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 quarter ended June 30, 2004
0 - 24968
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Commission File Number
THE SINGING MACHINE COMPANY, INC.
---------------------------------
(Exact Name of Small Business Issuer as Specified in its Charter)
DELAWARE 95-3795478
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(State of Incorporation ) (IRS Employer I.D. No.)
6601 Lyons Road, Building A-7, Coconut Creek, FL 33073
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(Address of principal executive offices)
(954) 596-1000
--------------
(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 JULY 30, 2004
----- ----------------------------
Common Stock, $0.01 par value 8,802,318
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Page No.
--------
Consolidated Balance Sheets - June 30, 2004 (Unaudited)
and March 31, 2004 .............................................. 3
Consolidated Statements of Operations - Three months
ended June 30, 2004 and 2003 (Unaudited) .................... 4
Consolidated Statements of Cash Flows - Three months ended
June 30, 2004 and 2003 (Unaudited) .......................... . . 5
Notes to Consolidated Financial Statements ...................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ............................. 11
Item 3. Quantitative and Qualitative Disclosure About Market Risk . . . . 23
Item 4. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . 24
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ............................................... 25
Item 2. Changes in Securities ........................................... 25
Item 3. Defaults Upon Senior Securities ................................. 25
Item 4. Submission of Matters to a Vote of Security Holders ............. 25
Item 5. Other Information ............................................... 25
Item 6. Exhibits and Reports on Form 8-K ................................ 25
SIGNATURES ............................................................... 27
Exhibits
2
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
June 30 March 31
2004 2004
------------ ------------
(UNAUDITED)
Assets
------
Current Assets
Cash and cash equivalents $ 313,574 $ 356,342
Restricted Cash 863,968 874,283
Accounts Receivable, less allowances of $76,617
and $98,009, respectively 2,020,834 3,806,166
Due from manufacturers 228,169 95,580
Inventories 4,763,060 5,923,267
Prepaid expense and other current assets 1,112,962 783,492
Insurance receivable 800,000 800,000
Refundable tax 1,111,401 1,178,512
------------ ------------
TOTAL CURRENT ASSETS 11,213,968 13,817,642
PROPERTY AND EQUIPMENT, at cost less accumulated depreciation
of $2,700,000 and $2,567,000 respectively 869,782 983,980
OTHER ASSETS
Other non-current assets 551,070 615,773
------------ ------------
TOTAL ASSETS $ 12,634,820 $ 15,417,395
============ ============
Liabilities and Shareholders' (Deficit) Equity
----------------------------------------------
Current Liabilities
Bank overdraft $ 55,504 $ 62,282
Accounts payable 3,852,160 4,651,675
Accrued expenses 2,796,912 3,481,905
Customer credits on account 1,806,784 2,111,484
Convertible debentures, net of unamortized discount of $2,221,796 1,778,204 1,445,489
and $2,554,511, respectively
Subordinated debt-related parties 1,000,000 1,000,000
Note payable - related party 40,000 --
Income taxes payable 2,554,952 2,447,746
------------ ------------
TOTAL CURRENT LIABILITIES 13,884,516 15,200,581
SHAREHOLDERS' (DEFICIT) 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, $0.01 par value; 18,900,000 shares authorized;
8,802,318 and 8,171,678 shares issued and outstanding 88,023 87,523
Additional paid-in capital 10,104,998 10,052,498
Accumulated (deficit)/retained earnings (11,442,717) (9,923,207)
------------ ------------
TOTAL SHAREHOLDERS' (DEFICIT) EQUITY (1,249,696) 216,814
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' (DEFICIT)$EQUITY $ 12,634,820 $ 15,417,395
============ ============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
3
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
FOR THREE MONTHS ENDING JUNE 30
-------------------------------
2004 2003
----------- -----------
NET SALES $ 3,856,872 $ 7,627,975
COST OF SALES
Cost of Goods Sold 3,086,733 5,901,866
----------- -----------
GROSS PROFIT 770,139 1,726,109
OPERATING EXPENSES
Advertising 69,589 270,770
Commissions 45,520 --
Compensation 686,215 1,299,195
Freight & Handling 90,688 225,866
Royalty Expense 32,731 83,964
Selling, general & administrative expenses 929,691 1,980,552
----------- -----------
TOTAL OPERATING EXPENSES 1,854,434 3,860,347
----------- -----------
LOSS FROM OPERATIONS (1,084,295) (2,134,238)
OTHER INCOME (EXPENSES)
Other income 11,700 7,669
Interest expense (114,200) (188,468)
Interest expense - Amortization (332,715) --
----------- -----------
NET OTHER EXPENSES (435,215) (180,799)
----------- -----------
LOSS BEFORE PROVISION FOR INCOME TAXES (1,519,510) (2,315,037)
PROVISION FOR INCOME TAXES -- 2,315
----------- -----------
NET LOSS $(1,519,510) (2,317,352)
=========== ===========
LOSS PER COMMON SHARE:
Basic and diluted $ (0.17) $ (0.28)
WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES:
Basic and diluted 8,787,483 8,278,469
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 THREE MONTHS ENDING JUNE 30
-------------------------------
2004 2003
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net Loss $(1,519,510) $(2,317,352)
Adjustments to reconcile net loss to net cash (used in)
provided by operating activities
Depreciation and amortization 133,437 175,519
Amortization of discount/deferred fees on convertible debentures 332,715 --
Changes in assets and liabilities:
Accounts Receivable 1,785,332 1,526,456
Due from manufacturer (132,589) --
Inventories 1,160,206 266,185
Prepaid expenses and other assets (329,471) (457,782)
Other non-current assets 64,703 --
Accounts payable (799,516) 1,299,330
Accrued expenses (631,993) (211,914)
Customer credits on account (304,700) --
Current income taxes 174,317 2,315
----------- -----------
Net cash (used in) provided by operating activities (67,066) 282,757
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment (19,240) (299,186)
Restricted cash 10,315 (23,711)
----------- -----------
Net cash used in investing activities (8,925) (322,897)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings from revolving credit facilities -- (1,879,453)
Repayments to revolving credit facilities -- --
Bank Overdraft (6,777) (269,994)
Proceeds from note payable 40,000 2,000,000
Payments on related party loan -- (200,000)
Proceeds from exercise of stock options and warrants -- 207,735
----------- -----------
Net cash provided by (used in) financing activities 33,223 (141,712)
----------- -----------
DECREASE IN CASH AND CASH EQUIVALENTS (42,768) (181,852)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 356,342 268,265
----------- -----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 313,574 $ 86,413
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
CASH PAID FOR THREE MONTHS ENDING JUNE 30
Interest $ 120,625 $ 188,469
=========== ===========
Taxes $ -- $ --
=========== ===========
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 it's subsidiary (the
"Company", "The Singing Machine"). All significant intercomany 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 June 30, 2004 are not
necessarily indicative of the results that may be expected for the remaining
quarters or the year ending March 31, 2005 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, 2004.
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.
INCOME TAXES.
