
compilations. With more than thirty years of marketing experience in the
United States ("U.S."), Canada and Europe, the Company has developed the
resources, knowledgeable personnel, information systems and distribution
capabilities to launch music, video, and consumer products quickly in the
North American and European markets through traditional retail and
direct-response marketing channels. On May 1, 1998, the Company launched its
new Internet service, K-tel Express (www.ktel.com), featuring a wide
spectrum of music products for purchase by the public around the globe. Open
for commerce 24 hours a day, 365 days a year, K-tel Express features more
than 250,000 music titles at value prices through this online shopping
service.

The Company experienced negative cash flow of $2,378,000 cash from
operations in fiscal 1998 and utilized another $3,246,000 to fund music
catalog additions and information systems. These cash requirements were
satisfied principally from borrowings under new credit facilities, advances
made by an affiliate of the Chairman of the Board and from the exercise of
stock options. As of June 30, 1998 the Company had $148,000 available for
borrowings under its credit facility. The Company will have to improve its
operations to comply with its credit facility covenants, as amended and
further amended. The covenants as of December 31, 1999 assume proceeds from
an equity placement, which cannot be assured. Future losses from businesses
such as K-tel Express or the inability to complete an equity placement may
result in further renegotiations of such covenants or the need to seek
replacement financing. The Company has obtained a commitment from its
Chairman of the Board to fund operations as necessary through fiscal 1999,
and is in the process of formalizing the commitment in the form of a credit
agreement. During the period from July 1, 1998 through October 9, 1998, an
affiliate of the Chairman of the Board has advanced an additional $3,000,000
to the Company, which has been used to fund operations and investments in
technology.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation - The accompanying consolidated 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 - Revenue is generally recognized upon shipment to the
customer. Most music sales are made with the right of return of unsold
units. Estimated reserves for returns are established by management based on
historical experience and product mix and are subject to the ongoing review
and adjustment by the Company. One United States customer represented 12% of
the Company's consolidated net sales for the year ended June 30, 1996. No
customer represented greater than 10% of net sales for the years ended June
30, 1998 or 1997.

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

Inventories - Inventories are valued at the lower of cost, determined on a
first-in, first-out basis, or net realizable value. The cost of finished
goods includes all direct product costs.

Rights to Use Music Product - Certain of the Company's compilation products
are master recordings under license from record companies and publishers. In
most instances, minimum guarantees or non-returnable advances are required
to obtain the licenses and are realized through future sales of the product.
The amounts paid for minimum guarantees or non-returnable advances are
capitalized and charged to expense as sales are made. When anticipated sales
appear to be insufficient to fully recover the minimum guarantees or
non-returnable advances, a provision against current operations is made for
anticipated losses. The unrealized portion of guarantees and advances is
included in royalty advances in the accompanying consolidated balance
sheets. Licenses are subject to audit by licensors.

In 1993 Dominion Entertainment, Inc. and K-tel Entertainment (U.K.), Ltd.
filed a lawsuit against a United Kingdom entertainment company regarding
infringement on a number of the Company's owned music master copyrights.
During December of 1996 the Company settled the lawsuit for $950,000. The
settlement consisted of a reimbursement of legal

22

costs (which produced an $850,000 net income benefit) to the Company which
was recorded as a reduction of selling, general and administrative expenses
in the accompanying statement of operations for the year ended June 30,
1997. The Company also entered into a license agreement with the United
Kingdom company which included an advance of future royalties. As of June
30, 1998 and 1997 approximately $389,000 and $569,000 of these amounts,
respectively, have been recorded as deferred income in the accompanying
balance sheets.

Property and Equipment - Property and equipment are stated at cost.
Depreciation and amortization is provided using straight line or declining
balance methods over the estimated useful lives of the assets which range
from three to nine years.

Software Development Costs - Payroll and other direct costs of materials and
services incurred during the application and development stage of developing
the software for K-tel Express, the Company's Internet retailing site, have
been capitalized. Such costs are being amortized on the straight-line basis
over three years.

Royalties - The Company has entered into license agreements with various
record companies and publishers under which it pays royalties on units sold.
The Company accrues royalties using contractual rates and certain estimated
rates on applicable units sold. On a quarterly basis the contractual royalty
liability is computed and the accrued royalty balance is adjusted
accordingly.

