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SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
For the quarter ended September 30, 1999
Commission File Number 000-26697
MP3.com, Inc.
Delaware (State or other jurisdiction of incorporation or organization) |
33-0840026 (I.R.S. Employer Identification No) |
|
4790 Eastgate Mall, San Diego, CA (Address of principal executive offices) |
92121 (Zip Code) |
(858) 623-7000
N/A
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past ninety days. Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date:
Common Stock, $0.001 per share par value, 68,528,723 shares as of October 31, 1999.
This report contains 31 pages
MP3.COM, INC.
FORM 10-Q
INDEX
Page | ||||||
Number | ||||||
PART I FINANCIAL INFORMATION | ||||||
Item 1. | Financial Statements | 3 | ||||
Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations | 9 | ||||
Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 28 | ||||
PART II OTHER INFORMATION | ||||||
Item 2. | Changes in Securities and Uses of Proceeds | 29 | ||||
Item 4. | Submission of Matters To A Vote Of Security Holders | 29 | ||||
Item 6. | Exhibits and Reports on Form 8-K | 30 |
2
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
MP3.COM, INC.
CONDENSED BALANCE SHEETS
ASSETS
September 30, | December 31, | |||||||||
1999 | 1998 | |||||||||
(Unaudited) | ||||||||||
Current assets: | ||||||||||
Cash and cash equivalents | $ | 166,689 | $ | 39 | ||||||
Short-term investments in marketable securities | 279,851 | | ||||||||
Accounts receivable, net of allowance for doubtful accounts | 1,808 | 293 | ||||||||
Unbilled receivables | 781 | 65 | ||||||||
Prepaid expenses and other current assets | 7,023 | | ||||||||
Total current assets | 456,152 | 397 | ||||||||
Property and equipment, net of accumulated depreciation | 7,101 | 52 | ||||||||
Long-term investments in marketable securities | 4,971 | | ||||||||
Other assets | 6,229 | 14 | ||||||||
Total assets | $ | 474,453 | $ | 463 | ||||||
LIABILITIES AND STOCKHOLDERS EQUITY | ||||||||||
Current liabilities: | ||||||||||
Accounts payable | $ | 3,437 | $ | 37 | ||||||
Accrued expenses | 4,432 | 104 | ||||||||
Line of credit and capital lease obligations | 1,234 | 14 | ||||||||
Deferred revenues | 31,336 | 15 | ||||||||
Deferred income taxes | | 94 | ||||||||
Total current liabilities | 40,439 | 264 | ||||||||
Deferred revenue | 14,000 | | ||||||||
Deferred income taxes | | 4 | ||||||||
Stockholders equity: | ||||||||||
Preferred stock, par value $0.001 per share; none authorized, issued and outstanding at September 30, 1999 and December 31, 1998 | ||||||||||
Convertible preferred stock, par value $0.001 per share; authorized 15,500,000 and 5,000,000 at September 30, 1999 and December 31, 1998, respectively; none issued and outstanding at September 30, 1999 and December 31, 1998 | ||||||||||
Common stock, par value $0.001 per share; authorized 300,000,000 and 51,000,000 at September 30, 1999 and December 31, 1998, respectively; 68,376,920 and 29,249,999 issued and outstanding at September 30, 1999 and December 31, 1998, respectively | 68 | 29 | ||||||||
Additional paid in capital | 474,673 | 701 | ||||||||
Note receivable from stockholder | (258 | ) | | |||||||
Deferred compensation | (26,474 | ) | (178 | ) | ||||||
Unrealized loss on investments available-for-sale | (19 | ) | | |||||||
Accumulated deficit | (27,976 | ) | (357 | ) | ||||||
Total stockholders equity | 420,014 | 195 | ||||||||
$ | 474,453 | $ | 463 | |||||||
The accompanying notes are an integral part of these condensed financial statements.
3
MP3.COM, INC.
CONDENSED STATEMENTS OF OPERATIONS
For The Three Months Ended | For The Nine Months | ||||||||||||||
Ended | |||||||||||||||
September 30, 1999 | September 30, 1998 | September 30, 1999 | |||||||||||||
Net revenues | $ | 4,051 | $ | 277 | $ | 6,629 | |||||||||
Cost of revenues | 1,687 | 83 | 2,741 | ||||||||||||
Gross profit | 2,364 | 194 | 3,888 | ||||||||||||
Operating expenses: | |||||||||||||||
Sales and marketing | 8,897 | 26 | 12,114 | ||||||||||||
Product development | 2,373 | 67 | 3,375 | ||||||||||||
General and administrative | 3,110 | 38 | 5,021 | ||||||||||||
Amortization of deferred compensation | |||||||||||||||
and other stock based compensation | 12,370 | 83 | 15,834 | ||||||||||||
Total operating expenses | 26,750 | 214 | 36,344 | ||||||||||||
Loss from operations | (24,386 | ) | (20 | ) | (32,456 | ) | |||||||||
Interest income (expense), net | 4,517 | (1 | ) | 4,837 | |||||||||||
Loss before income taxes | (19,869 | ) | (21 | ) | (27,619 | ) | |||||||||
Provision for income taxes | | 12 | | ||||||||||||
Net loss | $ | (19,869 | ) | $ | (33 | ) | $ | (27,619 | ) | ||||||
Net loss per share: | |||||||||||||||
Basic and diluted | $ | (0.33 | ) | $ | (0.00 | ) | $ | (0.54 | ) | ||||||
Weighted average shares basic and diluted | 60,333,000 | 26,179,000 | 51,272,000 | ||||||||||||
The accompanying notes are an integral part of these condensed financial statements.
4
MP3.COM, INC.
CONDENSED STATEMENT OF CASH FLOWS
Nine Months | ||||||
Ended | ||||||
September 30, 1999 | ||||||
Operating activities: | ||||||
Net loss | $ | (27,619 | ) | |||
Adjustments to reconcile net loss to cash provided by operating activities: | ||||||
Amortization of deferred compensation and other stock based | ||||||
compensation | 16,970 | |||||
Amortization of prepaid marketing costs | 2,524 | |||||
Charge associated with employee costs | 1,241 | |||||
Charge associated with facility relocation costs | 815 | |||||
Depreciation | 470 | |||||
Deferred income taxes | (98 | ) | ||||
Changes in operating assets and liabilities: | ||||||
Accounts receivable | (1,515 | ) | ||||
Unbilled receivables | (716 | ) | ||||
Prepaid expenses and other current assets | (6,040 | ) | ||||
Accounts payable | 3,400 | |||||
Deferred revenue | 45,320 | |||||
Accrued expenses | 3,087 | |||||
Cash provided by operating activities | 37,839 | |||||
Investing activities: | ||||||
Purchases of property and equipment | (8,248 | ) | ||||
Purchases of investments, net | (284,841 | ) | ||||
Other assets | (5,299 | ) | ||||
Cash used in investing activities | (298,388 | ) | ||||
Financing activities: | ||||||
Proceeds from line of credit | 1,234 | |||||
Payment of note payable | | |||||
Payments under capital lease obligations | (14 | ) | ||||
Issuance of common stock | 365,402 | |||||
Net proceeds from issuance of Series A preferred stock | 13,118 | |||||
Proceeds from issuance of Series B preferred stock | 2,500 | |||||
Net proceeds from issuance of Series C preferred stock | 44,959 | |||||
Cash provided by financing activities | 427,199 | |||||
Increase in cash and cash equivalents | 166,650 | |||||
Cash and cash equivalents at beginning of period | 39 | |||||
Cash and cash equivalents at end of period | $ | 166,689 | ||||
Supplemental disclosures of cash flow information: | ||||||
Interest paid | $ | 89 | ||||
Taxes paid | $ | 168 | ||||
Supplemental schedule of non-cash activities: | ||||||
Common stock issued for notes receivable | $ | 338 | ||||
Cancellation of stockholder note receivable | $ | 78 | ||||
Warrants for common stock and common stock issued in exchange | ||||||
for prepaid marketing costs | $ | 2,302 | ||||
Donation of 100,000 shares of MP3.com common stock to the | ||||||
MP3 Foundation | $ | 767 | ||||
The accompanying notes are an integral part of these condensed financial statements.
5
MP3.COM, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
Note 1 The Company and Summary of Significant Accounting Policies:
The Company
MP3.com, Inc. is developing a revolutionary approach to the promotion and distribution of music. MP3.com uses the Internet and file formats that make music files smaller to enable artists to distribute and promote their music and to enable consumers to conveniently access this music. Consumers can search, preview and download music free of charge.
