Back to GetFilings.com
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
|X| Annual Report Under Section 13 or 15(d) of the Securities Exchange Act of
1934.
For the fiscal year ended December 31, 2002
OR
|_| Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the transition period from ___________ to ____________
Commission File Number 001-13469
MEDIABAY, INC.
(Exact Name of Registrant as Specified in Its Charter)
Florida 65-0429858
(State or other jurisdiction (IRS employer of
incorporation or organization) identification no.)
2 Ridgedale Avenue 07927
Cedar Knolls, NJ --------------
- --------------------------------------- (Zip Code)
(Address of principal executive offices)
973-539-9528
(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock
(Title of Class)
Indicate by check mark whether the Registrant: (1) filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the past 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filling requirements for
the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained in this form, 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. |X|
Indicate by check mark whether the Registrant is an accelerated filer as defined
in Rule 12b-2 of the Securities Exchange Act of 1934. Yes |_| No |X|
The aggregate market value of the voting and non-voting common equity held by
non-affiliates as of June 28, 2002 (the last business day of the Registrant's
most recently completed second quarter) was approximately $45,504,807.
As of April 10, 2003, there were 14,341,376 shares of the Registrant's Common
Stock outstanding.
Documents Incorporated by Reference:
None
MEDIABAY, INC.
Form 10-K
Table of Contents
PART I
Item 1. Description of Business 1
Item 2. Description of Property 12
Item 3. Legal Proceedings 12
Item 4. Submission of Matters to a Vote of Security Holders 12
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters 13
Item 6. Selected Financial Data 13
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 15
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 31
Item 8. Financial Statements and Supplementary Data 31
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 31
PART III
Item 10. Directors and Executive Officers 32
Item 11. Executive Compensation 35
Item 12. Security Ownership of Certain Beneficial Owners and Management 39
Item 13. Certain Relationships and Related Transactions 42
Item 14. Controls and Procedures 44
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 45
The Company is restating its previously issued consolidated financial statements
as of December 31, 2000 and 2001 and for the years ended December 31, 1999, 2000
and 2001 to correct errors in the accounting treatment relating to previously
disclosed financing transactions. The amounts presented herein reflect the
restatement of these financial statements. The effects of this restatement on
the consolidated financial statements as of and for the years ended December 31,
2000 and 2001 are presented in Part II. Item 6 "Selected Financial Data" and
Item 7 "Management's Discussion and Analysis of Financial Condition and Results
of Operations" and Note 2 to Notes to the Consolidated Financial Statements of
this Form 10-K. The effects of this restatement on the consolidated financial
statements for the year ended December 31, 1999 and as of December 31, 1998 and
1999 are presented in Item 6 "Selected Financial Data."
PART I
Item 1. Description of Business
Forward-looking Statements
Certain statements in this Form 10-K and in the documents
incorporated by reference in this Form 10-K constitute "forward-looking"
statements within the meaning of the Private Securities Litigation Reform Act of
1995. All statements other than statements of historical facts included in this
Report, including, without limitation, statements regarding our future financial
position, business strategy, budgets, projected costs and plans and objectives
of our management for future operations are forward-looking statements. In
addition, forward-looking statements generally can be identified by the use of
forward-looking terminology such as "may," "will," "expect," "intend,"
"estimate," "anticipate," "believe," or "continue" or the negative thereof or
variations thereon or similar terminology. Although we believe that the
expectations reflected in such forward-looking statements are reasonable, we
cannot assure you that such expectations will prove to be correct. These forward
looking statements involve certain known and unknown risks, uncertainties and
other factors which may cause our actual results, performance or achievements to
be materially different from any results, performances or achievements expressed
or implied by such forward-looking statements. Important factors that could
cause actual results to differ materially from our expectations, include,
without limitation, our history of losses; our ability to meet stock repurchase
obligations, anticipate and respond to changing customer preferences, license
and produce desirable content, protect our databases and other intellectual
property from unauthorized access, pay our trade creditor and collect
receivables; dependence on third-party providers, suppliers and distribution
channels; competition; the costs and success of our marketing strategies,
product returns and member attrition. Undue reference should not be placed on
these forward-looking statements, which speak only as of the date hereof. We
undertake no obligation to update any forward-looking statements.
Introduction
MediaBay is a media company specializing in spoken audio content,
marketing and publishing, whose businesses include direct response and
interactive marketing, retail product distribution, media publishing and
broadcasting.
Our content library consists of more than 50,000 hours of spoken
audio content. The majority of our content is acquired under license from the
rightsholders.
Our customer base includes over 2.9 million spoken audio buyers who
have purchased via catalogs and direct mail marketing. We also have a total file
of 2.0 million e-mail addresses. Our old-time radio products are sold in over
7,000 retail locations including Costco, Target, Sam's Club, Barnes & Noble,
Borders, Amazon.com, and Cracker Barrel Old Country Stores.
Our web sites receive more than 2 million unique monthly web site
visitors and are among the most heavily trafficked bookselling web sites on the
Internet. We serve more than 400,000 classic radio streams of our content on a
monthly basis to web site visitors at RadioSpirits.com and MediaBay.com.
Business Divisions
We report financial results on the basis of four reportable
segments; Corporate, Audio Book Club ("ABC"), Radio Spirits ("Radio Spirits" or
"RSI") and MediaBay.com. A fifth division, Radio Classics, is aggregated with
Radio Spirits for financial reporting purposes. Except for corporate, each
segment serves a unique market segment within the spoken word audio industry.
The four segments serving the spoken word audio industry are as follows:
o Audio Book Club ("ABC") - is, we believe, the largest audiobook club
with a total member file of approximately 2.5 million names;
marketed via direct mail and the Internet at www.audiobookclub.com.
1
o Radio Spirits ("Radio Spirits" or "RSI")- markets old-time radio
programs to RSI catalog buyers through direct mail catalogs and, on
a wholesale basis, to major retailers, including Costco, Target,
Sam's Club, Barnes & Noble, Borders, Amazon.com and Cracker Barrel
Old Country Stores, and via the Internet at www.radiospirits.com.
o MediaBay.com - provides the infrastructure and support for all of
the Company's websites including www.Audiobookclub.com,
www.RadioSpirits.com and www.MediaBayDownloads.com. MediaBay.com
powers the Company's digital audio download service located at
www.MediaBayDownloads.com which offers many of the Company's classic
radio programs and audiobooks for purchase either via a secure
digital download subscription service or on a pay per download
basis, in either case, with desktop and mobile playback
capabilities.
o RadioClassics ("RCI")- currently distributes three national
"classic" radio programs collectively heard on more than 250 radio
stations weekly and can also be heard on dedicated channels on both
the Sirius Satellite Radio and XM Satellite Radio services.
Audio Book Club
We believe that Audio Book Club is the largest membership-based club
of its kind. Our total member file, which includes active and inactive members,
has grown significantly from approximately 64,000 names at December 31, 1995 to
approximately 2.5 million names at December 31, 2002.
In December 1998 and June 1999, MediaBay acquired its only two
competitors in the club segment of the audiobook market: The Columbia House
Audiobook Club from Time Warner and Sony and Doubleday's Audiobooks Direct club
from Bertelsmann.
Our Audio Book Club is modeled after the "Book-of-the-Month Club".
Audio Book Club members can enroll in the club through the mail by responding to
direct mail advertisements, online through our web site or by calling us. We
typically offer new members four audiobooks at an introductory price of $.99 or
less. By enrolling, the member typically commits to purchase a minimum number of
additional audiobooks, typically one or two, at Audio Book Club's regular
prices, which generally range from $10.00 to $40.00 per audiobook. Our members
continue to receive member mailings and typically purchase audiobooks beyond
their minimum purchase commitment.
We emphasize the timely introduction of new audiobook titles to our
catalogs and attempt to offer a balance between various genres and between
unabridged and abridged audiobooks, cassettes and compact discs to satisfy
differing member preferences.
We have formed our first such specialty club for audiobooks, Audio
Passages, a Christian audiobook club.
We engage in list rental programs to maximize the revenue generation
potential of these programs. As Audio Book Club's membership base and Radio
Spirits' catalog customer base continue to grow, we anticipate that our customer
and member lists will continue to be attractive to non-competitive direct
marketers as a source of potential customers.
Audiobookclub.com currently receives over 1.6 million unique
visitors per month and is one of the most heavily trafficked bookselling web
sites on the Internet.
Marketing
Since our inception, we have engaged in an aggressive marketing
program to expand our Audio Book Club member base. We devote significant efforts
to developing various marketing strategies in a concerted effort to increase
revenue and reduce marketing costs. We continually analyze the results of our
marketing activities in an effort to maximize sales, extend membership life
cycles, and efficiently target our marketing efforts to increase response rates
to our advertisements and reduce our per-member acquisition costs.
2
We have historically acquired new Audio Book Club members primarily
through direct mailings of member solicitation packages, acquisitions, Internet
advertising, and to a lesser extent from advertisements in magazines, newspapers
and other publications, package insert and telemarketing programs. We seek to
attract a financially sound and responsible membership base and target these
types of persons in our direct mail, Internet and other advertising efforts.
We select lists of names of membership candidates based on the
extensive knowledge and experience we have gained which we believe are
characteristic of persons who are likely to join Audio Book Club, purchase
sufficient quantities of audiobooks to be a profitable source of sales for us
and remain long-term members. We analyze our existing mailing lists and our
promotional campaigns to target membership lists, which are more likely to yield
higher response rates. We have gained substantial knowledge relating to the use
of third-party mailing lists and believe we can target potential members
efficiently and cost effectively by using third-party mailing lists.
Our Internet marketing program focuses on acquiring Audio Book Club
members through advertising agreements with other web sites that require payment
only when we enroll a bona fide member in Audio Book Club. This cost -per
- -acquisition arrangement results in substantially lower marketing costs and
direct control over the cost of acquiring members. We have significantly reduced
our cost to acquire a member online as a result of our revised marketing
strategy. The cost to acquire a member in December 2002 was approximately $12 as
compared to over $50 in January of 2000. We have acquired approximately 360,000
members online, including approximately 96,000 members in 2002 and 58,000
members in 2001. Unlike traditional web retailers, our members have a purchase
obligation associated with their membership and there is a strong likelihood
that they will remain members and repeat buyers for a sustained period.
Member Retention and Recurring Revenue
We encourage Audio Book Club members to purchase more than their
minimum purchase commitment by offering members selected promotions, spot
discounts and other incentives based on the volume of their purchases. Audio
Book Club members receive one mailing approximately every three weeks. Audio
Book Club mailings typically include a multi-page catalog which offers hundreds
of titles, including a featured selection, which is usually one of the most
popular titles at the time of mailing; alternate selections, which are best
selling and other current popular titles; and backlist selections, which are
long-standing titles that have continuously sold well.
