UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

Commission file number: 000-30063

ARTISTdirect, INC.

(310) 443-5360
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

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.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). [ ]

As of June 30, 2004, the registrant had 3,502,117 shares of common stock, par value $0.01 per share, issued and outstanding.

Documents incorporated by reference: None.

ARTISTDIRECT, INC. AND SUBSIDIARIES

INDEX

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ARTISTdirect, Inc. and Subsidiaries

See accompanying notes to condensed consolidated financial statements.

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ARTISTdirect, Inc. and Subsidiaries

See accompanying notes to condensed consolidated financial statements.

4

ARTISTdirect, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations (Unaudited)
(amounts in thousands, except for share data)

See accompanying notes to condensed consolidated financial statements.

5

ARTISTdirect, Inc. and Subsidiaries

See accompanying notes to condensed consolidated financial statements.

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ARTISTdirect, Inc. and Subsidiaries
Condensed Consolidated Statements of Comprehensive Loss (Unaudited)
(amounts in thousands)

See accompanying notes to condensed consolidated financial statements.

7

ARTISTdirect, Inc. and Subsidiaries

See accompanying notes to condensed consolidated financial statements.

8

ARTISTdirect, Inc. and Subsidiaries

See accompanying notes to condensed consolidated financial statements.

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ARTISTdirect, Inc. and Subsidiaries

1. BASIS OF PRESENTATION

     Organization

     ARTISTdirect, Inc. (“ADI”) was formed on October 6, 1999 upon its merger with ARTISTdirect, LLC (the “Capital Reorganization”). The Capital Reorganization was only a change in the form of ownership of ADI. ARTISTdirect, LLC was organized as a California limited liability company and commenced operations on August 8, 1996. ARTISTdirect, LLC had a 99% ownership interest in ARTISTdirect Agency LLC, Kneeling Elephant Records, LLC and ARTISTdirect New Media, LLC (the “Affiliated Companies”) and has consolidated their results since inception.

     On May 31, 2001, the Company, through its wholly-owned subsidiary, ARTISTdirect Recordings, Inc., entered into an agreement to acquire a 50% equity interest in a co-venture with Frederick W. (Ted) Field to form a new record label, ARTISTdirect Records, LLC (“ARTISTdirect Records”). This transaction became effective as of June 29, 2001. In April 2002, ADI’s ownership position in ARTISTdirect Records decreased to 45% as a result of a sale of a 5% interest to BMG. However, ADI’s ownership position increased to 65% during 2002, as a result of ADI’s agreement to accelerate its funding commitment to ARTISTdirect Records in 2002.

     Unless the context indicates otherwise, ARTISTdirect, Inc. and its subsidiaries are referred to herein as the “Company”.

     Business Activities

     The Company is a music entertainment company, headquartered in Los Angeles, California, that combines an on-line music network and a record label to provide an integrated offering for music fans, artists and marketing partners. The ARTISTdirect Network (www.artistdirect.com) is a network of Web sites offering multi-media content, music news and information, community around shared music interests, music-related specialty commerce and digital music services. Through the Company’s subsidiary, ARTISTdirect Records, the Company develops new musical artists and produces and distributes their recordings as an independent label utilizing both traditional channels and emerging Internet distribution channels.

     Principles of Consolidation

     The accompanying financial statements include the consolidated accounts of ADI and its subsidiaries in which it has controlling interests. All significant intercompany accounts and transactions have been eliminated for all periods presented. ADI has recorded 100% of the losses attributable to ARTISTdirect Records from May 31, 2001 through April 30, 2002 based on ADI’s commitment to fund 100% of ARTISTdirect’s operations during that time. From May 1, 2002 through December 31, 2002, ADI recorded approximately 83% of the losses of ARTISTdirect Records as a result of BMG’s equity purchase and from an assumption of a portion of ADI’s funding commitment to the record label. For the year ended December 31, 2003, ADI recorded approximately 73% of the losses of ARTISTdirect Records. However, given that ADI did not have voting or operational control, even with its majority ownership position in ARTISTdirect Records, through December 31, 2003, ADI accounted for this investment under the equity method of accounting as income (loss) from equity investments in the consolidated statements of operations.

     In February 2003, the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities. ADI adopted FIN 46 as of December 31, 2003. As a result of the adoption of FIN 46, the balance sheet of ARTISTdirect Records was consolidated as of December 31, 2003, and the operations of ARTISTdirect Records have been consolidated beginning January 1, 2004.

     As a result of the consolidation of the balance sheet of ARTISTdirect Records as of December 31, 2003, the Company’s statements of operations and cash flows for the three months and six months ended June 30, 2004 are not directly comparable to the statements of operations and cash flows for the three months and six months ended June 30, 2003.

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     The following is the adjustment resulting from the change to consolidation from equity accounting for ARTISTdirect Records, LLC effective December 31, 2003:

     The Company also recorded a cumulative effect of consolidation of ARTISTdirect Records, LLC of $5.255 million at December 31, 2003. This adjustment represents an increase in loans payable of $5.255 million at December 31, 2003, to reflect losses previously allocated to minority members (primarily BMG) of ARTISTdirect Records, LLC.

