<PAGE>
 
                   U. S. SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549


                                  FORM 10-KSB
                                        

(Mark One)

[X]                ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF
                      THE SECURITIES EXCHANGE ACT OF 1934




[ ]              TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF
                      THE SECURITIES EXCHANGE ACT OF 1934


      For the transition period from _______________ to _______________.

For the Fiscal Year Ended December 31, 1998     Commission File Number 000-21887

                              CD WAREHOUSE, INC.
                              ------------------
            (Exact name of registrant as specified in its charter)

            DELAWARE                                      73-1504999
            --------                                      ----------
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
incorporation or organization)

1204 Sovereign Row, Oklahoma City, Oklahoma                 73108
-------------------------------------------                 -----
 (Address of principal executive offices)                (Zip Code)

      Registrant's telephone number, including area code:  (405) 949-2422
 
Securities registered pursuant to Section 12(b) of the Act:  None

Securities registered pursuant to Section 12(g) of the Act:  Common Stock, $.01
                                                             par value per share
                               (Title of Class)

Check whether the registrant (1) has filed all reports required by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.

                            Yes  X          No
                                ---            ---

Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-B
is not contained in this form, and will not be contained, to the best of
registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB.  _______

Registrant's revenues for its most recent fiscal year were $15,261,903.

As of March 8, 1999, the aggregate market value of the voting stock held by non-
affiliates computed by reference to the price at which the stock was sold, or
the average bid and asked prices of such stock, was $39,183,855.

As of March 8, 1999, there were 3,635,295 shares of Common Stock outstanding.

Transitional Small Business Disclosure Format (check one):   Yes     No  X
                                                                ---     ---

DOCUMENTS INCORPORATED BY REFERENCE: Registrant's Proxy Statement for the 1999
Annual Meeting of Stockholders is incorporated by reference in Part III, Items 9
through 12, of this Form 10-KSB.
<PAGE>
 
                                  FORM 10-KSB

                               TABLE OF CONTENTS

Item      PART I                                                         Page

 1.       Description of Business                                          1

 2.       Description of Property                                         14

 3.       Legal Proceedings                                               14

 4.       Submission of Matters to a Vote of Security Holders             15


          PART II

 5.       Market for Common Equity and Related Stockholder Matters        15

 6.       Management's Discussion and Analysis or Plan of Operation       16

 7.       Financial Statements                                            22

 8.       Changes In and Disagreements With Accountants on Accounting 
          and Financial Disclosure                                        22
                    

          PART III

 9.       Directors, Executive Officers, Promoters and Control Persons; 
          Compliance With Section 16(a) of the Exchange Act               22
                    
10.       Executive Compensation                                          22

11.       Security Ownership of Certain Beneficial Owners and Management  23

12.       Certain Relationships and Related Transactions                  23

13.       Exhibits and Reports on Form 8-K                                23

Signatures                                                                25

Financial Information                                             Appendix A

                                       i
<PAGE>
 
                DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

          This Report includes "forward-looking statements" within the meaning
of Section 27A of the Securities Act of 1933, as amended (the "Act"), and
Section 21E of the Securities Exchange Act of 1934, as amended. All statements
other than statements of historical facts included in this Report, including,
without limitation, statements regarding the Company's future financial
position, business strategy, budgets, projected costs and plans and objectives
of Management for future operations, are forward-looking statements. In
addition, forward-looking statements generally can be identified by the use of
forward-looking terminology such as "may," "will," "expect," "intend,"
"estimate," "anticipate" or "believe" or the negative thereof or variations
thereon or similar terminology. Although the Company believes that the
expectations reflected in such forward-looking statements are reasonable, it can
give no assurance that such expectations will prove to have been correct. Such
statements are based upon numerous assumptions about future conditions which may
ultimately prove to be inaccurate and actual events and results may materially
differ from anticipated results described in such statements. Important factors
that could actual results to differ materially from the Company's expectations
("cautionary statements") include the risks inherent generally in the retail and
franchising industries, the impact of competition and pricing, changing market
conditions, the risks disclosed under "Item 6Management's Discussion and
Analysis or Plan of Operation" and elsewhere in this Report. All subsequent
written and oral forward-looking statements attributable to the Company, or
persons acting on its behalf, are expressly qualified in their entirety by the
cautionary statements. The Company assumes no duty to update or revise its
forward-looking statements based on changes in internal estimates or
expectations or otherwise. As a result, the reader is cautioned not to place
reliance on these forward-looking statements. Further, there can be no assurance
that the historical level of the Company's revenues and net income will continue
to be achieved in the future.


                                    PART I

Item 1.   Description of Business.

General

          CD Warehouse, Inc. (together with its wholly owned subsidiaries, the
"Company") is engaged in the franchising and ownership of music stores offering
new and pre-owned compact discs ("CD's") and related products under two similar
but distinct franchise systems, "CD Warehouse" and "Disc Go Round."  The term
"CD Warehouse System" encompasses the two franchise systems and their respective
stores, which variously operate under the trade names "CD Warehouse," "Disc Go
Round" and "CD Exchange."  Since its initial public offering in January 1997
(the "IPO"), the Company has engaged in a program of expansion to achieve strong
market recognition in the retail music industry.  This expansion has been
accomplished primarily through the sale of new franchises and the acquisition
and conversion of independently owned retail music stores to company-owned
stores, as well as the acquisition by the Company of existing franchised stores.
During 1998, the most significant factors contributing to the Company's store
and revenue growth were (i) the acquisition of the Disc Go Round franchise
system from Grow Biz International, Inc. ("Grow Biz"), consisting of the
franchise rights for 134 Disc Go Round retail music stores and the assets of
three company-owned Disc Go Round stores, and (ii) the acquisition, as company-
owned stores, of 21 CD Warehouse franchised stores.  At December 31, 1998, the
CD Warehouse System had an aggregate 314 stores in 40 states and the District of
Columbia., Canada, England, France, Guatemala and Venezuela, with 135 franchised
stores and 51 company-owned stores operating under the CD Warehouse concept
(utilizing either the CD Warehouse or CD Exchange trade name) and 128 franchised
stores operating under the Disc Go Round concept (utilizing either the Disc Go
Round or CD Exchange trade name).  The term "CD Warehouse" encompasses the CD
Warehouse and CD Exchange stores operating within the CD Warehouse franchise
system, and the term "Disc Go Round" encompasses the Disc Go Round and CD
Exchange stores operating within the Disc Go Round franchise system.

          CD Warehouse and Disc Go Round stores sell their products to the
general public in the market area where the respective store is located. A
typical store, located in a high traffic strip shopping center, will occupy
between 1,200 and 2,500 square feet and offer between 10,000 and 16,000
selections, with approximately 65% of the dollar sales volume being pre-owned
selections and the balance being new releases from the major music categories.
At each CD Warehouse and Disc Go Round store, a customer selects from a number
of new and pre-owned CD's and may listen to pre-owned CD's 

                                       1
<PAGE>
 
before purchase. CD Warehouse and Disc Go Round stores sell CD's, take
customers' CD's in trade or buy customers' CD's for cash. Typically, each store
carries the majority of the Billboard Top 100 selections as "new" inventory,
filling out its inventory selection with pre-owned CD's which are purchased for
$1 to $4 and remarketed for $6 to $9.

          During the year ended December 31, 1998, the Company had total
revenues of approximately $15,262,000, and net income of approximately $775,000.
The Company's expansion strategy for 1999 is to open 30 franchised stores and
open or acquire 35 company-owned stores. The Company also plans to further
develop and market its internet site, http://www.cdwarehouse.com, launched in
December 1998, which offers both new and used CDs. See "ITEM 1Description of
BusinessCompetition."

History

          The Company was formed in September 1996 to acquire the assets of
Compact Discs International, Ltd. ("CDIL"), a Texas limited partnership which
franchised stores throughout the United States and England under the name "CD
Warehouse." A portion of the proceeds of the Company's IPO was used to fund the
$3.2 million acquisition (the "CDIL Acquisition"), which was consummated
simultaneously with the closing of the IPO. See Item 12--Certain Relationships
and Related Transactions. In a related transaction (the "MacDonald
Acquisition"), which also occurred simultaneously with the closing of the IPO,
the Company acquired the equity interests of Bruce D. MacDonald (together with
his affiliates, "MacDonald") in various partnerships or other entities which
were franchisees of an aggregate 36 franchised CD Warehouse stores. See Item
12Certain Relationships and Related Transactions. As a result of the CDIL
Acquisition and the MacDonald Acquisition, the Company acquired the rights to
the CD Warehouse name, assumed CDIL's role as franchisor under the franchise
agreements to which CDIL was a party and acquired interests in the CD Warehouse
stores in which MacDonald had an interest.

Recent Events

          .   Effective January 1, 1998, the Company purchased the assets of a
              franchisee, ZDTMAC, a general partnership. The aggregate purchase
              price of $535,971 was paid $173,471 in cash and $362,500 in shares
              of the Company's common stock, par value $.01 per share (the
              "Common Stock"), valued for purposes of the acquisition at $3.625
              per share. Pursuant to the acquisition, the five CD Warehouse
              stores operated by ZDTMAC became company-owned stores.

          .   On May 28, 1998, the Company closed a private placement of an
              aggregate 1,624,300 shares of the Company's Common Stock. The
              Company received gross proceeds of $16,243,000 for the shares,
              which were sold for a purchase price of $10.00 per share. The
              shares were sold in the United States to certain "accredited
              investors" (as such term is defined in Regulation D of the
              Securities Act) in reliance on Rule 506 of Regulation D of the
              Act, and outside the United States to certain non-U.S. persons
              (who also were accredited investors) in reliance on Regulation S
              of the Act. Pursuant to certain registration rights afforded the
              purchasers of the shares, in September 1998 the Company effected a
              registration under the Securities Act of 1933, as amended, of
              substantially all such securities.

          .   In June 1998, the Company completed the acquisition of Disc Go
              Round, a 137-store retail music franchise system. The acquisition
              consisted of the franchise rights for 134 Disc Go Round retail
              music stores and the assets of three company-owned Disc Go Round
              stores, for an aggregate cash purchase price of approximately $7
              million.

          .   During October 1998 and through November 6, 1998, Compact Discs
              Management, Inc., ("CD Management"), a wholly owned subsidiary of
              the Company, made purchases of 93 partnership and limited
              liability company units from the owners of such units, paying an
              aggregate cash purchase price of $1,737,867. The units acquired
              represented the equity interests of the sellers in three entities
              which owned and operated 16 CD Warehouse franchised stores in the
              states of Arkansas, Kansas, Louisiana, Missouri, Nebraska,
              Oklahoma and Texas. As a result of these individual purchases, CD
              Management acquired 100% of these 16 stores, which are operated
              under the CD Warehouse system concept as company-owned stores.

                                       2
<PAGE>
 
          .   On February 22, 1999, the Company completed the purchase of a 16-
              store retail music chain located in San Diego, California and
              surrounding areas and operating under the name "Music Trader." The
              Company intends to operate the 16 stores as company-owned stores
              under the CD Warehouse concept. The total purchase price for the
              transaction, which was structured as an acquisition of the assets
              relating to the 16 stores, was $4,000,000, comprised of $3,000,000
              in cash and $1,000,000 in Common Stock of the Company, valued for
              purposes of the acquisition at $11.80 per share.

Business Strategy

          The Company's business strategy of offering a mix of both new and pre-
owned CD's is based on its belief that there is a growing consumer willingness
to purchase pre-owned CD's, which is providing an expanding market niche in the
retail music industry for CD resellers. The Company's business strategy is to
establish itself as the recognized industry leader in the domestic buy-sell-
trade retail CD marketplace by pursuing a three-fold approach: (1) offering
quality, pre-owned CD's at exceptional value; (2) offering to accept as a trade,
or buy for cash, selected CD's from customers; and (3) selling new releases at
competitive prices.

          According to the Recording Industry Association of America (the
"RIAA"), annual CD sales in the United States for 1998 were $11.4 billion in
1998, which represented a 15.1% increase from 1997 domestic CD sales of $9.9
billion. The lack of any audible difference between new and pre-owned CD's,
durability of the medium, cost savings and the accumulating stock of available
CDs for resale, suggest the possibility for rapid market growth in the pre-owned
CD market. Because the CD is encased in plastic and read by a laser, the playing
of CD's, and even the occasional careless handling of CDs, rarely cause damage
that will impair performance or result in any degradation of sound quality. In
the absence of pronounced abuse, CD's may reasonably be expected to last for
decades; premium (gold-plated) CD's may last for centuries. Such extraordinary
durability, coupled with the standard error-correction circuitry in CD players,
means that pre-owned CDs are essentially indistinguishable from new CDs in terms
of audible performance. By offering quality pre-owned CD's at substantial
savings and responding to consumers' desire to recycle merchandise they no
longer want or use but which has intrinsic value, the CD Warehouse remarketing
concept emphasizes consumer value.

          Management believes that, in addition to the Company, Hastings
Entertainment, Inc. and The Wherehouse are the only national chains selling pre-
owned CD's on any significant scale, and that the market for CD remarketers is
fragmented and underserved.  Accordingly, the Company believes that it can
increase its market share by expanding the CD Warehouse System in targeted
markets.  The Company's expansion strategy for 1999 is to open 30 franchised
stores and open or acquire 35 company-owned stores.  To accomplish this
objective, the Company employs a business strategy that includes the following
elements:

          Inventory Management System.  The Company considers its inventory
management system, which is a proprietary software program, to be essential to
the success of its business strategy and the CD Warehouse concept.  The program,
which has a database in excess of 270,000 titles and includes catalogs from all
the major record labels, assists each store in selectively procuring pre-owned
CD's by supplying buying directions for every CD offered.  The ability to access
this data instantly gives store operators the capability to make an informed
decision on every CD presented by a customer for purchase or trade, by reviewing
the title's historic sales data, as well as the recommended purchase price that
the CD has been assigned by the Company.  By scanning each CD (utilizing bar
coding capability), the program also includes point-of-sale recording of all
transactions, including customer profiles with which mailing lists may be
created.  Additionally, as each transaction is entered, the program provides for
the printing of customer receipts which concurrently compiles inventory by
title, including respective costs, selling price and gross profit results.
Accordingly, the program can generate reports of comprehensive data for any
selected period or any facet of store operations, including sales by title,
sales by dollar volume, inventory by title, individual transaction summaries,
acquisitions for any period, system adjustments, cash register reconciliation
and virtually any other pertinent financial information.