Significant management judgment is required in developing The Singing
Machine'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. Management evaluates its
ability to realize its deferred tax assets on a quarterly basis and adjusts its
valuation allowance when it believes that it is more likely than not that the
assets will not be realized. At March 31, 2004 and June 30, 2004, the Company
concluded that a valuation allowance was needed against all of the Company's
deferred tax assets, as it was not more likely than not that the deferred taxes
would be realized. At June 30, 2004 and March 31, 2004, The Singing Machine had
gross deferred tax assets of $8.7 million and $8.2 million, against which the
Company recorded full valuation allowances.
For the three months ended June 30, 2004, the Company recorded no tax
provision. This occurred because the Company has net operating losses during
this period and has not recorded a benefit for the current period's losses
because realizability is not more likely than not.
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.
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. Such compensation amounts are amortized over the
respective vesting periods of the option grant. The Company applied the
disclosure provisions of Statement of Financial Accounting Standards No. 148,
"Accounting for Stock-Based Compensation-Transition and Disclosure an amendment
of FASB Statement No. 148", which permits entities to provide pro forma net
earnings (loss) and pro forma earnings (loss) per share disclosures for employee
stock option grants as if the fair-valued based method defined in SFAS No. 123
had been applied to options granted.
6
Had compensation cost for the Company's stock-based compensation plan
been determined using the fair value method for awards under that plan,
consistent with Statement of Financial Accounting Standards (SFAS) No. 123,
"Accounting for Stock Based Compensation", the Company's net loss would have
been changed to the pro-forma amounts indicated below.
JUNE 30, 2004 JUNE 30, 2003
----------------- -----------------
Net loss As reported $(1,519,510) $(2,317,352)
Pro forma $(1,644,659) $(2,518,804)
Net loss per share - basic & diluted As reported $ (0.17) $ (0.28)
Pro forma $ (0.19) $ (0.30)
The effect of applying SFAS No. 123 is not likely to be representative
of the effects on reported net earnings for future years due to, among other
things, the effects of vesting.
For stock options and warrants issued to consultants, the Company
applies the fair value method of accounting as prescribed by SFAS No.123. There
were no consulting expenses relating to grants for the quarters ended June 30,
2004 and 2003.
For financial statement disclosure purposes and for purposes of valuing
stock options and warrants issued to consultants, the fair market value of each
stock option granted was estimated on the date of grant using the Black-Scholes
Option-Pricing Model in accordance with SFAS No. 123 using the following
weighted-average assumptions:
First Quarter 2005: expected dividend yield 0%, risk-free
interest rate of 4%, volatility 81.5% and
expected term of five years.
First Quarter 2004: expected dividend yield 0%, risk-free
interest rate of 4%, volatility 79.9% and
expected term of five years.
NOTE 2 - GOING CONCERN
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America, which contemplate continuation of the Company as a going concern.
On February 9, 2004, the Company entered into a factoring agreement
with Milberg Factors, Inc. As of March 31, 2004, the Company did not have any
advances outstanding under the factoring agreement; however, the Company was in
violation of the minimum required tangible net worth and working capital
covenants of the agreement. On July 14, 2004, this factoring agreement was
terminated.
The Company has a net deficit in shareholders equity and the Company is
experiencing difficulty in keeping payments current with various vendors. As a
result, the Company's independent registered public accounting firm has
expressed substantial doubt in the Company's ability to continue as a going
concern in their report for the years ended March 31, 2004 and 2003, which was
included the Company's annual report on Form 10-K.
Operations will be financed using the following methods:
o Vendor Financing. The Company's key vendors in China have
agreed to manufacture on behalf of the Company, without
advanced payments.
o A significant amount of committed customer orders have been
sold under customer letters of credit terms. The customer's
letters of credit will be used as collateral to provide
advances to our vendors. The customers will pay and take title
of the karaoke machines in China as the karaoke machines are
shipped. This will generate immediate funds to pay the vendors
and generate additional cash flows.
o As stated above a tax refund of $1.1 million is anticipated to
be received in September or October 2004. These funds will
also be used to pay the Company's vendors.
o For customers whose terms of sale are with open terms, the
Company will also seek to use a factoring arrangement with a
financial institution.
On June 16, 2004, a former executive and beneficial owner of the
Company advanced the Company a short-term loan of $40,000, to be used to meet
working capital obligations. The loan is non-interest bearing and is due on
demand.
7
On July 14, 2004, a director Jay Bauer has advanced the Company a
short-term loan of $200,000, to be used to meet working capital obligations. The
loan bears interest at 8.75% per annum and is due on demand.
There can be no assurances that forecasted results will be achieved or
that additional financing will be obtained. The financial statements do not
include any adjustments relating to the recoverability and classification of
asset amounts or the amounts and classification of liabilities that might be
necessary should the Company be unable to continue as a going concern.
NOTE 3 - LOANS AND LETTERS OF CREDIT
CREDIT FACILITY
The 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
These 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 $2.0 million. The balance at June 30, 2004 and March 31, 2004 was
$55,505 and $62,282, respectively. The interest rate is approximately 4%. At
June 30, 2004, the company does not have any additional availability under these
facilities.
RELATED PARTY LOANS
On 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 accrue interest at 9.5% per annum and as of June 30, 2004, all interest
was accrued and unpaid and totaled approximately $74,125. These loans were
originally scheduled to be repaid by October 31, 2003 and are now due on demand.
On June 16, 2004, a former executive and beneficial owner of the
Company advanced the Company a short-term loan of $40,000, to be used to meet
working capital obligations. The loan is non-interest bearing and is due on
demand.
On July 14, 2004, a director Jay Bauer has advanced the Company a
short-term loan of $200,000, to be used to meet working capital obligations. The
loan bears interest at 8.75% per annum and is due on demand.
NOTE 4 - CONVERTIBLE DEBENTURES WITH WARRANT
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 convertible at the option of the holders
into 1,038,962 common shares at a conversion price of $3.85 per common share,
subject to certain anti-dilution adjustment provisions, at any time after the
closing date. The repayment of the Convertible Debentures was subordinated to
the factoring agreement with Milberg Factors. The Company terminated this
factoring agreement effective as of July 14, 2004.
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.
8
In accounting for this transaction, the Company allocated the proceeds
based on the relative estimated fair value of the stock purchase warrants and
the convertible debentures. This allocation resulted in a discount on the
convertible debentures of $3.3 million, which is being amortized over the life
of the debt on a straight-line basis to interest expense, which is not
materially different from effective interest method. Total amortization for the
period ended June 30, 2004 is $332,715 and the unamortized discount is
$2,221,796.
On February 9, 2004, the Company amended its convertible debenture
agreements to increase the interest rate to 8.5% 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 Milberg, (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 and the fair value of these warrants was
estimated by using the Black-Scholes Option-Pricing Model and totaled $30,981.
This amount was expensed as a component of selling, general and administrative
expenses during the three months ended December 31, 2003. Pursuant to the
Convertible Debenture agreements, the Company was required to register the
shares of common stock underlying the debentures and detachable stock purchase
warrants issued in connection with the debentures. The registration of the
common shares was required to be effective by July 1, 2004. As the related Form
S-1 registration statement was not effective on July 1, 2004, the Company is
required to pay liquidating damages in the amount of $80,000 per month until the
registration statement becomes effective and is in technical default of the
Convertible Debenture agreements and related transaction documents.