In order to encourage members to maintain their relationship with
Audio Book Club and to maximize the long-term value of members, we seek to
provide friendly, efficient, and personalized service. Our goal is to simplify
the order process and to make members comfortable shopping via the Internet and
by mail order. Audio Book Club's membership club format makes it easy for
members to receive the featured selection without having to take any action.
Under the membership club reply system, the member receives the featured
selection unless he or she replies by the date specified on the order form by
returning the order form, calling us with a reply or replying online via our
Internet web site with a decision not to receive such selection. Members can
also use any of these methods to order additional selections from each catalog.
We maintain a database of information on each name in our member file,
including number and genre of titles ordered, payment history and the marketing
campaign from which the member joined. We also maintain a lifetime value
analysis of each mailing list we use and each promotional campaign we undertake.
Supply and Production
We have established relationships with substantially all of the major
audiobook publishers, including Random House Audio Publishing Group, Simon &
Schuster Audio, Harper Audio and Time Warner Audio Books for the supply of
audiobooks. As a club operator, we license a recording or a group of recordings
from the publisher for sale in a club format on a royalty or per copy basis and
3
subcontract the manufacturing, including duplicating and printing to a third
party.
Our licensing agreements, many of which are exclusive, have one to
three-year terms, require us to pay an advance against future royalties upon
signing the license, permit us to sell audiobooks in our inventory at the
expiration of the term during a sell-off period and prohibit us from selling an
audiobook prior to the publisher's release date for each audiobook.
Substantially all of the license agreements permit us to make our own
arrangements for the packaging, printing and cassette duplication of audiobooks.
Substantially all of our license agreements permit us to produce and sell
audiobook titles in cassette and compact disc form.
Fulfillment and Customer Service
Bookspan, formerly Doubleday Direct, currently provides order
processing and data processing services, warehousing and distribution services
for our Audio Book Club members. Bookspan's services include accepting member
orders, implementing our credit policies, inventory tracking, billing,
invoicing, cash collections and cash application and generating periodic
reports, such as reports of sales activity, accounts receivable aging, customer
profile and marketing effectiveness. Bookspan also provides us with raw data
from which we generate our own marketing and accounting reports using our
in-house management information systems department. Bookspan also packs and
ships the order, using the invoice as a packing list, to the club member.
Members are billed for their purchases at the time their orders are
shipped and are required to make payment promptly. We generally allow members in
good standing to order up to fifty dollars of products on credit, which may be
increased if the member maintains a good credit history with us. We monitor each
member's account to determine if the member has made excessive returns.
We have substantially reduced the number of SKUs (Stock Keeping
Units) in our inventory, resulting in fewer back orders on items ordered and
less delay in fulfilling orders. We have also extended the period of time
between when a catalog is mailed and when we ship the featured selection,
allowing members additional time to decline the featured selection if they
choose.
Radio Spirits
RSI Content
RSI has exclusive rights to a substantial portion of its library of
popular old-time radio and classic video programs, including vintage comedy,
mystery, detective, adventure and suspense programs. RSI's library consists of
over 60,000 radio programs, most of which are licensed on an exclusive basis,
including:
o H.G. Wells' "War of the Worlds" broadcast;
o hit series, such as The Shadow, The Lone Ranger, Superman, Tarzan,
Sherlock Holmes, The Life of Riley and Lights Out;
o recordings of stars, such as Bob Hope, Lucille Ball, Frank Sinatra
and Jack Benny; and
o recordings of comedy teams, such as Abbott and Costello, Burns and
Allen, and Martin and Lewis.
RSI leverages the content of its old-time radio and classic video
library by entering into marketing and co-branding arrangements, which provides
RSI a means to repackage these programs. RSI offers the following collections,
among others:
o "The Greatest Old-Time Radio Shows of the 20th Century - selected by
Walter Cronkite" - a collection of Mr. Cronkite's favorite old-time
radio programs. RSI has entered into a license agreement to use Mr.
Cronkite's name and likeness. This collection includes some of
radio's most memorable programs, a spoken foreword by Mr. Cronkite
and a companion informational booklet.
4
o "The Smithsonian Collections" - a collection of old-time radio
programs branded under this name. RSI has entered into an agreement
with the Smithsonian Institution to produce a series of recordings
of nostalgic radio programs to be sold through all major bookstore
chains carrying audio programs. Each Smithsonian collection features
a foreword by a recognized celebrity from radio's golden age such as
George Burns, Jerry Lewis and Ray Bradbury.
Marketing
RSI markets its library of old-time radio and video programs through
direct marketing, Internet, and retail channels. RSI's marketing efforts are
aimed at the direct marketing channel of distribution, via internally developed
catalogs, as well as through retail and online channels of distribution. RSI
produces several catalogs per year and mails them to its customer list and
selected third-party mailing lists three times per year. RSI has developed
wholesale distribution through several large, national book retailers, including
Barnes & Noble, Borders, and Waldenbooks; gift stores such as Cracker Barrel Old
Country Stores; and mass retailers like Costco, Sam's Club, and Target, as well
as on the Internet at Amazon.com. RSI also sells its products through its web
site at Radiospirits.com.
Direct Mail
RSI maintains a total file of over 400,000 names of customers and
prospects. This list includes all customers to which RSI's radio and video
programs or catalogs have been mailed. RSI engages in list rental programs to
maximize the revenue generation potential of its customer list.
Broadcast
RSI advertises its products on RadioClassics' nationally syndicated
old-time radio broadcast, which are broadcast weekly on over 250 radio stations.
Our old-time radio shows can also be heard on dedicated channels on both the
Sirius Satellite Radio and XM Satellite Radio services.
Internet
RSI also sells its old-time radio programs in cassette and compact
disc direct to consumers through its web site, Radiospirits.com.
Radiospirits.com offers visitors the opportunity to listen to free programs in
streaming audio while they are prompted to buy our programs. Consumers may also
download old-time radio content from the Internet at both Radiospirits.com and
MediaBay.com. This service enables the secure delivery of old-time radio content
over the Internet for playback on personal computers and portable playback
devices.
Wholesale
RSI also sells its radio programs on a wholesale basis through major
retailers and online retailers, including Costco, Target, Sam's Club, Barnes &
Noble, Borders, Amazon.com and Cracker Barrel Old Country Stores. RSI's products
are currently sold in approximately 7,000 retail locations.
RSI markets its old-time radio and classic video programs to
wholesale customers through its in-house sales personnel, independent sales
representatives and through third-party distributors. RSI also engages in
cooperative advertising to induce retailers to purchase its products.
Supply and Production
RSI has exclusive licensing rights to a substantial majority of its
old-time radio library. These rights have been principally acquired from the
original rightsholders (actors, directors, writers, producers or others) or
their estates. Engineers in our New Jersey facility use digital sound equipment
to improve the sound quality of RSI's old-time radio programs. RSI then
contracts with third-party manufacturers to duplicate and manufacture the
old-time radio cassettes and CDs, which it sells.
Fulfillment and Customer Service
RSI uses a third-party fulfillment center to process and fill
orders. RSI only accepts credit card orders or advance payments from consumers
and requires wholesale customers to generally pay invoices within 60 to 90 days.
RSI maintains a toll-free customer service telephone hotline for these customers
and can also be contacted by mail and e-mail. RSI's policy is to accept returns
of damaged products sold on a retail basis. RSI accepts returns of unsold
products sold on a wholesale basis.
5
MediaBay.com
MediaBay.com provides the infrastructure and support for all of the
Company's websites including www.Audiobookclub.com, www.RadioSpirits.com and
www.MediaBayDownloads.com. MediaBay.com powers the Company's digital audio
download service located at www.MediaBayDownloads.com which offers many of the
Company's classic radio programs and audiobooks for purchase either via a secure
digital download subscription service or on a pay per download basis, in either
case, with desktop and mobile playback capabilities
RadioClassics
Our RadioClassics subsidiary produces and syndicates three national
"classic" radio programs: "When Radio Was" hosted by Stan Freberg, "Radio Movie
Classics" hosted by Jeffrey Lyons, and "Radio Super Heroes." These three
programs are broadcast on more than 250 radio stations in the United States. Our
library of old-time radio programs provides the content and the basis for these
programs.
Our current syndicated radio shows provide an excellent forum to
introduce our old-time radio programs to existing and potential new listeners.
The syndication agreements also provide us with an average of 1 to 2 minutes per
hour for our own advertising and promotional use. We use this advertising and
promotional forum as a means to develop broader name recognition for Radio
Spirits and additional sales of old-time radio products from existing and first
time buyers as well. Our old-time radio content can also be heard on dedicated
channels on both the Sirius Satellite Radio and XM Satellite Radio services.
Competition
Although we believe our Audio Book Club is the only business which
sells audiobooks in a club format and we believe we are the largest producer,
marketer and seller of old-time radio programs, we compete for discretionary
consumer spending with other mail order clubs and catalogs and other direct
marketers and traditional and on-line retailers that offer products with similar
entertainment value as audiobooks and old-time radio programs, such as music on
cassettes and compact discs, printed books, videos, and laser and digital video
discs. Many of these competitors are well-established companies, which have
greater financial resources.
The audiobook and mail order industries are intensely competitive.
We compete with all other outlets through which audiobooks and other spoken word
content are offered, including:
o bookstores;
o audiobook stores which rent or sell only audiobooks;
o mail order companies that offer audiobooks for rental and sale
through catalogs;
o web sites such as Amazon.com; and
o retail establishments such as convenience stores, video rental
stores and wholesale clubs.
Intellectual Property
We have several United States registered trademarks and service
marks for slogans and designs used in our advertisements, member mailings and
member solicitation packages, including the Audio Book Club logo "MediaBay,"
"Radio Spirits", "MediaBay.com," "audiobookclub.com" and the MediaBay logos. We
believe that our trademarks and service marks have significant value and are
important to our marketing. We also own or license the rights to substantially
all of our radio programs in our content library.
We rely on trade secrets and proprietary know-how and employ various
methods to protect our ideas, concepts and membership database. In addition, we
typically obtain confidentiality agreements with our executive officers,
employees, list managers and appropriate consultants and service suppliers.
6
Employees
As of April 10, 2003, we had 50 full-time employees. Of these
employees, 5 served in corporate management; 28 served in operational positions
at our Audio Book Club operations; 5 served in operational positions at our
MediaBay.com operations and 12 served in operational positions at our old-time
radio operations. We believe our employee relations to be good. None of our
employees are covered by a collective bargaining agreement.
