SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q/A
AMENDMENT TO
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended DECEMBER 31, 2003
0 - 24968
Commission File Number
THE SINGING MACHINE COMPANY, INC.
(Exact Name of Small Business Issuer as Specified in its Charter)
DELAWARE 95-3795478
(State (I.R.S. Employer
of Incorporation) I.D. No.)
6601 LYONS ROAD, BUILDING A-7, COCONUT CREEK, FL 33073
(Address of principal executive offices )
(954) 596-1000 (Issuer's
telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirement for the past 90 days. Yes |X| No |_|
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS
Check whether the registrant filed all documents and reports required to be
filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of
securities under a plan confirmed by a court. Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X|
APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
NUMBER OF SHARES
CLASS OUTSTANDING ON DECEMBER 31, 2003
------------------------------ -------------------------------
Common Stock, $0.01 par value 8,752,320
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
INDEX
PAGE NO.
--------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets - December 31, 2003 (Unaudited) and March 31, 2003 3
Consolidated Statements of Operations - Three and Nine months (Unaudited) and 4
2002 (Unaudited, restated)..
Consolidated Statements of Cash Flows - Nine months ended December 31, 2003 5
(unaudited) and 2002 (Unaudited, restated))
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations 13
Item 3. Quantitative and Qualitative Disclosure About Market Risk 29
Item 4. Controls and Procedures 30
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 30
Item 2. Changes in Securities 32
Item 3. Defaults Upon Senior Securities 33
Item 4. Submission of Matters to a Vote of Security Holders 33
Item 5. Other Information 33
Item 6. Exhibits and Reports on Form 8-K 33
SIGNATURES 34
2
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
PART I - FINANCIAL INFORMATION
ITEM I. FINANCIAL STATEMENTS
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
MARCH 31, DECEMBER 31,
2003 2003
------------ -------------
(unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 235,958 $ 268,265
Restricted Cash 866,413 838,411
Accounts Receivable, less allowances of $816,235 14,729,176 5,762,944
and $405,759 respectively
Due from manufacturer 1,112,200 1,091,871
Inventories, net 8,029,371 25,194,346
Prepaid expense and other current assets 2,294,377 1,483,602
Deferred tax asset -- 1,925,612
------------ ------------
TOTAL CURRENT ASSETS 27,267,495 36,565,051
PROPERTY AND EQUIPMENT, at cost less accumulated
depreciation of $2,567,480 and $1,472,850 respectively 1,365,687 2,026,252
OTHER ASSETS
Other non-current assets 970,464 343,991
------------ ------------
TOTAL ASSETS $ 29,603,646 $ 38,935,294
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Bank overdraft $ 85,236 $ 316,646
Accounts payable 5,331,470 8,486,009
Accrued expenses 2,587,579 1,443,406
Subordinated debt-related parties 1,000,000 400,000
Revolving credit facilities 7,115,114 6,782,824
Income taxes payable 2,872,509 3,821,045
------------ ------------
TOTAL CURRENT LIABILITIES 18,991,908 21,249,930
------------ ------------
LONG TERM LIABILITIES
Convertible debentures, net of unamortized discount of $3,046,000 954,210 --
------------ ------------
TOTAL LIABILITIES 19,946,118 21,249,930
SHAREHOLDERS' EQUITY
Preferred stock, $1.00 par value; 1,000,000 shares authorized,
no shares issued and outstanding -- --
Common stock, Class A, $.01 par value; 100,000 shares authorized;
no shares issued and outstanding -- --
Common stock, $0.01 par value; 18,900,000 shares authorized;
8,752,320 and 8,171,678 shares issued and outstanding 87,523 81,717
Additional paid-in capital 10,234,410 4,843,430
Retained earnings (664,405) 12,760,217
------------ ------------
TOTAL SHAREHOLDERS' EQUITY 9,657,528 17,685,364
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 29,603,646 $ 38,935,294
============ ============
The accompanying notes are an integral part of these financial statements.
3
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
----------------------------- ------------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
(as restated) (as restated)
NET SALES $ 28,689,623 $ 45,659,446 $ 68,053,739 $ 81,915,443
COST OF SALES
Cost of goods sold 30,782,268 36,628,126 64,948,809 64,155,095
Impairment of tooling 508,480 -- 508,480 --
------------ ------------ ------------ ------------
GROSS PROFIT (2,601,125) 9,031,320 2,596,449 17,760,348
OPERATING EXPENSES:
Compensation 1,097,327 1,257,519 3,552,718 2,827,823
Freight & handling 523,177 944,169 1,153,353 1,605,445
Selling, general & administrative expenses 3,410,116 1,748,400 8,908,899 4,675,279
------------ ------------ ------------ ------------
TOTAL OPERATING EXPENSES 5,030,620 3,950,088 13,614,971 9,108,547
------------ ------------ ------------ ------------
(LOSS) EARNINGS FROM OPERATIONS (7,631,744) 5,081,232 (11,018,521) 8,651,801
OTHER INCOME (EXPENSES):
Other income 32,098 38,628 (50,882) 196,648
Interest expense (687,178) (117,704) (1,194,541) (228,597)
Interest income -- -- -- 11,943
------------ ------------ ------------ ------------
NET OTHER (EXPENSES) INCOME (655,079) (79,076) (1,245,422) (20,006)
NET (LOSS) EARNINGS BEFORE INCOME TAX (8,286,825) 5,002,156 (12,263,944) 8,631,795
INCOME TAX EXPENSE 2,163,776 1,681,629 1,160,678 2,674,659
------------ ------------ ------------ ------------
NET (LOSS) EARNINGS $(10,450,601) $ 3,320,527 $(13,424,622) $ 5,957,136
============ ============ ============ ============
(LOSS) EARNINGS PER SHARE:
Basic $ (1.20) $ 0.41 $ (1.58) $ 0.74
Diluted $ (1.20) $ 0.37 $ (1.58) $ 0.67
WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT
SHARES OUTSTANDING:
Basic 8,729,818 8,123,548 8,503,065 8,101,441
Diluted 8,729,818 8,944,027 8,503,065 8,947,897
The accompanying notes are an integral part of these financial statements.
4
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)
FOR THE NINE MONTHS ENDED
DECEMBER 31,
-------------------------------
2003 2002
------------ -------------
(restated)
CASH FLOWS FROM OPERATING ACTIVITIES
Net (loss) earnings $(13,424,622) $ 7,475,119
Adjustments to reconcile net (loss) earnings to net cash used
in operating activities
Depreciation and amortization 1,165,687 454,806
Impairment of tooling 508,480
Provision for inventory 4,996,685 --
Provision for bad debt 410,476 --
Amortization of discount on convertible debentures 444,584 --
Stock compensation expense 511,299 --
Deferred tax benefit 1,925,612 452,673
Changes in assets and liabilities:
(Increase) decrease in:
Accounts Receivable (9,376,708) (15,998,298)
Due from manufacturer (20,329) (264,908)
Inventories 12,168,290 (20,742,572)
Prepaid Expenses and other assets (858,011) (1,218,091)
Increase (decrease) in:
Accounts payable (3,154,539) 11,203,268
Accrued expenses 653,540 3,705,878
Income taxes payable (948,536) 572,254
------------ ------------
Net Cash Used in Operating Activities (4,998,092) (14,359,871)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Restricted cash (28,002) (3,640)
Purchase of property and equipment (434,065) (1,112,376)
------------ ------------
Net cash used in Investing Activities (462,067) (1,116,016)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings from revolving credit facilities 27,777,630 37,612,713
Repayments to revolving credit facilities (27,445,340) (27,449,625)
Proceeds from issuance of convertible debentures 4,000,000 --
Bank Overdraft (231,410) --
Payment of financing fees related to convertible debentures (255,000) --
Proceeds from subordinated debt-related parties, net 600,000 --
Proceeds from exercise of stock options and warrants 981,972 155,579
------------ ------------
Net cash provided by Financing Activities 5,427,852 10,318,667
------------ ------------
DECREASE IN CASH AND CASH EQUIVALENTS (32,307) (5,157,220)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 268,265 5,520,147
------------ ------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 235,958 $ 362,927
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
CASH PAID FOR THE NINE MONTHS ENDED DECEMBER 31, 2003
Interest $ 591,817 $ 228,597
============ ============
Income Taxes $ 1,388,102 $ 73,207
============ ============
NON-CASH FINANCING ACTIVITIES
Stock based compensation $ 511,299 $ --
============ ============
Discounts for warrants issued in connection with and beneficial
conversion feature of convertible debentures $ 3,494,274 $ --
============ ============
Financing fees in connection with convertible debenture issuance,
paid in stock and warrants 409,527 --
============ ============
The accompanying notes are an integral part of these financial statements.
5
THE SINGING MACHINE COMPANY, INC AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 - SUMMARY OF ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements include the
accounts of The Singing Machine Company, Inc. and International SMC (H.K.) Ltd.,
its wholly-owned subsidiary (the "Company", "The Singing Machine"). All
significant intercompany transactions and balances have been eliminated. The
unaudited consolidated financial statements have been prepared in conformity
with Rule 10-01 of Regulation S-X of the Securities and Exchange Commission and
therefore do not include information or footnotes necessary for a complete
presentation of financial position, results of operations and cash flows in
conformity with accounting principles generally accepted in the United States of
America. However, all adjustments (consisting of normal recurring accruals),
which, in the opinion of management, are necessary for a fair presentation of
the financial statements, have been included. Operating results for the period
ended December 31, 2003 are not necessarily indicative of the results that may
be expected for the remaining quarter or the year ending March 31, 2004 due to
seasonal fluctuations in The Singing Machine's business, changes in economic
conditions and other factors. For further information, please refer to the
Consolidated Financial Statements and Notes thereto contained in The Singing
Machine's Annual Report on Form 10-K for the year ended March 31, 2003.
INVENTORIES
Inventories are comprised of electronic karaoke audio equipment, accessories,
and compact discs and are stated at the lower of cost or market, as determined
using the first in, first out method. The following table represents the major
components of inventory at the dates specified.
DECEMBER 31, 2003 MARCH 31, 2003
----------------- --------------
Finished goods $ 13,463,330 $ 27,807,763
Inventory in transit 1,200,221 1,101,940
Provision for losses (6,634,180) (3,715,357)
----------------- --------------
Total Inventory $ 8,029,371 $ 25,194,346
================= ==============
Although management has taken a provision, which they estimate, based on recent
contacts with customers, to be a sufficient reserve for potential losses on
disposal of existing inventory, the Company's sales are highly seasonal and unit
sales and their related selling prices during peak seasons may not meet
expectations. Therefore, management's estimates could differ significantly from
actual outcome and have a material impact on future operations. The Company also
made the decision to discontinue certain models from their line. A reserve was
taken against the remaining inventories of these discontinued items to enable
the items to be sold through alternate sales arenas, such as through liquidation
facilities. Management believes that at September 30, 2003, there was not
sufficient evidence warranting an additional reserve against inventory at that
time, as the peak selling season had just begun and there were no indications
that the inventory would not be sold.
RECLASSIFICATIONS
Certain prior period amounts have been reclassified to conform to the current
period presentation.
STOCK BASED COMPENSATION
The Company accounts for stock options issued to employees using the intrinsic
value method in accordance with the provisions of Accounting Principles Board
("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. As such, compensation cost is measured on the date of grant as
the excess of the current market price of the underlying stock over the exercise
price, if any. Such compensation amounts are amortized over the respective
vesting periods of the option grant. The Company applied the disclosure
provisions of Statement of Financial Accounting Standards ("Statement") No. 148,
"Accounting for Stock-Based Compensation-
6
Transition and Disclosure, an amendment of Statement No. 123", "Accounting for
Stock Based Compensation", which permits entities to provide pro forma net
earnings (loss) and pro forma earnings (loss) per share disclosures for employee
stock option grants as if the fair-valued based method defined in Statement No.
123 had been applied to options granted.
Had compensation cost for the Company's stock-based compensation plan been
determined using the fair value method for awards under that plan, pursuant to
Statement No. 123, the Company's net (loss) earnings would have been changed to
the pro-forma amounts indicated below.
FOR THE THREE MONTHS ENDEDED FOR THE NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
----------------------------- -----------------------------
2003 2002 2003 2002
--------------- ------------ -------------- -------------
Net (loss) earnings As reported $ (10,450,601) $ 3,320,527 $ (13,424,622) $ 5,957,136
Pro forma $ (10,653,283) 3,291,655 $ (14,032,668) $ 5,870,518
Net (loss) earnings per share - basic As reported $ (1.20) $ 0.41 $ (1.58) $ 0.74
Pro forma $ (1.22) $ 0.41 $ (1.65) $ 0.72
Net (loss) earnings per share - diluted As reported $ (1.20) $ 0.37 $ (1.58) $ 0.67
Pro forma $ (1.22) $ 0.37 $ (1.65) $ 0.66
For stock options and warrants issued to non-employees, the Company applies the
fair value method of accounting pursuant to Statement 123. Due to a change in
status of a former employee, an expense of $220,835 was charged to compensation
expense in August 2003.
For financial statement disclosure purposes and for purposes of valuing stock
options and warrants issued to non-employees, the fair market value of each
stock option granted was estimated on the date of grant using the Black-Scholes
Option-Pricing Model in accordance with Statement No. 123 using the following
weighted-average assumptions:
Third Quarter 2004: expected dividend yield 0%, risk-free interest rate of 2.5%,
volatility 110.05% and expected term of five years. Third Quarter 2003: expected
dividend yield 0%, risk-free interest rate of 6.8%, volatility 42% and expected
term of two years.
RECENT ACCOUNTING PRONOUNCEMENTS
Statement No. 149, "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities" amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under Statement 133. Statement 149 is generally effective for
contracts entered into or modified after June 30, 2003 (with a few exceptions)
and for hedging relationships designated after June 30, 2003. The provisions of
Statement 149 did not have a material impact on the Company's financial position
or results of operations.