In connection with the Convertible Debentures the Company paid
financing fees as follows: 103,896 stock purchase warrants, with a fair value of
$268,386, 28,571 shares of common stock with a fair value of $141,141, and cash
of $255,000. Total financing fees of $664,527 were recorded as deferred fees and
are being amortized over the term of the debentures.
The unamortized deferred fees are reported in other non-current assets
in the accompanying balance sheets and total $445,737 as of June 30, 2004.
NOTE 5 - COMMITMENTS AND CONTINGENCIES
LEGAL MATTERS
From July 2, 2003 through October 2, 2003, seven securities class
action lawsuits and a shareholder's derivative action were filed against us and
certain of our officers and directors in the United States District Court for
the Southern District of Florida on behalf of all persons who purchased our
securities during the various class action periods specified in the complaints.
On September 18, 2003, United States District Judge William J. Zlock entered an
order consolidating the seven (7) purported class action law suits and one (1)
purported shareholder derivative action into a single action case styled Frank
Bielansky v. the Company, Salberg & Company, P.A., et al - Case Number: 03-80596
- - CIV - ZLOCK (the "Class Action"). The complaints that were filed allege
violations of Section 10(b) and Section 20(a) of the Securities Exchange Act of
1934 and Rule 10(b)-5. The complaints seek compensatory damages, attorney's fees
and injunctive relief.
The Company entered into a settlement agreement with the plaintiffs in
the Class Action in March 2004. At a hearing in April 2004, the Court gave
preliminary approval for the settlement and directed that notices be sent to
shareholders pursuant to the Settlement Agreement. The notices advised
shareholders of their rights and responsibilities concerning the settlement. The
Court set a hearing on July 30, 2004 before Judge Zlock to consider final
approval of the settlement. At the hearing, Judge Zlock signed the order giving
final approval to the settlement. The terms of the settlement will be
implemented after all final appeals period have expired.
Pursuant to the terms of the settlement agreement, we are required to
make a cash payment of $800,000 and Salberg & Company, P.A., our former auditor,
is required to make a payment of $475,000. Our cash payment of $800,000 is
covered by our liability insurance and our insurer has placed this payment in an
escrow account. In addition, we are obligated to issue 400,000 shares of our
common stock to the plaintiff. The settlement obligates us to implement certain
corporate governance changes, including an expansion or our Board of Directors
to six members with independent directors comprising at least 2/3 of the total
Board seats.
As of March 31, 2004, the Company recorded an expense equal to the
total estimated cost of the settlement less the amount expected to be reimbursed
by the Company's insurance carrier. The net charge associated with this matter
totaled approximately $462,000 and was included as a component of selling,
general and administrative expenses for the three months ended March 21, 2003.
9
NOTE 6 - STOCKHOLDERS' EQUITY
COMMON STOCK ISSUANCES
During the three months ended June 30, 2004 and 2003, the Company
issued the following shares of stock.
------------- ------------------------------ ---------------------
June 30, Number of Shares Issued Proceeds to Company
------------- ------------------------------ ---------------------
2004 50,000 None
------------- ------------------------------ ---------------------
2003 128,500 $207,735
------------- ------------------------------ ---------------------
On May 11, 2004, the Company issued 50,000 shares of common stock to a
former executive for consulting services rendered. The Company expensed the
consulting costs in the three months ended December, 31, 2003, the period which
services were provide.
EARNINGS PER SHARE
In accordance with Statement of Financial Accounting Standards No. 128,
"Earnings per Share," basic earnings per share are computed by dividing the net
earnings for the period by the weighted average number of common shares
outstanding. Diluted earnings per share is computed by dividing net earnings by
the weighted average number of common shares outstanding including the effect of
common stock equivalents.
All common stock equivalents have been excluded from the diluted per
share calculations in the three-month periods ended June 30, 2004 and 2003
because their inclusion would have been antidilutive.
The following represents the antidiluted common stock equivalents for
the three months ended June 30, 2004 and 2003:
o Options to purchase 521,815 and 637,681 shares of common
stock, respectively, with exercise prices ranging from $1.05
to $9.00 and $1.11 to $9.00, respectively.
o Warrants to purchase 591,040 and 0 shares of common stock,
respectively, with exercise price at $4.03.
o Convertible debentures convert into 1,038,962 and 0 shares of
common stock, respectively, with conversion price at $3.85.
NOTE 7 - SEGMENT INFORMATION
The Company operates in one segment and maintains its records
accordingly. The majority of sales to customers outside of the United States are
made by the Company's Subsidiary in Hong Kong. Sales by geographic region for
the quarter ended June 30 were as follows:
The geographic area of sales is based primarily on the location where the
product is delivered.
2004 2003
----------- -----------
North America $ 2,422,222 $ 3,863,002
Europe 1,405,482 3,764,973
Latin America 29,168 --
----------- -----------
$ 3,856,872 $ 7,627,975
=========== ===========
10
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 its'
Subsidiary (the "Singing Machine," "we," or "us") are primarily engaged in the
design, marketing, and sale of consumer karaoke audio equipment, accessories,
and musical recordings. The products are sold directly to distributors and
retail customers. Our electronic karaoke machines and audio software products
are marketed under The Singing Machine(R) trademark, in addition to MTV and
Nickelodeon and Care Bear trademarks.
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
major retail outlets as Best Buy, Circuit City, Costco, Kohl's, K-Mart, J.C.
Penney, Radio Shack and Sam's Club.
We had a net loss of $1,519,510 for the three month period ended June
30, 2004, and as of June 30, 2004 we had negative working capital of $2,670,548.
RESTATEMENT OF FINANCIAL STATEMENTS
In June 2003, management revised its position on taxation of our
subsidiary's income by the United States and by the Hong Kong tax authorities.
With regard to taxation in Hong Kong, our subsidiary had previously
applied for a Hong Kong offshore claim income tax exemption based on the
locality of profits of the Hong Kong subsidiary. Management believed that the
exemption would be approved because the source of all profits of our Hong Kong
subsidiary 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
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, we 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 we had
originally taken the position that the foreign income of the Hong Kong
subsidiary qualified for a deferral under the Internal Revenue Code allowing for
such income to be indefinitely deferred and not taxed in the United States until
such income is repatriated. 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
are quite complex and subject to interpretation. Each case is determined based
on the individual facts and circumstances. Due to certain inter-company loans
made in 2002 and 2003, the profits previously considered to be indefinitely
deferred
11
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 ended June
30, 2002 is to decrease net income by $118,334. The net effect on net income per
share is to decrease net income per share basic and diluted by $0.01 for the
quarter ended June 30, 2002.
QUARTER ENDED JUNE 30, 2004 COMPARED TO THE QUARTER ENDED JUNE 30, 2003
- -----------------------------------------------------------------------
NET SALES
Net sales for the quarter ended June 30, 2004 were $3,856,872, compared
to net sales of $7,627,975 for the comparative period of 2003. Sales decreased
$3,771,103 or 49.4% from the comparative period. The decrease is a result of a
planned management decision, to defer the launch of our new products until the
quarter ended September 30, 2004. This management decision provided us with the
opportunity to focus on selling existing models in inventory to generate cash
for operations.
