10-Q 1 d10q.txt FORM 10-Q FOR MUZAK HOLDINGS LLC 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, 2002. or [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to __________. Commission file number: 333-78571 333-78571-01 MUZAK HOLDINGS LLC MUZAK HOLDINGS FINANCE CORP. (Exact Name of Registrants as Specified in their charter) DELAWARE 04-3433730 DELAWARE 04-3433728 (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporated or Organization) 3318 LAKEMONT BLVD FORT MILL, SC 29708 (803) 396-3000 (Address, Including Zip Code and Telephone Number including Area Code of Registrants' Principal Executive Offices) Indicate by check mark whether the registrants have filed all documents and 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 registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days. Yes [X] No [_] Muzak Holdings Finance Corp. meets the conditions set forth in General Instruction H(1) (a) and (b) of Form 10-Q and is therefore filing this form with the reduced disclosure format. 1 PART I- FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. MUZAK HOLDINGS LLC CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited)

The Notes are an integral part of these consolidated financial statements. 2 MUZAK HOLDINGS LLC CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (in thousands)

The Notes are an integral part of these consolidated financial statements. 3 MUZAK HOLDINGS LLC CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands)

The Notes are an integral part of these consolidated financial statements. 4 MUZAK HOLDINGS LLC CONSOLIDATED STATEMENT OF CHANGES IN MEMBERS' INTEREST (Unaudited) (in thousands, except for units)

The Notes are an integral part of these consolidated financial statements. 5 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION Muzak Holdings LLC and its subsidiaries ("the Company"), a Delaware limited liability company, provides business music programming to clients through its integrated nationwide network of owned operations and franchises. As of June 30, 2002, ABRY Partners, LLC and its respective affiliates, collectively own approximately 64.2% of the beneficial interests in the Company's voting interests. 2. BASIS OF PRESENTATION The condensed consolidated financial statements include the accounts of the Company and its subsidiaries: Muzak LLC, Muzak Capital Corporation, Muzak Holdings Finance Corporation, Muzak Finance Corporation, Business Sound Inc., Electro Systems Corporation, BI Acquisition LLC, MLP Environmental Music LLC, Audio Environments Inc., Background Music Broadcasters Inc., Telephone Audio Productions Inc., Vortex Sound Communications Company Inc., Music Incorporated, and Muzak Houston, Inc. All significant intercompany items have been eliminated in consolidation. The accompanying unaudited interim consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X, and accordingly, certain financial information has been condensed and certain footnote disclosures have been omitted. Such information and disclosures are normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States. For further information, refer to the consolidated financial statements and footnotes thereto included in the Muzak Holdings LLC Annual Report on Form 10-K for the fiscal year ended December 31, 2001. The financial statements as of June 30, 2002 and 2001 and for the three and six months then ended are unaudited; however, in the opinion of management, such statements include all adjustments (consisting solely of normal recurring adjustments) necessary for a fair statement of the financial information included herein in accordance with generally accepted accounting principles in the United States. The preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States 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 consolidated financial statements and reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. Results of operations for interim periods are not necessarily indicative of results for the full year. Certain prior year items have been reclassified to conform with the 2002 presentation. 3. PROPERTY AND EQUIPMENT Property and equipment consists of the following (in thousands):

Included in equipment and other at June 30, 2002 and December 31, 2001 is $12.9 million and $11.6 million, respectively, of equipment under capital leases, gross of accumulated depreciation of $8.1 million and $6.6 million, respectively. Depreciation of property and equipment was $11.4 and $23.0 million for the quarter and six months ended June 30, 2002, respectively, and $9.8 million and $19.1 million for the quarter and six months ended June 30, 2001, respectively. 6 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 4. INTANGIBLE ASSETS The Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142") on January 1, 2002. In connection with the adoption of SFAS No. 142, the Company reclassified other intangibles of $6.4 million related to trained workforce to goodwill and ceased amortization of goodwill. During the first quarter, the Company evaluated the useful lives of its existing intangible assets and concluded that, with the exception of goodwill, all of its intangible assets have definite lives and that the existing useful lives are reasonable. SFAS No. 142 requires that goodwill be tested annually at the reporting unit level for impairment using a two-step process. A reporting unit is the operating segment unless, at businesses one level below the operating segment, discrete financial information is prepared and regularly reviewed by management. The first step is to identify a potential impairment and, in transition, this step must be measured as of the beginning of the fiscal year. The