**UNITED STATES**

###### **SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**Amendment No. 2**

**FORM 10-K/A**

 

| **ý**                                                                                                                                                                                                               |   | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                     |   |                                                                                                |
| **FOR THE FISCAL YEAR ENDED JANUARY 28,  2006**                                                                                                                                                                     |
|                                                                                                                                                                                                                     |   |                                                                                                |
| **OR**                                                                                                                                                                                                                   |
|                                                                                                                                                                                                                     |   |                                                                                                |
| **o**                                                                                                                                                                                                                    |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT**     |
|                                                                                                                                                                                                                     |   |                                                                                                |
| **FOR THE TRANSITION PERIOD FROM               TO               ** |

 

**COMMISSION FILE NUMBER: 0-14818**

 

**TRANS WORLD ENTERTAINMENTCORPORATION**

(Exact name of registrant as specified in itscharter)

 

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

 

**38 Corporate Circle**

**Albany, New York 12203**

(Address of principal executive offices, includingzip code)

 

**(518) 452-1242**

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) ofthe Act: **None**

 

Securities registered pursuant to Section 12(g) ofthe Act:  **CommonStock, $0.01 par value**

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined inthe Rule 405 of the Securities Act. Yes o No ý

 

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o No ý

 

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

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof the Registrant’s Knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anamendment to this Form 10-K. o

 

Indicateby checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act).        Yes ý    No o

 

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

 

As of July 30,2005, 32,184,026 shares of the Registrant’s Common Stock, excluding 23,404,549shares of stock held in Treasury, were issued and outstanding. The aggregatemarket 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 30,2005 as reported on the National Market tier of The NASDAQ Stock Market, Inc.was $207,286,769. Shares of Common Stock held by the Company’s controllingshareholder, who controls approximately 38.7% of the outstanding Common Stock,have been excluded for purposes of this computation. Because of suchshareholder’s control, shares owned by other officers, directors and 5%shareholders have not been excluded from the computation. As of March 25,2006, there were 30,620,302 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 7, 2006 Annual Meeting of Shareholders** | ** ** | **III**                                                                            |

 

 

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EXPLANATORYNOTE

 

We are filing this Amendment No. 2 to our AnnualReport on Form 10-K for the year ended January 28, 2006, in order to correcttwo printer errors in the table included in the section entitled “Item 6.Selected Consolidated Financial Data” under the captions “Net income (loss)”and “Earnings (loss) per share” for 2006 and to add this explanatory note toAmendment No. 1 to our Annual Report filed on January 14, 2006. Except for thechanges noted above, there are no other changes contained in this amendedreport to the Company’s Annual Report on Form 10-K filed with the Commission onApril 13, 2006.

 

**PART I**

 

**Cautionary Statement for Purposes of the “Safe Harbor” Provisions ofthe Private Securities Litigation Reform Act of 1995**

 

Thisdocument includes forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. These statements relate toanalyses and other information that are based on forecasts of future resultsand estimates of amounts not yet determinable. These statements also relate to theCompany’s future prospects, developments and business strategies. Thestatements contained in this document that are not statements of historicalfact may include forward-looking statements that involve a number of risksand uncertainties.

 

We have used the words “anticipate”, “believe”, “could”,“estimate”, “expect”, “intend”, “may”, “plan”, “predict”, “project”, andsimilar terms and phrases, including references to assumptions, in thisdocument to identify forward-looking statements. These forward-lookingstatements are made based on management’s expectations and beliefs concerningfuture events and are subject to uncertainties and factors relating to ouroperations and business environment, all of which are difficult to predict and manyof which are beyond the Company’s control, that could cause actual results todiffer materially from those matters expressed in or implied by theseforward-looking statements. The following factors are among those that may causeactual results to differ materially from the Company’s forward-lookingstatements.

 

•**                 **highly competitive nature of the retailentertainment business;

•                  competitive pricing (price and product changes);

•                  adverse publicity;

•                  interest rate fluctuations;

•                  dependence on key employees; 

•                  change in laws; 

•                  the Company’s level of debt and related restrictionsand limitations;

•                  new product introductions (“hit releases”);

•                  future cash flows; 

•                  availability of new real estate; 

•                  new technology, including digital downloading; and

•                  product liability claims

 

Thereader should keep in mind that any forward-looking statement made by us inthis 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 forus to predict these events or how they may affect us. In light of theserisks and uncertainties, you should keep in mind that any forward-lookingstatements made in this report or elsewhere might not occur.

 

Inaddition, the preparation of financial statements in accordance with accountingprinciples generally accepted in the United States (“GAAP”) requires us to makeestimates and assumptions. These estimates and assumptions affect:

 

•**                 **the reported amounts and timing of revenue andexpenses,

•**                 **the reported amounts and classification of assetsand liabilities, and

•**                 **the disclosure of contingent assets and liabilities.

 

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

 

**Item 1. BUSINESS**

 

# **CompanyBackground**

# ** **

Trans World Entertainment Corporation, which,together with its consolidated subsidiaries, is referred to herein as “theCompany”, was incorporated in New York in 1972. It owns 100% of the outstandingcommon stock of Record Town, Inc., through which its principal operationsare conducted. The Company operates retail stores and four e-commerce sites andis one of the largest specialty retailers of entertainment software, includingmusic, video, and video games and related products in the United States.

 

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During 2005, the Company acquired an 80% interest ina company that is fully consolidated for financial reporting purposes.

 

On July 22, 2004, the Company acquired theremaining 29% of the issued and outstanding shares of Second Spin Inc. (“SecondSpin”), for cash of $2.0 million. Prior to the step acquisition, the Company hadconsolidated all of the net assets and operations of Second Spin in itsConsolidated Balance Sheets and Consolidated Statements of Operations due toSecond Spin’s accumulated operating losses, and accordingly, no minorityinterest had been reflected in the Consolidated Balance Sheets.

 

In October 2003, the Company acquiredsubstantially all of the net assets of 111 stores from Wherehouse EntertainmentInc. (“Wherehouse”), a specialty music retailer located primarily in theWestern United States for $35.2 million in cash. The Company also acquired in October 2003substantially all of the net assets of 13 specialty stores of CD World Inc. (“CDWorld”), located in New Jersey and Missouri for $1.9 million in cash. See Note3 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-Kfor further information.

 

**RecentDevelopments**

 

Subsequentto fiscal 2005 year end, effective March 27, 2006, the Company acquiredthe net assets of Musicland Holding Corp. (“Musicland”). Musicland, anentertainment specialty retailer which operates retail stores and websitesunder the names Sam Goody (www.SamGoody.com), Suncoast Motion Picture Company (www.Suncoast.com),On Cue and www.MediaPlay.com, filed a voluntary petition to restructure underChapter 11 of the United States Bankruptcy Code in January 2006. Thetransaction represents total consideration of $104.2 million in cash and $18.1million in assumed liabilities, including certain customer obligations, rent andoccupancy liabilities, and employee obligations. Under the terms of the AssetPurchase Agreement, the Company agreed to acquire 335 of Musicland’s 400 remainingstores, with the remainder of the stores being liquidated under an agencyagreement with Hilco Merchant Resources, LLC. See Note 13 of Notes to theConsolidated Financial Statements on this Annual Report on Form 10-K fordetail.

 

On March 16,2006, the Company acquired an 80% interest in a company that will be fullyconsolidated for financial reporting purposes. The Company has committed atotal funding of $5.2 million over two years, of which $1.2 million was fundedas of March 25, 2006.

 

***Stores and Store Concepts***

 

At January 28,2006, the Company operated 782 stores totaling approximately 4.8 million squarefeet in 46 states, the District of Columbia, the Commonwealth of Puerto Ricoand the U.S. Virgin Islands.

 

***Mall Stores***

 

At January 28,2006, the Company operated 546 mall-based stores in four concepts,predominantly under the f.y.e (“For Your Entertainment”), brand including:

 

*Traditional f.y.e stores*. The Traditional f.y.e mall store averages 5,700 square feet and carriesa full complement of entertainment software, including music, video, video gamesand related accessories. There were 515 Traditional f.y.e stores at January 28, 2006.

 

# ***Super f.y.estores.***The Super f.y.e concept carries the samemerchandise categories as Traditional f.y.e mall locations, but with a muchbroader and deeper assortment. This concept is a semi-anchor or destinationlocation in major regional malls. There were 13 Super f.y.e stores at January 28,2006 that averaged 25,000 square feet.

# ** **

# ***f.y.e Moviestores.***Saturday Matinee and f.y.e Movie storesspecialize in the sale of DVD and related accessories. They are located inlarge, regional shopping malls and average 2,200 square feet. The Company operated17 Saturday Matinee and f.y.e Movie stores at January 28, 2006.

# ** **

*f.y.e Games store*.The Company operated one f.y.e Games store at January 28, 2006 occupying 2,300square feet.

 

***Freestanding Stores***

 

At January 28,2006, the Company operated 235 freestanding stores, under the brand names of f.y.e,Coconuts Music and Movies, Strawberries, Wherehouse Music and Movies, CD World,Streetside Records, Spec’s Music, and Second Spin. They carry a full complementof entertainment products and are located in freestanding, strip center anddowntown locations. The freestanding stores average approximately 6,200 squarefeet.

 

The Company also operates a single Planet Musicstore, a 31,400 square foot freestanding superstore in Virginia Beach, VA. Thestore offers an extensive catalog of music, DVD, video games and relatedmerchandise.

 

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***E-Commerce Sites***

 

TheCompany operates four retail Web sites including, **www.fye.com**,**www.coconuts.com, www.wherehouse.com,** and**www.secondspin.com**. These sites offersubstantially the same complement of products as offered in the Company’sstores.

 

# **MerchandiseCategories**

# ** **

Salesby merchandise category as a percentage of total sales for 2005, 2004 and 2003,and comparable store sales for 2005 and 2004, were as follows:
| ** **                  | ** ** | **2005** | ** ** | **Comparable  Store Sales** | ** ** | **2004** | ** ** | **Comparable  Store Sales** | ** ** | **2003** | ** ** |
|-----------------------------|------------|----------|------------|----------------------------------|------------|----------|------------|----------------------------------|------------|----------|------------|
| Music:                      |       |     |       |                             |       |     |       |                             |       |     |       |
| Compact discs               |       | 53.0     | %          | (8.5                             | )%         | 53.9     | %          | (0.8                             | )%         | 53.9     | %          |
| Audio cassettes and singles |       | 0.6      |       | (42.5                            | )          | 1.1      |       | (38.4                            | )          | 1.8      |       |
| Total Music                 |       | 53.6     |       | (9.2                             | )          | 55.0     |       | (2.0                             | )          | 55.7     |       |
| Video:                      |       |     |       |                             |       |     |       |                             |       |     |       |
| DVD                         |       | 28.4     |       | 0.7                              |       | 26.4     |       | 14.6                             |       | 23.6     |       |
| VHS                         |       | 1.6      |       | (45.5                            | )          | 2.8      |       | (35.3                            | )          | 4.6      |       |
| Total Video                 |       | 30.0     |       | (3.7                             | )          | 29.2     |       | 6.5                              |       | 28.2     |       |
| Video games                 |       | 7.3      |       | 2.3                              |       | 6.5      |       | 9.6                              |       | 6.1      |       |
| Other                       |       | 9.1      |       | 4.4                              |       | 9.3      |       | (5.6                             | )          | 10.0     |       |
| Total                       |       | 100.0    | %          | (5.7                             | )%         | 100.0    | %          | 0.8                              | %          | 100.0    | %          |

 

The “Other”category includes electronics, accessories, boutique, and other sales, none ofwhich individually exceeds 5%.

 

# **BusinessEnvironment**

# ** **

The Company’s stores offer predominantly entertainmentsoftware, including music, video and video games. These categories represented91% of the Company’s sales in 2005. The balance of categories, including electronics,boutique and software accessory products represented 9% of the Company’s salesin 2005. Management believes there will be continued growth in its DVD and videogames businesses.

 

Theentertainment software industry, including music, video, and video games,totaled approximately $38 billion in the United States in 2006. This statisticis compiled from three sources: (1) Recording Industry Association ofAmerica (“RIAA”); (2) Rentrak Home Video Essentials (title revenues),including DVD and VHS; and (3) NPD Funworld’s estimate of retail video gamesales.

 

Accordingto statistics obtained from the RIAA, the overall approximate retail value ofthe music industry in 2005 was $12.27 billion, including shipments of physicalproducts and value of various digital revenue streams. This compares with 2004industry retail value of $12.34 billion. Overall album shipments, includingboth physical and digital albums were 794.7 million units in 2005, a 3.9%decline from 2004. The number of overall physical units in all formats shippedto all distribution channels in 2005 decreased by 8.0% when compared to 2004 .

 

Accordingto statistics obtained from Rentrak Home Video Essentials, overall video sales,including DVD and VHS, were $16.1 billion, a decrease of 0.1% from 2004. DVDretail sales in 2005 were $15.7 billion, an increase of 4.5% over 2004.

 

TheNPD Group published that video games sales in 2005 were $10.5 billion includingportable and console hardware, software and accessories, an increase of 6% over2004 sales.

 

# **Competition**

# ** **

Music sales have suffered from the unauthorizedduplication of music and specialty retailers have been impacted by theproliferation of mass merchants (e.g. Wal-Mart and Target) and electronicssuperstores (e.g. Best Buy and Circuit City) that offer entertainment softwareand have gained a larger share of the market. The Company also competes withlarge specialty retail chains that offer similar products in similar stylestores, including Tower Records, primarily in free-standing locations. However,the number of specialty and independent retailers has decreased due to theirreliance on sales of recorded music. The Company has taken advantage ofcompetitor exits from markets, made acquisitions, diversified its products andtaken other measures to position itself competitively within its industry. TheCompany believes it effectively competes in the following ways:

 

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•                  Location and convenience: a strength of the Companyis its convenient store locations that are often the exclusive retailers incenters offering a full complement of entertainment software;

•                  Marketing: the Company uses newspaper, radio andtelevision advertising and in-store visual displays to market to  consumers;

•                  Selection and assortment: the Company differentiatesitself by maintaining a high in-stock position in a large assortment ofproduct, particularly CDs and DVDs;

•                  Customer service: the Company believes it offerspersonalized customer service at its stores;

•                  Price perception: the Company communicates a valuemessage by promoting value-priced merchandise, off-brand product and closeoutmerchandise and by offering a broad selection of used CDs, DVDs and video games;

•                  Listening and Viewing Stations (“LVS”): the Company’sLVS is a sampling and selection tool designed to encourage customer purchases. Thethird generation of LVS (“LVS 3”) is currently installed in 185 of the Company’small stores. The Company expects to complete the installation of LVS 3 in allstores during 2006. LVS 3 enhances the customers’ in-store experience throughimproved product information displays and product search and suggestioncapabilities. It also supports in-store digital downloading.

 

## **Seasonality**

## ** **

TheCompany’s business is seasonal, with the fourth fiscal quarter constituting theCompany’s peak selling period. In 2005, the fourth quarter accounted for 37% ofannual sales. In anticipation of increased sales activity during these months,the Company purchases additional inventory and hires additional temporaryemployees to supplement its permanent 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 canalso be affected by the timing of new product releases, new store openings orclosings and the performance of existing stores.

 

**Advertising**

** **

TheCompany makes extensive use of visual displays. It uses a mass-media marketingprogram, including newspaper, radio, and television advertisements. Themajority of vendors from whom the Company purchases merchandise offeradvertising allowances to promote their merchandise that are accounted for as areduction of the cost of inventory to the extent that such allowances exceedthe cost incurred for the advertising.

 

**Suppliers and Purchasing**

 

TheCompany purchases inventory from approximately 900 suppliers. 71% of purchasesin 2005 were made from ten suppliers: EMD (EMI Music Distribution), Sony/BMG (Sony-BertelsmannMusic Group), WEA (Warner/Electra/Atlantic Corp.), UMVD (Universal Music andVideo Distribution), Fox Video Inc., Paramount Home Video, Buena Vista HomeVideo, Sony Computer Entertainment and Sony Pictures Home Entertainment. TheCompany does not have material long-term purchase contracts; rather, itpurchases products from its suppliers on an order-by-order basis. Historically,the Company has not experienced difficulty in obtaining satisfactory sources ofsupply and management believes that it will retain access to adequate sourcesof supply.

 

## **Trade Customs and Practices**

## ** **

Undercurrent trade practices with large suppliers, retailers of music and videoproducts are generally entitled to return unsold merchandise they havepurchased for other titles carried by the suppliers. Two of the four largestmusic suppliers charge a related merchandise return penalty and the remainingtwo suppliers charge a return handling fee. Most manufacturers and distributorsof video products do not typically charge a return penalty or handling fee. Merchandisereturn policies and other trade practices have not changed significantly inrecent years. The Company generally adapts its purchasing policies to changesin the policies of its largest suppliers.

 

## **Employees**

## ** **

As of January 28,2006, the Company employed approximately 8,100 employees, of whom approximately3,670 were employed on a full-time basis. All other employees are employed on apart-time or temporary basis. The Company hires seasonal sales employees duringits fourth quarter peak selling season to ensure continued levels of customerservice. Store managers, district managers and regional managers are eligibleto receive incentive compensation based on the sales and profitability ofstores for which they are responsible. None of the Company’s employees arecovered by collective bargaining agreements and management believes that theCompany enjoys favorable relations with its employees.

 

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**Information Systems**

 

TheCompany continually assesses its information system needs to increaseefficiency, improve decision-making and support growth. It utilizes primarilyIBM AS400 technology to run its management information systems, including itsmerchandising, distribution and accounting systems. Management believes itssystems contribute to enhanced customer service and operational efficiency, aswell as provide the ability to monitor critical performance indicators versusplans and historical results.

 

TheCompany’s point-of-sale and merchandising systems allow for the daily reportingof sales, inventory and gross margin by store and by item. The Company replacedits point-of-sale system in 2005, through a capital lease transaction at a costof $12.0 million (see Note 5 of Notes to the Consolidated Financial Statementsfor detail).

 

# **AvailableInformation**

# ** **

TheCompany’s headquarters are located at 38 Corporate Circle, Albany, New York12203, and its telephone number is (518) 452-1242. The Company’s corporate Website address is www.twec.com. The Company makes available free of charge itsExchange Act Reports (Forms 10-K, 10-Q, 8-K and any amendments thereto) on itsWeb site as soon as practical after the reports are filed with the Securitiesand Exchange Commission (“SEC”). The public may read and copy anymaterials the Company files with the SEC at the SEC’s Public Reference Room at450 Fifth Street, N.W., Washington, D.C. 20549. Information on the operation ofthe Public Reference Room can be obtained by calling the SEC at1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxyand information statements, and other information regarding issuers that fileelectronically with the SEC. This information can be obtained from the sitehttp://www.sec.gov.

 

TheCompany’s Common Stock, $0.01 par value, is quoted on the NASDAQ NationalMarket under the trading symbol “TWMC”. The Company’s fiscal year end is theSaturday closest to January 31. The fiscal 2005 (“2005”) year ended onJanuary 28, 2006; fiscal 2004 (“2004”) year ended on January 29,2005; and fiscal 2003 (“2003”) year ended on January 31, 2004.

 

**Item 1A. RISK FACTORS**

Thefollowing is a discussion of certain factors, which could affect the financialresults of the Company.

 

**The Company’s results of operations are affected by the availability ofnew products.**

TheCompany’s business is affected by the release of “hit” music, video and videogame titles, which can create fluctuations in sales. It is not possible todetermine the timing of these fluctuations or the future availability of hittitles. The Company does not control the content of new products and is dependentupon the major music and movie producers to continue to produce hit products.To the extent that new hits are not available, or not available at pricesattractive to consumers, or, if manufacturers fail to introduce or delay theintroduction of new products, the Company’s results of operations may beadversely affected.

 

**The Company’s results of operations may suffer if the Company doesnot accurately predict consumer acceptance of new product or distributiontechnologies.**

Theentertainment industry is characterized by changing technology, evolvingstandards, frequent new and enhanced product introductions and rapid productobsolescence. These characteristics require that the Company respond quickly totechnological changes and understand the impact of these changes on customers’preferences. If the Company is unable to participate in new product ordistribution technologies that consumers accept, its results of operations may suffer.

 

**Increased competition from existing retailers and alternative distributionchannels may adversely affect the Company’s results of operations.**

Theretail entertainment business is highly competitive. The Company competes witha wide variety of entertainment retailers, including regional and nationalmall-based music chains, deep-discount retailers, mass merchandisers, consumerelectronics outlets, record clubs and independent operators, some of which havegreater financial and other resources than the Company. The Company alsoexpects continued growth in competing home entertainment options, including theInternet and larger numbers of television and music channels offered by cablecompanies. In particular, Internet and cable technologies coupled withhigh-quality digital recording technologies allows direct downloading of recordedmusic by consumers via the Internet. Some of these technological enhancements,including the ability to download music, video and video games onto PCs orother devices, or play games over the Internet through consoles, could reduceretail sales of CDs, DVDs and video games. A wide selection of music and videoservices can now be offered to consumers through:

 

•                  the Internet,

•                  cable companies,

•                  direct broadcast satellite companies,

•                  telephone companies, and

•                  other telecommunications companies.

 

If technologicaladvances were to result in significant changes in existing distributionchannels for pre-recorded music, video and video games, the Company’s resultsof operations could be affected.

 

**A decline in current levels of consumer spending could adversely affectresults of operations.**

TheCompany’s results of operations is affected by the level of consumer spending,which reflects the general state of local economies in which the Companyoperates.

 

**The Company’s operating results fluctuate from period to period.**

As isthe case with many retailers, a significant portion of the Company’s sales, andan even greater portion of the Company’s earnings is generated in the fourthfiscal quarter, which includes the holiday selling season. Less thansatisfactory sales for such period could have an adverse effect on the Company’sresults of operations.

 

**Growth Strategy – the failure to grow the Company’s business may limitits earnings.**

Historically,the Company’s growth has come from the opening of new stores and the acquisitionof stores. The Company opens new stores if it finds desirable locations and isable to negotiate suitable lease terms. Any lack of availability of new storesor acquisition opportunities may impact the Company’s ability to increasesales and earnings.

 

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**A change in one or more of the Company’s vendors’ policies or theCompany’s relationship with those vendors could adversely affect the Company’s resultsof operations.**

Themajority of the Company’s purchases come from ten major suppliers. As isstandard in the music industry, the Company does not maintain long-termcontracts with its suppliers but instead makes purchases on an order-by-orderbasis. If the Company fails to maintain customary trade terms or enjoy positivevendor relations, it could have an adverse effect on the Company’s results ofoperations.

 

**If the Company’s vendors fail to provide marketing and merchandisingsupport at historical levels, the Company’s results of operations could benegatively impacted.**

Themanufacturers of entertainment products have typically provided retailers withsignificant marketing and merchandising support for their products. As part ofthis support, the Company receives cooperative advertising and marketdevelopment payments from these vendors. These cooperative advertising andmarket development payments enable the Company to actively promote andmerchandise the products that it sells and drive sales at the Company’s storesand on its websites. If the Company’s vendors fail to provide this support athistorical levels, the Company’s results of operations could be negativelyimpacted.

 

**If the Company fails to successfully complete and integrate futureacquisitions, the Company’s results of operationscould be negatively impacted.**

As part ofthe Company’s efforts to grow and compete, the Company may engage inacquisitions. The Company’s pursuit of future acquisitions is subject to itsability to negotiate favorable terms for these acquisitions. Accordingly, theCompany cannot be assured that future acquisitions will be completed. Inaddition, to facilitate future acquisitions, the Company may take actionsthat could dilute the equity interests of its stockholders, increase its debtor assume contingent liabilities, all of which may have a negative effecton the price of the Company’s common stock. Finally, if any acquisitions arenot successfully integrated with its business, the Company’s ongoing operationsand results of operations could be adversely affected.

 

**Loss of Key Personnel could harm the Company’s results of operations.**

TheCompany believes that its future prospects depend to a significant extent onthe services of its executive officers, as well as its ability to attract andretain qualified key personnel. The loss of the services of certain of theCompany’s executive officers and other key management personnel could harm theCompany’s results of operations.

 

**Control by and Dependence on Key Personnel - Robert J. Higgins has astrong influence on the outcome of any vote of the Company’s Shareholders andif the Company were to lose his services, it may not be able to replacehis skills and experience.**

RobertJ. Higgins serves as Chairman of the Board of Trans World and its ChiefExecutive Officer and owns approximately 40.6% of the outstanding common stockof Trans World, as of March 15, 2006. Further, if the Company were to loseMr. Higgins’ services, it may not be able to replace his skills andexperience, and this could have an adverse effect on the Company’s financialresults.

 

**If, in the future, the Company concludes that its internal controlsover financial reporting are not adequate, or if the Company’s auditorsconclude that the Company’s evaluation of internal controls over financialreporting is not adequate, investors could lose confidence in the reliabilityof the Company’s financial statements, which could result in a decrease in thevalue of the Company’s common stock. The effectiveness of the Company’sdisclosure and internal controls may be limited.**

Asdirected by Section 404 of the Sarbanes-Oxley Act of 2002, the Securitiesand Exchange Commission adopted rules requiring public companies toinclude a report of management on the company’s internal control over financialreporting in their annual reports on Form 10-K. There is a risk that inthe future the Company may identify internal control deficiencies thatsuggest that the Company’s controls are no longer effective. This could resultin an adverse reaction in the financial markets due to a loss of confidence inthe reliability of the Company’s financial statements, which could cause adecline in the market price of the Company’s common stock.

 

Disclosurecontrols and procedures and internal controls over financial reporting may notprevent all errors and intentional misrepresentations. In the event that thereare errors or misrepresentations in the Company’s historical financialstatements or the SEC disagrees with the Company’s accounting, the Company may needto restate its financial statements. There is no guarantee that existingcontrols will prevent or detect all material issues or be effective in futureconditions, which could materially and adversely impact the Company’s financialresults in the future.

 

**Anti-takeover provisions – New York anti-takeover law provisions andthe classified Board Amendment, may discourage unsolicited takeovers.**

In August 2000,the Company’s Board of Directors adopted a Classified Board Amendment whichtogether with anti-takeover provisions eschewed by New York State Law may discourageopen market purchases or a non-negotiated tender or exchange offer for thestock of the Company. This may be adverse to the interests of ashareholder who might receive a premium in a transaction of this type.

 

**Item 1B. UNRESOLVED SEC COMMENTS**

 

TheCompany has  not received within 180 daysor more before January 28, 2006,  written comments from the Securities andExchange Commission regarding its periodic or current reports under theSecurities Exchange Act of 1934, as amended that remain unresolved.