Basis of Presentation
The financial statements as of September 30, 1999, for the three and nine months ended September 30, 1999, and for the three months ended September 30, 1998 are unaudited and have been prepared by MP3.com pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). The unaudited financial statements have been prepared on the same basis as the audited financial statements and, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary to state fairly the financial information included, in accordance with generally accepted accounting principles. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such SEC rules and regulations. The results of operations for the interim period ended September 30, 1999 are not necessarily indicative of the results which may be reported for any other interim period or for the year ending December 31, 1999. The financial statements for the period from March 17, 1998 (inception) to September 30, 1998 have not been presented as the operating activity was insignificant and disclosure would not be meaningful.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Net Loss Per Share
MP3.com computes net loss per share following SFAS No. 128, Earnings Per Share and SEC Staff Accounting Bulletin No. 98. Under the provisions of SFAS No. 128, basic net income (loss) per share is computed by dividing the net income (loss) available to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares, composed of unvested restricted common shares, incremental common shares issuable upon the exercise of stock options, and common shares issuable on assumed conversion of Series A, B, and C preferred stock, are included in diluted net income (loss) per share to the extent these shares are dilutive. Common equivalent shares are not included in the computation of dilutive net loss per share for the three and nine months ended September 30, 1999 and the three months ended September 30, 1998 because the effect would be anti-dilutive.
Under the provisions of SAB 98, common shares issued for nominal consideration, if any, would be included in the per share calculations as if they were outstanding for all periods presented. No common shares have been issued for nominal consideration.
6
NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
Note 1 The Company and Summary of Significant Accounting Policies (continued):
The following table sets forth the computation of basic and diluted net loss per share as follows:
Three Months Ended | |||||||||
September 30, | September 30, | ||||||||
1999 | 1998 | ||||||||
Numerator: | |||||||||
Net loss | $ | (19,869 | ) | $ | (33 | ) | |||
Denominator: | |||||||||
Weighted average shares outstanding | 65,235,000 | 26,179,000 | |||||||
Weighted average unvested common shares subject to repurchase agreements | (4,902,000 | ) | | ||||||
Denominator for basic and diluted calculation | 60,333,000 | 26,179,000 | |||||||
Net loss per share: | |||||||||
Basic and diluted | $ | (0.33 | ) | $ | (0.00 | ) | |||
Nine Months | |||||
Ended | |||||
September 30, | |||||
1999 | |||||
Numerator: | |||||
Net loss | $ | (27,619 | ) | ||
Denominator: | |||||
Weighted average shares outstanding | 56,174,000 | ||||
Weighted average unvested common shares subject to repurchase agreements | (5,021,000 | ) | |||
Denominator for basic and diluted calculation | 51,153,000 | ||||
Net loss per share: | |||||
Basic and diluted | $ | (0.54 | ) | ||
Diluted common stock equivalents include common stock options, as if converted, and restricted stock that has not yet fully vested. Potentially dilutive securities total approximately 9,806,000 common shares for the three and nine months ended September 30, 1999, respectively, and were excluded from historical diluted earnings per share because of their anti-dilutive effect.
Comprehensive Income
MP3.com adopted the provisions of SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for reporting comprehensive income and its components in financial statements. Comprehensive income, as defined, includes all changes in equity (net assets) during a period from non-owner sources. Net income (loss) and other comprehensive income (loss), including foreign currency translation adjustments, and unrealized gains and losses on investments shall be reported, net of their related tax effect, to arrive at comprehensive income. There were no differences between MP3.coms net loss and its total comprehensive loss for the three or nine months ended September 30, 1999, except for unrealized losses on investments of approximately $19.
7
NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
Note 1 The Company and Summary of Significant Accounting Policies (continued):
Segment Information
MP3.com adopted the provisions of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. SFAS 131 requires public companies to report financial and descriptive information about their reportable operating segments. MP3.com identifies its operating segments based on how management internally evaluates separate financial information (if available), business activities and management responsibility. MP3.com believes it operates in a single business segment and adoption of this standard did not have a material impact on MP3.coms financial statements. Through September 30, 1999, there have been no foreign operations.
A summary of advertising and merchandise revenue from customers is as follows:
Nine Months Ended | ||||
September 30, 1999 | ||||
Advertising | $ | 5,875 | ||
Merchandise | 754 | |||
$ | 6,629 | |||
Note 2 Stockholders Equity
Issuance of Common Stock
On July 21, 1999, the Company effected its initial public offering of common stock. A total of 13,697,233 shares were sold at a price of $28.00 per share. The offering resulted in net proceeds to the Company of approximately $361.3 million, net of an underwriting fee of $20.3 million and estimated offering expenses of $1.9 million. Upon the closing of the Companys initial public offering, all 12,871,681 shares of the Series A, B, and C Convertible Preferred Stock converted into 19,307,516 shares of common stock.
Stock Options
During the nine months ended September 30, 1999, MP3.com granted additional options to purchase 11,521,210 shares of common stock at a weighted average exercise price of $3.00 per share. Included in the options to purchase 11,521,210 shares are options to purchase 450,000 shares granted at a weighted average exercise price of $1.00 outside of MP3.coms equity incentive plan. All options to purchase 450,000 shares were exercised in their entirety in May 1999.
Note 3 Recent Events
During November 1999, MP3.com entered into an agreement with an internationally known CD manufacturer and fulfillment company (the Supplier) whereby the Supplier will perform various manufacturing and fulfillment services for MP3.com for 10 years. In connection with execution of the Supplier supply agreement, MP3.com purchased 1,500,000 shares of the Suppliers common shares and a warrant for 1,780,000 common shares for approximately $13.3 million. Our agreement requires us to hold the common shares for at least one year. The warrant expires in October 2003, and the exercise price is Cn$15.00 per share. The Supplier is a publicly traded company on the Toronto Stock Exchange, Montreal Exchange, and NASDAQ. Additionally, the Supplier entered into an advertising agreement with MP3.com whereby MP3.com will deliver various advertising products through March 2001 and receive $1.5 million in cash during the term of the advertising agreement.
8
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This document contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as may, will, should, except, plan, anticipate, believe, estimate, predict, potential or continue, the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We are under no obligation to update any of the forward-looking statements after the filing of this Form 10-Q to conform such statements to actual results or to changes in our expectations.
The following discussion should be read in conjunction with our financial statements and the related notes and the other financial information appearing elsewhere in this Form 10-Q. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made under the caption Managements Discussion and Analysis of Financial Condition and Results of Operations, under the caption Risk Factors, in the audited financial statements and related footnotes included herein and in the Companys Registration Statement on Form S-1 dated July 21, 1999 (No. 333-78545).
Given our short operating history and our limited operations during 1998, we believe that comparisons between the nine months ended September 30, 1999 and the period from March 17, 1998 (inception) to September 30, 1998 would not be meaningful; therefore, these comparisons are not discussed below.
Overview
MP3.com is pioneering a revolutionary approach to the promotion and distribution of music. Our website has grown into a premier online music destination. We use the Internet and file formats that make music files smaller to enable a growing number of artists to broadly distribute and promote their music and to enable consumers to conveniently access this expanding music catalog. Our website contains more than 208,000 songs available for preview from over 35,000 artists, which we believe represents one of the largest collections of digital music available on the Internet. Consumers can search, preview and download music free of charge.
We receive revenue from online advertising, electronic commerce and offline advertising. For the nine months ended September 30, 1999, 57% of our revenues were from the sale of advertising space on our website. We also receive revenue from the sale of CDs online and from advertisers for their sponsorship of CD samplers, which are distributed free of charge to consumers and contain collections of music from artists that have posted music on our website.
Our unique business model provides the following advantages for artists and consumers:
| creates an easy and convenient way for consumers to listen to, download and purchase music; | |
| dramatically lowers costs for artists to promote and distribute their music; | |
| enables artists to reach a large number of consumers worldwide; | |
| enables consumers to discover local and lesser-known artists in ways they cannot through traditional music retailers; and |
facilitates direct communication between fans and artists.
We believe that large numbers of artists and consumers are drawn to MP3.com because they have historically been under served by the traditional music industry. We expect to continue introducing new products and services designed to meet their entertainment, electronic commerce, communications and information needs. MP3.com was incorporated in March 1998. During 1998, our operations consisted largely of developing the infrastructure necessary to download music on the Internet. Since the beginning of 1999, our
9
The Three Months Ended September 30, 1999 Compared To September 30, 1998:
Results of Operations
Net Revenues
For the three months ended September 30, 1999, net revenues were $4,051,000 consisting of online advertisements (49% of net revenues) on our website, offline advertisements through the distribution of our CD sampler products (41% of net revenues), and the online sale of CDs and music-related merchandise (10% of net revenues). This compares to $277,000 during the same period one year ago, and $1,911,000 during the second quarter of 1999. The increase in net revenues during the third quarter of 1999 over the same period in 1998 was mostly attributable to a significant increase in online banner and sponsorship advertisements, offline advertisements, and CD sales on our website.
