<PAGE> 1
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 1998
Commission File No. 0-23141
N2K INC.
(Exact name of registrant as specified in its charter)
Delaware 06-1455771
(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)
55 Broad Street, 26th Floor, New York, New York 10004
(Address of principal executive offices and Zip Code)
Registrant's telephone number, including area code: (212) 378-5555
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES [X] NO [ ]
Indicate the number of shares outstanding of each of the registrant's classes of
common stock as of April 30, 1998: 14,189,089 shares of common stock, par value
$.001 per share.
<PAGE> 2
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
N2K INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
March 31, 1998
--------------------------------
Pro Forma Actual December 31,
(Note 1) 1997
------------ -------------- -----------
(Unaudited)
<S> <C> <C> <C>
ASSETS
------
CURRENT ASSETS:
Cash and cash equivalents $ 89,361,516 $ 27,781,516 $ 36,831,748
Accounts receivable, net 1,082,993 1,082,993 892,020
Receivable for Common stock subject to put rights 2,999,995 2,999,995 2,999,995
Prepaid expenses 13,105,737 13,105,737 16,786,535
Inventory 162,134 162,134 90,039
Advances and recoupable costs 169,498 169,498 203,350
------------ ------------ ------------
Total current assets 106,881,873 45,301,873 57,803,687
------------ ------------ ------------
PROPERTY AND EQUIPMENT:
Computer equipment 6,106,060 6,106,060 4,638,311
Office furniture and equipment 1,243,162 1,243,162 1,147,102
Leasehold improvements 2,036,689 2,036,689 1,882,684
Property and equipment under capital leases 1,801,663 1,801,663 1,801,663
------------ ------------ ------------
11,187,574 11,187,574 9,469,760
Less- Accumulated depreciation and amortization (2,895,392) (2,895,392) (2,290,452)
------------ ------------ ------------
Net property and equipment 8,292,182 8,292,182 7,179,308
------------ ------------ ------------
OTHER ASSETS:
Intangible assets, net 225,839 225,839 244,154
Restricted cash 167,000 167,000 167,000
Other 171,795 171,795 138,206
------------ ------------ ------------
Total other assets 564,634 564,634 549,360
------------ ------------ ------------
$115,738,689 $ 54,158,689 $ 65,532,355
============ ============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Current portion of capital lease obligations $450,691 $450,691 $464,147
Accounts payable 2,249,847 2,249,847 1,504,143
Accrued merchandise costs 2,091,090 2,091,090 1,169,898
Accrued compensation 1,156,842 1,156,842 1,341,354
Accrued royalties 641,100 641,100 629,989
Other accrued liabilities 4,016,296 4,016,296 3,251,595
------------ ------------ ------------
Total current liabilities 10,605,866 10,605,866 8,361,126
------------ ------------ ------------
CAPITAL LEASE OBLIGATIONS 550,246 550,246 653,558
------------ ------------ ------------
OTHER LONG-TERM LIABILITIES 403,441 403,441 369,741
------------ ------------ ------------
COMMON STOCK SUBJECT TO PUT RIGHTS 2,999,995 2,999,995 2,999,995
------------ ------------ ------------
STOCKHOLDERS' EQUITY:
Common stock, $.001 par value, 100,000,000 shares
authorized, 14,162,004 shares issued and outstanding
pro forma; 12,162,004 and 12,118,100 shares issued and
outstanding 14,162 12,162 12,118
Additional paid-in capital 170,931,226 109,353,226 109,197,798
Accumulated deficit (69,766,247) (69,766,247) (56,061,981)
------------ ------------ ------------
Total stockholders' equity 101,179,141 39,599,141 53,147,935
------------ ------------ ------------
$115,738,689 $ 54,158,689 $ 65,532,355
============ ============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
<PAGE> 3
N2K INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
For the
Three Months Ended
March 31
-----------------------------------
1998 1997
------------ --------------
(Unaudited)
<S> <C> <C>
NET REVENUES $ 7,031,422 $ 1,115,897
COST OF REVENUES 5,936,338 890,202
------------- -------------
Gross profit 1,095,084 225,695
OPERATING EXPENSES:
Operating and development 6,001,282 2,601,838
Sales and marketing 8,102,123 1,065,838
General and administrative 1,194,794 945,357
------------- -------------
Operating loss (14,203,115) (4,387,338)
INTEREST AND OTHER INCOME 523,165 47,890
INTEREST EXPENSE (24,316) (18,942)
------------- -------------
Loss from continuing operations (13,704,266) (4,358,390)
LOSS FROM DISCONTINUED OPERATIONS -- (159,943)
------------- -------------
NET LOSS $ (13,704,266) $ (4,518,333)
============= =============
BASIC AND DILUTED LOSS PER COMMON SHARE:
Loss from continuing operations $ (1.13) $ (1.49)
Loss from discontinued operations -- (.06)
------------- -------------
Net loss per Common share $ (1.13) $ (1.55)
============= =============
SHARES USED IN COMPUTING BASIC AND DILUTED LOSS PER COMMON SHARE 12,146,810 2,923,216
============= ==============
</TABLE>
The accompanying notes are an integral part of these statements.