 

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**Item 2. PROPERTIES**

 

**RetailStores**

 

At January 28, 2006, the Company operated 781 storesunder operating leases, some of which have renewal options. Substantially allof the leases provide for the payment of fixed monthly rentals and expenses formaintenance, property taxes and insurance. Many leases provide for added rentbased on store sales in excess of specified levels. The following table liststhe 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** | ** ** |
|----------|------------|-------------------------|------------|-----------------|------------|-------------------------|------------|
|     |       |                    |       |            |       |                    |       |
| 2006     |       | 186                     |       | 2010            |       | 69                      |       |
|     |       |                    |       |            |       |                    |       |
| 2007     |       | 135                     |       | 2011            |       | 39                      |       |
|     |       |                    |       |            |       |                    |       |
| 2008     |       | 132                     |       | 2012            |       | 31                      |       |
|     |       |                    |       |            |       |                    |       |
| 2009     |       | 118                     |       | 2013 and beyond |       | 71                      |       |

 

The Company expects that as most leases expire itwill exercise renewal rights or obtain new leases for the same or similarlocations. The Company owns one store.

 

**Corporate Offices and Distribution Center Facilities**

 

TheCompany leases its Albany, New York, distribution facility and corporate officespace from its largest shareholder and Chairman and Chief Executive Officerunder three capital lease arrangements that extend through 2015. These leasesare at fixed rentals with provisions for biennial increases based on increasesin the Consumer Price Index. The Company incurs all property taxes, insuranceand maintenance costs. The office portion of the facility is approximately 53,200square feet and the distribution center portion is approximately 128,100 squarefeet. The Company owns a 236,600 square foot distribution center with 59,200square feet of adjacent office space in North Canton, Ohio. The Company alsoleases a 198,200 square foot distribution center in Carson, California; thislease includes two five-year renewal options and expires in December 2015.

 

TheCompany believes that its existing distribution facilities are adequate to meetthe Company’s planned business needs. Shipments from the distributionfacilities to the Company’s stores are made at least once a week and currentlyprovide approximately 74% of all merchandise requirements. The balance of thestores’ requirements are satisfied through direct shipments from vendors. Companyoperated trucks service approximately 86 of its stores. The remaining storesare serviced by common carriers chosen on the basis of geography and rateconsiderations.

 

TheCompany leases a 43,500 square foot facility in Johnstown, New York, where itmanufactures many of its store fixtures. The operating lease expires in December 2006.The Company believes that its costs of production are equal to or lower thanpurchasing the fixtures from outside suppliers.

 

TheCompany leases an additional 31,700 square feet of office space in Albany, NewYork. The operating lease expires in June 2014 and includes two, five-yearoptions to renew.

 

##### **Item 3. LEGALPROCEEDINGS**

##### ** **

TheCompany is subject to various legal proceedings and claims that have arisen inthe ordinary course of its business and have not been finally adjudicated. Althoughthere can be no assurance as to the ultimate disposition of these matters, itis 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 andfinancial condition of the Company.

 

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

 

Nomatters were submitted to a vote of security holders during the fourth quarterof the fiscal year ended January 28, 2006.

 

8

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**PART II**

 

**Item 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDERMATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES**

 

**Market Information**. TheCompany’s Common Stock trades on the NASDAQ Stock Market under the symbol “TWMC.”  As of January 28, 2006, there were 535 shareholdersof record. The following table sets forth high and low last reported saleprices for each fiscal quarter during the period from January 31, 2004through March 18, 2005.

 
| ** **                                 | ** ** | **Closing Sales Prices** | ** ** |
|--------------------------------------------|------------|------------------------------------|------------|
| ** **                                 | ** ** | **High**                           | ** ** | **Low** | ** ** |
| 2004                                       |       |                               |       |   |   |
| 1st Quarter                                |       | $                                  | 10.79      |   | $ | 7.45 |   |
| 2nd Quarter                                |       | $                                  | 10.65      |   | $ | 9.38 |   |
| 3rd Quarter                                |       | $                                  | 11.54      |   | $ | 8.83 |   |
| 4th Quarter                                |       | $                                  | 12.77      |   | $ | 10.62 |   |
|                                       |       |                               |       |   |   |
| 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 (through  March 31, 2006) |       | $                                  | 6.17       |   | $ | 5.06 |   |

 

On March 31,2006, the last reported sale price on the Common Stock on the NASDAQ NationalMarket was $5.57.

 

Optionsfor the Company’s Common Stock trade on the Chicago Board Options Exchange.

 

On May 28,2003, the Company’s Board of Directors authorized the repurchase of 10 millionoutstanding shares of the Company’s Common Stock from time to time on the openmarket. The Company had repurchased 15 million shares of common stock underpreviously announced programs. As of January 28, 2006, the Company hadpurchased the 10 million shares outstanding under the stock repurchase program,at a total cost of $88.5 million. During 2005 the Company purchased 3.1 millionshares at a total cost of $31.3 million. The following table shows the purchaseof equity securities purchased under the repurchase program as required by Item703 of Regulation S-K. 

 
| **Period**                                            | ** ** | **Total Number of Shares  Purchased** | ** ** | **Average Price Paid per  Share** | ** ** | **Total Number of Shares  Purchased as Part of  Publicly Announced  Programs** | ** ** | **Maximum Number of  Shares that May Yet Be  Purchased Under the  Plan** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|
| October 30, 2005 – November 26,  2005  |       | 226,100                                              |       | $                                                | 6.63       |                                                                                                              | 226,100    |                                                                                                             | 434,541    |   |
| November 27, 2005 – December 31,  2005 |       | 434,541                                              |       | $                                                | 6.44       |                                                                                                              | 434,541    |                                                                                                             | —     |   |
| January 1, 2006 – January 28,  2006    |       | —                                               |       | —                                           |       | —                                                                                                            |       | —                                                                                                           |       |
| Total                                                 |       | 660,641                                              |       | $                                                | 6.51       |                                                                                                              | 660,641    |                                                                                                             | —     |   |

 

9

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Thefollowing table contains information about the Company’s Common Stock that may beissued upon the exercise of options, warrants and rights under all of theCompany’s equity compensation plans as of January 28, 2006:

 
| **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                     |       | 9,860                                                                                                                                                |       | $                                                                                                                    | 8.94       |                                                                                                                                                                                                                   | 5,451      |   |
| Equity Compensation Plans and  Agreements not Approved by Shareholders |       | —                                                                                                                                               |       | —                                                                                                               |       | —                                                                                                                                                                                                                 |       |
|                                                                        |            |                                                                                                                                                      |            |                                                                                                                      |            |                                                                                                                                                                                                                        |            |  |

 

**Dividend Policy:**TheCompany has never declared dividends on its Common Stock and does not plan topay cash dividends on its Common Stock in the foreseeable future. The Company’scredit agreement does not restrict the payment of cash dividends so long aspayment conditions per the agreement are met. Any future determination as tothe payment of dividends will depend upon capital requirements, limitationsimposed by the Company’s credit agreement and other factors the Company’s Boardof Directors may consider.

 

10

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**Item 6. SELECTED CONSOLIDATED FINANCIAL DATA**

 

The following table sets forth selected incomestatement and balance sheet data for the five fiscal years ended January 28,2006 from the Company’s audited consolidated financial statements. Each fiscalyear of the Company consisted of 52 weeks. The information should be read inconjunction with the Company’s audited consolidated financial statements andrelated notes and other financial information included herein, including Item7, “Management’s Discussion and Analysis of Financial Condition and Results ofOperations”.

 
| ** **                                                                                                                                                         | ** ** | **Fiscal Year Ended**                               | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                                                                         | ** ** | **January 28,  2006**                                    | ** ** | **January 29,  2005** | ** ** | **January 31,  2004** | ** ** | **February 1,  2003** | ** ** | **February 2,  2002** | ** ** |
| * *                                                                                                                                                           | * *   | ***($ in thousands, except  per share and store data)*** |       |
| ***INCOME STATEMENT DATA:***                                                                                                                                       |       |                                                          |       |   |   |   |   |   |   |   |   |
| Sales                                                                                                                                                              |       | $                                                             | 1, 238,486 |   | $ | 1,365,133 |   | $ | 1,330,626 |   | $ | 1,281,869 |   | $ | 1,388,032 |   |
| Cost of sales                                                                                                                                                      |       | 806,873                                                       |       | 869,999 |   | 842,726 |   | 815,071 |   | 935,256 |   |
| Gross profit                                                                                                                                                       |       | 431,613                                                       |       | 495,134 |   | 487,900 |   | 466,798 |   | 452,776 |   |
| Selling, general and  administrative expenses                                                                                                                      |       | 426,854                                                       |       | 450,162 |   | 459,441 |   | 465,893 |   | 422,737 |   |
| Goodwill impairment charge (1)                                                                                                                                     |       | —                                                        |       | — |   | — |   | 40,914 |   | — |   |
| Income (loss) from operations                                                                                                                                      |       | 4,759                                                         |       | 44,972 |   | 28,459 |   | (40,009 | ) | 30,039 |   |
| Interest expense                                                                                                                                                   |       | 2,954                                                         |       | 2,444 |   | 2,147 |   | 2,349 |   | 2,477 |   |
| Other income                                                                                                                                                       |       | (2,171                                                        | )          | (1,039 | ) | (718 | ) | (1,231 | ) | (2,120 | ) |
| Income (loss) before income  taxes, extraordinary gain – unallocated negative goodwill and cumulative  effect of a change in accounting principle             |       | 3,976                                                         |       | 43,567 |   | 27,030 |   | (41,127 | ) | 29,682 |   |
| Income tax expense (benefit)                                                                                                                                       |       | 1,090                                                         |       | 4,892 |   | 8,302 |   | (9,341 | ) | 12,891 |   |
| Income (loss) before  extraordinary gain – unallocated negative goodwill and cumulative effect of  change in accounting principle                             |       | 2,886                                                         |       | 38,675 |   | 18,728 |   | (31,786 | ) | 16,791 |   |
| Extraordinary gain – unallocated  negative goodwill , net of income taxes (2)                                                                                 |       | —                                                        |       | 3,166 |   | 4,339 |   | — |   | — |   |
| Cumulative effect of change in  accounting principle, net of income taxes (3)(4)                                                                                   |       | (2,277                                                        | )          | — |   | — |   | (13,684 | ) | — |   |
| Net income (loss)                                                                                                                                                  |       | $                                                             | 609        |   | $ | 41,841 |   | $ | 23,067 |   | $ | (45,470 | ) | $ | 16,791 |   |
| Basic earnings (loss) per share:                                                                                                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |
| Earnings (loss) per share before  extraordinary gain – unallocated negative goodwill and cumulative effect of  change in accounting principle                 |       | $                                                             | 0.09       |   | $ | 1.12 |   | $ | 0.50 |   | $ | (0.79 | ) | $ | 0.40 |   |
| Extraordinary gain – unallocated  negative goodwill                                                                                                           |       | —                                                        |       | 0.09 |   | 0.12 |   | — |   | — |   |
| Cumulative effect of change in  accounting principle                                                                                                               |       | (0.07                                                         | )          | — |   | — |   | (0.34 | ) | — |   |
| Basic earnings (loss) per share                                                                                                                                    |       | $                                                             | 0.02       |   | $ | 1.21 |   | $ | 0.62 |   | $ | (1.13 | ) | $ | 0.40 |   |
| Weighted average number of shares  outstanding - basic                                                                                                             |       | 31,962                                                        |       | 34,531 |   | 37,422 |   | 40,224 |   | 41,938 |   |
| Diluted earnings (loss) per  share:                                                                                                                                |       |                                                          |       |   |   |   |   |   |   |   |   |
| Earnings (loss) per share before  extraordinary gain – unallocated negative goodwill and cumulative effect of  change in accounting principle                 |       | $                                                             | 0.09       |   | $ | 1.06 |   | $ | 0.49 |   | $ | (0.79 | ) | $ | 0.39 |   |
| Extraordinary gain – unallocated  negative goodwill                                                                                                           |       | —                                                        |       | 0.09 |   | 0.11 |   | — |   | — |   |
| Cumulative effect of change in  accounting principle                                                                                                               |       | (0.07                                                         | )          | — |   | — |   | (0.34 | ) | — |   |
| Diluted earnings (loss) per share                                                                                                                                  |       | $                                                             | 0.02       |   | $ | 1.15 |   | $ | 0.60 |   | $ | (1.13 | ) | $ | 0.39 |   |
| Weighted average number of shares  outstanding – diluted                                                                                                      |       | 32,124                                                        |       | 36,297 |   | 38,209 |   | 40,224 |   | 42,553 |   |
|                                                                                                                                                               |       |                                                          |       |   |   |   |   |   |   |   |   |
| Pro forma amounts assuming new  accounting principle was applied retroactively:                                                                                    |       |                                                          |       |   |   |   |   |   |   |   |   |
| Income before extraordinary gain  – unallocated negative goodwill and cumulative effect of a change in  accounting principle, as reported                     |       | $                                                             | 2,886      |   | $ | 38,675 |   | $ | 18,728 |   | $ | (31,786 | ) | $ | 16,791 |   |
| Pro forma income before  extraordinary gain – unallocated negative goodwill and cumulative effect of a  change in accounting principle                        |       | 2,922                                                         |       | 38,946 |   | 18,533 |   | (32,115 | ) | 17,283 |   |
| Pro forma net income                                                                                                                                               |       | 2,922                                                         |       | 42,112 |   | 22,872 |   | (45,799 | ) | 17,283 |   |
| Per share amounts:                                                                                                                                                 |       |                                                          |       |   |   |   |   |   |   |   |   |
| Basic earnings per share before  extraordinary gain – unallocated negative goodwill and cumulative effect of a  change in accounting principle, as reported   |       | $                                                             | 0.09       |   | $ | 1.12 |   | $ | 0.50 |   | $ | (0.79 | ) | $ | 0.40 |   |
| Pro forma basic earnings per  share before extraordinary gain – unallocated negative goodwill and  cumulative effect of a change in accounting principle      |       | $                                                             | 0.09       |   | $ | 1.13 |   | $ | 0.50 |   | $ | (0.80 | ) | $ | 0.41 |   |
| Pro forma basic earnings per  share                                                                                                                                |       | $                                                             | 0.09       |   | $ | 1.22 |   | $ | 0.61 |   | $ | (1.14 | ) | $ | 0.41 |   |
| Diluted earnings per share before  extraordinary gain – unallocated negative goodwill and cumulative effect of a  change in accounting principle, as reported |       | $                                                             | 0.09       |   | $ | 1.06 |   | $ | 0.49 |   | $ | (0.79 | ) | $ | 0.39 |   |
| Pro forma diluted earnings per  share before extraordinary gain – unallocated negative goodwill and  cumulative effect of a change in accounting principle    |       | $                                                             | 0.09       |   | $ | 1.07 |   | $ | 0.49 |   | $ | (0.80 | ) | $ | 0.40 |   |
| Pro forma diluted earnings per  share                                                                                                                              |       | $                                                             | 0.09       |   | $ | 1.16 |   | $ | 0.60 |   | $ | (1.14 | ) | $ | 0.40 |   |

 

11

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| ** **                                             | ** ** | **Fiscal Year Ended**                               | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                             | ** ** | **January 28,  2006**                                    | ** ** | **January 29,  2005** | ** ** | **January 31,  2004** | ** ** | **February 1,  2003** | ** ** | **February 2,  2002** | ** ** |
| *** ***                                           |       | ***($ in thousands, except  per share and store data)*** |       |
| ***BALANCE SHEET DATA: (at the  end of the period)***  |       |                                                          |       |   |   |   |   |   |   |   |   |
| *** ***                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Total assets                                           |       | $                                                             | 800,323    |   | $ | 859,653 |   | $ | 817,758 |   | $ | 803,396 |   | $ | 935,418 |   |
| Current portion of debt and  capital lease obligations |       | 3,659                                                         |       | 780 |   | 395 |   | 1,640 |   | 4,711 |   |
| Long-term obligations                                  |       | 19,474                                                        |       | 12,037 |   | 7,465 |   | 7,860 |   | 9,500 |   |
| Shareholders’ equity                              |       | $                                                             | 378,512    |   | $ | 404,323 |   | $ | 399,184 |   | $ | 392,104 |   | $ | 448,066 |   |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| ***OPERATING DATA:***                                  |       |                                                          |       |   |   |   |   |   |   |   |   |
| Store count (open at end of  period):                  |       |                                                          |       |   |   |   |   |   |   |   |   |
| Mall stores                                            |       | 546                                                           |       | 560 |   | 595 |   | 650 |   | 686 |   |
| Freestanding stores                                    |       | 236                                                           |       | 250 |   | 286 |   | 205 |   | 216 |   |
| Total stores                                           |       | 782                                                           |       | 810 |   | 881 |   | 855 |   | 902 |   |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |
| Comparable store sales  increase/(decrease) (5)        |       | (5.7                                                          | )%         | 0.8 | % | 1.3 | % | (5.0 | )% | (2.7 | )% |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |
| Total square footage (in  thousands)                   |       | 4,824                                                         |       | 5,002 |   | 5,484 |   | 4,944 |   | 5,076 |   |

 

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*(1)**      **The Companyrecorded a non-cash goodwill impairment charge in fiscal 2002 related to SFAS No. 142,“Goodwill and Other Intangible Assets” concerning the accounting for goodwill.*

 

*(2)**      **The Company’sacquisition of the net assets of Wherehouse Entertainment Inc. and CD WorldInc. stores in fiscal 2003 resulted in extraordinary gains recorded in 2003 and 2004 in accordance with SFAS No. 141,“Business Combinations” . The gain represents the excess of fair value of netassets acquired over the purchase price of the acquired assets. For additionaldiscussion regarding the extraordinary gain, refer to Note 3 in Notes to theConsolidated Financial Statements in this Annual Report on Form 10-K.*

 

*(3)**      **The Companyadopted guidance relating to the Financial Accounting Standards Board’s (“FASB’s”)Emerging Issues Task Force (“EITF”) Statement No. 02-16, “Accounting by aCustomer (Including a Reseller) for Certain Consideration Received from aVendor”, 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 “cumulativeeffect of a change in accounting principle” in 2002.*

 

*(4)**      **The Companyadopted FASB Interpretation No. (“FIN”) 47, “Accounting for ConditionalAsset Retirement Obligations—an interpretation of FASB Statement No. 143”,effective January 28, 2006 resulting in a one-time, non-cash, after taxcharge of $2.3 million, which was classified as a “cumulative effect of achange in accounting principle” in 2005. For additional discussion regardingthe cumulative effect of the change in accounting principle, refer to Note 2 inNotes to the Consolidated Financial Statements in this Annual Report on Form 10-K.*

 

*(5)**      **A store isincluded in comparable store sales calculations at the beginning of itsthirteenth full month of operation. Mall stores relocated in the same shoppingcenter after being open for at least thirteen months are considered comparablestores. Closed stores that were open for at least thirteen months are includedin comparable store sales through the month immediately preceding the month ofclosing.*

 

12

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**Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

**Overview**

 

Management’s Discussion and Analysis of FinancialCondition and Results of Operations provides information that the Company’smanagement believes necessary to achieve an understanding of its financial conditionand results of operations. To the extent that such analysis contains statementswhich are not of a historical nature, such statements are forward-lookingstatements, which involve risks and uncertainties. These risks include, but arenot limited to, changes in the competitive environment for the Company’smerchandise, including the entry or exit of non-traditional retailers of theCompany’s merchandise to or from its markets; releases by the music, DVD, and videogames industries of an increased or decreased number of “hit releases”; generaleconomic factors in markets where the Company’s merchandise is sold; and otherfactors discussed in the Company’s filings with the Securities and ExchangeCommission. The following discussion and analysis of the Company’s financialcondition and results of operations should be read in conjunction with “SelectedConsolidated Financial Data” and the consolidated financial statements andrelated notes included elsewhere in this report.

 

Subsequentto the fiscal year ended January 28, 2006 and effective March 27,2006, the Company acquired the net assets of Musicland Holding Corp. (“Musicland”).Musicland, an entertainment specialty retailer which operates retail stores andWeb sites under the names Sam Goody (www.SamGoody.com), Suncoast Motion PictureCompany (www.Suncoast.com), On Cue and www.MediaPlay.com, filed a voluntarypetition to restructure under Chapter 11 of the United States Bankruptcy Codein January 2006. See Note 13 of Notes to the Consolidated FinancialStatements in this Annual Report on Form 10-K for further detail.

 

On March 16,2006, the Company acquired an 80% interest in a company that will be fullyconsolidated for financial reporting purposes. The Company has committed atotal funding of $5.2 million over two years, of which $1.2 million was fundedas of March 25, 2006.

 

At January 28,2006, the Company operated 782 stores totaling approximately 4.8 million squarefeet in 46 states, the District of Columbia, the Commonwealth of Puerto Ricoand the U.S. Virgin Islands. In the fiscal year ended January 28, 2006(referred to herein as “2005”), the Company’s sales decreased as compared to thefiscal year ended January 29, 2005, (referred to herein as “2004”) as aresult of lower comparable sales and from operating fewer stores during the year.Earnings decreased in 2005 as a result of lower sales and gross margins, partiallyoffset by lower selling, general and administrative expenses.

 

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

 

***Developing its Brands – f.y.e.brand***

 

TheCompany strives to increase consumer awareness of its various branded storesand Internet sites. Particular attention is paid to its national mall-basedbrand f.y.e (“For Your Entertainment”), since its launch in 2001. The f.y.ebrand initiative is aimed at broadening the Company’s customer base by creatinga more relevant entertainment shopping experience and differentiating f.y.efrom its competition. It is centered on an engaging and personalized approachin marketing and merchandising, an interactive in-store and on-lineentertainment experience and a best-in-retail-class customer service level– all designed to draw customers into stores and enhance long-term customerloyalty. During 2005, the Company also introduced its customer loyalty program,f.y.e. Backstage Pass, which is designed to build stronger connections witheach customer.

 

***Improving MerchandiseAssortment***

 

TheCompany edits the product mix of its stores toward regional tastes in order toincrease the productivity of its stores, seeking to serve key customer segmentswithin each store. This involves tailoring the overall CD inventory and squarefootage allocation in line with a store’s trend, and increasing inventory andsquare footage allocations for other, growing categories. The Company is alsoevaluating introduction of new products to complement its core categories of CD,DVD and video games. In particular, the Company is seeing growth and positiveresults with the introduction of new products including portable DVD players,mobile phones, MP3 players and accessories in the electronics, accessories andboutique categories and will continue to refine that mix. In 2005, an area ofsuccess was the 20% growth over 2004 in the Company’s used product business andthis growth is expected to continue in 2006 as the Company expands into theunderdeveloped DVD business as well as increase promotions and in-storemerchandising.

 

TheCompany is embracing new digital media sales in its stores and on itse-commerce sites and regards digital downloading as a means to grow sales. Withthe introduction of its third generation Listening and Viewing Stations (“LVS 3”)in all stores in 2006, the Company will pursue growth in this category. LVS 3will support the digital download of music and videos in the future.

 

***Growing Store Count***

 

TheCompany has historically grown its sales by opening new stores and by acquiringspecialty retailers in its business. The Company continues to assess andevaluate the expansion of its national store network, seeking prudentadditions, as competitors abandon locations and where

 

13

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economicsare compelling. Management believes there are opportunities to expand into newmarkets, fill-in existing markets, and reposition stores in its currentportfolio, particularly with its freestanding formats.

 

In October 2003, the Company acquiredsubstantially all of the net assets of 111 stores from Wherehouse EntertainmentInc. (“Wherehouse”), a specialty music retailer located primarily in theWestern United States, for $35.2 million in cash. The acquired stores have beenan excellent fit both strategically and operationally with the Company’s freestandingstores and provided an intelligent opportunity to expand its West Coast presence.The Company also acquired in October 2003 substantially all of the netassets of 13 specialty stores of CD World Inc. (“CD World”), located in NewJersey and Missouri, for $1.9 million in cash. See Note 3 of Notes to theConsolidated Financial Statements in this Annual Report on Form 10-K forfurther information.

 

Historically,about 10% of the Company’s stores are being evaluated at any time for closure. Thecomposition of these stores changes from time-to-time as the result ofcompetitive changes and other factors. The Company aggressively closes storeswhen minimum operating thresholds are not achieved. In recent years, theCompany has experienced a net store decline, as closings have outnumberedopenings and acquisitions.

 

During2005, the Company closed 47 stores, opened 19 stores and repositioned 16 stores.Management believes it will close approximately 35 stores in 2006 and open about50 new stores. The Company anticipates that its store growth will continue inthe future. Subsequent to the fiscal year ended January 28, 2006 andeffective March 27, 2006, the Company acquired the net assets of 335stores from Musicland Holding Corp. (“Musicland”). Musicland, an entertainmentspecialty retailer which operates retail stores and websites under the namesSam Goody (SamGoody.com), Suncoast Motion Picture Company (Suncoast.com), OnCue and MediaPlay.com. The acquisition of the Musicland stores provides theCompany with the ability to leverage their store locations, and strategicallyincrease its national presence and provide further growth opportunities. SeeNote 13 of Notes to the Consolidated Financial Statements in this Annual Reporton Form 10-K for detail.

 

**Key Performance Indicators**

 

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

 

**Sales:**  The Company measures the rate of comparablestore sales change. A store is included in comparable store sales calculationsat the beginning of its thirteenth full month of operation. Mall storesrelocated in the same shopping center after being open for at least thirteenmonths are considered comparable stores. Closed stores that were open for atleast thirteen months are included in comparable store sales through the monthimmediately preceding the month of closing. The Company further analyzes salesby store format (i.e. mall versus freestanding) and by product category.

 

**Cost of Sales and Gross Profit:**  Gross profitis 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 productssold, vendor discounts and allowances and distribution costs. The Companyrecords its distribution and product shrink expenses in cost of sales. Distributionexpenses include those costs associated with purchasing, receiving, inspectingand warehousing merchandise and costs associated with product returns tovendors. 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 andrelated costs, occupancy charges, professional and service fees, generaloperating and overhead expenses and depreciation charges (excluding thoserelated to distribution operations, as discussed in Note 4 of Notes to theConsolidated Financial Statements in this Annual Report on Form 10-K). SG&Aexpenses also include asset impairment charges and write-offs, if any, andmiscellaneous items, other than interest.

 

**Balance Sheet and Ratios:**  The Company views cash, netinventory investment (inventory less accounts payable) and working capital (currentassets less current liabilities) as indicators of its financial position. SeeLiquidity and Capital Resources for further discussion of these items.