          The Company believes that its inventory management system contributes
to more efficient system-wide management of inventory by reducing the need to
purchase new titles from music distributors for new store inventories and
affording existing stores the opportunity to sell excess inventory. As new
stores are developed, opening packages of inventory are assembled by the Company
and sold to the franchisees. The demand for inventory by new stores allows

                                       3
<PAGE>
 
existing stores to sell excess inventory. If, for example, it is determined that
a store may be overstocked on a particular selection, the Company may purchase
the selection and resell it to another unit or as part of the opening inventory
of a new store. The Company believes that this is a significant advantage in
comparison to its competitors, since the Company can review all titles available
and source its own system for inventory. Management anticipates as much as 75%
of the opening inventory for a new store can be purchased from system stores.
This constant inventory turnover allows existing stores to make a reasonable
profit and provide a source of capital while providing an opportunity for the
Company to acquire quality inventory to open new stores or update an existing
location's inventory.

          The Company currently is developing enhancements of its proprietary
software system.  These enhancements will include such features as (i) a
communication upgrade that will allow all stores to communicate with the Company
and with each other, and (ii) an accounting package that will produce a profit
and loss statement from the information captured by a store's point-of-sale
register.  The Company expects to introduce the software upgrade to all CD
Warehouse stores during the third quarter of 1999.  Disc Go Round stores utilize
an inventory and point-of-sale software that offers comparable management
reporting capability but lacks the CD Warehouse database.

          Customer Service. The Company emphasizes excellent customer service
and seeks to employ, and to sell franchises to, motivated and energetic people.
The Company also seeks to foster enthusiasm for its customer service philosophy
and its franchise concepts through annual franchise conventions, regional
meetings and other frequent contacts with its franchisees and store managers.

          Targeted Expansion.  The Company believes that its existing core and
developing markets offer significant growth opportunity for both company-owned
and franchised store development.  The Company concentrates its expansion of
stores in markets where it can cluster stores, thereby expanding consumer
awareness and creating significant operating, distribution and advertising
efficiencies.  To increase its penetration of core markets, the Company co-
develops markets with franchisees, divides markets among franchisees or divides
markets among the Company and franchisees.  The Company also clusters its
company-owned stores and franchised stores through the use of area development
agreements and its site selection approval process.  The Company believes that
this approach has contributed to increased average store sales.

Store Locations

          The table below shows the location, as of December 31, 1998, of all CD
Warehouse and Disc Go Round stores (which also includes, for each franchise
system, stores operating under the trade name "CD Exchange") in the United
States, Canada, England, France, Guatemala and Venezuela:

DOMESTIC

ALABAMA                          ARKANSAS                DELAWARE 
Daphne++                         Fort Smith++            Newark+              
Homewood++                       Little Rock *           Wilmington+          
Hoover++                         North Little Rock*                           
Huntsville*                                              FLORIDA              
Huntsville++                     CALIFORNIA              Bradenton++          
Mobile++                         Huntington Beach+       Coral Gables*        
                                 Palm Desert+            Davie++              
                                                         Daytona Beach*       
ARIZONA                          COLORADO                Deland*              
Mesa+                            Arvada+                 Fern Park*           
Scottsdale*                      Colorado Springs++      Ft. Lauderdale (2)++
                                 Ft. Collins*            Ft. Myers++          
                                 Littelton+              Gainesville++        
                      

                                       4
<PAGE>
 
FLORIDA (cont'd)                 IOWA                    MINNESOTA           
Jacksonville+                    Ames+                   Bemidji+            
Jacksonville (2)*                Cedar Rapids++          Blaine+             
Lake Park++                      Cedar Rapids+           Brooklyn Center+    
Naples++                         Clive+                  Burnsville+         
Neptune Beach*                   Davenport++             Duluth+             
North Miami*                     Davenport+              Eden Prairie*       
Orange Park*                     Des Moines (2)++        Edina+              
Orlando*                         Des Moines+             Maple Grove+        
Orlando+                         Sioux City++            Maplewood+          
Ormond Beach*                    Waterloo++              Minneapolis(2)+     
Palm Harbor*                     Waterloo+               Minnetonka*         
Port Charlotte++                                         Roseville+          
Sarasota++                       KANSAS                  St. Cloud+          
Sanford*                         Overland Park*                              
Tallahassee(2)++                 Shawnee*                MISSOURI            
Tampa+                           Wichita++               Arnold++            
Venice++                                                 Ballwin++           
                                 KENTUCKY                Cape Girardeau++    
GEORGIA                          Lexington+              Gladstone*          
Atanta(3)+                       Louisville(2)+          Independence*       
Augusta+                         Paducah++               Lee Summit*         
Duluth+                          Richmond+               O'Fallon++          
Marietta+                                                Springfield*        
Marietta++                       LOUISIANA               St. Louis++         
Martinez++                       Baton Rouge*                                
Morrow+                          Baton Rouge++           MONTANA             
                                 Lafayette*              Bozeman++           
IDAHO                            Metarie*                Great Falls++       
Idaho Falls++                    New Orleans++                               
                                 Shreveport++            NEBRASKA            
ILLINOIS                         Shreveport+             Lincoln+            
Burbank+                                                 Omaha*              
Carbondale++                     MARYLAND                                    
Chicago(2)+                      Elkridge++              NEVADA              
Harwood Heights+                 Frederick+              Las Vegas(2)+       
Moline+                          Laurel++                                    
North Riverside+                                         NEW JERSEY          
Palatine++                       MICHIGAN                Belleville++        
Sterling+                        Ann Arbor+              Denville+           
Streamwood++                     East Lansing++          Freehold+           
                                 Grand Rapids(2)+        Laurel Springs++    
INDIANA                          Holland+                Northfield++        
Bloomington+                     Kalamazoo++             Voorhees+           
Indianapolis++
Indianapolis(3)+
Mishawaka+

                                       5
<PAGE>
 
NEW YORK                         PENNSYLVANIA            Houston (5)* 
Endicott+                        Allentown+              Houston+     
Guilderland+                     Conshohocken+           Hurst++      
Huntington Station++             Easton+                 Irving++     
Rockville Center++               Erie+                   Lewisville++ 
Wantaugh++                       Greensburg+             Lubbock++    
White Plains++                   Harrisburg+             Mesquite++   
                                 Mechanicsburg+          Midland*     
NORTH CAROLINA                   Monroeville+            North Richland Hills++
Cary+                            Philadelphia+           Plano++               
Charlotte++                      Pittsburgh++            Rockwall++            
Charlotte+                       Pittsburg+              Round Rock++          
Durham+                          State College+          San Angelo++          
Fayettville+                     West Mifflin++          San Antonio (6)++     
Goldsboro++                                              San Marcos++          
Raleigh+                         SOUTH CAROLINA          Sherman++             
Wilmington+                      Columbia+               Texarkana++           
                                 Greenville++            Waco*                 
NORTH DAKOTA                     Greenville+             Webster*              
Fargo+                                                   Wichita Falls*        
                                 SOUTH DAKOTA                                  
OHIO                             Sioux Falls+            UTAH                  
Beavercreek+                                             Provo++               
Boardman++                       TENNESSEE               Provo+                
Brooklyn+                        Antioch+                Salt Lake City+       
Canton++                         Bartlett+               St. George++          
Centerville+                     Clarksville++           Taylorsville++        
Cincinnati(2)+                   Jackson++                                     
Cleveland Heights++              Madison+                VERMONT               
Columbus (3)++                   Memphis*                Burlington+           
Holland++                        Murfreesboro++                                
Mayfield Heights++               Nashville++             VIRGINIA              
Miamisburg++                                             Alexandria++          
Parma Heights++                  TEXAS                                         
Toledo++                         Abilene*                WASHINGTON            
Youngstown+                      Arlington (2)++         Belleville++          
                                 Austin (3)++            Bremerton+            
OKLAHOMA                         Austin+                 Kennewick+            
Edmond*                          Carrollton++            Linwood+              
Norman*                          College Station+        Seattle ++            
Oklahoma City - North May*       Corpus Christi++        Seattle(3)+           
Oklahoma City-NW Expressway*     Corpus Christi+                               
Shawnee*                         Dallas - Montfort*      WISCONSIN             
Stillwater*                      Dallas (7)++            Appleton++            
Tulsa*                           Denton ++               Appleton+             
Tulsa++                          Duncanville++           Brookfield++          
                                 El Paso*                Brookfield+           
OREGON                           Ft. Worth (2) ++        East Milwaukee+       
Beaverton+                       Garland*                Green Bay+            
Portland+                        Grand Prairie++         Greenfield+           

                                       6
<PAGE>
 
WISCONSIN (cont'd)               INTERNATIONAL           London++           
Greenfield++                                             Watford++          
Janesville+                      CANADA                                     
Kenosha++                        Charlottetown/PE+       FRANCE             
Madison(3)+                      Dartmouth/NS+           Caen++             
Madison++                        Halifax/NS+                                
Racine++                         Ottawa/ON+              GUATEMALA          
                                 Thunder Bay/ON+         Guatemala City++   
WYOMING                          Winnipeg/MB (3)+                           
Casper+                                                  VENEZUELA          
                                 ENGLAND                 Caracus++          
DISTICT OF COLUMBIA              Ealing++                 
Washington++                     Leeds++                   

--------------------

*    Indicates company-owned store.
++   Indicates CD Warehouse store.
+    Indicates Disc Go Round store.


Expansion Strategy

          The first CD Warehouse store opened in Dallas, Texas in August 1992
and, as of December 31, 1998, the CD Warehouse System had an aggregate stores
314 stores in 40 states and the District of Columbia, Canada, England, France,
Guatemala and Venezuela, with 135 franchised stores and 51 company-owned stores
operating under the CD Warehouse concept and 128 franchised stores operating
under the Disc Go Round concept. Key elements of the Company's expansion
strategy include:

          Aggressive, Balanced Growth. The Company's expansion strategy is to
increase the number of franchised stores by selective utilization of Company-
owned stores in a particular market area. The Company believes that, in many
cases, the Company will be able to take advantage of a promising new location by
establishing a Company-owned store when a delay in finding a qualified
franchisee might jeopardize the Company's ability to secure the site. Company-
owned stores also provide a training ground for Company-owned store and district
managers and a controllable testing ground for new products and promotions,
operating and training methods and merchandising techniques. However, the
cornerstone of the Company's expansion strategy remains the addition of new
franchised stores in the system, which enables the Company to expand its system
more quickly with no capital investment.

          Name Recognition and New Market Penetration.  The Company believes the
visibility of its stores at high traffic, Class A, strip shopping centers has
generated good name recognition in the areas in which stores currently are
located.  The Company's expansion strategy involves the building-out of existing
markets and the further penetration of developing markets through the clustering
of both company-owned and franchised stores.  This expansion strategy is
designed to take advantage of operational and advertising efficiencies through
store clustering within television and other advertising markets, thereby
increasing market penetration and consumer awareness.  To accelerate penetration
of larger markets, the Company intends to continue to co-develop markets with
franchisees or divide markets among franchisees, and intends to utilize market
co-development where appropriate.  In determining which new markets to develop,
the Company considers many factors, including the size of the market,
demographics, cost of media, population trends, competition and real estate
availability and pricing.

                                       7
<PAGE>
 
          International Franchise Expansion. There are seven CD Warehouse
franchised stores and eight Disc Go Round franchised stores currently operating
in Canada, England, France, Guatemala and Venezuela. In January 1997, the
Company entered into a master franchise agreement (the "Worldwide Area
Development Agreement") with Mark E. Kane, the founder of CDIL. The Worldwide
Area Development Agreement provides for a period of ten years for development of
franchise operations worldwide, excluding the United States, Canada and Mexico,
and includes a provision which allows the Company, at its option, to purchase
Mr. Kane's interest in any franchised operations developed pursuant to the
Worldwide Area Development Agreement. The development schedule under the
agreement requires that Mr. Kane open 100 stores over the ten-year period. The
agreement provides that Mr. Kane will pay the Company an amount to be jointly
determined between the Company and Mr. Kane on a country-by-country basis,
provided that the Company will receive a franchise fee of not less than $3,000
per store, a minimum royalty of 1% of gross sales based on individual store
sales volume and 20% of the total fee received from each subfranchisee by Mr.
Kane. In June 1998, the Company filed an arbitration claim against Mr. Kane,
alleging breach of the Worldwide Area Development Agreement and seeking
cancellation of the agreement. See Item 3--Legal Proceedings and Item 12--
Certain Relationships and Related Transactions.

          Consideration of Acquisitions. During 1998, the most significant
factors attributable to the Company's store and revenue growth were (i) the
acquisition of the Disc Go Round franchise system from Grow Biz, consisting of
the franchise rights for 134 Disc Go Round retail music stores and the assets of
three company-owned Disc Go Round stores, and (ii) the acquisition, as company-
owned stores, of 21 CD Warehouse franchised stores. The Company intends to
pursue the acquisition of other local and regional pre-owned music retailers to
implement its strategy of building out current markets and establishing itself
in new target markets that may be concurrently developed by the Company as well
as franchised stores. Consistent with this strategy, on February 22, 1999, the
Company completed the purchase of a 16-store retail music chain located in San
Diego, California and surrounding areas and operating under the name "Music
Trader."

