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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549


FORM 10-K

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended July 31, 2002

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to

Commission File No. 333-54035

MTS, INCORPORATED

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)


|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|California                                                     |  | 94-1500342                             
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification Number)

|                      |  |                          
|--------------------- |  | -------------------------
|2500 DEL MONTE STREET |  | WEST SACRAMENTO, CA 95691

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)


REGISTRANTS TELEPHONE NUMBER, INCLUDING AREA CODE:

(916) 373-2502



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Securities registered pursuant to Section 12(b) of the Act:

|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of Each Class |  | Name of Each Exchange on Which Registered
|                    |  |                                          
|None                |  | None                                     

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

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

Indicate by check mark whether registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months and (2) has been subject to such filing
requirements for the past 91 days. YES þ NO o

As of July 31, 2002, 1,000 shares of the Registrants Class B Common Stock were issued and outstanding.

None of such shares were held by non-affiliates of the Registrant.



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|                  |                                                                                               |  |  |  |  |  |  | 
|----------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I           
|                  | ITEM 1. BUSINESS                                                                             
|                  | ITEM 2. PROPERTIES                                                                           
|                  | ITEM 3. LEGAL PROCEEDINGS                                                                    
|                  | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                  
|PART II          
|                  | ITEM 5. MARKET FOR THE REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS            
|                  | ITEM 6. SELECTED FINANCIAL DATA                                                              
|                  | ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                  | ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                          
|                  | ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                          
|                  | ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 
|PART III         
|                  | ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                  
|                  | ITEM 11. EXECUTIVE COMPENSATION                                                              
|                  | ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                      
|                  | ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                      
|                  | ITEM 14. CONTROLS AND PROCEDURES                                                             
|PART IV          
|                  | ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K                     
|SIGNATURES       
|CERTIFICATIONS   
|INDEX OF EXHIBITS
|EXHIBIT 10.21    
|EXHIBIT 10.22    
|EXHIBIT 99.1     
|EXHIBIT 99.2     



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MTS, INCORPORATED
FORM 10-K
FOR THE FISCAL YEAR ENDED JULY 31, 2002

INDEX

|                                                                                              |  |  |    | 
|--------------------------------------------------------------------------------------------- |  |  | -- | 
|PART I                                                                                        |  |  | 3  | 
|Item 1. Business                                                                              |  |  | 4  | 
|Item 2. Properties                                                                            |  |  | 16 | 
|Item 3. Legal Proceedings                                                                     |  |  | 17 | 
|Item 4. Submission of Matters to a Vote of Security Holders                                   |  |  | 18 | 
|PART II                                                                                       |  |  | 18 | 
|Item 5. Market for Registrants Common Equity and Related Shareholder Matters                 |  |  | 18 | 
|Item 6. Selected Financial Data                                                               |  |  | 19 | 
|Item 7. Managements Discussion and Analysis of Financial Condition and Results
of Operations |  |  | 19 | 
|Item 7A. Quantitative and Qualitative Disclosure About Market Risk                            |  |  | 31 | 
|Item 8. Financial Statements and Supplementary Data                                           |  |  | 32 | 
|Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure  |  |  | 58 | 
|PART III                                                                                      |  |  | 58 | 
|Item 10. Directors and Executive Officers of the Registrant                                   |  |  | 58 | 
|Item 11. Executive Compensation                                                               |  |  | 59 | 
|Item 12. Security Ownership of Certain Beneficial Owners and Management                       |  |  | 63 | 
|Item 13. Certain Relationships and Related Transactions                                       |  |  | 64 | 
|Item 14. Controls and Procedures                                                              |  |  | 66 | 
|PART IV                                                                                       |  |  | 67 | 
|Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K                      |  |  | 67 | 
|Signatures                                                                                    |  |  | 68 | 
|Certifications                                                                                |  |  | 69 | 




PART I

Except as otherwise specifically indicated, all references in this Form 10-K to
the Company or Tower refer to MTS, Incorporated, a California corporation,
and its consolidated subsidiaries.

The Private Securities Litigation Reform Act of 1995 provides a safe harbor
for forward-looking statements to encourage companies to provide prospective
information about their companies. With the exception of historical
information, the matters discussed in this Form 10-K are forward-looking
statements and may be identified by the use of words such as believe,
expect, anticipate, plan, estimate, intend and potential. Such
statements reflect the current views of the Company with respect to future
events and are subject to certain risks, uncertainties and assumptions.
Readers

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are encouraged to review all of the Companys filings with the Securities and
Exchange Commission (SEC) that describe additional important factors,
including risk factors, that could cause actual results to differ materially
from those contemplated by the statements made herein. A variety of factors
could cause the Companys actual results to differ materially from the
anticipated results expressed in such forward-looking statements, including,
among other things: (i) consumer demand for the Companys products, which is
believed to be related to a number of factors, including overall consumer
spending patterns, weather conditions, and new releases available from
suppliers; (ii) an increase in competition, including Internet competition and
competition resulting from electronic or other alternative methods of delivery
of music and other products to consumers, or unanticipated margin or other
disadvantages relative to competitors; (iii) the continued availability and
cost of adequate capital to fund the Companys operations; (iv) higher than
anticipated interest, occupancy, labor, distribution and inventory shrinkage
costs; (v) unanticipated adverse litigation expenses or results; (vi) higher
than anticipated costs associated with the implementation of the Companys
Restructuring Plan and/or lower than anticipated resulting operations and cash
flow benefits; (vii) unanticipated increases in the cost of merchandise sold by
the Company; (viii) changes in foreign currency exchange rates and economic and
political risk; (ix) the adverse effects of acts or threats of war, terrorism
or other armed conflict on the United States and international economies; (x)
the ability of the Company to comply with the ongoing monthly affirmative and
negative covenants as prescribed by the Companys Amended and Restated Term
Loan Agreement with JPMorgan Chase and other lenders, and by the Companys Loan
and Security Agreement with The CIT Group/Business Credit Inc., and other
lenders; (xi) the ability of the Company to continue to service its senior
subordinated notes; and (xii) the ability of the Company to successfully defend
itself in ongoing and future litigation. All forward-looking statements
included in this Form 10-K are based on information available to the Company on
the date hereof, and the Company assumes no obligation to update any such
forward-looking statements. For further information on other factors, which
could affect the financial results of the Company and such forward-looking
statements, see Risk Factors.




ITEM 1. BUSINESS

GENERAL

Founded in 1960, the Company is one of the largest specialty retailers of
recorded music headquartered in the United States in terms of revenues and is
one of the largest and most widely recognized music retailers in the world. As
of July 31, 2002, the Company operated a total of 171 stores worldwide,
consisting of 103 U.S. stores in 21 states and 68 international stores in five
countries. Subsequent to year-end, following the sale of its Japan operations
on October 11, 2002, the Company currently operates a total of 119 stores
worldwide, including 16 international stores in four countries.

The Company offers a diversified line of music and video products including
compact discs, recorded audio cassettes, recorded video cassettes, DVD and
other complementary products, including books, magazines, blank tapes, video games, personal electronics and accessories.

Tower attracts and retains customers who buy music on a year-round basis by
providing an extensive product selection in an interactive, entertaining
environment. Tower stores

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feature extended store hours, in-store listening stations and knowledgeable and
motivated sales personnel. The Company believes these factors make Tower stores
a preferred shopping destination. Tower offers one of the broadest selections
of recorded music, including recent releases, older catalog releases and other
various music formats primarily in stand-alone shopping locations in densely
populated urban and suburban areas.

Most of the Companys domestic stores exceed 10,000 square feet and carry at
least 50,000 music titles. Flagship stores, which are located in major
metropolitan areas, such as, Chicago, Honolulu, London, Los Angeles, New
Orleans, New York, Philadelphia, San Francisco, Seattle and Washington, D.C.,
typically exceed 20,000 square feet and carry between 80,000 and 120,000 music
titles.

Due to the Companys high per store sales volume and long-standing
relationships with vendors and music manufacturers, the Company receives
substantial marketing support, competitive purchasing terms, short lead times
on inventory fulfillment, product return rights and drop shipments of orders
directly to its stores. Tower monitors the quantity and mix of inventory in
each of its stores through a central inventory management system. Additionally,
corporate management gives Towers store managers some discretion in managing
the level and mix of the inventory in their stores in order to most effectively
market to each stores demographic customer base.

For the 2002 fiscal year, the Company derived approximately 44% of its total
net revenues from international sales. Substantially all of the
Companys net revenue from
international sales will be lost in fiscal 2003 due to the sale of the Japanese
operations and the restructuring efforts in the United Kingdom and Ireland. As
of July 31, 2002, Tower operated 52 stores in Japan; eight in England; five in
Mexico, two in Ireland, and one in Singapore. The Company sold its Japan
operations on October 11, 2002. As a result of restructuring efforts and the
sale of the Japanese operations, the Company has 16 international stores, of
which ten are planned for closure or franchising due to the restructuring
efforts of the United Kingdom and Ireland. In addition, the Company has
entered into franchise agreements with local operators in Colombia, Ecuador,
Israel, Malaysia, Philippines, Argentina, Hong Kong, Taiwan and the United Arab
Emirates. As of July 31, 2002, there were a total of 58 stores that operate
under franchise agreements.

During the third quarter of the Companys 2001 fiscal year, the Company
commenced a business plan and restructuring process and retained a consulting
firm to assist the Company in its efforts. These efforts produced a
three-phase restructuring plan that was adopted by the Company in February 2001
(the Restructuring Plan).

The Restructuring Plan contains several initiatives designed to improve the
Companys operations, including closing and liquidating most stand-alone and
combination bookstores, selling the Companys Argentina, Hong Kong, Taiwan and
Singapore operations and converting them to franchises, closing the Companys
Canadian operations, closing under-performing domestic record, outlet and
frame/gallery stores, and monitoring the performance of additional stores. The
Restructuring Plan also contains several initiatives intended to improve cash
flow by reducing overhead expenses, reducing working capital and reducing
capital expenditures until internally generated cash flow will support further
growth.

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The Company began implementing the Restructuring Plan shortly after its
adoption. Management believes that, as of July 31, 2002, the Company has
substantially completed its restructuring initiatives through phase two of the
three-phase Restructuring Plan. Phase one included the identification and
closing of unprofitable operations both domestically and internationally and
the initiatives to improve cash flow. Phase two included further reductions in
working capital levels after the holiday season to meet planned levels and the
closing of six additional domestic stores, including two outlet stores. Phase
three will include the closure and possible franchising of the United Kingdom
and Ireland operations. As a result, the Company has established and recorded
a restructuring accrual for the United Kingdom and Ireland operations in the
current period.

Management expects to substantially complete the final phase of the
Restructuring Plan by mid fiscal 2003. Upon completion of the Restructuring
Plan and in conjunction with the hiring of a retail operations turn-around
specialist, the Company plans to implement a new business plan targeted at
improving operations, continue to monitor under performing stores and assets in
addition to evaluating its ongoing working capital commitments. Any significant
shortfalls in future operational results could require the Company to implement
additional restructuring efforts and continue to record charges to operations
for restructuring costs, asset impairments and inventory reserves into future
periods.

OPERATIONS

As of July 31, 2002, Tower operated a total of 171 stores worldwide, consisting
of 103 U.S. retail stores in 21 states and 68 international stores in five
countries. The Companys operating structure consists of (i) its U.S. stores,
Internet division and wholesaling operations, (ii) its Asian stores, Internet
division and wholesaling operations, and (iii) its U.K. and Ireland stores and
Internet division. As of July 31, 2002, the Companys operations were directed
by an Executive Committee comprised of nine committee members. Subsequent to
year-end, following the sale of its Japan operations on October 11, 2002,
the Company will operate a total of 119 stores worldwide, including 16
international stores in four countries.

UNITED STATES. As of July 31, 2002, the Companys U.S. operations consisted of
103 retail stores. In the U.S., Tower has organized its operations into four
territories, each headed by a territory manager who has responsibility for
sales and merchandising, day-to-day operations and administration. Towers
corporate headquarters provides central support to each territory, including
systems, distribution, accounting and national marketing programs. The
corporate headquarters also gives final approval for all new store sites and
store design and oversees quality standards and other critical elements of the
Tower concept.

ASIA. As of July 31, 2002, Towers Asian operations consisted of 52 stores in
Japan and one in Singapore. As part of the Restructuring Plan implemented by
the Company in February 2001, the Hong Kong and Taiwan operations were
converted to franchises during 2001. All Japanese store managers report to the
Director of Asian Operations located in Japan. The Singapore store is managed
from the Companys corporate headquarters. Product is purchased through a
variety of sources worldwide. Following the sale of its Japanese operations on
October 11, 2002, the Company plans to franchise

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its remaining store in Singapore.

UNITED KINGDOM AND IRELAND. As of July 31, 2002, the Company operated eight
stores in England and two in Ireland. All store managers in the United Kingdom
and Ireland report to the Director of European Operations located in London.
Product is purchased through a variety of sources worldwide. The Company
expects to close or franchise its operations in the United Kingdom and Ireland
during fiscal 2003. As a result, the Company has established and recorded a
restructuring accrual for the United Kingdom and Ireland operations in the
current period. Subsequent to year-end, the Company has closed four of the
eight stores in the United Kingdom.

JOINT VENTURES AND FRANCHISES

The Company has a joint venture operation in Mexico, which operates five
stores. This arrangement enables Tower to enter into the Mexican market and
obtain an improved understanding of local product demand and operating
procedures while benefiting from a sharing of capital commitments. Under the
joint venture arrangement, local investors manage store operations, utilizing
input from the Company.

The Company has entered into franchise agreements to operate stores in
Colombia, Ecuador, Israel, Malaysia, Philippines, Argentina, Hong Kong, Taiwan
and the United Arab Emirates. Additional franchised stores are planned for
other countries. The Company has focused its franchising operations in
developing markets to leverage its brand with minimal capital requirements.
Franchised stores are managed by the local operator with input from the Company
on store format and merchandising. The Company benefits from franchise
agreements through the distribution of products as well as through royalty
income and trademark licensing fees. The Company anticipates that future
expansion to other international markets will be through franchising agreements
or joint ventures.

TOWERRECORDS.COM

Through its wholly-owned subsidiary, Tower Direct LLC, the Company operates an
Internet company under the name, TowerRecords.com. TowerRecords.com operates
as an online retailer of music and complementary entertainment products and
information. TowerRecords.com has garnered high rankings and reviews from
Internet and industry experts in surveys of the Internets best websites. The
Company plans to continue to leverage its brand name through its Internet
capabilities to customers in Tower stores as well as Internet users in
non-Tower locations. The Tower website offers customers thousands of titles of
music and video items in stock and ready for immediate shipping from the
Companys state-of-the-art fulfillment and distribution center, which is owned
and operated by the Companys wholly-owned subsidiary, Three As Holdings, LLC,
doing business as Bayside Entertainment Distribution. Tower also continues to
focus on its core business of traditional brick-and-mortar retail operations.
The Company markets its Internet site through the same advertising and
marketing channels used for its retail stores and also through strategic
alliances with well-known Internet companies, such as AOL Time Warner Inc. and
Yahoo! Inc.

STORE FORMAT AND LOCATIONS

Tower has differentiated itself from competing music retailers with its
strategic store

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locations, which generally feature a large, centrally located store in a
densely populated urban area complemented by nearby urban and suburban
stand-alone stores. Towers flagship stores in major markets typically exceed
20,000 square feet, with the majority of all stores exceeding 10,000 square
feet. Newer domestic stores range from 15,000 to 30,000 square feet, depending
on the market and location. The Company believes that its larger, stand-alone
locations provide it with various operating efficiencies, including lower rent
expense than comparable mall-based retailers. The Companys large base of
high-volume, stand-alone stores enables it to receive drop-shipments of product
directly to store locations (thereby reducing the costs associated with
warehousing and distribution). The Company believes that the selection of
locations for its stores is critical to the success of its operations. The
site-selection process consists of an in-depth analysis of regional
demographics, consumer purchasing habits and traffic within a specific area.
Senior management is actively involved in this process and grants all final
site approval. During the fiscal year ended July 31, 2002, the Company opened
two and relocated two stores in the United States, opened three stores
internationally and closed nine stores. In addition, the Companys sale of its
Japanese operations on October 11, 2002, represented the sale of 52
international stores.

