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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended March 31, 2004
0 - 24968
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Commission File Number
THE SINGING MACHINE COMPANY, INC.
---------------------------------
(Exact Name Registrant as Specified in its Charter)
Delaware 95-3795478
- ------------------------ -----------------------------------
(State of incorporation) (I.R.S. Employer Identification No.)
6601 Lyons Road, Building A-7, Coconut Creek, FL 33073
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(Address of principal executive offices)
(954) 596-1000
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(Issuer's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
Title of each class Name of each Exchange on which Registered
- ------------------- -----------------------------------------
Common Stock American Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
None
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. [X[ Yes [_] No
Indicate by check mark if disclosure of delinquent filers pursuant Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
form 10-K. [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). [_] Yes [X] No
The aggregate market value of the Registrant's voting stock held by
non-affiliates, based upon the closing price for the common stock of $0.71 per
share as reported on the American Stock Exchange on June 18, 2004 was
approximately $6,249645 (based on 8,802,318 shares outstanding).
APPLICABLE ONLY TO CORPORATE ISSUERS: State the number of shares outstanding of
each of the Issuer's classes of common stock, as of the latest practicable date.
There were 8,802,318 shares of common stock, issued and outstanding at June 18,
2004.
DOCUMENTS INCORPORATED BY REFERENCE
NONE
THE SINGING MACHINE COMPANY, INC. AND SUBSIDIARY
INDEX TO ANNUAL REPORT ON FORM 10-KSB
FOR THE FISCAL YEAR ENDED MARCH 31, 2004
PART I
Item 1. Business
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
PART II
Item 5. Market for Company's Common Equity and Related Stockholder Matters
Item 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Item 7A Quantitative and Qualitative Disclosures About Market Risk
Item 8. Financial Statements and Supplementary Date
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Item 9A. Controls and Procedures
PART III
Item 10. Directors, Executive Officers, Promoters and Control Persons;
Compliance With Section 16(a) of the Exchange Act
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13. Certain Relationships and Related Transactions
Item 14. Principal Accountant Fees and Services
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
2
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this Annual Report on Form 10-K, including
without limitation, statements containing the words "believes," "anticipates,"
"estimates," "expects," "intends," and words of similar import, constitute
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. These forward-looking statements are subject to
certain risks and uncertainties that could cause actual results to differ
materially from those reflected in these forward-looking statements. Factors
that might cause such a difference include, but are not limited to, those
discussed in the section entitled "Management's Discussion and Analysis of
Financial Position and Results of Operations - Factors That May Affect Future
Results and Market Price of Stock."
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
revisions to these forward- looking statements. Readers should carefully review
the risk factors described in other documents the Company files from time to
time with the Securities and Exchange Commission.
PART I
ITEM 1. BUSINESS
OVERVIEW
The Singing Machine Company, Inc. (the "Singing Machine" "we," "us" or
"our") is engaged in the development, production, distribution, marketing and
sale of consumer karaoke audio equipment, accessories and music. We contract for
the manufacture of all electronic equipment products with factories located in
Asia. We also produce and market karaoke music, including compact disks plus
graphics ("CD+G's"), and audiocassette tapes containing music and lyrics of
popular songs for use with karaoke recording equipment. All of our recordings
include two versions of each song; one track offers music and vocals for
practice and the other track is instrumental only for performance by the
participant. Virtually all of the cassettes sold by us are accompanied by
printed lyrics, and our karaoke CD+G's contain lyrics, which appear on the video
screen. We contract for the reproduction of music recordings with independent
studios.
We were incorporated in California in 1982. We originally sold our
products exclusively to professional and semi-professional singers. In 1988, we
began marketing karaoke equipment for home use. In May 1994, we merged into a
wholly owned subsidiary incorporated in Delaware with the same name. As a result
of that merger, the Delaware Corporation became the successor to the business
and operations of the California Corporation and retained the name The Singing
Machine Company, Inc. In July 1994, we formed a wholly owned subsidiary in Hong
Kong, now known as International SMC (HK) Ltd. ("International SMC" or "Hong
Kong subsidiary"), to coordinate our production and finance in Asia.
In November 1994, we closed an initial public offering of 2,070,000
shares of our common stock and 2,070,000 warrants. In April 1997, we filed a
voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code. On
March 17, 1998, our plan of reorganization was approved by the U.S. Bankruptcy
Court. On June 10, 1998, our plan of reorganization had been fully implemented.
Our common stock currently trades on the American Stock Exchange under the
symbol "SMD." We were listed on the AMEX on March 8, 2001. Our principal
executive offices are located in Coconut Creek, Florida.
As used herein, the "Singing Machine," "we," us" and similar terms
include The Singing Machine Company, Inc. and its subsidiary, International SMC,
unless the context indicates otherwise.
RECENT DEVELOPMENTS
We had a challenging year in the twelve month period ended March 31,
2004 ("fiscal 2004"). During fiscal 2004, we reported a net loss of $22.7
million, or $2.65 per diluted share, on sales of $70.5 million which compares to
net income of $1.2 million in fiscal 2003 or $.14 per diluted share, on sales of
$95.6 million. Sales decreased primarily from increased competition in the
United States and in international markets.
Our gross profit decreased to $1.8 million or 2.6% of total revenues in
fiscal 2004 compared to gross profit of $23.3 million or 24.4% of total revenues
in fiscal 2003. Gross profit decreased as a result of our need to sell inventory
at lower margins in order to generate cash from operations, increase liquidity
and liquidate prior year excess inventory. During fiscal 2004, we also recorded
inventory provisions totaling approximately $7 million and an impairment charge
for tooling totaling approximately $443,000, both of which also negatively
impacted our gross profit.
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Our net loss for fiscal 2004 was $22.7 million, which includes
inventory write-downs of approximately $7.0 million, as well as non cash
accruals for litigation, severance pay, lease termination and other unusual or
non-recurring expenses in the aggregate amount of $4.6 million. A more detailed
explanation of our financial results is contained under "Management's Discussion
and Analysis of Results of Operations and Financial Condition" on pages 10-20.
PRODUCT LINES
We currently have a product line of 40 different models of karaoke
machines plus 7 accessories such as microphones, incorporating such features as
CD plus graphics player, sound enhancement, echo, tape record/playback features,
and multiple inputs and outputs for connection to compact disc players, video
cassette recorders, and home theater systems. Ten of these karaoke machines are
models that we plan on discontinuing after we sell our excess inventory in
fiscal 2005. Our machines sell at retail prices ranging from $30 for basic units
to $300 for semi-professional units. We currently offer our music in two formats
- - multiplex cassettes and CD+G's with retail prices ranging from $6.99 to
$19.99. We currently have a song library of over 3,500 recordings, which we
license from publishers. Our library of master recordings covers the entire
range of musical tastes including popular hits, golden oldies, country, rock and
roll, Christian, Latin music and rap. We even have backing tracks for opera and
certain foreign language recordings.
MARKETING, SALES AND DISTRIBUTION
Our karaoke machines and music are sold nationally and internationally
to a broad spectrum of customers, primarily through mass merchandisers,
department stores, direct mail catalogs and showrooms, music and record stores,
national chains, specialty stores, and warehouse clubs. Our karaoke machines and
karaoke music are currently sold in such stores as Best Buy, Circuit City,
Costco, J.C. Penney, Kohl's, Radio Shack, and Sam's Club.
In fiscal 2004, approximately 61% of our sales were domestic sales and
39% were international sales. Domestic sales are sales that are made in the
United States and international sales are sales that are made outside of the
United States. Our domestic sales are primarily made by our in-house sales team
and our independent sales representatives. Our independent sales representatives
are paid a commission based upon sales in their respective territories. We
utilize some of our outside independent sales representatives to help us provide
service to our mass merchandisers and other retailers. The sales representative
agreements are generally one (1) year agreements, which automatically renew on
an annual basis, unless terminated by either party on 30 days' notice. At March
31, 2004, we worked with 16 independent sales representatives in the United
States. Our international sales are primarily made by our in-house sales
representatives and our eight independent distributors.
We also market our products at various national and international trade
shows each year. We regularly attend the following trade shows and conventions:
the Consumer Electronics Show each January in Las Vegas; the American Toy Fair
each February in New York and the Hong Kong Electronics Show each October in
Hong Kong.
Our licensing agreements with MTV Networks, Inc., a division of Viacom
International, Inc., Hard Rock Academy, Inc. and Universal Music Entertainment,
Inc. have also helped us to expand our product name.
LICENSE AGREEMENTS
We entered into our licensing agreement with MTV in November 2000 and
have amended the agreement five times since that date. Our license covers the
sale of MTV products in the United States, Canada and Australia. During fiscal
2004, our line consisted of nine MTV branded machines and a wide assortment of
MTV branded music. Our license agreement as amended with MTV, currently expires
on August 31, 2004, subject to MTV's option, at its sole discretion, to extend
the agreement for an additional four month period. The license period contains a
minimum guaranteed royalty payment of $100,000, which is recoupable against
sales throughout the calendar year, unless the license agreement is cancelled.
We entered into our licensing agreement with Hard Rock Academy, a
division of Hard Rock Cafe in December 2001. This license agreement allows us to
produce and market a line of karaoke machines and complimentary music that are
co-branded with the Singing Machine and Hard Rock Academy name. The first
co-branded machine was produced during the fourth quarter of fiscal 2003. The
agreement originally contained a minimum guaranteed royalty payment, but in
September 2003 Hard Rock agreed to release us from our minimum guaranteed
payment obligations during the remaining term of the license agreement. This
agreement expires on December 31, 2005 and does not contain any automatic
renewal provisions.
In February 2003, we entered into a multi-year license agreement with
Universal Music Entertainment to market a line of Motown Karaoke machines and
music. This agreement and its subsidiary agreement signed in March 2003, allow
us to be the first to use original artist recordings for our CD+G formatted
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karaoke music. Over the term of the license agreement, we are obligated to make
guaranteed minimum royalty payments in the amount of $300,000. The Universal
Music Entertainment license expires on March 31, 2006 and does not contain any
automatic renewal provisions.
We entered into a license agreement with Care Bears in September 2003.
Under this agreement, we are marketing a line of Care Bears branded karaoke
machines and music. Over the term of the license, we are obligated to make
guaranteed minimum royalty payments in the amount of $200,000. This license
expires on January 1, 2006 and does not contain any automatic renewal
provisions.
We entered into a license agreement with Nickelodeon, Inc., a division
of Viacom International, Inc. in December 2002. Under this agreement, we
licensed Nickelodeon branded machines and a wide assortment of music. This
license will expire on December 31, 2004 and will not be renewed.
We distribute all of our licensed products through our established
distribution channels, including Best Buy, Circuit City, Costco, JC Penny,
Kohl's, Radio Shack and Sam's Club. Our distribution network also includes the
online versions of these retail customers.
The following table sets forth the percentage of total sales that have
been generated under the MTV License, our Nickelodeon License and our other
licenses (Care Bears, Hard Rock Academy and Universal Music).
