**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 
| **ý**                                                                                                                           | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                           |
| **FOR THE QUARTERLY PERIOD ENDED  OCTOBER 29, 2005**                                                                            |
| ** **                                                                                                                           |
| **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 WORLDENTERTAINMENT CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **New York**                                                    | ** ** | **14-1541629**         |
|-----------------------------------------------------------------|------------|------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer       |
|                                                            |       | Identification Number) |
|                                                            |       |                   |
| **38 Corporate Circle**                                         |
| **Albany, New York 12203**                                      |
| (Address of principal executive  offices, including zip code)   |
|                                                            |
| **(518) 452-1242**                                              |
| (Registrant’s telephone number,  including area code)      |

 

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 of1934 during the preceding 12 months (or for shorter period that the Registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý No o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

Common Stock, $.01 par value,

30,981,126 shares outstanding as of November 26,2005

 

 

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**TRANS WORLD ENTERTAINMENTCORPORATION AND SUBSIDIARIES**

**QUARTERLY REPORT ON FORM 10-Q**

**INDEX TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 
| PART 1. FINANCIAL INFORMATION                                                                                                                              |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                            |   |
| Item 1 - Financial Statements                                                                                                                                   |   |
|                                                                                                                                                            |   |
| Condensed Consolidated  Balance Sheets (unaudited) at October 29, 2005, January 29, 2005  and October 30, 2004 (unaudited)                       |   |
|                                                                                                                                                            |   |
| Condensed Consolidated  Statements of Operations (unaudited) – Thirteen Weeks and Thirty-nine Weeks  Ended October 29, 2005 and October 30, 2004 |   |
|                                                                                                                                                            |   |
| Condensed Consolidated  Statements of Cash Flows (unaudited)–Thirty-nine Weeks Ended October 29,  2005 and October 30, 2004                      |   |
|                                                                                                                                                            |   |
| Notes to Condensed  Consolidated Financial Statements (unaudited)                                                                                               |   |
|                                                                                                                                                            |   |
| Item 2 - Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                            |   |
|                                                                                                                                                            |   |
| Item 3 –  Quantitative and Qualitative Disclosures about Market Risk                                                                                       |   |
|                                                                                                                                                            |   |
| Item 4 – Controls and  Procedures                                                                                                                          |   |
|                                                                                                                                                            |   |
| PART II. OTHER INFORMATION                                                                                                                                 |   |
|                                                                                                                                                            |   |
| Item 2 – Changes in  Securities and Use of Proceeds                                                                                                        |   |
|                                                                                                                                                            |   |
| Item 6 - Exhibits and  Reports on Form 8-K                                                                                                                 |   |
|                                                                                                                                                            |   |
| Signatures                                                                                                                                                      |   |

 

2

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**TRANS WORLD ENTERTAINMENTCORPORATION AND SUBSIDIARIES**

**PART 1. FINANCIAL INFORMATION**

**Item 1 - Financial Statements**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands, except shareamounts)**

**(unaudited)**

 
| ** **                                                                                                                        | ** ** | **October 29,  2005** | ** ** | **January 29,  2005** | ** ** | **October 30,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                        |       |                       |       |                       |       |                       |       |
| CURRENT ASSETS:                                                                                                                   | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| Cash and cash equivalents                                                                                                         |       | $                          | 16,805     |                       | $          | 229,768                    |       | $ | 18,658 |   |
| Merchandise inventory                                                                                                             |       | 477,732                    |       | 431,246                    |       | 459,246                    |       |
| Income taxes receivable                                                                                                           |       | 13,030                     |       | —                     |       | 11,940                     |       |
| Deferred taxes                                                                                                                    |       | 12,397                     |       | 15,526                     |       | 8,657                      |       |
| Other current assets                                                                                                              |       | 13,513                     |       | 13,006                     |       | 12,186                     |       |
| Total current assets                                                                                                              |       | 533,477                    |       | 689,546                    |       | 510,687                    |       |
|                                                                                                                              |       |                       |       |                       |       |                       |       |
| NET FIXED ASSETS                                                                                                                  |       | 129,918                    |       | 130,196                    |       | 121,088                    |       |
| DEFERRED TAXES                                                                                                                    |       | 27,640                     |       | 25,039                     |       | 31,386                     |       |
| OTHER ASSETS                                                                                                                      |       | 13,876                     |       | 14,872                     |       | 14,063                     |       |
| TOTAL ASSETS                                                                                                                      |       | $                          | 704,911    |                       | $          | 859,653                    |       | $ | 677,224 |   |
|                                                                                                                              |       |                       |       |                       |       |                       |       |
| **LIABILITIES**                                                                                                                   |       |                       |       |                       |       |                       |       |
| CURRENT LIABILITIES:                                                                                                              |       |                       |       |                       |       |                       |       |
| Accounts payable                                                                                                                  |       | $                          | 252,014    |                       | $          | 358,396                    |       | $ | 224,777 |   |
| Borrowings under line of credit                                                                                                   |       | —                     |       | —                     |       | 3,940                      |       |
| Income taxes payable                                                                                                              |       | —                     |       | 8,592                      |       | —                     |       |
| Accrued expenses and other current liabilities                                                                                    |       | 35,550                     |       | 43,712                     |       | 35,965                     |       |
| Current portion of long-term debt                                                                                                 |       | 470                        |       | 448                        |       | 442                        |       |
| Current portion of capital lease obligations                                                                                      |       | 3,108                      |       | 332                        |       | 431                        |       |
| Total current liabilities                                                                                                         |       | 291,142                    |       | 411,480                    |       | 265,555                    |       |
|                                                                                                                              |       |                       |       |                       |       |                       |       |
| LONG-TERM DEBT, less current  portion                                                                                             |       | 4,708                      |       | 5,060                      |       | 5,177                      |       |
| CAPITAL LEASE OBLIGATIONS, less  current portion                                                                                  |       | 15,668                     |       | 6,977                      |       | 7,137                      |       |
| DEFERRED RENT AND OTHER  LIABILITIES                                                                                              |       | 29,290                     |       | 31,813                     |       | 22,002                     |       |
| TOTAL LIABILITIES                                                                                                                 |       | 340,808                    |       | 455,330                    |       | 299,871                    |       |
|                                                                                                                              |       |                       |       |                       |       |                       |       |
| **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;  55,657,325, 55,014,598 and 54,559,643 shares issued, respectively) |       | 557                        |       | 550                        |       | 546                        |       |
| Additional paid-in capital                                                                                                        |       | 299,016                    |       | 292,922                    |       | 289,672                    |       |
| Unearned compensation – restricted stock                                                                                     |       | (34                        | )          | (46                        | )          | (50                        | )          |
| Accumulated other comprehensive loss                                                                                              |       | (1,094                     | )          | (1,094                     | )          | —                     |       |
| Treasury stock at cost (24,444,349, 21,988,949 and 21,149,849 shares,  respectively)                                              |       | (213,262                   | )          | (186,298                   | )          | (176,425                   | )          |
| Retained earnings                                                                                                                 |       | 278,920                    |       | 298,289                    |       | 263,610                    |       |
| TOTAL SHAREHOLDERS’ EQUITY                                                                                                   |       | 364,103                    |       | 404,323                    |       | 377,353                    |       |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                   |       | $                          | 704,911    |                       | $          | 859,653                    |       | $ | 677,224 |   |

 

*See Notes to Condensed Consolidated Financial Statements.*

 