Advertising - The Company expenses the costs of advertising when the
advertising takes place, except for direct response advertising, which is
capitalized and amortized over its expected period of future benefits.
Direct response advertising consists primarily of television advertising
whereby customers respond specifically to the advertising and where the
Company can identify the advertising that elicited the response. At June 30,
1998 $1,337,000 of advertising was reported as assets. Advertising expense
was $16,808,000, $11,520,000 and $12,520,000 for each of the years ended
June 30, 1998, 1997 and 1996 respectively.

Foreign Currency - The operations of all foreign entities are measured in
local currencies. Assets and liabilities are translated into U.S. dollars at
year end exchange rates. Revenues and expenses are translated at the average
exchange rates prevailing during the year. Adjustments resulting from
translating the financial statements of foreign entities into U.S. dollars
are recorded as a separate component of shareholders' investment.

Stock-based Compensation - The Company accounts for stock-based awards to
employees using the intrinsic value method based under Accounting Principles
Board ("APB") No. 25, Accounting for Stock Issued to Employees, and
recognizes compensation expense for certain stock based awards granted to
employees. The Company has adopted the disclosure provisions of SFAS No.
123, Accounting for Stock Based Compensation, which requires disclosure of
certain pro forma information as if the Company adopted the fair value
method of accounting for stock based compensation prescribed by FASB No. 123
(See Note 7).

Income Taxes - Deferred income taxes are provided for temporary differences
between the financial reporting basis and tax basis of the Company's assets
and liabilities at currently enacted tax rates.

Stock Split - On April 21, 1998, the Board of Directors declared a
two-for-one stock split of the Company's Common Stock in the form of a stock
dividend payable to shareholders of record on May 1, 1998. All disclosures
and applicable per share data have been retroactively restated to reflect
this split.

Net Income (Loss) Per Share - During the year ended June 30, 1998 the
Company adopted Statement of Financial Accounting Standards No. 128,
"Earnings Per Share." As a result, all previously reported earnings (loss)
per share have been restated. Basic earnings (loss) per share have been
computed by dividing net income (loss) by the weighted average number of
shares outstanding during the period. Diluted earnings (loss) per share have
been computed assuming the exercise of stock options and their related
income tax effect. For all periods presented common stock equivalents that
were anti-dilutive were excluded from the per share calculation.

23

1998 1997 1996
--------- --------- ---------

Basic Earnings Per Share Computation
Weighted Average Shares Outstanding 7,736 7,527 7,460

Diluted Earnings Per Share Computation
Weighted Average Shares Outstanding 7,736 7,527 7,460
Stock Options -- 381 --
--------- --------- ---------
Denominator for Diluted Earnings per Share Computation 7,736 7,908 7,460
========= ========= =========

Use of Estimates - The preparation of consolidated financial statements in
conformity with generally accepted accounting principles requires management
to make estimates and assumptions that affect the reported amounts of
assets, liabilities, disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Principal estimates include allowances
for bad debts, return reserves, royalty obligations and product replacement
costs. Ultimate results could differ materially from those estimates.

Recently Issued Accounting Standards - The Financial Accounting Standards
Board has released SFAS No. 130, "Reporting Comprehensive Income", effective
for fiscal years beginning after December 15, 1997. SFAS No. 130 establishes
standards for reporting and display in the financial statements of total net
income and the components of all other non-owner changes in equity, referred
to as comprehensive income. The Company will adopt SFAS 130 in Fiscal 1999
and is currently analyzing the impact it will have on the disclosures in its
financial statements.

The Financial Accounting Standards Board has released Statement of Financial
Accounting Standards No. 131 ("SFAS 131"), "Disclosures about Segments of an
Enterprise and Related Information" which requires a disclosure of business
segments in the financial statements of the Company. The Company expects to
adopt SFAS No. 131 in fiscal 1999 and anticipates a change in segment
disclosure at the time of adoption.

Reclassifications - Certain June 30, 1997 amounts have been reclassified to
conform with current period presentation.

3. ACQUSITION OF CERTAIN ASSETS OF REGAL SHOP INTERNATIONAL LTD.

On March 4, 1998 the Company acquired $3,250,000 of media rights and other
assets of United Kingdom based Regal Shop International Ltd. for purchase
consideration of $350,000 cash and the assumption of $2,900,000 of debt. The
Company has accounted for the acquisition as a purchase, and the purchase
price in excess of the fair value of the net assets acquired of $500,000 has
been allocated to goodwill which is being amortized over five years. Media
rights of $2,400,000 are included in Other assets as of June 30, 1998 and
are being amortized over a five year period. This acquisition was not
material to the Company's consolidated financials.

