SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
OR
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________ to ________
Commission file number 1-13469
MediaBay, Inc.
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(Exact name of Registrant as Specified in its Charter)
Florida 65-0429858
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(State or other jurisdiction of (I.R.S. Employment
incorporation or organization) Identification No.)
2 Ridgedale Avenue, Cedar Knolls, New Jersey 07927
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (973) 539-9528
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Indicate by checkmark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months
(or for shorter period that the registrant was required to file such reports)
and (2) has been subject to such filing requirement for the past 90 days.
Yes X No
----- -----
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|
Indicate by check mark whether the Registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No |X|
Indicate the number of shares outstanding of each of the Registrant's classes of
common equity, as of the latest practical date.
As of November 10, 2005, there were 10,439,284 shares of the Registrant's Common
Stock outstanding.
1
MEDIABAY, INC.
Quarter ended September 30, 2005
Form 10-Q
Index
Page
PART I: Financial Information
Item 1: Financial Statements (unaudited)
Condensed Consolidated Balance Sheets at September 30, 2005
and December 31, 2004, (unaudited) 3
Condensed Consolidated Statements of Operations for the
three and nine months ended September 30, 2005 and 2004, (unaudited) 4
Condensed Consolidated Statements of Cash Flows for the nine
months ended September 30, 2005 and 2004, (unaudited) 5
Notes to Condensed Consolidated Financial Statements (unaudited) 6
Item 2: Management's Discussion and Analysis of Financial Condition
and Results of Operations 19
Item 3: Quantitative and Qualitative Disclosures of Market Risk 38
Item 4: Controls and Procedures 38
PART II: Other Information
Item 5: Other Information 39
Item 6: Exhibits 39
Signatures 39
2
PART I: FINANCIAL INFORMATION
Item 1: Financial Statements
MEDIABAY, INC.
Condensed Consolidated Balance Sheets
(Dollars in thousands)
(Unaudited)
September 30, December 31,
2005 2004
--------- ---------
Assets
Current Assets:
Cash and cash equivalents $ 10,362 $ 3,122
Accounts receivable, net of allowances for sales returns and doubtful accounts of
$1,638 and $2,708 at September 30, 2005 and December 31, 2004, respectively 696 1,285
Inventory 937 1,530
Prepaid expenses and other current assets 268 199
Royalty advances 382 489
--------- ---------
Total current assets 12,646 6,625
Fixed assets, net 1,398 243
Other intangibles 44 50
Goodwill 9,658 9,658
--------- ---------
$ 23,745 $ 16,576
========= =========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses $ 4,334 $ 5,361
Accounts payable, related party -- 315
Short-term debt, net of original issue discount of $53 at September 30, 2005 and $54
December 31, 2004, respectively 31 29
Preferred dividends payable 319 --
Current portion of long-term debt -- 200
--------- ---------
Total current liabilities 4,684 5,905
--------- ---------
Long-term debt, net of original issue discount of $126 and $908 at September 30, 2005 and
December 31, 2004 615 9,102
Related party long-term debt including accrued interest -- 7,750
--------- ---------
Total liabilities 5,299 22,757
--------- ---------
Commitments and Contingencies -- --
Preferred stock, no par value, authorized 5,000,000 shares; no shares of Series A
outstanding at September 30, 2005 and 25,000 shares of Series A
outstanding at December 31, 2004; 200 shares of Series B issued and
outstanding at September 30, 2005 and December 31, 2004; no shares of
Series C issued and outstanding at September 30, 2005 and 43,527
shares of Series C issued and outstanding at December 31, 2004; and
21,063 shares of Series D issued and outstanding at September 30, 2005
and no
shares of Series D issued and outstanding at December 31, 2004 11,502 6,873
Common stock, no par value, authorized 300,000,000, issued and outstanding 10,439,284 as
of September 30, 2005; and authorized 150,000,000 shares, issued and outstanding
4,140,663 at December 31, 2004 121,432 101,966
Contributed capital 42,638 17,682
Accumulated deficit (157,126) (132,702)
--------- ---------
Total stockholders' equity (deficit) 18,446 (6,181)
--------- ---------
$ 23,745 $ 16,576
========= =========
See accompanying notes to condensed consolidated financial statements.
3
MEDIABAY, INC.
Condensed Consolidated Statements of Operations
(Dollars in thousands, except per share data)
(Unaudited)
Three months ended Nine months ended
September 30, September 30,
---------------------- ----------------------
2005 2004 2005 2004
-------- -------- -------- --------
Sales, net of returns, discounts and allowances of $124
and $983 and $1,554 and $4,286 for the three and
nine months ended September 30, 2005 and 2004,
respectively $ 1,387 $ 3,849 $ 7,012 $ 14,334
Cost of sales 1,002 1,875 4,101 6,672
Cost of sales - strategic charges -- 2,100 305 2,100
-------- -------- -------- --------
Gross profit 385 (126) 2,606 5,562
Expenses:
Advertising and promotion 478 1,131 1,265 3,758
General and administrative 1,708 1,559 5,295 5,301
Termination charges -- -- 697 --
Depreciation and amortization 15 28 58 116
-------- -------- -------- --------
Operating loss (1,816) (2,844) (4,709) (3,343)
Interest income 92 -- 167 --
Interest expense 126 741 752 6,808
Loss on early extinguishment of debt -- -- 579 1,532
-------- -------- -------- --------
Loss before income taxes (1,850) (3,585) (5,873) (11,691)
Income tax expense -- -- -- --
-------- -------- -------- --------
Net loss (1,850) (3,585) (5,873) (11,691)
Dividends on preferred stock 390 199 1,127 378
Deemed dividend on beneficial conversion of
Series D Preferred Stock -- -- 17,423 --
-------- -------- -------- --------
Net loss applicable to common shares $ (2,240) $ (3,784) $(24,423) $(12,061)
======== ======== ======== ========
Basic and diluted loss applicable to common shares
per common share: $ (0.25) $ (1.23) $ (3.82) $ (4.40)
======== ======== ======== ========
See accompanying notes to condensed consolidated financial statements.
4
MEDIABAY, INC.
Condensed Consolidated Statements of Cash Flows
(Dollars in thousands)
(Unaudited)
Nine months ended
September 30,
2005 2004
-------- --------
Cash flows used in operating activities:
Net loss applicable to common shares $(24,423) $(12,061)
Adjustments to reconcile net loss to net cash provided by operating activities:
Deemed dividend on beneficial conversion of
Series D Preferred Stock 17,423 --
Loss on extinguishment of debt 579 1,532
Non-current accrued interest and dividends payable 306 1,090
Amortization of deferred financing costs and original issue discount 225 1,060
Depreciation and amortization 58 116
Cost of sales - strategic charges 305 2,100
Payment of accrued dividends through issuance of common stock 85 --
Amortization of deferred member acquisition costs 16 2,203
Non-cash beneficial conversion charge included in interest expense -- 3,991
Expense of inducement to convert -- 391
Non-cash stock compensation -- 82
Changes in asset and liability accounts, net of strategic charges:
Decrease in accounts receivable, net 811 1,977
Increase in inventory 593 62
Increase in prepaid expenses (121) (40)
Decrease (increase) in royalty advances 108 (790)
Increase in deferred member acquisition costs -- (339)
Decrease in accounts payable, accrued expenses and preferred dividends payable (1,515) (5,656)
-------- --------
Net cash used in operating activities (5,550) (4,282)
-------- --------
Cash flows used in investing activities:
Acquisition of fixed assets, including website development costs (1,207) (77)
Acquisition of intanglible assets -- (20)
-------- --------
Net cash used in investing activities (1,207) (97)
-------- --------
Cash flows from financing activities:
Net proceeds from issuance of preferred stock 31,488 --
Proceeds from issuance of long-term debt -- 13,500
Proceeds from exercise of stock options 40 1
Payment of long-term debt (11,742) (5,988)
Redemption of Series A and Series C Preferred Stock (5,789) --
Increase in deferred financing costs -- (2,071)
-------- --------
Net cash provided by financing activities 13,997 5,442
-------- --------
Net increase in cash and cash equivalents 7,240 1,063
Cash and cash equivalents at beginning of period 3,122 683
-------- --------
Cash and cash equivalents at end of period $ 10,362 $ 1,746
======== ========
See accompanying notes to condensed consolidated financial statements.
5
MEDIABAY, INC.
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share data)
(Unaudited)
(1) Organization
MediaBay, Inc. ("MediaBay" or "the Company") is a Florida corporation
formed on August 16, 1993. The Company is a digital media, marketing and
publishing company specializing in spoken audio entertainment.
Today, the Company has two principal content libraries: (1) Audiobooks
which it sells via digital download and on CD and cassette through
Soundsgood.com, the Audio Book Club and third-party websites; and (2) an archive
of the history of American radio which it produces and sells on CD and cassettes
through its catalog, a mail order-based continuity program, retail outlets, its
on-line download subscription service and third-party websites. The Company
broadcasts its radio programs through a syndicated radio show on 200 commercial
stations across the United States, as well as its 24-hour Radio Classics
channels on Sirius and XM Satellite Radio.
(2) Significant Accounting Policies
Basis of Presentation
The interim unaudited condensed consolidated financial statements should
be read in conjunction with the Company's audited consolidated financial
statements contained in its Annual Report on Form 10-K. The preparation of
financial statements in accordance with accounting principles generally accepted
in the United States of America requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, the
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenue and expenses during the
reporting period. Actual results could differ from these estimates. On an
ongoing basis management reviews its estimates based on current available
information. Changes in facts and circumstances may result in revised estimates.
In the opinion of management, the interim unaudited financial statements include
all material adjustments, all of which are of a normal recurring nature,
necessary to present fairly the Company's financial position, results of
operations and cash flows for the periods presented. The results for any interim
period are not necessarily indicative of results for the entire year or any
other interim period.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany accounts have
been eliminated.
Cash and Cash Equivalents
Securities with maturities of three months or less when purchased are
considered to be cash equivalents.
Fair Value of Financial Instruments
The carrying amount of cash, accounts receivable, accounts payable and
accrued expenses approximates fair value due to the short maturity of those
instruments.
6
The fair value of long-term debt is estimated based on the interest rates
currently available for borrowings with similar terms and maturities. The
carrying value of the Company's long-term debt approximates fair value.
Inventory
Inventory, consisting primarily of audiocassettes and compact discs held
for resale, is valued at the lower of cost (weighted average cost method) or
market.
Prepaid Expenses
Prepaid expenses consist principally of deposits and other amounts being
expensed over the period of benefit. All current prepaid expenses will be
expensed over a period no greater than twelve months from the date of the
Balance Sheet.
Deferred Member Acquisition Costs
Promotional costs directed at current members are expensed on the date the
promotional materials are mailed. The cost of any premiums, gifts or the
discounted audiobooks in the promotional offer to new members is expensed as
incurred. The Company accounts for direct response advertising for the
acquisition of new members in accordance with AICPA Statement of Position 93-7,
"Reporting on Advertising Costs" ("SOP 93-7"). SOP 93-7 states that the cost of
direct response advertising (a) whose primary purpose is to elicit sales to
customers who could be shown to have responded specifically to the advertising
and (b) that results in probable future benefits should be reported as assets
net of accumulated amortization.
SOP 93-7 requires that the realizability of the amounts of direct-response
advertising reported as assets should be evaluated at each balance sheet date by
comparing the carrying amounts of the assets to their probable remaining future
net revenues. At September 30, 2005, we had no direct-response advertising
reported as assets, since we have determined that probable future benefits from
any direct advertising we have incurred would not exceed the amounts expended.