FOR THE
FISCAL YEAR
ENDED DECEMBER 31
----------------------------
2004 2003
----- -----
MTV 11.8% 32.3%
Nickelodeon 5.5% 0%
Other Licenses 3.9% 0%
---- ----
Total Licensed Sales 21.2% 32.3%
DISTRIBUTORSHIP AGREEMENTS
In November 2001, we signed an international distributorship agreement
with Arbiter Group, PLC ("Arbiter"). Arbiter is the exclusive distributor of
Singing Machine(R) karaoke machines and music products in the United Kingdom and
a non-exclusive distributor in all other European countries. The agreement
terminates on December 31, 2004, subject to an automatic renewal provision. If
either party does not give notice on or before December 1 of year during the
term of the agreement, the agreement will automatically be renewed for another
year on the same terms.
In March 2003, we signed an international distributorship agreement
with Top-Toy (Hong Kong) Ltd. Top Toy is the exclusive distributor of Singing
Machine(R) karaoke machines and music products in Denmark, Norway, Sweden,
Iceland and Faeroe Islands. The agreement is for three years, from April 1, 2003
through March 31, 2006. The agreement contains an automatic renewal provision
whereby if either party does not give notice at least 3 months before March 31,
2006, the agreement will automatically be renewed for another year on the same
terms.
We also have verbal agreements with six other independent distributors
who sell our products throughout Europe
SALES
As a percentage of total revenues, our net sales in the aggregate to
our five largest customers during the fiscal years ended March 31, 2004, 2003,
and 2002, respectively, were approximately 53%, 67% and 87%, respectively. In
fiscal 2004, three major customers accounted for 20%, 12% and 10% of our net
revenues.
In fiscal 2004, Arbiter, Giochi and Best Buy accounted for more than
10% of our net revenues. Arbiter and Giochi are independent distributors of our
products. In fiscal 2003 and 2002, Best Buy and Toys R Us each accounted for
more than 10% of our revenues. In fiscal 2003 Target and in fiscal 2002 Costco
also accounted for more than 10% of our revenues. Although we have
long-established relationships with all of our customers, we do not have
contractual arrangements with any of them. A decrease in business from any of
our major customers could have a material adverse effect on our results of
operations and financial condition.
5
During the last three years, our revenues from foreign operations have
increased. Sales by customer geographic regions were as follows:
FOR THE
FISCAL YEAR
ENDED MARCH 31
-------------------------------------------
2004 2003 2002
----------- ----------- -----------
North America $43,044,496 $77,696,780 $62,381,366
Latin America 753,399 1,366,496 45,073
Europe 25,783,789 15,714,846 --
Asia/Australia 959,444 835,644 49,314
----------- ----------- -----------
$70,541,128 $95,613,766 $62,475,753
=========== =========== ===========
RETURNS
Returns of electronic hardware and music products by our customers are
generally not permitted except in approved situations involving quality defects,
damaged goods, goods shipped in error or goods that are shipped on a consignment
basis. Our policy is to give credit to our customers for the returns in
conjunction with the receipt of new replacement purchase orders. Our total
returns represented 9.4% and 10.4% of our net sales in fiscal 2004 and 2003,
respectively.
DISTRIBUTION
We distribute hardware products to retailers and wholesale distributors
through two methods: shipment of products from inventory held at our warehouse
facilities in Florida and California (domestic sales), and shipments directly
through our Hong Kong subsidiary and manufacturers in Asia of products (direct
sales). Domestic sales, which account for substantially all of our music sales,
are made to customers located throughout the United States from inventories
maintained at our warehouse facilities. In the fiscal year ended March 31, 2004,
approximately 39% of our sales were sales from our domestic warehouses
("Domestic Sales") and 61% were sales shipped directly from Asia ("Direct
Sales").
Domestic Sales. Our strategy of selling products from a domestic
warehouse enables us to provide timely delivery and serve as a "domestic
supplier of imported goods." We purchase karaoke machines overseas from certain
factories in China for our own account, and warehouse the products in leased
facilities in Florida and California. We are responsible for costs of shipping,
insurance, customs clearance, duties, storage and distribution related to such
products and, therefore, warehouse sales command higher sales prices than direct
sales. We generally sell from our own inventory in less than container-sized
lots.
Direct Sales. We ship some hardware products sold by us directly to
customers from Asia through International SMC, our subsidiary. Sales made
through International SMC are completed by either delivering products to the
customers' common carriers at the shipping point or by shipping the products to
the customers' distribution centers, warehouses, or stores. Direct sales are
made in larger quantities (generally container sized lots) to customers' world
wide, who pay International SMC pursuant to their own international,
irrevocable, transferable letters of credit or on open account.
MANUFACTURING AND PRODUCTION
Our karaoke machines are manufactured and assembled by third parties
pursuant to design specifications provided by us. Currently, we have ongoing
relationships with six factories, located in Guangdong Province of the People's
Republic of China, who assemble our karaoke machines. During fiscal 2005, we
expect that 95% of our karaoke products will be produced by one of these
factories, which has agreed to extend financing to us. We are indebted to this
factory in the amount of $2.4 million and have worked out a payment plan
regarding our outstanding invoice. Additionally, this factory has agreed to
provide us with financing for fiscal year 2005. See "Management's Discussion and
Analysis of Financial Condition - Liquidity" beginning on page 17. We believe
that the manufacturing capacity of our factories is adequate to meet the demands
for our products in fiscal year 2005. However, if our primary factory in China
were prevented from manufacturing and delivering our karaoke products, our
operation would be severely disrupted while alternative sources of supply are
located. See "Risk Factors - We are relying on one factory to manufacture and
produce the majority of our karaoke machines for fiscal 2005" on page 22. In
manufacturing our karaoke related products, these factories use molds and
certain other tooling, most of which are owned by International SMC. Our
products contain electronic components manufactured by other companies such as
Panasonic, Sanyo, Toshiba, and Sony. Our manufacturers purchase and install
these electronic components in our karaoke machines and related products. The
finished products are packaged and labeled under our trademark, The Singing
Machine(R).
6
We have obtained copyright licenses from music publishers for all of
the songs in our music library. We contract with outside studios on a work-for
hire basis to produce recordings of these songs. After the songs have been
recorded, we author the CD+G's in our in house studio. We use outside companies
to mass-produce the CD+G's and audiocassettes, once the masters have been
completed.
While our equipment manufacturers purchase our supplies from a small
number of large suppliers, all of the electronic components and raw materials
used by us are available from several sources of supply, and we do not
anticipate that the loss of any single supplier would have a material long-term
adverse effect on our business, operations, or financial condition. Similarly,
we use a small number of studios to record our music (including our in house
production), we do not anticipate that the loss of any single studio would have
a material long-term adverse effect on our business, operations or financial
condition. To ensure that our high standards of product quality and factories
meet our shipping schedules, we utilize Hong Kong based employees of
International SMC as our representatives. These employees include product
inspectors who are knowledgeable about product specifications and work closely
with the factories to verify that such specifications are met. Additionally, key
personnel frequently visit our factories for quality assurance and to support
good working relationships.
All of the electronic equipment sold by us is warranted to the end user
against manufacturing defects for a period of ninety (90) days for labor and
parts. All music sold is similarly warranted for a period of 30 days. During the
fiscal years ended March 31, 2004, 2003 and 2002, warranty claims have not been
material to our results of operations.
COMPETITION
Our business is highly competitive. 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. We believe that our brand name is well
recognized in the industry and helps us compete in the karaoke machine category.
Our primary competitors for producing karaoke music are Pocket Songs, UAV,
Sybersound and Sound Choice. We believe that competition for karaoke music is
based primarily on popularity of song titles, price, reputation, and delivery
times.
In addition, we compete with all 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
videocassettes. Our financial position depends, among other things, on our
ability to keep pace with changes and developments in the entertainment industry
and to respond to the requirements of our customers. Many of our competitors
have significantly greater financial, marketing, and operating resources and
broader product lines than we do.
TRADEMARKS
We have obtained registered trademarks for The Singing Machine name and
the logo in which the microphone is used in our name in the United States and in
the European Community. We have also filed trademark applications in Australia
and Hong Kong. In fiscal 2003, we filed an intent to use application for the
mark Karaoke Vision in the United States.
Our trademarks are a significant asset because they provide product
recognition. We believe that our intellectual property is significantly
protected, but there are no assurances that these rights can be successfully
asserted in the future or will not be invalidated, circumvented or challenged.
COPYRIGHTS AND LICENSES
We hold federal and international copyrights to substantially all of
the music productions comprising our song library. However, since each of those
productions is a re-recording of an original work by others, we are subject to
contractual and/or statutory licensing agreements with the publishers who own or
control the copyrights of the underlying musical compositions. We are obligated
to pay royalties to the holders of such copyrights for the original music and
lyrics of all of the songs in our library that have not passed into the public
domain. We are currently a party to many different written copyright license
agreements.
The majority of the songs in our song library are subject to written
copyright license agreements, oftentimes referred to as synchronization
licenses. Our written licensing agreements for music provide for royalties to be
paid on each song. The actual rate of royalty is negotiable, but typically
ranges from $0.09 to $0.18 per song on each CD that is sold. Similarly, the
terms of the licenses vary, but typically are for terms of 2 to 5 years. Our
written licenses typically provide for quarterly royalty payments, although some
publishers require reporting on a semi-annual basis.
We currently have compulsory statutory licenses for certain songs in
our song library which are reproduced on audiocassettes. The Federal Copyright
Act creates a compulsory statutory license for all non-dramatic musical works,
7
which have been distributed to the public in the United States. Royalties due
under compulsory licenses are payable quarterly and are based on the statutory
rate. We also have written license agreements for substantially all of the
printed lyrics, which are distributed with our audiocassettes, which licenses
also typically provide for quarterly payments of royalties at the statutory
rate.
GOVERNMENT REGULATION
Our karaoke machines must meet the safety standards imposed in various
national, state, local and provincial jurisdictions. Our karaoke machines sold
in the United States are designed, manufactured and tested to meet the safety
standards of Underwriters Laboratories, Inc. ("ULE") or Electronic Testing
Laboratories ("ETL"). In Europe and other foreign countries, our products are
manufactured to meet the CE marking requirements. CE marking is a mandatory
European product marking and certification system for certain designated
products. When affixed to a product and product packaging, CE marking indicates
that a particular product complies with all applicable European product safety,
health and environmental requirements within the CE marking system. Products
complying with CE marking are now accepted to be safe in 28 European countries.
However, ULE or ETL certification does not mean that a product complies with the
product safety, health and environmental regulations contained in all fifty
states in the United States. Therefore, we maintain a quality control program
designed to ensure compliance with all applicable US and federal laws pertaining
to the sale of our products. Our production and sale of music products is
subject to federal copyright laws.
The manufacturing operations of our foreign suppliers in China are
subject to foreign regulation. China has permanent "normal trade relations"
("NTR") status under US tariff laws, which provides a favorable category of US
import duties. China's NTR status became permanent on January 1, 2002, following
enactment of a bill authorizing such status upon China's admission to the World
Trade Organization ("WTO") effective as of December 1, 2001. This substantially
reduces the possibility of China losing its NTR status, which would result in
increasing costs for us.
