<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________
Commission File 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 October 31, 1998: 14,228,755 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
(Unaudited)
<TABLE>
<CAPTION>
September 30 December 31
ASSETS 1998 1997
------ --------------- ---------------
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $54,277,085 $ 36,831,748
Accounts receivable, net 1,806,477 892,020
Receivable for Common stock subject to put rights 2,999,995 2,999,995
Prepaid expenses 9,678,148 16,786,535
Inventory 314,359 90,039
Advances and recoupable costs 170,906 203,350
--------------- ---------------
Total current assets 69,246,970 57,803,687
--------------- ---------------
PROPERTY AND EQUIPMENT:
Computer equipment 10,328,407 4,638,311
Office furniture and equipment 1,681,678 1,147,102
Leasehold improvements 2,245,143 1,882,684
Property and equipment under capital leases 1,801,663 1,801,663
--------------- ---------------
16,056,891 9,469,760
Less- Accumulated depreciation and amortization (4,536,030) (2,290,452)
--------------- ---------------
Net property and equipment 11,520,861 7,179,308
--------------- ---------------
OTHER ASSETS:
Intangible assets, net 187,148 244,154
Restricted cash 167,000 167,000
Other 1,083,276 138,206
--------------- ---------------
Total other assets 1,437,424 549,360
=============== ===============
$82,205,255 $ 65,532,355
=============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of capital lease obligations $ 373,507 $ 464,147
Accounts payable 1,899,303 1,504,143
Accrued merchandise costs 1,469,257 1,169,898
Accrued compensation 1,394,277 1,341,354
Accrued royalties 584,553 629,989
Other accrued liabilities 11,571,900 3,251,595
--------------- ---------------
Total current liabilities 17,292,797 8,361,126
--------------- ---------------
CAPITAL LEASE OBLIGATIONS 393,234 653,558
--------------- ---------------
OTHER LONG-TERM LIABILITIES 393,686 369,741
--------------- ---------------
COMMON STOCK SUBJECT TO PUT RIGHTS 2,999,995 2,999,995
--------------- ---------------
STOCKHOLDERS' EQUITY:
Common stock, $.001 par value, 100,000,000 shares
authorized, 14,228,755 and 12,118,100 shares issued and
outstanding 14,229 12,118
Additional paid-in capital 171,356,553 109,197,798
Accumulated deficit (110,245,239) (56,061,981)
--------------- ---------------
Total stockholders' equity 61,125,543 53,147,935
=============== ===============
$82,205,255 $ 65,532,355
=============== ===============
</TABLE>
The accompanying notes are an integral part of these statements.
<PAGE> 3
N2K INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<TABLE>
<CAPTION>
For the For the
Three Months Ended Nine Months Ended
September 30 September 30
----------------------------------- -----------------------------------
1998 1997 1998 1997
--------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
NET REVENUES $ 10,506,150 $ 3,569,969 $ 27,644,496 $ 6,506,864
COST OF REVENUES 8,171,623 2,792,248 21,752,122 4,917,368
--------------- --------------- --------------- ---------------
Gross profit 2,334,527 777,721 5,892,374 1,589,496
OPERATING EXPENSES:
Operating and development 7,706,640 3,514,269 19,873,600 9,338,665
Sales and marketing 14,210,184 2,631,707 34,669,317 5,369,740
General and administrative 1,130,385 1,227,684 3,608,607 3,261,334
Encoded Music restructuring charge 4,304,249 - 4,304,249 -
--------------- --------------- --------------- ---------------
Operating loss (25,016,931) (6,595,939) (56,563,399) (16,380,243)
--------------- --------------- --------------- ---------------
INTEREST AND OTHER INCOME 988,356 80,891 2,446,254 166,312
INTEREST EXPENSE (19,250) (434,386) (66,113) (484,486)
--------------- --------------- --------------- ---------------
Loss from continuing operations (24,047,825) (6,949,434) (54,183,258) (16,698,417)
LOSS FROM DISCONTINUED OPERATIONS - - - (415,970)
GAIN ON DISPOSAL OF DISCONTINUED OPERATIONS - 1,574,493 - 1,574,493
--------------- --------------- --------------- ---------------
NET LOSS $ ( 24,047,825) $ (5,374,941) $ (54,183,258) $ (15,539,894)
=============== =============== =============== ===============
BASIC AND DILUTED LOSS PER COMMON SHARE:
Loss from continuing operations $ (1.69) $ (2.25) $ (4.03) $ (5.58)
Loss from discontinued operations - - - (.14)
Gain on disposal of discontinued operations - .51 - .53
--------------- --------------- --------------- ---------------
Net loss per Common share $ (1.69) $ (1.74) $ (4.03) $ (5.19)
=============== =============== =============== ===============
SHARES USED IN COMPUTING BASIC AND DILUTED LOSS
PER COMMON SHARE 14,220,967 3,083,032 13,434,772 2,994,770
=============== =============== =============== ===============
</TABLE>
The accompanying notes are an integral part of these statements.
