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 September 30, 2004
0 - 24968
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
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(Issuer's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirement for the past 90 days. Yes x No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes No x
APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
CLASS NUMBER OF SHARES
OUTSTANDING ON SEPTEMBER 30, 2004
Common Stock, $0.01 par value 9,202,318
1
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Page No.
--------
Consolidated Balance Sheets - September 30, 2004 (Unaudited)
and March 31, 2004 .............................................. 3
Consolidated Statements of Operations - Three months and six
months ended September 30, 2004 and 2003 (Unaudited) ............ 4
Consolidated Statements of Cash Flows - Six months ended
September 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 ............................. 12
Item 3. Quantitative and Qualitative Disclosure About Market Risk ....... 24
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 ............................................................... 29
Exhibits
2
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30 MARCH 31
2004 2004
-------------- --------------
(UNAUDITED)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 928,096 $ 356,342
Restricted Cash 1,544,302 874,283
Accounts Receivable, less allowances of $295,089 and $98,009,
respectively 7,473,955 3,806,166
Due from manufacturer 244,579 95,580
Inventories 3,410,275 5,923,267
Prepaid expenses and other current assets 582,954 783,492
Insurance receivable -- 800,000
Refundable tax -- 1,178,512
-------------- --------------
TOTAL CURRENT ASSETS 14,184,161 13,817,642
PROPERTY AND EQUIPMENT, at cost less accumulated depreciation
of $2,700,000 and $2,567,000, respectively 1,382,096 983,980
OTHER NON-CURRENT ASSETS 483,579 615,773
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TOTAL ASSETS $ 16,049,836 $ 15,417,395
============== ==============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Bank overdraft $ -- $ 62,282
Accounts payable 7,151,949 4,651,675
Accrued expenses 1,397,626 3,481,905
Customer credits on account 1,560,621 2,111,484
Due to factor 474,968 --
Subordinated debt-related parties 1,000,000 1,000,000
Income tax payable 2,563,295 2,447,746
-------------- --------------
TOTAL CURRENT LIABILITIES 14,148,459 13,755,092
LONG TERM LIABILITIES
Convertible debentures, net of unamortized discount of $2,498,263
and $2,554,511, respectively 1,501,737 1,445,489
-------------- --------------
TOTAL LONG TERM LIABILITIES 1,501,737 1,445,489
SHAREHOLDERS' EQUITY
Preferred stock, $1.00 par value; 1,000,000 shares authorized, no
shares issued and outstanding -- --
Common stock, Class A, $.01 par value; 100,000 shares authorized;
no shares issued and outstanding -- --
Common stock, $0.01 par value; 18,900,000 shares authorized;
9,202,318 and 8,752,318 shares issued and outstanding 92,023 87,523
Additional paid-in capital 11,028,636 10,052,498
Accumulated deficit (10,721,019) (9,923,207)
-------------- --------------
TOTAL SHAREHOLDERS' EQUITY 399,640 216,814
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TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 16,049,836 $ 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)
Three Months Three Months Six Months Six Months
Ending Ending Ending Ending
-------------- -------------- -------------- --------------
Sept 30, 2004 Sept 30, 2003 Sept 30, 2004 Sept 30, 2003
-------------- -------------- -------------- --------------
NET SALES $ 18,753,288 $ 32,851,576 $ 22,610,160 $ 40,479,551
COST OF GOODS SOLD 14,492,944 27,431,545 17,579,677 33,333,411
-------------- -------------- -------------- --------------
GROSS PROFIT 4,260,344 5,420,031 5,030,483 7,146,140
OPERATING EXPENSES
Advertising 352,206 867,325 421,795 1,115,434
Commissions 313,143 547,156 358,663 560,256
Compensation 649,565 1,343,812 1,335,780 2,455,391
Freight & Handling 206,456 495,955 297,144 721,821
Royalty Expense 333,602 749,167 366,333 833,131
Selling, general and administrative expenses 1,248,535 2,669,154 2,178,226 4,846,883
-------------- -------------- -------------- --------------
TOTAL OPERATING EXPENSES 3,103,507 6,672,569 4,957,941 10,532,916
-------------- -------------- -------------- --------------
INCOME (LOSS) FROM OPERATIONS 1,156,837 (1,252,538) 72,542 (3,386,776)
-------------- ~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~
OTHER INCOME (EXPENSES) --
Other income(expense) 105,571 (90,649) 117,271 (82,980)
Interest expense (129,504) (262,094) (243,704) (450,562)
Interest expense - Amortization of discount
on convertible debentures (411,206) (56,801) (743,921) (56,801)
-------------- -------------- -------------- --------------
NET OTHER EXPENSES (435,139) (409,544) (870,354) (590,343)
-------------- -------------- -------------- --------------
INCOME (LOSS) BEFORE INCOME TAXES 721,698 (1,662,082) (797,812) (3,977,119)
INCOME TAXES BENEFIT -- 1,005,413 -- 1,003,098
-------------- -------------- -------------- --------------
NET INCOME (LOSS) $ 721,698 $ (656,669) $ (797,812) $ (2,974,021)
============== ============== ============== ==============
INCOME (LOSS) PER COMMON SHARE:
Basic $ 0.08 (0.08) $ (0.09) (0.35)
Diluted $ 0.06 (0.08) $ (0.09) (0.35)
WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES:
Basic 8,811,014 8,490,658 8,799,313 8,389,165
Diluted 12,813,594 8,490,658 8,799,313 8,389,165
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
4
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR SIX MONTHS ENDING SEPTEMBER 30
-------------- --------------
2004 2003
-------------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net Loss $ (797,812) $ (2,974,021)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities
Depreciation and amortization 177,380 466,301
Amortization of discount/deferred fees on convertible
debentures 743,886 157,172
Stock compensation 293,000 511,933
Changes in assets and liabilities:
Accounts Receivable (3,667,789) (15,368,857)
Insurance receivable 800,000 --
Due from manufacturer (148,999) 1,090,357
Inventories 2,512,992 4,631,260
Prepaid expenses and other assets 200,537 83,557
Other non-current assets 132,194 --
Accounts payable 2,500,274 7,153,298
Accrued expenses (2,084,279) 1,054,718
Customer credits on account (550,863) --
Current income taxes 1,294,061 (1,185,998)
-------------- --------------
Net cash provided by (used in) operating
activities 1,404,582 (4,380,280)
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CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment (575,495) (157,178)
Restricted cash (670,019) (29,192)
-------------- --------------
Net cash used in investing activities (1,245,514) (186,370)
-------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowing from revolving credit facilities 28,633,112
Repayment to revolving credit facilities -- (28,902,525)
Borrowing from factoring 474,968 --
Bank Overdraft (62,282) (268,856)
Proceeds from issuance of convertible debt -- 4,000,000
Payment of financing fees related to convertible debt -- (255,000)
Proceeds from note payable -- 637,122
Proceeds from related party loan 240,000 700,000
Payments on related party loan (240,000) --
Proceeds from exercise of stock options and warrants -- 860,535
-------------- --------------
Net cash provided by financing activities 412,686 5,404,388
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INCREASE IN CASH AND CASH EQUIVALENTS 571,754 837,738
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 356,342 268,265
-------------- --------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 928,096 $ 1,106,003
============== ==============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
CASH PAID FOR SIX MONTHS ENDING SEPTEMBER 30
Interest $ 238,740 $ 350,192
============== ==============
Taxes $ -- $ 205,000
============== ==============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
5
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(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 its 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 September 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 September 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 September 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 September 30, 2004, the Company recorded no tax
provision. This occurred because the Company has net operating losses for the
year to date period. The Company has not recorded a benefit for the current
period's losses because realizability is unlikely.