SEASONALITY AND SEASONAL FINANCING
Our business is highly seasonal, with consumers making a large
percentage of karaoke purchases around the traditional holiday season in our
second and third quarter. These seasonal purchasing patterns and requisite
production lead times cause risk to our business associated with the
underproduction or overproduction of products that do not match consumer demand.
Retailers also attempt to manage their inventories more tightly, requiring that
we ship products closer to the time that retailers expect to sell the products
to consumers. These factors increase the risk that we may not be able to meet
demand for certain products at peak demand times, or that our own inventory
levels may be adversely impacted by the need to pre-build products before orders
are placed. As of March 31, 2004, we had inventory of $5.2 million (net of
reserves totaling $6.6 million) compared to inventory of $25.2 million as of
March 31, 2003 (net of reserves totaling $3.7 million). In fiscal 2003, we
overestimated the demand for our products and as result had $25 million of
excess inventory at year end.
Our financing of seasonal working capital during fiscal 2004 was
different from prior years because of the excess inventory that we had on hand
as of March 31, 2003. During fiscal 2004, we purchased approximately $9.1
million of new inventory and the remainder of our sales were from the
liquidation of the excess inventory on hand. We financed the purchase of new
inventory with our short-term lines of credit in Hong Kong and through
financing, with one of our factories in China.
During fiscal 2005, we plan on financing our inventory purchases by
using credit that has been extended to us by one of our factories in China, by
using our short term lines of credit in Hong Kong and with letters of credit
that are issued by our customers to be used as collateral for payment to our
vendors. As of June 30, 2004, we expect to order an aggregate of approximately
$28 million of inventory during fiscal 2005.
BACKLOG
We ship our products in accordance with delivery schedules specified by
our customers, which usually request delivery within three months of the date of
the order. In the consumer electronics industry, orders are subject to
cancellation or change at any time prior to shipment. In recent years, a trend
toward just-in-time inventory practices in the consumer electronics industry has
resulted in fewer advance orders and therefore less backlog of orders for the
Company. We believe that backlog orders at any given time may not accurately
indicate future sales. As of June 20, 2004, we had backlog of $32.8 million
compared to backlog of $33.4 million at the same period in 2003. We believe that
we will be able to fill all of these orders in fiscal year 2005. However, these
orders can be cancelled or modified at any time prior to delivery.
EMPLOYEES
As of March 31, 2004, we employed 40 persons, all of whom are full-time
employees, including three executive officers. Fifteen of our employees are
located at International SMC's corporate offices in Hong Kong. The remaining
twenty five employees are based in the United States, including two executive
positions; ten are engaged in warehousing and technical support, and thirteen in
accounting, marketing, sales and administrative functions.
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ITEM 2. PROPERTIES
Our corporate headquarters are located in Coconut Creek, Florida in an
18,000 square foot office and warehouse facility, of which 7600 square feet has
been subleased. Our four leases for this office space expire on August 31, 2005.
We have leased 9,393 square feet of office and showroom space in Hong Kong from
which we oversee China based manufacturing operations. Our two leases for this
space in the Ocean Center building expire on April 30, 2005 and May 31, 2005,
respectively.
We have one warehouse facility in Compton California. The Compton
warehouse facility has 79,000 square feet and the lease expires on February 23,
2008. We terminated our lease for warehouse space in Rancho Domingeuz,
Caliofnria effective as of May 1, 2004.
We believe that the facilities are well maintained, in substantial
compliance with environmental laws and regulations, and adequately covered by
insurance. We also believe that these leased facilities are not unique and could
be replaced, if necessary, at the end of the term of the existing leases.
ITEM 3. LEGAL PROCEEDINGS
Class Action and Derivative Lawsuit
- -----------------------------------
From July 2, 2003 through October 2, 2003, seven securities class
action lawsuits and a shareholder's derivative action were filed against us and
certain of our officers and directors in the United States District Court for
the Southern District of Florida on behalf of all persons who purchased our
securities during the various class action periods specified in the complaints.
On September 18, 2003, United States District Judge William J. Zlock entered an
order consolidating the seven (7) purported class action law suits and one (1)
purported shareholder derivative action into a single action case styled Frank
Bielansky v. the Company, Salberg & Company, P.A., et al - Case Number: 03-80596
- - CIV - ZLOCK (the "Class Action"). The complaints that were filed allege
violations of Section 10(b) and Section 20(a) of the Securities Exchange Act of
1934 and Rule 10(b)-5. The complaints seek compensatory damages, attorney's fees
and injunctive relief.
We entered into a settlement agreement with the plaintiffs in the Class
Lawsuit in March 2004. At a hearing in April 2004, the Court gave preliminary
approval for the settlement and directed that notices be sent to shareholders
pursuant to the Settlement Agreement. The notices advised shareholders of their
rights and responsibilities concerning the settlement. The Court has set a
hearing on July 30, 2004 before Judge Zlock to consider final approval of the
settlement.
Pursuant to the terms of the settlement agreement, we are required to
make a cash payment of $800,000 and Salberg & Company, P.A., our former auditor,
is required to make a payment of $475,000. Our cash payment of $800,000 is
covered by our liability insurance and our insurer has placed this payment in an
escrow account pending final approval of the Settlement. In addition, we are
obligated to issue 400,000 shares of our common stock. The pending settlement
would also obligate us to implement certain corporate governance changes,
including an expansion or our Board of Directors to six members with independent
directors comprising at least 2/3 of the total Board seats.
Bankruptcy Filing in Fiscal year 1997
- -------------------------------------
We filed a voluntary petition for relief under Chapter 11 of the
Bankruptcy Code in the United States Bankruptcy Court for the Southern District
of Florida, case number 97-22199-BKC-RBR, on April 11, 1997. On March 17, 1998,
the U.S. Bankruptcy Court confirmed our First Amended Plan of Reorganization. As
of June 10, 1998, our plan has been fully implemented.
Other Matters
- -------------
We are involved in various other litigation and legal matters,
including claims related to intellectual property, product liability which we
are addressing or defending in the ordinary course of business. Management
believes that any liability that may potentially result upon resolution of such
matters will not have a material adverse effect on our business, financial
condition or results of operation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Our annual meeting of shareholders was held on February 26, 2004.
Proxies for the meeting were solicited pursuant to Regulation 14A of the
Securities Exchange Act of 1934 and there was no solicitation in opposition to
that of management.
9
All of management's nominees for directors as listed in the proxy
statement were elected with the number of votes cast for each nominee as
follows:
Shares Voted Votes
"FOR" Withheld
--------- --------
Bernard Appel 7,986,945 52,617
Jay Bauer 7,986,945 52,617
Yi Ping Chan 7,373,655 665,907
Richard Ekstract 7,616,891 422,671
The proposal to approve an amendment to our Year 2001 Stock Option Plan
to allow for the grant of stock awards under the Year 2001 Stock Option Plan was
ratified and approved by the following votes:
Shares Voted Shares Voted Shares Broker
"FOR" "AGAINST" "ABSTAINING" "NON-VOTE"
- ----------- --------- ------------ ----------
1,921,599 1,351,142 45,720 4,721,101
The proposal to approve the appointment of Grant Thornton LLP as
independent accountants for the Company for the year ended March 31, 2004, was
ratified by the following vote:
Shares Voted Shares Voted Shares Broker
"FOR" "AGAINST" "ABSTAINING" "NON-VOTE"
- ----------- --------- ------------ ----------
7,605,366 8,122 2,794 --
PART II
ITEM 5. MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock currently trades on the American Stock Exchange under
the symbol "SMD." Set forth below is the range of high and low information for
our common stock as traded on the American Stock Exchange during fiscal 2004 and
fiscal 2003. This information regarding trading on AMEX represents prices
between dealers and does not reflect retail mark-up or markdown or commissions,
and may not necessarily represent actual market transactions.
FISCAL PERIOD HIGH LOW
2004:
First quarter (April 1 - June 30, 2003) $7.94 $2.85
Second quarter (July 1 - September 30, 2003) 5.03 2.70
Third quarter (October 1 - December 31, 2003) 4.43 1.80
Fourth quarter (January 1 - March 31, 2004) 2.43 1.14
2003:
First quarter (April 1 - June 30, 2002) $16.89 $12.06
Second quarter (July 1 - September 30, 2002 12.74 8.05
Third quarter (October 1 - December 31, 2002) 13.49 8.50
Fourth quarter (January 1 - March 31, 2003) 9.19 5.30
As of July 1, 2004, there were approximately 311 record holders of our
outstanding common stock.
COMMON STOCK
We have never declared or paid cash dividends on our common stock and
our Board of Directors intends to continue its policy for the foreseeable
future. Future dividend policy will depend upon our earnings, financial
condition, contractual restrictions and other factors considered relevant by our
Board of Directors and will be subject to limitations imposed under Delaware
law.
On March 14, 2002, we affected a 3 for 2 stock split for all
shareholders on record as of March 4, 2002.
10
SALES OF UNREGISTERED SECURITIES
Effective as of April 15, 2003, we issued an aggregate of 50,000
options to Jack Dromgold as consideration for services that he had rendered to
us. The options had an exercise price of $7.60 per share and vested in five
equal installments over a five year period beginning on January 1, 2004. We
issued these options to Mr. Dromgold in reliance upon Section 4(2) of the
Securities Act, because he was knowledgeable, sophisticated and had access to
comprehensive information about us. We inadvertently failed to report these
options in the first quarter of fiscal 2004. These options expired in March
2004, ninety days after Mr. Dromgold's resignation from our company.
ITEM 6. SELECTED FINANCIAL DATA
*RESTATED
2004 2003 2002* 2001* 2000
------------ ------------ ------------ ------------ ------------
STATEMENT OF OPERATIONS:
Net Sales $ 70,541,128 $ 95,613,766 $ 62,475,753 $ 34,875,351 $ 19,032,320
Earnings(loss) before income taxes $(21,924,919) $ 1,416,584 $ 8,184,559 $ 4,188,021 $ 577,686
Income tax expense (benefit) 758,505 $ 198,772 $ 1,895,494 $ 494,744 $ 160,299
Net earnings (loss) $(22,683,424) $ 1,217,813 $ 6,289,065 $ 3,696,277 $ 737,985
BALANCE SHEET:
Working capital $ (1,382,929) $ 15,281,023 $ 14,577,935 $ 6,956,879 $ 2,985,120
Current ratio 0.90 1.72 3.82 4.37 7.77
Property, plant and equipment, net $ 983,980 $ 1,096,424 $ 574,657 $ 263,791 $ 99,814
Total assets $ 14,761,572 $ 38,935,294 $ 21,403,196 $ 10,509,682 $ 4,346,901
Shareholders' equity $ 216,814 $ 17,685,364 $ 16,225,433 $ 8,450,237 $ 3,906,286
PER SHARE DATA:
Earnings (loss) per common share
- - basic $ (2.65) $ 0.15 $ 0.88 $ 0.59 $ 0.23
Earnings (loss) per common share
- - diluted $ (2.65) $ 0.14 $ 0.79 $ 0.50 $ 0.19
Cash dividends paid 0.00 0.00 0.00 0.00 0.00
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATION
OVERVIEW
We had a challenging year in the twelve month period ended March 31,
2004 ("fiscal 2004"). During fiscal 2004, we reported a net loss of $22.7
million, or $2.65 per diluted share, on sales of $70.5 million which compares to
net income of $1.2 million in fiscal 2003 or $.14 per diluted share, on sales of
$95.6 million. Sales decreased primarily from increased competition in the
United States and in international markets. In fiscal 2003, we overestimated
the demand for our products and as result had $25 million of excess inventory at
year end. In addition, both our retail customers and our international
distributors carried excess Singing Machine inventory into fiscal 2004, which
impacted our ability to sell into the trade and distribution channels.
