SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
0 - 24968
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Commission File Number
THE SINGING MACHINE COMPANY, INC.
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(Exact Name of Small Business Issuer as Specified in its Charter)
Delaware 95-3795478
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(State of Incorporation) (IRS Employer I.D. No.)
6601 Lyons Road, Building A-7, Coconut Creek, FL 33073
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(Address of principal executive offices )
(954) 596-1000
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(Issuer's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirement for the past 90 days. Yes x No
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS
Check whether the registrant filed all documents and reports required to be
filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of
securities under a plan confirmed by a court. Yes x No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes No x
--- ---
APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
CLASS NUMBER OF SHARES
OUTSTANDING ON NOVEMBER 10, 2003
Common Stock, $0.01 par value 8,712,169
1
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Page No.
--------
Consolidated Balance Sheets - September 30, 2003 (Unaudited)
and March 31, 2003 .............................................. 3
Consolidated Statements of Operations - Three and Six months
ended September 30, 2003 (unaudited) and 2002(Unaudited,restated). 4
Consolidated Statements of Cash Flows - Six months ended
September 30, 2003(unaudited)and 2002 (Unaudited,restated)....... 5
Notes to Consolidated Financial Statements ...................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ............................. 12
Item 3. Quantitative and Qualitative Disclosure About Market Risk ....... 16
Item 4. Controls and Procedures ......................................... 22
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ............................................... 23
Item 2. Changes in Securities ........................................... 23
Item 3. Defaults Upon Senior Securities ................................. 24
Item 4. Submission of Matters to a Vote of Security Holders ............. 24
Item 5. Other Information ............................................... 24
Item 6. Exhibits and Reports on Form 8-K ................................ 24
SIGNATURES ............................................................... 25
Exhibits
2
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
PART I - FINANCIAL INFORMATION
ITEM I. FINANCIAL STATEMENTS
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, MARCH 31,
2003 2003
----------- -----------
ASSETS
------
CURRENT ASSETS
Cash and cash equivalents $ 1,106,003 $ 268,265
Restricted Cash 867,603 838,411
Accounts Receivable, less allowances of $171,411 and $405,759,
respectively 21,131,801 5,762,944
Due from manufacturer 1,514 1,091,871
Inventories, net 20,563,086 25,194,346
Prepaid expense and other current assets 1,351,910 1,483,602
Deferred tax asset 1,925,612 1,925,612
----------- -----------
TOTAL CURRENT ASSETS 46,947,529 36,565,051
PROPERTY AND EQUIPMENT, at cost less accumulated depreciation of
$1,857,998 and $1,472,850, respectively 2,007,911 2,026,252
OTHER ASSETS
Other non-current assets 1,039,594 343,991
----------- -----------
TOTAL ASSETS $49,995,034 $38,935,294
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES
Bank overdraft 47,790 316,646
Accounts payable $15,639,307 $8,486,009
Accrued expenses 2,839,322 1,443,406
Subordinated debt-related parties 1,100,000 400,000
Notes payable 637,122 --
Revolving credit facility 6,513,411 6,782,824
Income taxes payable 2,635,047 3,821,045
----------- -----------
TOTAL CURRENT LIABILITIES 29,411,999 21,249,930
LONG TERM LIABILITIES
Convertible debentures, net of discount 595,423 --
----------- -----------
TOTAL LIABILITIES 30,007,422 21,249,930
SHAREHOLDERS' EQUITY
Preferred stock, $1.00 par value; 1,000,000 shares authorized, no
shares issued and outstanding -- --
Common stock, Class A, $.01 par value; 100,000 shares authorized; no
shares issued and outstanding -- --
Common stock, $0.01 par value; 18,900,000 shares authorized;
8,712,169 and 8,171,678 shares issued and outstanding 87,122 81,717
Additional paid-in capital 10,114,294 4,843,430
Retained earnings 9,786,196 12,760,217
----------- -----------
TOTAL SHAREHOLDERS' EQUITY 19,987,612 17,685,364
----------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $49,995,034 $38,935,294
=========== ===========
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
3
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
Three Months Ended Six Months Ended
September 30, September 30, September 30, September 30,
2003 2002 2003 2002
------------ ------------ ------------ ------------
(as restated) (as restated)
NET SALES $ 31,984,251 $ 32,269,779 $ 39,364,117 $ 36,256,025
COST OF SALES 28,180,712 24,367,626 34,166,542 27,526,988
------------ ------------ ------------ ------------
GROSS PROFIT 3,803,539 7,902,153 5,197,575 8,729,037
OPERATING EXPENSES
Compensation 1,343,812 799,406 2,455,391 1,570,304
Freight & handling 495,955 598,222 721,821 661,276
Selling, general & administrative
expenses 3,216,310 1,600,913 5,407,139 2,869,709
------------ ------------ ------------ ------------
TOTAL OPERATING EXPENSES 5,056,077 2,998,541 8,584,351 5,101,289
------------ ------------ ------------ ------------
(LOSS) EARNINGS FROM OPERATIONS (1,252,538) 4,903,612 (3,386,776) 3,627,748
OTHER INCOME (EXPENSES)
Other income (expenses) (90,649) 144,119 (82,980) 163,564
Interest expense (318,895) (109,344) (507,363) (122,509)
Interest income -- 339 -- 11,943
------------ ------------ ------------ ------------
NET OTHER (EXPENSES) INCOME
(409,544) 35,114 (590,343) 52,998
NET (LOSS) EARNINGS BEFORE INCOME
TAX (1,662,082) 4,938,726 (3,977,119) 3,680,746
INCOME TAX (BENEFIT) EXPENSE (1,005,413) 1,111,364 (1,003,098) 993,030
NET (LOSS) EARNINGS $ (656,669) $ 3,827,362 $ (2,974,021) $ 2,687,716
============ ============ ============ ============
(LOSS) EARNINGS PER SHARE:
Basic $ (0.08) $ 0.47 $ (0.35) $ 0.33
Diluted $ (0.08) $ 0.43 $ (0.35) $ 0.30
WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT
SHARES OUTSTANDING:
Basic 8,490,658 8,119,026 8,389,165 8,090,102
Diluted 8,490,658 8,881,970 8,389,165 8,899,023
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
4
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)
FOR THE SIX MONTHS ENDED SEPTEMBER 30,
--------------------------------------
2003 2002
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net (loss) earnings $ (2,974,021) $ 2,687,717
Adjustments to reconcile net (loss) earnings to net cash used in
operating activities
Depreciation and amortization 466,301 289,134
Non-cash interest expense, related to convertible debt 157,172 --
Stock compensation expense 511,933 --
Changes in assets and liabilities:
(Increase) decrease in:
Restricted cash (29,192) (1,002,982)
Accounts Receivable (15,368,857) (10,846,197)
Due from manufacturer 1,090,357 477,531
Inventories 4,631,260 (22,108,034)
Prepaid Expenses and other assets 83,557 154,594
Increase (decrease) in:
Accounts payable 7,153,298 16,400,765
Accrued expenses 1,054,718 971,539
Bank Overdraft (268,856) --
Income taxes payable (1,185,998) 923,029
------------ ------------
Net Cash Used in Operating Activities (4,678,328) (12,052,904)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment (157,178) (1,003,832)
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Net cash used in Investing Activities (157,178) (1,003,832)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net revolving credit facility (28,902,525) 21,665,040
Repayments from revolving credit facility 28,633,112 (13,621,768)
Proceeds from issuance of convertible debt 4,000,000 --
Payment of financing fees related to convertible debt (255,000) --
Proceeds from related party loan, net 700,000 --
Proceeds from note payable 637,122 --
Proceeds from exercise of stock options and warrants 860,535 151,753
------------ ------------
Net cash provided by Financing Activities 5,673,244 8,195,025
------------ ------------
DECREASE IN CASH AND CASH EQUIVALENTS 837,738 (4,861,711)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 268,265 5,520,147
------------ ------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,106,003 $ 658,436
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
CASH PAID FOR THE SIX MONTHS ENDED SEPTEMBER 30, 2003
Interest $ 350,192 $ 57,383
============ ============
Income Taxes $ 205,000 $ 51,107
============ ============
NON-CASH FINANCING ACTIVITIES
Interest expense associated with discounts for warrants and
beneficial conversion of convertible debentures $ 157,172 $ --
============ ============
Expense associated with stock based compensation $ 511,933 $ --
============ ============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
5
THE SINGING MACHINE COMPANY, INC AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 - SUMMARY OF ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements include
the accounts of The Singing Machine Company, Inc. and International SMC (H.K.)
Ltd., its wholly-owned subsidiary (the "Company", "The Singing Machine"). All
significant intercompany transactions and balances have been eliminated. The
unaudited consolidated financial statements have been prepared in conformity
with Rule 10-01 of Regulation S-X of the Securities and Exchange Commission and
therefore do not include information or footnotes necessary for a complete
presentation of financial position, results of operations and cash flows in
conformity with accounting principles generally accepted in the United States of
America. However, all adjustments (consisting of normal recurring accruals),
which, in the opinion of management, are necessary for a fair presentation of
the financial statements, have been included. Operating results for the period
ended September 30, 2003 are not necessarily indicative of the results that may
be expected for the remaining quarters or the year ending March 31, 2004 due to
seasonal fluctuations in The Singing Machine's business, changes in economic
conditions and other factors. For further information, please refer to the
Consolidated Financial Statements and Notes thereto contained in The Singing
Machine's Annual Report on Form 10-K for the year ended March 31, 2003.
INVENTORIES
Inventories are comprised of electronic karaoke audio equipment,
accessories, and compact discs and are stated at the lower of cost or market, as
determined using the first in, first out method. The following table represents
the major components of inventory at the dates specified.
September 30, 2003 March 31, 2003
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Finished goods $ 22,084,376 $ 27,807,763
Inventory in transit 834,055 1,101,940
Less Inventory reserve (2,355,345) (3,715,357)
------------ ------------
Total Inventory $ 20,563,086 $ 25,194,346
============ ============
6
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the
current year presentation.
STOCK BASED COMPENSATION
The Company accounts for stock options issued to employees using the
intrinsic value method in accordance with the provisions of Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations. As such, compensation cost is measured
on the date of grant as the excess of the current market price of the underlying
stock over the exercise price. Such compensation amounts are amortized over the
respective vesting periods of the option grant. The Company applied the
disclosure provisions of Statement of Financial Accounting Standards No. 148,
"Accounting for Stock-Based Compensation-Transition and Disclosure an amendment
of FASB Statement No. 148", which permits entities to provide pro forma net
earnings (loss) and pro forma earnings (loss) per share disclosures for employee
stock option grants as if the fair-valued based method defined in SFAS No. 123
had been applied to options granted.
Had compensation cost for the Company's stock-based compensation plan
been determined using the fair value method for awards under that plan,
consistent with Statement of Financial Accounting Standards (SFAS) No 123,
"Accounting for Stock Based Compensation" (Statement No. 123), the Company's net
earnings would have been changed to the pro-forma amounts indicated below.
