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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C.  20549

FORM 10-K

xANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES         EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED FEBRUARY 3, 2007
ORTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACTFOR THE TRANSITION PERIOD FROM _______ TO _______

COMMISSION FILE NUMBER: 0-14818

TRANS WORLD ENTERTAINMENT CORPORATION(Exact name of registrant as
specified in its charter)

|                                                                 |                                          
|---------------------------------------------------------------- | -----------------------------------------
|New
  York                                                       | 14-1541629                               
|(State or other jurisdiction of
  incorporation or organization) | (I.R.S. Employer Identification
  Number)

38 Corporate CircleAlbany, New York 12203(Address of principal
executive offices, including zip code)

(518) 452-1242(Registrants telephone
number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:  Common Stock, $0.01 par value

Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in the Rule 405 of the Securities Act. Yeso No x

Indicate by check mark if the registrant is not
required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yeso No x

Indicate by a check mark whether
the Registrant (1) has filed all reports required to be filed by Sections 13 or
15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for shorter period that the Registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90
days. Yes x  No o

Indicate by check mark if
disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not
contained herein, and will not be contained, to the best of the Registrants
Knowledge, in definitive proxy or information statements incorporated by reference
in Part III of this Form 10-K or an amendment to this Form 10-K. o

Indicate by checkmark whether the
registrant is a large accelerated filer, an accelerated filer or
non-accelerated filer (as defined in Rule 12b-2 of the Act).

Large accelerated filer o          Accelerated
filer x          Non-accelerated
filer o

Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x

As of July 28, 2006, 30,838,399
shares of the Registrants Common Stock, excluding 25,104,990 shares of stock
held in Treasury, were issued and outstanding.
The aggregate market value of the voting stock held by non-affiliates of
the Registrant, based upon the closing sale price of the Registrants Common
Stock on July 28, 2006 as reported on the National Market tier of The NASDAQ
Stock Market, Inc. was $103,569,030.
Shares of Common Stock held by the Companys controlling shareholder,
who controls approximately 40.3% of the outstanding Common Stock, have been
excluded for purposes of this computation.
Because of such shareholders control, shares owned by other officers,
directors and 5% shareholders have not been excluded from the computation. As
of March 30, 2007, there were 30,992,763 shares of Common Stock Issued and
Outstanding.

|                                                                                                                                                  |  |                                                                            
|------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------------------------
|Documents
  of Which Portions Are Incorporated by Reference                                                                                       |  | Parts
  of the Form 10-K into Which Portion of
  Documents are Incorporated
|                                                                                                                                                  |  |                                                                            
|Proxy
  Statement for Trans World Entertainment Corporations June
  6, 2007 Annual Meeting of Shareholders to be filed on or about
  May 9, 2007 |  | III                                                                        

1

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PART I

Cautionary Statement for Purposes of the Safe Harbor
Provisions of the Private Securities Litigation Reform Act of 1995

This document includes
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. These statements relate to analyses and other
information that are based on forecasts of future results and estimates of
amounts not yet determinable. These statements also relate to the Companys
future prospects, developments and business strategies. The statements
contained in this document that are not statements of historical fact may
include forward-looking statements that involve a number of risks and
uncertainties.

We have used the words
anticipate, believe, could, estimate, expect, intend,
may, plan,
predict, project, and similar terms and phrases, including references to
assumptions, in this document to identify forward-looking statements.  These forward-looking statements are made
based on managements expectations and beliefs concerning future events and are
subject to uncertainties and factors relating to our operations and business
environment, all of which are difficult to predict and many of which are beyond
the Companys control, that could cause actual results to differ materially from
those matters expressed in or implied by these forward-looking statements. The
following factors are among those that may cause actual results to differ
materially from the Companys forward-looking statements.

| |   |                                                                        
| | - | -----------------------------------------------------------------------
| |  | highly competitive nature of the
  retail entertainment business;      
| |   |                                                                        
| |  | competitive pricing;                                                   
| |   |                                                                        
| |  | adverse publicity;                                                     
| |   |                                                                        
| |  | interest rate fluctuations;                                            
| |   |                                                                        
| |  | dependence on key employees;                                           
| |   |                                                                        
| |  | change in laws;                                                        
| |   |                                                                        
| |  | accelerated  declines in music CD industry sales;                      
| |   |                                                                        
| |  | the Companys level of debt and
  related restrictions and limitations;
| |   |                                                                        
| |  | new product introductions (hit
  releases);                          
| |   |                                                                        
| |  | future cash flows;                                                     
| |   |                                                                        
| |  | availability of new real estate;                                       
| |   |                                                                        
| |  | new technology, including digital
  downloading; and                   
| |   |                                                                        
| |  | product liability claims.                                              

The reader should keep in mind that
any forward-looking statement made by us in this document, or elsewhere, speaks
only as of the date on which we make it. New risks and uncertainties come up
from time-to-time, and its impossible for us to predict these events or how
they may affect us. In light of these risks and uncertainties, you should keep
in mind that any forward-looking statements made in this report or elsewhere
might not occur.

In addition, the preparation of
financial statements in accordance with accounting principles generally accepted
in the United States (GAAP) requires us to make estimates and assumptions.
These estimates and assumptions affect:

| |   |                                                                         
| | - | ------------------------------------------------------------------------
| |  | the reported amounts and timing
  of revenue and expenses,              
| |   |                                                                         
| |  | the reported amounts and
  classification of assets and liabilities, and
| |   |                                                                         
| |  | the disclosure of contingent
  assets and liabilities.                  

Actual results may vary from our
estimates and assumptions. These estimates and assumptions are based on
historical results, assumptions that we make, as well as assumptions by
third-parties.

Item 1. BUSINESS

Company Background

Trans World Entertainment
Corporation, which, together with its consolidated subsidiaries, is referred to
herein as the Company, was incorporated in New York in 1972.  It owns 100% of the outstanding common stock
of Record Town, Inc., through which its principal operations are
conducted.  The Company operates retail
stores and five e-commerce sites and is one of the largest specialty retailers
of entertainment software, including music, home video, and video games and
related products in the United States.

In March 2006, the Company acquired
substantially all of the net assets of Musicland Holding Corp.
(Musicland).  Musicland, an
entertainment specialty retailer which operated retail stores and websites
under the names Sam Goody (samgoody.com), Suncoast Motion Picture Company
(suncoast.com), On Cue and MediaPlay.com, filed a voluntary petition to
restructure under Chapter 11 of the United States Bankruptcy Code in January
2006.  The transaction represented total
consideration of $78.8 million in cash and $16.3 million in assumed
liabilities, including certain customer obligations, rent and occupancy
liabilities and employee obligations. Under the terms of the Asset Purchase
Agreement, the Company agreed to acquire 335 of Musiclands 400 remaining
stores, with the remainder of the stores being liquidated under an agency
agreement with Hilco Merchant Resources, LLC.
As of February 3, 2007 the Company operated 210 of the 335 acquired stores.   See Note 3 of Notes to the Consolidated
Financial Statements of this Annual Report on Form 10-K for detail.

2

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In March 2006, the Company acquired
an 80% interest in Mix & Burn LLC, a company that is fully consolidated for
financial reporting. The Company committed funding of $5.2 million, of which
$4.0 million was funded as of February 3, 2007.

Stores and Store Concepts

At February 3, 2007, the Company
operated 992 stores totaling approximately 6.0 million square feet in the
United States, the District of Columbia, the Commonwealth of Puerto Rico and
the U.S. Virgin Islands.

Mall Stores

At February 3, 2007, the Company
operated 737 mall-based stores, predominantly under the f.y.e. (For Your
Entertainment) brand, including:

| |                                                                                                                                                                                                                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Traditional stores. The Traditional store averages about 5,600 square
  feet and carries a full complement of entertainment software, including
  music, home video, video games and related accessories. There were 587
  Traditional f.y.e. stores at the end of Fiscal 2006.                                                           
| |                                                                                                                                                                                                                                                                                                                                           
| | Superstores. The Superstores carry the same merchandise categories as Traditional
  locations, but with a much broader and deeper assortment. This concept is a
  semi-anchor or destination location in major regional malls. There were 13
  f.y.e. mall Superstores at the end of Fiscal 2006 that averaged about 24,000
  square feet.
| |                                                                                                                                                                                                                                                                                                                                           
| | Video only stores.At the end of Fiscal 2006, the Company operated
  137 video only stores, under the Suncoast and Saturday Matinee brands. These
  stores specialize in the sale of home video and related accessories. They are
  located in large, regional shopping malls and average about 2,400 square
  feet.                       

Freestanding Stores

The Company operated 255
freestanding stores, as of February 3, 2007, under the brand names of f.y.e.
(For Your Entertainment), Sam Goody, Coconuts Music and Movies,
Strawberries, Wherehouse Music and Movies, CD World, Specs Music, and Second
Spin.  They carry a full complement of
entertainment software, including music, home video, video games and related
accessories and are located in freestanding, strip center and downtown
locations.   The freestanding stores
average approximately 6,400 square feet (excluding f.y.e. Superstores and
Planet Music).  The Company operates 6
freestanding f.y.e. Superstores that average about 53,000 square feet and a
single 31,400 square foot Planet Music store in Virginia Beach, VA.

The Company is in the process of
re-branding its freestanding stores to f.y.e. (For Your Entertainment).  This initiative is expected to be completed
during Fiscal 2007.

E-Commerce Sites

The Company operates five retail web sites
including, www.fye.com, www.wherehouse.com,
www.secondspin.com, www.samgoody.com and www.suncoast.com.  These sites offer substantially the same
complement of products as offered in the Companys stores.

3

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Merchandise
Categories

Sales by merchandise category as a percentage of total
sales for Fiscal 2006, 2005 and 2004, and comparable store sales for Fiscal
2006 and 2005, were as follows:

|            |  |      |  |               |   |      |  |               |       |      |  |  |  |       |   |  |  |  |      |    |  |  |  |       |   | 
|----------- |  | ---- |  | ------------- | - | ---- |  | ------------- | ----- | ---- |  |  |  | ----- | - |  |  |  | ---- | -- |  |  |  | ----- | - | 
|            |  |      |  |               |   |      |  |               |       |      |  |  |  |       |   | 
|            |  |      |  | Comparable    |   |      |  | Comparable    |       |      | 
|            |  | 2006 |  | Store
  Sales |   | 2005 |  | Store
  Sales |       | 2004 | 
|            |  |      |  |               |   |      |  |               |       |      | 
|Music       |  |      |  | 44.2          | % |      |  |               | (14.0 | )%   |  |  |  | 53.6  | % |  |  |  | (9.2 | )% |  |  |  | 55.0  | % | 
|Home Video  |  |      |  | 37.6          |   |      |  |               | 1.2   |      |  |  |  | 30.0  |   |  |  |  | (3.7 | )  |  |  |  | 29.2  |   | 
|Video games |  |      |  | 7.8           |   |      |  |               | 4.0   |      |  |  |  | 7.3   |   |  |  |  | 2.3  |    |  |  |  | 6.5   |   | 
|Other       |  |      |  | 10.4          |   |      |  |               | 7.9   |      |  |  |  | 9.1   |   |  |  |  | 4.4  |    |  |  |  | 9.3   |   | 
|            |  |      |  |               |   |      |  |               |       |      |  |  |  |       |   |  |  |  |      |    |  |  |  |       |   | 
|Total       |  |      |  | 100.0         | % |      |  |               | (6.2  | )%   |  |  |  | 100.0 | % |  |  |  | (5.7 | )% |  |  |  | 100.0 | % | 
|            |  |      |  |               |   |      |  |               |       |      |  |  |  |       |   |  |  |  |      |    |  |  |  |       |   | 

The Other category includes electronics, accessories
and trend item sales, none of which individually exceeded 5% of total sales.

Business
Environment

Music, home video and video games represent an
approximately $38 billion industry nationwide, and represented approximately
90% of the Companys sales in Fiscal 2006.

According to statistics from Nielsen Soundscan, the
total number of music albums sold, including CD, cassette, LP and digital
albums, was 588.2 million units in 2006, a 4.9% decline from 2005. Excluding
digital albums, total sales were 555.6 million units in 2006, a 7.8% decline
from 2005.

According to statistics obtained from Rentrak Home
Video Essentials, overall home video sales in 2006, including DVD and VHS, were
$15.9 billion, a decrease of 0.9% from 2005. DVD retail sales in 2006 were
$15.7 billion, flat compared to 2005.

The NPD Group published that video games sales in 2006
were $12.5 billion including portable and console hardware, software and
accessories, an increase of 19% over 2005 sales.

Competition

Music sales have suffered from the legal (e.g., iTunes)
and illegal downloading of music and specialty retailers have been impacted by
the proliferation of mass merchants (e.g., Wal-Mart and Target) and electronics
superstores (e.g., Best Buy and Circuit City) that offer entertainment software
and have gained a larger share of the market. The number of specialty and
independent retailers has dramatically decreased due to their reliance on sales
of recorded music. The Company has taken advantage of competitor exits from
markets, made acquisitions, diversified its products and taken other measures
to position itself competitively within its industry. The Company believes it
effectively competes in the following ways:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Location and convenience: a strength of the Company
  is its convenient store locations that are often the exclusive retailer in
  centers offering a full complement of entertainment software;                                                                                                                                                                                                
| |   |                                                                                                                                                                                                                                                                                                                                                                                                 
| |  | Marketing: the Company uses newspaper, radio and
  television advertising and in-store visual displays to market to consumers;                                                                                                                                                                                                                                                                  
| |   |                                                                                                                                                                                                                                                                                                                                                                                                 
| |  | Selection and assortment: the Company differentiates
  itself by maintaining a high in-stock position in a large assortment of
  product, particularly CDs and DVDs;                                                                                                                                                                                                                            
| |   |                                                                                                                                                                                                                                                                                                                                                                                                 
| |  | Customer service: the Company believes it offers
  personalized customer service at its stores;                                                                                                                                                                                                                                                                                                 
| |   |                                                                                                                                                                                                                                                                                                                                                                                                 
| |  | Listening and Viewing Stations (LVS): the
  Companys LVS is a sampling and selection tool designed to encourage customer
  purchases. The third generation of LVS (LVS 3) is currently installed in
  over 700 of the Companys stores. LVS 3 enhances the customers in-store
  experience through improved product information displays and product search
  and suggestion capabilities;
| |   |                                                                                                                                                                                                                                                                                                                                                                                                 
| |  | In-store CD burning and digital downloading: The
  Company has begun offering CD burning and digital downloading stations in
  selected stores and plans on expanding these capabilities to a greater number
  of stores in Fiscal 2007.                                                                                                                                                        

Seasonality

The Companys business is seasonal, with the fourth
fiscal quarter constituting the Companys peak selling period. In Fiscal 2006,
the fourth quarter accounted for approximately 40% of annual sales. In
anticipation of increased sales activity during these months, the Company
purchases additional inventory and hires additional temporary employees to supplement
its full-time store sales staff. If, for any reason, the Companys net sales
were below seasonal norms during the fourth quarter, the Companys operating
results could be adversely affected. Quarterly sales can also be affected by
the timing of new product releases, new store openings or closings and the
performance of existing stores.

4

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Advertising

The Company makes extensive use of visual displays. It
uses a mass-media marketing program, including newspaper, radio, and television
advertisements. The majority of vendors from whom the Company purchases
merchandise offer advertising allowances to promote their merchandise.

Suppliers and Purchasing

The Company purchases inventory from approximately 990
suppliers. In Fiscal 2006, 68% of purchases were made from ten suppliers
including EMI Music Distribution, Sony-Bertelsmann Music Group,
Warner/Electra/Atlantic Corp., Universal Music and Video Distribution, Fox
Video Inc., Paramount Home Video, Buena Vista Home Video, Warner Home
Entertainment, Universal Studios Home Entertainment and Sony Pictures Home
Entertainment. The Company does not have material long-term purchase contracts;
rather, it purchases products from its suppliers on an order-by-order basis.
Historically, the Company has not experienced difficulty in obtaining
satisfactory sources of supply and management believes that it will continue to
have access to adequate sources of supply.

Trade
Customs and Practices

Under current trade practices with large suppliers,
retailers of music and home video products are generally entitled to return
unsold merchandise they have purchased in exchange for other titles carried by
the suppliers. Two of the four largest music suppliers charge a related
merchandise return penalty and the remaining two largest suppliers charge a
combination of return penalties and return handling fees. Most manufacturers
and distributors of home video products do not typically charge a return
penalty or handling fee. Under current trade practices with large suppliers,
retailers of video games and related products are generally entitled to
markdown support from suppliers to help clear slow turning merchandise.
Merchandise return policies and other trade practices have not changed
significantly in recent years. The Company generally adapts its purchasing
policies to changes in the policies of its largest suppliers.

Employees

As of February 3, 2007, the Company employed
approximately 9,600 people, of whom approximately 4,400 were employed on a
full-time basis. All others were employed on a part-time or temporary basis.
The Company hires seasonal sales employees during its fourth quarter peak
selling season to ensure continued levels of customer service. Store managers,
district managers and regional managers are eligible to receive incentive
compensation based on the sales and profitability of stores for which they are
responsible. Sales support managers are generally eligible to receive incentive
compensation based on the sales and profitability of the Company as a whole.
None of the Companys employees are covered by collective bargaining agreements
and management believes that the Company enjoys favorable relations with its
employees.

Information Systems

The Company continually assesses its information
system needs to increase efficiency, improve decision-making and support
growth. It utilizes primarily IBM AS400 technology to run its management
information systems, including its merchandising, distribution and financial
systems. Management believes its systems contribute to enhanced customer
service and operational efficiency, as well as provide the ability to monitor
critical performance indicators versus plans and historical results.

Available
Information

The Companys headquarters are located at 38 Corporate
Circle, Albany, New York 12203, and its telephone number is (518) 452-1242. The
Companys corporate web site address is www.twec.com. The Company makes
available, free of charge, its Exchange Act Reports (Forms 10-K, 10-Q, 8-K and
any amendments thereto) on its web site as soon as practical after the reports
are filed with the Securities and Exchange Commission (SEC). The public may
read and copy any materials the Company files with the SEC at the SECs Public
Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Information
on the operation of the Public Reference Room can be obtained by calling the
SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains
reports, proxy and information statements, and other information regarding
issuers that file electronically with the SEC. This information can be obtained
from the site http://www.sec.gov. The Companys Common Stock, $0.01 par value,
is quoted on the NASDAQ National Market under the trading symbol TWMC. The
Companys fiscal year end is the Saturday closest to January 31. The fiscal
2006 (2006) year ended on February 3, 2007; fiscal 2005 (2005) year ended
on January 28, 2006; and fiscal 2004 (2004) year ended on January 29, 2005.

5

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Item 1A. RISK FACTORS

The following is a discussion of certain factors,
which could affect the financial results of the Company.

The Companys results of operations are affected by the
availability of new products.

The Companys business is affected by the release of
hit music, home video and video game titles, which can create fluctuations in
sales. It is not possible to determine the timing of these fluctuations or the
future availability of hit titles. The Company is dependent upon the major
music and movie producers to continue to produce hit products. To the extent
that new hit releases are not available, or not available at prices attractive
to consumers, or, if manufacturers fail to introduce or delay the introduction
of new products, the Companys results of operations may be adversely affected.

The Companys results of operations may suffer if the Company
does not accurately predict consumer acceptance of new product or distribution
technologies.

The entertainment industry is characterized by
changing technology, evolving format standards, frequent new and enhanced
product introductions and rapid product obsolescence. These characteristics
require that the Company respond quickly to technological changes and
understand the impact of these changes on customers preferences. If the
Company is unable to participate in new product or distribution technologies,
its results of operations may suffer.

Increased competition from existing retailers and alternative
distribution channels may adversely affect the Companys results of operations.

The Company competes with a wide variety of
entertainment retailers, including regional music chains, deep-discount
retailers, mass merchandisers, consumer electronics outlets, internet
retailers, record clubs and independent operators, some of which have greater
financial and other resources than the Company. The Company also expects
continued growth in competing home entertainment options. Some of these,
including the ability to download music, video and video games onto PCs or
other devices, or the ability to play video games over the Internet through
consoles, could reduce retail sales of CDs, DVDs and video games. If
technological advances were to result in significant changes in existing
distribution channels for pre-recorded music, home video and video games, the
Companys results of operations could be adversely affected.

A decline in general economic condition, including declines
in current levels of consumer spending could adversely affect results of
operations.

The Companys results of operations are affected by the
level of consumer spending, which reflects the general state of local economies
in which the Company operates. Changes in consumer preference or discretionary
consumer spending could harm our business.

The Companys operating results fluctuate from period to
period.

As is the case with many retailers, a significant
portion of the Companys sales, and an even greater portion of the Companys
earnings, are generated in the fourth fiscal quarter, which includes the
holiday selling season. Less than satisfactory sales for such period could have
an adverse effect on the Companys results of operations.

Growth Strategy  the failure to grow the Companys business
may limit its earnings.

Historically, the Companys growth has come from the
opening of new stores and the acquisition of stores. The Company opens new
stores if it finds desirable locations and is able to negotiate suitable lease
terms. A lack of new store growth may impact the Companys ability to increase
sales and earnings.

A change in one or more of the Companys vendors policies or
the Companys relationship with those vendors could adversely affect the
Companys results of operations.

The majority of the Companys purchases come from ten
major suppliers. As is standard in its industry, the Company does not maintain
long-term contracts with its suppliers but instead makes purchases on an
order-by-order basis. If the Company fails to maintain customary trade terms or
enjoy positive vendor relations, it could have an adverse effect on the
Companys results of operations.

If the Companys vendors fail to provide marketing and
merchandising support at historical levels, the Companys results of operations
could be adversely affected.

The manufacturers of entertainment products have
typically provided retailers with significant marketing and merchandising
support for their products. As part of this support, the Company receives
cooperative advertising and market development allowances from these vendors.
These allowances enable the Company to actively promote and merchandise the
products it sells at its stores and on its websites. If the Companys vendors
fail to provide this support at historical levels, the Companys results of
operations could be negatively impacted.

6

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Loss of Key Personnel could adversely affect the Companys
results of operations.The Company believes that its future prospects depend
to a significant extent on the services of its executive officers, as well as
its ability to attract and retain qualified key personnel. The loss of the
services of certain of the Companys executive officers and other key
management personnel could adversely affect the Companys results of
operations.

Control by and Dependence on Key Personnel -Robert
J. Higgins has a significant influence on the outcome of any vote of the
Companys Shareholders and if the Company were to lose his services, it may not
be able to replace his skills and experience. Robert J. Higgins serves as
Chairman of the Board of the Company and its Chief Executive Officer and owns
approximately 40.3% of the outstanding common stock of the Company, as of
February 3, 2007. Further, if the Company were to lose Mr. Higgins services,
it may not be able to replace his skills and experience, and this could have an
adverse effect on the Companys financial results.

If, in the future, the Company concludes that its internal
controls over financial reporting are not adequate, or if the Companys
auditors conclude that the Companys evaluation of internal controls over
financial reporting is not adequate, investors could lose confidence in the
reliability of the Companys financial statements, which could result in a
decrease in the value of the Companys common stock. The effectiveness of the
Companys disclosure and internal controls may be limited.
As directed by Section 404 of the Sarbanes-Oxley Act
of 2002, the Securities and Exchange Commission adopted rules requiring public
companies to include a report of management on the companys internal control
over financial reporting in their annual reports on Form 10-K. There is a risk
that in the future, the Company may identify internal control deficiencies that
suggest that the Companys controls are no longer effective. This could result
in an adverse reaction in the financial markets due to a loss of confidence in
the reliability of the Companys financial statements, which could cause a
decline in the market price of the Companys common stock.

Disclosure controls and procedures and internal
controls over financial reporting may not prevent all errors and intentional
misrepresentations. In the event that there are errors or misrepresentations in
the Companys historical financial statements or the SEC disagrees with the
Companys accounting, the Company may need to restate its financial statements.
There is no guarantee that existing controls will prevent or detect all
material issues or be effective in future conditions, which could materially
and adversely impact the Companys financial results in the future.

Anti-takeover provisions  New York anti-takeover law
provisions and the classified Board Amendment, may discourage unsolicited
takeovers.In August 2000, the Companys Board of Directors
adopted a Classified Board Amendment which together with anti-takeover
provisions eschewed by New York State Law may discourage open market purchases
or a non-negotiated tender or exchange offer for the stock of the Company. This
may be adverse to the interests of certain shareholders.

Item 1B. UNRESOLVED SEC COMMENTS

The Company has not received within 180 days or more before February 3,
2007, written comments from the Securities and Exchange Commission regarding
its periodic or current reports under the Securities Exchange Act of 1934, as
amended, that remain unresolved.

7

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Item 2. PROPERTIES

Retail Stores

At February 3,
2007, the Company operated 991 stores under operating leases, many of which
have renewal options. Substantially all of the leases provide for the payment
of fixed monthly rentals and expenses for maintenance, property taxes and
insurance. Many leases provide for added rent based on store sales in excess of
specified levels. The following table lists the leases due to expire as of the
fiscal year-end in each of the years shown, assuming any renewal options are
not exercised:

|     |  |               |  |      |                 |               |    |  | 
|---- |  | ------------- |  | ---- | --------------- | ------------- | -- |  | 
|Year |  | No.
of
Leases |  | Year |                 | No.
of
Leases |   
|     |  |               |  |      |                 |               |   
|2007 |  | 395           |  |      | 2011            |               | 54 |  | 
|     |  |               |  |      |                 |               |    |  | 
|2008 |  | 173           |  |      | 2012            |               | 40 |  | 
|     |  |               |  |      |                 |               |    |  | 
|2009 |  | 141           |  |      | 2013            |               | 19 |  | 
|     |  |               |  |      |                 |               |    |  | 
|2010 |  | 87            |  |      | 2014 and beyond |               | 82 |  | 

As leases
expire, the Company will evaluate the decision to exercise renewal rights or
obtain new leases for the same or similar locations based on store
profitability. The Company owns one store.

Corporate Offices and Distribution Center
Facilities

The Company
leases its Albany, New York, distribution facility and corporate office space
from its largest shareholder and Chairman and Chief Executive Officer under
three capital lease arrangements that extend through 2015. These leases are at
fixed rentals with provisions for biennial increases based on increases in the
Consumer Price Index. The Company incurs all property taxes, insurance and
maintenance costs. The office portion of the facility is approximately 39,800
square feet and the distribution center portion is approximately 141,500 square
feet. The Company owns a 236,600 square foot distribution center with 59,200
square feet of adjacent office space in North Canton, Ohio. The Company also
leases a 198,300 square foot distribution center in Carson, California; this
lease includes two five-year renewal options and expires in December 2015.

The Company
believes that its existing distribution facilities are adequate to meet the
Companys planned business needs. Shipments from the distribution facilities to
the Companys stores are made at least once a week and currently provide
approximately 70% of all merchandise shipment requirements to stores. The
balance of the stores requirements is satisfied through direct shipments from
vendors. Company operated trucks service approximately 55 of its stores. The
remaining stores are serviced by common carriers chosen on the basis of
geography and rate considerations.

The Company
leases an 82,560 square foot facility in Johnstown, New York, where it
manufactures many of its store fixtures. The operating lease expires in
December 2007. The Company believes that its costs of production are equal to
or lower than purchasing the fixtures from outside suppliers.

The Company
leases an additional 31,700 square feet of office space in Albany, New York.
The operating lease expires in June 2014 and includes two, five-year options to
renew.

8

---



Item
3. LEGAL PROCEEDINGS

The Company is subject to various legal proceedings and claims that
have arisen in the ordinary course of its business and have not been finally
adjudicated. Although there can be no assurance as to the ultimate disposition
of these matters, it is managements opinion, based upon the information
available at this time, that the expected outcome of these matters,
individually or in the aggregate, will not have a material adverse effect on
the results of operations and financial condition of the Company.

Item
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters
were submitted to a vote of security holders during the fourth quarter of the
fiscal year ended February 3, 2007.

9

---



PART II

Item 5. MARKET FOR THE REGISTRANTS COMMON
EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information.
The Companys Common Stock trades on the NASDAQ Stock Market under the symbol
TWMC. As of March 30, 2007, there were 486 shareholders of record. The
following table sets forth high and low last reported sale prices for each
fiscal quarter during the period from January 30, 2005 through March 30, 2007.

|                                       |  |                      |       |     |   |       | 
|-------------------------------------- |  | -------------------- | ----- | --- | - | ----- | 
|                                       |  | Closing Sales Prices |      
|                                       |  |                      |      
|                                       |  | High                 |       | Low |  
|2005                                   |  |                      |       |     |   |       | 
|1st
  Quarter                          |  | $                    | 15.39 |     | $ | 12.55 | 
|2nd
  Quarter                          |  | $                    | 14.91 |     | $ | 10.39 | 
|3rd
  Quarter                          |  | $                    | 10.74 |     | $ | 6.39  | 
|4th
  Quarter                          |  | $                    | 6.95  |     | $ | 4.74  | 
|                                       |  |                      |       |     |   |       | 
|2006                                   |  |                      |       |     |   |       | 
|1st
  Quarter                          |  | $                    | 6.17  |     | $ | 5.06  | 
|2nd
  Quarter                          |  | $                    | 7.35  |     | $ | 5.03  | 
|3rd
  Quarter                          |  | $                    | 6.50  |     | $ | 5.50  | 
|4th
  Quarter                          |  | $                    | 6.88  |     | $ | 5.45  | 
|                                       |  |                      |       |     |   |       | 
|2007                                   |  |                      |       |     |   |       | 
|1st
  Quarter (through March 30, 2007) |  | $                    | 5.82  |     | $ | 5.20  | 

On March 30,
2007, the last reported sale price on the Common Stock on the NASDAQ National
Market was $5.68

On May 28,
2003, the Companys Board of Directors authorized the repurchase of 10 million
outstanding shares of the Companys Common Stock from time to time on the open
market. The Company had repurchased 15 million shares of common stock under
previously announced programs. As of January 28, 2006, the Company had
purchased all the 10 million shares outstanding under the stock repurchase
program, at a total cost of $88.5 million. There are currently no share
repurchase programs outstanding.

Dividend Policy: The
Company has never declared dividends on its Common Stock and does not plan to
pay cash dividends on its Common Stock in the foreseeable future. The Companys
credit agreement does not restrict the payment of cash dividends so long as
payment conditions per the agreement are met. Any future determination as to
the payment of dividends will depend upon capital requirements, limitations
imposed by the Companys credit agreement and other factors the Companys Board
of Directors may consider.

10

---



Five-Year Performance Graph:

The following line graph
reflects a comparison of the cumulative total return of the Companys Common
Stock from January 31, 2002 through January 31, 2007 with the Nasdaq Index
(U.S. Stocks) and with the Nasdaq National Market Retail Trade Stocks index.
Because none of the Companys leading competitors has been an independent
publicly traded company over the period, the Company has elected to compare
shareholder returns with the published index of retail companies compiled by
NASDAQ. All values assume a $100 investment on January 31, 2002, and that all
dividends were reinvested.