Our gross profit decreased to $1.8 million or 2.6% of total revenues in
fiscal 2004 compared to gross profit of $23.3 million or 24.4% of total revenues
in fiscal 2003. Our net loss for fiscal 2004 was $22.7 million, which includes
several unusual operating expenses: litigation expenses severance expenses,
lease termination costs, write off of prepaid royalties tooling impairment
charges, write off of capitalized cost of reorganization intangible.
11
In July 2003, we made a decision to restate our audited financial
statements for the fiscal years ended March 31, 2002 and March 31, 2001 because
we revised our position on the taxation of the income of International SMC, our
Hong Kong subsidiary. See "Restatement" on pages 12-13. As a result of this
restatement we were named as a defendant in several class action lawsuits and a
derivative lawsuit. The shareholder complains were consolidated into one lawsuit
in the United States District Court for Southern Florida. We entered into a
settlement agreement with the class action plaintiffs in April 2004 and are
waiting for final approval of the settlement on July 30, 2004. See "Legal
Proceedings" on page 9. We incurred approximately $706,000 for the settlement
and related expenses, net of reimbursement from our insurance carrier.
In July 2003, we raised $1 million in subordinated debt financing from
an investment group comprised of an officer, directors and an associate of one
of our directors. On August 19, 2004, LaSalle amended the credit agreement,
which extended the loan until March 31, 2004 and waived the condition of
default. On September 8, 2003, we raised $4 million in an offering of 8%
convertible subordinated debentures to six accredited investors. The proceeds of
the debenture were used to pay down our accounts payable liabilities, finance
operations and pay down a portion of our loan with LaSalle. On December 31,
2003, we again violated the tangible net worth requirement and working capital
requirements under our credit agreement with LaSalle. On January 31, 2004, we
paid off our loan with LaSalle and LaSalle released its security interests in
our assets. We entered into a factoring agreement with Milberg Factors effective
as of February 9, 2004.
Despite the reduction in expenses and the additional capital, we still
had minimal liquidity during fiscal 2004. As such, we were forced to sell excess
inventory at or below cost. During fiscal 2004, we sold approximately 20.2% of
our inventory at prices at or below cost. As such, our gross profit decreased to
2.6% of our net sales. As of March 31, 2004, we did not have any advances
outstanding under our factoring agreement with Milberg; however, we were in
violation of the covenants relating to working capital and tangible net worth.
Because of our limited liquidity, we received a going concern uncertainty
paragraph on our audited financial statements for fiscal 2004. Although our cash
on hand as of July 1, 2004 is limited, we believe that we will have sufficient
cash from operations to fund our operating requirements for the next three
months. After three months, we expect to begin collecting accounts receivable
from the sales of our karaoke products in the second and third quarters. If
there is a need for additional funds, short term loans will be obtained. See
"Liquidity" beginning on page 17. We will continue to sell older inventory
models at discounted prices to generate cash as well as continuing to reduce
operating expenses.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
income and expense items expressed as a percentage of the Company's total
revenues:
2004 2003 2002*
Total revenues 100.0% 100.0% 100.0%
Cost of sales 97.4% 75.6% 65.4%
Operating expenses 31.2% 22.7% 21.4%
Operating (loss) income (28.6%) 1.7% 13.2%
Other (expenses), income, net (2.5%) (0.2%) (0.1%)
(Loss) Income before taxes (31.1%) 1.5% 13.1%
Provision (benefit) for income taxes 1.1% .2% 3.0%
(Loss) income (32.2%) 1.3% 10.1%
*AS RESTATED.
RESTATEMENT OF FINANCIAL STATEMENTS
In June 2003, management revised its position on taxation of its
subsidiary's income by the United States and by the Hong Kong tax authorities.
With regard to taxation in Hong Kong, our subsidiary had previously
applied for a Hong Kong offshore claim income tax exemption based on the
locality of profits of the Hong Kong subsidiary. Management believed that the
exemption would be approved because the source of all profits of the Hong Kong
subsidiary 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, we can claim United States foreign
tax credits in 2002 for these Hong Kong taxes, which is reflected in the final
restated amounts.
With regard to United States taxation of foreign income, we had
originally taken the position that the foreign income of the Hong Kong
subsidiary qualified for a deferral under the Internal Revenue Code allowing for
such income to be indefinitely deferred and not taxed in the United States until
such income is repatriated. Full disclosure of the amount and nature of the
indefinite deferral for fiscal year 2002 was reflected in the income tax
footnote of the consolidated financial statements for that year. The Internal
Revenue Code, regulations and case law regarding international income taxation
is quite complex and subject to interpretation. Each case is determined based on
the individual facts and circumstances. Due to certain inter-company loans made
in 2002 and 2003, the profits previously considered to be indefinitely deferred
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.
12
The net effect of the above two adjustments is to decrease net income
by $1,776,217 and $468,424 in fiscal 2002 and 2001. The net effect on net income
per share is to decrease net income per share basic and diluted by $0.25 and
$0.23, respectively in fiscal 2002 and decrease net income per share basic and
diluted by $0.07 and $0.06, respectively in fiscal 2001.
FISCAL YEAR ENDED MARCH 31, 2004 COMPARED WITH FISCAL YEAR ENDED MARCH 31, 2003
- -------------------------------------------------------------------------------
NET SALES
Net sales for the fiscal year ended March 31, 2004 decreased to $70.5
million compared to revenues of $95.6 million in the fiscal year ended March 31,
2003. The decrease in net sales was due to both decreases in unit volume as well
as pricing, due to increases in competition in the United States and
international markets. In fiscal year 2004, 61% of our sales were direct sales,
which represent sales made by International SMC, and 39% were domestic sales,
which represent sales made from our warehouse in the United States.
The sales decreases occurred in all segments of our business. Our total
hardware sales decreased to $67.7 million, in fiscal 2004 compared to total
hardware sales of $87 million in fiscal 2003. The total decrease of hardware
sales of $19.3 million from the previous year sales level is the primary due to
the increasing market competition. Also we had to lower our price in order to
move the overstocked inventory from fiscal year 2003.
In addition, there was a significant decrease in our music sales. Music
sales decreased to $2.8 million, or 4% of net sales, in fiscal 2004, compared to
$9.1 million, or 9.5% of net sales, in fiscal 2003. The decrease in music sales
is also a result of increased competition in this category, both domestically as
well as internationally.
GROSS PROFIT
Gross profit for fiscal 2004 was $1,818,550 or 2.6% of total revenues
compared to $23,284,731 or 24.4% of sales for fiscal 2003. The decrease in gross
margin compared to the prior year is primarily due to the following factors: (i)
write-down of inventories, (ii) sales made at lower prices to generate cash from
operation, (iii) increased sales by International SMC, the gross profit margin
is lower for the sales shipped from Hong Kong due to the volume discount and
reduction of the warehousing and insurance expenses and (iv) tooling impairment
cost of $443,000.
At the end of fiscal 2004, our inventory levels were much higher than
we expected. We determined that due to liquidation sales, inventory would be
sold at a loss; therefore, a decrease in the value of specific inventory items
was made. The total amount of the provision for inventory was $6.6 million in
fiscal 2004 compared to a provision of $3.7 million in fiscal 2003.
13
In addition to the write-down of inventories, due to competitive price
pressure, a significant amount of sales shipped in current year were made at
lower margins than in previous years. In the fourth quarter, we sold $1 million
of inventory with a negative margin of $366,751 (after applying inventory
valuation reserves).
Our product line did not sell as well as our retailers and mass
merchants had expected. As a result, we agreed to give our customers pricing
concessions and allowed them to return inventory to us. We issued over $1
million in customer credits during the fourth quarter, which reduced our sales
and gross profit margins equally. Our gross margins were also negatively
affected by the return of $1.8 million in inventory.
Our decrease in our gross margin percentage in fiscal 2004 compared to
fiscal 2003 was also reduced by the mix of our sales. The percentage of sales
made by our Hong Kong subsidiary increased from 52% of the total sales in fiscal
2003 to 61% in fiscal 2004. Usually, sales made by International SMC
historically maintain a lower gross profit margin because there are no variable
expenses from these sales. Other variable expenses that are normally included
with sales are advertising allowances, returns and commissions.
Our gross profit may not be comparable to those of other entities,
since some entities include the costs of warehousing, inspection, freight
charges and other distribution costs in their cost of sales. We account for the
above expenses as operating expenses and classify them under selling, general
and administrative expenses
OPERATING EXPENSES
Operating expenses were $22,013,849 or 31.2% of net sales in fiscal
2004 compared to $21,670,501 or 22.7% of net sales in fiscal 2003. The primary
factors that contributed to the increase in operating expenses are:
o Increased compensation expenses in the amount of $953,000 in
fiscal 2004 of which approximately $323,000 was for severance
payments to four former executive officers,
o Increased selling, general and administrative expenses of
$2,706,000 due to
o increased legal fees in the amount of $1,080,000 of
which approximately $706,000 was for the class action
settlement, and increased consulting fees in the
amount of approximately $370,000 which was related to
consulting work performed by our lender,
o increased rent expenses in the amount of $690,000 due
to the expansion of the warehouse facility in Rancho
Dominguez in fiscal 2003. The increase warehouse
space was necessary to stock the unanticipated unsold
inventories in fiscal year 2004 and expenses of
$180,000 for early termination of the lease in Rancho
Dominguez, California
o a write off of the capitalized cost of reorganization
of $185,000,
o increased accounting expenses in the amount of
$426,000, which was due to the additional work needed
to restate our financial statements for the fiscal
years ended March 31, 2001 and 2002 and work required
on the filing of certain registration statements and
o increased bank fees and loan cost in the amount of
$271,000, which was related to the loan agreement
with Lasalle bank.
This increase in expenses was offset by decreases in our advertising
expenses and our freight and handling charges in the amount of $2,692,000 and
$689,000, respectively. Advertising expense consists of two components:
co-operative advertising and direct advertising expense. Co-operative
advertising is paid directly to the customer and the allowances are based on the
amount of sales. The customer provides copies of advertising on which these
funds are spent, but has complete discretion as to the use of these funds. As we
believe that there is a separate and identifiable benefit associated with the
co-operative advertising, such amounts are recorded as a component of operating
expenses. Co-operative advertising expenses decreased to $2,340,439 in fiscal
2004 compared to $5,032,367 in fiscal 2003 because our sales decreased. Our
royalty expenses were $2,294,727 in fiscal 2004 compared to $2,257,653 in fiscal
2003. Our royalty expenses in fiscal 2004 included a write-off of $980,000 in
pre-paid royalties under our licensing agreement with MTV.