second step of the goodwill impairment test measures the amount of the impairment loss (also measured as of the beginning of the fiscal year in year of transition), if any, and must be completed by the end of the Company's fiscal year. The Company completed its testing of goodwill in accordance with SFAS No. 142 during the quarter ended June 30, 2002. As the fair value of goodwill exceeds the carrying amount of goodwill, the Company did not record an impairment charge. SFAS No. 142 requires goodwill of a reporting unit to be tested for impairment on an annual basis and between annual tests in certain circumstances. A detailed determination of the fair value of a reporting unit may be carried forward from one year to the next if the assets and liabilities that make up the reporting unit have not changed significantly since the most recent fair value determination, the most recent fair value determination resulted in an amount that exceeded the carrying amount of the reporting unit by a substantial margin, and based on the analysis and events that have occurred since the most recent fair value determination, the likelihood that a current fair value determination would be less than the current carrying amount of the reporting unit is remote. Based on the most recent fair value determination, the Company has elected to carry forward the detailed determination performed during the second quarter of 2002 to 2003. Unamortized intangible assets consist of the following (in thousands):

The following presents net loss exclusive of amortization of goodwill and trained workforce (in thousands):

7 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Amortized intangible assets consist of the following (in thousands):

Aggregate amortization expense was $6.0 million and $12.3 million for the quarter and six months ended June 30, 2002, respectively, and $8.5 million and $17.5 million for the quarter and six months ended June 30, 2001, respectively. The estimated future aggregate amortization expense is as follows (in thousands): Fiscal year ending ------------------ 2002..................................... $23,163 2003..................................... 18,285 2004..................................... 14,986 2005..................................... 14,150 2006..................................... 14,117 5. DEFERRED CHARGES AND OTHER ASSETS, NET Deferred charges and other assets, net, consist of the following (in thousands):

6. ACCRUED EXPENSES Accrued expenses are summarized below (in thousands):

8 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. DEBT Debt obligations consist of the following (in thousands):

Senior Credit Facility The Senior Credit Facility is guaranteed by the Company and certain 100% owned subsidiaries. The non-guarantor subsidiary is considered minor and the consolidated amounts in the Company's financial statements are representative of the combined guarantor's financial statements. The Amended Senior Credit Facility contains restrictive covenants including maintenance of interest, senior and total leverage, and fixed charge ratios and various other restrictive covenants which are customary for such facilities. In March 2002, the Company entered into the sixth amendment under the Senior Credit Facility, which increased its aggregate revolving loan commitment under the Senior Credit Facility by $20.0 million, for a total commitment of $55.0 million, and amended certain financial covenants and applicable margins. As amended in March 2002, indebtedness under the Term Loan A and the Revolving Loans bear interest at a per annum rate equal to the Company's choice of (i) the Alternate Base Rate (which is the highest of prime rate and the Federal Funds Rate plus .5%) plus a margin ranging from 2.00% to 3.00% or (ii) the offered rates for Eurodollar deposits ("LIBOR") of one, two, three, or six months, as selected by the Company, plus a margin ranging from 3.00% to 4.00%. Margins, which are subject to adjustment based on the changes in the Company's ratio of consolidated total debt to EBITDA (i.e., earnings before interest, taxes, depreciation, amortization, other non cash charges, and certain other items as defined by the agreement) were 2.50% in the case of Alternate Base Rate and 3.50% in the case of LIBOR as of June 30, 2002. Indebtedness under the Term Loan B bears interest at a per annum rate equal to the Company's choice of (i) the Alternate Base Rate (as described above) plus a margin of 3.5% or (ii) LIBOR of one, two, three, or six months, as selected by the Company plus a margin of 4.5%. The weighted average rate of interest on the Senior Credit Facility, including the effects of the interest rate swap, if any, was 6.2% and 9.9% at June 30, 2002 and 2001, respectively. 9 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Senior Subordinated Notes On March 18, 1999, Muzak LLC together with its wholly owned subsidiary, Muzak Finance Corp., co-issued $115.0 million in principal amount of 9 7/8% Senior Subordinated Notes ("Senior Subordinated Notes") which mature on March 15, 2009. Interest is payable semi-annually, in arrears, on March 15 and September 15 of each year. The Senior Subordinated Notes are general unsecured obligations of the Company and Muzak Finance and are subordinated in right of payment to all existing and future Senior Indebtedness of the Company and Muzak Finance. The Senior Subordinated Notes are guaranteed by MLP Environmental Music LLC, Business Sound Inc., BI Acquisition LLC, Audio Environments Inc., Background Music Broadcasters Inc., Muzak Capital Corporation, Telephone Audio Productions Inc., Muzak Houston Inc., Vortex Sound Communications Company Inc., and Music Incorporated. The