3

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** TRANS WORLD ENTERTAINMENT CORPORATION ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                                                                                       | ** ** | **Thirteen Weeks Ended**   | ** ** | **Thirty-nine Weeks Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                       | ** ** | **October 29,  2005** | ** ** | **October 30,  2004**  | ** ** | **October 29,  2005** | ** ** | **October 30,  2004** | ** ** |
| ** **                                                                                                       | ** ** | ** **                 | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Sales                                                                                                            |       | $                          | 241,395    |                        | $          | 270,013 |   | $ | 779,923 |   | $ | 851,678 |   |
| Cost of sales                                                                                                    |       | 158,397                    |       | 170,045                     |       | 499,485 |   | 535,367 |   |
| Gross profit                                                                                                     |       | 82,998                     |       | 99,968                      |       | 280,438 |   | 316,311 |   |
| Selling, general and  administrative expenses                                                                    |       | 102,325                    |       | 108,863                     |       | 311,337 |   | 327,458 |   |
| Loss from operations                                                                                             |       | (19,327                    | )          | (8,895                      | )          | (30,899 | ) | (11,147 | ) |
| Other income                                                                                                     |       | (152                       | )          | (60                         | )          | (1,607 | ) | (392 | ) |
| Interest expense                                                                                                 |       | 773                        |       | 638                         |       | 2,005 |   | 1,693 |   |
| Loss  before income taxes and extraordinary gain  - unallocated negative goodwill                                |       | (19,948                    | )          | (9,473                      | )          | (31,297 | ) | (12,448 | ) |
| Income tax benefit                                                                                               |       | (8,480                     | )          | (4,299                      | )          | (11,928 | ) | (16,444 | ) |
| Income  (loss) before extraordinary gain  - unallocated negative goodwill                                        |       | (11,468                    | )          | (5,174                      | )          | (19,369 | ) | 3,996 |   |
| Extraordinary  gain - unallocated negative goodwill, net of income taxes of 0, $359 and 0,  $1,979, respectively |       | —                     |       | 570                         |       | — |   | 3,166 |   |
| Net income (loss)                                                                                                |       | $                          | (11,468    | )                           | $          | (4,604 | ) | $ | (19,369 | ) | $ | 7,162 |   |
|                                                                                                             |       |                       |       |                        |       |   |   |   |   |
| BASIC INCOME (LOSS) PER SHARE:                                                                                   |       |                       |       |                        |       |   |   |   |   |
| Income  (loss) per share before extraordinary gain  -unallocated negative goodwill                               |       | $                          | (0.36      | )                           | $          | (0.15 | ) | $ | (0.60 | ) | $ | 0.11 |   |
| Extraordinary  gain - unallocated negative goodwill, net of income taxes                                         |       | —                     |       | $                           | 0.01       |   | — |   | $ | 0.09 |   |
| Basic income (loss) per share                                                                                    |       | $                          | (0.36      | )                           | $          | (0.14 | ) | $ | (0.60 | ) | $ | 0.20 |   |
|                                                                                                             |       |                       |       |                        |       |   |   |   |   |
| Weighted  average number of common shares outstanding – basic                                               |       | 31,624                     |       | 33,812                      |       | 32,350 |   | 34,965 |   |
|                                                                                                             |       |                       |       |                        |       |   |   |   |   |
| DILUTED INCOME (LOSS) PER SHARE:                                                                                 |       |                       |       |                        |       |   |   |   |   |
| Income  (loss) per share before extraordinary gain  -unallocated negative goodwill                               |       | $                          | (0.36      | )                           | $          | (0.15 | ) | $ | (0.60 | ) | $ | 0.11 |   |
| Extraordinary  gain - unallocated negative goodwill, net of income taxes                                         |       | —                     |       | $                           | 0.01       |   | — |   | $ | 0.09 |   |
| Diluted income (loss) per share                                                                                  |       | $                          | (0.36      | )                           | $          | (0.14 | ) | $ | (0.60 | ) | $ | 0.20 |   |
|                                                                                                             |       |                       |       |                        |       |   |   |   |   |
| Weighted  average number of common shares outstanding – diluted                                             |       | 31,624                     |       | 33,812                      |       | 32,350 |   | 36,653 |   |

 

*See Notes to Condensed Consolidated Financial Statements.*

 

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**TRANS WORLD ENTERTAINMENTCORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                               | ** ** | **Thirty-nine Weeks Ended** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                               | ** ** | **October 29,  2005**  | ** ** | **October 30,  2004** | ** ** |
| Net cash used by operating  activities                                   |       | $                           | (172,792   | ) | $ | (128,495 | ) |
|                                                                     |       |                        |       |   |   |
| Cash flows from investing  activities:                                   |       |                        |       |   |   |
| Purchases of fixed assets                                                |       | (29,063                     | )          | (22,602 | ) |
| Acquisition of interest in subsidiary, net of cash acquired              |       | —                      |       | (2,000 | ) |
| Proceeds from sale of available for sale securities                      |       | 813                         |       | — |   |
| Net cash used by investing  activities                                   |       | (28,250                     | )          | (24,602 | ) |
|                                                                     |       |                        |       |   |   |
| Cash flows from financing  activities:                                   |       |                        |       |   |   |
| Proceeds from long-term debt                                             |       | —                      |       | 5,760 |   |
| Proceeds from capital leases                                             |       | 12,863                      |       | (141 | ) |
| Payments of long-term debt                                               |       | (332                        | )          | 3,940 |   |
| Payments of capital lease obligations                                    |       | (1,394                      | )          | (292 | ) |
| Payments for purchases of treasury stock                                 |       | (26,972                     | )          | (30,362 | ) |
| Proceeds from the exercise of stock options                              |       | 3,914                       |       | 928 |   |
| Net cash used by financing  activities                                   |       | (11,921                     | )          | (20,167 | ) |
|                                                                     |       |                        |       |   |   |
| Net decrease in cash and cash  equivalents                               |       | (212,963                    | )          | (173,264 | ) |
| Cash and cash equivalents,  beginning of year                            |       | 229,768                     |       | 191,922 |   |
| Cash and cash equivalents, end of  period                                |       | $                           | 16,805     |   | $ | 18,658 |   |
| Supplemental disclosure of  non-cash investing and financing activities: |       |                        |       |   |   |
| Income tax benefit resulting from exercises of stock options             |       | $                           | 2,187      |   | $ | 383 |   |
| Issuance of shares under restricted stock plan                           |       | —                      |       | 51 |   |
| Issuance of treasury stock under incentive stock programs                |       | 8                           |       | — |   |

 

*See Notes to Condensed Consolidated Financial Statements.*

 

5

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**TRANS WORLD ENTERTAINMENTCORPORATION AND SUBSIDIARIES**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)**

**October 29, 2005 and October 30,2004**

 

**Note 1. Nature of Operations**

 

TransWorld Entertainment Corporation and its subsidiaries is one of the largestspecialty retailers of music, video, including DVD and VHS, video games andrelated products in the United States. The Company operates retail entertainment stores and e-commerce sites,including www.fye.com, www.coconuts.com, www.wherehouse.com, andwww.secondspin.com, in a single industry segment.  As of October 29, 2005, the Companyoperated 800 stores totaling approximately 4.9 million square feet in 46 states,the District of Columbia, the Commonwealth of Puerto Rico and the U.S. VirginIslands.

 

**Note 2: Basis of Presentation**

 

The accompanying unaudited condensed consolidated financial statementsconsist of Trans World Entertainment Corporation, its wholly owned subsidiaryRecord Town, Inc. (“Record Town”) and Record Town’s subsidiaries, all ofwhich are wholly owned (“the Company”). During the thirteen weeks ended October 29,2005, the Company acquired an 80% interest in a Company that is fullyconsolidated for financial reporting purposes. All significant intercompanyaccounts and transactions have been eliminated.

 

Theinterim condensed consolidated financial statements have been prepared pursuantto the rules and regulations of the United States Securities and ExchangeCommission (“SEC”).  The informationfurnished in these condensed consolidated financial statements reflects allnormal, recurring adjustments which, in the opinion of management, arenecessary for the fair presentation of such financial statements.  The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements, and thereported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  Certain information and footnote disclosuresnormally included in the financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to rules and regulations applicable tointerim financial statements.