RISK FACTORS
Risks Related to our Operations
Our products are sold in a niche market that is still evolving and may have
limited future growth potential.
We believe that the market for audiobooks has expanded rapidly in
recent years. However, consumer interest in audiobooks and old time radio may
decline in the future, and growth trends in these markets may stagnate or
decline. The sale of audiobooks through mail order clubs and over the Internet
are emerging retail concepts, and audiobooks are still evolving as a niche
market. As is typically the case in an evolving industry, the ultimate level of
demand and market acceptance for our products is subject to a high degree of
uncertainty. A decline in the popularity of audiobooks and old time radio would
limit our future growth potential and negatively impact our future operating
results.
We may be unable to anticipate changes in consumer preference for our products
and may lose sales opportunities.
Our success depends largely on our ability to anticipate and respond
to a variety of changes in the audiobook and old-time radio industries. These
changes include economic factors affecting discretionary consumer spending,
modifications in consumer demographics and the availability of other forms of
entertainment. The audiobook and old time radio markets are characterized by
changing consumer preferences, which could affect our ability to:
o plan for catalog offerings;
o introduce new titles;
o anticipate order lead time;
o accurately assess inventory requirements; and
o develop new product delivery methods.
Although we evaluate many factors and attempt to anticipate the
popularity and life cycle of audiobook titles, the ultimate level of demand for
specific titles is subject to a high level of uncertainty. Sales of audiobook
titles typically decline rapidly after the first few months following release.
If sales of specific titles decline more rapidly than we expect, we could be
left with excess inventory, which we might be forced to sell at reduced prices.
If we fail to anticipate and respond to factors affecting the audiobook industry
in a timely manner, we could lose significant amounts of capital or potential
sales opportunities.
We may experience system interruptions, which affect access to our websites and
our ability to sell products over the Internet.
Our future revenues may depend in part on the number of web site
visitors who join as Audio Book Club members and who make online purchases. The
satisfactory performance, reliability and availability of our web sites,
transaction-processing systems and network infrastructure are critical to our
ability to attract and retain visitors at our web sites. If we experience system
interruptions that prevent customers and potential customers from accessing our
web sites, consumer perception of our on-line business could be adversely
affected, and we could lose sales opportunities and visitor traffic.
We may not be able to license or produce desirable spoken word content, which
could reduce our revenues.
7
We could lose sales opportunities if we are unable to continue to
obtain the rights to additional audiobook libraries or selected audiobook
titles. We may not be able to renew existing license and supply arrangements for
audiobook publishers' libraries or enter into additional arrangements for the
supply of new audiobook titles.
If our third-party providers fail to perform their services properly, our
business and results of operations could be adversely affected.
Third-party providers conduct all of our Audio Book Club customer
service operations, process orders and collect payments for us. If these
providers fail to perform their services properly, Audio Book Club members could
develop negative perceptions of our business, collections of receivables could
be delayed and our operations might not function efficiently.
If our marketing strategies to acquire new members are not successful, our costs
would increase, and we will not acquire as many members as we anticipate, which
would inhibit our sales growth.
If our direct mail and other marketing strategies are not
successful, our per member acquisition costs may increase and we may acquire
fewer new members than anticipated. As a result, our operating results would be
negatively impacted and our sales growth would be inhibited.
The public may become less receptive to unsolicited direct mail campaigns.
The success of our direct mail campaigns is dependent on many
factors including the public's acceptance of direct mail solicitations. Negative
public reception of direct mail solicitations will result in lower customer
acquisitions rates and higher customer acquisition costs and will negatively
impact operating results and sales growth.
Increased member attrition could negatively impact our future revenues and
operating results.
Increases in membership attrition above the rates we anticipate
could materially reduce our future revenues. We incur significant up front
expenditures in connection with acquiring new members. A member may not honor
his or her commitment, or we may choose to terminate a specific membership for
several reasons, including failure to pay for purchases, excessive returns or
cancelled orders. As a result, we may not be able to fully recoup our costs
associated with acquiring new members. In addition, once a member has satisfied
his or her initial commitment to purchase additional audiobooks at regular
prices, the member has no further commitment to make purchases.
The closing of retail stores which carry our products could negatively impact
our wholesale sales of these products.
Bankruptcy filings by major retailers may limit the number of
outlets for our old-time radio products. With fewer chains and stores available
as distribution outlets, competition for shelf space will increase and our
ability to sell our products could be impacted negatively. Moreover, our
wholesale sales could be negatively impacted if any of our significant retail
customers were to close a significant number of their locations or otherwise
discontinue selling our products.
If third parties obtain unauthorized access to our member and customer databases
and other proprietary information, we would lose the competitive advantage they
provide.
We believe that our member file and customer lists are valuable
proprietary resources, and we have expended significant amounts of capital in
acquiring these names. Our member and customer lists, trade secrets, trademarks
and other proprietary information have limited protection. Third parties may
copy or obtain unauthorized access to our member and customer databases and
other proprietary know-how, trade secrets, ideas and concepts.
Competitors could also independently develop or otherwise obtain
access to our proprietary information. In addition, we rent our lists for
one-time use only to third parties that do not compete with us. This practice
subjects us to the risk that these third parties may use our lists for
unauthorized purposes, including selling them to our competitors. Our
confidentiality agreements with our executive officers, employees, list managers
and appropriate consultants and service suppliers may not adequately
8
protect our trade secrets. If our lists or other proprietary information were to
become generally available, we would lose a significant competitive advantage.
If we are unable to pay our accounts payable in a timely manner, our suppliers
and service providers may refuse to supply us with products or provide services
to us.
At December 31, 2002, we owed approximately $11.5 million to trade
and other creditors. Approximately $4.6 million of these accounts payable were
more than 60 days past due. If we do not make satisfactory payments to our
vendors they may refuse to continue to provide us products or services on
credit, which could interrupt our supply of products or services.
Higher than anticipated product return rates could reduce our future operating
results.
We experienced product return rates of approximately 26%, 24%, and
26% during the years ended December 31, 2002, 2001 and 2000, respectively. If
members and customers return products to us in the future at higher rates than
in the past or than we currently anticipate, our net sales would be reduced and
our operating results would be adversely affected.
If we are unable to collect our receivables in a timely manner, it may
negatively impact our cash flow and our operating results.
We are subject to the risks associated with selling products on
credit, including delays in collection or uncollectibility of accounts
receivable. If we experience significant delays in collection or
uncollectibility of accounts receivable, our liquidity and working capital
position could suffer and we could be required to increase our allowance for
doubtful accounts, which would increase our expenses.
Increases in costs of postage could negatively impact our operating results.
We distribute millions of mailings each year, and postage is a
significant expense in the operation of our business. We do not pass on the
costs of member mailings and member solicitation packages. Even small increases
in the cost of postage, multiplied by the millions of mailings we conduct, would
result in increased expenses and would negatively impact our operating results.
We face significant competition from a wide variety of sources for the sale of
our products.
We compete with other web sites, which offer similar entertainment
products or content, including digital download of spoken word content. New
competitors, including large companies, may elect to enter the markets for
audiobooks and spoken word content. We also compete for discretionary consumer
spending with mail order clubs and catalogs, other direct marketers and
retailers that offer products with similar entertainment value as audiobooks and
old time radio and classic video programs, such as music on cassettes and
compact discs, printed books, videos, and laser and digital video discs. Many of
these competitors are well-established companies, which have greater financial
resources that enable them to better withstand substantial price competition or
downturns in the market for spoken word content.
The audiobook and mail order industries are intensely competitive.
We compete with all other outlets through which audiobooks and other spoken word
content are offered, including:
o bookstores;
o audiobook stores which rent or sell only audiobooks;
o mail order companies that offer audiobooks for rental and sale
through catalogs;
o web sites such as Amazon.com; and
o retail establishments such as convenience stores, video rental
stores and wholesale clubs.
Risks Related to Our Financial Condition
Our obligations to repurchase shares of our common stock in the future will
divert available cash from use in operations; and we may not have the funds
available to meet our obligations.
9
We granted sellers in our acquisitions the right to sell back to us
shares of our common stock that we issued to them. Unless our common stock
satisfies specific price targets and/or trading volume requirements, these
rights could require us to purchase up to 305,000 shares in the future at a cost
to us of approximately $4.6 million as follows: (i) 25,000 shares at a cost of
$350,000 commencing December 31, 2003, (ii) 230,000 shares at a cost of
$3,450,000 commencing December 31, 2004 and (iii) 50,000 shares at a cost of
$750,000 commencing December 31, 2005. Even if we have the funds available to
meet those obligations, such payments will adversely affect our cash flow and
will divert cash from use in operations. We may not have sufficient funds to
meet these obligations to repurchase stock in the future, which could result in
the holders of these rights commencing lawsuits to enforce their rights.
Risks Related to Our Capital Structure
The Herrick family exerts significant influence over shareholder matters.
Norton Herrick, Michael Herrick and Howard Herrick, their family
members and affiliates own approximately 40% of our outstanding common stock. As
significant shareholders and directors, they are able generally to direct our
affairs and exert significant influence over matters, which require director or
shareholder vote, including the election of directors, amendments to our
Articles of Incorporation or approval of the dissolution, merger, or sale of
MediaBay, our subsidiaries or substantially all of our assets. This
concentration of ownership by the Herrick family could delay or prevent a change
in our control, even when a change in control might be in the best interests of
other shareholders.
The terms of our debt impose restrictions on our business.
As of December 31, 2002 we had approximately $4.6 million of debt
outstanding under our revolving line of credit and approximately $12.5 million
principal amount of debt outstanding and related accrued interest under
convertible promissory notes. Our line of credit restricts our ability to raise
financing for working capital purposes because it requires us to use any
proceeds from equity or debt financings, with limited exceptions, to repay
amounts outstanding under the credit agreement. In addition to limiting our
ability to incur additional indebtedness, our existing indebtedness under our
revolving line of credit limits or prohibits us from, among other things:
o merging into or consolidating with another corporation;
o selling all or substantially all of our assets;
o declaring or paying cash dividends; or
o materially changing the nature of our business.
We have to make substantial payments on our debt during 2003 and 2004 and may
not have the funds to do so.
We are required to make monthly payments of principal on the line of
credit of $180,000 in April through June 2003; $190,000 in July through
September 2003, $200,000 in October through December 2003 and $225,000 in
January through March 2004. The remaining balance of $1.6 million under our line
of credit is due on April 30, 2004, an additional $10.0 million, including
accrued and unpaid interest, is due upon demand of the holders of certain
convertible promissory notes, which may be made at various times following
repayment of the line of credit and an additional $3.2 million under convertible
promissory notes is due on December 31, 2004. We might not have sufficient funds
to repay the debt, obtain other financing to replace the debt or obtain an
extension of its maturity. In addition, if an event of default occurs under the
convertible promissory notes or senior credit facility, the indebtedness would
become due and payable.