FOR THE THREE MONTHS ENDED FOR THE SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
--------- ---------- ----------- ----------
Net loss As reported $(656,669) $3,827,362 $(2,974,021) $2,687,716
Pro forma $(858,121) $3,798,490 $(3,376,925) $2,629,972
Net (loss) earnings per As reported $(0.08) $0.47 $(0.35) $0.33
share - basic
Pro forma $(0.10) $0.47 $(0.40) $0.33
Net (loss) earnings per As reported $(0.08) $0.43 $(0.35) $0.30
share -diluted
Pro forma $(0.10) $0.43 $(0.40) $0.30
Stock based compensation $511,933 -- $511,933 --
The effect of applying Statement No. 123 is not likely to be
representative of the effects on reported net earnings for future years due to,
among other things, the effects of vesting.
For stock options and warrants issued to consultants, the Company
applies the fair value method of accounting as prescribed by SFAS 123. There
were no consulting expenses relating to grants for the quarters ended September
30, 2003 and 2002.
For financial statement disclosure purposes and for purposes of valuing
stock options and warrants issued to consultants, the fair market value of each
stock option granted was estimated on the date of grant using the Black-Scholes
Option-Pricing Model in accordance with SFAS 123 using the following
weighted-average assumptions:
Second Quarter 2004: expected dividend yield 0%, risk-free interest
rate of 2.5%, volatility 85.3% and expected term
of two years.
Second Quarter 2003: expected dividend yield 0%, risk-free interest
rate of 6.8%, volatility 42% and expected term of
two years.
7
RECENT ACCOUNTING PRONOUNCEMENTS
SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities" amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under SFAS 133. SFAS 149 is generally effective for contracts
entered into or modified after June 30, 2003 (with a few exceptions) and for
hedging relationships designated after June 30, 2003. The Company does not
expect the provisions of SFAS 149 to have a material impact on its financial
position or results of operations.
SFAS No. 150, "Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 improves
the accounting for certain financial instruments that, under previous guidance,
issuers could account for as equity. The new Statement requires that those
instruments be classified as liabilities in statements of financial position.
This statement is effective at the beginning of the second quarter of fiscal
2004. The Company does not expect the provisions of SFAS 150 to have a material
impact on its financial position or results of operations.
NOTE 2 - GOING CONCERN
The accompanying unaudited consolidated financial statements have been
prepared in conformity with accounting principles generally accepted in the
United States of America, which contemplate continuation of the Company as a
going concern.
On March 14, 2003, the Company was notified of its violation of the net
worth covenant of its Loan and Security Agreement (the "Agreement") with its
commercial lender and the Company was declared in default under the Agreement.
The lender amended the Agreement under amendment 14 on August 19, 2003,
extending the loan until March 31, 2004, waiving the condition of default.
NOTE 3 - RESTATEMENT OF FINANCIAL STATEMENTS FOR THE FISCAL YEARS 2002 AND 2001
In June 2003, our management revised its position on taxation of the
income of International SMC (H.K.) Ltd., its wholly owned subsidiary, income by
the United States and by the Hong Kong tax authorities for the reasons stated
below.
With regard to taxation in Hong Kong, International SMC had previously
applied for a Hong Kong offshore claim income tax exemption based on the
locality of its profits. Management believed that the exemption would be
approved because the source of all profits of International SMC is from
exporting to customers outside of Hong Kong. Accordingly, no provision for
income taxes was provided in the consolidated financial statements as of March
31, 2002 and 2001. However, full disclosure was previously reflected in the
audited financial statements for years ended March 31, 2002 and 2001 of the
estimated amount that would be due to the Hong Kong tax authority should the
exemption be denied. Management is continuing its exemption application process.
However, due to the extended period of time that the application has been
outstanding, as well as management's reassessment of the probability that the
application will be approved, management has determined to restate the 2002 and
2001 consolidated financial statements to provide for such taxes. The effect of
such restatement is to increase income tax expense by $748,672 and $468,424 in
fiscal 2002 and 2001, respectively. However, the Company can claim United States
foreign tax credits in 2002 for these Hong Kong taxes, which is reflected in the
final restated amounts.
With regard to United States taxation of foreign income, the Company
had originally taken the position that the foreign income of the Hong Kong
subsidiary qualified for a deferral under the Internal Revenue Code (Section
956) allowing for such income to be indefinitely deferred and not taxed in the
United States until such income is repatriated, or brought back into the United
States as taxable income. It was expected that this income would remain in Hong
Kong. Full disclosure of the amount and nature of the
8
indefinite deferral for fiscal year 2002 was reflected in the income tax
footnote of the consolidated financial statements for that year. The internal
revenue code, regulations and case law regarding international income taxation
is quite complex and subject to interpretation. Each case is determined based on
the individual facts and circumstances. Due to certain inter-company loans,
relating to inventory purchases, made in 2002 and 2003, the profits previously
considered to be indefinitely deferred became partially taxable as "deemed
dividends" under section 956 of the Internal Revenue Code. Although certain
arguments against the imposition of a "deemed dividend" may be asserted,
management has determined to restate the fiscal year 2002 consolidated financial
statements based on its reassessment of its original position. The effect of
such restatement is to increase income tax expense by $1,027,545 in fiscal year
2002, which includes the utilization of the foreign tax credits referred to
above.
The net effect of the above two adjustments for the quarter and six
months ended September 30, 2002 is to decrease net income by $1,060,257 and
$941,923, respectively. The net effect on net income per share is to decrease
net income per share basic and diluted by $0.13 and $0.12 for the quarter and
$0.12 and $0.11 for the six months ended September 30, 2002.
NOTE 4 - LOANS AND LETTERS OF CREDIT
CREDIT FACILITY
The Company's Hong Kong Subsidiary maintains separate credit facilities
at two international banks.
One facility has a maximum credit available of $5.5 million U.S.
dollars. The primary purpose of the facilities is to provide the Subsidiary with
the following abilities:
o Overdraft facilities
o Issuance and negotiation of letters of credit, both regular and
discrepant
o Trust receipts
o A Company credit card
The second facility is primarily for the guarantee and clearance of
customer's letters of credit.
The facilities are secured by a corporate guarantee from the U.S.
Company, maintain restricted cash on deposit with the lender and maintain net
worth as outlined in the agreement.
The Company executed a short term loan with an international bank in
May of 2003. The $2,000,000 loan carries interest at a SIBOR (Singapore
Interbank Money Offer Rate) rate plus 2.75%. The rate at September 30, 2003 was
3.89%. The loan was paid in full by October 31, 2003. The balance of this loan
at September 30, 2003 was $637,122.
LOAN AND SECURITY AGREEMENT
On April 26, 2001, the Company executed a Loan and Security Agreement
(the "Agreement") with a commercial lender (the "Lender"). On August 19, 2003,
this loan was amended through March 31, 2004. The following is a description of
the terms as amended.
The Lender will advance up to 70% of the Company's eligible accounts
receivable, plus up to 20% of the eligible aged inventory and 40% of new
purchases up to the inventory sublimit of $7.5 million, plus up to 40% of the
commercial letters of credit opened for the purchase of eligible inventory up to
$3 million, less reserves at the discretion of the lender. The limits of
eligibility will reduce as per the agreement.
The outstanding loan limit varies between zero and $12,500,000, as
stipulated in the Agreement. The Lender also provides the Company the ability to
issue commercial letters of credit up to $3,000,000,
9
which shall reduce the loan limits above. The loans bear interest at the
commercial lender's prime rate plus 2.5%. The loans are secured by a first lien
on all present and future assets of the Company except for certain tooling
located at a vendor in China. This amendment expires March 31, 2004.
The Agreement contains covenants including a restriction on the payment
of dividends as well as a financial covenant stipulating a minimum tangible net
worth of $15,000,000 as of August 31, 2003. The outstanding balance of the
facility at September 30, 2003 was $6,513,411.
SUBORDINATED DEBT
As of July 10, 2003, the Company obtained $1 million in subordinated
debt financing from a certain officer, directors and an associate of a director.
The loans are accruing interest at 9.5% per year. These loans were originally
scheduled to be paid back by October 31, 2003; however, have since been
subordinated to the Company's credit facility.
As of July 28, 2003, an unrelated party posted a $1 million standby
letter of credit as further collateral on the revolving credit facility. The
facility is accruing interest at 9.5% per year. According to the terms of
amendment 14 of the credit facility agreement, this will be released upon
completion of the applicable paperwork.
NOTE 5 - 8% CONVERTIBLE DEBENTURES WITH WARRANTS
In September 2003, we issued and sold in a private offering $4 million
of 8% Convertible Debentures due February 20, 2006 ("Convertible Debentures"),
representing $4 million in gross proceeds to the Company. The net cash proceeds
to the Company were $3,745,000 after deduction of cash commissions and other
expenses.
The Convertible Debentures are subordinated to the Company's Commercial
Lender and are convertible at the option of the holders into Common Shares at
the conversion rates referred to below, subject to certain anti-dilution
adjustment provisions, at any time after the closing date. Each Convertible
Debenture will be convertible into common shares, representing an initial
conversion price of $3.85 per Common Share.
The Convertible Debenture has an optional redemption feature for the
Company, whereas at any time after the effective date, the closing price for any
15 consecutive days exceeds the set price by 200%, the Company shall have the
right to redeem no less than the entire principal amount at a cash price equal
to 100% of the principal amount plus any accrued but unpaid interest and fees.
In meeting the conversion, redemption, payment at maturity and other related
terms of these convertible debt securities, we have the right, at our option, to
satisfy these obligations in cash, Common Shares or any combination thereof. In
the event that the holders of the Convertible Debentures exercise their right to
have us redeem these Debentures, it is our current intention that we would meet
this obligation in common stock.
In the case of the Convertible Debentures, these securities rank
equally and ratably with all of our existing and future unsecured and
unsubordinated indebtedness. The Convertible Debentures are subordinated to all
of our senior indebtedness, which includes, among other obligations, all of our
existing and future unsecured and unsubordinated indebtedness.
These Convertible Debentures were issued with detachable warrants to
purchase 457,143 shares of the company's common stock at a purchase price of
$4.025 per share. These warrants may be exercised at anytime after September 8,
2003 and before September 7, 2006. The warrants are subject to certain
anti-dilution provisions. The warrants are also subject to an adjustment
provision; whereas the price of the warrants may be changed under certain
circumstances.
10
The Convertible Debentures accrue interest at the stated rate of 8% per
annum. Interest is payable quarterly on March 1, June 1, September 1, and
December 1. The interest may be payable in cash, shares of Common Stock, or a
combination thereof subject to certain provisions and at the discretion of the
Company. At September 30, 2003, $26,667 was accrued for interest on this debt.
For accounting purposes, the Company allocated $1.18 million of the
proceeds to the fair value of the warrants and allocated $2.3 million as a
discount for beneficial conversion. The remaining amount is allocated to the
Convertible Debenture. Both the fair value of the warrants and the value
allocated to the beneficial conversion are being amortized over the life of the
debt on a straight line basis. The expense realized at September 30, 2003 was
$77,685 and was included in interest expense.
NOTE 6 - COMMITMENTS AND CONTINGENCIES
LEGAL MATTERS
CLASS ACTION. From July 2003 through August 2003, eight securities class
action lawsuits were filed against The Singing Machine and certain of its
officers and directors in the United States District Court for the Southern
District of Florida on behalf of all persons who purchased The Singing Machine's
securities during the various class action periods specified in the complaints.
These complaints have all been consolidated into one action styled Bielansky, et
al. v. Salberg & Co., et al., Case No. 03-80596-ZLOCH (the Shareholder Action).