Fixed Assets, Net
Fixed assets, consisting primarily of furniture, leasehold improvements,
computer equipment, and third-party web site development costs, are recorded at
cost. Depreciation and amortization, which includes the amortization of
equipment under capital leases, is provided by the straight-line method over the
estimated useful life of three years (the lease term) for computer equipment and
five years (the lease term) for sound equipment under capital leases, five years
for equipment, seven years for furniture and fixtures, five years for leasehold
improvements, and three years from the date the assets are put into service for
Internet web site development costs. Ongoing maintenance and other recurring
charges are expensed as incurred.
Other Intangibles, Net
Intangible assets, principally consisting of purchased intellectual
property, which is reviewed for impairment on each reporting date, and
non-compete agreements, which are being amortized over their contractual term.
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 accordance with Statement of Financial Accounting
Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets", the Company
ceased amortization of goodwill as of January 1, 2002. Goodwill is tested for
impairment annually or when certain triggering events require such tests and are
written down, with a resulting charge to operations, only in the period in which
the recorded value of goodwill is more than its fair value.
7
Revenue Recognition
During the nine months ended September 30, 2005 and September 30, 2004,
the Company derived its principal revenue through sales of audiobooks, classic
radio shows and other spoken word audio products directly to consumers
principally through direct mail and the Internet. The Company also sold classic
radio shows to retailers either directly or through distributors. The Company
derived additional revenue through rental of its proprietary database of names
and addresses to non-competing third parties through list rental brokers. The
Company also derived 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 or directly from the broadcaster. Allowances for future
returns are based upon historical experience and evaluation of current trends.
Downloadable content revenue from the sale of individual content titles is
recognized in the period when the content is downloaded and the customer's
credit card is processed. Downloadable content revenue from the sale of
downloadable content subscriptions is recognized pro rata over the term of the
subscription period.
Shipping and Handling Revenue and Costs
Amounts paid to the Company for shipping and handling by customers is
included in sales. Amounts the Company incurs for shipping and handling costs
are included in cost of sales. The Company recognizes shipping and handling
revenue upon shipment of merchandise. Shipping and handling expenses are
recognized on a monthly basis from invoices from the third party fulfillment
houses, which provide the services.
Cost of Sales
Cost of sales includes the following:
o Product costs (including free audiobooks in the initial enrollment
offer to prospective members)
o Royalties to publishers and rightsholders
o Fulfillment costs, including shipping and handling
o Customer service
o Direct response billing, collection and accounts receivable
management
Cooperative Advertising and Related Selling Expenses
In accordance with EITF No. 01-9, "Accounting for Consideration Given by a
Vendor to a Customer (Including a Reseller of the Vendor's Products)", the
Company classifies the cost of sales incentives as a reduction of net sales.
Bad Debt Expense
The Company records an estimate of its anticipated bad debt expense based
on historical experience.
General and Administrative Costs
General and administrative costs include the following:
o Bad debt expense
o Payroll and related items
o Commissions
8
o Insurance
o Office expenses
o Telephone and postage
o Public and investor relations
o Dues and subscriptions
o Rent and utilities
o Travel and entertainment
o Bank charges
o Professional fees, principally legal and auditing fees
o Consulting
Stock-Based Compensation
The Company accounts for employee stock options in accordance with
Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock
Issued to Employees." In October 1995, SFAS No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123") was issued. SFAS 123, which prescribes the
recognition of compensation expense based on the fair value of options on the
grant date, allows companies to continue applying APB 25 if certain pro forma
disclosures are made assuming a hypothetical fair value method application. In
December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment," which is
a revision of SFAS No. 123, "Accounting for Stock-Based Compensation". SFAS
123(R) requires that the compensation cost relating to share-based payment
transactions be recognized in financial statements. The compensation cost will
be measured based on the fair value of the equity or liability instruments
issued. The Statement is effective as of the beginning of the first annual
period beginning after June 15, 2005. Had compensation expense for the Company's
stock options been recognized on the fair value on the grant date under SFAS
123, the Company's net loss and net loss per share for the three months ended
September 30, 2005 and 2004 would have been as follows:
Three Months Ended Nine months Ended
September 30, September 30,
------------------------- ----------------------
2005 2004 2005 2004
----------- -------- -------- --------
Net loss applicable to common shares, as reported $ ( 2,240) $ (3,784) $(24,423) $(12,061)
Add: Stock-based employee compensation expense included in
reported net loss applicable to common shares, net
of related tax effects -- -- -- --
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all
awards, net of related tax effects -- (206) (755) (1,828)
----------- -------- -------- --------
Pro forma net loss applicable to common shares $ (2,240) $ (3,990) $(25,178) $(13,889)
=========== ======== ======== ========
Net loss per share
Basic and diluted - as reported $ (0.25) $ (1.23) $ (3.82) $ (4.40)
=========== ======== ======== ========
Basic and diluted - pro forma $ (0.25) $ (1.30) $ (3.93) $ (4.69)
=========== ======== ======== ========
9
No dividend yield and the following assumptions were used in the pro forma
calculation of compensation expense:
No. of Exercise Assumed Risk-free Fair Value per
Date Shares Price Volatility Interest Rate Share
---- ------ ----- ---------- ------------- ------
First Nine months 2004 601,250 $5.52 97% 4.00% $.51
First Nine months 2005 801,667 $3.54 41% 3.35% $.96
Income Taxes
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amount of existing assets and liabilities and their respective tax
basis and operating loss and tax credit carryforwards. A valuation allowance is
provided when it is more likely than not that some portion or all of the
deferred tax assets will not be realized. Deferred tax assets and liabilities
are measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in the period that includes the enactment date.
Royalties
The Company is liable for royalties to licensors based upon revenue earned
from the respective licensed product. The Company pays certain publishers and
other rightsholders advances for rights to products. Royalties earned on the
sale of the products are payable only in excess of the amount of the advance.
Advances, which have not been recovered through earned royalties, are recorded
as an asset. Advances not expected to be recovered through royalties on sales
are charged to royalty expense.
Use of Estimates
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, the disclosure of contingent assets and liabilities at
the date of the financial statements, and the reported amounts of revenue and
expenses during the reporting period. Actual results could differ from these
estimates. On an ongoing basis, management reviews its estimates based on
current available information. Changes in facts and circumstances may result in
revised estimate.
Reclassifications
Certain amounts relating to 2004 have been reclassified to conform to the
current presentation.
(3) Goodwill and Other Intangibles
Goodwill and indefinite-lived intangible assets are tested for impairment
annually or when certain triggering events require such tests and are written
down, with a resulting charge to operations, only in the period in which the
recorded value of goodwill and indefinite-lived intangible assets is more than
their fair value.
The Company amortizes other intangible assets over their estimated useful
lives. Amortization expense for other intangible assets was $6 and $30 for the
nine months ended September 30, 2005 and 2004, respectively. The Company
estimates intangible amortization expenses of $8 in 2005:
10
The following table presents details of Other Intangibles at September 30,
2005 and December 31, 2004:
September 30, 2005 December 31, 2004
---------------------------- ------------------------------
Accumulated Accumulated
Cost Amortization Net Cost Amortization Net
------ ------------ ------ ------- ------------ -------
Mailing Agreements $ 592 $ 592 $ -- $ 592 $ 592 $ --
Customer Lists 4,380 4,380 -- 4,380 4,380 --
Non-Compete Agreements 313 294 19 313 288 25
Other 25 -- 25 25 -- 25
------ ------ ------ ------ ------ ------
Total Other Intangibles $5,310 $5,266 $ 44 $5,310 $5,260 $ 50
====== ====== ====== ====== ====== ======
Goodwill of $9,658 as of September 30, 2005 and December 31, 2004 is
attributable to the Company's Radio Spirits business. The Company conducted its
annual impairment test for 2004 in January 2005, utilizing the services of an
independent appraiser, which did not result in an impairment loss. Any future
impairment losses incurred will be reported in operating results.
(4) Debt
As of
September 30, December 31,
2005 2004
--------- ---------
Credit agreement, senior secured debt,
net of original issue discount $ -- $ 8,661
Premier debt, net of original issue discount 646 670
Related party notes and related accrued interest,
net of original issue discount -- 7,750
--------- ---------
Total debt 646 17,081
Less: current portion (31) (229)
--------- ---------
Long-term debt $ 615 $ 16,852
========= =========
March Payment and Conversion of Debt
On March 23, 2005, the Company completed the March Financing described
below.
Concurrently with the March Financing, the Company repaid from the net
proceeds all of the principal and accrued and unpaid interest due on the
Company's outstanding senior notes issued on April 28, 2004, in the aggregate
amount of approximately $9,400. The Company reported a charge in the first
quarter of 2005 of $579 to reflect the write-off of unamortized financing
charges related to the repayment of this debt.
Also in connection with the March Financing, the Company entered into an
agreement (the "Herrick Agreement") with the Herrick Entities, described below
(the "Herrick Agreement"). Pursuant to the Herrick Agreement, concurrently with
the Financing, among other actions, all $5,784 principal amount of the
convertible notes of the Company owned by the Herrick Entities were converted
into an aggregate of approximately 1.7 million shares of Common Stock, at their
stated conversion rate of $3.36 per share.
The Company also paid to Norton Herrick and Huntingdon all accrued and
unpaid interest dividends due to them in the amount $2,271.
11
(5) Stockholders' Equity and Stock Options and Warrants
The following table presents information regarding the Company's
outstanding preferred stock at September 30, 2005 and December 31, 2004:
As of
September 30, December 31,
2005 2004
------- -------
Series A Convertible Preferred Stock $ -- $ 2,500
Series B Convertible Preferred Stock 20 20
Series C Convertible Preferred Stock -- 4,353
Series D Convertible Preferred Stock, total outstanding at September
30, 2005 $21,063, net of cash fees and expenses of $2,048; value
ascribed to investors' and advisors' warrants of $7,533 11,482 --
------- -------
Total Preferred Stock $11,502 $ 6,873
======= =======
March 2005 Sale of Series D Convertible Preferred Stock and Warrants
On March 21, 2005, the Company agreed to issue an aggregate of (a) 35,900
shares (the "Offering Shares") of its Series D Convertible Preferred Stock (the
"Series D Preferred") convertible into 10,878,788 shares of the Company's common
stock, (b) 5,439,394 five-year common stock purchase warrants (the "Offering
Warrants"), valued at $10,852 using an accepted valuation method and (c)
preferred warrants (the "Over-Allotment Warrants" and, together with the
Offering Shares and the Offering Warrants, the "Offering Securities")
exercisable for a limited time, for additional proceeds to the Company of
$8,975, to purchase (1) up to 8,975 additional shares of Series D Preferred (the
"Additional Shares" and, together with the Offering Shares, the "Preferred
Shares") and (2) up to 1,359,849 additional warrants identical to the Offering
Warrants (the "Additional Warrants" and, together with the Offering Warrants,
the "Warrants"), to accredited investors (the "Investors") for an aggregate
purchase price of $35,900 (the "Financing").
Immediately prior to the Financing, holders of a majority of the Company's
voting securities approved by written consent (the "Shareholder Consent") (a) an
amendment to the Articles of Incorporation of the Company, increasing the number
of authorized shares of the common stock of the Company ("Common Stock") from
150,000,000 to 300,000,000, (b) a change of control which may occur as a result
of the Financing, and (c) the Company's issuance, in connection with the
transactions contemplated by the Financing documents, of Common Stock in excess
of 19.99% of the number of shares of Common Stock outstanding immediately prior
to the Financing.
While such actions were approved by a majority of the shareholders prior
to the Financing, the Company was not permitted to effect them until it
satisfied certain information requirements to the shareholders of the Company
not party to the Shareholder Consent. As a result, the Shareholder Consent did
not become effective until May 3, 2005.
