SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 Form 10-Q |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2003 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______________ to ______________ Commission file number 1-13469 MediaBay, Inc. (Exact Name of Registrant as Specified in its Charter) Florida 65-0429858 (State or Other Jurisdiction of (I.R.S. Employment Incorporation or Organization) Identification No.) 2 Ridgedale Avenue, Cedar Knolls, New Jersey 07927 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone number, Including Area Code: (973) 539-9528 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| As of August 11, 2003, there were 14,124,068 shares of the Registrant's Common Stock outstanding. 1 MEDIABAY, INC. Quarter ended June 30, 2003 Form 10-Q Index Page ---- PART I: Financial Information Item 1: Financial Statements (unaudited) Condensed Consolidated Balance Sheets at June 30, 2003 and December 31, 2002, (unaudited) 3 Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2003 and 2002, (unaudited) 4 Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2003 and 2002, (unaudited) 5 Notes to Condensed Consolidated Financial Statements (unaudited) 6 Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations. 16 Item 3: Quantitative and Qualitative Disclosures of Market Risk 22 Item 4: Controls and Procedures 22 Part II: Other Information Item 2: Changes in Securities and Use of Proceeds 23 Item 6: Exhibits and Reports on Form 8-K 23 Signatures 24 2 PART I: Financial Information Item 1: Financial Statements MEDIABAY, INC. Condensed Consolidated Balance Sheets (Dollars in thousands) (Unaudited) June 30, 2003 December 31, 2002 ------------- ----------------- Assets Current assets: Cash and cash equivalents $ 28 $ 397 Accounts receivable, net of allowances for sales returns and doubtful accounts of $4,214 and $5,325 at June 30, 2003 and December 31, 2002, respectively 6,213 7,460 Inventory 5,095 5,244 Prepaid expenses and other current assets 637 503 Royalty advances 1,036 1,044 -------- -------- Total current assets 13,009 14,648 Fixed assets, net of accumulated depreciation of $724 and $665 at June 30, 2003 and December 31, 2002, respectively 295 358 Deferred member acquisition costs 6,150 7,396 Deferred income taxes 16,224 16,224 Other intangibles, net 115 122 Goodwill 9,658 9,871 -------- -------- $ 45,452 $ 48,619 ======== ======== Liabilities and Stockholders' Equity Current liabilities: Accounts payable and accrued expenses $ 16,009 $ 16,616 Current portion - long-term debt 3,490 2,368 -------- -------- Total current liabilities 19,499 18,984 -------- -------- Long-term debt and related accrued interest, net of original issue discount of $354 and $567 at June 30, 2003 and December 31, 2002, respectively 13,107 14,680 -------- -------- Common stock subject to contingent put rights 1,100 4,550 -------- -------- Preferred stock, no par value, authorized 5,000,000 shares; 25,000 shares of Series A issued and outstanding at June 30, 2003 and December 31, 2002 and 3,350 shares and no shares of Series B at June 30, 2003 and December 31, 2002, respectively 2,828 2,500 Common stock; no par value, authorized 150,000,000 shares; issued and outstanding 94,800 14,341,376 at June 30, 2003 and 14,341,376 at December 31, 2002, respectively 94,547 2,500 Contributed capital 11,281 8,251 Accumulated deficit (96,911) (95,146) -------- -------- Total stockholders' equity 11,745 10,405 -------- -------- $ 45,452 $ 48,619 ======== ======== 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 Six months ended June 30, June 30, -------- -------- 2003 2002 2003 2002 -------- -------- -------- -------- Sales, net of returns, discounts and allowances of $5,043 and $4,160 and $9,421 and $6,291 for the three and six months ended June 30, 2003 and 2002, respectively $ 9,407 $ 11,977 $ 20,105 $ 21,457 Cost of sales 4,124 5,194 9,359 9,483 -------- -------- -------- -------- Gross profit 5,283 6,783 10,746 11,974 Expenses: Advertising and promotion 2,612 2,588 5,459 4,776 General and administrative 2,206 2,547 5,680 5,033 Depreciation and amortization 99 448 198 945 -------- -------- -------- -------- Operating profit (loss) 366 1,200 (591) 1,220 Interest expense 532 805 1,055 1,538 -------- -------- -------- -------- Income (loss) before income taxes (166) 395 (1,646) (318) Income tax expense -- -- -- -- -------- -------- -------- -------- Net income (loss) (166) 395 (1,646) (318) Dividends on preferred stock 62 57 118 102 ======== ======== ======== ======== Net income (loss) applicable to common shares $ (228) $ 338 $ (1,764) $ (420) ======== ======== ======== ======== Basic and diluted earnings (loss) per share common share: $ (.02) $ .02 $ (.12) $ (.03) See accompanying notes to condensed consolidated financial statements. 4 MEDIABAY, INC. Condensed Consolidated Statements of Cash Flows (Dollars in thousands) (Unaudited) Six months ended June 30, 2003 2002 -------- -------- Cash flows from operating activities: Net (loss) applicable to common shares $ (1,764) $ (420) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Net settlement expenses (690) -- Depreciation and amortization 198 945 Amortization of deferred member acquisition costs 3,131 2,617 Amortization of deferred financing costs and original issue discount 248 820 Non-current accrued interest and dividends payable 534 -- Changes in asset and liability accounts, net of asset acquisition: Decrease (increase) in accounts receivable, net 1,246 (586) Decrease (increase) in inventory 149 (371) (Increase) decrease in prepaid expenses (132) 617 Decrease (increase) in royalty advances 8 (226) Increase in deferred member acquisition costs (1,885) (4,647) (Decrease) increase in accounts payable and accrued expenses (383) 2,007 -------- -------- Net cash provided by operating activities 660 756 -------- -------- Cash flows from investing activities: Acquisition of fixed assets (15) (91) Assets acquired, net of cash (250) (379) -------- -------- Net cash used in investing activities (265) (470) -------- -------- Cash flows from financing activities: Net proceeds from issuance of long-term debt -- 500 Payment of long-term debt (1,050) (774) Increase in deferred financing costs (42) (45) Proceeds from exercise of stock options and warrants -- 212 Net proceeds from issuance of Preferred Stock 328 -- -------- -------- Net cash used in financing activities (764) (107) -------- -------- Net (decrease) increase in cash and cash equivalents (369) 179 Cash and cash equivalents at beginning of period 397 64 -------- -------- Cash and cash equivalents at end of period $ 28 $ 243 ======== ======== See accompanying notes to condensed consolidated financial statements. 