 

14

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**Fiscal Year Ended January 28,2006 (“2005”)**

**Compared to Fiscal Year Ended January 29,2005 (“2004”)**

 

**Sales.**The followingtable 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 | )% |
|                                  |            |            |            |            |            |                             |            |  |  |  |  |  |

 

Salesdecreased in 2005 due to a decrease in the store count from 810 at the end of2004 to 782 at the end of 2005. The decrease in sales was also the result of acomparable store sales decrease of 5.7%. In 2005, comparable store sales decreased5.4% for mall-based stores and decreased 6.3% for freestanding stores. A storeis included in comparable store sales calculations at the beginning of itsthirteenth full month of operation. Not including comparable store sales, salesfrom new and acquired stores, sales from stores closed during the year andInternet 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 averageretail for units sold decreased 0.5%.

 

Salesby merchandise category for 2005 and 2004 and comparable store sales bycategory for 2005 were as follows:

 
| ** **                  | ** ** | ** **                  | ** ** | ** ** | ** ** | **Total Comparable** | ** ** |
|-----------------------------|------------|-----------------------------|------------|------------|------------|---------------------------|------------|
| ** **                  | ** ** | **2005**                    | ** ** | **2004**   | ** ** | **Store Sales**      | ** ** |
| * *                    |       | ***($ in thousands)*** |       |       |       |
| Music:                      |       |                        |       |       |       |                      |       |
| Compact discs               |       | $                           | 655,806    |       | $          | 736,149                   |       | (8.5 | )% |
| Audio cassettes and singles |       | 7,906                       |       | 14,463     |       | (42.5                     | )          |
| Total Music                 |       | 663,712                     |       | 750,612    |       | (9.2                      | )          |
| Video:                      |       |                        |       |       |       |                      |       |
| DVD                         |       | 352,184                     |       | 360,262    |       | 0.7                       |       |
| VHS                         |       | 19,781                      |       | 37,781     |       | (45.5                     | )          |
| Total Video                 |       | 371,965                     |       | 398,043    |       | (3.7                      | )          |
| Video games                 |       | 90,408                      |       | 89,297     |       | 2.3                       |       |
| Other                       |       | 112,401                     |       | 127,181    |       | 4.4                       |       |
| Total                       |       | $                           | 1,238,486  |       | $          | 1,365,133                 |       | (5.7 | )% |

 

The “Other”category includes electronics, accessories, boutique and other sales, none ofwhich individually exceeds 5%.

 

***Music***

 

TheCompany’s stores offer a wide range of new and used CDs across most musicgenres, including new releases from current artists as well as an extensivecatalog 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 newreleases and increased digital downloading. According to Soundscan, total CDunit sales in the United States declined 7.2%.

 

TheCompany is working to introduce digital distribution channels in its stores andthrough its e-commerce sites. The Company has rolled-out the third generationof LVS, or LVS 3, in over 185 mall stores at the end of 2005 and expects to installit in all stores in 2006. This next generation of technology for the customersenhances overall in-store and online experience through new product informationdisplays and full catalog search capabilities. It is also positioned to deliverin-store digital downloading in the future. Management believes that music willbe the category with the highest sales for the foreseeable future.

 

***Video***

 

TheCompany offers DVDs in all its stores. Total sales for 2005 in the videocategory decreased 6.6%. Total sales in the DVD category decreased  2.2% in 2005, due to a lower store count,partially offset by a comparable store sales increase of 0.7%. The increase inDVD comparable store sales reflects the continued industry growth in thiscategory offset by a lack of strong new releases and increased competition. TheCompany plans to continue to grow market share in this category by adding moreproduct and increasing square footage allocations. The video category,including DVD and VHS, represented 30.0% of the Company’s total sales in 2005. Accordingto statistics obtained from Rentrak Home Video Essentials, DVD retail sales in2005 were $15.7 billion, an increase of 4.5% over 2004.

 

***Video games***

 

TheCompany offers video game hardware and software in most of its stores, with amix that favors software. Comparable sales in the video games categoryincreased 2.3% in 2005. The results in this category were positively impactedby Microsoft’s Xbox 360 which was released in

 

15

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November 2005.The comparable store sales increase in this category was partially offset by hardwareshortages, delays in release of highly anticipated software titles and consumeranticipation of next-generation hardware. Video games represented 7.3% of theCompany’s total sales in 2005. According to the NPD Group, industry sales for2005 were $10.5 billion including portable and console hardware, software andaccessories, an increase of 6% over 2004.

 

**Gross Profit.**Thefollowing table sets forth a year-over-year comparison of the Company’s GrossProfit:

 
| ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **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       | %          |                        |       |   |   |

 

Grossprofit as a percentage of sales decreased in 2005 as compared to 2004 due to anincrease in the Company’s distribution center costs by 30 basis points, a shiftin the mix of sales from music to DVD and video games categories of 30 basispoints and more competitive pricing in DVD, video games and accessoriescategories of 50 basis points.

 

**Selling, General and Administrative Expenses.**The following table sets forth a year-over-yearcomparison 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       | %          |                        |       |   |   |

 

TheCompany’s SG&A expenses decreased in 2005 due to the operation of fewerstores. The Company operated an average of 796 stores in 2005 compared to anaverage of 846 stores in 2004, a decrease of 6%. The increase in the SG&Aexpenses rate as a percentage of sales was due to lower sales.

 

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

 

**Income Tax Expense.**The following table sets forth a year-over-yearcomparison 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 wasnegatively impacted by changes in Ohio State tax legislation. The legislationphases out state corporation franchise taxes which are based on income. Theimpact of the Ohio tax legislation resulted in an increase in the statevaluation allowance of $1.9 million, associated with deferred tax assets,principally net operating losses that, based on management’s estimates, willnot be realized during the phase-out period. Additionally, the valuationallowance was increased by $0.9 million for deferred tax assets attributable tostate net operating losses impacted as a result of projected lower futuretaxable income within certain states’ expiration periods. During 2005, theCompany recognized a tax benefit of $2.0 million, attributable to the effect ofadditional deductible temporary differences. For a reconciliation of thefederal statutory tax rate to the Company’s effective income tax rate, see Note6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.

 

The effective tax rate for 2004 was positively impactedby a benefit arising from the closing of a federal income tax examination and adecrease in the valuation allowance. The benefit of $10.5 million was recordedin the second fiscal quarter and included the closing of all matters notpreviously settled in relation to corporate-owned life insurance (“COLI”)policies, which were part of the Company’s acquisition of Camelot in 1999(see Note 6 of Notes to the Consolidated Financial Statements in this AnnualReport on Form 10-K). The original income tax payable amounts which wererecorded during the years covered by the examination were reversed subsequentto the final settlement resulting in the tax benefit. With the closing of thetax examination, the Company has surrendered the remaining COLI policies. In addition,the valuation allowance was decreased by $2.2 million to account for theplanned utilization of federal and state net operating loss carryforwardsduring the

 

16

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expiration periods previously considered uncertain(see Note 6 of Notes to the Consolidated Financial Statements in this AnnualReport on Form 10-K).

 

**Cumulative Effect of a Change in Accounting Principle.**The Company adopted FIN 47, *Accountingfor Conditional Asset Retirement Obligations—an interpretation of FASBStatement No. 143*, effective January 28, 2006. Inaccordance with FIN 47, the Company recorded an asset and a correspondingliability for the present value of the estimated asset retirement obligationsassociated with the fixed assets and leasehold improvements at its storelocations that arise under the terms of operating leases. The Companyrecognized an expense for the cumulative effect of this change in accountingprinciple in the fourth quarter of 2005 of $2.3 million, net of income taxes of$1.5 million.

 

**Extraordinary Gain.**In2004, the Company recorded an extraordinary gain as the result of acquiringsubstantially all the net assets of Wherehouse Entertainment Inc. and CD WorldInc. in October 2003 for $35.2 million and $1.9 million, respectively. Thepurchase price was allocated on a preliminary basis using information availableat the time. The gain represents the excess of the fair value of net assetsacquired over the purchase price. In accordance with SFAS No.141, *Business Combinations*, the allocation of the purchase priceto the assets and liabilities acquired was finalized and adjusted in 2004,resulting in an extraordinary gain of $3.2 million, which is net of incometaxes of $2.0 million, related to unallocated negative goodwill. Theextraordinary gain represents adjustments to the value of liquidated inventory($2.5 million), an adjustment to customer liabilities related to gift cardsbased on the redemption experience since acquisition ($2.1 million) andoccupancy related expenses ($0.6 million).

 

**Net Income.**Thefollowing table sets forth a year-over-year comparison of the Company’s netincome:

 
| ** **                                                                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** | **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 decreasein income before extraordinary gain and cumulative effect of a change inaccounting principle, and net income in 2005 as compared to 2004 is due to thedecrease in income from operations driven by lower sales and resulting lower grossprofit, partially offset by lower SG&A expenses, and a lower income tax benefitof $2.0 million recorded in 2005, compared to a benefit of $10.5 million, whichwas recorded in the second fiscal quarter of 2004 (see Note 6 of Notes to theConsolidated Financial Statements in this Annual Report on Form 10-K).

 

17

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**Fiscal Year Ended January 29,2005 (“2004”)**

**Compared to Fiscal Year Ended January 31,2004 (“2003”)**

 

**Sales.**The followingtable sets forth a year-over-year comparison of the Company’s total Sales: 

 
| ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **2004 vs. 2003** | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|-----------------------------|------------|
| ***($ in thousands)*** | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$**                       | ** ** | **%** | ** ** |
| Sales                            |       | $          | 1,365,133  |       | $          | 1,330,626                   |       | $ | 34,507 |   | 2.6 | % |
|                                  |            |            |            |            |            |                             |            |  |  |  |  |  |

 

Salesincreased in 2004 despite a decrease in the store count from 881 at the end of 2003to 810 at the end of 2004. The increase in sales resulted from a comparablestore sales increase of 0.8%. In 2004, comparable store sales increased 1.9%for mall-based stores and decreased 1.3% for freestanding stores. A store isincluded in comparable store sales calculations at the beginning of itsthirteenth full month of operation. Sales from new and acquired stores andstores closed during the year, excluded from comparable store sales, for 2004and 2003 are $145.8 million and $121.2 million, respectively. Product unitssold in 2004 increased 3.4% over 2003, and average retail for units solddecreased 0.6%.

 

Salesby merchandise category and comparable store sales for 2004 and 2003 were asfollows:

 
| ** **                  | ** ** | **2004**                         | ** ** | **2003**   | ** ** | **Comparable  Store Sales** | ** ** |
|-----------------------------|------------|----------------------------------|------------|------------|------------|----------------------------------|------------|
| ** **                  | ** ** | ***($ in thousands)*** | ** ** | ** ** | ** ** | ** **                       | ** ** |
| Music:                      |       |                             |       |       |       |                             |       |
| Compact discs               |       | $                                | 736,149    |       | $          | 717,145                          |       | (0.8 | )% |
| Audio cassettes and singles |       | 14,463                           |       | 23,819     |       | (38.4                            | )          |
| Total Music                 |       | 750,612                          |       | 740,964    |       | (2.0                             | )          |
| Video:                      |       |                             |       |       |       |                             |       |
| DVD                         |       | 360,262                          |       | 313,977    |       | 14.6                             |       |
| VHS                         |       | 37,781                           |       | 60,891     |       | (35.3                            | )          |
| Total Video                 |       | 398,043                          |       | 374,868    |       | 6.5                              |       |
| Video games                 |       | 89,297                           |       | 80,888     |       | 9.6                              |       |
| Other                       |       | 127,181                          |       | 133,906    |       | (5.8                             | )          |
| Total                       |       | $                                | 1,365,133  |       | $          | 1,330,626                        |       | 0.8 | % |

 

The “Other”category includes electronics, accessories, boutique and other sales, none ofwhich individually exceeds 5%.

 

***Music***

 

TheCompany’s stores offer a wide range of CDs across most music genres, includingnew releases from current artists as well as an extensive catalog of music frompast periods and artists. This category represented 55% of the Company’s salesin 2004.

 

The Company’s annual CD unit sales increased 4.0% in2004. Despite positive comparable store sales during the first and secondquarters of 2004, annual comparable store sales in the CD category declined in2004. The decrease is largely due to weak industry new releases and effects ofthe much publicized unauthorized duplication of music. The Company’s annual CDunit sales compared favorably with the Soundscan reported industry increase of1.9% in 2004. The industry increase marked the first rise in four years.Despite the growing popularity of legal digital music downloads, the CD formataccounts for 98% of the 666 million albums sold, according to Soundscan.

 

TheCompany is actively embracing digital media in its stores and through itse-commerce activities and regards digital downloading as yet another format forselling media products. In the fourth quarter of 2004, the Company unveiled thef.y.e Download Zone, a subscription-based digital music service, wherecustomers can have access to over a million songs for a monthly fee of $14.95.

 

***Video***

 

TheCompany offers DVDs and VHS in all of its stores. The growth in the DVD formathas more than offset the corresponding decline in VHS for the Company. Theincrease in the Company’s comparable store sales for video was driven by DVDcomparable store sales which increased 14.6%. The Company plans to continue togrow its business and market share in this category by adding more product andincreasing square footage allocations. The video category, including DVD andVHS, represented 29% of the Company’s total sales in 2004.

 

Accordingto statistics obtained from Rentrak Home Video Essentials, video sales,including DVD and VHS, increased 15% to $16.1 billion in 2004, as compared to2003. The increase in 2004 was driven by a 27% increase in DVD sales. VHS salesdeclined by 57% during the same period.

 

18

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***Video games***

 

TheCompany offers game hardware and software in most of its stores, with a mixthat favors software. The Company’s video games business improved steadilyduring the second half of 2004, reversing first half results. The Company’scomparable sales in this category increased 9.6% in 2004. The results in the videogames category were driven by the Company’s initiatives to improve productselection and increase the category’s visibility in its stores. The video gamescategory was also positively impacted by the success of new releases, includingGrand Theft Auto – San Andreas and Halo2. The category represented 7% of theCompany’s total sales in 2004.

 

Softwaresales for the game industry were $6.2 billion, up 8%, or $400 million oversales in 2003. Industry sales for 2004 of $9.9 billion including portable andconsole hardware, software and accessories, decreased by less than 1% over 2003sales, according to The NPD Group, which tracks video games sales in the UnitedStates. For 2004, console software, portable game software and portable gamehardware also experienced unit sales increases of 8%, 13% and 9%, respectively.

 

**Gross Profit.**Thefollowing table sets forth a year-over-year comparison of the Company’s GrossProfit:

 
| ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **2004 vs. 2003** | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|-----------------------------|------------|
| ***($ in thousands)*** | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$**                       | ** ** | **%** | ** ** |
| Gross Profit                     |       | $          | 495,134    |       | $          | 487,900                     |       | $ | 7,234 |   | 1.5 | % |
|                             |       |       |       |       |       |                        |       |   |   |   |   |   |
| As a percentage of sales         |       | 36.3       | %          | 36.7       | %          |                        |       |   |   |

 

Thedecrease in the gross profit rate as a percentage of sales was due to acontinued shift in the mix of the Company’s sales toward DVD and video games,and higher markdowns in the electronics, accessories and boutique categoriesdue to fourth quarter promotions and clearance activity. The Company alsoincurred higher product shrink expenses and distribution costs associated withbringing its Carson, California distribution facility into full productionduring the year.

 

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

 
| *** ***                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **2004 vs. 2003** | ** ** |
|-----------------------------------------------|------------|------------|------------|------------|------------|-----------------------------|------------|
| ***($ in thousands)***              | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$**                       | ** ** | **%** | ** ** |
| Selling, general and administrative  expenses |       | $          | 450,162    |       | $          | 459,441                     |       | $ | (9,279 | ) | (2.0 | )% |
|                                          |       |       |       |       |       |                        |       |   |   |   |   |   |
| As a percentage of sales                      |       | 33.0       | %          | 34.5       | %          |                        |       |   |   |

 

TheCompany’s SG&A expenses were lower in 2004 due to the absence ofnon-recurring charges including the write-off of long-lived assets of $3.7million related to the outsourcing of its Internet operations, and transitioncosts of $2.3 million associated with the Wherehouse acquisition in 2003. TheCompany also recognized approximately $5.0 million lower incentive bonuses in2004 as compared to 2003. The improvement in the SG&A expenses rate as apercentage of sales was also due to the increase in 2004 sales.

 

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

 
| ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **2004 vs. 2003** | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|-----------------------------|------------|
| ***($ in thousands)*** | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$**                       | ** ** |
| Income tax expense               |       | $          | 4,892      |       | $          | 8,302                       |       | $ | (3,410 | ) |
|                             |       |       |       |       |       |                        |       |
| Effective tax rate               |       | 11.2       | %          | 30.7       | %          |                        |       |
|                                  |            |            |            |            |            |                             |            |  |  |  |

 

For 2004, the Company’s effective tax rate of 11.2%was positively impacted by a benefit arising from the closing of a federalincome tax examination and a decrease in the valuation allowance. The benefitof $10.5 million was recorded in the second fiscal quarter and included theclosing of all matters not previously settled in relation to corporate-ownedlife insurance (“COLI”) policies, which were part of the Company’sacquisition of Camelot in 1999 (see Note 6 of Notes to the ConsolidatedFinancial Statements in this Annual Report on Form 10-K). The originalincome tax payable amounts which were recorded during the years covered by theexamination were reversed subsequent to the final settlement resulting in thetax benefit. With the closing of the tax examination, the Company hassurrendered the remaining COLI policies. In addition, the valuation allowancewas decreased by $2.2 million to account for the planned utilization of federaland state net operating loss carryforwards during the expiration periodspreviously considered uncertain.

 

For 2003, the Company’s effective tax rate of 30.7%was positively impacted by improved earnings before taxes and the settlement ofits COLI litigation with the IRS. An increase in earnings improves the rate dueto the rate leverage on fixed-base state taxes recorded in income tax

 

19

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expense. The Company recorded an additional taxbenefit of $2.1 million as a result of the COLI settlement payment terms withthe IRS that it recorded in the second quarter (see Note 6 of Notes to theConsolidated Financial Statements in this Annual Report on Form 10-K). Fora reconciliation of the federal statutory tax rate to the Company’s effectiveincome tax rate, see Note 6 of Notes to the Consolidated Financial Statementsin this Annual Report on Form 10-K.

 

**Extraordinary Gain.**In2004, the Company recorded an extraordinary gain as the result of acquiringsubstantially all the net assets of Wherehouse Entertainment Inc. and CD WorldInc. in October 2003 for $35.2 million and $1.9 million, respectively. Thepurchase price was allocated on a preliminary basis using information availableat the time. The gain represents the excess of the fair value of net assetsacquired over the purchase price. In accordance with SFAS No.141, *Business Combinations*, the allocation of the purchase priceto the assets and liabilities acquired was finalized and adjusted in 2004,resulting in an extraordinary gain of $3.2 million, which is net of incometaxes of $2.0 million, related to unallocated negative goodwill. Theextraordinary gain represents adjustments to the value of liquidated inventory($2.5 million), an adjustment to customer liabilities related to gift cardsbased on the redemption experience since acquisition ($2.1 million) andoccupancy related expenses ($0.6 million).

 

**Net Income.**Thefollowing table sets forth a year-over-year comparison of the Company’s netincome:

 
| ** **                                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** | **2004 vs. 2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|-----------------------------|------------|
| ***($ in thousands)***                                                                                                    | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$**                       | ** ** | **%** | ** ** |
| Income before extraordinary gain                                                                                                    |       | $          | 38,675     |       | $          | 18,728                      |       | $ | 19,947 |   | 106.5 | % |
| Extraordinary gain – unallocated  negative goodwill, net of income taxes of $1,979 and $2,437 for 2004 and  2003, respectively |       | 3,166      |       | 4,339      |       |                        |       |   |   |
|                                                                                                                                |       |       |       |       |       |                        |       |   |   |
| Net income                                                                                                                          |       | $          | 41,841     |       | $          | 23,067                      |       | $ | 18,774 |   | 81.4 | % |
|                                                                                                                                |       |       |       |       |       |                        |       |   |   |
| Net income as a percentage of  sales                                                                                                |       | 3.1        | %          | 1.7        | %          |                        |       |   |   |

 

Theincrease in income before extraordinary gain and net income in 2004 as comparedto 2003 is due to increased sales and resulting gross profit, lower SG&Aexpenses and the income tax benefit recorded in the second fiscal quarter of2004 (see Note 6 of Notes to the Consolidated Financial Statements in thisAnnual Report on Form 10-K).

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

**Liquidity and Cash Flows:**  The Company’s primary sources ofworking capital are cash provided by operations and borrowing capacity underits revolving credit facility. The Company’s cash flows fluctuate from quarterto quarter due to various items, including seasonality of sales and earnings, merchandiseinventory purchases and the related terms on the purchases, store openings, taxpayments, capital expenditures and stock repurchase activity. Managementbelieves it will have adequate resources to fund its cash needs for theforeseeable future, and anticipates that cash flows from operations will besufficient to fund its capital spending, its seasonal increase in inventory,income tax payments and other operating cash requirements and commitments. Managementanticipates any cash requirements due to an unanticipated shortfall in cashfrom operations, will be funded by the Company’s revolving credit facility,discussed hereafter. Management believes its reported cash flows are indicativeof cash flow for the foreseeable future and is not currently aware of anytrends, uncertainties or other significant events that would cause liquidity toincrease or decrease in a material way except as discussed under SubsequentEvents - Note 13 of Notes to the Consolidated Financial Statements in thisAnnual Report on Form 10-K. However, there can be no assurance, that theCompany will continue to generate cash flows at or above current levels or thatwe will be able to maintain the Company’s ability to borrow under the revolvingcredit facility. The Company does not expect any material changes in the mix(between equity and debt) or the relative cost of capital resources.

 

Thefollowing table sets forth a three year summary of key components of cash flowand working capital:

 
| ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **2005 vs. 2004** | ** ** | ** ** | ** ** | **2004 vs. 2003** | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|-----------------------------|------------|------------|------------|-----------------------------|------------|
| ***($ in thousands)*** | ** ** | **2005**   | ** ** | **2004**   | ** ** | **$**                       | ** ** | **%**      | ** ** | **2003**                    | ** ** | **$** | ** ** | **%** | ** ** |
| Operating  Cash Flows            |       | $          | 25,247     |       | $          | 105,931                     |       | $          | (80,684    | )                           | (76        | )% | $ | 66,883 |   | $ | 39,048 |   | 58 | % |
| Investing  Cash Flows            |       | (40,517    | )          | (35,398    | )          | (5,119                      | )          | (14        | )%         | (54,033                     | )          | 18,635 |   | 34 | % |
| Financing  Cash Flows            |       | (17,289    | )          | (32,687    | )          | 15,398                      |       | 47         | %          | (17,978                     | )          | (14,709 | ) | (82 | )% |
|                             |       |       |       |       |       |                        |       |       |       |                        |       |   |   |   |   |
| Capital  Expenditures            |       | (41,330    | )          | (33,398    | )          | (7,932                      | )          | (24        | )%         | (16,989                     | )          | (16,409 | ) | 97 | % |
|                             |       |       |       |       |       |                        |       |       |       |                        |       |   |   |   |   |
| Cash  and Cash Equivalents       |       | 197,209    |       | 229,768    |       | (32,559                     | )          | (14        | )%         | 191,922                     |       | 37,846 |   | 20 | % |
| Merchandise  Inventory           |       | 402,712    |       | 431,246    |       | (28,534                     | )          | (7         | )%         | 424,783                     |       | 6,463 |   | 2 | % |
| Working  Capital                 |       | 257,467    |       | 278,066    |       | (20,599                     | )          | (7         | )%         | 253,475                     |       | 24,591 |   | 10 | % |
| Inventory  turns                 |       | 1.9        |       | 2.0        |       |                        |       |       |       | 2.1                         |       |   |   |   |   |
|                                  |            |            |            |            |            |                             |            |            |            |                             |            |  |  |  |  |  |  |  |  |  |

 

Thedecrease in cash from operating activities in 2005 was the result of lower netincome of $0.6 million as compared to net income of $41.8 million in 2004. Itwas further due to a net $7.0 million cash use in 2005, in net inventory(inventory less accounts payable) as compared to a $48.1 million net cashsource in 2004. The net $7.0 million cash use in 2005 was the result of largerthan usual inventory payments in early 2005 for inventory received in thefourth quarter of 2004.

 

TheCompany used less cash in 2005 for the payment of accrued expenses ($2.8million cash use in 2005 as compared to $10.4 million cash use in 2004) andtaxes ($7.9 million cash use in 2005 as compared to $15.1 million cash use in2004). All other operating cash sources, net, were approximately $10.7 million.

 

TheCompany monitors various statistics to measure its management of inventory,including inventory turn (annual cost of sales divided by average inventorybalances), inventory investment per square foot and inventory leverage (accountspayable divided by inventory). Inventory turn for 2005 was 1.9 compared to 2.0in 2004. Inventory investment per square foot was $83 per square foot at theend of 2005 as compared to $86 per square foot at the end of 2004. Inventoryleverage was 80% as of January 28, 2006 compared with 83% as of January 29,2005. Management considers these results to be in a normal operating range. Managementdoes not anticipate large fluctuations in inventory or accounts payablebalances for its existing stores in the foreseeable future.

 

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

 

TheCompany had capital expenditures in 2004 of $24.5 million for new storeopenings and relocations and for store improvements. The Company further madeinvestments in its store technology and upgraded its LVS for $5.2 million. Theremainder for 2004 was for other technology upgrades.

 

TheCompany typically finances its capital expenditures through cash generated fromoperations. It may also receive landlord allowances or concessions forstore openings, relocations or improvements. The Company anticipates capitalspending of $45.0 million in 2006.

 

Cashused in financing activities was $17.3 million in 2005, as compared to $32.7million in 2004. In 2005, the primary sources of cash were $12.9 millionthrough capital lease transactions and $4.2 million from the exercise of stockoptions. In 2005 and 2004, the primary use of cash in financing activities was$31.3 million and $40.2 million, respectively, to repurchase outstanding sharesof the Company’s Common Stock under

 

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programsauthorized by the Board of Directors. The most recent share repurchase programwas authorized by the Company’s Board of Directors in May 2003. As of January 28,2006, the Company had purchased all the 10 million shares authorized under thisprogram at a cost of $88.5 million.