4. NOTES PAYABLE

1998 1997
------------ ------------

Term Loan $ 4,000,000 $ --
Revolving Line of Credit 3,738,000 836,000
Other 174,000 --
------------ ------------

Total $ 7,912,000 $ 836,000
Less Current Portion 3,738,000 836,000
------------ ------------
Total Long Term Debt $ 4,174,000 $ --
============ ============

24

Until November 20, 1997 the Company had a revolving credit agreement with a
U.S. bank that provided borrowings of up to $2,500,000 based upon a monthly
borrowing base derived from certain of the Company's U.S. Subsidiaries'
accounts receivable. The loan was secured by assets of the Company's U.S.
Subsidiaries, including accounts receivable, inventories, equipment and
owned music master recordings and was guaranteed by the Company.

On November 20, 1997 certain of the Company's U.S. Subsidiaries entered into
a new four-year $10 million credit facility with another lending
institution. The credit facility consists of a $4,000,000 term loan due in
full November 20, 2001 and a $6 million revolving credit facility, limited
to a percent of eligible receivables and inventory, that expires November
20, 2001. Borrowings under the facility bear interest at a variable rate
based on a "base rate" announced by a banking affiliate associated with the
lending institution (8.5% at June 30, 1998) and are secured by the assets of
certain U.S. Subsidiaries, including accounts receivable, inventories,
equipment, music library and general intangibles. The loan agreement
contains certain financial and other covenants or restrictions, including
the maintenance of a minimum tangible net worth by the Company, limitations
on capital expenditures, restrictions on music library acquisitions,
limitations on the incurrence of indebtedness and restrictions on dividends
to the Company. The Company has guaranteed the obligations of its
subsidiaries under the credit facility and has pledged the stock of those
subsidiaries and its assets to secure the Company's obligations under its
guaranty. On November 20, 1997 a portion of the proceeds from the funding of
the credit facility were used to repay in full the bank revolving credit
agreement discussed in the preceding paragraph and such agreement was
terminated. As of June 30, 1998 the amount outstanding under the revolving
credit facility was $3,738,000 and the maximum additional available under
the borrowing limitations at June 30, 1998 was $148,000. The maximum amount
outstanding under the line of credit was $4,417,000 during fiscal 1998. The
Company was either in compliance with or had obtained waivers for all
covenants, limitations and restrictions. The Company has renegotiated
certain financial covenants with the lender for fiscal 1999. Future losses
from businesses such as K-tel Express or the inability to complete an equity
placement may result in further renegotiations of such covenants or the need
to seek replacement financing.

5. NOTE PAYABLE TO AFFILIATE

From time to time the Company has borrowed from K-5 Leisure Products, Inc.,
("K-5") an affiliate controlled by the Company's Chairman of the Board and
Chief Executive Officer. The Company pays interest at prime rate (8.5% at
June 30, 1998) on the unpaid principal amount of financing which is due on
demand. As of June 30, 1998 and 1997 K-5 Leisure Products, Inc. had advanced
$1,000,000 and $1,500,000 to the Company. Subsequent to June 30, 1998 an
additional $3,000,000 was advanced to the Company.

6. INCOME TAXES

The Company operates in several countries and is subject to various tax
regulations and tax rates. The provisions for income taxes is computed based
on income reported for financial statement purposes in accordance with the
tax rules and regulations of the taxing authorities where the income is
earned.

The provision (benefit) for income taxes consists of the following for the
years ended June 30 (in thousands):

1998 1997 1996
---------- ---------- ----------

Income (loss) before provision (benefit) for income taxes:
United States $ (3,702) $ 1,694 $ 141
Foreign 1,323 1,728 (535)
---------- ---------- ----------
Total $ (2,379) $ 3,422 $ (394)
========== ========== ==========

Provision (benefit) for income taxes:
Currently payable
United States $ (119) $ 111 $ 210
Foreign 147 107 141
---------- ---------- ----------

Total currently payable and
total provision for income taxes $ 28 $ 218 $ 351
========== ========== ==========

25

A reconciliation of the U.S. Federal statutory rate to the effective tax
rate for the years ended June 30 are as follows:

1998 1997 1996
------- ------- -------

Federal statutory rate 34% 34% 34%
State Taxes, net of Federal benefit 2% 1% (26)%
Change in valuation allowance (39)% (29)% (99)%
Effect of different tax rates on foreign earnings 2% -- 2%
------- ------- -------
(1)% 6% (89)%
======= ======= =======