5 MEDIABAY, INC. Notes to Condensed Consolidated Financial Statements (Dollars in thousands, except per share data) (Unaudited) (1) Organization MediaBay, Inc. (the "Company" or "MediaBay"), a Florida corporation, was formed on August 16, 1993. MediaBay is a marketer of spoken audio products, including audiobooks and old-time radio shows, through direct response, retail and Internet channels. The Company markets audiobooks primarily through its Audio Book Club. Its old-time radio programs are marketed through direct-mail catalogs, over the Internet at RadioSpirits.com and, on a wholesale basis, to major retailers. (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. Revenue Recognition The Company derives its principal revenue through sales of audiobooks, classic radio shows and other spoken word audio products directly to consumers principally through direct mail. The Company also sells classic radio shows to retailers either directly or through distributors. The Company derives additional revenue through rental of its proprietary database of names and addresses to non-competing third parties through list rental brokers. The Company also derives a small amount of revenue from advertisers included in its nationally syndicated classic radio shows. The Company recognizes sales to consumers, retailers and distributors upon shipment of merchandise. List rental revenue is recognized on notification by the list brokers of rental by a third party when the lists are rented. The Company recognizes advertising revenue upon notification of the airing of the advertisement by the media buying company representing the Company. Allowances for future returns are based upon historical experience and evaluation of current trends. 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. 6 Cooperative Advertising and Related Selling Expenses The Company classifies the cost of certain credits, allowances, adjustments and payments given to customers for the services or benefits provided as a reduction of net sales. 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. 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 and six months ended June 30, 2003 and 2002 would have been as follows: Three Months Ended Six Months June 30, Ended June 30, -------------------- --------------------- 2003 2002 2003 2002 ---- ---- ---- ---- Net (loss) income applicable to common shares, as reported $ (228) $ 338 $(1,764) $ (420) 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 -- -- (36) (147) ------- ------- ------- ------- Pro forma net (loss) income applicable to common shares $ (228) $ 338 $(1,800) $ (567) ======= ======= ======= ======= Net (loss) income per share Basic and diluted - as reported $ (.02) $ .02 $ (.12) $ (.03) ======= ======= ======= ======= Basic and diluted - pro forma $ (.02) $ .02 $ (.13) $ (.04) ======= ======= ======= ======= 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 Date Shares Price Volatility Interest Rate per Share ---- ------ ----- ---------- ------------- --------- First Six Months 2002 140,500 $1.88 165% 4.49% $1.05 First Six Months 2003 40,000 $1.50 165% 4.85% $ .98 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. 7 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. Accordingly, the Company has capitalized direct response advertising costs and amortizes these costs over the period of future benefit, which has been determined to be generally 30 months. The costs are being amortized on accelerated basis consistent with the recognition of related revenue. Royalties The Company is liable for royalties to licensors based upon revenue earned from the respective licensed product. The Company pays certain of its 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. Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. (3) Goodwill and Other Intangibles In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). The Company adopted SFAS 142 on January 1, 2002. SFAS 142 changed the accounting for goodwill and indefinite-lived intangible assets from an amortization method to an impairment-only approach. 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 over periods from three to seven years. Other intangible assets primarily relate to mailing and non-compete agreements, customer lists, and license agreements associated with the Company's Audio Book Club and Radio Spirits divisions. Amortization expense for other intangible assets was $61 and $121 and $385 and $821 for the three and six months ended June 30, 2003 and 2002, respectively. The Company estimates intangible amortization expenses of the following: Six months ended December 31, 2003 $ 61 Year ended December 31, 2004 23 Year ended December 31, 2005 8 Year ended December 31, 2006 8 Year ended December 31, 2007 8 Year ended December 31, 2008 1 ------- Total $109 ======= 8 The following table presents details of Other Intangibles at June 30, 2003 and December 31, 2002: June 30, 2003 December 31, 2002 ---------------------------- ---------------------------- Accumulated Accumulated Cost Amortization Net Cost Amortization Net ---- ------------ --- ---- ------------ --- Mailing Agreements $ 592 $ 592 $ -- $ 592 $ 524 $ 68 Customer Lists 4,380 4,380 -- 4,380 4,380 -- Non-Compete Agreements 313 203 110 200 151 49 Other 5 -- 5 5 -- 5 ------ ------ ------ ------ ------ ------ Total Other Intangibles $5,290 $5,175 $ 115 $5,177 $5,055 $ 122 ====== ====== ====== ====== ====== ====== Goodwill of $9,658 and $9,871 as of June 30, 2003 and December 31, 2002 respectively is attributable to the Company's Radio Spirits business. The change of $213 is related to the finalization of the acquisition of Great American Audio, which occurred in March 2002. (4) Long-term Debt Bank Debt As of August 1, 2003, the Company had $3,300 of indebtedness outstanding under the Amended and Restated Credit Agreement dated as of October 3, 2002, as amended, by and among the Company and Radio Spirits, Inc. and Audio Book Club, Inc., wholly-owned subsidiaries of the Company, as co-borrowers, and ING (U.S.) Capital LLC, as administrative agent, and the other lenders named therein (the "Credit Agreement"). The maturity date of the Credit Agreement is April 30, 2004; provided however, that the Company is required to make monthly payments of principal of $190 in August through September 2003, $200 in October through December 2003 and $225 in January through March 2004. The Company is not permitted to make any additional borrowings under the Credit Agreement. The interest rate on the credit facility is equal to the prime rate plus 2 1/2%. The Company granted the lenders under the Credit Agreement a security interest in substantially all of the Company's assets and the assets of its subsidiaries and pledged the stock of its subsidiaries. The Company is required to maintain Minimum EBITDA, as defined below, of the following: o $4,000,000 for the period beginning on January 1, 2001 and ending prior to June 30, 2003; o $5,000,000 for the period beginning on January 1, 2001 and ending prior to September 30, 2003; o $6,000,000 for the period beginning on January 1, 2001 and ending prior to December 31, 2003. o $7,000,000 for the period beginning on January 1, 2001 and ending prior to March 31, 2004 Under the Credit Agreement, "EBITDA" means, for any period, the sum of (i) net income, (ii) interest expense, (iii) income tax expense, (iv) depreciation expense, (v) extraordinary and nonrecurring losses and (vi) amortization expense, less extraordinary and nonrecurring gains (in each case, determined in accordance with generally accepted accounting principles) plus adjustments for (x) the pro forma effect of any Permitted Acquisition (as defined in the Credit Agreement) and (y) non-cash stock compensation; provided that EBITDA shall be adjusted for the effect of treating the Company's advertising expense and new member acquisition costs as expensed as incurred. The Company was in compliance with this covenant at June 30, 2003. 