Back to GetFilings.com
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 December 31, 2003
0 - 24968
---------
Commission File Number
THE SINGING MACHINE COMPANY, INC.
---------------------------------
(Exact Name of Small Business Issuer as Specified in its Charter)
Delaware 95-3795478
---------- ------------
(State of Incorporation ) (IRS Employer I.D. No.)
6601 Lyons Road, Building A-7, Coconut Creek, FL 33073
------------------------------------------------------
(Address of principal executive offices )
(954) 596-1000
--------------
(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:
NUMBER OF SHARES
CLASS OUTSTANDING ON DECEMBER 31, 2003
Common Stock, $0.01 par value 8,752,320
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Page No.
--------
Consolidated Balance Sheets - December 31, 2003 (Unaudited)
and March 31, 2003 .............................................. 3
Consolidated Statements of Operations - Three and Nine months
ended December 31, 2003 (unaudited) and 2002(Unaudited,restated). 4
Consolidated Statements of Cash Flows - Nine months ended
December 31, 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 ............................. 13
Item 3. Quantitative and Qualitative Disclosure About Market Risk ....... 27
Item 4. Controls and Procedures ......................................... 27
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ............................................... 28
Item 2. Changes in Securities ........................................... 29
Item 3. Defaults Upon Senior Securities ................................. 30
Item 4. Submission of Matters to a Vote of Security Holders ............. 30
Item 5. Other Information ............................................... 30
Item 6. Exhibits and Reports on Form 8-K ................................ 30
SIGNATURES ............................................................... 31
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
DECEMBER 31, MARCH 31,
2003 2003
------------ ------------
(UNAUDITED)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 235,958 $ 268,265
Restricted Cash 866,413 838,411
Accounts Receivable, less allowances of $816,235 and $405,759
respectively 14,729,176 5,762,944
Due from manufacturer 1,112,200 1,091,871
Inventories, net 8,029,371 25,194,346
Prepaid expense and other current assets 2,294,377 1,483,602
Deferred tax asset -- 1,925,612
------------ ------------
TOTAL CURRENT ASSETS 27,267,495 36,565,051
PROPERTY AND EQUIPMENT, at cost less accumulated depreciation of
$2,567,480 and $1,472,850 respectively 1,365,687 2,026,252
OTHER ASSETS
Other non-current assets 970,464 343,991
------------ ------------
TOTAL ASSETS $ 29,603,646 $ 38,935,294
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Bank overdraft $ 85,236 $ 316,646
Accounts payable 5,331,470 8,486,009
Accrued expenses 2,587,579 1,443,406
Subordinated debt-related parties 1,000,000 400,000
Revolving credit facilities 7,115,114 6,782,824
Income taxes payable 2,872,509 3,821,045
------------ ------------
TOTAL CURRENT LIABILITIES 18,991,908 21,249,930
------------ ------------
LONG TERM LIABILITIES
Convertible debentures, net of unamortized discount of $3,046,000 954,210 --
------------ ------------
TOTAL LIABILITIES 19,946,118 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;
8,752,320 and 8,171,678 shares issued and outstanding 87,523 81,717
Additional paid-in capital 10,234,410 4,843,430
Retained earnings (664,405) 12,760,217
------------ ------------
TOTAL SHAREHOLDERS' EQUITY 9,657,528 17,685,364
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 29,603,646 $ 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 Nine Months Ended
December 31, December 31,
------------------------------ ------------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
(as restated) (as restated)
NET SALES $ 28,689,623 $ 45,659,446 $ 68,053,739 $ 81,915,443
COST OF SALES
Cost of goods sold 30,782,268 36,628,126 64,948,809 64,155,095
Impairment of tooling 508,480 -- 508,480 --
------------ ------------ ------------ ------------
GROSS PROFIT (2,601,125) 9,031,320 2,596,449 17,760,348
OPERATING EXPENSES:
Compensation 1,097,327 1,257,519 3,552,718 2,827,823
Freight & handling 523,177 944,169 1,153,353 1,605,445
Selling, general & administrative expenses 3,410,116 1,748,400 8,908,899 4,675,279
------------ ------------ ------------ ------------
TOTAL OPERATING EXPENSES 5,030,620 3,950,088 13,614,971 9,108,547
------------ ------------ ------------ ------------
(LOSS) EARNINGS FROM OPERATIONS (7,631,744) 5,081,232 (11,018,521) 8,651,801
OTHER INCOME (EXPENSES):
Other income 32,098 38,628 (50,882) 196,648
Interest expense (687,178) (117,704) (1,194,541) (228,597)
Interest income -- -- -- 11,943
------------ ------------ ------------ ------------
NET OTHER (EXPENSES) INCOME (655,079) (79,076) (1,245,422) (20,006)
NET (LOSS) EARNINGS BEFORE INCOME TAX (8,286,825) 5,002,156 (12,263,944) 8,631,795
INCOME TAX EXPENSE 2,163,776 1,681,629 1,160,678 2,674,659
------------ ------------ ------------ ------------
NET (LOSS) EARNINGS $(10,450,601) $ 3,320,527 $(13,424,622) $ 5,957,136
============ ============ ============ ============
(LOSS) EARNINGS PER SHARE:
Basic $ (1.20) $ 0.41 $ (1.58) $ 0.74
Diluted $ (1.20) $ 0.37 $ (1.58) $ 0.67
WEIGHTED AVERAGE COMMON AND
COMMON EQUIVALENT SHARES OUTSTANDING:
Basic 8,729,818 8,123,548 8,503,065 8,101,441
Diluted 8,729,818 8,944,027 8,503,065 8,947,897
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 NINE MONTHS ENDED
DECEMBER 31,
------------------------------
2003 2002
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES (restated)
Net (loss) earnings $(13,424,622) $ 7,475,119
Adjustments to reconcile net (loss) earnings to net cash used in
operating activities
Depreciation and amortization 1,165,687 454,806
Impairment of tooling 508,480
Provision for inventory 4,996,685 --
Provision for bad debt 410,476 --
Amortization of discount on convertible debentures 444,584 --
Stock compensation expense 511,299 --
Deferred tax benefit 1,925,612 452,673
Changes in assets and liabilities:
(Increase) decrease in:
Accounts Receivable (9,376,708) (15,998,298)
Due from manufacturer (20,329) (264,908)
Inventories 12,168,290 (20,742,572)
Prepaid Expenses and other assets (858,011) (1,218,091)
Increase (decrease) in:
Accounts payable (3,154,539) 11,203,268
Accrued expenses 653,540 3,705,878
Income taxes payable (948,536) 572,254
------------ ------------
Net Cash Used in Operating Activities (4,998,092) (14,359,871)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment (434,065) (1,112,376)
------------ ------------
Net cash used in Investing Activities (434,065) (1,112,376)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings from revolving credit facilities 27,777,630 37,612,713
Repayments to revolving credit facilities (27,445,340) (27,449,625)
Proceeds from issuance of convertible debentures 4,000,000 --
Bank Overdraft (231,410) --
Restricted cash (28,002) (3,640)
Payment of financing fees related to convertible debentures (255,000) --
Proceeds from subordinated debt-related parties, net 600,000 --
Proceeds from exercise of stock options and warrants 981,972 155,579
------------ ------------
Net cash provided by Financing Activities 5,399,850 10,315,027
------------ ------------
DECREASE IN CASH AND CASH EQUIVALENTS (32,307) (5,157,220)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 268,265 5,520,147
------------ ------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 235,958 $ 362,927
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
CASH PAID FOR THE NINE MONTHS ENDED DECEMBER 31, 2003
Interest $ 591,817 $ 228,597
============ ============
Income Taxes $ 1,388,102 $ 73,207
============ ============
NON-CASH FINANCING ACTIVITIES
Stock based compensation $ 511,299 $ --
============ ============
Discounts for warrants issued in connection with and beneficial $ 3,494,274 $ --
conversion feature of convertible debentures
============ ============
Financing fees in connection with convertible debenture issuance,
paid in stock and warrants 409,527
============ ============
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 December 31, 2003 are not necessarily indicative of the results that may
be expected for the remaining quarter 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.
December 31, 2003 March 31, 2003
----------------- --------------
Finished goods $ 13,463,330 $ 27,807,763
Inventory in transit 1,200,221 1,101,940
Provision for losses (6,634,180) (3,715,357)
------------ ------------
Total Inventory $ 8,029,371 $ 25,194,346
============ ============
Although management has taken a provision, which they estimate, based on recent
contacts with customers, to be a sufficient reserve for potential losses on
disposal of existing inventory, the Company's sales are highly seasonal and unit
sales and their related selling prices during peak seasons may not meet
expectations. Therefore, management's estimates could differ significantly from
actual outcome and have a material impact on future operations. The Company also
made the decision to discontinue certain models from their line. A reserve was
taken against the remaining inventories of these discontinued items to enable
the items to be sold through alternate sales arenas, such as through liquidation
facilities. Management believes that at September 30, 2003, there was not
sufficient evidence warranting an additional reserve against inventory at that
time, as the peak selling season had just begun and there were no indications
that the inventory would not be sold.