Revenue from online advertising. For the third quarter of 1999, revenues from online advertising were $1,971,000 or 49% of net revenues compared to $233,000 (84% of net revenues) for the comparable period one year ago and $1,264,000 (66% of net revenues) for the second quarter of 1999. Online advertising revenues consist of banner and sponsorship advertisements on our website. The increase in the level of advertising revenue in the third quarter of 1999 when compared to both the third quarter of 1998 and the second quarter of 1999 was primarily due to the expansion of our customer base, increased awareness regarding MP3.com and the mp3 technology, and development and expansion of music and our websites content. The duration of our banner advertising commitments range from one month to in excess of three years. Sponsorship advertising contracts involve more integration with our website, including the placement of buttons that provide users with direct links to the advertisers website.
Revenue from offline advertising. For the three months ended September 30, 1999, revenues from offline advertising were $1,667,000 (41% of net revenues), compared to zero for the comparable period one year ago and $382,000 (20% of net revenues) during the second quarter of 1999. During the three months ended September 30, 1999, offline advertising revenues consisted of CD sampler products. The increase in offline advertising revenue is primarily due to the recent introduction during the second quarter of 1999 of our CD sampler product.
Revenue from online sales of CDs and other music-related merchandise. During the third quarter of 1999, revenues from online sales of CDs and other music-related merchandise was $413,000 (10% of net revenues) compared to $44,000 (16% of net revenues) for the comparable period one year ago and $265,000 (14% of net revenues) for the second quarter of 1999. Online e-commerce sales consist of our DAM and compilation CDs and, to a lesser extent, other music-related merchandise. Since these products were released during September 1998, there was minimal revenue from online sales of CDs and music-related merchandise during the period ended September 30, 1998. The increase in online sales of CDs and other music-related merchandise during third quarter of 1999 as compared to the second quarter of 1999 was primarily due to increased musical content available on our website and increased brand awareness. In the future, if the number of visitors to our website continues to grow and the quantity and quality of the musical content available continues to improve, revenue from the online sale of CDs could constitute an increasing portion of total net revenues. In the future, if the number of visitors to our website continues to grow and the quantity and quality of the musical content available continues to improve, revenue from the online sale of CDs could constitute an increasing portion of total net revenues.
Cost of Revenues
Cost of revenues for the three months ended September 30, 1999 was $1,687,000 (42% of net revenues) compared to $83,000 (30% of net revenues) during the comparable period one year ago resulting in gross margins of 58% and 70%, respectively. The cost of revenues increased, as a percentage of net revenue, due primarily to increased fulfillment costs associated with increased CD volume, associated with increased
10
Sales and Marketing
During the three months ended September 30, 1999, sales and marketing expense was $8,897,000 (220% of net revenues) compared to $26,000 (9% of net revenues) during the third quarter of 1998. The increase in sales and marketing expense, both in absolute dollar amounts and as a percentage of net revenue, was primarily due to new marketing programs, substantial increases in sales and marketing payroll and related expenses, a one-time charge related to employee costs, marketing and promotion costs associated with the Alanis Morissette and Tori Amos 5 1/2 Weeks Summer 1999 tour sponsorship, amortization of prepaid marketing expenses with our arrangements with internationally known artists, and costs associated with the growth of our business. We anticipate that overall sales and marketing expense will increase significantly in the foreseeable future; however, sales and marketing expense as a percentage of net revenues may fluctuate depending on the timing of new marketing programs and the addition of sales and marketing personnel.
On May 12, 1999, we entered into a three-year agreement with Boutit, Inc., which also does business under the name No Limit Records. Under this agreement, we obtained rights to a number of No Limit master recordings. Some of the artists represented by No Limit include Master P and Snoop Dogg, along with other respected platinum-selling artists. No Limit artists also may participate in our chatrooms, display MP3.com signs at concert performances, hold concerts with artists that have posted music on our website and cooperate with us on other promotional activities. We will record all revenues generated under the agreement and will recognize royalty expense (to be included in cost of sales) representing the royalties payable to No Limit. The royalty percentage due to No Limit will vary depending on the source of revenue. No Limit also became a stockholder of MP3.com at the closing of our initial public offering in July 1999. As part of our agreement, we issued 89,285 shares of our common stock in a private placement concurrent with the closing of our initial public offering at the initial public offering price of $28.00. We are amortizing a $2.5 million charge over the term of the agreement to reflect this issuance.
In the future, we anticipate that we will enter into arrangements with additional leading artists and creative talent agencies to secure their promotional and marketing services and obtain rights to their music. Future expenses may include costs related to promotional events, which will be expensed to sales and marketing in the period the event is held. Depending upon the terms and timing of promotional activities, substantial sales and marketing expenses may be incurred in any quarterly or annual period.
Product Development
During the third quarter of 1999, product development expense was $2,373,000 (59% of net revenues) compared to $67,000 (24% of net revenues) during the same quarter of 1998. The increase in the level of product development expense, as a percentage of net revenue, was primarily due to increased payroll and related expenses associated with hiring more employees, expensed computer supplies, increased computer equipment depreciation, and costs associated with the growth of our business. We anticipate that overall product development expenses will increase in the foreseeable future; however, product development expenses as a percentage of net revenues may fluctuate depending on the level of future net revenues and the timing of investments in product development and hiring.
General and Administrative
General and administrative expense was $3,110,000 (77% of net revenues) during the third quarter of 1999 compared to $38,000 (14% of net revenues) during the same quarter of 1998. The increase in general and administrative expense, both in absolute dollar amount and as a percentage of net revenue, was primarily a
11
Amortization of Deferred Compensation and Other Stock Based Compensation
During the three months ended September 30, 1999, we recorded aggregate deferred compensation of $21,030,000 for the grant of stock options which were granted at exercise prices less than the deemed fair value on the grant date. Deferred compensation is being amortized over the vesting period of the options, which is generally four years. Of total deferred compensation, $12,370,000 was amortized to expense during the third quarter of 1999 compared to $83,000 during the comparable period one year ago. The increase is primarily related to the increase in the granting of stock options to newly hired executive management and employees.
Interest Income (Expense), Net
Interest income (net of interest expense), during the three months ended September 30, 1999 was $4,517,000 compared to interest expense of $1,000 during the same period of 1998. The interest income during the third quarter of 1999 is directly related to interest income earned on cash and cash equivalent balances, short and long term investments associated with proceeds from the issuance of common stock in connection with our initial public offering in July 1999, the exercise of stock options, and the issuance of Series A, B, and C convertible preferred stock of an aggregate of approximately $423.7 million during 1999. Interest expense during the same period of 1998 is due to interest incurred on a capital lease, partially offset by interest income earned on cash balances.
Provision For Income Taxes
Due to the loss from operations for both book and tax purposes, no provision for income taxes was recorded for the three months ended September 30, 1999. For the same period of 1998, we recorded a provision for income taxes of $12,000, related to the amortization of deferred compensation, which is not deductible for income tax purposes.
The Nine Months Ended September 30, 1999
Results of Operations
Net Revenues
For the nine months ended September 30, 1999, net revenues were $6,629,000 consisting primarily of the sale of online advertisements (57% of net revenues) on our website, offline advertisements (31% of net revenues) and, to a lesser extent, the online sale of CDs and music-related merchandise (12% of net revenues). The level of net revenues during the first nine months of 1999 reflected increased banner and sponsorship advertisements, the sale of new offline advertising in the form of sponsorship CD samplers and an artist service convention known as the MP3 Summit that were introduced during 1999, and CD sales on our website.
Revenue from online advertising. For the first nine months of 1999, banner and sponsorship advertisements on our website were $3,795,000 (57% of net revenues). Sponsorship advertising contracts involve more integration with our website, including the placement of buttons that provide users with direct links to the advertisers website. The increase in the level of advertising revenues is primarily due to an increase in number of advertisers, increased awareness regarding MP3.com and the mp3 technology, and development and expansion of our music content.
12
Revenue from offline advertising. For the nine months ended September 30, 1999, revenues from offline advertising were $2,079,000 (31% of net revenues). The increase in offline advertising revenue is primarily due to the initial introduction of our new CD sampler product that did not exist previously, and to a lesser extent, the MP3 Summit.
Revenue from online sales of CDs and other music-related merchandise. Revenue from the online sale of CDs and music-related merchandise was $755,000 (12% of net revenues) during the nine months ended September 30, 1999. Revenue from online sales of CDs and music-related merchandise increased primarily due to increased musical content available on our website and increased brand awareness.