The complaints in the Shareholder Action allege violations of Section
10(b) and Section 20(a) of the Securities Exchange Act of 1934 and Rule 10(b)-5
promulgated there under. These complaints seek compensatory damages, attorney's
fees and injunctive relief. While the specific factual allegations vary
slightly in each case, the complaints generally allege that defendants falsely
represented the Company's financial results for the years ended March 31, 2002
and 2001.
In July 2003, a shareholder filed a derivative action against the
Company, its board of directors and senior management purporting to pursue the
action on behalf of the Company and for its benefit. No pre-lawsuit demand was
made on the board of directors for them to investigate the allegations or to
bring action. The Company is named as a nominal defendant in this case. This
case has been consolidated into the Shareholder Action identified above.
This derivative complaint alleges claims for breach of fiduciary
duty, abuse of control, gross mismanagement, waste of corporate assets and
unjust enrichment. The complaint alleges that the individual defendants
breached their fiduciary duties and engaged in gross mismanagement by allegedly
ignoring indicators of the lack of control over the Company's accounting and
management practices, allowing the Company to engage in improper conduct and
otherwise failing to carry out their duties and obligations to the Company. The
plaintiff's seek damages for breach of fiduciary duties, punitive and
compensatory damages, restitution, and bonuses or other incentive-based or
equity based compensation received by the CEO and CFO under the Sarbanes-Oxley
Act of 2002
The court in the Shareholder Action has directed plaintiffs' counsel
to file one amended consolidated complaint no later than November 14, 2003.
The Company intends to vigorously defend the Shareholder Action. As
the outcome of litigation is difficult to predict, significant changes in the
estimated exposures could occur which could have a material affect on the
Company's operations.
A second shareholder derivative suit was filed in October 2003, which
makes generally the same allegations. The second derivative suit has not been
served on the Company or on any of its current or former officers and
directors. This suit was transferred to the same judge to which the Shareholder
Action was assigned and has been consolidated into the Shareholder Action.
In August 2003, we were advised that the Securities and Exchange
Commission had commenced an informal inquiry of our company. We are cooperating
fully with the SEC staff. It appears that the investigation is focused on the
restatement of our audited financial statements for fiscal 2002 and 2001. We
have been advised that an informal inquiry should not be regarded as an
indication by the SEC or its staff that any violations of law have occurred or
as a reflection upon any person or entity that may have been involved in those
transactions.
OTHER MATTERS. The Company is also subject to various other legal
proceedings and other claims
11
that arise in the ordinary course of its business. In the opinion of management,
the amount of ultimate liability, if any, in excess of applicable insurance
coverage, is not likely to have a material effect on the financial condition,
results of operations or liquidity of the Company. However, as the outcome of
litigation or other legal claims is difficult to predict, significant changes in
the estimated exposures could occur, which could have a material impact on the
Company's operations.
NOTE 7 - WARRANTS
During the quarter the Company issued warrants to purchase shares of
its common stock. In relation to the Convertible Debenture (Note 5), 457,143
warrants, at a fair value of $1.18 million, were issued to the Debenture
holders. The remaining 103,896, valued at $268,000, were issued in lieu of a
cash payment of commissions and other costs relating to the closing of the
Debenture. The fair value of these warrants was recorded as a component of
deferred fees and is being amortized over the term of the debenture on a
straight line basis.
NOTE 8 - STOCKHOLDERS' EQUITY
COMMON STOCK ISSUANCES
During the second quarter of fiscal 2004 and 2003, the Company issued
the following shares of common stock upon exercise of outstanding options and
warrants.
- -------------------- ----------------------------- --------------------------
September 30, Number of Shares Issued Proceeds to Company
- -------------------- ----------------------------- --------------------------
2004 320,000 $652,800
- -------------------- ----------------------------- --------------------------
2003 34,350 $70,074
- -------------------- ----------------------------- --------------------------
During the second quarter of fiscal 2004, the Company issued 91,991
shares of its common stock. Of these shares, 28,571 were issued in lieu of a
cash payment of commission and closing costs relating to the Convertible
Debenture. Certain executives received 63,420 shares of common stock in lieu of
a portion of their cash compensation and bonuses for fiscal 2004. There were no
shares of common stock issued in the six months ended September 30, 2002.
EARNINGS PER SHARE
In accordance with Statement of Financial Accounting Standards No. 128,
"Earnings per Share," basic earnings per share are computed by dividing the net
earnings for the period by the weighted average number of common shares
outstanding. Diluted earnings per share is computed by dividing net earnings by
the weighted average number of common shares outstanding including the effect of
common stock equivalents.
The following table presents a reconciliation of basic and diluted
earnings per share:
FOR THE THREE MONTHS FOR THE SIX MONTHS ENDED
ENDED SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
----------- ----------- ----------- -----------
(as restated) (as restated)
Net (loss) income $ (656,669) $ 3,827,362 $(2,974,021) $ 2,687,716
Loss available to common shares $ (656,669) $ 3,827,362 $(3,562,486) $ 2,687,716
Weighted average shares outstanding - basic 8,490,658 8,119,028 8,389,165 8,090,102
Weighted average shares outstanding - diluted 8,490,658 8,881,970 8,389,165 8,899,023
Loss per share - Basic $ (0.08) $ 0.47 $ (0.35) $ 0.33
=========== =========== =========== ===========
Loss per share -Diluted $ (0.08) $ 0.43 $ (0.35) $ 0.30
=========== =========== =========== ===========
12
For the three months and six months ended September 30, 2003, common
stock equivalents were excluded from the calculation of diluted earnings per
share, as there was a net operating loss for the period and their effects would
have been antidilutive. For the three months and six months ended September 30,
2002, 359,348 and 306,899 common stock equivalents were not included in the
computation of diluted earnings per share because their effect was antidilutive.
For the six months ended September 30, 2003, there were 1,019,400
common stock options outstanding with exercise prices between $2.04 and $11.09.
In addition, there is a potential 1,038,962 shares that may be converted in
relation to the Convertible Debenture if certain conditions exist. There will
also be a probable issuance of common stock with a value of $100,000 upon
settlement of an investment banking agreement.
NOTE 9 - SEGMENT INFORMATION
The Company operates in one segment and maintains its records
accordingly. The majority of sales to customers outside of the United States are
made by the Company's Subsidiary. Sales by geographic region for the quarters
ended September 30 were as follows:
FOR THE THREE MONTHS ENDED SEPTEMBER 30, FOR THE SIX MONTHS ENDED SEPTEMBER 30,
2003 2002 2003 2002
SALES:
United States $ 17,690,952 $ 25,912,078 $ 21,553,954 $ 29,261,287
Australia 310,579 242,652 310,579 242,652
Europe 14,467,066 6,371,304 17,809,897 6,800,800
Other 382,979 251,549 805,121 624,855
Less: Advertising (867,325) (507,804) (1,115,434) (673,569)
------------ ------------ ------------ ------------
Consolidated Net Sales $ 31,984,251 $ 32,269,779 $ 39,364,117 $ 36,256,025
============ ============ ============ ============
The geographic area of sales is based primarily on the location where the
product is delivered.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
Certain statements contained in this Quarterly Report on Form 10- Q, including
without limitation, statements containing the words believes, anticipates,
estimates, expects, and words of similar import, constitute forward-looking
statements. You should not place undue reliance on these forward-looking
statements. Our actual results could differ materially from those anticipated in
these forward-looking statements for many reasons, including the risks faced by
us described below and elsewhere in this Quarterly Report, and in other
documents we file with the Securities and Exchange Commission.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which reflect
13
management's opinions only as of the date hereof. We undertake no obligation to
revise or publicly release the results of any revision to these forward-looking
statements.
OVERVIEW
The Singing Machine Company, Inc., a Delaware corporation, and our wholly-owned
Hong Kong subsidiary (collectively, the "Company, "Singing Machine," "we" or
"us") are primarily engaged in the development, marketing, and sale of consumer
karaoke audio equipment, accessories, and musical recordings. The products are
sold directly to distributors and retail customers. Our electronic karaoke
machines and audio software products are marketed under The Singing Machine(R)
trademark.
For the six months ended September 30, 2003, there were 1,019,400 common stock
options outstanding with exercise prices between $2.04 and $11.09. In addition,
there is a potential 1,038,962 shares that may be converted in relation to the
Convertible Debenture if certain conditions exist. There will also be a probable
issuance of common stock with a value of $100,000 upon settlement of an
investment banking agreement.
Our products are sold throughout the United States, primarily through department
stores, lifestyle merchants, mass merchandisers, direct mail catalogs and
showrooms, music and record stores, national chains, specialty stores and
warehouse clubs. Our karaoke machines and karaoke software are currently sold in
such retail outlets as Best Buy, Circuit City, Costco, Radio Shack, Toys R Us,
Target and J.C. Penney.
We had a net loss after estimated tax benefit of $2,974,021 for the six month
period ended September 30, 2003. Our working capital as of September 30, 2003,
was approximately $16.5 million.
RESTATEMENT OF FINANCIAL STATEMENTS
In June 2003, our management revised its position on taxation of the income of
International SMC (H.K.) Ltd., its wholly owned subsidiary, income by the United
States and by the Hong Kong tax authorities for the reasons stated below.
With regard to taxation in Hong Kong, International SMC had previously applied
for a Hong Kong offshore claim income tax exemption based on the locality of its
profits. Management believed that the exemption would be approved because the
source of all profits of International SMC is from exporting to customers
outside of Hong Kong. Accordingly, no provision for income taxes was provided in
the consolidated financial statements as of March 31, 2002 and 2001. However,
full disclosure was previously reflected in the audited financial statements for
years ended March 31, 2002 and 2001 of the estimated amount that would be due to
the Hong Kong tax authority should the exemption be denied. Management is
continuing its exemption application process. However, due to the extended
period of time that the application has been outstanding, as well as
management's reassessment of the probability that the application will be
approved, management has determined to restate the 2002 and 2001 consolidated
financial statements to provide for such taxes. The effect of such restatement
is to increase income tax expense by $748,672 and $468,424 in fiscal 2002 and
2001, respectively. However, the Company can claim United States foreign tax
credits in 2002 for these Hong Kong taxes, which is reflected in the final
restated amounts.
With regard to United States taxation of foreign income, the Company had
originally taken the position that the foreign income of the Hong Kong
subsidiary qualified for a deferral under the Internal Revenue Code (Section
956) allowing for such income to be indefinitely deferred and not taxed in the
United States until such income is repatriated, or brought back into the United
States as taxable income. It was expected that this income would remain in Hong
Kong. Full disclosure of the amount and nature of the indefinite deferral for
fiscal year 2002 was reflected in the income tax footnote of the consolidated
financial statements for that year. The internal revenue code, regulations and
case law regarding international income taxation is quite complex and subject to
interpretation. Each case is determined based on the individual facts and
circumstances. International SMC (HK) Ltd. paid certain payables, in the
aggregate of approximately $10 million over the fiscal years 2002 and 2003 for
the Company for the purchase inventory. These funds may not have been repaid
within a reasonable period of time; thereby creating this event. This caused
profits previously considered to be indefinitely deferred to become partially
taxable as "deemed dividends" under section 956 of the Internal Revenue Code.
Although certain arguments against the imposition of a "deemed dividend" may be
asserted, management has determined to restate the fiscal year 2002 consolidated
financial statements based on its reassessment of its original position. The
effect of such restatement is to increase income tax expense by $1,027,545 in
14
fiscal year 2002, which includes the utilization of the foreign tax credits
referred to above.