The Preferred Shares have a face value of $1,000 per share ("Stated
Value") and are convertible at any time at the option of the holder into shares
("Conversion Shares") of common stock at the rate of $3.30 per Conversion Share,
subject to certain anti-dilution adjustments, including for issuances of Common
Stock for consideration below the conversion price. The Preferred Shares are
also mandatorily convertible at the option of the Company, subject to its
satisfaction of certain conditions, commencing June 10, 2005, which is 30 days
after May 11, 2005, the effective date of the registration statement registering
the shares underlying the Series D Preferred Stock. Under certain circumstances
under the control of the Company, the holders will also have the right to
require the Company to redeem their Preferred Shares at their Stated Value.
Cumulative dividends will accrue on the Preferred Shares on an annualized basis
in an amount equal to 6% of their Stated Value until they are converted or
redeemed and will be payable quarterly in arrears, beginning April 1, 2005, in
cash or, at the Company's option, subject to its satisfaction of certain
conditions, in shares of
12
Common Stock ("Dividend Shares") valued at 93% of the average of the daily
volume weighted average per-share price of the Common Stock for the five trading
days prior to the applicable payment date. The Preferred Shares are non-voting.
Subject to certain exceptions for accounts receivable and equipment and capital
lease financings, the Company may not incur additional indebtedness for borrowed
money or issue additional securities that are senior to or pari passu to the
Preferred Shares without the prior written consent of holders of at least
two-thirds of the Preferred Shares then outstanding.
Each Warrant is exercisable to purchase one share of Common Stock
(collectively, the "Warrant Shares"), at an exercise price of $3.36 per share
for a period of five years commencing September 23, 2005, subject to certain
anti-dilution adjustments, including for issuances of Common Stock for
consideration below the exercise price. In addition, once exercisable, the
Warrants permit cashless exercises during any period when the Warrant Shares are
not covered by an effective resale registration statement.
The Over-Allotment Warrants are exercisable until February 9, 2006 for the
purchase of Additional Shares and Additional Warrants, at an exercise price
equal to the Stated Value of the Additional Shares purchased, with the purchase
of each Additional Share including an Additional Warrant exercisable for a
number of Warrant Shares equal to 50% of the Conversion Shares underlying such
Additional Share.
As part of the Financing, the Forest Hill Select Fund L.P. and related
entities (the "Forest Hill Entities") exchanged 300,000 shares of Common Stock
and 66,667 common stock warrants previously purchased by them from the Company
in October 2004 for $900 of the Offering Securities. The Forest Hill Entities
also purchased $1,000 of the Offering Securities. The Company included an
additional 19,841 shares of Common Stock, as well as 8,333 shares of Common
Stock underlying certain additional warrants, already beneficially owned and
retained by Forest Hill Capital, for resale in the registration statement
declared effective May 11, 2005.
In connection with the Financing, the Company also entered into an
agreement with Norton Herrick and certain of his affiliates (the "Herrick
Entities") pursuant to which, concurrently with the Financing:
o all $5,784 principal amount of the convertible notes of the Company
owned by the Herrick Entities (the "Herrick Notes") and 10,684 of
their shares of the Series A Convertible Preferred Stock of the
Company ("Series A Preferred") were converted into an aggregate of
approximately 2.03 million shares of Common Stock (the "Herrick
Shares"), at their stated conversion rate of $3.36 per share;
o the Company agreed to redeem the remaining 14,316 shares of Series A
Preferred held by the Herrick Entities and all 43,527 of their
shares of the Series C Convertible Preferred Stock of the Company
(collectively, the "Redemption Securities") for $5,784, the
aggregate stated capital of such shares, on the earlier of the
effective date of the Shareholder Consent (May 3, 2005);
o the Herrick Entities waived certain of their registration rights and
the Company agreed to include the Herrick Shares for resale in the
registration statement declared effective May 11, 2005 so long as
such Herrick Shares are owned by the Herrick Entities and not
otherwise transferred, including, but not limited to, in the Herrick
Financing (as defined below); and
o the Herrick Entities consented to the terms of the Financing and the
agreements entered into in connection with the Financing, as the
Company was required to obtain such consents pursuant to the terms
of the Herrick Notes, the Series A Preferred and the Series C
Preferred.
o Herrick and Huntingdon also entered into a voting agreement and
proxy with the Company pursuant to which they agreed not to take any
action to contradict or negate the Shareholder Consent.
o the Company entered into a registration rights agreement dated the
date hereof with Herrick and Huntingdon in which the parties are
granted "piggy-back" registration rights and, with respect to the
shares of Common Stock issuable to Herrick and Huntingdon upon
conversion of the Herrick Notes and Series A Preferred Stock,
Herrick and Huntingdon are granted the same automatic registration
rights as the Investors under the Registration Rights Agreement.
13
o the Company also entered into another registration rights agreement
dated March 23, 2005, with Herrick and Huntingdon in which the
parties are granted "piggy-back" registration rights and, with
respect to the shares of our common stock issuable to Herrick and
Huntingdon upon exercise of the warrants held by Herrick and
Huntingdon.
The Company received $35,000 of gross proceeds (not including the
securities exchanged by the Forest Hill Entities for $900 of the purchase price)
in the Financing. Merriman Curhan Ford & Co. ("Merriman") acted as a financial
advisor with respect to certain of the investors in the Financing for which it
received compensation from the Company of $2,625 plus a five-year warrant (the
"Merriman Warrant") to purchase 1,193,182 shares of Common Stock at an exercise
price of $4.14 per share commencing upon May 3, 2005, the effective date of the
Shareholder Consent. Merriman also received a structuring fee from the Company
with respect to the Financing in the amount of $175. In addition, the Company
issued to Satellite Strategic Finance Associates, LLC and Satellite Strategic
Finance Partners, Ltd., investors in the Financing, warrants to purchase an
aggregate of 41,667 shares of Common Stock (identical to the Warrants), and
reimbursed them $55 for expenses, for consulting services rendered by it in
connection with the Financing. The Company incurred cash fees and expenses
including fees paid to advisors of $3,512. Warrants issued to advisors were
valued at $1,986 using an accepted valuation method.
The Preferred Shares are convertible at any time at the option of the
holder into shares ("Conversion Shares") of common stock at the rate of $3.30
per Conversion Share and each Warrant is exercisable to purchase one share of
Common Stock (collectively, the "Warrant Shares"), at an exercise price of $3.36
per share. The market price for the Company's common stock at March 21, 2005 was
$4.14. The Company recorded as dividends an amount of $17,423 to reflect the
value of the deemed dividend for beneficial conversion feature of Series D
Preferred Stock.
As of September 30, 2005, 14,837 shares of Series D Preferred Stock plus
accrued dividends thereon were converted into 4,521,599 shares of common stock
and 21,063 shares of Series D Preferred Stock are outstanding.
Stock Options and Warrants
From January 1, 2005 to September 30, 2005, the Company issued options to
purchase 801,667 shares of its common stock to employees, officers, directors
and consultants under its stock incentive plans. From January 1, 2005 to
September 30, 2005, options to purchase 62,280 shares of its common stock were
either cancelled or expired. The Company issued non-plan warrants to purchase
6,674,243 shares of its common stock in connection with the Financing described
above. During the nine months ended September 30, 2005, the Company cancelled
non-plan warrants to purchase 76,667 shares of its common stock.
(6) Cost of Goods Sold - Strategic Charges
In the second quarter of 2005, the Company changed its negative option
book club and converted to a business selling audiobooks and other audio
entertainment without a negative option requirement. The Company has moved its
warehouse and fulfillment operations to a facility which also provides products
and accordingly the Company has changed from licensing and manufacturing many of
its audiobook titles to buying on a wholesale basis and accordingly has recorded
a $305 write-down of royalty advances to what the Company believes is net
realizable value at September 30, 2005.
The Company recorded $2,100 of strategic charges for the three months
ended September 30, 2004. These charges include: $1,000 of inventory written
down to net realizable value due to a reduction in Audio Book Club members and
the Company's new focus on delivering spoken word products via downloads and
14
$1,100 of write-downs to royalty advances paid to audiobook publishers and other
license holders, which the Company does not believe will be recoverable due to
its new focus on delivering spoken word products via downloads.
(7) Supplemental Cash Flow Information
No cash has been expended for income taxes for the nine months ended
September 30, 2005 and 2004. Cash paid for interest expense was $2,015 and $536
for the nine months ended September 30, 2005 and 2004, respectively.
The Company had the following non-cash activities for the nine months ended
September 30, 2005:
2005
-------
Conversions of subordinated notes into common stock $ 5,784
Conversion of preferred shares into common stock $14,837
Conversion of common shares and warrants into preferred stock and warrants sold in
the Financing $ 900
Issuance of warrants in connection with the Financing $12,838
(8) Net Loss Per Share of Common Stock
Basic (loss) earnings per share was computed using the weighted average
number of common shares outstanding for the three and nine months ended
September 30, 2005 of 8,989,725 and 6,400,211, respectively and for the three
and nine months ended September 30, 2004 of 3,077,271 and 2,738,765.
For the three months ended September 30, 2005 common equivalent shares
which were not included in the computation of diluted loss per share because
they would have been anti-dilutive were 49,019 common equivalent shares, as
calculated under the treasury stock method and 7,820,544 common equivalent
shares relating to convertible subordinated debt and convertible preferred stock
calculated under the "if-converted method". Dividends on the convertible
preferred stock added back to net income applicable to common stockholders would
have been $390 for the three months ended September 30, 2005.
For the nine months ended September 30, 2005 common equivalent shares
which were not included in the computation of diluted loss per share because
they would have been anti-dilutive were 780,501 common equivalent shares, as
calculated under the treasury stock method and 8,635,463 common equivalent
shares relating to convertible subordinated debt and convertible preferred stock
calculated under the "if-converted method". Interest expense and dividends on
the convertible subordinated debt and convertible preferred stock added back to
net income applicable to common stockholders would have been $1,303 for the nine
months ended September 30, 2005.
For the three months ended September 30, 2004 common equivalent shares
which were not included in the computation of diluted loss per share because
they would have been anti-dilutive were 4,170 common equivalent shares, as
calculated under the treasury stock method and 4,001,458 common equivalent
shares relating to convertible subordinated debt and convertible preferred stock
calculated under the "if-converted method". Interest expense and dividends on
the convertible subordinated debt and convertible preferred stock added back to
net income applicable to common stockholders would have been $378 for the three
months ended September 30, 2004.
For the nine months ended September 30, 2004 common equivalent shares
which were not included in the computation of diluted loss per share because
they would have been anti-dilutive were 146,156 common equivalent shares, as
calculated under the treasury stock method and 3,257,112 common equivalent
shares relating to convertible subordinated debt and convertible preferred stock
calculated under
15
the "if-converted method". Interest expense and dividends on the convertible
subordinated debt and convertible preferred stock added back to net income
applicable to common stockholders would have been $786 for the nine months ended
September 30, 2004.
(9) Segment Reporting
For 2005 and 2004, the Company has divided its operations into four
reportable segments: Corporate; Audio Book Club ("ABC") a business selling
audiobooks via direct mail and on the Internet; Radio Spirits ("RSI") which
produces, sells, licenses and syndicates old-time radio programs and
MediaBay.com a media portal offering spoken word audio content in secure digital
download formats. Segment operating income is total segment revenue reduced by
operating expenses identifiable with that business segment. Corporate includes
general corporate administrative costs, professional fees, interest expenses and
amortization of acquisition related costs. The Company evaluates performance and
allocates resources among its three operating segments based on operating income
and opportunities for growth. Inter-segment sales are recorded at prevailing
sales prices.