<PAGE> 4
N2K INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
For the
Three Months Ended
March 31
--------------------------------
1998 1997
----------- ----------
(Unaudited)
OPERATING ACTIVITIES:
<S> <C> <C>
Net loss $(13,704,266) $(4,518,333)
Adjustments to reconcile net loss to
net cash used in operating activities-
Depreciation and amortization 625,005 271,022
Amortization of marketing advances 4,129,619 --
Provision for doubtful accounts 188,460 --
Provision for future returns 21,499 54,000
Decrease (increase) in--
Accounts receivable 747,904 (188,997)
Prepaid expenses (448,821) (51,164)
Inventory (72,095) 49,234
Advances and recoupable costs 33,852 (495,453)
Other assets (88,832) 1,750
Increase (decrease) in--
Accounts payable (403,132) 311,970
Accrued merchandise costs 921,192 218,486
Accrued compensation (184,512) (293,256)
Accrued royalties 11,111 84,180
Other accrued liabilities 764,701 1,160,779
Other long-term liabilities 33,700 9,789
------------ -----------
Net cash used in operating activities (7,424,615) (3,385,993)
------------ -----------
INVESTING ACTIVITIES:
Purchases of and deposits on property and equipment (1,664,321) (781,244)
------------ -----------
Net cash used in investing activities (1,664,321) (781,244)
------------ -----------
FINANCING ACTIVITIES:
Net borrowings under line of credit -- 850,000
Payments on capital lease obligations (116,768) (47,551)
Proceeds from issuance of Common stock under the employee
stock purchase plan 18,848 --
Proceeds from exercise of Common stock options and warrants 136,624 --
------------ -----------
Net cash provided by financing activities 38,704 802,449
------------ -----------
DECREASE IN CASH AND CASH EQUIVALENTS (9,050,232) (3,364,788)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 36,831,748 4,483,450
------------ -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 27,781,516 $ 1,118,662
============ ===========
</TABLE>
The accompanying notes are an integral part of these statements.
<PAGE> 5
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
THE COMPANY:
Background
N2K Inc. (the "Company" or "N2K"), formerly Telebase Systems, Inc., was formed
as a result of the merger in February 1996, of N2K Inc., a New York corporation
("New York N2K"), which was founded in 1995, and Telebase Systems, Inc.
("Telebase"), which was founded in 1984 as a provider of on-line information
services. In 1994, recognizing increasing opportunities in the entertainment
market, Telebase expanded its strategy to include music entertainment. In April
1997, the Company discontinued its on-line information services business and in
August 1997, the Company sold substantially all of the net assets of this
business. The operations of the on-line information services business have been
accounted for as discontinued operations (see Note 2).
The Company is a music entertainment company using the Internet as a global
platform for promoting, marketing and selling music and related merchandise. The
Company's strategy is to build loyal user communities around genre-specific
websites that provide music content and enable consumers to purchase compact
discs ("CDs"), cassettes, LPs, videos and related music items through Music
Boulevard Network. The Company has also established its own record label, N2K
Encoded Music, which uses the Company's websites, as well as record stores and
other traditional distribution channels, to promote, distribute and sell
original and licensed artist recordings.
Stock Split and Reorganization
On October 15, 1997, the Company effected a one-for-four reverse stock split of
each outstanding share of Common stock in N2K Inc., a Pennsylvania corporation,
prior to the reorganization of N2K Inc. as a Delaware corporation, which
occurred on October 16, 1997. All share, stock option and warrant data have been
restated to reflect the reverse stock split.
Initial Public Offering
On October 17, 1997, the Company completed its initial public offering of
3,330,221 shares of Common stock at a price of $19 per share. Additionally, on
October 22, 1997, the underwriters exercised their over-allotment option for the
purchase of 499,533 shares at a price of $19 per share. The Company received net
cash proceeds of approximately $65,300,000 from the initial public offering.
<PAGE> 6
Pro Forma Consolidated Balance Sheet
On April 14, 1998, the Company completed its secondary public offering (the
"Secondary Offering") of 3,125,722 shares of Common stock at a price of $33 per
share. Of the 3,125,722 shares of Common stock offered, 2,000,000 were offered
by the Company, and 1,125,722 were offered by selling stockholders. The Company
received net proceeds of approximately $61,580,000. The pro forma consolidated
balance sheet reflects the receipt of the net proceeds of the Secondary
Offering as if it had occurred on March 31, 1998.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Quarterly Financial Information and Results of Operations
The financial statements as of March 31, 1998 and for the three months ended
March 31, 1998 and 1997, are unaudited and, in the opinion of management,
include all adjustments (consisting only of normal recurring adjustments)
necessary to present fairly the financial position as of March 31, 1998, and the
results of operations and cash flows for the three months ended March 31, 1998
and 1997. The results for the three months ended March 31, 1998 are not
necessarily indicative of the results to be expected for the entire year. While
the Company believes that the disclosures presented are adequate to make the
information not misleading, these Consolidated Financial Statements should be
read in conjunction with the Consolidated Financial Statements and the notes
included in the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 1997.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated.
Management's 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.
Cash and Cash Equivalents
For the purposes of the consolidated statements of cash flows, the Company
considers investment instruments with an original maturity of three months or
less to be cash equivalents. Cash equivalents are comprised of investments in
various mutual and money market funds, as well as short-term notes.
<PAGE> 7
Supplemental Disclosures of Cash Flow Information
For the three months ended March 31, 1998 and 1997, the Company paid interest of
$24,316 and $12,547, respectively. Income taxes paid in 1998 and 1997 were
immaterial. The Company incurred no capital lease obligations during the three
months ended March 31, 1998. The Company incurred $208,226 of capital lease
obligations during the three months ended March 31, 1997.