 

The information presented in the accompanyingunaudited condensed consolidated balance sheet as of January 29, 2005 hasbeen derived from the Company’s fiscal year 2005 audited consolidated financialstatements. All other information has been derived from the Company’s unauditedconsolidated financial statements as of and for the thirteen and thirty-nineweeks ended October 29, 2005 and October 30, 2004.  These unaudited condensed consolidatedfinancial statements should be read in conjunction with the audited financialstatements and notes thereto included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended January 29, 2005. Certain reclassifications havebeen made to prior periods to conform to the current period presentation.

 

The Company’s significant accounting policies arethe same as those described in Note 1 to the Company’s Consolidated FinancialStatements on Form 10-K for the fiscal year ended January 29, 2005.

 

6

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**Note 3. Seasonality**

 

TheCompany’s business is seasonal in nature, with the fourth fiscal quarterconstituting the Company’s peak selling period. In 2004, the fourth fiscal quarter accounted for approximately 38% ofannual sales.  In anticipation ofincreased sales activity during these months, the Company purchases additional merchandiseinventory and hires additional, temporary employees to supplement its permanentstore sales staff.  If, for any reason,the Company’s net sales are below seasonal norms during the fourth quarter, theCompany’s operating results, particularly operating and net income, could beadversely affected.  Additionally,quarterly sales results, in general, are affected by the timing of newreleases, the performance of existing stores and new store openings orclosings.

 

**Note 4. Stock Based Compensation**

 

The Company applies the intrinsicvalue-based method of accounting prescribed by Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees*, and related interpretations including FinancialAccounting Standards Board (“FASB”) Interpretation No. 44, *Accounting for Certain Transactions Involving Stock Compensation – AnInterpretation of APB No. 25*, in accounting for its fixed planstock options.  Under this method,compensation expense would be recorded on the date of grant only if the currentmarket price of the underlying stock exceeded the exercise price.  Unearned compensation recognized forrestricted stock awards is shown as a separate component of shareholders’equity and is amortized to expense over the vesting period of the stock awardusing the straight-line method. Statement of Financial Accounting Standards (“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 allowedby SFAS No. 123, the Company has elected to continue to apply theintrinsic value-based method of accounting described above, and has adopted thedisclosure requirements of SFAS No. 123 and SFAS No.148. The followingtable illustrates the effect on net income (loss) and income (loss) per shareif the Company had applied the fair value recognition provisions of SFAS No. 123to stock-based employee compensation:

 
| ** **                                                                                                                                    | ** ** | **Thirteen Weeks ended**                     | ** ** | **Thirty-nine Weeks ended**                  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **October 29,  2005**                   | ** ** | **October 30,  2004**                   | ** ** | **October 29,  2005** | ** ** | **October 30,  2004** | ** ** |
| ** **                                                                                                                                    | ** ** | **(in thousands except per share  amounts)** | ** ** | **(in thousands except per  share amounts)** | ** ** |
| Net income (loss), as reported                                                                                                                |       | $                                            | (11,468    | )                                            | $          | (4,604 | ) | $ | (19,369 | ) | $ | 7,162 |   |
| Add: Stock-based employee compensation expense included in reported net  income (loss), net of related income taxes                           |       | 57                                           |       | 27                                           |       | 122 |   | 106 |   |
| Deduct: Total stock-based employee compensation expense determined under  fair value based method for all awards, net of related income taxes |       | (643                                         | )          | (819                                         | )          | (2,202 | ) | (2,614 | ) |
| Proforma net income (loss)                                                                                                                    |       | $                                            | (12,054    | )                                            | $          | (5,396 | ) | $ | (21,449 | ) | $ | 4,654 |   |
| Income (loss) per share:                                                                                                                      |       |                                         |       |                                         |       |   |   |   |   |
| Basic - as reported                                                                                                                           |       | $                                            | (0.36      | )                                            | $          | (0.14 | ) | $ | (0.60 | ) | $ | 0.20 |   |
| Basic– proforma                                                                                                                          |       | $                                            | (0.38      | )                                            | $          | (0.16 | ) | $ | (0.66 | ) | $ | 0.13 |   |
| Diluted – as reported                                                                                                                    |       | $                                            | (0.36      | )                                            | $          | (0.14 | ) | $ | (0.60 | ) | $ | 0.20 |   |
| Diluted – proforma                                                                                                                       |       | $                                            | (0.38      | )                                            | $          | (0.16 | ) | $ | (0.66 | ) | $ | 0.13 |   |

 

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**Note 5. Defined Benefit Plan**

 

The Company maintains anon-qualified Supplemental Executive Retirement Plan (“SERP”) for certainexecutives of the Company.  The SERP,which is unfunded, provides eligible executives defined pension benefits thatsupplement benefits under other retirement arrangements.  The annual benefit amount is based on salaryand bonus at the time of retirement and number of years of service.

 

Prior to June 1, 2003, theCompany provided the Board of Directors with a noncontributory, unfundedretirement plan (“Director Retirement Plan”) that paid a retired director anannual retirement benefit equal to 60% of the annual retainer at the time ofretirement plus a 3% annual increase through the final payment.  Payments began at age 62 or retirement,whichever was later, and would continue for 10 years or the life of thedirector and his or her spouse, whichever period was shorter.  Partial vesting in the retirement plan beganafter six years of continuous service. Participants became fully vested after 12 years of continuous service onthe Board.  As of June 1, 2003, newdirectors are no longer covered by the Director Retirement Plan.  Current directors who were not yet vested intheir retirement benefits had the present value of benefits already accrued asof the effective date converted to deferred shares under the Directors StockOption Plan.  Directors that were fullyor partially vested in their retirement benefits were given a one time electionto continue to participate in the current retirement program or convert thepresent value of benefits already accrued to deferred shares under theDirectors Stock Option Plan as of the effective date.

 

The Company accounts for the SERPand the Director Retirement Plan in accordance with the provisions of SFAS No. 87,*Employers’ Accounting for Pensions*.

 

During the thirteen and thirty-nine weeks ended October 29, 2005, theCompany did not make any cash contributions to the SERP or the DirectorRetirement Plan, and presently expects to pay $35,000 in benefits relating toSERP and $6,250 in benefits relating to the Director Retirement Plan during2005. The following represents the components of the netperiodic pension cost related to the Company’s SERP and Director RetirementPlan for the respective periods:

 
| ** **                          | ** ** | **Thirteen weeks ended**   | ** ** | **Thirty-nine weeks ended** | ** ** |
|-------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                          | ** ** | **October 29,  2005** | ** ** | **October  30, 2004**       | ** ** | **October 29,  2005** | ** ** | **October 30,  2004** | ** ** |
| ** **                          | ** ** | **(in thousands)**         | ** ** | **(in thousands)**          | ** ** |
| Service cost                        |       | $                          | 133        |                        | $          | 101 |   | $ | 399 |   | $ | 303 |   |
| Interest cost                       |       | 196                        |       | 157                         |       | 588 |   | 471 |   |
| Amortization of prior service  cost |       | 85                         |       | 85                          |       | 255 |   | 255 |   |
| Amortization of net loss            |       | 62                         |       | 4                           |       | 186 |   | 12 |   |
| Net periodic pension cost           |       | $                          | 476        |                        | $          | 347 |   | $ | 1,428 |   | $ | 1,041 |   |
|                                     |            |                            |            |                             |            |  |  |  |  |  |  |  |  |  |

 

**Note 6. Extraordinary Gain**

 

TheCompany acquired substantially all the net assets of Wherehouse EntertainmentInc. and CD World Inc. in October 2003 for $35.2 million and $1.9 million,respectively. The purchase price was allocated on a preliminary basis usinginformation available at the time. In accordance with SFAS No. 141, *Business Combinations,* the allocation of the purchase priceto the assets and liabilities acquired were finalized during the thirteen weeksended October 30, 2004, after obtaining more information regarding assetvaluations and liabilities assumed.

 

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Duringthe thirteen and thirty-nine weeks ended October 30, 2004, the Companyadjusted the purchase accounting in accordance with the provisions of SFAS No. 141,resulting in an extraordinary gain of $0.6 million and $3.2 million,respectively, net of income taxes of $0.3 million and $2.0 millionrespectively, related to unallocated negative goodwill.  The gain represents the excess of the fairvalue of net assets acquired over the purchase price.