Company's non-guarantor subsidiary is minor and the consolidated amounts in the Company's financial statements are representative of the combined guarantors. The indenture governing the Senior Subordinated Notes prohibits the Company from making certain payments such as dividends and distributions of their capital stock; repurchases or redemptions of their capital stock, and investments (other than permitted investments) unless certain conditions are met by the Company. After March 15, 2004, the issuers may redeem all or part of the Notes at a redemption price equal to 104.938% of the principal which redemption price declines to 100% of the principal amount in 2007. Senior Discount Notes On March 18, 1999, the Company together with its wholly owned subsidiary Muzak Holdings Finance Corp., co-issued $75.0 million in principal amount at maturity, or $39.9 million in accreted value on the issue date, of 13% Senior Discount Notes (the "Senior Discount Notes") due March 2010. Cash interest on the Senior Discount Notes does not accrue and is not payable prior to March 15, 2004. The Senior Discount Notes were issued at a substantial discount from their principal amount at maturity. Until March 15, 2004, the Senior Discount Notes will accrete in value such that the accreted value on March 15, 2004 will equal the principal amount at maturity of the Senior Discount Notes. From and after March 15, 2004, interest on the Senior Discount Notes will accrue at a rate of 13% per annum. Interest will be payable semi-annually in arrears on each March 15 and September 15, commencing September 15, 2004, to holders of record of the Senior Discount Notes at the close of business on the immediately preceding March 1 and September 1. Related Party Notes In March 2002, MEM Holdings LLC contributed $10.0 million to the Company in the form of junior subordinated unsecured notes (the "sponsor notes"), the proceeds of which were used to repay outstanding revolving loan balances. MEM Holdings is a company that owns 64.2% of the voting interests in the Company. ABRY Broadcast Partners III and ABRY Broadcast Partners II are the beneficial owners of MEM Holdings. The sponsor notes accrue interest at 15% per annum; any accrued interest not paid as of March 31, June 30, September 30 or December 31 will bear interest at 15% per annum until such interest is paid or extinguished. The sponsor notes are junior and subordinate to payments for the Senior Credit Facility, and the Senior Subordinated Notes. At any time, the sponsor notes may be converted into Class A-2 units of the Company at the direction of MEM Holdings. If the sponsor notes have not been repaid in full as of September 2003, the sponsor notes will automatically be converted into Class A-2 units of the Company. Other Debt The Company has $2.2 million of promissory notes which, with the exception of one, bear interest at 9.887% and mature in November 2016. The Company is required to make interest only payments on a monthly basis through October 2006, and principal and interest payments for the remainder of the term. The note terms are the same for all but one of the notes. This note bears interest at 8% with principal and interest payments due monthly until maturity in October 2006. 10 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Liquidity The Company's principal sources of funds will continue to be cash flows from operations and borrowings under the senior credit facility. As of June 30, 2002, the Company had outstanding debt of $182.7 million under its senior credit facility, with additional available borrowings of up to $35.0 million. Based upon current and anticipated levels of operations, the Company believes that its cash flows from operations, combined with availability under the senior credit facility, as amended, will be adequate to meet its liquidity needs for the foreseeable future. The Company is continuing its efforts to improve working capital balances, while also implementing additional cost-saving initiatives, such as more efficiently utilizing its capital resources associated with new client locations. Overall, the Company's business plan anticipates continued growth in new client locations and operational improvements. The Company's future performance is subject to industry based factors such as the level of competition in the business music industry, competitive pricing, concentrations in and dependence on satellite delivery capabilities, rapid technological changes, the impact of legislation and regulation, its dependence on license agreements and other factors that are beyond its control. Annual Maturities Annual maturities of long-term debt obligations are as follows (in thousands): 2002........................................................ $ 3,388 2003........................................................ 7,855 2004........................................................ 27,742 2005........................................................ 62,733 2006........................................................ 81,700 Thereafter.................................................. 