10
Our ability to use our net operating losses may be limited in future periods,
which could increase our tax liability.
Under Section 382 of the Internal Revenue Code of 1986, utilization
of prior net operating losses is limited after an ownership change, as defined
in Section 382, to an annual amount equal to the value of the corporation's
outstanding stock immediately before the date of the ownership change multiplied
by the long-term tax exempt rate. In the event we achieve profitable operations,
any significant limitation on the utilization of net operating losses would have
the effect of increasing our tax liability and reducing after tax net income and
available cash reserves. We are unable to determine the availability of net
operating losses since this availability is dependent upon profitable
operations, which we have not achieved in prior periods.
Our stock price has been and could continue to be extremely volatile.
The market price of our common stock has been subject to significant
fluctuations since our initial public offering in October 1997. The securities
markets have experienced, and are likely to experience in the future,
significant price and volume fluctuations, which could adversely affect the
market price of our common stock without regard to our operating performance. In
addition, the trading price of our common stock could be subject to significant
fluctuations in response to:
o our ability to maintain listing of our common stock on NASDAQ;
o actual or anticipated variations in our quarterly operating
results;
o announcements by us or other industry participants,
o factors affecting the market for spoken word content;
o changes in national or regional economic conditions;
o changes in securities analysts' estimates for us, our
competitors' or our industry or our failure to meet such
analysts' expectations; and
o general market conditions.
Substantially all shares of common stock are currently eligible for sale and
could be sold in the market in the near future, which could depress our stock
price.
As of April 10, 2003, we have outstanding approximately 14.3 million
shares of common stock. Substantially all of our shares are currently freely
trading without restriction under the Securities Act of 1933, having been
registered for resale or held by their holders for over 2 years and are eligible
for sale under Rule 144(k). There are currently outstanding options and warrants
and other convertible securities to purchase approximately 27,552,215 shares of
our common stock at an average exercise price of $2.17 per share. A substantial
portion of these shares have been registered for resale. To the extent they are
exercised or converted, your percentage ownership will be further diluted and
our stock price could be further adversely affected. Moreover, as the underlying
shares are sold, the market price could drop significantly if the holders of
these restricted shares sell them or if the market perceives that the holders
intend to sell these shares.
11
Item 2. Description of Property
We lease approximately 12,000 square feet of office space in Cedar
Knolls, New Jersey pursuant to a lease agreement that expires in August 2003 at
a monthly rate of $16,000. We have the option to renew the lease for an
additional three-year period.
The Company entered into two ten-year leases on 7,000 square feet of
office and warehouse space in Bethel, Connecticut and 3,000 square feet of
warehouse space in Sandy Hook, Connecticut, respectively. Lease payments and
mandatory capital improvement payments, starting in 2004, are $4,000 per year
and $2,000 per year on the Bethel and Sandy Hook properties, respectively.
Item 3. Legal Proceedings
We are not a party to any lawsuit or proceeding, which we believe is
likely to have a material adverse effect on us.
Item 4. Submission of Matters to a Vote of Security Holders
An Annual Meeting of Shareholders was held on November 27, 2002, at
which time Mr. Michael Herrick and Mr. Roy Abrams were reappointed to serve as a
Class I directors until the Annual Meeting of Shareholders of the Company to be
held in 2005. Shareholder voting for these directors was as follows:
Director Votes For Votes Withheld
- -------- --------- --------------
Michael Herrick 13,772,495 51,123
Roy Abrams (*) 13,695,267 128,351
(*) In February 2003, Mr. Abrams resigned as a director.
The following directors serve as directors for the term indicated
opposite their respective names:
Director Class Expiration of Term
- -------- ----- ------------------
Norton Herrick I 2004
Paul Ehrlich I 2004
Joseph Rosetti I 2004
Michael Herrick II 2005
Mark Hershhorn II 2005
Howard Herrick III 2003
Carl Wolf III 2003
In addition, at the annual meeting, the Company's shareholders
approved the Company's issuance of common stock upon the conversion of certain
convertible notes or equity securities and upon exercise of warrants previously
issued and which may be issued to affiliates of the Company as set forth in the
proxy statement relating to the annual meeting by a vote of 7,740,102 votes for,
147,286 votes against, 35,700 votes abstaining and 5,900,530 broker non-votes.
12
PART II
Item 5. Market for Common Equity and Related Stockholder Matters
MediaBay's common stock has been quoted in the Nasdaq National Market under the
symbol "MBAY" since November 15, 1999. The following table shows the high and
low sales prices of our common stock as reported by the Nasdaq National Market.
High Low
---- ---
Fiscal Year Ended December 31, 2001
First Quarter $1.625 $.531
Second Quarter 1.05 .50
Third Quarter 1.06 .56
Fourth Quarter .99 .43
Fiscal Year Ended December 31, 2002
First Quarter 3.50 .59
Second Quarter 6.04 3.20
Third Quarter 4.90 .77
Fourth Quarter 1.63 .77
Fiscal Year Ended March 31, 2003
First Quarter 1.27 .77
On April 10, 2003 the last reported sale price of our common stock
on the Nasdaq National Market was $.84 per share. As of April 10, 2003, there
were approximately 148 record owners of our common stock. We believe that there
are more than 400 beneficial owners of our common stock.
Dividend Policy
We have never declared or paid and do not anticipate declaring or
paying any dividends on our common stock in the near future. The terms of our
debt agreements prohibit us from declaring or paying any dividends or
distributions on our common stock. Any future determination as to the
declaration and payment of dividends will be at the discretion of our Board of
Directors and will depend on then existing conditions, including our financial
condition, results of operations, capital requirements, business factors and
other factors as our Board of Directors deems relevant.
Sales of Securities and Use of Proceeds
During the three months ended December 31, 2002, we issued options
under our 2001 and 2000 Stock Incentive Plans to purchase a total of 915,000
shares of our common stock to officers, directors and consultants. We relied on
the exemptions provided by Section 4(2) of the Securities Act of 1933 in
connection with such issuances.
Equity Compensation Plan Table
See Part III, Item 12.
Item 6. Selected Financial Data
The Company is restating its previously issued consolidated
financial statements as of December 31, 2000 and 2001 and for the years ended
Decmber 31, 1999, 2000 and 2001 to correct errors in the accounting treatment
relating to previously disclosed financing transactions. The amounts presented
herein reflect the restatement of these financial statements. The effects of
this restatement on the consolidated financial statements as of and for the
years ended December 31, 2000 and 2001 are presented in Part II. Item 6
"Selected Financial Data" and Item 7 "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and Note 2 to Notes to the
Consolidated Financial Statements of this Form 10-K. The effects of this
restatement on the consolidated financial statements for the year ended December
31, 1999 and as of December 31, 1998 and 1999 are presented in Item 6 "Selected
Financial Data."
13
The balance sheet and statement of operations for the year ended
December 31, 1999 gives effect to the purchase of Doubleday Direct's Audiobooks
Direct club on June 15, 1999. Additionally, the balance sheet and statement of
operations data for the year ended December 31, 1998 gives effect to the
following transactions:
o The acquisition of Radio Spirits, Inc., the assets of an affiliated
company, Buffalo Productions, Inc., and a 50% interest in a joint
venture owned by the sole shareholder of Radio Spirits on December
14, 1998.
o The acquisition of substantially all of the assets used by Metacom,
Inc. in connection with its Adventures in Cassettes business on
December 14, 1998.
o The acquisition of substantially all of the assets used by Premier
Electronics Laboratories, Inc. in connection with its old-time radio
and classic video businesses on December 14, 1998.
o The acquisition of substantially all of the assets of Columbia
House's Audiobook Club on December 31, 1998.
Beginning in January 1999, the Company was required to capitalize
direct response marketing costs for the acquisition of new members in accordance
with AICPA Statement of Position 93-7 "Reporting on Advertising Costs" and
amortizes these costs over the period of future benefit. Since 1999 was the
first year we capitalized new member acquisitions costs, we capitalized direct
response advertising expenditures in 1999 and did not amortize advertising from
1998 since it had been previously expensed as incurred.
In the third quarter of 2001, we began to implement a series of
actions and decisions designed to improve gross profit margin, refine our
marketing efforts and reduce general and administrative costs. In connection
with the movement of the fulfillment of old-time radio products to a third party
provider, in the first quarter of 2002, we closed our old-time radio operations
in Schaumburg, Illinois and now run all of our operations, except for
fulfillment, from our corporate headquarters located in Cedar Knolls, New
Jersey. In the third quarter of 2001, as a result of the actions and decisions
made after our aforementioned review of our operations, we recorded $11.3
million of strategic charges. In addition to these strategic charges, we
recorded a charge of $2.0 million to write-off the entire carrying amount of our
cost method investment in I-Jam.
During the fourth quarter of 2000, the Company reviewed long-lived
assets and certain related identifiable intangibles, including goodwill, for
impairment. As a result, in the fourth quarter of 2000, the Company determined
that the goodwill associated with certain acquired businesses was impaired and
recorded an impairment charge of $38.2 million.
As a result of the series of strategic initiatives described above,
our operations have improved. Although realization of net deferred tax assets is
not assured, we have determined, based on our improved operations, that it is
more likely than not that a portion of our deferred tax asset relating to
temporary differences between the tax bases of assets or liabilities and their
reported amounts in the financial statements will be realized in future periods.
Accordingly, in 2001, we reduced the valuation allowance for deferred tax assets
in the amount of $17.2 million and recorded an income tax benefit.
As a result of the capitalization of direct response advertising
costs, recording of the goodwill write-off, the strategic charges and the income
tax benefit, as well as fluctuations in operating results depending on the
timing, magnitude and success of Audio Book Club new member advertising
campaigns, comparisons of our historical operating results from year to year may
not be meaningful.