DEPRECIATION AND AMORTIZATION
Our depreciation and amortization expenses were $750,359 for fiscal
2004 compared to $622,298 for fiscal 2003. This increase in depreciation and
amortization expenses can be attributed to our investment in tooling and dies
for the new models, in addition to the acceleration in the depreciation method
used to write off the useful life of the tools and dies.
14
NET OTHER EXPENSES
Net other expenses were $1,729,620 in fiscal 2004 compared to $197,646
in fiscal 2003. Net other expenses increased because our interest expense
increased to $1.7 million in fiscal 2004 compared to $406,000 in fiscal 2003.
Our interest expense increased because we recorded $917,853 for the amortization
of the discount and related deferred financing fees on our convertible
debentures and approximately $800,000 relates to interest expense on the LaSalle
loan, interest on the convertible debentures, interest on the insiders loan, and
interest expense incurred at our Hong Kong subsidiary. We expect interest
expense to increase further in fiscal 2005, as we will have a full year's worth
of amortization of the discount on the convertible debentures and related
deferred financing fees.
INCOME BEFORE TAXES
We had a net loss before taxes of $21,924,919 in fiscal 2004 compared
to net income of $1,416,584 in fiscal 2003.
INCOME TAX EXPENSE
Significant management judgment is required in developing our provision
for income taxes, including the determination of foreign tax liabilities,
deferred tax assets and liabilities and any valuation allowances that might be
required against the deferred tax assets. Management evaluates its ability to
realize its deferred tax assets on a quarterly basis and adjusts its valuation
allowance when it believes that it is more likely than not that the asset will
not be realized. At December 31, 2003 and March 31, 2004, we concluded that a
valuation allowance was needed against all of our deferred tax assets, as it was
not more likely than not that the deferred taxes would be realized. At March 31,
2004 and 2003, we had gross deferred tax assets of $8.2 million and $1.9
million, against which we recorded valuation allowances totaling $8.2 million
and $0, respectively.
For the fiscal year ended March 31, 2004, we recorded a tax provision
of $758,505. This occurred because the valuation allowance established against
our deferred tax assets exceeded the amount of the benefit created from carrying
back a portion of the current year's losses. The carry-back of the losses from
the current year resulted in an income tax receivable of $1.1 million, which is
included in refundable tax in the accompanying balance sheets. We have now
exhausted our ability to carry back any further losses and therefore will only
be able to recognize tax benefits to the extent that we has future taxable
income.
Our subsidiary has applied for an exemption of income tax in
Hong Kong. Therefore, no taxes have been expensed or provided for at the
subsidiary level. Although no decision has been reached by the governing body,
the parent company has reached the decision to provide for the possibility that
the exemption could be denied and accordingly has recorded a provision for Hong
Kong taxes in fiscal 2003 and 2002. There was no provision for Hong Kong income
taxes in fiscal 2004 due to the subsidiary's net operating loss for the year.
Hong Kong income taxes payable totaled $2.4 million at March 31, 2004 and 2003
and is included in the accompanying balance sheets as income taxes payable.
We effectively repatriated approximately $2.0 million, $5.6 million and
$5.7 million from our foreign operations in 2004, 2003 and 2002, respectively.
Accordingly, these earnings were taxed as a deemed dividend based on U.S.
statutory rates. We have no remaining undistributed earnings of our foreign
subsidiary.
We operate within multiple taxing jurisdictions and are
subject to audit in those jurisdictions. Because of the complex issues involved,
any claims can require an extended period to resolve. In management's opinion,
adequate provisions for income taxes have been made.
NET LOSS/NET INCOME
As a result of the foregoing, we had a net loss of $22.7 million in
2004 compared to net income of $1.2 million in fiscal 2003.
FISCAL YEAR ENDED MARCH 31, 2003 COMPARED WITH FISCAL YEAR ENDED MARCH 31, 2002
NET SALES
Net sales for the fiscal year ended March 31, 2003 increased 53.0% to
$95,613,766 compared to $62,475,753 for the fiscal year ended March 31, 2002.
Our growth was driven in large part by the addition of international sales in
Europe, Asia, and Australia. We also generated $30,884,344 million or 32.3% of
our net sales from products sold under the MTV license in fiscal 2003.
Strong sales of our music titles were also driving forces in our
revenue growth for fiscal 2003. In fiscal 2003, our sales of music increased to
$8,894,743 or 9.3% of sales as compared to $6,306,547 or 10.1% of net sales in
fiscal 2002. In fiscal 2004, 52% of our sales were direct sales, which represent
sales made by International SMC, and 48% were domestic sales, which represent
sales made from our warehouse in the United States.
15
GROSS PROFIT
Gross profit for the fiscal year ended March 31, 2003 was $23,284,731
or 24.4% of sales as compared to $21,622,913 or 34.6% of sales for the fiscal
year ended March 31, 2002. The decrease in gross margin compared to the prior
year is due primarily to the following factors: (i) increased sales from
International SMC both to domestic and international customers; (ii) a write
down of the value of inventory and (iii) a reduction of sales due to a
guaranteed gross profit agreement with Transworld.
International sales were primarily in Europe, Canada and Australia.
Sales to international customers historically maintain lower selling prices, and
thus, a lower gross profit margin. The main reason for this is that the sales
are made to distributors in those countries and there are no additional variable
expenses. Other variable expenses that are seen in conjunction with U.S. sales
are advertising allowances, handling charges, returns and commissions.
In fiscal 2003, we entered into a guaranteed gross profit agreement
with Transworld, a specialty music retailer. We guaranteed Transworld that it
would earn a minimum gross profit of $3,573,000 from the sale of our karaoke
products during the period between September 1, 2002 through January 15, 2003.
Under this agreement, we agreed to pay Transworld for the difference between the
gross profit earned on its sales of our karaoke products and the minimum
guarantee. As of the settlement date of the contract, Transworld had not
realized the minimum guarantee of gross profit. As such, we had to provide them
with a check in the amount of $2.5 million, which was recorded in the fourth
quarter of fiscal 2003 as a reduction to revenue.
At the end of fiscal 2003, our inventory level was much higher than we
had expected. As of March 31, 2003, we had inventory on hand of $25 million. We
determined that due to liquidation sales, inventory would be sold at a loss;
therefore, a decrease in the value of specific inventory items was made. The
total amount of the provision for inventory was $3,715,357 at March 31, 2003.
Gross profit may not be comparable to those of other entities, since
some entities include the costs of warehousing, inspection, freight charges and
other distribution costs in their cost of sales. We account for the above
expenses as operating expenses and classify them under selling, general and
administrative expenses.
OPERATING EXPENSES
Operating expenses were $21,670,501 or 22.7% of total revenues in
fiscal 2003 up from $13,387,533 or 21.4% of total revenues, in fiscal 2002. The
primary factors that contributed to the increase of approximately $8.3 million
in operating expenses for the fiscal year 2003 are:
o increased advertising expenses of $2,654,729 due to increased
use of our outside advertising agency to oversee more
advertising projects for us, the production of a television
commercial, as well as cooperative advertising with customers,
which is variable based on the level of sales
o the increase in depreciation in the amount of $239,686 due to
the addition of molds for new product additions for fiscal
year 2003,
o compensation expense in the amount of $1,151,012 due to the
addition of key personnel in Florida, at our California
facility and at International SMC, which include the executive
vice-president of sales, sales administration, music licensing
coordinator, and music production personnel, as well as
warehouse employees and repair personnel.
o increased freight and handling charges to customers in the
amount of $869,525,
o expansion of the California warehouse and its associated
expenses in the amount of $873,919,
o expansion of International SMC's operations and its related
expenses, in the amount of $580,906.
o increases in product development fees for the development of
future product in the amount of $571,370.
Other increases in operating expenses were to selling expenses, which
are considered variable. These expenses are based directly on the level of sales
and include royalty expenses and commissions. We also incurred $79,000 of
expenses for catalogue expenses and show expenses. These expenses are not
variable and do not change based on the level of sales. Show expenses are costs
that are associated with the Consumer Electronics Show and Toy Fair, such as
promotional materials, show space and mock up samples.
Our advertising expense increased $2,654,729 for the fiscal year ended
March 31, 2003 as compared to fiscal 2002. Advertising expense consists of two
components: co-operative advertising and direct advertising expense.
Co-operative advertising is paid directly to the customer and the allowances are
based on the amount of sales. The customer provides copies of advertising on
which these funds are spent, but has complete discretion as to the use of these
funds. As we believe that there is a separate and identifiable benefit
associated with the co-operative advertising, such amounts are recorded as a
component of operating expenses. Co-operative advertising expenses accounted for
$2,320,705 of the increase in advertising expenses. In fiscal 2002, we embarked
16
on our first television advertising and continued with the use of print
advertising, radio spots, sponsorships, promotions and other media. This is
considered direct advertising, whereby we actually contract for advertising of
the product. The increased costs for our advertising firm were $334,024 over the
prior year. The expense for direct advertising is at our discretion and is not
variable based on the level of sales attained. Both of these types of
advertising are direct expenses of the Company.
DEPRECIATION AND AMORTIZATION
Our depreciation and amortization expenses were $622,298 for the fiscal
year ended March 31, 2003 as compared to $394,456 for the fiscal year ended
March 31, 2002. The increase in depreciation and amortization expenses can be
attributed to the Company's acquisition of new molds and tooling for our
expanded product line, as well as minimal costs for additional computer
equipment and furniture for additional personnel.
OTHER EXPENSES
Net other expenses were $197,646 for the fiscal year ended March 31,
2003 as compared with net other expenses of $50,821 for the fiscal year ended
March 31, 2002. Our interest expense increased during the fiscal year ended
March 31, 2003 compared to the same period of the prior year primarily due to
our increased borrowings under our credit facility with LaSalle during this
period. Prior to August 2002, we had cash reserves to fund operations and did
not need to borrow under our revolving credit facility. However, in August 2002,
we began borrowing our credit facility with LaSalle. Our interest income
decreased from $16,934 during the fiscal year 2002 to $11,943 during the fiscal
year 2003 due to our interest earning's cash balance is lower than previous
year. We expect interest expense to increase in fiscal 2004 as compared to prior
years due to the credit facility accruing interest at a higher rate, effective
as of August 19, 2003 when we entered into the Fourteenth Amendment to our
credit facility. As of December 31, 2003, our credit facility accrued interest
at 6.5%, which is prime plus 2.5%, our former default rate. Since interest is
calculated based on the average monthly balance of the credit facility, we can
not reasonably estimate the degree to which this year's expense will exceed last
years. We do know, however, that the interest spread is 1.75% higher than in the
same period last year.