Segment Reporting
Three Months Ended September 30, 2005
Corporate ABC RSI Mbay.com Inter-segment Total
---------- --------- -------- -------- ------------- -----
Sales, net of returns, discounts and
allowances $ -- $ 531 $ 815 $ 41 $ -- $ 1,387
Operating (loss) profit before depreciation
and amortization (742) (781) (124) (154) -- (1,801)
Depreciation and amortization 2 10 3 -- -- 15
Interest (income)
Interest expense, net (34) -- -- -- -- (34)
Dividends on preferred stock (390) -- -- -- -- (390)
Net income (loss) applicable to common shares (1,168) (791) (127) (154) -- (2,240)
Total assets -- 10,850 12,932 9 (46) 23,745
Acquisition of fixed assets -- 627 -- -- -- 627
Three Months Ended September 30, 2004
Corporate ABC RSI Mbay.com Inter-segment Total
---------- --------- -------- -------- ------------- -----
Sales, net of returns, discounts and
allowances $ -- $ 2,654 $ 1,154 $ 52 $ (11) $ 3,849
Operating (loss) profit before depreciation
and amortization (353) (2,103) (270) (99) 9 (2,816)
Depreciation and amortization 2 17 9 -- -- 28
Interest expense, net (740) -- (1) -- -- (741)
Dividends on preferred stock (199) -- -- -- -- (199)
Net income (loss) applicable to common shares (1,294) (2,120) (280) (99) 9 (3,784)
Total assets -- 19,096 13,623 10 (62) 32,667
Acquisition of fixed assets -- 10 -- -- -- 10
Nine months Ended September 30, 2005
Corporate ABC RSI Mbay.com Inter-segment Total
---------- --------- -------- -------- ------------- -----
Sales, net of returns, discounts and
allowances -- 4,093 2,786 133 -- 7,012
Operating (loss) profit before depreciation
and amortization (2,949) (951) (331) (429) 9 (4,651)
Depreciation and amortization 7 34 17 -- -- 58
Interest expense, net (584) -- (1) -- -- (585)
Loss on early retirement of debt (579) -- -- -- -- (579)
Dividends on preferred stock (18,550) -- -- -- -- (18,550)
Deemed dividend on beneficial conversion of
Series D Preferred Stock
Net income (loss) applicable to common shares (22,669) (985) (349) (429) 9 (24,423)
Total assets -- 10,850 12,932 9 (46) 23,745
Acquisition of fixed assets -- 1,207 -- -- -- 1,207
16
Nine months Ended September 30, 2004
Corporate ABC RSI Mbay.com Inter-segment Total
---------- --------- -------- -------- ------------- -----
Sales, net of returns, discounts and
allowances -- 9,719 4,514 158 (57) 14,334
Operating (loss) profit before depreciation
and amortization (1,194) (2,229) 501 (315) 10 (3,227)
Depreciation and amortization 22 66 28 -- -- 116
Interest expense, net (6,805) -- (3) -- -- (6,808)
Loss on early retirement of debt (1,532) -- -- -- -- (1,532)
Dividends on preferred stock (378) -- -- -- -- (378)
Net income (loss) applicable to common shares (9,931) (2,295) 470 (315) 10 (12,061)
Total assets -- 19,996 13,623 10 (62) 32,667
Acquisition of fixed assets -- 68 9 -- -- 77
(10) Recent Accounting Pronouncements
Consolidation of Variable Interest Entities
In March 2005, the FASB issued Staff Position (FSP) No. FIN 46(R)-5,
Implicit Variable Interests under FASB Interpretation No. 46 (revised December
2003), Consolidation of Variable Interest Entities. This FSP clarifies that when
applying the variable interest consolidation model, a reporting enterprise
should consider whether it holds an implicit variable interest in a variable
interest entity (VIE) or potential VIE when specific conditions exist. FSP No.
FIN 46(R)-5 is effective as of April 1, 2005. The Company does not anticipate an
impact from the adoption of this statement.
Share-Based Payment
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment,"
which is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation".
SFAS 123(R) requires that the compensation cost relating to share-based payment
transactions be recognized in financial statements. The compensation cost will
be measured based on the fair value of the equity or liability instruments
issued. The Statement is effective as of the beginning of the first annual
period beginning after June 15, 2005. Beginning in January 2006, the value of
all options granted by the Company will be recorded as compensation expense and
will be reported as general and administrative expense. Currently, the value of
options granted to officers and directors at or above market at the date of the
grant are not recorded as expenses by the Company. We do not yet know the impact
that any future share-based payment transactions will have on our financial
position or results of operations.
Inventory Costs
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs." SFAS
151 amends ARB No. 43, "Inventory Pricing", to clarify the accounting for
certain costs as period expense. The Statement is effective for fiscal years
beginning after September 15, 2005; however, early adoption of this Statement is
permitted. The Company does not anticipate an impact from the adoption of this
statement.
Accounting Changes and Error Corrections
In May 2005, the FASB issued SFAS No. 154 "Accounting Changes and Error
Corrections--A Replacement of APB Opinion No. 20 and FASB Statement No. 3". This
Statement requires retrospective application to prior periods' financial
statements of changes in accounting principle, unless it is impracticable to
determine either the period-specific effects or the cumulative effect of the
change. This Statement does not change the guidance for reporting the correction
of an error in previously issued financial statements or a change in accounting
estimate. The provisions of this Statement shall be effective for accounting
changes
17
and correction of errors made in fiscal years beginning after December 15, 2005.
The Company is not able to assess at this time the future impact of this
Statement on its consolidated financial position or results of operations.
(11) Subsequent Events
The Company effected a one for six reverse stock split effective October
25, 2005. All references in the financial statements and notes thereto to the
number of shares outstanding, per share amounts, and stock option, warrant and
convertible security data relating to the Company's commons shares have been
restated to reflect the effect of the stock split for all periods presented.
On November 9, 2005, the period to exercise warrants to purchase
additional shares of the Series D Preferred Stock granted to the investors in
the March sale of Series D Convertible Preferred Stock was further extended to
February 9, 2006.
18
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Certain statements in this Form 10-Q 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 ability to implement and the success of our new strategy
and transition our business and the risks related thereto: our history of losses
and declining revenues; our ability to license and sell new spoken word content,
anticipate and respond to changing customer preferences, license and produce
desirable content, protect our databases and other intellectual property from
unauthorized access, and collect receivables; dependence on third-party
providers, suppliers and distribution channels; competition; the costs and
success of our marketing strategies, product returns, attrition; and risks
relating to our capital structure. 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
We are a digital media and publishing company specializing in spoken word
audio entertainment. We maintain a library of more than 75,000 hours of audio
content, which we distribute through our consumer brands, Soundsgood.com,
AudioBookClub, Radio Spirits and Radio Classics. Our content is distributed on
the internet via our digital download subscription services, our websites, mail
order, some of the nation's largest retailers, and to cell phones via our ring
tone offering. We are also MSN Music's exclusive provider of spoken word
products for downloading via the Web, and have a growing list of digital
distribution partners that include Real Networks, Loudeye, and XM and Sirius
Satellite Radio. During our 12 years of operations, MediaBay has serviced 2.9
million customers that have purchased our spoken word products.
Today we have three principal content libraries; (1) Thousands of best
selling Audiobooks, educational courses, university lectures, theatre plays,
self improvement courses, television soundtracks, stand-up comedy, children's
storytelling, parenting advice and study guides which we sell via digital
download and on CD and cassette, through Soundsgood.com, the Audio Book Club and
third-party websites; (2) a proprietary archive of the history of American radio
which we produce and sell on CD and cassettes through our catalog, a mail order
based continuity program, retail outlets, and our on-line download subscription
service and third-party websites, and (3) a library of classic television shows
and movies. We also broadcast our radio programs through a syndicated radio show
on more than 200 commercial stations across the United States, as well as our
24-hour Radio Classics channels number 133 on Sirius and 164 on XM Satellite
Radio.
We are transitioning our business from primarily selling hard goods (CD's
and cassettes) via our negative option, mail order AudioBookClub to digital
distribution via wireless and Internet downloads. Our digital distribution
strategy is two pronged: (1) to operate our own downloadable content stores and
subscription services which are co-branded via partnerships with celebrities and
corporate affiliates: and (2) to wholesale our audio content to the leading
music services, broadband portals, cell phone, satellite radio and television
companies, both domestically and internationally. Marketing partners are
selected based on
19
their ability to drive large numbers of customers to our audio stores with
specific customer demographics that we can match to our vast library of audio
content. We believe this approach will reduce our customer acquisition costs and
accelerate our entry into the digital distribution marketplace.
In addition to our growing list of marketing partners, we also intend to
use various organic means to market our downloadable content stores, including
marketing to our existing customer list of approximately 2.9 million audio
buyers that participated in the AudioBookClub or have purchased from Radio
Spirits. We also anticipate working with manufacturers of digital music players,
smart phones, and PDAs to include samples of our audio content on those devices
for consumers to preview when they purchase these new devices, with the hope
that these samples will attract consumers to our content stores.
In October 2005, we launched our new digital storefront and technology
platform, www.Soundsgood.com. Soundsgood.com is a fully enabled digital download
service that offers thousands of digital audiobooks, classic radio shows and
other spoken word audio content on an ala carte basis or as part of a monthly
subscription. The service offers users audio content that can be downloaded
directly to the users personal computer, burned to CD or transferred to any
Window's Media compatible device that plays secured WMA (Windows Media Audio)
files. There over 70 digital devices on the market today that are
"PlaysforSure"(TM) compliant and we are working closely with Microsoft
Corporation to ensure that our content works seamlessly on these devices and the
many new smart cellular phones that will run the new Windows Mobile 5.0
operating system. In addition, some of our audio newspapers and radio shows are
or will be distributed in MP3 format which work on iPods, and a multitude of MP3
music players and cell phones.
We recently have executed several agreements to expand the digital
distribution of our audio content: an exclusive distribution agreement with
Microsoft's MSN Music to provide our spoken word content to the MSN audience,
which has 350 million unique monthly visitors. A content distribution agreement
with Real Networks, which operates Rhapsody, the largest music subscription
service in the United States, and Loudeye to act as our digital sales agent in
distributing our catalog of products to potentially 70 music services for which
they host and source content. In addition, we have executed a promotional
agreement with WFAN and the Imus in the Morning Show to promote Soundsgood.com
nationally on close to 100 radio stations across the country and is simulcast on
MSNBC television five days a week. Imus program listeners will be directed to
SoundsGood.com following interviews with authors who appear on the show.
SoundsGood.com will be branded as the show's exclusive bookseller via a
"Soundsgood Minute", and listeners will be informed how they can access
audiobooks and our other audio programs, via digital downloads or on traditional
media such as CDs and cassette tapes. We have also executed distribution
agreements for our growing library of classic radio ring tones which will soon
be, or are available on Nextel, Verizon, Alltell, T-Mobile Alltel, nTelos,
Midwest Wireless, Verizon Wireless and Verizon Wireless Puerto Rico services.
We have acquired the rights to distribute digital audiobooks from
substantially all of the major publishing houses in the United States and have a
growing number of titles with various international rights of distribution. Our
content library consists of all genres of audiobooks, classic American radio
shows, educational courses, university lectures, theatre plays, self improvement
courses, television soundtracks, stand-up comedy, children's storytelling,
parenting advice and study guides.
Today, some of our largest digital content partners include BBC,
Blackstone, Brilliance Audio, CBS Radio, Harper Collins, Hay House, Oasis,
Penguin Group USA Audio, Random House, Simon & Schuster, Sound Room Publishers,
Time Warner Audio and Zondervan. In addition to Audio Book Club, we distribute
our content through proprietary web sites soundsgood.com and radiospirits.com,
as well as through partner channels including Loudeye, MSN Music, Sirius
Satellite Radio and XM Satellite Radio.