187,332 Total interest paid by the Company on all indebtedness was $4.3 million and $16.6 million for the quarter and six months ended June 30, 2002 and 2001, respectively and $3.0 million and $13.2 million for the quarter and six months ended June 30, 2001. The weighted average interest rate on all indebtedness was 8.7% and 10.3% as of June 30, 2002 and 2001, respectively. Interest Rate Protection Programs The Company had an interest rate swap agreement which terminated in April 2002. The effect of this agreement on the operating results of the Company was to increase interest expense by $0.4 million and $1.6 million for the quarter and six months ended June 30, 2002, respectively and $0.5 million and $0.8 million for the quarter and six months ended June 30, 2001. The Company entered into a three year interest rate cap on April 19, 2002, for which it paid a premium of $0.4 million. The interest rate cap protects the Company against LIBOR increases above 7.25% and is designated as a hedge of interest rates. Accordingly, the derivative will be recognized on the balance sheet at its fair value. The hedge is considered 100% effective for exposures to interest rate fluctuations. As a result of the 100% effectiveness of the hedge, changes in the fair value of the derivative will be recorded in other comprehensive loss. The Company will amortize the premium paid for the cap over the life of the agreement using the caplets approach and any amounts received under the cap will be recorded as a reduction to interest expense. The fair market value of the interest rate cap was $0.3 million as of June 30, 2002. The fair values of interest rate caps are obtained from dealer quotes which represents the estimated amount the Company would receive or pay to terminate agreements taking into consideration current interest rates and creditworthiness of the counterparties. 8. Manditorily Redeemable Preferred Units On March 8, 2002, the Company entered into the second amendment to the Securities Purchase Agreement which amended the consolidated capital expenditure covenant for 2001 and subsequent years and allowed for an increase to consolidated operating cash flow for amounts designated by the Company with respect to license fees up to a certain amount. In connection with this amendment, the Company incurred $0.3 million in fees. 11 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company was in violation of unit coverage and total leverage ratio under the Securities Purchase Agreement as of June 30, 2002. As a result of the default, the preferred units will accrue at a preferential return of 17% per annum as long as the default is continuing. The Company projects that it will be in compliance as of September 30, 2002, and therefore, the preferred units will resume accruing at 15% per annum on October 1, 2002. 9. Related Party Transactions During the six months ended June 30, 2002, the Company incurred fees of $0.2 million under the Management and Consulting Services Agreement with ABRY Partners. Either the Company or ABRY Partners, with the approval of the Board of Directors of the Company, may terminate the Management Agreement by prior written notice to the other. During the quarter ended March 31, 2002, the Company borrowed $10.0 million from MEM Holdings under junior subordinated notes. At any time, the sponsor notes may be converted into Class A-2 units of the Company at the direction of MEM Holdings. If the sponsor notes have not been repaid in full as of September 2003, the sponsor notes will automatically be converted into Class A-2 units of the Company. 10. MUZAK HOLDINGS FINANCE CORP. Muzak Holdings Finance Corp. had no operating activities during the six months ended June 30, 2002 and 2001. 11. COMMITMENTS AND CONTINGENCIES Litigation The Company is involved in various claims and lawsuits arising out of the normal conduct of its business. Although the ultimate outcome of these legal proceedings cannot be predicted with certainty, the management of the Company believes that the resulting liability, if any, will not have a material effect upon the Company's consolidated financial statements or liquidity. The industry wide agreement between business music providers and Broadcast Music Inc. ("BMI") expired in December 1993. Since this time the Company has been operating under an interim agreement pursuant to which the Company has continued to pay royalties at the 1993 rates. Business music providers and BMI have been negotiating the terms of a new agreement. The Company is involved in a rate court proceeding, initiated by BMI in Federal Court in New York. At issue are the music license fees payable by the Company and its owned operations as well as licensed independent franchisees to BMI. The period from which such "reasonable" license fees are payable covers the period January 1, 1994 to June 30, 2002, and likely several years thereafter. BMI contends that those fee levels understate reasonable fee levels by as much as 100%. The Company vigorously contests BMI's assessment. The eventual court ruling setting final fees for the period covered will require retroactive adjustment, upward or downward, likely back to January 1, 1994, and possibly will also entail payment of pre-judgment interest. Discovery in the proceeding has commenced and is not yet completed. A trial date has not been set. The industry wide agreement between business music providers and American Society of Composers, Authors and Publishers ("ASCAP") expired in May 1999. Negotiations between ASCAP and the Company began in June 1999, and the Company has continued to pay ASCAP royalties at the 1999 rates. In October 1998, the Digital Millennium Copyright Act was enacted. The Act provides for a statutory license from the copyright owners of master recordings to make and use ephemeral copies of such recordings. Ephemeral copies refer to temporary copies of master sound recordings made to enable or facilitate the digital transmission of such recordings. The Digital Millennium Copyright Act did not specify the rate and terms of the license. As a result, the United States Copyright Office convened a Copyright Arbitration Royalty Panel to recommend an ephemeral royalty rate. In February 2002, the Panel recommended an ephemeral royalty rate of ten percent (10%) of gross proceeds applicable to the use of ephemeral copies. That recommendation was subject to review by the Librarian of Congress, who could have modified or adopted such recommendation. 