Cost of Revenues
Cost of revenues for the nine months ended September 30, 1999 was $2,741,000 (41% of net revenues) representing gross profit as a percentage of sales of 59%. The level of cost of revenues increased, as a percentage of net revenue, due primarily to increased fulfillment costs associated with increased CD volume, bandwidth costs, royalties to artists, CD sampler production costs, costs associated with the MP3 Summit, as well as an increase, as a percentage of net revenues, in CD and other music-related merchandise sales (which typically have lower associated gross margins).
Sales and Marketing
Sales and marketing expense for the first nine months of 1999 was $12,114,000 (183% of net revenues). Sales and marketing expense, both in absolute dollar amounts and as a percentage of net revenue, was primarily due to new marketing programs, substantial increases in sales and marketing payroll and related expenses, a one-time charge related to employee costs, marketing and promotions costs associated with the Alanis Morissette and Tori Amos 5 1/2 Weeks summer 1999 tour sponsorship, the contribution of 100,000 shares of our common stock to the MP3 Foundation, amortization of the No Limit and other internationally known artists prepaid marketing, and the costs associated with the growth of our business.
Product Development
Product development expense during the nine months ended September 30, 1999 was $3,375,000 (51% of net revenues). Product development expense, as a percentage of net revenue, was primarily due to payroll and related expenses associated with hiring more employees, expensed computer supplies, computer equipment depreciation and the costs associated with the increase in our size.
General and Administrative
General and administrative expense during the first nine months of 1999 was $5,021,000 (76% of net revenues). General and administrative expense, both in absolute dollar amount and as a percentage of net revenue, was primarily a result of finance and administrative payroll and related expenses, legal and accounting expenses, facility related costs, the charge associated with the relocation to our new corporate facility and costs associated with the increase in our infrastructure.
Amortization of Deferred Compensation and Other Stock Based Compensation
During the nine months ended September 30, 1999, we recorded aggregate deferred compensation of $39,218,000 for the grant of stock options that were granted at exercise prices less than the deemed fair value on the grant date, resulting in amortization of deferred compensation of $15,465,000. Additionally, in connection with the sale of preferred stock to a director of MP3.com, we recognized the intrinsic value of $369,000 as stock based compensation during the nine months ended September 30, 1999.
Interest Income (Expense), Net
Interest income (net of interest expense) during the first nine months of 1999 was $4,837,000 resulting from interest incurred on cash and cash equivalent balances and short and long-term investments in
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Provision For Income Taxes
There was no provision for income taxes due to the loss before income taxes during the first nine months of 1999.
Liquidity and Capital Resources
Overview
To date, our operations have been financed from internally generated cash, the sale of convertible preferred stock in 1999, the proceeds from our initial public offering and, to a lesser extent, capital equipment lease arrangements and equipment financing through our line of credit with Imperial Bank. As of September 30, 1999, we had approximately $166.7 million in cash and cash equivalents and short-term investment grade investments of $279.8 million. Additionally, a $3,000,000 line of credit with Imperial Bank with a sub-limit of $1,500,000 for equipment financing was available to fund our operations. Borrowings under the line of credit accrue interest at the banks prime rate plus 1% (9.25% as of September 30, 1999), mature in February 2000, and are secured by most of our assets. We are required to comply with debt covenants, the most restrictive of which is a minimum liquidity ratio which requires MP3.com to maintain a cash balance of two times current liabilities plus all bank debt or a cash balance equal to six months historical cash spending. Currently, due to our cash balance after our initial public offering during July 1999, we do not believe the debt covenants will place limitations on our growth strategy. As of September 30, 1999, we were in compliance with all debt covenants. As of September 30, 1999, there was approximately $1.2 million outstanding under the line of credits equipment financing sub-limit. This indebtedness requires monthly payments of interest only through August 1999, at which time the outstanding principal amount for the equipment sub-limit will be converted into a three-year fully amortizing term loan with the bank.
Operating Activities
Net cash provided by operating activities during the nine months ended September 30, 1999 was approximately $37.8 million and consisted primarily of the following:
| net loss of approximately $27,619,000; | |
| amortization of deferred compensation and other stock based compensation of approximately $16,970,000; | |
| amortization of prepaid marketing costs of approximately $2,524,000; | |
| charge associated with employee costs of approximately $1,241,000; | |
| charge associated with the relocation of our facilities of approximately $815,000; | |
| an increase in accounts and unbilled receivables of approximately $2,232,000; | |
| an increase in prepaid expenses and other assets of approximately $6,040,000; | |
| an increase in accounts payable and accrued expenses of approximately $6,487,000; and | |
| an increase in deferred revenue of approximately $45,320,000. |
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Investing Activities
Cash used in investing activities during the nine months ended September 30, 1999 was approximately $298.4 million consisting primarily of property and equipment expenditures of $8,248,000, net purchases of short and long-term investment grade investments of $284,841,000, and purchases of equity investments of approximately $3,325,000.
Financing Activities
Cash provided by financing activities during 1999 was approximately $427,199,000, and consisted primarily of proceeds from the issuance of common stock in connection with our initial public offering during July 1999s the exercise of stock options and the issuance of Series A, B, and C convertible preferred stock.
We have no material financial commitments other than obligations under our credit facilities and operating leases. We expect to substantially increase expenditures for applications including:
| computer equipment and furniture and fixtures associated with new employees and facility expansion; | |
| website computer equipment; | |
| product fulfillment equipment, infrastructure and new employees; | |
| bandwidth and networking equipment and infrastructure; | |
| additional sales and marketing employees; | |
| equipment and additional employees related to product development; | |
| increased promotion and branding efforts; | |
| investments in entities with whom we have collaborative arrangements; and | |
| development and acquisition of content. |
Capital requirements in any particular period will depend on the timing of these expenditures.
Recent Events
During November 1999, we entered into an agreement with an internationally known CD manufacturer and fulfillment company (the Supplier) whereby the Supplier will perform various manufacturing and fulfillment services for MP3.com for 10 years. In connection with execution of the supply agreement with the Supplier, MP3.com purchased 1,500,000 shares of the Suppliers common shares and a warrant for 1,780,000 shares of common shares for approximately $13.3 million. The common shares purchased are subject to a restriction for one year. The warrant expires in October 2003 and the exercise price is Cn$15.00 per share. The Supplier is a publicly traded company on the Toronto Stock Exchange, Montreal Exchange, and NASDAQ. Additionally, the Supplier entered into an advertising agreement with MP3.com whereby MP3.com will deliver various advertising products through March 2001 and receive $1.5 million during the term of the advertising agreement.
Future Capital Requirements
We believe that our cash and cash equivalent balances, short and long-term investments in marketable securities, funds available under our existing line of credit reduced by our financing commitment to the Cox Interactive Media joint venture will be sufficient to satisfy our cash requirements for at least the next 12 months. We intend to invest our cash in excess of current operating requirements in short-term, interest-bearing, investment-grade securities.
To the extent our net revenues increase in the future, we anticipate significant increases in our working capital requirements to finance higher relative levels of associated accounts receivable, unbilled receivables and other assets, offset by increases in accounts payable and other liabilities. However, we do not expect the
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We may need to raise additional capital if we expand more rapidly than initially planned, to develop new or enhanced products and/or services, to respond to competitive pressures or to acquire complementary products, content, businesses or technologies. If additional funds are raised through the sale of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced, our stockholders may experience additional dilution and these securities may have rights, preferences or privileges senior to those of our stockholders. There can be no assurance that additional financing will be available at all or on terms favorable to us. If adequate funds are not available or are not available on acceptable terms, our ability to fund our expansion, take advantage of unanticipated opportunities, develop or enhance products or services or otherwise respond to competitive pressures could be significantly limited. Our business may be harmed by these limitations.
Year 2000 Readiness Disclosure
Many existing computer programs cannot distinguish between a year beginning with "20 and a year beginning with "19 because they use only the last two digits to refer to a year. For example, these programs cannot tell the difference between the year 2000 and the year 1900. As a result, these programs may malfunction or fail completely.
Since our business and, consequently, our hardware, telecommunication and software systems are new, we believe most of these systems are already year 2000 compliant and we do not expect internal year 2000 problems to materially affect us. Nevertheless, because our business relies heavily on the Internet and on computer and telecommunication systems, including those of our suppliers, customers and other third parties, the year 2000 problem could seriously harm us. Therefore, we established a year 2000 readiness team to assess the effect that the year 2000 problem may have on us and to develop a year 2000 readiness plan.