We were notified, by a customer in the quarter ended June 30, 2004 that
they would not continue participating in a promotion program. During the year
ended March 31,2004 and as a result of this promotion program, this customer was
given a credit in the amount of $372,000. As a result of the customer's decision
not to continue participation in this program, the amount previously credited to
their account was reversed during the quarter ended June 30, 2004.
GROSS PROFIT
Gross profit for the quarter ended June 30, 2004 was $770,139 or 20.0%
of sales as compared to $1,726,109 or 22.6% of sales for the quarter ended June
30, 2003. The decrease in gross margin percentage compared to the prior year is
due primarily to sales of existing older models that we held in inventory at
reduced costs to generate cash for operations in the first quarter of fiscal
2005. The sales of these older models at reduced prices resulted in lower profit
margins on these sales. Due to the level of inventory of older model machines of
$4,763,060 at June 30, 2004, we anticipate that the gross profit percentage for
the sale of these models will be lower for the balance of fiscal 2005, compared
to the sales of newer model machines being introduced in the second quarter of
fiscal 2005.
OPERATING EXPENSES
Total operating expenses were $1,854,434 for the quarter ended June 30,
2004, compared to $3,860,347 for the comparative period of 2003. Operating
expenses decreased compared to prior period by 52% or $2,005,913. This decrease
of expenses is a result of two primary factors:
o In fiscal 2004, one of our primary objectives was to reduce
our operating expenses. Total controllable operating expenses
decreased 51% from the comparative last year quarter or
$1,663,841. Controllable expenses include selling, general and
administrative and compensation, expense. Selling, general and
administrative expense was reduced by $1,050,861 or 53%, to
$929,691, from $1,980,552. Compensation expense on a
comparative basis was reduced by $612,980 or 47% from
$1,299,195 to $686,215.
o In addition, variable selling related expenses -advertising,
commissions, freight & handling and royalty, decreased as a
percent of sales from 7.6% to 6.2% of sales. In total,
variable expenses decreased $342,072, from $580,600 in the
quarter ended June 30, 2003 to $238,528 in the quarter ended
June 30, 2004.
Management anticipates that the controllable operating expense will
continue to be at approximately the same levels as the quarter ended June 30,
2004 for the balance of the fiscal year.
OTHER EXPENSES
Other expenses were $435,224 for the quarter ended June 30, 2004,
compared to other expense of $180,799 for the quarter ended June 30, 2003. The
significant increase over prior year is the result of amortization of the
discount on the convertible debentures totaling $332,715 compared to zero for
the comparative
12
period of last year. The Company did not close on the convertible debenture
until September 2004, therefore for the comparative period; the amortization on
discount of the convertible debentures was zero. Interest expense decreased for
the quarter ended June 30, 2004 vs. the quarter ended June 30, 2003. For the
quarter ended June 30, 2004 interest expense decreased to $114,200 from
$188,468. The decrease is a result of reduced borrowings, compared to the prior
year.
INCOME TAXES
For the three months ended June 30, 2004, we recorded no tax
provision. This occurred because we have net operating losses during
this period and have not recorded a benefit for the current period's losses
because realizability is not more likely than not.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
At June 30, 2004, we had cash on hand of $313,574 and a bank overdraft
of $55,504 compared to cash on hand of $356,342 and a bank overdraft of $62,282
at March 31, 2004. Our current liabilities decreased to $13,937,515 from
$15,200,581 as of March 31, 2004. We had a working capital deficit of $2,670,548
as of June 30, 2004.
As of June 30, 2004, our current liabilities consist of accounts
payable of $3.9 million, accrued expenses of $2.8 million, customer credits on
account of $1.8 million, a bank overdraft of $55,504, subordinated debt of $1
million, convertible debenture of $1.8 million, related party notes payable of
$40,000 and an income tax payable of $2.6 million. Our most significant account
payable is a $2.4 million obligation to a factory in China. We have agreed to a
verbal payment plan with the factory, which provides that we will begin making
payments in September 2004. The payments will continue through the year-end
March 2005. We are current on approximately 22% of our accounts payable.
As of June 30, 2004, we did not have any advances outstanding under a
factoring agreement with Milberg; however, we were in violation of the covenants
relating to working capital and tangible net worth. We terminated our factoring
agreement with Milberg Factors, effective as of July 14, 2004. We paid a $25,000
fee to terminate this agreement prior to the scheduled expiration date of
February 9, 2006. Milberg has agreed to release its security interest in all our
assets and accounts receivable. We have accrued the $25,000 fee as legal expense
for the quarter ended June 30, 2004, which is included as selling, general &
administrative expenses in the accompanying statements of operation.
We are actively seeking financing from other sources to fund
operations.
Our Hong Kong subsidiary, International SMC, has credit facilities at
Hong Kong Shanghai Bank and Fortis Bank. The primary purpose of these facilities
is to provide International SMC with access to letters of credit so that it can
purchase inventory for direct shipment of goods into the United States and
international markets. These facilities are secured by a corporate guarantee
from the U.S. parent company and restricted cash on deposit with the lender. The
maximum credit under the facilities is $2.0 million. The balance at June 30,
2004 and March 31, 2004 was $55,505 and $62,282, respectively. The interest rate
is approximately 4% per annum. As of June 30, 2004 there was no availability
under these facilities.
As of June 30, 2004, our cash on hand is limited. Our average monthly
operating costs are approximately $600,000 and we expect that we will need
approximately $1.8 million for working capital during the next three-month
period between July and September. Our primary expenses are normal operating
costs including salaries, payments under the severance agreements for two of our
former executives, lease payments for our warehouse space in Compton, California
and other operating costs.
On June 16, 2004, a former executive and 10% beneficial owner of the
Singing Machine advanced us a short-term loan of $40,000, to be used to meet
working capital obligations. The loan is non-interest bearing and is due on
demand.
13
On July 14, 2004, a director, Jay Bauer, advanced us a short-term loan
of $200,000, to be used to meet working capital obligations. The loan bears
interest at 8.75% per annum and is due on demand.
We currently expect to order between $8 and $12 million of new
inventory for domestic stock for the year. During fiscal 2005, we will attempt
to liquidate the excess inventory from fiscal 2004. We believe this inventory is
marketable and saleable; however, there can be no assurances that we will be
able to liquidate this inventory during our upcoming fiscal year.
Cash flows used in operating activities were $67,066 for the quarter
ended June 30, 2004. Cash used in operating activities primarily related to
decreases in accounts payable, accrued expense and customer credits on account
of $1.7 million, which was offset by cash flows provided by collection of
accounts receivable.
Cash used in investing activities for the quarter ended June 30, 2004
was $19,240. Cash used in investing activities resulted from the purchase of
fixed assets in the amount of $19,240. The purchase of fixed assets consists of
the tooling and molds required for production of new machines for this fiscal
year.
Cash flows provided by financing activities were $33,223 for the
quarter ended June 30, 2004. This cash inflow was primarily from a loan from a
related party.