 

Theincrease in operating cash flows in 2004 was due to increased earnings and theincrease in accounts payable, offset by decreases in accrued expenses andincome taxes payable in 2004. Inventory increased $4.0 million (net ofadjustments related to extraordinary gain) in 2004 as compared to a decrease of$5.3 million in 2003. The rate of inventory turn (which is a measure of howfast inventory is sold and is calculated by dividing current year’s cost ofsales by average inventory) for 2004 was 2.0 comparing with 2.1 in 2003. Inventorywas $86 per square foot at the end of 2004 as compared to $77 per square footat the end of 2003. The increase in inventory can be attributed to the factthat the Company anticipated greater sales than actually realized in the fourthquarter of 2004. Management does not anticipate significant changes to itsinventory turn rates and inventory investment per square foot for theforeseeable future. Income taxes payable decreased $15.2 million due to therecording of a tax benefit of $10.5 million in the second quarter of 2004 andtax payments of $12.5 million compared to a provision of $8.5 million in 2004.The seasonality of the Company’s earnings results in substantially all ofincome tax payments to be made subsequent to year-end. Accounts payableleveraging (the percentage of merchandise inventory financed by vendor creditterms, e.g., accounts payable divided by merchandise inventory) increased to83.1% as of January 29, 2005 compared with 72.0% as of January 31,2004. The increase in leverage was due to the absence of last year’s inventoryrelated to the acquired Wherehouse stores, which was funded in October 2003without the corresponding accounts payable, and of which a significant amountwas on hand at prior year-end. The decrease in accrued expenses in 2004 of$10.4 million was due to lower accruals for gift cards ($2.7 million), loweraccruals for employee incentive costs ($4.1 million) and the absence ofaccruals for acquisition related costs in 2003 ($1.8 million). See Note 3 ofNotes to the Consolidated Financial Statements in this Annual Report on Form 10-Kfor detail.

 

Cashused in investing activities was $35.4 million in 2004, as compared to $54.0million in 2003. In 2004, the primary uses of cash were $33.4 million forcapital expenditures and $2.0 million for the acquisition of businesses (seeNote 3 in Notes to the Consolidated Financial Statements in this Annual Reporton Form 10-K for further detail). The majority of the Company’s capitalexpenditures in 2004 were spent on store improvements, relocations and newstore openings. The Company also made investments in technology in its storesincluding upgrading and maintenance of LVS. The investment in technology was$5.2 million. The remainder of the Company’s capital expenditures in 2004related to miscellaneous MIS (Management Information Systems) projects. In2003, primary uses of cash were $37.0 million for the acquisition of businesses(see Note 3 in Notes to the Consolidated Financial Statements in this AnnualReport on Form 10-K) and store improvements, relocations and new storeopenings. In 2003, the Company made investments of $4.0 million in technologyin its stores including upgrading and maintenance of LVS and continued enhancementof the Company’s Web site **www.fye.com**.

 

Cashused in financing activities was $32.7 million in 2004, as compared to $18.0million in 2003. In 2004 and 2003, the primary use of cash used in financingactivities was $40.2 million and $17.0 million, respectively, to repurchaseoutstanding shares of the Company’s Common Stock under programs authorized bythe Board of Directors. The current share repurchase program was authorized bythe Company’s Board of Directors in May 2003, and allows the Company to repurchaseup to 10 million shares of Common Stock from time to time on the open market. Asof January 2004, the Company had completed the purchase of 15 millionshares of common stock under previously announced programs. As of January 29,2005, the Company had purchased 6.9 million shares under this plan, at a totalcost of $57.2 million, and 3.1 million shares were available for purchase underthe current program. In 2004, the Company purchased 3.8 million shares.

 

EffectiveMarch 27, 2006, the Company acquired 335 Musicland stores for a total cashconsideration of $104.2 million and $18.1 million in assumed liabilitiesincluding certain customer obligations, rent and occupancy liabilities andother employee obligations. See Note 13 of Notes to the Consolidated FinancialStatements on this Annual Report on Form 10-K.

 

On January 5,2006, the Company entered into a new five year, $100 million revolving securedCredit Agreement with Bank of America, N.A that expires in January 2010.The revolving credit facility contains provisions governing additionalindebtedness and acquisitions and is secured by the Company’s eligibleinventory, proceeds from the sale of inventory and by the stock of the Company’ssubsidiaries. Prior to the new credit agreement the Company had a three year,$100 million secured revolving credit facility with Congress FinancialCorporation that would have expired in July 2006. Subsequent to January28, 2006, the Company entered into a First Amendment of the Credit Agreementwith Bank of America N.A on March 26, 2006, which increases the maximum amountavailable for borrowing under the revolving secured credit facility to $130million.

 

As of January 28,2006 and January 29, 2005, the Company had $0.5 million and $0.3 million,respectively, in outstanding letter of credit obligations under the creditagreements with Bank of America, N.A and Congress Financial Corporation,respectively. The Company had $99.5 million and $99.7 million, available forborrowing as of January 28, 2006 and January 29, 2005, respectively. Interestexpense in 2005 was $3.0 million, of which $1.5 million was incurred forcapital leases. Interest expense in 2004 was $2.4 million, of which $2.0million was incurred for capital leases.

 

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During 2005, the Company financed the replacement ofits point-of-sale system through a capital lease arrangement in the amount of$12.0 million. The lease arrangement has an average interest rate of5.76% and will be repaid in monthly installments of $229,000 over 5 years. Asof January 28, 2006, the outstanding balance on the lease was $10.4million.

 

During 2005, the Company purchased software licensesthrough a capital lease arrangement for $0.9 million, with an interest rate of5.75%. The capital lease will be repaid in quarterly installments of $122,000over 2 years. As of January 28, 2006, the outstanding balance on the leasewas $0.5 million.

 

During 2005, the Company acquired an 80% interest ina company that is fully consolidated for financial reporting purposes. TheCompany has committed funding of $3.0 million over a period of three years, ofwhich $1.0 million was funded as of January 28, 2006.

 

During2004, the Company borrowed $5.8 million under a mortgage loan to finance thepurchase of real estate. The mortgage loan is repayable in monthlyinstallments of $64,000 over 10 years with a fixed interest rate of 6.0% and iscollateralized by the real estate. The mortgage loan contains a minimum networth (shareholders’ equity) covenant of $290 million, excluding the impact, ifany, of certain non-cash charges. As of January 28, 2006, the outstandingbalance on the loan was $5.1 million.

 

**Contractual Obligations andCommitments**. The followingtable summarizes the Company’s contractual obligations at January 28, 2006,and the effect that such obligations are expected to have on liquidity and cashflows in future periods.

 
| **Contractual  Obligation**                           | ** **                | **2006** | ** ** | **2007 -  2008** | ** ** | **2009 -  2010** | ** ** | **2011 and  Beyond** | ** ** | **Total** | ** ** |
|-------------------------------------------------------|---------------------------|----------|------------|-----------------------|------------|-----------------------|------------|---------------------------|------------|-----------|------------|
| ***$***                                               | *** in  thousands*** |     |       |                  |       |                  |       |                      |       |      |       |   |
| **Operating lease obligations**                       |                      | $        | 101,583    |                  | $          | 156,691               |       | $                         | 83,373     |      | $          | 50,596 |   | $ | 392,243 |   |
| **Capital lease obligations**                         |                      | 5,195    |       | 9,539                 |       | 7,418                 |       | 9,356                     |       | 31,508    |       |
| **Long-term debt (principal)**                        |                      | 477      |       | 1,043                 |       | 1,176                 |       | 2,368                     |       | 5,064     |       |
| **Long-term debt (interest)**                         |                      | 291      |       | 491                   |       | 358                   |       | 257                       |       | 1,397     |       |
| **Purchase obligations (1)**                          |                      | —   |       | —                |       | —                |       | —                    |       | —    |       |
| **Deferred rent and other long-term liabilities (2)** |                      | 1,637    |       | 9,797                 |       | 1,649                 |       | 1,550                     |       | 14,633    |       |
| **Pension benefits**                                  |                      | 50       |       | 2,362                 |       | 2,426                 |       | 7,101                     |       | 11,939    |       |
| **Total**                                             |                      | $        | 109,233    |                  | $          | 179,923               |       | $                         | 96,400     |      | $          | 71,228 |   | $ | 456,784 |   |
|                                                       |                           |          |            |                       |            |                       |            |                           |            |           |            |  |  |  |  |  |  |

 

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(1)          Purchase obligations include all legally bindingcontracts such as software acquisition/license commitments and legally bindingservice contracts or other commitments. Purchase orders for inventory and otherservices are not included in the table above. Purchase orders representauthorization to purchase rather than binding agreements. For the purposes ofthis table, contractual obligations for purchase of goods or services aredefined as agreements that are enforceable and legally binding and that specifyall significant terms, including: fixed or minimum quantities to be purchased;fixed, minimum or variable price provisions; and the approximate timing of thetransaction. Our purchase orders are based on our current inventory needs andare fulfilled by our suppliers within short time periods. 

(2)          As part of a settlement agreement with the IRS,the Company is required to pay interest of approximately $180,000 every sixmonths, through fiscal year 2007, and a final principal payment of $7.1 millionin 2007. These payments are pursuant to the settlement of matters with regardto corporate owned life insurance polices and the principal portion is reportedin other long-term liabilities in the Consolidated Balance Sheets as of January 28,2006. Included in deferred rent and other long-term liabilities are unfavorablelease valuations of $1.0 million and the long-term portion of deferred rent of$8.7 million which are not reflected in the table above as the underlyingagreements are not legally binding. Also included in long-term liabilities isthe long-term portion of the straight line rent liability of $10.6 million,which is included in operating lease obligations in the table above.

 

Included in deferred rent and other long term liabilities above, is thelong-term liability corresponding to the present value of the estimated assetretirement obligations associated with the fixed assets and leaseholdimprovements at the Company’s store locations that arise under the terms of operatingleases.

 

During 2005, the Company acquired an 80% interest in a Company that isfully consolidated for financial reporting purposes. The Company has committedfunding of $3.0 million over a period of three years, of which $1.0 million wasfunded as of January 28, 2006 and the remaining obligations are includedin deferred rent and other long term liabilities above.

 

Subsequent to January 28, 2006, the Company acquired an 80% interestin a company that will be fully consolidated for financial reporting purposesin 2006. The Company has committed funding of $5.2 million over a period of twoyears of which $1.2 million was committed as of March 25, 2006. Thiscommitment has not been included in the table above as it does not represent acontractual obligation as of January 28, 2006.

 

The Company offers a 401(k) Savings Plan to eligible employees (see alsoNote 9 of Notes to the Consolidated Financial Statements in

 

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this Annual Report on Form 10-K). Total expense related to theCompany’s matching contribution was $957,000, $897,000 and $858,000 in 2005,2004 and 2003, respectively. The Company expects to expense and fund an amountin 2006 that is comparable to these historical amounts.

 

**Related Party Transactions.**

 

TheCompany leases its 181,000 square foot distribution center/office facility inAlbany, New York from Robert J. Higgins, its Chairman, Chief Executive Officerand largest shareholder, under three capital leases that expire in the year2015. The original distribution center/office facility was constructed in 1985.

 

Under the three capital leases, dated April 1,1985, November 1, 1989 and September 1, 1998 (the “Leases”), theCompany paid Mr. Higgins an annual rent of $1.9 million, $1.8 million and $1.8million in 2005, 2004 and 2003 respectively. Pursuant to the terms of the leaseagreements, effective January 1, 2006 and every two years thereafter,rental payments will increase in accordance with the biennial increase in theConsumer Price Index. Under the terms of the lease agreements, the Company isresponsible for property taxes, insurance and other operating costs withrespect to the premises. Mr. Higgins’ obligation for principal andinterest on his underlying indebtedness relating to the real property isapproximately $1.1 million per year. None of the leases contain any realproperty purchase options at the expiration of their terms.

 

TheCompany leases one****of its retailstores from Mr. Higgins under an operating lease. Annual rental paymentsunder this lease were $40,000 in 2005, 2004 and 2003. Under the terms of thelease, the Company pays property taxes, maintenance and a contingent rental ifa specified sales level is achieved. Total additional charges for the store,including contingent rent, were approximately $4,400, $14,500 and $4,600 in 2005,2004 and 2003 respectively.

 

TheCompany regularly utilizes privately chartered aircraft owned or partiallyowned by Mr. Higgins. Under an unwritten agreement with Quail AeroServices of Syracuse, Inc., a corporation in which Mr. Higgins holdsa 47.5% share, the Company paid $0, $1,000, and $60,000 for chartered aircraftservices in 2005, 2004, and 2003, respectively. The Company also charters anaircraft from Crystal Jet, a corporation wholly-owned by Mr. Higgins. Paymentsto Crystal Jet aggregated $6,000, $10,000 and $13,000 in 2005, 2004 and 2003,respectively. The Company also charters an aircraft from Richmor Aviation, anunaffiliated corporation that leases an aircraft owned by Mr. Higgins. Paymentsto Richmor Aviation in 2005, 2004 and 2003 were $276,000, $314,000 and $235,000,respectively. The Company believes that the charter rates and terms are asfavorable to the Company as those generally available to it from othercommercial charters.

 

MichaelSolow, a member of the Company’s Board of Directors, is a partner of the lawfirm Kaye Scholer LLP, which rendered legal services to the Company in 2004 and2003 for which the Company incurred fees of $115,000 and $202,000 respectively.Kaye Scholer concluded its representation of the Company in 2004.

 

**CRITICAL ACCOUNTING POLICIES AND ESTIMATES**

 

Thepreparation of financial statements and related disclosures in conformity withaccounting principles generally accepted in the United States requires thatmanagement apply accounting policies and make estimates and assumptions thataffect results of operations and the reported amounts of assets and liabilitiesin the financial statements. Management continually evaluates its estimates andjudgments including those related to merchandise inventory and return costs, valuationof long-lived assets, income taxes, stock-based compensation, and accountingfor gift card liability. Management bases its estimates and judgments onhistorical experience and other factors that are believed to be reasonableunder the circumstances. Actual results may differ from these estimatesunder different assumptions or conditions. Note 1 of the Notes to theConsolidated Financial Statements in this Annual Report on Form 10-K includesa summary of the significant accounting policies and methods used by theCompany in the preparation of its consolidated financial statements. Managementbelieves that of the Company’s significant accounting policies, the following may involvea higher degree of judgment or complexity:

 

**Merchandise Inventory and ReturnCosts:** Inventory is statedat the lower of cost or market as determined by the average cost method. Theaverage cost method attaches a cost to each item and is a blended average ofthe original purchase price and those of subsequent purchases or other costadjustments throughout the life cycle of that item.

 

Inventoryvaluation 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 obsoleteinventory. Typically, newer releases generate a higher product demand. Somevendors offer credits to reduce the cost of products that are selling moreslowly, thus allowing for a reduction in the selling price and reducing thepossibility for items to become obsolete. The Company records obsolescence andany adjustments to market value (if lower than cost) based on current andanticipated demand, customer preferences, and market conditions. The provisionfor inventory shrink is estimated as a percentage of sales for the period fromthe 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 shrinkresults from the last physical inventory. Physical inventories are taken atleast annually for all stores throughout the year and inventory records areadjusted accordingly.

 

Shrinkexpense, including obsolescence was $15.1 million, $17.2 million and $14.0million, in 2005, 2004 and 2003 respectively. As a rate to sales, this equaled 1.2%,1.3% and 1.0%, respectively. The Company expects to realize approximately thesame rate of shrink and obsolescence

 

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forthe foreseeable future as recorded in 2005. Presently, a 0.1% change in therate of shrink and obsolescence provision would equal approximately $1.2million in additional charge or benefit to cost of sales, based on 2005 sales.

 

The Company is generally entitled to return merchandisepurchased from major vendors for credit against other purchases from thesevendors. Certain vendors reduce the credit with a merchandise return chargeranging from 0% to 20% of the original merchandise purchase price depending onthe type of merchandise being returned. Certain other vendors charge a handlingfee based on units returned. The Company records merchandise return charges incost of sales. The Company incurred merchandise return charges in its fiscalyears 2005, 2004 and 2003 of $5.6 million, $12.4 million and $13.5 million,respectively. Merchandise returns decreased 11% in 2005. Return penalties werelower in 2005 than in prior years as the major vendors have decreased theup-front incentives and in turn, lowered the back-end penalty rate. The levelof merchandise return charges incurred is directly related to the level ofmerchandise returns.

 

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

 

•**             **significant underperformance relative to historicalor projected future operating results;

•**             **significant changes in the manner of the use ofacquired assets or the strategy for the Company’s overall business;

•**             **significant negative industry or economic trends;

 

If theCompany determines that the carrying value of a long-lived asset may notbe recoverable it tests for impairment to determine if an impairment charge isneeded. Impairment losses recorded in 2005, 2004 and 2003 were $0, $0 and $3.7million, respectively. The 2003 amount which is reflected in SG&A expensesin the Consolidated Statement of Operations represents the write-down of thefixed assets of www.fye.com pursuant to the Company’s decision to outsource theoperation of its f.y.e. Web site. Losses for store closings in the ordinarycourse of business represent the write down of the net book value of abandonedfixtures and leasehold improvements. The loss on disposal of fixed assetsrelated to store closings was $2.5 million, $2.8 million and $2.5 million in2005, 2004 and 2003, respectively, and is included in SG&A expenses. Lossesdue to the write down of fixed assets related to store closings are included inLoss on disposal of fixed assets in the Consolidated Statements of Cash Flows. Storeclosings usually occur at the expiration of the lease, at which time leaseholdimprovements, which constitute a majority of the abandoned assets, are fullydepreciated. Also, actual store closures usually occur within three months ofthe planned store closure date. As a result, changes in depreciation estimatesas required by Accounting Principles Board, Opinion No. 20, *Accounting Changes* (“APB 20”), do not have a material impacton financial results.

 

**Income Taxes:** Income taxes are accounted for under the asset andliability method. Deferred tax assets and liabilities are recognized for thefuture tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases and tax operating loss carryforwards. Deferred tax assetsand liabilities are measured using enacted tax rates expected to apply totaxable income in the years in which those temporary differences are expectedto be recovered or settled. The effect on deferred tax assets and liabilitiesof a change in tax rates is recognized in the results of operations in theperiod that includes the enactment date.

 

Accounting for income taxes requires management to makeestimates and judgments regarding interpretation of various taxingjurisdictions, laws and regulations as well as the ultimate realization ofdeferred tax assets. These estimates and judgments include the generation offuture taxable income, viable tax planning strategies and support of taxfilings. Valuation allowances are recorded against deferred tax assets if,based upon management’s estimates of realizability, it is more likely than notthat some portion or all of these deferred tax assets will not be realized. Foradditional discussion regarding income taxes, refer to Note 6 in Notes to theConsolidated Financial Statements in this Annual Report on Form 10-K.

 

**Stock-based Compensation:**For periods 2005 and prior, the Company applied theintrinsic value-based method of accounting prescribed by Accounting PrinciplesBoard (“APB”) Opinion No.25, *Accounting for StockIssued to Employees*,**and relatedinterpretations including FASB Interpretation No. 44,*Accountingfor Certain Transactions Involving Stock Compensation – An Interpretation ofAPB No.25*, in accounting for its fixed plan stock options. Underthis method, compensation expense would be recorded on the date of grant onlyif the current market price of the underlying stock exceeded the exercise price.Unearned compensation recognized for restricted stock awards is shown as aseparate component of shareholders’ equity and is amortized to expense over thevesting 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 disclosurerequirements using a fair value-based method of accounting for stock-basedemployee compensation plans. As allowed by SFAS No.123, the Company elected tocontinue to apply the intrinsic value-based method of accounting describedabove, and adopted the disclosure requirements of SFAS No.123 and SFAS No.148.The Company adopted the expense recognition provisions of SFAS No.123(R), effectivefor fiscal 2006 that began on January 29, 2006.

 

In December 2005, the Company’s Board of Directors approved the acceleration of vesting of previously granted unvested annual options awarded to employees and officers under the Company’s Stock Option Plans which had exercise prices greater than $10.00 per share. Options to purchase 2.3 million shares became exercisable immediately, representing 24% of total options outstanding, as a result of the vesting acceleration. 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

 

25

 

Company will adopt on January 29, 2006. The acceleration of vesting of these stock options resulted in compensation expenses of $5.9 million, in the pro forma net income (loss) results (see Note 1 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K).

 

**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 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 as of a reporting period end. 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 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 card sales and redemptions have not changed significantly over time.

 

**Recently Issued AccountingPronouncements.**

 

In February 2006, the FASBissued SFAS No. 155, *Accounting for CertainHybrid Financial Instruments - an amendment of FASB Statements No. 133 and140*, to simplify and make more consistent the accounting for certainfinancial instruments. Specifically, SFAS No. 155 amends SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities*, to permit fair value remeasurement for any hybridfinancial instrument with an embedded derivative that otherwise would requirebifurcation, provided that the whole instrument is accounted for on a fairvalue basis. SFAS No. 155 amends SFAS No. 140, **Accounting forTransfers and Servicing of Financial Assets and Extinguishment of Liabilities**,to allow a qualifying special-purpose entity to hold a derivative financialinstrument that pertains to a beneficial interest other than another derivativefinancial instrument. SFAS No. 155 applies to all financial instrumentsacquired or issued after the beginning of an entity’s first fiscal year thatbegins after September 15, 2006, with earlier application allowed. The adoptionof SFAS No.155 is not expected to have a significant impact on the Company’sconsolidated financial position or results of operations.

 

In May 2005,the FASB issued SFAS No. 154, *Accounting Changes andError Corrections, a replacement of APB Opinion No. 20, Accounting Changesand FASB Statement No. 3, Reporting Accounting Changes in InterimFinancial Statements*. SFAS No. 154 provides guidance on theaccounting for and reporting of accounting changes and error corrections. Itestablishes, unless impracticable, retrospective application as the requiredmethod for reporting a change in accounting principle in the absence ofexplicit transition requirements specific to the newly adopted accountingprinciple. SFAS No. 154 also provides guidance for determining whetherretrospective application of a change in accounting principle is impracticableand for reporting a change when retrospective application is impracticable. Theprovisions of SFAS No. 154 are effective for accounting changes andcorrections of errors made in fiscal periods beginning after December 15,2005. The adoption of the provisions of SFAS No. 154 is not expected tohave a material impact on the Company’s consolidated financial condition orresults of operations.

 

In June 2005,the Emerging Issues Task Force (“EITF”) issued EITF No. 05-6, *Determining the Amortization Period of Leasehold Improvements(purchased after lease inception) or Acquired in a Business Combination (“EITF05-6”)*. EITF 05-6 provides that the amortization period for leaseholdimprovements acquired in a business combination or purchased after theinception of a lease be the shorter of (a) the useful life of the assetsor (b) a term that includes required lease periods and renewals that arereasonably assured upon the acquisition of the purchase. The provisions of EITF05-6 are effective on a prospective basis for leasehold improvements purchasedor acquired beginning July 1, 2005. The adoption of EITF 05-6 did not havea material effect on the Company’s consolidated financial position or resultsof operations.

 

In December 2004, the FASBissued SFAS No.123(R), *Share-Based Payment: anamendment of FASB Statements No. 123 and 95.* SFAS No.123(R)requires an enterprise to measure the cost of employee services received inexchange for an award of equity instruments based on the fair value of theaward at the grant date (with limited exceptions) and recognize thecompensation cost over the period during which an employee is required toprovide service in exchange for the award. In March 2005, the SEC issuedStaff Accounting Bulletin No.107 (“SAB 107”), which expresses views of the SECstaff regarding the application of SFAS No.123(R). Among other things, SAB 107provides interpretive guidance related to the interaction between SFAS No.123(R)and certain SEC rules and regulations, and provides the SEC staff’s viewsregarding the valuation of share-based payment arrangements for publiccompanies. In February 2006, the FASB published FASB Staff Position No. FAS123(R)-4 (“FSP No.123(R)-4”), *Classification of Optionsand Similar Instruments Issued as Employee Compensation That Allow for CashSettlement upon the Occurrence of a Contingent Event*, to amendguidance in SFAS No.123(R), on classifying options and similar instrumentsissued as part of employee compensation arrangements. As amended, SFAS No.123(R)requires options issued as compensation to employees to be classified asliabilities if the cash settlement feature can be exercised only upon theoccurrence of a contingent event that is outside the employee’s control, andsuch event is deemed probable to occur. The Company will adopt the expenserecognition provisions of SFAS No.123(R) in its first quarter of fiscal 2006which began on January 29, 2006. If the Company had applied the provisionsof SFAS No.123(R) to the financial statements for the period ended January 28,2006, net loss would have been greater by approximately $7.3 million or $(0.23)per share.

 

26

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**Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

TheCompany does not hold any financial instruments that expose it to significantmarket risk and does not engage in hedging activities. To the extent theCompany borrows under its credit facility, the Company is subject to riskresulting from interest rate fluctuations since interest on the Company’sborrowings under its credit facility can be variable. If interest rates on theCompany’s credit facility were to increase by 25 basis points, and to theextent borrowings were outstanding, for every $1,000,000 outstanding on thefacility, income before income taxes would be reduced by $2,500 per year. Informationabout the fair value of financial instruments is included in Note 1of Notes tothe 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 FinancialStatements is included in Item 15, and the Consolidated Financial Statementsfollow the signature page to this Annual Report on Form 10-K and areincorporated herein by reference.

 

Thequarterly results of operations are included herein in Note 12 of Notes to the ConsolidatedFinancial Statements in this Annual Report on Form 10-K.

 

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

 

None.

 

**Item 9A. CONTROLS AND PROCEDURES**

 

**ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures:**Under the supervision and with theparticipation of our management, including our principal executive officer andprincipal financial officer, we conducted an evaluation of the effectiveness ofour disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended (the Exchange Act). Basedon this evaluation, our principal executive officer and our principal financialofficer concluded that, as of the end of the period covered by this annualreport, our disclosure controls and procedures were effective, in that theyprovide reasonable assurance that information required to be disclosed by us inthe reports we file or submit, under the Exchange Act, is recorded, processed,summarized and reported within the time period specified in the Securities andExchange Commission’s rules and forms.

 

**Management’s Report on Internal ControlOver Financial Reporting:**  Management is responsible for establishing andmaintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and15d – 15(f) under the Securities Exchange Act of 1934, as amended). Underthe supervision and with the participation of the Company’s management,including our principal executive officer and principal financial officer, weconducted an evaluation of the effectiveness of our internal control overfinancial reporting based on the framework set forth by the Committee ofSponsoring Organizations of the Treadway Commission (“COSO”) in *Internal Control-Integrated Framework*. Based on ourevaluation under the framework in *Internal Control-Integrated Framework*, our management concluded that our internalcontrol over financial reporting was effective as of January 28, 2006.

 

The Company’s independent registered public accountingfirm, KPMG LLP, have issued an audit report on the Company’s assessment of theeffectiveness of internal control over financial reporting as of January 28,2006, which is included in Item 8 of this Annual Report on Form 10-Kand incorporated herein by reference.

 

**Changes in Controls and Procedures:**No change in our internalcontrol over financial reporting occurred during the quarterly period ended January 28,2006 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**Item 9B. Other Information**

 

Noevents have occurred which would require disclosure under this Item.