RECLASSIFICATIONS
Certain prior period amounts have been reclassified to conform to the
current period 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, if any. 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
("Statement") No. 148, "Accounting for Stock-Based Compensation-Transition and
Disclosure, an amendment of Statement No. 123", "Accounting for Stock Based
Compensation", 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 Statement No. 123 had been
applied to options granted.
6
Had compensation cost for the Company's stock-based compensation plan
been determined using the fair value method for awards under that plan, pursuant
to Statement No. 123, the Company's net (loss) earnings would have been changed
to the pro-forma amounts indicated below.
FOR THE THREE MONTHS ENDED DECEMBER 31, FOR THE NINE MONTHS ENDED DECEMBER 31,
2003 2002 2003 2002
------------------ ------------------- ----------------- -------------------
Net (loss) earnings As reported $(10,450,601) $3,320,527 $(13,424,622) $5,957,136
Pro forma $(10,653,283) $3,291,655 $(14,032,668) $5,870,518
Net (loss) earnings per share - As reported $(1.20) $0.41 $(1.58) $0.74
basic
Pro forma $(1.22) $0.41 $(1.65) $0.72
Net (loss) earnings per share As reported $(1.20) $0.37 $(1.58) $0.67
- -diluted
Pro forma $(1.22) $0.37 $(1.65) $0.66
For stock options and warrants issued to non-employees, the Company
applies the fair value method of accounting pursuant to Statement 123. Due to a
change in status of a former employee, an expense of $220,835 was charged to
compensation expense in August 2003.
For financial statement disclosure purposes and for purposes of valuing
stock options and warrants issued to non-employees, 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 Statement No. 123 using
the following weighted-average assumptions:
Third Quarter 2004: expected dividend yield 0%, risk-free interest
rate of 2.5%, volatility 110.05% and
expected term of five years.
Third Quarter 2003: expected dividend yield 0%, risk-free interest
rate of 6.8%, volatility 42% and expected
term of two years.
RECENT ACCOUNTING PRONOUNCEMENTS
Statement 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 Statement 133. Statement 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 provisions of Statement 149 did not have a material impact on the
Company's financial position or results of operations.
Statement No. 150, "Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity" 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 for instruments entered into or modified after May 31, 2003. The
provisions of Statement 150 did not have a material impact on the Company's
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 (See Management Discussion and Analysis - Liquidity and Capital
Resources).
On March 14, 2003, the Company was notified of its violation of the
tangible 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 on August 19, 2003. Pursuant to this
fourteenth amendment the loan was extended until March 31, 2004 and the
condition of default was waived.
As of December 31, 2003, the Company again violated the tangible net
worth and working capital covenants of the Agreement. As of January 31, 2004 the
loan was paid in full, the facility was terminated and the UCC filings were
released.
7
NOTE 3 - RESTATEMENT OF FINANCIAL STATEMENTS FOR THE FISCAL YEARS 2002 AND 2001
In June 2003, management revised its position on taxation of the income
of International SMC (H.K.) Ltd., its wholly-owned subsidiary, 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. 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 nine
months ended December 31, 2002 is to decrease net income by $576,060 and
$1,517,983, respectively. The net effect on net income per share is to decrease
net income per share basic and diluted by $0.07 and $0.06 for the quarter and
$0.18 and $0.17 for the nine months ended December 31, 2002.
NOTE 4 - IMPAIRMENT OF TOOLING
Pursuant to Statement No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets", the Company recorded a loss on impairment of
tooling. In December 2003, and as a result of the Company's decision to
discontinue certain models, management estimated that the amounts recoverable on
certain tooling through future operations, on an undiscounted basis, were below
their book values. An expense of $508,480 was charged to operations for this
impairment.
NOTE 5 - PROVISION FOR INCOME TAX
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 December 31, 2003,
the Company concluded that a valuation allowance was needed against all of the
Company's deferred tax assets, as it is not more likely than not that the
deferred taxes will be realized. For the three months ended December 31, 2003,
the Company recorded a tax provision of $2.2 million. This provision was created
because the valuation allowance established against the deferred tax asset
exceeded the amount of the benefit created from carrying back a portion of the
current period losses. The carry-back of the losses from the current period
resulted in an income tax receivable of $1.2 million, which is included in
prepaid and other current assets in the accompanying balance sheets.
The Company's wholly-owned 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 2004, 2003, 2002, and 2001. For the nine months ended
December 31, 2003, a provision of $424,763 was recorded at the Hong Kong
statutory rate of 17.5%. Accrued Hong Kong taxes payable on the current and
prior earnings of the Company's Hong Kong subsidiary totaled $2.9 million at
December 31, 2003.
8
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.
NOTE 6 - LOANS AND LETTERS OF CREDIT
CREDIT FACILITY
The Company's Hong Kong Subsidiary maintains separate credit facilities
at two international banks. The primary purpose of the facilities is to provide
the Subsidiary with the following abilities:
o Overdraft protection facilities
o Issuance and negotiation of letters of credit, both regular
and discrepant
o Trust receipts
o A Company credit card
The facilities are secured by a corporate guarantee from the U.S.
Company, restricted cash on deposit with the lender and require that the Company
maintain a minimum tangible net worth. The maximum available credit under the
facilities is $5.5 million. The balance at December 31, 2003 and 2002 was
$4,640,728 and $0, respectively.
LOAN AND SECURITY AGREEMENT
On April 26, 2001, the Company executed a Loan and Security Agreement
(the "Agreement") with a commercial lender (the "Lender"), which as amended on
August 19, 2003, was due to expire on March 31, 2004. At December 31, 2003 and
2002 the amount outstanding was $2,474,386 and $10,163,088, respectively. As of
January 31, 2004 the loan was paid in full, the facility was terminated and the
UCC filings were released.
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 annum and paid quarterly. These
loans were originally scheduled to be paid back by October 31, 2003; however,
the notes have since been subordinated to the Company's credit facility and the
total amount outstanding of $1 million will not be repaid until either the
subordination is released by the Company's lender or the credit facility is
closed.
NOTE 7 - 8% CONVERTIBLE DEBENTURES WITH WARRANTS
In September 2003, the Company issued $4 million of 8% Convertible
Debentures in a private offering which are due February 20, 2006 ("Convertible
Debentures"). The net cash proceeds received by the Company were $3,745,000
after deduction of cash commissions and other expenses.
The Convertible Debentures are subordinated to the Company's Lender and
are convertible at the option of the holders into 1,038,962 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 may
be convertible into common shares, at a conversion price of $3.85 per Common
Share. of the registration statement
The Convertible Debentures are subordinated to the Company's Lender and
are convertible at the option of the holders into 1,038,962 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 may
be convertible into common shares, representing an initial conversion price of
$3.85 per Common Share
These Convertible Debentures were issued with 457,143 detachable stock
purchase warrants with an exercise price of $4.025 per share. These warrants may
be exercised at anytime after September 8, 2003 and before September 7, 2006 and
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.
The Convertible Debentures bear 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. On February 9, 2004 the stated rate of interest was raised to 8.5%.
9
In accounting for this transaction, the Company allocated $1.2 million
of the proceeds to the estimated fair value of the stock purchase warrants and
$2.3 million as the estimated fair value of the beneficial conversion feature.
These amounts resulted in a discount in the convertible debentures of $3.5
million, which is being amortized over the life of the debt on a straight-line
basis to interest expense. Total amortization for the nine months ended December
31, 2003 was $444,584.
In connection with the Convertible Debentures the Company paid
financing fees as follows: 103,896 stock purchase warrants, with a fair value of
$264,671, 28,571 shares of common stock with a fair value of $141,141, and cash
of $255,000. Total financing fees of $660,812 were recorded as deferred fees and
are being amortized over the term of the debentures on a straight-line basis.
The unamortized deferred fees are reported in other non-current assets in the
accompanying balance sheets.
NOTE 8 - COMMITMENTS AND CONTINGENCIES
LEGAL MATTERS
CLASS ACTION. From July 2003 through August 2003, eight securities
class action lawsuits were filed against the Company 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.
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 plaintiffs
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 whom the Shareholder Action was
assigned and has been consolidated into the Shareholder Action.
OTHER MATTERS. 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.
The Company entered into a separation and release agreement with an
executive on December 19, 2003. The agreement provided for the individual to
receive $159,281 in settlement of the Company's contract. The amount has been
expensed as compensation at December 31, 2003.
The Company entered into a settlement agreement with an investment
banker on November 17, 2003. Pursuant to this agreement, the Company will pay
the sum of $181,067 over a six month period and has issued to the investment
banker 40,151 shares of stock with a fair value of $94,355.