          New Store Concept. During 1998, the Company investigated the need for
a new, consistent appearance, both externally and internally, for stores
operating under the CD Warehouse concept. A prototype unit, which was a company-
owned store, opened in March 1998 in Norman, Oklahoma. The prototype carries
slightly more inventory (18,000 titles) than is currently carried by existing CD
Warehouse stores (10,000 to 16,000 titles), and utilizes updated decor and
lighting schemes. The Company believes that it can derive greater profits by
offering a larger variety in both new and pre-owned CD titles. Based on the
success of the prototype, modifications were made and a uniform, low cost
remodel plan has been devised for CD Warehouse franchisees. The Company is in
the process of converting all company-owned stores to the new design, and all
new CD Warehouse franchised stores will be required to conform to such design.

Operations

          Acquisition of Pre-owned CD's.  A key component of the two franchise
concepts within the CD Warehouse System is the purchase or trade of selected
CD's from customers; accordingly, the Company obtains a significant portion of
its pre-owned CD inventory primarily from within the system itself.
Additionally, utilizing its inventory management system, which is a proprietary
program, the Company affords existing stores the opportunity to sell excess
inventory.  As new stores are developed, opening packages of inventory are
assembled by the Company and sold to the franchisees.  The demand for inventory
by new stores allows existing stores to sell excess inventory.  If, for example,
it is determined that a store may be overstocked on a particular selection, the
Company may purchase the selection and resell it as part of the opening
inventory of a new store.  The Company believes that this is a significant
advantage in comparison to its competitors since the Company can review all
titles available and source its own system for inventory.  As much as 75% of the
opening inventory for a new store can be purchased from system stores.  This
constant inventory turnover allows existing stores to make a reasonable profit
and provide a source of capital while providing an opportunity for the Company
to acquire quality inventory to open new stores or update an existing location's
inventory.

          Purchasing of New CD's, Other Point-of-Sale Items and Store Fixtures.
For new music releases, the Company contracts with outside third-party
distributors. The Company negotiates with vendors on behalf of the system for
inventory display racks, lighting and related products which are then shipped
directly from the manufacturers to the individual stores.

          As the system grows, the Company believes that additional quantity
discounts can be negotiated with the respective equipment and product suppliers.
The Company maintains its own distribution facility to provide its franchised
and Company-owned stores with supplies and related materials.

                                       8
<PAGE>
 
Marketing and Advertising

          CD Warehouse Stores. The Company provides new stores with certain pre-
opening items and point-of-sale materials. Additional point-of-sales materials
are available to all stores at no cost from the record companies. Pursuant to
the franchise agreement, which provides for each store to spend 2.5% of sales
specifically on advertising, each CD Warehouse franchisee currently conducts its
own marketing and advertising activities independently through newspapers and
radio. In May 1997, the Company was instrumental in the formation of an
advertising co-op in Dallas, Texas. All CD Warehouse stores in the Dallas, Texas
trade area formed the co-op and agreed to contribute to the co-op 1.25% of sales
on a monthly basis. The co-op meets monthly to determine how the co-op funds
will be utilized to promote the sales of music in the Dallas market area. In
July 1998, the Company activated a concept-wide advertising fund (the "SAF").
The Company did not require franchisees to participate in the SAF until there
was an aggregate of 200 stores, including company-owned stores, operating under
the CD Warehouse concept. With the acquisition of the 16 Music Trader stores in
February 1999, the number of franchised and company-owned stores operating under
the CDWI concept exceeded 200, and SAF participation is now mandatory. The
Company expects that the SAF will become the primary creative and production
vehicle for all marketing efforts respecting the CD Warehouse concept.

          Disc Go Round Stores. Disc Go Round franchisees under existing
franchise agreements are required to spend 5% of their gross sales on approved
advertising and marketing. In addition, all Disc Go Round franchisees are
required to pay the Company an annual advertising production fee of $500.

          Under the current form of Disc Go Round franchise agreement,
applicable for renewals, Disc Go Round franchisees are pay required to spend
during each calendar quarter 2.5% of the store's gross sales to advertise and
promote the store, of which 1 3/4% is spent directly by the store in local
market advertising, and 3/4% is paid to the Company to be deposited into a
concept-wide advertising fund to market the Disc Go Round concept.

Franchising Program

          CD Warehouse

          General. As of December 31, 1998, there were a total of 179 CD
Warehouse stores in 32 states and the District of Columbia, and seven CD
Warehouse stores in England, France, Guatemala and Venezuela. The Company
expects to open 30 new CD Warehouse franchised stores by the end of 1999.
However, there can be no assurance that all of these stores will be opened or
that the development schedule set forth in each area development agreement will
be achieved. Pursuant to the terms of existing area development agreements, a
total of 54 stores are committed to be opened over the next two years.

          The CD Warehouse franchise agreement provides the franchisee the right
to use or be provided, as the case may be, the Company's trade names, service
marks and trademarks; design plans, color schemes, signs and fixtures for store
premises; buying and selling guidelines; computerized inventory management
system; initial inventory, operations and financial control guidelines; initial
management training; and advertising assistance.

          Franchise Sourcing and Selection.  The majority of new franchises are
individuals responding to advertisements in national publications such as
Entrepreneur Magazine and The Franchise Handbook.  Various publications also
publish articles or rankings of top-selling franchises (e.g., in February 1999,
Entrepreneur Magazine ranked the Company 20th in its list of 101 fastest-growing
franchises and 57th in its 20th Annual Franchise 500), which also elicit
inquiries from potential franchisees.  Franchisees are approved by the Company
on the basis of the applicant's net worth and liquidity, together with an
assessment of work ethic and personality compatibility with the Company's
operating philosophy.

          Franchise Marketing Program. The Company's franchise marketing program
seeks to attract prospective franchisees with management experience, a minimum
level of net worth and strong interest in the retail music business. The Company
markets its franchise opportunities by advertising in selected business
magazines and franchise-oriented publications. Each inquiry is responded to and
an initial determination is made as to the prospect's qualifications to become a
CD Warehouse franchisee. Once an inquiry is received, the prospect is mailed the
Company's brochure and marketing materials. The inquiry is then followed up on
within a period of two weeks.

                                       9
<PAGE>
 
          The Company has established a home page via the Internet (World Wide
Web) that will provide detail on the franchise opportunities presented by
operating a CD Warehouse store. The Company's homepage can be accessed at
http://www/cdwi.com/.

          Training and Support.  The Company's philosophy is one of service and
commitment to its system.  Each franchise owner/operator and each company store
manager is required to complete a comprehensive training program in store
operation and management.  Topics covered in the training course include the
Company's philosophy of store operation and management, customer service,
merchandising, marketing, pricing, inventory and cost control, record keeping,
labor scheduling and personnel management.  Training is based on standard
operating policies and procedures contained in an operations manual provided to
all franchisees, which the franchisee is required to follow by terms of the
franchise agreement.  Additionally, trainees are provided with a complete
orientation to Company operations by meeting with members of the senior
management of the Company.  Training continues through the opening of the store,
where Company field personnel assist and guide the franchisee in all areas of
operation.

          The Franchise Agreement; Terms and Conditions. The domestic offer and
sale of CD Warehouse franchises is made by its Uniform Franchise Offering
Circular prepared in accordance with federal and state laws and regulations.
States that regulate the sale and operation of franchises require a franchisor
to register or file certain notices with the state authorities prior to offering
and selling franchises in those states.

          Under the current form of domestic franchise agreement, CD Warehouse
franchisees generally pay the Company (i) an initial franchise fee of $15,000,
(ii) royalties equal to 5% of monthly gross sales and (iii) a marketing fee
equal to 2.5% of monthly gross sales.  CD Warehouse franchisees existing prior
to January 27, 1997 (the date of the CDIL Acquisition), who enter into a
franchise agreement for a new location on or prior to December 31, 1998, will
pay the Company (i) an initial franchise fee of $6,000;  (ii) royalties equal to
5% of monthly gross sales and (iii) a marketing fee equal to 2% of monthly gross
sales.  Franchisees are generally granted exclusive territory with respect to
the operation of CD Warehouse stores only in the immediate vicinity of their
stores.

          The franchise agreement requires franchisees to purchase from the
Company certain proprietary software and the store's initial inventory, and to
comply with the Company's procedures of operation, to permit inspections and
audits by the Company and to remodel stores to conform with standards in effect
from time to time for the CD Warehouse system. The Company may terminate the
franchise agreement upon the failure of the franchisee to comply with the
conditions of the agreement and upon the occurrence of certain events, such as
insolvency or bankruptcy of the franchisee or the commission by the franchisee
of any unlawful or deceptive practice which in the judgment of the Company is
likely to adversely affect the CD Warehouse system. The Company's ability to
terminate franchise agreements pursuant to such provisions is subject to
applicable bankruptcy and state laws and regulations.

          The franchise agreement prohibits the transfer or assignment of any
interest in a franchise without the prior written consent of the Company.  The
franchise agreement also gives the Company a right of first refusal to purchase
any interest in a franchise if a proposed transfer would result in a change of
control of that franchise.  The refusal right, if exercised, would allow the
Company to purchase the interest proposed to be transferred under the same terms
and conditions and for the same price as offered by the proposed transferee.

          The term of each franchise agreement is ten years, and franchisees
generally have the right to renew for an additional ten-year term.  All of the
franchise agreements assigned to the Company in connection with the CDIL
Acquisition will expire between 2002 and 2006.

                                       10
<PAGE>
 
          Unit Economics. The Company believes that future CD Warehouse stores
can be opened for an initial investment of $123,300 to $150,300. The estimated
initial investment is comprised of the following:

 
                                                        Minimum     Maximum
                                                        -------     -------
                                                                           
        Franchise Fee.........................         $ 15,000    $ 15,000
        Inventory.............................           40,000      50,000
        Leasehold Improve.....................           18,000      22,000
        Contractor............................           11,000      15,000
        Computer Hardware.....................            7,100       7,100
        Proprietary Software..................            1,500       1,500
        Signage (exterior and interior).......            7,200       7,200
        Fixtures and equipment................           17,000      19,500
        Lease and utility deposits............            1,500       3,000
        Initial working capital...............            5,000      10,000
                                                       --------    --------
               Total..........................         $123,300    $150,300
                                                       ========    ======== 

          Management believes that a key indicator of the success of a franchise
location is the sales to capitalization ratio. That ratio is defined as the
annual sales revenue generated by the business divided by the capitalization
costs to open the business.  For the year ended December 31, 1998, average unit
sales on a comparable basis were $348,000.  Based on an average initial
estimated capitalization of $136,800, the sales to capitalization ratio to open
a new CD Warehouse store is 2.54 to 1.

          Franchise Financing. Typically, franchisees obtain their own sources
of financing and do not require the Company's assistance. However, the Company
provides inventory and equipment financing through CD Warehouse Finance Company,
a wholly owned subsidiary of the Company.

          Disc Go Round

          General. As of December 31, 1998, there were a total of 120 Disc Go
Round stores in 32 states and eight Disc Go Round stores in Canada. The Company
has determined that it will not sell or offer for sale any additional Disc Go
Round franchises. Additionally, while the Company will honor its ongoing
obligations as the franchisor under the Disc Go Round franchise agreements that
it acquired, it intends to encourage the existing Disc Go Round franchisees to
become CD Warehouse franchisees and to convert their Disc Go Round stores to CD
Warehouse stores.

          The Franchise Agreement; Terms and Conditions. The domestic renewal of
Disc Go Round franchises is made by a Uniform Franchise Offering Circular
prepared in accordance with federal and state laws and regulations.

          Generally, the form of franchise agreement under which substantially
all of the existing Disc Go Round franchises currently operate provides that
Disc Go Round franchisees pay the Company (i) royalties equal to 5% of weekly
gross sales, (ii) an annual marketing fee of $500 and (iii) a marketing fee
equal to 5% of gross sales, with the Company having the option to increase the
advertising expenditure to 6% of the franchisee's gross sales, of which up to 2%
would be paid to the Company as an advertising fee for deposit into a system-
wide advertising fund.

          Under the form of domestic franchise agreement applicable to renewing
Disc Go Round franchisees, franchisees generally will pay the Company (i) a
renewal franchise fee of $5,000, (ii) royalties equal to 5% of monthly gross
sales and (iii) a marketing fee equal to 2.5% of monthly gross sales.
Franchisees are generally granted exclusive territory with respect to the
operation of Disc Go Round stores only in the immediate vicinity of their
stores.

          The Disc Go Round franchise agreement requires franchisees to comply
with the Company's procedures of operation, to permit inspections and audits by
the Company and to remodel stores to conform with standards in effect from time
to time for the Disc Go Round system. The Company may terminate the franchise
agreement upon the failure of the franchisee to comply with the conditions of
the agreement and upon the occurrence of certain events, such as insolvency or
bankruptcy of the franchisee or the commission by the franchisee of any unlawful
or deceptive practice which in the 

                                       11
<PAGE>
 
judgment of the Company is likely to adversely affect the Disc Go Round system.
The Company's ability to terminate franchise agreements pursuant to such
provisions is subject to applicable bankruptcy and state laws and regulations.

          The franchise agreement prohibits the transfer or assignment of any
interest in a franchise without the prior written consent of the Company. The
franchise agreement also gives the Company a right of first refusal to purchase
any interest in a franchise if a proposed transfer would result in a change of
control of that franchise. The refusal right, if exercised, would allow the
Company to purchase the interest proposed to be transferred under the same terms
and conditions and for the same price as offered by the proposed transferee.

          Existing Disc Go Round franchises may be renewed for a renewal term of
five years; however, franchisees will not have the right to a subsequent term of
renewal. The Company's ability to not renew franchise agreements pursuant to
such provision is subject to applicable state laws and regulations.

Company Store Program

          Company-owned stores permit market penetration, or seeding, in the
absence of an immediately viable multi-location franchise operator. Company
stores provide an opportunity to continually refine the Company's standard store
model in order to respond to market dynamics. Variations in inventory mix,
ancillary product offerings, and marketing and sales techniques can be tested
and refined before implementation throughout the system.

          Managers of Company-owned stores are required to comply with all
Company operating standards and undergo training and receive support from the
Company similar to the training and support provided to franchisees. See Item
1Description of Business. The Company's Director of Company Store Operations and
his staff regularly visit company-owned stores to ensure compliance with Company
standards and procedures and to provide advice and support.