The net effect of the above two adjustments for the quarter and six months ended
September 30, 2002 is to decrease net income by $1,060,257 and $941,923,
respectively. The net effect on net income per share is to decrease net income
per share basic and diluted by $0.13 and $0.12 for the quarter and $0.12 and
$0.11 for the six months ended September 30, 2002.
THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THE THREE MONTHS ENDED
- ------------------------------------------------------------------------
SEPTEMBER 30, 2002
- ------------------
NET SALES
Net sales for the quarter ended September 30, 2003 decreased less than one
percent to $31,984,251 compared to $32,269,779 for the quarter ended September
30, 2002. Due to the addition of new distributors and increased purchasing of
existing customers, our international sales increased $8.3 million over the same
period of the prior year from $6.9 million to $15.9 million at September 30,
2003. Advertising allowances to customers reduced sales $507,804 and $867,325
for the three months ended September 30, 2003 and 2002, respectively.
Advertising allowances consist of co-operative advertising, marketing
development funds, specific advertising and slotting fees.
GROSS PROFIT
Gross profit for the quarter ended September 30, 2003 was $3,803,539 or 11.9% of
sales as compared to $7,902,153 or 24.5% of sales for the quarter ended
September 30, 2002. Approximately 6% of this decrease can be attributed to the
increase of advertising allowances and royalties to the calculation of gross
profit. Another factor in this decrease is the increased sales from our Hong
Kong subsidiary to international and domestic customers. International sales
were primarily in Europe for the quarter. Sales to international customers
historically maintain lower selling prices, and thus a lower gross profit
margin. The reason that sales to international customers normally have a lower
profit margin than sales to U.S. customers is that many of the expenses and
risks incurred with U.S. customers, such as commission and returns, are not
incurred with international customers. Because there is less risk with the
international sales, the Company is willing to receive a lower profit margin on
these sales. Due to the increased inventory levels that were carried forward
from March 31, 2003, pricing pressure based on increased competition and
increasing international sales, the Company anticipates that the gross profit
percentage for the remainder of the fiscal year will remain below last year's.
OPERATING EXPENSES
Operating expenses were $5,056,077 or 15.8% of total revenues for the quarter
ended September 30, 2003. The expenses increased over prior year by $2,057,536,
and, as a percentage of sales, increased from 9.3% at September 30, 2002. The
primary factors that contributed to the increase in operating expenses for the
quarter ended September 30, 2003 are:
(i) Increased compensation and related expenses in the amount of $48,000
(ii) Stock based compensation in the amount of $511,000
(iii) Increased commissions of $298,900 due to the mix of customers serviced by
our independent sales representatives
(iv) Increased expenses of $349,600 due to the increased need for space to
hold our level of inventory in California.
(v) Increased accounting and legal fees of $250,800
15
(vi) Increased fees associated with our credit facility of $359,200, including
amortization of the $300,000 success fee, consulting fees and interest
expense
(vii) Settlement with AG Edwards, $200,000.
(viii) Various other smaller expenses, such as courier service, office supplies,
travel and others contributed to the remainder of the increase which was
$40,000.
OTHER EXPENSES
Other expenses were $409,544 for the quarter ended September 30, 2003, as
compared with net other income of $35,114 at September 30, 2002. Our interest
expense increase is due to the increased use of our credit facility at a higher
interest rate than the prior year. For the quarter ended September 2002, the
Company was just beginning to use its credit facilities to finance operations.
The Company expects interest expense to continue to increase for the remainder
of fiscal 2004 due to the credit facility accruing interest at a higher rate
than last year, which interest rate was increased in the Fourteenth Amendment to
our credit agreement with our commercial lender in August 2003, and the
amortization of deferred fees and discounts associated with our convertible
debentures and subordinated debt.
INCOME TAX EXPENSE (BENEFIT)
The Company's tax expense is based on an aggregation of the taxes on earnings of
its Hong Kong and domestic operations on an annualized basis. Income tax rates
in Hong Kong are approximately 16%, while the statutory income tax rate in the
United States is 34%. The Company's effective tax rate during the second quarter
of fiscal 2004 was 61% as compared to 23% during the second quarter of fiscal
2003. The effective tax rate is a result of estimated tax benefits for fiscal
2004 resulting from estimated United States pretax loss for fiscal 2004 offset
by estimated tax expense related to the estimated Hong Kong pretax income for
fiscal 2004. The estimated profits and losses are incorporated into our
world-wide tax model, which calculates the effective tax rate for the period.
This model is updated quarterly with actual results from the prior quarters and
updated estimates for those quarters remaining. As the effective tax rates are
based on estimates, the Company's future effective income tax rate will
fluctuate based on the changes in the estimates.
SIX MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THE SIX MONTHS ENDED
- --------------------------------------------------------------------
SEPTEMBER 30, 2002
- ------------------
NET SALES
Net sales for the six months ended September 30, 2003 increased 8.6% to
39,364,117 as compared to $36,256,025 for the quarter ended September 30, 2002.
Sales to the European countries increased $11.0 million over the same period in
the prior year, as sales in the United States decreased $7.7 million. Our sales
in the United States decreased primarily because of the increased competition in
this market. New customers and increased concentration in existing customers
contributed to the increase in the European market. The Company believes that
sales in various other areas of the world, as well as in the United States will
continue to fuel the company's growth. A portion of the decreased sales in the
United States can be attributed to advertising allowances accrued for customers.
Advertising allowances consist of co-operative advertising, marketing
development funds, specific advertising and slotting fees. These allowances are
variable and are negotiated every year.
GROSS PROFIT
Gross profit for the quarter ended September 30, 2003 was $5,197,575 or 13.2% of
sales as compared to $27,526,988 or 24.1% of sales for the quarter ended
September 30, 2002.
Approximately 6% of this decrease can be attributed to the increase of
advertising allowances and royalties to the calculation of gross profit. Another
factor in this decrease is the increased sales from our Hong Kong subsidiary to
international and domestic customers. Another factor in the decrease in gross
margin percentage compared to the prior year is increased sales from our Hong
Kong subsidiary to international and domestic customers and our sale of excess
inventory at reduced prices. In the six months ended September 30, 2003,
approximately 71% of our sales were made from our Hong Kong subsidiary compared
16
with 80% in the six months ended September 30, 2002. Sales to international
customers historically maintain lower selling prices, and thus a lower gross
profit margin. The reason that sales to international customers normally have a
lower profit margin than sales to U.S. customers is that many of the expenses
and risks incurred with U.S. customers, such as commissions and returns, are not
incurred with international customers. Because there is less risk with the
international sales, the Company is willing to receive a lower profit margin on
these sales. Due to the increased inventory levels that were carried forward
from March 31, 2003, pricing pressure based on increased competition and
increasing international sales, the Company anticipates that the gross profit
percentage for the remainder of the fiscal year will remain below last year's.
OPERATING EXPENSES
Operating expenses were $8,584,351 or 21.8% of total revenues for the six months
ended September 30, 2003. The expenses increased over prior year by $3.5
million. The primary factors that contributed to this increase in operating
expenses for the six months ended September 30, 2003 are:
(i) Increased compensation and related expenses in the amount of $374,100
(ii) Stock based compensation expenses in the amount of $511,000
(iii) Increased commissions of $196,100 due to the mix of customers serviced by
our independent sales representatives
(iv) Increased expenses of $649,000 due to the increased need for space to
hold our level of inventory in California.
(v) Other expenses associated with research and development, $77,000
(vi) Freight expenses, $60,000 (vii) Costs associated with customer service,
$44,000
(viii) Increased depreciation due to the addition of new tools, $76,000 (ix)
Increased accounting and legal fees of $469,000
(x) Increased fees associated with our credit facility of $485,000, including
a portion of the amortization of the $300,000 success fee, consulting
fees and interest expense (xi) Settlement with AG Edwards of $200,000
(xii) Contribution of machines to non-profit organizations of $139,000
(xiii) Various other smaller expenses, such as insurance, investor relations,
office supplies and travel contributed to the remaining $219,800.
OTHER EXPENSES
Other expenses were $590,343 for the six months ended September 30, 2003, as
compared with net other income of $52,998 at September 30, 2002. Our interest
expense increase is due to the increased use of our credit facility at a higher
interest rate than the prior year, as well as the amortization of expenses
associated with the convertible debentures and subordinated debt. The Company
expects interest expense to continue to increase for the remainder of fiscal
2004 due to the credit facility accruing interest at a higher rate than last
year and the amortization of expenses associated with the convertible debentures
and subordinated debt.
INCOME TAX EXPENSE (BENEFIT)
The Company's tax expense is based on an aggregation of the taxes on earnings of
its Hong Kong and domestic operations on an annualized basis. Income tax rates
in Hong Kong are approximately 16%, while the statutory income tax rate in the
United States is 34%. The Company's effective tax rate during the second quarter
of fiscal 2004 was 25% as compared to 19% during the second quarter of fiscal
2003. The effective tax rate is a result of estimated tax benefits for fiscal
2004 resulting from estimated United States pretax loss for fiscal 2004 offset
by estimated tax expense related to the estimated Hong Kong pretax
17
income for fiscal 2004. The estimated profits and losses are incorporated into
our world-wide tax model, which calculates the effective tax rate for the
period. This model is updated quarterly with actual results from the prior
quarters and updated estimates for those quarters remaining. As the effective
tax rates are based on estimates, the Company's future effective income tax rate
will fluctuate based on the changes in the estimates.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 2003, the Company had cash on hand of $1,106,003 and a bank
overdraft of $47,790 compared to cash on hand of $268,265 and a bank overdraft
of $316,646 at March 31, 2003. Our current assets consist predominantly of
accounts receivable and inventory. Our accounts receivable increased due to the
amount of sales that occurred in September. We expect these receivables to be
collected in a timely fashion. Our inventory has been steadily decreasing since
March 31, 2003, as we are shipping goods to our customers. Our current
liabilities increased to $30,250,370 as of September 30, 2003, compared to
$21,249,930 at September 30, 2002. The majority of these current liabilities
consist of accounts payable, of which 95% are within terms set by our vendors.
Because we had minimal liquidity as of June 30, 2003 and had defaulted under a
credit agreement with our commercial lender, we received a going concern
paragraph from our independent certified public accountants for our audited
financial statements for fiscal 2003. In their report dated June 24, 2003, our
independent certified public accountants stated that our event of default under
our credit agreement with our commercial lender raised substantial doubt our
ability to continue as a going concern. Since June 24, 2003, the date of our
audit report, we have taken steps to improve our financial position. In August
2003, our commercial lender expressly waived our event of default of the minimum
tangible net worth requirement under our credit agreement and agreed to extend
our credit facility until March 31, 2004. In July 2003, we raised $1 million in
subordinated debt financing from an investment group composed of an officer,
directors and an associate of a director. These loans are subordinated to our
credit facility and accrue interest at 9.5% per annum. It is expected that these
loans will be repaid at the end of this fiscal year. As of July 28, 2003, an
unrelated party posted a $1 million standby letter of credit as further
collateral on the revolving credit facility. Our lender agreed to release Bank
Von Ernst, the unrelated party, from its obligations under the standby letter
when it received certain documents relating to the $3 million investment in our
company, as described in the Fourteenth Amendment to our credit agreement. To
the best of our knowledge, the lender has received all of these documents and is
completing its internal due diligence process prior to releasing Bank Von Ernst
from its obligations under the standby letter of credit.