 

27

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**PART III**

 

**Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

(a) Identificationof Directors

 

Incorporatedherein by reference is the information appearing under the captions “Electionof Directors” and “Board of Directors Meetings and Its Committees” in theCompany’s definitive Proxy Statement for the Registrant’s 2006 Annual Meetingof Shareholders to be filed with the Securities and Exchange Commission within120 days after January 28, 2006.

 

(b) Identificationof Executive Officers

 

Incorporatedherein by reference is the information appearing under the caption “ExecutiveOfficers and Compensation” in the Company’s definitive Proxy Statement for theRegistrant’s 2006 Annual Meeting of Shareholders to be filed with theSecurities and Exchange Commission within 120 days after January 28, 2006.

 

(c) Codeof Ethics

 

Wehave adopted the Trans World Entertainment Corporation Code of Ethics thatapplies to all officers, directors, employees and consultants of the Company.The Code of Ethics is intended to comply with Item 406 of Regulation S-Kof the Securities Exchange Act of 1934 and with applicable rules of TheNASDAQ Stock Market, Inc. Our Code of Ethics is posted on our Internetwebsite under the “Corporate” page. Our Internet website address iswww.twec.com. To the extent required or permitted by the rules of the SECand Nasdaq, we will disclose amendments and waivers relating to our Code ofEthics in the same place as our website.

 

**Item 11. EXECUTIVE COMPENSATION**

 

Incorporated herein by reference is the informationappearing under the caption “Executive Officers and Compensation” in theCompany’s definitive Proxy Statement for the Registrant’s 2006 Annual Meetingof Shareholders to be filed with the Securities and Exchange Commission within120 days after January 28, 2006.

 

**Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENTAND RELATED STOCKHOLDER MATTERS**

 

Incorporatedherein by reference is the information appearing under the captions “EquityOwnership of Directors and Executive Officers” and “Principal Shareholders” inthe Company’s definitive Proxy Statement for the Registrant’s 2006 AnnualMeeting of Shareholders to be filed with the Securities and Exchange Commissionwithin 120 days after January 28, 2006.

 

Informationon Trans World Entertainment Common Stock authorized for issuance under equitycompensation plans is contained in our Proxy Statement for our 2006 AnnualMeeting of Shareholders under the caption “Stock Option Plans” and isincorporated herein by reference. See Note 9 of Notes to the ConsolidatedFinancial Statements in this Annual Report on Form 10-K for a descriptionof the Company’s employee stock option plans.

 

**Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

Incorporatedherein by reference is the information appearing under the caption “RelatedParty Transactions” in the Company’s definitive Proxy Statement for theRegistrant’s 2006 Annual Meeting of Shareholders to be filed with theSecurities and Exchange Commission within 120 days after January 28, 2006.

 

**Item 14. PRINCIPAL ACCOUNTING FEES AND SERVICES**

 

Incorporated herein by reference is the informationappearing under the caption “Other Matters” in the Company’s definitive ProxyStatement for the Registrant’s 2006 Annual Meeting of Shareholders to be filedwith the Securities and Exchange Commission within 120 days after January 28,2006.

 

28

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**PART IV**

 

**Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K**

 

15(a) (1) Financial Statements

 

Theconsolidated financial statements and notes are listed in the Index toFinancial Statements on page F-1 of this report.

 

15(a) (2) Financial Statement Schedules

 

Consolidatedfinancial statement schedules not filed herein have been omitted as they arenot applicable or the required information or equivalent information has beenincluded in the consolidated financial statements or the notes thereto.

 

15(a) (3) Exhibits

 

Exhibitsare as set forth in the “Index to Exhibits” which follows the Notes to theConsolidated Financial Statements and immediately precedes the exhibits filed.

 

15(b) Reports on Form 8-K

 

A Form 8-Kwas filed on November 10, 2005, incorporating by reference Trans WorldEntertainment’s November 10, 2005 press release announcing the Company’sfinancial results for its third quarter ended October 29, 2005.

 

A Form 8-K/Awas filed on December 21, 2005, incorporating by reference Trans WorldEntertainment’s press release dated December 20, 2006, announcing theacceleration of vesting of “underwater” unvested stock options held byemployees and executive officers.

 

A Form 8-Kwas filed on January 4, 2006, incorporating be reference Trans WorldEntertainment’s January 4, 2006 press release announcing the Company’sfinancial results for the five and nine-week periods ending December 31,2005.

 

A Form 8-Kwas filed on January 10, 2006, incorporating be reference Trans WorldEntertainment’s January 5, 2006 press release announcing the Company’s  new five year, $100 million revolving securedcredit facility agreement (“Credit Agreement”) with Bank of America, N.A.

 

A Form 8-Kwas filed on February 22, 2006, incorporating by reference Trans WorldEntertainment’s February 17, 2006 entry into an Asset Purchase Agreementwith Musicland Holding Corp. and the related press release announcing the sameevent.

 

A Form 8-Kwas filed on March 9, 2006, incorporating by reference Trans WorldEntertainment’s March 9, 2006 press release announcing the Company’sfinancial results for its fourth quarter and year ended January 28, 2006.

 

A Form 8-Kwas filed on March 23, 2006, incorporating by reference Trans World Entertainment’sMarch 22, 2006 press release announcing the approval by the United StatesBankruptcy Court for the Southern District of New York of the Company’s bid toacquire all of the assets of Musicland Holding Corp.

 

A Form 8-Kwas filed on March 29, 2006, incorporating by reference Trans WorldEntertainment’s March 29, 2006 press release announcing the completion ofthe Company’s acquisition of Musicland stores and the First Amendment to theCompany’s Credit Agreement with Bank of America N.A.

 

A Form 8-Kwas filed on March 30, 2006, incorporating by reference Trans WorldEntertainment’s March 30, 2006 press release announcing the Company’s acquisitionof a majority interest in Mix and Burn LLC, a provider of digital content services.

 

15(c) Exhibits

 

Exhibitsare as set forth in the “Index to Exhibits” which follows the Notes to theConsolidated Financial Statements and immediately precedes the exhibits filed.

 

15(d) Other Financial Statements

Notapplicable.

 

29

----

 

**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|   |                | TRANS WORLD ENTERTAINMENT CORPORATION |
|--------|---------------------|---------------------------------------|
|   |                |                                  |
|   |                |                                  |   |   |
| Date:  | April 13, 2006 |                                  |  By: /s/ ROBERT J. HIGGINS |   |
|   |                |                                  | Robert J. Higgins |
|   |                |                                  | Chairman and Chief Executive Officer |
|        |                     |                                       |  |  |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| **Name**                          | ** ** | **Title**                                                        | ** **                                           | **Date**            |
|-----------------------------------|------------|------------------------------------------------------------------|------------------------------------------------------|---------------------|
| /s/ ROBERT J. HIGGINS             |       |                                                             | Chairman and Chief Executive Officer                 |                | April 13, 2006 |
|  (Robert J. Higgins)         |       | (Principal Executive Officer)                                    |                                                 |                |
|                              |       |                                                             |                                                 |                |
| /s/ JOHN J. SULLIVAN              |       |                                                             | Executive Vice President and Chief Financial Officer |                | April 13, 2006 |
|  (John J. Sullivan)          |       | (Principal Financial and Chief Accounting Officer) and Secretary |                                                 |                |
|                              |       |                                                             |                                                 |                |
| /s/ MARK A. COHEN                 |       |                                                             | Director                                             |                | April 13, 2006 |
|  (Mark A. Cohen)             |       |                                                             |                                                 |                |
|                              |       |                                                             |                                                 |                |
| /s/ MARTIN E. HANAKA              |       |                                                             | Director                                             |                | April 13, 2006 |
|  (Martin E. Hanaka)          |       |                                                             |                                                 |                |
|                              |       |                                                             |                                                 |                |
| /s/ ISAAC KAUFMAN                 |       |                                                             | Director                                             |                | April 13, 2006 |
|  (Isaac Kaufman)             |       |                                                             |                                                 |                |
|                              |       |                                                             |                                                 |                |
| /s/ DR. JOSEPH G. MORONE     |       | Director                                                         |                                                 | April 13, 2006 |
|  (Dr. Joseph G. Morone) |       |                                                             |                                                 |                |
|                              |       |                                                             |                                                 |                |
| /s/ LORI SCHAFER                  |       |                                                             | Director                                             |                | April 13, 2005 |
|  (Lori Schafer)              |       |                                                             |                                                 |                |
|                              |       |                                                             |                                                 |                |
| /s/ MICHAEL B. SOLOW              |       |                                                             | Director                                             |                | April 13, 2006 |
|  (Michael B. Solow)          |       |                                                             |                                                 |                |
|                              |       |                                                             |                                                 |                |
| /s/ EDMOND THOMAS                 |       |                                                             | Director                                             |                | April 13, 2006 |
|  (Edmond Thomas)             |       |                                                             |                                                 |                |
|                                   |            |                                                                  |                                                      |                     |  |  |  |  |  |  |  |

 

30

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**TRANS WORLD ENTERTAINMENTCORPORATION**

**INDEX TO CONSOLIDATED FINANCIALSTATEMENTS**

 
| Reports of  Independent Registered Public Accounting Firm                                                                                                                           |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                |   |
| **Consolidated Financial Statements**                                                                                                                                               |   |
|                                                                                                                                                                                |   |
| Consolidated Balance Sheets at January 28,  2006 and January 29, 2005                                                                                                     |   |
|                                                                                                                                                                                |   |
| Consolidated Statements of  Operations - Fiscal years ended January 28, 2006, January 29, 2005,  and January 31, 2004                                                |   |
|                                                                                                                                                                                |   |
| Consolidated Statements of  Shareholders’ Equity and Comprehensive Income (Loss) - Fiscal years ended January 28,  2006, January 29, 2005, and January 31, 2004 |   |
|                                                                                                                                                                                |   |
| Consolidated Statements of  Cash Flows - Fiscal years ended January 28, 2006, January 29, 2005,  and January 31, 2004                                                |   |
|                                                                                                                                                                                |   |
| Notes to Consolidated  Financial Statements                                                                                                                                         |   |

 

F-1

----

 

**Report ofIndependent Registered Public Accounting Firm**

 

TheBoard of Directors and Shareholders

TransWorld Entertainment Corporation:

 

Wehave audited the accompanying consolidated balance sheets of Trans WorldEntertainment Corporation and subsidiaries as of January 28, 2006 and January 29,2005, and the related consolidated statements of operations, shareholders’equity and comprehensive income (loss), and cash flows for each of the fiscalyears in the three-year period ended January 28, 2006. These consolidatedfinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Trans WorldEntertainment Corporation and subsidiaries as of January 28, 2006 and January 29,2005, and the results of their operations and their cash flows for each of thefiscal years in the three-year period ended January 28, 2006, inconformity with U.S. generally accepted accounting principles.

 

Asdiscussed in note 2 to the consolidated financial statements, the Companychanged its method of accounting for conditional asset retirement obligationsassociated with operating leases, effective January 28, 2006.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of Trans WorldEntertainment Corporation’s internal control over financial reporting as of January 28,2006, based on criteria established in *InternalControl – Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), and our report dated April 13,2006 expressed an unqualified opinion on management’s assessment of, and theeffective operation of, internal control over financial reporting.

 

 
| /s/ KPMG LLP        |   |
|---------------------|--------|
|                |
| Albany, New York    |
| April 13, 2006 |

 

F-2

----

 

**Report of Independent RegisteredPublic Accounting Firm**

 

TheBoard of Directors and Stockholders

TransWorld Entertainment Corporation:

 

Wehave audited management’s assessment, included in the accompanying Management’sReport on Internal Control Over Financial Reporting, that Trans WorldEntertainment Corporation and subsidiaries maintained effective internalcontrol over financial reporting as of January 28, 2006, based on criteriaestablished 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 effectiveinternal control over financial reporting, and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. Our audit included obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

Acompany’s internal control over financial reporting is a process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles. A company’s internal controlover financial reporting includes those policies and procedures that (1) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls may becomeinadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate.

 

In ouropinion, management’s assessment that Trans World Entertainment Corporation andsubsidiaries maintained effective internal control over financial reporting asof January 28, 2006, is fairly stated, in all material respects, based oncriteria established in *InternalControl—Integrated Framework* issued by COSO. Also, in our opinion,Trans World Entertainment Corporation and subsidiaries maintained, in allmaterial respects, effective internal control over financial reporting as of January 28,2006, based on criteria established in *InternalControl—Integrated Framework* issued by COSO.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofTrans World Entertainment Corporation and subsidiaries as of January 28,2006 and January 29, 2005, and the related consolidated statements ofoperations, shareholders’ equity and comprehensive income (loss), and cashflows for each of the fiscal years in the three-year period ended January 28,2006, and our report dated April 13, 2006 expressed a unqualified opinionon those consolidated financial statements.

 

 
| /s/  KPMG LLP        |   |
|----------------------|--------|
|                 |
|                 |
| Albany,  New York    |
| April 13,  2006 |

 

F-3

----

 

**TRANS WORLD ENTERTAINMENTCORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**($ in thousands)**

 
| ** **                                                                                                                                     | ** ** | **January 28,  2006** | ** ** | **January 29,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                     |       |                       |       |                       |       |
| CURRENT ASSETS                                                                                                                                 |       |                       |       |                       |       |
| Cash and cash equivalents                                                                                                                      |       | $                          | 197,209    |                       | $          | 229,768 |   |
| Accounts receivable                                                                                                                            |       | 8,671                      |       | 6,202                      |       |
| Merchandise inventory                                                                                                                          |       | 402,712                    |       | 431,246                    |       |
| Income taxes receivable                                                                                                                        |       | 892                        |       | —                     |       |
| Prepaid expenses and other                                                                                                                     |       | 5,737                      |       | 6,804                      |       |
| Deferred taxes                                                                                                                                 |       | 11,266                     |       | 15,526                     |       |
| Total current assets                                                                                                                           |       | 626,487                    |       | 689,546                    |       |
|                                                                                                                                           |       |                       |       |                       |       |
| FIXED ASSETS, net                                                                                                                              |       | 132,464                    |       | 130,196                    |       |
|                                                                                                                                           |       |                       |       |                       |       |
| DEFERRED TAXES                                                                                                                                 |       | 27,511                     |       | 25,230                     |       |
| OTHER ASSETS                                                                                                                                   |       | 13,861                     |       | 14,681                     |       |
| TOTAL ASSETS                                                                                                                                   |       | $                          | 800,323    |                       | $          | 859,653 |   |
|                                                                                                                                           |       |                       |       |                       |       |
| **LIABILITIES**                                                                                                                                |       |                       |       |                       |       |
| CURRENT LIABILITIES                                                                                                                            |       |                       |       |                       |       |
| Accounts payable                                                                                                                               |       | $                          | 322,831    |                       | $          | 358,396 |   |
| Income taxes payable                                                                                                                           |       | —                     |       | 8,592                      |       |
| Accrued expenses and other                                                                                                                     |       | 42,530                     |       | 43,712                     |       |
| Current portion of long-term debt                                                                                                              |       | 477                        |       | 448                        |       |
| Current portion of capital lease  obligations                                                                                                  |       | 3,182                      |       | 332                        |       |
| Total current liabilities                                                                                                                      |       | 369,020                    |       | 411,480                    |       |
|                                                                                                                                           |       |                       |       |                       |       |
| LONG —TERM DEBT, less current  portion                                                                                                    |       | 4,587                      |       | 5,060                      |       |
| CAPITAL LEASE OBLIGATIONS, less  current portion                                                                                               |       | 14,887                     |       | 6,977                      |       |
| DEFERRED RENT AND OTHER  LIABILITIES                                                                                                           |       | 33,317                     |       | 31,813                     |       |
| TOTAL LIABILITIES                                                                                                                              |       | 421,811                    |       | 455,330                    |       |
|                                                                                                                                           |       |                       |       |                       |       |
| **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; 55,727,575 shares and 55,014,598 shares issued  in 2005 and 2004, respectively) |       | 557                        |       | 550                        |       |
| Additional paid-in capital                                                                                                                     |       | 298,699                    |       | 292,922                    |       |
| Unearned compensation –  restricted stock                                                                                                 |       | (30                        | )          | (46                        | )          |
| Accumulated other comprehensive  loss                                                                                                          |       | (2,048                     | )          | (1,094                     | )          |
| Treasury stock at cost  (25,104,990 and 21,988,949 shares in 2005 and 2004, respectively)                                                      |       | (217,564                   | )          | (186,298                   | )          |
| Retained earnings                                                                                                                              |       | 298,898                    |       | 298,289                    |       |
| TOTAL SHAREHOLDERS’ EQUITY                                                                                                                |       | 378,512                    |       | 404,323                    |       |
| TOTAL LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                               |       | $                          | 800,323    |                       | $          | 859,653 |   |

 

*See Notes to Consolidated Financial Statements.*

 

F-4

----

 

**TRANS WORLD ENTERTAINMENTCORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**($ in thousands, except per shareamounts)**

 
| ** **                                                                                                                                    | ** ** | **Fiscal Year Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **January 28,  2006**      | ** ** | **January 29,  2005** | ** ** | **January 31,  2004** | ** ** |
| ** **                                                                                                                                    | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Sales                                                                                                                                         |       | $                               | 1,238,486  |   | $ | 1,365,133 |   | $ | 1,330,626 |   |
| Cost of sales                                                                                                                                 |       | 806,873                         |       | 869,999 |   | 842,726 |   |
| Gross profit                                                                                                                                  |       | 431,613                         |       | 495,134 |   | 487,900 |   |
| Selling, general and  administrative expenses                                                                                                 |       | 426,854                         |       | 450,162 |   | 459,441 |   |
| Income from operations                                                                                                                        |       | 4,759                           |       | 44,972 |   | 28,459 |   |
| Interest expense                                                                                                                              |       | 2,954                           |       | 2,444 |   | 2,147 |   |
| Other income                                                                                                                                  |       | (2,171                          | )          | (1,039 | ) | (718 | ) |
| Income before income taxes,  extraordinary gain – unallocated negative goodwill and cumulative effect of  change in accounting principle |       | 3,976                           |       | 43,567 |   | 27,030 |   |
| Income tax expense                                                                                                                            |       | 1,090                           |       | 4,892 |   | 8,302 |   |
| Income before extraordinary gain –  unallocated negative goodwill and cumulative effect of a change in accounting  principle             |       | 2,886                           |       | 38,675 |   | 18,728 |   |
| Extraordinary gain – unallocated  negative goodwill, net of income taxes of $1,979 and $2,437 in 2004 and 2003,  respectively            |       | —                          |       | 3,166 |   | 4,339 |   |
| Cumulative effect of a change in  accounting principle, net of income taxes of $1,505 million in 2005                                         |       | (2,277                          | )          | — |   | — |   |
| NET INCOME                                                                                                                                    |       | $                               | 609        |   | $ | 41,841 |   | $ | 23,067 |   |
| BASIC EARNINGS PER SHARE:                                                                                                                     |       |                            |       |   |   |   |   |
| Earnings per share before  extraordinary gain – unallocated negative goodwill and cumulative effect of a  change in accounting principle |       | $                               | 0.09       |   | $ | 1.12 |   | $ | 0.50 |   |
| Extraordinary gain – unallocated  negative goodwill                                                                                      |       | —                          |       | 0.09 |   | 0.12 |   |
| Cumulative effect of a change in  accounting principle                                                                                        |       | (0.07                           | )          | — |   | — |   |
| Basic earnings per share                                                                                                                      |       | $                               | 0.02       |   | $ | 1.21 |   | $ | 0.62 |   |
|                                                                                                                                          |       |                            |       |   |   |   |   |
| Weighted average number of common  shares outstanding – basic                                                                            |       | 31,962                          |       | 34,531 |   | 37,422 |   |
|                                                                                                                                          |       |                            |       |   |   |   |   |
| DILUTED EARNINGS PER SHARE:                                                                                                                   |       |                            |       |   |   |   |   |
| Earnings per share before  extraordinary gain – unallocated negative goodwill and cumulative effect of a  change in accounting principle |       | $                               | 0.09       |   | $ | 1.06 |   | $ | 0.49 |   |
| Extraordinary gain – unallocated  negative goodwill                                                                                      |       | —                          |       | 0.09 |   | 0.11 |   |
| Cumulative effect of a change in  accounting principle                                                                                        |       | (0.07                           | )          | — |   | — |   |
| Diluted earnings per share                                                                                                                    |       | $                               | 0.02       |   | $ | 1.15 |   | $ | 0.60 |   |
|                                                                                                                                          |       |                            |       |   |   |   |   |
| Weighted average number of common  shares outstanding – diluted                                                                          |       | 32,132                          |       | 36,297 |   | 38,209 |   |

 

*See Notes to Consolidated FinancialStatements.*

 

F-5

----

 

**TRANS WORLD ENTERTAINMENTCORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)**

**($ in thousands)**

 
| ** **                                                                                                         | ** ** | **Common  Shares** | ** ** | **Stock  Amount** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Unearned  Compensation  Restricted  Stock** | ** ** | **Treasury  Shares** |   | **Stock  Amount** | ** ** | **Accum.  Other  Comp.  Loss** | ** ** | **Retained  Earnings** | ** ** | **Shareholders’  Equity** |   |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|----------------------------------|------------|-----------------------------------------------|------------|----------------------|--------|-------------------|------------|--------------------------------|------------|------------------------|------------|--------------------------------|--------|
| Balance as of  February 1, 2003                                                                          |       | 54,046             |       | $                 | 540        |                             | $          | 287,402                                       |       | $                    | (116   | )                 | (15,105    | )                              | $          | (129,103               | )          | —                         |   | $ | 233,381 |   | $ | 392,104 |   |
| Net income                                                                                                         |       | —             |       | —            |       | —                           |       | —                                        |       | —               |   | —            |       | —                         |       | 23,067                 |       | 23,067                         |   |
| Repurchase of shares of treasury  stock                                                                            |       | —             |       | —            |       | —                           |       | —                                        |       | (3,042               | )      | (16,952           | )          | —                         |       | —                 |       | (16,952                        | )      |
| Amortization of unearned  compensation – restricted stock                                                     |       | —             |       | —            |       | —                           |       | 93                                            |       | —               |   | —            |       | —                         |       | —                 |       | 93                             |   |
| Issuance of stock to Directors                                                                                     |       | —             |       | —            |       | 50                               |       | —                                        |       | —               |   | —            |       | —                         |       | —                 |       | 50                             |   |
| Exercise of stock options and  related tax benefit                                                                 |       | 200                |       | 2                 |       | 820                              |       | —                                        |       | —               |   | —            |       | —                         |       | —                 |       | 822                            |   |
| 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 income (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 |   |

 

*See Notes to Consolidated Financial Statements.*

 

F-6

----

 

**TRANS WORLD ENTERTAINMENTCORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**($ in thousands)**

 
| ** **                                                                         | ** ** | **Fiscal Year Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **January 28,**            | ** ** | **January 29,** | ** ** | **January 31,** | ** ** |
| ** **                                                                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| OPERATING ACTIVITIES:                                                              |       |                            |       |   |   |   |   |
| Net income                                                                         |       | $                               | 609        |   | $ | 41,841 |   | $ | 23,067 |   |
| Adjustments to reconcile net  income to net cash provided by operating activities: |       |                            |       |   |   |   |   |
| Depreciation and amortization of  fixed assets                                     |       | 37,069                          |       | 39,796 |   | 40,539 |   |
| Amortization of intangible assets                                                  |       | 94                              |       | 47 |   | — |   |
| Amortization of lease valuations,  net                                             |       | (428                            | )          | (844 | ) | (893 | ) |
| Stock compensation programs                                                        |       | 319                             |       | 90 |   | 143 |   |
| Loss on disposal of fixed assets                                                   |       | 2,538                           |       | 2,848 |   | 2,544 |   |
| Loss on impairment of fixed  assets                                                |       | —                          |       | — |   | 3,682 |   |
| Gain on sale of available for  sale securities                                     |       | (813                            | )          | — |   | — |   |
| Deferred tax expense (benefit)                                                     |       | 4,186                           |       | 6,948 |   | (4,106 | ) |
| Cumulative effect of change in  accounting principle, net of income taxes          |       | 2,277                           |       | — |   | — |   |
| Extraordinary gain on acquisition  of businesses, net of income taxes              |       | —                          |       | (3,166 | ) | (4,339 | ) |
| Changes in operating assets and  liabilities, net of effects of acquisitions:      |       |                            |       |   |   |   |   |
| Accounts receivable                                                                |       | (2,469                          | )          | 2,980 |   | 1,009 |   |
| Merchandise inventory                                                              |       | 28,534                          |       | (4,009 | ) | 5,275 |   |
| Prepaid expenses and other                                                         |       | 1,067                           |       | (104 | ) | (1,218 | ) |
| Other assets                                                                       |       | 544                             |       | (2,777 | ) | (353 | ) |
| Accounts payable                                                                   |       | (35,565                         | )          | 52,098 |   | (20,661 | ) |
| Income taxes receivable/(payable)                                                  |       | (7,863                          | )          | (15,151 | ) | 12,479 |   |
| Accrued expenses and other                                                         |       | (2,831                          | )          | (10,442 | ) | 12,849 |   |
| Deferred rent and other  liabilities                                               |       | (2,021                          | )          | (4,224 | ) | (3,134 | ) |
| Net cash provided by operating  activities                                         |       | 25,247                          |       | 105,931 |   | 66,883 |   |
|                                                                               |       |                            |       |   |   |   |   |
| INVESTING ACTIVITIES:                                                              |       |                            |       |   |   |   |   |
| Purchases of fixed assets                                                          |       | (41,330                         | )          | (33,398 | ) | (16,989 | ) |
| Acquisition of businesses                                                          |       | —                          |       | (2,000 | ) | (37,044 | ) |
| Proceeds from sale of  available-for-sale securities                               |       | 813                             |       | — |   | — |   |
| Net cash used by investing  activities                                             |       | (40,517                         | )          | (35,398 | ) | (54,033 | ) |
|                                                                               |       |                            |       |   |   |   |   |
| FINANCING ACTIVITIES:                                                              |       |                            |       |   |   |   |   |
| Proceeds from long-term debt                                                       |       | —                          |       | 5,760 |   | — |   |
| Proceeds from capital lease  obligations                                           |       | 12,877                          |       | — |   | — |   |
| Payments of long-term debt                                                         |       | (444                            | )          | (252 | ) | — |   |
| Payments of capital lease obligations                                              |       | (2,117                          | )          | (551 | ) | (1,640 | ) |
| Payments of debt issue costs                                                       |       | (495                            | )          |   |   |   |   |
| Payments for purchases of  treasury stock                                          |       | (31,270                         | )          | (40,247 | ) | (16,952 | ) |
| Proceeds from exercise of stock  options                                           |       | 4,160                           |       | 2,603 |   | 614 |   |
| Net cash used by financing  activities                                             |       | (17,289                         | )          | (32,687 | ) | (17,978 | ) |
|                                                                               |       |                            |       |   |   |   |   |
| Net increase (decrease) in cash  and cash equivalents                              |       | (32,559                         | )          | 37,846 |   | (5,128 | ) |
| Cash and cash equivalents,  beginning of year                                      |       | 229,768                         |       | 191,922 |   | 197,050 |   |
| Cash and cash equivalents, end of  year                                            |       | 197,209                         |       | 229,768 |   | $ | 191,922 |   |
| Supplemental disclosure of  non-cash investing and financing activities:           |       |                            |       |   |   |   |   |
| Issuance of stock under incentive  stock programs                                  |       | $                               | 7          |   | $ | 10 |   | — |   |
| Issuance of restricted shares  under restricted stock plan                         |       | —                          |       | 51 |   | — |   |
| Income tax benefit resulting from  exercises of stock options                      |       | 1,621                           |       | 1,946 |   | 208 |   |

 

*See Notes to Consolidated Financial Statements.*

 

F-7

----

 

**TRANS WORLD ENTERTAINMENTCORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1. Nature of Operations and Summary of Significant AccountingPolicies**

 

**Nature of Operations:** Trans World Entertainment Corporation and subsidiaries (“the Company”) isone of the largest specialty retailers of music, video, video games and relatedproducts in the United States. The Company operates a chain of retailentertainment stores and e-commerce sites, **www.fye.com**, **www.coconuts.com, www.wherehouse.com,** and **www.secondspin.com,** in a single industry segment. As of January 28,2006, the Company operated 782 stores totaling approximately 4.8 million squarefeet in 46 states, the District of Columbia, the Commonwealth of Puerto Ricoand the U.S. Virgin Islands, with a majority of the stores concentrated in theeastern half of the United States. The Company’s business is seasonal innature, with the peak selling period being the holiday season in the Company’sfourth fiscal quarter.