Deferred income taxes are provided for the temporary differences between the
financial reporting basis and the tax basis of the Company's assets and
liabilities. Temporary differences, which are all deferred tax assets, are
as follows (in thousands):

June 30, June 30,
1998 1997
----------- ----------

Net operating loss carryforwards $ 13,522 $ 5,486
Alternative minimum tax credits 432 411
Reserve for returns 1,477 1,419
Depreciation and amortization 263 136
Royalty reserves 355 964
Inventory reserves 274 943
Nondeductible accruals 286 647
Allowance for bad debts 198 284
Valuation allowance (16,807) (10,290)
----------- ----------
$ -- $ --
=========== ==========

A valuation allowance equal to the aggregate amount of deferred tax assets
has been established until such time as realizability is assured.

For U.S. tax reporting purposes, the Company has net operating loss
carryforward ("NOL") of approximately $36,649,000. Of this amount
approximately $8,590,000 is available only through the year 2000 and another
$8,492,000 will be available only through 2001. The rest of the NOL
carryforward will be available through the year 2013. However, of the amount
available through 2013, $14,877,000 relates to deductions associated with
the exercise of stock options. The tax benefit of approximately $5,355,000
associated with this stock option deduction will be recorded as additional
paid-in capital when realized. The tax NOL carryforward may be reduced in
future years, without financial statement benefit, to the extent of
intercompany dividends received from foreign subsidiaries. Also, the NOL
carryforwards are subject to review and possible adjustment by taxing
authorities. In addition, the Company has approximately $432,000 in U.S.
federal alternative minimum tax credits which may be utilized in the future
of offset any regular corporate income tax liability. NOL's available in
foreign countries approximated $1,400,000 as of June 30, 1998.

7. CAPITAL TRANSACTIONS

Stock Incentive Plan

The Company has in place a Stock Incentive Plan for officers and other key
employees of the Company. Under the terms of this plan the Board of
Directors has the sole authority to determine the employees to whom options
and awards are granted, the type, size and terms of the awards, timing of
the grants, the duration of the exercise period and any other matters
arising under the plan. The common stock incentives may take the form of
incentive stock options, nonqualified stock options, stock appreciation
rights and/or restricted stock. The Company's 1987 plan covered a maximum of
700,000 shares of common stock. There were 495,400 net shares granted under
this plan as of June 30, 1998. In February 1997 the Company's Board of
Directors approved a new stock option plan covering a maximum of 600,000
shares of common stock. There were 575,000 shares granted under this plan as
of June 30, 1998.

26

Restricted and Non-Qualified Stock Options

In addition to stock options granted under the terms of the Stock Incentive
Plan, the Board of Directors has the sole authority to grant employees,
officers and directors restricted and non-qualified stock options outside
the Stock Incentive Plan. The Board of Directors determines the type, size
and terms of the grants, timing of the grants, the duration of the exercise
period and any other matters pertaining to options or awards granted outside
of the Stock Incentive Plan.

The Share information for all plans is summarized below:

Incentive Non-qualified Restricted
Stock Options Stock Options Stock Options
-------------- -------------- --------------

Outstanding July 1, 1995 300,050 94,750 345,000

Granted -- -- --
Exercised - at prices ranging from
$.75 - $1.50 per share (48,800) (4,250) -
Forfeited (30,250) (4,250) (290,000)
-------------- -------------- --------------
Outstanding June 30, 1996 221,000 86,250 55,000

Granted 83,000 -- 860,000
Exercised - at prices ranging from
$.75 - $3.375 per share (47,174) (36,250) --
Forfeited (12,050) (6,000) (30,000)
-------------- -------------- --------------
Outstanding June 30, 1997 244,776 44,000 885,000

Granted 590,000 500,000 231,000
Exercised - at prices ranging from
$.75 - $14.345 per share (247,100) (47,000) (455,000)
Forfeited (7,100) -- --
-------------- -------------- --------------
Outstanding June 30, 1998 580,576 497,000 661,000
============== ============== ==============

Exercise Prices $.75 - $14.345 $.75 - $14.345 $2.00 - $4.125

Options Excercisable (1) 9,476 26,000 631,000

(1) Subsequent to year end the Company announced it would allow employees who
were granted options under the existing stock option plans the opportunity
to exercise certain unvested stock options during the months of September,
October and November of 1998. The options not exercised during this period
will revert back to the original vesting schedule. Under this plan 250,300
additional Incentive Options may be exercisable during this period that are
not included in the above table.