<PAGE> 4
N2K INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<TABLE>
<CAPTION>
For the
Nine Months Ended
September 30
-----------------------------------
1998 1997
--------------- ---------------
<S> <C> <C>
OPERATING ACTIVITIES:
Net loss $ (54,183,258) $ (15,539,894)
Adjustments to reconcile net loss to
net cash used in operating activities-
Depreciation and amortization 2,307,834 959,312
Gain on disposal of discontinued operations - (1,574,493)
Encoded Music restructuring charge 4,304,249 -
Amortization of marketing advances 14,926,452 158,000
Loss on disposal of property and equipment - 79,620
Amortization of discount on Management and Senior Notes - 227,000
Provision for doubtful accounts 99,793 56,574
Provision for future returns 192,000 447,641
Issuance of Common stock for services rendered 62,500 -
Issuance of Common stock options for services rendered 229,920 -
Decrease (increase) in--
Restricted cash - (300,000)
Accounts receivable (684,250) (1,135,991)
Prepaid expenses (7,818,065) (3,804,769)
Inventory (224,320) 23,697
Advances and recoupable costs 32,444 (1,149,660)
Other assets (1,259,910) (24,501)
Increase (decrease) in--
Accounts payable 395,160 (90,250)
Accrued merchandise costs 299,359 539,621
Accrued compensation 52,923 (119,340)
Accrued royalties (45,436) 259,151
Accrued Encoded Music restructuring (499,316) -
Other accrued liabilities 3,993,372 763,000
Other long-term liabilities 23,945 3,036
--------------- ---------------
Net cash used in operating activities (37,794,604) (20,222,246)
--------------- ---------------
INVESTING ACTIVITIES:
Purchases of and deposits on property and equipment (6,277,541) (2,636,803)
Proceeds from disposal of discontinued operations - 3,000,000
--------------- ---------------
Net cash (used in) provided by investing activities (6,277,541) 363,197
--------------- ---------------
FINANCING ACTIVITIES:
Net borrowings under line of credit - 650,000
Proceeds from Management and Senior Notes - 7,771,600
Payments on capital lease obligations (350,964) (158,229)
Proceeds from issuance of Preferred stock, net - 7,215,531
Proceeds from issuance of Common stock, net 61,407,188 -
Proceeds from issuance of Common stock under the employee
stock purchase plan 94,742 -
Proceeds from exercise of Common stock options and warrants 366,516 75,663
--------------- ---------------
Net cash provided by financing activities 61,517,482 15,554,565
--------------- ---------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 17,445,337 (4,304,484)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 36,831,748 4,483,450
--------------- ---------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 54,277,085 $ 178,966
=============== ===============
</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 an on-line 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
merchandise. 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 recordings. The Company recently restructured its N2K Encoded Music
label (see Note 3).
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 22, 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
Secondary Offering
On April 20, 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 $61,560,000.
Summary of Significant Accounting Policies:
Quarterly Financial Information and Results of Operations
The financial statements as of September 30, 1998 and for the three and nine
months ended September 30, 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 September
30, 1998, and the results of operations and cash flows for the three and nine
months ended September 30, 1998 and 1997. The results for the three and nine
months ended September 30, 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 nine months ended September 30, 1998 and 1997, the Company paid interest
of $64,277 and $77,030, respectively. Income taxes paid in 1998 and 1997 were
immaterial. The Company incurred no capital lease obligations during the nine
months ended September 30, 1998. The Company incurred $208,226 of capital lease
obligations during the nine months ended September 30, 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, and 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 September 30, 1998, no such write-down was required.
<PAGE> 8
Common Stock Subject to Put Rights
America 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.
Accordingly, the value of these shares is not included in Stockholders' equity.
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 November 2, 1998 was $5.13 per Common share. As of
November 2, 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 November 2, 1998, there is no charge as the market
value of the Company's Common Stock is below $19.00 per Common share. 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.