(LINE GRAPH)

|                                      |      |  |      |  |      |  |      |  |      |  |     
|------------------------------------- | ---- |  | ---- |  | ---- |  | ---- |  | ---- |  | ----
|                                      | 2002 |  | 2003 |  | 2004 |  | 2005 |  | 2006 |  | 2007
|                                      |      |  |      |  |      |  |      |  |      |  |     
|Trans World Entertainment Corporation | 100  |  | 40   |  | 94   |  | 157  |  | 66   |  | 70  
|NASDAQ (U.S. Stocks)                  | 100  |  | 69   |  | 107  |  | 107  |  | 121  |  | 130 
|NASDAQ Retail Trade Stocks            | 100  |  | 80   |  | 118  |  | 143  |  | 153  |  | 166 

11

---



Item 6.
SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth selected Statement of
Operations and Balance Sheet data for the five fiscal years ended February 3,
2007 from the Companys audited Consolidated Financial Statements. The fiscal
year ended February 3, 2007 consisted of 53 weeks while all the other fiscal
years of the Company presented consisted of 52 weeks. The information should be
read in conjunction with the Companys audited Consolidated Financial
Statements and related notes and other financial information included herein,
including Item 7, Managements Discussion and Analysis of Financial Condition
and Results of Operations.

|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------- | --------- | -------------------- | - | -------------------- | - | -------------------- | --------- | -------------------- | - | --------- | - | - | --------- | -
|                                                                                                                                                                       |  | Fiscal
  Year Ended                               |          
|                                                                                                                                                                       |  |                                                   |          
|                                                                                                                                                                       |  | February
  3,
  2007                              |           | January
  28,
  2006 |   | January
  29,
  2005 |   | January
  31,
  2004 |           | February
  1,
  2003 |  
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |  
|STATEMENT OF OPERATIONS DATA:                                                                                                                                          |  | ($ in thousands, except per share and store data) |          
|                                                                                                                                                                       |  |                                                   |          
|Sales                                                                                                                                                                  |  | $                                                 | 1,471,157 |                      | $ | 1,238,486            |   | $                    | 1,365,133 |                      | $ | 1,330,626 |   | $ | 1,281,869 |  
|Cost of sales                                                                                                                                                          |  |                                                   | 951,935   |                      |   | 806,873              |   |                      | 869,999   |                      |   | 842,726   |   |   | 815,071   |  
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Gross profit                                                                                                                                                           |  |                                                   | 519,222   |                      |   | 431,613              |   |                      | 495,134   |                      |   | 487,900   |   |   | 466,798   |  
|Selling, general and administrative expenses                                                                                                                           |  |                                                   | 519,246   |                      |   | 426,854              |   |                      | 450,162   |                      |   | 459,441   |   |   | 465,893   |  
|Goodwill impairment charge (1)                                                                                                                                         |  |                                                   |          |                      |   |                     |   |                      |          |                      |   |          |   |   | 40,914    |  
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|(Loss) income from operations                                                                                                                                          |  |                                                   | (24       | )                    |   | 4,759                |   |                      | 44,972    |                      |   | 28,459    |   |   | (40,009   | )
|Interest expense                                                                                                                                                       |  |                                                   | 5,504     |                      |   | 2,954                |   |                      | 2,444     |                      |   | 2,147     |   |   | 2,349     |  
|Other income                                                                                                                                                           |  |                                                   | (4,435    | )                    |   | (2,171               | ) |                      | (1,039    | )                    |   | (718      | ) |   | (1,231    | )
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|(Loss) income before income taxes, extraordinary gain 
unallocated
  negative goodwill and cumulative effect of a change in accounting principle                      |  |                                                   | (1,093    | )                    |   | 3,976                |   |                      | 43,567    |                      |   | 27,030    |   |   | (41,127   | )
|Income tax (benefit) expense                                                                                                                                           |  |                                                   | (2,041    | )                    |   | 1,090                |   |                      | 4,892     |                      |   | 8,302     |   |   | (9,341    | )
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Income (loss) before extraordinary gain  unallocated negative
  goodwill and cumulative effect of change in accounting principle                                      |  |                                                   | 948       |                      |   | 2,886                |   |                      | 38,675    |                      |   | 18,728    |   |   | (31,786   | )
|Extraordinary gain  unallocated negative goodwill, net of
income
  taxes (2),(6)                                                                                      |  |                                                   | 10,721    |                      |   |                     |   |                      | 3,166     |                      |   | 4,339     |   |   |          |  
|Cumulative effect of a change in accounting principle,  net of
income taxes (3)(4)                                                                                     |  |                                                   |          |                      |   | (2,277               | ) |                      |          |                      |   |          |   |   | (13,684   | )
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Net income (loss)                                                                                                                                                      |  | $                                                 | 11,669    |                      | $ | 609                  |   | $                    | 41,841    |                      | $ | 23,067    |   | $ | (45,470   | )
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Basic earnings (loss) per share:                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Earnings (loss) per share before extraordinary gain 
unallocated
  negative goodwill and cumulative effect of change in accounting principle                          |  | $                                                 | 0.03      |                      | $ | 0.09                 |   | $                    | 1.12      |                      | $ | 0.50      |   | $ | (0.79     | )
|Extraordinary gain  unallocated negative goodwill                                                                                                                     |  |                                                   | 0.35      |                      |   |                     |   |                      | 0.09      |                      |   | 0.12      |   |   |          |  
|Cumulative effect of change in accounting principle                                                                                                                    |  |                                                   |          |                      |   | (0.07                | ) |                      |          |                      |   |          |   |   | (0.34     | )
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Basic earnings (loss) per share                                                                                                                                        |  | $                                                 | 0.38      |                      | $ | 0.02                 |   | $                    | 1.21      |                      | $ | 0.62      |   | $ | (1.13     | )
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Weighted average number of shares outstanding - basic                                                                                                                  |  |                                                   | 30,797    |                      |   | 31,962               |   |                      | 34,531    |                      |   | 37,422    |   |   | 40,224    |  
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Diluted earnings (loss) per share:                                                                                                                                     |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Earnings (loss) per share before extraordinary gain 
unallocated
  negative goodwill and cumulative effect of change in accounting principle                          |  | $                                                 | 0.03      |                      | $ | 0.09                 |   | $                    | 1.06      |                      | $ | 0.49      |   | $ | (0.79     | )
|Extraordinary gain  unallocated negative goodwill                                                                                                                     |  |                                                   | 0.33      |                      |   |                     |   |                      | 0.09      |                      |   | 0.11      |   |   |          |  
|Cumulative effect of change in accounting principle                                                                                                                    |  |                                                   |          |                      |   | (0.07                | ) |                      |          |                      |   |          |   |   | (0.34     | )
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Diluted earnings (loss) per share                                                                                                                                      |  | $                                                 | 0.36      |                      | $ | 0.02                 |   | $                    | 1.15      |                      | $ | 0.60      |   | $ | (1.13     | )
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Weighted average number of shares outstanding 
diluted                                                                                                                |  |                                                   | 31,986    |                      |   | 32,124               |   |                      | 36,297    |                      |   | 38,209    |   |   | 40,224    |  
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|                                                                                                                                                                       |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Proforma amounts assuming new accounting principles were applied
  retroactively:                                                                                      |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Income (loss) before extraordinary gain  unallocated
negative
  goodwill and  cumulative effect of a
  change in accounting principle, as reported                    |  | $                                                 | 948       |                      | $ | 2,886                |   | $                    | 38,675    |                      | $ | 18,728    |   | $ | (31,786   | )
|Proforma income (loss) before extraordinary gain 
unallocated
  negative goodwill and  cumulative effect of a change
  in accounting principle                        |  |                                                   | 948       |                      |   | 2,922                |   |                      | 38,946    |                      |   | 18,533    |   |   | (32,115   | )
|Pro forma net income                                                                                                                                                   |  |                                                   | 11,669    |                      |   | 2,922                |   |                      | 42,122    |                      |   | 22,872    |   |   | (45,799   | )
|Per share amounts:                                                                                                                                                     |  |                                                   |           |                      |   |                      |   |                      |           |                      |   |           |   |   |           |  
|Basic earnings (loss) per share before extraordinary gain 
  unallocated negative  goodwill and
  cumulative effect of a change in accounting principle, as reported  |  | $                                                 | 0.03      |                      | $ | 0.09                 |   | $                    | 1.12      |                      | $ | 0.50      |   | $ | (0.79     | )
|Proforma basic earnings (loss) per share before extraordinary
gain 
  unallocated negative goodwill and cumulative effect of a change in accounting
  principle       |  | $                                                 | 0.03      |                      | $ | 0.09                 |   | $                    | 1.13      |                      | $ | 0.50      |   | $ | (0.80     | )
|Pro forma basic earnings per share                                                                                                                                     |  | $                                                 | 0.38      |                      | $ | 0.09                 |   | $                    | 1.22      |                      | $ | 0.61      |   | $ | (1.14     | )
|Diluted earnings (loss) per share before extraordinary gain

  unallocated negative goodwill and cumulative effect of a change in accounting
  principle, as reported |  | $                                                 | 0.03      |                      | $ | 0.09                 |   | $                    | 1.06      |                      | $ | 0.49      |   | $ | (0.79     | )
|Proforma diluted earnings (loss) per share before extraordinary
gain 
  unallocated negative goodwill and cumulative effect of a change in accounting
  principle     |  | $                                                 | 0.03      |                      | $ | 0.09                 |   | $                    | 1.07      |                      | $ | 0.49      |   | $ | (0.80     | )
|Pro forma diluted earnings per share                                                                                                                                   |  | $                                                 | 0.36      |                      | $ | 0.09                 |   | $                    | 1.16      |                      | $ | 0.60      |   | $ | (1.14     | )

12

---



|                                                                  |  |                                                   |         |                      |   |                      |    |                      |         |                      |   |         |   |   |         |   
|----------------------------------------------------------------- |  | ------------------------------------------------- | ------- | -------------------- | - | -------------------- | -- | -------------------- | ------- | -------------------- | - | ------- | - | - | ------- | --
|                                                                  |  | Fiscal
  Year Ended                               |        
|                                                                  |  |                                                   |        
|                                                                  |  | February
  3,
  2007                              |         | January
  28,
  2006 |   | January
  29,
  2005 |    | January
  31,
  2004 |         | February
  1,
  2003 |  
|                                                                  |  |                                                   |         |                      |   |                      |    |                      |         |                      |  
|                                                                  |  | ($ in thousands, except per share and store data) |        
|                                                                  |  |                                                   |        
|BALANCE SHEET DATA (at the end of the period):                    |  |                                                   |        
|                                                                 
|Total assets                                                      |  | $                                                 | 829,690 |                      | $ | 799,657              |    | $                    | 859,653 |                      | $ | 817,758 |   | $ | 803,396 |   
|Current portion
  of long-term debt and capital lease obligations |  |                                                   | 3,393   |                      |   | 3,659                |    |                      | 780     |                      |   | 395     |   |   | 1,640   |   
|Long-term
  obligations                                           |  |                                                   | 16,085  |                      |   | 19,474               |    |                      | 12,037  |                      |   | 7,465   |   |   | 7,860   |   
|Shareholders
  equity                                            |  | $                                                 | 393,205 |                      | $ | 378,512              |    | $                    | 404,323 |                      | $ | 399,184 |   | $ | 392,104 |   
|                                                                  |  |                                                   |         |                      |   |                      |    |                      |         |                      |   |         |   |   |         |   
|OPERATING DATA:                                                   |  |                                                   |         |                      |   |                      |    |                      |         |                      |   |         |   |   |         |   
|Store count
  (open at end of period):                            |  |                                                   |         |                      |   |                      |    |                      |         |                      |   |         |   |   |         |   
|Mall stores                                                       |  |                                                   | 737     |                      |   | 546                  |    |                      | 560     |                      |   | 595     |   |   | 650     |   
|Freestanding
  stores                                             |  |                                                   | 255     |                      |   | 236                  |    |                      | 250     |                      |   | 286     |   |   | 205     |   
|Total stores                                                      |  |                                                   | 992     |                      |   | 782                  |    |                      | 810     |                      |   | 881     |   |   | 855     |   
|                                                                  |  |                                                   |         |                      |   |                      |    |                      |         |                      |   |         |   |   |         |   
|Comparable store
  sales (decrease) / increase(5)                 |  |                                                   | (6.2    | %)                   |   | (5.7                 | %) |                      | 0.8     | %                    |   | 1.3     | % |   | (5.0    | %)
|                                                                  |  |                                                   |         |                      |   |                      |    |                      |         |                      |   |         |   |   |         |   
|Total square
  footage (in thousands)                             |  |                                                   | 5,950   |                      |   | 4,824                |    |                      | 5,002   |                      |   | 5,484   |   |   | 4,944   |   

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|1. | The Company recorded a non-cash goodwill impairment charge
  in fiscal 2002 related to SFAS No. 142, Goodwill and Other Intangible
  Assets.                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|2. | The Companys acquisition of substantially all of net
  assets of Wherehouse Entertainment Inc. and CD World Inc. stores in fiscal
  2003 resulted in extraordinary gains recorded in 2003 and 2004 in accordance
  with SFAS No. 141, Business Combinations. The gains represent the excess
  of fair value of net assets acquired over the purchase price of the acquired
  assets.                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|3. | The Company adopted Financial Accounting Standards Boards
  (FASBs) Emerging Issues Task Force (EITF) Statement No. 02-16,
  Accounting by a Customer (Including a Reseller) for Certain Consideration
  Received from a Vendor, effective as of the beginning of 2002, resulting in
  a one-time, non-cash, after-tax charge of $13.7 million, which was classified
  as a cumulative effect of a change in accounting principle in 2002.                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|4. | The Company adopted FASB Interpretation No. (FIN) 47,
  Accounting for Conditional Asset Retirement Obligationsan interpretation of
  FASB Statement No. 143, effective January 28, 2006 resulting in a one-time,
  non-cash, after tax charge of $2.3 million, which was classified as a
  cumulative effect of a change in accounting principle in 2005. For
  additional discussion regarding the cumulative effect of the change in
  accounting principle, refer to Note 2 in Notes to the Consolidated Financial
  Statements in this Annual Report on Form 10-K.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|5. | A store is included in comparable store sales calculations
  at the beginning of its thirteenth full month of operation. Mall stores
  relocated in the same shopping center after being open for at least thirteen
  months are considered comparable stores. Closed stores that were open for at
  least thirteen months are included in comparable store sales through the
  month immediately preceding the month of closing.                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|6. | The Companys acquisition of substantially all of
the net assets of Musicland Holding Corp. stores in fiscal 2006 resulted in
an extraordinary gain recorded in 2006 in accordance with SFAS No. 141,
Business Combinations. The gain represents the excess of fair value of net
assets acquired over the purchase price of the acquired assets. For
additional discussion regarding the extraordinary gain, refer to Note 3 in
Notes to the Consolidated Financial Statements in this Annual Report on Form
10-K.                                                          

13

---



Item 7. MANAGEMENTS DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Managements
Discussion and Analysis of Financial Condition and Results of Operations
provides information that the Companys management believes necessary to
achieve an understanding of its financial condition and results of operations.
To the extent that such analysis contains statements which are not of a
historical nature, such statements are forward-looking statements, which
involve risks and uncertainties. These risks include, but are not limited to,
changes in the competitive environment for the Companys merchandise, including
the entry or exit of non-traditional retailers of the Companys merchandise to
or from its markets; releases by the music, home video, and video game
industries of an increased or decreased number of hit releases; general
economic factors in markets where the Companys merchandise is sold; and other
factors discussed in the Companys filings with the Securities and Exchange Commission.
The following discussion and analysis of the Companys financial condition and
results of operations should be read in conjunction with Selected Consolidated
Financial Data and the Consolidated Financial Statements and related notes
included elsewhere in this report.

In
March, 2006, the Company acquired substantially all of the net assets of
Musicland Holding Corp. (Musicland). Musicland, an entertainment specialty
retailer, operated retail stores and websites under the names Sam Goody (samgoody.com),
Suncoast Motion Picture Company (suncoast.com), On Cue and MediaPlay.com, and
filed a voluntary petition to restructure under Chapter 11 of the United States
Bankruptcy Code in January 2006. See Note 3 of Notes to the Consolidated
Financial Statements in this Annual Report on Form 10-K for further detail.

In March 2006,
the Company acquired an 80% interest in Mix & Burn LLC, a company that is
fully consolidated for financial reporting. The Company has committed funding
of $5.2 million, of which $4.0 million was funded as of February 3, 2007.

At February 3,
2007, the Company operated 992 stores totaling approximately 6.0 million square
feet in the United States, the District of Columbia, the Commonwealth of Puerto
Rico and the U.S. Virgin Islands. In the fiscal year ended February 3, 2007
(referred to herein as 2006), the Companys sales increased as compared to
the fiscal year ended January 28, 2006, (referred to herein as 2005) as a
result of increased store count related to the Musicland acquisition, partially
offset by a decrease in comparable store sales. Income before extraordinary
items decreased in 2006 as greater overall sales and gross margin were not able
to offset increased SG&A expenses associated with the higher average store
count and integration costs associated with the Musicland acquisition.
Comparable store sales decreased 6.2% during Fiscal 2006 as double digit
comparable store sale declines in music were partially offset by positive
comparable store sales in home video, video games and accessories and related
products.

The Company
focuses on the following areas in its effort to improve its business:

Developing
its Brands  f.y.e. brand

The Company is
creating a recognized national brand under the name f.y.e. (For Your
Entertainment). The f.y.e. brand initiative is aimed at broadening the
Companys customer base by creating a more relevant entertainment shopping
experience and differentiating f.y.e. from its competition. It is centered on
an engaging and personalized approach in marketing and merchandising, an
interactive in-store and on-line entertainment experience and a
best-in-retail-class customer service level  all designed to draw customers
into stores and enhance long-term customer loyalty. As of February 3, 2007, the
Company had over 650 f.y.e. stores and is in the process of re-branding the
remaining of its freestanding stores to f.y.e. during 2007. The video only
Suncoast brand will be retained. There were 118 Suncoast stores at February 3,
2007. During 2005, the Company introduced its customer loyalty program, f.y.e.
Backstage Pass, which is designed to drive repeat business.

Improving
Merchandise Assortment and Product Mix

The Company
tailors the product mix of its stores toward regional tastes in order to
optimize the productivity of its stores, seeking to serve key customer segments
within each store. This involves tailoring the overall square footage
allocation in line with a stores trend, and increasing inventory and square
footage allocations for growth categories. As music sales have continued to
decline on an industry wide basis, the Company has been able to offset the
impact by shifting square footage allocations from music to home video, video
game, and other product categories. In addition, the acquisition of the video
only Suncoast stores in March 2006 has helped diversify the product mix and
lower music as a percentage of the total business. This is evident as music has
decreased to 44.2% of total sales in Fiscal 2006 compared to 53.6% in Fiscal
2005.

The
acquisition of Mix and Burn in 2006 will allow the Company to offer customers
CD burning and digital downloading stations in selected stores during 2007.

14

---



Store
Openings

The Company
has historically grown its sales by opening new stores and by acquiring
specialty retailers in its business. During 2006, the Company acquired 335
stores and closed 189 stores, including 125 of the acquired stores, opened 64
stores and repositioned 15 stores. In 2007, the Company will open very few new
stores.

Historically,
about 10% of the Companys stores are evaluated at any time for closure. The
composition of these stores changes from time-to-time as the result of
competitive changes and other factors. The Company closes stores when minimum
operating thresholds are not achieved. In 2006, the Company experienced a
significant net store increase, as acquired stores and new store openings
outpaced store closings.

Key
Performance Indicators

Management
monitors a number of key performance indicators to evaluate its performance,
including:

Sales:The Company
measures the rate of comparable store sales change. A store is included in
comparable store sales calculations at the beginning of its thirteenth full
month of operation. Mall stores relocated in the same shopping center after
being open for at least thirteen months are considered comparable stores.
Closed stores that were open for at least thirteen months are included in
comparable store sales through the month immediately preceding the month of
closing. The Company further analyzes sales by store format and by product
category.

Cost of Sales and Gross Profit:
Gross profit is a function of the cost of product in relation to its retail
selling value. Changes in gross profit are impacted primarily by sales levels,
mix of products sold, vendor discounts and allowances and distribution costs.
The Company records its distribution and product shrink expenses in cost of
sales. Distribution expenses include those costs associated with purchasing, receiving,
inspecting and warehousing merchandise and costs associated with product
returns to vendors. Cost of sales also includes obsolescence costs and is
reduced by the benefit of vendor allowances.

Selling, General and Administrative
(SG&A) expenses: Included in SG&A expenses
are payroll and related costs, occupancy charges, professional and service
fees, general operating and overhead expenses and depreciation charges
(excluding those related to distribution operations, as discussed in Note 4 of
Notes to the Consolidated Financial Statements in this Annual Report on Form
10-K). SG&A expenses also include asset impairment charges and write-offs,
if any, and miscellaneous items, other than interest.

Balance Sheet and Ratios:The
Company views cash, net inventory investment (merchandise inventory less
accounts payable) and working capital (current assets less current liabilities)
as indicators of its financial position. See Liquidity and Capital Resources
for further discussion of these items.

15

---



Fiscal Year Ended February 3, 2007 (2006)
Compared to Fiscal Year Ended January 28, 2006 (2005)

Sales. The following
table sets forth a year-over-year comparison of the Companys total sales:

|                 |  |      |           |      |   |           |  |                 |         |  |  |      |  
|---------------- |  | ---- | --------- | ---- | - | --------- |  | --------------- | ------- |  |  | ---- | -
|                 |  |      |           |      |   |           |  | 2006 vs.
  2005 |        
|                 |  |      |           |      |   |           |  |                 |        
|($ in thousands) |  | 2006 |           | 2005 |   | $         |  | %               |        
|                 |  |      |           |      |   |           |  |                 |        
|Sales            |  | $    | 1,471,157 |      | $ | 1,238,486 |  | $               | 232,671 |  |  | 18.8 | %

Sales
increased in 2006 due to an increase in the average store count. Due to the
Musicland acquisition, average store count increased from 801 in Fiscal 2005 to
1,044 in Fiscal 2006. Additionally, the 53rd week in Fiscal 2006
contributed approximately $23.0 million in sales. These factors were partially
offset by a comparable store sales decrease of 6.2%. Non-comparable store sales
for Fiscal 2006 and 2005 were $349.5 million and $37.6 million, respectively.
Total product units sold in Fiscal 2006 increased 13.4% over Fiscal 2005, and
the average retail price for units sold increased 3.8% as a larger portion of
the Companys total units sold represented DVDs, video games and electronics
which, in general, sell at higher average retail unit prices than CDs.

Sales and
percentage of total by merchandise category for Fiscal 2006 and 2005, sales
change by category for Fiscal 2006 and comparable store sales by category for Fiscal
2006 were as follows:

|                 |  |              |           |        |  |           |   |        |           |                          |  |                                     |   |  |      |    |  |       |   
|---------------- |  | ------------ | --------- | ------ |  | --------- | - | ------ | --------- | ------------------------ |  | ----------------------------------- | - |  | ---- | -- |  | ----- | --
|                 |  |              |           |        |  |           |   |        |           |                          |  |                                     |  
|($ in thousands) |  | 2006
  Sales |           | %Total |  | 2005Sales |   | %Total |           | Total %
  Sales
  Change |  | Comparable
  Store %
  Sales Change |  
|                 |  |              |           |        |  |           |   |        |           |                          |  |                                     |  
|                 |  |              |           |        |  |           |   |        |           |                          |  |                                     |   |  |      |    |  |       |   
|Music            |  | $            | 650,352   |        |  | 44.2      | % | $      | 663,712   |                          |  | 53.6                                | % |  | (2.0 | )% |  | (14.0 | )%
|Home Video       |  |              | 552,722   |        |  | 37.6      |   |        | 371,965   |                          |  | 30.0                                |   |  | 48.6 |    |  | 1.2   |   
|Video games      |  |              | 114,514   |        |  | 7.8       |   |        | 90,408    |                          |  | 7.3                                 |   |  | 26.7 |    |  | 4.0   |   
|Other            |  |              | 153,569   |        |  | 10.4      |   |        | 112,401   |                          |  | 9.1                                 |   |  | 36.6 |    |  | 7.9   |   
|                 |  |              |           |        |  |           |   |        |           |                          |  |                                     |   |  |      |    |  |       |   
|Total            |  | $            | 1,471,157 |        |  | 100.0     | % | $      | 1,238,486 |                          |  | 100.0                               | % |  | 18.8 | %  |  | (6.2  | )%
|                 |  |              |           |        |  |           |   |        |           |                          |  |                                     |   |  |      |    |  |       |   

The Other
category includes electronics, accessories and trend item sales, none of which
individually exceed 5% of total sales.

Music

The Companys
stores offer a wide range of new and used CDs across most music genres,
including new releases from current artists as well as an extensive catalog of
music from past periods and artists. The music category represented 44.2% of
the Companys sales in Fiscal 2006 compared to 53.6% in Fiscal 2005. The music
category has declined as a percentage of total sales due to a shift in square
footage allocations to higher growth categories and due to the acquisition of
over 160 video only Suncoast stores in March 2006 (118 remain open at February
3, 2007) which has shifted a larger portion of total sales into the home video
category.

Total sales in
the music category declined 2.0% from $663.7 million in Fiscal 2005 to $650.4
million in Fiscal 2006. The Companys annual CD unit sales decreased 2.7% in
Fiscal 2006. This decrease in total music sales is due to lower comparable
store sales, partially offset by increased average store count.

On a
comparable store basis, music sales declined 14.0% due to continued industry
sales declines and the aforementioned shift in store square footage
allocations. According to Soundscan, total CD unit sales in the United States
declined 6.2% during the period corresponding with the Companys Fiscal 2006.

Home
Video

The Company
offers DVDs in all its stores. The home video category represented 37.6% of the
Companys sales in Fiscal 2006 compared to 30.0% in Fiscal 2005. The majority
of the increase is due to the addition of the video only Suncoast stores in
March 2006. The increase is also partially due to the increase in store square
footage to support the home video category.

Total sales
for Fiscal 2006 in the home video category, including DVD and VHS, increased
48.6% from $372.0 million in Fiscal 2005 to $552.7 million in Fiscal 2006.
Total sales in the DVD category increased 55.5% in 2006 and represented 99.1%
of total home video sales in 2006. The total sales increase in home video is
due the addition of the Suncoast stores, a greater average store count and an increase
in comparable store sales.

Comparable
store sales, during Fiscal 2006, increased 5.5% in the DVD category. Comparable
store sales in the total home video category, including VHS, increased only
1.2% due to the declining VHS category as the Company has discontinued carrying
VHS during Fiscal 2006.

16

---



The increase
in DVD comparable store sales reflects the increase in inventory and floor
space to support growth in this category. According to statistics obtained from
Rentrak Home Video Essentials, overall home video sales in calendar year 2006,
including DVD and VHS, were $15.9 billion, a decrease of 0.9% from 2005. DVD
retail sales in calendar year 2006 were $15.7 billion, flat compared to 2005.

Video
games

The Company
offers video game hardware and software in most of its stores. Total sales in
the video game category increased 26.7% from $90.4 million in Fiscal 2005 to
$114.5 million in Fiscal 2006 and represented 7.8% of the Companys total sales
in Fiscal 2006 compared to 7.3% in Fiscal 2005.

Comparable
store sales in the video games category increased 4.0% in 2006. The increase
was due to the release of Sonys Play Station 3 and Nintendos Wii in November
2006 and Microsofts Xbox 360 which was released in November 2005. According to
the NPD Group, video games sales during calendar year 2006, including portable
and console hardware, software and accessories increased 19% over calendar year
2005 sales.

Other

The Other
category consists of electronics, accessories and trend items and represented
10.4% of total sales in Fiscal 2006 compared to 9.1% in Fiscal 2005. Total
sales in this category increased 36.6% to $153.6 million in Fiscal 2006
compared to $112.4 million in Fiscal 2005. This increase is due to the increase
in average store count and a comparable store sale increase of 7.9%.

Gross Profit. The
following table sets forth a year-over-year comparison of the Companys Gross
Profit:

|                           |  |      |         |      |   |         |   |                 |        |  |  |      |  
|-------------------------- |  | ---- | ------- | ---- | - | ------- | - | --------------- | ------ |  |  | ---- | -
|                           |  |      |         |      |   |         |   | 2006 vs.
  2005 |       
|                           |  |      |         |      |   |         |   |                 |       
|($ in thousands)           |  | 2006 |         | 2005 |   | $       |   | %               |       
|                           |  |      |         |      |   |         |   |                 |       
|Gross Profit               |  | $    | 519,222 |      | $ | 431,613 |   | $               | 87,609 |  |  | 20.3 | %
|                          
|As a
  percentage of sales |  |      | 35.3    | %    |   | 34.9    | % |                 |        |  |  |      |  

Gross profit as a percentage of sales increased 40 basis points in
Fiscal 2006 as compared to Fiscal 2005 due to higher overall product margins (20
basis points) and the leveraging of distribution expenses over the total sales
increase (20 basis points).

Selling, General and Administrative Expenses.
The following table sets forth a year-over-year comparison of the Companys
SG&A expenses:

|                                               |  |      |         |      |   |         |   |                 |        |  |  |      |  
|---------------------------------------------- |  | ---- | ------- | ---- | - | ------- | - | --------------- | ------ |  |  | ---- | -
|                                               |  |      |         |      |   |         |   | 2006 vs.
  2005 |       
|                                               |  |      |         |      |   |         |   |                 |       
|($ in thousands)                               |  | 2006 |         | 2005 |   | $       |   | %               |       
|                                               |  |      |         |      |   |         |   |                 |       
|Selling, general and administrative
  expenses |  | $    | 519,246 |      | $ | 426,854 |   | $               | 92,392 |  |  | 21.6 | %
|                                               |  |      |         |      |   |         |   |                 |        |  |  |      |  
|As a percentage of sales                       |  |      | 35.3    | %    |   | 34.5    | % |                 |        |  |  |      |  

The Companys
SG&A expenses increased in Fiscal 2006 due to the operation of a greater
number of stores. The Company operated an average of 1,044 stores in 2006
compared to an average of 801 stores in 2005, an increase of 30%. SG&A
expenses as a percentage of sales increased 80 basis points, due to the
recording of $7.9 million in transition costs related to the Musicland
acquisition and a comparable store sales decrease of 6.2%.

Interest Expense.
Interest expense in Fiscal 2006 was $5.5 million compared to $3.0 million in
Fiscal 2005. The increase is due to increased borrowings on the Companys line
of credit to fund the Musicland acquisition, along with higher variable
interest rates.

Other Income. For
Fiscal 2006, other income includes a $3.5 million gain on the sale of an
investment. For Fiscal 2005, other income includes a realized gain of $0.8
million on the sale of available-for-sale securities. Other income also
includes interest income, which was $0.9 million and $1.4 million in Fiscal
2006 and 2005, respectively.

17

---



Income Tax (Benefit) Expense.
The following table sets forth a year-over-year comparison of the Companys
income tax (benefit) expense:

|                               |  |      |        |      |   |       |   |                 |        |  
|------------------------------ |  | ---- | ------ | ---- | - | ----- | - | --------------- | ------ | -
|                               |  |      |        |      |   |       |   | 2006 vs.
  2005 |       
|                               |  |      |        |      |   |       |   |                 |       
|($ in thousands)               |  | 2006 |        | 2005 |   | $     |  
|                               |  |      |        |      |   |       |  
|                              
|Income tax
  expense (benefit) |  | $    | (2,041 | )    | $ | 1,090 |   | $               | (3,131 | )
|                               |  |      |        |      |   |       |   |                 |        |  
|Effective
  tax rate           |  |      | 186.7  | %    |   | 27.4  | % |                 |        |  

The 2006
income tax benefit is attributable to a tax favored gain from the sale of an
investment, which resulted in a $1.4 million reduction of the valuation allowance
attributable to losses on investments, favorable settlements of income tax
examinations ($0.9 million) and federal income tax credits ($0.3 million),
partially offset by unfavorable state tax legislation enacted during the year
and changes in managements estimates of the realization of state net operating
losses. For a reconciliation of the federal statutory tax rate to the Companys
effective income tax rate, see Note 6 of Notes to the Consolidated Financial
Statements in this Annual Report on Form 10-K.

For Fiscal
2005, the Companys effective tax rate was negatively impacted by changes in
Ohio State tax legislation. The legislation phased out state corporation
franchise taxes which are based on income. The impact of the Ohio tax
legislation resulted in an increase in the state valuation allowance of $1.9
million, associated with deferred tax assets, principally net operating losses
that, based on managements estimates, will not be realized during the
phase-out period. Additionally, the valuation allowance was increased by $0.9
million to reserve for deferred tax assets attributable to state net operating
losses impacted as a result of projected lower future taxable income within
certain states expiration periods. During Fiscal 2005, the Company recognized
a tax benefit of $2.0 million attributable to the effect of additional
deductible temporary differences.

Cumulative Effect of a Change in Accounting
Principle. The Company adopted FIN 47, Accounting
for Conditional Asset Retirement Obligationsan interpretation of FASB
Statement No. 143, effective January 28, 2006. In accordance with
FIN 47, the Company recorded an asset and a corresponding liability for the
present value of the estimated asset retirement obligations associated with the
fixed assets and leasehold improvements at its store locations that arise under
the terms of operating leases. The Company recognized an expense for the
cumulative effect of this change in accounting principle in the fourth quarter
of Fiscal 2005 of $2.3 million, net of income taxes of $1.5 million.