Advances and Recoupable Costs
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 50,
"Financial Reporting in the Record and Music Industry," advances to artists and
producers and other recoupable costs are capitalized as an asset when the
current popularity and past performance of the artist or producer provides a
sound basis for estimating the probable future recoupment of such advances from
earnings otherwise payable to the artist or producer. Any portion of such
advances not deemed to be recoupable from future royalties is reserved at the
balance sheet date. All other significant advances which do not meet the above
criteria are expensed when paid and included in operating and development
expenses on the accompanying consolidated statement of operations.
Property and Equipment
Property and equipment are stated at cost. Depreciation is calculated on a
straight-line basis over the estimated useful lives of the assets. Computer
equipment is depreciated primarily over an estimated useful life of 4 years and
office furniture and equipment is depreciated over an estimated useful life of 4
to 8 years. Leasehold improvements are amortized over the shorter of the
estimated useful life or the lease term. Improvements and betterments are
capitalized while maintenance and repair costs are charged to expense as
incurred. Upon retirement or disposition, the applicable property amounts are
relieved from the accounts and any gain or loss is recorded in the consolidated
statement of operations.
Intangible Assets
Intangible assets consist of acquired technology costs and the Rocktropolis
tradename and are being amortized over 5 years on a straight-line basis.
The Company evaluates the realizability of intangible assets based on estimates
of undiscounted future cash flows over the remaining useful life of the asset.
If the amount of such estimated undiscounted future cash flows is less than the
net book value of the asset, the asset is written down to its net realizable
value. As of March 31, 1998, no such write-down was required.
Common Stock Subject to Put Rights
American Online Inc. ("AOL") and the Company entered into an agreement, pursuant
to which AOL agreed to purchase from the Company at the initial public offering
price per share of $19.00 (less underwriting discounts and commissions) an
aggregate amount of $3,000,000 or 169,779 shares of the Company's Common stock
(the "AOL Purchase"). The Company has granted AOL certain shelf and other
registration rights with respect to the shares purchased by AOL in the AOL
Purchase, including the right to require the Company to register such shares
for resale, and to have such registration statement declared effective on or
before April 16, 1998 and to maintain the effectiveness of such registration
statement for a period of two years from the consummation of the AOL Purchase.
As the Company has failed to cause such registration statement to be declared
effective by April 16, 1998, AOL has the right to require the Company to
repurchase such shares for cash at a price equal to the greater of the original
purchase price therefor (which is being held by AOL in a segregated account)
and the then-current fair market value. The current fair market value of the
Company's Common stock as of May 13, 1998 was $22.25 per Common share. As of
May 13, 1998, these shares had not been registered, and AOL had not exercised
its put right. If the Company is required to purchase the AOL shares, the
Common stock subject to put rights on the Company's consolidated balance sheet
will be accreted to its fair value based upon the price of the Company's stock
at each reporting date. The fair value will be recorded as a charge to retained
earnings at each reporting date and will reduce earnings available to Common
shareholders. As of May 13, 1998, this charge is approximately $551,782. The
Company's repurchase obligation is secured by an escrow in the form of cash and
/or letter of credit in an amount to be agreed upon by the Company and AOL,
which amount shall not be less than $3,000,000 nor more than $7,500,000.
Accordingly, the value of these shares is not included in Stockholders' equity.
<PAGE> 8
Revenue Recognition
Revenues from the sale of music CDs and cassettes sold via the Internet include
shipping and handling charges and are recognized at the time of shipment. The
Company records the estimated gross profit which will be lost due to current
period shipments being returned in future periods as a reduction of revenues and
cost of revenues in the period of shipment.
Beginning in January 1997, in connection with the Company's first record
release, revenues began to be derived from the sale of original and licensed
artist recordings. Revenues are recognized at the time of shipment. Provision is
made for the estimated effect of sales returns where right-of-return privileges
exist. Returns of product from customers are accepted in accordance with
standard industry practice. The full amount of the returns allowance (estimated
returns to be received net of distribution, royalty and inventory costs) is
shown as a reduction of accounts receivable in the accompanying consolidated
financial statements. If the amount is a net liability, it is included in
accounts payable.
The Company has numerous agreements with other companies in the entertainment
business which provide for, among other things, the Company to pay a percentage
of revenues, as defined, derived from customers entering the Company's website
via the websites of these other companies. The Company records these costs in
cost of revenues at the time the related revenues are recorded.
<PAGE> 9
Advertising revenues are derived from the sale of advertising on the Company's
websites. Advertising revenues are recognized in the period the advertisement is
displayed, provided that no significant Company obligations remain and
collection of the resulting receivable is probable. Company obligations
typically include guarantees of minimum number of "impressions," or times that
any advertisement is viewed by users on the Company's websites. To the extent
minimum guaranteed impressions are not met, the Company defers recognition of
the corresponding revenues until guaranteed impression levels are achieved.
Revenues from the sale of certain advertising on the Company's websites are
shared with third parties under the terms of certain agreements. The Company
records advertising revenues net of amounts allocable to third parties under the
terms of such agreements. To date, amounts allocable to third parties have not
been significant. For the three months ended March 31, 1998 and 1997,
advertising revenues were $712,160 and $34,900, respectively.
The Company recognizes advertising revenue as a result of barter transactions.