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
balance sheets. If the amount, inclusive of the related returns allowance items
due to/from the Company's distributor, is a net liability, it is included in
accrued liabilities.
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
<PAGE> 9
via the websites of these other companies. The Company records these amounts in
sales and marketing expenses in the accompanying consolidated statements of
operations.
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 such advertising revenues gross and records amounts allocable to third
parties under the terms of such agreements in sales and marketing expenses. To
date, amounts allocable to third parties have not been significant. For the nine
months ended September 30, 1998 and 1997, advertising revenues were $2,845,136
and $420,988, respectively. Advertising revenues for the three months ended
September 30, 1998 and 1997 were $1,112,001 and $222,390, 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
clearly estimates the fair value of the transaction, which generally consists of
advertising or merchandise. Barter revenue and the corresponding expenses are
recognized in the period the advertising is displayed. Advertising revenues
related to barter transactions for the nine months ended September 30, 1998 and
1997 were $1,718,354 and $242,945, respectively. Advertising revenues related to
barter transactions for the three months ended September 30, 1998 and 1997 were
$704,749 and $132,225, respectively.
Operating and Development Expenses
Operating and development expenses consist 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 products. For the nine months
ended September 30, 1998 and 1997, the Company incurred costs of $5,432,386 and
$2,989,307, respectively, relating to research and development. Research and
development costs for the three months ended September 30, 1998 and 1997, were
$2,198,516 and $1,094,243, respectively. These amounts are included in operating
and development expenses as shown in the accompanying consolidated statements of
operations.
<PAGE> 10
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. For the nine months
ended September 30, 1998 and 1997, advertising and promotion expenses, excluding
the amortization of the Company's marketing advances (see Note 4), were
$15,463,024 and $3,099,210, respectively. Advertising and promotional expense,
excluding the amortization of the Company's marketing advances (see Note 4), for
the three months ended September 30, 1998 and 1997 were $6,864,873 and
$1,779,128, respectively. These amounts are included in sales and marketing
expenses in the accompanying consolidated statements of operations.
Loss Per Common Share
In February 1997, the Financial Accounting Standards Board issued SFAS No. 128,
"Earnings per Share," which supersedes Accounting Principles Board Opinion No.
15. SFAS No. 128 requires dual 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 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 For the Nine Months
Ended September 30, Ended September 30,
1998 1997 1998 1997
--------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
Loss (numerator) $ (24,047,825) $ (5,374,941) $ (54,183,258) $ (15,539,894)
Shares (denominator) 14,220,967 3,083,032 13,434,772 2,994,770
Per share amount $ (1.69) $ (1.74) $ (4.03) $ (5.19)
</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. Therefore, options to purchase
2,195,905 shares of Common stock at a weighted average exercise price of $10.56
<PAGE> 11
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 September 30, 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.
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 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
consisted 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 5). In connection with the sale, the Company
entered into a services agreement under which it will provide 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 Nine Months
Ended September 30, 1997
------------------------
<S> <C>
Revenues $ 2,411,057
===============
Loss before income taxes $ (415,970)
Income taxes -
---------------
Loss $ (415,970)
===============
</TABLE>
There were no revenues or losses from discontinued operations for the nine
months ended September 30, 1998.
3. ENCODED MUSIC RESTRUCTURING:
In August 1998, management announced a restructuring of its record label, N2K
Encoded Music. The restructuring was done in an effort to streamline the cost
structure of Encoded Music, as well as create efficiencies that will leverage
the Company's strengths in the Internet music space. This restructuring will
focus Encoded Music's future efforts on artist releases, genres and specialty
products that can be successfully launched from an Internet platform.
Accordingly, the Company recorded a restructuring charge of $4,304,249. This
charge represented (i) certain costs relating to severance due to a reduction in
Encoded Music's workforce; (ii) costs associated with the termination of certain
of its contractual commitments; and (iii) non-cash costs associated with the
write-down of certain assets and other miscellaneous costs. The Company's
management believes that this provision is adequate based upon the decisions
currently made by management. However, the amount the Company ultimately
incurs could be different from these estimates.
At September 30, 1998, $3,804,933 of restructuring charges remained in accrued
liabilities. The balance was comprised of $1,894,245 for severance costs,
$1,066,845 to terminate certain of its existing contracts, and $843,843 for
other miscellaneous costs.