PRODUCTS

The Company offers a diverse line of products including compact discs, recorded
audio cassettes, recorded video cassettes, DVD and other complementary
products, including books, magazines, blank tapes, video games, personal
electronics and accessories.

RECORDED MUSIC. The Companys primary source of revenue is the sale of recorded
music on compact discs and audio cassettes. For fiscal years 2002 and 2001,
recorded music sales accounted for approximately 83.5% and 86.3%, respectively,
of Towers worldwide net revenues. The Companys stores carry a wide selection
of compact discs and audio cassettes purchased from all major and most
independent recording companies, which, except for new releases and special
promotions, are arranged in the stores by genre and alphabetically by artist or
group. Tower differentiates itself from its competitors through the breadth and
depth of its product selection. Towers strategy is to offer the broadest
selection of recorded music for its customers, including recent BILLBOARD Top
50 releases as well as a comprehensive variety of older releases and diverse
music formats. Most of the Companys stores carry at least 50,000 music titles,
while flagship stores located in major markets, such as, Chicago, Honolulu,
London, Los Angeles, New Orleans, New York, Philadelphia, San Francisco,
Seattle and Washington, D.C., usually carry between 80,000 and 120,000 music
titles.

VIDEO PRODUCTS. In addition to recorded music, the majority of Tower stores
sell videocassettes, and DVD products. For fiscal years 2002 and 2001, video
sales accounted for approximately 11.0% and 9.8%, respectively, of Towers
worldwide net revenues. Selected stores also offer video rentals. DVD offers
the consumer laser technology in a smaller disc format with superior picture
quality and audio fidelity. The Company believes that it is well positioned to
capitalize on the growing DVD market. DVD sales increased by 24% from fiscal
2001 to fiscal 2002.

COMPLEMENTARY PRODUCTS. To complement music buyers interests, Tower stores
also sell books, magazines, blank tapes, video games, personal electronics and
accessories. As of July 31, 2002, the Company operated three stand-alone
bookstores. For

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fiscal years 2002 and 2001, sales of complementary products accounted for
approximately 5.5% and 3.9%, respectively, of Towers worldwide net revenues.

MARKETING, ADVERTISING AND PROMOTION

Tower has long been recognized throughout the world for its unique brand of
retailing and seeks to maximize its use of marketing, advertising and
promotional activity by leveraging enhancement of its brand. The Companys
fully integrated marketing plan focuses on delivering to the customer a
comprehensive service of discovery, education and experience throughout all
aspects of the marketing mix.

In catering to a wide range of customers with diverse tastes, the Company
maintains a commitment to providing an extensive selection of packaged
entertainment, including a breadth of selection spanning all musical genres,
merchandised in stores that celebrate the unique interests and needs of the
communities in which they are located. Tower believes its dedication to
showcasing a multitude of recording artists, from emerging to super-star to
local favorites, with in-store appearances and live performances, as well as
author signings, sponsorships of local festivals, events and promotional
tie-ins advantageously differentiates it from its competitors.

The Company believes that differentiated customer service is an important
factor in overall customer satisfaction, brand loyalty and long term repeat
purchases. Tower maintains a commitment to providing its customers with
superior service throughout all aspects of its integrated marketing approach,
including advance release notification in Towers in-house produced publication
PULSE! and direct mail segmentation campaigns, sales promotions, in-store
customer education and discovery focus, utilizing point-of-purchase print
collateral and employing expert staff and product specialists to create an
informative, interesting and exciting shopping environment.

As one of the nations largest independent entertainment software retailers,
with over 40 years in the retail community, Tower has developed solid
relationships with its suppliers. As a result, the Company receives
substantial marketing support funds from both its major and independent vendors
through co-op advertising, and continues to achieve economies of scale in its
advertising and distribution. The Company believes that this level of support
is rooted in its vendors recognition of the unique contribution it makes to
the music industry.

Marketing support inflows offset a significant portion of the Companys
advertising, marketing and promotional expenses and enables Tower to leverage
brand equity with its customers across assorted media. The Company utilizes
newspaper, magazine, direct mail and broadcast advertising, tailoring local and
national advertising campaigns to create specific demand for products, while
reinforcing brand messaging and recognition.

Additionally, Tower leverages brand exposure and extension via third party
partnerships with nationally known entities, including media partners, VH-1,
Bravo and Rolling Stone, and partners such as Student Advantage. The Company
believes that leveraging partnerships forms a core component to the Companys
competitive advantage and as a result enables it to gain market share from its
competitors in certain markets.

The Company also markets packaged entertainment through its subsidiary Tower
Direct, LLC, which maintains a website at http://www.towerrecords.com. The
Internet site is

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marketed through strategic alliances with well-known Internet companies, such
as AOL and Yahoo!, and also through other advertising vehicles including new
release pre-order email campaigns designed to target early adopters, and email
consumer segmentation campaigns.

SUPPLIERS

RECORDED MUSIC. The majority of Towers music purchases come from five major
suppliers with which Tower has developed long-standing relationships. As a
result of these relationships and Towers high sales volume, the Company
receives substantial marketing support allowances, competitive purchasing
terms, short lead times on inventory fulfillment, competitive pricing programs
and drop shipments of orders directly to its stores. In addition, the Company
purchases product from numerous independent distributors and labels. Unsold
music product may be returned to domestic manufacturers at any time that the
title remains in the current music catalog of a manufacturer; however,
restocking fees are generally assessed for returned product. Product deletions
are generally made only after advance notice, allowing the Company to return
excess inventory before a title is discontinued. None of the Companys major
domestic suppliers limits returns of inventory.

COMPLEMENTARY PRODUCTS. Book and magazine purchases require coordination with a
greater number of vendors than music purchases. Returned books and magazines
are not subject to restocking charges. Pre-recorded video cassettes, DVD
products, personal electronics and video games are purchased from a limited
number of vendors for shipment through the Companys U.S. distribution
operations, or are drop-shipped directly to stores. For the most part, unsold
video products and video games may be returned to distributors for full
refunds. Personal electronics are generally not returnable for a full refund.

PURCHASING, INVENTORY MANAGEMENT AND DISTRIBUTION

Unlike most of its competitors, Towers purchasing is partly decentralized.
Tower store managers are given discretion to manage the levels and mix of
merchandise in their stores, subject to certain limitations established by the
Companys national headquarters. Managers work closely with territory and
national product managers to customize product inventory in their stores to the
demographics and buying patterns of their local markets.

The Companys ISP (In Store Processing) system, using the IBM AS/400 computer
system, enables management to monitor the levels and mix of its inventory in
each of its stores. The ISP system provides store managers instantaneous
on-line information regarding quantities on hand, turns at the store level and
on a combined basis, historical movement reports by SKU, pricing and cost data
and customer service information. The ISP system also identifies slow-moving,
deleted and overstocked titles to prompt the return of this inventory for
refund. The system provides suggested replenishment information to store
buyers. By utilizing the ISP system, store managers are able to pre-set and
manage timely reorder points. This system enables the store managers to carry
appropriate levels of deep-catalog product and to maintain sufficient inventory
levels for fast-moving product.

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The Company uses its U.S. distribution operation to distribute products when it
is more efficient than drop shipping to Tower stores. The Company also
wholesales products; particularly independent label recorded music, to other
retailers in both the U.S. and international markets.

The Company also sells recorded music both via mail order and over the
Internet. The Company maintains a website at http://www.towerrecords.com and an
online store on AOL at keyword TOWER. Mail order and Internet sales are
fulfilled through the Companys U.S. distribution facility allowing, in many
cases, overnight delivery to customers.

COMPETITION

The retail music and video industry is highly competitive. The Company competes
with a wide variety of music retailers, including regional and national
mall-based music chains, international chains, deep-discount retailers, mass
merchandisers, consumer electronics outlets, record clubs, e-commerce
retailers, mail order, and independent operators. In addition, a uniform format
has been developed that will enable music companies to sell their products via
direct Internet download. The Company believes that sales via the Internet
will continue to be a more significant part of an integrated operating strategy
and accordingly has determined to emphasize order fulfillment for, and
co-market with, its Internet subsidiary. In addition, consolidation continues
to occur in the home entertainment industry. In January 2001, Musicland was
acquired by Best Buy Co., Inc., both competitors of the Company. Also,
recently, Time Warner was acquired by AOL, and Vivendi Universal acquired
Seagram Co. Ltd., which included the Universal Music Group, a major supplier to
the Company. Bertelsmann AG, also a major supplier to the Company, acquired an
interest in Napster. In addition, KAZAA BV, a company utilizing a model
similar to Napsters, has been facilitating music downloads via the Internet,
and the major suppliers of recorded music to the Company are exploring and, in
some cases, have implemented direct, fee-based sales to the consumer via the
Internet.

The Company believes the principal competitive factors in the retail music
industry are brand name recognition, merchandising, selection, pricing,
inventory management, marketing, store location, management expertise and
customer service. The Company believes that it competes favorably with respect
to each of these factors.

MAJOR INTERNATIONAL CHAINS. In certain of its major, metropolitan markets, the
Company competes directly with HMV Group plc and Virgin. Both are large
international music retailers-that, like the Company, emphasize a broad
selection of titles. Management believes that in the markets, in which Tower
competes, Tower carries a deeper catalog selection than its competitors,
including HMV and Virgin.

MALL-BASED MUSIC RETAILERS. The Company also competes with various mall-based
music retailers such as Musicland, Trans World Entertainment Corporation, and
Wherehouse Entertainment, Inc.

DISCOUNTERS AND CONSUMER ELECTRONICS STORES. Specialty music retailers have
experienced increasing competition from large discounters and consumer
electronics stores such as Wal-Mart, Kmart, Target, Circuit City, Best Buy,
Barnes and Noble and Borders. Many of these large discounters and consumer
electronics stores

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typically feature BILLBOARD Top 50 recordings with minimal or no gross margin
with the intent of generating additional store traffic and cross-selling other,
higher margin products, such as consumer electronics.

MAIL ORDER CLUBS. The Company also competes with mail order clubs such as BMG
Music and Columbia House. The largest mail order clubs are affiliated with
major manufacturers of pre-recorded music and video and may have advantageous
sourcing and marketing relationships with their affiliates.

INTERNET AND OTHER. The Internet has become an established avenue for retailing
and the purchase of music and video and continues to grow in popularity with
entertainment software consumers. The Companys e-commerce competitors include
Amazon.com, Cdnow.com, BarnesandNoble.com, mp3.com and others, most of which
have one or more marketing alliances. The Company expects continued growth in
competing home entertainment options, including the Internet and larger numbers
of television and music channels offered by cable companies. The further
development of Internet and cable technologies, coupled with high quality
digital recording technologies, enable direct downloading of recorded music by
consumers via the Internet, which could result in significant changes in
existing distribution channels for pre-recorded music. Such a development could
have a material adverse effect on the Companys business, financial condition
and results of operations. See Risk Factors-Increased Competition From
Existing Retailers and Competing Home Entertainment Options May Adversely
Affect the Companys Results.

SEASONALITY

Retail music sales in the United States are typically higher during the
calendar fourth quarter as a result of consumer purchasing patterns due to
increased store traffic and impulse buying by holiday shoppers. As a result,
the majority of U.S. music retailers, and more specifically, the mall-based
retailers rely heavily on the calendar fourth quarter to achieve annual sales
and profitability. Towers deep-catalog approach to pre-recorded music appeals
to customers who purchase music on a year-round basis. Consequently, Tower has
historically had reduced seasonal reliance. In addition, international markets
exhibit less fourth quarter seasonality than U.S. markets and Towers
international presence has historically further reduced the Companys reliance
on the U.S. holiday shopping season. Nevertheless, in each of fiscal 2002 and
2001, the second quarter (November 1 through January 31) accounted for
approximately 30% of annual sales. See Note 15 to Consolidated Financial
Statements.

TRADEMARKS

Tower regards its trademarks and service marks as having significant worldwide
value and as being important to its marketing efforts and brand name
recognition. Tower has registered its TOWER RECORDS-VIDEO-BOOKS trademark and
variations thereof, along with numerous other trademarks, with the United
States Patent and Trademark Office on the Principal Register. The Company also
has registered its TOWER trademark, or variations thereof, in numerous foreign
countries. The Companys policy is to pursue the registration of its trademarks
whenever possible and to vigorously oppose any infringement of its trademarks
and trade names.

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EMPLOYEES

As of July 31, 2002, the Company employed approximately 4,828 persons, of whom
approximately 730 were employed on a part-time basis. Subsequent to year-end,
following the sale of its Japan operations on October 11, 2002, the company
employed 3,171 persons, of whom approximately 717 were employed on a part-time
basis. None of the Companys employees is covered by a collective bargaining
agreement. The Company considers its employee relations to be good.

RISK FACTORS

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

The Companys Substantial Indebtedness May Restrict the Conduct of the
Companys Business

The Company is substantially leveraged. The Companys aggregate outstanding
indebtedness was $312.2 million and the Companys shareholders deficit was
$(40.8) million at July 31, 2002. The Company also has substantial rental
obligations. The Companys substantial degree of leverage could have the
following effects: (i) the Companys ability to obtain additional financing for
working capital, capital expenditures, acquisitions, general corporate purposes
or other purposes in the future could be reduced, (ii) a substantial portion of
the Companys cash flow from operations must be dedicated to the payment of
principal and interest on its indebtedness, which reduces the funds available
to the Company for other purposes, (iii) certain of the Companys borrowings
are at variable rates of interest, which exposes the Company to interest rate
fluctuation risk, (iv) the Company may be hindered in its ability to adjust
rapidly to changing market conditions, and (v) the Company could be more
vulnerable in the event of a downturn in general economic conditions or its
business.

The Companys cash flow and capital resources may not be sufficient for payment
of interest on and principal of its indebtedness in the future. If the
Companys cash flow and capital resources are insufficient to fund its debt
service obligations, the Company may be forced to reduce or delay capital
expenditures, sell assets, seek to obtain additional equity capital, or
refinance its debt. In the absence of sufficient cash flow and capital
resources, the Company could face substantial liquidity problems and could be
required to dispose of material assets or operations to meet its debt service
and other obligations.

The Companys credit facility was refinanced on October 11, 2002 with an
asset-based line of credit and a term loan, each of which matures on April 1,
2005. At July 31, 2002, the Company had $194 million outstanding under its
then-existing credit facility. At July 31, 2002, the Companys credit facility
was, and continues to be subject to maximum borrowings, certain financial ratio
tests and maintaining a minimum rolling quarterly EBITDA. The Companys future
operating performance and ability to service its senior subordinated notes and
its credit facility will be subject to the Companys ability to successfully
restructure its domestic operations, future economic conditions and to
financial, business and other factors, many of which are beyond the Companys
control. See Managements Discussion and Analysis of Financial Condition and
Results of Operations.

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The Companys new credit facility contains a number of significant covenants
that restrict the manner in which the Company conducts its business and
requires the Company to comply with specified ratios and financial tests. The
Indenture entered into by the Company in connection with the issuance of its
subordinated notes also contains certain restrictive covenants. The Companys
ability to comply with these covenant requirements may be affected by events
beyond its control, including prevailing economic, financial and industry
conditions. The breach of any such covenants or restrictions could result in a
default under the relevant financing agreements that would permit the relevant
lenders or debt holders to declare all amounts outstanding thereunder to be due
and payable, together with accrued and unpaid interest, and the commitments of
the lenders under the credit facility to make further extensions of credit
thereunder could be terminated, any of which would harm the Companys business.

In addition, in fiscal 2003, the Company is obligated to make interest payments
on its subordinated notes in the amount of $5,156,250 on each of November 1,
2002 and May 1, 2003. The Company must make semi-annual payments on the
subordinated notes until their maturity in May 2005. In the event the Company
is unable to make payments on its subordinated notes, the Companys business,
financial condition and results of operations would be materially and adversely
affected.

The Companys Business Could be Harmed by a Lack of Availability of Popular
Music

The Companys business is affected by the release of hit music titles, which
can create cyclical trends in sales distinctive to the music industry. It is
not possible to determine the timing of these cycles or the future availability
of hit titles. Entertainment product sales depend to some extent upon the
availability of hit products. If there are no hit products, entertainment
companies may be unprofitable even though the general economy is doing well.
The Company cannot determine in advance the timing of these cycles or the
future availability of hit products. Hit products are important because they
generate customer traffic in stores. The Company does not control the content
of the products it sells and is dependent upon the major music and movie
producers to continue to produce hit products. To the extent that new hits are
not available, or not available at prices attractive to consumers, the
Companys sales may be adversely affected.