          The following table sets forth the number of stores opened and closed
throughout the CD Warehouse System during fiscal 1998:

<TABLE>
<CAPTION>
 
                                  December 31,                                                December 31,
                                     1997          Opened         Closed       Transfers          1998
                                  ------------   ----------     ----------   -------------    ------------
<S>                               <C>            <C>            <C>          <C>              <C> 
Franchised Stores
  Domestic-CD Warehouse             131               32            (7)          (28)              128 
  Domestic-Disc Go Round             --              128*           (6)           (2)              120
                                    ---              ---           ---           ---               ---
                                    131              160           (13)          (30)              248

  International-CD Warehouse          6                1            --            --                 7
  International-Disc Go Round        --                8*           --            --                 8
                                    ---              ---           ---           ---               ---
                                      6                9            --            --                15

Company-owned Stores
  Domestic-CD Warehouse              13                7            (2)           33                51
  Domestic-Disc Go Round             --                3*           --            (3)               --
                                    ---              ---           ---           ---               ---
                                     13               10            (2)           30                51

    Total                           150              179           (15)           --               314
                                    ===              ===           ===           ===               ===
</TABLE>

*    In June 1998, the Company completed the acquisition of the Disc Go Round
     franchise system from Grow Biz, consisting of the franchise rights for 134
     Disc Go Round retail music stores (126 domestic and 8 international) and
     the assets of three company-owned Disc Go Round stores.

                                       12
<PAGE>
 
Governmental Regulation

          The Company is subject to various federal, state and local laws
affecting its business. Each of the Company's stores is subject to licensing and
regulation by a number of governmental authorities, which include taxing, zoning
and building agencies in the state or municipality in which the store is
located. Difficulties in obtaining or failures to obtain required licenses or
approvals could delay or prevent the opening a new store in a particular area.

          The Company is subject to Federal Trade Commission ("FTC") regulation
and various state laws that regulate the offer and sale of franchises. The FTC
has adopted a rule that requires franchisors to make certain disclosures to
prospective franchise owners prior to the offer or sale of franchises. This rule
requires the disclosure of information necessary for a franchise owner to make
an informed decision as to whether to enter into a franchise relationship and
delineates the circumstances in which franchisors may make predictions on future
sales, income and profits. Failure to comply with this rule constitutes an
unfair or deceptive act or practice under the Federal Trade Commission Act.
Additionally, numerous states have in recent years adopted laws regulating
franchise operations and the franchisor-franchisee relationship, and similar
legislation is pending in Congress and several other states. Existing laws and
pending proposals vary from filing and disclosure requirements in the offer and
sale of franchises to the application of statutory standards regulating the
establishment and termination of franchise relationships. These laws generally
apply to both area and individual franchises. Although the foregoing matters may
result in some modification in the Company's franchising activities and some
delays or failures in enforcing certain of its rights and remedies under certain
area or individual franchise agreements, such modifications, delays or failures
have not had a material adverse effect on the Company's operations or business.
However, the law applicable to franchise operations and relationships is still
developing, and the Company is unable to predict the effect, if any, on its
operations of additional requirements or restrictions that may be enacted or
promulgated or of court decisions that may be adverse to the franchise industry.
While it is difficult to assess potential effects of federal and state
legislation in the U.S. or new international laws that may impact the industry,
the Company does not anticipate any material adverse effects from such
legislation or laws at this time.

          The Company's operations are also subject to federal and state laws
governing such matters as wages, working conditions and overtime.

Competition

          The Company competes in the retail music industry, which is highly
competitive in price, selection, service and location and is often affected by
changes in consumer trends, economic conditions, demographics, traffic patterns
and technological innovations.  The following profile provides an overview and
comparison of how the retail "new release" CD industry and the emerging retail
"remarketing" or "buy-sell-trade" CD industry are currently structured and
segmented.

          According to the RIAA, CD sales in the United States were over $11.4
billion in 1998.  The Company has various competitors in the industry which sell
new recordings and music related merchandise.  These companies vary from those
who are specialty music stores in malls (such as Musicland and Camelot), those
who utilize freestanding buildings (such as Blockbuster Music, Wherehouse
Records, and Hastings Entertainment) and those who sell via the internet (such
as CDNow and Amazon.com).  Empirical studies conducted by the Company indicate
that companies in mall locations typically charge $15.99 to $17.99 for their
front-line CD products.  Those in freestanding buildings generally have much
larger facilities (between 12,000 to 20,000 square feet).  Their selling price
for front-line items range between $13.99 and $15.99, with the latest top 20
releases on sale for $11.99 to $13.99 per CD.  None of these "superstores" sell
pre-owned music except for Wherehouse Records and Hastings Entertainment, which
have generally offered an inventory of pre-owned CDs in less than 500 square
feet of space with limited selections.

          Other retailers offering music include major national discount stores,
including Wal-Mart, K-Mart and Target stores.  These national discounters
maintain a very small number of new music titles while offering no pre-owned
music. Their pricing will typically vary from $11.99 to $13.99 per item in
approximately 1,000 square feet of space.  In another category are the multi-
media electronic stores (such as Best Buy and Circuit City), which have
generally utilized approximately 1,000 square feet of space and discount their
new releases from $9.99 to $12.99 per item.

          The Company also competes on the internet with retailers which sell
new and used CD's online. The Company's retail website,
http://www.cdwarehouse.com, commenced operations in December 1998. The online
commerce market 

                                       13
<PAGE>
 
is new, rapidly evolving and intensely competitive, and the Company expects that
competition will further intensify in the future. Barriers to entry are minimal,
and current and new competitors can launch new sites at a relatively low cost.

          The Company believes that CD Warehouse stores compete favorably with
its competition in the pre-owned CD market in terms of price, selection, service
and location.

          The Company also competes in the franchise industry for prospective
franchisees.  With respect to the only franchisor known to the Company to engage
in a business similar to that of the Company, the Company believes that it
competes favorably.

Trademarks and Service Marks

          The names "CD Warehouse," "Disc Go Round," "CD Exchange" are
registered with the United States Patent and Trademark Office. The Company also
has registered its copyright on its proprietary software system and has made
application for the service marks for the phrases "The Future of Music" and "A
New Spin on Music." The Company believes that its trademarks, service marks and
copyright have significant value and are important to its marketing efforts.

Employees

          The Company as of March 15, 1999 employs 250 full-time and 150 part-
time employees. None of the Company's employees are represented by a labor union
and the Company believes that its relations with its employees are good.

Item 2.   Description of Property.

          The Company's principal executive offices are located at 1204
Sovereign Row, Oklahoma City, OK 73108. The total facility is approximately
11,000 square feet and is held under a 60-month lease with a monthly lease
payment of $6,420. The expiration date of the lease is August 31, 2002.
Approximately 6,500 square feet is used for administrative purposes and the
balance of the space is utilized as a warehouse.

          The Company leases space for its 51 company-owned retail stores,
typically for a fixed monthly rental and operating costs. Rental expense under
these store leases totaled $724,160 for 1998. Total rental amounts of $2,693,626
under these noncancelable leases are due as follows: 1999--$1,009,722; 2000--
$793,692; 2001--$523,363; 2002--$268,651; 2003--$94,245; and thereafter--$3,953.

Item 3.   Legal Proceedings.

          On November 9, 1998, Jimick Products, Inc. ("Jimick") filed a petition
for a temporary injunction in the District Court of Oklahoma County, State of
Oklahoma against the Company, alleging that the Company breached an Area Wide
Development Agreement and certain franchise agreements entered into between
Jimick and the Company in May 1997. Jimick alleged, inter alia, that certain of
the Disc Go Round franchised stores acquired by the Company in June 1998 and
located in Jimick's development area encroached upon Jimick's development area
in violation of its agreements with the Company. The petition sought a temporary
injunction to disallow the conversion of Disc Go Round stores that were located
in Jimick's development area to CD Warehouse stores and to prevent the Company
from providing proprietary information regarding the CD Warehouse concept from
being disclosed to the Disc Go Round franchisees. On November 20, 1998, the
Court issued an order denying Jimick's request for a temporary injunction.

          On November 9, 1998, Jimick also filed a demand for arbitration with
the American Arbitration Association ("AAA") based on the same allegations set
forth above. The demand for arbitration seeks restitution for an unspecified
amount of damages and injunctive relief together with costs of the action and
attorneys' fees. The Company believes this action is without merit and intends
to fight it vigorously.

          On June 24, 1998, the Company filed a demand for arbitration with the
AAA against Mark E. Kane ("Kane"), alleging that Kane had breached a Worldwide
Area Development Agreement entered into between the Company and Kane on October
1, 1996, based on Kane's failure to perform pursuant to the terms and conditions
of the agreement including his failure to pay franchise and royalty fees due
thereunder. The Company seeks, in part, the cancellation of 

                                       14
<PAGE>
 
the exclusive worldwide franchise arrangement with Kane, a determination that
the agreement be terminated and the award of damages for unpaid franchise and
royalty fees.

          On January 26, 1999, the Company filed a demand for arbitration with
the AAA against Kane and Compact Disc International, Ltd. ("CDIL"), alleging
anticipatory breach of Kane's covenant not to compete contained in the Asset
Purchase Agreement entered into between the Company, Kane and CDIL on October 1,
1996. The Company seeks, as damages for such breach, the 300,000 shares of
Company stock owned by Kane and held in escrow to collateralize Kane's
indemnification obligations under the agreement.

          From time to time, the Company additionally may be involved in
litigation relating to claims arising out of its normal business operation. The
Company believes that any such litigation should not have a material adverse
effect on the Company's financial position.

Item 4.   Submission of Matters to Vote of Security Holders.

          No matters were submitted to a vote of security holders during the
fourth quarter of the fiscal year covered by this report.


                                    PART II

Item 5.   Market for Common Equity and Related Stockholder Matters.

Market for Common Equity

          The Company's Common Stock began trading on the NASDAQ Small Cap
Market System on January 22, 1997, under the symbol "CDWI." The following table
sets forth, for the periods indicated, the high and low sale price per share for
the Company's Common Stock:

<TABLE>
<CAPTION>
                                                           1998                                1997
                                            --------------------------------    ---------------------------------
                                                  High              Low               High               Low
                                            --------------    --------------    --------------    ---------------
<S>                                           <C>               <C>               <C>               <C>
      First Quarter.....................         $ 7 11/16          $  3 1/2            $5 1/2             $3 5/8
      Second Quarter....................         $  16 3/4          $7 13/16            $4 1/2             $2 1/2
      Third Quarter.....................         $24 15/16          $  6 3/4            $4 3/8             $2 3/4
      Fourth Quarter....................         $  23 5/8          $      5            $    5             $3 5/8
</TABLE>

          At March 10, 1999, there were approximately 84 registered holders of
record of the Common Stock.
 
          The Company has not paid cash dividends on its Common Stock since its
inception and intends to retain earnings for the continued expansion of its
business.

Recent Sales of Unregistered Securities

          The following sets forth certain information regarding recent sales of
the Company's securities which were not registered under the Securities Act.

          Pursuant to an Asset Purchase Agreement between CD Management and
Music Trader, Inc. ("Music Trader"), Jeffrey D. Clark and Debbi McGill-Clark,
dated February 22, 1999, the Company purchased substantially all of the assets
related to Music Trader's retail music business. One million dollars of the
$4,000,000 purchase price was paid by the issuance to Music Trader of 84,745
shares of restricted Common Stock of the Company, calculated by dividing
$1,000,000 by the average of the closing prices of the common stock, as quoted
by Nasdaq, for the five trading days preceding the closing. Pursuant to the
terms of the Asset Purchase Agreement, Music Trader was granted certain
"piggyback" registration rights with respect to the 84,745 shares issued in
connection with the transaction.

          No sales commissions were paid in connection with the above stock
issuance. The securities were issued in reliance on the exemption from
registration provided by Section 4(2) of the Securities Act.

                                       15
<PAGE>
 
Item 6.   Management's Discussion and Analysis or Plan of Operation.

          Certain forward-looking statements contained herein regarding the
Company's business and prospects are based upon numerous assumptions about
future conditions which may ultimately prove to be inaccurate and actual events
and results may materially differ from anticipated results described in such
statements. The Company's ability to achieve such results is subject to certain
risks and uncertainties, such as those inherent generally in the retail and
franchising industries, the impact of competition and pricing, changing market
conditions, and other risks. Any forward-looking statements contained herein
represent the Company's judgment as of the date hereof. The Company disclaims,
however, any intent or obligation to update these forward-looking statements. As
a result, the reader is cautioned not to place undue reliance on these forward-
looking statements. As used in herein, the word "Company" means CD Warehouse,
Inc. and its wholly owned subsidiaries, Compact Discs Management, Inc., and CD
Warehouse Finance Company unless the context indicates otherwise.

Statements of Operations

          The following table sets forth the Company's results of operations for
the year ended December 31, 1998 and 1997. The information should be read in
conjunction with the historical Financial Statements included elsewhere in this
document.