 

**Note 7. Long-Term Debt and Capital Lease Obligations**

 

Duringthe thirty-nine weeks ended October 29, 2005, the Company financed thereplacement of its point-of-sale system through a capital lease arrangement inthe amount of $12.0 million. The lease arrangement bears an averageinterest rate of 5.76% and will be repaid in monthly installments of $229 thousandover 5 years. During the thirteen weeks ended October 29, 2005, the Companypurchased software licenses through a capital lease arrangement for $0.9million, bearing an average interest rate of 5.75%. The capital lease will berepaid in quarterly installments of $122 thousand over 2 years.

 

During2004, the Company borrowed $5.8 million under a mortgage loan with South TrustBank to finance the purchase of real estate. The mortgage loan isrepayable in monthly installments of $64 thousand over 10 years with a fixedinterest rate of 6.0% and is collateralized by the real estate. The mortgageloan contains a minimum net worth (shareholders’ equity) covenant of $290million, excluding the impact, if any, of certain non-cash charges.

 

**Note 8. Comprehensive Income (Loss)**

 

TheCompany accounts for comprehensive income (loss) in accordance with SFAS No. 130,*Reporting Comprehensive Income*, which requiresonly additional disclosures in the consolidated financial statements.  Items of other comprehensive income that theCompany currently reports are the excess additional minimum pension liabilityover unrecognized prior service cost with respect to the SERP and unrealizedgains (losses) on available-for-sale securities.  The Company’s total comprehensive income(loss) for the thirteen and thirty-nine weeks ended October 29, 2005 and October 30,2004 was as follows:

 
| ** **                                                                                                                | ** ** | **Thirteen Weeks ended**   | ** ** | **Thirty-nine Weeks ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                | ** ** | **October 29,  2005** | ** ** | **October 30,  2004**  | ** ** | **October 29,  2005** | ** ** | **October 30,  2004** | ** ** |
| ** **                                                                                                                | ** ** | **($ in thousands)**  | ** ** | **($ in thousands)**   | ** ** |
| Net income (loss)                                                                                                         |       | $                          | (11,468    | )                           | $          | (4,604 | ) | $ | (19,369 | ) | $ | 7,162 |   |
|                                                                                                                      |       |                       |       |                        |       |   |   |   |   |
| Other comprehensive income  (loss), net of income taxes:                                                                  |       |                       |       |                        |       |   |   |   |   |
| Change in unrealized gain on available-for-sale securities, net of  income taxes of 0 and 0, and $306 and 0, respectively |       | —                     |       | —                      |       | 442 |   | — |   |
| Reclassification adjustment for realized gain on Available-for-sale  securities included in income                        |       | —                     |       | —                      |       | (442 | ) | — |   |
| Total comprehensive income (loss)                                                                                         |       | $                          | (11,468    | )                           | $          | (4,604 | ) | $ | (19,369 | ) | $ | 7,162 |   |

 

9

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**Note 9. Recently Issued Accounting Standards.**

 

In May 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes and FASB Statement No. 3, Reporting Accounting Changesin Interim Financial 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 to havea material impact on the Company’s consolidated financial condition or resultsof operations.

 

In November 2004, the FASB issued SFAS No. 151*, Inventory Costs, an amendment of ARB No. 43*,Chapter 4. SFAS No. 151 clarifies that abnormal inventory costs suchas costs of idle facilities, excess freight and handling costs, and wastedmaterials (spoilage) are required to be recognized as current periodcharges.  The provisions of SFAS No. 151are effective for fiscal years beginning after June 15, 2005. The adoptionof SFAS No. 151 is not expected to have a significant impact on theCompany’s consolidated financial condition or results of operations.

 

In December 2004,the FASB issued 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 the compensationcost over the period during which an employee is required to provide service inexchange for the award. In March 2005, the SEC issued Staff AccountingBulletin No. 107 (“SAB 107”), which expresses views of the SEC staffregarding 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. The Company is required to adopt SFAS No. 123(R) in its firstquarter of 2006 and is currently evaluating the potential effects of thisstandard on its stock compensation arrangements and related effects on theCompany’s consolidated financial condition and results of operations. If theCompany had applied the provisions of SFAS No. 123(R) to the condensedconsolidated financial statements for the thirteen and thirty-nine weeks ended October 29,2005, the net loss would have been higher by approximately $0.6 million, or$0.02 per share, and $2.1 million, or $0.06 per share, respectively.

 

In June 2005, the Emerging Issues Task Force (“EITF”)issued EITF No. 05-6, *Determining theAmortization Period of Leasehold Improvements (purchased after lease inception)or Acquired in a Business Combination*(“EITF 05-6”). EITF 05-6provides that the amortization period for leasehold improvements acquired in abusiness combination or purchased after the inception of a lease be the shorterof (a) the useful life of the assets or (b) a term that includesrequired lease periods and renewals that are reasonably assured upon theacquisition of the purchase. The provisions of EITF 05-6 are effective on aprospective basis for leasehold improvements purchased or acquired beginning July 1,2005. The adoption of EITF 05-6 did not have a material effect on the Company’scondensed consolidated financial statements for the thirteen and thirty-nineweeks ended October 29, 2005.

 

10

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**Note 10. Depreciation and Amortization**

 

Depreciationand amortization of fixed assets included in the condensed consolidatedstatements of operations is as follows:

 
| ** **                                          | ** ** | **Thirteen  Weeks Ended**  | ** ** | **Thirty-nine  Weeks Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------|------------|------------------------------|------------|
| ** **                                          | ** ** | **October 29,  2005** | ** ** | **October  30, 2004**        | ** ** | **October  29, 2005** | ** ** | **October  30, 2004** | ** ** |
| ** **                                          | ** ** | **(in  thousands)**        | ** ** | **(in  thousands)**          | ** ** |
| Cost of sales                                       |       | $                          | 778        |                         | $          | 603 |   | $ | 2,328 |   | $ | 1,789 |   |
| Selling, general & administrative expenses |       | 8,585                      |       | 7,945                        |       | 25,171 |   | 24,904 |   |
| Total                                               |       | $                          | 9,363      |                         | $          | 8,548 |   | $ | 27,499 |   | $ | 26,693 |   |
|                                                     |            |                            |            |                              |            |  |  |  |  |  |  |  |  |  |

 

 

**Note 11. Earnings Per Share**

 

Weightedaverage shares are calculated as follows:

 

 
| ** **                                                | ** ** | **Thirteen Weeks Ended** | ** ** | **Thirty-nine Weeks Ended** | ** ** |
|-----------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                | ** ** | **October  29, 2005**    | ** ** | **October  30, 2004**       | ** ** | **October  29, 2005** | ** ** | **October 30,  2004** | ** ** |
| ** **                                                | ** ** | **(in thousands)**       | ** ** | **(in thousands)**          | ** ** |
| Weighted average common shares outstanding – basic   |       | 31,624                   |       | 33,812                      |       | 32,350 |   | 34,965 |   |
| Dilutive effect of employee stock  options                |       | —                   |       | —                      |       | — |   | 1,688 |   |
| Weighted average common shares outstanding – diluted |       | 31,624                   |       | 33,812                      |       | 32,350 |   | 36,653 |   |
|                                                      |       |                     |       |                        |       |   |   |   |   |
| Anti-dilutive stock options                               |       | 9,947                    |       | 9,625                       |       | 9,851 |   | 4,012 |   |

 

Forthe thirteen and thirty-nine week periods ended October 29, 2005, theimpact of outstanding stock options was not considered because the Company reporteda net loss and such impact would be anti-dilutive.

 

**Note 12. Income Taxes**

 

The Company recorded an income tax charge of $1.1million resulting from changes in the Ohio state income tax law enacted during thethirty-nine weeks ended October 29, 2005. The legislation phases out statecorporation franchise tax, which is based on income. The tax charge representsa write-off of the state deferred tax assets allocated to Ohio, principally netoperating losses that, based on management’s estimates, will not be realizedduring the phase-out period.