INCOME TAX EXPENSE
Our tax expense is based on an aggregation of the taxes on earnings of
International SMC and our domestic operations. Income tax rates in Hong Kong are
approximately 16%, while the statutory income tax rate in the United States is
34%. Our effective tax rate in fiscal 2003 was 14% as compared to 23% in fiscal
2002. This decrease in the effective tax rate is a result of our company
generating a pretax loss in the United States in fiscal 2003, resulting in a tax
benefit, as compared to pretax income in the United States in fiscal 2002. Our
future effective income tax rate will fluctuate based on the level of earnings
of International SMC and our domestic operations.
NET INCOME
As a result of the foregoing, our net income was $1,217,812 for the
fiscal year ended March 31, 2003 compared to net income of $6,289,065 for fiscal
2002.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 2004, we had cash on hand of $356,342 and current assets
of $13,161,819. Our current assets consist primarily of cash on hand of
$356,342, restricted cash of $874,283, accounts receivable of $3.8 million,
inventories of $5.2 million, an insurance receivable of $800,000 for settlement
of the class action lawsuit and a refundable tax credit of $1.18 million.
As of March 31, 2004, our current liabilities consist of accounts
payable of $3.9 million, accrued expenses of $3.48 million, customer credit on
account of $2.1 million, a bank overdraft of $62,282, subordinated debt of $1
million and an income tax payable of $2.44 million. Our most significant account
payable is a $2.4 million obligation to a factory in China. We have agreed to a
verbal payment plan with the factory, which provides that we will begin making
payments in September 2004. The payments will continue through the year end
March 2005, We are current on approximately 80% of our accounts payable.
We entered into a factoring agreement with Milberg Factors, effective
as of February 9, 2004. Pursuant to the agreement, Milberg, at its discretion,
will advance us 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 and include covenants requiring the Singing
Machine to maintain $7.5 million of tangible net worth and $7.5 million of
working capital at all times as defined in the agreement. 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.
17
We borrowed approximately $250,000 under the factoring agreement in the
fourth quarter of fiscal 2004 and repaid all outstanding amounts. As of March
31, 2004, we did not have any advances outstanding under the factoring
agreement; however, we were in violation of the covenants relating to working
capital and tangible net worth. We terminated our factoring agreement with
Milberg Factors, effective as of July 14, 2004. We paid a $25,000 fee to
terminate this agreement prior to the scheduled expiration date of February 9,
2006. Milberg has agreed to release its security interest in all our assets and
accounts receivable. We are now actively seeking financing from other sources.
Our Hong Kong subsidiary, International SMC, has access to credit
facilities at Hong Kong Shanghai Bank and Fortis Bank. The primary purpose of
the facilities is to provide International SMC with access to letters of credit
so that it can purchase inventory for direct shipment of goods into the United
States and international markets. The facilities are secured by a corporate
guarantee from the U.S. parent company and restricted cash on deposit with the
lender. The maximum available credit under the facilities is $2.0 million. The
balance at March 31, 2004 and 2003 was $62,282 and $316,646, respectively. The
interest rate is approximate 4% per annum. As of March 31, 2004 there was no
availability under these facilities.
As of June 1, 2004, our cash on hand is limited. Our average monthly
operating costs are approximately $600,000 and we expect that we will need
approximately $1.5 million for working capital during the next three month
period between July and September. Our primary expenses are normal operating
costs including salaries, payments under the severance agreements for two of our
former executives, lease payments for our warehouse space in Compton, California
and other operating costs.
On July 14, 2004, a director Jay Bauer has advanced the Company a short
term loan of $200,000, to be used to meet working capital obligations. The loan
bears interest at 8.75% per annum and is due on demand.
Our commitments for debt and other contractual arrangements are
summarized as follows:
YEARS ENDING MARCH 31,
-------------------------------------------------------------------------------------
TOTAL 2005 2006 2007 2008 2009
---------- ---------- ---------- ---------- ---------- ----------
Merchandise License Guarantee $ 525,000 $ 375,000 $ 150,000 -- -- --
Property Leases $2,657,506 $ 838,792 $ 579,851 $ 495,545 $ 371,659 $ 371,659
Equipment Leases $ 120,263 $ 71,746 $ 19,502 $ 7,969 $ 13,044 $ 8,002
Subordinated Debt-related parties $1,000,000 -- $1,000,000 -- -- --
Convertible Debentures $4,000,000 -- $4,000,000 -- -- --
Each of the contractual agreements (except the equipment leases)
provides that all amounts due under that agreement can be accelerated if we
default under the terms of the agreement. For example, if we fail to make a
minimum guaranteed royalty payment that is required under a Merchandise License
Agreement on a timely basis, the licensor can declare us in default and require
that all amounts due under the Merchandise License Agreement are immediately due
and payable.
Merchandise license guarantee reflects amounts that we are obligated to
pay as guaranteed royalties under our various license agreements. In fiscal
2005, we have guaranteed minimum royalty payments under our license agreements
with Care Bears, MTV and Motown (Universal Music).
We have leases for office and warehouse space in California, Florida
and Hong Kong. We have equipment leases for forklifts and copy machines.
On September 8, 2003, we issued an aggregate of $4,000,000 of 8%
convertible debentures in a private offering to six accredited investors. The
debentures initially are convertible into 1,038,962 shares of our common stock
at $3.85 per share, subject to adjustment in certain situations. 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
debentures and warrants.
On February 9, 2004 we amended our convertible debenture agreements to
increase the interest rate to 8.5% and to grant warrants to purchase an
aggregate of 30,000 shares of our common stock to the debenture holders on a
pro-rata basis. These concessions are in consideration of the debenture holder's
agreements to (i) enter into new subordination agreements with Milberg, (ii) to
waive all liquidated damages due under the transaction documents through July 1,
2004 and (iii) to extend the effective date of the Form S-1 registration
statement until July 1, 2004. The new warrants have an exercise price equal to
$1.52 per share and the fair value of these warrants was estimated by using the
Black-Scholes Option-Pricing Model and totaled $30,981. This amount was expensed
as a component of selling, general and administrative expenses. Pursuant to the
convertible debenture agreements, we were required to register the shares of
common stock underlying the debentures and detachable stock purchase warrants
18
issued in connection with the debentures. The registration of the common shares
was required to be effective by July 1, 2004. Because we did not have the
registration statement declared effective by July 14, 2004, we are in technical
default of the convertible debenture agreements. As such, we are accruing
liquidated damages in the amount of $80,000 per month. Additionally, the
convertible debenture holders could declare us in default of the convertible
debentures and accelerate all payments due under the convertible debentures,
which is the principal amount of $4 million plus any liquidated damages and
other fees that are assessed. One of the reasons that we are in technical
default is because we have not received all the information that we have
requested from the debenture holders for the registration statement. We are
working to cure our event of default by filing the registration statement as
soon as possible. Additionally, we are trying to enter into another amendment of
the convertible debentures and transaction documents with the convertible
debenture holders which would extend the filing date for the registration
statement and eliminate all liquidated damages. There can be no assurances that
we will be able to enter into an amendment of the convertible debenture
agreements.
WORKING CAPITAL REQUIREMENTS DURING THE SHORT AND LONG TERM
During the three month period between July and September, we plan on
financing our working capital needs from
(i) Collection of accounts receivable;
(ii) Sales of existing inventory;
(iii) Seeking additional financial company for advance in account
receivables.
(iv) Continued support from factories in China in financing our
purchases of karaoke machines for fiscal 2005; and
(iv) Utilizing credit facilities that are available to
International SMC to finance all direct shipments.
Our sources of cash for working capital in the longer term, the six
month period between September and March 2004, are the same as our sources
during the short term. We expect to receive a tax refund of $1.1 million at the
end of September 2004. If we need additional financing we intend to approach
Milberg and request that it modify the terms of its factoring agreement or
permit us to obtain financing from a third party. However, we can not assure
that Milberg will be willing to waive any of the conditions of the factoring
agreement and/or let us seek capital from a third party. If we need to obtain
additional financing and fail to do so, it may have a material adverse effect on
our ability to meet our financial obligations and to continue our operations.
During fiscal 2005, we will strive to keep our operating costs at a
minimum. In order to reduce the need to maintain inventory in our warehouse in
California and Florida, we intend to generate a larger share of our total sales
through sales directly from International SMC. The goods are shipped directly to
our customers from the ports in China and are primarily backed by customer
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. These sales in which the customer
purchase the good for delivery at a specific destination are referred to as
"FOB" sales. We will also assist our customers in the forecasting and management
of their inventories of our product.
We are also planning to finance a significant amount of our sales with
customer issued letters of credit, using International SMC's credit facility
with Hong Kong Bank and relying on financing from one of our factories in China.
We anticipate that total purchases of approximately $28 million that will be
financed by the above methods. We currently expect to order approximately $8
million in new inventory, which will be financed by using International SMC's
credit facility and financing from a Chinese factory.
However, these purchase orders can be cancelled at any time prior to
delivery and we can not assure you that our customers will complete these
purchases. In the event that we do not sell sufficient products in our second
and third quarter, we have considered other sources of financing, such as trying
to secure an additional credit facility, private offerings and/or a venture
capital investment. We expect that our profit margin for sales of our karaoke
products will continue to be under price pressure, because of the older
competition in the marketplace. During fiscal 2005, we plan on introducing three
new karaoke machines which will command higher prices and a higher profit
margin. The Company also will continue to cut our operating expenses.
We may incur an operating charge in fiscal 2004. In connection with the
settlement of the class action lawsuit, we have agreed to issue approximately
400,000 share of our common stock to the class action plaintiffs. The
convertible debentures and warrants provide that if we issue any additional
securities at a price that is lower than the set price of the debentures and the
warrants, the price of the debentures and warrants will be adjusted accordingly.
However, there is an exception for the stock issued for acquisitions or
strategic investments, the primary purpose of which is not for raise capital. We
believe that the issuance of the securities to the class action plaintiffs may
fall with this exception. We will need to discuss the issue with the
institutional investors to see if they agree with our position. There can be no
assurances that they will agree with our position that the conversion price of
the debentures and the exercise price of the warrants should not be adjusted.
19
Additionally, we are in default of the convertible debenture agreements
and related transaction documents. Under the terms of the convertible
debentures, we are accruing liquidated damages of $80,000 for each month that we
do not have a registration statement filed.
Except for the foregoing, we do not have any present commitment that is
likely to result in our liquidity increasing or decreasing in any material way.
In addition, except for the Singing Machine's need for additional capital to
finance inventory purchases, the Singing Machine knows of no trend, additional
demand, event or uncertainty that will result in, or that is reasonably likely
to result in, the Singing Machine's liquidity increasing or decreasing in any
material way
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. The exchange rate of the
Hong Kong dollar to the U.S. dollar has been fixed by the Hong Kong government
since 1983 at HK$7.80 to U.S. $1.00 and, accordingly, has not represented a
currency exchange risk to the U.S. dollar. We cannot assure you that the
exchange rate between the United States and Hong Kong currencies will continue
to be fixed or that exchange rate fluctuations 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 86% of
net sales in fiscal 2004 and 2003, and 81% of net sales in fiscal 2002.