12 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In June 2002, the Librarian of Congress published his final decision to adopt the Copyright Arbitration Royalty Panel's recommendation of a ten percent (10%) ephemeral royalty rate, which covers the period from October 1998 through the present. As a result, we are required to remit payment by October 20, 2002 for the above mentioned period. With respect to future revenue subject to such ephemeral royalty rate, we believe our exposure is minimal, as we believe our current satellite technologies do not require use of ephemeral copies. Nonetheless, there can be no assurances that the collective for the copyright owners will refrain from investigating or otherwise challenging the applicability of the statute to our satellite technologies. During the quarter ended June 30, 2002, the Company increased its estimated reserve for prior period licensing royalties and related expenses by $3.1 million to $4.0 million. This charge is recorded in cost of music and other business services revenues. Other Commitments As of June 30, 2002, the Company has approximately $32.5 million in outstanding capital expenditure commitments over a five year period. The Company is the lessee under various operating and capital leases for equipment, vehicles, satellite capacity, and buildings for periods ranging from 2 years to 15 years. 13 MUZAK HOLDINGS LLC ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Form 10-Q contains statements which, to the extent they are not historical fact, constitute forward-looking statements within the meaning of Section 27A of the securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934 (the "Safe Harbor Acts"). All forward-looking statements involve risks and uncertainties. The forward-looking statements in this Form 10-Q are intended to be subject to the safe harbor protection provided by the Safe Harbor Acts. Risks and uncertainties that could cause actual results to vary materially from those anticipated in the forward-looking statements included in this Form 10-Q include, but are not limited to, industry-based factors such as the level of competition in the business music industry, competitive pricing, concentrations in and dependence on satellite delivery capabilities, rapid technological changes, the impact of legislation and regulation, as well as factors more specific to the Company such as the substantial leverage and debt service requirements, limitations imposed by the Company's debt facilities, the Company's history of net losses, and the Company's ability to identify, complete and integrate acquisitions, the Company's future capital requirements, the Company's dependence on license agreements, and risks associated with general economic conditions. Recent Developments General Business In October 1998, the Digital Millennium Copyright Act was enacted. The Act provides for a statutory license from the copyright owners of master recordings to make and use ephemeral copies of such recordings. Ephemeral copies refer to temporary copies of master sound recordings made to enable or facilitate the digital transmission of such recordings. The Digital Millennium Copyright Act did not specify the rate and terms of the license. As a result, the United States Copyright Office convened a Copyright Arbitration Royalty Panel to recommend an ephemeral royalty rate. In February 2002, the Panel recommended an ephemeral royalty rate of ten percent (10%) of gross proceeds applicable to the use of ephemeral copies. That recommendation was subject to review by the Librarian of Congress, who could have modified or adopted such recommendation In June 2002, the Librarian of Congress published his final decision to adopt the Copyright Arbitration Royalty Panel's recommendation of a ten percent (10%) ephemeral royalty rate, which covers the period from October 1998 through the present. As a result, we are required to remit payment by October 20, 2002 for the above mentioned period. With respect to future revenue subject to such ephemeral royalty rate, we believe our exposure is minimal, as we believe our current satellite technologies do not require use of ephemeral copies. Nonetheless, there can be no assurances that the collective for the copyright owners will refrain from investigating or otherwise challenging the applicability of the statute to our satellite technologies. Pan Am Sat announced the successful launch of the Galaxy IIIC satellite on June 15, 2002. Galaxy IIIR, will co-locate with Galaxy IIIC until it is put into service in the fall of 2002. Once the Galaxy IIIC has been successfully put into service, the Company will explore the availability of insurance to cover increased costs in the event of a Galaxy IIIC satellite failure. 