     Going Concern

     The Company has incurred losses and negative cash flows from operations in every fiscal period since inception and had an accumulated deficit of $224.1 million at June 30, 2004 and $222.7 million at December 31, 2003. For the six months ended June 30, 2004, the Company incurred a net loss of $1.4 million and negative operating cash flows of $3.2 million. For the year ended December 31, 2003, the Company incurred a net loss of $21.7 million and negative operating cash flows of $5.4 million. As of June 30, 2004, the Company had a net working capital deficiency of $8.8 million and a stockholders’ deficiency of $18.3 million. As of December 31, 2003, the Company had a net working capital deficiency of $9.5 million and a stockholders’ deficiency of $16.9 million.

     ADI’s operations to date and its loans to ARTISTdirect Records have been funded by the sale of preferred and common stock. ADI has funded a large portion of the operations of ARTISTdirect Records. Management expects the Company’s operating losses to continue for the near-term.

     Although the Company has limited cash resources available to fund its ongoing working capital requirements, the Company currently believes that it has adequate cash resources to maintain its operations at current levels through the remainder of 2004 and into early 2005. During 2003, the Company restructured its operations, laid off most of its staff and reduced operating costs, and has been attempting to raise additional funds through various means, although there can be no assurances that the Company will be successful in this regard. The failure to raise additional capital could seriously harm the business of ARTISTdirect Records and impair the value of the Company’s investment in ARTISTdirect Records. To the extent that the Company’s estimate of its cash flow requirements is inaccurate or the Company is unable to obtain the capital necessary to sustain its business operations on a timely basis and under acceptable terms and conditions, the Company may further reduce its operations and/or consider a formal or informal restructuring or reorganization.

     As a result of the conditions described above, the Company’s auditors have included an explanatory paragraph in their opinion on the Company’s December 31, 2003 consolidated financial statements indicating that there is substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Interim Financial Information

     The unaudited interim financial statements of the Company included herein have been prepared in accordance with the instructions for Form 10-Q under the Securities Exchange Act of 1934, as amended, and Article 10 of Regulation S-X under the Securities Act of 1933, as amended. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements.

     In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, necessary to present fairly the financial position of the Company at June 30, 2004, the results of operations for the three months and six months ended June 30, 2004 and 2003, and the cash flows for the six months ended June 30, 2004 and 2003. The results for the three months and six months ended June 30, 2004 are not necessarily indicative of the expected results for the full year or any future period. The balance sheet as of December 31, 2003 is derived from the Company’s audited financial statements. These financial statements should be read in conjunction with the consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K/A for the fiscal year ended December 31, 2003, as filed with the Securities and Exchange Commission.

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Estimates

     In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Some of the more significant estimates are allowance for sales return and inventory obsolescence, allowances for bad debts, impairment of long-lived assets and goodwill, stock-based compensation and the valuation allowance on deferred tax assets. Actual results could differ from those estimates.

Loss Per Common Share

     The Company computes net loss per share in accordance with SFAS No. 128, “Earnings per Share” and Securities and Exchange Commission Staff Accounting Bulletin No. 98 (“SAB 98”). SFAS No. 128 requires companies with complex capital structures to present basic and diluted EPS. Basic EPS is measured as the income or loss available to common shareholders divided by the weighted average outstanding common shares for the period. Diluted EPS is similar to basic EPS but presents the dilutive effect on a per share basis of potential common shares (e.g., convertible securities, options and warrants) as if they had been converted at the beginning of the periods presented. Potential common shares that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from the calculation of diluted EPS.

     The calculation of diluted loss per share excludes approximately 999,000 and 780,000 of potential common shares for the three months and six months ended June 30, 2004 and 2003, respectively, since the effect would be anti-dilutive.

Stock-Based Compensation

     The Company accounts for stock-based employee compensation in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25 and FASB Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation”, and complies with the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation”. Under APB No. 25, compensation expense is recorded based on the difference, if any, between the fair value of the Company’s stock and the exercise price on the measurement date. The Company accounts for stock issued to non-employees in accordance with SFAS No. 123, which requires entities to recognize as expense over the service period the fair value of all stock-based awards on the date of grant and EITF 96-18, “Accounting for Equity Investments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, which addresses the measurement date and recognition approach for such transactions.

     Stock-based compensation included in cost of revenue represents the amortization of non-cash compensation expense related to vendor warrants and stock options granted to artists and their advisors in connection with entering into contractual commitments to operate their online commerce activities. The Company records the fair value of options and warrants granted to non-employees as compensation expense over the period of service. The Company determines the fair value of these options and warrants based on the Black-Scholes option-pricing model.

     Stock-based compensation included in operating expenses represents the amortization of non-cash compensation expense related to equity instruments granted to employees, directors, professional firms, artists and artist advisors. Compensation for equity grants to non-employees is recorded in the same manner as described above. The Company records stock compensation for employee option grants equal to the excess of the fair value of its common stock over the exercise price on the grant date. The Company records the compensation over the vesting period.