Statement No. 150, "Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity" improves the accounting for
certain financial instruments that, under previous guidance, issuers could
account for as equity. The new Statement requires that those instruments be
classified as liabilities in statements of financial position. This statement is
effective for instruments entered into or modified after May 31, 2003. The
provisions of Statement 150 did not have a material impact on the Company's
financial position or results of operations.
NOTE 2 - GOING CONCERN
The accompanying unaudited consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America, which contemplate continuation of the Company as a going concern
(See Management Discussion and Analysis - Liquidity and Capital Resources).
7
On March 14, 2003, the Company was notified of its violation of the tangible net
worth covenant of its Loan and Security Agreement (the "Agreement") with its
commercial lender and the Company was declared in default under the Agreement.
The lender amended the Agreement on August 19, 2003. Pursuant to this fourteenth
amendment the loan was extended until March 31, 2004 and the condition of
default was waived.
As of December 31, 2003, the Company again violated the tangible net worth and
working capital covenants of the Agreement. As of January 31, 2004 the loan was
paid in full, the facility was terminated and the UCC filings were released.
NOTE 3 - RESTATEMENT OF FINANCIAL STATEMENTS FOR THE FISCAL YEARS 2002 AND 2001
In June 2003, management revised its position on taxation of the income of
International SMC (H.K.) Ltd., its wholly-owned subsidiary, by the United States
and by the Hong Kong tax authorities for the reasons stated below.
With regard to taxation in Hong Kong, International SMC had previously applied
for a Hong Kong offshore claim income tax exemption based on the locality of its
profits. Management believed that the exemption would be approved because the
source of all profits of International SMC is from exporting to customers
outside of Hong Kong. Accordingly, no provision for income taxes was provided in
the consolidated financial statements as of March 31, 2002 and 2001. However,
full disclosure was previously reflected in the audited financial statements for
years ended March 31, 2002 and 2001 of the estimated amount that would be due to
the Hong Kong tax authority should the exemption be denied. Management is
continuing its exemption application process. However, due to the extended
period of time that the application has been outstanding, as well as
management's reassessment of the probability that the application will be
approved, management has determined to restate the 2002 and 2001 consolidated
financial statements to provide for such taxes. The effect of such restatement
is to increase income tax expense by $748,672 and $468,424 in fiscal 2002 and
2001, respectively. However, the Company can claim United States foreign tax
credits in 2002 for these Hong Kong taxes, which is reflected in the final
restated amounts.
With regard to United States taxation of foreign income, the Company had
originally taken the position that the foreign income of the Hong Kong
subsidiary qualified for a deferral under the Internal Revenue Code (Section
956) allowing for such income to be indefinitely deferred and not taxed in the
United States until such income is repatriated, or brought back into the United
States as taxable income. It was expected that this income would remain in Hong
Kong. Full disclosure of the amount and nature of the indefinite deferral for
fiscal year 2002 was reflected in the income tax footnote of the consolidated
financial statements for that year. The internal revenue code, regulations and
case law regarding international income taxation is quite complex and subject to
interpretation. Each case is determined based on the individual facts and
circumstances. Due to certain inter-company loans, relating to inventory
purchases, made in 2002 and 2003, the profits previously considered to be
indefinitely deferred became partially taxable as "deemed dividends" under
section 956 of the Internal Revenue Code. Although certain arguments against the
imposition of a "deemed dividend" may be asserted, management has determined to
restate the fiscal year 2002 consolidated financial statements based on its
reassessment of its original position. The effect of such restatement is to
increase income tax expense by $1,027,545 in fiscal year 2002, which includes
the utilization of the foreign tax credits referred to above.
The net effect of the above two adjustments for the quarter and nine months
ended December 31, 2002 is to decrease net income by $576,060 and $1,517,983,
respectively. The net effect on net income per share is to decrease net income
per share basic and diluted by $0.07 and $0.06 for the quarter and $0.18 and
$0.17 for the nine months ended December 31, 2002.
In September, 2004, the management revised the cash flow for the period ending
March 31, June 30, September 30, and December 31, 2003. The amendments are
related to the reclassification of the "Restrict Cash" and "Bank Overdraft".
There is no effect to the Statement of Operations. The following table shows the
reclassification of the cash flow:
8
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
COMPRESSED CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED EXCEPT FOR PERIOD ENDING 03/31/03)
FOR PERIOD ENDING
----------------------------------------------------------------
03/31/03 03/31/03 06/30/03 06/30/03
------------ ------------ ------------ ------------
AS REPORTED AS AMENDED AS REPORTED AS AMENDED
------------ ------------ ------------ ------------
Cash flows from operating activities
Net Income $ 1,217,812 $ 1,217,812 $ (2,317,352) $ (2,317,352)
Net Cash Used in Operating Activities (11,532,761) (11,524,680) (10,948) 282,757
------------ ------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Net cash used in Investing Activities (1,144,064) (1,468,791) (299,186) (322,897)
------------ ------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net cash provided by Financing Activities 7,424,943 7,741,589 128,282 (141,712)
------------ ------------ ------------ ------------
DECREASE IN CASH AND CASH EQUIVALENTS (5,251,882) (5,251,882) (181,852) (181,852)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 5,520,147 5,520,147 268,265 268,265
------------ ------------ ------------ ------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 268,265 $ 268,265 $ 86,413 $ 86,413
============ ============ ============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for interest $ 406,126 $ 406,126 $ 188,469 $ 188,469
============ ============ ============ ============
Cash paid during the year for income taxes $ 153,849 $ 153,849 $ -- $ --
============ ============ ============ ============
` FOR PERIOD ENDING
----------------------------------------------------------------
09/30/03 09/30/03 12/31/03 12/31/03
------------ ------------ ------------ ------------
AS REPORTED AS AMENDED AS REPORTED AS AMENDED
------------ ------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income $ (2,974,021) $ (2,974,021) $(13,424,622) $(13,424,622)
Net Cash Used in Operating Activities (4,678,328) (4,380,280) (4,998,092) (4,998,092)
------------ ------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Net cash used in Investing Activities (157,178) (186,370) (434,065) (462,067)
------------ ------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net cash provided by Financing Activities 5,673,244 5,404,388 5,399,850 5,427,852
------------ ------------ ------------ ------------
DECREASE IN CASH AND CASH EQUIVALENTS 837,738 837,738 (32,307) (32,307)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 268,265 268,265 268,265 268,265
------------ ------------ ------------ ------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,106,003 $ 1,106,003 $ 235,958 $ 235,958
============ ============ ============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for interest $ 350,192 $ 350,192 $ 591,817 $ 591,817
============ ============ ============ ============
Cash paid during the year for income taxes $ 205,000 $ 205,000 $ 205,000 $ 205,000
============ ============ ============ ============
NOTE 4 - IMPAIRMENT OF TOOLING
9
Pursuant to Statement No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets", the Company recorded a loss on impairment of tooling. In
December 2003, and as a result of the Company's decision to discontinue certain
models, management estimated that the amounts recoverable on certain tooling
through future operations, on an undiscounted basis, were below their book
values. An expense of $508,480 was charged to operations for this impairment.
NOTE 5 - PROVISION FOR INCOME TAX
Significant management judgment is required in developing the Company's
provision for income taxes, including the determination of foreign tax
liabilities, deferred tax assets and liabilities and any valuation allowances
that might be required against the deferred tax assets. At December 31, 2003,
the Company concluded that a valuation allowance was needed against all of the
Company's deferred tax assets, as it is not more likely than not that the
deferred taxes will be realized. For the three months ended December 31, 2003,
the Company recorded a tax provision of $2.2 million. This provision was created
because the valuation allowance established against the deferred tax asset
exceeded the amount of the benefit created from carrying back a portion of the
current period losses. The carry-back of the losses from the current period
resulted in an income tax receivable of $1.2 million, which is included in
prepaid and other current assets in the accompanying balance sheets.
The Company's wholly-owned subsidiary, has applied for an exemption of income
tax in Hong Kong. Therefore, no taxes have been expensed or provided for at the
Subsidiary level. Although the governing body has reached no decision to date,
the U.S. parent company has reached the decision to provide for the possibility
that the exemption could be denied and accordingly has recorded a provision in
fiscal 2004, 2003, 2002, and 2001. For the nine months ended December 31, 2003,
a provision of $424,763 was recorded at the Hong Kong statutory rate of 17.5%.
Accrued Hong Kong taxes payable on the current and prior earnings of the
Company's Hong Kong subsidiary totaled $2.9 million at December 31, 2003.
The Company operates within multiple taxing jurisdictions and is subject to
audit in those jurisdictions. Because of the complex issues involved, any claims
can require an extended period to resolve. In management's opinion, adequate
provisions for income taxes have been made.
NOTE 6 - LOANS AND LETTERS OF CREDIT
CREDIT FACILITY
The Company's Hong Kong Subsidiary maintains separate credit facilities at two
international banks. The primary purpose of the facilities is to provide the
Subsidiary with the following abilities:
o Overdraft protection facilities
o Issuance and negotiation of letters of credit, both regular and discrepant o
Trust receipts o A Company credit card
The facilities are secured by a corporate guarantee from the U.S. Company,
restricted cash on deposit with the lender and require that the Company maintain
a minimum tangible net worth. The maximum available credit under the facilities
is $5.5 million. The balance at December 31, 2003 and 2002 was $4,640,728 and
$0, respectively.
LOAN AND SECURITY AGREEMENT
On April 26, 2001, the Company executed a Loan and Security Agreement (the
"Agreement") with a commercial lender (the "Lender"), which as amended on August
19, 2003, was due to expire on March 31, 2004. At December 31, 2003 and 2002 the
amount outstanding was $2,474,386 and $10,163,088, respectively. As of January
31, 2004 the loan was paid in full, the facility was terminated and the UCC
filings were released.
SUBORDINATED DEBT
As of July 10, 2003, the Company obtained $1 million in subordinated debt
financing from a certain officer, directors and an associate of a director. The
loans are accruing interest at 9.5% per annum and paid quarterly. These loans
were originally scheduled to be paid back by October 31, 2003; however, the
notes have since been subordinated to the Company's credit facility and the
total amount outstanding of $1 million will not be repaid until either the
subordination is released by the Company's lender or the credit facility is
closed.
10
NOTE 7 - 8% CONVERTIBLE DEBENTURES WITH WARRANTS
In September 2003, the Company issued $4 million of 8% Convertible Debentures in
a private offering which are due February 20, 2006 ("Convertible Debentures").
The net cash proceeds received by the Company were $3,745,000 after deduction of
cash commissions and other expenses.
The Convertible Debentures are subordinated to the Company's Lender and are
convertible at the option of the holders into 1,038,962 Common Shares at the
conversion rates referred to below, subject to certain anti-dilution adjustment
provisions, at any time after the closing date. Each Convertible Debenture may
be convertible into common shares, at a conversion price of $3.85 per Common
Share. of the registration statement
The Convertible Debentures are subordinated to the Company's Lender and are
convertible at the option of the holders into 1,038,962 Common Shares at the
conversion rates referred to below, subject to certain anti-dilution adjustment
provisions, at any time after the closing date. Each Convertible Debenture may
be convertible into common shares, representing an initial conversion price of
$3.85 per Common Share
These Convertible Debentures were issued with 457,143 detachable stock purchase
warrants with an exercise price of $4.025 per share. These warrants may be
exercised at anytime after September 8, 2003 and before September 7, 2006 and
are subject to certain anti-dilution provisions. The warrants are also subject
to an adjustment provision; whereas the price of the warrants may be changed
under certain circumstances.
The Convertible Debentures bear interest at the stated rate of 8% per annum.
Interest is payable quarterly on March 1, June 1, September 1, and December 1.
The interest may be payable in cash, shares of Common Stock, or a combination
thereof subject to certain provisions and at the discretion of the Company. On
February 9, 2004 the stated rate of interest was raised to 8.5%.
In accounting for this transaction, the Company allocated $1.2 million of the
proceeds to the estimated fair value of the stock purchase warrants and $2.3
million as the estimated fair value of the beneficial conversion feature. These
amounts resulted in a discount in the convertible debentures of $3.5 million,
which is being amortized over the life of the debt on a straight-line basis to
interest expense. Total amortization for the nine months ended December 31, 2003
was $444,584.
In connection with the Convertible Debentures the Company paid financing fees as
follows: 103,896 stock purchase warrants, with a fair value of $264,671, 28,571
shares of common stock with a fair value of $141,141, and cash of $255,000.
Total financing fees of $660,812 were recorded as deferred fees and are being
amortized over the term of the debentures on a straight-line basis. The
unamortized deferred fees are reported in other non-current assets in the
accompanying balance sheets.
NOTE 8 - COMMITMENTS AND CONTINGENCIES
LEGAL MATTERS
Class Action. From July 2003 through August 2003, eight securities class action
lawsuits were filed against the Company and certain of its officers and
directors in the United States District Court for the Southern District of
Florida on behalf of all persons who purchased The Singing Machine's securities
during the various class action periods specified in the complaints. These
complaints have all been consolidated into one action styled Bielansky, et al.
v. Salberg & Co., et al., Case No. 03-80596-ZLOCH (the Shareholder Action).
The complaints in the Shareholder Action allege violations of Section 10(b) and
Section 20(a) of the Securities Exchange Act of 1934 and Rule 10(b)-5
promulgated there under. These complaints seek compensatory damages, attorney's
fees and injunctive relief.
In July 2003, a shareholder filed a derivative action against the Company, its
board of directors and senior management purporting to pursue the action on
behalf of the Company and for its benefit. No pre-lawsuit demand was made on the
board of directors for them to investigate the allegations or to bring action.
The Company is named as a nominal defendant in this case. This case has been
consolidated into the Shareholder Action identified above.
11
This derivative complaint alleges claims for breach of fiduciary duty, abuse of
control, gross mismanagement, waste of corporate assets and unjust enrichment.