 

The Company recorded an income tax benefit of $10.5million in the thirty-nine weeks ended October 30, 2004.  The benefit was the result of closing afederal income tax examination, including all matters not previously settled inrelation to Company Owned Life Insurance (“COLI”) policies, which were part ofthe Company’s acquisition of Camelot in 1999. The original income tax payable amounts relating to the years covered bythe examination were reversed subsequent to the final settlement resulting in theincome tax benefit.  With the closing ofthe tax examination, the Company has surrendered the remaining COLI policies.

 

11

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**Note 13. Legal Proceedings**

 

TheCompany is subject to legal proceedings and claims that have arisen in theordinary course of its business and which have not been finallyadjudicated.  Although there can be noassurance as to the ultimate disposition of these matters, it is management’sopinion, based upon the information available at this time, that the expectedoutcome of these matters, individually or in the aggregate, will not have amaterial adverse effect on the Company’s financial condition or results ofoperations.

 

**Note 14. Contractual Obligations and Commitments.**

 

The Company’s Annual Report on Form 10-K for the year ended January 29,2005 provides a summary of the Company’s contractual obligations at January 29,2005, and the effect that such obligations are expected to have on liquidityand cash flows in future periods. The following information relating tocommitments entered into during the thirteen weeks ended October 29, 2005should be read in conjunction with the unaudited condensed consolidatedfinancial statements and related notes included elsewhere in this report and theaudited financial statements included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended January 29, 2005.

 

During the thirteen weeks ended October 29, 2005, the Companyacquired an 80% interest in a Company that is fully consolidated for financialreporting purposes. The Company’s has committed funding of $3.0 million over aperiod of three years, of which $500 thousand has been funded as of October 29,2005.

 

12

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**Item 2 - Management’s Discussion and Analysis of Financial Conditionand**

## **Results of Operations**

**October 29, 2005 and October 30,2004**

 

**Overview**

 

Management’s Discussion and Analysis of Financial Condition and Results ofOperations provides information that the Company’s management believesnecessary to achieve an understanding of its financial condition and results ofoperations.  To the extent that suchanalysis contains statements which are not of a historical nature, suchstatements are forward-looking statements, which involve risks anduncertainties.  These risks include, butare not 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, video,including DVD and VHS, and video games industries of an increased or decreasednumber of “hit releases”; general economic factors in markets where the Company’smerchandise is sold; and other factors discussed in the Company’s filings withthe SEC.  The following discussion andanalysis of the Company’s financial condition and results of operations shouldbe read in conjunction with the unaudited condensed consolidated financialstatements and related notes included elsewhere in this report and the auditedfinancial statements included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended January 29, 2005.

 

At October 29, 2005, the Company operated 800 stores totalingapproximately 4.9 million square feet in 46 states, the District of Columbia,the Commonwealth of Puerto Rico and the U.S. Virgin Islands. The Company’sstores offer predominantly entertainment software, including music, video,including DVD and VHS, and video games.  Intotal, these categories represented 91% and 92% of the Company’s total sales inthe thirteen weeks and thirty-nine weeks ended October 29, 2005,respectively.  The balance of categories,including software accessories, boutique and electronic products represented 9%and 8% of the Company’s total sales in the thirteen weeks and thirty-nine weeksended October 29, 2005, respectively.

 

The Company strives to understand general economic and business trends andto manage the business in response to those trends, and monitors a number ofkey performance indicators in this regard, 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 stores relocated in the same shopping mallafter being open for at least thirteen months are considered comparablestores.  Closed stores that were open forat least thirteen months are included in comparable store sales through themonth immediately preceding the month of closing.  The Company further analyzes sales by storeformat (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 the mix of products sold andby allowances negotiated with vendors. The Company records its distribution and product shrink expenses in costof sales. Distribution expenses include those costs associated with purchasing,receiving, inspecting and warehousing merchandise and costs associated withproduct returns to vendors.  Cost ofsales also includes obsolescence costs and is reduced by the benefit of vendorallowances.

 

13

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**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 and amortization charges(excluding those related to cost of sales, as discussed in Note 10 to theCondensed Consolidated Financial Statements). SG&A expenses also include asset impairment charges and write-offs,if any, and miscellaneous items, other than interest.

 

**Balance Sheet and Ratios:** The Company views cash, net inventory investment (merchandise inventoryless accounts payable) and working capital (current assets less currentliabilities) as indicators of its financial condition.  See Liquidity and Capital Resources for discussionof items related to liquidity.

 

**CRITICAL ACCOUNTING POLICIES ANDESTIMATES**

 

The preparation of financial statements and relateddisclosures in conformity with accounting principles generally accepted in theUnited States requires that management apply accounting policies and makeestimates and assumptions that affect results of operations and the reportedamounts of assets and liabilities in the financial statements.  Management continually evaluates its estimatesand judgments including those related to merchandise inventory and returncosts, valuation of long-lived assets and income taxes.  Management bases its estimates and judgmentson historical experience and other factors that are believed to be reasonableunder the circumstances.  Actual resultsmay differ from these estimates under different assumptions or conditions.  Note 1 of Notes to the Consolidated FinancialStatements on Form 10-K for the year ended January 29, 2005 includesa summary of the significant accounting policies and methods used by theCompany in the preparation of its condensed consolidated financial statements.Management believes that of the Company’s significant accounting policies, thefollowing may involve a higher degree of judgment or complexity:

 

**Merchandise Inventory and Return Charges:**Merchandise inventory is stated at thelower of cost or market as determined by the average cost method. Merchandise inventoryvaluation requires significant judgment and estimates regarding obsolescence,shrink and any adjustments to market value, if market value is lower than cost.The Company records obsolescence and any adjustments to market value (if lowerthan cost) based on current and anticipated demand and market conditions. Theprovision for inventory shrink is estimated as a percentage of sales for theperiod from the last date a physical inventory was performed to the end of aperiod.  Shrink estimates are based on historical results andtrends.  Physical inventories are taken at least annually for all stores,and inventory records are adjusted accordingly.

 

The Company is entitled to returnmerchandise purchased from major vendors for credit against other purchasesfrom these vendors.  Select vendorsreduce the credit with a merchandise return charge ranging from 0% to 20% ofthe original merchandise purchase price depending on the type of merchandisebeing returned.  The Company recordsmerchandise return charges in cost of sales.

 

14

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**Valuation of Long-Lived Assets: **The Company assessesthe potential impairment of long-lived assets to determine if any part of thecarrying values may not be recoverable. Factors that the Company considers whenassessing impairment include:

 

•**  **significant underperformancerelative to historical results;

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

•**  **significant negative industry oreconomic trends.

 

If the Company determines that the carrying value of a long-lived assetmay not be recoverable based on one or more of the above indicators, theCompany would test for impairment to determine if a write-down is needed.

 

**Income Taxes:** Income taxes are accounted for under the asset andliability method.  Deferred tax assetsand liabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases and tax operating losscarryforwards.  Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled.  The effect ondeferred tax assets and liabilities of a change in tax laws and rates isrecognized in the results of operations in the period that includes theenactment date.  Accounting for incometaxes requires management to make estimates and judgments regardinginterpretation of various taxing jurisdictions, laws and regulations as well asthe ultimate realization of deferred tax assets.  These estimates and judgments include thegeneration of future taxable income, viable tax planning strategies and supportof tax filings.  Valuation allowances arerecorded against deferred tax assets if, based upon management’s estimates ofrealizability, it is more likely than not that some portion or all of thesedeferred tax assets will not be realized.