Extraordinary Gain.
In Fiscal 2006, the Company recorded an extraordinary gain as a result of
acquiring substantially all of the net assets of Musicland Holding Corp. on
March 27, 2006. From March 27, 2006 to February 3, 2007, the Company allocated
the purchase price in accordance with the provisions of SFAS No. 141, Business
Combinations, resulting in an extraordinary gain  unallocated
negative goodwill of $10.7 million, net of income taxes $6.7 million. The
extraordinary gain represents the excess of the fair value of net assets
acquired over the purchase price. The purchase price was allocated on a
preliminary basis during the thirteen weeks ended April 29, 2006 using
information available at the time. The extraordinary gain recorded as of April
29, 2006 was $0.9 million, which was net of income taxes of $0.7 million. In
accordance with SFAS No.141, the allocation of the purchase price to the assets
and liabilities acquired must be finalized within twelve months following the
date of acquisition. Accordingly, the purchase price allocation has been
adjusted between April 29, 2006 and February 3, 2007, resulting in an
adjustment to the extraordinary gain of $9.8 million, which is net of income
taxes of $6.0 million. The pre-tax increase in the extraordinary gain from
April 29, 2006 to February 3, 2007 represents adjustments to the value of
acquired inventory ($1.9 million), an adjustment to customer liabilities
related to the former Musicland loyalty program ($3.4 million), an adjustment
to customer liabilities related to gift cards based on the redemption
experience since acquisition ($6.1 million) and an adjustment to occupancy
related expenses ($1.5 million) and an adjustment to the cash purchase price
($2.9 million).

18

---



Net Income. The
following table sets forth a year-over-year comparison of the Companys net
income:

|                                                                                                                                |  |      |        |      |   |        |   |                 |        |   |  |         |   
|------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------ | ---- | - | ------ | - | --------------- | ------ | - |  | ------- | --
|                                                                                                                                |  |      |        |      |   |        |   | 2006 vs.
  2005 |       
|                                                                                                                                |  |      |        |      |   |        |   |                 |       
|($ in thousands)                                                                                                                |  | 2006 |        | 2005 |   | $      |   | %               |       
|                                                                                                                                |  |      |        |      |   |        |   |                 |       
|Income before extraordinary gain  unallocated negative
goodwill
  and cumulative effect of a change in accounting principle    |  | $    | 948    |      | $ | 2,886  |   | $               | (1,938 | ) |  | (67.2   | %)
|Extraordinary gain  unallocated negative
  goodwill, net of income taxes of $6,739 and $0 for 2006 and 2005,
  respectively    |  |      | 10,721 |      |   |       |   |                 |        |   |  |         |   
|                                                                                                                               
|Cumulative effect of a change in accounting
  principle, net of income taxes of $0 and $1,505 for 2006 and 2005,
  respectively |  |      |       |      |   | (2,277 | ) |                 |        |   |  |         |   
|                                                                                                                                |  |      |        |      |   |        |   |                 |        |   |  |         |   
|Net income                                                                                                                      |  | $    | 11,669 |      | $ | 609    |   | $               | 11,060 |   |  | 1,816.1 | % 
|                                                                                                                                |  |      |        |      |   |        |   |                 |        |   |  |         |   
|                                                                                                                                |  |      |        |      |   |        |   |                 |        |   |  |         |   
|Net income as a percentage of sales                                                                                             |  |      | 0.8    | %    |   | 0.1    | % |                 |        |   |  |         |   

Income before
extraordinary items decreased to $0.9 million in Fiscal 2006 as increased sales
and gross profit associated with the increased average store count was not
enough to offset a 6.2% decline in comparable store sales and the increase in
SG&A expenses, including integration expenses of $7.9 million related to
the Musicland acquisition. Income before extraordinary items in Fiscal 2006 was
positively impacted by an income tax benefit of $2.0 million. The increase in
net income in Fiscal 2006 is due to the extraordinary gain, net of tax, of $10.7
million recorded in relation to the Musicland acquisition.

19

---



Fiscal
Year Ended January 28, 2006 (2005)
Compared to Fiscal Year Ended January 29, 2005 (2004)

Sales.
The following table sets forth a year-over-year comparison of the Companys
total Sales:

| |                  |  |      |           |      |   |           |  |                 |          |   |  |        | 
| | ---------------- |  | ---- | --------- | ---- | - | --------- |  | --------------- | -------- | - |  | ------ | 
| |                  |  |      |           |      |   |           |  | 2005 vs.
  2004 |         
| |                  |  |      |           |      |   |           |  |                 |         
| | ($ in thousands) |  | 2005 |           | 2004 |   | $         |  | %               |         
| |                  |  |      |           |      |   |           |  |                 |         
| | Sales            |  | $    | 1,238,486 |      | $ | 1,365,133 |  | $               | (126,647 | ) |  | (9.3)% | 

Sales decreased in 2005 due to a decrease in the
average store count from 853 during 2004 to 801 during 2005. The decrease in
sales was also the result of a comparable store sales decrease of 5.7%. In
2005, comparable store sales decreased 5.4% for mall-based stores and decreased
6.3% for freestanding stores. A store is included in comparable store sales
calculations at the beginning of its thirteenth full month of operation. Not
including comparable store sales, sales from new and acquired stores, sales
from stores closed during the year and Internet sales, for 2005 and 2004 were
$37.6 million and $145.8 million, respectively. Product units sold in 2005
decreased 9.0% over 2004, and average retail for units sold decreased 0.5%.

Sales by merchandise category for 2005 and 2004 and
comparable store sales by category for 2005 were as follows:

|                 |  |      |           |        |  |       |   |        |           |                        |  |                                   |   |  |       |     |  |      |   
|---------------- |  | ---- | --------- | ------ |  | ----- | - | ------ | --------- | ---------------------- |  | --------------------------------- | - |  | ----- | --- |  | ---- | --
|                 |  |      |           |        |  |       |   |        |           |                        |  |                                   |  
|($ in thousands) |  | 2005 |           | %Total |  | 2004  |   | %Total |           | Total % 
  SalesChange |  | Comparable 
  Store %Sales Change |  
|                 |  |      |           |        |  |       |   |        |           |                        |  |                                   |  
|                 |  |      |           |        |  |       |   |        |           |                        |  |                                   |   |  |       |     |  |      |   
|Music            |  | $    | 663,712   |        |  | 53.6  | % | $      | 750,612   |                        |  | 55.0                              | % |  | (11.6 | ) % |  | (9.2 | )%
|Home Video       |  |      | 371,965   |        |  | 30.0  |   |        | 398,043   |                        |  | 29.2                              |   |  | (6.6  | )   |  | (3.7 | ) 
|Video games      |  |      | 90,408    |        |  | 7.3   |   |        | 89,297    |                        |  | 6.5                               |   |  | 1.2   |     |  | 2.3  |   
|Other            |  |      | 112,401   |        |  | 9.1   |   |        | 127,181   |                        |  | 9.3                               |   |  | (11.6 | )   |  | 4.4  |   
|                 |  |      |           |        |  |       |   |        |           |                        |  |                                   |   |  |       |     |  |      |   
|Total            |  | $    | 1,238,486 |        |  | 100.0 | % | $      | 1,365,133 |                        |  | 100.0                             | % |  | (9.3  | ) % |  | (5.7 | )%
|                 |  |      |           |        |  |       |   |        |           |                        |  |                                   |   |  |       |     |  |      |   

The Other category includes electronics, accessories
and trend items, none of which individually exceeds 5% of total sales.

Music

The Companys stores offer a wide range of new and
used CDs across most music genres, including new releases from current artists
as well as an extensive catalog of music from past periods and artists. The
music category represented 53.6% of the Companys sales in 2005.

The Companys annual CD unit sales decreased 12.4% in
2005. This decrease is due to a lower store count, weak industry new releases
and increased digital downloading. According to Soundscan, total CD unit sales
in the United States declined 7.2% during the same period.

Home Video

Total sales for 2005 in the home video category
decreased 6.6%. Total sales in the DVD category decreased 2.2% in 2005, and
were partially offset by a comparable store sales increase of 0.7%. The
increase in DVD comparable store sales reflected the continued industry growth
in this category offset by a lack of strong new releases and increased
competition. The home video category, including DVD and VHS, represented 30.0%
of the Companys total sales in 2005. According to statistics obtained from
Rentrak Home Video Essentials, DVD industry retail sales in 2005 were $15.7
billion, an increase of 4.5% over 2004.

Video games

Comparable sales in the video games category increased
2.3% in 2005. The results in this category were positively impacted by
Microsofts Xbox 360 which was released in November 2005. The comparable store
sales increase in this category was partially offset by hardware shortages,
delays in releases of highly anticipated software titles and consumer
anticipation of next-generation hardware. Video games represented 7.3% of the Companys
total sales in 2005. According to the NPD Group, industry sales for 2005 were
$10.5 billion including portable and console hardware, software and
accessories, an increase of 6% over 2004.

Other

The Other category predominantly consists of
electronics, accessories and trend items and represented 9.1% of total sales in
Fiscal 2005 compared to 9.3% in Fiscal 2004. Total sales in these categories
decreased 11.6% to $112.4 million in Fiscal 2005 compared to $127.2 million in
Fiscal 2004. This decrease is due to the decrease in average store count,
partially offset by a comparable store sale increase of 4.4%.

20

---



Gross
Profit. The following table sets forth a year-over-year
comparison of the Companys Gross Profit:

|                         |  |      |         |      |   |         |   |                 |         |   |  |          | 
|------------------------ |  | ---- | ------- | ---- | - | ------- | - | --------------- | ------- | - |  | -------- | 
|                         |  |      |         |      |   |         |   | 2005 vs.
  2004 |        
|                         |  |      |         |      |   |         |   |                 |        
|($ in thousands)         |  | 2005 |         | 2004 |   | $       |   | %               |        
|                         |  |      |         |      |   |         |   |                 |        
|Gross Profit             |  | $    | 431,613 |      | $ | 495,134 |   | $               | (63,521 | ) |  | (12.8) % | 
|                         |  |      |         |      |   |         |   |                 |         |   |  |          | 
|As a percentage of sales |  |      | 34.9    | %    |   | 36.3    | % |                 |         |   |  |          | 

Gross profit as a percentage of
sales decreased in 2005 as compared to 2004 due to an increase in the Companys
distribution center costs by 30 basis points, a shift in the mix of sales from
music to DVD and video games categories of 30 basis points and more competitive
pricing in DVD, video games and accessories categories of 50 basis points.

Selling,
General and Administrative Expenses.The following table sets
forth a year-over-year comparison of the Companys SG&A expenses:

|                                             |  |      |         |      |   |         |   |                 |         |   |  |         | 
|-------------------------------------------- |  | ---- | ------- | ---- | - | ------- | - | --------------- | ------- | - |  | ------- | 
|                                             |  |      |         |      |   |         |   | 2005 vs.
  2004 |        
|                                             |  |      |         |      |   |         |   |                 |        
|($ in thousands)                             |  | 2005 |         | 2004 |   | $       |   | %               |        
|                                             |  |      |         |      |   |         |   |                 |        
|Selling, general and administrative expenses |  | $    | 426,854 |      | $ | 450,162 |   | $               | (23,308 | ) |  | (5.2) % | 
|                                             |  |      |         |      |   |         |   |                 |         |   |  |         | 
|As a percentage of sales                     |  |      | 34.5    | %    |   | 33.0    | % |                 |         |   |  |         | 

The Companys SG&A expenses decreased in 2005 due
to the operation of fewer stores. The Company operated an average of 801 stores
in 2005 compared to an average of 853 stores in 2004, a decrease of 6%. The
increase in the SG&A expenses rate as a percentage of sales was due to
lower sales.

Interest
Expense. Interest expense was $3.0 million during 2005
compared to $2.4 million during 2004. The increase was due to a full year of
interest being recorded on the real estate mortgaged in 2004 (See Footnote 4 in
the Notes to the Consolidated Financial Statements) and interest expense recorded
on the $12.0 million capital lease financing of the Companys point of sale
system in 2005 (See Footnote 8 in the Notes to the Consolidated Financial
Statements).

Other
Income. Other income includes interest income of $1.4
million. For 2005, other income also included a realized gain of $0.8 million
on the sale of available-for-sale securities.

Income
Tax Expense. The following table sets forth a year-over-year
comparison of the Companys provision for income taxes:

|                   |  |      |       |      |   |       |   |                 | 
|------------------ |  | ---- | ----- | ---- | - | ----- | - | --------------- | 
|                   |  |      |       |      |   |       |   | 2005 vs.
  2004 | 
|                   |  |      |       |      |   |       |   |                 | 
|($ in thousands)   |  | 2005 |       | 2004 |   | $     |  
|                   |  |      |       |      |   |       |  
|                  
|Income tax expense |  | $    | 1,090 |      | $ | 4,892 |   | $ (3,802)       | 
|                   |  |      |       |      |   |       |   |                 | 
|Effective tax rate |  |      | 27.4  | %    |   | 11.2  | % |                 | 

For 2005, the Companys effective tax rate was
negatively impacted by changes in Ohio State tax legislation. The legislation
phased out state corporation franchise taxes which are based on income. The
impact of the Ohio tax legislation resulted in an increase in the state
valuation allowance of $1.9 million, associated with deferred tax assets,
principally net operating losses that, based on managements estimates, will
not be realized during the phase-out period. Additionally, the valuation
allowance was increased by $0.9 million to reserve for deferred tax assets
attributable to state net operating losses impacted as a result of projected
lower future taxable income within certain states expiration periods. During
2005, the Company recognized a tax benefit of $2.0 million attributable to the
effect of additional deductible temporary differences. For a reconciliation of
the federal statutory tax rate to the Companys effective income tax rate, see
Note 6 of Notes to the Consolidated Financial Statements in this Annual Report
on Form 10-K.

The effective tax rate for 2004 was positively
impacted by a benefit arising from the closing of a federal income tax
examination and a decrease in the valuation allowance. The benefit of $10.5
million was recorded in the second fiscal quarter and included the closing of
all matters not previously settled in relation to corporate-owned life
insurance (COLI) policies, which were part of the Companys acquisition of
Camelot in 1999. The original income tax payable amounts which were recorded
during the years covered by the examination were reversed subsequent to the
final settlement resulting in the tax benefit. With the closing of the tax
examination, the Company has surrendered the remaining COLI policies. In
addition, the valuation allowance was decreased by $2.2 million to account for
the planned utilization of federal and state net operating loss carryforwards
during the expiration periods previously considered uncertain.

21

---



Cumulative
Effect of a Change in Accounting Principle. The Company
adopted FIN 47, Accounting for Conditional Asset Retirement Obligationsan interpretation
of FASB Statement No. 143, effective January 28, 2006. In accordance
with FIN 47, the Company recorded an asset and a corresponding liability for
the present value of the estimated asset retirement obligations associated with
the fixed assets and leasehold improvements at its store locations that arise
under the terms of operating leases. The Company recognized an expense for the
cumulative effect of this change in accounting principle in the fourth quarter
of Fiscal 2005 of $2.3 million, net of income taxes of $1.5 million.

Extraordinary
Gain.In Fiscal 2004, the Company recorded an extraordinary
gain as the result of acquiring substantially all the net assets of Wherehouse
Entertainment Inc. and CD World Inc. in October 2003 for $35.2 million and $1.9
million, respectively. The purchase price was allocated on a preliminary basis
using information available at the time. The gain represents the excess of the
fair value of net assets acquired over the purchase price. In accordance with
SFAS No.141, Business Combinations, the allocation of the purchase price
to the assets and liabilities acquired was finalized and adjusted in 2004,
resulting in an extraordinary gain of $3.2 million, which is net of income
taxes of $2.0 million, related to unallocated negative goodwill. The
extraordinary gain represents adjustments to the value of liquidated inventory
($2.5 million), an adjustment to customer liabilities related to gift cards
based on the redemption experience since acquisition ($2.1 million) and occupancy
related expenses ($0.6 million).

Net
Income. The following table sets forth a year-over-year
comparison of the Companys net income:

|                                                                                                                                |  |      |        |      |   |        |   |                 |         |   |  |         | 
|------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------ | ---- | - | ------ | - | --------------- | ------- | - |  | ------- | 
|                                                                                                                                |  |      |        |      |   |        |   | 2005 vs.
  2004 |        
|                                                                                                                                |  |      |        |      |   |        |   |                 |        
|($ in thousands)                                                                                                                |  | 2005 |        | 2004 |   | $      |   | %               |        
|                                                                                                                                |  |      |        |      |   |        |   |                 |        
|Income before extraordinary
  gain  unallocated negative goodwill and cumulative effect of a change in
  accounting principle  |  | $    | 2,886  |      | $ | 38,675 |   | $               | (35,789 | ) |  | (92.5)% | 
|Extraordinary
  gain  unallocated negative goodwill, net of income taxes of $0 and $1,979
  for 2005 and 2004, respectively    |  |      |       |      |   | 3,166  |   |                 |         |   |  |         | 
|                                                                                                                                |  |      |        |      |   |        |   |                 |         |   |  |         | 
|Cumulative
  effect of a change in accounting principle, net of income taxes of $1,505 and
  $0 for 2005 and 2004, respectively |  |      | (2,277 | )    |   |       |   |                 |         |   |  |         | 
|                                                                                                                                |  |      |        |      |   |        |   |                 |         |   |  |         | 
|                                                                                                                               
|Net income                                                                                                                      |  | $    | 609    |      | $ | 41,841 |   | $               | (41,232 | ) |  |         | 
|                                                                                                                                |  |      |        |      |   |        |   |                 |         |   |  |         | 
|                                                                                                                               
|Net income as a
  percentage of sales                                                                                           |  |      | 0.1    | %    |   | 3.1    | % |                 |         |   |  |         | 

The decrease in income before extraordinary gain and
cumulative effect of a change in accounting principle, and net income in 2005
as compared to 2004 is due to the decrease in income from operations driven by
lower sales and resulting lower gross profit, partially offset by lower
SG&A expenses, and a lower income tax benefit of $2.0 million recorded in
2005 compared to a benefit of $10.5 million, which was recorded in the second
fiscal quarter of 2004.

22

---



LIQUIDITY
AND CAPITAL RESOURCES

Liquidity
and Cash Flows: The Companys primary sources of working
capital are cash provided by operations and borrowing capacity under its
revolving credit facility. The Companys cash flows fluctuate from quarter to
quarter due to various items, including seasonality of sales and earnings,
merchandise inventory purchases and the related terms on the purchases, store
openings, tax payments and capital expenditures. Management believes it will have
adequate resources to fund its cash needs for the foreseeable future, and
anticipates that cash flows from operations will be sufficient to fund its
capital spending, its seasonal increase in merchandise inventory, income tax
payments and other operating cash requirements and commitments. Management
anticipates any cash requirements due to an unanticipated shortfall in cash
from operations, would be funded by the Companys revolving credit facility,
discussed hereafter. Management believes its reported cash flows for Fiscal
2006 are indicative of cash flow for Fiscal 2007, with the exception of cash
usage associated with the acquisition of Musicland, and is not currently aware
of any trends, uncertainties or other significant events that would cause liquidity
to increase or decrease in a material way. However, there can be no assurance
that the Company will continue to generate cash flows at or above current
levels or that we will be able to maintain the Companys ability to borrow
under the revolving credit facility. The Company does not expect any material
changes in the mix (between equity and debt) or the relative cost of capital
resources.

The following table sets forth a three year summary of
key components of cash flow and working capital:

|                            |  |      |          |      |   |         |   |               |         |      |  |      |               |   |         |   |   |         |   |  |     |   
|--------------------------- |  | ---- | -------- | ---- | - | ------- | - | ------------- | ------- | ---- |  | ---- | ------------- | - | ------- | - | - | ------- | - |  | --- | --
|                            |  |      |          |      |   |         |   | 2006 vs. 2005 |         |      |  |      | 2005 vs. 2004 |  
|                            |  |      |          |      |   |         |   |               |         |      |  |      |               |   |         |  
|($ in
thousands)            |  | 2006 |          | 2005 |   | $       |   | %             |         | 2004 |  | $    |               |   | %       |  
|                            |  |      |          |      |   |         |   |               |         |      |  |      |               |   |         |  
|Operating Cash Flows        |  | $    | 47,268   |      | $ | 25,247  |   | $             | 22,021  |      |  | 87   | %             | $ | 105,931 |   | $ | (80,684 | ) |  | (76 | )%
|Investing Cash Flows        |  |      | (122,871 | )    |   | (40,517 | ) |               | (82,354 | )    |  | (203 | )%            |   | (35,398 | ) |   | (5,119  | ) |  | (14 | )%
|Financing Cash Flows        |  |      | (2,976   | )    |   | (17,289 | ) |               | 14,313  |      |  | 83   | %             |   | (32,687 | ) |   | 15,398  |   |  | 47  | % 
|                            |  |      |          |      |   |         |   |               |         |      |  |      |               |   |         |   |   |         |   |  |     |   
|Capital Expenditures        |  |      | (48,289  | )    |   | (41,330 | ) |               | (6,959  | )    |  | (17  | )%            |   | (33,398 | ) |   | (7,932  | ) |  | (24 | )%
|Acquisition of Business     |  |      | (78,810  | )    |   |        |   |               | (78,810 | )    |  |     |               |   | (2,000  | ) |   | 2,000   |   |  |    |   
|                            |  |      |          |      |   |         |   |               |         |      |  |      |               |   |         |   |   |         |   |  |     |   
|Cash and Cash
  Equivalents |  |      | 118,630  |      |   | 197,209 |   |               | (78,579 | )    |  | (40  | )%            |   | 229,768 |   |   | (32,559 | ) |  | (14 | )%
|Merchandise Inventory       |  |      | 504,860  |      |   | 402,712 |   |               | 102,148 |      |  | 25   | %             |   | 431,246 |   |   | (28,534 | ) |  | (7  | )%
|Working Capital             |  |      | 266,204  |      |   | 273,623 |   |               | (7,419  | )    |  | (3   | )%            |   | 289,999 |   |   | (16,376 | ) |  | (6  | )%
|Inventory turns             |  |      | 1.8      |      |   | 1.9     |   |               |         |      |  |      |               |   | 2.0     |   |   |         |   |  |     |   

Cash from operating activities increased by
approximately $22.0 million in Fiscal 2006. The most significant factor driving
the increase was the decrease (cash source) in net merchandise inventory
(merchandise inventory less accounts payable) as compared to Fiscal 2005,
excluding the merchandise inventory acquired in the Musicland acquisition. The
change in net inventory provided cash of approximately $14.3 million in Fiscal
2006, compared to a cash use of approximately $10.2 million in Fiscal 2005,
resulting in a $24.5 million increase in cash from operating activities. This
was partially offset by a decrease in income before depreciation, amortization,
stock compensation and gains and losses for which proceeds are presented in
investing activities of approximately $2.6 million. Additional cash uses of
approximately $2.9 million for accrued expenses and changes in prepaid expenses
and other assets resulting in decreases in cash from operating activities of
approximately $2.0 million, as compared to Fiscal 2005, were offset by changes
in accounts receivable resulting in an increase in cash from operating
activities of approximately $3.3 million and changes in current and deferred
taxes resulting an increase in cash from operating activities of approximately
$1.5 million.

The Company monitors various statistics to measure its
management of inventory, including inventory turn (annual cost of sales divided
by average merchandise inventory balances), inventory investment per square
foot and inventory leverage (accounts payable divided by merchandise
inventory). Inventory turn in Fiscal 2006 was 1.8 compared to 1.9 in Fiscal
2005. Inventory investment per square foot was $85 per square foot at the end
of Fiscal 2006 as compared to $83 per square foot at the end of Fiscal 2005.
Inventory leverage was 62% as of February 3, 2007 compared with 76% as of January
28, 2006. Management considers these results to be in a normal operating range.
Management does not anticipate large fluctuations in merchandise inventory or
accounts payable balances in the foreseeable future.

Cash used in investing activities was $122.9 million
in Fiscal 2006, as compared to $40.5 million in Fiscal 2005. In Fiscal 2006,
the primary uses of cash in investing activities were $48.3 million for capital
expenditures and $78.8 million for the acquisition of the net assets of
Musicland Holding Corp. These uses were partially offset by proceeds from the
sale of an investment of approximately $4.2 million. The Company had capital
expenditures in 2006 of $16.7 million for new store openings, relocations and
store improvements. An additional $5.3 million was invested in the expansion of
LVS 3 (Listening and Viewing Stations) to a greater number of stores. Another
$13.5 million was invested in general MIS software and equipment. An investment
of $8.4 million was made in store visual displays and other store related
projects. Other capital expenditures totaled $4.4 million.

23

---



Capital expenditures were $41.3 million in Fiscal
2005. Included in Fiscal 2005 capital expenditures was $16.0 million for new
store openings, relocations and other store improvements. The Company further
made investments in its store technology and upgraded its LVS (in-store
Listening and Viewing Stations) for $10.7 million. The Company also replaced
its store point-of-sale system for $12.0 million.

The Company typically finances its capital
expenditures through cash generated from operations. It may also receive
landlord allowances or concessions for store openings, relocations or
improvements. The Company anticipates capital spending of approximately $35
million in 2007.

In March, 2006, the Company acquired 335 Musicland
stores for a total cash consideration of $78.8 million, and $16.3 million in
assumed liabilities including certain customer obligations, rent and occupancy
liabilities and other employee obligations. See Note 3 of Notes to the
Consolidated Financial Statements of this Annual Report on Form 10-K.

Cash used in financing activities was $3.0 million in
Fiscal 2006, as compared to a $17.3 million use of cash in Fiscal 2005. In
Fiscal 2006, the primary uses of cash were payments of long-term debt and
capital lease obligations of $0.5 million and $3.2 million, respectively,
partially offset by $0.7 million in proceeds and excess tax benefits received
from the exercise of stock awards. In Fiscal 2005, the primary use of cash in
financing activities was $31.3 million to repurchase outstanding shares of the
Companys Common Stock under programs authorized by the Board of Directors.
There are currently no open share repurchase programs.

The decrease in cash from operating activities in
Fiscal 2005 compared to Fiscal 2004 was the result of lower net income of $0.6
million as compared to net income of $41.8 million in 2004. It was further due
to a $10.2 million cash use in Fiscal 2005 in net merchandise inventory (merchandise
inventory less accounts payable) as compared to a $44.1 million cash source in
Fiscal 2004. The Company used less cash in Fiscal 2005 for the payment of
accrued expenses ($2.8 million cash use in Fiscal 2005 as compared to $10.4
million cash use in Fiscal 2004) and taxes ($7.9 million cash use in Fiscal
2005 as compared to $15.1 million cash use in Fiscal 2004) compared to Fiscal
2004. All other operating cash sources in Fiscal 2005, net, were approximately
$10.7 million.

Cash used in investing activities was $40.5 million in
Fiscal 2005, as compared to $35.4 million in Fiscal 2004. In Fiscal 2005, the
primary use of cash used in investing activities was $41.3 million for capital
expenditures. The Company had capital expenditures in Fiscal 2005 of $16.0
million for new store openings and relocations and for store improvements. The
Company further made investments in its store technology and upgraded its LVS
(in-store Listening and Viewing Stations) for $10.7 million. The Company also
replaced its store point-of-sale system for $12.0 million.

In January, 2006, the Company entered into a new
five-year, $100 million revolving secured Credit Agreement with Bank of
America, N.A that expires in January 2010. The revolving credit facility
contains provisions governing additional indebtedness and acquisitions and is
secured by the Companys eligible inventory, proceeds from the sale of
inventory and by the stock of the Companys subsidiaries. In March, 2006, the
Company and Bank of America N.A., entered into a First Amendment to the Credit
Agreement which increased the amount available for borrowing by the Company
under the Credit Agreement to $130 million and in October, 2006, the Company
and Bank of America N.A. entered into a Second Amendment to the Credit Agreement
increasing the amount available to the Company for borrowing to $150 million.
The terms and conditions under the aforementioned amendments were the same as
the original Credit Agreement.

As of February 3, 2007 and January 28, 2006, the
Company had $36 thousand and $0.5 million, respectively, in outstanding letter
of credit obligations under the credit agreements with Bank of America, N.A.
The Company had $150.0 million and $99.5 million, available for borrowing as of
February 3, 2007 and January 28, 2006, respectively. Interest expense in Fiscal
2006 was $5.5 million, of which $2.1 million was incurred for capital leases.
Interest expense in Fiscal 2005 was $3.0 million, of which $1.5 million was
incurred for capital leases.

During Fiscal 2005, the Company financed the
replacement of its point-of-sale system through a capital lease arrangement in
the amount of $12.0 million. The lease arrangement has an average
interest rate of 5.76% and will be repaid in monthly installments of approximately
$229,000 through June 2010. As of February 3, 2007, the outstanding balance on
the lease was $8.2 million.

During Fiscal 2004, the Company borrowed $5.8 million
under a mortgage loan to finance the purchase of real estate. The mortgage
loan is repayable in monthly installments of $64,000 over 10 years with a fixed
interest rate of 6.0% and is collateralized by the real estate. As of February
3, 2007, the outstanding balance on the loan was $4.6 million.

24

---



Contractual Obligations and Commitments. The following
table summarizes the Companys contractual obligations as of February 3, 2007,
and the effect that such obligations are expected to have on liquidity and cash
flows in future periods.

|                                                  |  |      |         |              |   |               |  |                   |        |       |   |        |  |   |         | 
|------------------------------------------------- |  | ---- | ------- | ------------ | - | ------------- |  | ----------------- | ------ | ----- | - | ------ |  | - | ------- | 
|Contractual
  Obligation                          |  | 2007 |         | 2008-
  2009 |   | 2010 -
  2011 |  | 2012 and
  Beyond |        | Total |  
|                                                  |  |      |         |              |   |               |  |                   |        |       |  
|$ in
thousands                                    |  |      |         |              |   |               |  |                   |        |       |   |        |  |   |         | 
|Operating lease obligations                       |  | $    | 116,934 |              | $ | 163,132       |  | $                 | 70,000 |       | $ | 48,293 |  | $ | 398,359 | 
|Capital lease obligations                         |  |      | 4,831   |              |   | 9,418         |  |                   | 4,672  |       |   | 7,392  |  |   | 26,313  | 
|Long-term debt (principal)                        |  |      | 506     |              |   | 1,107         |  |                   | 1,252  |       |   | 1,726  |  |   | 4,591   | 
|Long-term debt (interest)                         |  |      | 261     |              |   | 427           |  |                   | 286    |       |   | 132    |  |   | 1,106   | 
|Purchase obligations (1)                          |  |      |        |              |   |              |  |                   |       |       |   |       |  |   |        | 
|IRS Settlement (3)                                |  |      | 7,435   |              |   |              |  |                   |       |       |   |       |  |   | 7,435   | 
|Deferred rent and other long-term liabilities (2) |  |      | 3,890   |              |   | 1,961         |  |                   | 978    |       |   | 938    |  |   | 7,767   | 
|Pension benefits                                  |  |      | 50      |              |   | 115           |  |                   | 244    |       |   | 6,091  |  |   | 6,500   | 
|                                                  |  |      |         |              |   |               |  |                   |        |       |   |        |  |   |         | 
|Total                                             |  | $    | 133,907 |              | $ | 176,160       |  | $                 | 77,432 |       | $ | 64,572 |  | $ | 452,071 | 
|                                                  |  |      |         |              |   |               |  |                   |        |       |   |        |  |   |         | 

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | For the purposes of this table, contractual
  obligations for purchase of goods or services are defined as agreements that
  are enforceable and legally binding and that specify all significant terms,
  including: fixed or minimum quantities to be purchased; fixed, minimum or
  variable price provisions; and the approximate timing of the transaction. The
  Companys purchase orders are based on its current inventory needs and are
  fulfilled by its suppliers within short time periods.                                                                                                                                                                                                                                                                                                            
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|(2) | Included in deferred rent and other long-term
  liabilities in the Consolidated Balance Sheet as of February 3, 2007 are
  unfavorable lease valuations of $3.0 million and the long-term portion of
  deferred rent of $7.1 million which are not reflected in the table above as
  these amounts do not represent contractual obligations. Also included in
  long-term liabilities is the long-term portion of the straight line rent
  liability of $8.9 million, which is included in operating lease obligations
  in the table above.                                                                                                                                                                                                                                                                         
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|    | Included in deferred rent and other long term liabilities
  in the table above are the estimated asset retirement obligations associated
  with the fixed assets and leasehold improvements at the Companys store
  locations that arise under the terms of operating leases.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|    | In March, 2006, the Company acquired an 80% interest
  in Mix & Burn, LLC which is fully consolidated for financial reporting
  purposes. The Company has committed funding of $5.2 million of which $4.0
  million was funded as of February 3, 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|(3) | During 2000, the United States District Court for
  the District of Delaware issued an opinion upholding the IRS disallowance of
  deductions of interest expense related to corporate-owned life insurance
  policies through fiscal 1994. During 2003, the Company and the IRS reached a
  settlement agreement on this issue. Under the final payment terms, the
  Company has agreed with the IRS to make annual interest payments and a final
  principal payment of approximately $7.1 million in June 2007. This amount and
  accrued interest is recorded in income taxes payable in the Consolidated
  Balance Sheets. The total payment of $7.4 million due in June 2007 includes
  the final principal payment of approximately $7.1 million and approximately
  $0.3 million related to annual interest.
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|(4) | The Company offers a 401(k) Savings Plan to eligible
  employees (see also Note 9 of Notes to the Consolidated Financial Statements
  in this Annual Report on Form 10-K). Total expense related to the Companys
  matching contribution was approximately $1,003,000, $957,000 and $897,000 in
  2006, 2005 and 2004 respectively. The Company expects to expense and fund an
  amount in 2007 that is comparable to these historical amounts, however, is
  not contractually obligated to do so and, as such, no amount is recorded in
  the table above.                                                                                                                                                                                                                                                        

25

---



Related Party Transactions.