During the three-month period between July and September 2004, we plan
on financing our working capital needs from
o Collection of accounts receivable;
o Sales of existing inventory;
o Continued support from factories in China in financing our
purchases of karaoke machines for fiscal 2005; and
o Utilizing credit facilities that are available to
International SMC to finance all direct shipments.
o We are also trying to secure a new factoring agreement so that
we can sell our accounts receivable to the factor to finance
our working capital needs. There can be no assurances that we
will be able to obtain a new factoring agreement.
Our sources of cash for working capital in the longer term, the
six-month period between September and March 2004, are the same as our sources
during the short term. We expect to receive a tax refund of $1.1 million at the
end of September or October 2004. If we need additional financing, we intend to
approach other financing companies for financing. 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 to continue our operations.
During fiscal 2005, we will strive to keep our operating costs at a
minimum. In order to reduce the need to maintain inventory in our warehouses in
California and Florida, we intend to generate a larger share of our total sales
through sales directly from International SMC. Sales originating from
International SMC are shipped directly to our customers from the ports in China
and are primarily backed by customer letters of credit. Our 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 to reduce the amount of required warehouse inventory.
We are also planning to finance a significant amount of our working
capital needs with customer issued letters of credit, using International SMC's
credit facility with Hong Kong Bank and relying on financing from one of our
factories in China. We anticipate that total purchases of approximately $28
million that will be financed by the above methods. We currently expect to order
between approximately $8 and $12 million in new inventory, which will be
financed by using International SMC's credit facility and financing from a
Chinese factory.
Customer orders can be cancelled at any time prior to delivery and we
cannot assure you that our customers will complete these purchases. In the event
that we do not sell sufficient products in our second and third quarter, we have
considered other sources of financing, such as trying to secure an additional
credit facility, private offerings and/or a venture capital investment. We
expect that our profit margin for sales of our karaoke products will continue to
be under price pressure, because of the sale of older models. During fiscal
2005, we plan on introducing three new karaoke machines, which will command
higher prices and a higher profit margin. We also will continue to cut its
operating expenses.
14
BACKLOG
We ship our products in accordance with delivery schedules specified by
our customers, which usually request delivery within three months of the date of
the order. In the consumer electronics industry, orders are subject to
cancellation or change at any time prior to shipment. In recent years, a trend
toward just-in-time inventory practices in the consumer electronics industry has
resulted in fewer advance orders and therefore less backlog of orders for the
Singing Machine. We believe that backlog orders at any given time may not
accurately indicate future sales. As of August 9, 2004, we had backlog of $28
million compared to backlog of $39 million at the same period in 2003. We
believe that we will be able to fill all of these orders in fiscal year 2005.
However, these orders can be cancelled or modified at any time prior to
delivery.
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 our fiscal
second and third quarter, combined, accounted for approximately 86% of net sales
in fiscal 2004 and 85% of net sales in fiscal 2003.
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.
FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK
RISKS ASSOCIATED WITH OUR BUSINESS
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 July 1, 2004, our cash on hand is limited and we have a working
capital deficit of $2.7 million. We need approximately $1.5 million in working
capital in order to finance our operations over the next three months. We will
finance our working capital needs from the collection of accounts receivable and
sales of existing inventory. See "Liquidity" beginning on page 14. As of June
30, 2004, our inventory was valued at $5.9 million. We are trying to obtain
additional financing from a company that will factor our accounts receivable. If
these sources do not provide us with adequate financing, we may try to seek
financing from a third party. 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 other form of liquidation or reorganization proceeding.
WE MAY BE DEEMED TO BE INSOLVENT AND WE MAY GO OUT OF BUSINESS
As of July 1, 2004, our cash position is limited. We are not able to
pay all of our creditors on a timely basis. We are past due on approximately 78%
of our accounts payable, which total $3.9 million as of June 30, 2004. Included
in the accounts payable that are past due are amounts totaling $2.4 million with
a factory in China. If we are not able to pay our current debts as they become
due, we may be deemed to be insolvent. We may be required to file a petition for
bankruptcy under Chapter 11 of the U.S. Bankruptcy Code or enter into some other
form of liquidation or reorganization proceedings.
OUR INDEPENDENT REGISTERED PUBLIC ACCOUNTANTING FIRM RAISED SUBSTANTIAL DOUBT
ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN AS OF MARCH 31, 2004 AND 2003
We received a report dated June 16, 2004 (except for the last
paragraph of note 7, as to which the date is July 14, 2004) from our independent
registered public accounting firm covering the consolidated financial statements
for our fiscal year ended March 31, 2004 that included an explanatory paragraph
which stated that the financial statements were prepared assuming the Singing
Machine would continue as a going concern. This report stated that our operating
performance in fiscal 2004 and our minimal liquidity raised substantial doubt
about our ability to continue as a going concern. If we are not able to raise
additional capital, we may need to curtail or stop our business operations. We
may be required to file a petition for bankruptcy under Chapter 11 of the U.S.
Bankruptcy Code or enter into some other form of liquidation or reorganization
proceedings.
15
WE ARE IN TECHNICAL DEFAULT OF THE TERMS OF THE CONVERTIBLE DEBENTURES AND THERE
COULD BE A MATERIAL ADVERSE EFFECT ON OUR OPERATIONS AND FINANCIAL RESULTS IF WE
ARE DEEMED TO BE IN DEFAULT
We are in technical default of the terms of the $4 million in
convertible debentures that we issued to 6 institutional investors in September
2003. We had an obligation to have the registration statement registering the
securities issued to the institutional investors filed and declared effective by
July 1, 2004. As of August 16, 2004, the registration statement has not been
declared effective. As such, under the terms of the registration rights
agreement we are accruing liquidated damages in the amount of $80,000 for each
month that the registration statement is not declared effective. Additionally,
the institutional investors could declare us in default of the convertible
debentures and demand repayment of the debentures and all other amounts due
under the transaction documents evidencing their $4 million investment.
IF WE ARE UNABLE TO EFFECTIVELY AND EFFICIENTLY IMPLEMENT OUR PLAN TO REMEDIATE
THE MATERIAL WEAKNESSES WHICH HAVE BEEN IDENTIFIED IN OUR INTERNAL CONTROLS AND
PROCEDURES, THERE COULD BE A MATERIAL ADVERSE EFFECT ON OUR OPERATIONS OR
FINANCIAL RESULTS
We have identified a number of material weaknesses in our internal
controls and procedures in connection with the audit of our financial statements
for fiscal 2004. The deficiencies in our internal controls relate to:
o weaknesses in our financial reporting processes as a result of
a lack of adequate staffing in the accounting department,
o accounting for consigned inventory and inventory costing.
We are implementing a number of procedures to correct these weaknesses
in our internal controls. However, no assurances can be given that we will be
able to successfully implement our revised internal controls and procedures or
that our revised controls and procedures will be effective in remedying all of
the identified material weaknesses in our prior controls and procedures. In
addition, we may be required to hire additional employees, and may experience
higher than anticipated capital expenditures and operating expenses, during our
implementation of these changes. If we are unable to implement these changes
effectively or efficiently there could be a material adverse effect on our
operations or financial results.