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
6
disclosure provisions of Statement of Financial Accounting Standards No. 148,
"Accounting for Stock-Based Compensation-Transition and Disclosure an amendment
of FASB Statement No. 148", which permits entities to provide pro forma net
earnings (loss) and pro forma earnings (loss) per share disclosures for employee
stock option grants as if the fair-valued based method defined in SFAS No. 123
had been applied to options granted.
Had compensation cost for the Company's stock-based compensation plan been
determined using the fair value method for awards under that plan, consistent
with Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for
Stock Based Compensation", the Company's net loss would have been changed to the
pro-forma amounts indicated below.
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
------------------------ ---------------------------
Net loss As reported $(797,812) $(2,974,021)
Pro forma $(956,776) $(3,376,925)
Net loss per share - basic & diluted As reported $(0.09) $(0.35)
Pro forma $(0.18) $(0.40)
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 September 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:
For the period ended September 30, 2004:
Expected dividend yield 0%, risk-free interest rate of 4%, volatility
81.5% and expected term of five years.
For the period ended September 30, 2003:
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.
The Company has an accumulated deficit in shareholders equity and 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 in 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 Asset based lending facility with an US bank for factoring credit of
$2.5 million to financing the account receivables in the USA
On June 16 2004, Edward Steele, former officer and director, advanced
$40,000 to us. The loan was interest free and paid in full on August 30, 2004.
On July 14, 2004, Josef A. Bauer, a director, advanced a short-term loan
of $200,000 to us which we are to use to meet our working capital obligations.
The interest rate on the loan is 8.5% per annum and the loan is payable on
demand. On August 26, 2004, we repaid Mr. Bauer a total of $202,109, including
$2,109 in interest.
7
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
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 credit facilities have been increase to $4
million by increasing fixed deposit with the bank, which is used as collateral.
The balance due at September 30, 2004 and March 31, 2004 was 0 and $62,282,
respectively. The interest rate is approximately 4%. At September 30, 2004, the
Company has used all credit facilities to open the letter of credit to the
factories for the purchase. The company does not have any additional
availability under these facilities.
RELATED PARTY LOANS
On July 14, 2004, Josef A. Bauer, a director, advanced a short-term loan
of $200,000 to us which we are to use to meet our working capital obligations.
The interest rate on the loan is 8.5% per annum and the loan is payable on
demand. On August 26, 2004, we repaid Mr. Bauer a total of $202,109, including
$2,109 in interest.
On June 16, 2004, Edward Steele, former officer and director, advanced
$40,000 to us. The loan was interest fee and paid in full on August 30, 2004.
On or about July 10, 2003, certain officers and directors of our company
advanced $1 million to our company pursuant to written loan agreements. The
officer was Yi Ping Chan and the directors were Josef A. Bauer and Howard Moore.
Mr. Moore resigned from our Board, effective as October 17, 2003. Additionally,
Maureen LaRoche, a business associate of Mr. Bauer, participated in the
financing. The loans accrue interest at 9.5% per annum and as of September 30,
2004, all interest was accrued, and the unpaid amount totaled approximately
$23,750. These loans were originally scheduled to be repaid by October 31, 2003
and are now due on demand. These loans were subordinated to Milberg's factoring
agreement, which we terminated effective as of July 14, 2004 and subsequently
subordinated to Crestmark Bank.
NOTE 4 - ACCOUNTS RECEIVABLE FACTORING AGREEMENT
On August 4, 2004, the Company has started to factor its accounts
receivables through Crestmark bank in Detroit, Michigan. The agreement allows
the Company, at the discretion of Crestmark, to factor its outstanding
receivables, with recourse, up to a maximum of the lesser of $2.5 million or 70%
of eligible accounts receivable. The Company will pay 1% of gross receivables in
fees with a $9,000 minimum maintenance fee per month. The average balance of the
line will be subject to interest on a monthly basis at prime plus 2%. The rate
is currently 6.75%. The agreement contains a liquidated damages fee of $162,000
for early termination.
Crestmark Bank also received a security interest in all of the Company's
accounts receivables and inventory located in the United States. The Company's
debenture holders have subordinated their $4 million secured convertible
debentures to the Crestmark debt.
As of September 30, 2004, the outstanding amount due to Crestmark bank for
factoring is $474,968.
8
NOTE 5 - 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
and were initially convertible 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 a factoring agreement with Milberg Factors, which
was terminated 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.
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.
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.
On November 8, 2004, the Company executed a letter agreement with the
debenture holders, whereby the Company agreed to change the interest rate on the
debenture to 9% in exchange for the debenture holders agreeing to (i) execute a
subordination agreement with Crestmark Bank, (ii) waive all liquidated damages
due under the transaction documents through January 7, 2005, and (iii) withdraw
any demand for repayment under the debenture.
According to the anti-dilution adjustment provision, If the Singing
Machine sells shares of its common stock at an effective price less than Set
Price, the debentures' holders are entitled to convert their debentures into
shares at a new conversion price, which equals to the original set price minus
75% of the difference between the Set Price and the new price if the event
occurs before September 8, 2004. On July 30, 2004, the Singing Machine received
the court approval of the Class Action Lawsuit (case# 03-CV-80596). The Singing
Machine issued 400,000 shares to the plaintiff as part of the settlement on
September 23, 2004. The market closing price on July 30, 2004 was $0.60 per
share. The event has triggered the conversion price reset for the convertible
debentures.