Cash expenditures related to this restructuring for the three months ended
September 30, 1998 were $499,316. Cash expenditures for the fourth quarter of
1998 and the years ended December 31, 1999 and 2000 are expected to be
approximately $445,000, $2,059,000, and $644,000, respectively. Actual costs
incurred are charged against the accrued Encoded Music restructuring account
when paid.
The Company plans to continue to evaluate its Encoded Music label in order to
further improve the operating efficiencies of the division.
<PAGE> 13
4. PREPAID EXPENSES:
Prepaid expenses as of September 30, 1998 and December 31, 1997, consist of the
following:
<TABLE>
<CAPTION>
September 30 December 31
1998 1997
--------------- ---------------
<S> <C> <C>
Marketing Advances:
AOL $ 12,775,000 $ 12,775,000
Netscape Communications Corporation ("Netscape") 3,185,837 3,000,000
Ticketmaster Ticketing Company, Inc. ("Ticketmaster") 4,000,000 -
Excite Inc. ("Excite") 4,300,000 3,300,000
Disney Online 833,334 -
AOL Bertelsmann Online 825,000 -
Infoseek Corporation ("Infoseek") 250,000 -
Other 1,205,170 481,276
--------------- ---------------
27,374,341 19,556,276
Less: Accumulated amortization of marketing advances (17,696,193) (2,769,741)
--------------- ---------------
$ 9,678,148 $ 16,786,535
=============== ===============
</TABLE>
The Company is amortizing the costs associated with its marketing advances over
the contractual terms of each strategic alliance which is one to three years,
and the amortization method is primarily on a straight-line basis or as
impressions are received. Amortization expense for the nine months ended
September 30, 1998 and 1997 was $14,926,452 and $158,000, respectively.
Amortization expense for the three months ended September 30, 1998 and 1997 was
$5,996,753 and $158,000, respectively. These amounts are included in sales and
marketing expenses in 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 September 30, 1998, no such write down was
required.
As of September 30, 1998, the net book value of the marketing advances relating
to Ticketmaster is approximately $2,387,000. In November 1998, a legal action
was filed which may affect the realizability of this net asset (See Legal
Proceedings in Part II, Item I of this Report). As a result, the Company may be
required to write down the net book value relating to the Ticketmaster marketing
advance in the fourth quarter.
As of September 30, 1998, long-term marketing advances were $814,163 and are
classified as other assets on the accompanying consolidated balance sheets.
<PAGE> 14
5. OTHER ACCRUED LIABILITIES:
Other accrued liabilities as of September 30, 1998 and December 31, 1997,
consist of the following:
<TABLE>
<CAPTION>
September 30 December 31
1998 1997
--------------- ---------------
<S> <C> <C>
Accrued Encoded Music restructuring $ 3,804,933 $ -
Accrued advertising 3,769,484 652,138
Accrued discontinued operations disposal costs (Note 2) 65,778 671,407
Other 3,931,705 1,928,050
--------------- ---------------
$ 11,571,900 $ 3,251,595
=============== ===============
</TABLE>
6. CREDIT AGREEMENTS:
The Company had a line of credit with a bank of $2,000,000 which expired on June
30, 1998. The Company currently does not have a line of credit. There were no
borrowings on the line of credit for the nine months ended September 30, 1998.
The maximum amount outstanding on the line of credit was $850,000 for the nine
months ended September 30, 1997. The weighted average interest rate was 8.45%
for the nine months ended September 30, 1997. Interest expense for the nine
months ended September 30, 1997 was $48,672.
7. SUBSEQUENT EVENT:
On October 23, 1998, the Company and CDnow, Inc. ("CDnow") issued a joint press
release announcing the execution of a definitive merger agreement. CDnow is an
online retailer of CDs and other music related products. The merger will be
effected through the formation of a new publicly traded company, initially to be
called CDnow/N2K, Inc. The agreement provides for each existing N2K stockholder
to receive 0.83 shares of common stock in the new company for each N2K share
owned by such party, and each existing CDnow shareholder to receive 1.00 share
of common stock in the new company for each CDnow share owned by such party. The
merger agreement and press release are filed as exhibits to the Company's
Current Report on Form 8-K dated October 22, 1998 and filed October 29, 1998.
<PAGE> 15
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. is an on-line 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, cassettes, LPs, videos and related music items. 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 recently restructured its N2K Encoded Music
label. See "--Recent Events."
The Company was founded as Telebase Systems, Inc. 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 related merchandise in 1995. In February
1996, Telebase merged with N2K Inc., a New York corporation, 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. In April 1998, the Company consummated its secondary public offering.