The complaint alleges that the individual defendants breached their fiduciary
duties and engaged in gross mismanagement by allegedly ignoring indicators of
the lack of control over the Company's accounting and management practices,
allowing the Company to engage in improper conduct and otherwise failing to
carry out their duties and obligations to the Company. The plaintiffs seek
damages for breach of fiduciary duties, punitive and compensatory damages,
restitution, and bonuses or other incentive-based or equity based compensation
received by the CEO and CFO under the Sarbanes-Oxley Act of 2002
The court in the Shareholder Action has directed plaintiffs' counsel to file one
amended consolidated complaint no later than November 14, 2003.
12
The Company intends to vigorously defend the Shareholder Action. As the outcome
of litigation is difficult to predict, significant changes in the estimated
exposures could occur which could have a material affect on the Company's
operations.
A second shareholder derivative suit was filed in October 2003, which makes
generally the same allegations. The second derivative suit has not been served
on the Company or on any of its current or former officers and directors. This
suit was transferred to the same judge to whom the Shareholder Action was
assigned and has been consolidated into the Shareholder Action.
Other Matters. In August 2003, we were advised that the Securities and Exchange
Commission had commenced an informal inquiry of our company. We are cooperating
fully with the SEC staff. It appears that the investigation is focused on the
restatement of our audited financial statements for fiscal 2002 and 2001. We
have been advised that an informal inquiry should not be regarded as an
indication by the SEC or its staff that any violations of law have occurred or
as a reflection upon any person or entity that may have been involved in those
transactions.
The Company entered into a separation and release agreement with an executive on
December 19, 2003. The agreement provided for the individual to receive $159,281
in settlement of the Company's contract. The amount has been expensed as
compensation at December 31, 2003.
The Company entered into a settlement agreement with an investment banker on
November 17, 2003. Pursuant to this agreement, the Company will pay the sum of
$181,067 over a six month period and has issued to the investment banker 40,151
shares of stock with a fair value of $94,355.
The Company amended its convertible debenture agreements to increase the
interest rate to 8.5% effective as of February 9, 2004 and to grant warrants to
purchase an aggregate of 30,000 shares of the Company's common stock to the
debenture holders on a pro-rata basis. These concessions are in consideration of
the debenture holder's agreements to (i) enter into new subordination agreements
with the Company's new lender, (ii) to waive all liquidated damages due under
the transaction documents through July 1, 2004 and (iii) to extend the effective
date of the Form S-1 registration statement until July 1, 2004. The new warrants
have an exercise price equal to $1.52 per share, the fair market value of the
Company's common stock on February 9, 2004, the date of the grant. The fair
value of these warrants as calculated pursuant to Statement No. 123 is $30,981
and has been expensed as other operating expenses in the accompanying statements
of operations.
The Company is also subject to various other legal proceedings and other claims
that arise in the ordinary course of its business. In the opinion of management,
the amount of ultimate liability, if any, in excess of applicable insurance
coverage, is not likely to have a material effect on the financial condition,
results of operations or liquidity of the Company. However, as the outcome of
litigation or other legal claims is difficult to predict, significant changes in
the estimated exposures could occur, which could have a material impact on the
Company's operations.
NOTE 9 - STOCKHOLDERS' EQUITY
COMMON STOCK ISSUANCES
During the nine months ended December 31, 2003, the Company issued 580,642
shares of its common stock. Of these shares, 28,571 were issued in lieu of a
cash payment of commission and closing costs relating to the Convertible
Debentures. Certain executives received 63,420 shares of common stock in lieu of
a portion of their cash compensation and bonuses for fiscal 2004. The fair value
of this stock, $290,165 was charged to compensation expense. 40,151 shares of
stock were issued in lieu of a settlement with an investment banker, at an
estimated fair value of $94,355. The remaining 448,500 shares of stock issued
were through the exercise of vested stock options. There were no shares of
common stock issued in the nine months ended December 31, 2002.
EARNINGS PER SHARE
In accordance with Statement No. 128, "Earnings per Share," basic earnings per
share are computed by dividing the net earnings for the period by the weighted
average number of common shares outstanding. Diluted earnings per share is
computed by dividing net earnings by the weighted average number of common
shares outstanding including the effect of common stock equivalents.
13
The following table presents a reconciliation of basic and diluted earnings per
share:
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------- ----------------------------
2003 2002 2003 2002
-------------- ------------ -------------- ------------
(as restated) (as restated)
Net (loss) income $ (10,450,601) $ 3,320,527 $ (13,424,622) $ 5,957,136
Loss available to common shares $ (10,450,601) $ 3,320,527 $ (13,424,622) $ 5,957,136
Weighted average shares outstanding - basic 8,729,818 8,123,548 8,503,065 8,101,441
Weighted average shares outstanding - diluted 8,729,818 8,944,027 8,503,065 8,947,897
Loss per share - Basic $ (1.20) $ 0.41 $ (1.58) $ 0.74
============== ============ ============== ============
Loss per share -Diluted $ (1.20) $ 0.37 $ (1.58) $ 0.67
============== ============ ============== ============
For the three months and nine months ended December 31, 2003, 1,120,120 common
stock equivalents were excluded from the calculation of diluted earnings per
share, as there was a net operating loss for the periods and their effects would
have been antidilutive. For the three months and nine months ended December 31,
2002, 90,000 and 0 common stock equivalents were not included in the computation
of diluted earnings per share because their effect was antidilutive.
For the nine months ended December 31, 2003, there were 1,120,120 common stock
options outstanding with exercise prices between $1.97 and $14.30. In addition,
there is a potential 1,038,962 shares that may be issued in connection with the
Convertible Debentures if certain conditions exist. (See Note 7.)
NOTE 10 - SEGMENT INFORMATION
The Company operates in one segment and maintains its records accordingly. The
majority of sales to customers outside of the United States are made by the
Company's wholly-owned Subsidiary. Sales by geographic region for the quarters
ended December 31 were as follows:
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
----------------------------- ------------------------------
2003 2002 2003 2002
-------------- ------------- -------------- --------------
SALES:
United States $ 19,847,863 $ 41,028,985 $ 41,184,176 $ 72,402,914
Australia 582,385 286,368 892,964 529,020
Canada 307,182 706,476 832,007 733,801
Europe 8,687,809 6,178,010 26,497,706 12,998,917
Other 210,407 29,945 708,343 100,143
Less: Allowances (946,023) (2,570,338) (2,061,457) (3,243,907)
-------------- ------------- -------------- --------------
Consolidated Net Sales $ 28,689,623 $ 45,659,446 $ 68,053,739 $ 83,520,888
============== ============= ============== ==============
The geographic area of sales is based primarily on the location where the
product is delivered.
NOTE 11 - SUBSEQUENT EVENTS
On January 7, 2004, the Company entered into the fifth amendment of its
licensing agreement with MTV Networks. The amendment reduced the minimum royalty
guarantee for calendar 2003 from $1.5 million to $1.3 million. The amendment
also extended the expiration date of the original agreement to April 30, 2004,
with options to extend for an additional two periods until December 31, 2004 at
the discretion of MTV. In accordance with this amendment, each of the three
license periods contain minimum guarantee royalty payments of $100,000 each for
a total of $300,000 if all extensions are exercised Each of the minimum
guaranteed royalty payments is recoupable against sales throughout the calendar
year, unless the contract is cancelled.
On February 9, 2004, the Company entered into a factoring agreement with Milberg
Factors, Inc. ("Milberg") of New York City. The agreement allows the Company, at
the discretion of Milberg, to borrow against its outstanding receivables up to a
maximum of the lesser of $3.5 million or 80% of the purchase price. The Company
will pay .8%
14
of gross receivables in fees and the average balance of the line will be subject
to interest on a monthly basis at prime plus .75% with a minimum rate not to
decrease below 4.75%. The agreement contains minimum aggregate charges in any
calendar year of $200,000, limits on incurring any additional indebtedness and
the Company must maintain tangible net worth and working capital above $7.5
million. Millberg also received a security interest in all of the Company's
accounts receivable and inventory located in the United States and a pledge of
66 2/3 of the stock of International SMC, our Hong Kong subsidiary.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
Certain statements contained in this Quarterly Report on Form 10- Q, including
without limitation, statements containing the words believes, anticipates,
estimates, expects, and words of similar import, constitute forward-looking
statements. You should not place undue reliance on these forward-looking
statements. Our actual results could differ materially from those anticipated in
these forward-looking statements for many reasons, including the risks faced by
us described below and elsewhere in this Quarterly Report, and in other
documents we file with the Securities and Exchange Commission.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which reflect management's opinions only as of the date hereof. We
undertake no obligation to revise or publicly release the results of any
revision to these forward-looking statements.
OVERVIEW
The Singing Machine Company, Inc., a Delaware corporation, and our wholly-owned
Hong Kong subsidiary International SMC HK Ltd. ("International SMC"),
(collectively, the "Company, "Singing Machine," "we" or "us") are primarily
engaged in the development, marketing, and sale of consumer karaoke audio
equipment, accessories, and musical recordings. The products are sold directly
to distributors and retail customers. Our electronic karaoke machines and audio
software products are marketed under The Singing Machine(C) trademark.
Our products are sold throughout the United States, primarily through department
stores, lifestyle merchants, mass merchandisers, direct mail catalogs and
showrooms, music and record stores, national chains, specialty stores and
warehouse clubs. Our karaoke machines and karaoke software are currently sold in
such retail outlets as Best Buy, Circuit City, Costco, Radio Shack, Toys R Us,
Target and J.C. Penney.
We had a net loss after estimated tax expense of $13,424,622 for the nine month
period ended December 31, 2003.
As of December 31, 2003, we had 8,752,320 shares of our common stock issued and
outstanding. As of December 31, 2003, there were 1,651,159 common stock options
and warrants outstanding with exercise prices between $1.97 and $14.30. In
addition, we are obligated to issue 1,038,962 shares of our common stock to the
holders of our convertible debentures if they elect to convert their debentures
into common stock.
RESTATEMENT OF FINANCIAL STATEMENTS
In June 2003, our management revised its position on taxation of the income of
International SMC (H.K.) Ltd., its Hong Kong subsidiary, by the United States
and by the Hong Kong tax authorities for the reasons stated below.
With regard to taxation in Hong Kong, International SMC had previously applied
for a Hong Kong offshore claim income tax exemption based on the locality of its
profits in China. Management believed, based on advice from its then auditors,
that the exemption would be approved because the source of all profits of
International SMC was from exporting to customers outside of Hong Kong.
Accordingly, no provision for income taxes was provided in the consolidated
financial statements as of March 31, 2002 and 2001. However, full disclosure was
previously reflected in the audited financial statements for the fiscal years
ended March 31, 2002 and 2001 of the estimated amount that would be due to the
Hong Kong tax authority should the exemption be denied. In June 2003, we revised
our position on the taxation of the income of International SMC because we
received different advice from our new auditors. We dismissed our former
accountant on March 24, 2003 and engaged our new auditors effective as of March
27, 2003.
15
Management is continuing its exemption application process. However, due to the
extended period of time that the application has been outstanding, as well as
management's reassessment of the probability that the application will be
approved, management has decided to restate the 2002 and 2001 consolidated
financial statements to provide for such taxes. The effect of such restatement
is to increase income tax expense by $748,672 and $468,424 in fiscal 2002 and
2001, respectively. However, we can claim United States foreign tax credits in
2002 for these Hong Kong taxes, which is reflected in the final restated
amounts.
With regard to United States taxation of foreign income, in fiscal 2002 and 2003
we had taken the position that the foreign income of International SMC qualified
for a deferral under the Internal Revenue Code (Section 956) allowing for such
income to be indefinitely deferred and not taxed in the United States until such
income is repatriated, or brought back into the United States as taxable income.
The basis of this position was primarily due to the fact that the amount of
income in question was very low and fully repaid within a reasonable time after
year end. It was expected that this income would remain in Hong Kong. Full
disclosure of the amount and nature of the indefinite deferral for the income of
International SMC for fiscal year 2002 was reflected in the income tax footnote
of the consolidated financial statements for that year. During fiscal 2002 and
2003, International SMC paid for inventory delivered to the United States parent
company, in the aggregate of approximately $10 million. Our prior auditors
advised us that the funds advanced by International SMC were reimbursed by the
United States parent company within a short enough time period that a deemed
dividend had not occurred. Our new auditors questioned this treatment and
management decided to restate the income tax expense to treat the advances as
deemed dividends. The effect of such restatement is to increase income tax
expense by $1,027,545 in fiscal year 2002, which includes the utilization of the
foreign tax credits referred to above.
The net effect of the above two adjustments is to decrease net income by
$576,060 and $1,517,983 and decrease net income per share basic and diluted by
$0.07 and $0.07 for the quarter and $0.18 and $0.17 for the nine months ended
December 31, 2002.
THREE MONTHS ENDED DECEMBER 31, 2003 COMPARED TO THE THREE MONTHS ENDED DECEMBER
31, 2002
NET SALES
Net sales for the quarter ended December 31, 2003 decreased 37% percent to
$28,689,623 compared to $45,659,446 for the quarter ended December 31, 2002.
Sales in the United States declined 55.2%, or $24,391,452 from the quarter ended
December, 2002. These decreases are composed of decreases of machine sales of
57% or $15,974,640 from $27,891,528 in 2002 and music sales of 77% or $3,757,221
from $4,885,225 in 2002. Sales decreases were partially offset by a reduction in
advertising allowances of 70% or $2,124,315 from $3,070,338 in 2002 and a 35.9%
increase in international sales, from $7.2 million for the quarter ended
December 31, 2002 to $9.8 million for the quarter ended December 31, 2003.
Decreases in domestic machine sales of machines in the United States are
primarily attributable to an increase in competition at our large customers and
erosion of the average selling price per unit as compared to the same period in
2002. The decrease in music sales is attributable to the loss of placement of
our music at one major customer and a reduction of sales with two other major
retailers. Advertising allowances consist of co-operative advertising, marketing
development funds and specific advertising.