14
(1) Years Ended December 31,
--------------------------------------------------------
(3) (4) (5)
Restated Restated Restated
1998 1999 2000 2001 2002
---- ---- ---- ---- ----
(thousands, except per share data)
Statement of Operations Data:
Net sales 14,894 46,227 44,426 41,805 45,744
Cost of sales 9,452 23,687 23,044 19,783 20,651
Cost of sales - write-downs -- -- -- 2,261 --
Advertising and promotion 8,910 8,118 11,023 11,922 10,156
Advertising and promotion - write-downs -- -- -- 3,971 --
General and administrative 3,330 10,762 14,406 11,483 11,168
Asset write-downs and strategic charges -- -- -- 7,044 --
Depreciation and amortization 367 6,812 7,984 5,156 1,314
Non-cash write-down of intangibles -- -- -- -- 1,224
Non-cash write-down of goodwill -- -- 38,226 -- --
-------- -------- -------- -------- --------
Operating (loss) income (7,165) (3,152) (50,257) (19,815) 1,231
Interest income (expense), net 180 (6,271) (2,940) (2,790) (2,974)
-------- -------- -------- -------- --------
Loss before income tax benefit (expense)
and extraordinary item (6,985) (9,423) (53,197) (22,605) (1,743)
Income tax benefit (expense) -- -- -- 17,200 (550)
-------- -------- -------- -------- --------
Loss before extraordinary item (6,985) (9,423) (53,197) (5,405) (2,293)
Extraordinary gain (loss) on early extinguishment
of debt -- 999 (2,152) -- --
-------- -------- -------- -------- --------
Net loss (6,985) (8,424) (55,349) (5,405) (2,293)
Dividends on preferred stock -- -- -- -- 217
-------- -------- -------- -------- --------
Net loss applicable to common shares $ (6,985) $ (8,424) $(55,349) $ (5,405) $ (2,510)
======== ======== ======== ======== ========
Basic and diluted loss per share:
Basic and diluted loss before extraordinary item $ (1.13) $ (1.15) $ (4.18) $ (0.39) $ (0.18)
======== ======== ======== ======== ========
Basic and diluted loss applicable to common shares $ (1.13) $ (1.03) $ (4.35) $ (0.39) $ (0.18)
======== ======== ======== ======== ========
Basic and diluted weighted average number of shares outstanding 6,188 8,205 12,718 13,862 14,086
======== ======== ======== ======== ========
(1) As of December 31,
---------------------------------------------------------
(2) (3) (4) (5)
Restated Restated Restated Restated
1998 1999 2000 2001 2002
---- ---- ---- ---- ----
(thousands, except per share data)
Balance Sheet Data:
Working capital (deficit) $ 6,571 $ 1,599 $ 313 $ (4,167) $ (4,336)
Total assets 64,339 93,973 49,932 44,452 48,619
Current liabilities 8,231 20,275 17,103 15,491 18,984
Long-term debt 38,095 36,134 15,340 15,849 14,680
Common stock subject to contingent put rights 8,284 4,283 4,550 4,550 4,550
Stockholders' equity 9,729 33,281 12,939 8,562 10,405
(1) Restated to reflect a change in the accounting for warrants issued
in December 1998, charges related beneficial conversion features
within convertible notes, and the recording of compensation expense
for warrants. See Note 2, Restatement, in the notes to the
consolidated financial statements.
(2) Restated to reflect an original issue discount on long-term debt
relating to accounting for warrants issued in a December 1998
financing transaction of $1,905 and a corresponding increase in
stockholders' equity
(3) Restated to reflect an increase in non-cash expenses and net loss
applicable to common shares of $1,716, resulting in an increase of
$0.21 in the loss per share. As previously reported, net loss and
loss per share for the year ended December 31, 1999 were $6.7
million and $0.82, respectively.
(4) Restated to reflect an increase in non-cash expenses and net loss of
$701, resulting in an increase of $0.05 in the loss per share. As
previously reported, net loss and loss per share for the year ended
December 31, 2000 were $54.6 million and $4.30, respectively.
(5) Restated to reflect an increase in non-cash interest expense and net
loss of $555, resulting in an increase of $0.04 in the loss per
share. As previously reported, net loss and loss per share for the
year ended December 31, 2001 were $4.9 million and $ 0.35,
respectively.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Restatement of Previously Issued Financial Statements
As discussed in Note 2, Restatement of Previously Issued Financial
Statements, the Company has restated its financial statements as of December 31,
2001 and for the years ended December 31, 2001 and 2000 to correct errors in the
accounting treatment of certain previously disclosed financing transactions. The
Management's Discussion and Analysis of Financial Condition and Results of
Operations gives effect to this restatement.
15
Introduction
We are a seller of spoken audio and nostalgia products, including
audiobooks and old-time radio shows, through direct response, retail and
Internet channels. Our content and products are sold in multiple formats,
including physical (cassette and compact disc) and secure digital download
formats.
We report financial results on the basis of four business segments;
Corporate, Audio Book Club ("ABC"), Radio Spirits ("Radio Spirits" or "RSI") and
MediaBay.com. A fifth division, Radio Classics, is aggregated with Radio Spirits
for financial reporting purposes. Except for corporate, each segment serves a
unique market segment within the spoken word audio industry. In 2002, our Audio
Book Club segment had net sales of approximately $34.3 million, our Radio
Spirits segment had net sales of approximately $11.4 million, our MediaBay.com
segment had sales of approximately $0.2 million and we had eliminating
inter-segment sales of $0.2 million.
In the third quarter of 2001, we began to implement a series of
actions and decisions designed to improve gross profit margin, refine our
marketing efforts and reduce general and administrative costs. Specifically, we
(i) reduced the number of items offered for sale at both its Radio Spirits and
Audio Book Club subsidiaries, (ii) moved fulfillment of our old-time radio
products to a third party fulfillment provider, (iii) limited our investment and
marketing efforts in downloadable audio due to lack of customer acceptance at
this time, and the limited number and high price point of digital audio download
players currently produced and (iv) refined our marketing of old-time radio
products and our marketing efforts to existing Audio Book Club members. In
connection with the movement of the fulfillment of old-time radio products to a
third party provider, in the first quarter of 2002, we closed our old-time radio
operations in Schaumburg, Illinois and now run all of our operations, except for
fulfillment, from our corporate headquarters located in Cedar Knolls, New
Jersey. In the third quarter of 2001, as a result of the actions and decisions
made after our aforementioned review of our operations, we recorded $11.3
million of write-downs and strategic charges, as described below. In addition to
these strategic charges, we recorded a charge of $2.0 million to write-off the
entire carrying amount of our cost method investment in I-Jam.
During the fourth quarter of 2000, we reviewed long-lived assets and
certain related identifiable intangibles, including goodwill, for impairment in
accordance with Statement of Financial Accounting Standards No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
Of" ("SFAS 121") due to a change in facts and circumstances. We determined that
the revised estimates of cash flows from certain of our acquired operations
would no longer be sufficient to recover the carrying value of goodwill
associated with these businesses. As a result, in the fourth quarter of 2000, we
determined that the goodwill associated with these businesses was impaired and
recorded an impairment charge of $38.2 million. The impairment charge was
measured as the difference between the carrying value of the goodwill and its
fair value, which was based upon discounted cash flows.
As a result of the series of strategic initiatives, described above,
our operations have improved. Although realization of net deferred tax assets is
not assured, we have determined, based on our improved operations, that it is
more likely than not that a portion of our deferred tax asset relating to
temporary differences between the tax bases of assets or liabilities and their
reported amounts in the financial statements will be realized in future periods.
Accordingly, in 2001 we reduced the valuation allowance for deferred tax assets
in the amount of $17.2 million and recorded an income tax benefit.
During the fourth quarter of 2002, the Company reviewed the carrying
amounts of its intangible assets and determined, based on decisions made in the
fourth quarter of 2002, that the value of certain intangible assets could no
longer be supported by anticipated future operations. Specifically, the Company
made a strategic decision to no longer compete in the DVD market and accordingly
wrote off the value of certain video and DVD rights it had acquired in the
amount of $90. The Company made the decision in the fourth quarter of 2002 to no
longer pursue other companies, which may be infringing on the Freeny patent and
accordingly began discussions with E-Data regarding a re-negotiation of the
agreement between the two parties. On April 3, 2003, the parties concluded their
negotiations and the Company will be returning certain acquired rights to E-Data
in return for 25,000 shares of MediaBay common stock provided to E-Data in the
original transaction. Because the decision not to pursue possible infringers was
made in 2002 and the discussions with E-Data Commenced in 2002, the Company has
written-off the unamortized carrying value of the E-Data license, less the
market value of the 25,000 shares of MediaBay common stock to be returned to
MediaBay, which has been recorded as a receivable due from E-Data to the
Company. The Company has recorded a write-off of $148,000 in 2002. The Company
also made the strategic decision in the fourth quarter of 2002 to discontinue
future mailings to the Columbia House lists of members of other clubs, which
could not support the carrying value of the Columbia
16
House mailing agreement. Accordingly, in the fourth quarter of 2002, the Company
wrote off the remaining value of the Columbia House mailing agreement of $986.
As a result of the recording of the goodwill write-off, the
strategic charges, the write-off of intangibles and the income tax benefit, as
well as fluctuations in operating results depending on the timing, magnitude and
success of Audio Book Club new member advertising campaigns, comparisons of our
historical operating results from year to year may not be meaningful.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results
of operations are based on our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of financial statements requires us to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosures of contingent assets
and liabilities. On an on-going basis we evaluate our estimates including those
related to product returns, bad debts, the carrying value and net realizable
value of inventories, the recoverability of advances to publishers and other
rightsholders, the future revenue associated with deferred advertising and
promotion costs, investments, fixed assets, the valuation allowance provided to
reduce our deferred tax assets and valuation of goodwill and other intangibles.
The Securities and Exchange Commission ("SEC") defines "critical
accounting policies" as those that require application of management's most
difficult, subjective or complex judgments, often as a result of the need to
make estimates about the effect of matters that are inherently uncertain and may
change in subsequent periods.
Our significant accounting policies are described in Note 3 to the
Notes to Consolidated Financial Statements. Not all of these significant
accounting policies require management to make difficult, subjective or complex
judgments or estimates. However the following policies are considered to be
critical within the SEC definition:
Revenue Recognition
The Company derives its principal revenue through sales of audiobooks,
classic radio shows and other spoken word audio products directly to
consumers principally through direct mail. The Company also sells classic
radio shows to retailers either directly or through distributors. The
Company derives additional revenue through rental of its proprietary
database of names and addresses to non-competing third parties through
list rental brokers. The Company also derives a small amount of revenue
from advertisers included in its nationally syndicated classic radio
shows. The Company recognizes sales to consumers, retailers and
distributors upon shipment of merchandise. List rental revenue is
recognized on notification by the list brokers of rental by a third party
when the lists are rented. The Company recognizes advertising revenue upon
notification of the airing of the advertisement by the media buying
company representing the Company. Allowances for future returns are based
upon historical experience and evaluation of current trends.