We have assessed the corporate systems and operations that we believe could be affected by the year 2000 problem. We have focused our year 2000 review on three areas:
| information technology infrastructure; | |
| non-information technology systems; and | |
| third-party compliance. |
Information Technology Infrastructure
Because our consumer and business systems are essential to our business, our year 2000 team has assessed and evaluated our information technology systems, including our computers, hardware, and software systems. As the team has identified critical computer, hardware, or software information technology systems that require replacement, upgrade, or modification, we have made the required replacement, upgrade, or modification immediately. We use the following information technology for our internal infrastructure:
| website and Internet ordering systems; | |
| main enterprise software systems, including those used for music delivery, production, shipping, and accounting; | |
| individual workstations, including personal computers; and | |
| networking related hardware and software systems. |
We currently believe that all of our critical information technology systems are year 2000 compliant. In addition, we are in the process of implementing a new accounting system which is certified year 2000 compliant by the vendor. We expect this system to be in place by the end of 1999. We have conducted and continue to conduct year 2000 compliance testing of our individual workstations and networking related
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Non-Information Technology Systems
Some non-information technology systems used in our business, including air conditioning, fire sprinkler and telephone systems, our facilitys security system, the security system for our facilitys campus, and other equipment, may contain software that is vulnerable to year 2000 problems. The year 2000 problem could cause failures in these systems which could disrupt our operations. We have assessed the year 2000 readiness of many of these systems and equipment and have determined that all significant non-information technology systems are year 2000 compliant.
Third-Party Compliance
Our material third party business relationships include:
| customers who place orders for products using the Internet; | |
| our Internet service providers; and | |
| vendors and suppliers who provide the goods that we offer to our customers. |
We are unable to predict, and have not attempted to assess, the year 2000 readiness of our customers or the systems they use to interact with us. Since we take all of our product orders and offer most of our artist services over the Internet, our operations would be harmed if a significant number of our customers were unable to use the Internet and place orders due to year 2000 problems.
We have assessed the year 2000 readiness of our Internet service providers and the systems they use to interact with us and determined that they have implemented strategies for becoming year 2000 compliant. Our Internet service providers expect to be year 2000 compliant prior to December 31, 1999. Since our business is reliant on the ability of our Internet service providers to direct customers to our website, our operations would be materially and adversely affected if those providers were unable to provide their services.
Year 2000 disruptions in the systems or equipment used by our suppliers could result in our customers being unable to obtain products and services in a timely manner. We have reviewed our vendors year 2000 compliance plans and statements, and have determined most all are year 2000 compliant.
Most Reasonable Worst Case Scenario
It is possible that year 2000 problems could disrupt one or more of the following:
| customers access to the Internet and their ability to place orders using our website (we believe this is more likely for international customers than domestic customers); | |
| artists uploading of music content to our website; | |
| the fulfillment of customer orders; and | |
| credit card transactions. |
In the first case, there is no alternative technology available known to us which would allow us to continue to run our business. In the last three cases, there is a less efficient higher cost alternative which would allow us to continue to run our business. In any event, any of these alternatives would result in increased costs, reduced revenues or service delays, which would increase our operating losses. Extended disruptions may impact both short-term and long-term customer and supplier relationships and further impact our future profitability.
Costs
Our year 2000 assessment, remediation and testing activities have been conducted by internal personnel, and we have not tracked the amount of employee time expended on these tasks. Accordingly, we are unable to
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Contingency Plan
In addition to the less efficient higher cost alternatives discussed above, we are currently developing contingency plans to be implemented if we encounter year 2000 problems. We have completed these plans. However, notwithstanding these plans and the other efforts of our year 2000 team, we cannot assure you that we will be year 2000 ready, or that year 2000 problems will not adversely affect our business, financial condition and results of operations.
Risks Related To Our Business Model
Our Business Model Is Not Typical Of Traditional, More Established Business Enterprises And May Not Generate Sufficient Revenues For Our Business To Survive. |
Our model for conducting business and generating revenues is new and unproven and may evolve rapidly. Our business model depends upon our ability to generate revenue streams from multiple sources through our website, including:
| website advertising fees from third parties; | |
| online sales of CDs and music-related merchandise; | |
| promotional activity fees; and | |
| marketing our artist and consumer information. |
Since our business revenue may evolve rapidly, these sources of revenue may change or increase or decrease in importance, as well. It is uncertain whether a music-based website that relies on attracting people to learn about, listen to and download music, mostly from lesser-known artists, can generate sufficient revenues to survive. We cannot assure you that this business model will succeed or will be sustainable as our business grows. In order for our business to be successful, we must not only develop services that directly generate revenue, but also provide content and services that attract consumers to our website frequently. We will need to develop new offerings as consumer preferences change and new competitors emerge. We cannot assure you that we will be able to provide consumers with an acceptable blend of products, services, and informational and community offerings that will attract consumers to our website frequently. We provide many of our products and services without charge, and we may not be able to generate sufficient revenue to pay for these products and services. Accordingly, we are not certain that our business model will be successful or that we can sustain revenue growth or be profitable.
We Are Competing In A New Market Which May Not Develop Or Where We May Fail To Gain Market Acceptance For Our Products And Services. |
The market for online music promotion and distribution is new and rapidly evolving. As a result, demand and market acceptance for our products and services expose us to a high degree of uncertainty and risk. We are attempting to capitalize on a talent pool of artists not currently served by the traditional recording industry. We cannot assure you that consumers will continue to be interested in listening to or purchasing music from these artists or that the traditional music industry will not successfully serve these artists in the future. If this new market fails to develop, develops more slowly than expected or becomes saturated with competitors, or our products and services do not achieve or sustain market acceptance, our business could be harmed. We believe the future popularity of downloadable digital music will depend, in part, on the availability of portable devices to store and replay this music. To the extent that consumer acceptance or distribution of these portable devices is delayed or these devices are not available at affordable prices, our market and thus a portion of our revenues, may not grow at a sufficient pace and our business could be harmed.
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We Have A Limited Operating History That Makes An Evaluation Of Our Business Difficult.
MP3.com was incorporated in March 1998. During 1998, our operating activities consisted largely of developing the infrastructure necessary to download music on the Internet. Our limited operating history makes it difficult to evaluate our current business and prospects. Due to our limited operating history, it will be difficult to accurately predict our future revenues or results of operations. This may result in one or more future quarters where our financial results may fall below the expectation of analysts and investors. As a result, the trading price of our common stock might decline. Operating results may vary depending on a number of factors, many of which are outside our control.
Rapid Growth In Our Operations And Infrastructure Is Placing A Significant Strain On Our Resources, And Failure To Manage This Growth Effectively Could Disrupt Our Operations And Prevent Us From Generating The Revenues We Expect. |
We currently are experiencing a period of rapid expansion in our website traffic, personnel, facilities and infrastructure. For example, the number of daily visitors to our website increased approximately 89% from December 1998 to September 1999. Our number of employees increased from eight on December 31, 1998 to 253 on October 31, 1999. We expect further significant expansion will be required to address potential growth in our artist and consumer bases, the breadth of our product and service offerings, and other opportunities. This expansion has placed, and we expect it will continue to place, a significant strain on our management, operational and financial resources. Our failure to manage growth could disrupt our operations and ultimately prevent us from generating the revenues we expect.
Our Continued Reliance On Revenue From Online Advertising May Not Provide Sufficient Financial Returns For Our Business To Grow Or Survive. |
Although our business model contemplates multiple sources of revenue, we anticipate that in the foreseeable future we will depend substantially on revenue from online advertising. In 1998, revenue from online advertising accounted for 91% of our net revenues, and in the third quarter of 1999 accounted for 49% of our net revenues. We currently depend on a small group of customers for our revenue from online advertising. In the third quarter of 1999, one customers accounted for approximately 12% of net revenues, and our top ten customers accounted for approximately 54% of net revenues. If any of these important customers were to leave us, our business could be harmed. If we do not increase revenue from online advertising, our business may not grow or survive. Increasing our revenue from online advertising depends largely on our ability to:
| conduct successful selling and marketing efforts aimed at advertisers; | |
| increase the size of our sales force; | |
| increase the size of the MP3.com audience by increasing both our artist and consumer bases; | |
| increase the amount of revenues per advertisement; | |
| target advertisements to appropriate segments of our audience; and | |
| measure accurately the size and demographic characteristics of our audience. |
Our failure to achieve these objectives could reduce our revenue from online advertising and ultimately prevent us from generating the revenues we expect.