10
The Company amended its convertible debenture agreements to increase
the interest rate to 8.5% effective as of February 9, 2004 and to grant warrants
to purchase an aggregate of 30,000 shares of the Company's common stock to the
debenture holders on a pro-rata basis. These concessions are in consideration of
the debenture holder's agreements to (i) enter into new subordination agreements
with the Company's new lender, (ii) to waive all liquidated damages due under
the transaction documents through July 1, 2004 and (iii) to extend the effective
date of the Form S-1 registration statement until July 1, 2004. The new warrants
have an exercise price equal to $1.52 per share, the fair market value of the
Company's common stock on February 9, 2004, the date of the grant. The fair
value of these warrants as calculated pursuant to Statement No. 123 is $30,981
and has been expensed as other operating expenses in the accompanying statements
of operations.
The Company is also subject to various other legal proceedings and
other claims 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 9 - STOCKHOLDERS' EQUITY
COMMON STOCK ISSUANCES
During the nine months ended December 31, 2003, the Company issued
580,642 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
Debentures. Certain executives received 63,420 shares of common stock in lieu of
a portion of their cash compensation and bonuses for fiscal 2004. The fair value
of this stock, $290,165 was charged to compensation expense. 40,151 shares of
stock were issued in lieu of a settlement with an investment banker, at an
estimated fair value of $94,355. The remaining 448,500 shares of stock issued
were through the exercise of vested stock options. There were no shares of
common stock issued in the nine months ended December 31, 2002.
EARNINGS PER SHARE
In accordance with Statement 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 ENDED FOR THE NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
2003 2002 2003 2002
(as restated) (as restated)
Net (loss) income $(10,450,601) $ 3,320,527 $(13,424,622) $ 5,957,136
Loss available to common shares $(10,450,601) $ 3,320,527 $(13,424,622) $ 5,957,136
Weighted average shares outstanding - basic 8,729,818 8,123,548 8,503,065 8,101,441
Weighted average shares outstanding - diluted 8,729,818 8,944,027 8,503,065 8,947,897
Loss per share - Basic $ (1.20) $ 0.41 $ (1.58) $ 0.74
============ ============ ============ ============
Loss per share -Diluted $ (1.20) $ 0.37 $ (1.58) $ 0.67
============ ============ ============ ============
For the three months and nine months ended December 31, 2003, 1,120,120
common stock equivalents were excluded from the calculation of diluted earnings
per share, as there was a net operating loss for the periods and their effects
would have been antidilutive. For the three months and nine months ended
December 31, 2002, 90,000 and 0 common stock equivalents were not included in
the computation of diluted earnings per share because their effect was
antidilutive.
For the nine months ended December 31, 2003, there were 1,120,120
common stock options outstanding with exercise prices between $1.97 and $14.30.
In addition, there is a potential 1,038,962 shares that may be issued in
connection with the Convertible Debentures if certain conditions exist. (See
Note 7.)
11
NOTE 10 - 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 wholly-owned Subsidiary. Sales by geographic region for
the quarters ended December 31 were as follows:
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
2003 2002 2003 2002
SALES: ------------ ------------ ------------ ------------
United States $ 19,847,863 $ 41,028,985 $ 41,184,176 $ 72,402,914
Australia 582,385 286,368 892,964 529,020
Canada 307,182 706,476 832,007 733,801
Europe 8,687,809 6,178,010 26,497,706 12,998,917
Other 210,407 29,945 708,343 100,143
Less: Allowances (946,023) (2,570,338) (2,061,457) (3,243,907)
------------ ------------ ------------ ------------
Consolidated Net Sales $ 28,689,623 $ 45,659,446 $ 68,053,739 $ 83,520,888
============ ============ ============ ============
The geographic area of sales is based primarily on the location where the
product is delivered.
NOTE 11 - SUBSEQUENT EVENTS
On January 7, 2004, the Company entered into the fifth amendment of its
licensing agreement with MTV Networks. The amendment reduced the minimum royalty
guarantee for calendar 2003 from $1.5 million to $1.3 million. The amendment
also extended the expiration date of the original agreement to April 30, 2004,
with options to extend for an additional two periods until December 31, 2004 at
the discretion of MTV. In accordance with this amendment, each of the three
license periods contain minimum guarantee royalty payments of $100,000 each for
a total of $300,000 if all extensions are exercised Each of the minimum
guaranteed royalty payments is recoupable against sales throughout the calendar
year, unless the contract is cancelled.
On February 9, 2004, the Company entered into a factoring agreement with Milberg
Factors, Inc. ("Milberg") of New York City. The agreement allows the Company, at
the discretion of Milberg, to borrow against its outstanding receivables up to a
maximum of the lesser of $3.5 million or 80% of the purchase price. The Company
will pay .8% of gross receivables in fees and the average balance of the line
will be subject to interest on a monthly basis at prime plus .75% with a minimum
rate not to decrease below 4.75%. The agreement contains minimum aggregate
charges in any calendar year of $200,000, limits on incurring any additional
indebtedness and the Company must maintain tangible net worth and working
capital above $7.5 million. Millberg also received a security interest in all of
the Company's accounts receivable and inventory located in the United States and
a pledge of 66 2/3 of the stock of International SMC, our Hong Kong subsidiary.
12
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 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 International SMC HK Ltd. ("International
SMC"), (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(C) trademark.
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 expense of $13,424,622 for the
nine month period ended December 31, 2003.
As of December 31, 2003, we had 8,752,320 shares of our common stock
issued and outstanding. As of December 31, 2003, there were 1,651,159 common
stock options and warrants outstanding with exercise prices between $1.97 and
$14.30. In addition, we are obligated to issue 1,038,962 shares of our common
stock to the holders of our convertible debentures if they elect to convert
their debentures into common stock.
RESTATEMENT OF FINANCIAL STATEMENTS
In June 2003, our management revised its position on taxation of the
income of International SMC (H.K.) Ltd., its Hong Kong subsidiary, 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 in China. Management believed, based on advice from its
then auditors, that the exemption would be approved because the source of all
profits of International SMC was 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 the
fiscal 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. In June 2003,
we revised our position on the taxation of the income of International SMC
because we received different advice from our new auditors. We dismissed our
former accountant on March 24, 2003 and engaged our new auditors effective as of
March 27, 2003.
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 decided 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, we can claim United States foreign tax credits in
2002 for these Hong Kong taxes, which is reflected in the final restated
amounts.
13
With regard to United States taxation of foreign income, in fiscal 2002
and 2003 we had taken the position that the foreign income of International SMC
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. The basis of this position was primarily due to the fact that
the amount of income in question was very low and fully repaid within a
reasonable time after year end. It was expected that this income would remain in
Hong Kong. Full disclosure of the amount and nature of the indefinite deferral
for the income of International SMC for fiscal year 2002 was reflected in the
income tax footnote of the consolidated financial statements for that year.
During fiscal 2002 and 2003, International SMC paid for inventory delivered to
the United States parent company, in the aggregate of approximately $10 million.
Our prior auditors advised us that the funds advanced by International SMC were
reimbursed by the United States parent company within a short enough time period
that a deemed dividend had not occurred. Our new auditors questioned this
treatment and management decided to restate the income tax expense to treat the
advances as deemed dividends. 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 is to decrease net income
by $576,060 and $1,517,983 and decrease net income per share basic and diluted
by $0.07 and $0.07 for the quarter and $0.18 and $0.17 for the nine months ended
December 31, 2002.
THREE MONTHS ENDED DECEMBER 31, 2003 COMPARED TO THE THREE MONTHS ENDED DECEMBER
31, 2002
NET SALES
Net sales for the quarter ended December 31, 2003 decreased 37% percent to
$28,689,623 compared to $45,659,446 for the quarter ended December 31, 2002.
Sales in the United States declined 55.2%, or $24,391,452 from the quarter ended
December, 2002. These decreases are composed of decreases of machine sales of
57% or $15,974,640 from $27,891,528 in 2002 and music sales of 77% or $3,757,221
from $4,885,225 in 2002. Sales decreases were partially offset by a reduction in
advertising allowances of 70% or $2,124,315 from $3,070,338 in 2002 and a 35.9%
increase in international sales, from $7.2 million for the quarter ended
December 31, 2002 to $9.8 million for the quarter ended December 31, 2003.
Decreases in domestic machine sales of machines in the United States are
primarily attributable to an increase in competition at our large customers and
erosion of the average selling price per unit as compared to the same period in
2002. The decrease in music sales is attributable to the loss of placement of
our music at one major customer and a reduction of sales with two other major
retailers. Advertising allowances consist of co-operative advertising, marketing
development funds and specific advertising.
GROSS PROFIT
Gross profit for the quarter ended December 31, 2003 was ($2,601,125)
or (8.3%) of net sales compared to $9,031,320 or 19.8% of net sales for the
quarter ended December 31, 2002. This decrease in gross profit can be attributed
to sales of our karaoke machines at lower prices and pricing pressure based on
increased competition. In addition, we took a reserve against the value of
inventory in the amount of $4,998,126 from historical cost for its anticipated
recovery value. Another factor in decreased gross profit is the shortfall on the
minimum royalty guarantee in our MTV license agreement. We expensed an
additional $609,000 in the quarter to cover this shortfall. We also wrote down
the remaining book value of dies associated with items that we are discontinuing
from our line in the amount of $508,480. We anticipate that the gross profit
percentage for the remainder of the fiscal year will remain below last year's.
