UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

or

For the transition period from     to   

Commission File Number: 0-29583

Loudeye Corp.

1130 Rainier Avenue South, Seattle, WA 98144
(Address of principal executive offices) (Zip Code)

206-832-4000
(Registrant’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 requirements for the past 90 days.

     Yes þ No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes o No þ

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Loudeye Corp.

Form 10-Q Quarterly Report
For the Quarter Ended September 30, 2004

TABLE OF CONTENTS

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LOUDEYE CORP. AND SUBSIDIARIES

The accompanying notes are an integral part of these condensed consolidated financial statements.

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LOUDEYE CORP. AND SUBSIDIARIES

(1) Stock-based compensation, consisting of amortization of deferred stock-based compensation and the fair value of options issued to non-employees for services rendered, is allocated as follows:

The accompanying notes are an integral part of these condensed consolidated financial statements.

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LOUDEYE CORP. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

The accompanying notes are an integral part of these condensed consolidated financial statements.

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LOUDEYE CORP. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these consolidated financial statements.

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LOUDEYE CORP. AND SUBSIDIARIES

1. ORGANIZATION and RISKS

Loudeye

     Loudeye Corp. (“Loudeye”) provides digital media services and media restoration services. Loudeye is headquartered in Seattle, Washington and has offices in the United States, the United Kingdom, France, Germany and Italy.

     As discussed in Note 5, on June 22, 2004, Loudeye acquired On Demand Distribution Limited (“OD2”), a privately held digital music provider based in Europe. As discussed in Note 5, under the terms of the OD2 transaction, Loudeye is obligated to pay an additional £9.6 million (approximately $17.3 million based on exchange rates as of September 30, 2004) in deferred consideration through November 30, 2005, to OD2’s shareholders, plus additional contingent consideration of up to £10.0 million (approximately $18.0 million based on exchange rates as of September 30, 2004) if OD2 achieves certain financial performance targets during the period through November 30, 2006. The payments are to be made in British pounds, and accordingly, Loudeye is exposed to risks with changes in the prevailing exchange rate. Any decrease in the value of the U.S. dollar against the British pound will cause a proportional increase in the amount of the future consideration Loudeye must pay to the former OD2 shareholders. Loudeye may elect to pay amounts due to OD2’s shareholders in shares of Loudeye’s common stock. However, in accordance with the rules of the NASDAQ Stock Market, approval of Loudeye’s stockholders (excluding shares issued in connection with the OD2 transaction) will be required prior to any election to satisfy these payments in shares. Loudeye has scheduled a special stockholder meeting for December 8, 2004, seeking approval of its stockholders for issuance of shares of common stock to satisfy the deferred and contingent consideration obligations. Such approval cannot be assured. If stockholder approval is not obtained, Loudeye would not be able to pay the additional amounts due related to the OD2 transaction in 2005 unless it obtains additional funds through an equity or debt financing transaction. In addition, as a result of Loudeye’s acquisition of OD2, Loudeye will be required to provide additional funding to support OD2’s ongoing operations. There can be no assurance that Loudeye’s cash balances after December 31, 2004 will be sufficient to sustain its operations in 2005 and to fund the ongoing operations of OD2.

     Loudeye has incurred net losses and negative cash flows from operations since inception and has an accumulated deficit of $203.6 million at September 30, 2004. Loudeye’s operating expenses have increased as a result of the OD2 acquisition. Historically, Loudeye has funded its operations through equity transactions, leases and debt. However, there can be no assurance that Loudeye’s cash balances after December 31, 2004 will be sufficient to sustain its operations until profitable operations and positive cash flows are achieved.

     Accordingly, Loudeye may require additional capital or debt financing subsequent to December 31, 2004 to fund its operations and the amounts due in 2005 related to the OD2 transaction. There can be no assurance that additional capital or debt will be available to Loudeye on acceptable terms, or at all. If Loudeye lacks necessary cash or debt financing capacity during 2005, Loudeye may not only be unable to pay the scheduled OD2 transaction amounts in 2005 but might also have to delay or abandon some or all of its development plans or otherwise forego market opportunities. Loudeye’s inability to execute on its strategy could result in increased expenses and decreased revenues, either or both of which could seriously harm Loudeye’s business, results of operations and financial condition subsequent to December 31, 2004.