A Substantial Portion Of Our Revenues And Revenue Growth For At Least The Next Three Years Will Come From Groupe Arnault. If This Relationship Is Not Renewed, Or If Other Significant Sources Of Revenue Are Not Developed, We May Not Have Sufficient Revenues To Sustain Our Growth And Our Stock Price May Fall. |
We have recently entered into a three-year advertising, promotion and marketing agreement with Groupe Arnault. We anticipate that for at least the next three years a substantial portion of our revenues will come
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In Order To Provide Music And Other Content On Our Website, We Rely Heavily On The Contributions Of Artists Who, Over Time, May Be Difficult To Attract And Retain. |
Our success depends on having a website that offers high quality and diverse music choices, all of which come from outside artists. Our failure to attract and retain artists who can provide us with music and other content would limit the overall quality and quantity of the offerings on our website and harm our business. Because our contracts with artists are, with few exceptions, non-exclusive and can be terminated by the artist at any time, our retention of artists requires that we offer sufficient benefits, including artist services and artist-oriented content, to encourage them to continue providing us with content. If we are not able to maintain our ability to serve and provide valuable tools to artists, artists may leave our website and remove their music and other content. This could also prevent us from attracting new artists. We may also lose artists who gain recognition on our website and then are recruited by or attracted to the traditional music industry. The loss of artists and the inability to attract new artists would impair our ability to generate advertising revenue targeted to our artist community and generate CD revenues.
Our Brand Name And Revenues Could Be Damaged If The Music Provided By Lesser-Known Artists Fails To Meet Consumer Expectations. |
Although most of the artists that post music on our website are not bound by record contracts, some artists, including most internationally-recognized artists, typically sign multi-year exclusive recording contracts that may prevent them from posting music on our website. To post music on our website, these artists must typically get permission from their record company. As a result, our access to internationally-recognized artists and our ability to distribute this music or place their music on our website and on our CDs are limited. For this reason, and because of the emphasis of our business model on underserved artists, we expect our music to continue to concentrate principally on lesser-known and local artists. If the music provided by these lesser-known and local artists fails to meet consumer expectations, our brand name could be damaged and our business may not generate sufficient revenues to survive.
Development Of New Standards For The Electronic Delivery Of Music May Diminish Our Brand Identity And Disrupt The Way We Do Business. |
We currently rely on mp3 technology for both brand identity and as a delivery method for the digital distribution of music. Mp3 is an open standard adopted by the Moving Picture Experts Group that makes music files smaller. We do not own or control mp3 technology. The onset of competing industry standards for the electronic delivery of music could significantly affect the way we operate our business as well as the publics perception of MP3.com as a company. For example, some of the major recording studios have recently announced a plan to develop a universal standard for the electronic delivery of music, called the
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MP3 Technology Is Controversial Within The Traditional Music Industry And May Face Continued Opposition, Which May Negatively Affect The Perception Of Our Business, Lead To Market Confusion, Alienate Advertisers And Consumers And Reduce Our Revenue. |
The traditional music industry has not embraced the development of the mp3 format to deliver music, in part because users of mp3 technology can download and distribute unauthorized or pirated copies of copyrighted recorded music over the Internet. Although our business model for the digital distribution of music can support more than one audio compression format and method of delivery, and is intended to discourage music piracy and ensure that only legitimate music is posted on our website, our brand identity is currently linked to the mp3 technology. As a result, we may face opposition from a number of different music industry sources including record companies and studios, the Recording Industry Association of America and established artists with record contracts, due to our current brand identity and its potentially negative associations. In addition, adverse news or events relating to mp3 technology may lead to confusion in the public markets regarding our company and its prospects, alienate advertisers and consumers, reduce revenues and harm our overall financial results.
Without The Continued Development And Maintenance Of The Internet And The Availability Of Increased Bandwidth To Consumers, Our Business May Not Succeed. |
Given the online nature of our business, without the continued development and maintenance of the Internet infrastructure, we could fail to meet our overall strategic objectives and ultimately fail to generate the website traffic and revenues we expect. This continued development of the Internet includes maintenance of a reliable network with the necessary speed, data capacity and security, as well as timely development of complementary products including high speed modems, for providing reliable Internet access and services. Because global commerce on the Internet and the online exchange of information is new and evolving, we cannot predict whether the Internet will prove to be a viable commercial marketplace in the long term. The success of our business will rely on the continued improvement of the Internet as a convenient means of consumer interaction and commerce, as well as an efficient medium for the delivery and distribution of music. Our business will depend on the ability of our artists and consumers to continue to upload and download mp3 and other music files, as well as to conduct commercial transactions with us, without significant delays or aggravation that may be associated with decreased availability of Internet bandwidth and access to our website. Our penetration of a broader consumer market will depend, in part, on continued proliferation of high speed Internet access. Even compressed in mp3 format, a typical three minute song file can occupy more than three megabytes of storage space. This file could take as much as two minutes to download over an xDSL or cable modem compared to 10 to 20 minutes over a conventional 56Kbps modem. The Internet has experienced, and is likely to continue to experience, significant growth in the numbers of users and amount of traffic. As the Internet continues to experience increased numbers of users, increased frequency of use and
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We May Have Difficulty Competing For Or Executing Business Partnerships And Making Acquisitions That We May Need To Expand Our Content And Distribution Channels, Which Could Impair Our Overall Strategic Goals. |
Our business strategy includes entering into business partnerships and may include acquiring complementary businesses, technologies, content or products. For example, in June 1999 we entered into a joint venture with Cox Interactive Media to create and operate music-related websites. We cannot assure you that this joint venture or any other business partnership will be successful. In addition, in July 1999 we entered into an agreement with Groupe Arnault under which Groupe Arnault had an exclusive right through December 1999 to negotiate the terms of a joint venture with us covering the territories of Europe and Asia which was extended until November 18, 1999. We cannot guarantee that we and Groupe Arnault will establish this joint venture or that, if established, this joint venture will be successful and provide us with desired international presence or branding. We may be unable to complete suitable business partnerships and acquisitions on commercially reasonable terms, if at all. We expect to face competition for business partnership and acquisition candidates and sponsorships. This competition could impair our ability to successfully pursue these aspects of our business strategy. Business partnerships or acquisitions could disrupt our ongoing business, distract our management and employees and increase our expenses. If we acquire a company, we could face difficulties assimilating that companys personnel and operations. In addition, the key personnel of the acquired company may decide not to work for us. Acquisitions of additional services or technologies also involve risks of incompatibility and lack of integration into our existing operations. If we finance the acquisitions by incurring debt or issuing equity securities, this could dilute our existing stockholders. Any amortization of goodwill or other assets, or other charges resulting from the costs of acquisitions, could adversely affect our operating results.
Financial Risks
Our Quarterly Revenues And Operating Results Are Not Indicative of Future Performance And Are Difficult To Forecast, And Our Stock Price May Fall If Our Performance Does Not Meet Analysts Or Investors Expectations. |
As a result of our limited operating history, we do not have historical financial data for a significant number of periods upon which to forecast quarterly revenues and results of operations. We believe that period-to-period comparisons of our operating results are not meaningful and should not be relied upon as indicators of future performance. In addition, our revenue and earnings may vary substantially as a result of holiday-based buying and the business cycles of the music industry and of Internet commerce in general. However, the actual effect of these factors on the price of our stock will be difficult to assess due to our limited operating history. In one or more future quarters our results of operations may fall below the expectations of securities analysts and investors, and the trading price of our common stock may drop.
We Expect Net Losses In The Future And May Never Achieve Profitability, Which May Cause Our Stock Price To Fall. |
In 1998, we had a net loss of approximately $360,000. During the first nine months of 1999, we had a net loss of approximately $27.6 million. We expect substantial net losses and negative cash flow for the foreseeable
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Unless We Obtain Additional Financing, We May Not Be Able To Meet Our Strategic Business Objectives. |
Our available cash and equivalents and short and long-term investments in marketable securities are expected to be sufficient to meet our cash requirements for at least the next 12 months. However, we may need to raise additional funds in order to:
| finance unanticipated working capital requirements; | |
| develop or enhance existing services or products; | |
| fund distribution relationships; | |
| respond to competitive pressures; or | |
| acquire complementary businesses, technologies, content or products. |
We cannot assure you that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, our ability to fund our expansion, take advantage of unanticipated opportunities, develop or enhance services or products or otherwise respond to competitive pressures would be significantly limited. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our stockholders will be reduced, and these securities may have rights, preferences or privileges senior to those of our stockholders.
Our Stock Price and Trading Volume Has Been And May Continue To Be Extremely Volatile. |
The trading price of our common stock has been and is likely to continue to be extremely volatile. Our stock price could be subject to wide fluctuations in response to a variety of factors, including the following:
| actual or anticipated variations in quarterly operating results; | |
| announcements of technological innovations; | |
| new products or services offered by us or our competitors; | |
| changes in financial estimates by securities analysts; | |
| announcements of significant acquisitions, strategic partnerships, joint ventures or capital commitments by us or our competitors; | |
| additions or departures of key personnel; | |
| sales of common stock; and | |
| other events or factors, may of which are beyond our control. |
In addition, the stock market in general, and the Nasdaq National Market and the stock prices of Internet-related companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of such companies. These broad market and industry factors may materially adversely affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a companys securities, securities class-action litigation has often been instituted against such companies. Such litigation, if instituted, could result in substantial costs and a diversion of managements attention and resources, which could adversely affect our business, financial condition and the market price of our common stock.