In August 2003, our commercial lender extended our credit facility until March
31, 2004. Under our amended credit facility, LaSalle Bank will, at its
discretion, advance up to 70% of the Company's eligible accounts receivable,
plus up to 20% of eligible inventory, plus us up to 60% of commercial letters of
credit issue by LaSalle minus reserves as set forth in the loan documents. The
loan is secured by a first lien on all present and future assets of the Company,
except specific tooling located in China. As of September 30, 2003, the balance
due under our credit facility was $6,513,411.
On September 8, 2003, we issued an aggregate of $4,000,000 of 8% convertible
debentures in a private offering to six accredited investors. The debentures
initially are convertible into shares of common stock at a price of $3.85 per
share, subject to adjustment in certain situations. Each investor also received
warrants equal to 40% of the subscription amount. The exercise price of the
warrants is $4.025 per share and the warrants expire on September 7, 2006. We
also have an obligation to register the shares of common stock underlying the
debenture and warrants and file a registration statement on Form S-1 to register
the shares on October 9, 2003. For reporting purposes these convertible
debentures were recorded as $1.6 million of debt and $2.4 million of equity. The
common stock shares underlying these debentures are antidilutive at September
30, 2003, due to the Company's net loss for the period.
During fiscal 2004, we planned on significantly decreasing our capital
expenditures and ordered approximately $15 million in new inventory for the
holiday season. As of September 30, 2003, our inventory was valued at $20.5
million. Approximately, $4.4 million of this amount represents unsold inventory
that we held at the end of our fiscal year. As of March 31, 2003, we had excess
inventories of approximately $26 million. As of November 1, 2003, we delivered
$12.5 million of this $26 million inventory to our customers. Of the remaining
$13.5 million, we have committed orders or partial orders for about $9 million
which is
18
scheduled to be delivered to customers over the next three months.
The Company's commitments for debt and other contractual arrangements are
summarized as follows:
- --------------------------------------- -------------- -----------------------------------------------------------------
Years ending March 31,
- --------------------------------------- -------------- -----------------------------------------------------------------
Total 2004 2005 2006 2007 2008
- --------------------------------------- -------------- -------------- ------------ ------------ ------------ -----------
Merchandise License Guarantee $1,595,000 $1,395,000 $150,000 $ 50,000 -- --
- --------------------------------------- -------------- -------------- ------------ ------------ ------------ -----------
Property Leases $3,638,771 $1,330,158 $924,338 $517,071 $495,545 $371,659
- --------------------------------------- -------------- -------------- ------------ ------------ ------------ -----------
Equipment Leases $ 86,016 $ 46,525 $ 19,965 $ 10,322 $ 7,969 $ 1,235
- --------------------------------------- -------------- -------------- ------------ ------------ ------------ -----------
Revolving Credit Facility $6,513,411 $6,513,411 -- -- -- --
- --------------------------------------- -------------- -------------- ------------ ------------ ------------ -----------
We should be able to satisfy our liquidity requirements for the remainder of
fiscal 2004 by using credit that has been extended to us under our credit
agreement with LaSalle and cash that is collected from the sale of our karaoke
products.
Except for the foregoing, we do not have any present commitment that is likely
to result in our liquidity increasing or decreasing in any material way. In
addition, except for the Company's need for additional capital to finance
inventory purchases, the Company knows of no trend, additional demand, event or
uncertainty that will result in, or that is reasonably likely to result in, the
Company's liquidity increasing or decreasing in any material way.
Due to a decrease in the amount of sales in the United States, the Company does
not expect to meet the minimum guarantee under its licensing agreement with MTV.
In this respect, we have taken an additional expense of $366,000 for the six
months ended September 30, 2003.
Cash flows used in operating activities were $4,678,328 for the six months ended
September 30, 2003. Cash flows were used in operating activities primarily due
to increases in accounts receivable in the amount of $15.4 million, increases in
accounts payable of $7.1 million and decreases in existing inventory of $4.6
million.
Cash used in investing activities for the six months ended September 30, 2003
was $157,178. Cash used in investing activities resulted from the purchase of
fixed assets in the amount of $157,178. The purchase of fixed assets consists of
the tooling and molds required for production of new machines for this fiscal
year. Tooling and molds are depreciated over five years.
Cash flows provided by financing activities were $5,673,244 for the six months
ended September 30, 2003. This consisted of proceeds from the exercise of
options in the amount of $860,535. The Company also issued convertible
debentures with attached warrants. This transaction resulted in a net increase
of $4 million. The Company received subordinated debt of $1 million from
insiders in July of 2003 and paid $300,000 to a director who had previously
loaned money to the Company on a short term basis. Our short term note payable
with a bank had been reduced to $637,122 by September 30, 2003. The remainder of
cash provided from financing activities was provided by net borrowings on the
credit line at LaSalle National Bank in the amount of $267,000 to fund ongoing
operations.
EXCHANGE RATES
We sell all of our products in U.S. dollars and pay for all of our manufacturing
costs in either U.S. or Hong Kong dollars. Operating expenses of the Hong Kong
office are paid in Hong Kong dollars. We cannot assure you that the exchange
rate fluctuations between the United States and Hong Kong currencies will not
have a material adverse effect on our business, financial condition or results
of operations.
19
SEASONAL AND QUARTERLY RESULTS
Historically, the Company's operations have been seasonal, with the highest net
sales occurring in the second and third quarters (reflecting increased orders
for equipment and music merchandise during the Christmas selling months) and to
a lesser extent the first and fourth quarters of the fiscal year. Sales in the
Company's fiscal second and third quarter, combined, accounted for approximately
85% of net sales in fiscal 2003, 81% of net sales in fiscal 2002 and 75% of net
sales in fiscal 2001.
The Company's results of operations may also fluctuate from quarter to quarter
as a result of the amount and timing of orders placed and shipped to customers,
as well as other factors. The fulfillment of orders can therefore significantly
affect results of operations on a quarter-to-quarter basis.
INFLATION
Inflation has not had a significant impact on the Company's operations. The
Company has historically passed any price increases on to its customers since
prices charged by the Company are generally not fixed by long-term contracts.
CRITICAL ACCOUNTING POLICIES
The U.S. Securities and Exchange Commission defines critical accounting
policies as "those that are both most important to the portrayal of a company's
financial condition and results, and require management's most difficult,
subjective or complex judgments, often as a result of the need to make estimates
about the effect of matters that are inherently uncertain. The management of the
Company believes that a high degree of judgment or complexity is involved in the
following areas:
Collectibility of Accounts Receivable. The Company's allowance for
doubtful accounts is based on management's estimates of the creditworthiness of
its customers, current economic conditions and historical information, and, in
the opinion of management, is believed to be an amount sufficient to respond to
normal business conditions. Management sets 100% reserves for customers in
bankruptcy and other reserves based upon historical collection experience.
Should business conditions deteriorate or any major customer default on its
obligations to the Company, this allowance may need to be significantly
increased, which would have a negative impact on operations.
Reserves on Inventories. The Company establishes a reserve on inventory
based on the expected net realizable value of inventory on an item-by-item basis
when it is apparent that the expected realizable value of an inventory item
falls below its original cost. A charge to cost of sales results when the
estimated net realizable value of specific inventory items declines below cost.
Management regularly reviews the Company's investment in inventories for such
declines in value.
Income Taxes. Significant management judgment is required in developing
the Company's provision for income taxes, including the determination of foreign
tax liabilities, deferred tax assets and liabilities and any valuation
allowances that might be required against the deferred tax assets. At March 31,
2003 and 2002, the Company had net deferred tax assets of $1.9 million and $191
thousand, respectively. Management evaluates its ability to realize its deferred
tax assets on a quarterly basis and adjusts its valuation allowance as
necessary. There is no related valuation allowance at March 31, 2003 and 2002.
The Company's Hong Kong subsidiary has applied for an exemption of
income tax in Hong Kong. Therefore, no taxes have been expensed or provided for
at the Subsidiary level. Although the governing body has reached no decision to
date, the U.S. parent company has reached the decision to provide for the
possibility that the exemption could be denied and accordingly has recorded a
provision in fiscal 2003, 2002, and 2001.
20
The Company may be deemed to have constructively repatriated or
brought back in the United States approximately $5.6 million, $5.7 million and
$0 in income from its foreign operations in 2003, 2002 and 2001, respectively.
Accordingly, these earnings were taxed as a deemed dividend based on U.S.
statutory rates. No provision has been made for U.S. taxes on the remaining
undistributed earnings of the Company's foreign subsidiaries of approximately
$3.6 million at March 31, 2003 and $1.9 million at March 31, 2002, as it is
anticipated that such earnings would be permanently reinvested in their
respective operations in accordance with section 956 of the Internal Revenue
Code.
The Company operates within multiple taxing jurisdictions and is
subject to audit in those jurisdictions. Because of the complex issues involved,
any claims can require an extended period to resolve. In management's opinion,
adequate provisions for income taxes have been made.
Other Estimates. The Company makes other estimates in the ordinary
course of business relating to sales returns and allowances, warranty reserves,
and reserves for promotional incentives. Historically, past changes to these
estimates have not had a material impact on our financial condition. However,
circumstances could change which may alter future expectations.
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK
A SMALL NUMBER OF OUR CUSTOMERS ACCOUNT FOR A SUBSTANTIAL PORTION OF OUR
REVENUES, AND THE LOSS OF ONE OR MORE OF THESE KEY CUSTOMERS COULD SIGNIFICANTLY
REDUCE OUR REVENUES, PROFITABILITY AND CASH FLOW
We rely on a few large customers to provide a substantial portion of our
revenues. As a percentage of total revenues, our net sales to our five largest
customers during the fiscal period ended March 31, 2003, 2002 and 2001 were
approximately 67%, 77% and 87% respectively. In fiscal 2003, three major
customers accounted for 21%, 17% and 15% of our net sales. Although we have
long-established relationships with many of our customers, we do not have
long-term contractual arrangements with any of them. A substantial reduction in
or termination of orders from any of our largest customers could adversely
affect our revenues, profitability and cash flow.
WE ARE SUBJECT TO THE RISK THAT SOME OF OUR LARGE CUSTOMERS MAY RETURN KARAOKE
PRODUCTS THAT THEY HAVE PURCHASED FROM US AND IF THIS HAPPENS, IT WOULD REDUCE
OUR REVENUES AND PROFITABILITY
In February 2002, one of our largest customers, Best Buy returned approximately
$2.75 million in karaoke products to us that it had not been able to sell during
the Christmas season. Best Buy kept this inventory in its retail stores, but
converted the sales to consignment sales. Although we were not contractually
obligated to accept this return of the karaoke products, we did this because we
valued our relationship with Best Buy. Because we are dependent upon a few large
customers, we are subject to the risk that any of these customers may elect to
return unsold karaoke products to us in the future. If any of our customers were
to return karaoke products to us and we were to accept such returns, it would
reduce our revenues and profitability.