The Companys Sales May Suffer if the Company Does Not Accurately Predict Which
New Product or Distribution Technologies Will be Accepted by Consumers

The emergence of new technologies may attract consumers from one technology to
another and reduce sales and profit margins of existing technologies. For
example, the shift from cassettes to CDs reduced the demand for cassettes. New
technologies are also increasing the ways products can be offered to the
public. A wide selection of music and video services can now be offered to
consumers by the Internet, cable companies, direct broadcast satellite
companies, telephone companies, and other telecommunications companies. In
particular, Internet and cable technologies coupled with high-quality digital
recording technologies allows direct downloading of recorded music by consumers
via the Internet. If technological advances were to result in significant
changes in existing distribution channels for pre-recorded music, the Companys
business, financial condition or results of operations could be harmed. If the
Company is

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unable to predict or participate in new product or distribution technologies
that consumers accept widely, the Companys sales may suffer.

Increased Competition From Existing Retailers and Competing Home Entertainment
Options May Adversely Affect the Companys Results

The retail music business is highly competitive. The Company competes with a
wide variety of music retailers, including regional and national mall-based
music chains, international chains, deep-discount retailers, mass
merchandisers, consumer electronics outlets, mail order, record clubs and
independent operators, some of which have greater financial and other resources
than the Company. In retail music sales, some of the Companys competitors
have been expanding into the Companys markets. The Company also expects
continued growth in competing home entertainment options, including the
Internet and larger numbers of television and music channels offered by cable
companies. This increased competition may reduce sales at the Companys
stores, reduce the Companys gross margins, increase the Companys operating
expenses and decrease the Companys profit margins in specific markets. If
these competing home entertainment options continue to grow, retail stores may
cease being a primary channel for distribution of recorded music, which could
harm the Companys ability to compete within the music retail business. See
Competition Internet and Other. In addition, consolidation continues to
occur in the home entertainment industry. In January 2001, Musicland was
acquired by Best Buy, both competitors of the Company. Also, recently, Time
Warner was acquired by AOL, and Vivendi acquired Seagram, which included the
Universal Music Group, a major supplier to the Company. Bertelsmann, also a
major supplier to the Company, acquired an interest in Napster. In addition,
KAZAA BV, a company utilizing a model similar to Napsters, has been
facilitating music downloads via the Internet, and the major suppliers of
recorded music to the Company are exploring and, in some cases, have
implemented direct, fee-based sales to the consumer via the Internet.

A Decline in Current Levels of Consumer Spending Could Reduce Sales

The Companys business is directly affected by the level of consumer spending.
One of the primary factors that affect consumer spending is the general state
of the local economies in which the Company operates. Lower levels of consumer
spending in regions in which the Company has significant operations could have
a negative impact on the Companys business, financial condition or results of
operations.

Foreign Currency Exchange Rate Fluctuations and Other Risks Relating to the
Companys International Operations Could Adversely Affect the Companys Results

The Company has substantial operations and assets located outside the United
States, primarily in the United Kingdom and, until October 11, 2002, Japan.
With respect to international operations, principally all of the Companys
revenues and costs (including borrowing costs) are incurred in the local
currency. The Companys financial performance on a U.S. Dollar-denominated
basis has historically been significantly affected by changes in currency
exchange rates. Changes in certain exchange rates could negatively affect the
Companys business, financial condition and results of operations.

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See Managements Discussion and Analysis of Financial Condition and Results of
Operations.

International operations are also subject to a number of other special risks,
including trade barriers, exchange controls, governmental expropriation,
political risks and risks of increases in taxes. In addition, the laws of
certain foreign countries do not protect the Companys trademark, trade name,
copyright and other intellectual property rights to the same extent as do the
laws of the United States. Also, various jurisdictions outside the United
States have laws limiting the right and ability of non-U.S. subsidiaries and
affiliates to pay dividends and remit earnings to affiliated companies unless
specified conditions are met. Earnings of international subsidiaries are
subject to income taxes of non-U.S. jurisdictions that could reduce cash flow
available to meet required debt service and other obligations of the Company.

A Change in One or More of the Companys Vendors Policies or the Companys
Relationship With Those Vendors Could Adversely Affect the Companys Operations

The majority of the Companys purchases come from five major suppliers. As is
standard in the music industry, the Company does not maintain long-term
contracts with its suppliers but instead makes purchases through purchase
orders. If the Company fails to maintain customary trade terms or enjoy
positive vendor relations, it would have an adverse effect on the Companys
results of operations and financial condition.

Loss of Key Personnel Could Harm the Companys Business

The Company believes that its future prospects depend to a significant extent
on the services of its executive officers, as well as its ability to attract
and retain additional key personnel with the skills and expertise necessary to
manage its planned growth. The loss or unavailability of the services of
certain of the Companys executive officers and other key management personnel
could harm the Companys business, financial condition and results of
operations. See Directors and Executive Officers of the Registrant.

Control of the Company by Russell M. Solomon May Impede Changes to the Company

Russell M. Solomon, Chairman and a director of the Company, beneficially owns a
majority of the outstanding voting securities of the Company. Accordingly, Mr.
Solomon has the ability to elect all of the members of the Board of Directors
of the parent corporation and to determine the outcome of any matter submitted
to the shareholders for approval, including corporate transactions such as
mergers, consolidations and the sale of all or substantially all of the assets
of the Company.




ITEM 2. PROPERTIES

The Companys headquarters are located in approximately 91,000 square feet of
leased facilities in West Sacramento, California. These facilities house the
Companys management, marketing, sales and corporate finance personnel. The
lease for these facilities terminates on April 30, 2004. The Company believes
that there is sufficient

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office space available at favorable leasing terms in the Sacramento area to
satisfy any additional needs of the Company that may result from future
expansion.

As of July 31, 2002, Towers total leased space consisted of approximately 2.7
million square feet of space worldwide. As of July 31, 2002, the Company was a
party to approximately 203 real estate leases and subleases, relating to nearly
all of its store locations as well as its administrative and warehouse
facilities. Substantially all of these are recorded as operating leases. The
leases expire between calendar year 2002 and calendar year 2024, with renewal
options varying between one and 20 years. Lease terms typically provide a
minimum payment plus modifications for changes in the consumer price index
and/or other specified increases. Most of the U.S. stores operate as
stand-alone locations.




ITEM 3. LEGAL PROCEEDINGS

The Company is party to various claims, legal actions and complaints arising in
the ordinary course of its business. The Company was named and served as a
co-defendant in three antitrust actions following the May 10, 2000 announcement
that the major music distributors (EMI Music Distribution, Bertelsmann Music
Group, Inc., Warner-Elektra-Atlantic Corporation, Sony Music Entertainment,
Inc., Universal Music and Video Distribution Corp.) had entered into a
settlement agreement (consent decree) with the Federal Trade Commission (FTC)
in response to the FTCs investigation into the implementation of minimum
advertised pricing (MAP) programs by the major record companies. The first
of these antitrust actions, entitled Arnold Samotny et al vs. BMG
Music, et al,
was filed on June 2, 2000 in the United States District Court for the Northern
District of Illinois Eastern Division. The second action, filed on August 8,
2000, is entitled State of Florida et al vs. BMG et aland is a consumers
antitrust action brought by 45 States Attorneys General in a consolidated
action in the United States District Court Southern District of New York. The
third case, Allison Lacy et al vs. BMG Music et alwas filed September 14, 2000
in the United States District Court for the Eastern District of Tennessee.
These three antitrust lawsuits allege that co-defendant music distributors,
retailers and the Company were engaged in a conspiracy to fix the prices of
CDs, in violation of federal and state antitrust, unfair trade practices, and
consumer protection statutes.

The above actions were consolidated and coordinated for pretrial purposes with
venue set in Portland, Maine before Federal Judge D. Brock Hornsby, who has
issued discovery orders in the coordinated action, captioned Compact Disc
Minimum Advertised Price Antitrust Litigation, MDL Docket No. 1361. An answer
was filed on behalf of the Company, in April 2001. The Company attended a
settlement conference on April 30, 2002 and reached a settlement with all
plaintiffs for $275,000, which was accrued for as of July 31, 2002. The
settlement agreement was finalized on September 27, 2002, and the case against
the Company was dismissed.

The Company entered into a consulting contract with Chilmark Partners, LLC
(Chilmark) on May 18, 2001. By letter to Chilmark dated June 12, 2002, the
Company terminated the contract. On July 29, 2002, Chilmark filed suit against
the Company in the U.S. District Court for the Northern District of Illinois,
alleging breach of contract and seeking other remedies under the contract and
attachment of proceeds of the Companys sale of its Japan operations. In
August 2002, Chilmarks request for such an

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attachment was denied. The litigation continues with respect to Chilmarks
breach of contract claim and its request for damages under the terms of the
contract. As of October 11, 2002, Chilmarks total damage request was
approximately $2.6 million. The Company believes it has meritorious defenses
with respect to each of Chilmarks claims and intends to defend against the
claims vigorously; however, the litigation is in the preliminary stage and
there can be no assurance that the Company will prevail in this action. If
Chilmark receives a favorable judgment for all or a substantial portion of the
total $2.6 million in damages Chilmark is seeking, such an outcome could have a
material adverse effect on the Companys financial condition, results of
operations and cash flows.




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

On April 10, 2002, the Companys shareholders approved by written consent (i)
the sale of the Companys Japanese operations under the terms of a Stock
Purchase Agreement dated as of April 11, 2002, as amended, and (ii) the making
of payments in connection with such sale to certain officers of the Company of
its then-wholly-owned subsidiary, Tower Records Kabushiki Kaisha, which may
have been subject to the provisions of Section 280G of the Internal Revenue
Code of 1986, as amended.




PART II




ITEM 5. MARKET FOR THE REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

There is no established public market for any class of the Companys common
stock. As of July 31, 2002, Tower Records, Incorporated was the only
shareholder of record of the Company. See Security Ownership of Certain
Beneficial Owners and Management.

The Company has not paid cash dividends on its Common Stock and does not
anticipate paying any such dividends in the foreseeable future.

Currently, each of the Loan and Security Agreement governing the Companys line
of credit and the Amended and Restated Term Loan Agreement governing the
Companys term loan restricts the payment of dividends by the Company.

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ITEM 6. SELECTED FINANCIAL DATA

|                                   |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |         |      |       | 
|---------------------------------- | -------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------- | ------------ | ----- | -------------------------- | ----- | ---- | ------- | ----- | ----- | ---- | ------- | ----- | ----- | - | ------- | ---- | ----- | - | ------- | ---- | ----- | 
|                                   |                                                                                                                            |                                           |              |       | FISCAL YEAR ENDED JULY 31,
|                                   |                                                                                                                            |                                           |              |       |                           
|                                   |                                                                                                                            |                                           |              |       | 2002                       |       | 2001 |         | 2000  |       | 1999 |         | 1998 
|                                   |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |      
|                                   |                                                                                                                            |                                           |              |       | (DOLLARS IN MILLIONS)     
|INCOME STATEMENT DATA:             |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |        
|                                   | Net revenues                                                                                                               |                                           | $            | 982.8 |                            |       | $    | 1,079.5 |       |       | $    | 1,099.9 |       |       | $ | 1,026.4 |      |       | $ | 1,008.1 |     
|                                   | Cost of sales (a)                                                                                                          |                                           |              | 692.2 |                            |       |      | 768.4   |       |       |      | 745.4   |       |       |   | 694.9   |      |       |   | 684.2   |     
|                                   |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |        
|                                   |                                                                                                                            |                                           | Gross Profit |       |                            | 290.6 |      |         |       | 311.1 |      |         |       | 354.5 |   |         |      | 331.5 |   |         |      | 323.9 | 
|                                   | Selling, general and
administrative expenses (b)                                                                           |                                           |              | 271.7 |                            |       |      | 294.7   |       |       |      | 301.4   |       |       |   | 276.3   |      |       |   | 269.3   |     
|                                   | Restructuring and asset impairment
costs                                                                                   |                                           |              | 21.8  |                            |       |      | 23.3    |       |       |      | 0.0     |       |       |   | 0.0     |      |       |   | 0.0     |     
|                                   | Depreciation and amortization                                                                                              |                                           |              | 28.3  |                            |       |      | 30.5    |       |       |      | 28.3    |       |       |   | 23.4    |      |       |   | 22.3    |     
|                                   |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |        
|                                   | (Loss) income from operations                                                                                              |                                           |              | (31.2 | )                          |       |      | (37.4   | )     |       |      | 24.8    |       |       |   | 31.8    |      |       |   | 32.3    |     
|                                   | Other (income) expense:                                                                                                    |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |         |     
|                                   |                                                                                                                            | Interest expense                          |              |       | 25.1                       |       |      |         | 25.2  |       |      |         | 21.0  |       |   |         | 17.6 |       |   |         | 14.9 |      
|                                   |                                                                                                                            | Foreign currency translation
(gain) /loss |              |       | (1.3                       | )     |      |         | 4.3   |       |      |         | 9.2   |       |   |         | 14.7 |       |   |         | (1.1 | )    
|                                   |                                                                                                                            | Other expenses                            |              |       | 3.5                        |       |      |         | 2.4   |       |      |         | 3.6   |       |   |         | 4.1  |       |   |         | 0.5  |      
|                                   |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |        
|                                   | (Loss) income before taxes, minority
interest, extraordinary item, and
cumulative effect of change in
accounting principle |                                           |              | (58.5 | )                          |       |      | (69.3   | )     |       |      | (9.0    | )     |       |   | (4.6    | )    |       |   | 18.0    |     
|                                   | (Benefit) provision for income
taxes                                                                                       |                                           |              | (1.3  | )                          |       |      | 21.0    |       |       |      | 1.1     |       |       |   | 3.7     |      |       |   | 8.1     |     
|                                   |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |        
|                                   | (Loss) income before minority
interest, extraordinary item, and
cumulative effect of change in
accounting principle        |                                           |              | (57.2 | )                          |       |      | (90.3   | )     |       |      | (10.1   | )     |       |   | (8.3    | )    |       |   | 9.9     |     
|                                   | Other items (c)                                                                                                            |                                           |              | 0.0   |                            |       |      | 0.0     |       |       |      | 0.0     |       |       |   | (0.5    | )    |       |   | 0.0     |     
|                                   |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |        
|                                   |                                                                                                                            | Net (loss) income                         |              | $     | (57.2                      | )     |      | $       | (90.3 | )     |      | $       | (10.1 | )     |   | $       | (8.8 | )     |   | $       | 9.9  |      
|                                   |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |        
|BALANCE SHEET DATA (AT PERIOD END) |                                                                                                                            |                                           |              |       |                            |       |      |         |       |       |      |         |       |       |   |         |      |       |   |        
|                                   | Total assets                                                                                                               |                                           | $            | 476.1 |                            |       | $    | 527.0   |       |       | $    | 627.3   |       |       | $ | 586.2   |      |       | $ | 545.4   |     
|                                   | Total debt (including
current maturities)                                                                                  |                                           |              | 312.2 |                            |       |      | 297.7   |       |       |      | 311.6   |       |       |   | 283.1   |      |       |   | 231.9   |     
|                                   | Shareholders (deficit) equity                                                                                             |                                           | $            | (40.8 | )                          |       | $    | 21.4    |       |       | $    | 107.4   |       |       | $ | 115.7   |      |       | $ | 120.8   |     

(a)  Includes $14.2 and $20.7 million of inventory write-downs related to the
Restructuring Plan in fiscal 2002 and 2001, respectively (See Note 2 to
Consolidated Financial Statements).

(b)  Includes $5.9 and $2.7 million of professional fees related to the
Restructuring Plan in fiscal 2002 and 2001, respectively (See Note 2 to
Consolidated Financial Statements).

(c)  Other items are comprised of minority interests in net income of
subsidiaries, cumulative effect of change in accounting principle, and
extraordinary item.