20
March 2005 Equity Financing
On March 23, 2005, pursuant to an agreement executed on March 21, 2005, we
received an infusion of gross cash proceeds of $35 million in private equity
financing from several institutional investors. We retired all of our borrowings
and increased our cash reserves.
The Preferred Shares are convertible at any time at the option of the
holder into shares ("Conversion Shares") of common stock at the rate of $3.30
per Conversion Share and each Warrant is exercisable to purchase one share of
Common Stock (collectively, the "Warrant Shares"), at an exercise price of $3.36
per share. The market price for our common stock at March 21, 2005 was $4.14. We
recorded as a non-cash deemed dividend an amount of $17,423 to reflect the value
of the beneficial conversion feature of the Series D Preferred Stock and
increased contributed capital by $17,423. The recording of the deemed dividend
had no effect on our cash or net equity.
Strategy
In response to the music industry's recent success in creating a market
for legal digital downloads using digital rights management solutions that are
intended to prevent piracy of copyrighted content, we intend to become a leading
distributor for downloadable, spoken word audio entertainment. We intend to
build this new distribution channel by utilizing our nearly twelve years of
experience operating the Audio Book Club and our old-time radio business. During
those twelve years, we have serviced approximately 2.9 million customer accounts
and plan to leverage this list of audio buyers to attract new digital shoppers.
We intend to use the Windows Media Digital Rights Management (DRM) system,
and other easy to use, rights management technologies that may evolve over time.
Beginning this past Christmas season, 70 new digital devices that support the
Microsoft "PlaysforSure(TM)" digital rights management and device platform
became available for sale by many of the leading device manufacturers. Examples
of companies offering a "PlaysforSure(TM)" device include Hewlett Packard, Dell,
Creative, Rio, i-River and Samsung. Many of these devices have large file
storage capacities and make, what we believe, could be a perfect match for our
content, which is typically one half hour in length for our classic radio shows,
to an average of 6 to 10 hours for an audiobook.
In addition, the rapid evolution of cell and smart phones with hard drives
and media players presents a large potential user base of digital devices for
our content, as more than 500 million new handsets are sold each year in the
market place. These portable devices, coupled with the ubiquitous installed base
of personal computers with CD burners and USB port memory discs are making
digital audio content portable and more accessible to users.
We believe the proliferation of broadband Internet service, the Microsoft
digital rights management solution, and an expanding user base of portable
devices have created an inflection point where downloads are a better way to
distribute audio than traditional CDs and tapes via a retail store or by mail
order. Broadband Internet and ubiquitous wireless networks means companies like
MediaBay can deliver audio files quickly and affordably. Downloads provide
consumers a more convenient way to purchase audio in real time and provides
incredible opportunity for broad choice since there are no inventory
requirements. This distribution is better for the environment and most
importantly, provides real savings for the consumer.
We have determined that future investment in our mail order, hard goods
based, Audio Book Club would not provide the returns adequate to justify future
expenditures. Accordingly, in 2004, we discontinued marketing to attract new
Audio Book Club members and are developing plans to transition current members
to new programs including encouraging existing members to begin downloading
spoken word.
21
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 2 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
We derive our principal revenue through sales of audiobooks, classic radio
shows and other spoken word audio products directly to consumers principally
through direct mail. We also sell classic radio shows to retailers either
directly or through distributors. We derive additional revenue through rental of
our proprietary database of names and addresses to non-competing third parties
through list rental brokers. We also derive a small amount of revenue from
advertisers included in our nationally syndicated classic radio shows. We
recognize 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. We recognize
advertising revenue upon notification of the airing of the advertisement by the
media buying company representing us. 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. We adopted
EITF No. 01-9 effective January 1, 2002, and, as such, have classified the cost
of these sales incentives as a reduction of sales.
Downloadable content revenue from the sale of individual content titles is
recognized in the period when the content is downloaded and the customer's
credit card is processed. Content revenue from the sale of content subscriptions
is recognized pro rata over the term of the subscription period. Rebates and
refunds are recorded as a reduction of revenue in the period in which the rebate
or refund is paid in accordance with Emerging Issues Task Force Issue No. 01-9,
Accounting for Consideration Given by a Vendor to a Customer (Including a
Reseller of the Vendor's Products).
22
Accounts Receivable Valuation
We record an estimate of our anticipated bad debt expense and return rates
based on our historical experience. If the financial condition of our customers,
including either individual consumers or retail chains, were to deteriorate, or
if the payment or buying behavior were to change, resulting in either their
inability or refusal to make payment to us, additional allowances would be
required.
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. We determine the utilization of deferred tax
assets in the future based on current year projections by management.
Based on a change in our strategy, which we believe will result in lower
sales and losses in the near term, but ultimately will be more profitable, we
have determined that it is "not more likely than not" that we will, in the
foreseeable future, be able to realize all or part of our net deferred tax
asset. We have accordingly made an adjustment to the deferred tax asset
recording an increase to the valuation allowance, resulting in a deferred tax
expense charged against income in the fourth quarter of 2004, the period when
such determination was made.
Deferred Member Acquisition Costs
Promotional costs directed at current members are expensed on the date the
promotional materials are mailed. The cost of any premiums, gifts or the
discounted audiobooks in the promotional offer to new members is expensed as
incurred. The Company accounts for direct response advertising for the
acquisition of new members in accordance with AICPA Statement of Position 93-7,
"Reporting on Advertising Costs" ("SOP 93-7"). SOP 93-7 states that the cost of
direct response advertising (a) whose primary purpose is to elicit sales to
customers who could be shown to have responded specifically to the advertising
and (b) that results in probable future benefits should be reported as assets
net of accumulated amortization.
SOP 93-7 requires that the realizability of the amounts of direct-response
advertising reported as assets should be evaluated at each balance sheet date by
comparing the carrying amounts of the assets to their probable remaining future
net revenues. At September 30, 2005, we had no direct-response advertising
reported as assets, since we have determined that probable future benefits from
any direct advertising we have incurred would not exceed the amounts expended.
We do not expect to capitalize any marketing costs until we have determined
probable future benefits based on buying patterns of future customers.
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, 2004, we had $9.7 million
of goodwill, all of which relates to our Radio Spirits operations. We completed
our annual impairment test as of January 2005, utilizing the services of an
independent third-party appraiser, which did not result in an impairment loss.
However, if conditions or circumstances were to change resulting in a
deterioration of our Radio Spirits business, a future impairment of goodwill
could be necessary.
23
Results of Operations
The following table sets forth, for the periods indicated, historical
operating data as a percentage of net sales.
Three Months Nine months
Ended September 30, Ended September 30,
2005 2004 2005 2004
------ ------ ------ ------
Sales 100.0% 100.0% 100.0% 100.0%
Cost of sales 72.2 48.7 58.5 46.5
Cost of sales - strategic charges -- 54.6 4.3 14.7
------ ------ ------ ------
Gross profit 27.8 (3.3) 37.2 38.8
Advertising and promotion 34.5 29.4 18.0 26.2
General and administrative expense 123.2 40.5 75.5 35.1
Termination charges -- -- 10.0 --
Depreciation and amortization expense
1.0 0.7 0.8 0.8
Interest (income) 6.6 -- (2.4) --
Interest expense 9.0 19.3 10.7 58.2
Loss on early extinguishment of debt -- -- 8.3 --
Income tax expense (benefit) -- -- -- --
------ ------ ------ ------
Net (loss) (133.4) (93.1) (71.5) (81.6)
Dividends on preferred stock 28.1 (5.2) 16.1 (2.6)
Deemed dividends on beneficial conversion
of preferred stock -- -- 248.5 --
====== ====== ====== ======
Net (loss) applicable to common shares (161.4)% (98.3)% (348.3)% (84.2)%
====== ====== ====== ======
Results of Operations
Three months ended September 30, 2005 compared to three months ended
September 30, 2004:
Net Sales
(In thousands) Change from
2004 2005 2004 to 2005 % Change
------- ------- ------------ --------
Audio Book Club $ 2,654 $ 531 $(2,123) (80.0%)
---------------------------------------------------------
Radio Spirits
Catalog 515 512 (3) (0.6%)
Wholesale 287 176 (111) (38.6%)
Continuity 341 126 (215) (63.1%)
---------------------------------------------------------
1,143 814 (329) (28.8%)
---------------------------------------------------------
MediaBay.com 52 42 (10) (19.8%)
---------------------------------------------------------
$ 3,849 $ 1,387 $(2,462) (64.0%)
========================================================
Audio Book Club sales decreased principally due to a decrease in club
membership as a result of substantially discontinuing our advertising
expenditures for new customers.
In the second quarter of 2005, we changed our negative option book club
and converted to a business selling audiobooks and other audio entertainment
without a negative option requirement. As a result of this change, we anticipate
lower returns from our customers in future periods.
24
Wholesale sales of old-time radio products decreased principally due to
reduced sales to our major customers. Sales of our World's Greatest Old-Time
Radio continuity program decreased principally due to the lack of advertising
expenditures for new customers.
Cost of Sales
(In thousands) 2004 2005
As a % As a % From 2004 to 2005
$ Of Net Sales $ Of Net Sales Change % Change
- ------------ - ------------ ------ --------
Audio Book Club $1,275 48.0% $ 527 99.3% $ 748 58.7%
Radio Spirits
Catalog 242 47.0% 207 40.4% 35 14.6%
Wholesale 229 79.8% 213 121.1% 16 6.8%
Continuity 129 37.8% 55 43.4% 74 57.6%
----------------------- ---------------------- -----------------------
Total Radio Spirits 600 52.5% 475 58.3% 125 20.9%
MediaBay.com -- -- -- -- -- --
Cost of sales 1,875 48.7% 1,002 72.2% 873 46.6%
----------------------- ---------------------- -----------------------
Cost of sales - strategic
charge 2,100 54.6% -- -- 2,100 100%
----------------------- ---------------------- -----------------------
$3,975 103.3% $1,002 -- $2,973 74.8%
======================= ====================== =======================
The principal reason for the decline in cost of sales at Audio Book Club
was a reduction in sales of 80.0% as described above. Cost of sales as a
percentage of sales at Audio Book Club for the three months ended September 30,
2005 was 99.3%, compared to 48.0% for the same period in 2004. The increase in
cost of sales as a percentage of sales is principally due to moving our
warehouse and fulfillment operations to a facility which allows us to drop ship
from its inventory and accordingly we have changed from licensing and
manufacturing our audiobook titles to buying on a wholesale basis. Under our new
buying arrangement we are buying products at a fixed percentage off of
manufacturer's suggested retail price. Cost of sales as a percentage of sales at
Audio Book Club also increased due to an increase in fulfillment costs as a
percentage of sales due to the fixed cost of fulfillment being allocated over
lower sales, as well as one-time programming and transition costs associated
with the change in our fulfillment operations and the move from a negative
option book club to a business selling audiobooks and other audio entertainment
without a negative option requirement.
Cost of Radio Spirits catalog sales decreased as a percentage of sales to
40.4% for the three months ended September 30, 2005 as compared to 47.0% for the
three months ended September 30, 2004 principally due to the mix of product sold
to higher margin products and less discounting in the catalogs. The cost of
Radio Spirits wholesale sales as percentage of sales increased to 121.1% for the
three months ended September 30, 2005 as compared to 79.8% for the three months
ended September 30, 2004 principally due to a greater portion of fixed costs
(allocated obsolescence and product development costs, the fixed cost of
warehousing and fulfillment and royalty advances) in relation to the lower sales
volume. The cost of World's Greatest Old-Time Radio continuity sales as a
percentage of sales increased to 43.4% from 37.8% principally due to the fixed
cost associated with warehousing and fulfillment in relation to the lower sales
volume as we have not marketed for new customers.
