<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 June 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 July 15, 1998: 14,219,938 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>
June 30 December 31
ASSETS 1998 1997
------ ---- ----
(Unaudited)
<S> CURRENT ASSETS: <C> <C>
Cash and cash equivalents $ 68,435,539 $ 36,831,748
Accounts receivable, net 853,606 892,020
Receivable for Common stock subject to put rights 2,999,995 2,999,995
Prepaid expenses 15,059,821 16,786,535
Inventory 154,908 90,039
Advances and recoupable costs 89,456 203,350
------------- -------------
Total current assets 87,593,325 57,803,687
------------- -------------
PROPERTY AND EQUIPMENT:
Computer equipment 8,742,063 4,638,311
Office furniture and equipment 1,581,070 1,147,102
Leasehold improvements 2,206,449 1,882,684
Property and equipment under capital leases 1,801,663 1,801,663
------------- -------------
14,331,245 9,469,760
Less- Accumulated depreciation and amortization (3,631,688) (2,290,452)
------------- -------------
Net property and equipment 10,699,557 7,179,308
------------- -------------
OTHER ASSETS:
Intangible assets, net 206,150 244,154
Restricted cash 167,000 167,000
Other 256,391 138,206
------------- -------------
Total other assets 629,541 549,360
------------- -------------
$ 98,922,423 $ 65,532,355
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of capital lease obligations $ 414,716 $ 464,147
Accounts payable 1,781,151 1,504,143
Accrued merchandise costs 1,174,252 1,169,898
Accrued compensation 1,678,537 1,341,354
Accrued royalties 397,075 629,989
Other accrued liabilities 4,456,722 3,251,595
------------- -------------
Total current liabilities 9,902,453 8,361,126
------------- -------------
CAPITAL LEASE OBLIGATIONS 468,250 653,558
------------- -------------
OTHER LONG-TERM LIABILITIES 402,240 369,741
------------- -------------
COMMON STOCK SUBJECT TO PUT RIGHTS 2,999,995 2,999,995
------------- -------------
STOCKHOLDERS' EQUITY:
Common stock, $.001 par value, 100,000,000 shares
authorized, 14,219,314 and
12,118,100 shares issued and outstanding 14,219 12,118
Additional paid-in capital 171,332,680 109,197,798
Accumulated deficit (86,197,414) (56,061,981)
------------- -------------
Total stockholders' equity 85,149,485 53,147,935
------------- -------------
$ 98,922,423 $ 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 Six Months Ended
June 30 June 30
------------------------------ ------------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
NET REVENUES $ 10,003,724 $ 1,820,998 $ 17,138,347 $ 2,936,895
COST OF REVENUES 7,853,153 1,263,358 13,580,500 2,125,120
------------ ------------ ------------ ------------
Gross profit 2,150,571 557,640 3,557,847 811,775
OPERATING EXPENSES:
Operating and development 7,537,232 3,222,558 13,653,800 5,824,396
Sales and marketing 10,673,263 1,643,755 18,972,292 2,738,033
General and administrative 1,283,429 1,088,293 2,478,223 2,033,650
------------ ------------ ------------ ------------
Operating loss (17,343,353) (5,396,966) (31,546,468) (9,784,304)
------------ ------------ ------------ ------------
INTEREST AND OTHER INCOME 934,313 37,531 1,457,478 85,421
INTEREST EXPENSE (22,127) (31,158) (46,443) (50,100)
------------ ------------ ------------ ------------
Loss from continuing operations (16,431,167) (5,390,593) (30,135,433) (9,748,983)
LOSS FROM DISCONTINUED OPERATIONS -- (256,027) -- (415,970)
------------ ------------ ------------ ------------
NET LOSS $(16,431,167) $ (5,646,620) $(30,135,433) $(10,164,953)
------------ ------------ ------------ ------------
BASIC AND DILUTED LOSS PER COMMON SHARE:
Loss from continuing operations $ (1.18) $ (1.81) $ (2.31) $ (3.31)
Loss from discontinued operations
-- (.09) -- (.14)
------------ ------------ ------------ ------------
Net loss per Common share $ (1.18) $ (1.90) $ (2.31) $ (3.45)
============ ============ ============ ============
SHARES USED IN COMPUTING BASIC AND
DILUTED LOSS PER COMMON SHARE 13,912,045 2,976,270 13,035,160 2,949,907
============ ============ ============ ============
</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
Six Months Ended
June 30
------------------------------
1998 1997
------------ ------------
<S> <C> <C>
OPERATING ACTIVITIES:
Net loss $(30,135,433) $(10,164,953)
Adjustments to reconcile net loss to
net cash used in operating activities-
Depreciation and amortization 1,382,740 588,023
Amortization of marketing advances 8,929,699 --
Loss on disposal of property and equipment -- 79,620
Provision for doubtful accounts 214,530 56,574
Provision for future returns 37,000 82,000
Issuance of Common stock for services rendered 62,500 --
Issuance of Common stock options for services rendered 229,920 --
Decrease (increase) in--
Accounts receivable (213,116) (390,826)
Prepaid expenses (7,202,985) (284,959)
Inventory (64,869) 57,745
Advances and recoupable costs 113,894 (1,392,122)
Other assets (412,859) (11,598)
Increase (decrease) in--
Accounts payable 277,008 1,039,466
Accrued merchandise costs 4,354 (106,146)
Accrued compensation 337,183 46,291
Accrued royalties (232,914) 116,271
Other accrued liabilities 1,205,127 (267,233)
Other long-term liabilities 32,499 19,171
------------ ------------
Net cash used in operating activities (25,435,722) (10,532,676)