     Loudeye segregates its business in two business segments, digital media services and media restoration services. As discussed in Note 6, Loudeye completed the sale of its media restoration services business in May 2004.

     The consolidated financial statements at December 31, 2003, and the unaudited interim condensed consolidated financial statements at September 30, 2004, do not include any adjustments that may result from the outcome of the aforementioned uncertainties.

Risks

     Loudeye is subject to a number of risks similar to other companies in a comparable stage of development, including, but not limited to, reliance on key personnel, successful marketing of its services in emerging markets, competition from other companies with greater technical, financial, management and marketing resources, successful development of new services, the enhancement of existing services and the ability to secure adequate financing to support future operations.

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     Assuming Loudeye’s stockholders approve the issuance of additional shares to OD2 stockholders to pay future required payments, Loudeye believes that its existing cash, cash equivalents, and short-term investments will be sufficient to fund its operations and meet its working capital and capital expenditure requirements for the next twelve months. If Loudeye’s stockholders do not approve such issuances. Loudeye will be required to satisfy such amounts in cash, which would likely cause a significant strain on Loudeye’s cash resources, Loudeye may need to obtain additional equity or debt financing and Loudeye may have difficulty pursuing its business objectives. Since Loudeye has incurred net losses since inception, Loudeye has relied on sales of equity securities, proceeds from the exercises of stock options and warrants and borrowings under its credit facilities to fund its working capital needs. Such capital may not be available in the future if it is needed. The availability of such capital will depend on a number of factors, some of which are outside Loudeye’s control. These include general market conditions, conditions in the private equity and public markets, the then-current market price of Loudeye’s common stock and Loudeye’s historical financial performance and future prospects.

Basis of Consolidation

     The consolidated financial statements include the accounts of Loudeye and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. Loudeye has included the results of operations of acquired entities from the date of acquisition (see Note 5).

Unaudited Interim Financial Information

     The interim condensed consolidated financial statements are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in Loudeye’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 22, 2004. The interim financial information included herein reflects all adjustments (consisting only of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the results for interim periods. The unaudited results of operations for the three and nine months ended September 30, 2004 and 2003 are not necessarily indicative of the results to be expected for the full years.

Use of Estimates

     The preparation of the financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

     Management’s assessments of the impairment of property and equipment, goodwill and intangible assets are sensitive accounting estimates that could result in additional impairment charges in the near term. Factors that impact these estimates include, but are not limited to, possible changes in business plans and declining financial results.

     Management evaluates the potential loss exposure on various claims and lawsuits arising in the normal course of business. An accrual is made if the amount of a particular claim or lawsuit is probable and reasonably estimable.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Cash and Cash Equivalents

     Loudeye considers all highly liquid investments with a remaining maturity of three months or less at the date of acquisition to be cash equivalents. Cash and cash equivalents consist of demand deposits and money market accounts maintained with financial institutions and certain other investment grade instruments, which at times exceed federally insured limits. Loudeye has not experienced any losses on its cash and cash equivalents.

Marketable Securities

     Loudeye has invested amounts in investment-grade government obligations, institutional money market funds and other obligations with FDIC insured U.S. banks. Marketable securities are accounted for as available for sale. Marketable securities are classified in current assets as they are considered by management as available to support current operations. Available for sale marketable securities are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders’

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equity. Realized gains and losses are included in investment income. The cost of securities sold is based upon the specific identification method.

Restricted Investments

     Loudeye has approximately $305,000 of short-term investments which are utilized as collateral for certain irrevocable standby letters of credit. Accordingly, these investments are classified as restricted investments in the accompanying condensed consolidated balance sheets. These securities all mature within one year and reported amounts approximate fair value due to the relatively short maturities of these investments. These investments are related to standby letters of credit required for certain lease agreements which expire in October 2005. Accordingly, the restricted investments have been classified in long-term assets in the accompanying consolidated balance sheets.

Fair Value of Financial Instruments and Concentrations of Credit Risk

     Financial instruments that potentially subject Loudeye to concentrations of credit risk consist of cash and cash equivalents, marketable securities, and long-term obligations. Fair values of cash and cash equivalents approximate their carrying value due to the short period of time to maturity. Marketable securities are reported at their market value. The carrying value of Loudeye’s line of credit and long-term obligations approximate fair value because the interest rates of the obligations are variable.

