10-Q 1 d10q.txt MUZAK 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 September 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 LLC MUZAK FINANCE CORP. (Exact Name of Registrants as Specified in their charter) DELAWARE 04-3433729 DELAWARE 56-2187963 (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 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. Muzak Finance Corp. had 100 shares of outstanding common stock as of November 14, 2002. 1 PART I-FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. MUZAK LLC CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited)

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

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

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

The Notes are an integral part of these consolidated financial statements. 5 MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION Muzak LLC ("the Company"), a Delaware limited liability company, is a wholly owned subsidiary of Muzak Holdings LLC (the "Parent"). The Company provides business music programming to clients through its integrated nationwide network of owned operations and franchises. All of the operating activities are conducted through the Company and its subsidiaries. As of September 30, 2002, ABRY Partners, LLC and its respective affiliates, collectively own approximately 64.2% of the beneficial interests in the Parent's voting interests. 2. BASIS OF PRESENTATION The condensed consolidated financial statements include the accounts of the Company and its subsidiaries: Muzak Capital 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 LLC Annual Report on Form 10-K for the fiscal year ended December 31, 2001. The financial statements as of September 30, 2002 and 2001 and for the three and nine 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. This Form 10-Q and the Form 10-Q for the three and six months ended June 30, 2002 can be found on the Company's website, www.muzak.com. 3. PROPERTY AND EQUIPMENT Property and equipment consists of the following (in thousands):

6 MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Included in equipment and other at September 30, 2002 and December 31, 2001 is $13.7 million and $11.6 million, respectively, of equipment under capital leases, gross of accumulated depreciation of $8.8 million and $6.6 million, respectively. Depreciation of property and equipment was $11.8 million and $34.8 million for the quarter and nine months ended September 30, 2002, respectively, and $10.5 million and $29.6 million for the quarter and nine months ended September 30, 2001, respectively. 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. 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. Unamortized intangible assets consist of the following (in thousands): September 30, 2002 December 31, 2001 Carrying Amount Carrying Amount (unaudited) ---------------------------------------------- Goodwill ............ $ 140,805 $137,917 Trained workforce ... -- 2,868 The following presents net loss exclusive of amortization of goodwill and trained workforce (in thousands):