GROSS PROFIT
Gross profit for the quarter ended December 31, 2003 was ($2,601,125) or (8.3%)
of net sales compared to $9,031,320 or 19.8% of net sales for the quarter ended
December 31, 2002. This decrease in gross profit can be attributed to sales of
our karaoke machines at lower prices and pricing pressure based on increased
competition. In addition, we took a reserve against the value of inventory in
the amount of $4,998,126 from historical cost for its anticipated recovery
value. Another factor in decreased gross profit is the shortfall on the minimum
royalty guarantee in our MTV license agreement. We expensed an additional
$609,000 in the quarter to cover this shortfall. We also wrote down the
remaining book value of dies associated with items that we are discontinuing
from our line in the amount of $508,480. We anticipate that the gross profit
percentage for the remainder of the fiscal year will remain below last year's.
OPERATING EXPENSES
Operating expenses were $5,468,029 or 19.1% of net sales for the quarter ended
December 31, 2003 compared to operating expenses of $3,950,088 or 8.7% for the
quarter ended December 31, 2002. The expenses increased over
16
prior year by $1.1 million. The primary factors that contributed to the increase
in operating expenses for the quarter ended December 31, 2003 are:
(i) Increased sales and music costs of $562,028 made up of increased commissions
of $257,456, increase in freight to customers of $192,220, increased payroll and
related costs of $255,313 which are offset by decreases in advertising and
public relations of $92,394, reduced handling charges of $27,116 and other
decreases totaling $23,451 primarily made up of decreases in showroom rent and
sales expenses.
(ii) Increases in expenses at the wholly-owned Hong Kong subsidiary totaling
$554,588 which is primarily comprised of increases in depreciation of newly
acquired assets of $109,588, $392,000 for the recognition of bad debts and the
remaining increases of $53,000 is primarily bank charges and development
expenses.
(iii)Increased in SG&A of the Florida Operations of $189,571 which is primarily
attributable to increases in accounting of $66,541, amortization of loan costs
$48,704, bad debt expense $249,512, legal costs $90,964, and consulting fees of
$117,981 which were offset by decreases in payroll and related costs of
$296,592, and other decreases totaling $87,539 consisting of primarily
insurance, travel and outside computer services.
(iv) Decreases in warehousing expenses offset the above increases by $174,017
which was consisted of reductions in payroll and related costs of $219,408,
lower packaging and warehouse expenses totaling $62,359 which were offset by
increased rent paid to store the additional inventory carried forward from
fiscal 2003 of $86,302, and other increases totaling $21,449 which was primarily
additional repairs and maintenance.
OTHER EXPENSES
Net other expenses were $655,079 for the quarter ended December 31, 2003
compared with net expenses of $79,076 at December 31, 2002. Our interest expense
increase significantly to $687,178 in the quarter ended December 31, 2003
compared to interest expense of $117,704 in the quarter ended December 31, 2002.
Our increased interest expense was due to the increased use of our credit
facility at a higher interest rate than the prior year and the amortization of
deferred fees and discounts associated with our convertible debentures.
INCOME TAXES
Significant management judgment is required in developing the Company's
provision for income taxes, including the determination of foreign tax
liabilities, deferred tax assets and liabilities and any valuation allowances
that might be required against the deferred tax assets. At December 31, 2003,
the Company concluded that a valuation allowance was needed against all of the
Company's deferred tax assets, as it is not more likely than not that the
deferred taxes will be realized. For the three months ended December 31, 2003,
the Company recorded a tax provision of $2.2 million. This occurred because the
valuation allowance established against the deferred tax asset exceeded the
amount of the benefit created from carrying back a portion of the current period
losses. The carry-back of the losses from the current period resulted in an
income tax receivable of $1.2 million, which is included in prepaid and other
current assets in the accompanying balance sheets. The Company has now exhausted
its ability to carry back any further losses and therefore will not be able to
recognize tax benefits on future losses including its expected fourth quarter
loss.
The Company's wholly-owned subsidiary, has applied for an exemption of income
tax in Hong Kong. Therefore, no taxes have been expensed or provided for at the
Subsidiary level. Although the governing body has reached no decision to date,
the U.S. parent company has reached the decision to provide for the possibility
that the exemption could be denied and accordingly has recorded a provision in
fiscal 2004, 2003, 2002, and 2001. For the nine months ended December 31, 2003,
a provision of $424,763 was recorded at the Hong Kong statutory rate of 17.5%.
Current Hong Kong taxes payable on the earnings of the Company's Hong Kong
subsidiary totaled $2.9 million at December 31, 2003.
The Company operates within multiple taxing jurisdictions and is subject to
audit in those jurisdictions. Because of the complex issues involved, any claims
can require an extended period to resolve. In management's opinion, adequate
provisions for income taxes have been made.
17
NET LOSS (EARNINGS)
As a result of the forgoing, our net loss for the three months ended December
31, 2003 was $10,450,601 as compared with net income of $3,320,527 for the three
months ended December 31, 2002.
NINE MONTHS ENDED DECEMBER 31, 2003 COMPARED TO THE NINE MONTHS ENDED DECEMBER
31, 2002
NET SALES
Net sales for the nine months ended December 31, 2003 decreased 16.9% to
$68,053,739 as compared to $81,915,443 for the nine months ended December 31,
2002. Sales to International customers increased $14.6 million over the same
period in the prior year, as sales in the United States decreased $33.7 million.
New customers and increased purchases by existing customers contributed to the
increase in the European market. Our sales in the United States decreased
primarily because of the increased competition in this market. Approximately
$5.6 million of this decrease is from the music sector of our business. We lost
one significant customer and had reduced sales in two other major retailers. A
portion of the decreased sales in the United States can be attributed to
advertising allowances accrued for customers. Advertising allowances consist of
co-operative advertising, marketing development funds and specific advertising.
These allowances are variable and are negotiated every year and since there is
no separate and identifiable benefit to the company, such amounts are recorded
as a reduction of sales.
GROSS PROFIT
Gross profit for the nine months ended December 31, 2003 was $2,596,449 or 3.8%
of sales as compared to $17,760,348 or 21.7% of sales for the nine months ended
December 31, 2002.
The decrease in gross profit during the nine months ended December 31, 2003 is a
result of:
o Competitive pricing pressure on machine pricing
o Sales of excess inventory at significantly reduces prices
o A 31% decline in the sales of higher margin music
o A reserve against the value of inventory on hand at December 31, in the
amount of $4,998,126 for our anticipated recovery value
o An impairment charge for tools in the amount of $508,480
o Increased sales from International SMC to international and domestic
customers. These sales usually carry lower gross margins, as the customer
pays for the ocean freight and clearance of the goods.
o Increased expense of the guaranteed minimum royalty on our MTV license of
$998,000.
Even though we have taken a reserve that we believe is sufficient to cover any
losses against the value of inventory, there can be no assurance that we will be
able to recover its remaining value through sales of the products. Any
additional reduction that may be necessary may have a material impact in future
periods. As we continue to reduce the amount of inventory in our warehouses, we
anticipate gross margins to remain low.
OPERATING EXPENSES
Operating Expenses increased over the same period in the prior year to $13.6
million from $11.5 million. The primary reasons for the increase in operating
expenses are as follows:
i) Increases in total cash and stock compensation of $724,895
ii) Increases in bad debt expense and at the wholly-owned Hong Kong subsidiary
of $392,000
18
iii) Increases with respect to the need to warehouse the excess inventory
carried over from March 2003 totaling $492,119
iv) Increases paid to legal, accounting fees totaling $626,185
v) Increased costs related to the amendments required to secure the financing
from LaSalle and related consulting costs totaling $432,223
vi) Increases in bad debts for the domestic operations attributable to the KB
Toys and FAO bankruptcy filings of $263,289
vii) Increase in charitable contributions, insurance and fixing fees associated
with the production of music and customer service totaling $304,134
viii) Offset by a decrease to direct advertising $697,119 and decreases in
freight to customers of $452,092
OTHER EXPENSES
Other expenses were $1,245,424 for the nine months ended December 31, 2003
compared to net other expenses of $20,006 at
December 31, 2002. Our
interest expense increased by $965,944 during the nine months ended December 31,
2003 compared to interest expense in the same period of the prior year. Our
interest expense increased due to the increased use of our credit facility at a
higher interest rate than the prior year, as well as the amortization of
deferred expenses associated with the convertible debentures. The remaining
$259,474 is attributable to other miscellaneous expenses such as exchange
differences.
INCOME TAXES
Significant management judgment is required in developing the Company's
provision for income taxes, including the determination of foreign tax
liabilities, deferred tax assets and liabilities and any valuation allowances
that might be required against the deferred tax assets. At December 31, 2003,
the Company concluded that a valuation allowance was needed against all of the
Company's deferred tax assets, as it is not more likely than not that the
deferred taxes will be realized. For the nine months ended December 31, 2003,
the Company recorded a tax provision of $1.2 million. This occurred because the
valuation allowance established against the deferred tax asset exceeded the
amount of the benefit created from carrying back a portion of the current period
losses. The carry-back of the losses from the current period resulted in an
income tax receivable of $1.2 million, which is included in prepaid and other
current assets in the accompanying balance sheets. The Company has now exhausted
its ability to carry back any further losses and therefore will not be able to
recognize tax benefits on future losses including its expected fourth quarter
loss.
The Company's wholly-owned subsidiary, has applied for an exemption of income
tax in Hong Kong. Therefore, no taxes have been expensed or provided for at the
Subsidiary level. Although the governing body has reached no decision to date,
the U.S. parent company has reached the decision to provide for the possibility
that the exemption could be denied and accordingly has recorded a provision in
fiscal 2004, 2003, 2002, and 2001. For the nine months ended December 31, 2003,
a provision of $424,763 was recorded at the Hong Kong statutory rate of 17.5%.
Current Hong Kong taxes payable on the earnings of the Company's Hong Kong
subsidiary totaled $2.9 million at December 31, 2003.
The Company operates within multiple taxing jurisdictions and is subject to
audit in those jurisdictions. Because of the complex issues involved, any claims
can require an extended period to resolve. In management's opinion, adequate
provisions for income taxes have been made.
NET LOSS (EARNINGS)
As a result of the forgoing, our net loss for the nine months ended December 31,
2003 was $13,424,622 compared with net income of $5,957,136 for the nine months
ended December 31, 2002.
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LIQUIDITY AND CAPITAL RESOURCES
At December 31, 2003, we had cash on hand of $235,958 and a bank overdraft of
$85,236 compared to cash on hand of $268,265 and a bank overdraft of $316,646 at
March 31, 2003. Our current assets consist predominantly of accounts receivable
and inventory. Our accounts receivable increased to $14,729,176 for the nine
months ended December 31, 2003 due to the amount of sales that occurred in
November and December, as well as some customer terms which exceed 45 days.
Our inventory has been steadily decreasing since March 31, 2003, as we are
shipping goods to our customers. As of December 31, 2003, we had $8 million in
inventory, net of a provision for loss of $6,195,197 compared to $25 million as
of March 31, 2003.
Our current liabilities decreased to $18,911,314 as of December 31, 2003,
compared to $21,249,930 at March 31, 2003. Current liabilities consist of
accounts payable of $5,329,648, accrued expenses of $2,587,567, accrual for
income taxes of $2,872,509, subordinated debt of $1 million, bank overdraft of
$85,136 and the revolving credit facilities of $7,109,622.
Approximately $2.7 million or 51% of our accounts payable are due to two
factories in China. This amount is aged beyond the terms originally set by the
factories.. We have been in contact with these factories regarding these amounts
and they have not pursued any means of collection. We intend to enter into
payment plans with these factories, but cannot ensure that this will occur. If
these factories pursue any claims against us, it could have a material effect on
our operations. The remainder of accounts payable of $2.6 million are within
terms set by our vendors.
During fiscal 2003, we had a credit facility with LaSalle Business Credit, LLC.
Under this agreement, LaSalle advanced up funds to us based on our eligible
accounts receivable and inventory. The loan was secured by a first lien on all
of present and future assets, except specific tooling located in China. During
fiscal 2004, the maximum amount that we were permitted to borrow under the
credit facility was $7.5 million.
Because we had minimal liquidity and had defaulted under our credit agreement
with LaSalle, we received a going concern paragraph from our independent
certified public accountants for our audited financial statements for fiscal
2003. On March 14, 2003, we were notified by LaSalle that we were in violation
of the tangible net worth covenant in our credit facility and were declared in
default. LaSalle amended the credit facility on August 19, 2003 in a fourteenth
amendment, which extended the loan until March 31, 2004 and the condition of
default was waived. On December 31, 2003, we violated the tangible net worth
requirement and working capital requirement of our credit facility.
On January 31, 2004, we paid this loan in full, terminated this credit facility
and LaSalle released its security interest in our assets.
On February 9, 2004, we executed a factoring agreement with Milberg Factors,
Inc. Pursuant to the agreement, Milberg, at its discretion, will advance the
Company the lesser of 80% of our accounts receivable or $3.5 million. All
receivables submitted to Milberg are subject to a fee equal to 0.8% of the gross
invoice value. The average monthly balance of the line will incur interest at a
rate of prime plus .75%. Other terms of the agreement include minimum fees of
$200,000 per calendar year, $7.5 million tangible net worth and $7.5 million
working capital. To secure these advances, Milberg received a security interest
in all of our accounts receivable and inventory located in the United States and
a pledge of 66 2/3% of the stock in International SMC (HK) Ltd, our wholly-owned
subsidiary. This agreement is effective for an initial term of two years, with
successive automatic renewals unless either party gives notice of termination.
Although this credit line is not equivalent to our previous lines, we believe
that advances under this credit facility, as well as collection of our
outstanding accounts receivable, will allow us enough available cash flow to
continue operations until August 2004 and prepare for the upcoming fiscal year.
We have been receiving collections of accounts receivable since the termination
of our LaSalle agreement, which have served as working capital and enabled us to
pay our obligations.