According to the Emerging Issue Task Force (EITF) Issue No. 00-27, if the
terms of a contingent conversion option do not permit an issuer to compute the
number of shares that the holder would receive if the contingent event occurs
and the conversion price is adjusted, an issuer should wait until the contingent
event occurs and then compute the resulting number of shares that would be
received pursuant to the new conversion price. The incremental intrinsic value
that resulted from the price reset equals additional shares multiplied by the
stock market price at the issuing date of the debentures, which would be
recorded as discount of convertible debentures and amortized over the remaining
life of the debentures. The new adjusted conversion price of stock is $1.41
[3.85- (3.85-0.60) X 75%] while the conversion price of warrant is $1.46. As of
July 30,2004, the number of shares issuable upon conversion of debenture is
2,831,858. The amount of $687,638 was recorded as additional discounts of the
debentures and will be amortized for the remaining life of the debentures. Total
amortization for the six months ending September 30, is $743,921 and the
unamortized discount is $2,498,263 as of September 30, 2004.
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.
9
The unamortized deferred fees are reported in other non-current assets in
the accompanying balance sheets and total $378,246 as of September 30, 2004.
NOTE 6 - 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 plaintiffs. 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 31, 2004.
The court entered an order approving the settlement agreement on July 30,
2004. The Company has issued the 400,000 shares to the plaintiffs on September
23, 2004. The cost of the 400,000 shares is $240,000 based on the stock closing
price on September 23, 2004. The remaining balance of the accrued expense in the
amount of $222,000 ($462,000 - $240,000) has been recorded as the reduction of
selling, general and administrative expenses for 3 months ending September 30,
2004.
NOTE 7 - STOCKHOLDERS' EQUITY
COMMON STOCK ISSUANCES
During the six months ended September 30, 2004 and 2003, the Company
issued the following shares of stock.
----------------------------------------------------------------------
Sept 30, Number of Shares Issued Proceeds to Company
----------------------------------------------------------------------
2004 450,000 None
----------------------------------------------------------------------
2003 320,000 $652,800
----------------------------------------------------------------------
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.
On September 23, 2004, the Company has issued the 400,000 thousand shares
to the plaintiffs on September 23, 2004 for the class action settlement.
10
EARNINGS (LOSS) 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.
4,002,580 common stock equivalents have been included in the diluted per
share calculations in the six months periods ended September 30, 2004 and 2003.
The following represents the antidiluted common stock equivalents for the
six months ended September 30, 2004 and 2003:
o Options to purchase 579,682 and 1,019,400 shares of common stock,
respectively, with exercise prices ranging from $0.57 to $9.00 and $1.11
to $9.00, respectively.
o Warrants to purchase 591,040 shares of common stock, respectively, with
exercise price at $1.46. There were none used in 2003.
o Convertible debentures convert into 2,831,858 shares of common stock,
respectively, with conversion price at $1.41. There were none used in
2003.
NOTE 8 - 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 September 30 were as follows:
The geographic area of sales is based primarily on the location where the
product is delivered.
FOR THE THREE MONTHS ENDING SEPT 30 FOR THE SIX MONTHS ENDING SEPT 30
2004 2003 2004 2003
North America $ 15,657,623 $ 17,690,952 $ 18,079,845 $ 21,553,954
Europe 2,857,421 14,467,066 4,262,903 17,809,897
Australia 238,245 310,579 238,245 310,579
Others -- 382,979 29,168 805,121
------------------ ------------------ ------------------ ------------------
$ 18,753,289 $ 32,851,576 $ 22,610,161 $ 40,479,551
================== ================== ================== ==================
11
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, 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, J.C. Penney, Radio
Shack and Sam's Club.
We had a net income of $721,698 and a net loss of $797,812 for the three months
September 30, 2004 respectively. These improvements were partially offset by
non-cash charges to income for the amortization of discount on the debenture.
The amortization costs related to the debenture was $411,206 in the quarter
compared to the amortization costs in the amount of $56,801 in the comparative
quarter since the debenture was not finalized until September 16, 2003
QUARTER ENDED SEPTEMBER 30, 2004 COMPARED TO THE QUARTER ENDED SEPTEMBER 30,
2003
NET SALES
Net sales for the quarter ended September 30, 2004 were $18,753,289 compared to
net sales of $32,851,576 for the comparative period of 2003. Sales decreased
$14,098,287 or 42% from the comparative period. The decrease in sales is a
combination of four primary reasons:
1) Management made a decision not to pursue lower margin businesses
which tie up cash flow buy not providing enough profit margin.
2) The variety of karaoke machines offered to the trade was scaled back
from prior years. This has helped us manage our working capital more
effectively with an improved control over inventories and accounts
payables to our vendors.
3) Our liquidity concerns discouraged customers from purchasing from
us.
4) Our major distributors in Europe ordered less karaoke machines
because they had a high level of inventory from last year.
GROSS PROFIT
Gross profit for the quarter ended September 30, 2004 was $4,260,345 or 22% of
sales as compared to $5,420,031 or 16% of sales for the quarter ended September
30, 2003. The increase in gross margin percentage compared to the prior year is
12
due primarily to sales of the new models at higher gross profit margin percents
than older models, and also the sales of existing older models that have been
written down to the lower of cost or market, in the prior year.
OPERATING EXPENSES
Total operating expenses were $3,103,507 for the quarter ended September 30,
2004, compared to $6,672,569 for the comparative period of 2003. Operating
expenses decreased compared to prior period by 53% or $3,569,062. This decrease
of expenses is a result of two primary factors:
o In fiscal 2004 and 2005, one of our primary objectives is to reduce
our operating expenses. Total controllable operating expenses
decreased 52% from the comparative last year quarter or $2,114,866.
Controllable expenses include selling, general and administrative
expenses and compensation expense. Selling, general and
administrative expense was reduced by $1,050,861 or 53%, to
$1,248,535, from $2,669,154. Compensation expense on a comparative
basis was reduced by $649,565 or 51% to $694,247 from $1,343,812. In
addition legal and professional fees were reduced by$222,000 in the
quarter, as a result of an over accrual for expenses relating to the
final settlement and issuance of shares relating to the class action
law suit.
o In addition, variable selling related expenses -advertising,
commissions, freight & handling and royalty, decreased as a percent
of sales from 8.0% to 6.4% of sales. In total, variable expenses
decreased $1,454,196, from $2,659,603 in the quarter ended September
30, 2003 to $1,205,407 in the quarter ended September 30, 2004.