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

The following discussion should be read in conjunction with historical
consolidated financial information and the consolidated financial statements of
the Company and the notes thereto included elsewhere in this Form 10-K. The
results shown herein are not necessarily indicative of the results to be
expected in any future period. The following

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discussion contains forward-looking statements that involve known and unknown
risks and uncertainties. The Private Securities Litigation Reform Act of 1995
provides a safe harbor for forward-looking statements to encourage companies
to provide prospective information about their companies. With the exception
of historical information, the matters discussed in this Form 10-K are
forward-looking statements and may be identified by the use of words such as
believe, expect, anticipate, plan, estimate, intend and
potential. Such statements reflect the current views of the Company with
respect to future events and are subject to certain risks, uncertainties and
assumptions. Readers are encouraged to review all of the Companys filings
with the SEC that describe additional important factors, including risk
factors, that could cause actual results to differ materially from those
contemplated by the statements made herein. A variety of factors could cause
the Companys actual results to differ materially from the anticipated results
expressed in such forward-looking statements, including, among other things:
(i) consumer demand for the Companys products, which is believed to be related
to a number of factors, including overall consumer spending patterns, weather
conditions, and new releases available from suppliers; (ii) an increase in
competition, including Internet competition and competition resulting from
electronic or other alternative methods of delivery of music and other products
to consumers, or unanticipated margin or other disadvantages relative to
competitors; (iii) the continued availability and cost of adequate capital to
fund the Companys operations; (iv) higher than anticipated interest,
occupancy, labor, distribution and inventory shrinkage costs; (v) unanticipated
adverse litigation expenses or results; (vi) higher than anticipated costs
associated with the implementation of the Companys Restructuring Plan and/or
lower than anticipated resulting operations and cash flow benefits; (vii)
unanticipated increases in the cost of merchandise sold by the Company; (viii)
changes in foreign currency exchange rates and economic and political risk;
(ix) the adverse effects of acts or threats of war, terrorism or other armed
conflict on the United States and international economies; (x) the ability of
the Company to comply with the ongoing monthly affirmative and negative
covenants as prescribed by the Companys Amended and Restated Term Loan
Agreement with JPMorgan Chase and other lenders, and by the Companys Loan and
Security Agreement with The CIT Group/Business Credit, Inc., and other lenders;
(xi) the ability of the Company to continue to service its senior subordinated
notes; and (xii) the ability of the Company to successfully defend itself in
ongoing and future litigation. All forward-looking statements included in this
Form 10-K are based on information available to the Company on the date hereof,
and the Company assumes no obligation to update any such forward-looking
statements. For further information on other factors, which could affect the
financial results of the Company and such forward-looking statements, see Risk
Factors.

RESTRUCTURING PLAN

During the third quarter of the Companys 2001 fiscal year, the Company
commenced a business plan and restructuring process and retained a consulting
firm to assist the Company in its efforts. These efforts produced a
three-phase restructuring plan that was adopted by the Company in February 2001
(the Restructuring Plan).

The Restructuring Plan contains several initiatives designed to improve the
Companys operations, including closing and liquidating most stand-alone and
combination bookstores, selling the Companys Argentina, Hong Kong, Taiwan and
Singapore

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operations and converting them to franchises, closing the Companys Canadian
operations, closing under-performing domestic record, outlet and frame/gallery
stores, and monitoring performance of additional stores. The Restructuring
Plan also contains several initiatives intended to improve cash flow, by
reducing overhead expenses, reducing working capital and reducing capital
expenditures until internally generated cash flow will support further growth.

The Company began implementing its Restructuring Plan shortly after its
adoption. Management believes that as of July 31, 2002, the Company has
substantially completed its restructuring initiatives through phase two of a
three-phase Restructuring Plan. Phase one included the identification and
closing of unprofitable operations both domestically and internationally and
the initiatives to improve cash flow. Phase two included further reductions in
working capital levels after the holiday season to meet planned levels and the
closing of six additional domestic stores, including two outlet stores. Phase
three includes the closure and possible franchising of the United Kingdom and
Ireland operations. As a result, the Company has established and recorded a
restructuring accrual for the United Kingdom and Ireland operations in the
current period.

During fiscal 2002, the Company recorded pre-tax
restructuring and asset
impairment charges of $41.9 million, as a result of steps the Company is taking
in connection with the Restructuring Plan. Of the $41.9 million in total
pre-tax restructuring and asset impairment charges, $14.2 million related to
inventory write-downs was recorded in cost of sales and $5.9 million in
professional fees was recorded in selling, general and administrative expenses.
The remaining $21.8 million of the total pre-tax restructuring and asset
impairment charges were reported separately. The $21.8 million charge was
primarily due to $13.6 million for the write-down of leasehold improvements and
various other property in stores to be closed, $4.7 million for accrual of
lease termination costs, and $2.9 million of involuntary termination and
benefits. The involuntary termination benefits include amounts that have been
either paid or accrued for and cover approximately 509 employees at both the
retail and corporate level, from clerks to management.

During fiscal 2001, the Company recorded pre-tax restructuring and asset
impairment charges of $46.7 million, as a result of steps the Company is taking
in connection with the Restructuring Plan. Of the $46.7 million in total
pre-tax restructuring and asset impairment charges, $20.7 million related to
inventory write-downs was recorded in cost of sales and $2.7 million in
professional fees was recorded in selling, general and administrative expenses.
The remaining $23.3 million of the total pre-tax restructuring and asset
impairment charges were reported separately. The $23.3 million charge was
primarily due to $14.2 million for the write-down of leasehold improvements and
various other property in stores to be closed, $1.9 million for accrued and
partially paid lease termination costs, and $1.6 million of involuntary
termination and benefits. The involuntary termination benefits include amounts
that have been either paid or accrued for and cover approximately 170 employees
at both the retail and corporate level, from clerks to management.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements requires that we make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the

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financial statements and revenues and expenses
during the period. The Company bases its estimates on historical
experience and other assumptions that it believes to be
reasonable under the circumstances, the results of which form the basis for
making judgments about carrying values of assets and liabilities that are not
readily apparent from other sources. The Company continually evaluates the information
used to make these estimates as its business and the economic environment
change. The use of estimates is pervasive throughout the Company's financial statements,
but the accounting policies and estimates it considers most critical are as
follows:

INVENTORY VALUATION

Inventories are valued at the lower of cost or market value. Inventory
valuation requires significant judgments and estimates, including merchandise
markdowns and provisions for shrinkage. The Company evaluates all of
its inventory units
to determine excess or slow-moving units based on current quantities and
projections of future demand and market conditions. Due to industry return
policies, which generally provide for full recovery of cost upon return, the
Company does not provide an allowance for inventory markdowns.

RESTRUCTURING CHARGES

The Company has restructuring charges in both fiscal 2001 and 2002 to close stores,
liquidate inventory and to sell some international operations, some
of which were converted to franchises. These charges required judgments about exit costs to be
incurred for employee severance, contract and lease terminations, the future
net realizable value of long-lived assets, inventory to be disposed
of and
other liabilities. The ability to obtain agreements with lessors to terminate
leases or with other parties to assign leases can also affect the accuracy of
current estimates.

IMPAIRMENT OF LONG-LIVED ASSETS

It is the Company's policy to review its long-lived assets for possible impairment
whenever events or circumstances indicate that the carrying amount of an asset
may not be recoverable. The Company recognizes losses relating to the impairment of
long-lived assets when future undiscounted cash flows are less than an assets
carrying value. Assumptions and estimates used in the evaluation of
impairment, including current and future economic trends for stores in many
geographic regions, are subject to a high degree of judgment and complexity and
changes in the assumptions and estimates may affect the carrying value of
long-lived assets, and could result in additional impairment charges in future
periods.

For a detailed discussion of our accounting policies and related estimates and
judgments, see Note 1 of the Notes to the Consolidated Financial Statements, in
Financial Statements and Supplementary Data. While the Company believes that the historical experience and other factors considered provide
a meaningful basis for the accounting policies applied in the preparation of
the Consolidated Financial Statements, it cannot guarantee that its estimates
and assumptions will be accurate, which could require the Company to make adjustments to
these estimates in future periods.

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RESULTS OF OPERATIONS

FISCAL YEAR ENDED JULY 31, 2002 COMPARED TO FISCAL YEAR ENDED JULY 31, 2001

NET REVENUES. Net revenues were $982.8 million for the fiscal year ended July
31, 2002, a decrease of $96.7 million or 9.0% (or a decrease of $64.0 million
or 6.0% excluding the effects of U.S. Dollar foreign translation fluctuations)
from $1.08 billion for the fiscal year ended July 31, 2001. The Companys net
revenues were derived from U.S. net revenues of $553.3 million and
international net revenues of $429.5 million for the fiscal year ended July 31,
2002, compared to $631.3 million in the U.S. and $448.3 million internationally
for the fiscal year ended July 31, 2001. Recorded music sales for the fiscal
year ended July 31, 2002 represented 83.5% of the Companys net revenues versus
86.3% for the fiscal year ended July 31, 2001. Retail sales represented 96.0%
of the Companys net revenues for the fiscal year ended July 31, 2002 versus
95.5% for the fiscal year ended July 31, 2001.

The overall decrease in total Company revenues was driven primarily by the
closing of unprofitable stores associated with the Restructuring Plan, the
adverse effect of foreign currency fluctuations, a decline in same store sales
of 3.48% worldwide associated with a decline in consumer spending attributed
to the events of September 11, 2001, an overall downturn in the
domestic economy and
weak new releases from product manufacturers. During the fiscal year ended
July 31, 2002, the Company opened five stores, relocated two stores and closed
nine stores, bringing its total number of owned and operated retail stores to
171.

GROSS PROFIT. Gross profit was $290.6 million for the fiscal year ended July
31, 2002, a decrease of $20.5 million or 6.6% (or an increase of $2.6 million
or 0.8% excluding the effects of U.S. Dollar foreign translation fluctuations
and the impact of the Companys Restructuring Plan) from $311.1 million for the
fiscal year ended July 31, 2001. Management attributes the increase in gross
profit, excluding the effects of currency fluctuations, to improved gross
profit percentages, which were achieved through price increases, from its
domestic video rental, Internet and wholesale operations. Gross profit as a
percentage of net revenues increased to 29.6% (or 31.0% excluding the effects
of inventory write-downs associated with the Restructuring Plan) for the fiscal
year ended July 31, 2002, compared to 28.8% (or 30.7% excluding the effects of
the inventory write-downs associated with the Restructuring Plan) for the
fiscal year ended July 31, 2001. Management attributes the percentage
increase primarily to improving margins associated with the Companys domestic
video rental, Internet and wholesale operations.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses (excluding the effects of $5.9 and $2.7 million in
professional fees related to the Restructuring Plan for the fiscal years ended
July 31, 2002 and 2001, respectively) were $265.8 million for the fiscal year
ended July 31, 2002, a decrease of $26.2 million or 9.0% from $292.0 million
for the fiscal year ended July 31, 2001. Excluding the effect of professional
fees related to the Restructuring Plan, decreases in personnel, occupancy and
other cost savings initiatives resulting from the Restructuring Plan
contributed primarily to the reduction in overall operating costs. In
addition, net

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advertising and marketing revenue increased by $3.8 million to $14.1 million
from $10.3 million for the fiscal years ended July 31, 2002 and 2001,
respectively. As a percentage of net revenues, selling, general and
administrative expenses (excluding the effects of the professional fees related
to the Restructuring Plan) remained constant at 27.1% for the fiscal years
ended July 31, 2002 and July 31, 2001.

RESTRUCTURING AND IMPAIRMENT COSTS. The Company recorded pre-tax restructuring
and asset impairment charges related to the implementation of the Restructuring
Plan of $41.9 million for the fiscal year ended July 31, 2002, compared to
$46.7 million for the fiscal year ended July 31, 2001, a decrease of $4.8
million. Of the $41.9 and $46.7 million in total pre-tax restructuring and
asset impairment charges for the fiscal year ended July 31, 2002 and 2001,
respectively, $14.2 and $20.7 million for the fiscal year ended July 31, 2002
and 2001, respectively, were related to inventory write-downs and were recorded
in cost of sales. Professional fees in the amount of $5.9 and $2.7 million for
the fiscal year ended July 31, 2002 and 2001, respectively, were recorded in
selling, general and administrative expenses. The remaining $21.8 and $23.3
million for the fiscal year ended July 31, 2002 and 2001, respectively, of
total pre-tax restructuring and asset impairment charges were reported
separately.

DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense was $28.3
million for the fiscal year ended July 31, 2002, compared to $30.5 million for
the fiscal year ended July 31, 2001, a decrease of approximately $2.2 million.
The decrease was primarily due to the reduction in fixed assets associated with
the Restructuring Plan.

LOSS FROM OPERATIONS. The Companys consolidated loss from operations was $31.2
million for the fiscal year ended July 31, 2002, compared to a consolidated
loss from operations of $37.4 million for the fiscal year ended July 31, 2001,
a decrease of $6.2 million (or a increase to operating income of $1.4 million
excluding the effects of the Restructuring Plan). The improvement in
operations was primarily attributable to decreases in selling, general and
administrative expenses, as previously discussed, offset by the reduction of
revenue and gross profit.

OTHER EXPENSE. Other expense was $27.3 million for the fiscal year ended July
31, 2002, compared to $31.9 million for the fiscal year ended July 31, 2001,
which represented a decrease of $4.6 million, due partly to a reduction in net
non-cash foreign currency translation gain of $1.3 million for the fiscal year
ended July 31, 2002, compared to a net foreign currency translation loss of
$4.3 million for the fiscal year ended July 31, 2001. This non-cash translation
loss largely represented the translation back to U.S. Dollars at the spot rate
of the Companys Japanese Yen-denominated debt and to a lesser extent,
translation of intercompany obligations from the United Kingdom. The Company
does significant business transactions in currencies other than the U.S.
Dollar. Exchange losses and gains result from the day-to-day fluctuations in
foreign currency exchange rates, due primarily to the volatile Japanese Yen and
more recently the pound sterling and Euro as well as other Asian currencies
against the U.S. Dollar.

Net interest was $25.1 million for the fiscal year ended July 31, 2002, nearly
unchanged from $25.2 million for the fiscal year ended July 31, 2001.

NET LOSS. As a result of the above, the Company reported a net loss of $57.2
million for the fiscal year ended July 31, 2002, a decrease of $33.1 million
from a net loss of

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$90.3 million for the fiscal year ended July 31, 2001. The decrease in net loss
is primarily due to a one-time non-cash charge of $48.7 million
against the Companys deferred tax asset accounts for the fiscal
year ended June 31, 2001. In addition, the decrease in net loss
is a result of the factors previously discussed and due to an
increase in the tax valuation allowance, an increase in the tax
benefit and changes in the effective income tax rates.

FISCAL YEAR ENDED JULY 31, 2001 COMPARED TO FISCAL YEAR ENDED JULY 31, 2000

NET REVENUES. Net revenues were $1.08 billion for the fiscal year ended July
31, 2001, a decrease of $20.4 million or 1.9% (or an increase of $12.9 million
or 1.2% excluding the effects of U.S. Dollar foreign translation fluctuations)
from $1.10 billion for the fiscal year ended July 31, 2000. The Companys net
revenues were derived from U.S. net revenues of $631.3 million and
international net revenues of $448.3 million for the fiscal year ended July 31,
2001 compared to $649.6 million in the U.S. and $450.3 million internationally
for the fiscal year ended July 31, 2000. Recorded music sales for the period
ended July 31, 2001 represented 86.3% of the Companys net revenues versus
87.8% for the fiscal year ended July 31, 2000. Retail sales represented 95.5%
of the Companys net revenues for the fiscal year ended July 31, 2001 versus
95.8% for the fiscal year ended July 31, 2000. The overall decrease in total
revenues was driven primarily by adverse foreign exchange rate fluctuations and
a decline in same store sales of 0.69% worldwide associated with a weak roster
of new releases and diminished availability of compact disc singles and
cassettes leading to lower consumer sales. Also contributing to the decrease
in sales was the closure of 23 stores worldwide.