<PAGE> 16
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 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 and shipping and handling fees,
and promotional discounts, such as discounted selling prices and reduced
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, expanding and improving customer
service operations, introducing new products and services, and selling
advertising and sponsorship programs on its websites. Management has increased
the resources within the Company to support these functions.
The Company currently intends to increase 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.
Recent Events
=============
Encoded Music Restructuring
- ---------------------------
In August 1998, management announced a restructuring of its record label, N2K
Encoded Music. The restructuring was done in an effort to streamline the cost
structure of Encoded Music, as well as create efficiencies that will leverage
the Company's strengths in the Internet music space. This restructuring will
focus Encoded Music's future efforts on artist releases, genres and speciality
products that can be successfully launched from an Internet platform.
Accordingly, the Company recorded a restructuring charge of $4.3 million. This
charge represented (i) certain costs relating to severance due to a reduction in
Encoded Music's workforce; (ii) costs associated with the termination of certain
of its contractual commitments; and (iii) non-cash costs associated with the
write-down of certain assets and other miscellaneous costs. The Company's
management believes that this provision is adequate based upon the decisions
currently made by management. However, the amount the Company ultimately
incurs could be different from these estimates.
<PAGE> 17
The Company plans to continue to evaluate its Encoded Music label in order to
further improve the operating efficiencies of the division.
Merger
- ------
On October 23, 1998, the Company and CDnow, Inc. ("CDnow") issued a joint press
release announcing the execution of a definitive merger agreement. CDnow is an
online retailer of CDs and other music related products. The merger will be
effected through the formation of a new publicly traded company, initially to be
called CDnow/N2K, Inc. The agreement provides for each existing N2K stockholder
to receive 0.83 shares of common stock in the new company for each N2K share
owned by such party, and each existing CDnow shareholder to receive 1.00 share
of common stock in the new company for each CDnow share owned by such party. The
merger agreement and press release are filed as exhibits to the Company's
Current Report on Form 8-K dated October 22, 1998 and filed October 29, 1998.
<PAGE> 18
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 September 30, 1998 Compared With Three Months Ended
September 30, 1997
- --------------------------------------------------------------------------------
The Company incurred net losses of $24.0 million and $5.4 million for the three
months ended September 30, 1998 and 1997, respectively.
Net Revenues. Net revenues for the three months ended September 30, 1998 totaled
$10.5 million compared to $3.6 million for the three months ended September 30,
1997. Net revenues for the three months ended September 30, 1998 and 1997
consisted primarily of sales of CDs and cassettes produced by others. Net sales
of CDs produced by the Company totaled $1.0 million for the three months ended
September 30, 1998 compared to $1.6 million for the three months ended September
30, 1997. Net sales derived from advertising sold on the Company's websites
totaled $1.1 million for the three months ended September 30, 1998 compared to
$222,000 for the three months ended September 30, 1997.
Cost of Revenues. Cost of revenues totaled $8.2 million for the three months
ended September 30, 1998 compared to $2.8 million for the three months ended
September 30, 1997. Cost of revenues consists of payments to third parties for
the cost and distribution of CDs and cassettes, fulfillment of customer orders,
manufacturing expenses, royalties and copyrights. The Company's gross profit as
a percentage of revenues remained relatively constant. The Company expects
<PAGE> 19
revenues from the sale of advertising and other music related merchandise, which
generate higher gross profit, to increase in future periods.
Operating and Development Expenses. Operating and development expenses increased
from $3.5 million for the three months ended September 30, 1997 to $7.7 million
for the three months ended September 30, 1998, primarily due to increased
staffing and related overhead expenses as the Company expanded its operations.
Specifically, the Company had dedicated resources in the expansion of customer
service operations. Operating and development personnel totaled 203 full-time
employees as of September 30, 1998 compared to 100 full-time employees as of
September 30, 1997. Operating and development expenses consist primarily of
software engineering, multimedia production, graphic design, customer service,
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 $2.6
million for the three months ended September 30, 1997 to $14.2 million for the
three months ended September 30, 1998. The increase in sales and marketing
expenses was primarily attributable to the amortization of the costs associated
with the Company's new strategic alliances and the expansion of the Company's
on-line advertising and off-line media campaign. Sales and marketing expenses
consist primarily of the amortization of the costs associated with the Company's
various strategic alliances, external advertising, credit card processing
charges, profit participations payable to strategic alliance partners,
promotions, trade shows, 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 and promotional programs
designed to acquire new customers and retain existing customers, but total sales
and marketing expenses will decline as a percentage of revenues.