 

15

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**RESULTS OFOPERATIONS**

**Thirteen and Thirty-nine WeeksEnded October 29, 2005**

**Compared to the Thirteen andThirty-nine Weeks Ended October 30, 2004**

 

The following table sets forth a period over periodcomparison of the Company’s sales for the thirteen and thirty-nine weeks ended October 29,2005 and October 30, 2004, by category:

 
| ** **       | ** ** | **Thirteen weeks ended** | ** ** | **Thirty-nine weeks ended** | ** ** |
|------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **       | ** ** | **October  29, 2005**    | ** ** | **October  30, 2004**       | ** ** | **Change** | ** ** | **%** | ** ** | **Comp  Store  Sales** | ** ** | **October  29, 2005** | ** ** | **October  30, 2004** | ** ** | **Change** | ** ** | **%** | ** ** | **Comp  Store  Sales** | ** ** |
| ** **       | ** ** | **(in thousands)**       | ** ** | ** **                  | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Sales**        | ** ** | $                        | 241,395    |                        | $          | 270,013 |   | $ | (28,618 | ) | -10.6 | % | **-7.5** | **%** | $ | 779,923 |   | $ | 851,678 |   | $ | (71,755 | ) | -8.4 | % | **-4.5** | **%** |
| As a % of sales  | ** ** | ** **               | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Music            |       | 58                       | %          | 58                          | %          |   |   |   |   | -8.0 | % | 58 | % | 59 | % |   |   |   |   | -6.5 | % |
| Video            |       | 27                       | %          | 27                          | %          |   |   |   |   | -7.6 | % | 27 | % | 27 | % |   |   |   |   | -4.7 | % |
| Video Games      |       | 6                        | %          | 7                           | %          |   |   |   |   | -13.3 | % | 7 | % | 6 | % |   |   |   |   | 7.1 | % |
| Other            |       | 9                        | %          | 8                           | %          |   |   |   |   | -1.0 | % | 8 | % | 8 | % |   |   |   |   | 3.1 | % |
|             |       |                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Store Count:** |       |                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Mall             |       | 556                      |       | 585                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Freestanding     |       | 244                      |       | 267                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total**        | ** ** | **800**                  | ** ** | **852**                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                  |            |                          |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Sales.**The decreasein sales resulted from a comparable store sales decrease of 7.5% and 4.5%,respectively for the thirteen and thirty-nine weeks ended October 29,2005, respectively. The decrease in sales was also due to the operation offewer stores.  The Company operated 800stores as of October 29, 2005 compared to 852 stores as of October 30,2004.

 

***Music:***

 

TheCompany’s stores offer a wide range of compact discs (“CDs”), audio cassettesand singles across most music genres, including new releases from currentartists as well as an extensive catalog of music from past periods and artists.During the thirteen and thirty-nine weeks ended October 29, 2005, CD saleswhich constituted 99% of music sales, decreased 7.3% and 5.6% on a comparablestore basis, respectively, as compared to the thirteen and thirty-nine weeksended October 30, 2004.  Thedecrease in CD sales was consistent with the decline in industry sales duringthe period, characterized generally by lack of strong new releases. The Company’smusic sales also decreased due to lower store count.

 

***Video:***

 

TheCompany offers DVDs and videocassettes, in all of its stores.  Comparable store sales in the DVD categorydecreased 3.0% in the thirteen weeks ended October 29, 2005 and was flatduring the thirty-nine weeks ending October 29, 2005.  DVD sales constituted 93% and 92% of totalvideo sales in the thirteen and thirty-nine weeks ended October 29, 2005respectively. The Company’s decrease in DVD sales was due to lower store countand a decrease in comparable store sales consistent with the decline inindustry sales during the period, characterized generally by lack of strong newreleases.

 

16

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***Video Games:***

 

TheCompany offers video game hardware and software in most of its stores, with amix that favors software.  Comparablestore sales decreased 13.3% and increased 7.1%, respectively, in the thirteenand thirty-nine weeks ended October 29, 2005.  During the thirteen weeks ended October 29,2005, sales in the video games category slowed due to lower sales of newreleases. For the thirty-nine week period ended October 29, 2005, lowersales of new releases in the third quarter was offset by strong sales of Sony’sPSP game system which was released in the first quarter.

 

***Other:***

 

## **The Company offers items relating to theuse, care and storage of entertainment software, along with boutique andelectronic products. Comparable store sales decreased 1.0% and increased 3.1%,respectively in the thirteen and thirty-nine weeks ended October 29, 2005**.  The increase inthe thirty-nine weeks ended October 29, 2005 is due to the Company’smerchandising initiatives to improve this category, including the expansion ofproduct lines and adding new items to complement the core merchandisecategories of music, video and video games.

 

**Gross Profit. **The following table sets forth a period over periodcomparison of the Company’s gross profit:

 
| ** **      | *** *** | **Thirteen weeks ended** | *** *** | ** **            | ** ** | **Thirty-nine weeks ended** | ** ** | ** ** | ** ** | ** **            | ** ** |
|-----------------|--------------|--------------------------|--------------|-----------------------|------------|-----------------------------|------------|------------|------------|-----------------------|------------|
| ** **      | *** *** | **(in thousands)**       | *** *** | **Change**            | ** ** | **(in thousands)**          | ** ** | **Change** | ** ** |
| ** **      | ** **   | **October  29, 2005**    | ** **   | **October  30, 2004** | ** ** | **$**                       | ** ** | **%**      | ** ** | **October  29, 2005** | ** ** | **October  30, 2004** | ** ** | **$** | ** ** | **%** | ** ** |
| Gross Profit    |         | $                        | 82,998       |                  | $          | 99,968                      |       | $          | (16,970    | )                     | (17.0      | )% | $ | 280,438 |   | $ | 316,311 |   | $ | (35,873 | ) | (11.3 | )% |
|            |         |                     |         |                  |       |                        |       |       |       |                  |       |   |   |   |   |   |   |
| As a % of sales |         | 34.4                     | %            | 37.0                  | %          |                        |       |       |       | 36.0                  | %          | 37.1 | % |   |   |   |   |
|                 |              |                          |              |                       |            |                             |            |            |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

For the thirteen weeks ended October 29, 2005, grossmargin as a percentage of sales declined by 260 basis points, resulting from adecrease in margin in music and DVD due to a more competitive pricingenvironment (90 basis points), higher distribution costs as a rate to sales (70basis points) and a decrease in vendor allowances and other miscellaneous items(100 basis points).

 

For the thirty-nine weeks ended October 29, 2005, thegross margin rate as a percentage of sales declined by 110 basis points,resulting from higher distribution costs as a rate to sales (70 basis points)and a decrease in vendor allowances and other miscellaneous items (40 basispoints).

 

17

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**Selling, General &Administrative Expenses (“SG&A”).**** **The following table setsforth a period over period comparison of the Company’s SG&A:

 
| ** **      | *** *** | **Thirteen weeks ended** | *** *** | ** **            | ** ** | **Thirty-nine weeks ended** | ** ** | ** ** | ** ** | ** **            | ** ** |
|-----------------|--------------|--------------------------|--------------|-----------------------|------------|-----------------------------|------------|------------|------------|-----------------------|------------|
| ** **      | *** *** | **(in thousands)**       | *** *** | **Change**            | ** ** | **(in thousands)**          | ** ** | **Change** | ** ** |
| ** **      | ** **   | **October  29, 2005**    | ** **   | **October  30, 2004** | ** ** | **$**                       | ** ** | **%**      | ** ** | **October  29, 2005** | ** ** | **October  30, 2004** | ** ** | **$** | ** ** | **%** | ** ** |
| SG&A        |         | $                        | 102,325      |                  | $          | 108,863                     |       | $          | (6,538     | )                     | (6.0       | )% | $ | 311,337 |   | $ | 327,458 |   | $ | (16,121 | ) | (4.9 | )% |
|            |         |                     |         |                  |       |                        |       |       |       |                  |       |   |   |   |   |   |   |
| As a % of sales |         | 42.4                     | %            | 40.3                  | %          |                        |       |       |       | 39.9                  | %          | 38.4 | % |   |   |   |   |
|                 |              |                          |              |                       |            |                             |            |            |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

## **Although variable SG&A expensesdecreased due to fewer stores in operation, fixed SG&A expenses remainedconsistent in the thirteen and thirty-nine weeks ended October 29, 2005 ascompared to the thirteen and thirty-nine weeks ended October 30, 2004,resulting in the reduction of expense leverage due to the decline in sales.**

## ** **

**Other Income.**Otherincome includes interest income. For the thirty-nine weeks ended October 29,2005, other income also includes a realized gain of $0.8 million on the sale ofavailable-for-sale securities during the second quarter.