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

8 MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. DEBT Debt obligations consist of the following (in thousands):

Senior Credit Facility The Senior Credit Facility is guaranteed by the Parent, 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, 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 2.75% in the case of Alternate Base Rate and 3.75% in the case of LIBOR as of September 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 6.1% and 9.3% at September 30, 2002 and 2001, respectively. Senior Subordinated Notes On March 18, 1999, the Company 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. 9 MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Senior Subordinated Notes are guaranteed by the Parent, 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. 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 Parent. 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 Parent 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 Parent. 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. 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 September 30, 2002, the Company had outstanding debt of $185.7 million under its senior credit facility, with additional available borrowings of up to $32.0 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 through December 2004. 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. 10 MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Annual Maturities Annual maturities of long-term debt obligations are as follows (in thousands): 2002 ........................................................ $ 3,368 2003 ........................................................ 7,855 2004 ........................................................ 27,742 2005 ........................................................ 65,733 2006 ........................................................ 81,700 Thereafter .................................................. 126,754 Total interest paid by the Company on all indebtedness was $8.6 million and $25.2 million for the quarter and nine months ended September 30, 2002, respectively and $10.1 million and $23.3 million for the quarter and nine months ended September 30, 2001. The weighted average interest rate on all indebtedness was 7.8% and 9.5% as of September 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 $1.6 million for the nine months ended September 30, 2002 and $0.8 million and $1.6 million for the quarter and nine months ended September 30, 2001, respectively. 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 $0.2 million as of September 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. 7. Related Party Transactions During the nine months ended September 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 Parent, 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 Parent 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 Parent. As of September 30, 2002, the Parent has obligations of $62.5 million of senior discount notes and mandatorily redeemable preferred units ("preferred units") of $104.7 million. These obligations are not reflected in the Company's accompanying balance sheets or income statements as the Company has no pledge of assets nor guarantee that provides security for the Parent's obligations. Cash interest on the senior discount notes does not accrue until March 15, 2004. Thereafter, cash interest on the senior discount notes will accrue at a rate of 13% per annum and will be payable in arrears on March 15 and September 15 of each year, commencing on September 15, 2004. The preferred units accrue a preferential return of 15% per annum, which is compounded quarterly. The Parent was in default of the unit coverage and total leverage ratio under the Securities Purchase Agreement as of June 30, 2002. As a result of the 11 MUZAK LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) default, the preferred units accrue at a preferential return of 17% per annum as long as the default is continuing. The Parent was in compliance as of September 30, 2002, and therefore, the preferred units resumed accruing at 15% per annum on October 1, 2002. The preferential return is payable in kind through October 2005, and thereafter the 15% preferential return will be payable in cash or in kind at the Parent's option. The Parent does not have any operations or assets other than its ownership of Muzak. Accordingly, the Parent is dependent on distributions from the Company in order to pay interest beginning in 2004 as discussed above. The Company's senior credit facility and senior subordinated notes indenture impose restrictions on its ability to make distributions to the Parent. The senior credit facility and the senior subordinated notes indenture permit the Company to make payments and distributions to the Parent after September 15, 2004 in an amount sufficient to permit the Parent to make cash interest payments when due, however the senior credit facility requires that certain financial covenant levels be met in order to make such distributions. During the nine months ended September 30, 2002, the Company incurred $0.3 million of financing fees in conjunction with an amendment to the manditorily redeemable preferred units agreement on behalf of the Parent. Such payment was recorded as a reduction of the Parent's investment in the Company. 8. MUZAK FINANCE CORP. Muzak Finance Corp. had no operating activities during the nine months ended September 30, 2002 and 2001. 9. 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 September 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. If the parties fail to progress in their negotiations toward a mutually acceptable rate by November 29, 2002, either party can pursue a rate court proceeding in federal court in New York to seek a court determined reasonable rate. 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 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 required by such determination, we remitted payment on 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 nine months ended September 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 September 30, 2002, the Company has approximately $28.4 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 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 September 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 September 30, 2002 and 2001 and for the three and nine 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):