The Company leases its 181,300
square foot distribution center/office facility in Albany, New York from Robert
J. Higgins, its Chairman, Chief Executive Officer and largest shareholder,
under three capital leases that expire in the year 2015.  The original distribution center/office
facility was occupied in 1985.

Under the three capital leases,
dated April 1, 1985, November 1, 1989 and September 1, 1998 (the Leases), the
Company paid Mr. Higgins an annual rent of $2.0 million, $1.9 million and $1.8
million in Fiscal 2006, 2005 and 2004 respectively.  Pursuant to the terms of the lease agreements, effective January
1, 2006 and every two years thereafter, rental payments will increase in accordance
with the biennial increase in the Consumer Price Index.  Under the terms of the lease agreements, the
Company is responsible for property taxes, insurance and other operating costs
with respect to the premises.  Mr.
Higgins obligation for principal and interest on his underlying indebtedness
relating to the real property is approximately $1.1 million per year. None of
the leases contain any real property purchase options at the expiration of
their terms.

The Company leases one of its
retail stores from Mr. Higgins under a long-term operating lease.  Annual rental payments under this lease were
$40,000 in Fiscal 2006, 2005 and 2004.
Under the terms of the lease, the Company pays property taxes,
maintenance and a contingent rental if a specified sales level is achieved.
Total additional charges for the store, including contingent rent, were
approximately $4,100, $4,400 and $14,500 in Fiscal 2006, 2005 and 2004
respectively.

The Company regularly utilizes
privately chartered aircraft owned or partially owned by Mr. Higgins, for
Company business.  The Company charters
an aircraft from Crystal Jet, a corporation wholly-owned by Mr. Higgins, for
Company business.  Payments to Crystal
Jet aggregated approximately $11,000, $6,000 and $10,000 in Fiscal 2006, 2005
and 2004, respectively.  The Company
also charters an aircraft from Richmor Aviation, an unaffiliated corporation
that leases an aircraft owned by Mr. Higgins, for Company business.  Payments to Richmor Aviation, to charter the
aircraft owned by Mr. Higgins, in Fiscal 2006, 2005 and 2004 were approximately
$526,000, $276,000 and $314,000, respectively.
The Company believes that the charter rates and terms are as favorable
to the Company as those generally available to it from other commercial charters.

Michael Solow, a member of the Companys
Board of Directors, is a partner of the law firm Kaye Scholer LLP, which
rendered legal services to the Company in Fiscal 2004 for which the Company
incurred fees of approximately $115,000.
Kaye Scholer concluded its representation of the Company in Fiscal 2004.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial
statements and related disclosures in conformity with accounting principles
generally accepted in the United States requires that management apply
accounting policies and make estimates and assumptions that affect results of
operations and the reported amounts of assets and liabilities in the financial
statements.  Management continually
evaluates its estimates and judgments including those related to merchandise
inventory and return costs, valuation of long-lived assets, income taxes,
stock-based compensation, and accounting for gift card liability.  Management bases its estimates and judgments
on historical experience and other factors that are believed to be reasonable
under the circumstances.  Actual results
may differ from these estimates under different assumptions or conditions.   Note 1 of the Notes to the Consolidated
Financial Statements in this Annual Report on Form 10-K includes a summary of
the significant accounting policies and methods used by the Company in the
preparation of its consolidated financial statements. Management believes that
of the Companys significant accounting policies, the following may involve a
higher degree of judgment or complexity:

Merchandise Inventory and Return Costs: Merchandise inventory is stated at the lower of
cost or market as determined by the average cost method. The average cost
method attaches a cost to each item and is a blended average of the original
purchase price and those of subsequent purchases or other cost adjustments
throughout the life cycle of that item.

Inventory valuation requires
significant judgment and estimates, including obsolescence, shrink and any
adjustments to market value, if market value is lower than cost.  Inherent
in the entertainment software industry is the risk of obsolete inventory. 
Typically, newer releases generate a higher product demand.  Some vendors
offer credits to reduce the cost of products that are selling more slowly, thus
allowing for a reduction in the selling price and reducing the possibility for
items to become obsolete.  The Company records obsolescence and any
adjustments to market value (if lower than cost) based on current and
anticipated demand, customer preferences, and market conditions. The provision
for inventory shrink is estimated as a percentage of sales for the period from
the last date a physical inventory was performed to the end of the fiscal
year.  Such estimates are based on historical results and trends and the
shrink results from the last physical inventory.  Physical inventories are
taken at least annually for all stores throughout the year and inventory
records are adjusted accordingly.

Shrink expense, including
obsolescence was $14.9 million, $15.1 million and $17.2 million, in Fiscal
2006, 2005 and 2004 respectively.  As a rate to sales, this equaled 1.0%,
1.2% and 1.3%, respectively.  The Company expects to realize approximately
the same rate of shrink and obsolescence for the foreseeable future as recorded
in Fiscal 2006.  Presently, a 0.1% change in the rate of shrink and
obsolescence provision would equal approximately $0.7 million in additional
charge or benefit to cost of sales, based on Fiscal 2006 sales since the last
physical inventories.

26

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The Company is generally entitled
to return merchandise purchased from major vendors for credit against other
purchases from these vendors.   Certain
vendors reduce the credit with a per unit merchandise return charge which
varies depending on the type of merchandise being returned.  Certain other vendors charge a handling fee
based on units returned.  The Company
records merchandise return charges in cost of sales.  The Company incurred merchandise return charges in its fiscal
years 2006, 2005 and 2004 of $3.6 million, $5.6 million and $12.4 million,
respectively. Return penalties were lower in Fiscal 2006 than in prior years as
the major vendors have decreased the up-front incentives and in turn, lowered
the back-end penalty rate.

Valuation of Long-Lived Assets:  The Company
assesses the impairment of long-lived assets to determine if any part of the
carrying value may not be recoverable. Factors that the Company considers to be
important when assessing impairment include:

| |   |                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------
| |  | significant underperformance relative
  to historical or projected future operating results;                           
| |   |                                                                                                                        
| |  | significant changes in the manner
  of the use of acquired assets or the strategy for the Companys overall
  business;
| |   |                                                                                                                        
| |  | significant negative industry or
  economic trends;                                                                    

If the Company determines that the
carrying value of a long-lived asset may not be recoverable, it tests for
impairment to determine if an impairment charge is needed.  There were no impairment losses recorded in
Fiscal 2006, 2005 or 2004.   Losses for
store closings in the ordinary course of business represent the write down of
the net book value of abandoned fixtures and leasehold improvements.  The loss on disposal of fixed assets related
to store closings was $2.2 million, $2.4 million and $2.8 million in Fiscal 2006,
2005 and 2004, respectively, and is included in SG&A expenses in the
Consolidated Statement of Operations and loss on disposal of fixed assets in
the Consolidated Statement of Cash Flows.
Store closings usually occur at the expiration of the lease, at which
time leasehold improvements, which constitute a majority of the abandoned
assets, are fully depreciated.  Also,
actual store closures usually occur within three to six months of the planned
store closure date.

Income Taxes:Income taxes are accounted for under the asset and liability method.  Deferred tax assets and
liabilities are
recognized for the future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and liabilities and
their respective tax bases and tax operating loss carryforwards.  Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled.  The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in the results of
operations in the period that includes the enactment date.

Accounting for income taxes
requires management to make estimates and judgments regarding interpretation of
various taxing jurisdictions, laws and regulations as well as the ultimate
realization of deferred tax assets.
These estimates and judgments include the generation of future taxable
income, viable tax planning strategies and support of tax filings.  Valuation allowances are recorded against
deferred tax assets if, based upon managements estimates of realizability, it
is more likely than not that some portion or all of these deferred tax assets will
not be realized.  For additional discussion
regarding income taxes, refer to Note 6 in Notes to the Consolidated Financial
Statements in this Annual Report on Form 10-K.

Stock-based Compensation:  The Companys
adoption of SFAS No. 123 (revised 2004), Share-Based Payment, or SFAS
123(R), in the first quarter of 2006 required that the Company recognize stock-based
compensation expense associated with the vesting of share based instruments in
the statement of operations. Determining the amount of stock-based compensation
to be recorded requires the Company to develop estimates to be used in calculating the
grant-date fair value of stock options. The Company calculate the grant-date fair values
using the Black-Scholes valuation model. The Black-Scholes model requires the Company to
make estimates of the following assumptions:

Expected volatilityThe estimated stock price volatility was derived
based upon the Companys actual historic stock prices over the expected life of
the options, which represents the Companys best estimate of expected
volatility.

Expected option lifeThe Companys estimate of an expected option life
was calculated based on actual historical data relating to grants, exercises
and cancellations.

Risk-free interest rateThe Company used the yield on zero-coupon U.S. Treasury
securities for a period that is commensurate with the expected life assumption
as the risk-free interest rate.

The amount of stock-based
compensation recognized during a period is based on the value of the portion of
the awards that are ultimately expected to vest. SFAS 123(R) requires
forfeitures to be estimated at the time of grant and revised, if necessary, in
subsequent periods if actual forfeitures differ from those estimates. The term
forfeitures is distinct from cancellations or expirations and represents
only the unvested portion of the surrendered option. The Company reviewed historical
forfeiture data and determined the appropriate forfeiture rate based on that
data. The Company will re-evaluate this analysis periodically and adjust the forfeiture
rate as necessary. Ultimately, the Company will recognize the actual expense over the
vesting period only for the shares that vest.

Accounting for Gift Card Liability: The Company sells gift cards that are redeemable
only for merchandise and have no expiration date. The Company derecognizes card
liability when either customers redeem cards, at which point the Company
records revenue; or the Company determines it does not have a legal obligation
to remit unredeemed cards to the relevant jurisdictions and the likelihood of
the cards being

27

---



redeemed becomes remote, at which
point the Company records breakage as a credit to SG&A expenses. The
Companys accounting for gift cards is based on estimating the Companys
liability for future card redemptions at the end of a reporting period.  Estimated liability is equal to two years of
unredeemed cards, plus an amount for outstanding cards that may possibly be
redeemed for the cumulative look-back period, exclusive of the last two
years.  The Companys ability to
reasonably and reliably estimate the liability is based on historical redemption
experience with gift cards and similar types of arrangements and the existence
of a large volume of relatively homogeneous transactions. The Companys
estimate is not susceptible to significant external factors and the
circumstances around gift card sales and redemptions have not changed
significantly over time.

Recently Issued Accounting Pronouncements.

In February 2007, the Financial
Accounting Standards Board (FASB) issued Statement of Financial Accounting
Standards (SFAS) No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities  including an amendment of FASB Statement No. 115.  SFAS No. 159 permits entities to choose to
measure many financial instruments and certain other items at fair value.  The objective of the statement is to provide
entities with the opportunity to mitigate volatility in reported earnings
caused by measuring related assets and liabilities differently without having
to apply complex hedge accounting provisions.
SFAS No. 159 is effective as of the beginning of an entitys fiscal year
beginning after November 15, 2007.   The
adoption of SFAS No. 159 is not expected to have a significant impact on the
Companys Consolidated Financial Statements.

In September 2006, the FASB issued
Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value
Measurements.  SFAS No. 157
defines fair value, establishes a framework for measuring fair value in
generally accepted accounting principles (GAAP), and expands disclosures about
fair value measurements.  SFAS No. 157
applies under other accounting pronouncements that require or permit fair value
measurements, however, does not require any new fair value measurements.  SFAS No. 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and
interim periods within those fiscal years.
The adoption of SFAS No. 157 is not expected to have a significant
impact on the Companys Consolidated Financial Statements.

In July 2006, the FASB issued
Interpretation No. (FIN) 48, Accounting for Uncertainty in Income TaxesAn
Interpretation of FASB Statement No. 109, which prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in
a tax return.  In particular, this interpretation requires uncertain
tax positions to be recognized only if they are more-likely-than-not to be
upheld based on their technical merits. Additionally, the measurement of the
tax position will be based on the largest amount that is determined to have
greater than a 50% likelihood of realization upon ultimate settlement. Any
resulting cumulative effect of applying the provisions of FIN 48 upon adoption
would be reported as an adjustment to the beginning balance of retained
earnings in the period of adoption. FIN 48 will be effective for the Companys
fiscal year beginning February 4, 2007. The Company is currently evaluating the
impact of this interpretation on the Companys Consolidated Financial
Statements.

28

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Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK

The Company does not hold any
financial instruments that expose it to significant market risk and does not
engage in hedging activities.  To the
extent the Company borrows under its revolving credit facility, the Company is
subject to risk resulting from interest rate fluctuations since interest on the
Companys borrowings under its revolving credit facility can be variable.  If interest rates on the Companys revolving
credit facility were to increase by 25 basis points, and to the extent
borrowings were outstanding, for every $1,000,000 outstanding on the facility,
income before income taxes would be reduced by $2,500 per year. Information
about the fair value of financial instruments is included in Note 1of Notes to
the Consolidated Financial Statements in this Annual Report on Form 10-K.

Item 8.  FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA

The index to the Companys
Consolidated Financial Statements is included in Item 15, and the Consolidated
Financial Statements follow the signature page to this Annual Report on Form
10-K and are incorporated herein by reference.

The quarterly results of operations
are included herein in Note 12 of Notes to the Consolidated Financial
Statements in this Annual Report on Form 10-K.

Item 9.  CHANGES IN
AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

Item 9A. CONTROLS AND PROCEDURES

Conclusion Regarding the Effectiveness of Disclosure Controls
and Procedures: Under the supervision
and with the participation of our management, including our principal executive
officer and principal financial officer, we conducted an evaluation of the
effectiveness of our disclosure controls and procedures, as such term is
defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of
1934, as amended (the Exchange Act). Based on this evaluation, our principal
executive officer and our principal financial officer concluded that, as of the
end of the period covered by this annual report, our disclosure controls and
procedures were effective, in that they provide reasonable assurance that
information required to be disclosed by us in the reports we file or submit,
under the Exchange Act, is recorded, processed, summarized and reported within
the time period specified in the Securities and Exchange Commissions rules and
forms.

Managements Report on Internal Control Over Financial
Reporting:  Management is responsible for establishing
and maintaining adequate internal control over financial reporting (as defined
in Rule 13a-15(f) and 15d  15(f) under the Securities Exchange Act of
1934, as amended). Under the supervision and with the participation of the
Companys management, including our principal executive officer and principal
financial officer, we conducted an evaluation of the effectiveness of our
internal control over financial reporting based on the framework set forth by
the Committee of Sponsoring Organizations of the Treadway Commission (COSO)
in Internal
Control-Integrated Framework. Based on our evaluation under the
framework in Internal Control- Integrated Framework, our management
concluded that our internal control over financial reporting was effective as
of February 3, 2007.

The Companys independent registered
public accounting firm, KPMG LLP, has issued an audit report on the Companys
assessment of the effectiveness of internal control over financial reporting as
of February 3, 2007, which is included in Item 8 of this Annual Report on
Form 10-K and incorporated herein by reference.

Changes in Controls and Procedures: No change in our internal control over financial
reporting occurred during the quarterly period ended February 3, 2007 that has
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.

Item 9B. Other Information

No events have occurred which would
require disclosure under this Item.

29

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PART III

Item 10.  DIRECTORS,
EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

(a) Identification of Directors

Incorporated herein by reference is
the information appearing under the captions Election of Directors and
Compensation of Directors in the Companys definitive Proxy Statement for the
Registrants 2007 Annual Meeting of Shareholders to be filed with the
Securities and Exchange Commission within 120 days after February 3, 2007.

(b) Identification of Executive
Officers

Incorporated herein by reference is
the information appearing under the caption Executive Compensation in the
Companys definitive Proxy Statement for the Registrants 2007 Annual Meeting
of Shareholders to be filed with the Securities and Exchange Commission within
120 days after February 3, 2007.

(c) Code of Ethics

We have adopted the Trans World
Entertainment Corporation Code of Ethics that applies to all officers,
directors, employees and consultants of the Company. The Code of Ethics is
intended to comply with Item 406 of Regulation S-K of the Securities
Exchange Act of 1934 and with applicable rules of The NASDAQ Stock Market, Inc.
Our Code of Ethics is posted on our Internet website under the Corporate
page. Our Internet website address is www.twec.com. To the extent required or
permitted by the rules of the SEC and NASDAQ, we will disclose amendments and
waivers relating to our Code of Ethics in the same place as our website.

Item 11.  EXECUTIVE
COMPENSATION

Incorporated herein by reference is
the information appearing under the caption Executive Compensation in the
Companys definitive Proxy Statement for the Registrants 2007 Annual Meeting
of Shareholders to be filed with the Securities and Exchange Commission within
120 days after February 3, 2007.

Item 12.  SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER
MATTERS

Incorporated herein by reference is
the information appearing under the captions Equity Ownership of Directors and
Executive Officers and Principal Shareholders in the Companys definitive
Proxy Statement for the Registrants 2007 Annual Meeting of Shareholders to be
filed with the Securities and Exchange Commission within 120 days after
February 3, 2007.

Information on Trans World
Entertainment Common Stock authorized for issuance under equity compensation
plans is contained in our Proxy Statement for our 2007 Annual Meeting of
Shareholders under the caption Stock Option Plans and is incorporated herein
by reference. See Note 9 of Notes to the Consolidated Financial Statements in
this Annual Report on Form 10-K for a description of the Companys employee
stock award plans.

The following table contains
information about the Companys Common Stock that may be issued upon the
exercise of options, warrants and rights under all of the Companys equity
compensation plans as of February 3, 2007:

|                                                                      |  |                                                                                             |  |                                                                                 |  |                                                                                                                                                      
|--------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                      |  |                                                                                             |  |                                                                                 |  |                                                                                                                                                      
|Plan Category                                                         |  | Number of Shares to be Issued
  upon Exercise of Outstanding
  Options, Warrants and Rights |  | Weighted Average Exercise
  Price of Outstanding Options,
  Warrants and Rights |  | Number of Shares Remaining
  Available for Future Issuance
  Under Equity Compensation
  Plans (Excluding Outstanding
  Options, Warrants and Rights)
|                                                                      |  |                                                                                            
|                                                                      |  | (Shares in
thousands)                                                                      
|                                                                     
|Equity Compensation Plan Approved by Shareholders                     |  | 10,059                                                                                      |  | $8.70                                                                           |  | 4,454                                                                                                                                                
|Equity Compensation Plans and Agreements not Approved by
Shareholders |  |                                                                                            |  |                                                                                |  |                                                                                                                                                     

30

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Item 13.  CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Incorporated herein by reference is
the information appearing under the caption Related Party Transactions in the
Companys definitive Proxy Statement for the Registrants 2007 Annual Meeting
of Shareholders to be filed with the Securities and Exchange Commission within
120 days after February 3, 2007.

Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Incorporated herein by reference is
the information appearing under the caption Other Matters in the Companys
definitive Proxy Statement for the Registrants 2007 Annual Meeting of
Shareholders to be filed with the Securities and Exchange Commission within 120
days after February 3, 2007.

31

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PART IV

Item 15.
EXHIBITS, AND FINANCIAL STATEMENT SCHEDULES

15(a)
(1) Financial Statements

The Consolidated Financial
Statements and Notes are listed in the Index to Consolidated Financial
Statements on page F-1 of this report.

15(a)
(2) Financial Statement Schedules

Consolidated Financial Statement
Schedules not filed herein have been omitted as they are not applicable or the
required information or equivalent information has been included in the
Consolidated Financial Statements or the notes thereto.

15(a)
(3) Exhibits

Exhibits are as set forth in the
Index to Exhibits which follows the Notes to the Consolidated Financial
Statements and immediately precedes the exhibits filed.

32

---



SIGNATURES

Pursuant to the requirements of
Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

|                     |                                         |                                       
|-------------------- | --------------------------------------- | --------------------------------------
|                     | TRANS WORLD ENTERTAINMENT
  CORPORATION
|                     |                                         |                                       
|Date: April 19, 2007 |                                         | By:
  /s/ ROBERT J. HIGGINS           
|                     |                                         |                                       
|                     |                                         | Robert
  J. Higgins                   
|                     |                                         | Chairman
  and Chief Executive Officer

Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.

|                         |  |                                                                   |  |               
|------------------------ |  | ----------------------------------------------------------------- |  | --------------
|Name                     |  | Title                                                             |  | Date          
|                         |  |                                                                   |  |               
|/s/ ROBERT J. HIGGINS    |  | Chairman and Chief Executive
  Officer                            |  | April 19, 2007
|                         |  | (Principal Executive Officer)                                     |  |               
|(Robert J. Higgins)      |  |                                                                   |  |               
|                         |  |                                                                   |  |               
|/s/ JOHN J. SULLIVAN     |  | Executive Vice President and
  Chief Financial Officer (Principal |  | April 19, 2007
|                         |  | Financial and Chief Accounting
  Officer) and Secretary           |  |               
|(John J. Sullivan)       |  |                                                                   |  |               
|                         |  |                                                                   |  |               
|/s/ BRETT BREWER         |  | Director                                                          |  | April 19, 2007
|                         |  |                                                                   |  |               
|(Brett Brewer)           |  |                                                                   |  |               
|                         |  |                                                                   |  |               
|/s/ MARK A. COHEN        |  | Director                                                          |  | April 19, 2007
|                         |  |                                                                   |  |               
|(Mark A. Cohen)          |  |                                                                   |  |               
|                         |  |                                                                   |  |               
|/s/ MARTIN E. HANAKA     |  | Director                                                          |  | April 19, 2007
|                         |  |                                                                   |  |               
|(Martin E. Hanaka)       |  |                                                                   |  |               
|                         |  |                                                                   |  |               
|/s/ ISAAC KAUFMAN        |  | Director                                                          |  | April 19, 2007
|                         |  |                                                                   |  |               
|(Isaac Kaufman)          |  |                                                                   |  |               
|                         |  |                                                                   |  |               
|/s/ DR. JOSEPH G. MORONE |  | Director                                                          |  | April 19, 2007
|                         |  |                                                                   |  |               
|(Dr. Joseph G. Morone)   |  |                                                                   |  |               
|                         |  |                                                                   |  |               
|/s/ LORI SCHAFER         |  | Director                                                          |  | April 19, 2007
|                         |  |                                                                   |  |               
|(Lori Schafer)           |  |                                                                   |  |               
|                         |  |                                                                   |  |               
|/s/ MICHAEL B. SOLOW     |  | Director                                                          |  | April 19, 2007
|                         |  |                                                                   |  |               
|(Michael B. Solow)       |  |                                                                   |  |               
|                         |  |                                                                   |  |               
|/s/ EDMOND THOMAS        |  | Director                                                          |  | April 19, 2007
|                         |  |                                                                   |  |               
|(Edmond Thomas)          |  |                                                                   |  |               

33

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TRANS WORLD ENTERTAINMENT CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                                                                                                                                  |  |                     
|----------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------
|                                                                                                                                                                  |  | Form 10-K
  Page No.
|                                                                                                                                                                  |  |                     
|Reports of
  Independent Registered Public Accounting Firm                                                                                                        |  | F-2                 
|                                                                                                                                                                  |  |                     
|Consolidated
  Financial Statements                                                                                                                               |  |                     
|                                                                                                                                                                  |  |                     
|Consolidated Balance Sheets at
February 3, 2007 and
  January 28, 2006                                                                                            |  | F-4                 
|                                                                                                                                                                  |  |                     
|Consolidated Statements of
Operations - Fiscal years
  ended
  February 3, 2007, January 28, 2006, and January 29, 2005                                           |  | F-5                 
|                                                                                                                                                                  |  |                     
|Consolidated Statements of
Shareholders Equity and
  Comprehensive Income (Loss) - Fiscal years ended
  February 3, 2007, January 28, 2006, and January 29, 2005 |  | F-6                 
|                                                                                                                                                                  |  |                     
|Consolidated Statements of Cash
Flows - Fiscal years
  ended
  February 3, 2007, January 28, 2006, and January 29, 2005                                           |  | F-7                 
|                                                                                                                                                                  |  |                     
|Notes to
  Consolidated Financial Statements                                                                                                                      |  | F-8                 

F-1

---



Report of Independent Registered
Public Accounting Firm

The Board of Directors and
Shareholders
Trans World Entertainment Corporation:

We have audited the accompanying
consolidated balance sheets of Trans World Entertainment Corporation and
subsidiaries (the Company) as of February 3, 2007 and January 28, 2006, and the
related consolidated statements of operations, shareholders equity and
comprehensive income (loss), and cash flows for each of the fiscal years in the
three-year period ended February 3, 2007.
These consolidated financial statements are the responsibility of the
Companys management.  Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

We conducted our audits in
accordance with the standards of the Public Company Accounting Oversight Board
(United States).  Those standards
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement.  An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, the consolidated
financial statements referred to above present fairly, in all material
respects, the financial position of Trans World Entertainment Corporation and
subsidiaries as of February 3, 2007 and January 28, 2006, and the results of
their operations and their cash flows for each of the fiscal years in the
three-year period ended February 3, 2007, in conformity with U.S. generally
accepted accounting principles.

As discussed in Note 1 to the
consolidated financial statements, during 2006 the Company changed its methods
of accounting for pension and other postretirement benefit obligations and for
share-based compensation.

We also have audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United
States), the effectiveness of Trans World Entertainment Corporations internal
control over financial reporting as of February 3, 2007, based on criteria
established in Internal Control  Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), and our report dated April 19, 2007 expressed an
unqualified opinion on managements assessment of, and the effective operation
of internal control over financial reporting.

/s/ KPMG LLP

Albany, New York
April 19, 2007

F-2

---



Report of Independent
Registered Public Accounting Firm

The Board of Directors and
Stockholders 
Trans World Entertainment Corporation:

We have audited managements
assessment, included in the accompanying Managements Report on Internal
Control Over Financial Reporting, that Trans World Entertainment Corporation
and subsidiaries (the Company) maintained effective internal control over
financial reporting as of February 3, 2007, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). The Companys management is
responsible for maintaining effective internal control over financial
reporting, and for its assessment of the effectiveness of internal control over
financial reporting. Our responsibility is to express an opinion on
managements assessment and an opinion on the effectiveness of the Companys
internal control over financial reporting based on our audit.

We conducted our audit in
accordance with the standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether effective internal control over
financial reporting was maintained in all material respects. Our audit included
obtaining an understanding of internal control over financial reporting,
evaluating managements assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other
procedures as we considered necessary in the circumstances. We believe that our
audit provides a reasonable basis for our opinion.

A companys internal control over
financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally
accepted accounting principles. A companys internal control over financial
reporting includes those policies and procedures that (1) pertain to the
maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally
accepted accounting principles, and that receipts and expenditures of the
company are being made only in accordance with authorizations of management and
directors of the company; and (3) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition
of the companys assets that could have a material effect on the financial
statements.

Because of its inherent
limitations, internal control over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of effectiveness to
future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the policies
or procedures may deteriorate.

In our opinion, managements
assessment that Trans World Entertainment Corporation and subsidiaries
maintained effective internal control over financial reporting as of February
3, 2007, is fairly stated, in all material respects, based on criteria
established in Internal ControlIntegrated Framework issued by COSO. Also,
in our opinion, Trans World Entertainment Corporation and subsidiaries
maintained, in all material respects, effective internal control over financial
reporting as of February 3, 2007, based on criteria established in Internal
ControlIntegrated Framework issued by COSO.

We also have audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United
States), the consolidated balance sheets of Trans World Entertainment
Corporation and subsidiaries as of February 3, 2007 and January 28, 2006, and
related consolidated statements of operations, shareholders equity and
comprehensive income (loss), and cash flows for each of the fiscal years in the
three-year period ended February 3, 2007, and our report dated April 19, 2007
expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP

Albany, New York 
April 19, 2007

F-3

---



TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS
($ in thousands)

|                                                                                                                                |  |                    |          |                    |   |          |  
|------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | ------------------ | - | -------- | -
|                                                                                                                                |  | February 3,
  2007 |          | January 28,
  2006 |  
|                                                                                                                                |  |                    |          |                   
|ASSETS                                                                                                                          |  |                    |          |                    |   |          |  
|CURRENT ASSETS                                                                                                                  |  |                    |          |                    |   |          |  
|Cash and cash equivalents                                                                                                       |  | $                  | 118,630  |                    | $ | 197,209  |  
|Accounts receivable                                                                                                             |  |                    | 7,874    |                    |   | 8,671    |  
|Merchandise inventory                                                                                                           |  |                    | 504,860  |                    |   | 402,712  |  
|Income taxes receivable                                                                                                         |  |                    |         |                    |   | 892      |  
|Prepaid expenses and other                                                                                                      |  |                    | 5,953    |                    |   | 6,083    |  
|Deferred taxes                                                                                                                  |  |                    | 9,039    |                    |   | 11,266   |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|Total current assets                                                                                                            |  |                    | 646,356  |                    |   | 626,833  |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|                                                                                                                               
|FIXED ASSETS, net                                                                                                               |  |                    | 138,252  |                    |   | 131,798  |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|DEFERRED TAXES                                                                                                                  |  |                    | 32,715   |                    |   | 27,511   |  
|OTHER ASSETS                                                                                                                    |  |                    | 12,367   |                    |   | 13,515   |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|TOTAL ASSETS                                                                                                                    |  | $                  | 829,690  |                    | $ | 799,657  |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|LIABILITIES                                                                                                                     |  |                    |          |                    |   |          |  
|CURRENT LIABILITIES                                                                                                             |  |                    |          |                    |   |          |  
|Accounts payable                                                                                                                |  | $                  | 311,372  |                    | $ | 307,687  |  
|Accrued expenses and other current
liabilities                                                                                  |  |                    | 51,741   |                    |   | 41,864   |  
|Income taxes payable                                                                                                            |  |                    | 13,646   |                    |   |         |  
|Current portion of long-term debt                                                                                               |  |                    | 506      |                    |   | 477      |  
|Current portion of capital lease
obligations                                                                                    |  |                    | 2,887    |                    |   | 3,182    |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|Total current liabilities                                                                                                       |  |                    | 380,152  |                    |   | 353,210  |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|LONG TERM DEBT, less current
  portion                                                                                         |  |                    | 4,085    |                    |   | 4,587    |  
|CAPITAL LEASE OBLIGATIONS, less
  current portion                                                                               |  |                    | 12,000   |                    |   | 14,887   |  
|DEFERRED RENT AND OTHER
  LIABILITIES                                                                                           |  |                    | 40,248   |                    |   | 48,461   |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|TOTAL LIABILITIES                                                                                                               |  |                    | 436,485  |                    |   | 421,145  |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|SHAREHOLDERS EQUITY                                                                                                            |  |                    |          |                    |   |          |  
|Preferred stock ($0.01 par value;
  5,000,000 shares authorized; none issued)                                                   |  |                    |         |                    |   |         |  
|Common stock ($0.01 par value;
  200,000,000 shares authorized;
  55,998,109 shares and 55,727,575 shares issued, respectively) |  |                    | 560      |                    |   | 557      |  
|Additional paid-in capital                                                                                                      |  |                    | 301,526  |                    |   | 298,699  |  
|Unearned compensation 
  restricted stock                                                                                      |  |                    |         |                    |   | (30      | )
|Treasury stock at cost
  (25,103,990 and 25,104,990 shares, respectively)                                                       |  |                    | (217,560 | )                  |   | (217,564 | )
|Accumulated other comprehensive
  loss                                                                                          |  |                    | (1,888   | )                  |   | (2,048   | )
|Retained earnings                                                                                                               |  |                    | 310,567  |                    |   | 298,898  |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|TOTAL SHAREHOLDERS EQUITY                                                                                                      |  |                    | 393,205  |                    |   | 378,512  |  
|                                                                                                                                |  |                    |          |                    |   |          |  
|TOTAL LIABILITIES AND SHAREHOLDERS
EQUITY                                                                                      |  | $                  | 829,690  |                    | $ | 799,657  |  
|                                                                                                                                |  |                    |          |                    |   |          |  

See Accompanying Notes to Consolidated Financial
Statements.