14 MUZAK HOLDINGS LLC Item 2. Management's Discussion and Analysis (Continued) During the first quarter of 2002, the Company increased its aggregate revolver commitments under the Senior Credit Facility by $20.0 million, for a total commitment of $55.0 million. In addition, in March 2002 the existing equity holders, including ABRY Partners LLC, contributed $10.0 million in the form of junior subordinated unsecured notes to the Company. The Company paid $1.5 million in financing fees related to these transactions during the first quarter of 2002. The increased revolver commitment and the $10.0 million from the sponsors enhances the Company's financial flexibility and provides sufficient liquidity to fund its organic business plan for the foreseeable future. Accounting Developments The Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142") on January 1, 2002. SFAS No. 142 requires that goodwill be tested annually at the reporting unit level for impairment using a two-step process. A reporting unit is the operating segment unless, at businesses one level below the operating segment, discrete financial information is prepared and regularly reviewed by management. The first step is to identify a potential impairment and, in transition, this step must be measured as of the beginning of the fiscal year. The Company completed its testing of goodwill in accordance with SFAS No. 142 during the quarter ended June 30, 2002. As the fair value of goodwill exceeds the carrying amount of goodwill, the Company did not record an impairment charge. General Muzak is the leading provider of business music programming in the United States based on market share. We believe that, together with our franchisees, we have a market share of approximately 60% of the estimated number of U.S. business locations currently subscribing to business music programming. Results of Operations Set forth below are discussions of the results of operations for Muzak Holdings LLC for the quarter and six months ended June 30, 2002 compared to the quarter and six months ended June 30, 2001. Revenues. Revenues were $54.1 million and $50.7 million for the quarters ended June 30, 2002 and 2001, respectively, an increase of 6.6%. Music and other business services revenue increased $3.3 million, or 8.9% in 2002 as compared to the quarter ended June 30, 2001. Revenues for the six months ended June 30, 2002 increased 4.3% to $105.0 million, up $4.3 million from the comparable 2001 period. Music and other business services revenue increased $6.0 million, or 8.1% for the six months ended June 30, 2002 as compared to 2001. The growth in music and other business services revenue is due to an increase in new client locations, offset by a 10.4% churn rate during the twelve months ended June 30, 2002. The 2001 churn rate was higher than historical levels due to more bankruptcies and business closures in our client base. However, our efforts on reducing our client churn rate have contributed to a reduction in our annualized churn rate during the six months ended June 30 of 2002 to 9.9% from 12.4% during the first six months of 2001. During the twelve months ended June 30, 2002, we added, net of churn of both acquisition locations and locations obtained through our sales and marketing efforts, approximately 8,700 Audio Architecture, 3,300 Voice, and 1,400 other locations. Equipment and related services revenue was flat for the quarter ended June 30, 2002 as compared to the quarter ended June 30, 2001 and decreased 6.3% or $1.7 million in 2002 as compared to the six months ended June 30, 2001. This decrease is largely due to a reduction in new store location build outs among our national chains, particularly within the retail sector. We expect that the full year 2002 equipment and related services revenue will be consistent with 2001 levels. 15 MUZAK HOLDINGS LLC Item 2. Management's Discussion and Analysis (Continued) Cost of Revenues. Cost of revenues was $21.9 million and $16.9 million for the quarters ended June 30, 2002 and 2001, respectively, an increase of 29.7%. Cost of revenues increased $5.7 million for the six months ended June 30, 2002 as compared to the six months ended June 30, 2001. During the quarter ended June 30, 2002, the Company increased its reserves for estimated prior period licensing royalties and related expenses by $3.1 million. Excluding this increase in reserve, total cost of revenues as a percentage of revenues was 34.7% and 33.3% for the quarters ended June 30, 2002 and 2001, respectively and 34.4% and 33.3% for the six months ended June 30, 2002 and 2001, respectively. Excluding this increase in reserve, costs of music and other business services revenue as a percentage of music and other business services revenue was 19.2% and 18.6% for the quarters ended June 30, 2002 and 2001 and 19.4% and 19.7% for the six months ended June 30, 2002 and 2001, respectively. The six month improvement in costs of music and other business services revenue is primarily due to the leveraging of fixed costs over a larger client base and labor savings achieved from the use of the Company's Voice website, offset slightly by an increase in licensing royalties and satellite expenses. The increase in the cost of equipment and related services revenues as a percentage of revenues is due to lower equipment and related services revenues together with a relatively fixed technician workforce. The Company has implemented new scheduling software to better manage and utilize its technician workforce. In addition, we experienced an increase in certain technician related costs, such as insurance, contractual union wage increases, and higher fuel and repair costs during the first six months of 2002. Selling, general and administrative expenses. Selling, general, and administrative expenses were $17.9 million and $17.1 million for the quarters ended June 30, 2002 and 2001, respectively and $35.9 million and $35.2 million for the six months ended June 30, 2002 and 2001, respectively. This slight increase is due to a $0.8 million and $1.6 million increase in amortization of subscriber acquisition costs, a non-cash component of selling, general, and administrative expenses for the quarter and six months ended June 30, 2002 as compared to the 2001 period. This increase is directly related to the increase in music and other business services revenue. Excluding the amortization of subscriber acquisition costs, selling, general, and administrative