<TABLE>
<CAPTION>
 
 
                                                             Years Ended
                                                           December 31,
                                                          --------------------------
                                                             1998          1997
                                                          -----------  -------------
                                                       (in thousands except share data)
<S>                                                    <C>             <C> 
Revenues:
 Retail store sales.....................................   $ 9,966        $ 3,352
     Wholesale merchandise sales........................     2,127          3,903
     Software income, net...............................        92             61
     Royalty income.....................................     2,827          1,394
     Management fees....................................        62            116
     Franchise and development fees.....................       188            263
                                                           -------        -------
       Total revenues...................................    15,262          9,089
 
Operating costs and expenses:
     Cost of sales  retail store sales..................     5,902          1,998
     Cost of sales  wholesale merchandise sales.........     1,915          3,608
     Retail store operating expenses....................     3,307          1,226
     General and administrative.........................     2,512          1,510
     Depreciation and amortization......................       617            239
                                                           -------        -------
Total costs and expenses................................    14,253          8,581
                                                           -------        -------
Operating income........................................     1,009            508
Other income, net.......................................       232            108
                                                           -------        -------
Income before provision for  income taxes...............     1,241            616
Provision for income taxes..............................       466            230
                                                           -------        -------
Net income..............................................   $   775        $   386
                                                           =======        =======
Net income per share-basic..............................   $   .27        $   .23
                                                           =======        =======
Net income per share-diluted............................   $   .25        $   .23
                                                           =======        =======
Shares used in computation-basic........................ 2,923,090      1,714,790
                                                         =========      =========
Shares used in computation-diluted.....................  3,136,485      1,714,790
                                                         =========      =========

</TABLE> 

                                       16
<PAGE>
 
Overview

          The Company was formed in September 1996 to acquire the franchise
operations of CDIL, a Texas limited partnership which franchised and operated
stores throughout the United States and England under the name "CD Warehouse."
The first CD Warehouse store was opened in 1992. Under the CD Warehouse name, as
of December 31, 1998, there were 179 domestic units operating in 32 states and
the District of Columbia, and 7 international units operating in England,
France, Guatemala and Venezuela.

          Simultaneously with the closing of the IPO on January 27, 1997, the
Company acquired the assets of CDIL, consisting primarily of CDIL's rights as
franchisor in the various franchise agreements to which it was a party, for a
purchase price of $3.2 million. In a related transaction (the "MacDonald
Acquisition"), which also occurred simultaneously with the closing of the
Offering, the Company acquired the equity interest of MacDonald, the then
largest CD Warehouse franchisee, in 36 franchised CD Warehouse stores. Pursuant
to the MacDonald Acquisition, the Company acquired 100% ownership of one store
and minority equity interests (including MacDonald's interest as a managing
general partner or limited liability company manager) in the other 35 franchised
stores in which MacDonald had an interest. Effective December 30, 1997, the
Company sold back to MacDonald the Company's various ownership interests in nine
partnerships, for an aggregate consideration of $169,807. The partnerships,
which act as franchisees of the Company, operate nine CD Warehouse stores.
Pursuant to the sale, MacDonald assumed the Company's interest in the
partnerships, which continue to operate as CD Warehouse franchisees.

          On June 26, 1998 the Company completed the acquisition, for an
aggregate purchase price of approximately $7 million, of the franchise rights to
134 Disc Go Round retail music stores from Grow Biz, as well as the acquisition
of the assets of three Disc Go Round stores owned and operated by Grow Biz.
Considering the above acquisition, as of December 31, 1998, the Company had 314
stores operating in 40 states and the District of Columbia domestically and in
five different countries.

              [The balance of this page intentionally left blank]

                                       17
<PAGE>
 
Results of Operations

          The Company derives its revenues primarily from retail sales of its
company-owned stores, wholesale merchandise sales to franchisees of the Company
and royalty fees from franchisees.  The Company also receives revenues from
initial franchise fees, area development fees, management fees and software
income.  Retail store cost of sales and operating expenses relate directly to
company-owned retail store sales.  Wholesale merchandise sales and associated
cost of sales relate to the Company's franchising operations.  Other expenses,
such as depreciation, amortization, and general and administrative expenses,
relate to company-owned store operations, as well as the Company's franchising
operations.  The number and sales volumes of company-owned retail stores
directly affect the Company's revenues and expenses.  The Company's revenues
and, to a lesser extent, expenses, also are affected by the number and sales
volumes of franchise stores.  Initial franchise fees are directly affected by
the number of franchised store openings.

          The following table sets forth the percentage relationship to total
revenues, unless otherwise indicated, of certain items included in the Company's
statement of income:

                                                     Years Ended December 31,
                                                     ------------------------
                                                        1998          1997
                                                     ----------    ----------
Revenues:
 Retail store sales................................     65.3%          36.9%
     Wholesale merchandise sales...................     14.0%          42.9%
     Software income, net..........................       .6%            .7%
     Royalty income................................     18.5%          15.3%
     Management fees...............................       .4%           1.3%
     Franchise and development fees................      1.2%           2.9%
                                                       -----          -----
       Total revenues..............................    100.0%         100.0%

Cost and expenses:
     Cost of sales  retail store sales (1).........     59.2%          59.6%
     Cost of sales  wholesale merchandise sales(2).     90.0%          92.5%
     Retail store operating expenses (1)...........     33.2%          36.6%
     General and administrative....................     16.5%          16.6%
     Depreciation and amortization.................      4.0%           2.6%
Operating income...................................      6.6%           5.6%
Net income.........................................      5.1%           4.2%
_____________________

(1)  As a percentage of retail store sales.
(2)  As a percentage of wholesale merchandise sales.


                                                    Year Ended December 31,
                                                    -----------------------
CD Warehouse stores only:                           1998               1997
                                                    ----               ----
Sales Data:
  System wide sales                             $54,845,432        $36,494,857
      Percentage increase (1)                            50%                34%

Average monthly sales per store                 $    28,973        $    25,467
                                                ===========        ===========

Change in comparable retail store sales (2)              16%                14%
                                                ===========        ===========

(1)  Represents percentage increase from comparable period in prior year.
(2)  Represents percentage increase for stores open in both periods reported

                                       18
<PAGE>
 
Year Ended December 31, 1998 compared to Year Ended December 31, 1997.

          Revenues

          Retail store sales increased $6,614,000 to $9,966,000 for the year
ended December 31, 1998 compared to $3,352,000 for the year ended December 31,
1997. The increase in retail store sales is the result of having 51 company or
majority owned stores in operation during the year ended December 31, 1998
compared to only 16 during the same period in 1997.

          Wholesale merchandise sales decreased $1,776,000, or 46% to $2,127,000
the year ended December 31, 1998 compared to $3,903,000 for the same period in
1997. The decrease is due to the Company discontinuing its "one-stop" warehouse
operations is May 1998 which acquired new CD releases from the major record
labels and sold them to the franchise system with minimal mark up. The Company
has determined to focus its efforts on warehousing used product to open new
stores and eventually sell used product to the franchise system.

          Royalty income increased $1,433,000 to $2,827,000 for the year ended
December 31, 1998 compared to $1,394,000 for the same period in 1997. As a
result of the acquisition of 134 Disc Go Round franchise stores on June 26,
1998, approximately $737,000 of additional royalty income has been recognized as
of December 31, 1998. Additionally, stores operating as CD Warehouse increased
their same store sales by 16% for the year ended December 31, 1998 with monthly
average sales for these stores increasing from $25,467 for the year ended
December 31, 1997 to $28,973 for the same period in 1998.

          Costs and Expenses

          Cost of sales for retail store sales increased $3,904,000 for the year
ended December 31, 1998 compared to the same period in 1997. This increase is
consistent with the increase of retail store revenue discussed above. Cost of
sales was 59% of sales for the year ended December 31, 1998 compared to 60% for
the year ended December 31, 1997.

          Costs of sales for wholesale merchandise decreased $1,693,000 or 47%
to $1,915,000 for the year ended December 31, 1998 compared to $3,608,000 in
1997. The decrease is consistent with the decrease in sales. Cost of sales was
90% of sales for the year ended December 31, 1998 compared to 92% for the
comparable period in 1997.

          Retail store operating expenses increased $2,081,000 to $3,307,000 for
the year ended December 31, 1998, compared to $1,226,000 for the year ended
December 31, 1997. The increase is due to the increase of company-owned stores
discussed above. Retail store operating expense was 33% of retail store revenue
for the year ended December 31, 1998 compared to 37% of retail store revenue for
the same period in 1997. The decrease resulted from better operating results of
company-owned and majority-owned stores that began operations during 1997. The
results for the year ended December 31, 1997 includes start up costs relating to
twelve new company stores compared to eight company stores in 1998.

          General and administrative expenses increased by $1,002,000 to
$2,512,000 for the year ended December 31, 1998 compared to $1,510,000 for the
year ended December 31, 1997. This increase resulted from the continued growth
in both company-owned stores (increase of 38 stores) and franchised stores
(increase of 126 stores). The year ended December 31, 1998 also included costs
(travel, personnel, support, etc) associated with absorbing the operations of
134 Disc Go Round franchise stores discussed above.

          Depreciation and Amortization

          Depreciation and amortization increased $378,000 to $617,000 for the
year ended December 31, 1998 compared to $239,000 for the same period in 1997.
This is due to the addition of 38 company-owned stores and the amortization of
goodwill associated with the acquisition of the franchise rights to 134 Disc Go
Round retail music stores on June 26, 1998 (approximately $38,000 per month).

                                       19
<PAGE>
 
          Other Income

          Other income increased $124,000 to $232,000 for the year ended
December 31, 1998 compared to $108,000 for the comparable period in 1997. This
is primarily due to interest earned of approximately $224,000 on the net
proceeds of the private placement completed in May 1998. The above increase is
offset by a reduction of equity income of unconsolidated partnerships of
$74,000. This reduction is due to the sale (in December 1997, January 1998 and
October, 1998) of the Company ownership interest in the 34 stores originally
acquired in January 1997.

          Net Income

          Net income increased $389,000 to $775,000 for the year ended December
31, 1998 compared to $386,000 for the same period in 1997. The increase in net
income is due to improved retail store operations, as indicated by reduced
percentages of cost of sales and operating expenses, an increase in royalties
generated by the increased number of franchise stores, an increase in same store
sales and the addition of 134 Disc Go Round franchise stores, offset by the
increase in general and administrative expenses.

Liquidity and Capital Resources

          At December 31, 1998 the Company had working capital of $8,543,000 and
cash and cash equivalents aggregating $4,442,000, compared to working capital of
$1,931,000 and cash and cash equivalents of $1,122,000 at December 31, 1997. Net
cash used for operating activities was $325,000 in 1998, compared to net cash
used for operating activities of $129,000 in 1997. The use of cash by operating
activities for the years ended December 31, 1998 and December 31, 1997 relates
to the continued growth in both company-owned and franchised stores.

          Net cash used for investing activities was $11,233,000 for the year
ended December 31, 1998, compared to $3,482,000 for the same period in 1997. The
significant use of cash for investing activities in 1998 relates to the
acquisition of Disc Go Round in June 1998 and the purchase of 16 stores in
October 1998. The increase in 1997 relates to the acquisition of the assets of
CDIL in January 1997. Both 1998 and 1997 also includes opening of company
stores.

          Net cash provided from financing activities was $14,878,000 for the
year ended December 31, 1998 compared to $4,718,000 for the same period in 1997.
The net cash provided from financing in 1998 relates primarily to the private
placement of 1,624,300 shares of common stock in May 1998. The net cash provided
from financing in 1997 relates to the IPO and collection of a stock subscription
in the amount of $350,000.

          The Company is in the process of developing an internet site which
will offer both new and used CDs. Although this site began operations in
December 1998, the total cost associated with developing the internet commerce
site has not yet been quantified by the Company. Although such costs may be
significant, the Company believes it has sufficient funds to cover this project.

          In October 1998 the Company formed a wholly owned subsidiary, CD
Warehouse Finance Company, to finance the growth of qualified franchisees. As of
December 31, 1998, the financing subsidiary has funded $218,000 for the
development of two new franchised stores. The Company expects the activity to
increase in the future and expects to fund its activities with a portion of the
proceeds of the May 1998 private placement.

          In addition to the working capital at December 31, 1998, the Company
finalized a $7,000,000 credit facility in February 1999 consisting of a
$2,000,000 line of credit and a $5,000,000 Term Loan Agreement with Bank One
Oklahoma, N. A. Amounts borrowed under the credit facility will bear an interest
rate equal to Bank One's prime rate. As of the date of this report, $3,000,000
of the Term Loan has been utilized to acquire 16 retail music stores operating
as Music Trader in San Diego, California on February 22, 1999. It is the
Company's opinion that the current working capital at December 31, 1998,
combined with the balance of the credit facility, will be sufficient to support
ongoing activities of the Company for the foreseeable future.

                                       20
<PAGE>
 
Year 2000 Issues

          The Year 2000 problem is the result of computer programs being written
using two digits (rather than four) to define the applicable year. The Company's
computer equipment and software and devices with imbedded technology that are
time-sensitive may recognize a date using "00" as the year 1900 rather than the
year 2000.  This could result in a system failure or miscalculations causing
disruptions of operations, including, among other things, a temporary inability
to process transactions, send invoices, or engage in similar normal business
activities.

          The Company has undertaken various initiatives intended to ensure that
its computer equipment and software will function properly with respect to dates
in the Year 2000 and thereafter. For this purpose, the term "computer equipment
and software" includes systems that are commonly thought of as IT systems,
including accounting, data processing, and telephone/PBX systems, cash
registers, hand-held terminals, scanning equipment, and other miscellaneous
systems, as well as systems that are not commonly thought of as IT systems, such
as alarm systems, fax machines, or other miscellaneous systems. Both IT and non-
IT systems may contain imbedded technology, which complicates the Company's Year
2000 identification, assessment, remediation, and testing efforts. Based upon
its identification and assessment efforts to date, the Company believes that
certain of the computer equipment and software it currently uses will require
replacement or modification. In addition, in the ordinary course of replacing
computer equipment and software, the Company attempts to obtain replacements
that are Year 2000 compliant. Utilizing both internal and external resources to
identify and assess needed Year 2000 remediation, the Company currently
anticipates that its Year 2000 identification, assessment, remediation and
testing efforts, which began in 1998, will be completed by June 1999, and that
such efforts will be completed prior to any currently anticipated impact on its
computer equipment and software. The Company estimates that as of December 31,
1998, it had completed approximately 60% of the initiatives that it believes
will be necessary to fully address potential Year 2000 issues relating to its
computer equipment and software. The projects comprising the remaining 40% of
the initiatives are in process and expected to be completed on or about June 30,
1999.