Such revenue is recognized based on the fair value received or sold, whichever
more clearly estimates the fair value of the asset, which generally consists
of advertising displayed by other companies or merchandise. Barter revenue and
the corresponding expenses are recognized in the period the advertising is
displayed. For the three months ended March 31, 1998, approximately $388,000
of advertising revenue was recognized related to barter transactions. There
was no revenue recognized related to barter transactions for the three months
ended March 31, 1997.
Operating and Development Expenses
Operating and development expenses consist primarily of software engineering,
multimedia production, graphic design, certain nonrecoverable advances and
recoupable costs, artist relations, telecommunications charges, inventory
management and computer operations which support the Company's music
entertainment business. For the three months ended March 31, 1998 and 1997, the
Company incurred costs of $1,531,841 and $913,501, respectively, relating to
research and development. These amounts are included in operating and
development expenses as show in the accompanying consolidated statements of
operations.
Advertising Expenses
Promotional costs incurred in connection with the N2K Encoded Music label are
capitalized for unreleased projects and expensed when the related product is
released. All other advertising and promotional costs incurred by the Company
are expensed the first time the advertising takes place. Advertising and
promotion expense is included in sales and marketing expenses in the
accompanying consolidated statements of operations. Excluding the amortization
of the Company's marketing advances, advertising and promotion expense was
$3,462,024 and $551,039 for the three months ended March 31, 1998 and 1997,
respectively.
Net Loss Per Common Share
In February 1997, the Financial Accounting Standards Board issued SFAS No. 128,
"Earnings per Share," which supersedes APB 15. SFAS No. 128 requires dual
<PAGE> 10
presentation of basic and diluted earnings (loss) per share for complex capital
structures on the face of the statements of operations. According to SFAS No.
128, basic earnings (loss) per share, which replaced primary earnings (loss) per
share, is calculated by dividing net income (loss) available to Common
stockholders by the weighted average number of Common shares outstanding for the
period. Diluted earnings (loss) per share, which replaced fully diluted earnings
(loss) per share, reflects the potential dilution from the exercise or
conversion of securities into Common stock, such as stock options.
The Company adopted SFAS No. 128 during the period ended December 31, 1997, as
earlier application was not permitted. As required by SFAS No. 128, all
prior-period loss per Common share data has been restated to conform with the
provisions of this statement.
The following is a summary of the numerators and denominators of the basic and
diluted net loss per Common share computations:
<TABLE>
<CAPTION>
For the Three Months Ended March 31
1998 1997
--------------- --------------
<S> <C> <C>
Loss (numerator) $ (13,704,266) $ (4,518,333)
Shares(denominator) 12,146,810 2,923,216
Per share amount $ (1.13) $ (1.55)
</TABLE>
Diluted net loss per share is the same as basic net loss per share as no
additional shares for the potential dilution from the exercise or conversion of
securities into Common stock are included in the denominator as the result is
anti-dilutive due to the Company's losses. Options to purchase 2,136,262 shares
of Common stock at a weighted average exercise price of $10.28 per share,
warrants to purchase 599,554 shares of Common stock at a weighted average
exercise price of $14.16 per share and the AOL Purchase were outstanding as of
March 31, 1998, but were not included in the computation of diluted net loss per
Common share.
Reclassifications
The consolidated financial statements for prior periods have been reclassified
to conform with the current period's presentation.
<PAGE> 11
2. DISCONTINUED OPERATIONS:
In April 1997, the Company's Board of Directors approved a formal plan of
disposal for its on-line information services business.
The on-line information services business was accounted for as discontinued
operations with a measurement date of April 4, 1997. The Company expected that
the sale of the on-line information services business would result in a gain on
the disposal of the segment's net assets which would be sufficient to offset the
losses of the segment from the measurement date to the disposal date. As a
result, no amounts were accrued in the accompanying consolidated financial
statements relating to the disposal of the segment. The net losses from
discontinued operations from the measurement date to the disposal date were
recorded as an adjustment to the net assets of the discontinued operations in
the accompanying consolidated balance sheets. The accompanying Consolidated
Financial Statements reflect the operating results and balance sheet items of
the discontinued operations separately from continuing operations.
Effective August 1, 1997, the Company entered into an agreement for the sale of
all of the net assets of the on-line information services business, except its
accounts receivable and accounts payable. The total purchase price of $6,000,000
consists of $3,000,000 which was paid in cash at closing, and up to an
additional $3,000,000 pursuant to an earn-out which, if and to the extent
earned, is payable at the purchaser's sole discretion on March 31, 1999 and
September 30, 1999, either in cash or that number of shares of its Common stock
having a market value equal to the amount to be paid. The earn-out is based upon
the revenues of the business which are generated from July 1, 1997 through
December 31, 1998. If revenues during the above period do not meet the specified
target, the earn-out is reduced. If revenues during the above period exceed the
specified target, the earn-out is increased, up to a maximum of $1,000,000. The
Company will record the earn-out as a gain on the sale of discontinued
operations when realized. At closing, the Company recorded a gain on the sale of
discontinued operations of $1,574,493. The gain was net of a provision for
certain disposal costs including accruals for future commitments relating to
severance and doubtful accounts relating to the on-line information services
business' accounts receivable. These costs are reflected in accrued discontinued
operations disposal costs (see Note 4). In connection with the sale, the Company
entered into a services agreement under which it provides certain services
and support personnel to the purchaser until September 1999 for a fixed
monthly fee.