Our results of operations may also fluctuate from quarter to quarter as
a result of the amount and timing of orders placed and shipped to customers, as
well as other factors. The fulfillment of orders can therefore significantly
affect results of operations on a quarter-to-quarter basis.
INFLATION
Inflation has not had a significant impact on the Company's operations.
The Company has historically passed any price increases on to its customers
since prices charged by the Company are generally not fixed by long-term
contracts.
CRITICAL ACCOUNTING POLICIES
We prepared our consolidated financial statements in accordance with
accounting principles generally accepted in the United States of America. As
such, management is required to make certain estimates, judgments and
assumptions that it believes are reasonable based on the information available.
These estimates and assumptions affect the reported amounts of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses for the periods presented. The significant accounting
policies which management believes are the most critical to aid in fully
understanding and evaluating our reported financial results included accounts
receivable - allowance for doubtful accounts, reserves on inventory, deferred
tax assets and our Hong Kong income tax exemption.
COLLECTIBILITY OF ACCOUNTS RECEIVABLE. The Singing Machine's allowance
for doubtful accounts is based on management's estimates of the creditworthiness
of its customers, current economic conditions and historical information, and,
in the opinion of management, is believed to be an amount sufficient to respond
to normal business conditions. Management sets 100% reserves for customers in
bankruptcy and other reserves based upon historical collection experience.
Should business conditions deteriorate or any major customer default on its
obligations to the Company, this allowance may need to be significantly
increased, which would have a negative impact on operations.
20
RESERVES ON INVENTORIES. The Singing Machine establishes 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 the Company's investment in inventories
for such declines in value.
INCOME TAXES. Significant management judgment is required in developing
our provision for income taxes, including the determination of foreign tax
liabilities, deferred tax assets and liabilities and any valuation allowances
that might be required against the deferred tax assets. Management evaluates its
ability to realize its deferred tax assets on a quarterly basis and adjusts its
valuation allowance when it believes that it is more likely than not that the
asset will not be realized. At December 31, 2003 and March 31, 2004, we
concluded that a valuation allowance was needed against all of our deferred tax
assets, as it was not more likely than not that the deferred taxes would be
realized. At March 31, 2004 and 2003, we had gross deferred tax assets of $8.2
million and $1.9 million, against which we recorded valuation allowances
totaling $8.2 million and $0, respectively.
For the fiscal year ended March 31, 2004, we recorded a tax provision
of $758,505. This occurred because the valuation allowance established against
our deferred tax assets exceeded the amount of the benefit created from carrying
back a portion of the current year's losses. The carry-back of the losses from
the current year resulted in an income tax receivable of $1.1 million, which is
included in refundable tax in the accompanying balance sheets. we have now
exhausted our ability to carry back any further losses and therefore will only
be able to recognize tax benefits to the extent that it has future taxable
income.
Our subsidiary has applied for an exemption of income tax in Hong Kong.
Therefore, no taxes have been expensed or provided for at the subsidiary level.
Although no decision has been reached by the governing body, the parent company
has reached the decision to provide for the possibility that the exemption could
be denied and accordingly has recorded a provision for Hong Kong taxes in fiscal
2003 and 2002. There was no provision for Hong Kong income taxes in fiscal 2004
due to the subsidiary's net operating loss for the year. Hong Kong income taxes
payable totaled $2.4 million at March 31, 2004 and 2003 and is included in the
accompanying balance sheets as income taxes payable.
We effectively repatriated approximately $2.0 million, $5.6
million and $5.7 from its foreign operations in 2004, 2003 and 2002,
respectively. Accordingly, these earnings were taxed as a deemed dividend based
on U.S. statutory rates. We have no remaining undistributed earnings of
the Company's foreign subsidiary.
We operate within multiple taxing jurisdictions and are subject to
audit in those jurisdictions. Because of the complex issues involved, any claims
can require an extended period to resolve. In management's opinion, adequate
provisions for income taxes have been made.
OTHER ESTIMATES. We makes other estimates in the ordinary course of
business relating to sales returns and allowances, warranty reserves, and
reserves for promotional incentives. Historically, past changes to these
estimates have not had a material impact on our financial condition. However,
circumstances could change which may alter future expectations.
Set forth below and elsewhere in this Annual Report on Form 10-K and in
the other documents we file with the SEC are risks and uncertainties that could
cause actual results to differ materially from the results contemplated by the
forward looking statements contained in this Annual Report.
FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK
RISKS ASSOCIATED WITH OUR BUSINESS
WE HAVE SIGNIFICANT WORKING CAPITAL NEEDS AND IF WE ARE UNABLE TO OBTAIN
ADDITIONAL FINANCING, WHEN NEEDED, WE MAY NOT HAVE SUFFICIENT CASH FLOW TO RUN
OUR BUSINESS
As of July 1, 2004, our cash on hand is limited. We need approximately
$1.5 million in working capital in order to finance our operations over the next
three months. We will finance our working capital needs from the collection of
accounts receivable, and sales of existing inventory. See "Liquidity" beginning
on page 17. As of March 31, 2004, our inventory was valued at $5.2 million. If
these sources do not provide us with adequate financing, we may try to seek
financing from a third party. If we are not able to obtain adequate financing,
when needed, it will have a material adverse effect on our cash flow and our
ability to run our business. If we have a severe shortage of working capital, we
may not be able to continue our business operations and may be required to file
a petition for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code or enter
into some other form of liquidation or reorganization proceeding.
21
WE MAY BE DEEMED TO INSOLVENT AND WE MAY GO OUT OF BUSINESS
As of March 31, 2004, our cash position is limited. We are not able to
pay all of our creditors on a timely basis. We are current on approximately 80%
of our accounts payable, which total $3.9 million as March 31, 2004. We are not
current on our account payable of $2.4 million to our factory in China. If we
are not able to pay our current debts as they become due, we may be deemed to be
insolvent. We may be required to file a petition for bankruptcy under Chapter 11
of the U.S. Bankruptcy Code or enter into some other form of liquidation or
reorganization proceedings.
OUR INDEPENDENT REGISTERED PUBLIC ACCOUNTANTING FIRM RAISED SUBSTANTIAL DOUBT
ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN AS OF MARCH 31, 2004 AND 2003
We received a report dated June 16, 2004 from our independent certified
public accountants covering the consolidated financial statements for our fiscal
year ended March 31, 2004 that included an explanatory paragraph which stated
that the financial statements were prepared assuming the Singing Machine would
continue as a going concern. This report stated that our operating performance
in fiscal 2004 and our minimal liquidity raised substantial doubt about our
ability to continue as a going concern. If we are not able to raise additional
capital,we may need to curtail or stop our business operations. We may be
required to file a petition for bankruptcy under Chapter 11 of the U.S.
Bankruptcy Code or enter into some other form of liquidation or reorganization
proceedings.
WE ARE IN TECHNICAL DEFAULT OF THE TERMS OF THE CONVERTIBLE DEBENTURES AND
THERE COULD BE A MATERIAL ADVERSE EFFECT ON OUR OPERATIONS AND FINANCIAL RESULTS
IF WE ARE DEEMED TO BE IN DEFAULT
We are in technical default of the terms of the $4 million in
convertible debentures that we issued to 6 institutional investors in September
2003. We had an obligation to have the registration statement registering the
securities issued to the institutional investors filed and declared effective by
July 1, 2004. As of July 14, 2004, the registration statement has not been
declared effective. As such, under the terms of the registration rights
agreement we are accruing liquidated damages in the amount of $80,000 for each
month that the registration statement is not declared effective. Additionally,
the institutional investors could declare us in default of the convertible
debentures and demand repayment of the debentures and all other amounts due
under the transaction documents evidencing their $4 million investment.
IF WE ARE UNABLE TO EFFECTIVELY AND EFFICIENTLY IMPLEMENT OUR PLAN TO REMEDIATE
THE MATERIAL WEAKNESSES WHICH HAVE BEEN IDENTIFIED IN OUR INTERNAL CONTROLS AND
PROCEDURES, THERE COULD BE A MATERIAL ADVERSE EFFECT ON OUR OPERATIONS OR
FINANCIAL RESULTS
We have identified a number of material weaknesses in our internal
controls and procedures in connection with the audit of our financial statements
for fiscal 2004. See " Controls and Procedures" on page 30. The deficiencies in
our internal controls relate to:
- weaknesses in our financial reporting processes as a result of
a lack of adequate staffing in the accounting department,
- accounting for consigned inventory and inventory costing.
We are implementing a number of procedures to correct these weaknesses
in our internal controls. However, no assurances can be given that we will be
able to successfully implement our revised internal controls and procedures or
that our revised controls and procedures will be effective in remedying all of
the identified material weaknesses in our prior controls and procedures. In
addition, we may be required to hire additional employees, and may experience
higher than anticipated capital expenditures and operating expenses, during our
implementation of these changes. If we are unable to implement these changes
effectively or efficiently there could be a material adverse effect on our
operations or financial results.
A SMALL NUMBER OF OUR CUSTOMERS ACCOUNT FOR A SUBSTANTIAL PORTION OF OUR
REVENUES, AND THE LOSS OF ONE OR MORE OF THESE KEY CUSTOMERS COULD SIGNIFICANTLY
REDUCE OUR REVENUES AND CASH FLOW
We rely on a few large customers to provide a substantial portion of
our revenues. As a percentage of total revenues, our net sales to our five
largest customers during the fiscal period ended March 31, 2004, 2003 and 2002
were approximately 53%, 67% and 87%, respectively. In fiscal 2004, three
customers accounted for 20%, 12% and 8% of our net sales. The customers are
Arbiter, Giochi and Best Buy respectively. We do not have long-term contractual
arrangements with any of our customers and they can cancel their orders at any
time prior to delivery. A substantial reduction in or termination of orders from
any of our largest customers would decrease our revenues and cash flow.
WE ARE RELYING ON ONE FACTORY TO MANUFACTURE AND PRODUCE THE MAJORITY OF OUR
KARAOKE MACHINES FOR FISCAL 2005, AND IF THE RELATIONSHIP WITH THIS FACTORY IS
DAMAGED OR INJURED IN ANY WAY , IT WOULD REDUCES OUR REVENUES AND PROFITABILITY
We have worked out a verbal agreement with a factory in China to
produce all of our karaoke machines for fiscal 2005. We owe this factory
approximately $2.4 million as of June 30, 2004 and have worked out a payment
plan with it. See "Liquidity" beginning on page 17. If the factory is unwilling
or unable to deliver our karaoke machines to us, our business will be adversely
affected. Because our cash on hand is minimal, we are relying on revenues
received from the sale of our ordered karaoke machines to provide cash flow for
our operations. If we do not receive cash from these sales, we may not be able
to continue our business operations.