In order to further increase our liquidity, we are selling our excess inventory
and reducing our cost structure. As of February 11, 2004, we have orders on hand
of about $2.5 million and had already shipped over $1.0 million, which
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is ahead of our projected target for most of the old inventory. Our goal is to
sell $3 to $4 million of old inventory by March 31, 2004. However, we can not
provide you with any assurances that we will be able to sell this inventory.
We have taken several steps to decrease our costs. Since June 2003, we have had
two rounds of lay-offs at our company. In January 2004, our senior executive
officers agreed to take 20% salary reductions and other employees also agreed to
salary reductions. Additionally, we have also subleased some of our warehouse
space in California and Florida and hope to sublease out more. As our plans are
put into place we should see reductions of our overhead expenses by more than
20% of last years amounts.
We do not intend to enter into any additional material commitments for the
Company in the near future. We will be incurring only normal course of business
expenses such as: rent, utilities, salaries and related expenses, accounting,
legal, bank charges, interest, office supplies, and other expenses that may
become necessary as they relate to repairs and maintenance of our leased
facilities and computer equipment. We will also incur expenses for any
outstanding operating leases that are currently in place (see commitment table
below).
We intend to finance our business in fiscal 2005 through:
(i) Continued support from our Chinese factories in financing our purchases and
entering into agreements for payment of old receivables;
(ii) Selling the remainder of our inventory on hand;
(iii) Continuing to reduce costs;
(iv) Using our credit facility with Milberg Factors; and
(v) Utilizing credit facilities that are available to our wholly-owned
subsidiary to finance all direct shipments.
In order to reduce the need to maintain inventory in United States locations in
fiscal 2005, we intend to generate a larger share of our total sales through FOB
sales from our wholly-owned subsidiary. These sales are shipped directly to our
customers from the ports in China and are primarily backed by letters of credit.
The customers take title to the merchandise at their consolidators in China and
are responsible for their shipment, duty, clearance and freight charges to their
locations. We will also assist our customers in the forecasting and management
of their inventories of our product.
If we need additional financing during our peak selling season, we intend to
approach Milberg. If Milberg is not willing to provide us with additional
financing, we will need to seek additional capital from other sources. However,
we can not assure that we will be able to obtain additional financing or that
the terms will be acceptable to us. If we need to obtain additional financing
and fail to do so, it may have a material adverse effect on our ability to meet
our financial obligations and continue to operate.
DEBT AND CONTRACTUAL OBLIGATIONS
Our commitments for debt and other contractual arrangements are summarized as
follows:
YEARS ENDING MARCH 31,
--------------------------------------------------------------
TOTAL 2004 2005 2006 2007 2008
------------ ------------ ---------- ------------ ----------- ----------
Merchandise License Guarantee $ 1,595,000 $ 1,395,000 $ 150,000 $ 50,000 -- --
Property Leases $ 3,638,771 $ 1,330,158 $ 924,338 $ 517,071 $ 495,545 $ 371,659
Equipment Leases $ 86,016 $ 46,525 $ 19,965 $ 10,322 $ 7,969 $ 1,235
Revolving Credit Facilities $ 7,115,114 $ 7,115,114 -- -- -- --
Convertible Debentures $ 4,000,000 -- -- $ 4,000,000 -- --
Merchandise license guarantee reflects amounts that we are obligated to pay as
guaranteed royalties under our various license agreements. In fiscal 2003, we
had guaranteed minimum royalty payments under our license agreements with MTV
Networks, Nickelodeon, Hard Rock Academy and Motown (Universal Music). In fiscal
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2004, we have guaranteed minimum royalty payments under the license agreement
with MTV and Motown (Universal Music).
We have leases for property in Rancho Dominguez and Compton California, as well
as in Coconut Creek, Florida. We have equipment leases for forklifts and copy
machines. Our revolving credit facility represents our credit facility with
LaSalle Business Credit, LLC, which was terminated as of January 31, 2004.
On September 8, 2003, we issued an aggregate of $4,000,000 of 8% convertible
debentures in a private offering to six accredited investors. The debentures
initially are convertible into 1,038,962 shares of common stock at $3.85 per
share, subject to adjustment in certain situations. We also issued an aggregate
of 457,143 warrants to the investors. The exercise price of the warrants is
$4.025 per share and the warrants expire on September 7, 2006. We have an
obligation to register the shares of common stock underlying the debenture and
warrants and filed a registration statement on Form S-1 to register the shares
on October 9, 2003.
Effective as of February 9, 2004, we amended the convertible debenture
agreements to increase the interest rate to 8.5% per annum effective as of
February 9, 2004, and grants warrants to purchase an aggregate of 30,000 shares
of the Company's common stock to the debenture holders on a pro-rata basis.
These concessions were in consideration of the debenture holder's agreements to
(i)enter into new subordination agreements with the Company's new lender,
Milberg Factors, (ii) to waive all liquidated damages due under the convertible
debentures and related transaction documents through July 1, 2004 and (iii) to
extend the effective date of the Form S-1 registration statement until July 1,
2004. The new warrants have an exercise price equal to $1.52 per share, the fair
market value of the Company's common stock on February 9, 2004, the date of the
grant.
SOURCES AND USES OF CASH
Cash flows used in operating activities were $4,998,092 for the nine months
ended December 31, 2003. Cash flows were used in operating activities primarily
due to increases in accounts receivable in the amount of $9.4 million, decreases
in accounts payable of $3.2 million and decreases in existing inventory of $12.2
million, as well as the loss for the period and other non-cash expenses such as
the tooling impairment and provision for inventory losses.
Cash used in investing activities for the nine months ended December 31, 2003
was $462,067. Cash used in investing activities resulted from the purchase of
fixed assets in the amount of $434,065. The purchase of fixed assets consists of
the tooling and molds required for production of new machines for this fiscal
year. Tooling and molds are depreciated over three years.
Cash flows provided by financing activities were $5,427,852 for the nine months
ended December 31, 2003. This consisted of proceeds from the exercise of options
in the amount of $981,972. We also issued convertible debentures with detachable
stock purchase warrants. This transaction resulted in a gross increase in cash
of $4 million. We received subordinated debt from related parties of $1 million
in July of 2003 and paid $400,000 to a director who had previously loaned money
to our Company on a short term basis. The remainder of cash provided from
financing activities was provided by net repayments on the credit line at
LaSalle National Bank in the amount of $4,308,438 and borrowings on the credit
lines in Hong Kong in the amount of $4,640,728 to fund ongoing operations.
EXCHANGE RATES
We sell all of our products in U.S. dollars and pay for all of our manufacturing
costs in either U.S. or Hong Kong dollars. Operating expenses of the Hong Kong
office are paid in Hong Kong dollars. We cannot assure you that the exchange
rate fluctuations between the United States and Hong Kong currencies will not
have a material adverse effect on our business, financial condition or results
of operations.
SEASONAL AND QUARTERLY RESULTS
Historically, our operations have been seasonal, with the highest net sales
occurring in the second and third quarters (reflecting increased orders for
equipment and music merchandise during the Christmas selling months) and to a
lesser extent the first and fourth quarters of the fiscal year. Sales in our
fiscal second and third quarter, combined, accounted for approximately 85% of
net sales in fiscal 2003, 81% of net sales in fiscal 2002 and 75% of net sales
in fiscal 2001.
22
Our results of operations may also fluctuate from quarter to quarter as a result
of the amount and timing of orders placed and shipped to customers, as well as
other factors. The fulfillment of orders can therefore significantly affect
results of operations on a quarter-to-quarter basis.
INFLATION
Inflation has not had a significant impact on our operations. We have
historically passed any price increases on to its customers since prices charged
by us are generally not fixed by long-term contracts.
CRITICAL ACCOUNTING POLICIES
The U.S. Securities and Exchange Commission defines critical accounting policies
as "those that are both most important to the portrayal of a company's financial
condition and results, and require management's most difficult, subjective or
complex judgments, often as a result of the need to make estimates about the
effect of matters that are inherently uncertain. Our management believes that a
high degree of judgment or complexity is involved in the following areas:
Reserves on Inventories. We establish a reserve on inventory based on the
expected net realizable value of inventory on an item-by-item basis when it is
apparent that the expected realizable value of an inventory item falls below its
original cost. A charge to cost of sales results when the estimated net
realizable value of specific inventory items declines below cost. Management
regularly reviews our investment in inventories for such declines in value.
Income Taxes. Significant management judgment is required in developing the
Company's provision for income taxes, including the determination of foreign tax
liabilities, deferred tax assets and liabilities and any valuation allowances
that might be required against the deferred tax assets. At December 31, 2003,
the Company concluded that a valuation allowance was needed against all of the
Company's deferred tax assets, as it is not more likely than not that the
deferred taxes will be realized. For the nine months ended December 31, 2003,
the Company recorded a tax provision of $1.2 million. This occurred because the
valuation allowance established against the deferred tax asset exceeded the
amount of the benefit created from carrying back a portion of the current period
losses. The carry-back of the losses from the current period resulted in an
income tax receivable of $1.2 million, which is included in prepaid and other
current assets in the accompanying balance sheets. The Company has now exhausted
its ability to carry back any further losses and therefore will not be able to
recognize tax benefits on future losses including its expected fourth quarter
loss.
The Company's wholly-owned subsidiary, has applied for an exemption of income
tax in Hong Kong. Therefore, no taxes have been expensed or provided for at the
Subsidiary level. Although the governing body has reached no decision to date,
the U.S. parent company has reached the decision to provide for the possibility
that the exemption could be denied and accordingly has recorded a provision in
fiscal 2004, 2003, 2002, and 2001. For the nine months ended December 31, 2003,
a provision of $424,763 was recorded at the Hong Kong statutory rate of 17.5%.
Current Hong Kong taxes payable on the earnings of the Company's Hong Kong
subsidiary totaled $2.9 million at December 31, 2003.
The Company operates within multiple taxing jurisdictions and is subject to
audit in those jurisdictions. Because of the complex issues involved, any claims
can require an extended period to resolve. In management's opinion, adequate
provisions for income taxes have been made.
Collectibility of Accounts Receivable. Our allowance for doubtful accounts is
based on management's estimates of the creditworthiness of its customers,
current economic conditions and historical experience, and, in the opinion of
management, is believed to be an amount sufficient to respond to normal business
conditions. Management sets 100% reserves for customers in bankruptcy and other
reserves based upon historical collection experience. Should business conditions
deteriorate or any major customer default on its obligations to our Company,
this allowance may need to be significantly increased, which would have a
negative impact on operations.
Other Estimates. We make other estimates in the ordinary course of business
relating to sales returns and allowances, warranty reserves, and reserves for
promotional incentives. Historically, past changes to these estimates have not
had a material impact on our financial condition. However, circumstances could
change which may alter future expectations.
23
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK
RISKS RELATED TO THE COMPANY'S BUSINESS AND OPERATIONS
WE HAVE SIGNIFICANT WORKING CAPITAL NEEDS AND IF WE ARE UNABLE TO OBTAIN
ADDITIONAL FINANCING, WHEN NEEDED, WE MAY NOT HAVE SUFFICIENT CASH FLOW TO RUN
OUR BUSINESS
As of February 13, 2004, our cash on hand is limited. During the next three
months, we plan on financing our working capital needs from the collection of
accounts receivable and using the funds that are advanced to us by Milberg under
our factoring agreement. We also plan on selling our remaining inventory on
hand. If these sources do not provide us with adequate financing, we may try to
seek financing from a third party; however, we will have to obtain consent from
Mlberg prior to obtaining any other financing. If we are not able to obtain
adequate financing, when needed, it will have a material adverse effect on our
cash flow and our ability to run our business. If we have a severe shortage of
working capital, we may not be able to continue our business operations and may
be required to file a petition for bankruptcy under Chapter 11 of the U.S.
Bankruptcy Code or enter into some liquidation or reorganization proceeding.
WE MAY BE DEEMED TO INSOLVENT AND WE MAY GO OUT OF BUSINESS
As of February 9, 2004, our cash position is limited. We are not able to pay all
of our creditors on a timely basis. We are not current on approximately $2.7
million of outstanding accounts payable, which represents accounts payable to
factories in China. If we are not able to pay our current debts as they become
due, we may be deemed to be insolvent and we may go out of business.
OUR INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS RAISED SUBSTANTIAL DOUBT ABOUT OUR
ABILITY TO CONTINUE AS A GOING CONCERN FOR THE FISCAL YEAR ENDED MARCH 31, 2003-
We received a report dated June 24, 2003 (except for Note 9, as to which the
date is July 8, 2003 and Note 15, as to which the date is July 10, 2003) from
our independent certified public accountants covering the consolidated financial
statements for our fiscal year ended March 31, 2003 that included an explanatory
paragraph which stated that the financial statements were prepared assuming the
Company would continue as a going concern. This report stated that a
then-existing default under our credit agreement with LaSalle Business Credit
raised substantial doubt about our ability to continue as a going concern.
We paid our loan with LaSalle in full effective as of January 31, 2004 and
terminated the agreement. We will replaced the LaSalle credit facility by
entering into a factoring agreement with Milberg Factors, Inc., effective as of
February 9, 2004. Pursuant to the agreement, Milberg, at its discretion, will
advance the Company with the lesser of 80% of our eligible accounts receivable
or $3.5 million. We do not know if this factoring agreement will provide us with
sufficient capital. If the agreement with Milberg does not provide sufficient
capital or that we are unable to obtain additional financing, we may have a
liquidity problem and this would affect our ability to continue our business
operations.
A SMALL NUMBER OF OUR CUSTOMERS ACCOUNT FOR A SUBSTANTIAL PORTION OF OUR
REVENUES, AND THE LOSS OF ONE OR MORE OF THESE KEY CUSTOMERS COULD SIGNIFICANTLY
REDUCE OUR REVENUES, PROFITABILITY AND CASH FLOW
We rely on a few large customers to provide a substantial portion of our
revenues. As a percentage of total revenues, our net sales to our five largest
customers during the fiscal period ended March 31, 2003, 2002 and 2001 were
approximately 67%, 77% and 87% respectively. In fiscal 2003, three major
customers accounted for 21%, 17% and 15% of our net sales. We do not have
long-term contractual arrangements with any of our customers and they can cancel
their orders at any time prior to delivery. A substantial reduction in or
termination of orders from any of our largest customers would decrease our
revenues, profitability and cash flow.