<PAGE> 12
Revenues and losses from discontinued operations in the accompanying
consolidated statements of operations were:
<TABLE>
<CAPTION>
For the Three Months
Ended March 31, 1997
--------------------
<S> <C>
Revenues $ 1,335,497
=============
Loss before income taxes $ (159,943)
Income taxes --
-------------
Loss $ (159,943)
=============
</TABLE>
There were no revenues or losses from discontinued operations for the three
months ended March 31, 1998.
3. PREPAID EXPENSES:
Prepaid expenses as of March 31, 1998 and December 31, 1997, consist of the
following:
<TABLE>
<CAPTION>
March 31, December 31,
1998 1997
---- ----
<S> <C> <C>
AOL marketing advances $12,775,000 $12,775,000
Excite Inc. ("Excite") marketing advances 3,300,000 3,300,000
Netscape Communications Corporation
("Netscape") marketing advances 3,000,000 3,000,000
Other 930,097 481,276
----------- -----------
20,005,097 19,556,276
Less: Accumulated amortization of marketing advances (6,899,360) (2,769,741)
----------- -----------
$13,105,737 $16,786,535
=========== ===========
</TABLE>
The Company is amortizing the costs associated with its marketing advances over
the contractual terms of the strategic alliance which is primarily one to three
years, and the amortization method is primarily on a straight-line basis.
Amortization for the three months ended March 31, 1998 was $4,129,619 and is
included in sales and marketing expenses on the accompanying financial
statements. The Company continually evaluates the realizability of the marketing
advances, and if necessary, will write down the asset to its net realizable
value based on estimates of undiscounted future cash flows from each advance
over the remaining useful life of the asset. As of March 31, 1998, no such write
down was required.
<PAGE> 13
4. OTHER ACCRUED LIABILITIES:
Other accrued liabilities as of March 31, 1998 and December 31, 1997, consist of
the following:
<TABLE>
<CAPTION>
March 31, December 31,
1998 1997
---- ----
<S> <C> <C>
Accrued discontinued operations disposal costs (Note 2) $ 509,770 $ 671,407
Accrued advertising 1,554,558 652,138
Other 1,951,968 1,928,050
---------------- ---------------
$ 4,016,296 $ 3,251,595
================ ===============
</TABLE>
5. CREDIT AGREEMENTS:
The Company had a line of credit with a bank of $2,000,000 that originally
expired on March 31, 1998. On March 30, 1998, pursuant to a letter agreement,
the line of credit was extended to June 30, 1998. The Company is obligated to
pay a commitment fee equal to 0.5% on the average daily unused portion of the
commitment. The line of credit bears interest at the "bank's prime rate," as
defined, and is secured by a security interest in substantially all of the
Company's assets. Maximum borrowings are limited to certain percentages of
eligible accounts receivable (as defined). There were no borrowings on the line
of credit for the three months ended March 31, 1998. The maximum amount
outstanding on the line of credit was $850,000 for the three months ended March
31, 1997. The weighted average interest rate was 8.3% for the three months ended
March 31, 1997. In addition, the line of credit requires the Company to meet
certain financial covenants. Interest expense for the three months ended March
31, 1997 was $8,343.
<PAGE> 14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Safe Harbor for Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995 with
respect to the financial condition, results of operations and business of the
Company, including statements related to revenues, cost of revenues, pricing,
margins, operating expenses, cash flow, strategic relationships, financing,
property and equipment purchases, acquisitions and investments, and exposure to
Year 2000 problems. Such statements may be identified by the use of certain
forward-looking terminology, such as "may," "will," "expect," "anticipate,"
"intend," "estimate," "believe," "goal," or "continue," or comparable
terminology. These forward-looking statements involve risks and uncertainties
that could cause actual results to differ materially from those contemplated.
Such risks and uncertainties include, but are not limited to, the impact from
competition with respect to Internet content, merchandise and recorded music;
dependence on strategic alliance partners, suppliers and distributors; market
acceptance of the Internet for commerce and as a medium for advertising and
technological changes and difficulties. Except as required by law, the Company
undertakes no obligation to update any forward-looking statement, whether as a
result of new information, future events or otherwise. Readers, however, should
carefully review the factors set forth in other reports or documents that the
Company files from time to time with the Securities and Exchange Commission.
Overview
N2K Inc. (the "Company" or "N2K"), is a music entertainment company using the
Internet as a global platform for promoting, marketing and selling music and
related merchandise. The Company's strategy is to build loyal user communities
around genre-specific websites that provide music content and enable consumers
to purchase compact discs ("CDs"), cassettes, LPs, videos and related music
items through Music Boulevard Network. The Company has also established its own
record label, N2K Encoded Music, which uses the Company's websites, as well as
record stores and other traditional distribution channels, to promote,
distribute and sell original and licensed artist recordings.
The Company was founded as Telebase Systems, Inc. ("Telebase") in 1984 as a
provider of on-line information services. In 1994, recognizing increasing
opportunities in the consumer entertainment market, Telebase expanded its
on-line business strategy to include music entertainment and began expending
significant resources to enter this market. Telebase launched its Music
Boulevard website and began selling recorded music and
<PAGE> 15
related merchandise in 1995. In February 1996, Telebase merged with New York
N2K, a New York corporation ("New York N2K") founded in 1995 as a developer of
on-line music entertainment content, and the merged entity changed its name to
N2K Inc. In April 1997, the Company decided to focus exclusively on its music
entertainment business and, accordingly, the Board of Directors approved a
formal plan of disposal for its on-line information services business. In August
1997, the Company sold substantially all of the net assets of this business. See
"--Discontinued Operations." In October 1997, the Company, which had previously
been incorporated in Pennsylvania, was reincorporated as a Delaware corporation
and consummated its initial public offering of the Company's Common stock. On
April 14, 1998, the Company completed its secondary public offering of the
Company's Common stock (the "Secondary Offering").