6 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Included in equipment and other at September 30, 2002 and December 31, 2001 is $13.7 million and $11.6 million, respectively, of equipment under capital leases, gross of accumulated depreciation of $8.8 million and $6.6 million, respectively. Depreciation of property and equipment was $11.8 million and $34.8 million for the quarter and nine months ended September 30, 2002, respectively, and $10.5 million and $29.6 million for the quarter and nine months ended September 30, 2001, respectively. 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. 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. Unamortized intangible assets consist of the following (in thousands): September 30, 2002 December 31, 2001 Carrying Amount Carrying Amount (unaudited) --------------------------------------------- Goodwill ................... $140,805 $137,917 Trained workforce .......... -- 2,868 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 $5.7 million and $18.0 million for the quarter and nine months ended September 30, 2002, respectively, and $8.8 million and $26.3 million for the quarter and nine months ended September 30, 2001, respectively. The estimated future aggregate amortization expense is as follows (in thousands): Fiscal year ending ------------------ 2002 ................................. $23,229 2003 ................................. 18,379 2004 ................................. 15,079 2005 ................................. 14,240 2006 ................................. 14,189 5. DEFERRED CHARGES AND OTHER ASSETS, NET Deferred charges and other assets, net, consist of the following (in thousands): September 30, December 31, 2002 2001 (Unaudited) ----------- -------- Subscriber acquisition costs, net ........ $ 39,105 $ 37,442 Other .................................... 12,623 12,578 -------- -------- $ 51,728 $ 50,020 ======== ======== 8 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. DEBT Debt obligations consist of the following (in thousands): September 30, December 31, 2002 2001 (Unaudited) ----------- --------- Related Party Notes ......................... $ 10,000 $ -- ======== ========= Long term debt: Revolving Loan-Senior Credit Facility ..... $ 22,800 $ 21,300 Senior Credit Facility .................... 162,860 166,207 Senior Discount Notes ..................... 62,530 56,861 Senior Subordinated Notes ................. 115,000 115,000 Other ..................................... 2,492 2,552 -------- --------- Total debt obligations ...................... 365,682 361,920 Less current maturities ..................... (7,153) (6,775) -------- --------- $358,529 $ 355,145 ======== ========= 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, 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 2.75% in the case of Alternate Base Rate and 3.75% in the case of LIBOR as of September 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 6.1% and 9.3% at September 30, 2002 and 2001, respectively. 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 Muzak LLC and Muzak Finance and are subordinated in right of payment to all existing and future Senior Indebtedness of Muzak LLC and Muzak Finance. 9 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Senior Subordinated Notes are guaranteed by the Company, 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. Under certain default scenarios, the sponsor notes are junior and subordinate to payments for the Senior Credit Facility, the Senior Subordinated Notes, and the Senior Discount 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. 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 September 30, 2002, the Company had outstanding debt of $185.7 million under its senior credit facility, with additional available borrowings of up to $32.0 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 through December 2004. 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 10 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 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 .................................... $ 3,368 2003 .................................... 7,855 2004 .................................... 27,742 2005 .................................... 65,733 2006 .................................... 81,700 Thereafter .............................. 189,284 Total interest paid by the Company on all indebtedness was $8.6 million and $25.2 million for the quarter and nine months ended September 30, 2002, respectively and $10.1 million and $23.3 million for the quarter and nine months ended September 30, 2001. The weighted average interest rate on all indebtedness was 8.7% and 10.0% as of September 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 $1.6 million for the nine months ended September 30, 2002 and $0.8 million and $1.6 million for the quarter and nine months ended September 30, 2001, respectively. 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 $0.2 million as of September 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. 7. 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. 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 accrued at a preferential return of 17% per annum during the quarter ended September 30, 2002. The Company is in compliance as of September 30, 2002, and therefore, the preferred units are accruing at 15% per annum beginning on October 1, 2002. 11 MUZAK HOLDINGS LLC NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. Related Party Transactions During the nine months ended September 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. 9. MUZAK HOLDINGS FINANCE CORP. Muzak Holdings Finance Corp. had no operating activities during the nine months ended September 30, 2002 and 2001. 10. 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 September 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. If the parties fail to progress in their negotiations toward a mutually acceptable rate by November 29, 2002, either party can pursue a rate court proceeding in federal court in New York to seek a court determined reasonable rate. 