WE ARE SUBJECT TO PRESSURE FROM OUR CUSTOMERS RELATING TO PRICE REDUCTIONS,
FINANCIAL INCENTIVES AND OTHER RISKS THAT FORCE US TO BEAR THE RISKS AND COSTS
OF CARRYING INVENTORY, AND IF WE ARE PRESSURED TO MAKE THESE CONCESSIONS TO OUR
CUSTOMERS, IT WILL REDUCE OUR REVENUES AND PROFITABILITY
Because there is intense competition in the karaoke industry, we are subject to
pricing pressure from our customers. Many of our customers have demanded that we
lower our prices or they will buy our competitor's products. If we do not meet
our customer's demands for lower prices, we will not sell as many karaoke
products. In the six months ended September 30, 2003, our sales to customers in
the United States decreased because we were unwilling to sell our products at
reduced prices. We are also subject to the risk that our customers might demand
certain financial incentives, such as large advertising or
21
cooperative advertising allowances, which effectively reduces our selling
prices. Additionally, many of our customers place orders with us several months
prior to the holiday season, but they schedule delivery two or three weeks
before the holiday season begins. As such, are subject to the risks and costs of
carrying inventory during the time period between the placement or the order and
the delivery date, which reduces our cash flow.
OUR SENIOR CORPORATE MANAGEMENT TEAM IS NEW TO THE SINGING MACHINE AND IS
REQUIRED TO DEVOTE SIGNIFICANT ATTENTION TO MATTERS ARISING FROM ACTIONS OF
PRIOR MANAGEMENT.
Beginning on May 2, 2003, through the present date, we have had two
Chief Executive Officers and a Chief Operating Officer resign. Additionally,
four out of five directors serving on our Board on May 2, 2003 have resigned
since that date. We hired a new Chief Operating Officer, Yi Ping Chan on March
31, 2003 and retained two new directors, Bernard Appel and Richard Ekstract, on
October 31, 2003. We are in the process of searching for a new Chief Executive
Officer. It will take some time for our new management team and our new board of
directors to learn about our business and to develop strong working
relationships with each other and our employees. Our new senior corporate
management team's ability to complete this process has been and continues to be
hindered by their need to develop effective policies and procedures within the
Company, to develop effective corporate governance procedures, to strengthen
reporting lines and to review internal controls. We cannot assure you that this
major restructuring of our board of directors and senior management team and the
accompanying distractions, in this environment, will not adversely affect our
results of operations.
WE MAY HAVE SIGNIFICANT RETURNS, MARKDOWNS AND PURCHASE ORDER CANCELLATIONS,
WHICH WOULD REDUCE OUR REVENUES AND PROFITABILITY
As is customary in the consumer electronics industry, we have, on occasion, (i)
permitted certain customers to return slow-moving items for credit, (ii)
provided price protection to certain customers by making price reductions
effective as to certain products then held by customers in inventory and (ii)
accepted customer cancellations of purchase orders issued to the Company. The
Company expects that it will continue to be required to make such accommodations
in the future. Any significant increase in the amount of returns, markdowns or
purchaser order cancellations could have a material adverse effect on our
revenues and profitability.
OUR LICENSING AGREEMENT WITH MTV NETWORKS IS IMPORTANT TO OUR BUSINESS AND IF WE
WERE TO LOSE OUT MTV LICENSE IT WOULD AFFECT OUR REVENUES AND PROFITABILITY
Our license with MTV Networks is particular important to our business. We
generated $30,884,344 million or 32.3% of our net sales from products sold under
the MTV license in fiscal 2003. For the six months ended September 30, 2003, we
generated only $4 million or 10.7% of our net sales under this agreement. Our
MTV license expires on December 31, 2003; however, MTV can terminate the license
agreement for certain reasons prior to December 31, 2003. If we were to lose our
MTV license, it would have an effect on our revenues and net income.
IF WE DO NOT ACCURATELY PREDICT THE DEMAND FOR OUR KARAOKE PRODUCTS, OUR
REVENUES, PROFITABILITY AND CASH FLOW WILL BE REDUCED
Because of our reliance on manufacturers in Asia for our machine production, our
production lead times are relatively long. Therefore, we must commit to
production in advance of customers orders. If we fail to forecast customers or
consumer demand accurately we may encounter difficulties in filling customer
orders or liquidating excess inventories, or may find that customers are
canceling orders or returning products. We have difficulty forecasting customer
demand because the purchases of karaoke machines and music are discretionary
purchases and we can not determine how many products our customers will
purchase. Distribution difficulties may have an adverse effect on our business
by increasing the amount of inventory and the cost of storing inventory. As of
September 30, 2003, we had approximately $20 million in inventory.
22
We will attempt to liquidate this inventory during fiscal 2004. However, if we
are unable to sell this inventory, our revenues, cash flow and profitability
will be reduced.
OUR INABILITY TO COMPETE AND MAINTAIN OUR NICHE IN THE KARAOKE PRODUCTS INDUSTRY
COULD HURT OUR BUSINESS
The business in which we are engaged is highly competitive. Our major
competitors for karaoke machines and related products are Craig and Memorex. We
believe that competition for karaoke machines is based primarily on price,
product features, reputation, delivery times, and customer support. Our primary
competitors for producing karaoke music are Compass, Pocket Songs, Sybersound,
UAV and Sound Choice. We believe that competition for karaoke music is based
primarily on popularity of song titles, price, reputation, and delivery times.
To the extent that we lower prices for to attempt to enhance or retain market
share, we may adversely impact our operating margins. Conversely, if we opt not
to match competitor's price reductions we may lose market share, resulting in
decreased volume and revenue. During fiscal 2004, management does not intend to
reduce prices. In addition, we must compete with all the other existing forms of
entertainment including, but not limited to: motion pictures, video arcade
games, home video games, theme parks, nightclubs, television and prerecorded
tapes, CD's and video cassettes.
WE ARE NAMED AS A DEFENDANT IN SEVERAL CLASS ACTION LAWSUITS, WHICH IF
DETERMINED ADVERSELY TO US, COULD HARM OUR BUSINESS AND FINANCIAL CONDITION
We are involved in a number of litigation matters. An unfavorable resolution of
pending litigation could have a material adverse effect on our financial
condition. Litigation may result in substantial costs and expenses and
significantly divert the attention of the Singing Machine's management
regardless of the outcome. There can be no assurance that the Singing Machine
will be able to achieve a favorable settlement of pending litigation or obtain a
favorable resolution of litigation if it is not settled. In addition, current
litigation could lead to increased costs or interruptions of normal business
operations of the Singing Machine.
MOST OF OUR SALES OCCUR IN OUR SECOND AND THIRD FISCAL YEAR AND IF WE OVER OR
UNDERESTIMATE THE DEMAND FOR OUR PRODUCTS, OUR REVENUES, PROFITABILITY AND CASH
FLOW WILL BE ADVERSELY AFFECTED
Sales of consumer electronics and toy products in the retail channel are highly
seasonal, causing the substantial majority of our sales to occur during the
second quarter ended September 30 and the third quarter ended December 31. Sales
in our second and third quarter, combined, accounted for approximately 85.6% of
net sales in fiscal 2003, 81% of net sales in fiscal 2002 and 75% of net sales
in fiscal 2001.
The seasonal pattern of sales in the retail channel requires significant use of
our working capital to manufacture and carry inventory in anticipation of the
holiday season, as well as early and accurate forecasting of holiday sales.
Failure to predict accurately and respond appropriately to consumer demand on a
timely basis to meet seasonal fluctuations, or any disruption of consumer buying
habits during their key period, would harm our revenues, profitability and cash
flow. In fiscal 2003, we overestimated the demand for our product and held $26
million of inventory as of March 31, 2003. Our increased inventory levels led to
a shortage in our available working capital and a liquidity crisis. Conversely,
if we underestimate the demand for our products, we will not maximize our
revenues.
OUR PRODUCTS ARE SHIPPED FROM CHINA AND ANY DISRUPTION OF SHIPPING COULD HARM
OUR BUSINESS AND REPUTATION
We rely principally on four contract ocean carriers to ship virtually all of the
products that we import to our warehouse facilities in Compton and Rancho
Dominguez, California. Retailers that take delivery of our products in China
rely on a variety of carriers to import those products. Any disruptions in
shipping, whether in California or China, caused by labor strikes, other labor
disputes, terrorism, and international incidents or
23
otherwise could significantly harm our business and reputation.
WE MAY SIGNIFICANT WORKING CAPITAL NEEDS AND IF WE ARE UNABLE TO OBTAIN
ADDITIONAL FINANCING, WHEN NEEDED, WE NOT HAVE SUFFICIENT CASH FLOW TO RUN OUR
BUSINESS
Although we have successfully restructured our credit agreement with our
commercial lenders and raised an additional $4 million of capital, we continue
to search for other lenders that are capable of providing credit facilities to
the company at more favorable terms. As of September 30, 2003, we believe that
we have sufficient working capital for the next six months. However, if we need
additional capital and are unable to obtain adequate do not have adequate
financing, when needed, it will have a material adverse effect on our cash flow
and our ability to run our business. If we have a severe shortage of working
capital, we may not be able to continue our business operations and may be
required to file a petition for Chapter 11 or enter into some liquidation or
reorganization proceeding.
OUR MANUFACTURING OPERATIONS ARE LOCATED IN THE PEOPLE'S REPUBLIC OF CHINA,
SUBJECTING US TO RISKS COMMON IN INTERNATIONAL OPERATIONS. IF THERE IS ANY
PROBLEM WITH THE MANUFACTURING PROCESS, OUR REVENUES AND NET PROFITABILITY MAY
BE REDUCED.
We are dependent upon six factories in the People's Republic of China to
manufacture all of our electronic products. Our arrangements with these
factories are subject to the risks of doing business abroad, such as import
duties, trade restrictions, work stoppages, and foreign currency fluctuations,
limitations on the repatriation of earnings, political instability, and other
factors, which could have an adverse impact on our business. Furthermore, we
have limited control over the manufacturing processes themselves. As a result,
any difficulties encountered by the third-party manufacturers that result in
product defects, production delays, cost overruns or the inability to fulfill
orders on a timely basis could adversely affect our revenues, profitability and
cash flow. We believe that the loss of any of our manufacturers would not have a
long-term material adverse effect on us because other manufacturers with whom we
do business would be able to increase production to fulfill our requirements.
However, the loss of our largest two manufacturers, could, in the short-term,
adversely affect our business until alternative supply arrangements were
secured.
WE DEPEND ON THIRD PARTY SUPPLIERS FOR PARTS FOR OUR KARAOKE MACHINES AND
RELATED PRODUCTS, AND IF WE CANNOT OBTAIN SUPPLIES AS NEEDED, OUR OPERATIONS
WILL BE SEVERELY DAMAGED
Our growth and ability to meet customer demand depends in part on our capability
to obtain timely deliveries of karaoke machines and our electronic products. We
rely on third party suppliers to produce the parts and materials we use to
manufacture and produce these products. If our suppliers are unable to provide
our factories with the parts and supplies, we will be unable to produce our
products. We cannot guarantee that we will be able to purchase the parts we need
at reasonable prices or in a timely fashion. In the last several years, there
have been shortages of certain chips that we use in our karaoke machines. We,
however, have anticipated this shortage and have made commitments to our
factories to purchase chips in advance. If we are unable to anticipate any
shortages of parts and materials in the future, we may experience severe
production problems, which would impact our sales.