OPERATING EXPENSES
Operating expenses were $5,468,029 or 19.1% of net sales for the
quarter ended December 31, 2003 compared to operating expenses of $3,950,088 or
8.7% for the quarter ended December 31, 2002. The expenses increased over prior
year by $1.1 million. The primary factors that contributed to the increase in
operating expenses for the quarter ended December 31, 2003 are:
(i) Increased sales and music costs of $562,028 made up of
increased commissions of $257,456, increase in freight to
customers of $192,220, increased payroll and related costs of
$255,313 which are offset by decreases in advertising and
public relations of $92,394, reduced handling charges of
$27,116 and other decreases totaling $23,451 primarily made up
of decreases in showroom rent and sales expenses.
(ii) Increases in expenses at the wholly-owned Hong Kong subsidiary
totaling $554,588 which is primarily comprised of increases in
depreciation of newly acquired assets of $109,588, $392,000
for the recognition of bad debts and the remaining increases
of $53,000 is primarily bank charges and development expenses.
14
(iii) Increased in SG&A of the Florida Operations of $189,571 which
is primarily attributable to increases in accounting of
$66,541, amortization of loan costs $48,704, bad debt expense
$249,512, legal costs $90,964, and consulting fees of $117,981
which were offset by decreases in payroll and related costs of
$296,592, and other decreases totaling $87,539 consisting of
primarily insurance, travel and outside computer services.
(iv) Decreases in warehousing expenses offset the above increases
by $174,017 which was consisted of reductions in payroll and
related costs of $219,408, lower packaging and warehouse
expenses totaling $62,359 which were offset by increased rent
paid to store the additional inventory carried forward from
fiscal 2003 of $86,302, and other increases totaling $21,449
which was primarily additional repairs and maintenance.
OTHER EXPENSES
Net other expenses were $655,079 for the quarter ended December 31,
2003 compared with net expenses of $79,076 at December 31, 2002. Our interest
expense increase significantly to $687,178 in the quarter ended December 31,
2003 compared to interest expense of $117,704 in the quarter ended December 31,
2002. Our increased interest expense was due to the increased use of our credit
facility at a higher interest rate than the prior year and the amortization of
deferred fees and discounts associated with our convertible debentures.
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 December 31, 2003,
the Company concluded that a valuation allowance was needed against all of the
Company's deferred tax assets, as it is not more likely than not that the
deferred taxes will be realized. For the three months ended December 31, 2003,
the Company recorded a tax provision of $2.2 million. This occurred because the
valuation allowance established against the deferred tax asset exceeded the
amount of the benefit created from carrying back a portion of the current period
losses. The carry-back of the losses from the current period resulted in an
income tax receivable of $1.2 million, which is included in prepaid and other
current assets in the accompanying balance sheets. The Company has now exhausted
its ability to carry back any further losses and therefore will not be able to
recognize tax benefits on future losses including its expected fourth quarter
loss.
The Company's wholly-owned 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 2004, 2003, 2002, and 2001. For the nine months ended
December 31, 2003, a provision of $424,763 was recorded at the Hong Kong
statutory rate of 17.5%. Current Hong Kong taxes payable on the earnings of the
Company's Hong Kong subsidiary totaled $2.9 million at December 31, 2003.
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.
NET LOSS (EARNINGS)
As a result of the forgoing, our net loss for the three months ended
December 31, 2003 was $10,450,601 as compared with net income of $3,320,527 for
the three months ended December 31, 2002.
NINE MONTHS ENDED DECEMBER 31, 2003 COMPARED TO THE NINE MONTHS ENDED DECEMBER
31, 2002
NET SALES
Net sales for the nine months ended December 31, 2003 decreased 16.9%
to $68,053,739 as compared to $81,915,443 for the nine months ended December 31,
2002. Sales to International customers increased $14.6 million over the same
period in the prior year, as sales in the United States decreased $33.7 million.
New customers and increased purchases by existing customers contributed to the
increase in the European market. Our sales in the United States decreased
primarily because of the increased competition in this market. Approximately
$5.6 million of this decrease is from the music sector of our business. We lost
one significant customer and had reduced sales in two other major retailers. 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 and specific advertising.
These allowances are variable and are negotiated every year and since there is
no separate and identifiable benefit to the company, such amounts are recorded
as a reduction of sales.
15
GROSS PROFIT
Gross profit for the nine months ended December 31, 2003 was $2,596,449
or 3.8% of sales as compared to $17,760,348 or 21.7% of sales for the nine
months ended December 31, 2002.
The decrease in gross profit during the nine months ended December 31,
2003 is a result of:
- Competitive pricing pressure on machine pricing
- Sales of excess inventory at significantly reduces prices
- A 31% decline in the sales of higher margin music
- A reserve against the value of inventory on hand at December
31, in the amount of $4,998,126 for our anticipated recovery
value
- An impairment charge for tools in the amount of $508,480
- Increased sales from International SMC to international and
domestic customers. These sales usually carry lower gross
margins, as the customer pays for the ocean freight and
clearance of the goods.
- Increased expense of the guaranteed minimum royalty on our MTV
license of $998,000.
Even though we have taken a reserve that we believe is sufficient to cover any
losses against the value of inventory, there can be no assurance that we will be
able to recover its remaining value through sales of the products. Any
additional reduction that may be necessary may have a material impact in future
periods. As we continue to reduce the amount of inventory in our warehouses, we
anticipate gross margins to remain low.
OPERATING EXPENSES
Operating Expenses increased over the same period in the prior year to
$13.6 million from $11.5 million. The primary reasons for the increase in
operating expenses are as follows:
i) Increases in total cash and stock compensation of $724,895
ii) Increases in bad debt expense and at the wholly-owned Hong
Kong subsidiary of $392,000
iii) Increases with respect to the need to warehouse the excess
inventory carried over from March 2003 totaling $492,119
iv) Increases paid to legal, accounting fees totaling $626,185
v) Increased costs related to the amendments required to secure
the financing from LaSalle and related consulting costs
totaling $432,223
vi) Increases in bad debts for the domestic operations
attributable to the KB Toys and FAO bankruptcy filings of
$263,289
vii) Increase in charitable contributions, insurance and fixing
fees associated with the production of music and customer
service totaling $304,134
viii) Offset by a decrease to direct advertising $697,119 and
decreases in freight to customers of $452,092
OTHER EXPENSES
Other expenses were $1,245,424 for the nine months ended December 31,
2003 compared to net other expenses of $20,006 at December 31, 2002. Our
interest expense increased by $965,944 during the nine months ended December 31,
2003 compared to interest expense in the same period of the prior year. Our
interest expense increased due to the increased use of our credit facility at a
higher interest rate than the prior year, as well as the amortization of
deferred expenses associated with the convertible debentures. The remaining
$259,474 is attributable to other miscellaneous expenses such as exchange
differences.
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 December 31, 2003,
the Company concluded that a valuation allowance was needed against all of the
Company's deferred tax assets, as it is not more likely than not that the
deferred taxes will be realized. For the nine months ended December 31, 2003,
the Company recorded a tax provision of $1.2 million. This occurred because the
valuation allowance established against the deferred tax asset exceeded the
16
amount of the benefit created from carrying back a portion of the current period
losses. The carry-back of the losses from the current period resulted in an
income tax receivable of $1.2 million, which is included in prepaid and other
current assets in the accompanying balance sheets. The Company has now exhausted
its ability to carry back any further losses and therefore will not be able to
recognize tax benefits on future losses including its expected fourth quarter
loss.
The Company's wholly-owned 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 2004, 2003, 2002, and 2001. For the nine months ended
December 31, 2003, a provision of $424,763 was recorded at the Hong Kong
statutory rate of 17.5%. Current Hong Kong taxes payable on the earnings of the
Company's Hong Kong subsidiary totaled $2.9 million at December 31, 2003.
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.
NET LOSS (EARNINGS)
As a result of the forgoing, our net loss for the nine months ended
December 31, 2003 was $13,424,622 compared with net income of $5,957,136 for the
nine months ended December 31, 2002.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 2003, we had cash on hand of $235,958 and a bank
overdraft of $85,236 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 to
$14,729,176 for the nine months ended December 31, 2003 due to the amount of
sales that occurred in November and December, as well as some customer terms
which exceed 45 days.
Our inventory has been steadily decreasing since March 31, 2003, as we
are shipping goods to our customers. As of December 31, 2003, we had $8 million
in inventory, net of a provision for loss of $6,195,197 compared to $25 million
as of March 31, 2003.
Our current liabilities decreased to $18,911,314 as of December 31,
2003, compared to $21,249,930 at March 31, 2003. Current liabilities consist of
accounts payable of $5,329,648, accrued expenses of $2,587,567, accrual for
income taxes of $2,872,509, subordinated debt of $1 million, bank overdraft of
$85,136 and the revolving credit facilities of $7,109,622.