Pro forma Option Information

Effective June 30, 1997 the Company adopted SFAS No. 123. "Accounting for
Stock-Based Compensation." As permitted by SFAS No. 123, the Company has
elected to continue to account for its stock option plans under the
provisions of APB Opinion No. 25, under which no compensation costs have
been recognized. Had compensation costs for these plans been recorded at
fair value consistent with the provisions of SFAS No. 123, the Company's net
income and earnings per share would have been as follows:

27

1998 1997
---------- ----------
Net income (in thousands):
As reported $ (2,407) $ 3,204
Pro forma $ (3,577) $ 2,757

Basic EPS:
As reported $ (.31) $ .43
Pro forma $ (.46) $ .37

Diluted EPS:
As reported $ (.31) $ .41
Pro forma $ (.46) $ .35

The weighted average fair values of options granted in fiscal 1998 was $6.10
and in fiscal 1997 was $2.20. No options were granted in fiscal 1996.

The fair value of each option is estimated on the date of grant using the
Black-Scholes option pricing model. The following assumptions were used to
estimate the fair value of options:

1998 1997
---------- ----------
Risk-free interest rate 5.12% 6.3%
Expected life 5 years 5 years
Expected volatility 100% 57%
Expected dividend yield None None

Because the measurement provisions of SFAS No. 123 have not been applied to
options granted prior to June 30, 1995, the resulting pro forma compensation
cost may not be representative of that to be expected in future years.

8. COMMITMENTS AND CONTINGENCIES

Litigation and Disputes

The Company is involved in legal actions in the ordinary course of its
business. Although the outcomes of any such legal actions cannot be
predicted, in the opinion of management, there is no legal proceeding
pending or asserted against or involving the Company for which the outcome
is likely to have a material adverse effect upon the consolidated financial
position or results of operations of the Company.

K-tel International Inc. v. Platinum Entertainment Inc. In September 1997
the Company commenced a declaratory judgment action against Platinum
Entertainment, Inc. ("Platinum") in Minnesota state court. The Company
alleged that it was entitled to $1.75 million which Platinum deposited in an
earnest money escrow account pursuant to Platinum's agreement to purchase
two of the Company's subsidiaries, K-tel International (USA), Inc. and
Dominion Entertainment, memorialized in the March 1997 Purchase and Sale
Agreement. The Company further alleged claims of breach of the March 1997
Purchase and Sale Agreement and related confidentiality agreement,
defamation, fraud, and promissory estoppel.

Platinum removed the action to federal court and asserted a counterclaim
against the Company seeking a declaration that Platinum was entitled to the
earnest money and alleging claims of breach of contract and fraudulent
inducement. While still engaged in the discovery process the parties settled
the action between themselves, agreeing to a payment to K-Tel International,
Inc. of $875,000 of the earnest money escrow and reimbursement by Platinum
of certain accounting fees paid by the Company, along with an exchange of
releases. The parties also stipulated to the dismissal of the action with
prejudice and the Court dismissed the action with prejudice by Order dated
July 7, 1998.

Early v. K-tel International Inc. On March 10, 1997 Mr. Christopher Early
filed a class action Complaint against K-tel International, Inc. ("the
Company"), Dominion Entertainment, Inc., and certain retailers in the
Circuit Court of Cook County, Illinois. The defendants removed the action to
the United States District Court for the Northern District of

28

Illinois on April 3, 1997. On March 30, 1998 Mr. Early obtained leave to
file an Amended Complaint adding K-tel International (USA), Inc. and one
additional retailer as defendants, purporting to allege class actions under
(1) the Illinois Consumer Fraud and Deceptive Trade Practices Act and (2)
the Racketeer Influenced and Corrupt Organizations Act for allegedly
deceptive packaging of certain tapes and compact discs which packaging
allegedly defrauded consumers into believing that certain recordings thereon
were original rather than new recordings. On behalf of the class, Early
purports to seek (1) treble damages; (2) compensatory damages; (3) punitive
damages; (4) an injunction prohibiting "the further sale of mislabeled tapes
and CD's;" and (5) attorneys' fees and costs. The defendants have moved to
dismiss the Amended Complaint and in the alternative for a partial summary
judgment on one aspect thereof. This motion has been fully briefed but not
ruled upon and discovery has not commenced. The Company has indemnified the
retailer defendants in this matter. The Company believes the case is without
merit and intends to contest the case vigorously.