CONSUMER DISCRETIONARY SPENDING MAY AFFECT KARAOKE PURCHASES AND IS AFFECTED BY
VARIOUS ECONOMIC CONDITIONS AND CHANGES
Our business and financial performance may be damaged more than most companies
by adverse financial conditions affecting our business or by a general weakening
of the economy. Purchases of karaoke machines and music are considered
discretionary for consumers. Our success will therefore be influenced by a
number of economic factors affecting discretionary and consumer spending, such
as employment levels, business, interest rates, and taxation rates, all of which
are not under our control. Adverse economic changes affecting these factors may
restrict consumer spending and thereby adversely affect our growth and
profitability.
24
WE MAY BE INFRINGING UPON THE COPYRIGHTS OF THIRD PARTIES AND IF WE ARE DOING
SO, OUR PROFITABILITY WILL BE REDUCED
Each song in our catalog is licensed to us for specific uses. Because of the
numerous variations in each of our licenses for copyrighted music, there can be
no assurance that we have complied with scope of each of our licenses and that
our suppliers have complied with these licenses. Additionally, third parties
over whom we exercise no control may use our sound recordings in such a way that
is contrary to our license agreement and by violating our license agreement we
may be liable for contributory copyright infringement. Any infringement claims
may have a negative effect on our ability to sell products and may result in a
fine or damages being assessed against our company.
WE ARE EXPOSED TO THE CREDIT RISK OF OUR CUSTOMERS, WHO ARE EXPERIENCING
FINANCIAL DIFFICULTIES, AND IF THESE CUSTOMERS ARE UNABLE TO PAY US, OUR
REVENUES AND PROFITABILITY WILL BE REDUCED
We sell products to retailers, including department stores, lifestyle merchants,
direct mail retailers, which are catalogs and showrooms, national chains,
specialty stores, and warehouse clubs. Some of these retailers, such as K-Mart,
Music Land and Frye's, have engaged in leveraged buyouts or transactions in
which they incurred a significant amount of debt, and some are currently
operating under the protection of bankruptcy laws. Despite the difficulties
experienced by retailers in recent years, we have not suffered significant
credit losses to date. Deterioration in the financial condition of our customers
could have a material adverse effect on our revenues and future profitability.
OUR OBLIGATION TO MAKE SEVERANCE PAYMENTS COULD PREVENT OR DELAY TAKEOVERS
Our employment agreements with Yi Ping Chan, April Green and Jack Dromgold
require us, under certain conditions, to make substantial severance payments to
them if they resign after a change of control. As of September 30, 2003, Mr.
Chan, Ms. Green and Mr. Dromgold are entitled to severance payments of $250,000,
$73,600 and $135,000, respectively. These provisions could delay or impede a
merger, tender, offer or other transaction resulting in a change in control of
the Company, even if such a transaction would have significant benefits to our
shareholders. As a result, these provisions could limit the price that certain
investors might be willing to pay in the future for shares of our common stock.
WE MAY BE SUBJECT TO CLAIMS FROM THIRD PARTIES FOR UNAUTHORIZED USE OF THEIR
PROPRIETARY TECHNOLOGY, COPYRIGHTS OR TRADE SECRETS AND ANY CLAIMS ASSERTED
AGAINST US COULD AFFECT OUR NET PROFITABILITY
We believe that we independently developed the technology used in our electronic
and audio software products and that it does not infringe on the proprietary
rights, copyrights or trade secrets of others. However, we cannot assure you
that we have not infringed on the proprietary rights of third parties or those
third parties will not make infringement violation claims against us. Any
infringement claims may have a negative effect on our profitability and
financial condition.
A DISRUPTION IN THE OPERATION OF OUR WAREHOUSE CENTERS IN CALIFORNIA OR FLORIDA
COULD IMPACT OUR ABILITY TO DELIVERY MERCHANDISE TO OUR STORES, WHICH COULD
ADVERSELY AFFECT OUR REVENUES AND PROFITABILITY
A significant amount of our merchandise is shipped to our customers from one of
our three warehouses, which are located in Compton, California, Rancho
Dominguez, California and Coconut Creek, Florida. Events such as fire or other
catastrophic events, any malfunction or disruption of our centralized
information systems or shipping problems may result in delays or disruptions in
the timely distribution of merchandise to our customers, which could adversely
impact our revenues and profitability.
25
OUR BUSINESS OPERATIONS COULD BE DISRUPTED IF THERE ARE LABOR PROBLEMS ON THE
WEST COAST
During fiscal 2003, approximately 48% of our sales were domestic sales, which
were made from our warehouses in California and Florida. During the third
quarter of fiscal 2003, the dock strike on the West Coast affected sales of two
of our karaoke products and we estimate that we lost between $3 and $5 million
in orders because we couldn't get the containers of these products off the pier.
If another strike or work slow-down were to occur and we do not have a
sufficient level of inventory, a strike or work slow-down would result in
increased costs to our company and may reduce our profitability.
THE MARKET PRICE OF OUR COMMON STOCK MAY BE VOLATILE WHICH MAY CAUSE INVESTORS
TO LOSE ALL OR A PORTION OF THEIR INVESTMENT
Within the past 12 months from October 2, 2002 through October 2, 2003, our
common stock has traded between a high of $13.49 and a low of $2.70. Market
prices of the securities of companies in the toy and entertainment industry are
often volatile. The market prices of our common stock may be affected by many
factors, including:
-unpredictable consumer preferences and spending trends;
-the actions of our customers and competitors (including new product
line announcements and i introductions;
-changes in our pricing policies, the pricing policies of our
competitors and general pricing trends in the consumer and electronics
and toy markets; -regulations affecting our manufacturing operations in
China;
-other factors affecting the entertainment and consumer electronics
industries in general; and
-sales of our common stock into the public market.
In addition, the stock market periodically has experienced significant price and
volume fluctuations which may have been unrelated to the operating performance
of particular companies.
RISKS ASSOCIATED WITH OUR CAPITAL STRUCTURE
IF OUR OUTSTANDING DERIVATIVE SECURITIES ARE EXERCISED OR CONVERTED, OUR
EXISTING SHAREHOLDERS WILL SUFFER DILUTION
As of September 30, 2003, there were outstanding stock options to purchase an
aggregate of 1,089,400 shares of common stock at exercise prices ranging from
$2.04 to $14.00 per share, not all of which are immediately exercisable. The
weighted average exercise price of the outstanding stock options is
approximately $5.46 per share. As of September 30, 2003, there were outstanding
immediately exercisable warrants to purchase an aggregate of 561,039 shares of
our common stock, which warrants are covered by this Prospectus. In addition, we
have issued $4,000,000 of convertible debentures, which are initially
convertible into an aggregate of 1,038,962 shares of common stock. To the extent
that the aforementioned convertible securities are exercised or converted,
dilution to our stockholders will occur.
FUTURE SALES OF OUR COMMON STOCK HELD BY CURRENT STOCKHOLDERS AND INVESTORS MAY
DEPRESS OUR STOCK PRICE
As of September 30, 2003, there were 8,712,169 shares of our common stock
outstanding. We have filed two registration statements registering an aggregate
3,794,250 of shares of our common stock (a registration statement on Form S-8 to
registering the sale of 1,844,250 shares underlying options granted under our
1994 Stock Option Plan and a registration statement on Form S-8 to register
1,950,000 shares of our common stock underlying options granted under our Year
2001 Stock Option Plan). An additional registration statement on Form S-1 was
filed on October 8, 2003, registering an aggregate of 2,755,314 shares of our
common stock. The market price of our common stock could drop due to the sale of
large
26
number of shares of our common stock, such as the shares sold pursuant to the
registration statements or under Rule 144, or the perception that these sales
could occur.
OUR STOCK PRICE MAY DECREASE IF WE ISSUE ADDITIONAL SHARES OF OUR COMMON STOCK
Our Certificate of Incorporation authorizes the issuance of 18,900,000 million
shares of common stock. As of September 30, 2003, we had 8,712,169 shares of
common stock issued and outstanding and an aggregate of 1,019,400 outstanding
options and warrants. As such, our Board of Directors has the power, without
stockholder approval, to issue up to 9,168,431 shares of common stock.
Any issuance of additional shares of common stock, whether by us to new
stockholders or the exercise of outstanding warrants or options, may result in a
reduction of the book value or market price of our outstanding common stock.
Issuance of additional shares will reduce the proportionate ownership and voting
power of our then existing stockholders.
PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW MAKE IT DIFFICULT FOR A
THIRD PARTY TO ACQUIRE OUR COMPANY AND COULD DEPRESS THE PRICE OF OUR COMMON
STOCK
Delaware law and our certificate of incorporation and bylaws contain provisions
that could delay, defer or prevent a change in control of our company or a
change in our management. These provisions could also discourage proxy contests
and make it more difficult for you and other stockholders to elect directors and
take other corporate actions. These provisions of our restated certificate of
incorporation include: authorizing our board of directors to issue additional
preferred stock, limiting the persons who may call special meetings of
stockholders, and establishing advance notice requirements for nominations for
election to our board of directors or for proposing matters that can be acted on
by stockholders at stockholder meetings.
We are also subject to certain provisions of Delaware law that could delay,
deter or prevent us from entering into an acquisition, including the Delaware
General Corporation Law, which prohibits a Delaware corporation from engaging in
a business combination with an interested stockholder unless specific conditions
are met. The existence of these provisions could limit the price that investors
are willing to pay in the future for shares of our common stock and may deprive
you of an opportunity to sell your shares at a premium over prevailing prices.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk represents the risk of loss that may impact our
financial position, results of operations or cash flows due to adverse changes
in financial and commodity market prices and interest rates. We are exposed to
market risk in the areas of changes in United States and international borrowing
rates and changes in foreign currency exchange rates. In addition, we are
exposed to market risk in certain geographic areas that have experienced or
remain vulnerable to an economic downturn, such as China. We purchase
substantially all our inventory from companies in China, and, therefore, we are
subject to the risk that such suppliers will be unable to provide inventory at
competitive prices. While we believe that, if such an event were to occur we
would be able to find alternative sources of inventory at competitive prices, we
cannot assure you that we would be able to do so. These exposures are directly
related to our normal operating and funding activities. Historically and as of
September 30, 2003, we have not used derivative instruments or engaged in
hedging activities to minimize market risk.
INTEREST RATE RISK:
Our exposure to market risk resulting from changes in interest rates
relates primarily to debt under our credit facility with LaSalle. Under our
credit facility, our interest rate is LaSalle's prime rate plus 2.5% per annum
("current interest rate"). As of September 30, 2003, our outstanding balance
under our credit facility was $6,513,411 and we are accruing interest at the
prime plus 2.5% per annum. We do not believe that
27
near-term changes in the interest rates, if any, will result in a material
effect on our future earnings, fair values or cash flows. On September 8, 2003,
we issued convertible notes in the amount of $4 million with a fixed interest
rate of 8% per annum.
FOREIGN CURRENCY RISK:
We have a wholly owned subsidiary in Hong Kong. Sales by these
operations made on a FOB China or Hong Kong basis are dominated in U.S. dollars.