Approximately $2.7 million or 51% of our accounts payable are due to
two factories in China. This amount is aged beyond the terms originally set by
the factories.. We have been in contact with these factories regarding these
amounts and they have not pursued any means of collection. We intend to enter
into payment plans with these factories, but cannot ensure that this will occur.
If these factories pursue any claims against us, it could have a material effect
on our operations. The remainder of accounts payable of $2.6 million are within
terms set by our vendors.
During fiscal 2003, we had a credit facility with LaSalle Business
Credit, LLC. Under this agreement, LaSalle advanced up funds to us based on our
eligible accounts receivable and inventory. The loan was secured by a first lien
on all of present and future assets, except specific tooling located in China.
During fiscal 2004, the maximum amount that we were permitted to borrow under
the credit facility was $7.5 million.
Because we had minimal liquidity and had defaulted under our credit
agreement with LaSalle, we received a going concern paragraph from our
independent certified public accountants for our audited financial statements
for fiscal 2003. On March 14, 2003, we were notified by LaSalle that we were in
violation of the tangible net worth covenant in our credit facility and were
declared in default. LaSalle amended the credit facility on August 19, 2003 in a
fourteenth amendment, which extended the loan until March 31, 2004 and the
condition of default was waived. On December 31, 2003, we violated the tangible
net worth requirement and working capital requirement of our credit facility.
On January 31, 2004, we paid this loan in full, terminated this credit
facility and LaSalle released its security interest in our assets.
On February 9, 2004, we executed a factoring agreement with Milberg
Factors, Inc. Pursuant to the agreement, Milberg, at its discretion, will
advance the Company the lesser of 80% of our accounts receivable or $3.5
million. All receivables submitted to Milberg are subject to a fee equal to 0.8%
of the gross invoice value. The average monthly balance of the line will incur
interest at a rate of prime plus .75%. Other terms of the agreement include
minimum fees of $200,000 per calendar year, $7.5 million tangible net worth and
$7.5 million working capital. To secure these advances, Milberg received a
security interest in all of our accounts receivable and inventory located in the
United States and a pledge of 66 2/3% of the stock in International SMC (HK)
Ltd, our wholly-owned subsidiary. This agreement is effective for an initial
term of two years, with successive automatic renewals unless either party gives
notice of termination.
Although this credit line is not equivalent to our previous lines, we
believe that advances under this credit facility, as well as collection of our
outstanding accounts receivable, will allow us enough available cash flow to
continue operations until August 2004 and prepare for the upcoming fiscal year.
We have been receiving collections of accounts receivable since the termination
of our LaSalle agreement, which have served as working capital and enabled us to
pay our obligations.
In order to further increase our liquidity, we are selling our excess
inventory and reducing our cost structure. As of February 11, 2004, we have
orders on hand of about $2.5 million and had already shipped over $1.0 million,
which is ahead of our projected target for most of the old inventory. Our goal
is to sell $3 to $4 million of old inventory by March 31, 2004. However, we can
not provide you with any assurances that we will be able to sell this inventory.
17
We have taken several steps to decrease our costs. Since June 2003, we have had
two rounds of lay-offs at our company. In January 2004, our senior executive
officers agreed to take 20% salary reductions and other employees also agreed to
salary reductions. Additionally, we have also subleased some of our warehouse
space in California and Florida and hope to sublease out more. As our plans are
put into place we should see reductions of our overhead expenses by more than
20% of last years amounts.
We do not intend to enter into any additional material commitments for
the Company in the near future. We will be incurring only normal course of
business expenses such as: rent, utilities, salaries and related expenses,
accounting, legal, bank charges, interest, office supplies, and other expenses
that may become necessary as they relate to repairs and maintenance of our
leased facilities and computer equipment. We will also incur expenses for any
outstanding operating leases that are currently in place (see commitment table
below).
We intend to finance our business in fiscal 2005 through:
(i) Continued support from our Chinese factories in financing our
purchases and entering into agreements for payment of old
receivables;
(ii) Selling the remainder of our inventory on hand;
(iii) Continuing to reduce costs;
(iv) Using our credit facility with Milberg Factors; and
(v) Utilizing credit facilities that are available to our
wholly-owned subsidiary to finance all direct shipments.
In order to reduce the need to maintain inventory in United States
locations in fiscal 2005, we intend to generate a larger share of our total
sales through FOB sales from our wholly-owned subsidiary. These sales are
shipped directly to our customers from the ports in China and are primarily
backed by letters of credit. The customers take title to the merchandise at
their consolidators in China and are responsible for their shipment, duty,
clearance and freight charges to their locations. We will also assist our
customers in the forecasting and management of their inventories of our product.
If we need additional financing during our peak selling season, we
intend to approach Milberg. If Milberg is not willing to provide us with
additional financing, we will need to seek additional capital from other
sources. However, we can not assure that we will be able to obtain additional
financing or that the terms will be acceptable to us. If we need to obtain
additional financing and fail to do so, it may have a material adverse effect on
our ability to meet our financial obligations and continue to operate.
Debt and Contractual Obligations
Our 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 Facilities $7,115,114 $7,115,114 -- -- -- --
Convertible Debentures $4,000,000 -- -- $4,000,000 -- --
Merchandise license guarantee reflects amounts that we are obligated to
pay as guaranteed royalties under our various license agreements. In fiscal
2003, we had guaranteed minimum royalty payments under our license agreements
with MTV Networks, Nickelodeon, Hard Rock Academy and Motown (Universal Music).
In fiscal 2004, we have guaranteed minimum royalty payments under the license
agreement with MTV and Motown (Universal Music).
We have leases for property in Rancho Dominguez and Compton California,
as well as in Coconut Creek, Florida. We have equipment leases for forklifts and
copy machines. Our revolving credit facility represents our credit facility with
LaSalle Business Credit, LLC, which was terminated as of January 31, 2004.
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 1,038,962 shares of common stock at
$3.85 per share, subject to adjustment in certain situations. We also issued an
aggregate of 457,143 warrants to the investors. The exercise price of the
warrants is $4.025 per share and the warrants expire on September 7, 2006. We
have an obligation to register the shares of common stock underlying the
debenture and warrants and filed a registration statement on Form S-1 to
register the shares on October 9, 2003.
Effective as of February 9, 2004, we amended the convertible debenture
agreements to increase the interest rate to 8.5% per annum effective as of
February 9, 2004, and grants warrants to purchase an aggregate of 30,000 shares
of the Company's common stock to the debenture holders on a pro-rata basis.
These concessions were in consideration of the debenture holder's agreements to
(i)enter into new subordination agreements with the Company's new lender,
Milberg Factors, (ii) to waive all liquidated damages due under the convertible
debentures and related transaction documents through July 1, 2004 and (iii) to
extend the effective date of the Form S-1 registration statement until July 1,
2004. The new warrants have an exercise price equal to $1.52 per share, the fair
market value of the Company's common stock on February 9, 2004, the date of the
grant.
Sources and uses of Cash
Cash flows used in operating activities were $4,998,092 for the nine
months ended December 31, 2003. Cash flows were used in operating activities
primarily due to increases in accounts receivable in the amount of $9.4 million,
decreases in accounts payable of $3.2 million and decreases in existing
inventory of $12.2 million, as well as the loss for the period and other
non-cash expenses such as the tooling impairment and provision for inventory
losses.
Cash used in investing activities for the nine months ended December
31, 2003 was $434,065. Cash used in investing activities resulted from the
purchase of fixed assets in the amount of $434,065. 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 three years.
18
Cash flows provided by financing activities were $5,399,851 for the
nine months ended December 31, 2003. This consisted of proceeds from the
exercise of options in the amount of $981,972. We also issued convertible
debentures with detachable stock purchase warrants. This transaction resulted in
a gross increase in cash of $4 million. We received subordinated debt from
related parties of $1 million in July of 2003 and paid $400,000 to a director
who had previously loaned money to our Company on a short term basis. The
remainder of cash provided from financing activities was provided by net
repayments on the credit line at LaSalle National Bank in the amount of
$4,308,438 and borrowings on the credit lines in Hong Kong in the amount of
$4,640,728 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.
SEASONAL AND QUARTERLY RESULTS
Historically, our 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 our
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.
Our 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 our operations. We have
historically passed any price increases on to its customers since prices charged
by us 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. Our management
believes that a high degree of judgment or complexity is involved in the
following areas:
Reserves on Inventories. We establish 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 our 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 December
31, 2003, the Company concluded that a valuation allowance was needed against
all of the Company's deferred tax assets, as it is not more likely than not that
the deferred taxes will be realized. For the nine months ended December 31,
2003, the Company recorded a tax provision of $1.2 million. This occurred
because the valuation allowance established against the deferred tax asset
exceeded the amount of the benefit created from carrying back a portion of the
current period losses. The carry-back of the losses from the current period
resulted in an income tax receivable of $1.2 million, which is included in
prepaid and other current assets in the accompanying balance sheets. The Company
has now exhausted its ability to carry back any further losses and therefore
will not be able to recognize tax benefits on future losses including its
expected fourth quarter loss.