 

**Income Tax Benefit. **The following table setsforth a period over period comparison of the Company’s income tax benefit:

 
| ** **                                               | ** ** | **Thirteen weeks ended  (in thousands)** | ** ** | **Thirty-nine weeks ended  (in thousands)** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **October  29, 2005**                    | ** ** | **October  30, 2004**                       | ** ** | **October  29, 2005** | ** ** | **October 30,  2004** | ** ** |
| Income tax benefit before IRS settlement benefit in 2004 |       | $                                        | (8,480     | )                                           | $          | (4,299 | ) | $ | (11,928 | ) | $ | (5,899 | ) |
|                                                     |       |                                     |       |                                        |       |   |   |   |   |
| Effective tax rate before IRS settlement benefit in 2004 |       | 42.5                                     | %          | 45.4                                        | %          | 38.1 | % | 47.4 | % |
|                                                     |       |                                     |       |                                        |       |   |   |   |   |
| IRS settlement benefit                                   |       | —                                   |       | —                                      |       | — |   | (10,545 | ) |
|                                                     |       |                                     |       |                                        |       |   |   |   |   |
| Income tax benefit                                       |       | $                                        | (8,480     | )                                           | $          | (4,299 | ) | $ | (11,928 | ) | $ | (16,444 | ) |

 

The Company recorded a lower tax benefit on a rate basis inthe thirty-nine weeks ended October 29, 2005, due to an income tax chargeof $1.1 million recorded in the thirty-nine weeks ended October 29, 2005(see Note 12 of Notes to the Condensed Financial Statements).

 

The Company recorded an income tax benefit of $10.5million in the thirty-nine weeks ended October 30, 2004.  The benefit was the result of closing afederal income tax examination. See Note 12 of Notes to the Condensed FinancialStatements for further detail.

 

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**Extraordinary Gain – Unallocated Negative Goodwill.** In October 2003, the Company acquiredsubstantially all of the net assets of Wherehouse Entertainment Inc. and CDWorld Inc. During the thirteen and thirty-nine weeks ended October 30,2004, the Company adjusted the purchase accounting in accordance with theprovisions of SFAS No. 141, resulting in an extraordinary gain of $0.6million and $3.2 million, respectively, net of income taxes of $0.3 million and$2.0 million respectively, related to unallocated negative goodwill. The gainrepresents the excess of the fair value of net assets acquired over thepurchase price.

 

**Net Income (Loss).**The following table setsforth a period over period comparison of the Company’s net income (loss):

 
| ** **                                                                                                           | ** ** | **Thirteen weeks ended  (in thousands)** | ** ** | **Thirty-nine weeks ended  (in thousands)** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **October 29,  2005**                    | ** ** | **October 30,  2004**                       | ** ** | **October 29,  2005** | ** ** | **October  30, 2004** | ** ** |
| ** **                                                                                                           | ** ** | ** **                               | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income (loss) before extraordinary gain                                                                              |       | $                                        | (11,468    | )                                           | $          | (5,174 | ) | $ | (19,369 | ) | $ | 3,996 | ** ** |
|                                                                                                                 |       |                                     |       |                                        |       |   |   |   | ** ** |
| Extraordinary gain – unallocated negative goodwill, net of income taxes  of 0, $359 and 0, $1,979, respectively |       | —                                   |       | 570                                         |       | — |   | 3,166 | ** ** |
|                                                                                                                 |       |                                     |       |                                        |       |   |   |   | ** ** |
| Net income (loss)                                                                                                    |       | $                                        | (11,468    | )                                           | $          | (4,604 | ) | $ | (19,369 | ) | $ | 7,162 | ** ** |

 

The decline in net income in the thirteen and thirty-nineweeks ended October 29, 2005 was due to the lower sales and gross profit,the recording of a tax charge for the change in Ohio state laws which wasincluded in income (loss) for the thirty-nine weeks ended October 29, 2005and the absence of a tax benefit recorded in the thirty-nine weeks ended October 30,2004 (See Note 12 of Notes to the Condensed Consolidated Financial Statements).

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

**Liquidity.**The Company’s primary sources of working capital are cashprovided by operations and borrowings under its revolving credit facility.  The Company’s cash flows fluctuate fromquarter to quarter due to various items, including seasonality of sales andresults from operations, merchandise inventory purchases and the related termson the purchases, tax payments, capital expenditures and stock repurchaseactivity.  Management believes theCompany will have adequate resources to fund its cash needs for the foreseeablefuture.  The following table sets forth asummary of key components of cash flow and working capital for the thirty-nineweeks ended October 29, 2005 and October 30, 2004:

 
| ** **                 | ** ** | **Thirty-nine weeks ended** | ** ** | **Change**            | ** ** |
|----------------------------|------------|-----------------------------|------------|-----------------------|------------|
| **(in  thousands)**        | ** ** | **October 29,  2005**       | ** ** | **October 30,  2004** | ** ** | **$** | ** ** |
| Operating  Cash Flows      |       | $                           | (172,792   | )                     | $          | (128,495 | ) | $ | (44,297 | ) |
| Financing  Cash Flows      |       | (11,921                     | )          | (20,167               | )          | 8,246 |   |
|                       |       |                        |       |                  |       |   |   |
| Capital  Expenditures      |       | (29,063                     | )          | (22,602               | )          | (6,461 | ) |
|                       |       |                        |       |                  |       |   |   |
| Cash  and Cash Equivalents |       | 16,805                      |       | 18,658                |       | (1,853 | ) |
| Inventories                |       | 477,732                     |       | 459,246               |       | 18,486 |   |
| Working  Capital           |       | 242,335                     |       | 245,132               |       | (2,797 | ) |
|                            |            |                             |            |                       |            |  |  |  |  |  |

 

TheCompany had cash balances of $16.8 million at October 29, 2005, comparedto $229.8 million at January 29, 2005 and $18.7 million at October 30,2004.  Inventory was $97 per square footat October 29, 2005, compared to $88 per square foot at October 30,2004. The increase in inventory is due to an expansion of the Company’sportable electronics category carrying a broader assortment of MP3 players andportable DVD players.  The increase isalso due to an earlier build up of inventory for the holiday selling season.

 

Cashused by operating activities was $172.8 million for the thirty-nine weeks endedOctober 29, 2005.  The primary usesof cash were a $106.4 million seasonal reduction of accounts payable, a $21.6million reduction in income taxes payable, and a $46.5 million increase inmerchandise inventory. The Company’s inventory and accounts payable are heavilyinfluenced by the seasonality of its business. A significant reduction ofaccounts payable occurs annually in the fiscal first quarter, reflectingpayments for merchandise inventory sold during the prior year’s holidayseason.  Similarly, merchandise inventoryincreases each year throughout the fall season and peaks during the holidayselling season.  The seasonality of theCompany’s earnings in its fiscal fourth quarter also results in the timing ofsubstantially all income tax payments to be made subsequent to year end. Thesecash uses are offset by a significant cash source in the fiscal fourth quarterfrom the seasonal increase in sales during the holiday season (see Note 3 ofNotes to the Condensed Financial Statements).

 

Cashused by financing activities was $11.9 million for the thirty-nine weeks ended October 29,2005.  The primary use of cash was $27.0million for the purchase of approximately 2.5 million shares of common stockunder a stock repurchase program authorized by the Company’s Board of Directorsin May 2003. The primary source of cash was through a capital leaseborrowings of $12.9 million (See Note 7 of Notes to the Condensed FinancialStatements) and the exercise of stock options of $3.9 million.