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 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, 2004, 2003 and 2002
were approximately 53%, 67% and 87%, respectively. In fiscal 2004, three
customers accounted for 20%, 12% and 8% 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 and cash flow.
WE ARE RELYING ON ONE FACTORY TO MANUFACTURE AND PRODUCE THE MAJORITY OF OUR
KARAOKE MACHINES FOR FISCAL 2005, AND IF THE RELATIONSHIP WITH THIS FACTORY IS
DAMAGED OR INJURED IN ANY WAY, IT WOULD REDUCES OUR REVENUES AND PROFITABILITY
We have worked out a verbal agreement with a factory in China to
produce all of our karaoke machines for fiscal 2005. We owe this factory
approximately $2.4 million as of June 30, 2004 and have worked out a payment
plan with it. See "Liquidity" beginning on page 14. If the factory is unwilling
or unable to deliver our karaoke machines to us, our business will be adversely
affected. Because our cash on hand is minimal, we are relying on revenues
received from the sale of our ordered karaoke machines to provide cash flow for
our operations. If we do not receive cash from these sales, we may not be able
to continue our business operations.
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 fiscal 2004 and 2003, a number of our customers and distributors
returned karaoke products that they had purchased from us. Our customers
returned goods valued at $1.8 million, or 2.5% of our net sales in fiscal 2004.
One of our largest customers (Best Buy) returned approximately $2.75 million in
karaoke products to us in February 2002 that it had not been able to sell during
the Christmas season in fiscal 2003. Best Buy agreed to keep this inventory in
its
16
retail stores, but converted the sale to a consignment sale. Although we were
not contractually obligated to accept this return of the karaoke products in
fiscal 2004 or fiscal 2003, we accepted the return of the karaoke products
because we valued our relationship with our customers and continue to conduct
business in the future. 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 REDUCTION AND
FINANCIAL INCENTIVES 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 experience lower
sales volume. In our fiscal year ended March 31, 2004, our sales to customers in
the United States decreased because of increased price competition. During
fiscal 2004, we sold 20.2% of our karaoke machines at prices that were equal to
or below cost. We will not be able to stay in business if we continue to sell
our karaoke machines at prices that are at or below cost. We are also subject to
pressure from our customers regarding certain financial incentives, such as
return credits or large advertising or cooperative advertising allowances, which
effectively reduce our selling prices. In fiscal 2004, we gave our customers
$2.1 million of credits on these accounts because the sell-through of our
products was not as strong as we had expected. We also provided our customers
with advertising allowances in the amount of $2.3 million during fiscal 2004 and
$4.1 million during fiscal 2003. We have historically provided our customers
with advertising allowances to our customers because it is standard practice in
the retail industry.
WE EXPERIENCE DIFFICULTY FORECASTING THE DEMAND FOR OUR KARAOKE PRODUCTS AND IF
WE DO NOT ACCURATELY FORECAST DEMAND, OUR REVENUES, NET INCOME AND CASH FLOW MAY
BE AFFECTED
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. We overestimated demand for our
products in fiscal 2003 and had $25.2 million in inventory as of March 31, 2003.
Because of this excess inventory, we had liquidity problems in fiscal 2004 and
our revenues, net income and cash flow were adversely affected. We had a net
loss of $22.7 million in fiscal 2004, which limited our cash flow.
WE ARE SUBJECT TO THE COSTS AND RISKS OF CARRYING INVENTORY FOR OUR CUSTOMERS
AND IF WE HAVE TOO MUCH INVENTORY, IT WILL AFFECT OUR REVENUES AND NET INCOME
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 or the order and the
delivery date, which reduces our cash flow. As of March 31, 2003, we had $25.2
million in inventory on hand, which impacted our cash flow and liquidity from
operations in fiscal 2004. As of June 30, 2004, our inventory was valued at $4.7
million, after a $6.8 million charge to reduce inventory to its net realizable
value had been taken. It is important that we sell this inventory during fiscal
2005, so we have sufficient cash flow for operations.
OUR GROSS PROFIT MARGINS HAVE DECREASED OVER THE PAST YEAR AND WE EXPECT
COMPETITIVE MARKET CONDITIONS
Over the past year, our gross profit margins have decreased. In the
fiscal year ended March 31, 2004, our gross profit margin was 2.6% of net sales
compared to 24.4% of net sales in fiscal year ended March 31, 2003. This decline
resulted from the closeout of older models and excessive inventory, price
competition and increased sales by International SMC. Sales made by
International SMC increased from 52% of our sale in fiscal 2003 to 61% in fiscal
2004. 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
2005.
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
17
Beginning on May 2, 2003, through the present date, four of our
executive officers have resigned. We hired a new Chief Operating Officer, Yi
Ping Chan on April 1, 2003, and a new Chief Financial Officer, Jeff Barocas, on
April 9, 2004. Three new directors have joined our Board since October 31, 2004
and one of them has resigned since that date. Bernard Appel joined our Board
effective as of October 31 and Harvey Judkowitz joined on March 29, 2004.
Richard Ekstract jointed our Board on October 31, 2003 and resigned for personal
reasons on June 2, 2004. We are in the process of searching for a new Chief
Executive Officer and new directors. 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. 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 overseeing
our liquidity situation 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.
THE SEC IS CONDUCTING AN INFORMAL INVESTIGATION OF THE COMPANY AND IF WE HAVE
DONE SOMETHING THAT DOES NOT COMPLY WITH THE FEDERAL SECURITIES LAWS, 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 for fiscal years 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
Singing Machine's financial results during the relevant class periods. In March
2004, we entered into a settlement agreement with the class action plaintiffs.
On July 30, 2004, a judge from the Southern District of Florida entered a formal
order approving the settlement agreement and the terms of the settlement will be
implemented after all applicable appeals periods have expired.
If any appeals are made during this time period, we will need to expend
additional times and resources on resolving this matter, whether through
continued settlement discussions or through litigation. 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 11.8% and 32.3% of our consolidated net sales from products sold under
the MTV license in fiscal 2004 and 2003, respectively. Our MTV license was
extended until September 1, 2004 with options for MTV to renew for an additional
four-month period through December 31, 2004. If we were to lose our MTV license,
it would have an adverse effect on our revenues and net income.
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 amount 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 86% of net sales
in fiscal 2004 and 2003 and 81% of net sales in fiscal 2002.
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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
reduce our prices. If we are forced to reduce our prices, it will result in
lower margins and reduced profitability. Because of intense competition in the
karaoke industry in the United States during fiscal 2004, we expect that the
intense pricing pressure in the low end of the market will continue in the
karaoke market in the United States in fiscal 2005. 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. Edward Steele, our former
Chief Executive Officer, has overseen our Product Development for the past
twelve years. Mr. Steele currently serves as a Senior Advisor and Director of
Product Development under a contract, which expires on February 28, 2005. We
have not yet identified a successor who will oversee product development if Mr.