F-4

---



TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS
($ in thousands, except per share amounts)

|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|----------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | --------- | ------------------ | - | ------------------ | - | - | --------- | -
|                                                                                                                                                |  | Fiscal Year Ended  |          
|                                                                                                                                                |  |                   
|                                                                                                                                                |  | February 3,
  2007 |           | January 28,
  2006 |   | January 29,
  2005 |  
|                                                                                                                                                |  |                    |           |                    |   |                    |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|Sales                                                                                                                                           |  | $                  | 1,471,157 |                    | $ | 1,238,486          |   | $ | 1,365,133 |  
|Cost of sales                                                                                                                                   |  |                    | 951,935   |                    |   | 806,873            |   |   | 869,999   |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|Gross profit                                                                                                                                    |  |                    | 519,222   |                    |   | 431,613            |   |   | 495,134   |  
|Selling, general and administrative expenses                                                                                                    |  |                    | 519,246   |                    |   | 426,854            |   |   | 450,162   |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|(Loss) income from operations                                                                                                                   |  |                    | (24       | )                  |   | 4,759              |   |   | 44,972    |  
|Interest expense                                                                                                                                |  |                    | 5,504     |                    |   | 2,954              |   |   | 2,444     |  
|Other income                                                                                                                                    |  |                    | (4,435    | )                  |   | (2,171             | ) |   | (1,039    | )
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|(Loss) income before income taxes, extraordinary gain 
unallocated
  negative goodwill and cumulative effect of change in accounting principle |  |                    | (1,093    | )                  |   | 3,976              |   |   | 43,567    |  
|Income tax (benefit) expense                                                                                                                    |  |                    | (2,041    | )                  |   | 1,090              |   |   | 4,892     |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|Income before extraordinary gain  unallocated negative
goodwill and
  cumulative effect of a change in accounting principle                    |  |                    | 948       |                    |   | 2,886              |   |   | 38,675    |  
|Extraordinary gain  unallocated negative goodwill, net of
income taxes
  of $6,739, $0 and $1,979 in 2006, 2005 and 2004, respectively         |  |                    | 10,721    |                    |   |                   |   |   | 3,166     |  
|Cumulative effect of a change in accounting principle, net of income
  taxes of $0, $1,505 and $0 in 2006, 2005 and 2004, respectively.         |  |                    |          |                    |   | (2,277             | ) |   |          |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|NET INCOME                                                                                                                                      |  | $                  | 11,669    |                    | $ | 609                |   | $ | 41,841    |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|BASIC EARNINGS PER SHARE:                                                                                                                       |  |                    |           |                    |   |                    |   |   |           |  
|Earnings per share before extraordinary gain  unallocated
negative
  goodwill and cumulative effect of a change in accounting principle        |  | $                  | 0.03      |                    | $ | 0.09               |   | $ | 1.12      |  
|Extraordinary gain  unallocated negative goodwill                                                                                              |  |                    | 0.35      |                    |   |                   |   |   | 0.09      |  
|Cumulative effect of a change in accounting principle                                                                                           |  |                    |          |                    |   | (0.07              | ) |   |          |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|Basic earnings per share                                                                                                                        |  | $                  | 0.38      |                    | $ | 0.02               |   | $ | 1.21      |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|Weighted average number of common shares outstanding 
basic                                                                                    |  |                    | 30,797    |                    |   | 31,962             |   |   | 34,531    |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|DILUTED EARNINGS PER SHARE:                                                                                                                     |  |                    |           |                    |   |                    |   |   |           |  
|Earnings per share before extraordinary gain  unallocated
negative
  goodwill and cumulative effect of a change in accounting principle        |  | $                  | 0.03      |                    | $ | 0.09               |   | $ | 1.06      |  
|Extraordinary gain  unallocated negative goodwill                                                                                              |  |                    | 0.33      |                    |   |                   |   |   | 0.09      |  
|Cumulative effect of a change in accounting principle                                                                                           |  |                    |          |                    |   | (0.07              | ) |   |          |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|Diluted earnings per share                                                                                                                      |  | $                  | 0.36      |                    | $ | 0.02               |   | $ | 1.15      |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  
|Weighted average number of common shares outstanding 
diluted                                                                                  |  |                    | 31,986    |                    |   | 32,132             |   |   | 36,297    |  
|                                                                                                                                                |  |                    |           |                    |   |                    |   |   |           |  

See Accompanying Notes to
Consolidated Financial Statements.

F-5

---



TRANS WORLD ENTERTAINMENT CORPORATION AND
SUBSIDIARIESCONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY AND
COMPREHENSIVE INCOME (LOSS)
($ in thousands)

|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|------------------------------------------------------------------------------------------------------------------ |  | --------------- | ------ | -------------- | - | ------------------------------ |  | -------------------------------------------- | ------- | ----------------- | - | ------------------------ | - | ----------------------------- | ------- | ------------------- | - | ---------------------- | - | - | ------ | - | - | ------- |  | - | ------- | -
|                                                                                                                   |  | Common
  Shares |        | Common
  Stock |   | Additional
  Paid-in
  Capital |  | Unearned
  Compensation
  Restricted
  Stock |         | Treasury
  Shares |   | Treasury Stock
  At Cost |   | Accum.
  Other
  Comp.
  Loss |         | Retained
  Earnings |   | Shareholders
  Equity |  
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |  
|Balance as of January 31, 2004                                                                                     |  |                 | 54,246 |                | $ | 542                            |  | $                                            | 288,272 |                   | $ | (23                      | ) |                               | (18,147 | )                   | $ | (146,055               | ) |   |       |   | $ | 256,448 |  | $ | 399,184 |  
|                                                                                                                  
|Comprehensive income:                                                                                              |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|                                                                                                                  
|Net income                                                                                                         |  |                 |       |                |   |                               |  |                                              |        |                   |   |                         |   |                               |        |                     |   |                       |   |   |       |   |   | 41,841  |  |   | 41,841  |  
|                                                                                                                  
|Excess of additional minimum pension liability over
unrecognized prior
  service cost, net of income taxes of $747 |  |                 |       |                |   |                               |  |                                              |        |                   |   |                         |   |                               |        |                     |   |                       |   | $ | (1,094 | ) |   |        |  |   | (1,094  | )
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|Total comprehensive income                                                                                         |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   | 40,747  |  
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|Repurchase of shares of treasury stock                                                                             |  |                 |       |                |   |                               |  |                                              |        |                   |   |                         |   |                               | (3,843  | )                   |   | (40,247                | ) |   |       |   |   |        |  |   | (40,247 | )
|                                                                                                                  
|Issuance of treasury stock under incentive stock
programs                                                          |  |                 |       |                |   |                               |  |                                              | 6       |                   |   |                         |   |                               | 1       |                     |   | 4                      |   |   |       |   |   |        |  |   | 10      |  
|                                                                                                                  
|Amortization of unearned compensation 
restricted stock                                                           |  |                 |       |                |   |                               |  |                                              |        |                   |   | 28                       |   |                               |        |                     |   |                       |   |   |       |   |   |        |  |   | 28      |  
|                                                                                                                  
|Issuance of restricted stock                                                                                       |  |                 | 5      |                |   |                               |  |                                              | 51      |                   |   | (51                      | ) |                               |        |                     |   |                       |   |   |       |   |   |        |  |   |        |  
|                                                                                                                  
|Issuance of stock to Directors                                                                                     |  |                 | 12     |                |   |                               |  |                                              | 52      |                   |   |                         |   |                               |        |                     |   |                       |   |   |       |   |   |        |  |   | 52      |  
|                                                                                                                  
|Exercise of stock options and related tax
benefit                                                                  |  |                 | 752    |                |   | 8                              |  |                                              | 4,541   |                   |   |                         |   |                               |        |                     |   |                       |   |   |       |   |   |        |  |   | 4,549   |  
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|Balance as of January 29, 2005                                                                                     |  |                 | 55,015 |                | $ | 550                            |  | $                                            | 292,922 |                   | $ | (46                      | ) |                               | (21,989 | )                   | $ | (186,298               | ) | $ | (1,094 | ) | $ | 298,289 |  | $ | 404,323 |  
|                                                                                                                  
|Comprehensive loss:                                                                                                |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|                                                                                                                  
|Net income                                                                                                         |  |                 |       |                |   |                               |  |                                              |        |                   |   |                         |   |                               |        |                     |   |                       |   |   |       |   |   | 609     |  |   | 609     |  
|                                                                                                                  
|Excess of additional minimum pension liability over
unrecognized prior
  service cost, net of income taxes of $741 |  |                 |       |                |   |                               |  |                                              |        |                   |   |                         |   |                               |        |                     |   |                       |   |   | (954   | ) |   |        |  |   | (954    | )
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|Total comprehensive loss                                                                                           |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   | (345    | )
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|Repurchase of shares of treasury stock                                                                             |  |                 |       |                |   |                               |  |                                              |        |                   |   |                         |   |                               | (3,117  | )                   |   | (31,270                | ) |   |       |   |   |        |  |   | (31,270 | )
|                                                                                                                  
|Issuance of treasury stock under incentive stock
programs                                                          |  |                 |       |                |   |                               |  |                                              | 3       |                   |   |                         |   |                               | 1       |                     |   | 4                      |   |   |       |   |   |        |  |   | 7       |  
|                                                                                                                  
|Amortization of unearned compensation 
restricted stock                                                           |  |                 |       |                |   |                               |  |                                              |        |                   |   | 16                       |   |                               |        |                     |   |                       |   |   |       |   |   |        |  |   | 16      |  
|                                                                                                                  
|Stock compensation and related tax
benefit                                                                         |  |                 | 713    |                |   | 7                              |  |                                              | 5,774   |                   |   |                         |   |                               |        |                     |   |                       |   |   |       |   |   |        |  |   | 5,781   |  
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|Balance as of January 28, 2006                                                                                     |  |                 | 55,728 |                | $ | 557                            |  | $                                            | 298,699 |                   | $ | (30                      | ) |                               | (25,105 | )                   | $ | (217,564               | ) | $ | (2,048 | ) | $ | 298,898 |  | $ | 378,512 |  
|                                                                                                                  
|Comprehensive income:                                                                                              |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|                                                                                                                  
|Net income                                                                                                         |  |                 |       |                |   |                               |  |                                              |        |                   |   |                         |   |                               |        |                     |   |                       |   |   |       |   |   | 11,669  |  |   | 11,669  |  
|Additional pension liability adjustment, net of
income taxes of $1,771                                             |  |                 |       |                |   |                               |  |                                              |        |                   |   |                         |   |                               |        |                     |   |                       |   |   | 2,445  |   |   |        |  |   | 2,445   |  
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|Total comprehensive income                                                                                         |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   | 14,114  |  
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|Adjustment to initially applySFAS
158, net of income taxes of $1,623                                               |  |                 |       |                |   |                               |  |                                              |        |                   |   |                         |   |                               |        |                     |   |                       |   |   | (2,285 | ) |   |        |  |   | (2,285  | )
|Issuance of treasury stock under incentive stock
programs                                                          |  |                 |       |                |   |                               |  |                                              | 2       |                   |   |                         |   |                               | 1       |                     |   | 4                      |   |   |       |   |   |        |  |   | 6       |  
|Stock compensation and related tax
benefit                                                                         |  |                 | 270    |                |   | 3                              |  |                                              | 2,842   |                   |   |                         |   |                               |        |                     |   |                       |   |   |       |   |   |        |  |   | 2,845   |  
|                                                                                                                  
|Reclassification of unearned compensation
upon adoption of
  SFAS 123(R)                                           |  |                 |       |                |   |                               |  |                                              | (30     | )                 |   | 30                       |   |                               |        |                     |   |                       |   |   |       |   |   |        |  |   |        |  
|Amortization of unearned compensation  restricted stock                                                           |  |                 |       |                |   |                               |  |                                              | 13      |                   |   |                         |   |                               |        |                     |   |                       |   |   |       |   |   |        |  |   | 13      |  
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  
|Balance as of February 3, 2007                                                                                     |  |                 | 55,998 |                | $ | 560                            |  | $                                            | 301,526 |                   | $ |                         |   |                               | (25,104 | )                   | $ | (217,560               | ) | $ | (1,888 | ) | $ | 310,567 |  | $ | 393,205 |  
|                                                                                                                   |  |                 |        |                |   |                                |  |                                              |         |                   |   |                          |   |                               |         |                     |   |                        |   |   |        |   |   |         |  |   |         |  

See Accompanying Notes to Consolidated
Financial Statements.

F-6

---



TRANS WORLD ENTERTAINMENT CORPORATION AND
SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)

|                                                                                    |  |                     |          |               |   |               |   |   |         |  
|----------------------------------------------------------------------------------- |  | ------------------- | -------- | ------------- | - | ------------- | - | - | ------- | -
|                                                                                    |  | Fiscal
  Year Ended |         
|                                                                                    |  |                     |         
|                                                                                    |  | February
  3,       |          | January
  28, |   | January
  29, |  
|                                                                                    |  | 2007                |          | 2006          |   | 2005          |  
|                                                                                    |  |                     |          |               |   |               |  
|OPERATING ACTIVITIES:                                                               |  |                     |          |               |   |               |   |   |         |  
|Net income                                                                          |  | $                   | 11,669   |               | $ | 609           |   | $ | 41,841  |  
|Adjustments to reconcile net income to net
  cash provided by operating activities: |  |                     |          |               |   |               |   |   |         |  
|Depreciation and amortization of fixed
  assets                                     |  |                     | 40,099   |               |   | 37,216        |   |   | 39,796  |  
|Amortization of intangible assets                                                   |  |                     | 263      |               |   | 94            |   |   |        |  
|Amortization of lease valuations, net                                               |  |                     | (3,150   | )             |   | (428          | ) |   | (844    | )
|Stock compensation programs                                                         |  |                     | 2,191    |               |   | 319           |   |   | 90      |  
|Loss on disposal of fixed assets                                                    |  |                     | 2,243    |               |   | 2,391         |   |   | 2,848   |  
|Gain on sale of available for sale
  securities and other investments               |  |                     | (3,528   | )             |   | (813          | ) |   |        |  
|Deferred tax (benefit) expense                                                      |  |                     | (4,387   | )             |   | 4,186         |   |   | 6,948   |  
|Cumulative effect of change in accounting
  principle, net of income taxes          |  |                     |         |               |   | 2,277         |   |   |        |  
|Extraordinary gain on acquisition of
  businesses, net of income taxes              |  |                     | (10,721  | )             |   |              |   |   | (3,166  | )
|Changes in operating assets and liabilities,
  net of effects of acquisitions:      |  |                     |          |               |   |               |   |   |         |  
|Accounts receivable                                                                 |  |                     | 819      |               |   | (2,469        | ) |   | 2,980   |  
|Merchandise inventory                                                               |  |                     | 10,520   |               |   | 28,534        |   |   | (4,009  | )
|Prepaid expenses and other                                                          |  |                     | 146      |               |   | 1,067         |   |   | (104    | )
|Other assets                                                                        |  |                     | (490     | )             |   | 544           |   |   | (2,730  | )
|Accounts payable                                                                    |  |                     | 3,804    |               |   | (38,776       | ) |   | 48,080  |  
|Income taxes receivable/payable                                                     |  |                     | 2,247    |               |   | (7,863        | ) |   | (15,151 | )
|Accrued expenses and other current
  liabilities                                    |  |                     | (3,305   | )             |   | (2,831        | ) |   | (10,442 | )
|Deferred rent and other liabilities                                                 |  |                     | (1,152   | )             |   | 1,190         |   |   | (206    | )
|                                                                                    |  |                     |          |               |   |               |   |   |         |  
|Net cash provided by operating activities                                           |  |                     | 47,268   |               |   | 25,247        |   |   | 105,931 |  
|                                                                                    |  |                     |          |               |   |               |   |   |         |  
|INVESTING ACTIVITIES:                                                               |  |                     |          |               |   |               |   |   |         |  
|Purchases of fixed assets                                                           |  |                     | (48,289  | )             |   | (41,330       | ) |   | (33,398 | )
|Acquisition of businesses                                                           |  |                     | (78,810  | )             |   |              |   |   | (2,000  | )
|Proceeds from sale of available-for-sale
  securities and other investments         |  |                     | 4,228    |               |   | 813           |   |   |        |  
|                                                                                    |  |                     |          |               |   |               |   |   |         |  
|Net cash used by investing activities                                               |  |                     | (122,871 | )             |   | (40,517       | ) |   | (35,398 | )
|                                                                                    |  |                     |          |               |   |               |   |   |         |  
|FINANCING ACTIVITIES:                                                               |  |                     |          |               |   |               |   |   |         |  
|Proceeds from long-term debt                                                        |  |                     |         |               |   |              |   |   | 5,760   |  
|Proceeds from capital lease obligations                                             |  |                     |         |               |   | 12,877        |   |   |        |  
|Payments of long-term debt                                                          |  |                     | (473     | )             |   | (444          | ) |   | (252    | )
|Payments of capital lease obligations                                               |  |                     | (3,182   | )             |   | (2,117        | ) |   | (551    | )
|Payments of debt issue costs                                                        |  |                     |         |               |   | (495          | ) |   |         |  
|Payments for purchases of treasury stock                                            |  |                     |         |               |   | (31,270       | ) |   | (40,247 | )
|Excess tax benefit from stock award
  exercises                                     |  |                     | 36       |               |   |              |   |   |        |  
|Proceeds from exercise of stock awards                                              |  |                     | 643      |               |   | 4,160         |   |   | 2,603   |  
|                                                                                    |  |                     |          |               |   |               |   |   |         |  
|Net cash used by financing activities                                               |  |                     | (2,976   | )             |   | (17,289       | ) |   | (32,687 | )
|                                                                                    |  |                     |          |               |   |               |   |   |         |  
|Net (decrease) increase in cash and cash
  equivalents                              |  |                     | (78,579  | )             |   | (32,559       | ) |   | 37,846  |  
|Cash and cash equivalents, beginning of
  year                                      |  |                     | 197,209  |               |   | 229,768       |   |   | 191,922 |  
|                                                                                    |  |                     |          |               |   |               |   |   |         |  
|Cash and cash equivalents, end of year                                              |  | $                   | 118,630  |               | $ | 197,209       |   | $ | 229,768 |  
|                                                                                    |  |                     |          |               |   |               |   |   |         |  
|Supplemental disclosures and non-cash
  investing and financing activities:         |  |                     |          |               |   |               |   |   |         |  
|Issuance of treasury stock under incentive
  stock programs                         |  | $                   | 6        |               | $ | 7             |   | $ | 10      |  
|Issuance of deferred / restricted shares
  under deferred / restricted stock plans  |  |                     | 105      |               |   |              |   |   | 51      |  
|Income tax benefit resulting from exercises
  of stock options                      |  |                     |         |               |   | 1,621         |   |   | 1,946   |  
|Interest paid                                                                       |  |                     | 5,529    |               |   | 2,901         |   |   | 2,331   |  

See Accompanying Notes to Consolidated Financial Statements.

F-7

---



TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Nature of Operations and Summary of Significant
Accounting Policies

Nature of Operations: Trans World Entertainment Corporation and
subsidiaries (the Company) is one of the largest specialty retailers of
entertainment software, including music, home video, video games and related
products in the United States. The Company operates a chain of retail
entertainment stores and e-commerce sites, www.fye.com,
www.wherehouse.com, www.secondspin.com, www.samgoody.com and www.suncoast.com in a single industry
segment. As of February 3, 2007, the Company operated 992 stores totaling
approximately 6.0 million square feet in the United States, the District of
Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands. The
Companys business is seasonal in nature, with the peak selling period being
the holiday season in the Companys fourth fiscal quarter.

Basis of Presentation: The consolidated financial statements consist of
Trans World Entertainment Corporation, its wholly-owned subsidiary, Record
Town, Inc. (Record Town), and Record Towns subsidiaries, all of which are
wholly-owned. During Fiscal 2006 and 2005, the Company acquired 80% interests in
two companies that are fully consolidated for financial reporting purposes. All
significant intercompany accounts and transactions have been eliminated.
Certain amounts in previously issued consolidated financial statements were
reclassified to conform to 2006 presentation. The preparation of financial
statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements, and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

Items Affecting Comparability: The Companys fiscal year is a 52 or 53-week period
ending the Saturday nearest to January 31. Fiscal 2006, 2005, and 2004 ended
February 3, 2007, January 28, 2006, and January 29, 2005, respectively. Fiscal
2006 had 53 weeks and 2005 and 2004 had 52 weeks. The 53rd week in Fiscal 2006 contributed approximately
 $23.0 million in sales.

The Company adopted the Financial
Accounting Standards Boards (FASB) Statement of Financial Accounting Standards
(SFAS) No. 158, Employers Accounting for Defined Benefit and Other
Postretirement Plans  an amendment of FASB Statements No. 87, 88, 106 and
132(R), effective February 3, 2007. In accordance with SFAS No. 158,
the Company recorded a liability equal to the underfunded status of the Company
sponsored Supplemental Executive Retirement Plan (SERP) and Director
Retirement Plan as of the November 1, 2006 measurement date. See Note 9 to the
Consolidated Financial Statements for detailed discussion.

Effective January 29, 2006, the
Company adopted SFAS No. 123(R), Share-Based Payment, using the modified
prospective transition method. Under this transition method, compensation cost
recognized during 2006 includes compensation expense for all stock-based awards
granted prior to, but not yet vested as of January 29, 2006 as well as awards
granted in Fiscal 2006, based on the grant-date fair value estimated in
accordance with the provisions of SFAS No. 123. Results for prior periods have
not been restated, as allowed for under the modified prospective transition
method.

For periods 2005 and prior, the
Company applied the intrinsic value-based method of accounting prescribed by
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations including
FASB Interpretation No. 44,Accounting for Certain Transactions Involving Stock
Compensation  An Interpretation of APB No. 25, in accounting for
its fixed plan stock options. Under this method, compensation expense would be
recorded on the date of grant only if the current market price of the
underlying stock exceeded the exercise price. Unearned compensation recognized
for restricted stock awards is amortized to expense over the vesting period of the stock award
using the straight-line method. SFAS No. 123, Accounting for Stock-Based Compensation,
as amended by SFAS No. 148, Accounting for Stock-Based Compensation  Transition
and Disclosure, established accounting and disclosure requirements
using a fair value-based method of accounting for stock-based employee
compensation plans. As allowed by SFAS No. 123, prior to 2006, the Company
elected to continue to apply the intrinsic value-based method of accounting
described above, and adopted the disclosure requirements of SFAS No. 123 and
SFAS No.148.

The Company adopted FASB
Interpretation No. (FIN) 47 Accounting for Conditional Asset Retirement
Obligationsan interpretation of FASB Statement No. 143, effective
January 28, 2006. In accordance with FIN 47, the Company recorded an asset and
a corresponding liability for the present value of the estimated asset
retirement obligations associated with the fixed assets and leasehold
improvements at its store locations that arise under the terms of operating
leases. See Note 2 to the Consolidated Financial Statements for detailed
discussion.

Concentration of Business Risks:The Company purchases merchandise inventory for its stores from approximately
990 suppliers, with approximately 68% of purchases being made from ten
suppliers including EMI Music Distribution, Sony-Bertelsmann Music Group, Warner/Electra/Atlantic
Corp., Universal Music and Video Distribution, Fox Video Inc., Paramount Home
Video, Buena Vista Home Video, Warner Home Entertainment, Universal Studios
Home Entertainment and Sony Pictures Home Entertainment. Historically, the Company
has not experienced difficulty in obtaining satisfactory sources of supply, and
management believes that it will retain access to adequate sources of supply.
However, a loss of a major supplier could cause a loss of sales, which would
have an adverse effect on operating results and also result in a decrease in
vendor support for the Companys advertising programs.

F-8

---



Cash and Cash Equivalents: The Company considers all highly liquid investments
purchased with an original maturity of three months or less to be cash
equivalents.

Concentration of Credit Risks: The Company maintains centralized cash management
and investment programs whereby excess cash balances are invested in short-term
money market funds and instruments considered to be cash equivalents. The
Companys investment portfolio is diversified and consists of short-term
investment grade securities consistent with its investment guidelines. These
guidelines include the provision that sufficient liquidity will be maintained
to meet anticipated cash flow needs. The Company maintains investments with
various financial institutions. These amounts often exceed the FDIC insurance
limits. The Company limits the amount of credit exposure with any one financial
institution and believes that no significant concentration of credit risk
exists with respect to cash investments.

Accounts Receivable: Accounts receivable are comprised of receivables and unbilled revenues
from advertising services performed for third parties, and amounts due under
operating or service agreements with unaffiliated entities, loans to related
business ventures, and other, individually insignificant amounts. There are no
provisions for uncollectible amounts from retail sales of merchandise inventory
since payment is received at the time of sale.

Merchandise Inventory and Return Costs: Merchandise inventory is stated at the lower of
cost or market as determined by the average cost method. Inventory valuation
requires significant judgment and estimates, including obsolescence, shrink and
any adjustments to market value, if market value is lower than cost. The
Company records obsolescence and any adjustments to market value (if lower than
cost) based on current and anticipated demand, customer preferences and market
conditions. The provision for inventory shrink is estimated as a percentage of
sales for the period from the last date a physical inventory was performed to
the end of the fiscal year. Such estimates are based on historical results and
trends, and the shrink results from the last physical inventory. Physical
inventories are taken at least annually for all stores throughout the year, and
inventory records are adjusted accordingly.

The Company is generally entitled
to return merchandise purchased from major vendors for credit against other
purchases from these vendors. Certain vendors reduce the credit with a per unit
merchandise return charge which varies depending on the type of merchandise
being returned. Certain other vendors charge a handling fee based on units
returned. The Company records merchandise return charges in cost of sales.

Fixed Assets and Depreciation: Fixed assets are recorded at cost and depreciated
or amortized over the estimated useful life of the asset using the
straight-line method. The estimated useful lives are as follows:

|                           |                                                                 
|-------------------------- | ----------------------------------------------------------------
|Leasehold improvements     | Lesser of estimated useful life
  of the asset or the lease term
|Fixtures and equipment     | 3-7 years (estimated useful life
  of the asset)                
|Buildings and improvements | 10-30 years                                                     

Major improvements and betterments
to existing facilities and equipment are capitalized. Expenditures for
maintenance and repairs are expensed as incurred. A majority of the Companys
operating leases are ten years in term. Amortization of capital lease assets is
included in depreciation and amortization expense.

Impairment of Long-Lived Assets: Long-lived assets are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount
of an asset may not be recoverable. Recoverability of assets to be held and used
is measured by a comparison of the carrying amount of an asset to undiscounted
future net cash flows expected to be generated by the asset over its remaining
useful life. If the carrying amount of an asset exceeds its estimated future
cash flows, an impairment charge is recognized by the amount by which the
carrying amount of the assets exceeds the fair value of the assets. Fair value
is generally measured based on discounted estimated future cash flows. Assets
to be disposed of would be separately presented in the Consolidated Balance
Sheets and reported at the lower of the carrying amount or fair value less
disposition costs. The assets and liabilities of a disposed group classified as
held-for-sale would be presented separately in the appropriate assets and
liabilities sections of the Consolidated Balance Sheets.

There were no impairment losses
recorded in Fiscal 2006, 2005 or 2004. Losses for store closings in the
ordinary course of business represent the write down of the net book value of
abandoned fixtures and leasehold improvements. The loss on disposal of fixed
assets related to store closings was $2.2 million, $2.4 million and $2.8
million in Fiscal 2006, 2005 and 2004, respectively, and is included in
SG&A expenses in the Consolidated Statement of Operations and loss on
disposal of fixed assets in the Consolidated Statement of Cash Flows. Store
closings usually occur at the expiration of the lease, at which time leasehold
improvements, which constitute a majority of the abandoned assets, are fully
depreciated. Also, actual store closures usually occur within three to six
months of the planned store closure date.

Conditional Asset Retirement Obligations: The Company records the fair value of an asset
retirement obligation (ARO) as a liability in the period in which it incurs a
legal obligation associated with the retirement of tangible long-lived assets
that result from the acquisition, construction, development, and/or normal use
of the asset. The Company also records a corresponding asset that is
depreciated over the life of the

F-9

---



asset. Subsequent to the initial measurement
of the ARO, the ARO is adjusted at the end of each period to reflect the
passage of time and changes in the estimated future cash flows underlying the
obligation.

Investments in Unconsolidated Affiliates: Investments in unconsolidated affiliates have been
recorded on the cost basis, with any decline in the market value below cost
that is deemed other than temporary charged to operations. Write-offs of
investments in unconsolidated affiliates for other than temporary decline in
market value are reflected in SG&A expenses in the Consolidated Statements
of Operations. There were no write-offs of investments in unconsolidated
affiliates in Fiscal 2006, 2005 and 2004.

Revenue Recognition: The Companys revenue is primarily from retail sales of merchandise
inventory. Revenue is recognized at the point-of-sale. Internet sales are
recognized as revenue upon delivery to and acceptance by the customer. Loyalty
card revenue is amortized over the life of the card. Sales are recorded net of
estimated amounts for sales returns and other allowances. Shipping and handling
fee income from the Companys Internet operations is recognized as net sales.
The Company records shipping and handling costs in cost of goods sold. Sales
are recorded net of applicable sales taxes.

Cost of Sales: In addition to the cost of product, the Company includes in cost of sales
those costs associated with purchasing, receiving, shipping, inspecting and
warehousing product. Also included are costs associated with the return of
product to vendors. Cost of sales further includes the cost of inventory shrink
and obsolescence and the benefit of vendor allowances and discounts.

Selling, General and Administrative (SG&A) Expenses: Included in SG&A expenses are payroll
and
related costs, store operating costs, occupancy charges, professional and
service fees, general operating and overhead expenses and depreciation charges
(excluding those related to distribution operations, as discussed in Note 4 of
Notes to the Consolidated Financial Statements in this Annual Report on Form
10-K). Selling, general and administrative expenses also include asset
impairment charges and write-offs, if any, and miscellaneous items, other than
interest.

Advertising Costs and Vendor Allowances: The Company often receives allowances from its
vendors to fund in-store displays, print advertising and other promotional
events. The Company accounts for vendor allowances in accordance with the
provisions of the Financial Accounting Standards Boards (FASBs) Emerging
Issues Task Force (EITF) Statement No. 02-16, Accounting by a Customer (Including a
Reseller) for Certain Consideration Received from a Vendor. Vendor
advertising allowances which exceed specific, incremental and identifiable
costs incurred in relation to the advertising and promotions offered by the
Company to its vendors are classified as a reduction in the purchase price of
merchandise inventory. Accordingly, advertising and sales promotion costs are
charged to operations, offset by direct vendor reimbursements, as incurred.
Total advertising expense, excluding vendor allowances, was $29.7 million,
$22.0 million, and $23.9 million in Fiscal 2006, 2005, and 2004, respectively.
In the aggregate, vendor allowances supporting the Companys advertising and
promotion included as a reduction of SG&A expenses, as reimbursements of
such costs in accordance with EITF No. 02-16, were $10.7 million, $9.6 million,
and $11.8 million in Fiscal 2006, 2005, and 2004, respectively.

Lease Accounting: The Company accounts for rent expense and leasehold improvements funded
by landlord incentives for allowances under operating leases (tenant
improvement allowances) in conformity with Generally Accepted Accounting
Principles (GAAP), as clarified by the Chief Accountant of the U.S.
Securities and Exchange Commission in a February 2005 letter to the American
Institute of Certified Public Accountants. The Companys calculation of
straight-line rent expense includes the impact of escalating rents for periods
in which it is reasonably assured of exercising lease options and includes in
the lease term any period during which the Company is not obligated to pay rent
while the store is being constructed (rent holiday). The Company accounts for
step rent provisions, escalation clauses and other lease concessions by
recognizing these amounts on a straight line basis over the initial lease term.
The Company capitalizes leasehold improvements funded by tenant improvement
allowances, depreciating them over the lives of the related leases. The tenant
improvement allowances are recorded as deferred rent in the Consolidated
Balance Sheet and are amortized as a reduction in rent expense over the life of
the related leases.