In third quarter of 2004 we recorded $2,100 in strategic charges for the
write-down of inventory and royalty advances.
25
Advertising and Promotion
From 2004 to 2005
2004 2005 Change % Change
---- ---- ------ --------
(In thousands)
Audio Book Club
New Customer $ 110 $ -- $ 110 100.0%
Current Customer 251 151 100 39.8%
--------------------------------------------------------
Total Audio Book Club 361 151 210 58.2%
--------------------------------------------------------
Radio Spirits
Catalog 203 199 4 1.8%
Wholesale 8 13 (5) (59.7%)
Continuity -- -- -- 83.2%
--------------------------------------------------------
Total Radio Spirits 211 212 (1) 0.4%
--------------------------------------------------------
New Projects 47 112 (65) (138.3%)
--------------------------------------------------------
Total Spending 619 475 144 23.3%
Amount Capitalized (96) -- 96 (100.0%)
Amount Amortized 608 3 605 99.5%
--------------------------------------------------------
Advertising and Promotion Expense $ 1,131 $ 478 $ 653 57.7%
=========================================================
Advertising and promotion expenses decreased $653,000 to $478,000 for the
three months ended September 30, 2005 as compared to $1.1 million in the prior
comparable period, principally due to lower amortization of deferred customer
acquisition costs. In the fourth quarter of 2004, based on the change in our
strategy, as described above, we determined that the future net revenue from our
Audio Book Club would not support the carrying amount of the direct-response
advertising reported as assets relating to the Audio Book Club. Accordingly, we
wrote-off the carrying amount of the asset in the fourth quarter for 2004
resulting in an increase in advertising expense in 2004 and lower expense in
2005. The decrease in spending was due to the lack of new customer marketing for
Audio Book Club new customers due to our change in strategy as described above
and decreased advertising to existing customers due to the reduction in Audio
Book Club customers because of customer attrition with no marketing to replace
leaving customers. During the three months ended September 30, 2005, we incurred
$112,000 related to new projects, principally marketing tests related to the
download business.
26
General and Administrative
2004 2005 From 2004 to 2005
(In thousands) ---------------------- ---------------------- --------------------
As a % As a %
$ of Net Sales $ of Net Sales Change % Change
------ ------------ ------ ------------- ------ ------
Audio Book Club $ 735 27.7% $ 521 98.2% $ 214 29.1%
Radio Spirits 321 28.1% 249 30.6% 72 22.4%
MediaBay.com 151 291.5% 196 471.7% (45) (29.8%)
Corporate 352 -- 742 -- (390) (110.8%)
------ ----- ------ ----- ------ -----
$1,559 40.5% $1,708 123.1% $ (149) (9.6%)
====== ===== ====== ===== ====== ======
The increase in general and administrative expenses of $149,000 for the
three months ended September 30, 2005 as compared to the three months ended
September 30, 2004 is principally due to increases in professional fees, public
and investor relations (including directors fees) related to being a public
company and travel and entertainment, partially offset by a decline in bad debt
expense at Audio Book Club. The principal reason for the decline in bad debt
expense at Audio Book Club was lower bad debts from remaining core Audio Book
Club members who historically have been very good paying customers. The increase
in professional fees was mainly attributable to legal and consulting fees
incurred to build the new digital download business. The increase in investor
and public relations costs was attributable to fees paid to directors as well as
an increase in public relations activity related to the download strategy. The
increase in travel and entertainment expenses relates mainly to business
development travel incurred to build the new digital download business.
Depreciation and Amortization
(In thousands) 2004 2005
----- -----
Depreciation
Audio Book Club $17 $10
Radio Spirits 9 3
--- ---
Total depreciation 26 13
Amortization
Corporate 2 2
--- ---
Total depreciation and amortization $28 $15
=== ===
The decrease in depreciation and amortization expenses for the three
months ended September 30, 2005 as compared to the three months ended September
30, 2004 is principally attributable to reductions in the amortization of
intangibles, which had been fully amortized or written off during the year ended
December 31, 2004 and certain equipment, which was fully depreciated in 2004.
27
Interest Expense
2004 2005 Change % Change
---- ---- ---- -----
(In thousands)
Total interest paid, net $307 $111 $196 63.8%
Accrued interest paid this period -- -- -- --
---- ---- ---- -----
Current interest paid 307 111 196 63.8%
Interest accrued -- -- -- --
Interest included in debt 165 -- 165 100.0%
Amortization of deferred financing costs and
original issue discount 269 15 254 94.5%
---- ---- ---- -----
Total interest expense $741 $126 $615 83.0%
==== ==== ==== =====
The decrease in interest expenses is principally due to the conversion of
debt into preferred stock and common stock in 2004 and the payment of the senior
debt facility and related party debt in connection with the March Financing in
March 2005 described below.
Preferred Stock Dividends
2004 2005
---- ----
$ (000's)
Dividends on Series A Preferred Stock $ 57 $
----
Dividends on Series B Preferred Stock 8 1
Dividends on Series C Preferred Stock 134 --
Dividends on Series D Preferred Stock -- 389
---- -----
Total dividends on preferred stock $199 $390
==== ====
The increase in preferred stock dividends for the three months ended
September 30, 2005 as compared to the three months ended September 30, 2004 is
due to dividends payable on the Series D Preferred Stock issued in March 2005,
as described in the Liquidity and Capital Resources section below.
During the second quarter of 2005, 1,180 shares of Series D Preferred
Stock and related dividends were converted into 361,700 shares of common stock
and during the third quarter an additional 13,657 shares of Series D Preferred
Stock and related dividends were converted into 4,159,822 shares of common
stock. These conversions and future conversions, if any, will reduce the
preferred stock dividend in future periods.
Loss Applicable to Common Stockholders
From 2004 to 2005
2004 2005 Change % Change
---- ---- ------ --------
(In thousands)
Loss applicable to common stockholders $ (3,784) $ (2,240) $ 1,544 (40.8%)
Principally due to lower interest expense, net of interest income and
advertising expense in 2005 and the strategic charge in 2004, partially offset
by lower gross profit due to decreased sales and higher preferred dividends
during the three months ended September 30, 2005, our net loss applicable to
common shares for the three months ended September 30, 2005 decreased $1.6
million to $2.2 million, or $0.25 per diluted share, as compared to a net loss
applicable to common shares for the three months ended September 30, 2004 of
$3.8 million, or $1.26 per diluted share of common stock, for the three months
ended September 30, 2004.
28
Nine months ended September 30, 2005 compared to nine months ended
September 30, 2004:
Net Sales
(In thousands)
2004 2005 $ Change % Change
------- ------- -------- -------
Audio Book Club $ 9,719 $ 4,093 $(5,626) (57.9%)
-----------------------------------------------
Radio Spirits
Catalog 2,125 1,730 (395) (18.6%)
Wholesale 1,270 615 (655) (51.5%)
Continuity 1,062 441 (622) (58.5%)
-----------------------------------------------
4,457 2,786 (1,672) (37.5%)
-----------------------------------------------
MediaBay.com 158 133 (25) (16.1%)
-----------------------------------------------
$14,334 $ 7,012 $(7,322) (51.1%)
===============================================
Audio Book Club sales decreased principally due to a decrease in club
membership as a result of discontinuing our advertising expenditures for new
members.
In the second quarter of 2005, we changed our negative option book club
and converted to a business selling audiobooks and other audio entertainment
without a negative option requirement. As a result of this change, we anticipate
lower returns from our customers in future periods.
The decrease in Radio Spirits catalog sales is principally attributable to
fewer customers, as we have not incurred marketing expenditures to attract new
members, and greater discounting in our catalogs. Wholesale sales of old-time
radio products decreased principally due to reduced sales to our major
customers. Sales of our World's Greatest Old-Time Radio continuity program
decreased principally due to the lack of advertising expenditures for new
customers.
Cost of Sales
(In thousands) 2004 2005 From 2004 to 2005
------------------ ------------------ -----------------------
As a % As a %
$ of Net Sales $ of Net Sales Change % Change
- ------------ - ------------ ------ --------
Audio Book Club $4,500 46.3% $2,558 62.5% $1,942 43.2%
------------------- ------------------- --------------------
Radio Spirits
Catalog 921 43.3% 762 44.1% 159 17.2%
Wholesale 834 65.7% 594 96.5% 240 28.8%
Continuity 416 39.2% 187 42.5% 230 55.1%
------------------- ------------------- --------------------
Total Radio Spirits 2,171 48.7% 1,543 55.4% 629 29.0%
------------------- ------------------- --------------------
MediaBay.com 1 0.6% -- 0.0% 1 100.0%
------------------- ------------------- --------------------
Cost of Sales 6,672 46.5% 4,101 58.5% 2,571 38.5%
Cost of sales -
strategic charges 2,100 14.7% 305 4.3% 1,795 85.5%
------------------- ------------------- --------------------
$8,772 61.2% $4,406 62.8% $4,366 49.8%
=================== =================== =====================
29
The principal reason for the decline in cost of sales at Audio Book Club
was a reduction in sales of 57.9% as described above. Cost of sales as a
percentage of sales at Audio Book Club for the nine months ended September 30,
2005 was 62.5%, compared to 46.3% for the same period in 2004. The increase in
cost of sales as a percentage of sales is principally due to an increase in
product costs as a percentage of sales since a smaller active membership
requires us to purchase finished goods from publishers rather than the licensing
and manufacturing of product due to lower sales and our inability to meet
manufacturing minimums and recoup advances to publishers, higher sales of
unabridged and CD titles with higher costs and higher manufacturing costs due to
lower volumes until in the second quarter of 2005 we moved our warehouse and
fulfillment operations to a facility which allows us to drop ship from its
inventory and accordingly we have changed from licensing and manufacturing our
audiobook titles to buying on a wholesale basis. Under our new buying
arrangement we are buying products at a fixed percentage off of manufacturer's
suggested retail price. The cost of the new arrangement will be dependent on
future sales volume. Additionally, an increase in fulfillment costs as a
percentage of sales due to the fixed cost of fulfillment being allocated over
lower sales as well as one time programming and transition costs associated with
the change in our fulfillment operations and the move from a negative option
book club to a business selling audiobooks and other audio entertainment without
a negative option requirement contributed to the increase in cost of sales as a
percentage of sales at Audio Book Club.
Cost of Radio Spirits catalog sales increased as a percentage of sales to
44.1% for the nine months ended September 30, 2005 as compared to 43.3% for the
nine months ended September 30, 2004 principally due to higher royalty and
fulfillment costs as a percentage of the lower sales volume due to the fixed
portion of royalty advances and warehousing and fulfillment costs. The cost of
wholesale sales as percentage of sales increased to 96.5% for the nine months
ended September 30, 2005 as compared to 65.7% for the nine months ended
September 30, 2004 principally due to a greater portion of fixed costs
(allocated obsolescence and product development costs, the fixed cost of
warehousing and fulfillment and royalty advances) in relation to the lower sales
volume. The cost of World's Greatest Old-Time Radio continuity sales as a
percentage of sales increased to 42.5% from 39.2% principally due to the fixed
cost associated with warehousing and fulfillment in relation to the lower sales
volume as we have not marketed for new customers.
In the second quarter of 2005, due to the change in strategy for our
audiobook club we recorded a $305 write-down of royalty advances to what we
believe is net realizable value at September 30, 2005. In third quarter of 2004
we recorded $2,100 in strategic charges for the write-down of inventory and
royalty advances.