          The Company has also mailed letters or verbally communicated with its
significant vendors and service providers to determine the extent to which
interfaces with such entities are vulnerable to Year 2000 issues and whether the
products and services purchased from such entities are Year 2000 compliant.  As
of December 31, 1998, the Company had received responses from a majority of such
third parties, and substantially all of the companies that have responded have
provided written assurances that they expect to address all their significant
Year 2000 issues on a timely basis.  The Company plans to make a follow-up
mailing to significant vendors and service providers that did not initially
respond, or whose responses were deemed unsatisfactory by the Company.

          The cost of its Year 2000 identification, assessment, remediation and
testing efforts, as well as currently anticipated costs to be incurred by the
Company with respect to Year 2000 issues of third parties, are not currently
expected to have a material adverse impact on the Company's financial position,
results of operations or cash flows in future periods.  As of December 31, 1998,
the Company had incurred minimal costs related to its Year 2000 identification,
assessment, remediation and testing efforts.  Other non-Year 2000 IT efforts
have not been materially delayed or impacted by Year 2000 initiatives.  The
Company presently believes that the Year 2000 issue will not pose significant
operational problems for the Company.  However, if all Year 2000 issues are not
properly identified, or assessment, remediation and testing are not effected
timely with respect to Year 2000 problems that are identified, there can be no
assurance that the Year 2000 issue will not materially adversely impact the
Company's results of operations or adversely affect the Company's relationships
with customers, vendors, or others. Additionally, there can be no assurance that
the Year 2000 issues of other entities will not have a material adverse impact
on the Company's systems or results of operations.

          The Company has begun, but not yet completed, a comprehensive analysis
of the operational problems and costs (including loss of revenues) that would be
reasonably likely to result from the failure by the Company and certain third
parties to complete efforts necessary to achieve Year 2000 compliance on a
timely basis. A contingency plan has not been developed for dealing with the
most reasonably likely worst case scenario, as such scenario has not yet been
clearly identified. The Company expects that it will complete such analysis and
contingency planning by December 31, 1999.

                                       21
<PAGE>
 
          The costs of the Company's Year 2000 identification, assessment,
remediation and testing efforts and the dates on which the Company believes it
will complete such efforts are based upon management's best estimates, which
were derived using numerous assumptions regarding future events, including the
continued availability of certain resources, third-party remediation plans, and
other factors.  There can be no assurance that these estimates will prove to be
accurate, and actual results could differ materially from those currently
anticipated.  Specific factors that could cause such material differences
include, but are not limited to, the availability and cost of personnel trained
in Year 2000 issues, the ability to identify, assess, remediate and test all
relevant computer codes and embedded technology, and similar uncertainties.  In
addition, variability of definitions of "compliance with Year 2000" and the
myriad of different products and services, and combinations thereof, sold by the
Company may lead to claims whose impact on the Company is not currently
estimable.  No assurance can be given that the aggregate cost of defending and
resolving such claims, if any, will not materially adversely affect the
Company's results of operations.  Although some of the Company's agreements with
manufacturers and others from whom it purchases products for resale contain
provisions requiring such parties to indemnify the Company under some
circumstances, there can be no assurance that such indemnification arrangements
will cover all of the Company's liabilities and costs related to claims by third
parties related to the Year 2000 issue.

Item 7.   Financial Statements.

          The consolidated financial statements of the Company are incorporated
by reference from pages F-1 through F-21 of the attached Appendix, and include
the following:

          Consolidated Financial Statements of CD Warehouse, Inc.

               (1)  Report of Independent Auditors
               (2)  Consolidated Balance Sheet at December 31, 1998
               (3)  Consolidated Statements of Income for the years ended
                    December 31, 1998 and December 31, 1997
               (4)  Consolidated Statements of Stockholders' Equity for the
                    years ended December 31, 1998 and December 31, 1997
               (5)  Consolidated Statement of Cash Flows for the years ended
                    December 31, 1998 and December 31, 1997
               (6)  Notes to Consolidated Financial Statements

Item 8.   Changes In and Disagreements With Accountants on Accounting and
          Financial Disclosure

          There have been no material disagreements between the Company and its
independent accountants on accounting and financial disclosure matters which are
required to be reported under this Item for the period for which this Report is
filed.


                                   PART III

Item 9.   Directors, Executive Officers, Promoters and Control Persons;
          Compliance With 16(a) of the Exchange Act

          The information required will be contained in the Company's Proxy
Statement for the 1999 Annual Meeting of Stockholders and is incorporated herein
by reference.

Item 10.  Executive Compensation.

          The information required will be contained in the Company's Proxy
Statement for the 1999 Annual Meeting of Stockholders and is incorporated herein
by reference.

                                       22
<PAGE>
 
Item 11.  Security Ownership of Certain Beneficial Owners and Management.

          The information required will be contained in the Company's Proxy
Statement for the 1999 Annual Meeting of Stockholders and is incorporated herein
by reference.

Item 12.  Certain Relationships and Related Transactions.

          The information required will be contained in the Company's Proxy
Statement for the 1999 Annual Meeting of Stockholders and is incorporated herein
by reference.

Item 13.  Exhibits and Reports on Form 8-K.

(a)       The following documents are filed as part of this report:

          (1)  Financial Statements are attached hereto as Appendix A and
               included herein on pages F-1 through F-21.

          (2)  The exhibits set forth on the following Exhibit Index are filed
               with this Report or are incorporated by reference as set forth
               therein:

<TABLE> 
<CAPTION> 
 
 Exhibit     
 Number                                Exhibit Index                                 Page
 -------                               -------------                                 ----
<S>       <C>                                                                   
     3.1  Amended and Restated Certificate of Incorporation (filed as Exhibit
          3.1 to the Company's Registration Statement on Form SB-2, file number
          333-15139 and incorporated herein by reference)                              #

     3.2  Amended and Restated Bylaws (filed as Exhibit 3.2 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)                                            #

     4.1  Specimen Certificate of the Common Stock (filed as Exhibit 4.1 to the
          Company's Registration Statement on Form SB-2, file number 333-15139
          and incorporated herein by reference)                                        #

    4.2   See Articles IV and VIII of the Company's Certificate of Incorporation
          and Article II of the Company's Bylaws (filed as Exhibit 4.2 to the
          Company's Registration Statement on Form SB-2, file number 333-15139
          and incorporated herein by reference)                                        #

     4.3  Form of Warrant Agreement between the Company and the Underwriters
          (filed as Exhibit 4.3 to the Company's Registration Statement on Form
          SB-2, file number 333-15139 and incorporated herein by reference)            #

    *4.4  Warrant Agreement dated May 22, 1998, by and among the Company,
          Comvest Partners, Inc. and Capital West Securities                          50

     4.5  Amended 1996 Stock Option Plan (filed as Exhibit 4.4 to the Company's
          Registration Statement on Form S-8 dated February 19, 1999, file
          number 333-72651 and incorporated herein by reference)                       #

    10.1  Employment Agreement by and between the Company and Grizzle (filed as
          Exhibit 10.1 to the Company's Registration Statement on Form SB-2,
          file number 333-15139 and incorporated herein by reference)                  #

    10.2  Employment Agreement by and between the Company and Johnson (filed as
          Exhibit 10.2 to the Company's Registration Statement on Form SB-2,
          file number 333-15139 and incorporated herein by reference)                  #

    10.3  Employment Agreement by and between the Company and Motley (filed as
          Exhibit 10.4 to the Company's Registration Statement on Form SB-2,
          file number 333-15139 and incorporated herein by reference)                  #
</TABLE> 
                                       23
<PAGE>

<TABLE> 
<CAPTION> 
 
 Exhibit     
 Number                                Name of Exhibit                             Page
 -------                               ---------------                             ----
<S>       <C>                                                                     <C> 
    10.4  Asset Purchase Agreement, dated as of June 16, 1998, by and between
          the Company and the Grow Biz International, Inc. (filed as Exhibit
          10.1 to the Company's Form 8-K dated June 26, 1998 and incorporated
          herein by reference)                                                       #

    10.5  Asset Purchase Agreement dated as of January 1, 1998, by and among CD
          Warehouse, Inc.; ZDTMAC; Compact Discs Management, Inc.; Texas ZDT
          Management, Ltd.; and the general and limited partners of Texas ZDT
          Management, Ltd. (filed as Exhibit 10.2 to the Company's Form 8-K
          dated January 1, 1998 and incorporated herein by reference)                #

    10.6  Form of Franchise Agreement (filed as Exhibit 10.10 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)                                          #

    10.7  Form of Lockup Agreement (filed as Exhibit 10.11 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)                                          #

    10.8  Form of Development Agreement (filed as Exhibit 10.13 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)                                          #      

    10.9  Lease Agreement dated April 17, 1997 by and between Will Rogers
          Service Center Phase IV Associates and CD Warehouse, Inc. (filed as
          Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the
          Quarter ended June 30, 1998 and incorporated herein by reference)          #

    10.10 WCMA(R) Note, Loan and Security Agreement dated as of December 4,
          1997, between the Company and Merrill Lynch Business Financial
          Services Inc. (filed as Exhibit 10.1 to the Company's Form 8-K dated
          February 10, 1998 and incorporated herein by reference)                    #

    10.11 Term WCMA(R) Loan and Security Agreement dated as of November 28,
          1997, between the Company and Merrill Lynch Business Financial
          Services Inc. (filed as Exhibit 10.2 to the Company's Form 8-K dated
          February 10, 1998 and incorporated herein by reference)                    #

    10.12 Loan Agreement, dated February 17, 1999, between the Company and Bank
          One, Oklahoma, N.A. (filed as Exhibit 5.1 to the Company's Form 8-K
          dated February 24, 1999 and incorporated herein by reference)              #

   *21.1  List of subsidiaries                                                      56

   *23.1  Consent of Ernst & Young LLP                                              57

   *27.1  Financial Data Schedule                                                   58

    * Filed herewith.

    # Incorporated by reference.
</TABLE> 
(b)  A report on Form 8-K was filed by the Company on November 11, 1998,
     reporting under "ITEM 5OTHER EVENTS" the Company's acquisition of 100% of
     the equity interests in three entities which own and operate 16 CD
     Warehouse franchised stores in the states of Arkansas, Kansas, Louisiana,
     Missouri, Nebraska, Oklahoma and Texas. No financial statements were filed
     as part of the Report.

                                       24
<PAGE>
 
          Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

March 16, 1999                    CD WAREHOUSE, INC.,
                                  a Delaware corporation


                                  /s/ Jerry W. Grizzle
                                  ------------------------------
                                  Jerry W. Grizzle
                                  Chairman of the Board of Directors;
                                  President and Chief Executive Officer

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

          NAME AND TITLE                                             DATE
          --------------                                             ----
 


/s/ Jerry W. Grizzle                                            March 16, 1999
------------------------------
  Jerry W. Grizzle
    Chairman of the Board of Directors;
    President and Chief Executive Officer



/s/ Gary D. Johnson                                             March 16, 1999
------------------------------
  Gary D. Johnson                                                
    Executive Vice President; Chief Operating
    Officer; Director



/s/ Doyle E. Motley                                             March 16, 1999
------------------------------
  Doyle E. Motley
    Sr. Vice President, Chief Financial Officer,
    Secretary and Treasurer
    (Principal Accounting Officer)



/s/ Robert O. McDonald                                          March 16, 1999
------------------------------
  Robert O. McDonald                                             
    Director



/s/ Christopher  M. Salyer                                      March 16, 1999
------------------------------
  Christopher  M. Salyer
    Director

                                       25
<PAGE>
 
                                  APPENDIX A
                                        



                        Consolidated Financial Statements

                        CD Warehouse, Inc.


                        Years ended December 31, 1998 and 1997
                        with Report of Independent Auditors
<PAGE>
 
                              CD Warehouse, Inc.

                       Consolidated Financial Statements

                    Years ended December 31, 1998 and 1997



                                    Contents

 
Report of Independent Auditors..........................................  F-2
 
Consolidated Financial Statements
 
Consolidated Balance Sheet..............................................  F-3
Consolidated Statements of Income.......................................  F-4
Consolidated Statements of Stockholders' Equity.........................  F-5
Consolidated Statements of Cash Flows...................................  F-6
Notes to Consolidated Financial Statements..............................  F-8
 

                                      F-1
<PAGE>
 
                        Report of Independent Auditors


The Board of Directors and Stockholders
CD Warehouse, Inc.


We have audited the accompanying consolidated balance sheet of CD Warehouse,
Inc. as of December 31, 1998 and the related consolidated statements of income,
stockholders' equity and cash flows for each of the two years in the period
ended December 31, 1998. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of CD
Warehouse, Inc. at December 31, 1998 and the consolidated results of its
operations and its cash flows for each of the two years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.



                                         ERNST & YOUNG LLP


Oklahoma City, Oklahoma
February 19, 1999

                                      F-2
<PAGE>
 
                              CD Warehouse, Inc.

                          Consolidated Balance Sheet

                               December 31, 1998

<TABLE> 
<S>                                                                            <C> 
Assets
Current assets:
 Cash and cash equivalents                                                     $ 4,442,454
 Accounts receivable, net of allowance for doubtful accounts of $111,049           976,438
 Notes receivable (Note 4)                                                          81,501
 Merchandise inventory                                                           4,366,422
 Prepaid expenses and other                                                        121,261
                                                                               -----------
Total current assets                                                             9,988,076

Furniture, fixtures and equipment, net (Note 5)                                  2,285,209
Notes receivable, due after one year (Note 4)                                      129,465
Intangibles and other assets, net (Note 6)                                      10,908,418
                                                                               -----------
Total assets                                                                   $23,311,168
                                                                               ===========
Liabilities and stockholders' equity
Current liabilities:
 Accounts payable                                                              $   640,019
 Accrued liabilities                                                               313,250
 Advances and deposits                                                              93,000
 Income taxes payable                                                              398,385
                                                                               -----------
Total current liabilities                                                        1,444,654

Deferred income taxes (Note 7)                                                      98,000
Commitments and contingencies (Note 9)

Stockholders' equity (Note 8):
 Preferred stock, $.01 par value; 5,000,000 shares authorized, none issued               -
 Common stock, $.01 par value; 10,000,000 shares authorized,
  3,550,550 shares issued and outstanding                                           35,506
 Additional paid-in capital                                                     20,571,755
 Retained earnings                                                               1,161,253
                                                                               -----------
Total stockholders' equity                                                      21,768,514
                                                                               -----------
Total liabilities and stockholders' equity                                     $23,311,168
                                                                               ===========
</TABLE> 

See accompanying notes.