9 In addition to limiting the Company's ability to incur additional indebtedness, the Credit Agreement prohibits the Company from, among other things: o merging into or consolidating with another entity; o selling all or substantially all of its assets; o declaring or paying cash dividends; and o materially changing the nature of its business. We anticipate making the principal payments from cash flow generated from operations. The balance of our bank debt, after making the above payments, of $1.6 million is due April 30, 2004. We are currently seeking to refinance or extend this debt. Historically we have been able to extend the maturity of this debt. (5) Stockholders' Equity and Stock Options and Warrants Stock Options and Warrants From January 1, 2003 to June 30, 2003, the Company issued options to purchase 160,000 shares of its common stock to certain directors, employees and consultants to the Company under its 2000 Stock Option plan. The Company also cancelled options to purchase 155,000 shares of its common stock. The Company also issued non-plan warrants to purchase 90,000 shares of its common stock to a former employee and consultant at prices ranging from $1.50 to $3.00 per share as part of non-competition agreements. Preferred Stock On May 7, 2003, the Company sold 3,350 shares of a newly created Series B Convertible Preferred Stock (the "Series B Stock") with a liquidation preference of $100 per share for $335. Of the total sold, 1,400 shares ($140) were purchased by Carl Wolf, Chairman and a director of the Company, and 200 shares ($20) were purchased by John Levy, Executive Vice President and Chief Financial Officer of the Company. The holders of shares of Series B Convertible Preferred Stock will receive dividends at the rate of $9.00 per share, payable quarterly, in arrears, in cash on each March 31, June 30, September 30 and December 31; provided that payment will accrue until the Company is permitted to make such payment in cash under its Agreement with its senior lender. The Series B Stock is convertible into shares of Common Stock into MediaBay Common Stock at a conversion rate equal to a fraction, (i) the numerator of which is equal to the number of Series B Stock times $100 plus accrued and unpaid dividends though the date of conversion and (ii) the denominator is $0.77, the average price of the Company's stock on May 6, 2003. In the event of a liquidation, dissolution or winding up of the Company, the holders of Series B Stock shall be entitled to receive out of the assets of the Company, a sum in cash equal to $100.00 per share before any amounts are paid to the holders of the Company common stock and on a pari passu with the holders of the Series A Convertible Preferred Stock. The holders of Series B Stock shall have no voting rights, except as required by law and except that the vote or consent of the holders of a majority of the outstanding shares of Series B Stock, voting separately as a class, will be required for any amendment, alteration or repeal of the terms of the Series B Stock that adversely effects the rights, preferences or privileges of the Series B Stock (6) Litigation Settlement In December 1998 the Company acquired certain assets from a third party. The parties also entered into certain other agreements including a mailing agreement and a non-compete agreement. As consideration for the assets acquired and the related transactions, including the mailing agreement and the non-compete agreement, the third party received cash consideration of $30,750 and an aggregate of 325,000 shares of the Company's common stock (the "Shares") and warrants to purchase an additional 100,000 shares of the Company's common stock. The parties also entered into a Registration and Shareholder Rights Agreement pursuant to which, the Company granted the third party the right under certain circumstances, commencing December 31, 2004, to require the Company to purchase from the third party the Shares at a price of $15.00 per Share. 10 During the fourth quarter of 2000, the Company reviewed long-lived assets and certain related identifiable intangibles. The Company determined that the revised estimates of cash flows from the assets acquired would no longer be sufficient to recover the carrying value of goodwill associated with the acquisition. As a result, in the fourth quarter of 2000, the Company recorded an impairment charge of $22,785, representing the entire amount of unamortized goodwill. In 2001, the Company commenced litigation alleging, among other things, that the Company was fraudulently induced to purchase certain of the assets. On June 16, 2003, Audio Book Club, Inc. ("ABC"), a wholly owned subsidiary of MediaBay entered into a settlement agreement with respect to the lawsuit. Pursuant to the settlement agreement, ABC received $350 in cash, the return for cancellation of 325,000 shares of MediaBay common stock issued in connection with the acquisition and the termination of put rights granted to the seller in the acquisition with respect to 230,000 of the shares (put rights with respect to the remaining 95,000 shares had previously terminated). The termination of the put rights terminated a $3,450 future contingent obligation of MediaBay and results in a corresponding increase in stockholders' equity. The calculation of the settlement of litigation recorded in Contributed Capital is as follows: Termination of contingent put rights $ 3,450 Return for cancellation of 325,000 shares of common stock 247 Cash received 350 ------- Total received in settlement of litigation 4,047 Legal and other costs incurred in connection with the litigation 1,040 ------- Settlement of litigation recorded in Contributed Capital $ 3,007 ======= (7) Net Income (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 six months ended June 30, 2003 of 14,341,376 and for the three and six months ended June 30, 2002 of 13,987,118 and 13,926,811, respectively. For the three months ended June 30, 2003 common equivalent shares which were not included in the computation of diluted loss per share because they would have been anti-dilutive were 586,000 common equivalent shares, as calculated under the treasury stock method and 16,910,000 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 $346 for the three months ended June 30, 2003. For the six months ended June 30, 2003 common equivalent shares which were not included in the computation of diluted loss per share because they would have been anti-dilutive were 813,000 common equivalent shares, as calculated under the treasury stock method and 16,781,000 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 $652 for the six months ended June 30, 2003. Differences in the weighted average number of common shares outstanding for purposes of computing diluted earnings per share for the three months ended June 30, 2002 were due to the inclusion of 3,232,627 common equivalent shares, as calculated under the treasury stock method and 15,708,000 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 was $280 for the three months ended June 30, 2002. 11 For the six months ended June 30, 2002, common equivalent shares, which were not included in the computation of diluted loss per share because they would have been anti-dilutive were 2,466,075 common equivalent shares, as calculated under the treasury stock method and 15,627,000 common equivalent shares relating to convertible debt and preferred stock calculated under the "if-converted method." Interest expense and dividends on the convertible subordinated debt and convertible preferred stock that were not added back to net loss were $571 for the six months ended June 30, 2002 due to their anti-dilutive effect. (8) Commitments On April 18, 2003, the Company signed a sixty-six month extension of its lease on its office space in Cedar Knolls, New Jersey. Minimum annual lease commitments including capital improvement payments under all non-cancelable operating leases are as follows: Year ending December 31, 2003............................................... $ 156 2004............................................... 