The Company's wholly-owned 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 2004, 2003, 2002, and 2001. For the nine months ended
December 31, 2003, a provision of $424,763 was recorded at the Hong Kong
statutory rate of 17.5%. Current Hong Kong taxes payable on the earnings of the
Company's Hong Kong subsidiary totaled $2.9 million at December 31, 2003.
19
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.
Collectibility of Accounts Receivable. Our allowance for doubtful
accounts is based on management's estimates of the creditworthiness of its
customers, current economic conditions and historical experience, 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 our Company, this allowance may need to be significantly
increased, which would have a negative impact on operations.
Other Estimates. We make 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
RISKS RELATED TO THE COMPANY'S BUSINESS AND OPERATIONS
WE HAVE SIGNIFICANT WORKING CAPITAL NEEDS AND IF WE ARE UNABLE TO OBTAIN
ADDITIONAL FINANCING, WHEN NEEDED, WE MAY NOT HAVE SUFFICIENT CASH FLOW TO RUN
OUR BUSINESS
As of February 13, 2004, our cash on hand is limited. During the next
three months, we plan on financing our working capital needs from the collection
of accounts receivable and using the funds that are advanced to us by Milberg
under our factoring agreement. We also plan on selling our remaining inventory
on hand. If these sources do not provide us with adequate financing, we may try
to seek financing from a third party; however, we will have to obtain consent
from Mlberg prior to obtaining any other financing. If we are not able to obtain
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 bankruptcy under Chapter 11 of the U.S.
Bankruptcy Code or enter into some liquidation or reorganization proceeding.
WE MAY BE DEEMED TO INSOLVENT AND WE MAY GO OUT OF BUSINESS
As of February 9, 2004, our cash position is limited. We are not able
to pay all of our creditors on a timely basis. We are not current on
approximately $2.7 million of outstanding accounts payable, which represents
accounts payable to factories in China. If we are not able to pay our current
debts as they become due, we may be deemed to be insolvent and we may go out of
business.
OUR INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS RAISED SUBSTANTIAL DOUBT ABOUT OUR
ABILITY TO CONTINUE AS A GOING CONCERN FOR THE FISCAL YEAR ENDED MARCH 31, 2003-
We received a report dated June 24, 2003 (except for Note 9, as to
which the date is July 8, 2003 and Note 15, as to which the date is July 10,
2003) from our independent certified public accountants covering the
consolidated financial statements for our fiscal year ended March 31, 2003 that
included an explanatory paragraph which stated that the financial statements
were prepared assuming the Company would continue as a going concern. This
report stated that a then-existing default under our credit agreement with
LaSalle Business Credit raised substantial doubt about our ability to continue
as a going concern.
We paid our loan with LaSalle in full effective as of January 31, 2004
and terminated the agreement. We will replaced the LaSalle credit facility by
entering into a factoring agreement with Milberg Factors, Inc., effective as of
February 9, 2004. Pursuant to the agreement, Milberg, at its discretion, will
advance the Company with the lesser of 80% of our eligible accounts receivable
or $3.5 million. We do not know if this factoring agreement will provide us with
sufficient capital. If the agreement with Milberg does not provide sufficient
capital or that we are unable to obtain additional financing, we may have a
liquidity problem and this would affect our ability to continue our business
operations.
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
20
customers accounted for 21%, 17% and 15% of our net sales. We do not have
long-term contractual arrangements with any of our customers and they can cancel
their orders at any time prior to delivery. A substantial reduction in or
termination of orders from any of our largest customers would decrease 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, 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 nine months ended December 31, 2003, our sales to
customers in the United States decreased because of increased competition and
the increased amount of inventory that we had on hand, which was sole near or
below cost. We are also subject to the risk that our customers might demand
certain financial incentives, such as large advertising or cooperative
advertising allowances, which effectively reduce 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, we are subject to the risks and costs of
carrying inventory during the time period between the placement of the order and
the delivery date, which reduces our cash flow.
OUR GROSS PROFIT MARGINS HAVE DECREASED OVER THE PAST YEAR AND WE EXPECT THE
TREND TO CONTINUE
Over the past year, our gross profit margins have decreased. In the
nine months ended December 31, 2003, our gross profit margin was 4.6% compared
to 21.7% in the nine months ended December 31, 2002 and for the three months
ended December 31, 2003 and 2002, our gross margin was (9.1%) and 19.8%,
respectively. This decline resulted from price competition and a shift in
customer orders from our parent company in the United States to our Hong Kong
subsidiary, International SMC. International SMC delivers our karaoke products
to customers directly from our manufacturer's factories in China and therefore
does not provide logistics, handling, warehousing and just in time inventory
support, which services are provided by our parent company in the United States.
Accordingly, the average sales price per unit realized by International SMC is
significantly lower than that of our parent company in the United States. We
expect further price competition and a continuing shift of sales volume to
International SMC. Accordingly, we expect that our gross profit margin will
decrease in fiscal 2004.
OUR SENIOR CORPORATE MANAGEMENT TEAM IS NEW TO THE SINGING MACHINE AND IS
REQUIRED TO DEVOTE SIGNIFICANT ATTENTION TO OUR FINANCING AGREEMENTS AND
SETTLING OUR CLASS ACTION LAWSUITS.
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 the 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 appointed 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 and our new board of
directors to learn about our business and to develop strong working
relationships with each other and our employees. In particular, coordination
between various divisions of our company have not been systematized and morale
has suffered as a consequence. Our new senior corporate management's ability to
complete this process has been and continues to be hindered by the time that it
needs to devote to other pressing business matters. New management needs to
spend significant time on restructuring our financing agreements and overseeing
legal matters, such as our class action lawsuit. We cannot assure you that this
major restructuring of our board of directors and senior management and the
accompanying distractions, in this environment, will not adversely affect our
results of operations.
21
THE SEC IS CONDUCTING AN INFORMAL INVESTIGATION OF THE COMPANY AND IF WE HAVE
DONE SOMETHING ILLEGAL, WE WILL BE SUBJECT TO FINES, PENALTIES AND OTHER
SANCTIONS BY THE SEC
In August 2003, we were advised that the SEC had commenced an informal
investigation of our company. It appears that the investigation is focused on
the restatement of our financial statements in fiscal 2002 and 2001; however,
the SEC may be reviewing other issues as well. If the SEC finds that our company
has not fully complied with all applicable federal securities laws, we could be
subject to fines, penalties and other sanctions imposed by the SEC.
WE ARE NAMED AS A DEFENDANT IN A CLASS ACTION LAWSUIT RELATING TO THE
RESTATEMENT OF OUR FINANCIAL STATEMENTS FOR FISCAL 2002 AND FISCAL 2001, WHICH
IF DETERMINED ADVERSELY TO US, COULD RESULT IN THE IMPOSITION OF DAMAGES AGAINST
US AND HARM OUR BUSINESS AND FINANCIAL CONDITION
We are named as a defendant in a class action lawsuit which arose from
the restatement of our financial statements for fiscal 2002 and 2001. In this
lawsuit, the plaintiffs allege that our executive officers and our company
violated Section 10(b) and Section 20(a) of the Securities Exchange Act of 1934
and Rule 10(b)-5. The plaintiffs seek compensatory damages, attorney's fees and
injunctive relief. While the specific factual allegations vary slightly in each
case, the complaints generally allege that our officers falsely represented the
Company's financial results during the relevant class periods. As of December
31, 2003, we had incurred approximately $125,000 of legal fees to defend the
class action lawsuit and it has significantly diverted the attention of our
management team. There can be no assurance that we will be able to settle this
litigation on acceptable terms or obtain a favorable resolution in court if we
do not settle this matter. If a significant monetary judgment is rendered
against us, we are not certain that we will have the ability to pay such a
judgment. Any losses resulting from these claims could adversely affect our
profitability and cash flow.
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 important to our business. We
generated $30,884,344 or 32.3% of our net sales from products sold under the MTV
license in fiscal 2003. During the nine months ended December 31, 2003, we
generated only $8.3 million or 12.2% of our net sales under this MTV license
agreement. Our MTV license was extended until April 30, 2004 with options for
MTV to renew for two additional periods through December 31, 2004; however, MTV
can terminate the license agreement for certain reasons over the course of the
calendar year 2004. If we were to lose our MTV license, it would have an effect
on our revenues and net income.
WE EXPERIENCE DIFFICULTY FORECASTING THE DEMAND FOR OUR KARAOKE PRODUCTS
Because of our reliance on manufacturers in Asia for our machine
production, our production lead times range from one to four months. Therefore,
we must commit to production in advance of customers orders. It is difficult to
forecast customer demand because we do not have any scientific or quantitative
method to predict this demand. Our forecasting is based on management's general
expectations about customer demand, the general strength of the retail market
and management's historical experiences. As of December 31, 2003, we had $14.2
million in inventory against which a $6.2 million reserve has been taken.. We
will attempt to liquidate this inventory over the next six months. However, if
we are unable to sell this inventory, our revenues, cash flow and profitability
will be reduced.