                                      F-3
<PAGE>
                               CD Warehouse, Inc.

                        Consolidated Statements of Income

                                                 YEAR ENDED DECEMBER 31,
                                                   1998           1997
                                                -----------   -----------

Revenues:
   Company operations:
     Retail store sales                         $ 9,965,694   $ 3,352,433
     Wholesale merchandise sales                  2,127,025     3,902,729
     Software income, net                            92,062        60,939
   Franchise operations:
     Royalty income                               2,827,205     1,393,717
     Franchise and development fees                 187,500       263,500
     Management fees                                 62,417       115,728
                                                -----------   -----------
Total revenues                                   15,261,903     9,089,046

Operating costs and expenses:
   Cost of sales--retail store sales              5,901,735     1,998,536
   Cost of sales--wholesale merchandise sales     1,914,723     3,608,480
   Retail store operating expenses                3,307,424     1,225,987
   General and administrative                     2,511,436     1,509,672
   Depreciation and amortization                    617,250       238,600
                                                -----------   -----------
Total costs and expenses                         14,252,568     8,581,275
                                                -----------   -----------
Operating income                                  1,009,335       507,771

Other income:
   Interest income                                  210,635        29,037
   Other, net                                        21,382        79,391
                                                -----------   -----------
                                                    232,017       108,428
                                                -----------   -----------
Income before income taxes                        1,241,352       616,199

Provision for income taxes (Note 7)                 466,000       230,000
                                                -----------   -----------
Net income                                      $   775,352   $   386,199
                                                ===========   ===========

Net income per share--basic and diluted:
   Basic                                        $      0.27   $      0.23
                                                ===========   ===========
   Diluted                                      $      0.25   $      0.23
                                                ===========   ===========

Shares used in computations:
   Basic                                          2,923,090     1,714,790
                                                ===========   ===========
   Diluted                                        3,136,485     1,714,790
                                                ===========   ===========

See accompanying notes.

                                      F-4
<PAGE>
                               CD Warehouse, Inc.

                 Consolidated Statements of Stockholders' Equity

<TABLE>
<CAPTION>


                                                   Common Stock          Additional
                                            --------------------------    Paid-in      Retained
                                               Shares         Amount      Capital      Earnings
                                            -----------------------------------------------------

<S>                                         <C>          <C>           <C>           <C>         
Balance at December 31, 1996                   350,000   $     3,500   $   346,500   $      (298)

Exercise of stock subscription                 350,000         3,500       346,500            --

Sale of common stock (net of offering
   costs)                                    1,040,000        10,400     4,256,343            --

Issuance of common stock in exchange for
   partnership interests                        80,000           800       399,200            --

Net income                                          --            --            --       386,199
                                            ----------   -----------   -----------   -----------
Balance at December 31, 1997                 1,820,000        18,200     5,348,543       385,901

Exercise of stock options                        6,250            63        23,375            --

Sale of common stock (net of offering
   costs)                                    1,624,300        16,243    14,838,337            --

Issuance of common stock in exchange for
   partnership interests                       100,000         1,000       361,500            --

Net income                                          --            --            --       775,352
                                            ----------   -----------   -----------   -----------
Balance at December 31, 1998                 3,550,550   $    35,506   $20,571,755   $ 1,161,253
                                            ==========   ===========   ===========   ===========
</TABLE>


See accompanying notes.

                                      F-5
<PAGE>
                               CD Warehouse, Inc.

                      Consolidated Statements of Cash Flows
<TABLE>
<CAPTION>


                                                                                YEAR ENDED DECEMBER 31,
                                                                                  1998            1997
                                                                              -----------    -----------
<S>                                                                           <C>            <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income                                                                    $   775,352    $   386,199
Adjustments to reconcile net income to net cash used for operating
   activities:
     Depreciation and amortization                                                617,250        238,600
     Deferred income taxes                                                         73,000         25,000
     Gain on disposal of assets, net                                               19,588        (21,432)
     Net changes in operating assets and liabilities, exclusive of 
       business acquisitions:
         Accounts receivable, net                                                (404,450)      (444,509)
         Inventories                                                             (849,087)    (1,287,056)
         Prepaid expenses and other                                               (57,446)       (53,816)
         Investment in partnerships                                               (57,955)        52,953
         Other assets                                                              (4,366)       (52,731)
         Accounts payable                                                        (552,103)       564,440
         Accrued liabilities                                                      116,343         83,765
         Advances and deposits                                                    (97,000)        90,000
         Income taxes payable                                                     193,385        205,000
         Minority interest                                                        (97,398)        84,418
                                                                              -----------    -----------
Total adjustments                                                              (1,100,239)      (515,368)
                                                                              -----------    -----------
Net cash used for operating activities                                           (324,887)      (129,169)
</TABLE> 

(Continued on following page)

                                      F-6
<PAGE>
                               CD Warehouse, Inc.

                Consolidated Statements of Cash Flows (continued)
<TABLE>
<CAPTION>


                                                             YEAR ENDED DECEMBER 31,
                                                             1998             1997
                                                         ------------    ------------
<S>                                                      <C>             <C>
CASH FLOWS FROM INVESTING ACTIVITIES
Notes receivable:
   Advances                                              $   (218,000)   $         --
   Collections                                                  7,034              --
Purchases of furniture, fixtures and equipment             (1,434,360)       (535,426)
Proceeds from disposal of assets                              115,030         179,012
Organizational costs                                               --            (775)
Acquisition of businesses:
   Excess of purchase price over assets acquired           (7,631,259)     (3,138,756)
   Accounts receivable                                        (54,740)        (72,739)
   Inventory                                               (1,743,899)       (398,346)
   Prepaid and other                                          (10,000)             --
   Furniture, fixtures and equipment                         (449,315)        (50,514)
   Investment in partnerships                                      --         (21,452)
   Other assets                                               (61,978)           (931)
   Accounts payable                                            87,890         543,229
   Accrued liabilities                                         60,687           1,673
   Advances and deposits                                      100,000              --
   Minority interest                                               --          12,980
                                                         ------------    ------------
Net cash used for investing activities                    (11,232,910)     (3,482,045)

CASH FLOWS FROM FINANCING ACTIVITIES
Notes payable:
   Advances                                                   280,938              --
   Repayments                                                (280,938)             --
Proceeds from sale of common stock, net                    14,854,580       4,368,016
Exercise of stock options                                      23,438              --
Exercise of stock subscription                                     --         350,000
                                                         ------------    ------------
Net cash provided by financing activities                  14,878,018       4,718,016
                                                         ------------    ------------
Net increase in cash and cash equivalents                   3,320,221       1,106,802

Cash and cash equivalents at beginning of year              1,122,233          15,431
                                                         ------------    ------------
Cash and cash equivalents at end of year                 $  4,442,454    $  1,122,233
                                                         ============    ============
</TABLE>


See accompanying notes.

                                      F-7
<PAGE>
 
                              CD Warehouse, Inc.

                  Notes to Consolidated Financial Statements

                               December 31, 1998


1. Summary of Significant Accounting Policies

Organization and Operations

CD Warehouse, Inc. and its wholly-owned subsidiaries, Compact Discs Management,
Inc. and CD Warehouse Finance Company (together the "Company") are engaged in
the franchising and ownership of retail music stores offering new and preowned
compact discs ("CDs") and related products. The Company was formed in Delaware
on September 5, 1996 and had only limited operations prior to its Initial Public
Offering and simultaneous business acquisition in January 1997. At December 31,
1998, the Company owns and operates 51 retail music stores located throughout
the United States and has 248 franchised stores throughout the United States,
and 15 stores located in Canada, England, France, Guatemala and Venezuela.

In December 1998, the Company established an internet website which will provide
a worldwide electronic store front for the sale of new and preowned CDs, related
music products, and concert and event tickets.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of CD
Warehouse, Inc. and its wholly-owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated.

Use of Estimates

The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.

Cash Equivalents

Cash equivalents include money-market investments and investments in commercial
paper with maturities of three months or less when purchased.

                                      F-8
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


1. Summary of Significant Accounting Policies (continued)


Fair Value of Financial Instruments

The following methods and assumptions were used to estimate the fair value of
each class of financial instruments for which it is practicable to estimate that
value.

The carrying amounts of cash and cash equivalents, trade receivables, and trade
accounts payable approximate fair value because of the short maturity of those
instruments. The Company's notes receivable from franchisees are at terms
consistent with market rate for the length of the note and risk of the borrower.
As such, the carrying amount for notes receivable approximates fair value.

Inventory

Inventory consists of new and preowned compact discs and is recorded at the
lower of average cost or market.

Furniture, Fixtures and Equipment

Furniture, fixtures and equipment, including leasehold improvements, are
recorded at cost and are depreciated on a straight-line basis over the estimated
useful lives of the assets which range from five to ten years.

Intangibles

Intangible assets relate principally to the excess cost over net assets acquired
of business and store acquisitions. Amortization of such costs are for periods
ranging from ten to twenty years.

Long-Lived Assets

In accordance with Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of," long-lived assets held and used by the Company are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. For purposes of evaluating
the recoverability of long-lived assets, the recoverability test is performed
using undiscounted net cash flows of the individual stores for long-lived assets
identified with individual stores, undiscounted net cash flows for acquired
franchises, and consolidated undiscounted net cash flows for long-lived assets,
not otherwise identifiable. No significant impairments were identified in 1998
or 1997.

                                      F-9
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


1. Summary of Significant Accounting Policies (continued)


Franchise Fees and Royalties

Initial franchise fees are nonrefundable and are recognized in income when all
material services or conditions relating to the sale of the franchise have been
substantially performed or satisfied by the Company. Area development fees are
nonrefundable and are recognized in income on a pro rata basis when the
conditions for revenue recognition under the individual development agreements
are met. Royalties from franchise operations are recognized in income as earned.

Advertising Costs

Costs incurred in connection with advertising and promotion of the Company's
products are expensed as incurred. Such costs amounted to approximately $392,000
and $131,000 in 1998 and 1997, respectively.

Stock Options

The Company accounts for employee stock-based compensation using the intrinsic
value method prescribed by Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations. No
compensation expense is recorded with respect to stock options granted at prices
equal to the market value of the Company's common stock at the date of grant.
Upon exercise, the excess of the proceeds over the par value of the shares
issued is credited to additional paid-in capital.

Advertising Fund

The Company operates an Advertising Fund which receives contributions from
franchisees and the Company based on sales. These funds are used to provide and
support national advertising for the CD Warehouse brand. These funds and the
related expenditures are not included in the accompanying consolidated financial
statements.

                                      F-10
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


1. Summary of Significant Accounting Policies (continued)


Net Income Per Share

The Company accounts for earnings per share in accordance with Statement of
Financial Accounting Standards No. 128 ("SFAS 128"), "Earnings Per Share." SFAS
128 requires the disclosure of Basic and Diluted Earnings per Share ("EPS").
Basic EPS is calculated using income available to common shareowners divided by
the weighted average of common shares outstanding during the year. Diluted EPS
is similar to Basic EPS except that the weighted average of common shares
outstanding is increased to include the number of additional common shares that
would have been outstanding if the dilutive potential common shares, such as
options, had been issued. The treasury stock method is used to calculate
dilutive shares which reduces the gross number of dilutive shares by the number
of shares purchasable from the proceeds of the options assumed to be exercised
(Note 8).

Supplemental Cash Flow Information

For the years ending December 31, 1998 and 1997, the Company had the following
noncash investing and financing activities:

     In 1998, the Company purchased partnership interests of a Company
     franchisee for cash of $173,471 and 100,000 shares of the Company's common
     stock valued at $3.625 per share. The noncash portion of this transaction
     is as follows:

        Costs in excess of net assets acquired, net              $ 281,412
        Inventory                                                  221,208
        Furniture, fixtures and equipment                           70,080
        Other assets                                                10,616
        Accounts payable and accrued liabilities                   (47,345)
                                                                 ---------
                                                                   535,971
        Less cash paid                                            (173,471)
                                                                 ---------
                                                                 $ 362,500
                                                                 =========

                                      F-11
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)

Supplemental Cash Flow Information (continued)


     In 1997, the Company purchased franchise interests of a Company franchisee
     for 80,000 shares of the Company's common stock valued at the initial
     public offering price of $5.00 per share:

        Costs in excess of net assets acquired, net              $301,806
        Inventory                                                  40,297
        Furniture, fixtures and equipment                          18,800
        Investment in partnerships                                 37,510
        Other assets                                                1,587
                                                                 --------   
                                                                 $400,000
                                                                 ========

Income taxes paid in 1998 totaled $199,615. Interest paid in 1998 totaled
$2,374. There was no interest or income taxes paid in 1997.

2. Public Offerings

In May 1998, the Company completed a private placement ("Placement") of
1,624,300 shares of common stock at $10.00 per share. Proceeds from the
Placement, after deducting the placement discount and placement expenses, were
approximately $14.8 million. The net proceeds from the Placement were used for
acquisitions, expansion, provision of financing to franchisees, and working
capital. The Company effected a Registration Statement on Form S-3 related to
such shares in September 1998.

In January 1997, the Company completed an Initial Public Offering ("Offering")
for 1,000,000 shares of its common stock at a price of $5 per share. In March
1997, the underwriters exercised an overallotment option and purchased an
additional 40,000 shares of common stock at $5 per share. The proceeds of the
Offering, after deducting the underwriting discount and offering expenses were
approximately $4.3 million.

                                      F-12
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


3. Business Acquisitions

In January 1998, the Company purchased five CD Warehouse stores from a
franchisee ("ZDTMAC") for cash of $173,471 and 100,000 shares of common stock
valued at $3.625 per share for a total purchase price of $535,971. The
acquisition was recorded under the purchase method of accounting and resulted in
an allocation of excess of purchase price over net assets acquired of $281,412
which is amortized on a straight-line basis over ten years.