GROSS PROFIT. Gross profit was $311.1 million for the fiscal year ended July
31, 2001, a decrease of $43.4 million or 12.2% (or a decrease of $12.3 million
excluding the negative effects of foreign exchange rate fluctuations and the
impact of the Companys Restructuring Plan) from $354.5 million for the fiscal
year ended July 31, 2000. Management attributes the decrease in gross profit
to the effects of inventory liquidations, a reduction in same store
sales and the impact of foreign exchange rate fluctuations on international
purchases. Gross profit as a percentage of net revenues decreased to 28.8% (or
30.7% excluding the effects of the write-offs associated with the Restructuring
Plan) for the fiscal year ended July 31, 2001, as compared to 32.2% for the
fiscal year ended July 31, 2000. Management believes the primary factors
contributing to the decrease in gross profit as a percentage of net revenues
were ongoing industry pricing pressures.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses were $294.7 million for the fiscal year ended July 31,
2001, a decrease of $6.7 million or 2.2% from $301.4 million for the fiscal year
ended July 31, 2000. Included in selling, general and administrative expenses
for the fiscal year ended July 31, 2001, was $2.7 million for professional fees
related to the Restructuring Plan. The decrease in selling, general and
administrative expenses was attributable to decreases in personnel and other
costs resulting from the closing of stores in connection with the Restructuring
Plan. In addition, net advertising and marketing revenue increased $1.3 million
to $10.3 million from $9.0 million for the fiscal years ended July 31, 2001 and
2000, respectively. The decrease was partly offset by increases in
distribution and store occupancy. As a percentage of net revenues, selling,
general and administrative expenses

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decreased 0.2% for the fiscal year ended July 31, 2001, as compared to the
fiscal year ended July 31, 2000 primarily due to the reduction in personnel,
rents and other cost savings related to the Restructuring Plan, which were
partly offset by the decrease in net revenues.

RESTRUCTURING AND IMPAIRMENT COSTS. The Company recorded pre-tax restructuring
and asset impairment charges of $46.7 million during 2001, as related to the
implementation of the Restructuring Plan. Of the $46.7 million in total
pre-tax restructuring and asset impairment charges, $20.7 million related to
inventory write downs was recorded in cost of sales and $2.7 million related to
professional fees was recorded in selling, general and administrative expenses.
The remaining $23.3 million of total pre-tax restructuring and asset
impairment charges were reported separately. The $23.3 million charge is
primarily due to $14.2 million for the write down of leasehold improvements and
various other property in stores that have been closed, $1.9 million for
accrual of lease termination and other costs, and $1.6 million of involuntary
termination and benefits. The involuntary termination benefits include amounts
that have been either paid or accrued for, and cover approximately 170
employees at both the retail and corporate level, from clerks to management.

DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense was $30.5
million for the fiscal year ended July 31, 2001 compared to $28.3 million for
the fiscal year ended July 31, 2000, an increase of approximately $2.2 million,
primarily due to a change in useful lives of its technology and intangible
assets, in compliance with Statement of Position (SOP)98-1, Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use, implemented
in fiscal 2000.

LOSS FROM OPERATIONS. The Companys consolidated loss from operations was $37.4
million for the fiscal year ended July 31, 2001, compared to consolidated
income from operations of $24.8 million for the fiscal year ended July 31,
2000, a decrease of $62.2 million. This decrease reflects the effects of the
$46.7 million in restructuring and asset impairment costs as described above as
well as increased losses associated with the Companys international
operations, decreases in gross margin and the increase in depreciation and
amortization expense as discussed above.

OTHER EXPENSE. Other expense was $31.9 million for the fiscal year ended July
31, 2001 compared to $33.8 million for the fiscal year ended July 31, 2000,
which represented a decrease of $1.9 million, due partly to a reduction in net
non-cash foreign currency transaction loss of $4.3 million for the fiscal year
ended July 31, 2001, compared to a net foreign currency transaction loss of
$9.2 million for the fiscal year ended July 31, 2000. This non-cash translation
loss largely represented the translation back to U.S. Dollars at the spot rate
of the Companys Japanese Yen-denominated debt and to a lesser extent,
translation of intercompany obligations from the United Kingdom. The Company
does significant business transactions in currencies other than the U.S.
Dollar. Exchange losses and gains result from the day-to-day fluctuations in
foreign currency exchange rates, due primarily to the volatile Japanese Yen and
more recently the pound sterling as well as other Asian currencies against the
U.S. Dollar.

Net interest expense increased to $25.2 million for the fiscal year ended July
31, 2001, as compared with $21.0 million for the fiscal year ended July 31,
2000. This increase was largely due to an increase in borrowings under the
Companys facility coupled with

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higher interest costs, under the terms of the Companys credit facility as
amended and restated April 23, 2001.

NET LOSS. As a result of the above, the Company reported a net loss of $90.3
million for the fiscal year ended July 31, 2001, an increase of $80.2 million
from a net loss of $10.1 million for the fiscal year ended July 31, 2000. The
increase in net loss includes $2.7 million in professional fees and $44.0
million in other costs associated with the Restructuring Plan, as well as the
$4.2 million impact from increased interest expense. The net loss also
includes an increase in net operating losses related to international
operations, which were closed prior to July 31, 2001. The net loss also
reflects the decrease in gross profit and the increase in depreciation, offset
by the reduction in selling, general and administrative expenses as discussed
above. Included in net loss for the fiscal year end July 31, 2001 is a
non-cash charge of $48.7 against the Companys deferred tax asset accounts.
The valuation allowance was recorded and is consistent with the application of
SFAS 109. The reserve will be reviewed by the Company on a periodic basis in
order to determine when the tax benefit will likely be recognized in the
future.

LIQUIDITY AND CAPITAL RESOURCES

The Companys principal capital requirements are to fund working capital needs,
to open new stores, to refurbish and expand existing stores, and to continue
development of the Companys technological infrastructure.

Net cash provided by operating activities was $3.4 and $44.7 million for the
fiscal year ended July 31, 2002, and July 31, 2001, respectively. In fiscal
2002, net increase in inventory was $1.4 million, which included a $14.2
million write-down of inventory related to the Companys Restructuring Plan.
In fiscal 2001, net reduction in inventory was $23.6 million, which included
$20.7 million in write-down of inventory related to the Companys Restructuring
Plan.

Net cash used in investing activities for fiscal 2002 was focused primarily on
store leasehold improvements and capital expenditure requirements, including
store relocations, refurbishment and technology investments totaling
approximately $10.3 million, with an additional $1.2 million used for video
rental acquisition. During fiscal 2002, the Company opened two and relocated
two stores in the U.S. and opened three stores internationally. Net cash used
in investing activities for fiscal 2001 was also focused primarily on capital
expenditure requirements, including store relocations, refurbishment and
technology investments totaling approximately $24.1 million with an additional
$1.5 million used for video rental acquisition.

Net cash provided by financing activities in fiscal 2002 was $15.2 million,
resulting principally from proceeds from life insurance policy loans, debt
issuance costs and net borrowings under the Companys credit facility. Net
borrowings under the Companys credit facility were $11.3 million for fiscal
2002, excluding the effects of foreign exchange rates. Net cash provided by
financing for fiscal 2001 was $10.3 million, which resulted primarily from net
borrowings under the Companys credit facility, debt issuance costs and
proceeds from life insurance loans. Net borrowings under the Companys credit
facility were $3.6 million.

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Total funded debt increased to $312.2 million as of July 31, 2002 from $297.7
million as of July 31, 2001. Outstanding debt under the Companys credit
facility was $193.6 million as of July 31, 2002, compared to $177.0 million as
of July 31, 2001.

Interest payments on the senior subordinated notes and under the credit
facility will continue to impose significant liquidity demands upon the
Company. The Company is obligated in fiscal 2003 to make interest payments on
its subordinated notes in the amount of $5,156,250 on each of November 1, 2002
and May 1, 2003, and must make semi-annual payments on the notes until their
maturity in May 2005. Based on actual advances made against the credit facility through
October 11, 2002, and if the Company makes maximum borrowings under its
existing line of credit, the Companys aggregate secured debt service
obligations in fiscal 2003 would be approximately $8.2 million. In addition to its debt
service obligations, the Company will require liquidity for capital
expenditures, lease obligations and general working capital needs. Total
capital expenditures for fiscal 2003 are expected to be approximately $8.5
million, of which approximately $7.5 million will be related to leasehold
improvements and required technological and capital improvements and $1.0
million will be used for video rental acquisitions. There are no
new store openings planned for fiscal 2003.

Subsequent to the end of fiscal 2002, on October 11, 2002, the Company
completed the sale of its Japanese operations to Nikko Principal Investments
Japan, Ltd. for an aggregate purchase price of 16 billion Japanese Yen
(approximately $129 million at then-current exchange rates), at an approximate
gain of $38 million. Net proceeds from the sale of approximately $112.6 million
were used to pay down the Companys credit facility. The balance of the
Companys credit facility was refinanced on October 11, 2002, with an
asset-based line of credit and a term loan, each of which matures on April 1,
2005. The Company entered into this Loan and Security Agreement with The CIT
Group/Business Credit, Inc. and other lenders providing for a line of credit of
up to $110 million, subject to achieving certain syndication requirements for
the final $35 million of the line of credit. On October 11, 2002 the line of
credit had an outstanding balance of $61.1 million, with
additional $13.9 million available. The Company also received a $26 million term loan pursuant to an
Amended and Restated Term Loan Agreement with JPMorgan Chase Bank and other
lenders.

The Company believes that the cash flow generated from its operations, together
with amounts available from other financing alternatives, will be sufficient to
fund its debt service requirements, lease obligations, working capital needs,
its currently anticipated expenditures and other operating expenses for the
next 12 months. However, the Companys ability to service its senior
subordinated notes which mature in 2005, the line of credit and the term loan
is subject to future economic conditions and financial, business and other
factors, many of which are beyond the Companys control.

The Companys current line of credit, term loan and senior subordinated notes
impose certain restrictions on the Companys ability to make capital
expenditures and limit the Companys ability to incur additional indebtedness.
Such restrictions could limit the Companys ability to respond to market
conditions, to provide for unanticipated capital investments or to take
advantage of business or acquisition opportunities. The covenants contained in
the line of credit, term loan and senior subordinated notes also, among other
things, limit the ability of the Company to dispose of assets, repay
indebtedness or amend other debt instruments, pay distributions, create liens
on assets, enter into sale and

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leaseback transactions, make investments, loans or advances and make
acquisitions.

The Company leases substantially all of its retail stores, warehouses and
administrative facilities pursuant to operating leases that expire on dates
through 2024 and generally have renewal options of one to 20 years. The terms
of the leases provide for fixed or minimum payments plus, in some cases,
contingent rents based on the consumer price index, or percentages of sales in
excess of specified minimum amounts or other specified increases. The Company
is generally responsible for maintenance, insurance and property taxes. The
Companys minimum obligations in fiscal 2003 on non-cancelable operating leases
are expected to be $45.4 million. Total rental expense (including taxes and
maintenance, when included in rent, contingent rents and accruals to recognize
minimum rents on the straight-line basis over the term of the lease) relating
to all operating leases for fiscal 2003 is expected to be $51.1 million.

INFLATION

The Company believes that the recent low rates of inflation in the United
States, Japan and the United Kingdom, where it primarily operates, have not had
a significant effect on its net sales or operating results. The Company
attempts to offset the effects of inflation through price increases and control
of expenses. However, there can be no assurance that during a period of
significant inflation, the Companys results of operations would not be
adversely affected.

FOREIGN EXCHANGE MANAGEMENT

As of July 31, 2002, the Company had substantial operations and assets located
outside the United States, primarily in the United Kingdom and Japan. With
respect to international operations, principally all of Towers revenues and
costs (including borrowing costs) are incurred in the local currency. The
Companys financial performance on a U.S. Dollar-denominated basis has
historically been significantly affected by changes in currency exchange rates.
The Company believes that the matching of revenues and expenses in local
currency, as well as its foreign exchange hedging activities and borrowings in
foreign currencies, mitigate the effect of fluctuating currency exchange rates.
Nonetheless, changes in certain exchange rates could adversely affect the
Companys business, financial condition and results of operations. See Risk
Factors  Foreign Currency Exchange Rate Fluctuations and Other Risks Relating
to the Companys International Operations Could Adversely Affect the Companys
Results and Quantitative and Qualitative Disclosures about Market Risk.

RECENT ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board finalized FASB
Statements No. 141, Business Combinations (SFAS 141), and No. 142, Goodwill and
Other Intangible Assets (SFAS 142). SFAS 141 requires the use of the purchase
method of accounting and prohibits the use of the pooling-of-interests method
of accounting for business combinations initiated after June 30, 2001. SFAS
141 also requires that the Company recognize acquired intangible assets apart
from goodwill if the acquired intangible assets meet certain criteria. SFAS
142 changes the accounting for goodwill, including goodwill recorded in past
business combinations. SFAS 142 requires, among other things, that companies
no longer amortize goodwill, but instead periodically test goodwill for

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impairment. The previous accounting principles governing goodwill generated
from a business combination will cease upon adoption of SFAS 142. The
Companys adoption of SFAS 141 and SFAS 142 did not materially impact its
financial position and results of operations.

In June 2001, the Financial Accounting Standards Board finalized FASB Statement
No. 143, Accounting for Asset Retirement Obligations (SFAS 143). SFAS 143
addresses financial accounting and reporting for obligations associated with
the retirement of tangible long-lived assets and the associated asset
retirement costs. This statement is effective for financial statements issued
for fiscal years beginning after June 15, 2002. The Companys future
adoption of SFAS 143 has been assessed by the Company and determined the impact
will not materially impact its financial position and results of operations.

In August 2001, the Financial Accounting Standards Board finalized FASB Statement
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS
144). SFAS 144 addresses financial accounting and reporting for the impairment
or disposal of long-lived assets. This statement is effective for financial
statements issued for fiscal years beginning after December 15, 2001.
Subsequent to year-end, the Company adopted this SFAS on August 1, 2002 on a
prospective basis which is in accordance with the newly issued guidance.

We are currently reviewing SFAS No. 145, Rescission of FASB Statements No. 4,
44 and 64, Amendment of FASB Statement No. 13, and Technical
Corrections,
which was issued in May 2002. The statement rescinds FASB No. 4, Reporting
Gains and Losses from Extinguishment of Debt, and an amendment of that
statement, FASB No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements. As a result, gains and losses from extinguishment of debt will
no longer be aggregated and classified as an extraordinary item, net of related
income tax effect, in the statement of operations. Instead, such gains and
losses will be classified as extraordinary items only if they meet the criteria
of unusual or infrequently occurring items. SFAS No. 145 also requires that
gains and losses from debt extinguishments, which were classified as
extraordinary items in prior periods, be reclassified to continuing from
operations if they do not meet the criteria for extraordinary items. The
provisions related to this portion of the statement are required to be applied
in fiscal years beginning after May 15, 2002, with earlier application
encouraged.

In June 2002, the FASB issued SFAS No. 146, Accounting for Exit or Disposal
Activities. SFAS No. 146 addresses significant issues regarding the
recognition, measurement and reporting of costs associated with exit and
disposal activities, including restructuring activities that are currently
accounted for pursuant to the guidance that the Emerging Issues Task Force
(EITF) set forth in EITF Issue 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring) (EITF 94-3). The scope of SFAS
No. 146 also includes (1) costs related to terminating a contract that is not a
capital lease and (2) termination benefits that employees who are involuntarily
terminated receive under the terms of a one-time benefit arrangement that is
not an ongoing benefit arrangement, or an individual deferred compensation
contract. SFAS No. 146 will be effective for exit or disposal activities that
are initiated after December 31, 2002.

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SUBSEQUENT REVIEW OF FORM 10-Q

The financial statements contained in the quarterly report on Form 10-Q for the
quarter ended April 30, 2002 were not reviewed by an independent public
accountant as required by Rule 10-01(D) of Regulation S-X because the Company
elected not to have Arthur Andersen LLP review such financial statements in
reliance on Securities and Exchange Release No. 34-45589. Subsequent review of
Form 10-Q for the quarter ended April 30, 2002 occurred and there were no
material changes as a result of the review prior to the submission of this
report.




ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to the impact of interest-rate changes and foreign
exchange rate fluctuations. The Company does not enter into market risk
sensitive instruments for trading purposes. In the ordinary course of its
business, the Company enters into debt instruments, including instruments with
short-term maturities. The Company could be exposed to a higher interest rate
at the time such debt instruments are renewed or refinanced. Certain of the
Companys debt instruments contain terms that permit the Company to cap the
interest rate at a maximum rate. In the past, the Company has purchased
interest rate hedges to manage the risk associated with interest rate
variations.

The Company is subject to risks resulting from interest rate fluctuations
because interest on the Companys borrowings under its line of credit is based
on variable rates. If the base borrowing rates (primarily LIBOR ) were to
increase 1% in fiscal 2003 the Companys interest expense related to its
asset-based line of credit for fiscal 2003 would increase
approximately $1.1 million.