WE ARE SUBJECT TO THE RISK THAT SOME OF OUR LARGE CUSTOMERS MAY RETURN KARAOKE
PRODUCTS THAT THEY HAVE PURCHASED FROM US AND IF THIS HAPPENS, IT WOULD REDUCE
OUR REVENUES AND PROFITABILITY
In February 2002, one of our largest customers, Best Buy returned approximately
$2.75 million in karaoke products to us that it had not been able to sell during
the Christmas season. Best Buy kept this inventory in its retail stores, but
converted the sales to consignment sales. Although we were not contractually
obligated to accept this return of the
24
karaoke products, we did this because we valued our relationship with Best Buy.
Because we are dependent upon a few large customers, we are subject to the risk
that any of these customers may elect to return unsold karaoke products to us in
the future. If any of our customers were to return karaoke products to us, it
would reduce our revenues and profitability.
WE ARE SUBJECT TO PRESSURE FROM OUR CUSTOMERS RELATING TO PRICE REDUCTIONS,
FINANCIAL INCENTIVES AND OTHER RISKS THAT FORCE US TO BEAR THE RISKS AND COSTS
OF CARRYING INVENTORY, AND IF WE ARE PRESSURED TO MAKE THESE CONCESSIONS TO OUR
CUSTOMERS, IT WILL REDUCE OUR REVENUES AND PROFITABILITY
Because there is intense competition in the karaoke industry, we are subject to
pricing pressure from our customers. Many of our customers have demanded that we
lower our prices or they will buy our competitor's products. If we do not meet
our customer's demands for lower prices, we will not sell as many karaoke
products. In the nine months ended December 31, 2003, our sales to customers in
the United States decreased because of increased competition and the increased
amount of inventory that we had on hand, which was sole near or below cost. We
are also subject to the risk that our customers might demand certain financial
incentives, such as large advertising or cooperative advertising allowances,
which effectively reduce our selling prices. Additionally, many of our customers
place orders with us several months prior to the holiday season, but they
schedule delivery two or three weeks before the holiday season begins. As such,
we are subject to the risks and costs of carrying inventory during the time
period between the placement of the order and the delivery date, which reduces
our cash flow.
OUR GROSS PROFIT MARGINS HAVE DECREASED OVER THE PAST YEAR AND WE EXPECT
THE TREND TO CONTINUE
Over the past year, our gross profit margins have decreased. In the nine months
ended December 31, 2003, our gross profit margin was 4.6% compared to 21.7% in
the nine months ended December 31, 2002 and for the three months ended December
31, 2003 and 2002, our gross margin was (9.1%) and 19.8%, respectively. This
decline resulted from price competition and a shift in customer orders from our
parent company in the United States to our Hong Kong subsidiary, International
SMC. International SMC delivers our karaoke products to customers directly from
our manufacturer's factories in China and therefore does not provide logistics,
handling, warehousing and just in time inventory support, which services are
provided by our parent company in the United States. Accordingly, the average
sales price per unit realized by International SMC is significantly lower than
that of our parent company in the United States. We expect further price
competition and a continuing shift of sales volume to International SMC.
Accordingly, we expect that our gross profit margin will decrease in fiscal
2004.
OUR SENIOR CORPORATE MANAGEMENT TEAM IS NEW TO THE SINGING MACHINE AND IS
REQUIRED TO DEVOTE SIGNIFICANT ATTENTION TO OUR FINANCING AGREEMENTS AND
SETTLING OUR CLASS ACTION LAWSUITS.
Beginning on May 2, 2003, through the present date, we have had two Chief
Executive Officers and a Chief Operating Officer resign. Additionally, four out
of the five directors serving on our Board on May 2, 2003 have resigned since
that date. We hired a new Chief Operating Officer, Yi Ping Chan on March 31,
2003 and appointed two new directors, Bernard Appel and Richard Ekstract, on
October 31, 2003. We are in the process of searching for a new Chief Executive
Officer. It will take some time for our new management and our new board of
directors to learn about our business and to develop strong working
relationships with each other and our employees. In particular, coordination
between various divisions of our company have not been systematized and morale
has suffered as a consequence. Our new senior corporate management's ability to
complete this process has been and continues to be hindered by the time that it
needs to devote to other pressing business matters. New management needs to
spend significant time on restructuring our financing agreements and overseeing
legal matters, such as our class action lawsuit. We cannot assure you that this
major restructuring of our board of directors and senior management and the
accompanying distractions, in this environment, will not adversely affect our
results of operations.
THE SEC IS CONDUCTING AN INFORMAL INVESTIGATION OF THE COMPANY AND IF WE HAVE
DONE SOMETHING ILLEGAL, WE WILL BE SUBJECT TO FINES, PENALTIES AND OTHER
SANCTIONS BY THE SEC
In August 2003, we were advised that the SEC had commenced an informal
investigation of our company. It appears that the investigation is focused on
the restatement of our financial statements in fiscal 2002 and 2001; however,
the SEC may be reviewing other issues as well. If the SEC finds that our company
has not fully complied with all applicable federal securities laws, we could be
subject to fines, penalties and other sanctions imposed by the SEC.
25
WE ARE NAMED AS A DEFENDANT IN A CLASS ACTION LAWSUIT RELATING TO THE
RESTATEMENT OF OUR FINANCIAL STATEMENTS FOR FISCAL 2002 AND FISCAL 2001, WHICH
IF DETERMINED ADVERSELY TO US, COULD RESULT IN THE IMPOSITION OF DAMAGES AGAINST
US AND HARM OUR BUSINESS AND FINANCIAL CONDITION
We are named as a defendant in a class action lawsuit which arose from the
restatement of our financial statements for fiscal 2002 and 2001. In this
lawsuit, the plaintiffs allege that our executive officers and our company
violated Section 10(b) and Section 20(a) of the Securities Exchange Act of 1934
and Rule 10(b)-5. The plaintiffs seek compensatory damages, attorney's fees and
injunctive relief. While the specific factual allegations vary slightly in each
case, the complaints generally allege that our officers falsely represented the
Company's financial results during the relevant class periods. As of December
31, 2003, we had incurred approximately $125,000 of legal fees to defend the
class action lawsuit and it has significantly diverted the attention of our
management team. There can be no assurance that we will be able to settle this
litigation on acceptable terms or obtain a favorable resolution in court if we
do not settle this matter. If a significant monetary judgment is rendered
against us, we are not certain that we will have the ability to pay such a
judgment. Any losses resulting from these claims could adversely affect our
profitability and cash flow.
OUR LICENSING AGREEMENT WITH MTV NETWORKS IS IMPORTANT TO OUR BUSINESS AND IF WE
WERE TO LOSE OUT MTV LICENSE IT WOULD AFFECT OUR REVENUES AND PROFITABILITY
Our license with MTV Networks is important to our business. We generated
$30,884,344 or 32.3% of our net sales from products sold under the MTV license
in fiscal 2003. During the nine months ended December 31, 2003, we generated
only $8.3 million or 12.2% of our net sales under this MTV license agreement.
Our MTV license was extended until April 30, 2004 with options for MTV to renew
for two additional periods through December 31, 2004; however, MTV can terminate
the license agreement for certain reasons over the course of the calendar year
2004. If we were to lose our MTV license, it would have an effect on our
revenues and net income.
WE EXPERIENCE DIFFICULTY FORECASTING THE DEMAND FOR OUR KARAOKE PRODUCTS
Because of our reliance on manufacturers in Asia for our machine production, our
production lead times range from one to four months. Therefore, we must commit
to production in advance of customers orders. It is difficult to forecast
customer demand because we do not have any scientific or quantitative method to
predict this demand. Our forecasting is based on management's general
expectations about customer demand, the general strength of the retail market
and management's historical experiences. As of December 31, 2003, we had $14.2
million in inventory against which a $6.2 million reserve has been taken.. We
will attempt to liquidate this inventory over the next six months. However, if
we are unable to sell this inventory, our revenues, cash flow and profitability
will be reduced.
OUR BUSINESS IS SEASONAL AND THEREFORE OUR ANNUAL OPERATING RESULTS WILL DEPEND,
IN LARGE PART, ON OUR SALES DURING THE RELATIVELY BRIEF HOLIDAY SEASON
Sales of consumer electronics and toy products in the retail channel are highly
seasonal, with a majority of retail sales occurring during the period from
September through December in anticipation of the holiday season, which includes
Christmas. A substantial majority of our sales occur during the second quarter
ended September 30 and the third quarter ended December 31. Sales in our second
and third quarter, combined, accounted for approximately 85.6% of net sales in
fiscal 2003, 81% of net sales in fiscal 2002 and 75% of net sales in fiscal
2001. Our sales would be disproportionately adversely affected by terrorist
attacks, military engagements or other extraordinary events that negatively
affect the retail environment or consumer buying patterns.
IF WE ARE UNABLE TO COMPETE IN THE KARAOKE PRODUCTS CATEGORY, OUR REVENUES
AND NET PROFITABILITY WILL BE REDUCED
Our major competitors for karaoke machines and related products are Craig and
Memorex. We believe that competition for karaoke machines is based primarily on
price, product features, reputation, delivery times, and customer support. Our
primary competitors for producing karaoke music are Compass, Pocket Songs,
Sybersound, UAV and Sound Choice. We believe that competition for karaoke music
is based primarily on popularity of song titles, price, reputation, and delivery
times. To the extent that we lower prices to attempt to enhance or retain market
share, we may adversely impact our operating margins. Conversely, if we opt not
to match competitor's price reductions we may lose market share, resulting in
decreased volume and revenue. To the extent our leading competitors reduce
prices on their karaoke machines and music, we must remain flexible to reduce
our prices. If we
26
are forced to reduce our prices, it will result in lower margins and reduced
profitability. In addition, we must compete with all the other existing forms of
entertainment including, but not limited to: motion pictures, video arcade
games, home video games, theme parks, nightclubs, television and prerecorded
tapes, CD's and video cassettes.
IF WE ARE UNABLE TO DEVELOP NEW KARAOKE PRODUCTS, OUR REVENUES MAY NOT
CONTINUE TO GROW
The karaoke industry is characterized by rapid technological change, frequent
new product introductions and enhancements and ongoing customer demands for
greater performance. In addition, the average selling price of any karaoke
machine has historically decreased over its life, and we expect that trend to
continue. As a result, our products may not be competitive if we fail to
introduce new products or product enhancements that meet evolving customer
demands. The development of new products is complex, and we may not be able to
complete development in a timely manner, or at all. During the past twelve
years, Edward Steele, our former Chief Executive Officer, oversaw new product
development. Mr. Steele will be retiring from our company on February 28, 2004
and we have not yet identified a successor who will oversee new product
development. To introduce products on a timely basis, we must:
o accurately define and design new products to meet market needs;
o design features that continue to differentiate our products from those of
our competitors;
o transition our products to new manufacturing process technologies;
o identify emerging technological trends in our target markets;
o anticipate changes in end-user preferences with respect to our customers'
products;
o bring products to market on a timely basis at competitive prices; and
o respond effectively to technological changes or product announcements by
others.
We believe that we will need to continue to enhance our karaoke machines and
develop new machines to keep pace with competitive and technological
developments and to achieve market acceptance for our products.
OUR PRODUCTS ARE SHIPPED FROM CHINA AND ANY DISRUPTION OF SHIPPING COULD
PREVENT OR DELAY OUR CUSTOMERS' RECEIPT OF INVENTORY
We rely principally on four contract ocean carriers to ship virtually all of the
products that we import to our warehouse facilities in Compton and Rancho
Dominguez, California. Retailers that take delivery of our products in China
rely on a variety of carriers to import those products. Any disruptions in
shipping, whether in California or China, caused by labor strikes, other labor
disputes, terrorism, and international incidents or otherwise prevent or delay
our customers' receipt of inventory. If we our customers do not receive their
inventory on a timely basis, they may cancel their orders or return products to
us. Consequently, our revenues and net income would be reduced.
OUR MANUFACTURING OPERATIONS ARE LOCATED IN THE PEOPLE'S REPUBLIC OF CHINA,
SUBJECTING US TO RISKS COMMON IN INTERNATIONAL OPERATIONS. IF THERE IS ANY
PROBLEM WITH THE MANUFACTURING PROCESS, OUR REVENUES AND NET PROFITABILITY MAY
BE REDUCED.
We are dependent upon six factories in the People's Republic of China to
manufacture all of our electronic products. Our arrangements with these
factories are subject to the risks of doing business abroad, such as import
duties, trade restrictions, work stoppages, foreign currency fluctuations,
limitations on the repatriation of earnings and political instability, which
could have an adverse impact on our business. Furthermore, we have limited
control over the manufacturing processes themselves. As a result, any
difficulties encountered by our third-party manufacturers that result in product
defects, production delays, cost overruns or the inability to fulfill orders on
a timely basis could adversely affect our revenues, profitability and cash flow.
WE DEPEND ON THIRD PARTY SUPPLIERS FOR PARTS FOR OUR KARAOKE MACHINES AND
RELATED PRODUCTS, AND IF WE CANNOT OBTAIN SUPPLIES AS NEEDED, OUR OPERATIONS
WILL BE SEVERELY DAMAGED
27
Our growth and ability to meet customer demand depends in part on our capability
to obtain timely deliveries of karaoke machines and our electronic products. We
rely on third party suppliers to produce the parts and materials we use to
manufacture and produce these products. If our suppliers are unable to provide
our factories with the parts and supplies, we will be unable to produce our
products. We cannot guarantee that we will be able to purchase the parts we need
at reasonable prices or in a timely fashion. In the last several years, there
have been shortages of certain chips that we use in our karaoke machines. If we
are unable to anticipate any shortages of parts and materials in the future, we
may experience severe production problems, which would impact our sales.