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 required by such determination, we remitted payment on 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 nine months ended September 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 September 30, 2002, the Company has approximately $28.4 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 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. This Form 10-Q and the Form 10-Q for the three and six months ended June 30, 2002 can be found on the Company's website, www.muzak.com. Recent Developments General Business Pan Am Sat announced the successful launch of the Galaxy IIIC satellite on June 15, 2002. Galaxy IIIC is now operating in the same orbital slot formerly occupied by Galaxy IIIR, and the transition to Galaxy IIIC has been a seamless one for the Company's clients. While the Company believes that Galaxy IIIC is operating within all performance and design specifications, the Company's risk management strategy continues to be to explore the availability of insurance to cover increased costs in the event of a Galaxy IIIC satellite failure. 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 required by such determination, we remitted payment on 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 current satellite technologies. 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, 14 MUZAK LLC Item 2. Management's Discussion and Analysis (Continued) 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 $1.8 million in financing fees related to these transactions during the nine months ended September 30, 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. 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 LLC for the quarter and nine months ended September 30, 2002 compared to the quarter and nine months ended September 30, 2001. Revenues. Revenues were $56.2 million and $50.5 million for the quarters ended September 30, 2002 and 2001, respectively, an increase of 11.2%. Music and other business services revenue increased $3.3 million, or 8.8% and equipment and related services revenue increased $2.3 million, or 18.3% in 2002 as compared to the quarter ended September 30, 2001. Revenues for the nine months ended September 30, 2002 increased 6.6% to $161.2 million, up $10.0 million from the comparable 2001 period. Music and other business services revenue increased $9.3 million, or 8.4% and equipment and related services revenue increased $0.6 million, or 1.6% for the nine months ended September 30, 2002 as compared to 2001. The increase in music and other business services revenue is due to a growth in new client locations at consistent prices, offset by a 10.4% churn rate during the twelve months ended September 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 nine months ended September 30, 2002 to 10.0% from 11.8% during the first nine months of 2001. During the twelve months ended September 30, 2002, we added, net of churn, approximately 8,200 Audio Architecture, 3,900 Voice, and 1,400 other locations. Due to an expected further reduction in new store location build outs among our national chains in 2002, particularly within the retail sector, the Company committed resources and renewed its focus on system sales such as sound systems, noise masking, drive-thru systems, and closed circuit television as a means to replace this expected reduction in equipment and labor revenues. The significant increase in equipment and related services revenue for the quarter ended September 30, 2002 as compared to the quarter ended September 30, 2001 is a direct result of this focus. We expect the full year 2002 equipment and related services revenue will slightly exceed the 2001 levels. Cost of Revenues. Cost of revenues was $19.7 million and $17.9 million for the quarters ended September 30, 2002 and 2001, respectively, an increase of 9.7%. Cost of revenues increased $7.4 million for the nine months ended September 30, 2002 as compared to the nine months ended September 30, 2001. During the nine months 15 MUZAK LLC Item 2. Management's Discussion and Analysis (Continued) ended September 30, 2002, the Company increased its reserves for estimated prior period licensing royalties and related expenses by $3.1 million. Excluding this increase in the reserve in 2002, costs of music and other business services revenue as a percentage of music and other business services revenue was 18.9% and 19.5% for the quarters ended September 30, 2002 and 2001 and 19.2% and 19.6% for the nine months ended September 30, 2002 and 2001, respectively. The 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, despite an increase in licensing royalties and satellite expenses. Costs of equipment and related services as a percentage of revenues was 79.2% and 83.0% for the quarters ended September 30, 2002 and 2001 and 81.0% and 74.8% for the nine months ended September 30, 2002 and 2001. The increase in the cost of equipment and related services revenues as a percentage of revenues for the nine months ended September 30, 2002 as compared to the 2001 period is due to the relatively fixed technician workforce and an increase in certain technician related costs, such as insurance, contractual union wage increases, and higher fuel and repair costs, despite lower equipment and related services revenue during the first half of 2002. The cost of equipment and related services revenues as a percentage of revenues in the third quarter of 2002 decreased as compared to the 2001 period due to lower equipment and related services revenues in the 2001 period as well as disruptions in the Company's technician work force's ability to install new client locations in the days following September 11, 2001. The improvement is also attributable to the Company's focus on efficient management of its labor technician costs. The Company fully implemented its scheduling software in June 2002, which is designed to better manage and utilize internal and external labor resources. The Company expects to continue to achieve savings from the efficient management of its labor resources which will be offset slightly by the increase in certain technician related costs such as contractual union wage increases and insurance. Selling, general and administrative expenses. Selling, general, and administrative expenses were $17.9 million and $16.4 million for the quarters ended September 30, 2002 and 2001, respectively and $53.9 million and $51.6 million for the nine months ended September 30, 2002 and 2001, respectively. This increase is partially due to a $0.8 million and $2.4 million increase in amortization of subscriber acquisition costs, a non-cash component of selling, general, and administrative expenses for the quarter and nine months ended September 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 26.1% and 27.6% for the quarters ended September 30, 2002 and 2001, respectively and 27.4% and 29.1% for the nine months ended September 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 nine months ended September 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 $17.6 million and $19.3 million for the quarters ended September 30, 2002 and 2001, respectively, a decrease of 8.9%. Depreciation and amortization was $52.8 million and $56.1 million for the nine months ended September 30, 2002 and 2001, respectively, a decrease of 5.8%. 