 

**Basis of Presentation:** The consolidated financial statements consist of Trans WorldEntertainment Corporation, its wholly-owned subsidiary, Record Town, Inc.(“Record Town”), and Record Town’s subsidiaries, all of which are wholly-owned.During 2005, the Company acquired an 80% interest in a newly formed companythat is fully consolidated for financial reporting purposes. All significantintercompany accounts and transactions have been eliminated. Certain amounts inpreviously issued consolidated financial statements were reclassified to conform to2005 presentation. The preparation of financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements, and the reported amountsof revenues and expenses during the reporting period. Actual results coulddiffer from those estimates.

 

**Items Affecting Comparability: **The Company’s fiscal year is a 52 or 53-week periodending the Saturday nearest to January 31. Fiscal 2005, 2004, and 2003ended January 28, 2006, January 29, 2005, and January 31, 2004,respectively, and each fiscal year consisted of 52 weeks.

 

On February 7,2005 the Office of the Chief Accountant of the U.S. Securities and ExchangeCommission issued a clarification of their interpretation of certain accountingissues and their application under U.S. generally accepted accountingprinciples relating to operating leases. After an internal review and discussionwith its independent auditors, the Company determined its then current methodof accounting for allowances provided by landlords to fund leaseholdimprovements needed to be revised. Historically, the Company accounted forthese allowances as reductions to the related leasehold improvements on its ConsolidatedBalance Sheets and as a reduction of related investing activities on its ConsolidatedStatements of Cash Flows. Management revised its method of accounting in 2004for these allowances to record them as deferred credits (“deferred rent”) onits Consolidated Balance Sheets and as a component of operating activities onits Consolidated Statements of Cash Flows. See Note 4 to the ConsolidatedFinancial Statements for detailed discussion.

 

TheCompany adopted FASB Interpretation No. (“FIN”) 47, *Accountingfor Conditional Asset Retirement Obligations—an interpretation of FASBStatement No. 143*, effective January 28, 2006. Inaccordance with FIN 47, the Company recorded an asset and a correspondingliability for the present value of the estimated asset retirement obligationsassociated with the fixed assets and leasehold improvements at its storelocations that arise under the terms of operating leases. See Note 2 to theConsolidated Financial Statements for detailed discussion.

 

**Revenue Recognition:**  The Company’s revenue is primarily fromretail sales of merchandise inventory. Revenue is recognized at the point-of-sale.Internet sales are recognized as revenue upon delivery to and acceptance by thecustomer. Loyalty card revenue is amortized over the life of the card. Salesare recorded net of estimated amounts for sales returns and other allowances.Shipping and handling fee income from the Company’s Internet operations isrecognized as net sales. The Company records shipping and handling costs incost of goods sold.

 

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

 

**Accounts Receivable:**Accounts receivable are comprised of receivables and unbilled revenuesfrom advertising services performed for third parties, and amounts due underoperating or service agreements with unaffiliated entities, loans to relatedbusiness ventures, and other, individually insignificant amounts. There are noprovisions for uncollectible amounts from retail sales of merchandise inventorysince payment is received at the time of sale.

 

**Cost of Sales:** Inaddition to the cost of product, the Company includes in cost of sales thosecosts associated with purchasing, receiving, shipping, inspecting and warehousingproduct. Also included are costs associated with the return of product tovendors. Cost of sales further includes the cost of inventory shrink andobsolescence and the benefit of vendor allowances and discounts.

 

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

 

F-8

----

 

**Vendor Allowances:**TheCompany often receives allowances from its vendors to fund in-store displays,print advertising and other promotional events. The Company accounts for vendorallowances in accordance with the provisions of the Financial AccountingStandards Board’s (“FASB’s”) Emerging Issues Task Force (“EITF”) Issue No. 02-16,*Accounting by a Customer (Including a Reseller) forCertain Consideration Received from a Vendor*. Vendor advertisingallowances which exceed specific, incremental and identifiable costs incurredin relation to the advertising and promotions offered by the Company to itsvendors are classified as a reduction in the purchase price of merchandiseinventory.

 

**Lease Accounting:**  In 2004, the Company revised its method ofaccounting for rent expense (and related deferred rent liability) and leaseholdimprovements funded by landlord incentives for allowances under operatingleases (tenant improvement allowances) to conform to GAAP, as clarified bythe Chief Accountant of the SEC in a February 2005 letter to the AmericanInstitute of Certified Public Accountants. For all stores, the Company hadcalculated straight-line rent expense using the initial lease term, but wasgenerally depreciating leasehold improvements over the shorter of theirestimated useful lives or the initial lease term plus the option periods. TheCompany corrected its calculation of straight-line rent expense to include theimpact of escalating rents for periods in which it is reasonably assured ofexercising lease options and to include in the lease term any period duringwhich the Company is not obligated to pay rent while the store is beingconstructed (“rent holiday”). The Company also corrected its calculation ofdepreciation expense for leasehold improvements for those leases which do notinclude an option period. This resulted in rent expense being recorded at an earlierdate for each lease and reduced future monthly rent expense, as the total rentdue under the lease was recognized over a greater number of months. The Companyaccounts for step rent provisions, escalation clauses and other leaseconcessions by recognizing these amounts on a straight line basis over theinitial lease term. See Note 4 to the Consolidated Financial Statements forfurther detail.

 

**Conditional Asset Retirement Obligations:**The Company recordsthe fair value of an asset retirement obligation (“ARO”) as a liability in theperiod in which it incurs a legal obligation associated with the retirement oftangible long-lived assets that result from the acquisition, construction,development, and/or normal use of the asset. The Company also records acorresponding asset that is depreciated over the life of the asset. Subsequentto the initial measurement of the ARO, the ARO is adjusted at the end of eachperiod to reflect the passage of time and changes in the estimated future cashflows underlying the obligation. The Company adopted FIN 47, *Accounting for Conditional Asset Retirement Obligations—aninterpretation of FASB Statement No. 143*, effective January 28,2006. In accordance with FIN 47, the Company recorded an asset and acorresponding liability for the present value of the estimated asset retirementobligations associated with the fixed assets and leasehold improvements at itsstore locations that arise under the terms of operating leases. See Note 2 tothe Consolidated Financial Statements.

 

**Concentration of Credit Risks:** The Company maintains centralizedcash management and investment programs whereby excess cash balances areinvested in short-term money market funds and instruments considered to be cashequivalents. The Company’s investment portfolio is diversified and consists ofshort-term investment grade securities consistent with its investmentguidelines. These guidelines include the provision that sufficient liquiditywill be maintained to meet anticipated cash flow needs. The Company maintains investmentswith various financial institutions. These amounts often exceed the FDIC insurancelimits. The Company limits the amount of credit exposure with any one financialinstitution and believes that no significant concentration of credit riskexists with respect to cash investments.

 

**Concentration of Business Risks:**The Company purchases inventory for its stores fromapproximately 900 suppliers, with approximately 71% of purchases being madefrom ten suppliers: EMD (EMI Music Distribution), Sony/BMG (Sony-BertelsmannMusic Group), WEA (Warner/Electra/Atlantic Corp.), UMVD (Universal Music andVideo Distribution), Fox Video Inc., Paramount Home Video, Buena Vista HomeVideo, Sony Computer Entertainment and Sony Pictures Home Entertainment.Historically,the Company has not experienced difficulty in obtaining satisfactory sources ofsupply, and management believes that it will retain access to adequate sourcesof 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 adecrease in vendor support for the Company’s advertising programs.

 

**Investments in Unconsolidated Affiliates:**Investments in unconsolidated affiliates have beenrecorded on the cost basis, with any decline in the market value below costthat is deemed other than temporary charged to operations. Write-off ofinvestments in unconsolidated affiliates for other than temporary decline inmarket value are reflected in SG&A expenses in the Consolidated Statementsof Operations. There were no write-off of investments in unconsolidatedaffiliates in 2005, 2004 and 2003.

 

**Merchandise Inventory and ReturnCosts:** Inventory is statedat the lower of cost or market as determined by the average cost method.Inventory valuation requires significant judgment and estimates, includingobsolescence, shrink and any adjustments to market value, if market value islower than cost. The Company records obsolescence and any adjustments to marketvalue (if lower than cost) based on current and anticipated demand, customerpreferences and market conditions. The provision for inventory shrink isestimated as a percentage of sales for the period from the last date a physicalinventory was performed to the end of the fiscal year. Such estimates are basedon historical results and trends, and the shrink results from the last physicalinventory. Physical inventories are taken at least annually for all storesthroughout the year, and inventory records are adjusted accordingly.

 

The Company is generally entitled to return merchandisepurchased from major vendors for credit against other purchases from thesevendors. Certain vendors reduce the credit with a merchandise return chargeranging from 0% to 20% of the original merchandise purchase price

 

F-9

----

 

depending on the type of merchandise being returned. Certainother vendors charge a handling fee based on units returned. The Companyrecords merchandise return charges in cost of sales.

 

**Fixed Assets and Depreciation:** Fixed assets are recorded at cost and depreciated or amortized over theestimated useful life of the asset using the straight-line method. The estimateduseful 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              |   | 30 years                                                       |

 

Majorimprovements and betterments to existing facilities and equipment arecapitalized. Expenditures for maintenance and repairs are expensed as incurred.A majority of the Company’s operating leases are ten years in term. Amortizationof capital lease assets is included in depreciation and amortization expense.

 

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

 

Impairmentlosses recorded in 2005, 2004 and 2003 were $0, $0 and $3.7 million,respectively. The 2003 amount, which is reflected in SG&A expenses in theConsolidated Statement of Operations, represents the write-down of the fixedassets of www.fye.com pursuant to the Company’s decision to outsource theoperation of its Web site. Losses for store closings in the ordinary course ofbusiness represent the write down of net book value of abandoned fixtures andleasehold improvements. The loss on disposal of fixed assets related to storeclosings was $2.2 million, $2.8 million and $2.5 million in 2005, 2004 and 2003,respectively, and is included in SG&A expenses. Losses due to the writedown of fixed assets related to store closings are included in loss on disposalof fixed assets in the Consolidated Statements of Cash Flows. Store closingsusually occur at the expiration of the lease, at which time leaseholdimprovements, which constitute a majority of the abandoned assets, are fullydepreciated. Also, actual store closures usually occur within three to sixmonths of the planned store closure date. As a result, changes in depreciationestimates as required by Accounting Principles Board, Opinion No. 20, *Accounting Changes* (“APB 20”), do not have a material impacton financial results.

 

**Advertising Costs:** The Company applies the guidance issued by theFASB’s Emerging Issues Task Force, EITF No. 02-16, *Accountingby a Customer**(Including a Reseller) forCertain Consideration Received from a Vendor*. Accordingly,advertising and sales promotion costs are charged to operations, offset bydirect vendor reimbursements, as incurred. Total advertising expense, excludingvendor allowances, were $22.0 million, $23.9 million, and $21.2 million in 2005,2004, and 2003 respectively. In the aggregate, vendor allowances supporting theCompany’s advertising and promotion included as a reduction of SG&A expensesas reimbursements of such costs in accordance with EITF No. 02-16 were $9.6million, $11.8 million, and $12.7 million in 2005, 2004, and 2003,respectively.

 

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

 

**Gift Cards:** TheCompany offers gift cards for sale. A deferred income account, which isincluded in accrued expenses and other in the Consolidated Balance Sheets, isestablished for gift cards issued. When gift cards are redeemed at the storelevel, revenue is recorded and the related liability is reduced. Breakage isestimated based on the historical relationship of the redemption of gift cardsredeemed to gift cards sold, over a certain period of time. The Company has theability to reasonably and reliably estimate gift card liability based onhistorical experience with redemption rates associated with a large volume of homogeneoustransactions, from a period of more than ten years. The Company’s estimate isnot susceptible to significant external factors and the circumstances aroundpurchases and redemptions have not changed significantly over time. The Companyrecorded breakage on its gift cards for 2005, 2004 and 2003 in the amount of $2.9million, $4.7 million and $3.5 million, respectively.

 

**Income Taxes:** Incometaxes are accounted for under the asset and liability method. Deferred taxassets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases, and taxoperating loss carryforwards. Deferred tax assets and liabilities are measuredusing enacted tax rates expected to apply to taxable income in the years inwhich those temporary differences are expected to be recovered or settled. Theeffect on deferred tax assets and liabilities of a change in tax rates isrecognized in the results of operations in the period that includes theenactment date. Deferred tax assets are subject to valuation allowances basedupon management’s estimates of realizability.

 

F-10

----

 

**Comprehensive Income (Loss):** The Company accounts for comprehensive income(loss) in accordance with Statement of Financial Accounting Standards (“SFAS”) No.130,*Reporting Comprehensive Income* andresults are presented within the Consolidated Statements of Shareholders’ Equityand Comprehensive Income (Loss). Comprehensive loss for 2005 consisted of net income,and the excess additional minimum pension liability over unrecognized priorservice cost. Comprehensive income for 2004 consisted of net income and theexcess additional minimum pension liability over unrecognized prior servicecost. In 2003, the Company did not have other items of comprehensive income asdefined by SFAS No.130, and accordingly, comprehensive income was equal to net income.

 

**Stock-Based Compensation:**  The Company applies the intrinsicvalue-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 – AnInterpretation of APB No. 25*, in accounting for its fixed plan stockoptions. Under this method, compensation expense is recorded on the date ofgrant only if the current market price of the underlying stock exceeds theexercise price. Unearned compensation recognized for restricted stock awards isshown as a separate component of shareholders’ equity and is amortized toexpense over the vesting period of the stock award using the straight-linemethod. SFAS No.123, *Accounting for Stock-BasedCompensation*, as amended by SFAS No.148, *Accountingfor Stock-Based Compensation – Transition and Disclosure,*established accounting and disclosure requirements using a fair value-basedmethod of accounting for stock-based employee compensation plans. As allowed bySFAS No.123, the Company has elected to continue to apply the intrinsicvalue-based method of accounting described above, and adopted the disclosurerequirements of SFAS No.123 and SFAS No.148. The Company will adopt the expenserecognition provisions of SFAS No.123(R), beginning with the first quarter ofits 2006 fiscal year that began on January 29, 2006.

 

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 will adopt on January 29, 2006. The acceleration of the vesting of these stock options will reduce the amounts recognized by the Company as share-based compensation expense, net of income taxes, by approximately $2.4 million in 2006, $1.9 million in 2007, $1.2 million in 2008, and $0.4 million in 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.

 

Thefollowing table illustrates the effect on net income (loss) and earnings (loss)per share if the Company had applied the fair value recognition provisions of SFASNo.123 to stock-based employee compensation for 2005, 2004 and 2003.

 
| ** **                                                                                                                                    | ** ** | **Fiscal Year**                                 | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                          | ** ** | **($ in thousands, except per  share amounts)** | ** ** |
| Net income, as reported                                                                                                                       |       | $                                                    | 609        |   | $ | 41,841 |   | $ | 23,067 |   |
| Add: Stock-based employee  compensation expense included in reported net income, net of related tax  effects                                  |       | 180                                                  |       | 159 |   | 93 |   |
| 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 | ) | (3,347 | ) |
| Pro forma net income (loss)                                                                                                                   |       | $                                                    | (6,732     | ) | $ | 39,081 |   | $ | 19,813 |   |
| Earnings (loss) per share:                                                                                                                    |       |                                                 |       |   |   |   |   |
| Basic - as reported                                                                                                                           |       | $                                                    | 0.02       |   | $ | 1.21 |   | $ | 0.62 |   |
| Basic– pro forma                                                                                                                         |       | $                                                    | (0.21      | ) | $ | 1.13 |   | $ | 0.53 |   |
| Diluted – as reported                                                                                                                    |       | $                                                    | 0.02       |   | $ | 1.15 |   | $ | 0.60 |   |
| Diluted – pro forma                                                                                                                      |       | $                                                    | (0.21      | ) | $ | 1.08 |   | $ | 0.52 |   |

 

Thefair values of the options granted have been estimated at the date of grantusing the Black Scholes option pricing model with the following assumptions:

 

F-11

----

 
| ** **                                                                | ** ** | **Stock Option Plan** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                | ** ** | **2005**                        | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dividend yield                                                            |       | 0%                              |       | 0% |   | 0% |   |
| Expected volatility                                                       |       | 55%                             |       | 57% |   | 59% |   |
| Risk-free interest rate                                                   |       | 3.71% - 4.34%                   |       | 3.71% |   | 3.16% |   |
| Expected option life in years                                             |       | 5 – 6.25                   |       | 5 |   | 5 |   |
| Weighted average fair value per  share of options granted during the year |       | $6.59                           |       | $3.49 |   | $1.16 |   |

 

**Earnings (Loss) Per Share:** Basic earnings (loss) per share is calculated by dividing net income(loss) by the weighted average common shares outstanding for the period. Dilutedearnings per share is calculated by dividing net income by the sum of theweighted average shares outstanding and additional common shares that wouldhave been outstanding if the dilutive potential common shares had been issuedfor the Company’s common stock options from the Company’s Stock Option Plans. SeeNote 9 to the Consolidated Financial Statements.

 

Thefollowing is a reconciliation of the basic weighted average number of sharesoutstanding to the diluted weighted average number of shares outstanding:

 
| ** **                                                 | ** ** | **Fiscal Year**    | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                 | ** ** | **(in thousands)** | ** ** |
| Weighted average common shares  outstanding – basic   |       | 31,962                  |       | 34,531 |   | 37,422 |   |
| Dilutive effect of employee stock  options                 |       | 170                     |       | 1,766 |   | 787 |   |
| Weighted average common shares  outstanding – diluted |       | 32,132                  |       | 36,297 |   | 38,209 |   |
|                                                       |       |                    |       |   |   |   |   |
| Antidilutive stock options                                 |       | 4,756                   |       | 1,631 |   | 5,322 |   |

 

Antidilutivestock options outstanding were excluded from the computation of dilutedearnings per share because the exercise price of the options was greater thanthe average market price of the common shares during the period.

 

**Fair Value of Financial Instruments:**The carrying amounts reported in the Consolidated BalanceSheets for cash and cash equivalents, accounts receivable, accounts payable andother current liabilities approximate fair value because of the immediate orshort-term maturity of these financial instruments. The carrying value of life insurancepolicies included in other assets approximates fair value based on estimatesreceived from insurance companies. The carrying value of the Company’slong-term debt including current portion, approximates fair value based onestimated discounted future cash flows for remaining maturities and ratescurrently offered to the Company for similar debt instruments. The Company hadoutstanding product import letters of credit with a fair value of $0.3 millionand $3.5 million as of January 28, 2006 and January 29, 2005respectively.

 

**Segment Information:**The Company has one reportable segment and, in accordance with therequirements of SFAS No. 131, *Disclosuresabout Segments of an Enterprise and Related Information*, thefollowing table shows revenues by merchandise category:

 
| ** **                  | ** ** | **Fiscal year**           | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                  | ** ** | **($ in thousands)** | ** ** |
| Music:                      |       |                           |       |   |   |   |   |
| Compact discs               |       | $                              | 655,806    |   | $ | 736,149 |   | $ | 717,145 |   |
| Audio cassettes and singles |       | 7,906                          |       | 14,463 |   | 23,819 |   |
| Total Music                 |       | 663,712                        |       | 750,612 |   | 740,964 |   |
| Video:                      |       |                           |       |   |   |   |   |
| DVD                         |       | 352,184                        |       | 360,262 |   | 313,977 |   |
| VHS                         |       | 19,781                         |       | 37,781 |   | 60,891 |   |
| Total Video                 |       | 371,965                        |       | 398,043 |   | 374,868 |   |
| Video games                 |       | 90,408                         |       | 89,297 |   | 80,888 |   |
| Other                       |       | 112,401                        |       | 127,181 |   | 133,906 |   |
| Total                       |       | $                              | 1,238,486  |   | $ | 1,365,133 |   | $ | 1,330,626 |   |

 

The “Other”category includes electronics, accessories, boutique, and other sales, none ofwhich individually exceeds 5%.

 

**Recently Issued Accounting Pronouncements:**

 

In February 2006, the FASBissued SFAS No. 155, *Accounting for CertainHybrid Financial Instruments - an amendment of FASB Statements No. 133 and140*, to simplify and make more consistent the accounting for certainfinancial instruments. Specifically, 

 

F-12

----

 

SFAS No. 155 amends SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities*, to permit fair value remeasurement for any hybridfinancial instrument with an embedded derivative that otherwise would requirebifurcation, provided that the whole instrument is accounted for on a fairvalue basis. SFAS No. 155 amends SFAS No. 140, **Accounting forTransfers and Servicing of Financial Assets and Extinguishment of Liabilities**,to allow a qualifying special-purpose entity to hold a derivative financialinstrument that pertains to a beneficial interest other than another derivativefinancial instrument. SFAS No. 155 applies to all financial instrumentsacquired or issued after the beginning of an entity’s first fiscal year thatbegins after September 15, 2006, with earlier application allowed. Theadoption of SFAS No.155 is not expected to have a significant impact on theCompany’s consolidated financial position or results of operations.

 

In May 2005,the FASB issued SFAS No. 154, *Accounting Changes andError Corrections, a replacement of APB Opinion No. 20, Accounting Changesand FASB Statement No. 3, Reporting Accounting Changes in InterimFinancial Statements*. SFAS No. 154 provides guidance on theaccounting for and reporting of accounting changes and error corrections. Itestablishes, unless impracticable, retrospective application as the requiredmethod for reporting a change in accounting principle in the absence of explicittransition requirements specific to the newly adopted accounting principle.SFAS No. 154 also provides guidance for determining whether retrospectiveapplication of a change in accounting principle is impracticable and forreporting a change when retrospective application is impracticable. Theprovisions of SFAS No. 154 are effective for accounting changes andcorrections of errors made in fiscal periods beginning after December 15,2005. The adoption of the provisions of SFAS No. 154 is not expected tohave a material impact on the Company’s consolidated financial condition orresults of operations.

 

In June 2005,the Emerging Issues Task Force (“EITF”) issued EITF No. 05-6, *Determining the Amortization Period of Leasehold Improvements(purchased after lease inception) or Acquired in a Business Combination (“EITF05-6”)*. EITF 05-6 provides that the amortization period forleasehold improvements acquired in a business combination or purchased afterthe inception of a lease be the shorter of (a) the useful life of theassets or (b) a term that includes required lease periods and renewalsthat are reasonably assured upon the acquisition of the purchase. Theprovisions of EITF 05-6 are effective on a prospective basis for leaseholdimprovements purchased or acquired beginning July 1, 2005. The adoption ofEITF 05-6 did not have a material effect on the Company’s consolidatedfinancial position or results of operations.

 

In December 2004, the FASBissued SFAS No. 123(R), *Share-Based Payment: anamendment of FASB Statements No. 123 and 95*. SFAS No.123(R)requires an enterprise to measure the cost of employee services received inexchange for an award of equity instruments based on the fair value of theaward at the grant date (with limited exceptions) and recognize thecompensation cost over the period during which an employee is required toprovide service in exchange for the award. In March 2005, the SEC issuedStaff Accounting Bulletin No. 107 (“SAB 107”), which expresses views ofthe SEC staff regarding the application of SFAS No. 123(R). Among otherthings, SAB 107 provides interpretive guidance related to the interactionbetween SFAS No. 123(R) and certain SEC rules and regulations, andprovides the SEC staff’s views regarding the valuation of share-based paymentarrangements for public companies. In February 2006, the FASB publishedFASB Staff Position No. FAS 123(R)-4 (“FSP No.123(R)-4”), *Classification of Options and Similar Instruments Issued as EmployeeCompensation That Allow for Cash Settlement upon the Occurrence of a ContingentEvent*, to amend guidance in SFAS No. 123(R), *Share-Based Payment*, on classifying options and similarinstruments issued as part of employee compensation arrangements. Asamended, SFAS No. 123(R) requires options issued as compensation toemployees to be classified as liabilities if the cash settlement feature can beexercised only upon the occurrence of a contingent event that is outside theemployee’s control, and such event is deemed probable to occur. The Company willadopt the expense recognition provisions of SFAS No. 123(R), beginningwith the first quarter of its 2006 fiscal year. If the Company had applied theprovisions of SFAS No. 123(R) to the financial statements for the periodending January 28, 2006, net loss would have been greater by approximately$7.3 million or $(0.23) per share.

 

**Note 2. Cumulative Effect of Change in Accounting Principle**

 

TheCompany adopted FIN 47, *Accounting for ConditionalAsset Retirement Obligations—an interpretation of FASB Statement No. 143*,effective January 28, 2006. In accordance with FIN 47, the Companyrecorded an asset and a corresponding liability for the present value of theestimated asset retirement obligations associated with the fixed assets andleasehold improvements at its store locations that arise under the terms ofoperating leases.