Management anticipates that the controllable operating expense will continue to
be at approximately the same level or lower levels as the quarter ended
September 30, 2004 for the balance of the fiscal year.
OTHER INCOME/EXPENSES
Net other expenses were $435,139 for the quarter ended September 30, 2004,
compared to other expense of $409,544 for the quarter ended September 30, 2003.
The increase over prior year is the result of non-cash amortization of the
discount on the convertible debentures totaling $411,206 compared to $56,801 for
the comparative period of last year. The Company did not close on the
convertible debenture until September 8, 2003, therefore for the comparative
period; the amortization on discount of the convertible debentures was $56,801.
Interest expense decreased for the quarter ended September 30, 2004 vs. the
quarter ended September 30, 2003. For the quarter ended September 30, 2004
interest expense decreased to $129,504 from $262,094. The decrease is a result
of reduced borrowings, compared to the prior year. Other income of $105,571 for
quarter ending September 30, 2004, is a result of the write off old credit
balance due to customers from accounts receivable, which were not deemed to be
applicable to customers' current balances.
INCOME TAXES
For the three month ended September 30, 2004, The Company has not recorded
a tax provision, since the Company has net operating losses for the six months
ending September 30, 2004. The Company has not recorded a benefit for the
current period's losses because realizability is unlikely.
13
SIX MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THE SIX MONTHS ENDED SEPTEMBER
30, 2003
NET SALES
Net sales for the six months ended September 30, 2004 were $22,610,161, compared
to net sales of $40,479,551 for the comparative period of 2003. Sales decreased
$ 17,869,390 or 44% from the comparative period. . The decrease in sales is a
combination of four primary reasons:
1) We loss approximately $2.3 million in sales because we made a
decision not to pursue low margin accounts which tied up cash flow
by not providing us with enough profit margin.
2) We loss approximately $1.5 million in sales because we did not meet
customers demands to introduce new karaoke models as a result of our
inventories being overstocked.
3) We loss approximately $11.3 million in sales from customers that
were discouraged from purchasing from us because of our liquidity
concerns.
4) We loss approximately $7 million in sales to our distributors in
Europe due to high levels of inventories on hand from the prior
year.
The decrease in sales from above accounts was partly offset by an increase in
sales from other accounts.
GROSS PROFIT
Gross profit for the six months ended September 30, 2004 was $5,030,484 or 22%
of sales as compared to $7,146,140 or 17% of sales for the six months ended
September 30, 2003. The year to date gross margins of 84% was generated in the
second quarter. The increase in gross margin percentage compared to the prior
year was due primarily to sales of the newer models at a higher gross profit
margin. In addition, the sales of existing older models have been written down
to the lower of cost or market in the prior year.
OPERATING EXPENSES
Total operating expenses were $4,957,941 for the six months ended September 30,
2004, compared to $10,532,916 for the comparative period of 2003. Operating
expenses decreased compared to prior period by 52% or $5,574,975. This decrease
of expenses is a result of two primary factors:
o In fiscal years 2004 and 2005, one of managements primary objectives was to
continually reduce our operating expenses. Total controllable operating expenses
for six months ending September 30, 2004 decreased 51% from the comparative
period last year or $3,788,268. Controllable expenses include selling, general
and administrative expenses and compensation expense. Selling, general and
administrative expense was reduced by $2,668,657 or 53%, to $2,178,226, from
$4,846,883.
The decrease of the selling, general and administration expenses of $2,226,657
were due to:
o decrease of $121,000 of accounting fees, which is related to the
improvement of our accounting department;
o decrease of $290,000 of consulting fees, which is related to a cut
down in consulting related to our borrowing agreement with our
previous lender;
o decrease of $165,000 of contribution expenses.
o decrease of $508,000 of legal expense, which is related to the
reversal of over accrued legal expense for the year ended March 31,
2004 for the class action settlement in the amount of approximate
$250,000 and reduction of the legal expenses.
o decrease of $345,000 of the rental expenses, which is related to the
early termination of our warehouse facility in Rancho Dominguez, CA
and subleasing our existing facilities;
o decrease of $360,000 of repair fee, which is result of we set up our
QC facility in our Campton, CA warehouse, and we only send the
defective product to factory for repair;
o decease of $165,000 loan amortization cost, which is related to the
termination of borrowing agreement with our previous lender.
Compensation expense on a comparative basis was reduced by $1,119,611 or 45% to
$1,335,780 from $2,455,391. The decrease of the compensation expenses is the
result of the corporate down size. We had 43 employees at the September 30, 2003
compared to 28 employees as at September 30, 2004.
In addition, variable selling related expenses, advertising, commissions,
freight & handling and royalty, decreased as a percent of sales from 7.9% to
6.3% of sales. In total, variable expenses decreased $1,796,707, from $3,230,642
in the six months ended September 30, 2003 to $1,433,935 in the quarter ended
September 30, 2004.
OTHER INCOME/EXPENSES
Net other expenses were $870,354 for the six months ended September 30, 2004,
compared to other expense of $590,343 for the six months ended September 30,
2003. The increase over prior year is the result of amortization of the discount
on the convertible debentures totaling $743,921 compared to $56,801 for the
comparative period of last year. Singing Machine did not close on the
convertible debenture until September 8, 2003. Interest expense decreased for
the six months ended September 30, 2004 vs. the six months ended September 30,
2003. For the six months ended September 30, 2004 interest expense decreased to
$243,704 from $450,562. The decrease is a result of reduced borrowings, compared
to the prior year.
INCOME TAXES
Singing Machine has not recorded a benefit for the current period's losses
because its realizability is unlikely.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 2004, Singing Machine had cash on hand of $928,096 in addition
to $1,544,302 of restricted cash and no bank overdrafts, for a total of
$2,472,398 compared to cash on hand of $356,342 and restricted cash of $874,283
and a bank overdraft of $62,282 at March 31, 2004, for a net balance of
$1,168,343. From March 31,2004 to September 30, 2004 the cash balances increased
$1,304,055. Our current liabilities increased to $14,148,459 from $13,755,092 as
of March 31, 2004, an increase of $393,367. We had net working capital of
$35,702 as of September 30, 2004 and a net working capital of $62,550 as of
March 31, 2004.