168 2005............................................... 192 2006............................................... 198 2007............................................... 204 Thereafter......................................... 310 ------- Total lease commitments............................ $ 1,228 ======= On May 1, 2003, the Company entered into a two-year consulting agreement with XNH Consulting Services, Inc. ("XNH"), a company wholly-owned by Norton Herrick, the Company's former Chairman. The agreement provides, among other things that XNH will provide consulting and advisory services to MediaBay and that XNH will be under the direct supervision of the Company's Board of Directors. For its services, the Company has agreed to pay XNH a fee of $8 per month and to provide Mr. Herrick with health insurance and other benefits applicable to the Company's officers to the extent such benefits may be provided under the Company's benefit plans. The consulting agreement provides that the indemnification agreement with Mr. Herrick entered into on November 15, 2002 pursuant to which, the Company agreed to indemnify Mr. Herrick to the maximum extent permitted by the corporate laws of the State of Florida or, if more favorable, the Company's Articles of Incorporation and By-Laws in effect at the time the agreement was executed, against all claims (as defined in the agreement) arising from or out of or related to Mr. Herrick's services as an officer, director, employee, consultant or agent of the Company or any subsidiary or in any other capacity shall remain in full force and effect and to also indemnify XNH on the same basis. Mr. Herrick resigned as Chairman of MediaBay, Inc. effective May 1, 2003 and the Company and Mr. Herrick terminated the employment agreement signed as of November 2, 2002 on May 1, 2003. (9) Supplemental Cash Flow Information Cash paid for interest expense was $284 and $357 for the six months ended June 30, 2003 and 2002, respectively. During the six months ended June 30, 2002, the Company issued 19,986 shares of the Company's common stock to consultants under consulting agreements. The shares have been valued at $50 and are being amortized to expense over the period of benefit. 12 (10) Segment Reporting For 2003 and 2002, the Company has divided its operations into four reportable segments: Corporate; Audio Book Club ("ABC") a membership-based club 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. The Company did not expend any funds or receive any income in the six months ended June 30, 2003 and 2002 from its RadioClassics subsidiary. Inter-segment sales are recorded at prevailing sales prices. Segment Reporting Three Months Ended June 30, 2003 Corporate ABC RSI Mbay.com Inter-segment Total --------- --- --- -------- ------------- ----- Sales, net of returns, discounts and allowances -- 7,274 2,110 35 (11) 9,408 Operating (loss) profit before depreciation and amortization (104) 448 260 (140) -- 327 Depreciation and amortization 61 26 11 -- -- 99 Interest expense 529 532 Dividends on preferred stock 62 -- 3 -- -- 62 Net income (loss) applicable to common shares (756) 422 246 (140) -- (228) Total assets -- 29,317 16,187 3 -- 45,452 Acquisition of fixed assets -- 3 1 -- (55) 4 Three Months Ended June 30, 2002 Corporate ABC RSI Mbay.com Inter-segment Total --------- --- --- -------- ------------- ----- Sales, net of returns, discounts and allowances $ -- $ 9,208 $ 2,775 $ 57 $ (63) $11,977 Operating (loss) profit before depreciation and amortization (1,104) 1,784 597 (115) 38 1,200 Depreciation and amortization 385 33 30 -- -- 448 Interest expense 768 -- 37 -- -- 805 Dividends on preferred stock 57 -- -- -- -- 57 Net income (loss) applicable to common shares (1,929) 1,784 560 (115) 38 338 Total assets -- 29,171 18,557 2 (65) 47,665 Acquisition of fixed assets -- 3 11 -- -- 14 Six Months Ended June 30, 2003 Corporate ABC RSI Mbay.com Inter-segment Total --------- --- --- -------- ------------- ----- Sales, net of returns, discounts and allowances -- 15,380 4,710 52 (37) 20,105 Operating (loss) profit before depreciation and amortization (1,269) 809 358 (296) 5 (393) Depreciation and amortization 121 54 26 -- -- 198 Interest expense 1,048 -- 7 -- -- 1055 Dividends on preferred stock 118 -- -- -- -- 118 Net income (loss) applicable to common shares (2,556) 755 328 (296) 5 (1,764) Total assets -- 29,317 16,187 3 (55) 45,452 Acquisition of fixed assets -- 13 2 -- -- 15 Six Months Ended June 30, 2002 Corporate ABC RSI Mbay.com Inter-segment Total --------- --- --- -------- ------------- ----- Sales, net of returns, discounts and allowances $ -- $17,129 $ 4,307 $ 107 $ (86) 21,457 Operating (loss) profit (2,116) 2,837 692 (231) 38 1,220 Operating (loss) profit before depreciation and amortization 821 64 60 -- -- 945 Interest expense 1,493 -- 45 -- -- 1,538 Dividends on preferred stock 102 -- -- -- -- 102 Net income (loss) applicable to common shares (3,711) 2,837 647 (231) 38 (420) Total assets -- 29,171 18,557 2 (65) 47,665 Acquisition of fixed assets -- 73 18 -- -- 91 13 (11) Recent Accounting Pronouncements In April 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities"("SFAS 149"). SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. With certain exceptions, SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. Management does not believe adoption of this standard will have a material impact on the Company's financial position or results of operations. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities." This interpretation defines when a business enterprise must consolidate a variable interest entity. This interpretation applies immediately to variable interest entities created after January 31, 2003. It applies in the first fiscal year or interim period beginning after June 15, 2003, to entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The adoption of this statement is not expected to have a material effect on the Company's financial position or results of operations. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure" ("SFAS 148") which amends SFAS No. 123. This statement provides alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation and amends the disclosure requirements of SFAS No. 123. The transition guidance and disclosure requirements are effective for fiscal years ending after December 15, 2002. The Company has included the required interim disclosure in Note 2 to these Financial Statements. The adoption of this statement did not have a material effect on the Company's financial position or results of operations. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". This interpretation requires a guarantor to recognize, at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. It also enhances guarantor's disclosure requirements to be made in its interim and annual financial statements about its obligations under certain guarantees it has issued. The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. In the normal course of business, the Company does not issue guarantees to third parties; accordingly, this interpretation will not have an effect on the Company's financial position or results of operations. In April 2002, SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections", was approved by the FASB. This statement is effective January 1, 2003. Among other things, this statement requires that gains or losses on the extinguishment of debt will generally be required to be reported as a component of income from continuing operations and will no longer be classified as an extraordinary item. Therefore, beginning in 2003, the Company's prior financial statements will need to be reclassified to include those gains and losses previously recorded as an extraordinary item as a component of income from continuing operations. In July 2002, the FASB issued SFAS No. 146, "Accounting for Exit or Disposal Activities" (SFAS 146"). SFAS 146 requires the recognition of a liability for costs associated with an exit plan or disposal activity when incurred and nullifies Emerging Issues Task Force (EITF) Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)", which allowed recognition at the date of an entity's commitment to an exit plan. The provisions of this statement are effective for exit or disposal activities that are initiated by the Company after December 31, 2002. 14 In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations," effective for fiscal years beginning after June 15, 2002. This statement addresses the diverse accounting practices for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The adoption of this statement did not have a material effect on the Company's financial position or results of operations. (12) Subsequent Events On July 31, 2003, a director exercised options to purchase 300,000 shares of MediaBay common stock at an exercise price of $.50 per share pursuant to an Option Agreement dated November 23, 2001. The options were exercised on a "cash-less" basis and the closing stock price on July 31, 2001 was $.78, accordingly, the Company issued to the director a certificate for 107,692 shares of MediaBay common stock. 15 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Dollars in thousands, except per share data) Forward-looking Statements 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 the Company's 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 the Company believes 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 the Company's actual results, performance or achievements to be materially different from any results, performances or achievements express or implied by such forward-looking statements. Important factors that could cause actual results to differ materially from our expectations, without limitation, the Company's history of losses; its ability to meet stock repurchase obligations, anticipate and respond to changing customer preferences, license and produce desirable content, protect its databases and other intellectual property from unauthorized access; pay trade creditors and collect receivables; dependence on third-party providers, suppliers and distribution channels; competition; the costs and success of its marketing strategies; product returns; and member attrition. Undue reference should not be placed on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to update any forward-looking statements. Introduction The Company is a marketer of spoken audio products, including audiobooks and old-time radio shows, through direct response, retail and Internet channels. The Company's content and products are sold in multiple formats, including physical (cassette and compact disc) and secure digital download formats. The Company reports financial results on the basis of four business segments; Corporate, Audio Book Club ("ABC"), Radio Spirits ("Radio Spirits" or "RSI") and MediaBay.com. A fifth division, Radio Classics, is aggregated with Radio Spirits for financial reporting purposes. Except for corporate, each segment serves a unique market segment within the spoken word audio industry. Results of Operations Three Months Ended June 30, 2003 Compared to Three Months Ended June 30, 2002 Sales, net of returns, discounts and allowances for the three months ended June 30, 2003 were $9,407 a decrease of $2,570, as compared to $11,977 for the three months ended June 30, 2002. The decrease in sales is principally due to decreased sales at our Audio Book Club of $1,934 in large part due to a decrease in membership and new member sales as a result of the timing and size of new member marketing activities during 2003 and higher return rates from members acquired in 2002 and $1,610 lower wholesale sales of our old-time radio products due to lower consumer demand and higher returns. This decrease was partially offset by $938 of sales in the three months ended June 30, 2003, of The World's Greatest Old-Time Radio continuity program, a program introduced in the third quarter of 2002, which is similar to Audio Book Club and offers old-time radio products. Cost of sales for the three months ended June 30, 2003 decreased $1,070 to $4,124 from $5,194 in the prior comparable period. Cost of sales as a percentage of net sales increased to 43.8% from 43.4%. Principally due to lower sales, as described above, gross profit decreased $1,500, to $5,283 for the three months ended June 30, 2003 as compared to $6,783 for the three months ended June 30, 2002. 16 Advertising and promotion expenses increased $24 to $2,612 for the three months ended June 30, 2003 as compared to $2,588 in the prior comparable period. The increase is principally due to increased advertising expenditures during the year ended December 31, 2002 compared to the year ended December 31, 2001, which resulted in increased amortization of deferred member acquisition costs in the three months ended June 30, 2003 as compared to the three months ended June 30, 2002. The Company actually spent $1,851 on advertising in the three months ended June 30, 2003; a reduction of $1,413, as compared to $3,264 spent on advertising in the three months ended June 30, 2002. General and administrative expenses for the three months ended June 30, 2003 decreased $341 to $2,206 from $2,547 for the three months ended June 30, 2002. The decrease in general and administrative expenses is due to lower professional fees and other general and administrative costs partially offset by a $248 increase in bad debt expense principally relating to higher bad debt rates at Audio Book Club relating to higher new member intake in 2002 principally from members obtained through the Internet. Depreciation and amortization expenses for the three months ended June 30, 2003 were $99, a decrease of $349, as compared to $448 for the prior comparable period. The decrease is principally attributable to reductions in the amortization of intangibles, which had been fully amortized or written off during the year ended December 31, 2002. Interest expense for the three months ended June 30, 2003 decreased $273 to $532 as compared to $805 for the three months ended June 30, 2002. The decrease is principally due to the pay down of a portion of our senior credit facility, a decrease in interest rates on our variable rate debt as interest rates have declined and inclusion in the three months ended June 30, 2002 of $215 for amortization of debt discount and deferred financing fees as compared to $128 for the three months ended June 30, 2003. Preferred dividends for the three months ended June 30, 2003 were $62 as compared to $57 for the three months ended June 30, 2002. The increase is due to the issuance in May 2003 of 3,350 shares of a newly created Series B Convertible Preferred Stock (the "Series B Stock") with a liquidation preference of $100 per share for $335. Principally due to lower sales and related gross profit, partially offset by lower general and administrative expenses, amortization and depreciation and interest expense, the Company reported a net loss applicable to common shares of $228, or $.02 per diluted share of common stock as compared to net income applicable to common shares for the three months ended June 30, 2003 of $338, or $.02 per diluted share for the three months ended June 30, 2002. Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002 Sales, net of returns, discounts and allowances for the six months ended June 30, 2003 were $20,105, a decrease of $1,352, as compared to $21,457 for the six months ended June 30, 2002. The decrease in sales is principally due to decreased sales at our Audio Book Club of $1,749 in large part due to a decrease in membership and new member sales as a result of the timing and size of new member marketing activities during 2003 and higher returns from members acquired in 2002, and $1,466 lower wholesale sales of our old-time radio products due to lower consumer demand and higher returns. The decrease was partially offset by $1,586 of sales in the six months ended June 30, 2003, of The World's Greatest Old-Time Radio continuity program, a program introduced in the third quarter of 2002, which is similar to Audio Book Club and offers old-time radio products and an increase in old-time radio direct-to-consumer sales of $199 principally from a radio advertising campaign. Cost of sales for the six months ended June 30, 2003 decreased $124 to $9,359 from $9,483 in the prior comparable period. Cost of sales as a percentage of net sales increased to 46.5% for the six months ended June 30, 2003 compared to 44.2% for the three months ended June 30, 2002. The increase in cost of goods sold as a percentage of net sales is principally due to an increase at the Radio Spirits operations as a result of discounting in the direct mail business relating to a new customer acquisition program marketed through a radio advertising campaign, increased returns in the wholesale business resulting in higher fulfillment costs as a percentage of revenue and increased provisions for obsolete inventory and an increase in new members in The World's Greatest Old-Time Radio continuity, whose initial purchases are at substantially reduced prices. Principally due 17 to lower sales, gross profit decreased $1,228 to $10,746 for the six months ended June 30, 2003 as compared to $11,974 for the six months ended June 30, 2002. Advertising and promotion expenses increased $683 to $5,459 for the six months ended June 30, 2003 as compared to $4,776 in the prior comparable period. The increase is principally due to increased advertising expenditures during the year ended December 31, 2002 compared to the year ended December 31, 2001, which resulted in increased amortization of deferred member acquisition costs in the six months ended June 30, 2003 as compared to the six months ended June 30, 2002. The Company actually spent $4,223 on advertising in the six months ended June 30, 2003; a reduction of $2,583, as compared to $6,806 spent on advertising in the six months ended June 30, 2002. General and administrative expenses for the six months ended June 30, 2003 increased $648 to $5,680 from $5,033 for the six months ended June 30, 2002. General and administrative expense increases are principally attributable to increased bad debt expense of $762, principally relating to higher bad debt rates at Audio Book Club relating to higher new member intake in 2002 principally from members obtained through the Internet, partially offset by lower professional fees and other expenses. Depreciation and amortization expenses for the six months ended June 30, 2003 were $198, a decrease of $747, as compared to $945 for the prior comparable period. The decrease is principally attributable to reductions in the amortization of intangibles, which had been fully amortized or written off during the year ended December 31, 2002. Net interest expense for the six months ended June 30, 2003 decreased $483 to $1,055 as compared to $1,538 for the six months ended June 30, 2001. The decrease is principally due to the pay down of a portion of our senior credit facility, a decrease in interest rates on our variable rate debt as interest rates have declined and inclusion in net interest expense of $248 and $449 for the six months ended June 30, 2003 and 2002, respectively, for amortization of debt discount related to warrants and beneficial conversion features related to our financings. Preferred stock dividends were $118 and $102 for the six months ended June 30, 2003 and 2002, respectively. The increase in preferred stock dividends is due to the issuance in May 2003 of 3,350 shares of a newly created Series B Convertible Preferred Stock (the "Series B Stock") with a liquidation preference of $100 per share for $335. Due to the lower sales and related gross profit, higher advertising expenses and bad debt expense, partially offset by lower amortization, depreciation and interest expense, the Company reported a net loss applicable to common shares of $1,764, or $.12 per diluted share of common stock as compared to a net loss applicable to common shares for the six months ended June 30, 2003 of $420, or $.03 per diluted share. Liquidity and Capital Resources Historically, the Company has funded its cash requirements through sales of equity and debt securities and borrowings from financial institutions and the Company's principal shareholders. At June 30, 2003, the Company owed approximately $12,562 to trade and other creditors. Approximately $5,638 of these accounts payable were more than 60 days past due. If the Company does not make satisfactory payments to its vendors they may refuse to continue to provide it products or services on credit, which could interrupt the Company's supply of products or services. The Company has implemented a series of initiatives to increase cash flow including significant reductions in marketing and advertising expenditures to attract new members to its Audio Book Club. There can be no assurance that the Company will not in the future require additional capital to pay its creditors, fund the expansion of operations, make acquisitions or for working capital. Management believes that additional sources of capital are available if required. For the six months ended June 30, 2003, cash decreased by $369, as the Company had net cash provided by operating activities of $660 and used net cash of $265 and $764 for investing and financing activities, respectively. Net cash provided by operating activities principally consisted of net income of $1,243, 18 depreciation and amortization expenses of $198, amortization of deferred financing costs and original issue discount of $248, non-current accrued interest and dividends payable of $534, decreases in accounts receivable, inventory and royalty advances of $1,246, $149 and $8, respectively, and a net decrease in deferred member acquisition costs of $1,246, partially offset by an increase in prepaid expenses of $132 and decreases in accounts payable and accrued expenses of $383 and net settlement costs of $690. On June 16, 2003, Audio Book Club, Inc. ("ABC"), a wholly owned subsidiary of MediaBay entered into a settlement agreement with respect to a lawsuit in which ABC was the plaintiff and arising out of an acquisition made by ABC. Pursuant to the settlement agreement, ABC received $350 in cash, the return for cancellation of 325,000 shares of MediaBay common stock issued in connection with the acquisition and the termination of put rights granted to the seller in the acquisition with respect to 230,000 of the shares (put rights with respect to the remaining 95,000 shares had previously