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 nine months of 2001, the Company recorded $6.9 million amortization expense related to goodwill and trained workforce. Depreciation was $34.8 million and $29.6 million in the nine months ended September 30, 2002 and 2001, respectively. This increase is due to the increase in property and equipment in conjunction with Muzak's growth in the number of client locations. Interest expense. Interest expense was $6.8 million and $7.4 million for the quarters ended September 30, 2002 and 2001, respectively, a decrease of $0.6 million, or 8.1%. Interest expense was $21.6 million and $24.5 16 MUZAK LLC Item 2. Management's Discussion and Analysis (Continued) million for the nine months ended September 30, 2002 and 2001, respectively, a decrease of 11.8%. This decrease is due to lower interest rates during the first nine months of 2002 as compared to the 2001 comparable period as well as to the termination of the interest rate swap. The effective interest rate for the nine months ended September 30, 2002 and 2001 was 7.8% and 9.5%, respectively. Income tax provision. Income tax benefit was $0.3 million for the quarter ended September 30, 2002 and the income tax provision for the quarter ended September 30, 2001 was $0.1 million. Income tax benefit was $0.9 million and $0.5 million for the nine months ended September 30, 2002 and 2001, respectively. 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 $5.4 million and $24.9 million for the quarter and nine months ended September 30, 2002, respectively, compared to a net loss of $10.7 million and $32.1 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 September 30, 2002 increased $2.4 million, or 14.6% to $18.6 million from $16.2 million for the quarter ended September 30, 2001. Adjusted EBITDA for the nine months ended September 30, 2002 increased $3.3 million or 6.7% as compared to the 2001 period. 17 MUZAK 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 nine months ended September 30, 2002, $18.8 million of cash was provided by our operating activities, $26.7 million of cash was used in investing activities, and $6.9 million of cash was provided by financing activities. Cash was primarily used during the first nine 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 September 30, 2002, we had outstanding debt of $185.7 million under our senior credit facility, with additional available borrowings of up to $32.0 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 through December 2004. 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 steady growth in new client locations, operational improvements, and increases in equipment and related services revenue. Muzak strives to fund both investments in new client locations and interest and principal payments primarily through cash generated from operations rather than through borrowings under the senior credit facility. Currently, Muzak is funding investments in new client locations through cash generated from operations but is borrowing under its senior credit facility for partial interest and principal payments. 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 nine months ended September 30, 2002, our total initial investment in new client locations was $33.1 million which was comprised of equipment and installation costs attributable to new client locations of $22.2 million and $10.9 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 $47.0 million including $32.0 million of equipment and installation costs attributable to new client locations, and $15.0 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 nine months ended September 30, 2002 was approximately $3.3 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 $4.8 million for 2002. 18 MUZAK 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 (1.82% and 4.75% respectively, at September 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. Certification Under the Sarbanes-Oxley Act. The certification by the Company's chief executive officer and the chief financial officer of this report on Form 10-Q, as required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350), accompanies this report to the Securities and Exchange Commission as additional correspondence. Item 3. Quantitative and Qualitative Disclosures About Market Risk For the period ended September 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. Item 4. Controls and Procedures Within 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure and control procedures. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company's disclosure and control procedures are effective. There were no significant changes in the Company's internal controls or in other factors that could significantly affect these subsequent to the date of their evaluation. 19 MUZAK LLC 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 10.1 Executive Employment Agreement dated as of November 5, 2002, among Muzak Holdings LLC, Muzak LLC, and Stephen P. Villa 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act 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 March 29, 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. 20 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 LLC MUZAK FINANCE CORP. By: /s/ William A. Boyd --------------------------------- Date: November 14, 2002 William A. Boyd Chief Executive Officer (Principal Executive Officer) By: /s/ Stephen P. Villa --------------------------------- Date: November 14, 2002 Stephen P. Villa Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer) 21 Muzak LLC Section 302 Certifications Certification of the Chief Financial Officer I, Stephen P. Villa,Chief Financial Officer of Muzak LLC certify that: 1. I have reviewed this quarterly report on Form 10-Q of Muzak LLC; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I, are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): (a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. November 14, 2002 Stephen P. Villa Chief Financial Officer 22 Muzak LLC Section 302 Certifications Certification of the Chief Executive Officer I, William A. Boyd,Chief Executive Officer of Muzak LLC certify that: 1. I have reviewed this quarterly report on Form 10-Q of Muzak LLC; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I, are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): (a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. November 14, 2002 William A. Boyd Chief Executive Officer 23

MUZAK LLC 10-Q