Cash flows provided by operating activities were $1,404,583 for the six months
ended September 30, 2004. Cash provided by operating activities primarily
related to a decrease in inventory, increase in accounts payable and receipt of
the tax refund in the amount of $1.1 million. This compares to a negative cash
flow from operations of $4,380,280 for the comparative six month period of
fiscal 2004 a improvement of $5,784,863. The significant changes were a result
of managements focus and control of working capital items, specifically
inventory and accounts receivable.
o Our main focus this year is to sell through the old inventory
carried over from previous years. We have developed less new model
this years so we could sell out the old items. As a result of this
focus, the inventory was decreased by $2.5 million.
o Our accounts receivable increased by $3.7 million due to the
seasonal operation. We started our delivery to our customers in
second quarter of the year. Our accounts receivable will increase in
the second quarter of the year and decrease by the end of the third
quarter.
o Our accounts payable increased by $2.5 million due to the seasonal
operation. We are not current with our primary vendor in China, in
the amount of $1.6 million at September 30, 2004. We have paid down
approximately $700,000 that is past due to the China vendor in the
quarter ending September 30, 2004. We have verbally agreed to a
payment plan that will continue through March 2005 without paying
interest and penalty for the past due amounts.
o Accrued expenses decreased as a result of the class action
settlement in the amount of $1.1 million, of which $800,000 was paid
by our insurance company and $240,000 was settle by 400,000 shares
of common stock. We also paid approximate $200,000 for the music
royalties.
14
Cash used in investing activities for the six months ended September 30, 2004
was $1,245,515. Cash used in investing activities resulted from the purchase of
fixed assets in the amount of $575,495, which consists of the tooling and molds
required for production of new machines for this fiscal year, and the increase
of fixed deposit in the bank, which is used as collateral for the additional
credit facility.
o We have received a federal tax refund in the amount of $1,122,093 in
the quarter ending September 30, 2004. The funds were used to pay
down loans from related party in the amount of $240,000, make a
fixed deposit in HSBC in the amount of $400,000, to obtain
additional credit facility of $1.2 million to finance purchases of
new Karaoke machines and pay down old accounts payable balances of
approximately $400,000 to Singing Machine's Chinese vendor.
Cash flows provided by financing activities were $412,686 for the six months
ended September 30, 2004. This cash inflow was primarily advances from Crestmark
Bank pursuant to the new factoring financial institution.
o As of September 30, 2004, we have been advanced $474,968 by
Crestmark bank. Singing Machine could borrow up to the lesser of the
$2.5 million or 70% of the eligible accounts receivable. As of
September 30, 2004, the funds available to borrow from Crestmark
bank are approximately $35,000.
o Our Hong Kong subsidiary, International SMC, has credit facilities
at HSBC 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. International SMC has increased the
fixed deposit in the amount of $640,000 with HSBC. The fixed deposit
was used as collateral for additional credit facility of $1.9
million. International SMC has utilized the additional facility to
open the letter of credit to the factories for the new shipment. The
balance at September 30, 2004 and March 31, 2004 was $0 and $62,282,
respectively. The interest rate is approximately 4% per annum. As of
September 30, 2004 there was no availability under these facilities.
If we need to use the facilities, we would use the available cash to
retire the letter of credit or to increase our fixed deposit as
collateral to increase our facilities.
o 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 has been repaid on
August 26, 2004.
On November 8, 2004, Singing Machine executed a letter agreement with the
debenture holders, whereby Singing Machine agreed to change the interest rate on
the debenture to 9% in exchange for the debenture holders agreeing to (i)
execute a subordination agreement with Crestmark Bank, (ii) waive all liquidated
damages due under the transaction documents through January 7, 2005, and (iii)
withdraw any demand for repayment under the debenture.
As of September 30, 2004, our available or unrestricted cash on hand has
increased by $571,754 to $928,096 from $356,342. Our average monthly fixed
operating costs are approximately $600,000, which includes the compensation and
the selling, general & administration expenses. We expect that we will need
approximately $1.8 million for working capital during the next three-month
period. Our primary expenses are normal operating costs including salaries,
lease payments for our warehouse space in Compton, California and other
operating costs.
During the three-month period between October and December 2004, we plan on
financing our working capital needs from
o Borrowing from our factoring agreement;
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.
Our sources of cash for working capital in the long term, 12 months and beyond,
are the same as our sources during the short term. 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.
15
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 the Hong Kong Bank and relying on financing from one of our
factories in China.
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 will
consider 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. 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 operating expenses.
Our commitments for debt and other contractual arrangements are summarized as
follows:
Years ending March 31,
--------------------------------------------------------------
Total 2005 2006 2007 2008 2009
--------------------------------------------------------------
Merchandise License Guarantee $ 525,000 $ 375,000 $ 150,000 $ -- $ -- $ --
Property Leases $2,285,847 $ 838,792 $ 579,851 $ 495,545 $ 371,659 $ --
Equipment Leases $ 71,746 $ 31,197 $ 19,502 $ 13,044 $ 6,310 $ 1,692
Subordinated Debt - Related Party $1,000,000 $ -- $1,000,000 $ -- $ -- $ --
Convertible Debentures $4,000,000 $ -- $4,000,000 $ -- $ -- $ --
Interest payments $ 896,667 $ 441,667 $ 455,000 $ -- $ -- $ --
Each of the contractual agreements (except the equipment leases) provides that
all amounts due under that agreement can be accelerated if we default under the
terms of the agreement. For example, if we fail to make a minimum guaranteed
royalty payment that is required under a Merchandise License Agreement on a
timely basis, the licensor can declare us in default and require that all
amounts due under the Merchandise License Agreement are immediately due and
payable.
Merchandise license guarantee reflects amounts that we are obligated to pay as
guaranteed royalties under our various license agreements. In fiscal 2005, we
have guaranteed minimum royalty payments under our license agreements with Care
Bears, MTV, Nickelodeon and Motown (Universal Music).
Property leases represents leases for office and warehouse space in California,
Florida and Hong Kong. Equipment leases represent leases for forklifts and copy
machines.
On September 8, 2003, we issued an aggregate of $4,000,000 of 8% convertible
debentures in a private offering to six accredited investors. The debentures
initially are convertible into 1,038,962 shares of our common stock at $3.85 per
share, subject to adjustment in certain situations. The conversion price has
been reset to $1.41 on July 30, 2004 pursuant to the antidilutions provisions
and the debentures are now convertible into 2,836,879 shares of common stock. It
may have significant impact on Singing Machine's results of operaton. We also
issued an aggregate of 457,143 warrants to the investors. The initial exercise
price of the warrants is $4.025 per share and the warrants expire on September
7, 2006. The exercise price has been adjusted to $1.46 on July 30, 2004 based on
the antidilution adjustment. We have an obligation to register the shares of
common stock underlying the debentures and warrants.