General and Administrative Expenses. General and administrative expenses
decreased slightly from $1.2 million for the three months ended September 30,
1997 to $1.1 million for the three months ended September 30, 1998. 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 increase in absolute dollars as
the Company incurs additional costs related to the growth of its business.
However, the Company expects total general and administrative expense will
decline as a percentage of revenue.
Encoded Music Restructuring Charge. In August 1998, the Company recorded a
restructuring charge related to its Encoded Music label. This restructuring
charge totaled $4.3 million for the three months ended September 30, 1998. See
"--Recent Events."
<PAGE> 20
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 of the financing of equipment through capital leases and the use of the
Company's revolving credit line. Interest and other income increased from
$81,000 for the three months ended September 30, 1997 to $988,000 for the three
months ended September 30, 1998 primarily due to the Company investing the
proceeds of its secondary public offering which occurred in the second quarter
of 1998. Interest expense decreased from $434,000 for the three months ended
September 30, 1997 to $19,000 for the three months ended September 30, 1998
primarily attributable to interest in 1997 relating to certain Management and
Senior Notes which did not exist in 1998.
Nine Months Ended September 30, 1998 Compared With Nine Months Ended
September 30, 1997
- --------------------------------------------------------------------------------
The Company incurred net losses of $54.2 million and $15.5 million for the nine
months ended September 30, 1998 and 1997, respectively.
Net Revenues. Net revenues for the nine months ended September 30, 1998 totaled
$27.6 million compared to $6.5 million for the nine months ended September 30,
1997. Net revenues for the nine months ended September 30, 1998 and 1997
consisted primarily of sales of CDs and cassettes produced by others. Net sales
of CDs produced by the Company totaled $2.8 million for the nine months ended
September 30, 1998 compared to $2.4 for the nine months ended September 30,
1997. Net sales derived from advertising sold on the Company's websites totaled
$2.8 million for the nine months ended September 30, 1998 compared to $421,000
for the nine months ended September 30, 1997.
Cost of Revenues. Cost of revenues totaled $21.8 million for the nine months
ended September 30, 1998 compared to $4.9 million for the nine months ended
September 30, 1997. The Company's gross profit as a percentage of revenues
decreased primarily due to decreased net revenues of CDs produced by the
Company, which generate higher gross profit, as a percentage of total net
revenues. The Company expects revenues from the sale of advertising and other
music related merchandise, which generate higher gross profit, to increase in
future periods.
Operating and Development Expenses. Operating and development expenses increased
from $9.3 million for the nine months ended September 30, 1997 to $19.9 million
for the nine months ended September 30, 1998, primarily due to increased
staffing and related overhead expenses as the Company expanded its operations.
Specifically, the Company had dedicated resources in the expansion of customer
service operations. 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.
<PAGE> 21
Sales and Marketing Expenses. Sales and marketing expenses increased from $5.4
million for the nine months ended September 30, 1997 to $34.7 million for the
nine months ended September 30, 1998. The increase in sales and marketing
expenses was primarily attributable to the amortization of the costs associated
with the Company's new strategic alliances and the expansion of the Company's
on-line advertising and off-line media campaign. The Company expects that levels
of sales and marketing expenditures will increase in future periods due to the
execution of new advertising and promotional programs designed to acquire new
customers and retain existing customers, but total sales and marketing expenses
will decline as a percentage of revenues.
General and Administrative Expenses. General and administrative expenses
increased slightly from $3.3 million for the nine months ended September 30,
1997 to $3.6 million for the nine months ended September 30, 1998. The Company
expects general and administrative expenses to continue to increase in absolute
dollars as the Company incurs additional costs related to the growth of its
business. However, the Company expects total general and administrative expense
will decline as a percentage of revenue.
Encoded Music Restructuring Charge. In August 1998, the Company recorded a
restructuring charge related to its Encoded Music label. This restructuring
charge totaled $4.3 million for the three months ended September 30, 1998. See
"--Recent Events."
Interest and Other Income and Interest Expense. Interest and other income
increased from $166,000 for the nine months ended September 30, 1997 to $2.4
million for the nine months ended September 30, 1998 primarily due to the
Company investing the proceeds of its initial public offering which occurred in
the fourth quarter of 1997 and the proceeds of its secondary public offering
which occurred in the second quarter of 1998. Interest expense decreased from
$484,000 for the nine months ended September 30, 1997 to $66,000 for the nine
months ended September 30, 1998 primarily attributable to interest in 1997
relating to certain Management and Senior Notes which did not exist in 1998.