A majority of the Companys revenues, expenses and capital purchasing
activities are transacted in U.S. Dollars. However, the Company does enter into
these transactions in other foreign currencies, in the past, primarily Japanese
Yen. The Company has used forward exchange contracts to hedge intercompany
transactions with foreign subsidiaries and affiliates, and in connection with
certain of its former Japanese subsidiarys purchases of product from third
parties. Such instruments are short-term instruments entered into in the
ordinary course of the Companys business, in order to reduce the impact of
exchange rate fluctuation on net income and shareholders equity. At July 31,
2002, the Company did not have any outstanding forward exchange contracts.

To finance expansion and operations in Japanese markets, the Company entered
into Japanese Yen-denominated borrowing arrangements. Unrealized gains and
losses resulting from the impact of foreign exchange rate movements on these
debt instruments are recognized as other income or expense in the period in
which the exchange rates change. Historically, the Company has not entered into
foreign exchange contracts to manage the risk associated with such currency
fluctuations.

The Company has not entered into any Euro hedging
contracts because the Company believes that the Companys volume
of transaction activity in the Euro does not necessitate the type of
hedging activity that the Company has engaged in with respect to the
Japanese Yen.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The following are included herein:

Report of Independent Public Accountants

Consolidated Balance Sheets as of July 31, 2002 and 2001

Consolidated Statements of Operations for the fiscal years ended July 31, 2002,
2001 and 2000

Consolidated Statements of Shareholders (Deficit) Equity and Comprehensive Loss for the fiscal years ended July 31, 2002, 2001 and 2000

Consolidated Statements of Cash Flows for the fiscal years ended July 31, 2002,
2001 and 2000

Notes to Consolidated Financial Statements

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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

The Board of Directors
MTS, Incorporated:

We have audited the accompanying consolidated balance sheet of MTS,
Incorporated and subsidiaries as of July 31, 2002 and the related consolidated
statements of operations, changes in shareholders (deficit) equity and
comprehensive loss, and cash flows for the year ended July 31, 2002. These
consolidated financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audit. The 2001 and 2000 financial
statements of MTS, Incorporated were audited by other auditors who have ceased
operations. Those auditors report, dated October 25, 2001, on those financial
statements was unqualified and included an explanatory paragraph that described
that the related financial statements were prepared assuming that the Company
will continue as a going concern.

We conducted our audit in accordance with auditing standards generally
accepted in the United States of America. 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
audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of MTS,
Incorporated and subsidiaries as of July 31, 2002, and the results of their
operations and their cash flows for the year then ended in conformity with
accounting principles generally accepted in the United States of America.

/s/ KPMG LLP

October 22, 2002

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MTS, INCORPORATED
CONSOLIDATED BALANCE SHEETS
AS OF JULY 31, 2002 AND 2001
(DOLLARS IN THOUSANDS)

|                                                    |                                                                                                                     |                                            |         |          |         |      |         |         |         | 
|--------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------- | -------- | ------- | ---- | ------- | ------- | ------- | 
|                                                    |                                                                                                                     |                                            |         | July 31,
|                                                    |                                                                                                                     |                                            |         |         
|                                                    |                                                                                                                     |                                            |         | 2002     |         | 2001
|                                                    |                                                                                                                     |                                            |         |          |         |     
|ASSETS                                              |                                                                                                                     |                                            |         |          |         |      |         |        
|Current Assets:                                     |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    | Cash and cash equivalents                                                                                           |                                            | $       | 37,352   |         |      | $       | 32,075  |        
|                                                    | Receivables, less allowance for doubtful accounts of
$1,646 and $1,685, respectively                                |                                            |         | 26,889   |         |      |         | 31,805  |        
|                                                    | Merchandise inventories                                                                                             |                                            |         | 236,373  |         |      |         | 249,128 |        
|                                                    | Prepaid expenses                                                                                                    |                                            |         | 8,652    |         |      |         | 8,970   |        
|                                                    |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    |                                                                                                                     | Total current assets                       |         |          | 309,266 |      |         |         | 321,978 | 
|Fixed assets, net                                   |                                                                                                                     |                                            | 146,768 |          |         |      | 178,021 |        
|Other assets                                        |                                                                                                                     |                                            | 20,060  |          |         |      | 26,976  |        
|                                                    |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    |                                                                                                                     | Total assets                               |         | $        | 476,094 |      |         | $       | 526,975 | 
|                                                    |                                                                                                                     |                                            |         |          |         |      |         |        
|LIABILITIES AND SHAREHOLDERS (DEFICIT) EQUITY      |                                                                                                                     |                                            |         |          |         |      |         |        
|Current Liabilities:                                |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    | Current maturities of long-term debt                                                                                |                                            | $       | 195,783  |         |      | $       | 179,374 |        
|                                                    | Accounts payable                                                                                                    |                                            |         | 155,829  |         |      |         | 163,336 |        
|                                                    | Reserve for restructuring costs                                                                                     |                                            |         | 6,839    |         |      |         | 2,225   |        
|                                                    | Accrued liabilities                                                                                                 |                                            |         | 39,570   |         |      |         | 39,399  |        
|                                                    | Deferred revenue, current portion                                                                                   |                                            |         | 2,348    |         |      |         | 2,780   |        
|                                                    |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    |                                                                                                                     | Total current liabilities                  |         |          | 400,369 |      |         |         | 387,114 | 
|Long-term Liabilities:                              |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    | Long-term debt, less current maturities                                                                             |                                            |         | 116,394  |         |      |         | 118,341 |        
|                                                    | Deferred revenue, less current portion                                                                              |                                            |         | 118      |         |      |         | 131     |        
|                                                    |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    |                                                                                                                     | Total liabilities                          |         |          | 516,881 |      |         |         | 505,586 | 
|                                                    |                                                                                                                     |                                            |         |          |         |      |         |        
|Commitments and contingencies (Notes 11, 16 and 17) |                                                                                                                     |                                            |         |          |         |      |         |        
|Shareholders (Deficit) Equity:                     |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    | Common Stock:                                                                                                       |                                            |         |          |         |      |         |         |        
|                                                    | Series B, no par value; 10,000,000 shares authorized;
1,000 shares issued and outstanding at July 31,
2002 and 2001 |                                            |         | 6        |         |      |         | 6       |        
|                                                    | Retained (deficit) earnings                                                                                         |                                            |         | (21,355  | )       |      |         | 35,848  |        
|                                                    | Accumulated other comprehensive loss                                                                                |                                            |         | (19,438  | )       |      |         | (14,465 | )      
|                                                    |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    |                                                                                                                     | Total shareholders (deficit) equity       |         |          | (40,787 | )    |         |         | 21,389  | 
|                                                    |                                                                                                                     |                                            |         |          |         |      |         |        
|                                                    |                                                                                                                     | Total liabilities and shareholders equity |         | $        | 476,094 |      |         | $       | 526,975 | 
|                                                    |                                                                                                                     |                                            |         |          |         |      |         |        

See accompanying notes to consolidated financial statements.

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MTS, INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED JULY 31, 2002, 2001 AND 2000
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE INFORMATION)

|                                                 |                                          |                               |            |                              |         |      |            |         |         |   |            |         |         |  
|------------------------------------------------ | ---------------------------------------- | ----------------------------- | ---------- | ---------------------------- | ------- | ---- | ---------- | ------- | ------- | - | ---------- | ------- | ------- | -
|                                                 |                                          |                               |            | FOR THE YEARS ENDED JULY 31,
|                                                 |                                          |                               |            |                             
|                                                 |                                          |                               |            | 2002                         |         | 2001 |            | 2000   
|                                                 |                                          |                               |            |                              |         |      |            |        
|Net revenue                                      |                                          | $                             | 982,804    |                              |         | $    | 1,079,519  |         |         |   | 1,099,931  |        
|Cost of sales (a)                                |                                          |                               | 692,232    |                              |         |      | 768,393    |         |         |   | 745,376    |        
|                                                 |                                          |                               |            |                              |         |      |            |         |         |   |            |        
|                                                 |                                          | Gross profit                  |            |                              | 290,572 |      |            |         | 311,126 |   |            |         | 354,555 |  
|Selling, general and administrative
expenses (b) |                                          |                               | 271,725    |                              |         |      | 294,681    |         |         |   | 301,445    |        
|Restructuring and asset impairment costs         |                                          |                               | 21,772     |                              |         |      | 23,329     |         |         |   |           |        
|Depreciation and amortization                    |                                          |                               | 28,300     |                              |         |      | 30,495     |         |         |   | 28,320     |        
|                                                 |                                          |                               |            |                              |         |      |            |         |         |   |            |        
|                                                 |                                          | (Loss) income from operations |            |                              | (31,225 | )    |            |         | (37,379 | ) |            |         | 24,790  |  
|Other income and (expenses):                     |                                          |                               |            |                              |         |      |            |         |         |   |            |        
|                                                 | Interest expense                         |                               |            | (25,106                      | )       |      |            | (25,234 | )       |   |            | (20,993 | )      
|                                                 | Foreign currency translation gain (loss) |                               |            | 1,275                        |         |      |            | (4,306  | )       |   |            | (9,204  | )      
|                                                 | Other expenses                           |                               |            | (3,443                       | )       |      |            | (2,430  | )       |   |            | (3,585  | )      
|                                                 |                                          |                               |            |                              |         |      |            |         |         |   |            |        
|                                                 |                                          | Loss before taxes             |            |                              | (58,499 | )    |            |         | (69,349 | ) |            |         | (8,992  | )
|(Benefit) provision for income taxes             |                                          |                               | (1,296     | )                            |         |      | 20,941     |         |         |   | 1,148      |        
|                                                 |                                          |                               |            |                              |         |      |            |         |         |   |            |        
|                                                 |                                          | Net loss                      |            | $                            | (57,203 | )    |            | $       | (90,290 | ) |            | $       | (10,140 | )
|                                                 |                                          |                               |            |                              |         |      |            |         |         |   |            |        
|Basic and diluted loss per share                 |                                          | $                             | (57,202.72 | )                            |         | $    | (90,290.12 | )       |         | $ | (10,139.85 | )      
|                                                 |                                          |                               |            |                              |         |      |            |         |         |   |            |        



|(a) |  | Includes $14.2 and $20.7 million of inventory write-downs related to
restructuring in 2002 and 2001, respectively (See Note 2 to Consolidated
Financial Statements).  
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(b) |  | Includes $5.9 and $2.7 million of professional fees related to
restructuring charges in 2002 and 2001, respectively (See Note 2 to
Consolidated Financial Statements).

See accompanying notes to consolidated financial statements.

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MTS, INCORPORATED
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS
(DEFICIT) EQUITY AND COMPREHENSIVE LOSS
FOR THE YEARS ENDED JULY 31, 2002, 2001 AND 2000
(DOLLARS IN THOUSANDS)

|                         |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |         |  
|------------------------ | -------------------------------------------- |  | ------------ | - | -------- | - | ------------- | - | ----------- | - | ------- | ------- | - | - | ------- | ------ | - | - | ------- | ------- | -
|                         |                                              |  | Common Stock |   |          |   |               |   |             |   |         |         |   |   |        
|                         |                                              |  |              |   |          |   |               |   | Accumulated |   |         |         |  
|                         |                                              |  | Series B     |   | Retained |   | Other         |   |             |   |        
|                         |                                              |  |              |   | Earnings |   | Comprehensive |   |             |   |        
|                         |                                              |  | Shares       |   | Amount   |   | (Deficit)     |   | Loss        |   | Total  
|                         |                                              |  |              |   |          |   |               |   |             |   |        
|Balance, July 31, 1999   |                                              |  | 1,000        |   |          | $ | 6             |   |             | $ | 136,278 |         |   | $ | (20,582 | )      |   | $ | 115,702 |        
|                         | Comprehensive loss:                          |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |         |  
|                         | Net loss                                     |  |              |  |          |   |               |  |             |   |         | (10,140 | ) |   |         |       |   |   |         | (10,140 | )
|                         | Foreign translation
adjustment, net of taxes |  |              |  |          |   |               |  |             |   |         |        |   |   |         | 1,798  |   |   |         | 1,798   |  
|                         |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |        
|Total comprehensive loss |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   | (8,342  | )      
|                         |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |        
|Balance, July 31, 2000   |                                              |  | 1,000        |   |          |   | 6             |   |             |   | 126,138 |         |   |   | (18,784 | )      |   |   | 107,360 |        
|                         | Comprehensive loss:                          |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |         |  
|                         | Net loss                                     |  |              |  |          |   |               |  |             |   |         | (90,290 | ) |   |         |       |   |   |         | (90,290 | )
|                         | Foreign translation
adjustment, net of taxes |  |              |  |          |   |               |  |             |   |         |        |   |   |         | 4,319  |   |   |         | 4,319   |  
|                         |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |        
|Total comprehensive loss |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   | (85,971 | )      
|                         |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |        
|Balance, July 31, 2001   |                                              |  | 1,000        |   |          |   | 6             |   |             |   | 35,848  |         |   |   | (14,465 | )      |   |   | 21,389  |        
|                         | Comprehensive loss:                          |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |         |  
|                         | Net loss                                     |  |              |  |          |   |               |  |             |   |         | (57,203 | ) |   |         |       |   |   |         | (57,203 | )
|                         | Foreign translation
adjustment, net of taxes |  |              |  |          |   |               |  |             |   |         |        |   |   |         | (4,973 | ) |   |         | (4,973  | )
|                         |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |        
|Total comprehensive loss |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   | (62,176 | )      
|                         |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |        
|Balance, July 31, 2002   |                                              |  | 1,000        |   |          | $ | 6             |   |             | $ | (21,355 | )       |   | $ | (19,438 | )      |   | $ | (40,787 | )      
|                         |                                              |  |              |   |          |   |               |   |             |   |         |         |   |   |         |        |   |   |         |        

See accompanying notes to consolidated financial statements.

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MTS, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED JULY 31, 2002, 2001 AND 2000
(DOLLARS IN THOUSANDS)