 

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## **The authorized stock repurchase program allowsthe Company to repurchase 10 million shares of Common Stock from time to timeon the open market and has no expiration date. As of October 29, 2005, theCompany had 660 thousand remaining shares authorized under the current program.**

 

## **The Company has a three-year, $100million secured revolving credit facility with Congress Financial Corporationthat expires in July 2006 and renews on a year-to-year basis thereafterwith the consent of both parties. The facility contains certain restrictiveprovisions, including provisions governing cash dividends and acquisitions andis collateralized by merchandise inventory and other assets. The Companyanticipates the amount of the revolving credit facility being fully availableto the Company through its term, and anticipates obtaining a similar,replacement facility upon its expiration. As of October 29, 2005, theCompany had $1.2 million in outstanding letter of credit obligations underthe revolving credit facility and $98.8 million was available for borrowing. Asof October 30, 2004, the Company had $3.9 million outstanding inborrowings and $1.2 million in outstanding letter of credit obligations underthe revolving credit facility.**

## ** **

During 2004, the Company borrowed $5.8 million under a mortgage loan withSouth Trust Bank to finance the purchase of real estate. The mortgage loanis repayable in monthly installments of $64 thousand over 10 years with a fixedinterest rate of 6.0% and is secured by the real estate. As of October 29,2005, the Company had a loan balance of $5.2 million outstanding.

 

The revolving credit facility restricts the amount of dividends that theCompany can declare up to 10% of its annual net income, excluding certainnon-cash gains.  Payment of any dividendsis further subject to levels of availability on the Company’s revolving creditfacility. The mortgage loan and the revolving credit facility contain a minimumnet worth (shareholders’ equity) covenant of $290 million, excluding theimpact, if any, of certain non-cash charges.

 

During2005, the Company financed the replacement of its point-of-sale system througha capital lease arrangement in the amount of $12.0 million.The lease arrangement bears an average interest rate of 5.76% andwill be repaid in monthly installments of $229 thousand over 5 years. As of October 29,2005, the outstanding balance on the lease was $10.9 million.  During the thirteen weeks ended October 29,2005, the Company purchased software licenses through a capital leasearrangement for $0.9 million, bearing an average interest rate of 5.75%. Thecapital lease will be repaid in quarterly installments of $122 thousand over 2years. As of October 29, 2005, the outstanding balance on the lease was$0.8 million.

 

During the thirteen weeks ended October 29, 2005, the Companyacquired an 80% interest in a Company that is fully consolidated for financialreporting purposes. The Company’s has committed funding of $3.0 million over aperiod of three years, of which $500 thousand has been funded as of October 29,2005.

 

**Capital Resources. **Duringthe thirty-nine weeks ended October 29, 2005, the Company made capitalexpenditures of $29.1 million. During the thirty-nine weeks ended October 29,2005, the Company opened 8 new stores, relocated 12 stores and closed 18stores. The Company plans to spend approximately $37 million for capitalexpenditures in 2005.

 

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**Item 3 - Quantitative and Qualitative Disclosures about Market Risk**

 

## **To the extentthe Company borrows under its revolving credit facility, the Company is subjectto risk resulting from interest rate fluctuations since interest on the Company’sborrowings under its credit facility can be variable.  Interest on the revolving credit facility ispayable monthly in arrears at a variable rate of either the prime rate or LIBORplus 1.65%.  If interest rates on theCompany’s revolving credit facility were to increase by 25 basis points, and tothe extent borrowings were outstanding, for every $1.0 million outstanding onthe facility, income before income taxes would be reduced by about $2,500 peryear. For a discussion of the Company’s accounting policies for financialinstruments and further disclosures relating to financial instruments, see “Natureof Operations and Summary of Significant Accounting Policies” in the Notes toConsolidated Financial Statements in the Company’s Form 10-K for the yearended January 29, 2005. The Company does not hold any derivativeinstruments and does not engage in hedging activities.**

 

**Item 4 –Controls and Procedures**

 

## ** (a)    Evaluation ofdisclosure controls and procedures.  The Company’s Chief ExecutiveOfficer and Chief Financial Officer after evaluating the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures (asdefined in the Securities Exchange Act of 1934 Rules 13a-15(e) and15d-15(e)) as of October 29, 2005, have concluded that as of such date theCompany’s disclosure controls and procedures were adequate and effective anddesigned to ensure that material information relating to the Company and itssubsidiaries would be made known to such officers on a timely basis.**

 

## ** (b) *   *Changes in internal controls*.*  Therehave been no changes in the Company’s internal controls over financialreporting that occurred during the fiscal quarter covered by this quarterlyreport that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal controls over financial reporting.**

 

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**PART II - OTHER INFORMATION**

 

## **Item 2 –Changes in Securities and Use of Proceeds**

 

On May 28, 2003, the Company’s Board of Directorsauthorized the repurchase of 10 million outstanding shares of the Company’sCommon Stock from time to time on the open market. The program has noexpiration date.  The Company hadrepurchased 15 million shares of common stock under previously announcedprograms. As of October 29, 2005 the Company had purchased 9.3 millionshares, at a total cost of $84.1 million, and 660 thousand shares remained tobe purchased under the current program. The following table shows the purchaseof equity securities purchased under the repurchase program as required byRegulation 229.703 Item 703:

 
| **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** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|-----------------------------------|------------|--------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| July 31,  2005 – August 27, 2005       |       | 352,700                               |       | 8.10                              |       | 352,700                                                                              |       | 1,348,741                                                                |       |
| August 28,  2005 – September 24, 2005  |       | 488,200                               |       | 7.77                              |       | 488,200                                                                              |       | 860,541                                                                  |       |
| September 25,  2005 – October 29, 2005 |       | 199,900                               |       | 7.83                              |       | 199,900                                                                              |       | 660,641                                                                  |       |
| Total                                                 |       | 1,040,800                             |       | 7.89                              |       | 1,040,800                                                                            |       | 660,641                                                                  |       |

 

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**Item 6 -Exhibits and Reports on Form 8-K**

 

**(A)**** ****Exhibits -**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                    |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                 |       | Chief Executive Officer  certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                             |
|                 |       |                                                                                                                               |
| 31.2                 |       | Chief Financial Officer  certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                             |
|                 |       |                                                                                                                               |
| 32                   |       | Certification pursuant to 18  U.S.C Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

**(B)**** ****Reports on Form 8-K –**

 

A Form 8-K was filed on August 11, 2005incorporating by reference the Company’s August 11, 2005 press releaseannouncing the Company’s financial results for the thirteen and twenty-sixweeks ended July 30, 2005.

 

A Form 8-K was filed on October 18, 2005incorporating by reference the Company’s October 18, 2005 press releaseproviding updated guidance for its third quarter and fiscal year 2005.

 

A Form 8-K was filed on October 25, 2005incorporating by reference the Company’s October 19, 2005 press releaseannouncing the appointment of James A. Litwak as the President and ChiefOperating Officer of the Company.

 

Omittedfrom this Part II are items which are not applicable or to which theanswer is negative to the periods covered**.**

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities and Exchange Act of 1934, the Registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 

**TRANS WORLD ENTERTAINMENT CORPORATION**

 
| December 8, 2005 | **By: /s/ ROBERT J. HIGGINS**                                                                            |   |
|-----------------------|----------------------------------------------------------------------------------------------------------|--------|
|                  | Robert J. Higgins                                                                                        |
|                  | Chairman and Chief Executive Officer                                                                     |
|                  | (Principal Executive Officer)                                                                            |
|                  |                                                                                                     |
| December 8, 2005 | **By: /s/ JOHN J. SULLIVAN**                                                                             |   |
|                  | John J. Sullivan                                                                                         |
|                  | Executive Vice President and Chief Financial  Officer (Principal Financial and Chief Accounting Officer) |
|                       |                                                                                                          |        |  |

 

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