Leases

The Company has entered into several office and warehouse leases which
expire through 2003. Commitments under these leases are $719,000 in 1999,
$757,000 in 2000, $713,000 in 2001, $293,000 in 2002 and $11,000 in 2003.
Rental expense was $885,000 in 1998, $988,000 in 1997 and $1,000,000 in
1996.

Other

The Company has made certain commitments for marketing, advertising and
technical services relating to K-tel Express that will be provided over the
next fiscal year that will require payments up to $600,000 and the issuance
of 15,000 restricted shares of the Company's common stock.

9. OPERATIONS BY GEOGRAPHIC AREA

The following table sets forth the Company's operations by geographic area
as of and for the fiscal years ended June 30 (in thousands):

1998 1997 1996
---------- ---------- ----------
Net Sales:
---------

North America $ 55,883 $ 47,786 $ 48,605
Europe 29,743 27,715 23,382
---------- ---------- ----------
Net Sales $ 85,626 $ 75,501 $ 71,987
========== ========== ==========

Operating Income (Loss):
-----------------------

North America $ (2,074) $ 2,672 $ 1,997
Europe 1,806 2,343 (38)
General Corporate Expenses, net (2,267) (1,433) (1,955)
---------- ---------- ----------
Operating Income (Loss) $ (2,535) $ 3,582 $ 4
========== ========== ==========

Identifiable Assets:
--------------------

North America $ 24,574 $ 22,781 $ 20,282
Europe 14,461 7,711 7,513
---------- ---------- ----------
Identifiable Assets $ 39,035 $ 30,492 $ 27,795
========== ========== ==========

29

10. RELATED PARTY TRANSACTIONS

K-5 Leisure Products, Inc., an affiliate controlled by the Company's
Chairman of the Board and Chief Executive Officer, has from time to time
made advances to the Company. Advances on this facility reached $1,500,000
as of November 20, 1997 when the debt was repaid in full from the borrowings
under the Company's credit facility. As of June 30, 1998 K-5 Leisure
Products, Inc. had advanced an additional $1,000,000 to the Company and an
additional $3,000,000 subsequent to June 30, 1998. The Company pays interest
on the unpaid principal amount of financing at the same rate as the Company
pays on its credit facility, until repayment of the loan, which is due on
demand. The Company paid interest of $95,000 in 1998, $59,000 in 1997 and no
interest was paid or due in 1996.

The Company purchased approximately $334,000 in fiscal 1998, $381,000 in
fiscal 1997 and $1,050,000 in fiscal 1996 of consumer convenience product
from an affiliate controlled by the Company's Chairman of the Board and
Chief Executive Officer. Management believes purchase prices for these
products were at prices comparable to transactions with an unrelated third
party. There was a payable amount of $9,000 at June 30, 1998, $255,000 at
June 30, 1997 and there was no balance payable at June 30, 1996.

The Company sold approximately $39,000 during fiscal 1998, $229,000 in
fiscal 1997 and $217,000 in fiscal 1996 of consumer convenience product to
an affiliate controlled by the Company's Chairman of the Board and Chief
Executive Officer. There was a balance receivable from the affiliate at June
30, 1998 of $4,000, $83,000 at June 30, 1997 and there was no receivable
balance owed to the Company at June 30, 1996. Outstanding balances are
settled on a timely basis. No interest was charged on the related
outstanding balances during fiscal 1998.

30

SCHEDULE II

K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES

VALUATION AND QUALIFYING ACCOUNTS

For the years ended June 30, 1998, 1997, and 1996

(In thousands)

Charged to
Balance at Costs and Charged to Balance at
Beginning of Expenses or Net Other End of
Period Sales Accounts Deductions Period
------------ --------------- ----------- ----------- -----------

Allowance for
Doubtful Accounts
- --------------------

1998 $ 952 $ 986 $ (1)(1) $ (1,276)(2) $ 661
1997 $ 1,035 $ 533 $ (29)(1) $ (587)(2) $ 952
1996 $ 771 $ 694 $ (15)(1) $ (415)(2) $ 1,035

Reserve for
Returns
- --------------------

1998 $ 4,930 $ 13,943 $ (9)(1) $ (14,106) $ 4,758
1997 $ 6,817 $ 10,096 $ (24)(1) $ (11,959) $ 4,930
1996 $ 6,802 $ 10,485 $ (18)(1) $ (10,452) $ 6,817

(1) Exchange rate change

(2) Uncollectible accounts written off, net of recoveries

31