terminated). The termination of the puts rights terminates a $3,450 future contingent obligation of MediaBay and results in a corresponding increase in stockholders' equity. The calculation of the settlement of litigation is as follows: Termination of contingent put rights $ 3,450 Return for cancellation of 325,000 shares of common stock 247 Legal and other costs incurred in connection with the litigation, net of cash received of $350 690 ------- Net settlement of litigation recorded in Contributed Capital $ 3,007 ======= The decrease in accounts receivable was primarily attributable to the collection of retail receivables from the holiday selling season from our radio programs. The decrease in deferred member acquisition cost is due to changes in the timing and reduction of the size of marketing campaigns to attract new members due both to an attempt to target the best performing members and cash constraints which have limited our ability to execute planned campaigns. The Company actually spent $4,223 on advertising in the six months ended June 30, 2003; a reduction of $2,583, as compared to $6,806 spent on advertising in the six months ended June 30, 2002. The increase in prepaid expenses is principally due to the timing of marketing activities. Net cash used in investing activities consists of acquisition of fixed assets of $15, principally computer equipment and the acquisition of intangible assets and goodwill, including legal fees and other costs incurred in obtaining covenants not to compete from a former employee and a former consultant of $92, and the acquisition of certain old-time radio assets of $158. In accordance with the terms of its senior credit facility, the Company repaid $1,050 of principal on its senior credit facility during the six months ended June 30, 2003. On April 9, 2003, the maturity date of the principal amount of the senior credit facility of $4,030 was extended to April 30, 2004 with certain conditions. In addition to its scheduled monthly principal payments of $190 in August through September 2003 and $200 in October through December 2003; the Company is required to make payments of $225 per month for the months of January, February and March 2004. The interest rate for the revolving credit facility is the prime rate plus 2.5%. On May 7, 2003, the Company sold 3,350 shares of a newly created Series B Convertible Preferred Stock (the "Series B Stock") with a liquidation preference of $100 per share for $335. Of the total sold, 1,400 shares ($140) were purchased by Carl Wolf, Chairman and a director of the Company, and 200 shares ($20) were purchased by John Levy, Executive Vice President and Chief Financial Officer of the Company. The holders of shares of Series B Convertible Preferred Stock will receive dividends at the rate of $9.00 per share, payable quarterly, in arrears, in cash on each March 31, June 30, September 30 and December 31; provided that payment will accrue until the Company is permitted to make such payment in cash under its Agreement with its senior lender. 19 The Series B Stock is convertible into shares of Common Stock into MediaBay Common Stock at a conversion rate equal to a fraction, (i) the numerator of which is equal to the number of Series B Stock times $100 plus accrued and unpaid dividends though the date of conversion and (ii) the denominator is the $0.77, the closing sale price of the Company's stock on May 6, 2003. In the event of a liquidation, dissolution or winding up of MediaBay, the holders of Series B Stock shall be entitled to receive out of the assets of MediaBay, a sum in cash equal to $100.00 per share before any amounts are paid to the holders of MediaBay common stock and on a pari passu with the holders of the Series A Convertible Preferred Stock. The holders of Series B Stock shall have no voting rights, except as required by law and except that the vote or consent of the holders of a majority of the outstanding shares of Series B Stock, voting separately as a class, will be required for any amendment, alteration or repeal of the terms of the Series B Stock that adversely effects the rights, preferences or privileges of the Series B Stock. On April 18, 2003 the Company signed a sixty-six month extension of its lease on its office space in Cedar Knolls, New Jersey. Minimum annual lease commitments including capital improvement payments under all non-cancelable operating leases are as follows: Year ending December 31, 2003............................................... $ 156 2004............................................... 168 2005............................................... 192 2006............................................... 198 2007............................................... 204 Thereafter......................................... 310 ------- Total lease commitments............................ $ 1,228 ======= On May 1, 2003, the Company entered into a two-year consulting agreement with XNH Consulting Services, Inc. ("XNH"), a company wholly-owned by Norton Herrick, the Company's former Chairman. The agreement provides, among other things that XNH will provide consulting and advisory services to MediaBay and that XNH will be under the direct supervision of the Company's Board of Directors. For its services, the Company has agreed to pay XNH a fee of $8 per month and to provide Mr. Herrick with health insurance and other benefits applicable to the Company's officers to the extent such benefits may be provided under the Company's benefit plans. The consulting agreement provides that the indemnification agreement with Mr. Herrick entered into on November 15, 2002 pursuant to which, the Company agreed to indemnify Mr. Herrick to the maximum extent permitted by the corporate laws of the State of Florida or, if more favorable, the Company's Articles of Incorporation and By-Laws in effect at the time the agreement was executed, against all claims (as defined in the agreement) arising from or out of or related to Mr. Herrick's services as an officer, director, employee, consultant or agent of the Company or any subsidiary or in any other capacity shall remain in full force and effect and to also indemnify XNH on the same basis. Mr. Herrick resigned as Chairman of MediaBay, Inc. effective May 1, 2003 and the Company and Mr. Herrick terminated the employment agreement signed as of November 2, 2002 on May 1, 2003. 20 Recent Accounting Pronouncements In April 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS 149"). SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. With certain exceptions, SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. Management does not believe adoption of this standard will have a material impact on the Company's financial position or results of operations. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities." This interpretation defines when a business enterprise must consolidate a variable interest entity. This interpretation applies immediately to variable interest entities created after January 31, 2003. It applies in the first fiscal year or interim period beginning after June 15, 2003, to entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The adoption of this statement is not expected to have a material effect on the Company's financial position or results of operations. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure, an amendment of FASB Statement 123" which amends SFAS No. 123. This statement provides alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation and amends the disclosure requirements of SFAS No. 123. The transition guidance and annual disclosure provisions are effective for fiscal years ending after December 15, 2002. The Company has included the required interim disclosure in Note 2 to the Financial Statements presented elsewhere in this report. The adoption of this statement did not have a material effect on the Company's financial position or results of operations. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". This interpretation requires a guarantor to recognize, at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. It also enhances guarantor's disclosure requirements to be made in its interim and annual financial statements about its obligations under certain guarantees it has issued. The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. In the normal course of business, the Company does not issue guarantees to third parties; accordingly, this interpretation will not have an effect on the Company's financial position or results of operations. In April 2002, SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections", was approved by the FASB. This statement is effective January 1, 2003. Among other things, this statement requires that gains or losses on the extinguishment of debt will generally be required to be reported as a component of income from continuing operations and will no longer be classified as an extraordinary item. Therefore, beginning in 2003, our prior financial statements will need to be reclassified to include those gains and losses previously recorded as an extraordinary item as a component of income from continuing operations. In July 2002, the FASB issued SFAS No. 146, "Accounting for Exit or Disposal Activities" ("SFAS 146"). SFAS 146 requires the recognition of a liability for costs associated with an exit plan or disposal activity when incurred and nullifies Emerging Issues Task Force (EITF) Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)", which allowed recognition at the date of an entity's commitment to an exit plan. The provisions of this statement are effective for exit or disposal activities that are initiated by the Company after December 31, 2002. 21 In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations," effective for fiscal years beginning after June 15, 2002. This statement addresses the diverse accounting practices for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The adoption of this statement did not have a material effect on the Company's financial position or results of operations. Quarterly Fluctuations The Company's operating results vary from period to period as a result of purchasing patterns of members, the timing, costs, magnitude and success of direct mail campaigns and Internet initiatives and other new member recruitment advertising, member attrition, the timing and popularity of new audiobook releases and product returns. The timing of new member enrollment varies depending on the timing, magnitude and success of new member advertising, particularly Internet advertising and direct mail campaigns. The Company believes 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 is exposed to market risk for the impact of interest rate changes. As a matter of policy the Company does not enter into derivative transactions for hedging, trading or speculative purposes. The Company's exposure to market risk for changes in interest rates relates to its variable rate debt. The Company has total debt outstanding as of June 30, 2003 of $16,597, net of original issue discount of $354, of which interest on $8,494 principal amount of this debt is payable at the prime rate plus 2.0 to 2.5%. If the prime rate were to increase the Company's interest expense would increase, however a hypothetical 10% change in interest rates would not have had a material impact on its fair values, cash flows, or earnings for the six months ended June 30, 2003. All of the Company's other debt is at fixed rates of interest. Item 4. Controls and Procedures The Company's certifying officers have concluded based on an evaluation of the Company's disclosure controls and procedures that was carried out under their supervision and with their participation that the disclosure controls and procedures as of the end of the quarter ended June 30, 2003 are effective in ensuring that material information relating to the Company, including its consolidated subsidiaries, is made known to the certifying officers by others within those entities, as appropriate to allow timely decisions regarding required disclosure, particularly during the period in which this Form 10-Q was being prepared and that information required to be disclosed by the Company in its reports that it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. In addition, there was no change in internal control over financial reporting during the quarter ended June 30, 2003 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 22 Part II - Other Information Item 2: Changes in Securities and Use of Proceeds (Dollars in thousands, except per share date) In the six months ended June 30, 2003, the Company issued plan options to purchase 160,000 shares of its common stock to officers, employees and Board members. The options have exercise prices ranging from $1.25 to $1.50, vest at various times and have a five-year exercise period. The Company also cancelled five-year plan options to purchase a total of 155,000 shares of common stock. We also issued non-plan warrants to purchase 90,000 shares of its common stock to a former employee and consultant at prices ranging from $1.50 to $3.00 per share. On May 7, 2003, the Company sold 3,350 shares of a newly created Series B Convertible Preferred Stock (the "Series B Stock") with a liquidation preference of $100 per share for $335. Of the total sold, 1,400 shares ($140) were purchased by Carl Wolf, Chairman and a director of the Company, and 200 shares ($20) were purchased by John Levy, Executive Vice President and Chief Financial Officer of the Company. The Series B Stock is convertible into shares of Common Stock into MediaBay Common Stock at a conversion rate equal to a fraction, (i) the numerator of which is equal to the number of Series B Stock times $100 plus accrued and unpaid dividends though the date of conversion and (ii) the denominator is the $0.77, the closing sale price of the Company's stock on May 6, 2003. The foregoing securities were issued in private transactions pursuant to an exemption from the registration requirement offered by Section 4(2) of the Securities Act of 1933. Item 6: Exhibits and Reports on Form 8-K. (a) Exhibits 31.1 Rule 13a-14(a) Certificate of Principal Executive Officer 31.2 Rule 13a-14(a) Certificate of Principal Financial Officer 32.1 Certification of Hakan Lindskog, 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 John Levy, Executive Vice President and 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 2002 (b) Reports on Form 8-K Report dated June 24, 2003 reporting changes in Company's certifying accountants. Report dated June 16, 2003, reporting Audio Book Club, Inc.'s ("ABC"), a wholly-owned subsidiary of MediaBay, settlement agreement with respect to a lawsuit in which ABC was the plaintiff. 23 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: August 11, 2003 By: /s/ Hakan Lindskog ------------------------------------- Hakan Lindskog Chief Executive Officer and President Dated August 11, 2003 By: /s/ John F. Levy ------------------------------------- John F. Levy Chief Financial Officer (principal accounting and financial officer) 24