30
Advertising and Promotion
(In thousands) From 2004 to 2005
---------------------
2004 2005 Change % Change
------- --------- ------- -------
Audio Book Club
New Customer $ 382 $ -- $ 382 100.0%
Current Customer 885 386 499 56.4%
------- --------- ------- -------
Total Audio Book Club 1,267 386 881 69.6%
------- --------- ------- -------
Radio Spirits
Catalog 543 580 24 6.8%
Wholesale 19 39 (20) (102.6%)
Continuity 6 -- 6 97.3%
------- --------- ------- -------
Total Radio Spirits $ 568 $ 619 $ 10 9.0%
------- --------- ------- -------
New Projects 61 244 (183) (300.0%)
------- --------- ------- -------
Total Spending 1,896 1,249 648 34.1%
Amount Capitalized (341) -- 341 (100.0%)
Amount Amortized 2,203 16 2,186 99.3%
------- --------- ------- -------
Advertising and Promotion Expense $ 3,758 $ 1,265 $ 2,492 66.3%
======= ========= ======= =======
Advertising and promotion expenses decreased $2.5 million to $1,265,000
for the nine months ended September 30, 2005 as compared to $3.8 million in the
prior comparable period, principally due to lower amortization of deferred
customer acquisition costs. In the fourth quarter of 2004, based on the change
in our strategy, described above, we determined that the future net revenue from
our Audio Book Club would not support the carrying amount of the direct-response
advertising reported as assets relating to the Audio Book Club. Accordingly, we
wrote-off the carrying amount of the asset in the fourth quarter for 2004
resulting in an increase in advertising expense in 2004 and lower expense in
2005. The decrease in spending was due to the lack of new customer marketing for
Audio Book Club new customers due to our change in strategy as described above
and decreased advertising to existing customers due to the reduction in Audio
Book Club customers because of customer attrition with no marketing to replace
leaving customers. During the nine months ended September 30, 2005 we incurred
$244,000 related to new projects, principally marketing tests related to the
download business.
31
General and Administrative
2004 2005 From 2004 to 2005
--------------------- -------------------- ---------------------
(In thousands) As a % As a %
$ Of Net Sales $ Of Net Sales Change % Change
------- ----------- ------- ------------ ------- ------
Audio Book Club $ 2,560 26.3% $ 1,552 37.9% $ 1,008 39.4%
Radio Spirits 804 18.0% 879 31.6% (75) (9.3%)
MediaBay.com 473 299.4% 561 423.2% (88) (18.6%)
Corporate 1,194 -- 2,302 -- (1,108) (92.8%)
------- ----- ------- ------ ------- ------
$ 5,031 35.1% $ 5,294 75.5% $ (263) (5.2%)
======= ===== ======= ====== ======= ======
The increase in general and administrative expenses of $263,000 for the
nine months ended September 30, 2005 as compared to the nine months ended
September 30, 2004 is principally due to increases in payroll and related costs,
public and investor relations (including directors fees) related to being a
public company, travel and entertainment and professional fees, partially offset
by lower bad debt expense. The principal reason for the decline in bad debt
expense at Audio Book Club was lower bad debts from remaining core Audio Book
Club members who historically have been good paying customers. The increase in
payroll was mainly attributable to various bonuses paid in the second quarter of
2005 and the hiring, retention and promotion of key employees. The increase in
investor and public relations costs was attributable to fees paid to directors,
as well as an increase in public relations activity related to the download
strategy. The increase in travel and entertainment expenses relates mainly to
business development travel incurred to build the new digital download business.
The increase in professional fees was mainly attributable to legal and
consulting fees associated with the transition to the new download business
strategy.
Termination costs
(In thousands) 2004 2005
------ -------
Termination costs $ -- $ 697
====== =======
In the second quarter of 2005, the employment of one senior executive who
had an employment agreement was terminated and the employment of several
employees, one of which had an employment agreement, were also terminated. We
agreed to make aggregate settlement payments totaling $697,000 payable through
March 2006.
32
Depreciation and Amortization
2004 2005
---- ----
(In thousands)
Depreciation
Audio Book Club $ 67 $ 34
Radio Spirits 28 17
---- ----
Total depreciation $ 95 $ 51
==== ====
Amortization
Corporate 21 7
---- ----
Total depreciation and amortization $116 $ 58
==== ====
The decrease in depreciation and amortization expenses for the nine months
ended September 30, 2005 as compared to the nine months ended September 30, 2004
is principally attributable to reductions in the amortization of intangibles,
which had been fully amortized or written off during the year ended December 31,
2004 and certain equipment, which was fully depreciated in 2004.
Interest Expense
2004 2005 Change
------- ------- -------
(In thousands)
Total interest paid $ 852 $ 2,126 $(1,274)
Accrued interest paid this period 74 1,599 (1,525)
------- ------- -------
Current interest paid 778 527 251
Interest included in debt 602 -- 602
Amortization of deferred financing costs and
original issue discount 1,058 225 833
Beneficial conversion expenses of January 2004 Notes 3,991 -- 3,991
Expense of inducement to convert, related party debt 390 -- 390
======= ======= ========
Total interest expense $ 6,808 $ 752 $ 7,009
======= ======= ========
The decrease in interest expenses is principally due to the conversion of
debt into preferred stock and common stock in 2004 and the payment of the senior
debt facility and related party debt in connection with the March Financing
described below.
Preferred Stock Dividends
2004 2005
------- -------
(In thousands)
Dividends on Series A Preferred Stock $ 171 $ 51
Dividends on Series B Preferred Stock 23 1
Dividends on Series C Preferred Stock 184 100
Dividends on Series D Preferred Stock -- 975
Deemed dividend for beneficial conversion
feature of Series D Preferred Stock -- 17,423
------- -------
Total dividends deemed or accrued on preferred stock $ 378 $18,550
======= =======
33
The Series D Preferred Shares are convertible at any time at the option of
the holder into shares of our common stock at the rate of $3.30 per share and
each warrant is exercisable to purchase one share of our common stock at an
exercise price of $3.36 per share. The market price for our common stock at
March 21, 2005 was $4.14. We recorded as a non-cash deemed dividend in an amount
of $17,423 to reflect the value of the beneficial conversion feature of the
Series D Preferred Stock and increased contributed capital by $17,423. The
recording of the dividend had no effect on our cash or net equity.
The increase in preferred stock dividends for the nine months ended
September 30, 2005 as compared to the nine months ended September 30, 2004 is
due to dividends for the Series D Preferred Stock issued in March 2005, as
described in the Liquidity and Capital Resources section below.
During the second quarter of 2005, 1,180 shares of Series D Preferred
Stock were converted into 361,700 shares of common stock and during the third
quarter an additional 13,657 shares of Series D Preferred Stock and related
dividends were converted into 4,159,822 shares of common stock. These
conversions and future conversions, if any, will reduce the preferred stock
dividend in future periods.
Loss Applicable to Common Stockholders
From 2004 to 2005
2004 2005 Change % Change
---- ---- ------ --------
(In thousands)
Loss applicable to common stockholders $(12,061) $(24,423) $(12,361) 102.5%
======== ======== ======== ======
Principally due to the deemed dividend for beneficial conversion of Series
D Preferred Stock of $17,423, lower sales and a loss on early extinguishment of
debt of $579 the strategic charge, termination costs and higher preferred
dividends, partially offset by lower advertising expenses as described above,
our net loss applicable to common shares for the nine months ended September 30,
2005 increased $12.4 million to $24.4 million, or $3.82 per diluted share, as
compared to a net loss applicable to common shares for the nine months ended
September 30, 2005 of $12.1 million, or $4.38 per diluted share of common stock,
for the nine months ended September 30, 2004.
Liquidity and Capital Resources
As of September 30, 2005, we had cash on hand of $10.4 million, which is
substantially greater than the $1.7 million cash on hand at September 30, 2004,
as a result of the March 2005 financing described below. We believe that we have
sufficient cash to operate the business for a minimum of twelve months.
March 2005 Equity Financing
On March 23, 2005, pursuant to an agreement executed on March 21, 2005, we
issued an aggregate of (a) 35,900 shares (the "Offering Shares") of our Series D
Convertible Preferred Stock (the "Series D Preferred") convertible into
10,878,788 of our common stock, (b) 5,439,394 five-year common stock purchase
warrants (the "Offering Warrants") and (c) preferred warrants (the
"Over-Allotment Warrants" and, together with the Offering Shares and the
Offering Warrants, the "Offering Securities") exercisable for a limited time,
for additional proceeds to us of $8.975 million, to purchase (1) up to 8,975
additional shares of Series D Preferred (the "Additional Shares" and, together
with the Offering Shares, the "Preferred Shares") and (2) up to 1,359,849
additional warrants identical to the Offering Warrants (the "Additional
Warrants" and, together with the Offering Warrants, the "Warrants"), to
accredited investors (the "Investors") for an aggregate purchase price of $35.9
million (the "March Financing").
Immediately prior to the March Financing, holders of a majority of our
voting securities approved by written consent (the "Shareholder Consent") (a) an
amendment to our Articles of Incorporation, increasing the number of our
authorized shares of the common stock ("Common Stock") from 150,000,000 to
300,000,000,
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(b) a change of control which may occur as a result of the Financing, and (c)
our issuance, in connection with the transactions contemplated by the Financing
documents, of Common Stock in excess of 19.99% of the number of shares of Common
Stock outstanding immediately prior to the Financing.
While such actions were approved by a majority of our shareholders prior
to the financing, we were not permitted to effect them until we satisfied
certain information requirements to our shareholders not party to the
Shareholder Consent. As a result, the Shareholder Consent did not become
effective until May 3, 2005.
The Preferred Shares have a face value of $1,000 per share ("Stated
Value") and are convertible at any time at the option of the holder into shares
("Conversion Shares") of common stock at the rate of $3.30 per Conversion Share,
subject to certain anti-dilution adjustments, including for issuances of Common
Stock for consideration below the conversion price. The Preferred Shares are
also mandatorily convertible at our option, subject to satisfaction of certain
conditions, commencing September 10, 2005, which is 30 days following the
effective date of the registration statement registering the common shares
underlying the Series D Preferred Stock. Under certain limited circumstances
within our control, the holders will also have the right to require us to redeem
their Preferred Shares at their Stated Value. Cumulative dividends will accrue
on the Preferred Shares on an annualized basis in an amount equal to 6% of their
Stated Value until they are converted or redeemed and will be payable quarterly
in arrears, beginning April 1, 2005, in cash or, at our option, subject to
satisfaction of certain conditions, in shares of Common Stock ("Dividend
Shares") valued at 93% of the average of the daily volume weighted average
per-share price of the Common Stock for the five trading days prior to the
applicable payment date. The Preferred Shares are non-voting. Subject to certain
exceptions for accounts receivable and equipment and capital lease financings,
we may not incur additional indebtedness for borrowed money or issue additional
securities that are senior to or pari passu to the Preferred Shares without the
prior written consent of holders of at least two thirds of the Preferred Shares
then outstanding.
Each Warrant is exercisable to purchase one share of Common Stock
(collectively, the "Warrant Shares"), at an exercise price of $3.36 per share
for a period of five years commencing September 23, 2005, subject to certain
anti-dilution adjustments, including for issuances of Common Stock for
consideration below the exercise price. In addition, once exercisable, the
Warrants permit cashless exercises during any period when the Warrant Shares are
not covered by an effective resale registration statement.
The Over-Allotment Warrants were initially exercisable until August 9,
2005 for the purchase of Additional Shares and Additional Warrants, at an
exercise price equal to the Stated Value of the Additional Shares purchased,
with the purchase of each Additional Share including an Additional Warrant
exercisable for a number of Warrant Shares equal to 50% of the Conversion Shares
underlying such Additional Share.