We record reductions to our revenue for future returns and record an
estimate of future bad debts arising from current sales in general and
administrative expenses. These allowances are based upon historical
experience and evaluation of current trends. If members and customers
return products to us in the future at higher rates than in the past or
than we currently anticipate, our net sales would be reduced and our
operating results would be adversely affected. In November 2001, the
Emerging Issues Task Force ("EITF") issued EITF No. 01-9, "Accounting for
Consideration Given by a Vendor to a Customer (Including a Reseller of the
Vendor's Products)", which addresses the income statement classification
of certain credits, allowances, adjustments, and payments given to
customers for the services or benefits provided. The Company adopted EITF
No. 01-9 effective January 1, 2002, and, as such, has classified the cost
of these sales incentives as a reduction of sales. The effect
17
on sales of applying EITF No. 01-9 in 2002 was $118,000.
Deferred Member Acquisition Costs
We are required to capitalize direct response marketing costs for the
acquisition of new members in accordance with AICPA Statement of Position
93-7 "Reporting on Advertising Costs" and amortize these costs over the
period of probable future benefits. In order to determine the amount of
advertising to be capitalized and the manner and period over which the
advertising should be amortized, we prepare estimates of probable future
revenues arising from the direct-response advertising in excess of future
costs to be incurred in realizing those revenues. If future revenue does
not meet our estimates or if members buying patterns were to shift,
adjustments to the amount and manner of amortization would be required. At
December 31, 2002 we had deferred member acquisition costs of $7.4
million, which is being amortized over the next thirty months.
Accounts Receivable Valuation
We record an estimate of our anticipated bad debt expense based on our
historical experience. If the financial condition of our customers,
including either individual consumers or retail chains, were to deteriorate,
resulting in their inability to make payment to us, additional allowances
would be required. For example, a one percent increase in returns as a
percentage of gross sales for the year ended 2002, assuming a constant gross
profit percentage and all other expenses unchanged, would have resulted in a
decrease in net sales of $619,000 and a increase in net loss available to
common shares of $340,000. A one percent increase in bad debt expenses as a
percentage of net sales, assuming all other expenses were unchanged, would
have resulted in an increase in general and administrative expenses and a
corresponding increase in net loss available to common shares of $457,000.
Income Taxes
The ultimate realization of deferred tax assets is dependent on the
generation of future taxable income during the periods in which temporary
timing differences become deductible. As a result of a series of strategic
initiatives, our operations have improved. Although realization of net
deferred tax assets is not assured, management has determined, based on the
Company's improved operations, that it is more likely than not that a
portion of our deferred tax asset relating to temporary differences between
the tax bases of assets or liabilities and their reported amounts in the
financial statements will be realized in future periods. At December 31,
2002, we have recorded a deferred tax asset in the amount of $16.2 million.
Should we determine we would be able to realize deferred tax assets in the
future in excess of the net recorded amount, an adjustment to our deferred
tax asset would increase income in the period such determination is made.
Likewise, should we determine that we will not be able to realize all or
part of our net deferred tax asset in the future, an adjustment to the
deferred tax asset would be charged to income in the period such
determination is made.
Goodwill
Goodwill represents the excess of the purchase price over the fair value of
net assets acquired in business combinations accounted for using the
purchase method of accounting. In July 2001, the Financial Accounting
Standards Board issued SFAS No. 142, "Goodwill and Other Intangible Assets".
SFAS No. 142 requires that an intangible asset that is acquired shall be
initially recognized and measured based on its fair value. The statement
also provides that goodwill should not be amortized, but shall be tested for
impairment annually, or more frequently if circumstances indicate potential
impairment, through a comparison of fair value to its carrying amount. At
December 31, 2002, we had $9.9 million of goodwill, all of which relates to
our Radio Spirits operations. The Company completed its initial transitional
impairment test as of January 1, 2002 and its annual impairment test as of
October 31, 2002 in connection with the annual budgeting and planning
process, which did not result in an impairment loss. However, if conditions
or circumstances were to
18
change resulting in a deterioration of our Radio Spirits business, a future
impairment of goodwill could be necessary.
Results of Operations
The following table sets forth, for the periods indicated,
historical operating data as a percentage of net sales.
Year Ended
December 31,
2000 2001 2002
---- ---- ----
Sales ............................................ 100% 100% 100%
==== ==== ====
Cost of sales .................................... 52 47 45
Cost of sales - write-downs ...................... -- 5 --
Advertising and promotion ........................ 25 29 22
Advertising and promotion - write-downs .......... -- 10 --
General and administrative expense ............... 32 27 24
Asset write-downs and strategic charges .......... -- 17 --
Depreciation and amortization expense ............ 18 12 3
Non-cash write-down of intangibles ............... -- -- 3
Non-cash write-down of goodwill .................. 86 -- --
Interest expense, net ............................ 7 7 7
Income tax expenses (benefit) .................... -- (41) 1
Extraordinary loss on early extinguishment of debt 5 -- --
Net (loss) ....................................... (125) (13) (5)
Dividends on preferred stock ..................... -- -- 0
Net (loss) applicable to common shares ........... (125) (13) (5)
Year ended December 31, 2002 compared with year ended December 31,
2001
Sales for the year ended December 31, 2002 increased $3.9 million or
9.4% to $45.7 as compared to $41.8 million for the year ended December 31, 2001.
Audio Book Club increased sales by $2.5 million, principally due to an increase
in club membership as a result of the Company's marketing efforts to grow the
business. For the year ended December 31, 2002, the Audio Book Club attracted
approximately 294,000 members as compared to approximately 211,000 members who
joined the Audio Book Club during the year ended December 31, 2001. The increase
in Radio Spirits sales, of $1.3 million, is principally attributable to sales of
the World's Greatest Old-Time Radio continuity program, a marketing program
introduced in 2002, which is similar to our Audio Book Club and offers old-time
radio products.
Cost of sales for the year ended December 31, 2002 was $20.7
million. Cost of sales for the year ended December 31, 2001 was $22.0 million,
of which $2.3 million represented a charge for the write-down of inventory in
the third quarter of 2001. Gross profit as a percentage of net sales for the
year ended December 31, 2002 was 55.0%, compared to 47.3% for 2001. Excluding
the write-down of inventory in the third quarter of 2001, gross profit as a
percentage of net sales was 52.7% for the year ended December 31, 2001. The
increase in gross profit is principally due to reduced product costs at both
Audio Book Club and Radio Spirits. The reduction in product costs is due to
better buying, combined purchasing at both Audio Book Club and Radio Spirits and
revisions in the mix of products and packaging at both Audio Book Club and Radio
Spirits.
Advertising and promotion expenses for the year ended December 31,
2002 were $10.2 million. Advertising and promotion expenses for the year ended
December 31, 2001 were $15.9 million of which, $4.0 million represented
write-downs to deferred member acquisition costs. The decrease in reported
advertising costs is principally due to lower expenditures relating to Audio
Book Club new member acquisitions in 2002 as compared to 2001 and the write-down
of deferred member acquisition
19
costs in the third quarter of 2001 which resulted in lower amortization of new
member acquisition costs in 2002 and thus lower reported advertising expense in
2002.
General and administrative expenses decreased $.3 million, or 2.7%,
to $11.2 million for the year ended December 31, 2002 from $11.5 million for the
prior comparable period. General and administrative expense decreases are
principally attributable to reductions at Radio Spirits partially offset by an
increase in bad debt expenses. Bad debt expenses increased $.3 million attendant
with an increase in net sales at Audio Book Club. Bad debt expense as a
percentage of net sales was 6.2% for the year ended December 31, 2002 as
compared to 6.1% for the year ended December 31, 2001. In February 2002, we
moved our Radio Spirits operation from Schaumburg, Illinois to our corporate and
Audio Book Club offices in Cedar Knolls, New Jersey. In addition to giving us
greater control over the operations, general and administrative expenses, other
than bad debt expense, for our Radio Spirits division for the year ended
December 31, 2002 declined by $.9 million as compared to the year ended December
31, 2001. At Radio Spirits, for the year ended December 31, 2002, we reduced
payroll and related costs by $.5 million, office expenses by $.1 million,
telephone expenses by .2 million and legal fees by $.1 million as compared to
the year ended December 31, 2001.
Depreciation and amortization expenses decreased $3.9 million to
$1.3 million for the year ended December 31, 2002 from $5.2 million for the year
ended December 31, 2001. The decrease is principally attributable to the
adoption of SFAS No. 142 "Goodwill and Other Intangible Assets" in 2002 and, to
a lesser extent, certain intangible assets were fully amortized in 2001. SFAS
No. 142 requires that an intangible asset that is acquired shall be initially
recognized and measured based on its fair value. The statement also provides
that goodwill should not be amortized, but shall be tested for impairment
annually, or more frequently if circumstances indicate potential impairment,
through a comparison of fair value to its carrying amount. Existing goodwill
continued to be amortized through the year ended December 31, 2001 at which time
amortization ceased. The amount of goodwill amortized during the year ended
December 31, 2001 was $.5 million. Based on our review for goodwill impairment
in 2002, the Company did not recognize any goodwill impairment in 2002 in
accordance with SFAS No. 142.
During the fourth quarter of 2002, the Company reviewed the carrying
amounts of its intangible assets and determined, based on decisions made in the
fourth quarter of 2002, that the value of certain intangible assets could no
longer be supported by anticipated future operations. Specifically, the Company
made a strategic decision to no longer compete in the DVD market and accordingly
wrote off the value of certain video and DVD rights it had acquired in the
amount of $90,000. The Company also made the strategic decision in the fourth
quarter of 2002 to discontinue future mailings to the Columbia House lists of
members of other clubs. Accordingly, in the fourth quarter of 2002, the Company
wrote off the unamortized value of the Columbia House mailing agreement of
$986,000.
Interest expense for the year ended December 31, 2002 was $3.0
million for the year ended December 31, 2002 and $2.8 million for the year ended
December 31, 2001. Included in interest expense is the amortization of debt
discount resulting from the issuance of warrants and beneficial conversion
features related to certain of our financings. The amount amortized was $.7
million and $.6 million for the years ended December 31, 2002 and 2001,
respectively.
Net loss before income taxes for the year ended December 31, 2002
was $1.7 million as compared to a net loss before income taxes for the year
ended December 31, 2001 of $22.6 million.
As a result of the series of strategic initiatives described above,
our operations have improved. Although realization of net deferred tax assets is
not assured, we determined in 2001, based on our improved operations, that it is
more likely than not that a portion of our deferred tax asset relating to
temporary differences between the tax bases of assets or liabilities and their
reported amounts in the financial statements will be realized in future periods.
Accordingly we reduced the valuation allowance for deferred tax assets in the
amount of $17.2 million and recorded an income tax benefit.
20
During then year ended December 31, 2002, we utilized $550,000 of
the $17.2 million deferred tax asset recorded in 2001. Accordingly, we recorded
an income tax expense of $550,000.