Steele were to leave our company. To introduce products on a timely basis, we
must:
o accurately define and design new products to meet market
needs;
o design features that continue to differentiate our products
from those of our competitors;
o transition our products to new manufacturing process
technologies;
o identify emerging technological trends in our target markets;
o anticipate changes in end-user preferences with respect to our
customers' products;
o bring products to market on a timely basis at competitive
prices; and
o 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 facility in Compton,
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 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 THIRD-PARTY FACTORIES 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 three factories in the People's Republic of China
to manufacture the majority of our karaoke machines. These factories will be
producing approximately 97% of our karaoke products in fiscal 2005. Our
arrangements with these factories are subject to the risks of doing business
abroad, such as import duties, trade restrictions, work stoppages, and foreign
currency fluctuations, limitations on the repatriation of earnings 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.
19
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
our third party manufacturers use to manufacture and produce these products. If
our suppliers are unable to provide our third-party 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.
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. Additionally, other extraordinary events such as
terrorist attacks or military engagements, which adversely affect the retail
environment may restrict consumer spending and thereby adversely affect our
sales growth and profitability.
WE MAY HAVE INFRINGED THE COPYRIGHTS OF CERTAIN MUSIC PUBLISHERS AND IF WE
VIOLATE FEDERAL COPYRIGHT LAWS, WE WILL BE SUBJECT TO MONETARY PENALTIES
Over the past several years, we have received notices from several
music publishers who have alleged that we did not have the proper copyright
licenses to sell certain songs included in our compact discs with graphics discs
("CDG"s). CDG's are compact discs which contain the musical recordings of the
karaoke songs and graphics which contain the lyrics of the songs. We have
settled or are in the process of settling all of these copyright infringement
issues with these publishers. We have spent approximately $70,000, in the
aggregate, to settle these copyright infringement suits in fiscal year 2003 and
2004. These copyright infringement claims may have a negative effect on our
ability to sell our music products to our customers. If 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 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 June 1, 2004, we are aware of
only two customers, FAO Schwarz and KB Toys, which are operating under the
protection of bankruptcy laws. 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.
20
A DISRUPTION IN THE OPERATION OF OUR WAREHOUSE CENTERS IN CALIFORNIA OR FLORIDA
COULD IMPACT OUR ABILITY TO DELIVER 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 two warehouses, which are located in Compton, 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.
OUR BUSINESS OPERATIONS COULD BE DISRUPTED IF THERE ARE LABOR PROBLEMS ON THE
WEST COAST
During fiscal 2004, approximately 39% of our sales were domestic
warehouse 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 June 1, 2003 through June 1, 2004, our common stock has traded
between a high of $6.55 and a low of $0.65. During this period, we have restated
our earnings, lost senior executives and Board members, had liquidity problems,
and incurred a net loss of $22.7 million in fiscal 2004. 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. As of July 7, 2004, investors hold a short position in
252,000 shares of our common stock, which represents 4.1% of our public float.
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 agreement with Yi Ping Chan requires us, under certain
conditions, to make substantial severance payments to him if he resigns after a
change of control. As of March 31, 2004, Mr. Chan is entitled to severance
payments of $250,000 if there is a change in control. Our employment agreement
with Edward Steele, requires us, under certain conditions, to make substantial
severance payments to him if he resigns after a change of control. As of March
31, 2004, Mr. Steele is entitled to severance payments of $125,000 if there is a
change in control. These provisions could delay or impede a merger, tender offer
or other transaction resulting in a change in control of the Singing Machine,
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
OUR COMMON STOCK MAY BE DELISTED FROM THE AMERICAN STOCK EXCHANGE, WHICH MAY
HAVE A MATERIAL ADVERSE IMPACT ON THE PRICING AND TRADING OF OUR COMMON STOCK
Our common stock is quoted on the American Stock Exchange ("Amex"). The
Amex, as a matter of policy, will consider the suspension of trading in, or
removal from listing of, any stock when, in the opinion of Amex, (i) the
financial condition and/or operating results of an issuer appear to be
unsatisfactory; (ii) it appears that the extent of public distribution or the
aggregate market value of the stock has become so reduced as to make further
dealings on the Amex inadvisable; (iii) the issuer has sold or otherwise
disposed of its principal operating assets; or (iv) the issuer has sustained
losses which are so substantial in relation to its overall operations or its
existing financial condition has become so impaired that it appears
questionable, in the opinion of Amex, whether the issuer will be able to
continue operations and/or meet its obligations as they mature.
21
As of June 30, 2004, we have not received any notices from AMEX
notifying us that they will delist us. However, we cannot assure you that Amex
will not take any actions in the near future to delist our common stock. If our
common stock were delisted from the Amex, we would trade on the Over-the-Counter
Bulletin Board and the market price for shares or our common stock could
decline. Further, if our common stock is removed from listing on Amex, it may
become more difficult for us to raise funds through the sale of our common stock
or securities convertible into our common stock.
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 the closing price for our common stock was $.50 per share on
August 9, 2004, 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.
We have prepared a table, which show the adjustments that will be
made to (i) the conversion price of our convertible debentures and (ii) the
number of shares issued to the debenture holders, if we issue or sell our
securities at the (a) closing price on August 9, 2004, which was $.50 per share,
(b) 75% of the closing price on August 9, 2004, which is $.375 per share and (c)
50% of the closing price on August 9, 2004, which is $.25 per share.
Price of Singing Machine Adjusted Conversion Number of Shares Issuable Upon
Common Stock Price of Debenture Conversion of Debenture
$0.50 $1.34 2,985,075
$0.375 $1.23 3,252,033
$0.25 $1.15 3,478,261
If stock is issued after September 8, 2004 but February 26, 2006 or
whenever all of the convertible debentures are converted into shares of our
common stock, the set price of the convertible debentures will be reduced to an
amount equal to 50% of the difference between set price and the effective
purchase price of the shares.
Price of Singing Machine Adjusted Conversion Number of Shares Issuable Upon
Common Stock Price of Debenture Conversion of Debenture
$0.50 $2.18 1,834,862
$0.375 $2.11 1,895,735
$0.25 $2.05 1,951,220
If the price of our securities continues to decrease, and we continue
to issue or sell our securities at price below $3.85 per share, our obligation
to issue shares upon conversion of the debentures is essentially limitless.
IF OUR OUTSTANDING DERIVATIVE SECURITIES ARE EXERCISED OR CONVERTED, OUR
EXISTING SHAREHOLDERS WILL SUFFER DILUTION
As of August 10, 2004, there were outstanding stock options to purchase
an aggregate of 1,027,530 shares of common stock at exercise prices ranging from
$1.30 to $14.30 per share, not all of which are immediately exercisable. The
weighted average exercise price of the outstanding stock options is
approximately $3.95 per share. As of August 10, 2004, there were outstanding
immediately exercisable option to purchase an aggregate of 961,170 shares of our
common stock. There were outstanding stock warrants to purchase 591,040 shares
of common stock at exercise prices ranging from $1.52 to $4.03 per share, all of
which are exercisable. The weighted average exercise price of the outstanding
stock warrants is approximately $3.98 per share. 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.
22
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 prior to September 8, 2004, 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
registering shares of common stock issuable upon conversion of the convertible
debentures and the warrants, we cannot sell any securities.
Additionally, we cannot:
o 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; and
o 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 shares of our common
stock.