     Loudeye is exposed to credit risk because it extends credit to its customers. Loudeye performs initial and ongoing evaluations of its customers’ financial condition and generally extends credit on open account, requiring collateral as deemed necessary.

     Loudeye had sales to certain significant customers, as a percentage of revenues, as follows:

     Revenues from Microsoft Corporation and Sony Corporation were reported in the digital media services segment and revenues from The Coca-Cola Company were reported primarily in the media restoration services segment, which Loudeye ceased providing with the sale of that business in January 2004.

Impairment of Long-lived Assets

     Loudeye assesses the recoverability of long-lived assets whenever events or changes in business circumstances indicate that the carrying value of an asset may not be recoverable. An impairment loss is considered when the sum of the expected undiscounted future net cash flows over the remaining useful life is less than the carrying amount of the asset.

Goodwill and Intangible Assets

     Loudeye accounts for goodwill and intangible assets in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (FAS 142). Under FAS 142, goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to, at a minimum, annual impairment tests. Loudeye completes its annual impairment test as of November 30 of each year. As disclosed in Note 5, Loudeye has recorded goodwill and intangible assets in connection with its acquisition of Overpeer, Inc. in March 2004 and OD2 in June 2004.

Foreign Currencies

     For operations outside the U.S. that prepare financial statements in currencies other than U.S. dollars, the financial statements are translated into U.S. dollars. Results of operations and cash flows are translated at average rates of exchange prevailing during the period. Assets and liabilities are translated at end of period exchange rates, except for equity transactions and advances not expected to be repaid in the foreseeable future, which are translated at historical cost. The effects of exchange rate fluctuation on translating

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foreign currency assets and liabilities into U.S. dollars are accumulated as a separate component in other comprehensive income (loss).

Revenue Recognition

     Loudeye recognizes revenue in accordance with Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition in Financial Statements,” (SAB 101) as amended by Staff Accounting Bulletin No. 104 (SAB 104), and Emerging Issues Task Force (EITF) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” Loudeye recognizes revenue associated with the license of software in accordance with Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by SOP 98-4, SOP 98-9 and related interpretations and Technical Practice Aids.

     Loudeye recognizes revenues from encoding services, digital music samples services, digital distribution services, Internet radio services, live and on-demand webcasting services, software licensing, content protection services, and media restoration services. Loudeye recognizes these revenues when persuasive evidence of an arrangement exists, the product and/or service has been delivered, the price is fixed or determinable and collectibility is probable.

     In arrangements that include rights to multiple products and/or services, Loudeye allocates the total arrangement consideration among each of the deliverables using the residual method, under which revenue is allocated to undelivered elements based on verifiable and objective evidence of the fair value of the undelivered elements. Multiple element arrangements may consist of implementation services, development services, encoding services, digital music samples services, digital distribution services, Internet radio services, and on-demand webcasting services. Verifiable and objective evidence is based upon the price charged when an element is sold separately.

     Under the provisions of SOP 97-2, in software arrangements that involve rights to multiple products and services, Loudeye allocates the total arrangement consideration among each of the deliverables using the residual method, under which revenue is allocated to the undelivered elements based on vendor-specific objective evidence of the fair value of such undelivered elements. Elements included in multiple element arrangements consist of software, intellectual property, implementation services, maintenance and consulting services. Vendor-specific objective evidence is based on the price charged when an element is sold separately or, in the case of an element not sold separately, the price established by management, if it is probable that the price, once established, will not change before market introduction.

     Deferred revenue arises from payments received or services rendered and billed in advance of the culmination of the earnings process. Deferred revenue expected to be realized within the next twelve months is classified as current.

     Encoding services consist of the conversion of audio and video content into digital media formats. Sales of encoding services are generally under nonrefundable time and materials or per unit contracts. Under the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye recognizes revenues as the encoding services are rendered and Loudeye has no continuing involvement in the goods and services delivered, which is generally the date the finished media is shipped to the customer.

     Digital music samples services are provided to customers using Loudeye’s proprietary streaming media software, tools, and processes. Music samples are streamed files containing selected portions, or samples, of a full music track and are typically 30 to 60 seconds in length. Customer billings are based on the volume of data streamed at rates agreed upon in the customer contract, subject to a nonrefundable monthly minimum fee. Under the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye recognizes revenue in the period in which the samples are delivered.