On February 9, 2004 we amended our convertible debenture agreements to increase
the interest rate to 8.5% and to grant warrants to purchase an aggregate of
30,000 shares of our 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. Pursuant to the
convertible debenture agreements, we were 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.
Because we did not have the registration statement declared effective by July
14, 2004, we are in technical default of the convertible debenture agreements.
As such, we are accruing liquidated damages in the amount of $80,000 per month.
Additionally, the convertible debenture holders could declare us in default of
the convertible debentures and accelerate all payments due under the convertible
debentures, which is the principal amount of $4 million plus any liquidated
damages and other fees that are assessed. We are working to cure our event of
default by filing the registration statement as soon as possible. Additionally,
we are trying to enter into another amendment of the convertible debentures and
transaction documents with the convertible debenture holders which would extend
the filing date for the registration statement and eliminate all liquidated
damages. There can be no assurances that we will be able to enter into an
amendment of the convertible debenture agreements.
GOING CONCERN
We have taken the following steps to improve our operation, which believe
will overcome the going concern qualification:
1) Reduce our operating expense and return the operation to
profitability.
Management's highest priority is to return Singing Machine to
profitability for a full year of operations. In order to accomplish
this, management is continually examining how we do business and the
related costs necessary to run the business. We are currently
reviewing warehousing costs and the opportunities for subleasing
excess space in Compton California. We are also looking at reducing
the amount of leased office space for our administrative personnel.
We have also under taken an evaluation of the costs we incur for
quality inspection, repacking and minor repair of products, returned
from our customers.
We have shown a profit improvement in the first two quarters of the
year. We had income from operation of $1.15 million and $0.07
million for the three months and six months ended September 30,
2004, respectively.
2) We are managing our cash flow effectively to meet the current and
long- term liabilities.
We have substantially reduced our current liabilities to both our
vendors in China and also our customers. As stated in our fiscal
year ending March 31, 2004, we owed our major suppliers in China
$2.4 million. Currently this liability has been reduced to
approximately $800 thousand. At April 1, 2004 we owed our customers
over $2.1 million for returned products. We have reduced this
liability to approximately $500 thousand at October 31, 2004. This
reduction in liabilities has gained the confidence from our
suppliers and the customers and will allow us to expand our sales
base for the year ended 2006 with sales to customers that would not
purchase from us, until such liabilities were paid off.
Specifically, liabilities were eliminated with Sears and Target.
Together these two customers accounted for almost $900 thousand of
liabilities at the beginning of the year. Base on the current cash
management forecast, we should be able to meet our liabilities for
the next twelve months.
3) In August, 2004, we have reached agreement with Crestmark Bank to
factor our accounts receivable.
Cresmark Bank will advance a maximum of $2.5 million against our accounts
receivables, for working capital purposes. We will seek additional financing as
needed.
To conclude the above discussion, we have taken necessary steps to return
the operation to profitability, and should be able to meet our liabilities for
the next twelve months. We expect to remove the going concern explanatory
paragraph from our auditor report for the fiscal year ending 2005.
INVENTORY SELL THROUGH
We monitor the inventory levels and sell through activity of our major customers
to properly accrue our sales return and maintain the appropriate level of
inventory. As of December 17, 2004, we are not aware of any major customer that
has a problem to sell through our inventory.
SEASONAL AND QUARTERLY RESULTS
Historically, our operations have been seasonal, with the highest net sales
occurring in our fiscal second and third quarters (reflecting increased orders
for equipment and music merchandise during the Christmas selling months) and to
a lesser extent the first and fourth quarters of the fiscal year. Sales in our
fiscal second and third quarter, combined, accounted for approximately 86% of
net sales in fiscal 2004 and 2003, and 81% of net sales in fiscal 2002.
Our results of operations may also fluctuate from quarter to quarter as a result
of the amount and timing of orders placed and shipped to customers, as well as
other factors. The fulfillment of orders can therefore significantly affect
results of operations on a quarter-to-quarter basis.
INFLATION
Inflation has not had a significant impact on Singing Machine's operations.
Singing Machine has historically passed any price increases on to its customers
since prices charged by Singing Machine are generally not fixed by long- term
contracts.
CRITICAL ACCOUNTING POLICIES
We prepared our consolidated financial statements in accordance with accounting
principles generally accepted in the United States of America. As such,
management is required to make certain estimates, judgments and assumptions that
it believes are reasonable based on the information available. These estimates
and assumptions affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses for the periods presented. The significant accounting policies which
management believes are the most critical to aid in fully understanding and
evaluating our reported financial results included accounts receivable -
allowance for doubtful accounts, reserves on inventory, deferred tax assets and
our Hong Kong income tax exemption.
Collectibility Of Accounts Receivable. The Singing Machine's allowance for
doubtful accounts is based on management's estimates of the creditworthiness of
its customers, current economic conditions and historical information, and, in
the opinion of management, is believed to be an amount sufficient to respond to
normal business conditions. Management sets 100% reserves for customers in
bankruptcy and other reserves based upon historical collection experience.
Should business conditions deteriorate or any major customer default on its
obligations to Singing Machine, this allowance may need to be significantly
increased, which would have a negative impact on operations.
Inventory. The Singing Machine reduces inventory on hand to its net realizable
value based on the expected on an item by item basis when it is apparent that
the expected realizable value of an inventory item falls below its original
cost. A charge to cost of sales results when the estimated net realizable value
of specific inventory items declines below cost. Management regularly reviews
Singing Machine's investment in inventories for such declines in value.
Income Taxes. Significant management judgment is required in developing our
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
asset will not be realized. At December 31, 2003 and March 31, 2004, we
concluded that a valuation allowance was needed against all of our deferred tax
assets, as it was not more likely than not that the deferred taxes would be
realized. At March 31, 2004 and 2003, we had gross deferred tax assets of $8.2
million and $1.9 million, against which we recorded valuation allowances
totaling $8.2 million and $0, respectively.
For the fiscal year ended March 31, 2004, we recorded a tax provision of
$758,505. This occurred because the valuation allowance established against our
deferred tax assets exceeded the amount of the benefit created from carrying
back a portion of the current year's losses. The carry-back of the losses from
the current year resulted in an income tax receivable of $1.1 million, which is
included in refundable tax in the accompanying balance sheets. We have received
the tax fund of $1.1 million on August 24, 2004, which has been used to pay the
related parties' loan and the vendors. we have now exhausted our ability to
carry back any further losses and therefore will only be able to recognize tax
benefits to the extent that it has future taxable income.