As part of the March Financing, Forest Hill Select Fund L.P. and related
entities (the "Forest Hill Entities") exchanged the 300,000 shares of Common
Stock and 66,667 October Warrants previously purchased by them in October 2004
for $900,000 of the Offering Securities.
In connection with the March Financing, we also entered into an agreement
(the "Herrick Agreement") with Herrick and Huntingdon (collectively, the
"Herrick Entities"), pursuant to which, concurrently with the March Financing:
o all $5.784 million principal amount of our convertible notes owned
by the Herrick Entities (the "Herrick Notes") and 10,684 of their
shares of our Series A Preferred Stock were converted into an
aggregate of approximately 2.03 million shares of Common Stock (the
"Herrick Shares"), at their stated conversion rate of $3.36 per
share;
o we also agreed to redeem the remaining 14,316 shares of Series A
Preferred Stock held by the Herrick Entities and all 43,527 of their
shares of our Series C Convertible Preferred Stock of the Company
(collectively, the "Redemption Securities") for $5.8 million, the
aggregate stated capital of such shares, on the earlier of the
effective date of the Shareholder Consent and September 1, 2005, and
both the Redemption Securities and the redemption price were placed
into escrow pending such date;
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o the Herrick Entities waived certain of their registration rights and
we agreed to include the Herrick Shares for resale in the Financing
Registration Statement, so long as such Herrick Shares are owned by
the Herrick Entities and not otherwise transferred, including, but
not limited to, in the Herrick Financing (as defined below); and
o the Herrick Entities consented to the terms of the Financing and the
agreements entered into in connection with the Financing, as we were
required to obtain such consents pursuant to the terms of the
Herrick Notes, the Series A Preferred Stock and the Series C
Preferred Stock.
o Herrick and Huntingdon also entered into a voting agreement and
proxy with us pursuant to which they agreed not to take any action
to contradict or negate the Shareholder Consent.
We received $35 million of gross proceeds (not including the securities
exchanged by the Forest Hill Entities for $900,000 of the purchase price) in the
March Financing. Merriman Curhan Ford & Co. ("Merriman") acted as a financial
advisor with respect to certain of the investors in the March Financing for
which it received compensation from us of $2,625,000 plus a five-year warrant to
purchase 1,193,182 shares of Common Stock at an exercise price of $4.14 per
share, the market price of our common stock on March 21, 2005, commencing on May
3, 2005, the effective date of the Shareholder Consent. Merriman also received a
structuring fee from us with respect to the Financing in the amount of $175,000.
In addition, we issued to Satellite Strategic Finance Associates, LLC and
Satellite Finance Partners. Ltd., investors in the Financing, warrants to
purchase an aggregate of 41,667 shares of our common stock (identical to the
Warrants), and reimbursed them $55,000 for expenses, for consulting services
rendered by it in connection with the Financing. We also incurred legal,
accounting and other costs of $657,000.
Concurrently with the March Financing, we repaid from net March Financing
proceeds all of the principal and accrued and unpaid interest due on our
outstanding senior notes issued on April 28, 2004, in the aggregate amount of
approximately $9.4 million. We reported a loss on early extinguishment of debt
of $579,000 in the first quarter of 2005 to reflect the write-off of unamortized
finance charges related to the repayment of this debt.
We used approximately $2,271,000 of the proceeds from the Financing to pay
all accrued and unpaid interest to the Herrick Entities on convertible notes and
the Series A Preferred Stock and Series C Preferred Stock.
As of November 10, 2005, 14,837 shares of Series D preferred Stock plus
accrued dividends thereon have been converted into 4,521,599 shares of common
stock and 21,063 shares of Series D Preferred Stock are outstanding.
On November 9, 2005, the period to exercise warrants to purchase
additional shares of the Series D Preferred Stock granted to the investors in
the March sale of Series D Convertible Preferred Stock was further extended to
February 9, 2006.
Activity during the nine months ended September 30, 2005.
For the nine months ended September 30, 2005, cash increased by $7.2
million, as we had net cash used in operating activities of $5.6 million, used
net cash of $1.2 million in investing activities and had cash provided by
financing activities of $14.0 million. Net cash used in operating activities
principally consisted of the net loss of $24.4 million, an increase in prepaid
expenses of $121,000, and a decrease in accounts payable, accrued expense and
preferred dividends payable of $1.5 million which were partially offset by the
non-cash charges consisting of the deemed dividend for beneficial conversion
feature of Series D preferred Stock of $17.4 million, the loss on early
extinguishment
36
of debt of $579,000, depreciation and amortization expenses of $58,000, cost of
sales strategic charges of $305,000, amortization of deferred financing costs
and original issue discount of $225,000, non-current accrued interest and
dividends payable of $306,000; payment of accrued dividends through issuance of
common stock of $85,000; as well as decreases in accounts receivable, inventory
and royalty advances of $811,000, $593,000 and $108,000. The decreases in
accounts receivable and inventory are primarily attributable to the reduction in
sales as described above and the remaindering of manufactured audio book
inventory under license due to the change in strategy discussed above. The
increase in prepaid expenses is principally due to the timing of payments of
marketing costs and other costs related to the download business and certain
Radio Spirit's catalog costs. The decrease in accounts payable and accrued
expenses is principally due to the payment of back royalties to publishers. The
decrease in royalty advances relates to the change in strategy for our Audio
Book Club, as we are no longer licensing and manufacturing products as described
above. The Company recorded as dividends an amount of $17,423 to reflect the
value of the deemed dividend for beneficial conversion feature of Series D
Preferred Stock.
Net cash used in investing activities consists of the acquisition of fixed
assets and website development costs of $1.2 million, principally computer
equipment and the cost of the development of the new websites offering
downloadable audio.
During the nine months ended September 30, 2005, we received net cash
proceeds from the sale of Series D Preferred Stock of $31.5 million, as
described above, repaid debt in the amount of $9.4 million, repaid accrued
interest, dividends and fees relating to the debt of $2.4 million and redeemed
Series A and Series C Preferred Stock in the amount of $5.8 million.
Recent Accounting Pronouncements
Consolidation of Variable Interest Entities
In March 2005, the FASB issued Staff Position (FSP) No. FIN 46(R)-5,
Implicit Variable Interests under FASB Interpretation No. 46 (revised December
2003), Consolidation of Variable Interest Entities. This FSP clarifies that when
applying the variable interest consolidation model, a reporting enterprise
should consider whether it holds an implicit variable interest in a variable
interest entity (VIE) or potential VIE when specific conditions exist. FSP No.
FIN 46(R)-5 is effective as of April 1, 2005. The Company does not anticipate an
impact from the adoption of this statement.
Share-Based Payment
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment,"
which is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation".
SFAS 123(R) requires that the compensation cost relating to share-based payment
transactions be recognized in financial statements. The compensation cost will
be measured based on the fair value of the equity or liability instruments
issued. The Statement is effective as of the beginning of the annual period
beginning after September 15, 2005. We do not yet know the impact that any
future share-based payment transactions will have on our financial position or
results of operations.
Inventory Costs
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs." SFAS
151 amends ARB No. 43, "Inventory Pricing", to clarify the accounting for
certain costs as period expense. The Statement is effective for fiscal years
beginning after September 15, 2005; however, early adoption of this Statement is
permitted. The Company does not anticipate an impact from the adoption of this
statement.
37
Accounting Changes and Error Corrections
In May 2005, the FASB issued SFAS No. 154 "Accounting Changes and Error
Corrections--A Replacement of APB Opinion No. 20 and FASB Statement No. 3". This
Statement requires retrospective application to prior periods' financial
statements of changes in accounting principle, unless it is impracticable to
determine either the period-specific effects or the cumulative effect of the
change. This Statement does not change the guidance for reporting the correction
of an error in previously issued financial statements or a change in accounting
estimate. The provisions of this Statement shall be effective for accounting
changes and correction of errors made in fiscal years beginning after December
15, 2005. The Company is not able to assess at this time the future impact of
this Statement on its consolidated financial position or results of operations.
Quarterly Fluctuations
Our operating results vary from period to period as a result of purchasing
patterns of our members and customers, member attrition, the timing and
popularity of new audiobook releases and product returns.
We believe that a significant portion of our sales of old-time radio and
classic video programs are gift purchases by consumers. Therefore, we tend to
experience increased sales of these products in the fourth quarter in
anticipation of the holiday season and the second quarter in anticipation of
Fathers' Day.
Item 3: Quantitative and Qualitative Disclosures of Market Risk
The Company has no exposure to market risk for changes in interest rates.
The Company has total debt outstanding as of November 10, 2005 of $646,000, all
of which is at fixed rates. Changes in the prime rate or LIBOR would not have an
impact on our fair values, cash flows, or earnings for the nine months ended
September 30, 2005.
Item 4. Controls and Procedures
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, as amended (the
Act), beginning with our Annual Report on Form 10-K for the fiscal year ending
December 31, 2007, we will be required to furnish a report by our management on
our internal control over financial reporting. This report will contain, among
other matters, an assessment of the effectiveness of our internal control over
financial reporting as of the end of our fiscal year, including a statement as
to whether or not any material weakness in our internal control over financial
reporting identified by management. If we identify one or more material
weaknesses in our internal control over financial reporting, we will be unable
to assert our internal control over financial reporting is effective. This
report will also contain a statement that our independent registered pubic
accountants have issued an attestation report on management's assessment of such
internal controls and a conclusion on the operating effectiveness of those
controls.
Management acknowledges its responsibility for internal controls over
financial reporting and seeks to continually improve those controls. In order to
achieve compliance with Section 404 of the Act within the prescribed period, we
are currently performing the system and process documentation and evaluation
needed to comply with Section 404, which is both costly and challenging. We
believe our process, which we began in the first quarter of 2005 and, we
believe, will continue through 2006 for documenting, evaluating and monitoring
our internal control over financial reporting is consistent with the objectives
of Section 404 of the Act.
As of the end of the period covered by this report, an evaluation was
carried out under the supervision and with the participation of our management,
including the Chief Executive Officer ("CEO") and Chief Financial Officer
("CFO"), of the effectiveness of our disclosure controls and procedures. Based
on that evaluation, the CEO and CFO have concluded that our disclosure controls
and procedures are effective at the reasonable assurance level to timely alert
them of information required to be disclosed by us in reports that we file or
submit under the Securities Exchange Act of 1934. During the quarter ended
September 30, 2005 there were no changes in our internal controls over financial
reporting that have materially affected, or are reasonably likely to materially
affect, our internal controls over financial reporting.
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Part II - Other Information
Item 5: Other Information
On November 9, 2005, the period to exercise warrants to purchase
additional shares of the Series D Preferred Stock granted to the investors in
the March sale of Series D Convertible Preferred Stock was extended to February
9, 2006.
Item 6: Exhibits
Exhibits
3.1 Amendment to Articles of Incorporation
31.1 Chief Executive Officer Certification Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
31.2 Chief Financial Officer Certification Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
32.1 Certification of Jeffrey Dittus, Chief Executive Officer of
MediaBay, Inc., pursuant to 18 U.S.C Section 1350, as Adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Robert Toro, Chief Financial Officer of
MediaBay, Inc., pursuant to 18 U.S.C Section 1350, as Adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 20
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, MediaBay, Inc. has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.
MediaBay, Inc.
Dated: November 11, 2005 By: /s/ Jeffrey Dittus
----------------------------------
Jeffrey Dittus
Chief Executive Officer
Dated: November 11, 2005 By: /s/ Robert Toro
----------------------------------
Robert Toro
Chief Financial Officer
(principal accounting and
financial officer)
39