------------ ------------
INVESTING ACTIVITIES:
Purchases of and deposits on property and equipment (4,570,311) (1,319,946)
------------ ------------
Net cash used in investing activities (4,570,311) (1,319,946)
------------ ------------
FINANCING ACTIVITIES:
Net borrowings under line of credit -- 850,000
Payments on capital lease obligations (234,739) (102,300)
Proceeds from issuance of Preferred stock, net -- 7,215,531
Proceeds from issuance of Common stock, net 61,437,639 --
Proceeds from issuance of Common stock under the employee
stock purchase plan 53,096 --
Proceeds from exercise of Common stock options and warrants 353,828 75,663
------------ ------------
Net cash provided by financing activities 61,609,824 8,038,894
------------ ------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 31,603,791 (3,813,728)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 36,831,748 4,483,450
============ ============
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 68,435,539 $ 669,722
============ ============
</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 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 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 June 30, 1998 and for the three and six months
ended June 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 June 30, 1998, and the
results of operations and cash flows for the three and six months ended June 30,
1998 and 1997. The results for the three and six months ended June 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 six months ended June 30, 1998 and 1997, the Company paid interest of
$46,443 and $43,622, respectively. Income taxes paid in 1998 and 1997 were
immaterial. The Company incurred no capital lease obligations during the six
months ended June 30, 1998. The Company incurred $208,226 of capital lease
obligations during the six months ended June 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 June 30, 1998, no such write-down was required.
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
<PAGE> 8
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 July 30, 1998 was $13.81 per Common share. As of
July 30, 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 July 30, 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 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 amounts in
sales and marketing expenses in the accompanying consolidated statements of
operations.
<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 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 six
months ended June 30, 1998 and 1997, advertising revenues were $1,733,135 and
$198,598, respectively. Advertising revenues for the three months ended June 30,
1998 and 1997 were $1,020,975 and $163,698, 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. For the three and six
months ended June 30, 1998, approximately $626,000 and $1,014,000, respectively,
of advertising revenue was recognized related to barter transactions. There was
no revenue recognized related to barter transactions for the three and six
months ended June 30, 1997.
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 six months
ended June 30, 1998 and 1997, the Company incurred costs of $3,352,286 and
$1,895,064, respectively, relating to research and development. Research and
development costs for the three months ended June 30, 1998 and 1997, were
$1,820,445 and $981,563, respectively. These amounts are included in operating
and development expenses as shown 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. For the six months
ended June 30, 1998 and 1997, advertising and promotion expenses, excluding the
amortization of the Company's marketing advances (see Note 3), were $8,598,151
and $1,320,082, respectively. Advertising and promotional expense, excluding the
amortization of the Company's marketing advances (see Note 3), for the three
months ended June 30, 1998 and 1997 were $4,997,598 and $787,024, respectively.
These amounts are included in sales and marketing expenses in the accompanying
consolidated statements of operations.
<PAGE> 10
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
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 Ended June 30 For the Six Months Ended June 30
---------------------------------- --------------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Loss (numerator) $(16,431,167) $ (5,646,620) $(30,135,433) $(10,164,953)
Shares (denominator) 13,912,045 2,976,270 13,035,160 2,949,907
Per share amount $ (1.18) $ (1.90) $ (2.31) $ (3.44)
</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 2,094,432 shares
of Common stock at a weighted average exercise price of $10.58 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
June 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.
<PAGE> 11
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
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 will provide certain services
and support personnel to the purchaser until September 1999 for a fixed monthly
fee.
Revenues and losses from discontinued operations in the accompanying
consolidated statements of operations were:
<TABLE>
<CAPTION>
For the Six Months
Ended June 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 six months
ended June 30, 1998.