 

Thefollowing table illustrates the effect on income before extraordinary gain, netincome and related per share amounts as if the Company had applied theprovisions of FIN 47 retroactively:

 
| ** **                                                                                                                                   | ** ** | **Fiscal Year** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| **(Amounts in thousands, except per share amounts)**                                                           | ** ** | **2005**             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income before extraordinary gain –  unallocated negative goodwill and cumulative effect of change in accounting  principle, as reported |       | $                    | 2,886      |   | $ | 38,675 |   | $ | 18,728 |   |
| Pro forma income before  extraordinary gain - unallocated negative goodwill and cumulative effect of  change in accounting principle         |       | $                    | 2,922      |   | $ | 38,946 |   | $ | 18,533 |   |

 

F-13

----

 
| Net income as reported                                                                                                                                 |   | $      | 609    |   | $      | 41,841 |   | $      | 23,067 |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
|                                                                                                                                                   |   |   |   |   |   |   |   |
| Pro forma net income                                                                                                                                   |   | $      | 2,922  |   | $      | 42,112 |   | $      | 22,872 |   |
|                                                                                                                                                   |   |   |   |   |   |   |   |
| Pro forma liability                                                                                                                                    |   | $      | 4,327  |   | $      | 4,408  |   | $      | 4,716  |   |
|                                                                                                                                                   |   |   |   |   |   |   |   |
| Basic earnings per share:                                                                                                                              |   |   |   |   |   |   |   |
| Income before extraordinary gain –  unallocated negative goodwill and cumulative effect of change in accounting  principle, per share as reported |   | $      | 0.09   |   | $      | 1.12   |   | $      | 0.50   |   |
| Pro forma income per share before  extraordinary gain- unallocated negative goodwill and cumulative effect of  change in accounting principle          |   | $      | 0.09   |   | $      | 1.13   |   | $      | 0.50   |   |
|                                                                                                                                                   |   |   |   |   |   |   |   |
| Net income per share as reported                                                                                                                       |   | $      | 0.02   |   | $      | 1.21   |   | $      | 0.62   |   |
|                                                                                                                                                   |   |   |   |   |   |   |   |
| Pro forma net income per share                                                                                                                         |   | $      | 0.09   |   | $      | 1.22   |   | $      | 0.61   |   |
|                                                                                                                                                   |   |   |   |   |   |   |   |   |   |   |
| Diluted earnings per share:                                                                                                                            |   |   |   |   |   |   |   |
|                                                                                                                                                   |   |   |   |   |   |   |   |
| Income before extraordinary gain –  unallocated negative goodwill and cumulative effect of change in accounting  principle, per share as reported |   | $      | 0.09   |   | $      | 1.06   |   | $      | 0.49   |   |
| Pro forma income per share before  extraordinary gain- unallocated negative goodwill and cumulative effect of  change in accounting principle          |   | $      | 0.09   |   | $      | 1.07   |   | $      | 0.49   |   |
|                                                                                                                                                   |   |   |   |   |   |   |   |
| Net income per share as reported                                                                                                                       |   | $      | 0.02   |   | $      | 1.15   |   | $      | 0.60   |   |
|                                                                                                                                                   |   |   |   |   |   |   |   |
| Pro forma net income per share                                                                                                                         |   | $      | 0.09   |   | $      | 1.16   |   | $      | 0.60   |   |

 

**Note 3. Business Combinations**

** **

During 2005, the Company acquired an 80% interest ina newly formed company that is fully consolidated for financial reportingpurposes. The Company has committed funding of $3.0 million over a period ofthree years, of which $1.0 million had been funded as of January 28, 2006.

 

On July 22, 2004, the Company acquired theremaining 29% of the issued and outstanding shares of Second Spin Inc., forcash of $2.0 million. The Company now owns 100% of the issued and outstandingshares of Second Spin Inc. In accordance with SFAS No. 141, *Business Combinations*, the transaction was accounted for asa step acquisition with the excess of purchase price over the fair valuereported as goodwill. The Company recorded goodwill of $62,000 related to thistransaction. Prior to the step acquisition, the Company had consolidated all of the netassets and operations of Second Spin Inc. in its Consolidated Balance Sheetsand Consolidated Statements of Operations due to Second Spin’s accumulatedoperating losses, and accordingly no minority interest had been reflected inthe consolidated financial statements.

 

In October 2003,the Company acquired substantially all the net assets of WherehouseEntertainment Inc. (“Wherehouse”) and CD World Inc. (“CD World”) for $35.2million and $1.9 million, respectively. The purchase price was allocated on apreliminary basis during 2003 using information available at the time.Extraordinary gain recorded in 2003 was $4.3 million, which is net of incometaxes of $2.4 million, related to unallocated negative goodwill. The gain representsthe excess of the fair value of net assets acquired in excess of the purchaseprice of the assets. In accordance with SFAS No.141, the allocation of thepurchase price to the assets and liabilities acquired was finalized andadjusted during 2004, resulting in an extraordinary gain of $3.2 million, whichis net of income taxes of $2.0 million, related to unallocated negativegoodwill. The extraordinary gain in 2004 represents adjustments to the value ofliquidated inventory ($2.5 million), an adjustment to customer liabilitiesrelated to gift cards based on the redemption experience since acquisition($2.1 million) and occupancy related expenses ($0.6 million).

 

**Note 4. Fixed Assets**

Fixedassets consist of the following:

 

F-14

----

 
| ** **                                    | ** ** | **January 28,**       | ** ** | **January 29,** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **2006**                   | ** ** | **2005**             | ** ** |
| * *                                      | * *   | **($ in  thousands)** | * *   |
| Buildings                                     |       | $                          | 26,275     |                 | $          | 26,275 |   |
| Fixtures and equipment                        |       | 196,296                    |       | 198,396              |       |
| Leasehold improvements                        |       | 159,707                    |       | 139,283              |       |
|                                          |       | 382,278                    |       | 363,954              |       |
| Allowances for depreciation and  amortization |       | (249,814                   | )          | (233,758             | )          |
|                                          |       | $                          | 132,464    |                 | $          | 130,196 |   |

 

Depreciationand amortization expense related to the Company’s distribution center facilityand equipment of $3.1 million, $2.5 million and $2.4 million in 2005, 2004 and2003, respectively, is included in cost of sales. All other depreciation andamortization of fixed assets is included in SG&A expenses.

 

Depreciationand amortization of fixed assets is included in the consolidated statements ofoperations as follows:

 
| ** **                                    | ** ** | **Fiscal Year**      | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|
| ** **                                    | ** ** | **2005**                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| * *                                      |       | **($ in thousands)** |       |
| Cost of sales                                 |       | $                         | 3,076      |   | $ | 2,466 |   | $ | 2,405 |   |
| Selling, general and  administrative expenses |       | 33,993                    |       | 37,330 |   | 38,134 |   |
| Total                                         |       | $                         | 37,069     |   | $ | 39,796 |   | $ | 40,539 |   |

 

On February 7, 2005, the Office of the ChiefAccountant of the U.S. Securities and Exchange Commission issued aclarification of their interpretation of certain accounting issues and theirapplication under U.S. generally accepted accounting principles relating tooperating leases. After an internal review and discussion with its independentauditors, the Company determined its then current method of accounting forallowances provided by landlords to fund leasehold improvements needed to berevised. Historically, the Company had accounted for these allowances asreductions to the related leasehold improvements on its Consolidated Balance Sheetsand as a reduction of related investing activities on its ConsolidatedStatements of Cash Flows. In 2004, Management revised its method of accountingfor these allowances to record them as deferred rent on its ConsolidatedBalance Sheets which were amortized as a reduction in rent expense over thelife of the related leases. This resulted in rent expense being recorded at anearlier date for each lease and reduced future monthly rent expense, as thetotal rent due under the lease was recognized over a greater number of months.

 

The net, unamortized allowances recorded in the January 29,2005 Consolidated Balance Sheets was $12.4 million, of which $10.0 million wasreflected under deferred rent and other long-term liabilities and the remainingamounts were included in accrued expenses and other. The cumulative adjustmentto the Consolidated Statements of Operations for 2004 as result of the revisionwas to decrease net income by approximately $0.2 million. The revision did not,however, affect the classification of the amortization of these allowances inthe Consolidated Statements of Operations.

 

In 2004, during the Company’s review of itsaccounting for allowances, described above, it came to light there were certainleasehold improvements recorded with useful lives exceeding the relatedremaining lease terms of the respective stores. The Company’s policy withrespect to leasehold improvements is to compute depreciation expense based onthe shorter of the useful life of the asset or its related store lease term. Thecumulative adjustment to the Consolidated Statements of Operations for 2004 asresult of the revision was to decrease net income by $0.5 million.

 

No adjustment was made to prior periods for therevision to the accounting for allowances or the adjustment to depreciation onleasehold improvements, as management considered these items to be immaterialto the Company’s consolidated financial statements. These items, individually,or together, did not change previously reported earnings per share in prioryears by more than $0.02, did not change previously reported total assets orliabilities by more than 4.0% and did not change reported net cash provided by(used in) operating activities or net cash used by investing activities by morethan $1.7 million.

 

**Note 5. Debt**

On January 5,2006, the Company entered into a new five year, $100 million revolving securedcredit facility agreement (“Credit Agreement”) with Bank of America, N.A. Atthe election of the Company, loans under the Credit Agreement bear interest onthe principal amount at a rate equal to either, the Prime Rate or AdjustedLIBOR plus 0.75%. The principal amount of the all outstanding loans under theCredit Agreement together with any accrued but unpaid interest, are due andpayable on January 6, 2010, unless otherwise paid earlier pursuant to theterms of the Credit Agreement. Payments of amounts due under the CreditAgreement are secured by the Company’s eligible inventory, proceeds from saleof inventory and the stock of the Company’s subsidiaries.

 

Thenew Credit Agreement replaces the Company’s previous Credit Agreement and willprovide for general corporate purposes. The Credit Agreement includes customaryprovisions, including affirmative and negative covenants, includingrepresentations, warranties and restrictions on additional indebtedness andacquisitions. The Credit Agreement also includes customary events of default,including, among other things, bankruptcy, and certain changes of control.

 

F-15

----

 

Priorto the new credit agreement the Company had a three year, $100 million securedrevolving credit facility with Congress Financial Corporation that would haveexpired in July 2006.

 

Subsequentto January 28, 2006, the Company entered into a First Amendment of theCredit Agreement with Bank of America, N.A on March 26, 2006, whichincreases the maximum amount available for borrowing under the revolvingsecured credit facility to $130 million.

 

During2005, 2004 and 2003, the highest aggregate balances outstanding under therevolving credit facility were $27.2 million, $28.0 million and $58.3 million,respectively. As of January 28, 2006 and January 29, 2005, theCompany had $0.5 million and $0.3 million, respectively, in outstanding letterof credit obligations under the credit agreements with Bank of America, N.A andCongress Financial Corporation, respectively. The Company had $99.5 million and$99.7 million, respectively, available for borrowing as of January 28,2006 and January 29, 2005.

 

During2004, the Company borrowed $5.8 million under a mortgage loan to finance thepurchase of real estate. The mortgage loan is repayable in monthlyinstallments of $64,000 over 10 years with a fixed interest rate of 6.0% and iscollateralized by the real estate. The mortgage loan contains a minimum networth (shareholders’ equity) covenant of $290 million, excluding the impact, ifany, of certain non-cash charges. As of January 28, 2006, the outstandingbalance on the loan was $5.1 million. The following table presents principalcash payments of long-term debt by expected maturity dates as of January 28,2006: 

 
| ** **                       | ** ** | **Long-term debt**                | ** ** |
|----------------------------------|------------|----------------------------------------|------------|
| *** ***                     | ** ** | **(****$ in thousands****)** | ** ** |
| 2006                             |       | 477                                    |       |
| 2007                             |       | 506                                    |       |
| 2008                             |       | 537                                    |       |
| 2009                             |       | 570                                    |       |
| 2010                             |       | 606                                    |       |
| Thereafter                       |       | 2,368                                  |       |
| Total                            |       | 5,064                                  |       |
| Less:  current portion           |       | 477                                    |       |
| Long  –term debt obligation |       | $                                      | 4,587      |   |
|                                  |            |                                        |            |  |

 

**Note 6. Income Taxes**

 

Incometax expense consists of the following:

 
| ** **             | ** ** | **Fiscal Year**           | ** ** |
|------------------------|------------|--------------------------------|------------|
| ** **             | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **             | ** ** | **($ in thousands)** | ** ** |
| Federal – current |       | $                              | (3,887     | ) | $ | (3,969 | ) | $ | 10,044 |   |
| State – current   |       | 791                            |       | 1,913 |   | 2,364 |   |
| Deferred               |       | 4,186                          |       | 6,948 |   | (4,106 | ) |
|                   |       | $                              | 1,090      |   | $ | 4,892 |   | $ | 8,302 |   |

 

Areconciliation of the Company’s effective income tax rate with the Federalstatutory rate is as follows:

 
| ** **                                               | ** ** | **Fiscal Year** | ** ** |
|----------------------------------------------------------|------------|----------------------|------------|
| ** **                                               | ** ** | **2005**             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Federal statutory rate                                   | * *   | *35.0*               | *%*        | *35.0* | *%* | *35.0* | *%* |
| State income taxes, net of  federal tax effect           | * *   | *52.2*               | *%*        | *2.1* | *%* | *3.5* | *%* |
| Change in federal valuation  allowance                   | * *   | *(5.9*               | *)%*       | *(2.1* | *)%* | *(0.4* | *)%* |
| Closing of federal tax  examination                      | * *   | *—*             | * *   | *(24.2* | *)%* | *—* | * * |
| Corporate-owned life insurance  payment settlement, net  | * *   | *5.9*                | *%*        | *0.5* | *%* | *(7.4* | *)%* |
| Cash surrender value – insurance/  benefit programs | * *   | *(4.2*               | *)%*       | *(0.2* | *)%* | *(0.8* | *)%* |
| Executive compensation                                   | * *   | *3.3*                | *%*        | *0.4* | *%* | *0.4* | *%* |
| Tax exempt income                                        | * *   | *(3.2*               | *)%*       | *(0.3* | *)%* | *(0.2* | *)%* |
| Closing of tax periods                                   | * *   | *(8.8*               | *)%*       | *—* | * * | *—* | * * |
| Tax credits                                              | * *   | *(7.8*               | *)%*       | *(0.2* | *)%* | *(0.3* | *)%* |
| Recognized deferred tax asset                            | * *   | *(43.3*              | *)%*       | *—* | * * | *—* | * * |
| Other                                                    | * *   | *4.2*                | *%*        | *0.2* | *%* | *0.9* | *%* |
| Effective income tax rate                                | * *   | *27.4*               | *%*        | *11.2* | *%* | *30.7* | *%* |
|                                                          |            |                      |            |  |  |  |  |  |

 

F-16

----

 

 

During2004, the Company closed a federal tax examination for periods through theCompany’s 2000 fiscal year. The settlement closed all outstanding mattersrelated to corporate-owned life insurance policies which were part of theCompany’s acquisition of CM Holdings Inc. (“Camelot”) in 1999. As a result ofthe closing agreement with the Internal Revenue Service (“IRS”), theCompany  recorded a tax benefit of $10.5million, which reversed federal income tax payable amounts originally recordedin the years covered by the examination. The closing of the federal taxexamination 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 netoperating loss carryforwards from Camelot. The amounts and utilization of thesestate net operating loss carryforwards had been uncertain until the closing ofthe federal tax examination in 2004. During 2005, the Company recognized a taxbenefit of $2.0 million attributable to the effect of additional deductibletemporary differences.

 

During2000, the United States District Court for the District of Delaware issued anopinion upholding the IRS’ disallowance of deductions of interest expenserelated to corporate-owned life insurance policies through fiscal 1994. Theoriginal accrual for additional income taxes resulting from disallowed interestexpense deductions was recorded following the 2000 court decision. During 2003,the Company and the IRS agreed on final computational and payment terms for anamount 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 withthe IRS to make annual interest payments and a final principal payment ofapproximately $7.1 million in 2007. The remaining accrued liabilitiesattributable to this matter as of January 28, 2006 and January 29, 2005 are$8.7 million which are included in deferred rent and other long-termliabilities in the Consolidated Balance Sheets.

 

Significantcomponents of the Company’s deferred tax assets are as follows:

 
| ** **                                                     | ** ** | **January 28,**                   | ** ** | **January 29,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------|------------|----------------------|------------|
| ** **                                                     | ** ** | **2006**                               | ** ** | **2005**             | ** ** |
| ** **                                                     | ** ** | **(****$ in thousands****)** | ** ** |
| DEFERRED TAX ASSETS                                            |       |                                   |       |                 |       |
| Accrued expenses                                               |       | $                                      | 1,031      |                 | $          | 1,101 |   |
| Accounts receivable                                            |       | 40                                     |       | 121                  |       |
| Inventory                                                      |       | 2,308                                  |       | 4,707                |       |
| Retirement and compensation  related accruals                  |       | 5,490                                  |       | 5,601                |       |
| Fixed assets                                                   |       | 2,537                                  |       | —               |       |
| Federal and state net operating  loss and credit carryforwards |       | 14,690                                 |       | 14,700               |       |
| Real estate leases, including  deferred rent                   |       | 12,511                                 |       | 11,764               |       |
| Losses on investments                                          |       | 3,714                                  |       | 4,000                |       |
| Goodwill                                                       |       | 7,264                                  |       | 7,897                |       |
| Other                                                          |       | 542                                    |       | 354                  |       |
| Gross deferred tax assets before  valuation allowance          |       | 50,127                                 |       | 50,245               |       |
| Less: valuation allowance                                      |       | (11,350                                | )          | (8,763               | )          |
| Total deferred tax assets                                      |       | $                                      | 38,777     |                 | $          | 41,482 |   |
|                                                           |       |                                   |       |                 |       |
| DEFERRED TAX LIABILITIES                                       |       |                                   |       |                 |       |
| Fixed assets                                                   |       | —                                 |       | 726                  |       |
| Total deferred tax liabilities                                 |       | —                                 |       | 726                  |       |
| NET DEFERRED TAX ASSET                                         |       | $                                      | 38,777     |                 | $          | 40,756 |   |

 

Thenet deferred tax asset is classified on the Company’s Consolidated BalanceSheets as follows:

 
| ** **                           | ** ** | **January 28,**                   | ** ** | **January 29,** | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|----------------------|------------|
| ** **                           | ** ** | **2006**                               | ** ** | **2005**             | ** ** |
| ** **                           | ** ** | **(****$ in thousands****)** | ** ** |
| Current deferred tax asset           |       | $                                      | 11,266     |                 | $          | 15,526 |   |
| Non-current deferred tax asset,  net |       | 27,511                                 |       | 25,230               |       |
|                                 |       | $                                      | 38,777     |                 | $          | 40,756 |   |

 

F-17

----

 

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

 

Asdisclosed in Note 3 to the Consolidated Financial Statements, the Companyacquired the remaining 29% interest in Second Spin, Inc. (“Second Spin”)during 2004. In connection with this step acquisition transaction, deferred taxassets amounting to $1.4 million were recorded at the date of the acquisitionrelated to the tax effects of Second Spin’s federal and state net operatingloss carryforwards and other deductible temporary differences. Prior to thisacquisition, a valuation allowance in the amount of the gross deferred taxasset had been recorded as management considered it more likely than not thatthe net operating loss carryforwards would not be realized by Second Spin as aseparate entity. Second Spin has been merged into the Company and inclusion inthe Company’s consolidated tax return will enable substantially all of thesenet operating loss carryforwards to be utilized within the expiration periods.

 

TheCompany had a net operating loss carryforward of $6.5 million for federalincome tax purposes and $203.2 million for state income tax purposes as of theend of 2005 that expire at various times through 2025 and are subject tocertain limitations and statutory expiration periods. The state net operatingloss carryforwards are subject to various business apportionment factors andmultiple jurisdictional requirements when utilized.

 

Inaddition, the Company has capital loss carryforwards of $6.4 million forfederal income tax purposes which expire in 2007. A 100% valuation allowancehas been established against the deferred tax asset related to these capitalloss carryforwards.

 

In assessing the propriety of deferred tax assets,management considers whether it is more likely than not that some portion orall of the deferred tax assets will not be realized. The ultimate realizationof deferred tax assets is dependent upon the generation of future taxable income.Management considers the scheduled reversal of deferred tax liabilities,projected future taxable income and tax planning strategies in making thisassessment. Based upon the level of projected future taxable income over theperiods in which the deferred tax assets are deductible, and tax planningstrategies, the valuation allowance was increased from $8.8 million to $11.4million, a level where management believes that it is more likely than not thatthe tax benefit will be realized. The net increase in the valuation allowanceincluded a $2.8 million increase reflected as state income taxes, net offederal tax effect, offset by a $0.2 million decrease to account for thereduction in deferred tax assets attributable to losses on investmentsresulting from an investment gain. The valuation allowance increaseprincipally relates to deferred tax assets attributable to state net operatinglosses and other deductible temporary differences impacted by lower futuretaxable income projections in certain states’ expiration periods and by changesin legislation, notably Ohio tax reform legislation enacted during 2005.The Ohio legislation phases out the state corporate franchise tax, and, basedon management’s estimates, certain Ohio deferred tax assets, principally netoperating losses, will not be realized during the phase-out period.

 

TheCompany paid income taxes, net of refunds, of approximately $4.7 million, $12.5million and $2.9 million during 2005, 2004 and 2003, respectively.

 

**Note 7. Commitments and Contingencies**

 

During2000, the United States District Court for the District of Delaware issued anopinion upholding the IRS’ disallowance of deductions of interest expenserelated to corporate-owned life insurance policies through fiscal 1994. Theoriginal accrual for additional income taxes resulting from disallowed interestexpense deductions was recorded following the 2000 court decision. During 2003,the Company and the IRS agreed on final computational and payment terms for anamount 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 agreedwith the IRS to make annual interest payments and a final principal payment ofapproximately $7.1 million in 2007. The remaining accrued liabilitiesattributable to this matter as of January 28, 2006 and January 29, 2005 are$8.7 million which are included in deferred rent and other long-termliabilities in the Consolidated Balance Sheets.

 

During 2005, the Company acquired an 80% interest ina newly formed company that is fully consolidated for financial reportingpurposes. The Company’s has committed funding of $3.0 million over a period ofthree years, of which $1.0 million was funded as of January 28, 2006.

 

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

 

**Note 8. Leases**

Asmore fully discussed in Note 11 to the Consolidated Financial Statements, theCompany leases its Albany, NY distribution center and administrative officesunder three capital lease arrangements with its Chief Executive Officer andlargest shareholder.

 

Fixedassets recorded under capital leases, which are included in fixed assets on theaccompanying Consolidated Balance Sheets, are as follows:

 

F-18

----

 
| ** **                                    | ** ** | **January 28,**           | ** ** | **January 29,** | ** ** |
|-----------------------------------------------|------------|--------------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **2006**                       | ** ** | **2005**             | ** ** |
| ** **                                    | ** ** | **($ in thousands)** | ** ** |
| Buildings                                     |       | $                              | 9,342      |                 | $          | 9,342 |   |
| Fixtures and equipment                        |       | 12,824                         |       | —               |       |
|                                          |       | 22,166                         |       | 9,342                |       |
| Allowances for depreciation and  amortization |       | (7,170                         | )          | (4,938               | )          |
|                                          |       | $                              | 14,996     |                 | $          | 4,404 |   |

 

The Company leases 781 stores under operatingleases, many of which contain renewal options, for periods ranging from five totwenty-five years. Most leases also provide for payment of operating expensesand real estate taxes. Some also provide for additional rent based on apercentage of sales.

 

Netrental expense was as follows: 

 
| ** **         | ** ** | **Fiscal Year**           | ** ** |
|--------------------|------------|--------------------------------|------------|
| ** **         | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **         | ** ** | **($ in thousands)** | ** ** |
| Minimum rentals    |       | $                              | 108,581    |   | $ | 115,422 |   | $ | 118,392 |   |
| Contingent rentals |       | 1,226                          |       | 1,372 |   | 1,279 |   |
|               |       | $                              | 109,807    |   | $ | 116,794 |   | $ | 119,671 |   |

 

Future minimum rental payments required under allleases that have initial or remaining non-cancelable lease terms in excess ofone year at January 28, 2006 are as follows:

 
| ** **                               | ** ** | **Operating**                  | ** ** | **Capital** | ** ** |
|------------------------------------------|------------|--------------------------------|------------|-------------|------------|
| ** **                               | ** ** | **Leases**                     | ** ** | **Leases**  | ** ** |
| ** **                               | ** ** | **($ in thousands)** | ** ** |
| 2006                                     |       | 101,583                        |       | 5,195       |       |
| 2007                                     |       | 87,279                         |       | 4,830       |       |
| 2008                                     |       | 69,412                         |       | 4,709       |       |
| 2009                                     |       | 50,407                         |       | 4,709       |       |
| 2010                                     |       | 32,966                         |       | 2,709       |       |
| Thereafter                               |       | 50,596                         |       | 9,356       |       |
| Total  minimum payments required         |       | $                              | 392, 243   |        | $          | 31,508 |   |
| Less: amounts representing  interest     |       |                           |       | 13,439      |       |
| Present  value of minimum lease payments |       |                           |       | 18,069      |       |
| Less:  current portion                   |       |                           |       | 3,182       |       |
| Long-term  capital lease obligations     |       |                           |       | $           | 14,887     |   |
|                                          |            |                                |            |             |            |  |  |  |

 

Interestrates on capital leases were between 5.65% to 27% per annum.

 

During 2005, the Company financed the replacement ofits point-of-sale system through a capital lease arrangement in the amount of$12.0 million. The lease arrangement has an average interest rate of5.76% and will be repaid in monthly installments of $229,000 over 5 years. Asof January 28, 2006, the outstanding balance on the lease was $10.4million.

 

During 2005, the Company purchased software licensesthrough a capital lease arrangement for $0.9 million, with an interest rate of5.75%. The capital lease will be repaid in quarterly installments of $122,000over 2 years. As of January 28, 2006, the outstanding balance on the leasewas $0.5 million.

 

**Note 9. Benefit Plans**

 

**401(k) Savings Plan**

 

TheCompany offers a 401(k) Savings Plan to eligible employees meeting certain ageand service requirements. This plan permits participants to contribute up to20% of their salary, including bonuses, up to the maximum allowable by IRSregulations. Participants are immediately vested in their voluntarycontributions plus actual earnings thereon. Participant vesting of the Company’smatching and profit sharing contribution is based

 

F-19

----

 

on theyears of service completed by the participant. Participants are fully vestedupon the completion of four years of service. All participant forfeitures ofnon-vested benefits are used to reduce the Company’s contributions in futureyears. Total expense related to the Plan was $957,000, $897,000 and $858,000 in2005, 2004 and 2003, respectively.