Store Closing Costs: Management periodically evaluates the closing of underperforming stores.
Reserves are established at the time a liability is incurred for the present
value of any remaining lease obligations, net of estimated sublease income, and
other exit costs, as prescribed by SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities.

Gift Cards: The Company offers gift cards for sale. A deferred income account, which
is included in accrued expenses and other current liabilities in the
Consolidated Balance Sheets, is established for gift cards issued. The deferred
income balance related to gift cards was approximately $21.0 million and $17.8
million at the end of Fiscal 2006 and 2005, respectively When gift cards are
redeemed at the store level, revenue is recorded and the related liability is
reduced. Breakage is estimated based on the historical relationship of the
redemption of gift cards redeemed to gift cards sold, over a certain period of
time. The Company has the ability to reasonably and reliably estimate gift card
liability based on historical experience with redemption rates associated with
a large volume of homogeneous transactions, from a period of more than ten
years. The Companys estimate is not susceptible to significant external
factors and the circumstances around purchases and redemptions have not changed
significantly over time. The Company recorded breakage on its gift cards for
Fiscal 2006, 2005 and 2004 in the amount of $3.6 million, $2.9 million and $4.7
million, respectively.

Income Taxes: Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their

F-10

---



respective tax bases, and tax
operating loss carryforwards. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. The
effect on deferred tax assets and liabilities of a change in tax rates is
recognized in the results of operations in the period that includes the
enactment date. Deferred tax assets are subject to valuation allowances based
upon managements estimates of realizability.

Comprehensive Income (Loss): The Company accounts for comprehensive income
(loss) in accordance with Statement of Financial Accounting Standards (SFAS)
No. 130, Reporting
Comprehensive Income and results are presented within the
Consolidated Statements of Shareholders Equity and Comprehensive Income
(Loss). Comprehensive
income for Fiscal 2006 consisted of net income and adjustments to the pension
liability recorded under SFAS No. 158. Comprehensive loss for Fiscal 2005 and
income for Fiscal 2004 consisted of net income and adjustments to the pension
liability recorded under SFAS No. 87.

Stock-Based Compensation: Effective January 29, 2006, the Company
adopted SFAS No. 123 (Revised 2004), Share-Based Payment (SFAS
No. 123 (R)), which amends SFAS No. 123 and supersedes APB
No. 25 in establishing
standards for the accounting for transactions in which an entity exchanges its
equity instruments for goods or services, as well as transactions in which an
entity incurs liabilities in exchange for goods or services that are based on
the fair value of the entitys equity instruments or that may be settled by the
issuance of those equity instruments. This Statement requires that the cost
resulting from all share-based payment transactions be recognized in the
financial statements based on the fair value of the share-based payment. This
Statement establishes fair value as the measurement objective in accounting for
share-based payment transactions with employees, except for equity instruments
held by employee share ownership plans. As allowed under SFAS No. 123 (R),
the Company elected the modified prospective method of adoption, under which
compensation cost is recognized in the financial statements beginning with the
effective date of SFAS No. 123 (R) for all share-based payments
granted after that date, and for all unvested awards granted prior to the
effective date of SFAS No. 123 (R). Accordingly, prior period amounts have
not been restated.

In the fourth quarter of 2005, the
Companys Board of Directors approved the acceleration of vesting of previously
granted unvested options awarded annually to employees and officers under the
Companys Stock Option Plans which had exercise prices greater than $10.00 per
share. Options to purchase 2,273,057 shares of the Companys common stock,
representing approximately 24% of the total options outstanding, became
immediately vested and exercisable as a result of this action. The number of shares
and exercise prices of the options subject to the acceleration remained
unchanged. Also, all of the other terms of the options remain the same. Based
upon an analysis performed in accordance with SFAS No.123, the acceleration of
vesting of these stock options resulted in compensation expense of $5.9
million, in the pro forma net income (loss) results. The decision to accelerate
vesting of these stock options was made primarily to avoid recognizing
compensation expense in the Consolidated Statement of Operations in future
financial statements upon the adoption of SFAS No.123 (R), Share-Based Payment,which
the Company adopted on January 29, 2006. The acceleration of the vesting of
these stock options reduced the amounts recognized by the Company as share-based
compensation expense, net of income taxes, by approximately $2.4 million in
Fiscal 2006 and will reduce compensation expense by approximately $1.9 million
in Fiscal 2007, $1.2 million in Fiscal 2008, and $0.4 million in Fiscal 2009.
The accelerated options included 1,355,000 options held by executive officers
and 918,057 options held by other employees. Based on the Companys closing
stock price of $6.25 per share on the date of accelerated vesting, the exercise
prices of all of the options were above the closing market price.

Total stock-based compensation
expense recognized in the Consolidated Statement of Operations for Fiscal 2006
was $2.2 million, before income taxes. The related total deferred tax benefit
was approximately $0.9 million. Prior to the adoption of SFAS No. 123(R), the
Company presented all tax benefits for deductions resulting from the exercise
of stock options as operating cash flows in the Consolidated Statements of Cash
Flows. SFAS No. 123(R) requires the tax benefits resulting from tax deductions
in excess of the compensation cost recognized for those options to be
classified and reported as both an operating cash outflow and a financing cash
inflow on a prospective basis upon adoption. As of February 3, 2007, there was
$3.3 million of unrecognized compensation cost related to stock option awards
that is expected to be recognized as expense over a weighted average period of
1.4 years.

F-11

---



The following table illustrates the
effect on net (loss) income and (loss) earnings per share if the Company had
applied the fair value recognition provisions of SFAS No. 123 to its
share-based payments for Fiscal 2005 and 2004.

|                                                                                                                                              |  |               |        |      |   |        |  
|--------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------ | ---- | - | ------ | -
|                                                                                                                                              |  |               |       
|($ in thousands except for per share
  amounts)                                                                                               |  | Fiscal
  Year |       
|                                                                                                                                              |  |               |       
|                                                                                                                                              |  | 2005          |        | 2004 |  
|                                                                                                                                              |  |               |        |      |  
|                                                                                                                                              |  |               |        |      |   |        |  
|Net income, as reported                                                                                                                       |  | $             | 609    |      | $ | 41,841 |  
|Add: Stock-based employee compensation expense included in reported
net
  income, net of related tax effects                                  |  |               | 180    |      |   | 159    |  
|Deduct: Total stock-based employee compensation expense determined
under
  fair value based method for all awards, net of related tax effects |  |               | (7,521 | )    |   | (2,919 | )
|                                                                                                                                              |  |               |        |      |   |        |  
|Pro forma net (loss) income                                                                                                                   |  | $             | (6,732 | )    | $ | 39,081 |  
|                                                                                                                                              |  |               |        |      |   |        |  
|Earnings (loss) per share:                                                                                                                    |  |               |        |      |   |        |  
|Basic - as reported                                                                                                                           |  | $             | 0.02   |      | $ | 1.21   |  
|Basic pro forma                                                                                                                              |  | $             | (0.21  | )    | $ | 1.13   |  
|Diluted  as reported                                                                                                                         |  | $             | 0.02   |      | $ | 1.15   |  
|Diluted  pro forma                                                                                                                           |  | $             | (0.21  | )    | $ | 1.08   |  

The fair values of the options
granted have been estimated at the date of grant using the Black - Scholes
option pricing model with the following assumptions:

|                                                                         |  |                     |                 |      |  |                 |  |  |       | 
|------------------------------------------------------------------------ |  | ------------------- | --------------- | ---- |  | --------------- |  |  | ----- | 
|                                                                         |  | Stock
  Option Plan |                
|                                                                         |  |                     |                
|                                                                         |  | 2006                |                 | 2005 |  | 2004            | 
|                                                                         |  |                     |                 |      |  |                 | 
|Dividend yield                                                           |  |                     | 0%              |      |  | 0%              |  |  | 0%    | 
|Expected volatility                                                      |  |                     | 65.9%
  - 71.2% |      |  | 55%             |  |  | 57%   | 
|Risk-free interest rate                                                  |  |                     | 4.64%
  - 5.04% |      |  | 3.71%
  - 4.34% |  |  | 3.71% | 
|Expected option life in years                                            |  |                     | 4.93
   7.12   |      |  | 5 
  6.25      |  |  | 5     | 
|Weighted average fair value per share of options granted during the
year |  |                     | $3.42           |      |  | $6.59           |  |  | $3.49 | 

Earnings Per Share: Basic earnings per share is calculated by dividing net income by the
weighted average common shares outstanding for the period. Diluted earnings per
share is calculated by dividing net income by the sum of the weighted average
shares outstanding and additional common shares that would have been
outstanding if the dilutive potential common shares had been issued for the Companys
common stock awards from the Companys Stock Award Plans.

The following is a reconciliation
of the basic weighted average number of shares outstanding to the diluted
weighted average number of shares outstanding:

|                                                       |  |               |        |      |  |        |  |  |        | 
|------------------------------------------------------ |  | ------------- | ------ | ---- |  | ------ |  |  | ------ | 
|                                                       |  | Fiscal
  Year |       
|                                                       |  |               |       
|                                                       |  | 2006          |        | 2005 |  | 2004   | 
|                                                       |  |               |        |      |  |        | 
|                                                       |  |               |        |      |  |        |  |  |        | 
|Weighted average common shares
  outstanding  basic   |  |               | 30,797 |      |  | 31,962 |  |  | 34,531 | 
|Dilutive effect of employee stock
  awards             |  |               | 1,189  |      |  | 170    |  |  | 1,766  | 
|                                                       |  |               |        |      |  |        |  |  |        | 
|Weighted average common shares
  outstanding  diluted |  |               | 31,986 |      |  | 32,132 |  |  | 36,297 | 
|                                                       |  |               |        |      |  |        |  |  |        | 
|                                                       |  |               |        |      |  |        |  |  |        | 
|Antidilutive stock awards                              |  |               | 7,290  |      |  | 4,756  |  |  | 1,631  | 
|                                                       |  |               |        |      |  |        |  |  |        | 

Antidilutive stock awards
outstanding were excluded from the computation of diluted earnings per share
because the exercise price of the options was greater than the average market
price of the common shares during the period.

F-12

---



Fair Value of Financial Instruments: The carrying amounts reported in the Consolidated
Balance Sheets for cash and cash equivalents, accounts receivable, accounts
payable and other current liabilities approximate fair value because of the
immediate or short-term maturity of these financial instruments. The carrying
value of life insurance policies included in other assets approximates fair value
based on estimates received from insurance companies. The carrying value of the
Companys long-term debt including current portion, approximates fair value
based on estimated discounted future cash flows for remaining maturities and
rates currently offered to the Company for similar debt instruments. The
Company had outstanding product import letters of credit with a fair value of
$36 thousand and $0.3 million as of February 3, 2007 and January 28, 2006
respectively.

Segment Information: The Company has one reportable segment in accordance with the
requirements of SFAS No. 131, Disclosures
about Segments of an Enterprise and Related Information. The
following table shows revenues by merchandise category:

|            |  |                  |           |      |   |           |  |   |           | 
|----------- |  | ---------------- | --------- | ---- | - | --------- |  | - | --------- | 
|            |  |                  |          
|            |  | Fiscal
  year    |          
|            |  |                  |          
|            |  | 2006             |           | 2005 |   | 2004      | 
|            |  |                  |           |      |   |           | 
|            |  | ($ in thousands) |          
|Music       |  | $                | 650,352   |      | $ | 663,712   |  | $ | 750,612   | 
|Home Video  |  |                  | 552,722   |      |   | 371,965   |  |   | 398,043   | 
|Video games |  |                  | 114,514   |      |   | 90,408    |  |   | 89,297    | 
|Other       |  |                  | 153,569   |      |   | 112,401   |  |   | 127,181   | 
|            |  |                  |           |      |   |           |  |   |           | 
|Total       |  | $                | 1,471,157 |      | $ | 1,238,486 |  | $ | 1,365,133 | 
|            |  |                  |           |      |   |           |  |   |           | 

The Other category includes
electronics, accessories and trend items, none of which individually exceeds 5%
of total sales.

Recently Issued Accounting Pronouncements:

In February 2007, the Financial
Accounting Standards Board (FASB) issued Statement of Financial Accounting
Standards (SFAS) No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities  including an amendment of FASB Statement No. 115.
SFAS No. 159 permits entities to choose to measure many financial instruments
and certain other items at fair value. The objective of the statement is to
provide entities with the opportunity to mitigate volatility in reported
earnings caused by measuring related assets and liabilities differently without
having to apply complex hedge accounting provisions. SFAS No. 159 is effective
as of the beginning of an entitys fiscal year beginning after November 15,
2007. SFAS No. 159 is not expected to significantly impact the Companys
Consolidated Financial Statements.

In September 2006, the FASB issued
Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value
Measurements. SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principles (GAAP),
and expands disclosures about fair value measurements. SFAS No. 157 applies
under other accounting pronouncements that require or permit fair value
measurements, however, does not require any new fair value measurements. SFAS
No. 157 is effective for financial statements issued for fiscal years beginning
after November 15, 2007, and interim periods within those fiscal years. The
adoption of SFAS No. 157 is not expected to have a significant impact on the
Companys Consolidated Financial Statements.

In July 2006, the FASB issued
Interpretation No. (FIN) 48, Accounting for Uncertainty in Income TaxesAn
Interpretation of FASB Statement No. 109, which prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in
a tax return. In particular, this interpretation requires uncertain tax
positions to be recognized only if they are more-likely-than-not to be upheld
based on their technical merits. Additionally, the measurement of the tax
position will be based on the largest amount that is determined to have greater
than a 50% likelihood of realization upon ultimate settlement. Any resulting
cumulative effect of applying the provisions of FIN 48 upon adoption would be
reported as an adjustment to the beginning balance of retained earnings in the
period of adoption. FIN 48 will be effective for the Companys fiscal year
beginning February 4, 2007. The Company is currently evaluating the impact of
this interpretation on the Companys Consolidated Financial Statements.

F-13

---



Note 2. Cumulative Effect of Change in Accounting Principle

The Company adopted FIN 47, Accounting
for Conditional Asset Retirement Obligationsan interpretation of FASB
Statement No. 143, effective January 28, 2006. In accordance with
FIN 47, the Company recorded an asset and a corresponding liability for the
present value of the estimated asset retirement obligations associated with the
fixed assets and leasehold improvements at its store locations that arise under
the terms of operating leases.

The following table illustrates the
effect on income before extraordinary gain, net income and related per share
amounts as if the Company had applied the provisions of FIN 47 retroactively:

|                                                                                                                                                      |  |             |       |      |   |        | 
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------- | ----- | ---- | - | ------ | 
|                                                                                                                                                      |  | Fiscal Year |      
|                                                                                                                                                      |  |             |      
|($ in thousands, except for per share
  amounts)                                                                                                      |  | 2005        |       | 2004 |  
|                                                                                                                                                     
|                                                                                                                                                      |  |             |       |      |  
|Income before extraordinary gain  unallocated
  negative goodwill and cumulative effect of change in accounting principle, as reported               |  | $           | 2,886 |      | $ | 38,675 | 
|Pro forma income before extraordinary gain - unallocated negative
goodwill and cumulative effect of
  change in accounting principle                  |  | $           | 2,922 |      | $ | 38,946 | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Net income as reported                                                                                                                                |  | $           | 609   |      | $ | 41,841 | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Proforma net income                                                                                                                                   |  | $           | 2,922 |      | $ | 42,112 | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Proforma liability                                                                                                                                    |  | $           | 4,327 |      | $ | 4,408  | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Basic earnings per share:                                                                                                                             |  |             |       |      |   |        | 
|Earnings per share before extraordinary gain 
  unallocated negative goodwill and
  cumulative effect of change in accounting principle, as reported |  | $           | 0.09  |      | $ | 1.12   | 
|Pro forma earnings per share before extraordinary
  gain- unallocated negative goodwill and cumulative effect of change in accounting principle       |  | $           | 0.09  |      | $ | 1.13   | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Basic earnings per share as reported                                                                                                                  |  | $           | 0.02  |      | $ | 1.21   | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Pro forma basic earnings per share                                                                                                                    |  | $           | 0.09  |      | $ | 1.22   | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Diluted earnings per share:                                                                                                                           |  |             |       |      |   |        | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Earnings per share before extraordinary gain 
  unallocated negative goodwill and
  cumulative effect of change in accounting principle, as reported |  | $           | 0.09  |      | $ | 1.06   | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Pro forma earnings per share before extraordinary
  gain- unallocated negative goodwill and cumulative effect of change in accounting principle       |  | $           | 0.09  |      | $ | 1.07   | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Diluted earnings per share as reported                                                                                                                |  | $           | 0.02  |      | $ | 1.15   | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|                                                                                                                                                      |  |             |       |      |   |        | 
|Pro forma diluted earnings per share                                                                                                                  |  | $           | 0.09  |      | $ | 1.16   | 
|                                                                                                                                                      |  |             |       |      |   |        | 

F-14

---



Note 3. Business Combinations

On March 27, 2006, the Company
acquired substantially all the net assets of Musicland Holding Corp.
(Musicland). The acquisition of Musiclands assets provided the Company with
the ability to leverage its overhead expenses over a greater store base, and
strategically increase the Companys national presence and provide further
growth opportunities. Under the terms of the Asset Purchase Agreement (APA),
the Company acquired 335 of Musiclands 400 stores, with the remainder of the
stores being liquidated under an agency agreement with Hilco Merchant Resources
LLC. Musicland, which operated retail stores and websites under the names Sam
Goody (samgoody.com), Suncoast Motion Picture Company (suncoast.com), On Cue
and MediaPlay.com, filed a voluntary petition to restructure under Chapter 11
of the United States Bankruptcy Code in January 2006. The acquisition was
accounted for using the purchase method of accounting. The Consolidated
Statement of Operations for Fiscal 2006 includes the results of Musicland
beginning March 27, 2006.

The purchase price for the acquired
Musicland assets was $78.8 million, including acquisition-related costs of $1.8
million. The total purchase price was allocated to the assets acquired and
liabilities assumed based on their estimated fair values as of February 3, 2007
as follows:

|                            |  |                  |         | 
|--------------------------- |  | ---------------- | ------- | 
|                            |  | ($ in thousands) |        
|                           
|Assets Acquired:            |  |                  |         | 
|Inventory                   |  | $                | 112,612 | 
|                            |  |                  |         | 
|Liabilities Assumed:        |  |                  |         | 
|Accrued expenses and other  |  | $                | 11,062  | 
|Other long-term liabilities |  |                  | 5,280   | 
|                            |  |                  |         | 
|Total liabilities assumed   |  | $                | 16,342  | 
|                            |  |                  |         | 
|Net assets acquired         |  | $                | 96,270  | 
|                            |  |                  |         | 

From March 27, 2006 to February 3,
2007, the Company allocated the purchase price in accordance with the
provisions of SFAS No. 141, Business Combinations, resulting in an
extraordinary gain  unallocated negative goodwill of $10.7 million, net of
income taxes $6.7 million. The extraordinary gain represents the excess of the
fair value of net assets acquired over the purchase price. The purchase price
was allocated on a preliminary basis during the thirteen weeks ended April 29,
2006 using information available at the time. The extraordinary gain recorded
as of April 29, 2006 was $0.9 million, which was net of income taxes of $0.7
million. In accordance with SFAS No.141, the allocation of the purchase price
to the assets and liabilities acquired must be finalized within twelve months
following the date of acquisition. Accordingly, the purchase price allocation
has been adjusted between April 29, 2006 and February 3, 2007, resulting in an
adjustment to the extraordinary gain of $9.8 million, which is net of income
taxes of $6.0 million. The pre-tax increase in the extraordinary gain from
April 29, 2006 to February 3, 2007 represents adjustments to the value of
acquired inventory ($1.9 million), an adjustment to customer liabilities
related to the former Musicland loyalty program ($3.4 million), an adjustment
to customer liabilities related to gift cards based on the redemption
experience since acquisition ($6.1 million) and an adjustment to occupancy
related expenses ($1.5 million) and an adjustment to the cash purchase price
($2.9 million).

The financial information in the
table below summarizes the combined results of operations of the Company and
Musicland, on a pro forma basis as though the companies had been combined at
the beginning of each period presented. This pro forma information is presented
for informational purposes only and is not necessarily indicative of the
results of operations that would have been achieved had the acquisition taken
place at the beginning of each period presented. The pro forma information does
not include one time items related to purchase accounting, including the
extraordinary gain arising from unallocated negative goodwill.

F-15

---



The pro forma Consolidated Statement of Operations for
Fiscal 2006 combines the historical results of the Company for Fiscal 2006 and
the historical results of Musicland for the period preceding the acquisition
from January 29, 2006 through March 27, 2006.The pro forma Consolidated Statement
of Operations for Fiscal 2005 combines the historical results of the Company
and Musicland for the periods. The following is the pro forma information,
exclusive of the effect of purchase accounting adjustments:

|                                                                                                                                                              |  |      |           |      |   |           |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | --------- | ---- | - | --------- | -
|($ in thousands, except for per share
  amounts)                                                                                                              |  | 2006 |           | 2005 |  
|                                                                                                                                                              |  |      |           |     
|                                                                                                                                                              |  |      |           |      |   |           |  
|Pro forma sales                                                                                                                                               |  | $    | 1,519,620 |      | $ | 1,625,981 |  
|Pro forma loss before extraordinary gain- unallocated negative goodwill and
  cumulative effect of a change in accounting principle                           |  |      | (1,573    | )    |   | (1,837    | )
|                                                                                                                                                              |  |      |           |      |   |           |  
|                                                                                                                                                              |  |      |           |      |   |           |  
|Pro forma net loss                                                                                                                                            |  | $    | (1,573    | )    | $ | (4,114    | )
|                                                                                                                                                              |  |      |           |      |   |           |  
|Pro forma net loss before extraordinary gain 
  unallocated negative goodwill and cumulative effect of a change in accounting
  principle, per basic share   |  | $    | (0.05     | )    | $ | (0.06     | )
|                                                                                                                                                              |  |      |           |      |   |           |  
|Pro forma net loss before extraordinary gain 
  unallocated negative goodwill and cumulative effect of a change in accounting
  principle, per diluted share |  | $    | (0.05     | )    | $ | (0.06     | )
|                                                                                                                                                              |  |      |           |      |   |           |  
|                                                                                                                                                              |  |      |           |      |   |           |  
|Pro forma net loss per basic share                                                                                                                            |  | $    | (0.05     | )    | $ | (0.13     | )
|                                                                                                                                                              |  |      |           |      |   |           |  
|                                                                                                                                                              |  |      |           |      |   |           |  
|Pro forma net loss per diluted share                                                                                                                          |  | $    | (0.05     | )    | $ | (0.13     | )
|                                                                                                                                                              |  |      |           |      |   |           |  

---

In March 2006, the Company acquired an 80% interest in
Mix & Burn LLC, a company that is fully consolidated for financial
reporting. The Company has committed funding of $5.2 million, of which $4.0
million has been funded as of February 3, 2007. Pro forma results of operations
including the results of Mix & Burn LLC have not been presented because the
pro forma effect of the acquisition would not be material to the Companys
results of operations. Mix & Burn LLC is a provider of digital content
services to retailers nationwide. Using its technology, consumers can create custom music CDs
from an extensive catalog of new and old content. This acquisition will enable the Companys retail locations to
offer customers new content, new products and new services relating to music
players and music player enabled cell phones in its stores.

Note 4. Fixed AssetsFixed assets consist of the following:

|                                             |  |                      |          |                      |   |          |  
|-------------------------------------------- |  | -------------------- | -------- | -------------------- | - | -------- | -
|                                             |  | February
  3,
  2007 |          | January
  28,
  2006 |  
|                                             |  |                      |          |                      |  
|                                             |  | ($ in thousands)     |         
|Buildings                                    |  | $                    | 26,493   |                      | $ | 26,275   |  
|Fixtures and equipment                       |  |                      | 229,115  |                      |   | 196,296  |  
|Leasehold improvements                       |  |                      | 157,935  |                      |   | 159,041  |  
|                                             |  |                      |          |                      |   |          |  
|                                             |  |                      | 413,543  |                      |   | 381,612  |  
|Allowances for depreciation and amortization |  |                      | (275,291 | )                    |   | (249,814 | )
|                                             |  |                      |          |                      |   |          |  
|                                             |  | $                    | 138,252  |                      | $ | 131,798  |  
|                                             |  |                      |          |                      |   |          |  

Depreciation and amortization expense related to the
Companys distribution center facility and equipment of $3.1 million, $3.1
million and $2.5 million in 2006, 2005 and 2004, respectively, is included in
cost of sales. All
other depreciation and amortization of fixed assets is included in SG&A
expenses.

F-16

---



Depreciation and amortization of fixed assets is
included in the Consolidated Statements of Operations as follows:

|                                             |  |                  |        |      |   |        |  |   |        | 
|-------------------------------------------- |  | ---------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                             |  | Fiscal
  Year    |       
|                                             |  |                  |       
|                                             |  | 2006             |        | 2005 |   | 2004   | 
|                                             |  |                  |        |      |   |        | 
|                                             |  | ($ in thousands) |       
|Cost of sales                                |  | $                | 3,108  |      | $ | 3,076  |  | $ | 2,466  | 
|Selling, general and administrative expenses |  |                  | 36,991 |      |   | 34,140 |  |   | 37,330 | 
|                                             |  |                  |        |      |   |        |  |   |        | 
|Total                                        |  | $                | 40,099 |      | $ | 37,216 |  | $ | 39,796 | 
|                                             |  |                  |        |      |   |        |  |   |        | 

Note 5. Debt

On January 5, 2006, the Company entered into a new
five year, $100 million revolving secured credit facility agreement (Credit
Agreement) with Bank of America, N.A. At the election of the Company, loans
under the Credit Agreement bear interest on the principal amount at a rate
equal to either, the Prime Rate or Adjusted LIBOR plus 0.75%. The principal
amount of all outstanding loans under the Credit Agreement together with any
accrued but unpaid interest, are due and payable on January 6, 2010, unless
otherwise paid earlier pursuant to the terms of the Credit Agreement. Payments
of amounts due under the Credit Agreement are secured by the Companys eligible
merchandise inventory, proceeds from sale of merchandise inventory and the
stock of the Companys subsidiaries.

The new Credit Agreement replaces the Companys
previous credit agreement and will provide for general corporate purposes. The
Credit Agreement includes customary provisions, including affirmative and
negative covenants, including representations, warranties and restrictions on
additional indebtedness and acquisitions. The Credit Agreement also includes
customary events of default, including, among other things, bankruptcy, and
certain changes of control.

On March 23, 2006, the Company entered into a First
Amendment of the Credit Agreement with Bank of America, N.A. which increased
the maximum amount available for borrowing under the revolving secured credit
facility to $130 million, under the same terms and conditions.

On October 20, 2006, the Company entered into a Second
Amendment of the Credit Agreement with Bank of America, N.A. which increased
the maximum amount available for borrowing under the revolving secured credit
facility to $150 million, under the same terms and conditions.

During Fiscal 2006, 2005 and 2004, the highest
aggregate balances outstanding under the revolving credit facility were $107.5
million, $27.2 million and $28.0 million, respectively. As of February 3, 2007
and January 28, 2006, the Company had $36 thousand and $0.5 million,
respectively, in outstanding letter of credit obligations under the Credit
Agreements with Bank of America, N.A. The Company had $150 million and $99.5
million, respectively, available for borrowing as of February 3, 2007 and
January 28, 2006.

During 2004, the Company borrowed $5.8 million under a
mortgage loan to finance the purchase of real estate. The mortgage loan is
repayable in monthly installments of $64,000 over 10 years with a fixed
interest rate of 6.0% and is collateralized by the real estate. As of February
3, 2007, the outstanding balance on the loan was $4.6 million. The following
table presents principal cash payments of long-term debt by expected maturity
dates as of February 3, 2007:

|                             |  |                  |       | 
|---------------------------- |  | ---------------- | ----- | 
|                             |  | Long-term
  debt |      
|                             |  |                  |      
|                             |  | ($ in thousands) |      
|2007                         |  |                  | 506   | 
|2008                         |  |                  | 537   | 
|2009                         |  |                  | 570   | 
|2010                         |  |                  | 606   | 
|2011                         |  |                  | 646   | 
|Thereafter                   |  |                  | 1,726 | 
|                             |  |                  |       | 
|Total                        |  |                  | 4,591 | 
|Less: current portion        |  |                  | 506   | 
|                             |  |                  |       | 
|Long term debt
  obligation |  | $                | 4,085 | 
|                             |  |                  |       | 

F-17

---



Note 6. Income Taxes

Income tax (benefit) expense consists of the
following:

|                  |  |                  |        |               |   |        |   |   |        |  
|----------------- |  | ---------------- | ------ | ------------- | - | ------ | - | - | ------ | -
|                  |  |                  |        | Fiscal
  Year |  
|                  |  |                  |        |               |  
|                  |  | 2006             |        | 2005          |   | 2004   |  
|                  |  |                  |        |               |   |        |  
|                  |  | ($ in thousands) |       
|Federal  current |  | $                | 2,090  |               | $ | (3,887 | ) | $ | (3,969 | )
|State  current   |  |                  | 256    |               |   | 791    |   |   | 1,913  |  
|Deferred          |  |                  | (4,387 | )             |   | 4,186  |   |   | 6,948  |  
|                  |  |                  |        |               |   |        |   |   |        |  
|                  |  | $                | (2,041 | )             | $ | 1,090  |   | $ | 4,892  |  
|                  |  |                  |        |               |   |        |   |   |        |  

A reconciliation of the Companys effective income tax
rate with the Federal statutory rate is as follows:

|                                                            |  |               |       |      |  |       |    |  |       |   
|----------------------------------------------------------- |  | ------------- | ----- | ---- |  | ----- | -- |  | ----- | --
|                                                            |  | Fiscal
  Year |      
|                                                            |  |               |      
|                                                            |  | 2006          |       | 2005 |  | 2004  |   
|                                                            |  |               |       |      |  |       |   
|Federal
  statutory rate                                    |  |               | 35.0  | %    |  | 35.0  | %  |  | 35.0  | % 
|State income
  taxes, net of federal tax effect             |  |               | 17.9  | %    |  | 52.2  | %  |  | 2.1   | % 
|Change in
  federal valuation allowance                     |  |               | 99.3  | %    |  | (5.9  | )% |  | (2.1  | %)
|Closing of
  federal tax examination                        |  |               |      |      |  |      |    |  | (24.2 | %)
|Corporate-owned
  life insurance  payment settlement,
  net |  |               | (21.4 | )%   |  | 5.9   | %  |  | 0.5   | % 
|Cash surrender
  value  insurance/ benefit  programs       |  |               | 10.7  | %    |  | (4.2  | )% |  | (0.2  | )%
|Executive
  compensation                                    |  |               | (13.1 | )%   |  | 3.3   | %  |  | 0.4   | % 
|Tax exempt
  income                                         |  |               | 17.7  | %    |  | (3.2  | )% |  | (0.3  | )%
|Closing of tax
  periods                                    |  |               | 18.1  | %    |  | (8.8  | )% |  |      |   
|Tax credits                                                 |  |               | 27.6  | %    |  | (7.8  | )% |  | (0.2  | )%
|Recognized
  deferred tax asset                             |  |               |      |      |  | (43.3 | %) |  |      |   
|Other                                                       |  |               | (5.1  | )%   |  | 4.2   | %  |  | 0.2   | % 
|                                                            |  |               |       |      |  |       |    |  |       |   
|Effective income
  tax rate                                 |  |               | 186.7 | %    |  | 27.4  | %  |  | 11.2  | % 
|                                                            |  |               |       |      |  |       |    |  |       |   

During 2004, the Company closed a federal tax
examination for periods through the Companys 2000 fiscal year. The settlement
closed all outstanding matters related to corporate-owned life insurance
policies which were part of the Companys acquisition of CM Holdings Inc.
(Camelot) in 1999. As a result of the closing agreement with the Internal
Revenue Service (IRS), the Company recorded a tax benefit of $10.5 million, which
reversed federal income tax payable amounts originally recorded in the years
covered by the examination. The closing of the federal tax examination further
resulted in the recording of a state deferred tax benefit, net of federal tax
effect of $0.9 million in 2004, attributable to state net operating loss
carryforwards from Camelot. The amounts and utilization of these state net
operating loss carryforwards had been uncertain until the closing of the
federal tax examination in 2004. During 2005, the Company recognized a tax
benefit of $2.0 million attributable to the effect of additional deductible
temporary differences. The Other category is comprised of various items, including non
deductible meals, dues, penalties, amortization and graduated rate brackets.