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 September 30, 1998, the Company had a cash balance of $54.3 million.
The Company believes that its current cash balance is sufficient to finance the
Company's planned operations and capital expenditures through at least September
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 $37.8 million and $20.2 million was used in operating activities for
the nine months ended September 30, 1998 and 1997, respectively, primarily as a
result of the net losses generated during those periods. The Company financed
its activities for the nine months ended September 30, 1998 through its initial
public offering in October 1997 and its secondary offering in April 1998 which
yielded total net proceeds of $126.4 million. Activities for the nine months
ended September 30, 1997 were financed through proceeds from the sale of
preferred stock and the issuance of certain short-term Management and Senior
Notes.
<PAGE> 22
Purchases of property and equipment totaled $6.3 million and $2.6 million for
the nine months ended September 30, 1998 and 1997, respectively. The Company
projects that total purchases of property and equipment will be approximately
$8.1 million in 1998, which includes $2.5 million for the creation of redundant
systems and $5.6 million to support the expansion of facilities and operating
systems for its websites and obtain computer-related equipment to support
increased personnel.
The Company has entered into a number of strategic alliance agreements,
including agreements with America Online Inc., Excite Inc., Netscape
Communications Corporation, Ticketmaster Ticketing Company Inc., AOL Bertelsmann
Online, Disney Online, Microsoft Corporation and Infoseek Corporation. The
Company's commitments as of September 30, 1998 under all of its strategic
alliance agreements include cash payments of approximately $8.9 million, $14.4
million, $10 million and $6.5 million for 1998, 1999, 2000, and 2001,
respectively. Payments totaling $7.9 million were made under the Company's
strategic alliances during the nine months ended September 30, 1998. Subsequent
to September 30, 1998, $250,000 was paid under the Company's strategic
alliances.
The Company had a commitment for a $2.0 million revolving line of credit, which
expired on June 30, 1998. The Company currently does not have a credit facility.
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.
In August 1998, the Company recorded a restructuring charge related to the
reorganization of its Encoded Music label. Cash expenditures related to the
restructuring during the three months ended September 30, 1998 were $499,000.
Cash expenditures related to the restructuring will be $445,000, $2.1 million
and $644,000 for the fourth quarter of 1998, 1999 and 2000, respectively.
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
<PAGE> 23
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 nine months ended September 30, 1997, the discontinued operations
generated revenues of $2.4 million. The discontinued operations generated a net
loss of $416,000 for the nine months ended September 30, 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.
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 has appointed a Year 2000 Program Coordinator
to perform an audit to assess the scope of the Company's risks and bring its
applications into compliance. The coordinator is undertaking an assessment of
the Company's compliance and has begun to develop a plan for ensuring compliance
for N2K's corporate business and information systems. To date, the Company has
experienced very few problems related to Year 2000 testing and those requiring
immediate modification have been fixed in the Company's day to day operating
environment. 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 Program Coordinator has begun to conduct an analysis to determine the extent
to which major suppliers' systems (insofar as they relate to the Company's
business) are subject to the Year 2000 issue. The Company's primary provider of
order fulfillment for direct-to-consumer music products, Valley Media Inc., has
indicated that it has begun its remediation efforts and expects to be in
compliance before the year 2000. 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.
The costs incurred by the Company during the nine months ended September 30,
1998 to address Year 2000 compliance were approximately $50,000. The Company
estimates that it will incur up to approximately $75,000 for the three months
ended December 31, 1998 and approximately $435,000 during fiscal 1999 to support
its compliance initiatives. Currently, the Company has not adopted a contingency
plan to address possible risks to its system. However, the Company expects to
have one adopted by the second quarter of 1999.
<PAGE> 24
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK
None.