|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |         |         |         |  
|---------------------------------------------- | ------------------------------------------------------------------------------ | -------------------------------------------- | ---------------------------------------------------- | ------- | ---------------------------- | ------- | ------- | ------- | ------ | ------- | ------ | ------- | ------- | ------- | -
|                                               |                                                                                |                                              |                                                      |         | FOR THE YEARS ENDED JULY 31,
|                                               |                                                                                |                                              |                                                      |         |                             
|                                               |                                                                                |                                              |                                                      |         | 2002                         |         | 2001    |         | 2000  
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |       
|CASH FLOWS FROM OPERATING ACTIVITIES           |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|                                               | Net loss                                                                       |                                              | $                                                    | (57,203 | )                            |         | $       | (90,290 | )      |         | $      | (10,140 | )      
|                                               | Adjustment to reconcile net loss to net
cash provided by operating activities: |                                              |                                                      |         |                              |         |         |         |        |         |        |         |        
|                                               | Depreciation and amortization                                                  |                                              |                                                      | 29,269  |                              |         |         | 33,199  |        |         |        | 30,658  |        
|                                               | Restructuring costs                                                            |                                              |                                                      |         |                              |         |         |         |        |         |        |         |        
|                                               |                                                                                |                                              | From inventory write-downs                           |         |                              | 14,157  |         |         |        | 20,675  |        |         |         |        |  
|                                               |                                                                                |                                              | From leasehold improvement write-offs                |         |                              | 13,251  |         |         |        | 14,159  |        |         |         |        |  
|                                               |                                                                                |                                              | From other                                           |         |                              | 4,536   |         |         |        | 7,249   |        |         |         |        |  
|                                               | Provision for losses on accounts
receivable                                    |                                              |                                                      | (39     | )                            |         |         | (500    | )      |         |        | 289     |        
|                                               | Loss on disposal of assets                                                     |                                              |                                                      | 1,820   |                              |         |         | 6,199   |        |         |        | 7,076   |        
|                                               | Exchange loss                                                                  |                                              |                                                      | 1,059   |                              |         |         | 6,130   |        |         |        | 12,556  |        
|                                               | Other non-cash expense                                                         |                                              |                                                      | 487     |                              |         |         | 448     |        |         |        | 176     |        
|                                               | Provision (benefit) from deferred taxes                                        |                                              |                                                      |        |                              |         |         | 26,932  |        |         |        | (3,151  | )      
|                                               | (Decrease) increase in cash resulting from
changes in:                         |                                              |                                                      |         |                              |         |         |         |        |         |        |         |        
|                                               |                                                                                | Accounts receivable                          |                                                      |         | 4,916                        |         |         |         | (348   | )       |        |         | (5,079  | )      
|                                               |                                                                                | Inventories                                  |                                                      |         | (1,402                       | )       |         |         | 23,626 |         |        |         | (21,716 | )      
|                                               |                                                                                | Prepaid expenses                             |                                                      |         | 318                          |         |         |         | 3,758  |         |        |         | (1,516  | )      
|                                               |                                                                                | Accounts payable                             |                                                      |         | (7,507                       | )       |         |         | (6,218 | )       |        |         | 15,369  |        
|                                               |                                                                                | Accrued liabilities and income taxes payable |                                                      |         | 171                          |         |         |         | (152   | )       |        |         | 5,823   |        
|                                               |                                                                                | Deferred revenue                             |                                                      |         | (445                         | )       |         |         | (192   | )       |        |         | (152    | )      
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|                                               |                                                                                |                                              | Net cash provided by operating activities            |         |                              | 3,388   |         |         |        | 44,675  |        |         |         | 30,193  |  
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|CASH FLOWS FROM INVESTING ACTIVITIES           |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|                                               | Acquisition of fixed assets                                                    |                                              |                                                      | (11,528 | )                            |         |         | (25,569 | )      |         |        | (39,999 | )      
|                                               | Acquisition of investments                                                     |                                              |                                                      | (2,669  | )                            |         |         | (3,100  | )      |         |        | (3,301  | )      
|                                               | Increase in deposits                                                           |                                              |                                                      | (854    | )                            |         |         | (393    | )      |         |        | (457    | )      
|                                               | Refund of deposits                                                             |                                              |                                                      | 821     |                              |         |         | 155     |        |         |        | 28      |        
|                                               | Increase in intangibles                                                        |                                              |                                                      | (453    | )                            |         |         | (304    | )      |         |        | (365    | )      
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|                                               |                                                                                |                                              | Net cash used in investing activities                |         |                              | (14,683 | )       |         |        | (29,211 | )      |         |         | (44,094 | )
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|CASH FLOWS FROM FINANCING ACTIVITIES           |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|                                               | Proceeds from employee loan repayments                                         |                                              |                                                      | 156     |                              |         |         | 373     |        |         |        | 280     |        
|                                               | Proceeds from life insurance loans                                             |                                              |                                                      | 3,526   |                              |         |         | 12,461  |        |         |        |        |        
|                                               | Debt issuance costs                                                            |                                              |                                                      | (1,475  | )                            |         |         | (3,320  | )      |         |        | (64     | )      
|                                               | Principal payments under long-term
financing agreements                        |                                              |                                                      | (86,820 | )                            |         |         | (74,453 | )      |         |        | (61,736 | )      
|                                               | Proceeds from issuance of long-term
financing agreements                       |                                              |                                                      | 99,851  |                              |         |         | 75,198  |        |         |        | 79,651  |        
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|                                               |                                                                                |                                              | Net cash provided by financing activities            |         |                              | 15,238  |         |         |        | 10,259  |        |         |         | 18,131  |  
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|Effect of exchange rate changes on cash        |                                                                                |                                              | 1,334                                                |         |                              |         | (15,134 | )       |        |         | (7,449 | )      
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|                                               |                                                                                |                                              | Net increase (decrease) in cash and
cash equivalents |         |                              | 5,277   |         |         |        | 10,589  |        |         |         | (3,219  | )
|Cash and cash equivalents, beginning of period |                                                                                |                                              | 32,075                                               |         |                              |         | 21,486  |         |        |         | 24,705 |        
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|Cash and cash equivalents, end of period       |                                                                                | $                                            | 37,352                                               |         |                              | $       | 32,075  |         |        | $       | 21,486 |        
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|Cash paid for interest                         |                                                                                | $                                            | 24,951                                               |         |                              | $       | 25,274  |         |        | $       | 21,094 |        
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        
|Cash paid for income taxes                     |                                                                                | $                                            | 106                                                  |         |                              | $       | 605     |         |        | $       | 6,581  |        
|                                               |                                                                                |                                              |                                                      |         |                              |         |         |         |        |         |        |        

See accompanying notes to consolidated financial statements.

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MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

CONSOLIDATION POLICYThe consolidated financial statements include the
accounts of MTS, INCORPORATED and its majority and wholly-owned subsidiaries
(Company). The Company has a 50% investment in a foreign joint venture that is
accounted for using the equity method.

All significant intercompany balances and transactions have been eliminated in
consolidation.

GENERALThe Company operates retail stores under the name Tower Records
offering a diversified line of recorded music products and other complementary
products throughout the United States, Japan, the United Kingdom and other
parts of the world.

CASH AND CASH EQUIVALENTSThe Company considers all highly liquid temporary
cash investments with original maturities of three months or less when
purchased to be cash equivalents for purposes of the statement of cash flows.

INVENTORIESInventories are stated at the lower of cost or market. Cost is
determined principally by the first-in, first-out method. The Company, absent
its restructuring efforts, does not provide an allowance for inventory
markdowns, due to music industry return policies, which generally provide for
full recovery of cost upon return.

FIXED ASSETSFixed assets are carried at cost. Depreciation is computed using
the straight-line method. Depreciation is computed on all fixed assets with the
exception of land. Buildings are depreciated over 40 years, leasehold
improvements over an average of 15 years, store fixtures over seven to ten
years, and equipment and vehicles over five years. Leasehold improvements are
amortized using the straight-line method over the shorter of their estimated
useful lives or the lease term. When assets are retired or otherwise disposed
of, the cost and related accumulated depreciation are removed from the accounts
and any resulting gain or loss is reflected in income for the period. The cost
of maintenance and repairs is charged to income as incurred; significant
renewals and betterments are capitalized. Amortization of video rental
cassettes is calculated based on a straight-line method over three years. When
the popularity of renting the new release declines (usually after approximately
six months) redundant copies are transferred from rental stock to merchandise
inventories for sale to customers at net realizable value. A write down to net
realizable value is recorded in cost of sales at the time of the transfer from
rental to held-for-sale classification.

The Company records software developed for internal use in accordance with
Statement of Position (SOP) 98-1, Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use. Accordingly, software
developed internally for the use by the Company is capitalized only during the
application development stage and only certain costs are capitalized.

STORE PREOPENING COSTSCosts of a noncapital nature incurred prior to opening

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of new stores are expensed as incurred.

INTANGIBLESIntangibles primarily represent the excess of cost over the fair
value of businesses acquired and debt issuance costs. The Company amortized
goodwill using the straight-line method over 20 years. Debt issuance costs are
amortized over the term of the related debt using the effective interest rate
method. Management periodically evaluates intangibles for indications of
impairment based on operating results of the related business. If this
evaluation indicates that the intangible asset will not be recoverable, as
determined based on the undiscounted cash flows related to the intangible asset
over the remaining life of the asset, the carrying value of the related
intangible asset will be reduced to fair value.

IMPAIRMENT OF LONG-LIVED ASSETSLong-lived assets and certain identifiable
intangibles are reviewed for impairment periodically or whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired,
the impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets. Assets to be
disposed of are reported at the lower of the carrying amount or fair value less
costs to sell.

GIFT CERTIFICATESThe Company offers gift certificates for sale. A deferred
income account is established for gift certificates issued. When gift
certificates are redeemed at the store level, the deferred income account is
charged and revenue is credited.

INCOME TAXESThe Company accounts for income taxes under the liability method.
Deferred taxes are recorded based on the difference between the financial
statement and tax basis of assets and liabilities. The valuation allowances are
established to reduce deferred tax assets if it is more likely than not that
all, or a portion, of the deferred tax asset will not be realized.

REVENUE RECOGNITIONThe Companys revenue is primarily from retail sales
comprised of recorded music (including compact discs and audio cassettes),
video sales (including recorded video cassettes, laser discs and DVD) and other
complementary products (including books, magazines, blank tapes, video games, personal electronics and accessories) through the Companys stores and
are recognized at the point of the retail transaction. Reductions of revenues
for returns by customers are generally provided at the point of the return due
to infrequency and occurrence within short intervals of the sale and
immateriality to the financial statements.

TRANSLATION OF FOREIGN CURRENCYThe value of the U.S. Dollar rises and falls
day-to-day on foreign currency exchanges. Since the Company does business in
several foreign countries, these fluctuations affect the Companys financial
position and results of operations. In accordance with Statement of Financial
Accounting Standards (SFAS) No. 52, Foreign Currency Translation, the
functional currency of foreign subsidiaries is the local currency, therefore,
all foreign assets and liabilities have been translated at the exchange rates
prevailing at the respective balance sheet dates, and all income statement
items have been translated using the weighted average exchange rates during the
respective years. The net gain or loss resulting from translation upon

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consolidation into the financial statements is reported as a separate component
of shareholders equity. Some transactions of the Company and its foreign
subsidiaries are made in currencies different from their functional currency.
Gains and losses from these transactions are included in income as they occur,
excluding gains and losses from long-term intercompany balances that are
reported as a separate component of shareholders equity.

FORWARD EXCHANGE CONTRACTSThe Company enters into forward exchange contracts
as an economic hedge against liabilities denominated in foreign currency.
Market value gains and losses on hedge contracts are recognized in the
statements of operations and offset forward exchange gains and losses
recognized on the liabilities denominated in foreign currency. Counter parties
to these forward exchange contracts are major financial institutions. Credit
loss from counter party non-performance is not anticipated.

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) 133, Accounting for Derivative
Instruments and Hedging Activities. The provisions of SFAS 133 require all
derivative instruments to be recognized on the balance sheet at fair value.
Derivatives that do not qualify as hedges under SFAS 133 must be adjusted to
fair value through income. If a derivative is a hedge, depending on the nature
of the hedge, changes in the fair value of the derivative are either offset
against the change in fair value of the underlying assets or liabilities
through earnings or recognized in other comprehensive income until the
underlying hedged item is recognized in earnings.

The Company adopted SFAS 133, as amended, on August 1, 2000. The Company
records its derivatives on the balance sheet at fair value and reports
adjustments to fair value through income. The effects to the financial
statements are immaterial.

ADVERTISING EXPENSEAdvertising expenses are recorded as an expense when
incurred. Cooperative advertising rebates and supplier promotional and in-store
advertising reimbursements earned are recognized as reductions to advertising
expense in the period the advertisements are run or the merchandising programs
are provided. Certain other rebates and listening station fees from media
vendors are also credited to advertising expense in the period the related
advertising expenses are incurred. Such rebates and reimbursements are in
consideration for ad production and placement activities performed by the
Company, and are negotiated under contractual agreements on a case-by-case
basis. Net advertising and marketing revenue was ($14,137,000), ($10,319,000)
and ($9,060,000) for the years ended July 31, 2002, 2001 and 2000,
respectively.

USE OF ESTIMATESThe preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates.

RECENT ACCOUNTING PRONOUNCEMENTSIn July 2001, the Financial Accounting
Standards Board finalized FASB Statements No. 141, Business

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Combinations (SFAS 141), and No. 142, Goodwill and Other Intangible Assets
(SFAS 142). SFAS 141 requires the use of the purchase method of accounting and
prohibits the use of the pooling-of-interests method of accounting for business
combinations initiated after June 30, 2001. SFAS 141 also requires that the
Company recognize acquired intangible assets apart from goodwill if the
acquired intangible assets meet certain criteria. SFAS 142 changes the
accounting for goodwill, including goodwill recorded in past business
combinations. SFAS 142 requires, among other things, that companies no longer
amortize goodwill, but instead periodically test goodwill for impairment. The
previous accounting principles governing goodwill generated from a business
combination will cease upon adoption of SFAS 142. The Companys adoption of
SFAS 141 and 142 did not materially impact its financial position and results
of operations.

In June 2001, the Financial Accounting Standards Board finalized FASB Statement
No. 143, Accounting for Asset Retirement Obligations (SFAS 143). SFAS 143
addresses financial accounting and reporting for obligations associated with
the retirement of tangible long-lived assets and the associated asset
retirement costs. This statement is effective for financial statements issued
for fiscal years beginning after June 15, 2002. The Companys future
adoption of SFAS 143 has been assessed by the Company and determined the impact
will not materially impact its financial position and results of operations.

In August 2001, the Financial Accounting Standards Board finalized FASB
Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets (SFAS 144). SFAS 144 addresses financial accounting and reporting for
the impairment or disposal of long-lived assets. This statement is effective
for financial statements issued for fiscal years beginning after December 15,
2001. Subsequent to year-end, the Company adopted this SFAS on August 1, 2002
on a prospective basis which is in accordance with the newly issued guidance.

We are currently reviewing SFAS No. 145, Rescission of FASB Statements No. 4,
44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections,
which was issued in May 2002. The statement rescinds FASB No. 4, Reporting
Gains and Losses from Extinguishment of Debt, and an amendment of that
statement, FASB No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements. As a result, gains and losses from extinguishment of debt will
no longer be aggregated and classified as an extraordinary item, net of related
income tax effect, in the statement of operations. Instead, such gains and
losses will be classified as extraordinary items only if they meet the criteria
of unusual or infrequently occurring items. SFAS No. 145 also requires that
gains and losses from debt extinguishments, which were classified as
extraordinary items in prior periods, be reclassified to continuing from
operations if they do not meet the criteria for extraordinary items. The
provisions related to this portion of the statement are required to be applied
in fiscal years beginning after May 15, 2002, with earlier application
encouraged.

In June 2002, the FASB issued SFAS No. 146, Accounting for Exit or Disposal
Activities. SFAS No. 146 addresses significant issues regarding the
recognition, measurement and reporting of costs associated with exit and
disposal activities, including restructuring activities that are currently
accounted for pursuant to the guidance that the Emerging Issues Task Force
(EITF) set forth in EITF Issue 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an

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Activity (including Certain Costs Incurred in a Restructuring) (EITF 94-3).
The scope of SFAS No. 146 also includes (1) costs related to terminating a
contract that is not a capital lease and (2) termination benefits that
employees who are involuntarily terminated receive under the terms of a
one-time benefit arrangement that is not an ongoing benefit arrangement, or an
individual deferred compensation contract. SFAS No. 146 will be effective for
exit or disposal activities that are initiated after December 31, 2002.

RECLASSIFICATIONSCertain reclassifications have been made to conform prior
years financial statements to the current years presentation.

NOTE 2RESTRUCTURING EFFECTS AND LIQUIDITY

RESTRUCTURING EFFECTS. During the third quarter of the Companys 2001 fiscal
year, the Company commenced a business plan and restructuring process and
retained a consulting firm to assist the Company in its efforts. These efforts
produced a three-phase restructuring plan that was adopted by the Company in
February 2001 (the Restructuring Plan).

The Restructuring Plan contains several initiatives designed to improve the
Companys operations, including closing and liquidating most stand-alone and
combination bookstores, selling the Companys Argentina, Hong Kong, Taiwan and
Singapore operations and converting them to franchises, closing the Companys
Canadian operations, closing under-performing domestic record, outlet and
frame/gallery stores, and monitoring performance of additional stores. The
Restructuring Plan also contains several initiatives intended to improve cash
flow by reducing overhead expenses, reducing working capital and reducing
capital expenditures until internally generated cash flow will support further
growth. In fiscal 2002, the Company began implementation of the closure and
possible franchising of its United Kingdom and Ireland operations. As a
result, the Company has established and recorded a restructuring accrual for
the United Kingdom and Ireland operations in the current period. Subsequent to
year-end four out of eight stores in the United Kingdom have closed.

The Company began implementing its Restructuring Plan shortly after its
adoption. Since the plan was implemented, the Company has closed seven out of
ten of its stand-alone bookstores and has liquidated most of its book
inventories. The Company has also closed several of its under performing record
and outlet stores and has arranged for the sale of two of its frame/gallery
stores. It has successfully converted the Argentina, Hong Kong and Taiwan
operations to franchises through the sale of the operating entities and closed
its Canadian operations. The Company has successfully reduced the number of
new store openings and remodels, while overhead expenses, capital expenditures
and working capital have also been closely managed to the Restructuring Plan.
In accordance with the Restructuring Plan, the Company continues to monitor
additional stores for possible future closure.