However, purchases of inventory and Hong Kong operating expenses are typically
denominated in Hong Kong dollars, thereby creating exposure to changes in
exchange rates. Changes in the Hong Kong dollar/U.S. dollar exchange rates may
positively or negatively affect our gross margins, operating income and retained
earnings. We do not believe that near-term changes in the exchange rates, if
any, will result in a material effect on our future earnings, fair values or
cash flows, and therefore, we have chosen not to enter into foreign currency
hedging transactions. We cannot assure you that this approach will be
successful, especially in the event of a significant and sudden change in the
value of the Hong Kong dollar.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
conducted an evaluation (the "Evaluation") of the effectiveness of the design
and operation of our disclosure controls and procedures, as defined in Rules
13a-14(c) and 15d-15(c) under the Securities Exchange Act of 1934, within 90
days of the filing date of this report (the "Evaluation Date").Based on this
Evaluation, our principal executive officer and principal financial officer
concluded that our disclosure controls and procedures are effective in timely
alerting them to material information required to be included in our periodic
SEC reports. It should be noted that the design of any system of controls is
based in part upon certain assumptions about the likelihood of future events,
and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions, regardless of how remote.
In addition, we reviewed our internal controls, and there have been no
significant changes in our internal controls or in other factors that could
significantly affect those controls subsequent to the date of their last
evaluation.
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From July 2003 through August 2003, eight securities class action
lawsuits were filed against The Singing Machine and certain of its officers and
directors in the United States District Court for the Southern District of
Florida on behalf of all persons who purchased The Singing Machine's securities
during the various class action periods specified in the complaints. These
complaints have all been consolidated into one action styled Bielansky, et al.
v. Salberg & Co., et al., Case No. 03-80596-ZLOCH (the Shareholder Action).
The complaints in the Shareholder Action allege violations of Section
10(b) and Section 20(a) of the Securities Exchange Act of 1934 and Rule 10(b)-5
promulgated there under. These complaints seek compensatory damages, attorney's
fees and injunctive relief. While the specific factual allegations vary slightly
in each case, the complaints generally allege that defendants falsely
represented the Company's financial results for the years ended March 31, 2002
and 2001.
In July 2003, a shareholder filed a derivative action against the
Company, its board of directors and senior management purporting to pursue the
action on behalf of the Company and for its benefit. No pre-lawsuit demand was
made on the board of directors for them to investigate the allegations or to
bring action. The Company is named as a nominal defendant in this case. This
case has been consolidated into the Shareholder Action identified above. The
derivative complaint alleges claims for breach of fiduciary duty, abuse of
control, gross mismanagement, waste of corporate assets and unjust enrichment.
The complaint alleges that the individual defendants breached their fiduciary
duties and engaged in gross mismanagement by allegedly ignoring indicators of
the lack of control over the Company's accounting and management practices,
allowing the Company to engage in improper conduct and otherwise failing to
carry out their duties and obligations to the Company. The plaintiff's seek
damages for breach of fiduciary duties, punitive and compensatory damages,
restitution, and bonuses or other incentive-based or equity based compensation
received by the CEO and CFO under the Sarbanes-Oxley Act of 2002.
The court in the Shareholder Action has directed plaintiffs' counsel to
file one amended consolidated complaint no later than November 14, 2003. The
Company intends to vigorously defend the Shareholder Action. As the outcome of
litigation is difficult to predict, significant changes in the estimated
exposures could occur which could have a material affect on the Company's
operations.
A second shareholder derivative suit was filed in October 2003, which
makes generally the same allegations. The second derivative suit has not been
served on the Company or on any of its current or former officers and directors.
This suit has been transferred to the same judge to which the Shareholder Action
has been assigned and has likewise been consolidated into the Shareholder
Action.
In August 2003, we were advised that the Securities and Exchange
Commission had commenced an informal inquiry of our company. We are cooperating
fully with the SEC staff. It appears that the investigation is focused on the
restatement of our audited financial statements for fiscal 2002 and 2001. We
have been advised that an informal inquiry should not be regarded as an
indication by the SEC or its staff that any violations of law have occurred or
as a reflection upon any person or entity that may have been involved in those
transactions.
We are also involved in certain routine litigation matters incidental
to our business and operations, which we do not believe are material to our
business. In September 2003, we had a disagreement with AG Edwards & Sons,
Inc.("AG Edwards") regarding the compensation that was payable to them under our
investment banking agreement with them. Both parties have agreed to enter into a
settlement agreement in which we have agreed to pay AG Edwards $100,000 in cash
over a five month period and $100,000 in stock valued at the current market
price. However, as of November 14, 2003, we have not yet finalized a definitive
settlement agreement with them.
29
ITEM 2. CHANGES IN SECURITIES
(a) Not Applicable.
(b) Not Applicable.
(c) During the three month period ended September 30, 2003, four employees
exercised stock options issued under our 1994 Amended and Restated Management
Stock Option Plan. The employee exercised options to acquire an aggregate of
320,000 shares of our common stock. The names of the option holder, the grant
date of the options, the dates of exercise, the number of shares purchased, the
exercise price and the proceeds received by the Company are listed below.
NO. OF
OPTIONS EXERCISE EXERCISE
NAME GRANT DATE EXERCISED PRICE DATE PROCEEDS
---- ---------- --------- ----- ---- --------
John Klecha 102,700 2.04 7/26/03 $209,508
Terry Garcia 45,000 2.04 7/25/03 $ 91,800
John Klecha 167,300 2.04 8/28/03 $341,292
Alicia Haskamp 5,000 2.04 9/11/03 $ 10,200
All of the above issuances were paid for with cash. The above employees
exercised their options in reliance upon Section 4(2) of the Securities Act of
1933, because they are knowledgeable, sophisticated and had access to
comprehensive information about the Company. The shares issued to our employees
were registered under the Securities Act on a registration statement on Form
S-8. As such, no restrictive legends were placed on the shares.
On September 8, 2003, we issued an aggregate of $4,000,000 of 8%
convertible debentures in a private offering to six accredited investors. The
debentures initially are convertible into shares of common stock at a price of
$3.85 per share, subject to adjustment in certain situations. Each investor also
received warrants equal to 40% of the subscription amount. The exercise price of
the warrants is $4.025 per share and the warrants expire on September 7, 2006.
We also have an obligation to register the shares of common stock underlying the
debenture and warrants, which we are satisfying by filing this registration
statement. The names of the investors, the amount of the debentures and the
number or warrants issuable to each investor are set forth below.
AMOUNT OF
NAME DEBENTURES NO. OF WARRANTS
- ---- ---------- ---------------
Omicron Master Trust $2,500,000 285,714
SF Capital Partners, Ltd $ 500,000 57,143
Bristol Investment Fund, Ltd. $ 300,000 34,286
Ascend Offshore Fund, Ltd. $ 478,000 54,629
Ascend Partners, LP $ 58,200 6,651
Ascend Partners Sapient LP $ 163,800 18,720
The offering and sale of the debentures and the warrants was made in reliance
upon Section 4(2) of the Securities Act of 1933, as amended. We used Roth
Capital as our placement agent and they received a commission equal to 5.5% of
the proceeds and a warrant to purchase 103,896 shares or our common stock. The
commission to Roth Capital was paid in cash and 28,571 shares of the Company's
common stock. We agreed to register the shares underlying Roth's warrant in a
registration statement. The common stock was only offered and sold to accredited
investors or persons who represented that they had no need for liquidity in
their investment and had adequate financial resources to withstand a total loss
of their investment. We issued these shares to these persons in reliance upon
Section 4(2) of the Securities Act, because the shareholders were knowledgeable,
sophisticated and had access to comprehensive information about us. We placed
legends on the debentures and the warrant agreements
30
stating that the securities were not registered under the Securities Act and set
forth the restrictions on their transferability and sale.
(d) Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
Not applicable.
ITEM 5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibits
10.1 Securities Purchase Agreement dated as of August 20, 2003 by and among
the Company and Omicron Master Trust, SF Capital Partners, Ltd.,
Bristol Investment Fund, Ltd., Ascend Offshore Fund, Ltd., Ascend
Partners, LP and Ascend Partners Sapient, LP (collectively, the
"Investors") (incorporated by referenced to Exhibit 10.1 in the
Company's registration statement filed with the SEC on October 7, 2003,
File No. 333-109574).
10.2 Amendment dated September 5, 2003 to Securities Purchase Agreement
between the Company and the Investors (incorporated by referenced to
Exhibit 10.2 in the Company's registration statement filed with the SEC
on October 7, 2003, File No. 333-109574).
10.3 Form of Debenture Agreement issued by the Company to each of the
Investors (incorporated by referenced to Exhibit 10.3 in the Company's
registration statement filed with the SEC on October 7, 2003, File No.
333-109574).
10.4 Form of Warrant Agreement issued by the Company to the Investors
(incorporated by referenced to Exhibit 10.4 in the Company's
registration statement filed with the SEC on October 7, 2003, File No.
333-109574).
10.5 Warrant Agreement between the Company and Roth Capital Partners, LLC
(incorporated by referenced to Exhibit 10.5 in the Company's
registration statement filed with the SEC on October 7, 2003, File No.
333-109574).
10.6 Registration Rights Agreement between the Company and each of the
Investors and Roth Capital Partners, LLC (incorporated by referenced to
Exhibit 10.6 in the Company's registration statement filed with the SEC
on October 7, 2003, File No. 333-109574).
31.1 Certification of Yi Ping Chan, Chief Executive Officer and Chief
Operating Officer of The Singing Machine Company, Inc., Pursuant to
Rule 13a-14(a) under the Securities Exchange Act of 1934.
31.2 Certification of April Green, Chief Financial Officer of The Singing
Machine Company, Inc., Pursuant to Rule 13a-14(a) under the Securities
Exchange Act of 1934.
32.1 Certification of Yi Ping Chan, Chief Executive Officer and Chief
Operating Officer of The Singing Machine Company, Inc., Pursuant to 18
U.S.C. Section 1350.
32.2 Certification of April Green, Chief Financial Officer of The Singing
Machine Company, Inc., Pursuant to 18 U.S.C. Section 1350.
*Filed herewith
31
(b) Reports on Form 8-K
The Company filed the following Current Reports on Form 8-K during the
quarterly period ended September 30, 2003:
DATE OF REPORT ITEMS REPORTED FINANCIAL STATEMENTS FILED
- -------------- -------------- --------------------------
June 7, 2003 5, 7 No
June 15, 2003 7, 9 No
August 1, 2003 5, 7 No
August 15, 2003 7, 9 No
August 28, 200 5, 7 No
32
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
THE SINGING MACHINE COMPANY, INC.
Dated November 14, 2003
By: /s/ April J. Green
-------------------------------------------
April J. Green
Chief Financial Officer
(On behalf of Registrant and
Chief Accounting Officer)
Dated November 14, 2003
By: /s/ Yi Ping Chan
-------------------------------------------
Yi Ping Chan
Chief Executive Officer
(On behalf of Registrant and
Chief Accounting Officer)
33
EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
- ----------- -----------
31.1 Certification of Yi Ping Chan, Chief Executive Officer and Chief
Operating Officer of The Singing Machine Company, Inc., Pursuant to Rule
13a-14(a) under the Securities Exchange Act of 1934.
31.2 Certification of April Green, Chief Financial Officer of The Singing
Machine Company, Inc., Pursuant to Rule 13a-14(a) under the Securities
Exchange Act of 1934.
32.1 Certification of Yi Ping Chan, Chief Executive Officer and Chief
Operating Officer of The Singing Machine Company, Inc., Pursuant to 18
U.S.C. Section 1350.
32.2 Certification of April Green, Chief Financial Officer of The Singing
Machine Company, Inc., Pursuant to 18 U.S.C. Section 1350.
34