     Digital distribution services consist primarily of rights clearing services, ringtune services and the hosting of digital media content for Loudeye’s customers for download by the end user. Customer billings for digital distribution services are generally based on a combination of a fixed monthly fee and a transactional fee per download. Under the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye recognizes revenue in the period in which the services are provided.

     Similar to the digital music samples services, Internet radio and video services are provided to customers using Loudeye’s proprietary media software, tools and processes. Internet radio and video services can consist of the rebroadcasting over the Internet of a customer’s over-the-air radio programming. Services provided may also include playlist selection and programming services for online radio channels and may include related video content, such as music videos. Under the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, revenue from the sale of Internet radio and video services is recognized on a monthly basis as the services are provided and customers are typically billed monthly in arrears.

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     Webcasting services are provided to customers using Loudeye’s proprietary streaming media software, tools and processes. Services for live webcast events may be sold separately or combined with on-demand webcasting services in which Loudeye may host an archive of the webcast event for future use on an on-demand basis. In addition, on-demand webcasting services are often sold separately without the live event component. As a result, Loudeye has verifiable and objective evidence of the fair value for both the live and on-demand services. Under the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye recognizes revenue for live webcasting in the period in which the webcast event occurs. Revenue for on-demand webcasting services are deferred and recognized ratably over the period in which the services are provided. Customer billings are typically based on the volume of data streamed at rates agreed upon in the customer contract or a set monthly fee.

     Content protection services consist primarily of anti-piracy, data mining and content promotion solutions related to peer-to-peer file sharing networks. Customer billings for content protection services are generally based on a fixed monthly fee, but may also contain a volume-based component and, for content promotion services, a fee based on customer sales volume. Under the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye recognizes revenue in the period in which the services are provided.

     Media restoration services consisted of services provided by Loudeye’s VidiPax subsidiary to restore and upgrade old or damaged archives of traditional media. Under the provisions of SAB 101, as amended by SAB 104, and EITF 00-21, Loudeye recognizes revenues as these services are rendered and Loudeye has no continuing involvement in the goods and services delivered, which generally is the date the finished media is shipped to the customer. As discussed in Note 6, Loudeye completed the sale of its VidiPax business in May 2004 pursuant to an agreement dated October 31, 2003.

Stock-based Compensation

     Loudeye accounts for stock-based employee compensation plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issues to Employees” (APB 25), as interpreted by Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB 25” (FIN 44), and related interpretations. Under APB 25, compensation expense is based on the difference between the exercise price of employee stock options granted and the fair value of Loudeye’s common stock at the date of grant. Deferred compensation, if any, is amortized over the vesting period of the related options, which is three to four years.

     Equity instruments issued to non-employees are accounted for in accordance with the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (FAS 123) and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Investments that are Issued to Other than Employees for Acquiring or in Conjunction with Selling Goods or Services” (EITF 96-18), and related interpretations.

     Stock-based compensation for the quarter ended September 30, 2004 totalled $65,000, of which $44,000 is included in cost of revenues, consisting of the amortization of deferred stock compensation. Stock-based compensation was $761,000 for the quarter ended September 30, 2003, of which $37,000 is included in cost of revenues, consisting of the amortization of deferred stock compensation of $139,000 and variable stock-based compensation expense of $55,000 accounted for under APB 25, and stock-based compensation expense of $567,000 accounted for under FAS 123 related to options granted to a member of Loudeye’s board of directors for consulting services.

     Stock-based compensation for the nine months ended September 30, 2004 totalled $268,000, of which $82,000 is included in cost of revenues, consisting of the amortization of deferred stock compensation of $247,000, stock-based compensation expense of $39,000, including $14,000 related to options granted to a consultant, and a credit of $18,000 for variable stock compensation related to stock options that were repriced in 2001. Stock-based compensation was $998,000 for the nine months ended September 30, 2003, of which $44,000 is included in cost of revenues, consisting of the amortization of deferred stock compensation of $225,000, variable stock-based compensation expense of $55,000 accounted for under APB 25, stock issued to former employees as severance and termination benefits of $30,000, and stock-based compensation expense of $668,000 accounted for under FAS 123 related to options granted to a member of Loudeye’s board of directors for consulting services.

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     The following table illustrates the effect on net loss and net loss per share if Loudeye had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation (in thousands):