The Company launched its first Internet website, Music Boulevard, in August
1995, and introduced its first music genre website, Jazz Central Station, in
January 1996. In January 1997, the Company launched its first release on the N2K
Encoded Music label. The Company is currently generating revenues from the sale
of CDs and cassettes produced by others, N2K Encoded Music CDs, the sale of
advertising on its websites and the sale of related merchandise. The Company
believes that increased sales of N2K Encoded Music CDs and advertising on its
websites will contribute to higher margins in the future. The margins from the
sale of CDs and cassettes produced by others are affected by product costs,
shipping and handling fees, credit card fees and promotional discounts, such as
discounted selling prices and free shipping and handling. The Company believes
that frequent promotional discounts will be necessary to build repeat customer
traffic to its websites, which will reduce its gross margins. The Company
believes that its future financial performance will be determined by its success
in improving margins on the sale of CDs and cassettes produced by others,
introducing new products and services, selling advertising and sponsorship
programs on its websites and by selling recorded music under its N2K Encoded
Music label. Management has increased the resources within the Company to
support these functions.
The Company currently intends to increase substantially its operating expenses
as a result of the Company's strategic alliances, to fund increased sales and
marketing, to enhance existing websites and to complete strategic relationships
important to the success of the Company. To the extent that such expenses
precede or are not subsequently followed by increased revenues, the Company's
business, results of operations and financial condition will be materially
adversely affected. There can be no assurance that the Company will be able to
generate sufficient revenues from the sale of music recordings, related
merchandise, advertising and sponsorship programs to achieve or maintain
profitability on a quarterly or annual basis in the future. The Company expects
negative cash flow from operations to continue for the foreseeable future as it
continues to develop and market its business.
<PAGE> 16
Results of Operations
Quarterly Results
The Company expects to experience significant fluctuations in future quarterly
operating results that may be caused by a variety of factors, including, without
limitation, (i) the Company's ability to retain existing customers, attract new
customers at a steady rate and maintain customer satisfaction, (ii) the
announcement or introduction of new or enhanced websites, products and strategic
alliances by the Company and its competitors, (iii) the mix of products sold by
the Company, (iv) seasonality of the recorded music industry, (v) seasonality of
advertising sales, (vi) Company promotions and sales programs, (vii) price
competition or higher recorded music prices in the industry, (viii) the level of
use of the Internet and increasing consumer acceptance of the Internet for the
purchase of consumer products such as those offered by the Company, (ix) the
Company's ability to upgrade and develop its systems and infrastructure in a
timely and effective manner, (x) the level of traffic on the Company's websites,
(xi) technical difficulties, system downtime or Internet brownouts, (xii) the
amount and timing of operating costs and capital expenditures relating to
expansion of the Company's business, operations and infrastructure and the
implementation of marketing programs, key agreements and strategic alliances,
(xiii) the number of recorded music releases introduced during the period, (xiv)
the level of merchandise returns experienced by the Company and (xv) general
economic conditions and economic conditions specific to the Internet, on-line
commerce and the recorded music industry. While the Company has a limited
operating history in the music entertainment business, it anticipates that
revenues will eventually track traditional music purchase and advertising sales
patterns. As a result, the Company believes that period-to-period comparisons of
its results of operations are not and will not necessarily be meaningful and
should not be relied upon as an indication of future performance.
Three Months Ended March 31, 1998 Compared To Three Months Ended March 31, 1997
The Company incurred net losses of $13.7 million and $4.5 million for the three
months ended March 31, 1998 and 1997, respectively.
Net Revenues. Net revenues for the three months ended March 31, 1998 totaled
$7.0 million compared to $1.1 million for the three months ended March 31, 1997.
Net revenues for the three months ended March 31, 1998 and 1997 consisted
primarily of sales of CDs and cassettes produced by others. Net sales of CDs
produced by the Company totaled $807,000 for the three months ended March 31,
1998 compared to $352,000 for the three months ended March 31, 1997. Net sales
derived from advertising sold on the Company's websites totaled $712,000 for the
three months ended March 31, 1998 compared to $35,000 for the three months ended
March 31, 1997.
Cost of Revenues. Cost of revenues totaled $5.9 million for the three months
ended March 31, 1998 compared to $890,000 for the three months ended March 31,
1997. Cost of revenues consists of payments to third parties for distribution of
CDs and cassettes, fulfillment of customer orders, manufacturing expenses,
royalties, copyrights, credit card processing charges and profit participations
payable to strategic alliance partners. The Company's gross profit as a
percentage of revenues
<PAGE> 17
decreased primarily due to increased marketing promotions including certain
shipping promotions. The Company expects revenues from the sale of advertising
and related merchandise to increase in future periods, which the Company
believes will contribute to higher margins and reduce the cost of revenues as a
percentage of revenues.
Operating and Development Expenses. Operating and development expenses increased
from $2.6 million for the three months ended March 31, 1997 to $6.0 million for
the three months ended March 31, 1998, primarily due to increased staffing and
related overhead expenses as the Company expanded its operations. Operating and
development personnel totaled 167 full-time employees as of March 31, 1998
compared to 100 full-time employees as of March 31, 1997. Operating and
development expenses consist primarily of software engineering, multimedia
production, graphic design, certain nonrecoverable advances and recoupable
costs, artist relations, telecommunications charges, inventory management and
computer operations which support the Company's music entertainment business.