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Substantial Future Sales of MP3.coms Common Stock in the Public Market Could Cause Its Stock Price to Fall. |
Sales of a large number of shares of our common stock in the public market or the perception that such sales could occur could cause the market price of our common stock to drop. As of September 30, 1999, we have 68,376,920 shares of common stock outstanding, of which approximately 10,350,000 shares are freely transferable without restriction or registration under the Securities Act of 1933, unless such shares are held by our affiliates, as that term is defined in Rule 144 under the Securities Act. The officers and directors and all of our existing stockholders have agreed with Credit Suisse First Boston or have otherwise agreed with us not to sell or otherwise dispose of any of their shares until January 17, 2000.
However, Credit Suisse First Boston may, in its sole discretion, at any time without notice, release all or any portion of the shares subject to lock-up agreements. Sales of common stock by existing stockholders in the public market, or the availability of such shares for sale, could adversely affect the market price of the common stock.
In July 1999 we filed a registration statement on Form S-8 with the Securities and Exchange Commission covering the 7,606,781 shares of common stock reserved for issuance under our 1998 Equity Incentive Plan and 1999 Employee Stock Purchase Plan and for options issued outside such plans. On January 17, 2000 at least 1,780,000 shares, most of which have been exercised on or before September 30, 1999, will no longer be restricted under the lock-up agreements. These shares could be freely transferable without restriction or registration under the Securities Act of 1933, unless such shares are held by our affiliates, as that term is defined in Rule 144 under the Securities Act. Sales of a large number of shares could have an adverse effect on the market price for our common stock.
On January 17, 2000, holders of 34,536,187 shares of common stock, of which 17,088,152 have certain registration rights, will be released from their lock-up agreements with Credit Suisse First Boston Corporation. These shares could become available for sale in the public market under Rule 144 or Rule 701. Additionally, 10% of the 3,347,233 shares purchased by Arkaro Holding B.V. will be available to sale to the public market on January 21, 2000, with an additional 10% becoming eligible on the 21st day of each of the next five months. If such holders, by exercising either their registration rights or their rights under Rule 144 or Rule 701, cause a large number of securities to be registered and/or sold in the public market, such sales could have an adverse effect on the market price for our common stock. If we were to include in a company-initiated registration shares held by such holders pursuant to the exercise of their registration rights, such sales may have an adverse effect on our ability to raise needed capital.
Risks Related To Sales, Marketing And Competition
Unless We Develop A Strong Brand Identity, Our Business May Not Continue To Grow And Our Financial Results May Suffer. |
We believe that our historical growth and brand recognition have been largely attributable to word of mouth. We have benefited from frequent and visible national and local media exposure. The frequency or quality of this media exposure may not continue. We believe that continuing to strengthen our brand will be critical to achieve widespread acceptance of our products and services. Favorable public perception of our brand will depend largely on our ability to continue providing users with high quality products and services and the success of our marketing efforts. We plan to increase our marketing expenditures to create and maintain brand recognition. However, brand promotion activities may not yield increased revenues and, even if they do, any increased revenues may not offset the expenses we incur in building our brand.
If We Do Not Transcend A Mere Association Between Our Company And The MP3 Format In The Minds Of Consumers, Our Brand Identity And Financial Results Could Suffer. |
The growth of our business will also depend in significant part on our ability to develop a brand identity that transcends a mere association with the mp3 format. We must pursue a brand development strategy that identifies our company as a primary source for interesting and diverse high quality music and artists above and
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If We Fail To Collect Accurate And Useful Data About Our Consumers, Potential Advertisers May Not Advertise On Our Website, Which May Result In Reduced Advertising Revenues. |
We plan to use consumer data to expand, refine and target our marketing and sales efforts. We collect most of our data from users who report information to us as they conduct transactions on our website. If a large proportion of users impede our ability to collect data or if they falsify data, our marketing and sales efforts would be less effective since advertisers generally require detailed demographic data on their target audiences. In addition, laws relating to privacy and the use of the Internet to collect personal information could limit our ability to collect data and utilize our database. Failure to collect accurate and useful data could result in a substantial reduction in advertising revenues, which represented 89% of our total revenues during the first nine months of 1999. Because we use e-mail for direct marketing, any legislative or consumer efforts to regulate unsolicited bulk e-mails, commonly referred to as spam, as well as other laws regulating the use of e-mail, could significantly impair our sales and marketing efforts and our associated advertising revenue.
We Expect Competition To Increase Significantly In The Future Which Could Reduce Our Revenues, Potential Profits And Overall Market Share. |
The market for the online promotion and distribution of music and music-related products is competitive. Barriers to entry on the Internet are relatively low, and we expect competition to increase significantly in the future. We face competitive pressures from numerous actual and potential competitors, many of which have longer operating histories, greater brand name recognition, larger consumer bases and significantly greater financial, technical and marketing resources than we do. We cannot assure you that websites maintained by our existing and potential competitors will not be perceived by consumers, artists, talent management companies and other music-related vendors or advertisers as being superior to ours. We also cannot assure you that we will be able to maintain or increase our website traffic levels, purchase inquiries and number of click-throughs on our online advertisements or that competitors will not experience greater growth in these areas than we do. Increased competition could result in advertising price reduction, reduced margins or loss of market share, any of which could damage the long-term or short-term prospects of our business.
Risks Related To Operations
Our Business Operations Could Be Significantly Disrupted If We Lose Members Of, Or Fail To Properly Integrate, Our Management Team. |
Our future performance will be substantially dependent on the continued services of our management and our ability to retain and motivate them. The loss of the services of any of our officers or senior managers could harm our business. We do not have long-term employment agreements with any of our key personnel, other than our Chief Executive Officer, and we do not maintain any key person life insurance policies except on our Chief Executive Officer. Almost all of our management team joined MP3.com in 1999. Since the completion of our initial public offering in July 1999, we have experienced turnover in our management team, and we may continue to experience turnover. Most of these individuals have not previously worked together and are currently being integrated as a management team. If our senior managers are unable to work effectively as a team, our business operations could be significantly disrupted.
We May Not Be Able To Hire And Retain A Sufficient Number Of Qualified Employees, And As A Result We May Not Be Able To Grow As We Expect, Or Maintain The Quality Of Our Services. |
Our future success will depend on our ability to attract, train, retain and motivate other highly skilled technical, managerial, marketing and customer support personnel. Competition for these personnel is intense, especially for engineers, web designers and advertising sales personnel, and we may be unable to successfully
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We Must Continue To Upgrade Our Technology Infrastructure, Or We Will Be Unable To Effectively Meet Demand On Our Website. |
In May 1999, an average of approximately 20 gigabytes of musical content was added to our website each week and traffic to the site increased by approximately 14% from the previous month. We must continue to add hardware and enhance software to accommodate the increased content and use of our website. If we are unable to increase the data storage and processing capacity of our systems at least as fast as the growth in demand, our website may become unstable and may fail to operate for unknown periods of time. Unscheduled downtime could harm our business and also could discourage users of our website and reduce future revenues.
Our New Financial Accounting System And Other Internal Systems May Not Work Effectively And As A Result We May Not Have The Information We Need To Record Transactions And Meet Our Accounting And Reporting Obligations, Which In Turn Could Affect Our Ability To Run Our Business Efficiently Or Profitably. |
In May 1999, we began installing a new financial accounting system. We anticipate this installation will be completed in stages through the remainder of 1999. If the accounting system does not work effectively, we may experience delays or failures in our accounting processes. This could adversely impact the promptness and accuracy of our transaction processes, and our financial accounting and reporting. To manage the expected growth of our operations and personnel, we will need to improve our operational and financial systems, transaction processing, procedures and controls. Our current and planned systems, transaction processing, procedures and controls may not be adequate to support future operations.
Our Data Warehousing And Web Server Systems May Stop Working Or Work Improperly Due To Natural Disasters, Failure Of Third-Party Services And Other Unexpected Problems. |
Since our data warehousing, web server and network facilities are all located in Southern California, an earthquake or other natural disaster could affect all of our facilities simultaneously. An unexpected event like a power or telecommunications failure, fire, flood or earthquake at our on-site data warehousing facility or at either of our two Internet service providers facilities could cause the loss of critical data and prevent us from offering our services to artists and consumers. Our business interruption insurance may not adequately compensate us for losses that may occur. In addition, we rely on third parties to securely store our archived data, house our web server and network systems, and connect us to the Internet. A failure by any of these third parties to provide these services satisfactorily would impair our ability to access archives and operate our website.