Our subsidiary has applied for an exemption of income tax in Hong Kong.
Therefore, no taxes have been expensed or provided for at the subsidiary level.
Although no decision has been reached by the governing body, the parent company
has reached the decision to provide for the possibility that the exemption could
be denied and accordingly has recorded a provision for Hong Kong taxes in fiscal
2003 and 2002. There was no provision for Hong Kong income taxes in fiscal 2004
due to the subsidiary's net operating loss for the year. Hong Kong income taxes
payable totaled $2.4 million at March 31, 2004 and 2003 and is included in the
accompanying balance sheets as income taxes payable.
We effectively repatriated approximately $2.0 million, $5.6 million and $5.7
from its foreign operations in 2004, 2003 and 2002, respectively. Accordingly,
these earnings were taxed as a deemed dividend based on U.S. statutory rates. We
have no remaining undistributed earnings of Singing Machine's foreign
subsidiary.
We operate within multiple taxing jurisdictions and are subject to audit in
those jurisdictions. Because of the complex issues involved, any claims can
require an extended period to resolve. In management's opinion, adequate
provisions for income taxes have been made.
Other Estimates. We makes other estimates in the ordinary course of business
relating to sales returns and allowances, warranty reserves, and reserves for
promotional incentives. Historically, past changes to these estimates have not
had a material impact on our financial condition. However, circumstances could
change which may alter future expectations.
FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK
RISKS ASSOCIATED WITH OUR BUSINESS
WE MAY BE DEEMED TO INSOLVENT AND WE MAY GO OUT OF BUSINESS
16
As of September 30, 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 24% of
our accounts payable, which total $1.7 million as of September 30, 2004. 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.
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 differences which constitute 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 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. The customers are Arbiter,
Giochi and Best Buy, respectively. 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 SIX FACTORIES TO MANUFACTURE AND PRODUCE THE MAJORITY OF OUR
KARAOKE MACHINES FOR FISCAL 2005, AND IF THE RELATIONSHIP WITH THESE FACTORIES
IS DAMAGED OR INJURED IN ANY WAY, IT WOULD REDUCES OUR REVENUES AND
PROFITABILITY
We have worked out a verbal agreement with six factories in China to produce
approximately 95% of our karaoke machines in fiscal 2005. We owe one of these
factories approximately $1.7 million as of November 10, 2004 and have worked out
a payment plan with it. See the "Liquidity" Section. 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
17
In fiscal 2004 and 2003, a number of our customers and distributors returned
karaoke products that they purchased from us. Our total returns represented 9.4%
and 10.4% of our net sales in fiscal 2004 and fiscal 2003, respectively. In the
fourth quarter of fiscal 2004, our customers returned goods valued at $1.8
million, or 2.5% of our net sales.
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 offered 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 $4.8 million. It
is important that we sell this inventory during fiscal 2005, so we have
sufficient cash flow for operations.
OUR SENIOR CORPORATE MANAGEMENT TEAM IS NEW TO THE SINGING MACHINE AND IS
REQUIRED TO DEVOTE SIGNIFICANT ATTENTION TO OUR FINANCING AGREEMENTS AND
SETTLING OUR CLASS ACTION LAWSUITS
Beginning on May 2, 2003, through the present date, 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. Four new directors have joined our Board since October 31, 2004 and two of
them had resigned since that date. Bernard Appel joined our Board effective as
of October 31, 2003 and Harvey Judkowitz joined on March 29, 2004. Richard
Ekstract joined our Board on October 31, 2003 and resigned for personal reasons
on June 2, 2004. Joseph Testa joined our board on September 8, 2004 and resigned
on October 22, 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 . 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.
18
OUR LICENSING AGREEMENT WITH MTV NETWORKS IS IMPORTANT TO OUR BUSINESS AND IF WE
WERE TO LOSE OUT MTV LICENSE IT COULD 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 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.
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. 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 wit 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.
19
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.
THE FACTORIES THAT MANUFACTURE OUR KARAOKE PRODUCTS ARE LOCATED IN THE PEOPLE'S
REPUBLIC OF CHINA, SUBJECTING US TO RISKS COMMON IN INTERNATIONAL OPERATIONS. IF
THERE IS ANY PROBLEM WITH THE MANUFACTURING PROCESS, OUR REVENUES AND NET
PROFITABILITY MAY BE REDUCED.
We are dependent upon six factories in the People's Republic of China to
manufacture the majority of our karaoke machines. One of these factories will be
producing approximately 68% 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. Also, since we do not have written agreements with any of these
factories, we are subject to additional uncertainty if the factories do not
deliver products to us on a timely basis.
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 that our
factories use to produce our karaoke products. If our suppliers are unable to
provide our factories with the parts and supplies, the factories 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 are used in our
karaoke machines. If we are unable to anticipate any shortages of parts and
materials in the future, the factories 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 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 CDG'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.
20
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 September 27, 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.
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.
OUR OBLIGATION TO MAKE SEVERANCE PAYMENTS COULD PREVENT OR DELAY TAKEOVERS
Our employment agreement with Yi Ping Chan and Edward Steele requires us, under
certain conditions, to make substantial severance payments upon resignation and
after a change of control. Mr. Chan is entitled to a severance payment of
$250,000 if he resigns after a change in control. Mr. Steele is entitled to a
severance payment of $125,000 upon resignation or change of 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
21
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.
As of September 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 $1.41 PER SHARE, THE
CONVERSION PRICE OF OUR DEBENTURES AT $1.41 PER SHARE WILL BE REDUCED AND THERE
WILL BE ADDITIONAL DILUTION TO OUR SHAREHOLDERS
We already had to reset the conversion price from $3.85 per share to $1.41 per
share. Given that the closing price for our common stock was $0.575 per share on
September 27, 2004 it is possible that we may again need to sell additional
securities for capital at a price lower than $1.41 per share. If we sell any
securities at a price lower than $1.41 per share, the conversion price of our
debentures currently set at $1.41 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 $1.41 per share, 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 September 27, 2004, which was $0.575 per share, and (b) 50% of
the closing price on September 27, 2004, which is $0.2875 per share.