CONSUMER DISCRETIONARY SPENDING MAY AFFECT KARAOKE PURCHASES AND IS
AFFECTED BY VARIOUS ECONOMIC CONDITIONS AND CHANGES
Our business and financial performance may be damaged more than most companies
by adverse financial conditions affecting our business or by a general weakening
of the economy. Purchases of karaoke machines and music are considered
discretionary for consumers. Our success will therefore be influenced by a
number of economic factors affecting discretionary and consumer spending, such
as employment levels, business, interest rates, and taxation rates, all of which
are not under our control. Adverse economic changes affecting these factors may
restrict consumer spending and thereby adversely affect our sales growth and
profitability.
WE MAY HAVE INFRINGED ON THE COPYRIGHTS OF CERTAIN MUSIC PUBLISHERS AND IF WE
VIOLATE FEDERAL COPYRIGHT LAWS, WE WILL BE SUBJECT TO MONETARY PENALTIES
Over the past two years, we have received notices from three music publishers
who have alleged that we did not have the proper copyright licenses to sell
certain songs included in our CD+G's. We have settled all of these copyright
infringement issues with these publishers. If we discover that we do not have
the proper copyright licenses for any other songs that are included in our
CD+G's and cassettes, we will be subject to additional liability under the
federal copyright laws, which could include settlements with the music
publishers and payment of monetary damages.
WE MAY BE INFRINGING UPON THE COPYRIGHTS OF THIRD PARTIES AND IF WE ARE DOING
SO, OUR PROFITABILITY WILL BE REDUCED
Each song in our catalog is licensed to us for specific uses. Because of the
numerous variations in each of our licenses for copyrighted music, there can be
no assurance that we have complied with scope of each of our licenses and that
our suppliers have complied with these licenses. Additionally, third parties
over whom we exercise no control may use our sound recordings in such a way that
is contrary to our license agreement and by violating our license agreement we
may be liable for contributory copyright infringement. Any infringement claims
may have a negative effect on our ability to sell products and may result in a
fine or damages being assessed against our company.
WE MAY BE SUBJECT TO CLAIMS FROM THIRD PARTIES FOR UNAUTHORIZED USE OF THEIR
PROPRIETARY TECHNOLOGY, COPYRIGHTS OR TRADE SECRETS AND ANY CLAIMS ASSERTED
AGAINST US COULD AFFECT OUR NET PROFITABILITY
We believe that we independently developed the technology used in our electronic
and audio software products and that it does not infringe on the proprietary
rights, copyrights or trade secrets of others. However, we cannot assure you
that we have not infringed on the proprietary rights of third parties or those
third parties will not make infringement violation claims against us. During
fiscal 2000, Tanashin Denki, Ltd., a Japanese company that holds a patent on a
cassette tape drive mechanism alleged that some of our karaoke machines violated
their patents. We settled the matters with Tanashin in December 1999.
Subsequently in December 2002, Tanashin again alleged that some of our karaoke
machines violated their patents. We entered into another settlement agreement
with them in May 2003. In addition to Tanashin, we could receive infringement
claims from other third parties. Any infringement claims may have a negative
effect on our profitability and financial condition.
WE ARE EXPOSED TO THE CREDIT RISK OF OUR CUSTOMERS, WHO ARE EXPERIENCING
FINANCIAL DIFFICULTIES, AND IF THESE CUSTOMERS ARE UNABLE TO PAY US, OUR
REVENUES AND PROFITABILITY WILL BE REDUCED
We sell products to retailers, including department stores, lifestyle merchants,
direct mail retailers, which are catalogs and showrooms, national chains,
specialty stores, and warehouse clubs. Some of these retailers, such as K-Mart,
FAO Schwarz and KB Toys, have engaged in leveraged buyouts or transactions in
which they incurred a significant amount of debt, and operated under the
protection of bankruptcy laws. As of February 4, 2004, we are
28
aware of only two customers, FAO Schwarz and KB Toys, which are operating under
the protection of bankruptcy laws. In fiscal 2003, FAO Schwarz and KB Toys
represented less than 1% of our revenues and we expect that revenues from this
account will be less than 2% of our revenues in fiscal 2004. Despite the
difficulties experienced by retailers in recent years, we have not suffered
significant credit losses to date. Deterioration in the financial condition of
our customers could result in bad debt expense to us and have a material adverse
effect on our revenues and future profitability.
A DISRUPTION IN THE OPERATION OF OUR WAREHOUSE CENTERS IN CALIFORNIA OR FLORIDA
COULD IMPACT OUR ABILITY TO DELIVERY MERCHANDISE TO OUR STORES, WHICH COULD
ADVERSELY AFFECT OUR REVENUES AND PROFITABILITY
A significant amount of our merchandise is shipped to our customers from one of
our three warehouses, which are located in Compton, California, Rancho
Dominguez, California and Coconut Creek, Florida. Events such as fire or other
catastrophic events, any malfunction or disruption of our centralized
information systems or shipping problems may result in delays or disruptions in
the timely distribution of merchandise to our customers, which could
substantially decrease our revenues and profitability.
OUR BUSINESS OPERATIONS COULD BE DISRUPTED IF THERE ARE LABOR PROBLEMS ON
THE WEST COAST
During fiscal 2003, approximately 48% of our sales were domestic sales, which
were made from our warehouses in California and Florida. During the third
quarter of fiscal 2003, the dock strike on the West Coast affected sales of two
of our karaoke products and we estimate that we lost between $3 and $5 million
in orders because we couldn't get the containers of these products off the pier.
If another strike or work slow-down occurs and we do not have a sufficient level
of inventory, a strike or work slow-down would result in increased costs to us
and may reduce our profitability.
THE MARKET PRICE OF OUR COMMON STOCK MAY BE VOLATILE WHICH MAY CAUSE
INVESTORS TO LOSE ALL OR A PORTION OF THEIR INVESTMENT
From December 1, 2002 through December 1, 2003, our common stock has traded
between a high of $13.10 and a low of $2.15. During this period, we have
restated our earnings, lost senior executives and Board members, had liquidity
problems and defaulted on our line of credit with LaSalle. Our stock price may
continue to be volatile based on similar or other adverse developments in our
business. In addition, the stock market periodically experiences significant
adverse price and volume fluctuations which may be unrelated to the operating
performance of particular companies.
IF INVESTORS SHORT OUR SECURITIES, IT MAY CAUSE OUR STOCK PRICE TO DECLINE
During the past year, a number of investors have held a short position in our
common stock. Based on reports received from ViWes InvestInfo, the ratio for the
number of shares short compared to the daily average volume in our stock as of
the dates was as follows:
SHARES AVERAGE DAILY
MONTH SHORT VOLUME RATIO
------- --------- ------------- -------
8/03 437,590 53,721 8.15
7/03 423,623 167,066 2.54
6/03 600,440 68,480 8.77
5/03 606,841 30,280 20.04
4/03 584,510 27,359 21.36
3/03 584,185 22,195 26.32
*Monthly data as of settlement on the 15th of each month.
The anticipated downward pressure on our stock price due to actual or
anticipated sales of our stock by some institutions or individuals who engage in
short sales of our common stock could cause our stock price to decline.
Additionally, if our stock price declines, it may be more difficult for us to
raise capital.
29
OUR OBLIGATION TO MAKE SEVERANCE PAYMENTS COULD PREVENT OR DELAY TAKEOVERS
Our employment agreements with Yi Ping Chan, April Green, Jack Dromgold and John
Dahl require us, under certain conditions, to make substantial severance
payments to them if they resign after a change of control. As of September 30,
2003, Mr. Chan, Ms. Green, Mr. Dromgold and Mr. Dahl are entitled to severance
payments of $250,000, $73,600, $135,000 and $75,000, respectively. These
provisions could delay or impede a merger, tender offer or other transaction
resulting in a change in control of the Company, even if such a transaction
would have significant benefits to our shareholders. As a result, these
provisions could limit the price that certain investors might be willing to pay
in the future for shares of our common stock.
RISKS ASSOCIATED WITH OUR CAPITAL STRUCTURE
IF OUR OUTSTANDING DERIVATIVE SECURITIES ARE EXERCISED OR CONVERTED, OUR
EXISTING SHAREHOLDERS WILL SUFFER DILUTION
As of December 31, 2003, there were outstanding stock options to purchase an
aggregate of 1,120,120 shares of common stock at exercise prices ranging from
$1.97 to $14.00 per share, not all of which are immediately exercisable. The
weighted average exercise price of the outstanding stock options is
approximately $4.81 per share. As of December 31, 2003, there were outstanding
immediately exercisable warrants to purchase an aggregate of 561,039 shares of
our common stock. In addition, we have issued $4,000,000 of convertible
debentures, which are initially convertible into an aggregate of 1,038,962
shares of common stock. To the extent that the aforementioned convertible
securities are exercised or converted, dilution to our stockholders will occur.
THE $4 MILLION PRIVATE PLACEMENT THAT WE CLOSED IN SEPTEMBER 2003 WILL
AFFECT OUR ABILITY TO RAISE CAPITAL IN THE FUTURE
On September 8, 2003, we closed a private offering in which we issued $4 million
of convertible debentures and stock purchase warrants to six institutional
investors. As part of this investment, we agreed to several limitations on our
corporate actions, some of which limit our ability to raise financing in the
future. If we enter into any financing transactions during the one year period
after the registration statement, of which this Prospectus is a part, is
effective we need to offer the institutional investors the right to participate
in such offering in an amount equal to the greater of (a) the principal amount
of the debentures currently outstanding or (b) 50% of the financing offered to
the outside investment group. For example, if we offer to sell $10 million worth
of our securities to an outside investment group, the institutional investors
will have the right to purchase up to $5 million of the offering. This right may
affect our ability to attract other investors if we require external financing
to remain in operations. Furthermore, for a period of 90 days after the
effective date of the registration statement, we cannot sell any securities.
Additionally, we can not:
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.
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 equity.
IF WE SELL ANY OF OUR SECURITIES AT A PRICE LOWER THAN $3.85 PER SHARE, THE
CONVERSION PRICE OF OUR DEBENTURES AT $3.85 PER SHARE WILL BE REDUCED AND THERE
WILL BE ADDITIONAL DILUTION TO OUR SHAREHOLDERS
Given that our common stock is trading at a price of $2.22 per share as of
December 2, 2003, it is possible that we may need to sell additional securities
for capital at a price lower than $3.85 per share. If we sell any securities at
a price lower than $3.85 per share, the conversion price of our debentures
currently set at $3.85 per share will be reduced and there will be more dilution
to our shareholders if and when the debentures are converted into shares of our
common stock. If we issue or sell any securities at a price less than $3.85 per
share prior to September 8, 2004, the set price of the debentures will be
reduced by an amount equal to 75% of the difference between the set price
30
and the effective purchase price for the shares If such dilutive issuances occur
after September 8, 2004 but before the earlier of February 20, 2006 or when all
the debentures are converted into shares of our common stock, the set price will
be reduced by an amount equal to 50% of the difference between the set price and
effective purchase price of such shares. So, if we sold 1 million shares of our
common stock on December 1, 2003 for a price of $2.85 per share, the set price
of the debentures would be reduced by $1.22 to $2.63 and the aggregate number of
shares of our common stock that would be issued upon conversion of the
debentures would be increased from 1,038,963 shares to 3,278,689 shares.
FUTURE SALES OF OUR COMMON STOCK HELD BY CURRENT STOCKHOLDERS AND
INVESTORS MAY DEPRESS OUR STOCK PRICE
As of December 31, 2003, there were 8,756,318 shares of our common stock
outstanding. Of these shares, approximately 5,954,796 shares are eligible for
sale under Rule 144. We have filed two registration statements registering an
aggregate 3,794,250 of shares of our common stock (a registration statement on
Form S-8 to registering the sale of 1,844,250 shares underlying options granted
under our 1994 Stock Option Plan and a registration statement on Form S-8 to
register 1,950,000 shares of our common stock underlying options granted under
our Year 2001 Stock Option Plan). An additional registration statement on Form
S-1, of which this Prospectus is a part, was filed in October 2003, registering
an aggregate of 2,795,465 shares of our common stock. The market price of our
common stock could drop due to the sale of large number of shares of our common
stock, such as the shares sold pursuant to the registration statements or under
Rule 144, or the perception that these sales could occur.
OUR STOCK PRICE MAY DECREASE IF WE ISSUE ADDITIONAL SHARES OF OUR COMMON
STOCK
Our Certificate of Incorporation authorizes the issuance of 18,900,000 shares of
common stock. As of December 31, 2003, we had 8,756,318 shares of common stock
issued and outstanding and an aggregate of 1,580,439 shares issuable under our
outstanding options and warrants. We also have an obligation to issue up to
1,038,962 shares upon conversion of our debentures and have reserved 207,791
additional shares for interest payment on the debentures. As such, our Board of
Directors has the power, without stockholder approval, to issue up to 7,423,561
shares of common stock.
Any issuance of additional shares of common stock, whether by us to new
stockholders or the exercise of outstanding warrants or options, may result in a
reduction of the book value or market price of our outstanding common stock.
Issuance of additional shares will reduce the proportionate ownership and voting
power of our then existing stockholders.
PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW MAKE IT DIFFICULT FOR A
THIRD PARTY TO ACQUIRE OUR COMPANY AND COULD DEPRESS THE PRICE OF OUR COMMON
STOCK
Delaware law and our certificate of incorporation and bylaws contain provisions
that could delay, defer or prevent a change in control of our company or a
change in our management. These provisions could also discourage proxy contests
and make it more difficult for you and other stockholders to elect directors and
take other corporate actions. These provisions of our restated certificate of
incorporation include: authorizing our board of directors to issue additional
preferred stock, limiting the persons who may call special meetings of
stockholders, and establishing advance notice requirements for nominations for
election to our board of directors or for proposing matters that can be acted on
by stockholders at stockholder meetings.