FUTURE SALES OF OUR COMMON STOCK HELD BY CURRENT STOCKHOLDERS AND INVESTORS MAY
DEPRESS OUR STOCK PRICE
As of August 10, 2004, there were 8,806,319 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 register the sale of 1,844,250 shares underlying options granted
under our 1994 Stock Option Plan and a registration statement on Form S-8 to
register 1,950,000 shares of our common stock underlying options granted under
our Year 2001 Stock Option Plan). An additional registration statement on Form
S-1, was filed 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 August 10, 2004, we had 8,806,319 shares of common
stock issued. We have an obligation to issue up to:
1,681,569 shares issuable under outstanding options and warrants; and
1,038,962 shares upon conversion of the convertible debentures.
We have also reserved up to 207,791 additional shares for interest
payment on the debentures and 1,946,113 additional shares that we may issue
pursuant to the anti-dilution provisions contained in the convertible debentures
which relate to price protection protections for the convertible debenture
holders. As such, our Board of Directors has the power, without stockholder
approval, to issue up to 3,661,245 shares of common stock.
Any issuance of additional shares of common stock, whether by us to new
stockholders or the exercise of outstanding warrants or options, may result in a
reduction of the book value or market price of our outstanding common stock.
Issuance of additional shares will reduce the proportionate ownership and voting
power of our then existing stockholders.
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 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
of 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
23
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 June 30, 2004,
we have not used derivative instruments or engaged in hedging activities to
minimize market risk.
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 ("Evaluation") of the effectiveness of the design and
operation of our disclosure controls and procedures, as of the end of the period
covered by this report (the "Evaluation Date"). In the course of the Evaluation,
we identified significant material weaknesses in our internal disclosure
controls and procedures.
Management and Grant Thornton LLP, have advised our Audit Committee
that during the course of the fiscal 2004 audit, they noted deficiencies in
internal controls relating to:
o weakness in our financial reporting process as a result of a
lack of adequate staffing in the accounting department, and
o accounting for consigned inventory and inventory costing.
Grant Thornton LLP has advised the Audit Committee that each of these
internal control deficiencies constitute a material weakness as defined in
Statement of Auditing Standards No. 60. Certain of these internal control
weaknesses may also constitute material weaknesses in our disclosure controls.
We have performed substantial additional procedures designed to ensure that
these internal control deficiencies did not lead to material misstatements in
our consolidated financial statements and to enable the completion of Grant
Thornton LLP's audit of our consolidated financial statements for the fiscal
year ended March 31, 2004, notwithstanding the presence of the internal control
weaknesses noted above. Based on these additional procedures, the Chief
Executive Officer and Chief Financial Officer have concluded that as of the
Evaluation Date our disclosure controls and procedures are effective except as
described above, to ensure that the information required to be disclosed by us
in reports that we file or submit under the Securities Exchange Act of 1934 are
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commission rules and forms.
We have not yet been able to implement any substantial corrective
actions as of the date of this quarterly report on Form 10-Q. We intend to
implement changes promptly to address these issues, and will consider
implementation of the following corrective actions as well as additional
procedures:
o Retention of outside professional advisors to evaluate our
existing internal controls and disclosure controls and make
suggestions for implementation;
o Retention of additional personnel in finance positions;
o Review and revision of our procedure for reporting consigned
inventory and inventory costing;
o Use of significant outside resources to supplement our
employees in the preparation of the consolidated financial
statements and other reports filed or submitted under the
Securities Exchange Act of 1934.
We will continue to evaluate the effectiveness of its disclosure
controls and internal controls and procedures on an ongoing basis, and will take
further action as appropriate.
24
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
CLASS ACTION AND DERIVATIVE LAWSUIT
From July 2, 2003 through October 2, 2003, seven securities class
action lawsuits and a shareholder's derivative action were filed against us and
certain of our officers and directors in the United States District Court for
the Southern District of Florida on behalf of all persons who purchased our
securities during the various class action periods specified in the complaints.
On September 18, 2003, United States District Judge William J. Zlock entered an
order consolidating the seven (7) purported class action law suits and one (1)
purported shareholder derivative action into a single action case styled Frank
Bielansky v. the Company, Salberg & Company, P.A., et al - Case Number: 03-80596
- - CIV - ZLOCK (the "Class Action"). The complaints that were filed allege
violations of Section 10(b) and Section 20(a) of the Securities Exchange Act of
1934 and Rule 10(b)-5. The complaints seek compensatory damages, attorney's fees
and injunctive relief.
We entered into a settlement agreement with the plaintiffs in the Class
Lawsuit in March 2004. At a hearing in April 2004, the Court gave preliminary
approval for the settlement and directed that notices be sent to shareholders
pursuant to the Settlement Agreement. At a hearing on July 30, 2004, the Court
entered an order approving the settlement agreement and it will become final
after all applicable appeals periods have expired.
Pursuant to the terms of the settlement agreement, we are required to
make a cash payment of $800,000 and Salberg & Company, P.A., our former auditor,
is required to make a payment of $475,000. Our cash payment of $800,000 is
covered by our liability insurance and our insurer has placed this payment in an
escrow account. In addition, we are obligated to issue 400,000 shares of our
common stock. The settlement would also obligate us to implement certain
corporate governance changes, including an expansion or our Board of Directors
to six members with independent directors comprising at least 2/3 of the total
Board seats.
ITEM 2. CHANGES IN SECURITIES
(a) Not Applicable.
(b) Not Applicable.
(c)) On May 112, 2004, we issued 50,000 shares of our common stock to Jack
Dromgold for consulting services that he had rendered to us regarding the
marketing of our products. Mr. Dromgold has comprehensive information about our
company because he served as our Executive Vice President of Sales for
approximately 2-1/2 years before be became a consultant to our company. The
shares issued to Mr. Dromgold were registered under the Securities Act on a
registration statement on Form S-8. The shares did not contain any restrictive
legends.
(d) Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
Not applicable.
ITEM 5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
31.1 Certification of the Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act
31.2 Certification of the Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act
32.1 Certifying Statement of the Chief Executive Officer pursuant
to Section 906 of the Sarbanes-Oxley Act
32.2 Certifying Statement of the Chief Financial Officer pursuant
to Section 906 of the Sarbanes-Oxley Act
25
(b) Reports on Form 8-K
The Company filed the following Current Reports on Form 8-K
during the quarterly period ended June 30, 2003:
Date of Report Items Reported Financial Statements Filed
-------------- -------------- --------------------------
4/14/04 Item 5 and 7 None
6/17/04 Item 5 None
6/30/04 Item 12 & 7 None
26
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 August 16, 2004
By: /s/ Jeffrey S. Barocas
-------------------------------------------
Jeffrey S. Barocas
Chief Financial Officer
(Principal Financial and
Accounting Officer)
/s/ Yi Ping Chan
------------------------------
Yi Ping Chan
Interim Chief Executive Officer and
Chief Operating Officer
(Duly Authorized to sign on behalf of the
Registrant))
27
EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
- ---------- -----------
31.1 Certification of the Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act
31.2 Certification of the Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act
32.1 Certifying Statement of the Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act
32.2 Certifying Statement of the Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act