<PAGE> 12
3. PREPAID EXPENSES:
Prepaid expenses as of June 30, 1998 and December 31, 1997, consist of the
following:
<TABLE>
<CAPTION>
June 30 December 31
1998 1997
------------ ------------
<S> <C> <C>
Marketing Advances:
AOL $ 13,187,500 $ 12,775,000
Netscape Communications Corporation
("Netscape") 4,000,000 3,000,000
Ticketmaster Ticketing Company, Inc. 4,000,000 --
Excite Inc. ("Excite") 3,800,000 3,300,000
Disney Online 833,334 --
Other 938,427 481,276
------------ ------------
26,759,261 19,556,276
Less: Accumulated amortization of marketing advances (11,699,440) (2,769,741)
------------ ------------
$ 15,059,821 $ 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 one to three years, and
the amortization method is primarily on a straight-line basis or as impressions
are received. Amortization expense for the six months ended June 30, 1998 and
1997 was $8,929,699 and $0, respectively. Amortization expense for the three
months ended June 30, 1998 and 1997 was $6,159,959 and $0, respectively. These
amounts are 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 June 30, 1998, no
such write down was required.
4. OTHER ACCRUED LIABILITIES:
Other accrued liabilities as of June 30, 1998 and December 31, 1997, consist of
the following:
<TABLE>
<CAPTION>
June 30 December 31
1998 1997
---------- ----------
<S> <C> <C>
Accrued advertising $1,688,361 $ 652,138
Accrued discontinued operations disposal costs (Note 2) 295,700 671,407
Other 2,472,661 1,928,050
---------- ----------
$4,456,722 $3,251,595
========== ==========
</TABLE>
<PAGE> 13
5. 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 six months ended June 30, 1998. The
maximum amount outstanding on the line of credit was $850,000 for the six months
ended June 30, 1997. The weighted average interest rate was 8.4% for the six
months ended June 30, 1997. Interest expense for the six months ended June 30,
1997 was $32,031.
<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. 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 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. On April 20, 1998, the Company closed on the sale of 3,125,722 shares
of Common stock in a public offering. Of the 3,125,722 shares of Common Stock
<PAGE> 15
offered, 2,000,000 were offered by the Company, and 1,125,722 were offered by
selling stockholders.
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 and
shipping and handling 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 June 30, 1998 Compared With Three Months Ended June 30, 1997
The Company incurred net losses of $16.4 million and $5.6 million for the three
months ended June 30, 1998 and 1997, respectively.
Net Revenues. Net revenues for the three months ended June 30, 1998 totaled
$10.0 million compared to $1.8 million for the three months ended June 30, 1997.
Net revenues for the three months ended June 30, 1998 and 1997 consisted
primarily of sales of CDs and cassettes produced by others. Net sales of CDs
produced by the Company totaled $939,000 for the three months ended June 30,
1998 compared to $441,000 for the three months ended June 30, 1997. Net sales
derived from advertising sold on the Company's websites totaled $1.0 million for
the three months ended June 30, 1998 compared to $164,000 for the three months
ended June 30, 1997.
Cost of Revenues. Cost of revenues totaled $7.9 million for the three months
ended June 30, 1998 compared to $1.3 million for the three months ended June 30,
1997. Cost of revenues consists of payments to third parties for distribution of
CDs and cassettes, fulfillment of customer orders, manufacturing expenses,
royalties and copyrights. The Company's gross profit as a percentage of revenues
decreased primarily due to increased marketing promotions, specifically certain
shipping promotions, and a decline in Encoded Music revenues, which typically
generate higher gross profit, as a percentage of total revenues. The Company
<PAGE> 17
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 cost of revenues as a percentage of revenues.
Operating and Development Expenses. Operating and development expenses increased
from $3.2 million for the three months ended June 30, 1997 to $7.5 million for
the three months ended June 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 179 full-time employees
as of June 30, 1998 compared to 104 full-time employees as of June 30, 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 $1.6
million for the three months ended June 30, 1997 to $10.7 million for the three
months ended June 30, 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 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 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 $1.1 million for the three months ended June 30, 1997 to $1.3
million for the three months ended June 30, 1998, primarily due to increased
staffing expenses, related overhead expenses and expenses associated with being
a public company. General and administrative personnel totaled 34 full-time
employees as of June 30, 1998 compared to 25 full-time employees as of June 30,
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. However, the
Company expects total general and administrative expense will decline as a
percentage of revenue.
<PAGE> 18
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
$38,000 for the three months ended June 30, 1997 to $934,000 for the three
months ended June 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.
Six Months Ended June 30, 1998 Compared With Six Months Ended June 30, 1997
The Company incurred net losses of $30.1 million and $10.2 million for the six
months ended June 30, 1998 and 1997, respectively.
Net Revenues. Net revenues for the six months ended June 30, 1998 totaled $17.1
million compared to $2.9 million for the six months ended June 30, 1997. Net
revenues for the six months ended June 30, 1998 and 1997 consisted primarily of
sales of CDs and cassettes produced by others. Net sales of CDs produced by the
Company totaled $1.7 million for the six months ended June 30, 1998 compared to
$793,000 for the six months ended June 30, 1997. Net sales derived from
advertising sold on the Company's websites totaled $1.7 million for the six
months ended June 30, 1998 compared to $199,000 for the six months ended June
30, 1997.