We May Lose Visitors To Our Website And Lose Revenues If Our Online Security Measures Fail. |
If the security measures that we use to protect personal information are ineffective, we may lose visitors to our website which could reduce our revenues. We rely on security and authentication technology licensed from third parties. With this technology, we perform real-time credit card authorization and verification. We cannot predict whether new technological developments could allow these security measures to be circumvented. In addition, our software, databases and servers may be vulnerable to computer viruses, physical or electronic break-ins and similar disruptions. We may need to spend significant resources to protect against security breaches or to alleviate problems caused by any breaches. We cannot assure that we can prevent all security breaches.
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Year 2000 Problems Could Lead To Malfunctions Of Our Computer And Communications Systems, And Prevent Us From Running Our Business. |
Many existing computer programs cannot distinguish between a year beginning with 20 and a year beginning with 19 because they use only the last two digits to refer to a year. For example, these programs cannot tell the difference between the year 2000 and the year 1900. As a result, these programs may malfunction or fail completely. If we or any third parties with whom we have a material relationship fail to achieve year 2000 readiness, our business may be seriously harmed. In particular, year 2000 problems could temporarily prevent us from offering our goods and services.
Risks Related To Government Regulation, Content and Intellectual Property
Government Regulation May Require Us To Change The Way We Do Business. |
The laws and regulations that govern our business change rapidly. Although our operations are currently based in California, the United States government and the governments of other states and foreign countries have attempted to regulate activities on the Internet. Evolving areas of law that are relevant to our business include privacy law, proposed encryption laws, content regulation and sales and use tax laws and regulations. Because of this rapidly evolving and uncertain regulatory environment, we cannot predict how these laws and regulations might affect our business. In addition, these uncertainties make it difficult to ensure compliance with the laws and regulations governing the Internet. These laws and regulations could harm us by subjecting us to liability or forcing us to change how we do business.
We May Be Liable To Third Parties For Music, Software And Other Content That Is Available On Our Website And On the CDs We Distribute. |
We may be liable to third parties for the content on our website and on the CDs we distribute:
| if the music, text, graphics, software or other content on our website or CDs violates their copyright, trademark, or other intellectual property rights; | |
| if our artists violate their contractual obligations to others by providing content on our website or CDs; or | |
| if anything on our website or CDs is deemed obscene, indecent or defamatory. |
We may also be liable for anything that is accessible from our website through links to other websites. We attempt to minimize these types of liability by requiring representations and warranties relating to our artists ownership of and rights to distribute and submit their content and by taking related measures to review content on our website and on our CDs. However, alleged liability could harm our business by damaging our reputation, requiring us to incur legal costs in defense, exposing us to awards of damages and costs and diverting managements attention away from our business. See Business Intellectual Property.
We May Not Be Able To Prevent Others From Using Our Trademarks, Copyrights, Software And Other Intellectual Property Assets. If Others Do Use These Assets, Their Value To Us, And Our Ability To Use Them To Generate Revenue, May Decrease. |
Our intellectual property includes our trademarks and copyrights, proprietary software, and other proprietary rights. We believe that our intellectual property is important to our success and our competitive position, and we try to protect it. However, our efforts may be inadequate. We do not have a registered trademark for the MP3.com name and may not be able to prevent others from using mp3 or MP3.com. Use of the MP3.com name by others could dilute our brand identity and confuse the market. In addition, our ability to conduct our business may be harmed if others claim we violate their intellectual property rights. For example, Sightsound.com, Inc. has asserted that many online music providers, including MP3.com, violate patent rights that it allegedly owns covering the sale of music over the Internet through digital downloads. If successful, these claims, or similar claims by others, could seriously harm our business by forcing us to cease using important intellectual property or requiring us to pay monetary damages. Even if
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk
The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we maintain a portfolio of cash equivalents, short-term and long-term investments in a variety of securities, including both government and corporate obligations.
Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of interest sensitive financial instruments at December 31, 1998 or September 30, 1999.
The following table presents the fair value balances of our cash equivalents and short-term and long-term investments that are subject to interest rate risk by year of expected maturity and average interest rates as of September 30, 1999 (dollars in thousands):
1999 | 2000 | 2001 | |||||||||||
Cash equivalents | $ | 160,871,000 | $ | | $ | | |||||||
Average interest rates | 5.40 | % | |||||||||||
Shot term investments | $ | | $ | 279,851,000 | $ | | |||||||
Average interest rates | 5.87 | % | |||||||||||
Long term investments, excluding equity investments | $ | | $ | | $ | 4,971,000 | |||||||
Average interest rate | 6.31 | % |
We did not hold derivative financial instruments as of September 30, 1999, and we have never held such instruments in the past. In addition, we had outstanding debt as of September 30, 1999 of approximately $1.2 million.
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PART II OTHER INFORMATION
Item 2. Changes in Securities and Uses of Proceeds
Changes in securities
On July 16, 1999, the Company filed an amendment to and restatement of the Companys Certificate of Incorporation effecting a three-for-two stock split of the Companys outstanding common stock and adopting certain anti-takeover and stockholder protection mechanisms.
On July 28, 1999, the Company filed an amendment to and restatement of the Companys Certificate of Incorporation removing all references to the Companys Series A, B and C preferred stock.
Recent Sales of Unregistered Securities
On May 12, 1999, the Company and Boutit, Inc., d/b/a No Limit Records, entered into a strategic partnership pursuant to a binding Memorandum of Agreement. Pursuant to this agreement, No Limit is bound to provide website content to the Company and perform promotional and other activities and the Company issued 89,286 shares of common stock to Boutit, Inc., an accredited investor, at $28.00 per share in a private placement concurrent with the closing of the Companys IPO. The Company relied upon the exemption provided by Section 4(2) under the Securities Act and Regulation D promulgated thereunder.
Use of Proceeds
The effective date of the Companys first registration statement on Form S-1 under the Securities and Exchange Act of 1933 (No. 333-78545) relating to the Companys initial public offering of its common stock, was July 20, 1999. A total of 13,697,233 shares of the Companys common stock in the aggregate were sold at a price of $28.00 per share to (i) an underwriting syndicate led by Credit Suisse First Boston, Hambrecht & Quest, and BancBoston Robertson Stephens, Inc. and (ii) Arkaro Holding B.V. The offering commenced on July 21, 1999, and closed on July 26, 1999. The initial public offering resulted in gross proceeds of approximately $383.5 million, of which $20.3 million was applied toward the underwriting discount. Expenses related to the offering totaled approximately $1.9 million. Net proceeds to the Company were $361.3 million. From the time of receipt through September 30, 1999, the net proceeds were all applied to temporary investments in corporate commercial paper and notes, municipal bonds and notes.
Item 4. Submission of Matters to a Vote of Security Holders
During the quarter ended September 31, 1999, the Company solicited the consent of stockholders for the following matters:
(1) On July 13, 1999, in an action by written consent, the Stockholders approved an amendment to the Companys Certificate of Incorporation to become effective prior to the Companys IPO effecting a stock split, approved an amendment to the Companys Certificate of Incorporation to become effective after the Companys IPO removing all references to the series A, B and C preferred stock, and approved an amendment to the Companys bylaws. Stockholders holding 25,337,010 shares of common stock and 14,736,000 shares of preferred stock consented to this action; | |
(2) On July 13, 1999, in an action by written consent, the Stockholders approved an amendment to the Companys 1998 Equity Incentive Plan and approved the Companys 1999 Employee Stock Purchase Plan and related offering documents. Stockholders holding 27,642,811 shares of common stock and 14,736,000 shares of preferred stock consented to this action; and | |
(3) On July 20, 1999, in an action by written consent, the Stockholders approved an amendment to the Companys Certificate of Incorporation amending the Companys 1998 Stock Option Plan to reduce the minimum exercise price for incentive stock options to 50% of the fair market value of the Companys Common Stock on the date of grant. Stockholders holding 27,324,061 shares of common stock and 10,987,012 shares of preferred stock consented to this action. |
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Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
Exhibit 10.1 | Sublease by and between the Company and ADC Wireless Systems, Inc dated as of July 22, 1999. |
Exhibit 27.1 Financial Data Schedule
(b) Reports on Form 8-K:
None
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
MP3.com, Inc. | |
(Registrant) |
Date: November 12, 1999
By: | /s/ PAUL L.H. OUYANG |
|
|
Paul L.H. Ouyang | |
Executive Vice President and | |
Chief Financial Officer | |
(Authorized Officer) | |
(Principal Financial and Accounting Officer) |
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