OUR BUSINESS IS SEASONAL AND THEREFORE OUR ANNUAL OPERATING RESULTS WILL DEPEND,
IN LARGE PART, ON OUR SALES DURING THE RELATIVELY BRIEF HOLIDAY SEASON
Sales of consumer electronics and toy products in the retail channel
are highly seasonal, with a majority of retail sales occurring during the period
from September through December in anticipation of the holiday season, which
includes Christmas. A substantial majority of our sales 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. Our sales would be disproportionately adversely affected by
terrorist attacks, military engagements or other extraordinary events that
negatively affect the retail environment or consumer buying patterns.
IF WE ARE UNABLE TO COMPETE IN THE KARAOKE PRODUCTS CATEGORY, OUR REVENUES AND
NET PROFITABILITY WILL BE REDUCED
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 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. To the extent our leading competitors
reduce prices on their karaoke machines and music, we must remain flexible to
22
reduce our prices. If we are forced to reduce our prices, it will result in
lower margins and reduced profitability. 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.
IF WE ARE UNABLE TO DEVELOP NEW KARAOKE PRODUCTS, OUR REVENUES MAY NOT CONTINUE
TO GROW
The karaoke industry is characterized by rapid technological change,
frequent new product introductions and enhancements and ongoing customer demands
for greater performance. In addition, the average selling price of any karaoke
machine has historically decreased over its life, and we expect that trend to
continue. As a result, our products may not be competitive if we fail to
introduce new products or product enhancements that meet evolving customer
demands. The development of new products is complex, and we may not be able to
complete development in a timely manner, or at all. During the past twelve
years, Edward Steele, our former Chief Executive Officer, oversaw new product
development. Mr. Steele will be retiring from our company on February 28, 2004
and we have not yet identified a successor who will oversee new product
development. To introduce products on a timely basis, we must:
- accurately define and design new products to meet market
needs;
- design features that continue to differentiate our products
from those of our competitors;
- transition our products to new manufacturing process
technologies;
- identify emerging technological trends in our target markets;
- anticipate changes in end-user preferences with respect to our
customers' products;
- bring products to market on a timely basis at competitive
prices; and
- respond effectively to technological changes or product
announcements by others.
We believe that we will need to continue to enhance our karaoke machines and
develop new machines to keep pace with competitive and technological
developments and to achieve market acceptance for our products.
OUR PRODUCTS ARE SHIPPED FROM CHINA AND ANY DISRUPTION OF SHIPPING COULD PREVENT
OR DELAY OUR CUSTOMERS' RECEIPT OF INVENTORY
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 otherwise prevent or delay
our customers' receipt of inventory. If we our customers do not receive their
inventory on a timely basis, they may cancel their orders or return products to
us. Consequently, our revenues and net income would be reduced.
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, foreign currency fluctuations,
limitations on the repatriation of earnings and political instability, 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 our 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 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.
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.
23
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 sales growth and
profitability.
WE MAY HAVE INFRINGED ON THE COPYRIGHTS OF CERTAIN MUSIC PUBLISHERS AND IF WE
VIOLATE FEDERAL COPYRIGHT LAWS, WE WILL BE SUBJECT TO MONETARY PENALTIES
Over the past two years, we have received notices from three music
publishers who have alleged that we did not have the proper copyright licenses
to sell certain songs included in our CD+G's. We have settled all of these
copyright infringement issues with these publishers. If we discover that we do
not have the proper copyright licenses for any other songs that are included in
our CD+G's and cassettes, we will be subject to additional liability under the
federal copyright laws, which could include settlements with the music
publishers and payment of monetary damages.
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 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.
During fiscal 2000, Tanashin Denki, Ltd., a Japanese company that holds a patent
on a cassette tape drive mechanism alleged that some of our karaoke machines
violated their patents. We settled the matters with Tanashin in December 1999.
Subsequently in December 2002, Tanashin again alleged that some of our karaoke
machines violated their patents. We entered into another settlement agreement
with them in May 2003. In addition to Tanashin, we could receive infringement
claims from other third parties. Any infringement claims may have a negative
effect on our profitability and financial condition.
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, FAO Schwarz and KB Toys, have engaged in leveraged buyouts or
transactions in which they incurred a significant amount of debt, and operated
under the protection of bankruptcy laws. As of February 4, 2004, we are aware of
only two customers, FAO Schwarz and KB Toys, which are operating under the
protection of bankruptcy laws. In fiscal 2003, FAO Schwarz and KB Toys
represented less than 1% of our revenues and we expect that revenues from this
account will be less than 2% of our revenues in fiscal 2004. 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 result in bad debt expense to us and have a material adverse
effect on our revenues and future profitability.
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
substantially decrease our revenues and profitability.
24
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 occurs and we do not have a sufficient level
of inventory, a strike or work slow-down would result in increased costs to us
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
From December 1, 2002 through December 1, 2003, our common stock has
traded between a high of $13.10 and a low of $2.15. During this period, we have
restated our earnings, lost senior executives and Board members, had liquidity
problems and defaulted on our line of credit with LaSalle. Our stock price may
continue to be volatile based on similar or other adverse developments in our
business. In addition, the stock market periodically experiences significant
adverse price and volume fluctuations which may be unrelated to the operating
performance of particular companies.
IF INVESTORS SHORT OUR SECURITIES, IT MAY CAUSE OUR STOCK PRICE TO DECLINE
During the past year, a number of investors have held a short position
in our common stock. Based on reports received from ViWes InvestInfo, the ratio
for the number of shares short compared to the daily average volume in our stock
as of the dates was as follows:
Shares Average Daily
Month* Short Volume Ratio
------ ----- ------ -----
8/03 437,590 53,721 8.15
7/03 423,623 167,066 2.54
6/03 600,440 68,480 8.77
5/03 606,841 30,280 20.04
4/03 584,510 27,359 21.36
3/03 584,185 22,195 26.32
*Monthly data as of settlement on the 15th of each month.
The anticipated downward pressure on our stock price due to actual or
anticipated sales of our stock by some institutions or individuals who engage in
short sales of our common stock could cause our stock price to decline.
Additionally, if our stock price declines, it may be more difficult for us to
raise capital.
OUR OBLIGATION TO MAKE SEVERANCE PAYMENTS COULD PREVENT OR DELAY TAKEOVERS
Our employment agreements with Yi Ping Chan, April Green, Jack Dromgold
and John Dahl 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, Mr. Dromgold and Mr. Dahl are entitled
to severance payments of $250,000, $73,600, $135,000 and $75,000, 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.
RISKS ASSOCIATED WITH OUR CAPITAL STRUCTURE
IF OUR OUTSTANDING DERIVATIVE SECURITIES ARE EXERCISED OR CONVERTED, OUR
EXISTING SHAREHOLDERS WILL SUFFER DILUTION
As of December 31, 2003, there were outstanding stock options to
purchase an aggregate of 1,120,120 shares of common stock at exercise prices
ranging from $1.97 to $14.00 per share, not all of which are immediately
exercisable. The weighted average exercise price of the outstanding stock
options is approximately $4.81 per share. As of December 31, 2003, there were
outstanding immediately exercisable warrants to purchase an aggregate of 561,039
shares of our common stock. 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.
25
THE $4 MILLION PRIVATE PLACEMENT THAT WE CLOSED IN SEPTEMBER 2003 WILL AFFECT
OUR ABILITY TO RAISE CAPITAL IN THE FUTURE
On September 8, 2003, we closed a private offering in which we issued
$4 million of convertible debentures and stock purchase warrants to six
institutional investors. As part of this investment, we agreed to several
limitations on our corporate actions, some of which limit our ability to raise
financing in the future. If we enter into any financing transactions during the
one year period after the registration statement, of which this Prospectus is a
part, is effective we need to offer the institutional investors the right to
participate in such offering in an amount equal to the greater of (a) the
principal amount of the debentures currently outstanding or (b) 50% of the
financing offered to the outside investment group. For example, if we offer to
sell $10 million worth of our securities to an outside investment group, the
institutional investors will have the right to purchase up to $5 million of the
offering. This right may affect our ability to attract other investors if we
require external financing to remain in operations. Furthermore, for a period of
90 days after the effective date of the registration statement, we cannot sell
any securities.
Additionally, we can not:
- sell any of our securities in any transactions where the
exercise price is adjusted based on the trading price of our
common stock at any time after the initial issuance of such
securities.
- sell any securities which grant investors the right to receive
additional shares based on any future transaction on terms
more favorable than those granted to the investor in the
initial offering
These limitations are in place until the earlier of February 20, 2006
or the date on which all the debentures are converted into equity.