     Pro forma information regarding net loss per share is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of such statement. The fair value for these options was estimated at the date of grant using the Black-Scholes option-pricing model.

     For purpose of pro forma disclosures, the estimated fair value of the options is amortized to operations over the vesting period of the options or the expected period of benefit. The Company’s unaudited pro forma information is as follows:

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2. iMUSIC

     During 2002, the Company’s wholly-owned subsidiary, ARTISTdirect Digital, Inc., began operating a record label under the brand name iMusic. Operations consist primarily of the sale of compact discs by artists signed to the iMusic record label. iMusic’s concept was to focus on the signing of established artists with a proven sales base and an ability to generally make records less expensively than developing artists. In addition, the Company expected that substantially less would be spent on marketing and promotion of these releases than on those of new artists. During the three months ended June 30, 2003, management of the Company decided to scale back the activity of its iMusic label in order to conserve capital. During the three months ended September 30, 2003, the Company executed an agreement with GC Music, pursuant to which the Company assigned its rights and obligations to six unreleased artists in exchange for a cash payment of $100,000 as a reduction to prior advances related to the six artists and a profit interest in the projects. The Company retains the distribution rights to the albums previously released under the original terms of its distribution agreements with its other signed artists. The Company does not plan to sign any additional artists or release any additional albums domestically or internationally under the iMusic label and expects very minimal sales activity in the future.

3. LOSS FROM SALE AND ABANDONMENT OF PROPERTY AND EQUIPMENT

     During the three months ended June 30, 2003, the Company determined that its fixed assets were impaired due to continuing losses, going concern issues, the delisting of its common stock from the NASDAQ Stock Market, and the likelihood that the majority of these assets would likely be abandoned in the near future. The Company determined that these factors were indicators of impairment and thus reduced the carrying amount of the fixed assets to their estimated fair value by recording a write-off of $2.225 million during the three months ended June 30, 2003. The leasehold improvements were subsequently abandoned when the Company vacated the premises, and most of the Company’s remaining property and equipment was subsequently sold to third party liquidators for cash. This amount has been reported as a loss from sale and abandonment of property and equipment in the condensed consolidated statements of operations for the three months and six months ended June 30, 2003.

4. INVESTMENT IN ARTISTDIRECT RECORDS, LLC

     In May 2001, ADI entered into an agreement with Frederick W. (Ted) Field to become Chairman and Chief Executive Officer of ADI and through its wholly-owned subsidiary, ARTISTdirect Recordings, Inc., to form a new record label, ARTISTdirect Records, LLC (“ARTISTdirect Records”), in partnership with ADI. On June 29, 2001, ADI’s stockholders approved the employment of Mr. Field and the formation of the ARTISTdirect Records record label. ARTISTdirect Records was formed as a 50/50 co-venture between ADI and Mr. Field. Mr. Field is the Chief Executive Officer of ARTISTdirect Records. The primary business activity of ARTISTdirect Records is the sale of compact discs by artists signed to the record label.

     ADI initially committed to fund a total of $50.0 million to ARTISTdirect Records over five years at the rate of $15.0 million per year, subject to a limit of $33.0 million in any three year period. Any funding in excess of these amounts required the approval of ADI’s Board of Directors.

     In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North America distribution agreement and worldwide license agreement with BMG Music, a wholly-owned partnership of Bertelsmann Music Group, Inc., the global music division of Bertelsmann AG (“BMG”). Under the terms of the agreement, BMG agreed to distribute the label’s releases in North America, and BMG licensed ARTISTdirect Records’ repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Records from ADI. As part of this transaction, BMG agreed to advance certain monies against net sales proceeds under the agreements and also assumed $5.0 million of ADI’s funding commitment to ARTISTdirect Records. As a result of the BMG equity purchase, ADI’s funding commitment was reduced to $45.0 million. In December 2002, BMG exercised its option to extend the term of the distribution and license agreement until September 2004.

     Under the distribution and license agreements, BMG made non-returnable advances to ARTISTdirect Records of $2.5 million in 2001, $2.5 million in 2002 and $5.0 million in 2003 that are recoupable from net sales proceeds from ARTISTdirect Records’ artist repertoire. The loan advances bear interest at a rate of LIBOR plus 4%, and the principal and interest are not repayable until December 31, 2015, or upon such time as ARTISTdirect Records achieves certain defined levels of excess cash flow and available cash. As of June 30, 2004 and December 31, 2003, the unrecouped balance related to distribution advances from BMG was $8.9 million and $8.7 million, respectively.

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     In August 2002, ADI’s Board of Directors approved an agreement (the “Accelerated Funding Agreement”) to accelerate up to $10.0 million of its funding commitment to ARTISTdirect Records. This funding was in addition to the $15.0 million that ADI was obligated to advance to ARTISTdirect Records in 2002 as part of the initial $50.0 million funding commitment. During 2002, ADI funded its $15.0 million commitment plus the additional $10.0 million bridge loan for total advances to the record label of $25.0 million in 2002 and $30.25 million from the inception of the record label through December 31, 2002. The $10.0 million o