The Company accrued preferred stock dividends of $0.2 million on the
outstanding 25,000 shares of Series A Preferred stock, which were issued in
January 2002.
Net loss applicable to common shares for the year ended December 31,
2002 was $2.5 million, or $.18 per diluted share of common stock as compared to
a net loss of $5.4 million, or $0.39 per diluted share of common stock for the
year ended December 31, 2001.
Year ended December 31, 2001 compared with year ended December 31, 2000
Sales for the year ended December 31, 2001 decreased $2.6 million,
or 5.9%, to $41.8 million from $44.4 million for the year ended December 31,
2001. The decrease in sales is primarily attributable to more focused marketing
at Audio Book Club to concentrate on more profitable new members and
non-recurring I-Jam marketing revenue we recorded in 2000.
Cost of sales for the year ended December 31, 2001 was $22.0
million, of which $2.3 million represented a charge for the write-down of
inventory in the third quarter of 2001. Excluding the write-down, cost of sales
for the year ended December 31, 2001 decreased $3.2 million, or 14.2%, to $19.8
million for the year ended December 31, 2001 from $23.0 million for the year
ended December 31, 2000. The decrease in cost of sales as a percentage of net
sales, is principally due to revisions in the merchandising of our products,
including increases in our selling prices and selection of products, which
contribute greater gross profit. As a result, gross profit as a percentage of
net sales, excluding the write-down, increased to 52.7% for the year ended
December 31, 2001 from 48.1% for the year ended December 31, 2000.
Advertising and promotion expenses for the year ended December 31,
2001 was $15.9 million of which, $4.0 million represented write-downs to
deferred member acquisition costs as described below. Excluding the write-downs,
advertising and promotion expenses increased $0.9 million or 8.2%, to $11.9
million for the year ended December 31, 2001 compared to $11.0 million for the
year ended December 31, 2000. Actual amounts incurred for advertising and
promotion, net of settlements with certain vendors principally for unprofitable
Internet marketing campaigns, for the year ended December 31, 2001 were $8.2
million, a decrease of $6.1 million, from the amount incurred in the year ended
December 31, 2000 of $14.3 million. The difference between the amount expended
and the amount recorded as expense is due to amortization of previously
capitalized direct response advertising costs.
General and administrative expenses decreased $2.9 million, or
20.3%, to $11.5 million for the year ended December 31, 2001 from $14.4 million
for the prior comparable period. General and administrative expense decreases
are principally attributable to decreases in bad debt expenses of $0.1 million
commensurate with the reduction in net sales, payroll and related costs due to
previously announced staff reductions and the inclusion in 2000 of non-cash
compensation expenses related to contingent warrants issued in 2000 of $0.5
million, office expenses of $0.2 million, telephone costs related to a reduction
in "800" service calls of $0.2 million, travel costs of $0.1 million, public
relations costs of $0.6 million and consulting services principally relating to
Internet maintenance and development of $0.4 million. Included in general and
administrative expenses in 2000 were $0.4 million of non-cash compensation
expense relating to contingent warrants issued in 2000. We also benefited from
settlements with certain vendors in 2001.
As a result of the actions and decisions made after our
aforementioned review of our operations, we recorded $11.3 million of strategic
charges in 2001. These charges include the following:
o $2.2 million of inventory written down to net realizable value due
to a reduction in the number of stock keeping units (SKU's);
21
o $2.4 million of write-downs of deferred member acquisition costs at
Audio Book Club related to new member acquisition campaigns that
have been determined to be no longer profitable and recoverable
through future operations based upon historical performance and
future projections;
o $1.9 million of write-downs to royalty advances paid to audiobook
publishers and other license holders primarily associated with
inventory titles that will no longer be carried and sold to members;
o $1.6 million of write-downs to deferred member acquisition costs at
Radio Spirits related to old-time radio new customer acquisition
campaigns that have been determined to be no longer profitable and
recoverable through future operations based upon historical
performance and future projections;
o a write-down of $0.7 million of customer lists acquired in the
Columbia House Audiobook Club purchase due to the inability to
recover this asset through future operations;
o $0.6 million of fixed assets of the old-time radio operations
written down to net realizable value due to the closing of the
Schaumburg, Illinois facility;
o $0.5 million of write-downs of royalty advances paid for
downloadable licensing rights that are no longer recoverable due to
the strategic decisions made;
o $0.4 million of write-downs of prepaid assets,
o $0.3 million of write-offs to receivables that are deemed
uncollectible,
o $0.2 million of net write-offs of capitalized website development
costs related to downloadable audio all of which are no longer
recoverable due to the strategic changes in the business; and
o $0.5 million accrued for lease termination costs in connection with
the closing of the Schaumburg, Illinois facility.
Of these charges, $2.2 million related to inventory write-downs has
been recorded to costs of sales - strategic charges, $4.0 million has been
recorded to advertising and promotion - write-downs and the remaining $5.1
million has been recorded to asset write-downs and strategic charges.
In addition to these strategic charges, we have recorded a charge of
$2.0 million to write-off the entire carrying amount of our investment in I-Jam.
This charge has been recorded to asset write-downs and strategic charges. We
have determined that an other than temporary decline in the value of this
investment has occurred, triggered by a strategic change in the direction of the
investee as a result of continued losses and operating deficiencies, along with
projected future losses.
During the year ended December 31, 2002, the Company recorded the
following activity in its accrual for shutdown expenses related to the move from
Illinois to New Jersey:
Beginning balance, January 1, 2002 $ 531
Employee related costs (115)
Lease termination costs (410)
-----
Balance accrued at December 31, 2002 $ 6
=====
Depreciation and amortization expenses decreased $2.8 million to
$5.2 million for the year ended December 31, 2001 from $8.0 million for the year
ended December 31, 2000. The decrease is principally attributable to the
write-down of goodwill taken in the fourth quarter of 2000. During the fourth
quarter of 2000, we reviewed long-lived assets and certain related identifiable
intangibles, including goodwill, for impairment in accordance with Statement of
Financial Accounting Standards No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121") due
to a change in facts and circumstances. In the fourth quarter of 2000, we made a
strategic decision to reduce spending on marketing to customers acquired in the
acquisitions of the Columbia House Audiobook Club, Doubleday Direct's Audiobooks
Direct and Adventures in Cassettes in order to focus its resources on more
profitable revenue sources. In addition, we sold the remaining inventory
acquired in its acquisition of Adventures in Cassettes and do not expect to
derive any future revenues associated with this business. Consequently, we
determined that the revised estimates of cash flows from such operations would
no longer be sufficient to recover the carrying value of goodwill associated
with these businesses. As a result, in the fourth quarter of 2000, we determined
that the goodwill associated with these businesses was impaired and recorded an
impairment charge of $38.2 million. The impairment charge was measured as the
difference between the carrying value of the goodwill and its fair value, which
was based upon discounted cash flows.
22
Interest expense for the year ended December 31, 2001 decreased $0.2
million to $2.8 million as compared to net interest expense of $3.0 million for
the year ended December 31, 2000. The reduction in interest expense is due to a
lower average outstanding principal balance on our debt, as well as lower
interest rates on the portion of our debt, which has adjustable interest rates.
Included in interest expense is the amortization of debt discount resulting from
the issuance of warrants and beneficial conversion features related to certain
of our financings. The amount amortized was $0.6 million and $0.3 million for
the years ended December 31, 2001 and 2000, respectively.
Net loss before income tax benefit for the year ended December 31,
2001 was $22.6 million as compared to a net loss before income taxes and an
extraordinary item in 2000 of $53.2 million for the year ended December 31,
2000.
As a result of the series of strategic initiatives described above,
our operations have improved. Although realization of net deferred tax assets is
not assured, we have determined, based on our improved operations, that it is
more likely than not that a portion of our deferred tax asset relating to
temporary differences between the tax bases of assets or liabilities and their
reported amounts in the financial statements will be realized in future periods.
Accordingly we reduced the valuation allowance for deferred tax assets in the
amount of $17.2 million and recorded an income tax benefit.
In April 2000, we repaid $20.3 million of our bank debt out of the
net proceeds from our follow-on primary offering. Accordingly, the Company
recorded an extraordinary loss of $2.2 million relating to the write-off of
deferred financing fees incurred in connection with such debt.
Due, in part, to the reduction in the valuation allowance for
deferred tax assets offset by the strategic charges enumerated above, we had a
net loss of $5.4 million, or $0.39 per diluted share of common stock for the
year ended December 31, 2001, as compared to a net loss of $55.3 million or
$4.35 per diluted share of common stock for the year ended December 31, 2000.
Liquidity and Capital Resources
Historically, we have funded our cash requirements through sales of
our equity and debt securities and borrowings from financial institutions and
our principal shareholders. We have implemented a series of initiatives to
increase cash flow. While these initiatives have successfully increased cash
provided by operating activities in 2002, there can be no assurance that we will
not require additional financing to repay debt or fund the expansion of
operations, acquisitions, working capital or other related uses. Management
believes that additional sources of capital are available if required.
For the year ended December 31, 2002, our cash increased by $.3
million, as we had cash provided by operating and financing activities of $1.0
million and $0.4 million, respectively, and we had cash used in investing
activities of $1.1 million. Net cash provided by operating activities
principally consisted of our net loss applicable to common shares of $2.5
million, decreased by depreciation and amortization expenses of $1.3 million,
amortization of deferred financing costs and debt discount of $1.5 million,
utilization of our deferred tax asset resulting in an income tax expense of
$0.6, non-current accrued interest and dividends payable $0.5 million, decreases
in prepaid expenses of $1.1 million and increases in accounts payable and
accrued expenses of $4.0 million. Net cash provided by operations was reduced by
increases in accounts receivable of $2.6 million, inventories of $1.1 million,
royalty advances of $0.3 million and a net increase in deferred member
acquisition costs of $2.5 million.
The decrease in prepaid expenses was principally the result of the
timing of direct mail campaigns in our Audio Book Club business. In 2001, we
incurred certain costs for a January 2002 campaign in December 2001. In 2002, we
mailed our campaign in December 2002 and not in January 2003. The increase in
accounts payable was principally due to increased advertising expenditures as
well as increases in fulfillment costs and inventory purchases as sales
increased. The increase in accounts receivable was primarily attributable to
higher net sales, principally at our Audio Book Club. The increase in
inventories is principally due to the expansion of wholesale sales at Radio
Spirits
23
requiring the maintenance of greater inventory. The increase in deferred member
acquisition cost is principally due to the expansion of our direct mail and
Internet advertising activities to attract new members to Audio Book Club.