This infrastructure is sufficient to support higher revenues and, accordingly,
the Company expects that, as revenues increase, operating and development
expenses will decrease as a percentage of revenues.
Sales and Marketing Expenses. Sales and marketing expenses increased from $1.1
million for the three months ended March 31, 1997 to $8.1 million for the three
months ended March 31, 1998. The increase in sales and marketing expenses was
primarily attributable to the amortization of the costs associated with the
Company's various strategic alliances, the expansion of the Company's on-line
and print advertising, public relations and other promotional expenditures, as
well as increased personnel and related expenses required to implement the
Company's marketing strategy. Sales and marketing personnel totaled 54 full-time
employees as of March 31, 1998 compared to 22 full-time employees as of March
31, 1997. Sales and marketing expenses consist primarily of the amortization of
the costs associated with the Company's various strategic alliances, external
advertising, promotion, trade show, advertising sales and personnel expenses
associated with marketing of the Company's websites and N2K Encoded Music CDs.
The Company expects that levels of sales and marketing expenditures will
increase in future periods due to the execution of new advertising programs to
promote the Company's websites and N2K Encoded Music releases, but total sales
and marketing expenses will decline as a percentage of revenues.
General and Administrative Expenses. General and administrative expenses
increased from $945,000 for the three months ended March 31, 1997 to $1.2
million for the three months ended March 31, 1998, primarily due to increased
staffing expenses, related overhead expenses and expenses associated with being
a public company. General and administrative personnel totaled 32 full-time
employees as of March 31, 1998 compared to 27 full-time employees as of March
31, 1997. General and administrative expenses consist of executive management,
accounting and human resources personnel, and expenditures for applicable
overhead costs. The Company expects general and administrative expenses to
continue to increase in absolute dollars as the Company expands its staff and
incurs additional costs related to the growth of its business.
Interest and Other Income and Interest Expense. Interest and other income and
interest expense primarily consists of interest income on short-term liquid
investments of the Company's excess cash and interest expense incurred as a
result
<PAGE> 18
of the financing of equipment through capital leases and the use of the
Company's revolving credit line. Interest and other income increased from
$48,000 for the three months ended March 31, 1997 to $523,000 for the three
months ended March 31, 1998 primarily due to the Company investing the proceeds
of its initial public offering which occurred in the fourth quarter of 1997.
Liquidity and Capital Resources
The Company has financed its operations and capital expenditures primarily
from equity financings, lease financings, a revolving bank credit line, and
short-term loans. At March 31, 1998, the Company had a cash balance of $27.8
million. On April 14, 1998, the Company completed its Secondary Offering and
received net proceeds of approximately $61.6 million. The Company believes that
the proceeds of the Secondary Offering, together with its current cash balance,
will be sufficient to finance the Company's planned operations and capital
expenditures through at least December 1999. The Company expects negative cash
flow from operations to continue for the foreseeable future, as it continues to
develop and market its operations. Inflation has not had any material impact on
the Company's operations.
Net cash of $7.4 million and $3.4 million was used in operating activities
for the three months ended March 31, 1998 and 1997, respectively, primarily as a
result of the net losses generated during those periods. The Company financed
activities for the three months ended March 31, 1998 through its initial public
offering which yielded net proceeds of $65.3 million. Activities for the three
months ended March 31, 1997 were financed through proceeds from the sale of
preferred stock.
Purchases of property and equipment totaled $1.7 million and $781,000 for the
three months ended March 31, 1998 and 1997, respectively. The Company projects
that total purchases of property and equipment will be approximately $7.3
million in 1998, which includes $2.5 million for creation of redundant systems
and $4.8 million to support the expansion of facilities and operating systems
for its websites and obtain computer-related equipment to support increased
personnel.
In 1997, the Company entered into a number of strategic alliance
agreements, including America Online Inc. ("AOL"), Excite Inc. ("Excite") and
Netscape Communications Corporation ("Netscape"). During April 1998, the Company
signed three additional strategic alliance agreements with Ticketmaster
Ticketing Company, Inc., AOL Bertelsmann Online, Disney Online, and Microsoft
Corporation. The Company's commitments under all of its strategic alliance
agreements, including those signed in April 1998, include cash payments of
approximately $17.1 million, $13.5 million and $4 million for 1998, 1999, and
2000, respectively. No payments were made under any of the Company's strategic
alliances during the three months ended March 31, 1998.
The Company has a commitment for a $2.0 million revolving line of credit with
CoreStates Bank, N.A. (the "CoreStates Facility"), which will expire on June 30,
1998. The Company is currently negotiating the terms of a new facility. The
CoreStates Facility bears interest at the bank's prime rate and is secured by a
security interest in substantially all of the Company's assets. Maximum
borrowings under the CoreStates Facility are limited to certain percentages of
eligible accounts receivable. The CoreStates Facility is subject to an unused
commitment fee in the amount of 0.5% of the unused portion of the facility on a
quarterly basis. As of March 31, 1998, the Company did not have any outstanding
borrowings under the CoreStates Facility.
<PAGE> 19
From time to time, in the ordinary course of business, the Company evaluates
possible acquisitions of, or investments in, businesses, products and
technologies that are complementary to those of the Company. A portion of the
Company's cash resources may therefore be used to fund acquisitions or
investments.