During 2000, the United States District Court for the
District of Delaware issued an opinion upholding the IRS disallowance of
deductions of interest expense related to corporate-owned life insurance
policies through fiscal 1994. The original accrual for additional income taxes
resulting from disallowed interest expense deductions was recorded following
the 2000 court decision. During 2003, the Company and the IRS agreed on final
computational and payment terms for an amount less than previously accrued,
which resulted in an income tax benefit of $2.1 million in 2003. Under the
final payment terms, the Company has agreed with the IRS to make annual
interest payments and a final principal payment of approximately $7.1 million
in 2007. The remaining accrued liability attributable to this matter as of
February 3, 2007, including accrued interest, is $7.2 million which is included
in income tax payable in the Consolidated Balance Sheet.

F-18

---



Significant components of the Companys deferred tax
assets are as follows:

|                                                                |  |                      |        |                      |   |         |  
|--------------------------------------------------------------- |  | -------------------- | ------ | -------------------- | - | ------- | -
|                                                                |  | February
  3,
  2007 |        | January
  28,
  2006 |  
|                                                                |  |                      |        |                      |  
|                                                                |  | ($ in thousands)     |       
|DEFERRED TAX ASSETS                                             |  |                      |        |                      |   |         |  
|Accrued expenses                                                |  | $                    | 1,888  |                      | $ | 1,031   |  
|Inventory                                                       |  |                      | 5,459  |                      |   | 2,308   |  
|Retirement and compensation related accruals                    |  |                      | 7,172  |                      |   | 5,490   |  
|Fixed assets                                                    |  |                      | 3,532  |                      |   | 2,537   |  
|Federal and state net operating loss and credit
  carryforwards |  |                      | 10,381 |                      |   | 14,690  |  
|Real estate leases, including deferred rent                     |  |                      | 11,839 |                      |   | 12,511  |  
|Losses on investments                                           |  |                      | 2,475  |                      |   | 3,714   |  
|Goodwill                                                        |  |                      | 6,251  |                      |   | 7,264   |  
|Other                                                           |  |                      | 493    |                      |   | 582     |  
|                                                                |  |                      |        |                      |   |         |  
|Gross deferred tax assets before valuation allowance            |  |                      | 49,490 |                      |   | 50,127  |  
|Less: valuation allowance                                       |  |                      | (7,736 | )                    |   | (11,350 | )
|                                                                |  |                      |        |                      |   |         |  
|Total deferred tax assets                                       |  | $                    | 41,754 |                      | $ | 38,777  |  
|                                                                |  |                      |        |                      |   |         |  
|                                                                |  |                      |        |                      |   |         |  
|DEFERRED TAX LIABILITIES                                        |  |                      |       |                      |   |        |  
|                                                                |  |                      |        |                      |   |         |  
|                                                                |  |                      |        |                      |   |         |  
|NET DEFERRED TAX ASSET                                          |  | $                    | 41,754 |                      | $ | 38,777  |  
|                                                                |  |                      |        |                      |   |         |  

The net deferred tax asset is classified on the
Companys Consolidated Balance Sheets as follows:

|                                    |  |                  |        |               |   |        | 
|----------------------------------- |  | ---------------- | ------ | ------------- | - | ------ | 
|                                    |  | February
  3,    |        | January
  28, |  
|                                    |  | 2007             |        | 2006          |  
|                                    |  |                  |        |               |  
|                                    |  | ($ in
thousands) |       
|Current deferred tax asset          |  | $                | 9,039  |               | $ | 11,266 | 
|Non-current deferred tax asset, net |  |                  | 32,715 |               |   | 27,511 | 
|                                    |  |                  |        |               |   |        | 
|                                    |  | $                | 41,754 |               | $ | 38,777 | 
|                                    |  |                  |        |               |   |        | 

The net deferred tax asset as of February 3, 2007
reflects the tax effect ($1.2 million) of the reduction of deductible temporary
differences related to the extraordinary gain  unallocated negative goodwill
associated with the Musicland acquisition and the tax effect ($0.2 million) of
the combined reductions in deductible temporary differences related to the exercise and
cancellation of stock options accounted for under SFAS No. 123(R), Share-Based
Payment, charged to Additional Paid-In Capital and to changes in
the Companys pension liability accounted for under SFAS No. 158, Employers
Accounting for Defined Benefit Pension and Other Postretirement Plans,
charged to Accumulated Other Comprehensive Loss.

The net deferred tax asset as of January 28, 2006,
reflects the tax effect ($1.5 million) of the cumulative effect of change in
accounting principle (see Note 2 of Notes to the Consolidated Financial
Statements) and the tax effect ($0.04 million) of the reduction of a deductible
temporary difference related to restricted stock that was charged to Additional
Paid -In Capital.

The Company had a net operating loss carryforward of
$1.8 million for federal income tax purposes and $161.4 million for state
income tax purposes as of the end of Fiscal 2006 that expire at various times
through 2025 and are subject to certain limitations and statutory expiration
periods. The state net operating loss carryforwards are subject to various
business apportionment factors and multiple jurisdictional requirements when
utilized.

In addition, the Company has capital loss
carryforwards of $3.5 million for federal income tax purposes which expire in
Fiscal 2007. A 100% valuation allowance has been established against the
deferred tax asset related to these capital loss carryforwards.

In assessing the propriety of deferred tax assets,
management considers whether it is more likely than not that some portion or
all of the deferred tax assets will not be realized. The ultimate realization
of deferred tax assets is dependent upon the generation of future taxable
income. Management considers the scheduled reversal of taxable temporary
differences, projected future taxable income and tax planning strategies in
making this assessment. Based upon historic and projected levels of taxable income
over the periods in which the deferred tax assets are deductible, and tax
planning strategies, the valuation allowance decreased from $11.4 million to
$7.7 million, a level where management believes that it is more likely than not
that the tax benefit will be realized. The net decrease in the valuation
allowance included a $2.2 million decrease reflected as state income taxes, net
of federal tax effect, due to the closing of tax examinations and higher
taxable income realized in Fiscal 2006 and $0.4 million included in income taxes related to the
extraordinary gain for unallocated negative goodwill. The federal

F-19

---



valuation allowance was decreased by $1.1 million to
account for the reduction in the deferred tax asset attributable to losses on
investments resulting from an investment gain.

During Fiscal 2006, the Company received a net income
tax refund of approximately $0.1 million. The Company paid income taxes, net of
refunds, of approximately $4.7 million and $12.5 million during Fiscal 2005 and
2004, respectively.

Note 7. Commitments and Contingencies

During 2000, the United States District Court for the
District of Delaware issued an opinion upholding the IRS disallowance of
deductions of interest expense related to corporate-owned life insurance
policies through fiscal 1994. The original accrual for additional income taxes
resulting from disallowed interest expense deductions was recorded following
the 2000 court decision. During 2003, the Company and the IRS agreed on final
computational and payment terms for an amount less than previously accrued,
which resulted in an income tax benefit of $2.1 million in 2003. Under the
final payment terms, the Company has agreed with the IRS to make annual
interest payments and a final principal payment of approximately $7.1 million
in 2007. The remaining accrued liability attributable to this matter as of
February 3, 2007, including accrued interest, is $7.2 million which is recorded
in income taxes payable in the Consolidated Balance Sheets. In addition, there
is an accrued liability of $1.5 million, representing exposure to potential
state income taxes associated with this matter included in deferred rent and
other liabilities in the Consolidated Balance Sheets as of February 3, 2007.
The entire accrued liability of $8.7 million, including accrued interest, was
included in deferred rent and other long-term liabilities in the Consolidated
Balance Sheets as of January 28, 2006.

In March 2006, the Company acquired an 80% interest in
Mix & Burn LLC, a company that is fully consolidated for financial
reporting. The Company has committed funding of $5.2 million, of which $4.0
million has been funded as of February 3, 2007.

The Company is subject to other legal proceedings and
claims that have arisen in the ordinary course of its business and have not
been finally adjudicated. Although there can be no assurance as to the ultimate
disposition of these matters, it is managements opinion, based upon the
information available at this time, that the expected outcome of these matters,
individually or in the aggregate, will not have a material adverse effect on
the results of operations and financial condition of the Company.

Note 8. Leases

As more fully discussed in Note 11 to the Consolidated
Financial Statements, the Company leases its Albany, NY distribution center and
administrative offices under three capital lease arrangements with its Chief
Executive Officer and largest shareholder.

Fixed assets recorded under capital leases, which are
included in fixed assets on the accompanying Consolidated Balance Sheets, are
as follows:

|                                             |  |                      |         |                      |   |        |  
|-------------------------------------------- |  | -------------------- | ------- | -------------------- | - | ------ | -
|                                             |  | February
  3,
  2007 |         | January
  28,
  2006 |  
|                                             |  |                      |         |                      |  
|                                             |  | ($ in thousands)     |        
|Buildings                                    |  | $                    | 9,342   |                      | $ | 9,342  |  
|Fixtures and equipment                       |  |                      | 12,824  |                      |   | 12,824 |  
|                                             |  |                      |         |                      |   |        |  
|                                             |  |                      | 22,166  |                      |   | 22,166 |  
|                                             |  |                      |         |                      |   |        |  
|Allowances for depreciation and amortization |  |                      | (10,325 | )                    |   | (7,170 | )
|                                             |  |                      |         |                      |   |        |  
|                                             |  | $                    | 11,841  |                      | $ | 14,996 |  
|                                             |  |                      |         |                      |   |        |  

The Company leases 991 stores under operating leases,
many of which contain renewal options, for periods ranging from five to
twenty-five years, with the majority being ten years. Most leases also provide
for payment of operating expenses and real estate taxes. Some also provide for
additional rent based on a percentage of sales.

Net rental expense was as follows:

|                   |  |                  |         |      |   |         |  |   |         | 
|------------------ |  | ---------------- | ------- | ---- | - | ------- |  | - | ------- | 
|                   |  | Fiscal
  Year    |        
|                   |  |                  |        
|                   |  | 2006             |         | 2005 |   | 2004    | 
|                   |  |                  |         |      |   |         | 
|                   |  | ($ in thousands) |        
|Minimum rentals    |  | $                | 130,802 |      | $ | 108,581 |  | $ | 115,422 | 
|Contingent rentals |  |                  | 1,453   |      |   | 1,226   |  |   | 1,372   | 
|                   |  |                  |         |      |   |         |  |   |         | 
|                   |  | $                | 132,255 |      | $ | 109,807 |  | $ | 116,794 | 
|                   |  |                  |         |      |   |         |  |   |         | 

F-20

---



Future minimum rental payments required under all
leases that have initial or remaining non-cancelable lease terms in excess of
one year at February 3, 2007 are as follows:

|                                          |  |                  |         |         |   |        | 
|----------------------------------------- |  | ---------------- | ------- | ------- | - | ------ | 
|                                          |  | Operating        |         | Capital |  
|                                          |  | Leases           |         | Leases  |  
|                                          |  |                  |         |         |  
|                                          |  | ($ in thousands) |        
|2007                                      |  |                  | 116,934 |         |   | 4,831  | 
|2008                                      |  |                  | 100,935 |         |   | 4,709  | 
|2009                                      |  |                  | 62,197  |         |   | 4,709  | 
|2010                                      |  |                  | 42,637  |         |   | 2,709  | 
|2011                                      |  |                  | 27,363  |         |   | 1,963  | 
|Thereafter                                |  |                  | 48,293  |         |   | 7,392  | 
|                                          |  |                  |         |         |   |        | 
|Total minimum payments
  required         |  | $                | 398,359 |         | $ | 26,313 | 
|                                          |  |                  |         |         |   |        | 
|Less: amounts representing interest       |  |                  |         |         |   | 11,426 | 
|                                          |  |                  |         |         |   |        | 
|Present value of
  minimum lease payments |  |                  |         |         |   | 14,887 | 
|Less: current portion                     |  |                  |         |         |   | 2,887  | 
|                                          |  |                  |         |         |   |        | 
|Long-term capital lease
  obligations     |  |                  |         |         | $ | 12,000 | 
|                                          |  |                  |         |         |   |        | 

Interest rates on capital leases were between 5.65%
and 28% per annum.

During 2005, the Company financed the replacement of
its point-of-sale system through a capital lease arrangement in the amount of
$12.0 million. The lease arrangement has an average interest rate of
5.76% and will be repaid in monthly installments of approximately $229,000
through June 2010. As of February 3, 2007, the outstanding balance on this
lease was $8.2 million.

Note 9. Benefit Plans

401(k) Savings Plan

The Company offers a 401(k) Savings Plan to eligible
employees meeting certain age and service requirements. This plan permits
participants to contribute up to 80% of their salary, including bonuses, up to
the maximum allowable by IRS regulations. Participants are immediately vested
in their voluntary contributions plus actual earnings thereon. Participant
vesting of the Companys matching and profit sharing contribution is based on
the years of service completed by the participant. Participants are fully
vested upon the completion of four years of service. All participant
forfeitures of non-vested benefits are used to reduce the Companys
contributions in future years. Total expense related to the Plan was
approximately $1,003,000, $957,000 and $897,000 in Fiscal 2006, 2005 and 2004,
respectively.

Stock Award Plans

The Company has six employee stock award plans, the
1986 Stock Option Plan, the 1994 Stock Option Plan, the 1998 Stock Option Plan,
the 1999 Stock Option Plan and the 2002 Stock Option Plan (the Old Plans);
and the 2005 Long Term Incentive Share Plan (the New Plan). The Compensation
Committee of the Board of Directors may grant options to acquire shares of the Companys
common stock to employees of the Company at the fair market value of the common
stock on the date of grant. The Company has stopped issuing stock options under
the Old Plans. Under the New Plan, the Company generally issues Stock-Settled
Appreciation Rights (SSARS) that become exercisable in 50% increments
commencing three years from the date of grant and have a maximum term of ten
years from issuance.

Options and SSARS authorized for issuance under the
Old and New Plans total 19.8 million. As of February 3, 2007, of the options
authorized for issuance under the Old Plans and New Plan, 9.7 million were
granted and are outstanding, 7.4 million of which were vested and exercisable.
Options available for future grants at February 3, 2007 and January 28, 2006
were 3.7 million and 4.7 million, respectively.

Under the terms of the Camelot merger agreement, all
options issued under the Camelot 1998 Stock Option Plan (the Camelot Plan)
were converted to the Companys options. The Camelot Plan provided for the
granting of either incentive stock options or nonqualified stock options to
purchase shares of the Companys common stock. Vesting of the options was
originally over a four-year period with a maximum term of ten years. Based on
the terms of the Camelot Plan, vesting was accelerated based on the market
performance of the Companys common stock whereby 50% of the options vested on
March 13, 1998. The remaining 50% vested on April 22, 1999 in connection with
the merger. At February 3, 2007, 16,950 options were outstanding and
exercisable. The Company stopped issuing stock options under the Camelot Stock
Option Plan as of April 22, 1999.

F-21

---



The following table summarizes information about the
stock awards outstanding under the Old Plans, the New Plan and the Camelot Plan as of February 3,
2007:

|                       |  |             |           |                            |  |                                       |  |                                |       |        |   |                                       |  |                               |           |  |   |       |  |   |           | 
|---------------------- |  | ----------- | --------- | -------------------------- |  | ------------------------------------- |  | ------------------------------ | ----- | ------ | - | ------------------------------------- |  | ----------------------------- | --------- |  | - | ----- |  | - | --------- | 
|                       |  |             |           |                            | 
|                       |  | Outstanding |           | Exercisable                | 
|                       |  |             |           |                            | 
|Exercise
  Price Range |  | Shares      |           | Average
  Remaining
  Life |  | Weighted
  Average
  Exercise
  Price |  | Aggregate 
  Intrinsic
  Value |       | Shares |   | Weighted
  Average
  Exercise
  Price |  | Aggregate
  Intrinsic
  Value |          
|                       |  |             |           |                            |  |                                       |  |                                |       |        |   |                                       |  |                               |          
|$2.67-$5.33            |  |             | 2,841,273 |                            |  | 6.9                                   |  | $                              | 4.08  |        | $ | 4,858,577                             |  |                               | 887,890   |  | $ | 3.55  |  | $ | 1,988,874 | 
|5.34-8.00              |  |             | 393,500   |                            |  | 8.7                                   |  |                                | 6.97  |        |   | 5,625                                 |  |                               | 76,875    |  |   | 7.17  |  |   |          | 
|8.01-10.00             |  |             | 1,913,810 |                            |  | 4.7                                   |  |                                | 8.44  |        |   |                                      |  |                               | 1,913,810 |  |   | 8.44  |  |   |          | 
|10.01-13.33            |  |             | 3,000,200 |                            |  | 3.9                                   |  |                                | 10.92 |        |   |                                      |  |                               | 2,992,700 |  |   | 10.92 |  |   |          | 
|13.34-16.00            |  |             | 1,365,995 |                            |  | 6.4                                   |  |                                | 14.57 |        |   |                                      |  |                               | 1,365,995 |  |   | 14.57 |  |   |          | 
|16.01-18.67            |  |             | 173,925   |                            |  | 1.2                                   |  |                                | 17.79 |        |   |                                      |  |                               | 173,925   |  |   | 17.79 |  |   |          | 
|18.68-24.00            |  |             | 2,000     |                            |  | 0.0                                   |  |                                | 23.75 |        |   |                                      |  |                               | 2,000     |  |   | 23.75 |  |   |          | 
|                       |  |             |           |                            |  |                                       |  |                                |       |        |   |                                       |  |                               |           |  |   |       |  |   |           | 
|Total                  |  |             | 9,690,703 |                            |  | 5.4                                   |  | $                              | 8.91  |        | $ | 4,864,202                             |  |                               | 7,413,195 |  | $ | 10.20 |  | $ | 1,988,874 | 
|                       |  |             |           |                            |  |                                       |  |                                |       |        |   |                                       |  |                               |           |  |   |       |  |   |           | 

The aggregate intrinsic value in the preceding table
represents the total pretax intrinsic value based on the Companys closing
stock price of $5.79 as of February 3, 2007, which would have been received by
the award holders had all award holders under the Old Plans, New Plan and
Camelot Plans exercised their awards as of that date. The total number of
in-the-money awards exercisable as of February 3, 2007 was 887,890.

The Company also has a stock award plan for
non-employee directors (the 1990 Plan). Awards under this plan are granted at
an exercise price determined by the Compensation Committee of the Board of
Directors. Under the 1990 Plan, awards generally become exercisable commencing
one year from the date of grant in increments of 25% per year with a maximum
term of ten years. In addition, directors of the Company receive annual grants
of deferred shares of Common Stock (Deferred Shares) issued under this plan
which vest equally in three years from date of grant. As of February 3, 2007,
there were 750,000 awards authorized for issuance and 363,401 awards have been
granted and are outstanding, 142,161 of which were vested and exercisable.
There are 54,105 shares of common stock reserved for possible future option
grants under the 1990 Plan.

In connection with the Companys merger with Camelot
in April 1999 all options issued under the Camelot Outside Director Stock
Option Plan (the Camelot Director Plan) were converted to the Companys
options. As of February 3, 2007, there were 4,750 options outstanding and
exercisable under the Camelot Director Plan. The Company no longer issues
options under the Camelot Director Plan. The 1990 Plan and Camelot Director
Plan are collectively referred to as the Director Plans.

The following table summarizes information about the
stock awards outstanding under the Director Plans at February 3, 2007:

|                       |  |             |         |                            |  |                                       |  |                                |       |        |   |                                       |  |                               |         |  |   |       |  |   |         | 
|---------------------- |  | ----------- | ------- | -------------------------- |  | ------------------------------------- |  | ------------------------------ | ----- | ------ | - | ------------------------------------- |  | ----------------------------- | ------- |  | - | ----- |  | - | ------- | 
|                       |  |             |         |                            | 
|                       |  | Outstanding |         | Exercisable                | 
|                       |  |             |         |                            | 
|Exercise
  Price Range |  | Shares      |         | Average
  Remaining
  Life |  | Weighted
  Average
  Exercise
  Price |  | Aggregate 
  Intrinsic
  Value |       | Shares |   | Weighted
  Average
  Exercise
  Price |  | Aggregate
  Intrinsic
  Value |        
|                       |  |             |         |                            |  |                                       |  |                                |       |        |   |                                       |  |                               |        
|$0.00-$2.67            |  |             | 249,901 |                            |  | 8.1                                   |  | $                              | 0.00  |        | $ | 1,446,927                             |  |                               | 47,411  |  | $ | 0.00  |  | $ | 274,510 | 
|2.68-5.33              |  |             | 4,500   |                            |  | 0.2                                   |  |                                | 3.36  |        |   | 10,935                                |  |                               | 4,500   |  |   | 3.36  |  |   | 10,935  | 
|5.34-8.00              |  |             | 30,000  |                            |  | 6.8                                   |  |                                | 6.44  |        |   |                                      |  |                               | 22,500  |  |   | 6.44  |  |   |        | 
|8.01-10.00             |  |             | 26,000  |                            |  | 4.4                                   |  |                                | 8.66  |        |   |                                      |  |                               | 26,000  |  |   | 8.66  |  |   |        | 
|10.01-13.33            |  |             | 53,250  |                            |  | 3.8                                   |  |                                | 11.80 |        |   |                                      |  |                               | 42,000  |  |   | 11.40 |  |   |        | 
|13.34-16.00            |  |             | 4,500   |                            |  | 1.2                                   |  |                                | 15.12 |        |   |                                      |  |                               | 4,500   |  |   | 15.12 |  |   |        | 
|                       |  |             |         |                            |  |                                       |  |                                |       |        |   |                                       |  |                               |         |  |   |       |  |   |         | 
|Total                  |  |             | 368,151 |                            |  | 6.9                                   |  | $                              | 3.07  |        | $ | 1,457,862                             |  |                               | 146,911 |  | $ | 6.35  |  | $ | 285,445 | 
|                       |  |             |         |                            |  |                                       |  |                                |       |        |   |                                       |  |                               |         |  |   |       |  |   |         | 

The aggregate intrinsic value in the preceding table
represents the total pretax intrinsic value based on the Companys closing
stock price of $5.79 as of February 3, 2007, which would have been received by
the award holders had all award holders under the Director Plans exercised
their awards as of that date. The total number of in-the-money awards
exercisable as of February 3, 2007 was 51,911.

F-22

---



The following tables summarize activity under the
Stock Award Plans:

|                         |  |                                        |   |                                  |              |                                     |  |                                        |       |                                  |  |                                     |   |  |              |  |  |   |       |  | 
|------------------------ |  | -------------------------------------- | - | -------------------------------- | ------------ | ----------------------------------- |  | -------------------------------------- | ----- | -------------------------------- |  | ----------------------------------- | - |  | ------------ |  |  | - | ----- |  | 
|                         |  | Employee
  Stock Award Plans           |   | Director
  Stock Award Plans     |             
|                         |  |                                        |   |                                  |             
|                         |  | Number of
  Shares Subject
  To Option |   | Option
  Price Range
  Per Share |              | Weighted
  Average
  Exercise Price |  | Number of
  Shares Subject
  To Option |       | Option
  Price Range
  Per Share |  | Weighted
  Average
  Exercise Price |  
|                         |  |                                        |   |                                  |              |                                     |  |                                        |       |                                  |  |                                     |  
|Balance January 31, 2004 |  | 8,446,391                              |   |                                  | $1.21-$23.75 |                                     |  | $                                      | 7.63  |                                  |  | 420,071                             |   |  | $0.00-$15.12 |  |  | $ | 4.98  |  | 
|Granted                  |  | 1,299,250                              |   |                                  | 7.50-10.31   |                                     |  |                                        | 10.30 |                                  |  | 62,080                              |   |  | 0.00-0.00    |  |  |   | 0.00  |  | 
|Exercised                |  | (706,614                               | ) |                                  | 1.21-10.92   |                                     |  |                                        | 3.54  |                                  |  | (57,145                             | ) |  | 0.00-10.94   |  |  |   | 2.93  |  | 
|Canceled                 |  | (135,826                               | ) |                                  | 2.66-17.79   |                                     |  |                                        | 8.02  |                                  |  | (30,111                             | ) |  | 0.00-8.95    |  |  |   | 0.52  |  | 
|                         |  |                                        |   |                                  |              |                                     |  |                                        |       |                                  |  |                                     |   |  |              |  |  |   |       |  | 
|Balance January 29, 2005 |  | 8,903,201                              |   |                                  | $1.21-$23.75 |                                     |  | $                                      | 8.34  |                                  |  | 394,895                             |   |  | $0.00-$15.12 |  |  | $ | 4.17  |  | 
|Granted                  |  | 1,371,725                              |   |                                  | 7.10-14.32   |                                     |  |                                        | 12.74 |                                  |  | 48,516                              |   |  | 0.00-13.28   |  |  |   | 4.11  |  | 
|Exercised                |  | (634,977                               | ) |                                  | 1.21-12.44   |                                     |  |                                        | 6.17  |                                  |  | (78,000                             | ) |  | 1.18-3.68    |  |  |   | 3.12  |  | 
|Canceled                 |  | (118,413                               | ) |                                  | 3.50-17.79   |                                     |  |                                        | 10.31 |                                  |  | (27,135                             | ) |  | 0.00-15.12   |  |  |   | 2.15  |  | 
|                         |  |                                        |   |                                  |              |                                     |  |                                        |       |                                  |  |                                     |   |  |              |  |  |   |       |  | 
|Balance January 28, 2006 |  | 9,521,536                              |   |                                  | $1.58-$23.75 |                                     |  | $                                      | 9.10  |                                  |  | 338,276                             |   |  | $0.00-$15.12 |  |  | $ | 4.56  |  | 
|Granted                  |  | 987,675                                |   |                                  | 5.32-7.29    |                                     |  |                                        | 5.38  |                                  |  | 105,000                             |   |  | 0.00-0.00    |  |  |   | 0.00  |  | 
|Exercised                |  | (232,762                               | ) |                                  | 1.58-3.96    |                                     |  |                                        | 2.73  |                                  |  | (34,500                             | ) |  | 0.00-1.35    |  |  |   | 0.18  |  | 
|Canceled                 |  | (585,746                               | ) |                                  | 2.80-17.79   |                                     |  |                                        | 8.48  |                                  |  | (40,625                             | ) |  | 8.02-15.12   |  |  |   | 10.05 |  | 
|                         |  |                                        |   |                                  |              |                                     |  |                                        |       |                                  |  |                                     |   |  |              |  |  |   |       |  | 
|Balance February 3, 2007 |  | 9,690,703                              |   |                                  | $3.16-$23.75 |                                     |  | $                                      | 8.91  |                                  |  | 368,151                             |   |  | $0.00-$15.12 |  |  | $ | 3.07  |  | 
|                         |  |                                        |   |                                  |              |                                     |  |                                        |       |                                  |  |                                     |   |  |              |  |  |   |       |  | 

During Fiscal 2006, 2005 and 2004, the Company
recognized expenses of approximately $477,000, $296,000 and $218,000,
respectively, for deferred shares issued to non-employee directors at an
exercise price below the closing stock price on the date of grant.

Restricted Stock Plan

Under the 1990 Restricted Stock Plan, the Compensation
Committee of the Board of Directors is authorized to grant awards for up to
900,000 restricted shares of Common Stock to executive officers and other key
employees of the Company. The shares are issued as restricted stock and are
held in the custody of the Company until all vesting restrictions are satisfied.
If conditions or terms under which an award is granted are not satisfied, the
shares are forfeited. Shares vest under these grants over a period of two to
five years, with vesting criteria that includes continuous employment until
applicable vesting dates have expired. As of February 3, 2007, a total of
330,000 shares have been granted, of which 240,000 shares have vested and
85,000 shares had been forfeited. Unearned compensation is recorded at the date
of award, based on the market value of the shares, and is included as a
separate component of shareholders equity and is amortized over the applicable
vesting period. The amount amortized to expense in Fiscal 2006, 2005 and 2004,
net of the impact of forfeitures, was approximately $13,000, $16,000 and $28,000,
respectively. As of February 3, 2007, outstanding awards and shares available
for grant totaled 5,000 and 655,000, respectively.

Defined Benefit Plans

The Company maintains a non-qualified Supplemental
Executive Retirement Plan (SERP) for certain Executive Officers of the
Company. The SERP, which is unfunded, provides eligible executives defined
pension benefits that supplement benefits under other retirement arrangements.
The annual benefit amount is based on salary and bonus at the time of retirement
and number of years of service.

The Company provides the Board of Directors with a
noncontributory, unfunded retirement plan (Director Retirement Plan) that
pays a retired director an annual retirement benefit equal to 60% of the annual
retainer at the time of retirement plus a 3% annual increase through the final
payment. Payments begin at age 62 or retirement, whichever is later, and
continue for 10 years or the life of the director and his or her spouse,
whichever period is shorter. Partial vesting in the retirement plan begins
after six years of continuous service. Participants become fully vested after
12 years of continuous service on the Board. After June 1, 2003, new directors
were not covered by the Director Retirement Plan. Directors who were not yet
vested in their retirement benefits as of June 1, 2003 had the present value of
benefits already accrued as of the effective date converted to Deferred Shares
under the Directors Plan. Directors that were fully or partially vested in
their retirement benefits were given a one time election to continue to
participate in the current retirement program or convert the present value of
benefits already accrued to Deferred Shares under the Directors Plan as of the
effective date.

The Company accounts for the SERP and the Director
Retirement Plan in accordance with SFAS No 158, Employers Accounting for Defined
Benefit and Other Postretirement Plans  an amendment of FASB Statements No.
87, 88, 106 and 132(R). SFAS No. 158 requires that the funded status
of defined benefit pension plans, or the difference between the fair value of
plan assets and the projected benefit obligation, be recognized in the
Consolidated Balance Sheet. This differs from the accounting under SFAS No. 87,
which required the difference between the fair value of plan assets and the
accumulated benefit obligation to be recorded in the Consolidated Balance
Sheet. SFAS No. 158 does not

F-23

---



require retrospective application. Accordingly, the
Consolidated Balance Sheet as of January 28, 2006 has not been restated. SFAS No.
158 also requires that defined benefit plan assets and obligations be measured
as of the date of the employers fiscal year-end statement of financial
position, however, this requirement of the statement is effective for fiscal
years ending after December 15, 2008. Accordingly, the Company has not adopted
this provision of SFAS No. 158 for the year ended February 3, 2007, however
this provision will be adopted in accordance with the aforementioned
requirements. For Fiscal 2006 and 2005, the measurement date for the plans is
November 1.

As a result of the adoption of SFAS No. 158, the
following incremental impacts were recognized in the Companys Consolidated
Balance Sheet as of February 3, 2007:

|                                                |  |                                   |   |             |  |                                    |  |   |        |   |  |  |   |         |   | 
|----------------------------------------------- |  | --------------------------------- | - | ----------- |  | ---------------------------------- |  | - | ------ | - |  |  | - | ------- | - | 
|Balance
  Sheet Impact of SFAS No. 158 Adoption |  |                                   |   |             |  |                                    | 
|                                                |  |                                   |   |             |  |                                    | 
|                                                |  | Before Adoption
  of SFAS No. 158 |   | Adjustments |  | After
  Adoption
  of SFAS No. 158 | 
|                                                |  |                                   |   |             |  |                                    | 
|                                                |  | ($ in
  thousands)                |  
|                                                |  |                                   |   |             |  |                                    |  |   |        |  
|Deferred taxes                                  |  |                                   | $ | 31,092      |  |                                    |  | $ | 1,623  |   |  |  | $ | 32,715  |   | 
|Other assets                                    |  |                                   |   | 15,767      |  |                                    |  |   | (3,400 | ) |  |  |   | 12,367  |   | 
|                                                |  |                                   |   |             |  |                                    |  |   |        |   |  |  |   |         |   | 
|Total Assets                                    |  |                                   |   | 831,467     |  |                                    |  |   | (1,777 | ) |  |  |   | 829,690 |   | 
|                                                |  |                                   |   |             |  |                                    |  |   |        |   |  |  |   |         |   | 
|Deferred rent and other liabilities             |  |                                   |   | 39,740      |  |                                    |  |   | 508    |   |  |  |   | 40,248  |   | 
|                                                |  |                                   |   |             |  |                                    |  |   |        |   |  |  |   |         |   | 
|Total Liabilities                               |  |                                   |   | 435,977     |  |                                    |  |   | 508    |   |  |  |   | 436,485 |   | 
|                                                |  |                                   |   |             |  |                                    |  |   |        |   |  |  |   |         |   | 
|Accumulated other comprehensive income (loss)   |  |                                   |   | 397         |  |                                    |  |   | (2,285 | ) |  |  |   | (1,888  | ) | 
|                                                |  |                                   |   |             |  |                                    |  |   |        |   |  |  |   |         |   | 
|Total Shareholders Equity                      |  |                                   | $ | 395,490     |  |                                    |  | $ | (2,285 | ) |  |  | $ | 393,205 |   | 

For Fiscal 2006, 2005 and 2004, net periodic pension
cost recognized under both plans totaled approximately $2.2 million, $1.9
million, and $1.4 million, respectively. The accrued pension liability for the
plans was approximately $13.3 million and $15.2 million at February 3, 2007 and
January 28, 2006, respectively. In addition, an intangible asset, which is
included in other assets in the Consolidated Balance Sheets, to reflect the
amount of projected benefit obligation representing unrecognized prior service
cost, of approximately $3.7 million was recorded at January 28, 2006. Under
SFAS 158, no intangible asset representing unrecognized prior service cost is
recorded as of February 3, 2007.