Cost of Revenues. Cost of revenues totaled $13.6 million for the six months
ended June 30, 1998 compared to $2.1 million for the six months ended June 30,
1997. The Company's gross profit as a percentage of revenues decreased primarily
due to increased marketing promotions, specifically certain shipping promotions,
and a decline in Encoded Music revenues, which typically generate higher gross
profits, as a percentage of total revenues. 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 cost of
revenues as a percentage of revenues.
Operating and Development Expenses. Operating and development expenses increased
from $5.8 million for the six months ended June 30, 1997 to $13.7 million for
the six months ended June 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.
Sales and Marketing Expenses. Sales and marketing expenses increased from $2.7
million for the six months ended June 30, 1997 to $19.0 million for the six
months ended June 30, 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 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 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.
<PAGE> 19
General and Administrative Expenses. General and administrative expenses
increased from $2.0 million for the six months ended June 30, 1997 to $2.5
million for the six months ended June 30, 1998, primarily due to increased
staffing expenses, related overhead expenses and expenses associated with being
a public company. 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. However, the
Company expects total general and administrative expense will decline as a
percentage of revenue.
Interest and Other Income and Interest Expense. Interest and other income
increased from $85,000 for the six months ended June 30, 1997 to $1.5 million
for the six months ended June 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.
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 June 30, 1998, the Company had a cash balance of $68.4
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 $25.4 million and $10.5 million was used in operating activities for
the six months ended June 30, 1998 and 1997, respectively, primarily as a result
of the net losses generated during those periods. The Company financed its
activities for the six months ended June 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 six months ended June
30, 1997 were financed through proceeds from the sale of preferred stock.
<PAGE> 20
Purchases of property and equipment totaled $4.6 million and $1.3 million for
the six months ended June 30, 1998 and 1997, respectively. The Company projects
that total purchases of property and equipment will be approximately $7.8
million in 1998, which includes $2.5 million for the creation of redundant
systems and $5.3 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 and Microsoft Corporation. During July 1998,
the Company signed an additional strategic alliance agreement with Infoseek
Corporation. The Company's commitments as of June 30, 1998 under all of its
strategic alliance agreements, including the one signed in July 1998, include
cash payments of approximately $11.4 million, $16.0 million, $9.0 million and
$6.5 million for 1998, 1999, 2000, and 2001, respectively. Payments totaling
$6.7 million were made under the Company's strategic alliances during the six
months ended June 30, 1998. Subsequent to June 30, 1998, $750,000 was paid under
the Company's strategic alliances.
The Company had a commitment for a $2.0 million revolving line of credit with
CoreStates Bank, N.A. (the "CoreStates Facility"), which expired on June 30,
1998. As of June 30, 1998, the Company did not have any outstanding borrowings
under the CoreStates Facility. 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.
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 six months ended June 30, 1997, the discontinued operations generated
revenues of $2.4 million. The discontinued operations generated a net loss of
$416,000 for the six months ended June 30, 1997.
<PAGE> 21
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.
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.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
None.
<PAGE> 22
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On or about June 22, 1998, an action entitled Kuhn v. N2K Inc. et al (Docket No.
98 CIV 4360 (HB)) was filed against the Company and its directors in the U.S.
District Court for the Southern District of New York. The complaint virtually
duplicates the one filed in May 1998 in the action entitled Bender v. Rosen
et al (Docket No. 98 CIV 3304 (HB)), which was discussed in the Company's
Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1998.
As did the plaintiff in Bender, the plaintiff in the Kuhn action alleges
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. The
new complaint also includes as defendants the lead underwriters for the
aforementioned public offering. Both complaints seek to recover unspecified
damages and other relief, as well as recovery of costs and expenses. The
plaintiffs in both cases have agreed to consolidate the actions and have
entered into a stipulation with the Company and the directors to that effect.
The Company believes that the claims in these actions are without merit and
intends to vigorously defend these claims.
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 following
additional applications of the net offering proceeds were made from April 1,
1998 through June 30, 1998:
<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 Netscape License Agreement 1,000,000
Payment under the Disney Online Contract 833,000
Payment under the Ticketmaster Contract 4,000,000
Other working capital needs 11,400,000
-----------
Total $21,046,000
===========
</TABLE>
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
<PAGE> 23
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 June
30, 1998.
<PAGE> 24
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: August 3, 1998 BY: /s/James E. Coane
---------------------------------------------
James E. Coane
President, Chief Operating Officer
and Director
Date: August 3, 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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<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> APR-01-1998
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<RECEIVABLES> 1,068,137
<ALLOWANCES> 214,531
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