IF WE SELL ANY OF OUR SECURITIES AT A PRICE LOWER THAN $3.85 PER SHARE, THE
CONVERSION PRICE OF OUR DEBENTURES AT $3.85 PER SHARE WILL BE REDUCED AND THERE
WILL BE ADDITIONAL DILUTION TO OUR SHAREHOLDERS
Given that our common stock is trading at a price of $2.22 per share as
of December 2, 2003, it is possible that we may need to sell additional
securities for capital at a price lower than $3.85 per share. If we sell any
securities at a price lower than $3.85 per share, the conversion price of our
debentures currently set at $3.85 per share will be reduced and there will be
more dilution to our shareholders if and when the debentures are converted into
shares of our common stock. If we issue or sell any securities at a price less
than $3.85 per share prior to September 8, 2004, the set price of the debentures
will be reduced by an amount equal to 75% of the difference between the set
price and the effective purchase price for the shares If such dilutive issuances
occur after September 8, 2004 but before the earlier of February 20, 2006 or
when all the debentures are converted into shares of our common stock, the set
price will be reduced by an amount equal to 50% of the difference between the
set price and effective purchase price of such shares. So, if we sold 1 million
shares of our common stock on December 1, 2003 for a price of $2.85 per share,
the set price of the debentures would be reduced by $1.22 to $2.63 and the
aggregate number of shares of our common stock that would be issued upon
conversion of the debentures would be increased from 1,038,963 shares to
3,278,689 shares.
FUTURE SALES OF OUR COMMON STOCK HELD BY CURRENT STOCKHOLDERS AND INVESTORS MAY
DEPRESS OUR STOCK PRICE
As of December 31, 2003, there were 8,756,318 shares of our common
stock outstanding. Of these shares, approximately 5,954,796 shares are eligible
for sale under Rule 144. 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, of which this Prospectus is a part, was filed in October 2003,
registering an aggregate of 2,795,465 shares of our common stock. The market
price of our common stock could drop due to the sale of large 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
shares of common stock. As of December 31, 2003, we had 8,756,318 shares of
common stock issued and outstanding and an aggregate of 1,580,439 shares
issuable under our outstanding options and warrants. We also have an obligation
to issue up to 1,038,962 shares upon conversion of our debentures and have
reserved 207,791 additional shares for interest payment on the debentures. As
such, our Board of Directors has the power, without stockholder approval, to
issue up to 7,423,561 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
26
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
December 31, 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 December 31, 2003, our outstanding balance
under our credit facility was $2,474,386 and we are accruing interest at the
prime plus 2.5% per annum. This loan was paid in full on January 30, 2004. We do
not believe that 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
27
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.
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 whom 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. We have entered into a settlement
agreement with AG Edwards, whereby we agreed to pay $181,067 over a six month
period and to issue them 40,151 shares of stock. These shares will be registered
by the form S-1 currently under amendment.
28
ITEM 2. CHANGES IN SECURITIES
(a) Not Applicable.
(b) Not Applicable.
(c) On December 19, 2003, we issued an aggregate of 221,920 options to our
employees, as consideration for services they had rendered to us. We issued
these options to our employees in reliance upon Section 4(2) of the Securities
Act, because our employees were knowledgeable, sophisticated and had access to
comprehensive information about us.
NAME NUMBER OF OPTIONS EXERCISE PRICE
---- ----------------- --------------
Frank Abell 1,320 $ 1.97
Josef Bauer 2,740 $ 1.97
Dan Becherer 4,910 $ 1.97
Almina Brady-Dykes 1,320 $ 1.97
Pam Broyles 500 $ 1.97
Elizabeth Canela 660 $ 1.97
Yi Ping Chan 52,800 $ 1.97
Belinda Cheung 110 $ 1.97
Jeffrey Chiu 220 $ 1.97
Brian Cino 660 $ 1.97
John Dahl 50,000 $ 1.97
April Green 4,380 $ 1.97
Alicia Haskamp 24,600 $ 1.97
Jeff Ho 5,000 $ 1.97
Michelle Ho 5,660 $ 1.97
Wilson Ho 220 $ 1.97
Irene Ko 660 $ 1.97
Rose Labadessa 5,000 $ 1.97
Bill Lau 5,990 $ 1.97
Doral Lee 5,660 $ 1.97
Nataly Lessard 1,320 $ 1.97
Marian McElligott 3,290 $ 1.97
Alyssa Malamud 1,000 $ 1.97
Bernardo Melo 4,000 $ 1.97
Rick Ng 110 $ 1.97
Dennis Norden 8,000 $ 1.97
Cathy Novello 880 $ 1.97
Jennifer O'Kuhn 440 $ 1.97
Jorge Otaegui 440 $ 1.97
John Petko 1,500 $ 1.97
Terri Phillips 660 $ 1.97
Melody Rawski 1,100 $ 1.97
Evelyn Romero 500 $ 1.97
Kristi Ronyak 1,000 $ 1.97
Rafael Ros 1,200 $ 1.97
Stacy Sethman 1,100 $ 1.97
Edward Steele 10,000 $ 1.97
John Steele 12,200 $ 1.97
Nicolas Venegas 440 $ 1.97
Ho Man Yeung 110 $ 1.97
Yen Yu 220 $ 1.97
On November 20, 2003, 40,151 shares of stock were issued to AG Edwards in
settlement of a disagreement on the terms of an investment banking agreement.
This stock was valued at $89,354, its market price on the date of grant. We
issued these shares to the AG Edwards & Sons, Inc. in reliance upon Section 4(2)
of the Securities Act, because it was knowledgeable, sophisticated and had
access to comprehensive information about us.
(d) Not applicable.
29
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
(A) EXHIBITS
EXHIBIT NO. DESCRIPTION
- ----------- --------------------------------------------------------------------
10.1 Factoring Agreement dated February 9, 2004 between Milberg Factors,
Inc. and the Company.*
10.2 Security Agreement for Goods and Chattels dated February 9, 2004
between Milberg Factors, Inc. and the Company.*
10.3 Security Agreement for Inventory dated February 9, 2004 between
Milberg Factors, Inc. and the Company.*
10.4 Second Amendment to the Transaction Documents dated February 9, 2004
between Omicron Master Trust, SF Capital Partners, Ltd, Bristol
Investment Fund, Ltd., Ascend Offshore Fund, ltd., Ascend Partners,
LP, Ascend Partners Sapient L.P. and the Company.*
10.5 Amendment to Domestic Licensing Agreement dated November 15, 2002
between the Company and MTV Networks, a division of Viacom
International, Inc.*
10.6 Fifth Amendment to Domestic Licensing Agreement dated December 23,
2003 between the Company and MTV Networks, a division of Viacom
International, Inc. (portions of this Exhibit 10.6 have been omitted
pursuant to a request for confidential treatment filed with the
Securities and Exchange Commission).*
10.7 Sales Agreement effective as of December 9, 2003 between the Company
and CPP Belwin, Inc. and its affiliates (portions of this Exhibit
10.7 have been omitted pursuant to a request for confidential
treatment filed with the Securities and Exchange Commission).*
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
(B) REPORTS ON FORM 8-K
During the three months ended December 31, 2003, we filed one Form 8-K. On
November 7, 2003, we filed a Form 8-K announcing our financial results for the
six months ended September 30, 2003.
30
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 FEBRUARY 17, 2004
By: /s/ April J. Green
-------------------------------------------
April J. Green
Chief Financial Officer
(On behalf of Registrant and
Chief Accounting Officer)
DATED FEBRUARY 17, 2004
By: /s/ Yi Ping Chan
-------------------------------------------
Yi Ping Chan
Chief Executive Officer
(On behalf of Registrant and
Principal Executive Officer)
31
EXHIBITS
EXHIBIT NO. DESCRIPTION
- ----------- -----------
10.1 Factoring Agreement dated February 9, 2004 between Milberg Factors,
Inc. and the Company.
10.2 Security Agreement for Goods and Chattels dated February 9, 2004
between Milberg Factors, Inc. and the Company.
10.3 Security Agreement for Inventory dated February 9, 2004 between
Milberg Factors, Inc. and the Company.
10.4 Second Amendment to the Transaction Documents dated February 9, 2004
between Omicron Master Trust, SF Capital Partners, Ltd, Bristol
Investment Fund, Ltd., Ascend Offshore Fund, ltd., Ascend Partners,
LP, Ascend Partners Sapient L.P. and the Company.
10.5 Amendment to Domestic Licensing Agreement dated November 15, 2002
between the Company and MTV Networks, a division of Viacom
International, Inc.
10.6 Fifth Amendment to Domestic Licensing Agreement dated December 23,
2003 between the Company and MTV Networks, a division of Viacom
International, Inc. (portions of this Exhibit 10.6 have been omitted
pursuant to a request for confidential treatment filed with the
Securities and Exchange Commission).
10.7 Sales Agreement effective as of December 9, 2003 between the Company
and CPP Belwin, Inc. and its affiliates (portions of this Exhibit
10.7 have been omitted pursuant to a request for confidential
treatment filed with the Securities and Exchange Commission).
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.