<PAGE> 25
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company and its directors are defendants in a consolidated purported class
action in the U.S. District Court for the Southern District of New York entitled
In re N2K Inc. Securities Litigation (Docket No. 98 CIV 3304 (HB)) (the
"Consolidated Action"). The Consolidated Action consolidates two purported class
actions, entitled Kuhn v. N2K Inc. et al. (Docket No. 98 CIV 4360 (HB)) and
Bender v. Rosen et al. (Docket No. 98 CIV 3304 (HB)) that were previously
discussed in the Company's Quarterly Report on Form 10-Q for the quarterly
period ended June 30, 1998 and March 31, 1998, respectively. The Consolidated
Action is a purported class action on behalf of Common stockholders, with
limited exceptions, and seeks to recover unspecified damages and other relief,
as well as recovery of costs and expenses, stemming from alleged violations of
the Securities Act of 1933, as amended, in connection with the public offering
of the shares of the Company's Common stock in April 1998. Although the Kuhn
complaint named as additional defendants certain underwriters of the
aforementioned public offering, the Consolidated Action is against the Company
and its directors. The Company believes that the claims in the Consolidated
Action are without merit and is vigorously defending the action. The defendants
moved to dismiss the complaint on August 21, 1998 for failure to state a claim
and/or for failure to plead fraud with the requisite particularity. The motion
to dismiss has been fully briefed and is sub judice.
On or about October 27, 1998, an action entitled Rubin v. Rosen et al. (Docket
No. 16743NC) was filed against the Company, the Company's directors and CDnow
Inc. ("CDnow") in the Chancery Court of Delaware for the County of New Castle.
The Rubin action is a purported class action on behalf of all Common
stockholders of N2K, with limited exceptions, alleging, inter alia, that the
consideration to be received by the purported class in connection with the
proposed merger transaction between the Company and CDnow (the "Merger") is
unfair and grossly inadequate and that the individual defendants breached their
fiduciary duties in connection with the Merger. Plaintiffs seek, inter alia,
injunctive relief, including, but not limited to, enjoining the Merger, and
unspecified damages, as well as costs and expenses. The Company has not yet
answered or responded to the complaint. The Company believes that the claims are
without merit and intends to defend the action vigorously.
On or about November 4, 1998, an action entitled Ticketmaster Ticketing Co. v.
N2K Inc. (Docket No. BC200194) was filed against the Company in California
Superior Court for the County of Los Angeles. The Ticketmaster action alleges
that the Company breached a marketing and advertising contract dated April 23,
1998 between Ticketmaster and the Company, which the Company terminated
effective October 31, 1998, based on alleged breaches of the agreement by
Ticketmaster. Ticketmaster seeks damages in an amount not less than $8 million,
plus pre- and post-judgment interest, as well as fees and costs. The Company has
not yet answered or responded to the complaint. The Company believes that the
claims are without merit and intends to defend the action vigorously.
<PAGE> 26
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
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 remaining net
offering proceeds were exhausted during the three months ended September 30,
1998. Such use of proceeds consisted of:
<TABLE>
<S> <C>
Purchase of property and equipment to expand the Company's
Infrastructure $ 2,900,000
Payment under the AOL Bertelsmann Contract 413,000
Payment under the Excite Contract 500,000
Payment under the Infoseek Contract 250,000
Other working capital needs 3,594,000
-----------
Total $ 7,657,000
===========
</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
September 30, 1998. The Company filed a Current Report on Form 8-K, dated
October 22, 1998, reporting the proposed merger of the Company and CDnow
discussed in Management's Discussion and Analysis of Financial Condition and
Results of Operations - Recent Events - Merger in Part I, Item 2 of this
Report.
<PAGE> 27
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: November 10, 1998 BY: /s/James E. Coane
---------------------------------------------
James E. Coane
President, Chief Operating Officer
and Director
Date: November 10, 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>
<ARTICLE> 5
<MULTIPLIER> 1
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JUL-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 54,277,085
<SECURITIES> 0
<RECEIVABLES> 2,122,419
<ALLOWANCES> 315,942
<INVENTORY> 314,359
<CURRENT-ASSETS> 69,246,970
<PP&E> 16,056,891
<DEPRECIATION> (4,536,030)
<TOTAL-ASSETS> 82,205,255
<CURRENT-LIABILITIES> 17,292,797
<BONDS> 0
0
0
<COMMON> 14,229
<OTHER-SE> 61,125,543
<TOTAL-LIABILITY-AND-EQUITY> 82,205,255
<SALES> 10,506,150
<TOTAL-REVENUES> 10,506,150
<CGS> 8,171,623
<TOTAL-COSTS> 8,171,623
<OTHER-EXPENSES> 27,351,458
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 19,250
<INCOME-PRETAX> (24,047,825)
<INCOME-TAX> 0
<INCOME-CONTINUING> (24,047,825)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (24,047,825)
<EPS-PRIMARY> (1.69)<F1>
<EPS-DILUTED> (1.69)
<FN>
<F1> EPS PRIMARY IS NOW BASIC
</FN>
</TABLE>