Discontinued Operations
Beginning in 1984, the Company operated an on-line information services
business. In 1994, the Company expanded its business strategy to include music
entertainment. In April 1997, the Company decided to focus exclusively on its
music entertainment business, and, as such, elected to discontinue its on-line
information services business. At that time, the Board of Directors approved a
formal plan of disposal for its on-line information services business. In August
1997, the Company sold substantially all of the net assets of this business.
The on-line information services business has been accounted for as a
discontinued operation. Accordingly, the operating results and assets and
liabilities of this business have been reflected separately from continuing
operations. The sale of the on-line information services business in August 1997
resulted in a gain of approximately $1.6 million, which was recorded in the
period ended September 30, 1997. See Note 2 of Notes to Consolidated Financial
Statements.
For the years three months ended March 31, 1997, the discontinued operations
generated revenues of $1.3 million. The discontinued operations generated a net
loss of $160,000 for the three months ended March 31, 1997.
Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information." SFAS No.
131 establishes standards for the way that public business enterprises report
information about operating segments in annual financial statements and requires
that those enterprises report selected information about operating segments in
interim financial reports issued to stockholders. It also establishes standards
for related disclosures about products and services, geographic areas, and major
customers. SFAS No. 131 is required to be adopted for the Company's 1998
year-end financial statements. The Company is evaluating the impact, if any, of
the adoption of this pronouncement on the Company's existing disclosures.
<PAGE> 20
Risks Associated with the Year 2000
The Year 2000 issue is the result of computer programs being written using two
digits rather than four to define the applicable year. In other words,
date-sensitive software may recognize a date using "00" as the year 1900 rather
than the year 2000. This could result in system failures or miscalculations
causing disruptions of operations, including, among others, a temporary
inability to process transactions, send invoices or engage in similar normal
business activities.
The Company does not believe that it has material exposure to the Year 2000
issue with respect to its own information systems since its existing systems
correctly define the Year 2000. The Company has begun to conduct an analysis to
determine the extent to which its major suppliers' systems (insofar as they
relate to the Company's business) are subject to the Year 2000 issue. The
Company is currently unable to predict the extent to which the Year 2000 issue
will affect its suppliers, or the extent to which it would be vulnerable to its
suppliers' failure to remediate any Year 2000 issues on a timely basis. The
failure of a major supplier subject to the Year 2000 issue to convert its
systems on a timely basis or a conversion that is incompatible with the
Company's systems could have a material adverse effect on the Company. In
addition, most of the purchases from Music Boulevard are made with credit cards,
and the Company's operations may be materially adversely affected to the extent
its customers are unable to use their credit cards due to Year 2000 issues that
are not rectified by their credit card providers.
<PAGE> 21
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company and 17 other entities have been named as defendants in a civil
action captioned Interactive Gift Express v. CompuServe, Inc. et al., which is
pending in the U.S. District Court, Southern District of New York, Docket 95 CV
6871 (BSJ). The Company has also been named as a defendant in a civil action
captioned Parsec Sight/Sound, Inc. v. N2K Inc. which is pending in the U.S.
District Court of Pennsylvania, Western District, Docket 98 CV 0118. The
plaintiffs in each of these actions allege infringement of certain intellectual
property rights, and each seeks treble damages and costs in an unspecified
amount, as well as other declaratory and injunctive relief. The Company believes
that the claims against it in each action are without merit and intends to
vigorously defend against each of them. Moreover, the Company believes that
these lawsuits, even if adversely determined, will not have a material adverse
effect on the Company's business, financial condition or results of operations.
A class action complaint has been filed against the Company and its directors
in the U.S. District Court for the Southern District of New York alleging
violations of the Securities Act of 1933 in connection with the public offering
of shares of the Company's Common stock in April, 1998. The Company has only
recently been served with the complaint in this legal action and is currently
reviewing with counsel the claims made therein.
ITEM 2. CHANGES IN SECURITIES
USE OF PROCEEDS FROM REGISTERED SECURITIES
With respect to the Company's Registration Statement (File No. 333-33105) filed
under the Securities Act of 1933, as amended, related to the initial public
offering of the Company's Common stock, which was declared effective by the
Securities and Exchange Commission on October 16, 1997, the following
additional applications of the net offering proceeds were made from January 1,
1998 through March 31, 1998:
<TABLE>
<S> <C>
Purchase of property and equipment to expand the Company's
infrastructure $1,700,000
Other working capital needs 5,800,000
----------
Total $7,500,000
==========
</TABLE>
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a. The following is a list of exhibits filed as part of this Form 10-Q.
27 Financial Data Schedule, which is submitted electronically to
the Securities and Exchange Commission for information only.
b. There were no reports on Form 8-K filed during the quarter ended March 31,
1998.
<PAGE> 22
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.
N2K Inc.
Date: May 14, 1998 BY: /s/James E. Coane
---------------------------------------------
James E. Coane
President, Chief Operating Officer
and Director
Date: May 14, 1998 BY: /s/Bruce Johnson
---------------------------------------------
Bruce Johnson
Senior Vice President, Secretary, Chief
Financial Officer (Principal Accounting
Officer and Principal Financial Officer)
and Director
<TABLE> <S> <C>
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<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> MAR-31-1998
<CASH> 27,781,516
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<ALLOWANCES> 188,460
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<COMMON> 12,162
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<CGS> 5,936,338
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