We are also subject to certain provisions of Delaware law that could delay,
deter or prevent us from entering into an acquisition, including the Delaware
General Corporation Law, which prohibits a Delaware corporation from engaging in
a business combination with an interested stockholder unless specific conditions
are met. The existence of these provisions could limit the price that investors
are willing to pay in the future for shares of our common stock and may deprive
you of an opportunity to sell your shares at a premium over prevailing prices.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk represents the risk of loss that may impact our financial position,
results of operations or cash flows due to adverse changes in financial and
commodity market prices and interest rates. We are exposed to market risk in the
areas of changes in United States and international borrowing rates and changes
in foreign currency exchange rates. In addition, we are exposed to market risk
in certain geographic areas that have experienced or remain vulnerable to an
economic downturn, such as China. We purchase substantially all our inventory
from companies in China, and,
31
therefore, we are subject to the risk that such suppliers will be unable to
provide inventory at competitive prices. While we believe that, if such an event
were to occur we would be able to find alternative sources of inventory at
competitive prices, we cannot assure you that we would be able to do so. These
exposures are directly related to our normal operating and funding activities.
Historically and as of December 31, 2003, we have not used derivative
instruments or engaged in hedging activities to minimize market risk.
INTEREST RATE RISK:
Our exposure to market risk resulting from changes in interest rates relates
primarily to debt under our credit facility with LaSalle. Under our credit
facility, our interest rate is LaSalle's prime rate plus 2.5% per annum
("current interest rate"). As of December 31, 2003, our outstanding balance
under our credit facility was $2,474,386 and we are accruing interest at the
prime plus 2.5% per annum. This loan was paid in full on January 30, 2004. We do
not believe that near-term changes in the interest rates, if any, will result in
a material effect on our future earnings, fair values or cash flows. On
September 8, 2003, we issued convertible notes in the amount of $4 million with
a fixed interest rate of 8% per annum.
FOREIGN CURRENCY RISK:
We have a wholly-owned subsidiary in Hong Kong. Sales by these operations made
on a FOB China or Hong Kong basis are dominated in U.S. dollars. However,
purchases of inventory and Hong Kong operating expenses are typically
denominated in Hong Kong dollars, thereby creating exposure to changes in
exchange rates. Changes in the Hong Kong dollar/U.S. dollar exchange rates may
positively or negatively affect our gross margins, operating income and retained
earnings. We do not believe that near-term changes in the exchange rates, if
any, will result in a material effect on our future earnings, fair values or
cash flows, and therefore, we have chosen not to enter into foreign currency
hedging transactions. We cannot assure you that this approach will be
successful, especially in the event of a significant and sudden change in the
value of the Hong Kong dollar.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including
our principal executive officer and principal financial officer, we conducted an
evaluation (the "Evaluation") of the effectiveness of the design and operation
of our disclosure controls and procedures, as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as of the end of the period
covered by this report (the "Evaluation Date").Based on this Evaluation, our
chief executive officer and our chief financial officer concluded that we
maintain disclosure controls and procedures that are effective in providing
reasonable assurance that information required to be disclosed in our reports
under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the time periods specified in the SEC's rules and forms, and
that such information is accumulated and communicated to our management,
including our chief executive officer and our chief financial officer, to allow
timely decisions regarding required disclosure.
In addition, we reviewed our internal controls, and there have been no
significant changes in our internal controls or in other factors that could
significantly affect those controls subsequent to the date of their last
evaluation.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From July 2003 through August 2003, eight securities class action lawsuits were
filed against The Singing Machine and certain of its officers and directors in
the United States District Court for the Southern District of Florida on behalf
of all persons who purchased The Singing Machine's securities during the various
class action periods specified in the complaints. These complaints have all been
consolidated into one action styled Bielansky, et al. v. Salberg & Co., et al.,
Case No. 03-80596-ZLOCH (the Shareholder Action).
The complaints in the Shareholder Action allege violations of Section 10(b) and
Section 20(a) of the Securities Exchange Act of 1934 and Rule 10(b)-5
promulgated there under. These complaints seek compensatory damages, attorney's
fees and injunctive relief. While the specific factual allegations vary slightly
in each case, the complaints generally allege that defendants falsely
represented the Company's financial results for the years ended March 31, 2002
and 2001.
32
In July 2003, a shareholder filed a derivative action against the Company, its
board of directors and senior management purporting to pursue the action on
behalf of the Company and for its benefit. No pre-lawsuit demand was made on the
board of directors for them to investigate the allegations or to bring action.
The Company is named as a nominal defendant in this case. This case has been
consolidated into the Shareholder Action identified above. The derivative
complaint alleges claims for breach of fiduciary duty, abuse of control, gross
mismanagement, waste of corporate assets and unjust enrichment. The complaint
alleges that the individual defendants breached their fiduciary duties and
engaged in gross mismanagement by allegedly ignoring indicators of the lack of
control over the Company's accounting and management practices, allowing the
Company to engage in improper conduct and otherwise failing to carry out their
duties and obligations to the Company. The plaintiff's seek damages for breach
of fiduciary duties, punitive and compensatory damages, restitution, and bonuses
or other incentive-based or equity based compensation received by the CEO and
CFO under the Sarbanes-Oxley Act of 2002.
The court in the Shareholder Action has directed plaintiffs' counsel to file one
amended consolidated complaint no later than November 14, 2003. The Company
intends to vigorously defend the Shareholder Action. As the outcome of
litigation is difficult to predict, significant changes in the estimated
exposures could occur which could have a material affect on the Company's
operations.
A second shareholder derivative suit was filed in October 2003, which makes
generally the same allegations. The second derivative suit has not been served
on the Company or on any of its current or former officers and directors. This
suit has been transferred to the same judge to whom the Shareholder Action has
been assigned and has likewise been consolidated into the Shareholder Action.
In August 2003, we were advised that the Securities and Exchange Commission had
commenced an informal inquiry of our company. We are cooperating fully with the
SEC staff. It appears that the investigation is focused on the restatement of
our audited financial statements for fiscal 2002 and 2001. We have been advised
that an informal inquiry should not be regarded as an indication by the SEC or
its staff that any violations of law have occurred or as a reflection upon any
person or entity that may have been involved in those transactions.
We are also involved in certain routine litigation matters incidental to our
business and operations, which we do not believe are material to our business.
In September 2003, we had a disagreement with AG Edwards & Sons, Inc.("AG
Edwards") regarding the compensation that was payable to them under our
investment banking agreement with them. We have entered into a settlement
agreement with AG Edwards, whereby we agreed to pay $181,067 over a six month
period and to issue them 40,151 shares of stock. These shares will be registered
by the form S-1 currently under amendment.
33
ITEM 2. CHANGES IN SECURITIES
(a) Not Applicable.
(b) Not Applicable.
(c) On December 19, 2003, we issued an aggregate of 221,920 options to our
employees, as consideration for services they had rendered to us. We issued
these options to our employees in reliance upon Section 4(2) of the Securities
Act, because our employees were knowledgeable, sophisticated and had access to
comprehensive information about us.
NUMBER OF EXERCISE
NAME OPERATONS PRICE
---------------------- ---------- --------
Frank Abell 1,320 $1.97
Josef Bauer 2,740 $1.97
Dan Becherer 4,910 $1.97
Almina Brady-Dykes 1,320 $1.97
Pam Broyles 500 $1.97
Elizabeth Canela 660 $1.97
Yi Ping Chan 52,800 $1.97
Belinda Cheung 110 $1.97
Jeffrey Chiu 220 $1.97
Brian Cino 660 $1.97
John Dahl 50,000 $1.97
April Green 4,380 $1.97
Alicia Haskamp 24,600 $1.97
Jeff Ho 5,000 $1.97
Michelle Ho 5,660 $1.97
Wilson Ho 220 $1.97
Irene Ko 660 $1.97
Rose Labadessa 5,000 $1.97
Bill Lau 5,990 $1.97
Doral Lee 5,660 $1.97
Nataly Lessard 1,320 $1.97
Marian McElligott 3,290 $1.97
Alyssa Malamud 1,000 $1.97
Bernardo Melo 4,000 $1.97
Rick Ng 110 $1.97
Dennis Norden 8,000 $1.97
Cathy Novello 880 $1.97
Jennifer O'Kuhn 440 $1.97
Jorge Otaegui 440 $1.97
John Petko 1,500 $1.97
Terri Phillips 660 $1.97
Melody Rawski 1,100 $1.97
Evelyn Romero 500 $1.97
Kristi Ronyak 1,000 $1.97
Rafael Ros 1,200 $1.97
Stacy Sethman 1,100 $1.97
Edward Steele 10,000 $1.97
John Steele 12,200 $1.97
Nicolas Venegas 440 $1.97
Ho Man Yeung 110 $1.97
Yen Yu 220 $1.97
On November 20, 2003, 40,151 shares of stock were issued to AG Edwards in
settlement of a disagreement on the terms of an investment banking agreement.
This stock was valued at $89,354, its market price on the date of grant.
34
We issued these shares to the AG Edwards & Sons, Inc. in reliance upon Section
4(2) of the Securities Act, because it was knowledgeable, sophisticated and had
access to comprehensive information about us.
(d) Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
Not applicable.
ITEM 5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
EXHIBIT NO. DESCRIPTION
--------- ---------------------------------------------------------------------
10.1 Factoring Agreement dated February 9, 2004 between Milberg Factors,
Inc. and the Company.*
10.2 Security Agreement for Goods and Chattels dated February 9, 2004
between Milberg Factors, Inc. and the Company.*
10.3 Security Agreement for Inventory dated February 9, 2004 between
Milberg Factors, Inc. and the Company.*
10.4 Second Amendment to the Transaction Documents dated February 9, 2004
between Omicron Master Trust, SF Capital Partners, Ltd, Bristol
Investment Fund, Ltd., Ascend Offshore Fund, ltd., Ascend Partners,
LP, Ascend Partners Sapient L.P. and the Company.*
10.5 Amendment to Domestic Licensing Agreement dated November 15, 2002
between the Company and MTV Networks, a division of Viacom
International, Inc.*
10.6 Fifth Amendment to Domestic Licensing Agreement dated December 23,
2003 between the Company and MTV Networks, a division of Viacom
International, Inc. (portions of this Exhibit 10.6 have been
omitted pursuant to a request for confidential treatment filed with
the Securities and Exchange Commission).*
10.7 Sales Agreement effective as of December 9, 2003 between the
Company and CPP Belwin, Inc. and its affiliates (portions of this
Exhibit 10.7 have been omitted pursuant to a request for
confidential treatment filed with the Securities and Exchange
Commission).*
31.1 Certification of Yi Ping Chan, Chief Executive Officer and Chief
Operating Officer of The Singing Machine Company, Inc., Pursuant to
Rule 13a-14(a) under the Securities Exchange Act of 1934.*
31.2 Certification of April Green, Chief Financial Officer of The Singing
Machine Company, Inc., Pursuant to Rule 13a-14(a) under the
Securities Exchange Act of 1934.*
32.1 Certification of Yi Ping Chan, Chief Executive Officer and Chief
Operating Officer of The Singing Machine Company, Inc., Pursuant to
18 U.S.C. Section 1350.*
32.2 Certification of April Green, Chief Financial Officer of The Singing
Machine Company, Inc., Pursuant to 18 U.S.C. Section 1350.*
*Filed herewith
(B) REPORTS ON FORM 8-K
During the three months ended December 31, 2003, we filed one Form 8-K. On
November 7, 2003, we filed a Form 8-K announcing our financial results for the
six months ended September 30, 2003.
35
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 17, 2004
By: /s/ Jeffrey Barocas
--------------------------------------------
Jeffrey Barocas
Chief Financial Officer
Dated January 17, 2004
By: /s/ YI PING CHANG
--------------------------------------------
Yi Ping Chang
Chief Executive Officer
36
EXHIBITS
EXHIBIT NO. DESCRIPTION
--------- ---------------------------------------------------------------------
10.1 Factoring Agreement dated February 9, 2004 between Milberg Factors,
Inc. and the Company.*
10.2 Security Agreement for Goods and Chattels dated February 9, 2004
between Milberg Factors, Inc. and the Company.*
10.3 Security Agreement for Inventory dated February 9, 2004 between
Milberg Factors, Inc. and the Company.*
10.4 Second Amendment to the Transaction Documents dated February 9, 2004
between Omicron Master Trust, SF Capital Partners, Ltd, Bristol
Investment Fund, Ltd., Ascend Offshore Fund, ltd., Ascend Partners,
LP, Ascend Partners Sapient L.P. and the Company.*
10.5 Amendment to Domestic Licensing Agreement dated November 15, 2002
between the Company and MTV Networks, a division of Viacom
International, Inc.*
10.6 Fifth Amendment to Domestic Licensing Agreement dated December 23,
2003 between the Company and MTV Networks, a division of Viacom
International, Inc. (portions of this Exhibit 10.6 have been
omitted pursuant to a request for confidential treatment filed with
the Securities and Exchange Commission).*
10.7 Sales Agreement effective as of December 9, 2003 between the
Company and CPP Belwin, Inc. and its affiliates (portions of this
Exhibit 10.7 have been omitted pursuant to a request for
confidential treatment filed with the Securities and Exchange
Commission).*
31.1 Certification of Yi Ping Chan, Chief Executive Officer and Chief
Operating Officer of The Singing Machine Company, Inc., Pursuant to
Rule 13a-14(a) under the Securities Exchange Act of 1934.*
31.2 Certification of April Green, Chief Financial Officer of The Singing
Machine Company, Inc., Pursuant to Rule 13a-14(a) under the
Securities Exchange Act of 1934.*
32.1 Certification of Yi Ping Chan, Chief Executive Officer and Chief
Operating Officer of The Singing Machine Company, Inc., Pursuant to
18 U.S.C. Section 1350.*
32.2 Certification of April Green, Chief Financial Officer of The Singing
Machine Company, Inc., Pursuant to 18 U.S.C. Section 1350.*
37