expenses as a percentage of revenues were 27.4% and 29.3% for the quarters ended June 30, 2002 and 2001, respectively and 28.6% and 30.6% for the six months ended June 30, 2002 and 2001, respectively. This improvement is attributable to the Company's continued focus on controlling expenses, including travel, salaries and other employee related expenses, telephone, and other administrative expenses. The six months ended June 30, 2002 and 2001 include $0.5 million and $0.7 million, respectively, of charges incurred in connection with exploring various financing alternatives. Depreciation and amortization expenses. Depreciation and amortization was $17.4 million and $18.5 million for the quarters ended June 30, 2002 and 2001, respectively, a decrease of 5.9%. Depreciation and amortization was $35.3 million and $36.8 million for the six months ended June 30, 2002 and 2001, respectively, a decrease of 4.2%. The decrease is due to the adoption of SFAS No. 142 on January 1, 2002. In connection with the adoption, the Company ceased amortization of goodwill on January 1, 2002. During the first six months of 2001, the Company recorded $4.6 million amortization expense related to goodwill and trained workforce. Depreciation was $23.0 million and $19.0 million in the six months ended June 30, 2002 and 2001, respectively. This increase is due to increase in property and equipment in conjunction with Muzak's growth in the number of client locations. Interest expense. Interest expense was $9.1 million and $9.6 million for the quarters ended June 30, 2002 and 2001, respectively, a decrease of $0.5 million, or 5.5%. Interest expense was $18.6 million and $20.5 million for the six months ended June 30,2002 and 2001, respectively, a decrease of 9.0%. This decrease is due to lower outstanding debt balances at lower interest rates during the first six months of 2002 as compared to the 2001 comparable period. The effective interest rate for the six months ended June 30, 2002 and 2001 was 9.4% and 10.2%, respectively. 16 MUZAK HOLDINGS LLC Item 2. Management's Discussion and Analysis (Continued) Income tax provision. Income tax benefit was $0.3 million and $0.2 million for the quarters ended June 30, 2002 and 2001, respectively, a decrease of 67.4%. Income tax benefit was $0.6 million for the six months ended June 30, 2002 and 2001. Although Muzak is a limited liability company and is treated as a partnership for income tax purposes, the Company has several subsidiaries that are corporations. The income tax benefits relate to these corporate subsidiaries. Net Loss. The combined effect of the foregoing resulted in a net loss of $11.8 million and $23.3 million for the quarter and six months ended June 30, 2002, respectively, compared to a net loss of $11.3 million and $24.8 million for the comparable 2001 period. The Company evaluates the operating performance of its business using several measures, one of them being adjusted EBITDA (defined as earnings before interest, income taxes (benefits), depreciation, amortization, non-cash charges and one-time expenses). Adjusted EBITDA is not intended to be a performance measure that should be regarded as an alternative to, or more meaningful than, either operating income or net income as an indicator of operating performance or cash flow as a measure of liquidity, as determined in accordance with generally accepted accounting principles, known as GAAP. However, management believes that adjusted EBITDA is a meaningful measure of performance and that it is commonly used in similar industries to analyze and compare companies on the basis of operating performance, leverage and liquidity, however it is not necessarily comparable to similarly titled amounts of other companies.

(a) One-time expenses were incurred in connection with exploring various financing alternatives and increasing reserves for prior period licensing royalties and related expenses. Adjusted EBITDA for the quarter ended June 30, 2002 increased $0.7 million, or 4.4% to $17.4 million from $16.7 million for the quarter ended June 30, 2001. Adjusted EBITDA for the six months ended June 30, 2002 increased $0.9 million or 2.7% as compared to the 2001 period. 17 MUZAK HOLDINGS LLC Item 2. Management's Discussion and Analysis (Continued) Liquidity and Capital Resources Sources and Uses. Our principal sources of funds have been cash generated from operations, borrowings under the senior credit facility, and contributions from the sponsors. Our future need for liquidity will arise primarily from capital expenditures for investments in new client locations and from interest and principal payments on our indebtedness. During the six months ended June 30, 2002, $12.6 million of cash was provided by our operating activities, $18.0 million of cash was used in investing activities, and $3.2 million of cash was provided by financing activities. Cash was primarily used during the first six months of 2002 to make investments relating to new client locations and to make interest payments on the senior credit facility. We expect that our principal sources of funds will continue to be cash flows from operations and borrowings under the senior credit facility. As of June 30, 2002, we had outstanding debt of $182.7 million under our senior credit facility, with additional available borrowings of up to $35.0 million. Based upon current and anticipated levels of operations, we believe that our cash flows from operations, combined with availability under the senior credit facility, will be adequate to meet our liquidity needs for the foreseeable future. We are continuing our efforts to improve working capital balances, while also implementing additional cost-saving