In June 1998, the Company acquired the assets of three retail stores and
franchise rights for 134 franchisees of Disc Go Round ("DGR"), a competing
retailer of new and preowned compact discs, for cash of $7 million and
assumption of liabilities of $100,000. The acquisition was accounted for under
the purchase method of accounting and resulted in an allocation of excess of
purchase price over net assets acquired of $6,830,992 which is amortized on a
straight-line basis over fifteen years.

In October 1998, the Company acquired, for cash of $1,737,867, the assets and
liabilities of three partnerships: Compact Disc Investments II, Ltd., Compact
Disc Investment V, Ltd., and Compact Disc Associates, L.L.C. which collectively
owned 16 CD Warehouse stores. The Company, through its wholly-owned subsidiary,
CD Management, Inc., previously owned a majority or minority interest in these
partnerships. Upon the acquisition of these assets and liabilities, the related
partnerships were dissolved. The acquisition was accounted for under the
purchase method of accounting and resulted in an allocation of excess of
purchase price over net assets acquired of $629,245, which is amortized on a
straight-line basis over ten years.

The 1998 acquisitions described above were accounted for by the purchase method
of accounting for business combinations. Accordingly, the accompanying
consolidated statements of income do not include any revenues or expenses
related to these acquisitions prior to the respective closing dates.  The cash
portions of the acquisitions were financed through proceeds from the

                                      F-13
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


3. Business Acquisitions (continued)

Company's private placement of common stock and operating cash flows.  Following
are the Company's unaudited pro forma results for 1998 and 1997 assuming the
acquisitions occurred on January 1, 1997 (in thousands, except for per share
data):
<TABLE>
<CAPTION>
                                                                                       
                                                                            1998           1997
                                                                        --------------------------
<S>                                                                     <C>            <C>
        Total revenues                                                  $20,658,280    $16,893,947
        Net income                                                       $1,068,014       $748,302
        Net income per common share:                                                   
         Basic                                                                 $.30           $.21
         Diluted                                                               $.28           $.21
        Weighted average common shares:                                                
         Basic                                                            3,550,550      3,550,550
         Diluted                                                          3,763,945      3,550,550
</TABLE> 
These unaudited pro forma results have been prepared for comparative purposes
only and include certain adjustments, including amortization of goodwill as a
result of the acquisitions and do not purport to be indicative of the results of
operations which would have actually resulted had the combinations been in
effect on January 1, 1997, or of future results of operations.

In January 1997, simultaneously with the closing of the Offering (Note 2), the
Company purchased substantially all of the assets of Compact Discs
International, Ltd. ("CDIL") for $3.2 million. Prior to the acquisition, CDIL
was engaged principally in the business of selling new and preowned audio
compact discs to its franchisees. Also in January 1997, the Company purchased
all of the franchise interests of the largest CDIL franchisee in exchange for
80,000 shares of the Company's common stock. These acquisitions were recorded in
January 1997 under the purchase method of accounting and resulted in an excess
of purchase price over net assets acquired of approximately $3.5 million which
is amortized on a straight-line basis over twenty years.

                                      F-14
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


4. Notes Receivable

During 1998, the Company formed CD Warehouse Finance Company to provide
financing to new and existing franchisees. The financing is provided in the form
of notes receivable, secured by store assets and guarantees of the franchisees.
The notes generally require monthly payments of principal and interest, have a
two to four year term, and bear interest at 10.05%. Amounts outstanding under
these notes totaled $210,966 at December 31, 1998.

5. Furniture, Fixtures and Equipment

At December 31, 1998, furniture, fixtures and equipment, including leasehold
improvements, were comprised of the following:

        Furniture, fixtures and equipment located at:
          Corporate headquarters                         $   405,052
          Retail stores                                    1,421,996
        Internet website development in progress             659,732
                                                         -----------
                                                           2,486,780
        Accumulated depreciation                            (201,571)
                                                         -----------
                                                         $ 2,285,209
                                                         ===========

Depreciation expense totaled $162,667 and $63,185 for 1998 and 1997,
respectively.


6. Intangibles and Other Assets

Intangibles and other assets consist of the following at December 31, 1998:


        Excess of purchase price over net assets acquired 
          in business acquisitions                            $ 11,389,967
        Deposits and other                                         132,209
                                                              ------------   
                                                                11,522,176    
        Accumulated amortization                                  (613,758)
                                                              ------------ 
                                                              $ 10,908,418
                                                              ============

Amortization of goodwill totaled $454,583 and $175,415 in 1998 and 1997,
respectively.

                                      F-15
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


7. Income Taxes

The significant components of income tax expense for the years ended December
31, 1998 and 1997 are as follows:

                                                      
                                        1998             1997      
                                   -------------------------------
                                                                  
        Current tax expense:                                      
         Federal                     $ 339,000        $ 180,000   
         State                          54,000           25,000   
                                     ----------       ----------
                                       393,000          205,000   
                                                                  
                                                                  
        Deferred tax expense:                                     
         Federal                        62,000           22,000   
         State                          11,000            3,000   
                                     ----------       ----------
                                        73,000           25,000   
                                     ----------       ----------
                                     $ 466,000        $ 230,000   
                                   =============================== 


The provision for income taxes differs from the computed "expected" income tax
provision using federal statutory rates on income before income taxes for the
following reasons:

                                                     Year ended December 31,  
                                                        1998            1997  
                                                   ----------------------------
                                                                              
     Computed "expected" income tax                 $ 422,059       $ 209,508 
     Increases in taxes resulting from:                                       
      State income taxes, net of federal benefit       43,013          18,488 
      Other                                               928           2,004 
                                                   ----------------------------
                                                    $ 466,000       $ 230,000 
                                                   ============================


Deferred income taxes and deferred tax liability at December 31, 1998 result
from differences in amortization of intangibles and depreciation of furniture
and fixtures for financial and tax purposes.

                                      F-16
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


8. Stockholders' Equity

Earnings Per Share
                                                                                
                                                       1998            1997
                                                 -------------------------------
     Income:                                     
       Income available to common shareowners      $  775,352       $  386,199
                                                 ===============================
                                                 
     Weighted average shares:                    
       Outstanding                                   2,923,090       1,714,790
     Dilutive shares assuming:                   
       Exercise of stock options                       276,750              --
       Exercise of warrants                            262,430              --
       Less: Shares purchasable with proceeds         (325,785)             --
                                                 --------------   --------------
     Total shares                                    3,136,485       1,714,790
                                                 ===============================
                                                 
     Basic EPS                                     $      0.27      $     0.23
                                                 ===============================
     Diluted EPS                                   $      0.25      $     0.23
                                                 ===============================

Options to purchase 261,000 shares of common stock at a range of $3.13 to $5.00
and warrants to purchase 100,000 shares of common stock at $7.50 per share were
outstanding during 1997 but were not included in the computation of the diluted
EPS because the exercise price was greater than the average market price of the
common shares.

Stock Option Plan

In December 1996, the Company adopted the 1996 Stock Option Plan which, as
amended, provides for grants of up to 600,000 shares of common stock to certain
employees, officers, directors and others. Generally, the purchase price of
stock issuable upon exercise of the options will be at least equal to the fair
market value of the stock on the dates of grant. Generally, options are
exercisable no longer than ten years from the dates of grant. The Company has
agreed to grant options to purchase 10,000 shares annually to each director. No
options were granted through December 31, 1996. In 1998 and 1997, options to
acquire 107,000 and 261,000 common shares, respectively, were granted at option
prices equal to the fair market value of the common stock on the date of grant.
No expense related to options granted was recorded in 1998 and 1997.

                                      F-17
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


8. Stockholders' Equity (continued)

Stock option transactions for 1998 and 1997 are summarized as follows:

<TABLE>
<CAPTION>
                                                              1998                       1997                     
                                                  --------------------------   --------------------------         
                                                                  Weighted                    Weighted            
                                                                  Average                     Average             
                                                                  Exercise                    Exercise            
                                                     Shares        Price         Shares        Price              
                                                  -------------------------------------------------------         
<S>                                               <C>             <C>         <C>             <C> 
                                                                                                                  
     Outstanding at beginning of year               261,000       $   3.84                                        
     Granted                                        107,000       $  11.18      261,000       $   3.84            
     Exercised                                       (6,250)      $   3.75           --                           
     Canceled, forfeited, or expired                     --                          --                                  
                                                  ----------                  -----------                         
     Outstanding at end of year                     361,750       $   6.01      261,000       $   3.84           
                                                  ==========                  ===========                         
     Exercisable at end of year                      88,042       $   3.84           --                           
                                                  ==========                  ===========                         
                                                                                                                  
     Weighted average fair value of options                                                                       
      granted during year                          $   4.34                    $   2.18                           
                                                  ==========                  ===========                          
</TABLE> 

Outstanding options to acquire 361,750 shares of stock at December 31, 1998 had
exercise prices ranging from $3.13 to $12.88 per share and had a weighted
average remaining contractual life of 9 years.

The following pro forma information, as required by Statement of Financial
Accounting Standards No. 123, "Accounting for Stock Based Compensation" ("SFAS
123"), presents net income and earnings per share information as if the Company
had accounted for stock options issued in 1998 and 1997 using the fair value
method prescribed by the Statement. The fair value of issued stock options was
estimated at the date of grant using a Black-Scholes option pricing model with
the following assumptions for 1998 and 1997, respectively: weighted average
risk-free interest rate of 5.49% and 5.81%; no dividends over the option term;
stock price volatility factor of .363 and .599, and a weighted average expected
option life of five years. For the purpose of the following pro forma
information, the estimated fair value as determined by the model was amortized
to expense over the respective vesting period. The SFAS 123 pro forma
information presented below is not necessarily indicative of the pro forma
effects to be presented in future periods.

                                      F-18
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


8. Stockholders' Equity (continued)

The SFAS 123 pro forma information is as follows:

                                                  Year ended December 31,
                                                  1998               1997 
                                               -----------------------------
                                           
     Net income:                           
       As reported                             $ 775,352          $ 386,199
       Pro forma                               $ 471,769          $ 348,951
                                                                   
     Basic earnings per share:                                             
       As reported                             $     .27          $     .23
       Pro forma                               $     .16          $     .20
                                                                        
     Diluted earnings per share:                                           
       As reported                             $     .25          $     .23
       Pro forma                               $     .15          $     .20

The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of fair value of its stock options.

Warrants

In connection with the Offering, the Company sold to the underwriters, for a
price of $.001 per warrant, warrants to purchase 100,000 shares of common stock.
The underwriters' warrants are exercisable at $7.50 per share through January
2002.

In connection with the Placement, the placement agents were granted warrants to
purchase 162,430 shares of common stock exercisable at $10.00 per share through
2003.

                                      F-19
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


9. Commitments and Contingencies

The Company has entered into employment agreements with three officers of the
Company. The employment agreements are for terms of one and five years with
renewal options of one and five years and total $380,000 annually for the three
individuals.

The Company has entered into operating leases primarily for its retail store
locations and corporate facilities. Rental expense under these leases totaled
$801,200 and $301,621 for 1998 and 1997, respectively. Total rental amounts of
$2,976,106 under these noncancelable leases are due as follows: 1999--
$1,086,762, 2000--$870,732, 2001--$600,403, 2002--$320,011, 2003--$94,245, and
thereafter--$3,953.

The Company is also involved in legal proceedings and litigation arising in the
ordinary course of business. In the opinion of management, the outcome of such
proceedings and litigation currently pending will not materially affect the
Company's consolidated financial statements.

10. Related Party Transactions

Pursuant to the purchase agreement with a predecessor franchisee (Note 3), the
franchisee served as an officer of the Company in 1997 and continued to provide
accounting services for the acquired franchise interests. The Company
compensated the officer for these accounting services and reimbursed certain
agreed upon office expenses. Amounts paid under this agreement totaled $109,288
in 1997. In December 1997, the individual resigned his position with the Company
and repurchased certain franchise interests from the Company. Total proceeds of
this sale amounted to $170,000 which approximated book value at the time of
sale. Additionally, the Company entered into a consulting arrangement with the
individual, which expired in March 1998, and provided for consideration of
$30,000.

The aforementioned reacquisition (Note 3) resulted in the Company entering into
an area development agreement (the "ADA") with the principal owner of CDIL (also
a stockholder of the Company). The ADA provides for the right to develop
franchise operations worldwide, except for the United States, Canada and Mexico.
The Company has the right, during a specified period of time, to cancel the ADA
and to acquire any franchise developed under the ADA at a specified multiple of
earnings. In addition, the Company has agreed to grant to the individual (1) ten
domestic franchises with no initial franchise fee and royalties of 2% of net
sales and (2) two renewal franchises with no franchise fee or royalty payments.
Except as provided for in the above mentioned franchise agreements, CDIL and the
individual have also entered into covenants not to compete with the Company for
a period of ten years.

                                      F-20
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


11. Business Segment Information

The Company is engaged principally in one line of business--the sale of
prerecorded music compact discs and related products in Company and franchisee
owned retail stores--which represents approximately 98% of consolidated
revenues. There are no material amounts of sales among geographic areas,
individual foreign countries, or individual customers. All of the Company's
long-lived assets are located within the domestic United States.

12. Subsequent Events (unaudited)

In February 1999, the Company acquired the assets of Music Traders, Inc., a 16
store retail music chain based in Southern California for cash of $3,000,000 and
84,745 shares of the Company's common stock for a total purchase price of
approximately $4,000,000.

In February 1999, the Company finalized a $7,000,000 credit facility consisting
of a $2,000,000 Line of Credit and a $5,000,000 Term Loan Agreement
("Agreement") with Bank One. Amounts borrowed under the Line of Credit or Term
Loan will bear an interest rate equal to the Bank One prime rate. This Agreement
replaced a credit facility with another financial institution which existed, but
was unused, as of December 31, 1998.

                                      F-21