The following is a summary of the Companys defined
benefit pension plans as of the most recent actuarial calculations:

|                                              |  |                    |         |                    |   |         |  
|--------------------------------------------- |  | ------------------ | ------- | ------------------ | - | ------- | -
|Obligation
  and Funded Status:               |  |                    |         |                    |  
|                                              |  |                    |         |                    |  
|                                              |  | February 3,
  2007 |         | January 28,
  2006 |  
|                                              |  |                    |         |                    |  
|                                              |  | ($ in thousands)   |        
|Change in Projected Benefit Obligation:       |  |                    |         |                    |   |         |  
|Benefit obligation at beginning of year       |  | $                  | 16,108  |                    | $ | 14,232  |  
|Service cost                                  |  |                    | 679     |                    |   | 531     |  
|Interest cost                                 |  |                    | 885     |                    |   | 782     |  
|Actuarial (gain)* / loss                      |  |                    | (4,346  | )                  |   | 604     |  
|Benefits paid                                 |  |                    | (50     | )                  |   | (41     | )
|                                              |  |                    |         |                    |   |         |  
|Projected
  Benefit obligation at end of year |  | $                  | 13,276  |                    | $ | 16,108  |  
|                                              |  |                    |         |                    |   |         |  
|                                              |  |                    |         |                    |   |         |  
|Fair value of plan assets at end of year      |  |                    |        |                    |   |        |  
|                                             
|Reconciliation of Funded Status:              |  |                    |         |                    |   |         |  
|Funded status                                 |  |                    | (13,276 | )                  |   | (16,108 | )
|Unrecognized prior service cost               |  |                    | 3,400   |                    |   | 3,742   |  
|Unrecognized net actuarial (gain) / loss      |  |                    | (171    | )                  |   | 4,451   |  
|                                              |  |                    |         |                    |   |         |  
|Accrued benefit cost                          |  |                    | (10,047 | )                  |   | (7,915  | )
|Additional liability                          |  |                    | (3,229  | )                  |   | (7,279  | )
|                                              |  |                    |         |                    |   |         |  
|Accrued pension
  liability                   |  | $                  | (13,276 | )                  | $ | (15,194 | )
|                                              |  |                    |         |                    |   |         |  

* The actuarial gain of $4.3 million in Fiscal 2006 is
due to the non-vested termination of two plan participants, an increase in the
discount rate from 5.50% to 5.75% and a 5 year extension of the assumed
retirement age for the Companys Chief Executive Officer.

F-24

---



|                                                                    |  |                    |         |                    |   |         |   |  |  | 
|------------------------------------------------------------------- |  | ------------------ | ------- | ------------------ | - | ------- | - |  |  | 
|Amounts
  recognized in the Consolidated Balance Sheets consist of: |  |                    |         |                    |   |         |  
|                                                                    |  |                    |         |                    |   |         |  
|                                                                    |  | February 3,
  2007 |         | January 28,
  2006 |   |         |  
|                                                                    |  |                    |         |                    |   |         |  
|                                                                    |  | ($ in thousands)   |         |                    |  
|                                                                    |  |                    |         |                    |  
|Accrued pension liability                                           |  | $                  | (13,276 | )                  | $ | (15,194 | ) |  |  | 
|Intangible assets                                                   |  |                    |        |                    |   | 3,742   |   |  |  | 
|Accumulated other comprehensive loss                                |  |                    | 1,888   |                    |   | 2,048   |   |  |  | 
|Deferred tax asset                                                  |  |                    | 1,341   |                    |   | 1,489   |   |  |  | 
|                                                                    |  |                    |         |                    |   |         |   |  |  | 
|Net amount
  recognized                                             |  | $                  | (10,047 | )                  | $ | (7,915  | ) |  |  | 
|                                                                    |  |                    |         |                    |   |         |   |  |  | 

The accumulated benefit obligation for the plans was
$12.8 million and $15.2 million at February 3, 2007 and January 28, 2006,
respectively, which exceeds plan assets ($0).

Information for pension plans with an accumulated
benefit obligation in excess of plan assets:

|                               |  |                      |        |                      |   |        |  |  |  | 
|------------------------------ |  | -------------------- | ------ | -------------------- | - | ------ |  |  |  | 
|                               |  | February
  3,
  2007 |        | January
  28,
  2006 |   |        |  | 
|                               |  |                      |        |                      |   |        |  | 
|                               |  | $ in thousands       |        |                      |   |       
|Projected benefit obligation   |  | $                    | 13,276 |                      | $ | 16,108 |  |  |  | 
|Accumulated benefit obligation |  | $                    | 12,768 |                      | $ | 15,194 |  |  |  | 
|Fair value of plan assets      |  |                      |       |                      |   |       |  |  |  | 

|                                           |  |      |       |                      |   |       |  |   |       | 
|------------------------------------------ |  | ---- | ----- | -------------------- | - | ----- |  | - | ----- | 
|Components
  of Net Periodic Pension Cost: |  |      |       |                      |   |       | 
|                                           |  |      |       |                      |   |       | 
|($ in thousands)                           |  | 2006 |       | Fiscal
  Year
  2005 |   | 2004  | 
|                                           |  |      |       |                      |   |       | 
|Service cost                               |  | $    | 679   |                      | $ | 531   |  | $ | 402   | 
|Interest cost                              |  |      | 885   |                      |   | 782   |  |   | 628   | 
|Amortization of prior service cost         |  |      | 343   |                      |   | 342   |  |   | 342   | 
|Amortization of net loss                   |  |      | 275   |                      |   | 243   |  |   | 18    | 
|                                           |  |      |       |                      |   |       |  |   |       | 
|Net periodic
  pension cost                |  | $    | 2,182 |                      | $ | 1,898 |  | $ | 1,390 | 
|                                           |  |      |       |                      |   |       |  |   |       | 

During Fiscal 2006, the pre-tax amounts recognized in
other comprehensive income are summarized below:

|                                                                            |  |                      |       |  |  |  |  |  |  | 
|--------------------------------------------------------------------------- |  | -------------------- | ----- |  |  |  |  |  |  | 
|($ in thousands)                                                            |  | Fiscal
  Year
  2006 |       |  |  |  |  |  | 
|Net prior service recognized as a component of net
  periodic pension cost  |  | $                    | 343   |  |  |  |  |  |  | 
|Net actuarial loss recognized as a component of net
  periodic pension cost |  |                      | 275   |  |  |  |  |  |  | 
|Net actuarial gain arising during the period                                |  |                      | 3,598 |  |  |  |  |  |  | 
|                                                                            |  |                      |       |  |  |  |  |  |  | 
|                                                                            |  |                      | 4,216 |  |  |  |  |  |  | 
|Income tax effect                                                           |  |                      | 1,771 |  |  |  |  |  |  | 
|                                                                            |  |                      |       |  |  |  |  |  |  | 
|Other comprehensive income                                                  |  | $                    | 2,445 |  |  |  |  |  |  | 
|                                                                            |  |                      |       |  |  |  |  |  |  | 

F-25

---



The pre-tax components of accumulated other
comprehensive loss, which have not yet been recognized as components of net
periodic pension cost as of February 3, 2007 are summarized below.

|                                     |   |                      |   | 
|------------------------------------ | - | -------------------- | - | 
|($ in thousands)                     |   | February
  3,
  2007 |  
|                                     |   |                     
|Net unrecognized actuarial gain      | $ | (171                 | ) | 
|Net unrecognized prior service cost  |   | 3,400                |   | 
|                                     |   |                      |  
|Accumulated other comprehensive loss | $ | 3,229                |   | 
|                                     |   |                      |   | 

In Fiscal 2007, approximately $342,000 of net
unrecognized prior service cost and approximately $2,000 of the net
unrecognized actuarial gain, recorded as components of accumulated other
comprehensive loss at February 3, 2007, will be recognized as components of net
periodic pension cost.

|                                                                            |  |             |   |             |      |      |  |      |   | 
|--------------------------------------------------------------------------- |  | ----------- | - | ----------- | ---- | ---- |  | ---- | - | 
|Assumptions:                                                                |  |             |   |             |      |      |  |      |   | 
|                                                                            |  |             |   |             |     
|                                                                            |  | Fiscal Year |   |             |     
|                                                                            |  |             |   |             |     
|                                                                            |  | 2006        |   | 2005        |      |      | 
|                                                                            |  |             |   |             |      |      | 
|Weighted-average assumptions used to determine
  benefit obligation:        |  |             |   |             |      |      |  |      |   | 
|Discount rate                                                               |  | 5.75        | % |             | 5.50 | %    |  |      |   | 
|Salary increase
  rate                                                      |  | 4.00        | % |             | 4.00 | %    |  |      |   | 
|Measurement date                                                            |  | Nov 1, 2006 |   | Nov 1, 2005 |      |      |  |     
|                                                                            |  |             |   |             |      |      |  |      |   | 
|                                                                            |  |             |  
|                                                                            |  | Fiscal Year |  
|                                                                            |  | 2006        |   | 2005        |      | 2004 | 
|                                                                            |  |             |   |             |      |      | 
|Weighted-average assumptions used to determine net
  periodic pension cost: |  |             |   |             |      |      |  |      |   | 
|Discount rate                                                               |  | 5.75        | % |             | 5.50 | %    |  | 6.00 | % | 
|Salary increase
  rate                                                      |  | 4.00        | % |             | 4.00 | %    |  | 4.00 | % | 
|                                                                            |  |             |   |             |      |      |  |      |   | 

The Company expects to make $50,450 in benefit payments
during 2007.

The discount rate is based on the rates implicit in
high-quality fixed-income investments currently available as of the measurement
date. The Citigroup Pension Discount Curve (CPDC) rates are intended to
represent the spot rates implied by the high quality corporate bond market in
the U.S. The projected benefit payments attributed to the projected benefit
obligation have been discounted using the CPDC mid-year rates and the discount
rate is the single constant rate that produces the same total present value.

The following benefit payments, which reflect expected
future service, as appropriate, are expected to be paid:

|                    |  |                  |       | 
|------------------- |  | ---------------- | ----- | 
|                    |  |                  |      
|Year                |  | Pension Benefits |      
|                    |  |                  |      
|                    |  | ($ in thousands) |      
|                    |  |                  |      
|2007                |  | $                | 50    | 
|2008                |  |                  | 51    | 
|2009                |  |                  | 64    | 
|2010                |  |                  | 101   | 
|2011                |  |                  | 143   | 
|2012 and thereafter |  | $                | 6,091 | 

F-26

---



Note 10. Shareholders Equity

On May 28, 2003, the Companys Board of Directors
authorized the repurchase of 10 million outstanding shares of the Companys
Common Stock from time to time on the open market. The Company had repurchased
15 million shares of common stock under previously announced programs. As of
the end of Fiscal 2005, the Company had purchased the 10 million shares
outstanding under the stock repurchase program, at a total cost of $88.5
million. There are currently no repurchase programs outstanding. As of February
3, 2007 and January 28, 2006, the Company held 25,103,990 and 25,104,990
shares, respectively, in treasury stock.

The Company has never declared dividends on its Common
Stock and does not plan to pay cash dividends on its Common Stock in the
foreseeable future. The Companys credit agreement does not restrict the
payment of cash dividends so long as payment conditions per the agreement are
met. Any future determination as to the payment of dividends will depend upon
capital requirements, limitations imposed by the Companys Credit Agreement
(see Note 5 to the Consolidated Financial Statements) and other factors the
Companys Board of Directors may consider.

Note 11. Related Party Transactions

The Company leases its 181,300 square foot
distribution center/office facility in Albany, New York from Robert J. Higgins,
its Chairman, Chief Executive Officer and largest shareholder, under three
capital leases that expire in the year 2015. The original distribution
center/office facility was occupied in 1985.

Under the three capital leases, dated April 1, 1985,
November 1, 1989 and September 1, 1998 (the Leases), the Company paid Mr.
Higgins an annual rent of $2.0 million, $1.9 million and $1.8 million in Fiscal
2006, 2005 and 2004 respectively. Pursuant to the terms of the lease
agreements, effective January 1, 2002 and every two years thereafter, rental
payments will increase in accordance with the biennial increase in the Consumer
Price Index. Under the terms of the lease agreements, the Company is
responsible for property taxes, insurance and other operating costs with
respect to the premises. Mr. Higgins obligation for principal and interest on
his underlying indebtedness relating to the real property is approximately $1.1
million per year. None of the leases contain any real property purchase options
at the expiration of its term.

The Company leases one of its retail stores from
Mr. Higgins under an operating lease. Annual rental payments under this lease
were $40,000 in Fiscal 2006, 2005 and 2004. Under the terms of the lease, the
Company pays property taxes, maintenance and a contingent rental if a specified
sales level is achieved. Total additional charges for the store, including
contingent rent, were approximately $4,100, $4,400 and $14,500 in Fiscal 2006,
2005 and 2004 respectively.

The Company regularly utilizes privately chartered
aircraft owned or partially owned by Mr. Higgins, for Company business. The
Company charters an aircraft from Crystal Jet, a corporation wholly-owned by
Mr. Higgins, for Company business. Payments to Crystal Jet aggregated
approximately $11,000, $6,000 and $10,000 in Fiscal 2006, 2005 and 2004,
respectively. The Company also charters an aircraft from Richmor Aviation, an
unaffiliated corporation that leases an aircraft owned by Mr. Higgins, for
Company business. Payments to Richmor Aviation, to charter the aircraft owned
by Mr. Higgins, in Fiscal 2006, 2005 and 2004 were approximately $526,000, $276,000
and $314,000, respectively. The Company believes that the charter rates and
terms are as favorable to the Company as those generally available to it from
other commercial charters.

Michael Solow, a member of the Companys Board of Directors, is a partner
of the law firm Kaye Scholer LLP, which rendered legal services to the Company
in Fiscal 2004 for which the Company incurred fees of $115,000. Kaye Scholer
concluded its representation of the Company in Fiscal 2004.

F-27

---



Note 12. Quarterly Financial
Information (Unaudited)

|                                                                                              |  |                                                |           |         |   |          |  |         |         |         |   |         |   |   |         |  
|--------------------------------------------------------------------------------------------- |  | ---------------------------------------------- | --------- | ------- | - | -------- |  | ------- | ------- | ------- | - | ------- | - | - | ------- | -
|                                                                                              |  | Fiscal 2006 Quarter Ended                      |          
|                                                                                              |  |                                                |          
|                                                                                              |  | 2006                                           |           | 2/03/07 |   | 10/28/06 |  | 7/29/06 |         | 4/29/06 |  
|                                                                                              |  |                                                |          
|                                                                                              |  | ($ in thousands, except for per share amounts) |          
|                                                                                              |  |                                                |          
|Sales                                                                                         |  | $                                              | 1,471,157 |         | $ | 586,680  |  | $       | 297,679 |         | $ | 298,261 |   | $ | 288,537 |  
|Gross profit                                                                                  |  |                                                | 519,222   |         |   | 203,755  |  |         | 108,811 |         |   | 106,212 |   |   | 100,444 |  
|Income (loss) before extraordinary gain -
  unallocated negative goodwill                     |  |                                                | 948       |         |   | 32,461   |  |         | (13,305 | )       |   | (10,217 | ) |   | (7,991  | )
|Extraordinary gain  unallocated negative
  goodwill, net of income taxes                     |  |                                                | 10,721    |         |   | 5,387    |  |         | 1,925   |         |   | 2,475   |   |   | 934     |  
|                                                                                              |  |                                                |           |         |   |          |  |         |         |         |   |         |   |   |         |  
|Net income (loss)                                                                             |  | $                                              | 11,669    |         | $ | 37,848   |  | $       | (11,380 | )       | $ | (7,742  | ) | $ | (7,057  | )
|                                                                                              |  |                                                |           |         |   |          |  |         |         |         |   |         |   |   |         |  
|Basic earnings (loss) per share before
  extraordinary gain  unallocated negative goodwill   |  | $                                              | 0.03      |         | $ | 1.05     |  | $       | (0.43   | )       | $ | (0.33   | ) | $ | (0.26   | )
|Extraordinary gain  unallocated negative
  goodwill, net of income taxes                     |  |                                                | 0.35      |         |   | 0.18     |  |         | 0.06    |         |   | 0.08    |   |   | 0.03    |  
|                                                                                              |  |                                                |           |         |   |          |  |         |         |         |   |         |   |   |         |  
|Basic earnings (loss) per share                                                               |  | $                                              | 0.38      |         | $ | 1.23     |  | $       | (0.37   | )       | $ | (0.25   | ) | $ | (0.23   | )
|                                                                                              |  |                                                |           |         |   |          |  |         |         |         |   |         |   |   |         |  
|Diluted earnings (loss) per share before
  extraordinary gain  unallocated negative goodwill |  | $                                              | 0.03      |         | $ | 1.00     |  | $       | (0.43   | )       | $ | (0.33   | ) | $ | (0.26   | )
|Extraordinary gain  unallocated negative
  goodwill, net of income taxes                     |  |                                                | 0.33      |         |   | 0.17     |  |         | 0.06    |         |   | 0.08    |   |   | 0.03    |  
|                                                                                              |  |                                                |           |         |   |          |  |         |         |         |   |         |   |   |         |  
|Diluted earnings (loss) per share                                                             |  | $                                              | 0.36      |         | $ | 1.17     |  | $       | (0.37   | )       | $ | (0.25   | ) | $ | (0.23   | )
|                                                                                              |  |                                                |           |         |   |          |  |         |         |         |   |         |   |   |         |  

|                                                                                                 |  |                                                |           |         |   |          |   |         |         |         |   |         |   |   |         |  
|------------------------------------------------------------------------------------------------ |  | ---------------------------------------------- | --------- | ------- | - | -------- | - | ------- | ------- | ------- | - | ------- | - | - | ------- | -
|                                                                                                 |  | Fiscal 2005 Quarter Ended                      |          
|                                                                                                 |  |                                                |          
|                                                                                                 |  | 2005                                           |           | 1/28/06 |   | 10/29/05 |   | 7/30/05 |         | 4/30/05 |  
|                                                                                                 |  |                                                |          
|                                                                                                 |  | ($ in thousands, except for per share amounts) |          
|                                                                                                 |  |                                                |           |         |   |          |   |         |         |         |   |         |   |   |         |  
|Sales                                                                                            |  | $                                              | 1,238,486 |         | $ | 458,563  |   | $       | 241,395 |         | $ | 253,118 |   | $ | 285,410 |  
|Gross profit                                                                                     |  |                                                | 431,613   |         |   | 151,175  |   |         | 82,998  |         |   | 92,875  |   |   | 104,565 |  
|Income (loss) before cumulative effect of a
  change in accounting principle                     |  |                                                | 2,886     |         |   | 22,255   |   |         | (11,468 | )       |   | (6,947  | ) |   | (954    | )
|Cumulative effect of a change in accounting
  principle, net of income taxes                     |  |                                                | (2,277    | )       |   | (2,277   | ) |         |        |         |   |        |   |   |        |  
|                                                                                                 |  |                                                |           |         |   |          |   |         |         |         |   |         |   |   |         |  
|Net income (loss)                                                                                |  | $                                              | 609       |         | $ | 19,976   |   | $       | (11,468 | )       | $ | (6,947  | ) | $ | (954    | )
|                                                                                                 |  |                                                |           |         |   |          |   |         |         |         |   |         |   |   |         |  
|Basic earnings (loss) per share before
  cumulative effect of a change in accounting principle   |  | $                                              | 0.09      |         | $ | 0.72     |   | $       | (0.36   | )       | $ | (0.21   | ) | $ | (0.03   | )
|Cumulative effect of a change in accounting
  principle, net of income taxes                     |  | $                                              | (0.07     | )       | $ | (0.07    | ) |         |        |         |   |        |   |   |        |  
|                                                                                                 |  |                                                |           |         |   |          |   |         |         |         |   |         |   |   |         |  
|Basic earnings (loss) per share                                                                  |  | $                                              | 0.02      |         | $ | 0.65     |   | $       | (0.36   | )       | $ | (0.21   | ) | $ | (0.03   | )
|                                                                                                 |  |                                                |           |         |   |          |   |         |         |         |   |         |   |   |         |  
|Diluted earnings (loss) per share before
  cumulative effect of a change in accounting principle |  | $                                              | 0.09      |         | $ | 0.70     |   | $       | (0.36   | )       | $ | (0.21   | ) | $ | (0.03   | )
|Cumulative effect of a change in accounting
  principle, net of income taxes                     |  | $                                              | (0.07     | )       | $ | (0.07    | ) |         |        |         |   |        |   |   |        |  
|                                                                                                 |  |                                                |           |         |   |          |   |         |         |         |   |         |   |   |         |  
|Diluted earnings (loss) per share                                                                |  | $                                              | 0.02      |         | $ | 0.63     |   | $       | (0.36   | )       | $ | (0.21   | ) | $ | (0.03   | )
|                                                                                                 |  |                                                |           |         |   |          |   |         |         |         |   |         |   |   |         |  

F-28

---



Index to Exhibits
Document Number and Description

Exhibit No.

|     |                                                                                                                                                                                                                                                                                                                                                                                 
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2.1  | Asset
  Acquisition Agreement dated February 17, 2006, between Trans World Entertainment
  Corporation and Musicland Holding Corp.-incorporated by reference to Exhibit
  99.2 to the Companys Current Report on Form 8-K filed February 22, 2006.
  Commission File No. 000-14818.                                                                                            
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|3.1  | Restated
  Certificate of Incorporation  incorporated herein by reference to Exhibit
  3.1 to the Companys Annual Report on Form 10-K for the year ended January
  29, 1994. Commission File No. 0-14818.                                                                                                                                                                     
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|3.2  | Certificate
  of Amendment to the Certificate of Incorporation  incorporated herein by
  reference to Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q for
  the fiscal quarter ended October 29, 1994. Commission File No. 0-14818.                                                                                                                                 
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|3.3  | Certificate
  of Amendment to the Certificate of Incorporation  incorporated herein by
  reference to Exhibit 3.4 to the Companys Annual Report on Form 10-K for the
  year ended January 31, 1998. Commission File No. 0-14818.                                                                                                                                              
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|3.4  | *3.4 Amended
  By-Laws  incorporated herein by reference to Exhibit 3.4 to the Companys
  Annual Report on Form 10-K for the year ended January 29, 2000. Commission
  File No. 0-14818.                                                                                                                                                                                      
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|3.5  | Certificate
  of Amendment to the Certificate of Incorporationincorporated herein by
  reference to Exhibit 3.5 to the Companys Registration Statement on Form S-4,
  No. 333-75231.                                                                                                                                                                                          
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|3.6  | Certificate
  of Amendment to the Certificate of Incorporationincorporated herein by
  reference to Exhibit 3.6 to the Companys Registration Statement on Form S-4,
  No. 333-75231.                                                                                                                                                                                          
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|3.7  | Certificate
  of Amendment to the Certificate of Incorporationincorporated herein by
  reference to Exhibit 4.2 to the Companys Current Report on Form 8-K filed
  August 11, 2000. Commission File No. 0-14818.                                                                                                                                                              
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|3.8  | Rights
  Agreement, between Trans World Entertainment Corporation and ChaseMellon
  Shareholder Services, L.L.C., as Rights Agent  incorporated herein by
  reference to Exhibit 1 to the Companys Current Report on Form 8-A filed
  August 11, 2000. Commission File No. 0-14818.                                                                                           
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|3.9  | Certificate
  of Amendment to the Certificate of Incorporation of Trans World Entertainment
  Corporation - incorporated herein by reference to Exhibit 2 to the Companys
  Current Report on Form 8-A filed August 11, 2000. Commission File No.
  0-14818.                                                                                                                   
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|4.1  | Credit
  Agreement dated January 5, 2006, between Trans World Entertainment
  Corporation and Bank of America N.A. - incorporated by reference to Exhibit
  99.2 to the Companys Current Report on Form 8-K filed January 10, 2006.
  Commission File No. 0-14818.                                                                                                             
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|4.2  | First
  Amendment to Credit Agreement between Trans World Entertainment Corporation
  and Bank of America N.A  incorporated by reference to Exhibit 4.1 to the
  Companys Current Report on Form 8-K filed March 23, 2006. Commission File
  No. 0-14818.                                                                                                                     
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|4.3  | Second
  Amendment to Credit Agreement between Trans World Entertainment Corporation
  and Bank of America N.A  incorporated by reference to Exhibit 4.1 to the
  Companys Current Report on Form 8-K filed October 23, 2006. Commission File
  No. 0-14818.                                                                                                                  
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|10.1 | Lease, dated
  April 1, 1985, between Robert J. Higgins, as Landlord, and Record Town, Inc.
  and Trans World Music Corporation, as Tenant and Amendment thereto dated
  April 28, 1986  incorporated herein by reference to Exhibit 10.3 to the
  Companys Registration Statement on Form S-1, No. 33-6449.                                                                  
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|10.2 | Second
  Addendum, dated as of November 30, 1989, to Lease, dated April 1, 1985, among
  Robert J. Higgins, and Trans World Music Corporation, and Record Town, Inc.,
  exercising five year renewal option  incorporated herein by reference to
  Exhibit 10.2 to the Companys Annual Report on Form 10-K for the year ended
  February 3, 1990. Commission File No. 0-14818.
|     |                                                                                                                                                                                                                                                                                                                                                                                 
|10.3 | Lease, dated
  November 1, 1989, between Robert J. Higgins, as Landlord, and Record Town,
  Inc. and Trans World Music Corporation, as Tenant  incorporated herein by
  reference to Exhibit 10.3 to the Companys Annual Report on Form 10-K for the
  year ended February 2, 1991. Commission File No. 0-14818.                                                              

F-29

---



|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|----- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.5  | Lease dated
  September 1, 1998, between Robert J. Higgins, as Landlord, and Record Town,
  Inc. and Trans World Music Corporation, as Tenant, for additional office
  space at 38 Corporate Circle  incorporated herein by reference to Exhibit
  10.1 to the Companys Quarterly Report on Form 10-Q for the fiscal quarter
  ended October 31, 1998. Commission File No. 0-14818.                                                                                                                                                                  
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.6  | Trans World
  Music Corporation 1986 Incentive and Non-Qualified Stock Option Plan, as
  amended and restated, and Amendment No. 3 thereto  incorporated herein by
  reference to Exhibit 10.5 of the Companys Annual Report on Form 10-K for the
  year ended February 2, 1991. Commission File No. 0-14818.                                                                                                                                                                                                                                        
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.7  | Trans World
  Music Corporation 1990 Stock Option Plan for Non-Employee Directors, as
  amended and restated  incorporated herein by reference to Annex A to Trans
  Worlds Definitive Proxy Statement on Form 14A filed as of May 19, 2000.
  Commission File No. 0-14818.                                                                                                                                                                                                                                                                          
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.8  | Trans World
  Entertainment Corporation Amended 1990 Restricted Stock Plan  incorporated
  herein by reference to Annex B to Trans Worlds Definitive Proxy Statement on
  Form 14A filed as of May 17, 1999. Commission File No. 0-14818.                                                                                                                                                                                                                                                                                                            
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.9  | Trans World
  Entertainment Corporation 1994 Stock Option Plan  incorporated herein by
  reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for
  the fiscal quarter ended July 30, 1994. Commission File No. 0-14818.                                                                                                                                                                                                                                                                                                          
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.10 | Trans World
  Entertainment Corporation 1998 Stock Option Plan  incorporated herein by
  reference to Annex B to Trans Worlds Definitive Proxy Statement on Form 14A
  filed as of May 7, 1998. Commission File No. 0-14818.                                                                                                                                                                                                                                                                                                                         
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.11 | Trans World
  Entertainment Corporation 1999 Stock Option Plan  incorporated herein by
  reference to Annex A to Trans Worlds Definitive Proxy Statement on Form 14A
  filed as of May 7, 1998. Commission File No. 0-14818.                                                                                                                                                                                                                                                                                                                         
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.12 | Form of
  Indemnification Agreement dated May 1, 1995 between the Company and its
  officers and directors incorporated herein by reference to Exhibit 10.1 to
  the Companys Quarterly Report on Form 10-Q for the fiscal quarter ended
  April 29, 1995. Commission File No. 0-14818.                                                                                                                                                                                                                                                               
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.13 | Trans World
  Entertainment Corporation 1997 Supplemental Executive Retirement Plan 
  incorporated herein by reference to Exhibit 10.1 to the Companys Quarterly
  Report on Form 10-Q for the fiscal quarter ended May 3, 1997. Commission File
  No. 0-14818.                                                                                                                                                                                                                                                                                     
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.14 | Employment
  Agreement, dated as of May 1, 2003, between the Company and Robert J.
  Higgins. Incorporated herein by reference to Exhibit 10.17 to the Companys
  Annual Report on Form 10-K for the year ended February 1, 2003. Commission
  File No. 0-14818.                                                                                                                                                                                                                                                                                      
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.15 | Agreement
  dated September 19, 2003 by and between a joint venture composed of Trans
  World Entertainment Corporation, Hilco Merchant Resources, LLC, Hilco Real
  Estate, LLC Gordon Brothers Retail Partners, LLC and The Ozer Group LLC as
  Agent and Wherehouse Entertainment, Inc., as Merchant to acquire certain
  assets of Wherehouse Entertainment Inc.  incorporated herein by reference
  to Exhibit 10.18 to the Companys Quarterly Report on Form 10-Q for the
  fiscal quarter ended November 1, 2003. Commission File No. 0-14818.
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.16 | Amendment
  No.1 dated October 1, 2003 to the agency agreement dated September 19, 2003
   incorporated herein by reference to Exhibit 10.19 to the Companys
  Quarterly Report on Form 10-Q for the fiscal quarter ended November 1, 2003.
  Commission File No. 0-14818.                                                                                                                                                                                                                                                                           
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.17 | Trans World
  Entertainment Corporation 2005 Long Term Incentive and Share Award Plan
  incorporated herein by reference to Appendix A to Trans World Entertainment
  Corporations Definitive Proxy Statement on Form 14A filed as of May 11, 2005.
  Commission file No. 0-14818.                                                                                                                                                                                                                                                                    
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|* 21  | Significant
  Subsidiaries of the Registrant.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|* 23  | Consent of
  KPMG LLP.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|*31.1 | Certification
  of Chief Executive Officer dated April 19, 2007, relating to the Registrants
  Annual Report on Form 10-K for the year ended February 3, 2007.                                                                                                                                                                                                                                                                                                                                                                                        
|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|*31.2 | Certification
  of Chief Financial Officer dated April 19, 2007, relating to the Registrants
  Annual Report on Form 10-K for the year ended February 3, 2007.                                                                                                                                                                                                                                                                                                                                                                                        

F-30

---



|    |                                                                                                                                                                                                                                                                                                                        
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*32 | Certification
  of Chief Executive Officer and Chief Financial Officer of Registrant, dated
  April 19, 2007, pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002 relating to the Registrants
  Annual Report on Form 10-K for the year ended February 3, 2007.

*Filed
herewith.

F-31

---