PRICE OF SINGING MACHINE ADJUSTED CONVERSION NUMBER OF SHARES ISSUABLE UPON
COMMON STOCK PRICE OF DEBENTURE CONVERSION OF DEBENTURE
------------------------- ------------------- ------------------------------
$ 0.575 $ 1.00 4,000,000
$ 0.2875 $ .85 4,705,882
$ 0.1438 $ 0.78 5,128,205
If the price of our securities continues to decrease, and we continue to issue
or sell our securities at price below $1.41 per share, our obligation to issue
shares upon conversion of the debentures is essentially limitless.
When the conversion price reset occurs, the effective conversion price will
decrease, the value of beneficial conversion will increase. The additional value
of beneficial conversion would be recognized as discount on the convertible
debentures.
IF OUR OUTSTANDING DERIVATIVE SECURITIES ARE EXERCISED OR CONVERTED, OUR
EXISTING SHAREHOLDERS WILL SUFFER DILUTION
As of November 3, 2004, there were outstanding stock options to purchase an
aggregate of 1,101,490 shares of common stock at exercise prices ranging from
$0.57 to $14.30 per share, not all of which are immediately exercisable. The
weighted average exercise price of the outstanding stock options is
approximately $3.68 per share. As of November 2004, there were outstanding
immediately exercisable option to purchase an aggregate of 580,882 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
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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. Under anti-dilution provision,
the convertible debentures are convertible into an aggregate of 2,831,858 shares
of common stock. To the extent that the aforementioned convertible securities
are exercised or converted, dilution to our stockholders will occur.
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 November 3, 2004, there were 9,02,813 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 4,959,228 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 November 3, 2004, we had 9,202,813 shares of
common stock issued. We have an obligation to issue up to:
1,692,530 shares issuable under outstanding options and warrants; and
2,831,858 shares upon conversion of the convertible debentures.
We have also reserved up to 207,791 additional shares for interest payment
on the debentures. As such, our Board of Directors has the power, without
stockholder approval, to issue up to 4,965,008 shares of common stock.
Any issuance of additional shares of common stock, whether by us to new
stockholders or the exercise of outstanding warrants or options, may result in a
reduction of the book value or market price of our outstanding common stock.
Issuance of additional shares will reduce the proportionate ownership and voting
power of our then existing stockholders.
PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW MAKE IT DIFFICULT FOR A
THIRD PARTY TO ACQUIRE OUR COMPANY AND COULD DEPRESS THE PRICE OF OUR COMMON
STOCK
Delaware law and our certificate of incorporation and bylaws contain provisions
that could delay, defer or prevent a change in control of our company or a
change in our management. These provisions could also discourage proxy contests
and make it more difficult for you and other stockholders to elect directors and
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take other corporate actions. These provisions of our restated certificate of
incorporation include: authorizing our board of directors to issue additional
preferred stock, limiting the persons who may call special meetings of
stockholders, and establishing advance notice requirements for nominations for
election to our board of directors or for proposing matters that can be acted on
by stockholders at stockholder meetings.
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
to find alternative sources of inventory at competitive prices, we cannot assure
you that we would be able to do so. These exposures are directly related to our
normal operating and funding activities. Historically and as of September 30,
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 defined in Rule
13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934, as of
September 30, 2004 (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. In response, we hired
an independent accounting firm as a consultant to review and implement
procedures on inventory costing and valuation, as well accounts receivables and
recognition in order to ensure that there were no 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. The Chief Executive Officer and Chief Financial Officer have
concluded that as of the Evaluation Date our disclosure controls and procedures
were not effective 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.
The Company is committed to improving the financial organization. As part
of this commitment, within the past six months the Company hired a new Chief
Financial Officer, Financial Controller, a staff accountant as well as a
EDI/Accounting administration person responsible for retrieving and updating
customers sales information and inventory.
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The Company has taken following actions to mitigate the deficiency of our
internal control during the six months ending September 30, 2004:
i) The Company has assigned one of its' qualified accountants on
temporary assignment from its Hong Kong subsidiary, to assist the
company in the monthly financial closing. The Company hired the
qualified staff accountant on September 20, 2004. The addition of
this qualified Staff Accountant will provide the Company the ability
to strengthen internal controls with the additional segregation of
finance functions. In addition with the new staff accountant the
Company is implementing standard month end closing procedures with
specific due dates to improve the accuracy and timeliness of the
Financial Statements. The financial statements has been analyzed and
reviewed on a monthly basis by senior accounting management.
ii) We have had several meeting with customer, who we have consigned our
inventory. The objective of those meeting is to establish standard
procedures for monthly reporting and reconciliation to ensure the
transaction has been recorded correctly. We now have our customer's
commitment to verify and reconcile the consigned inventory account
on a monthly basis. We will monitor the procedures for the next two
months to insure compliance to the new established procedures.
iii) The Company is implementing an actual FIFO perpetual cost system.
Our inventory costing module has been integrated into our general
ledger module. The costing information are automatically flow
through to financial statement without manual entry, which would
ensure the data integrity and accuracy. Also it would eliminate and
prevent the manual entry error, which created the costing problem in
the past.
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.
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.
The court entered an order approving the settlement agreement on July 30,
2004. The Company has issued the 400,000 shares to the plaintiffs on September
23, 2004. The cost of the 400,000 shares is $240,000 based on the stock closing
price on September 23, 2004.
ITEM 2. CHANGES IN SECURITIES
(a) On September 23, 2004, we issued 400,000 shares of our common stock to
escrow for the benefit of the plaintiffs from the class action lawsuit. This
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share issuance was exempt from registration pursuant to Section 3 (a) (10) of
the Securities Act of 1933 pursuant to a court approved settlement dated July
30, 2004.
(b) Not Applicable.
(c)) Not Applicable
(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
10.1 Letter Agreement with Debenture Holders dated November 8, 2004
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
(b) Reports on Form 8-K
The Company filed the following Current Reports on Form 8-K during the
quarterly period ended September 30, 2004:
Date of Report Items Reported Financial Statements Filed
8-K Current report, item 3.02 2004-09-28
8-K Current report, items 5.02 and 9.01 2004-09-07
8-K Current report, items 12 and 7 2004-08-17
10-Q Quarterly report [Sections 13 or 15(d)] 2004-08-16
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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 January 3, 2005 By: /s/ YI PING CHAN
--------------------------------------------
Chief Executive Officer and
Chief Operating Officer
Dated: January 3, 2005 By: /s/ JEFFREY S. BAROCAS
--------------------------------------------
Jeffrey S. Barocas
Chief Financial Officer (Principal Financial
Officer and Accounting Officer)
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