WE ARE SUBJECT TO THE RISK THAT SOME OF OUR LARGE CUSTOMERS MAY RETURN KARAOKE
PRODUCTS THAT THEY HAVE PURCHASED FROM US AND IF THIS HAPPENS, IT WOULD REDUCE
OUR REVENUES AND PROFITABILITY
In fiscal 2004 and 2003, a number of our customers and distributors
returned karaoke products that they had purchased from us. Our customers
returned goods valued at $1.8 million, or 2.5% of our net sales in fiscal 2004.
Best Buy, one of our largest customers, returned approximately $2.75 million in
karaoke products that it had not been able to sell during the Christmas season
in fiscal 2003. Best Buy agreed to keep this inventory in its retail stores, but
converted the sale to a consignment sale. Although we were not contractually
obligated to accept this return of the karaoke products in fiscal 2004 or fiscal
2003, we accepted the return of the karaoke products because we valued our
relationship with our customers. Because we are dependent upon a few large
customers, we are subject to the risk that any of these customers may elect to
return unsold karaoke products to us in the future. If any of our customers were
to return karaoke products to us, it would reduce our revenues and
profitability.
WE ARE SUBJECT TO PRESSURE FROM OUR CUSTOMERS RELATING TO PRICE REDUCTION AND
FINANCIAL INCENTIVES AND IF WE ARE PRESSURED TO MAKE THESE CONCESSIONS TO OUR
CUSTOMERS, IT WILL REDUCE OUR REVENUES AND PROFITABILITY
Because there is intense competition in the karaoke industry, we are
subject to pricing pressure from our customers. Many of our customers have
demanded that we lower our prices or they will buy our competitor's products. If
we do not meet our customer's demands for lower prices, we will not sell as many
karaoke products. In our fiscal year ended March 31, 2004, our sales to
customers in the United States decreased because of increased price competition.
During fiscal 2004, we sold 20.2% of our karaoke machines at prices that were
equal to or below cost. We will not be able to stay in business if we continue
to sell our karaoke machines at prices that are at or below cost. We are also
subject to pressure from our customers regarding certain financial incentives,
such as return credits or large advertising or cooperative advertising
allowances, which effectively reduce our selling prices. In fiscal 2004, we gave
22
our customers $2.1 million of credit on account because the sell-through of our
products was not as strong as we had expected. We also gave them advertising
allowances in the amount of $2.3 million during fiscal 2004 and $4.1 million
during fiscal 2003. We have historically offered advertising allowances to our
customers because it is standard practice in the retail industry.
WE EXPERIENCE DIFFICULTY FORECASTING THE DEMAND FOR OUR KARAOKE PRODUCTS AND IF
WE DO NOT ACCURATELY FORECAST DEMAND, OUR REVENUES, NET INCOME AND CASH FLOW MAY
BE AFFECTED
Because of our reliance on manufacturers in Asia for our machine
production, our production lead times range from one to four months. Therefore,
we must commit to production in advance of customers orders. It is difficult to
forecast customer demand because we do not have any scientific or quantitative
method to predict this demand. Our forecasting is based on management's general
expectations about customer demand, the general strength of the retail market
and management's historical experiences. We overestimated demand for our
products in fiscal 2004 and had $25.2 million in inventory as of March 31, 2003.
Because of this excess inventory, we had liquidity problems in fiscal 2004 and
our revenues, net income and cash flow were adversely affected. We had a net
loss of $22.7 million in fiscal 2004 and our cash flow was limited in fiscal
2004.
WE ARE SUBJECT TO THE COSTS AND RISKS OF CARRYING INVENTORY FOR OUR CUSTOMERS
AND IF WE HAVE TOO MUCH INVENTORY, IT WILL AFFECT OUR REVENUES AND NET INCOME
Many of our customers place orders with us several months prior to the
holiday season, but they schedule delivery two or three weeks before the holiday
season begins. As such, we are subject to the risks and costs of carrying
inventory during the time period between the placement or the order and the
delivery date, which reduces our cash flow. As of March 31, 2003, we had $25.2
million in inventory on hand, which impacted our cash flow and liquidity from
operations in fiscal 2004. As of March 31, 2004, our inventory was valued at
$5.2 million, after a $6.6 million reserve had been taken. It is important that
we sell this inventory during fiscal 2005, so we have sufficient cash flow for
operations.
OUR GROSS PROFIT MARGINS HAVE DECREASED OVER THE PAST YEAR AND WE EXPECT
COMPETITIVE MARKET
Over the past year, our gross profit margins have decreased. In the
fiscal year ended March 31, 2004, our gross profit margin was 2.6% of net sales
compared to 24.4% of net sales in fiscal year ended March 31, 2003. This decline
resulted from the closeout of older models and excessive inventory, price
competition and increased sales by International SMC. Sales made by
International SMC increased from 52% of our sale in fiscal 2003 to 61 % in
Fiscal 2004. International SMC delivers our karaoke products to customers
directly from our manufacturer's factories in China and therefore does not
provide logistics, handling, warehousing and just in time inventory support,
which services are provided by our parent company in the United States.
Accordingly, the average sales price per unit realized by International SMC is
significantly lower than that of our parent company in the United States. We
expect further price competition and a continuing shift of sales volume to
International SMC. Accordingly, we expect that our gross profit margin will
decrease in fiscal 2005.
OUR SENIOR CORPORATE MANAGEMENT TEAM IS NEW TO THE SINGING MACHINE AND IS
REQUIRED TO DEVOTE SIGNIFICANT ATTENTION TO OUR FINANCING AGREEMENTS AND
SETTLING OUR CLASS ACTION LAWSUITS
Beginning on May 2, 2003, through the present date, four of our
executive officers have resigned We hired a new Chief Operating Officer, Yi Ping
Chan on April 1, 2003, and a new Chief Financial Officer, Jeff Barocas, on April
9, 2004. Three new directors have joined our Board since October 31, 2004 and
one of them has resigned since that date. Bernard Appel joined our Board
effective as of October 31 and Harvey Judkowitz joined on March 29, 2004.
Richard Ekstract jointed our Board on October 31, 2003 and resigned for personal
reasons on June 2, 2004. We are in the process of searching for a new Chief
Executive Officer and new directors. It will take some time for our new
management and our new board of directors to learn about our business and to
develop strong working relationships with each other and our employees. Our new
senior corporate management's ability to complete this process has been and
continues to be hindered by the time that it needs to devote to other pressing
business matters. New management needs to spend significant time on overseeing
our liquidity situation and overseeing legal matters, such as our class action
lawsuit. We cannot assure you that this major restructuring of our board of
directors and senior management and the accompanying distractions, in this
environment, will not adversely affect our results of operations.
THE SEC IS CONDUCTING AN INFORMAL INVESTIGATION OF THE COMPANY AND IF WE HAVE
DONE SOMETHING 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
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has not fully complied with all applicable federal securities laws, we could be
subject to fines, penalties and other sanctions imposed by the SEC.
WE ARE NAMED AS A DEFENDANT IN A CLASS ACTION LAWSUIT RELATING TO THE
RESTATEMENT OF OUR FINANCIAL STATEMENTS FOR FISCAL 2002 AND FISCAL 2001, WHICH
IF DETERMINED ADVERSELY TO US, COULD RESULT IN THE IMPOSITION OF DAMAGES AGAINST
US AND HARM OUR BUSINESS AND FINANCIAL CONDITION
We are named as a defendant in a class action lawsuit which arose from
the restatement of our financial statements for fiscal 2002 and 2001. In this
lawsuit, the plaintiffs allege that our executive officers and our company
violated Section 10(b) and Section 20(a) of the Securities Exchange Act of 1934
and Rule 10(b)-5. The plaintiffs seek compensatory damages, attorney's fees and
injunctive relief. While the specific factual allegations vary slightly in each
case, the complaints generally allege that our officers falsely represented the
Company's financial results during the relevant class periods. In March 2004, we
have entered into a settlement agreement with the class action plaintiffs. See
"Business - Legal Matters." This settlement is subject to approval by the court
and the shareholders who are members of the class action lawsuit at a hearing
which will be held on July 30, 2004.
If this settlement agreement is not approved by the court and members
of the class action lawsuit, we will need to expend additional times and
resources on resolving this matter, whether through continued settlement
discussions or through litigation. If a significant monetary judgment is
rendered against us, we are not certain that we will have the ability to pay
such a judgment. Any losses resulting from these claims could adversely affect
our profitability and cash flow.
OUR LICENSING AGREEMENT WITH MTV NETWORKS IS IMPORTANT TO OUR BUSINESS AND IF WE
WERE TO LOSE OUT MTV LICENSE IT WOULD AFFECT OUR REVENUES AND PROFITABILITY
Our license with MTV Networks is important to our business. We
generated 11.8% and 32.3% of our consolidated net sales from products sold under
the MTV license in fiscal 2004 and 2003, respectively. Our MTV license was
extended until July 30, 2004 with options for MTV to renew for an additional
four months period through December 31, 2004. If we were to lose our MTV
license, it would have an effect on our revenues and net income.
OUR BUSINESS IS SEASONAL AND THEREFORE OUR ANNUAL OPERATING RESULTS WILL DEPEND,
IN LARGE PART, ON OUR SALES DURING THE RELATIVELY BRIEF HOLIDAY SEASON
Sales of consumer electronics and toy products in the retail channel
are highly seasonal, with a majority of retail sales occurring during the period
from September through December in anticipation of the holiday season, which
includes Christmas. A substantial 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 86% of net sales
in fiscal 2004, and 2003 and 81% of net sales in fiscal 2002.
IF WE ARE UNABLE TO COMPETE IN THE KARAOKE PRODUCTS CATEGORY, OUR REVENUES AND
NET PROFITABILITY WILL BE REDUCED
Our major competitors for karaoke machines and related products are
Craig and Memorex. We believe that competition for karaoke machines is based
primarily on price, product features, reputation, delivery times, and customer
support. Our primary competitors for producing karaoke music are Compass, Pocket
Songs, Sybersound, UAV and Sound Choice. We believe that competition for karaoke
music is based primarily on popularity of song titles, price, reputation, and
delivery times. To the extent that we lower prices to attempt to enhance or
retain market share, we may adversely impact our operating margins. Conversely,
if we opt not to match competitor's price reductions we may lose market share,
resulting in decreased volume and revenue. To the extent our leading competitors
reduce prices on their karaoke machines and music, we must remain flexible to
reduce our prices. If we are forced to reduce our prices, it will result in
lower margins and reduced profitability. Because of intense competition in the
karaoke industry in the United States during fiscal 2004, we expect that the
intense pricing pressure in the low end of the market will continue in the
karaoke market in the United States in fiscal 2005. In addition, we must compete
with all the other existing forms of entertainment including, but not limited
to: motion pictures, video arcade games, home video games, theme parks,
nightclubs, television and prerecorded tapes, CD's and video cassettes.
IF WE ARE UNABLE TO DEVELOP NEW KARAOKE PRODUCTS, OUR REVENUES MAY NOT CONTINUE
TO GROW
The karaoke industry is characterized by rapid technological change,
frequent new product introductions and enhancements and ongoing customer demands
for greater performance. In addition, the average selling price of any karaoke
machine has historicall