initiatives, such as more efficiently utilizing our capital resources associated with new client locations. Overall, Muzak's business plan anticipates continued growth in new client locations and operational improvements. Our future performance is subject to industry based factors such as the level of competition in the business music industry, competitive pricing, concentrations in and dependence on satellite delivery capabilities, rapid technological changes, the impact of legislation and regulation, our dependence on license agreements and other factors that are beyond our control. Capital Investments. The majority of our capital expenditures are comprised of the initial one-time investment for the installation of equipment for new client locations. During the six months ended June 30, 2002, our total initial investment in new client locations was $22.5 million which was comprised of equipment and installation costs attributable to new client locations of $15.3 million and $7.2 million in sales commissions (included in operating activities in the consolidated statement of cash flows) relating to these new locations. The sales commissions are capitalized in deferred charges and other assets, net and are amortized as a component of selling, general and administrative expenses over the initial contract term of five years. We also receive installation revenue relating to new locations. This revenue is deferred and amortized as a component of equipment and related services revenue over the initial contract term of five years. We currently anticipate that our total initial investment in new client locations during 2002 will be approximately $50.0 million including $34.0 million of equipment and installation costs attributable to new client locations, and $16.0 million in sales commissions relating to new client locations. The Company is focused on reducing the initial investment associated with new client locations through the re-use of equipment and efficiencies gained from vendor consolidation and labor management. We also invest in property and equipment to be used at our headquarters and within our owned operations. Our investment for such property and equipment for the six months ended June 30, 2002 was approximately $2.0 million, consisting of system upgrades, furniture and fixtures, computers, equipment to replenish the equipment exchange pool relating to our drive-thru systems client locations, and conversions from local broadcast technology to direct broadcast satellite transmission for existing client locations. We anticipate our investment in property and equipment to be used at headquarters, equipment for use in the exchange pool for servicing drive-thru systems client locations, and equipment for conversions will be approximately $4.0 million for 2002. 18 MUZAK HOLDINGS LLC Item 2. Management's Discussion and Analysis (Continued) Sensitivity to Interest Rate Changes. Due to the variable interest rates under the senior credit facility, we are sensitive to changes in interest rates. A 0.5% increase in each of LIBOR and the Alternate Base Rate (1.87% and 4.75% respectively, at June 30, 2002) would impact interest costs by approximately $0.9 million annually on the senior credit facility. The Company's interest rate swap terminated on April 19, 2002. We entered into an interest rate cap in April 2002 as our senior credit facility requires that we maintain an agreement for 50% of the outstanding balance of the senior credit facility to limit our interest rate exposure. The interest rate cap protects the Company against LIBOR increases above 7.25%. To the extent, LIBOR increased above 7.25%, the Company's exposure to increases would be limited to the unhedged portion of the senior credit facility. Item 3. Quantitative and Qualitative Disclosures About Market Risk For the period ended June 30, 2002, the Company did not experience any material changes in market risk disclosure that affect the quantitative and qualitative disclosures presented in the 10-K. PART II - OTHER INFORMATION ITEM 1. Legal Proceedings. There have been no material developments in legal proceedings involving the Company since those reported in the Company's Report on Form 10-K for fiscal year ended December 31, 2001. ITEM 6. Exhibits and Reports on Form 8-K. (a) Exhibits 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-OxleyAct of 2002 99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) Reports on Form 8-K The Company filed a Form 8-K on January 14, 2002 disclosing its violation of the maximum consolidated capital expenditures covenant of its Senior Credit Facility for the period ending December 31, 2001 as well as the expiration of its insurance covering increased costs in the event of a failure of PanAmSat Corporation's Galaxy IIIR satellite. The Company filed a Form 8-K on April 1, 2002 disclosing that it has obtained a waiver of the violation of the maximum consolidated capital expenditures covenant of its senior credit facility. In addition, the company disclosed it has increased its revolving commitments of its senior credit facility by $20.0 million, for a total commitment of $55.0 million. 19 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrants have duly caused this report to be signed on their behalf by the undersigned thereunto duly authorized. MUZAK HOLDINGS LLC MUZAK HOLDINGS FINANCE CORP. By: /s/ William A. Boyd --------------------------------- Date: August 14, 2002 William A. Boyd Chief Executive Officer (Principal Executive Officer) By: /s/ Stephen P. Villa --------------------------------- Date: August 14, 2002 Stephen P. Villa Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer) 20

MUZAK HOLDINGS FINANCE CORP 10-Q