Cash used in investing activities was for the acquisition of fixed
assets and the acquisition of the assets used by Great American Audio in their
old-time radio business including the license to The Shadow programs and the
cash paid in connection with the acquisition of an exclusive field of use
license" ("License") to U.S., Canadian and European patents in the spoken audio,
E-book and print-on-demand markets from E-Data Corporation. In the fourth
quarter of 2002, the Company made a strategic decision to no longer pursue other
companies which may be infringing on the Freeny Patent and accordingly impaired
the value of this asset. The Company has reduced the carrying value of the asset
to its net realizable value based upon the value of 25,000 shares of the
Company's common stock to be returned by E-Data to the Company. Accordingly, the
Company has recognized a charge included in non-cash write-down of intangibles
of $148,000.
During the year ended December 31, 2002, we repaid $1.6 million
under our senior credit facility.
On January 18, 2002, Evan Herrick, the son of Norton Herrick, our
Chairman, a brother of Howard Herrick an Executive Vice President and Director
and the brother of Michael Herrick, a Director, exchanged $2.5 million principal
amount of a $3.0 million principal amount convertible note of MediaBay, Inc. in
exchange for 25,000 shares of Series A Preferred Stock of MediaBay, having a
liquidation preference of $2.5 million. The preferred share dividend rate of 9%
($9.00 per share) is the same as the interest rate of the note, and is payable
in additional preferred shares, shares of common stock of MediaBay or cash, at
the holder's option, provided that if the holder elects to receive payment in
cash, the payment will accrue until MediaBay is permitted to make the payment
under its existing credit facility. On December 31, 2002, Evan Herrick sold the
note to the N. Herrick Irrevocable ABC Trust of which Howard Herrick is the
trustee and Norton Herrick is the sole beneficiary.
On February 22, 2002, as previously committed to on May 14, 2001,
Huntingdon Corporation, a business wholly owned by our chairman, purchased a
$500,000 principal amount convertible senior promissory note. The note is
convertible into shares of Common Stock at the rate of $1.82 of principal and/or
interest per share. This note was issued in consideration of a $0.5 million loan
made to us by Huntingdon.The Company recorded an original issue discount to the
note in the amount of $430,658 related to the warrants granted and the
beneficial conversion feature related to the note. The amount of the original
issue discount is being amortized over 16 months, through the earliest date upon
which the holder can demand repayment.
In May 2002, an unaffiliated third party holder of our subordinated
debt converted $1.0 million principal amount of its convertible note into
200,000 shares of our common stock. At December 31, 2002, the principal amount
of the subordinated debt held by the unrelated third party was $3.2 million.
During August and September of 2002, Huntingdon advanced $1.0
million to us, which was converted into a $1.0 million principal amount
convertible promissory note payable to Huntingdon (the "$1.0 Million Note") on
October 3, 2002. The $1.0 Million Note bears interest at the prime rate plus 2
1/2 %, is convertible into shares of common stock at a rate of $2.00 per share
and is due September 30, 2007, provided that the holder may make a demand for
repayment after the Company's existing credit facility is repaid. In connection
with the transaction, we issued to Huntingdon a ten-year warrant to purchase
250,000 shares of Common Stock at an exercise price of $2.00 per share (the
"Initial Warrant"). An original issue discount of $68,034 has been recorded and
is being amortized over 16 months, through the earliest date upon which the
holder can demand repayment.
24
On October 10, 2002, we issued to Huntingdon an additional $150,000
principal amount convertible promissory note to Huntingdon (the "$150,000
Note"). The $150,000 Note is convertible into shares of Common Stock at a rate
of $2.00 per share. The remaining terms of the $150,000 Note are similar to
those of the $1.0 Million Note. Warrants to purchase 37,500 of shares of Common
Stock at an exercise price of $2.00 were also issued to Huntingdon. The
remaining terms of this warrant are similar to those of the Initial Warrant. An
original issue discount of $11,687 has been recorded and is being amortized over
16 months, through the earliest date upon which the holder can demand repayment.
On November 15, 2002, we issued to Huntingdon an additional $350,000
principal amount convertible promissory note to Huntingdon (the "$350,000
Note"). The $350,000 Note is convertible into shares of Common Stock at a rate
of $1.25 per share. The remaining terms of the $350,000 Note are similar to
those of the $1.0 Million Note. At the time of the loan, warrants to purchase
140,000 of shares of Common Stock at an exercise price of $1.25 were also issued
to Huntingdon. The remaining terms of this warrant are similar to those of the
Initial Warrant. An original issue discount of $24,842 has been recorded and is
being amortized over 16 months, through the earliest date upon which the holder
can demand repayment.
On October 3, 2002, each of the $2.5 million and $500,000 principal
amount convertible notes previously issued to Huntingdon were amended to, among
other things, extend the maturity date to September 30, 2007, provided that the
holder of either note may demand repayment of the note on or after our credit
facility is repaid. The $800,000 million principal amount convertible note
issued to Huntingdon was also amended on October 3, 2002 to, among other things,
extend the maturity date to September 30, 2007, provided that beginning on the
90th day after our credit facility is repaid the holder may demand repayment.
Also on October 3, 2002, the $1.98 million principal amount
convertible promissory note previously issued to Norton Herrick and the $500,000
principal amount convertible promissory note issued to Evan Herrick, Norton
Herrick's son, were amended to, among other things, extend the maturity dates to
September 30, 2007; provided that the holder may demand repayment of the note on
or after October 31, 2004 and the holder of the $500,000 note may demand
repayment after December 31, 2004, in each case, if our credit facility has been
repaid.
We received proceeds from the exercise of stock options and warrants
in the amount of $200,000 during the year ended December 31, 2002.
Indebtedness
Following is a summary of the Company's indebtedness to its
creditors:
Credit Facility
As of April 10, 2003, the Company had $4,030,000 of indebtedness
outstanding under the Amended and Restated Credit Agreement dated as of October
3, 2002, as amended, by and among the Company and Radio Spirits, Inc. and Audio
Book Club, Inc., wholly-owned subsidiaries of the Company, as co-borrowers, and
ING (U.S.) Capital LLC, as administrative agent, and the other lenders named
therein (the "Credit Agreement"). The maturity date of the Credit Agreement is
April 30, 2004; provided however, that the Company is required to make monthly
payments of principal of $180,000 in April through June 2003, $190,000 in July
through September 2003, $200,000 in October through December 2003 and $225,000
in January through March 2004. The Company is not permitted to make any
additional borrowings under the Credit Agreement. The interest rate on the
credit facility is equal to the prime rate plus 2 1/2%. The Company granted the
lenders under the Credit Agreement a security interest in substantially all of
the Company's assets and the assets of its subsidiaries and pledged the stock of
its subsidiaries.
The Company is required to maintain Minimum EBITDA, as defined
below, of the following:
25
o $3,000,000 for the period beginning on January 1, 2001
and ending prior to March 31, 2003;
o $4,000,000 for the period beginning on January 1, 2001
and ending prior to June 30, 2003;
o $5,000,000 for the period beginning on January 1, 2001
and ending prior to September 30, 2003;
o $6,000,000 for the period beginning on January 1, 2001
and ending prior to December 31, 2003.
o $7,000,000 for the period beginning on January 1, 2001
and ending prior to March 31, 2004
Under the Credit Agreement, "EBITDA" means, for any period,
the sum of (i) net income, (ii) interest expense, (iii) income
tax expense, (iv) depreciation expense, (v) extraordinary and
nonrecurring losses and (vi) amortization expense, less
extraordinary and nonrecurring gains (in each case, determined
in accordance with generally accepted accounting principles)
plus adjustments for (x) the pro forma effect of any Permitted
Acquisition (as defined in the Credit Agreement) and (y)
non-cash stock compensation; provided that EBITDA shall be
adjusted for the effect of treating the Company's advertising
expense and new member acquisition costs as expensed as
incurred.
The Company was in compliance with this covenant at December
31, 2002.
In addition to limiting the Company's ability to incur additional
indebtedness, the Credit Agreement prohibits the Company from, among other
things:
o merging into or consolidating with another entity;
o selling all or substantially all of its assets;
o declaring or paying cash dividends; and
o materially changing the nature of its business.
We anticipate making the principal payments from cash flow generated
from operations.
The balance of our bank debt, after making the above payments, of
$1.6 million is due April 30, 2004. We are currently seeking to refinance or
extend this debt. Historically we have been able to extend the maturity of this
debt.
Notes Held by Norton Herrick
Norton Herrick, the Company's Chairman and principal shareholder,
holds a $1,984,250 principal amount Convertible Senior Subordinated Promissory
Note due September 30, 2007, except that the holder has the right to demand
repayment of the unpaid principal balance of, and interest on, the note at any
time on or after the later of (i) October 31, 2004 and (ii) the date on which
the Company has repaid all of its obligations under the Credit Agreement. This
note is the remaining portion held by Norton Herrick of a $15 million
subordinated note entered into between Norton Herrick and MediaBay on December
31, 1998.
Interest on this note accrues at the rate of 11% per annum and is
payable on a monthly basis, at the holder's option, in cash or common stock;
provided, however, that cash interest accrues until 10 days after the Company
has paid all of its obligations under the Credit Agreement. On October 3, 2002,
the note was amended to, among other things, provide that interest accrues on
unpaid interest at the interest rate of the note. This note is convertible into
shares of common stock at the rate of $.56 per share, subject to adjustment for
below conversion price issuances. This note is secured by a second lien on the
assets of Radio Spirits.
26
The Company is prohibited from incurring additional indebtedness
(with exceptions), selling all or substantially all of its assets and materially
changing the nature of its business without the prior written consent of the
holder of this note.
Notes held by Huntingdon Corporation
Huntingdon Corporation, a company wholly owned by Norton Herrick,
holds the following promissory notes:
o $2,500,000 principal amount Convertible Senior
Promissory Note (the "$2,500,000 Note") entered into on
May 14, 2001;
o $800,000 principal amount Convertible Senior
Subordinated Promissory Note (the "$800,000 Note")
entered into on May 14, 2001;
o $500,000 principal amount Convertible Senior Promissory
Note (the "$500,000 Note") entered into on February 22,
2002;
o $1,000,000 principal amount Convertible Senior
Promissory Note (the "$1,000,000 Note") entered into on
October 3, 2002;
o $150,000 principal amount Convertible Senior Promissory
Note (the "$150,000 Note") entered into on October 10,
2002; and
o $350,000 principal amount Convertible Senior Promissory
Note (the "$350,000 Note") entered into on November 15,
2002.
Each of the notes held by Huntingdon are due September 30, 2007,
provided that the holder has the right, at any time on or after the date on
which the Company has repaid all of its obligations under the Credit Agreement,
to demand repayment of the unpaid principal balance of and interest on the note;
provided, however that, with respect to the $800,000 Note, such demand can