 

**Stock Option Plans**

 

The Company has six employee stock option 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 common stock to employees of the Company at the fair market value of the common stock on the date of grant. Under the New and Old Plans, options generally become exercisable commencing one year from the date of grant in increments of 25% per year with a maximum term of ten years. The Company has stopped issuing stock options under the Old Plans.

 

Optionsauthorized for issuance under the Old and New Plans totaled 19.8 million. As ofJanuary 28, 2006, of the options authorized for issuance under the Old andNew Plans, 9.5 million were granted and are outstanding, 7.1 million of whichwere vested and exercisable. Options available for future grants at January 28,2006 and January 29, 2005 were 4.7 million and 1.6 million, respectively.

 

Under the terms of the Camelot merger agreement, alloptions issued under the Camelot 1998 Stock Option Plan (the “Camelot Plan”)were converted to the Company’s options. The Camelot Plan provided for thegranting of either incentive stock options or nonqualified stock options topurchase shares of the Company’s common stock. Vesting of the options wasoriginally over a four-year period with a maximum term of ten years. Based onthe terms of the Camelot Plan, vesting was accelerated based on the marketperformance 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 themerger. At January 28, 2006, 16,950 options were outstanding andexercisable. The Company stopped issuing stock options under the Camelot StockOption Plan as of April 22, 1999.

 

Thefollowing table summarizes information about the stock options outstandingunder the Plans and the Camelot Plan as of January 28, 2006:

 
| ** **                     | ** ** | **Outstanding** | ** ** | **Exercisable**              | ** ** |
|--------------------------------|------------|-----------------|------------|------------------------------|------------|
| **Exercise  Price Range** | ** ** | **Shares**      | ** ** | **Average  Remaining  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Price** | ** ** |
| $0.00-$2.66                    |       | 94,577          |       | 0.3                          |       | $ | 1.58 |   | $ | 325,345 |   | 94,577 |   | $ | 1.58 |   | $ | 325,345 |   |
| 2.67-5.33                      |       | 2,219,973       |       | 6.9                          |       | 3.52 |   | 3,329,960 |   | 684,698 |   | 3.57 |   | 992,812 |   |
| 5.34-8.00                      |       | 427,500         |       | 8.7                          |       | 7.21 |   | — |   | 32,500 |   | 7.39 |   | — |   |
| 8.01-10.00                     |       | 2,008,371       |       | 5.8                          |       | 8.43 |   | — |   | 1,499,097 |   | 8.57 |   | — |   |
| 10.01-13.33                    |       | 3,124,500       |       | 5.0                          |       | 10.90 |   | — |   | 3,110,250 |   | 10.90 |   | — |   |
| 13.34-16.00                    |       | 1,466,565       |       | 7.6                          |       | 14.56 |   | — |   | 1,466,565 |   | 14.56 |   | — |   |
| 16.01-18.67                    |       | 178,050         |       | 2.2                          |       | 17.79 |   | — |   | 178,050 |   | 17.79 |   | — |   |
| 18.68-24.00                    |       | 2,000           |       | 2.9                          |       | 23.75 |   | — |   | 2,000 |   | 23.75 |   | — |   |
| Total                          |       | 9,521,536       |       | 6.1                          |       | $ | 9.10 |   | $ | 3,655,305 |   | 7,067,737 |   | $ | 10.49 |   | $ | 1,318,157 |   |

 

Theaggregate intrinsic value in the preceding table represents the total pretaxintrinsic value based on the Company’s closing stock price of $5.02 as of January 28,2006, which would have been received by the option holders had all optionholders under the Plans and Camelot Plans exercised their options as of thatdate. The total number of in-the-money options exercisable as of January 28,2006 was 779,275.

 

TheCompany also has a stock option plan for non-employee directors (the “1990 Plan”).Options under this plan are granted at an exercise price determined by theCompensation Committee of the Board of Directors. Under the 1990 Plan, optionsgenerally become exercisable commencing one year from the date of grant in incrementsof 25% per year with a maximum term of ten years. In addition, directors of theCompany receive annual grants of deferred shares of Common Stock (“DeferredShares”) issued under this plan which vest equally in three years from date ofgrant. As of January 28, 2006, there were 750,000 options authorized forissuance and 333,526 options have been granted and are outstanding, 140,014 ofwhich were vested and exercisable. There are 118,480 shares of common stockreserved for possible future option grants under the 1990 Plan.

 

In connection with the Company’s merger with Camelotin April 1999 all options issued under the Camelot Outside Director StockOption Plan (the “Camelot Director Plan”) were converted to the Company’soptions. As of January 28, 2006, there were 4,750 options outstanding andexercisable under the Camelot Director Plan. The Company no longer issuesoptions under the Camelot Director Plan.

 

F-20

----

 

The following table summarizes information about thestock options outstanding under the two Director Plans at January 28, 2006:

 
| ** **                     | ** ** | **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                    |       | 179,401         |       | 7.9                          |       | $ | 0.03 |   | $ | 895,211 |   | 18,389 |   | $ | 0.33 |   | $ | 86,244 |   |
| 2.68-5.33                      |       | 4,500           |       | 1.3                          |       | 3.36 |   | 7,470 |   | 4,500 |   | 3.36 |   | 7,470 |   |
| 5.34-8.00                      |       | 30,000          |       | 7.8                          |       | 6.44 |   | — |   | 15,000 |   | 6.44 |   | — |   |
| 8.01-10.67                     |       | 76,875          |       | 2.5                          |       | 9.39 |   | — |   | 74,375 |   | 9.44 |   | — |   |
| 10.68-13.33                    |       | 40,750          |       | 5.3                          |       | 12.41 |   | — |   | 25,750 |   | 11.90 |   | — |   |
| 13.34-16.00                    |       | 6,750           |       | 1.6                          |       | 15.12 |   | — |   | 6,750 |   | 15.12 |   | — |   |
| Total                          |       | 338,276         |       | 6.2                          |       | $ | 4.56 |   | $ | 902,681 |   | 144,764 |   | $ | 8.48 |   | $ | 93,714 |   |

 

Theaggregate intrinsic value in the preceding table represents the total pretaxintrinsic value based on the Company’s closing stock price of $5.02 as of January 28,2006, which would have been received by the option holders had all optionholders under the two Director Plans exercised their options as of that date.The total number of in-the-money options exercisable as of January 28,2006 was 22,889.

 

Thefollowing tables summarize activity under the Stock Option Plans:

 
| ** **                    | ** ** | **Employee Stock Option Plans**                | ** ** | **Director Stock Option 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 February 1, 2003 |       | 6,621,924                                                     |       | $ 1.21-$23.75                             |       | $ | 9.11 |   | 278,750 |   | $ 1.18-$15.12 |   | $ | 6.19 |   |
| Granted                       |       | 2,350,100                                                     |       | 2.57-5.99                                      |       | 3.50 |   | 187,107 |   | 0.00-6.44 |   | 1.44 |   |
| Exercised                     |       | (162,457                                                      | )          | 1.21-4.58                                      |       | 3.62 |   | (36,786 | ) | 0.00-2.09 |   | 1.28 |   |
| Canceled                      |       | (363,176                                                      | )          | 2.57-18.00                                     |       | 9.24 |   | (9,000 | ) | 4.61-4.61 |   | 4.61 |   |
| 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 |   |

 

During2005, 2004 and 2003, the Company recognized expenses of $296,000, $218,000 and$50,000, respectively, for stock options issued to non-employee directors at anexercise price below the closing stock price on the date of grant.

 

**Restricted Stock Plan**

 

Underthe 1990 Restricted Stock Plan, the Compensation Committee of the Board ofDirectors is authorized to grant awards for up to 900,000 restricted shares ofCommon Stock to executive officers and other key employees of the Company. Theshares are issued as restricted stock and are held in the custody of theCompany until all vesting restrictions are satisfied. If conditions or termsunder which an award is granted are not satisfied, the shares are forfeited. Sharesvest under these grants over a period of two to five years, with vestingcriteria that includes continuous employment until applicable vesting dateshave expired. As of January 28, 2006, a total of 330,000 shares have beengranted, of which 262,000 shares had vested and 85,000 shares had beenforfeited. Unearned compensation is recorded at the date of award, based on themarket value of the shares, and is included as a separate component ofshareholders’ equity and is amortized over the applicable vesting period. Theamount amortized to expense in 2005, 2004 and 2003, net of the impact offorfeitures, was approximately $16,000, $28,000 and $93,000, respectively. Asof January 28, 2006, outstanding awards and shares available for granttotaled 5,000 and 633,000 respectively.

 

F-21

----

 

**Defined Benefit Plans**

 

The Company maintains a non-qualified Supplemental Executive RetirementPlan (“SERP”) for certain executive officers of the Company. The SERP, which isunfunded, provides eligible executives defined pension benefits that supplementbenefits under other retirement arrangements. The annual benefit amount isbased on salary and bonus at the time of retirement and number of years ofservice.

 

The Company provides the Board of Directors with a noncontributory,unfunded retirement plan (“Director Retirement Plan”) that pays a retireddirector an annual retirement benefit equal to 60% of the annual retainer atthe time of retirement plus a 3% annual increase through the final payment. Paymentsbegin at age 62 or retirement, whichever is later, and continue for 10 years orthe life of the director and his or her spouse, whichever period is shorter. Partialvesting in the retirement plan begins after six years of continuous service. Participantsbecome fully vested after 12 years of continuous service on the Board. TheCompany accounts for the SERP and the Director Retirement Plan in accordancewith the provisions of SFAS No. 87, *Employers’ Accounting forPensions*.

 

For 2005, 2004 and 2003, net periodic pension costs recognized under both planstotaled approximately $1.9 million, $1.4 million, and $1.2 million, respectively.The accrued pension liability for the plans, which is included in accruedexpenses and other in the Consolidated Balance Sheets, was approximately $15.2million and $12.0 million at January 28, 2006 and January 29, 2005,respectively. In addition, an intangible asset, which is included in otherassets in the Consolidated Balance Sheets, to reflect the excess of theaccumulated benefit obligation over the fair value of plan assets, net ofaccrued pension costs, of approximately $3.7 million and  $4.1 million was recorded at January 28,2006 and January 29, 2005.

 

The measurement date for the SERP and DirectorRetirement Plan is November 1 of each year using actuarial techniques whichreflect estimates for mortality, turnover and expected retirement. In addition,management makes assumptions concerning future salary increases. Generallydiscount rates are established as of the measurement date using theoreticalbond models that select high-grade corporate bonds with maturities or couponsthat correlate to the expected payouts of the applicable liabilities.

 

After June 1, 2003, new directors were not covered bythe retirement plan. Directors who were not yet vested in their retirementbenefits as of June 1, 2003 had the present value of benefits alreadyaccrued as of the effective date converted to Deferred Shares under theDirectors Plan. Directors that were fully or partially vested in theirretirement benefits were given a one time election to continue to participatein the current retirement program or convert the present value of benefitsalready accrued to Deferred Shares under the Directors Plan as of the effectivedate.

 

The following is a summary of theCompany’s defined benefit pension plans as of the most recent actuarialcalculations:

 

**Obligation andFunded Status:**

 
| ** **                                     | ** ** | **January 28,**           | ** ** | **January 29,** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|----------------------|------------|
| ** **                                     | ** ** | **2006**                       | ** ** | **2005**             | ** ** |
| ** **                                     | ** ** | **($ in thousands)** | ** ** |
| Change in Benefit Obligation:                  | ** ** | ** **                     | ** ** | ** **           | ** ** |
| Benefit obligation at beginning  of year       |       | $                              | 14,232     |                 | $          | 10,476 |   |
| Service cost                                   |       | 531                            |       | 402                  |       |
| Interest cost                                  |       | 782                            |       | 628                  |       |
| Actuarial loss                                 |       | 604                            |       | 2,767                |       |
| Benefits paid                                  |       | (41                            | )          | (41                  | )          |
| Benefit obligation at end of year              |       | $                              | 16,108     |                 | $          | 14,232 |   |
| ** **                                     | ** ** | ** **                     | ** ** | ** **           | ** ** |
| Fair value of plan assets at end  of year      |       | —                         |       | —               |       |
|                                           |       |                           |       |                 |       |
| Reconciliation of Funded Status:               | ** ** | ** **                     | ** ** | ** **           | ** ** |
| Funded status                                  |       | (16,108                        | )          | (14,232              | )          |
| Unrecognized prior service cost                |       | 3,742                          |       | 4,084                |       |
| Unrecognized net actuarial loss                |       | 4,451                          |       | 4,090                |       |
| Accrued pension cost                           |       | (7,915                         | )          | (6,058               | )          |
| Additional minimum liability (“AML”) |       | (7,279                         | )          | (5,925               | )          |
| Accrued pension liability  including AML       |       | $                              | (15,194    | )                    | $          | (11,983 | ) |
|                                                |            |                                |            |                      |            |  |  |  |

 

**Amounts recognized in theConsolidated Balance Sheets consist of:**

 
| ** **                                                         | ** ** | **January 28,**                   | ** ** | **January 29,** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------|------------|----------------------|------------|
| ** **                                                         | ** ** | **2006**                               | ** ** | **2005**             | ** ** |
| ** **                                                         | ** ** | **(****$ in thousands****)** | ** ** |
| Accrued pension liability,  including additional minimum liability |       | $                                      | (15,194    | )                    | $          | (11,983 | ) |
| Intangible assets                                                  |       | 3,742                                  |       | 4,084                |       |
| Accumulated other comprehensive  loss                              |       | 3,537                                  |       | 1,841                |       |
| Net amount recognized                                              |       | $                                      | (7,915     | )                    | $          | (6,058 | ) |
|                                                                    |            |                                        |            |                      |            |  |  |  |

 

F-22

----

 

Theaccumulated benefit obligation for the plans was $15.2 million and $12.0million at January 28, 2006 and January 29, 2005, respectively, whichexceeds plan assets ($0).

 

Informationfor pension plans with an accumulated benefit obligation in excess of planassets:

 
| ** **                     | ** ** | **January 28,**               | ** ** | **January 29,** | ** ** |
|--------------------------------|------------|------------------------------------|------------|----------------------|------------|
| ** **                     | ** ** | **2006**                           | ** ** | **2005**             | ** ** |
| ** **                     | ** ** | **$  in thousands** | ** ** |
| Projected benefit obligation   |       | $                                  | 16,108     |                 | $          | 14,232 |   |
| Accumulated benefit obligation |       | $                                  | 15,194     |                 | $          | 11,983 |   |
| Fair value of plan assets      |       | —                             |       | —               |       |

 

**Components of Net PeriodicPension Cost:**

 
| ** **                          | ** ** | **Fiscal Year** | ** ** |
|-------------------------------------|------------|----------------------|------------|
| ** **                          | ** ** | **2005**             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Service cost                        |       | $                    | 531        |   | $ | 402 |   | $ | 224 |   |
| Interest cost                       |       | 782                  |       | 628 |   | 629 |   |
| Amortization of prior service  cost |       | 342                  |       | 342 |   | 385 |   |
| Amortization of net (gain) / loss   |       | 243                  |       | 18 |   | — |   |
| Net periodic pension cost           |       | $                    | 1,898      |   | $ | 1,390 |   | $ | 1,238 |   |

 

**Assumptions:**

 
| ** **                                                          | ** **           | **Fiscal Year** | ** **  |
|---------------------------------------------------------------------|----------------------|----------------------|-------------|
| ** **                                                          | ** **           | **2005**             | ** **  | **2004** | ** ** |
| Weighted-average assumptions used  to determine benefit obligation: | ** **           | ** **           | ** **  | ** ** | ** ** |
|                                                                | Discount rate        |                 | 5.50        | % | 5.50 | % |
|                                                                | Salary increase rate |                 | 4.00        | % | 4.00 | % |
|                                                                | Measurement date     |                 | Nov 1, 2005 |   | Nov 1, 2004 |   |

 
| ** **                                                                       | ** **           | **Fiscal Year** | ** ** |
|----------------------------------------------------------------------------------|----------------------|----------------------|------------|
| ** **                                                                       | ** **           | **2005**             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Weighted-average assumptions used  to determine net periodic  pension cost: | ** **           | ** **           |       | ** ** |   | ** ** |   |
|                                                                             | Discount rate        |                 | 5.50       | % | 6.00 | % | 6.50 | % |
|                                                                             | Salary increase rate |                 | 4.00       | % | 4.00 | % | 4.00 | % |

 

TheCompany expects to make $50,000 in benefit payments during 2006.

 

AdditionalInformation:

 
| ** **                                                                                          | ** ** | **January 28,**                   | ** ** | **January 29,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|----------------------|------------|
| ** **                                                                                          | ** ** | **2006**                               | ** ** | **2005**             | ** ** |
| ** **                                                                                          | ** ** | **(****$ in thousands****)** | ** ** |
| Increase in additional minimum  liability included in other comprehensive loss, before income taxes |       | $                                      | 1,696      |                 | $          | 1,841 |   |
| Balance of additional minimum  liability included in other comprehensive loss, before income taxes  |       | $                                      | 3,537      |                 | $          | 1,841 |   |
| Income taxes related to  additional minimum liability included in other comprehensive loss          |       | $                                      | 1,489      |                 | $          | 747 |   |
| Balance, net of income taxes, of  additional minimum liability included in other comprehensive loss |       | $                                      | 2,048      |                 | $          | 1,094 |   |

 

Thefollowing benefit payments, which reflect expected future service, asappropriate, are expected to be paid:

 

F-23

----

 
| **Year**            | ** ** | **Pension Benefits**      | ** ** |
|---------------------|------------|--------------------------------|------------|
| *** ***        | ** ** | **($ in thousands)** | ** ** |
| 2006                |       | $                              | 50         |   |
| 2007                |       | 1,181                          |       |
| 2008                |       | 1,181                          |       |
| 2009                |       | 1,194                          |       |
| 2010                |       | 1,232                          |       |
| 2011 and thereafter |       | 7,101                          |       |
|                     |            |                                |            |  |

 

**Note 10. Shareholders’ Equity**

 

On May 28, 2003, the Company’s Board ofDirectors authorized the repurchase of 10 million outstanding shares of theCompany’s Common Stock from time to time on the open market. The Company hadrepurchased 15 million shares of common stock under previously announcedprograms. As of January 28, 2006, the Company had purchased the 10 millionshares outstanding under the stock repurchase program, at a total cost of $88.5million and there were no shares remaining to be purchased under the currentprogram. During 2005 the Company purchased 3.1 million shares at a total costof $31.3 million. The Company had completed the purchase of 15.0 million sharesat a total cost of $128.7 million under earlier authorized programs. As of January 28,2006 and January 29, 2005, the Company held 25,104,990 and 21,988,949 shares,respectively, in treasury stock.

 

TheCompany has never declared dividends on its Common Stock and does not plan topay cash dividends on its Common Stock in the foreseeable future. The Company’scredit agreement does not restrict the payment of cash dividends so long aspayment conditions per the agreement are met. Any future determination as tothe payment of dividends will depend upon capital requirements, limitationsimposed by the Company’s credit agreement (see Note 5 to the ConsolidatedFinancial Statements) and other factors the Company’s Board of Directors may consider.

 

**Note 11. Related Party Transactions**

TheCompany leases its 168,400 square foot distribution center/office facility inAlbany, New York from Robert J. Higgins, its Chairman, Chief Executive Officerand largest shareholder, under three capital leases that expire in the year2015. The original distribution center/office facility was constructed in 1985.

 

Under the three capital leases, dated April 1,1985, November 1, 1989 and September 1, 1998 (the “Leases”), theCompany paid Mr. Higgins an annual rent of $1.9 million, $1.8 million and$1.8 million in 2004, 2003 and 2002 respectively. Pursuant to the terms of thelease agreements, effective January 1, 2002 and every two yearsthereafter, rental payments will increase in accordance with the biennialincrease in the Consumer Price Index. Under the terms of the lease agreements,the Company is responsible for property taxes, insurance and other operatingcosts with respect to the premises. Mr. Higgins’ obligation for principaland interest on his underlying indebtedness relating to the real property isapproximately $1.1 million per year. None of the leases contain any realproperty purchase options at the expiration of their terms.

 

TheCompany leases one****of its retailstores from Mr. Higgins under an operating lease. Annual rental paymentsunder this lease were $40,000 in 2005, 2004 and 2003. Under the terms of thelease, the Company pays property taxes, maintenance and a contingent rental ifa specified sales level is achieved. Total additional charges for the store,including contingent rent, were approximately $4,400, $14,500 and $4,600 in2005, 2004 and 2003 respectively.

 

TheCompany regularly utilizes privately chartered aircraft owned or partiallyowned by Mr. Higgins. Under an unwritten agreement with Quail AeroServices of Syracuse, Inc., a corporation in which Mr. Higgins holdsa 47.5% share, the Company paid $0, $1,000, and $60,000 for chartered aircraftservices in 2005, 2004, and 2003, respectively. The Company also charters anaircraft from Crystal Jet, a corporation wholly-owned by Mr. Higgins. Paymentsto Crystal Jet aggregated $6,000, $10,000 and $13,000 in 2005, 2004 and 2003,respectively. The Company also charters an aircraft from Richmor Aviation, anunaffiliated corporation that leases an aircraft owned by Mr. Higgins. Paymentsto Richmor Aviation in 2005, 2004 and 2003 were $276,000, $314,000 and$235,000, respectively. The Company believes that the charter rates and termsare as favorable to the Company as those generally available to it from othercommercial charters.

 

MichaelSolow, a member of the Company’s Board of Directors, is a partner of the lawfirm Kaye Scholer LLP, which rendered legal services to the Company in 2004 and2003 for which the Company incurred fees of $115,000 and $202,000 respectively.Kaye Scholer concluded its representation of the Company in 2004.

 

F-24

----

 

**Note 12. Quarterly Financial Information (Unaudited)**

 
| ** **                                                                                      | ** ** | **Fiscal 2005 Quarter Ended**                                 | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2005**                                                                     | ** ** | **1/28/06** | ** ** | **10/29/05** | ** ** | **7/30/05** | ** ** | **4/30/05** | ** ** |
| ** **                                                                                      | ** ** | **($ in thousands, except 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 | ) |

 
| ** **                                                                    | ** ** | **Fiscal 2004 Quarter Ended**                                 | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2004**                                                                     | ** ** | **1/29/05** | ** ** | **10/30/04** | ** ** | **7/31/04** | ** ** | **5/1/04** | ** ** |
| ** **                                                                    | ** ** | **($ in thousands, except per share amounts)** | ** ** |
| Sales                                                                         |       | $                                                                            | 1,365,133  |   | $ | 513,455 |   | $ | 270,013 |   | $ | 277,182 |   | $ | 304,483 |   |
| Gross profit                                                                  |       | 495,134                                                                      |       | 178,823 |   | 99,968 |   | 103,038 |   | 113,305 |   |
| Income (loss) before  extraordinary gain                                      |       | 38,675                                                                       |       | 34,679 |   | (5,174 | ) | 7,129 |   | 2,041 |   |
| Extraordinary gain – unallocated  negative goodwill, net of income taxes |       | 3,166                                                                        |       | — |   | 570 |   | 2,178 |   | 418 |   |
| Net income (loss)                                                             |       | $                                                                            | 41,841     |   | $ | 34,679 |   | $ | (4,604 | ) | $ | 9,307 |   | $ | 2,459 |   |
| Basic earnings (loss) per share  before extraordinary gain                    |       | $                                                                            | 1.12       |   | $ | 1.04 |   | $ | (0.15 | ) | $ | 0.20 |   | $ | 0.06 |   |
| Extraordinary gain – unallocated  negative goodwill, net of income taxes |       | $                                                                            | 0.09       |   | — |   | $ | 0.01 |   | 0.06 |   | 0.01 |   |
| Basic earnings (loss) per share                                               |       | $                                                                            | 1.21       |   | $ | 1.04 |   | $ | (0.14 | ) | $ | 0.26 |   | $ | 0.07 |   |
| Diluted earnings (loss) per share  before extraordinary gain                  |       | $                                                                            | 1.06       |   | $ | 0.98 |   | $ | (0.15 | ) | $ | 0.19 |   | $ | 0.06 |   |
| Extraordinary gain – unallocated  negative goodwill, net of income taxes |       | $                                                                            | 0.09       |   | — |   | $ | 0.01 |   | 0.06 |   | 0.01 |   |
| Diluted earnings (loss) per share                                             |       | $                                                                            | 1.15       |   | $ | 0.98 |   | $ | (0.14 | ) | $ | 0.25 |   | $ | 0.07 |   |

 

**Note 13. Subsequent Event**

 

EffectiveMarch 27, 2006, the Company executed a definitive agreement to acquire thenet assets of Musicland Holding Corp. (“Musicland”). Musicland, anentertainment specialty retailer which operates retail stores and Web sitesunder the names Sam Goody (www.SamGoody.com), Suncoast Motion Picture Company (www.Suncoast.com),On Cue and www.MediaPlay.com, filed a voluntary petition to restructure underChapter 11 of the United States Bankruptcy Code in January 2006. The acquisitionof Musicland’s assets provides the Company with the ability to leverage theirstore locations, and strategically increase the Company’s national presence andprovide further growth opportunities. The transaction represents totalconsideration of $104.2 million in cash and $18.1 million in assumedliabilities subject to certain post closing adjustments, including adjustmentsrelating to the final determination of the value of the inventory. Under theterms of the Asset Purchase Agreement, the Company agreed to acquire the 335 ofMusicland’s remaining 400 stores, with the remainder of the stores beingliquidated under an agency agreement with Hilco Merchant Resources, LLC. As ofthe date of filing of this Report, the Company had not finalized the allocationof the purchase price.

 

F-25

----

 

On March 16,2006, the Company acquired an 80% interest in a company that will be fullyconsolidated for financial reporting purposes in 2006. The Company hascommitted a total funding of $5.2 million over two years, of which $1.2 millionwas funded as of March 25, 2006.

 

**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.                                                                                                                                    |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 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.                                                                  |
|                 |   |                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.5                 |   | Lease dated September 1, 1998, between Robert J. Higgins, as  Landlord, and Record Town, Inc. and Trans World, 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.                   |

 

F-26

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| 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 by reference to Appendix A to Trans World’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 14, 2005,  relating to the Registrant’s Annual Report on Form 10-K for the year  ended January 28, 2006.                                                                                                                                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| *31.2  |   | Certification of Chief Financial Officer dated April 14, 2005,  relating to the Registrant’s Annual Report on Form 10-K for the year  ended January 28, 2006.                                                                                                                                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| *32    |   | Certification of Chief Executive Officer and Chief Financial Officer of  Registrant, dated April 14, 2005, 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  January 28, 2006.                                                                                                                                                                                                                                       |

 

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*Filedherewith.

 

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