During fiscal 2002, the Company recorded pre-tax restructuring and asset
impairment charges of $41.9 million, as a result of steps the Company is taking
in connection with the Restructuring Plan. Of the $41.9 million in total
pre-tax restructuring and asset impairment charges, $14.2 million related to
inventory write-downs was recorded in cost of sales and $5.9 million in
professional fees was recorded in selling, general and administrative expenses.
The remaining $21.8 million of the total pre-tax restructuring

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and asset impairment charges were reported separately. The $21.8 million in
charges included $13.6 million for the write-down of leasehold improvements and
various other property in stores to be closed, $4.7 million for accrual of
lease termination costs, and $2.9 million of involuntary termination and
benefits. The involuntary termination benefits include amounts that have been
either paid or accrued for and cover approximately 509 employees at both the
retail and corporate level, from clerks to management.

During fiscal 2001, the Company recorded pre-tax restructuring and asset
impairment charges of $46.7 million, as a result of steps the Company is taking
in connection with the Restructuring Plan. Of the $46.7 million in total
pre-tax restructuring and asset impairment charges, $20.7 million related to
inventory write-downs was recorded in cost of sales and $2.7 million in
professional fees was recorded in selling, general and administrative expenses.
The remaining $23.3 million of the total pre-tax restructuring and asset
impairment charges were reported separately. The $23.3 million in charges
included $14.2 million for the write-down of leasehold improvements and various
other property in stores to be closed, $1.9 million for accrued and partially
paid lease termination costs, and $1.6 million of involuntary termination and
benefits. The involuntary termination benefits include amounts that have been
either paid or accrued for and cover approximately 170 employees at both the
retail and corporate level, from clerks to management.

As of July 31, 2000 there was no restructuring
liability. During fiscal 2001, the Company recorded an estimated
restructuring accrual of $19.5 million. The accrual related to
leasehold improvement write-offs, lease termination costs, employee
termination costs and other miscellaneous costs. These costs
encompassed the closing of most domestic stand-alone bookstores,
domestic under performing stores and the closing of the
Companys Argentina, Canadian, Hong Kong and Taiwan operations.
Payments and charges against the accrual during 2001 were
$17.2 million. At the end of fiscal 2001, the remaining
restructuring liability was $2.3 million and was mainly comprised of
the above costs that were accrued for and related to the closing of
the remaining Canadian store. During fiscal 2002, changes in
restructuring estimates of $300,000 and payments and charges of
$2.6 million were recorded in connection with the closure of the
Canadian store. During 2002, additional restructuring accruals of
$24.2 million were recorded in connection with further domestic
store closures, domestic corporate terminations and United Kingdom and
Ireland store closures. Payments and charges against the accrual
during 2002 were $17.4 million. At the end of fiscal 2002, the
restructuring liability was $6.8 million and was mainly
comprised of accruals for the United Kingdom and Ireland operations
closing and two store closures in the United States.

The number of employees to be terminated related to the employee termination
costs cover approximately 308 employees at both the retail and corporate level,
from clerks to management primarily in the United Kingdom and Ireland.

The change in the restructure reserve estimates is primarily due to the closure
of the Toronto store in October 2001 and the accrual for the closure and
possible franchising of the United Kingdom and Ireland operations.

Management expects to substantially complete the final phase of the
Restructuring Plan by mid-fiscal 2003. Upon completion of the Restructuring
Plan and in conjunction with the hiring of a retail operations turnaround
specialist, the Company plans to implement a

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new business plan targeted at
improving operations, continue to monitor under performing stores and assets in
addition to evaluating its ongoing working capital commitments. Any significant
shortfalls in future operational results and recommendations made by the retail
operations turnaround specialist could require the Company to implement
additional restructuring efforts and continue to record charges to operations
for restructuring costs, asset impairments and inventory reserves into future
periods.

LIQUIDITY. The Companys principal capital requirements are to fund working
capital needs, the opening of new stores, the refurbishment and expansion of
existing stores, and continued development of the Companys technological
infrastructure.

The Company refinanced its Senior Credit Facility (the Credit Facility) on
October 11, 2002. In April 2001, the Company extended and restated on a
short-term basis its outstanding obligations. The Credit Facility was further
amended in October 2001, April 2002, June 2002, September 2002 and October
2002. The Credit Facility provided for initial maximum borrowings of up to
$225.0 million, consisting of two sub-facilities (one for an initial maximum of
$98.4 million and one for an initial maximum Japanese Yen of 15,596,828,718,
which was equivalent to $126.6 million at inception), with a maturity date, as
amended, of October 11, 2002. Maximum borrowings available under the Credit
Facility declined during its one-year term by $15 million in July 2001, $5
million in October 2001, and $10 million in December 2001. The Company met all
scheduled reductions under the Credit Facility, as amended.

Subsequent to the end of fiscal 2002, on October 11, 2002, the Company
completed the sale of its Japanese operations to Nikko Principal Investments
Japan, Ltd. for an aggregate purchase price of 16 billion Japanese Yen
(approximately $129 million at then-current exchange rates). Net proceeds of
$112.6 million from the sale were used to pay down the Companys credit
facility. The balance of the Companys credit facility was refinanced on
October 11, 2002, with an asset-based line of credit and a term loan, each of
which matures on April 1, 2005. The Company entered into a Loan and Security
Agreement with The CIT Group/Business Credit, Inc. and other lenders providing
for a line of credit of up to $110 million, subject to achieving certain
syndication requirements for the final $ 35 million of the line of credit. On
October 11, 2002 the line of credit had an outstanding balance of $61.1
million, with an additional $13.9 million available. The Company also received
a $26 million term loan pursuant to an Amended and Restated Term Loan Agreement
with JPMorgan Chase Bank and other lenders.

The Companys credit facility was, at July 31, 2002, and continues to be,
subject to maximum borrowings, certain financial ratio tests and maintaining a
minimum rolling quarterly EBITDA. In addition, the line of credit requires
that the Company maintain a minimum cash availability level of $15 million. As
of July 31, 2002, approximately $197.7 million was available under the Credit
Facility, of which $193.6 million had been
drawn. The $193.6 million includes an increase of $4.9 million due to Japanese
Yen debt translated back to U.S. Dollars at the spot rate on July 31, 2002.
(See Note 7).

The Companys future operating performance and ability to service the notes,
the line of credit and the term loan will be subject to the success of the
Companys restructuring efforts, future economic conditions and other factors,
many of which are beyond the Companys control. There can be no assurance or
guaranty that the Company will be

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successful in its restructuring efforts. In
the event the Company is unable to successfully implement its restructuring
efforts, the Companys business, financial position and results of operations
would be materially and adversely affected.

Managements plans for addressing this uncertainty include continued focus on
cash flow improvements, margin improvement and further cost reductions related
to the Companys restructuring efforts. While it is the intent of the Company
to implement the actions described, no assurance can be provided that the
Company will be successful in its efforts. If the Company is not successful in
its efforts, the operations of the Company would be materially and adversely
affected. The accompanying financial statements do not include any adjustment
that might result from the outcome of these uncertainties.

NOTE 3EARNINGS PER SHARE

A reconciliation of the numerators and denominators of the basic and diluted
loss per share computations under SFAS No. 128 is as follows (in thousands,
except per share information):

|                                                          |                        |   |                              |            |      |   |         |            |   |   |         |            |  
|--------------------------------------------------------- | ---------------------- | - | ---------------------------- | ---------- | ---- | - | ------- | ---------- | - | - | ------- | ---------- | -
|                                                          |                        |   | FOR THE YEARS ENDED JULY 31,
|                                                          |                        |   |                             
|                                                          |                        |   | 2002                         |            | 2001 |   | 2000   
|                                                          |                        |   |                              |            |      |   |        
|Loss available to common shareholder                      |                        | $ | (57,203                      | )          |      | $ | (90,290 | )          |   | $ | (10,140 | )         
|                                                          |                        |   |                              |            |      |   |         |            |   |   |         |           
|Weighted average shares outstanding for
determination of: |                        |   |                              |            |      |   |         |            |   |   |         |           
|                                                          | Basic loss per share   |   |                              | 1,000      |      |   |         | 1,000      |   |   |         | 1,000      |  
|                                                          |                        |   |                              |            |      |   |         |            |   |   |         |           
|                                                          | Diluted loss per share |   |                              | 1,000      |      |   |         | 1,000      |   |   |         | 1,000      |  
|                                                          |                        |   |                              |            |      |   |         |            |   |   |         |           
|Basic loss per share:                                     |                        |   |                              |            |      |   |         |            |   |   |         |           
|                                                          | On net loss            |   | $                            | (57,202.72 | )    |   | $       | (90,290.12 | ) |   | $       | (10,139.85 | )
|                                                          |                        |   |                              |            |      |   |         |            |   |   |         |           

Diluted loss per share is the same as basic loss per share since the Company
has a simple capital structure with only common shares outstanding.

NOTE 4RECEIVABLES

Receivables consist of (in thousands):

|                                                                                                                                           |  |          |        |      |  |   |        | 
|------------------------------------------------------------------------------------------------------------------------------------------ |  | -------- | ------ | ---- |  | - | ------ | 
|                                                                                                                                           |  | July 31,
|                                                                                                                                           |  |         
|                                                                                                                                           |  | 2002     |        | 2001
|                                                                                                                                           |  |          |        |     
|Trade receivables, less allowance for doubtful
accounts of $1,274 and $1,257 for 2002 and
2001, respectively                               |  | $        | 17,812 |      |  | $ | 23,333 | 
|Officers and employees receivables, including
notes, less allowance for doubtful accounts of
$372 and $428 for 2002 and 2001, respectively |  |          | 233    |      |  |   | 83     | 
|Other receivables, mainly income tax                                                                                                       |  |          | 8,844  |      |  |   | 8,389  | 
|                                                                                                                                           |  |          |        |      |  |   |        | 
|                                                                                                                                           |  | $        | 26,889 |      |  | $ | 31,805 | 
|                                                                                                                                           |  |          |        |      |  |   |        | 

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The Company has receivables of approximately $9,939,000 and $11,835,000 from
sales of product for resale and supplies to unconsolidated foreign affiliates
at July 31, 2002 and 2001 respectively, included in trade receivables.

NOTE 5FIXED ASSETS

Fixed assets consist of (in thousands):

|                                                |  |          |         |      |  |   |         | 
|----------------------------------------------- |  | -------- | ------- | ---- |  | - | ------- | 
|                                                |  | July 31,
|                                                |  |         
|                                                |  | 2002     |         | 2001
|                                                |  |          |         |     
|Land                                            |  | $        | 9,724   |      |  | $ | 9,737   | 
|Buildings                                       |  |          | 18,636  |      |  |   | 19,101  | 
|Leasehold improvements                          |  |          | 124,087 |      |  |   | 144,630 | 
|Video Rental                                    |  |          | 3,291   |      |  |   | 3,907   | 
|Store Fixtures                                  |  |          | 43,407  |      |  |   | 50,486  | 
|Equipment                                       |  |          | 141,586 |      |  |   | 141,623 | 
|Vehicles                                        |  |          | 295     |      |  |   | 461     | 
|                                                |  |          |         |      |  |   |         | 
|                                                |  |          | 341,026 |      |  |   | 369,945 | 
|Less: accumulated depreciation and amortization |  |          | 194,258 |      |  |   | 191,924 | 
|                                                |  |          |         |      |  |   |         | 
|                                                |  | $        | 146,768 |      |  | $ | 178,021 | 
|                                                |  |          |         |      |  |   |         | 

The cost to build new store fixtures and improvements includes a portion of
interest expense. Interest capitalized was $283,000 and $611,000 for the years
ended July 31, 2002 and 2001 respectively.

Depreciation and amortization of fixed assets was $28,580,000, $32,452,000 and
$30,658,000 for the years ended July 31, 2002, 2001 and 2000, respectively.

NOTE 6OTHER ASSETS

Other assets consist of (in thousands):

|                                                                                           |                                                                                                                                          |   |          |       |      |   |        |       | 
|------------------------------------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------- | - | -------- | ----- | ---- | - | ------ | ----- | 
|                                                                                           |                                                                                                                                          |   | July 31,
|                                                                                           |                                                                                                                                          |   |         
|                                                                                           |                                                                                                                                          |   | 2002     |       | 2001
|                                                                                           |                                                                                                                                          |   |          |       |     
|Notes receivable, officers and employees,
less current portion                             |                                                                                                                                          | $ | 710      |       |      | $ | 1,084  |      
|Investment in foreign joint ventures                                                       |                                                                                                                                          |   | 752      |       |      |   | 1,250  |      
|Securities and artwork                                                                     |                                                                                                                                          |   | 46       |       |      |   | 46     |      
|Cash surrender value of officers life insurance                                           |                                                                                                                                          |   | 5,987    |       |      |   | 9,425  |      
|Deposits                                                                                   |                                                                                                                                          |   | 7,500    |       |      |   | 7,727  |      
|Goodwill, net of accumulated amortization of $166 for
2002 and $143 for 2001, respectively |                                                                                                                                          |   | 484      |       |      |   | 507    |      
|                                                                                           | Debt issuance costs and other intangibles
assets, net of accumulated amortization of $15,203
for 2002 and $10,953 for 2001, respectively |   |          | 4,581 |      |   |        | 6,937 | 
|                                                                                           |                                                                                                                                          |   |          |       |      |   |        |      
|                                                                                           |                                                                                                                                          | $ | 20,060   |       |      | $ | 26,976 |      
|                                                                                           |                                                                                                                                          |   |          |       |      |   |        |      

Cash surrender value of life insurance at July 31, 2002 includes $5.7 million
net of loans,

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from split value life insurance policies on the lives of the Companys Parents
principal shareholder and his wife for the benefit of certain family trusts.
Under the terms of the policies, the Company will receive the first proceeds of
the policies up to the aggregate premiums paid by the Company, except for one
group of policies as to which the Company will receive the first proceeds of
the policies up to the sum of the aggregate premiums paid by the Company plus
$2,944,000 net of loans representing the cash surrender value of the policies
when received by the Company in April 1998. The balance of the proceeds will
be paid to trusts for the benefit of Russell Solomon, Michael Solomon and their
family members. In October 2002, in conjunction with the Companys refinancing
efforts these Trusts terminated the split-dollar agreement with the Company and
surrendered the policies to the Company. As a result, the individual
policies will be cancelled and accordingly premiums approximating $3.3 million
per year will be eliminated. Prior to this termination, premiums on these
policies amounted to $3.3 million per year, which are recorded as expense, net
of increases in the cash surrender value of the policies. Life insurance
expense related to these policies amounted to $242,000, $231,000 and $282,000
in the years ended July 31, 2002, 2001 and 2000, respectively.

NOTE 7LONG-TERM DEBT

Long-term debt consists of (in thousands):

|                                                                                                                                                                              |                                                                                                               |   |          |         |      |   |         |         | 
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------- | - | -------- | ------- | ---- | - | ------- | ------- | 
|                                                                                                                                                                              |                                                                                                               |   | July 31,
|                                                                                                                                                                              |                                                                                                               |   |         
|                                                                                                                                                                              |                                                                                                               |   | 2002     |         | 2001
|                                                                                                                                                                              |                                                                                                               |   |          |         |     
|9.375% Senior Subordinated Notes,
uncollateralized, interest payable
semiannually, principal due May 2005                                                                     |                                                                                                               | $ | 110,000  |         |      | $ | 110,000 |        
|Senior Revolving Credit Facility, collateralized:                                                                                                                             |                                                                                                               |   |          |         |      |   |         |        
|                                                                                                                                                                              | Dollar-based, variable interest payable
monthly (5.38% to 7.25% at July 31, 2002),
principal due October 2002 |   |          | 81,000  |      |   |         | 61,000  | 
|                                                                                                                                                                              | Yen-based, variable interest payable
monthly (3.56% at July 31, 2002),
principal due October 2002             |   |          | 112,590 |      |   |         | 116,069 | 
|Other obligations, 7.0% to 12.5%, principal
and interest generally due in monthly
installments, collateralized by certain
real property, equipment and leasehold
improvements |                                                                                                               |   | 8,587    |         |      |   | 10,646  |        
|                                                                                                                                                                              |                                                                                                               |   |          |         |      |   |         |        
|Total Long-term Debt                                                                                                                                                          |                                                                                                               |   | 312,177  |         |      |   | 297,715 |        
|Less Current Portion                                                                                                                                                          |                                                                                                               |   | 195,783  |         |      |   | 179,374 |        
|                                                                                                                                                                              |                                                                                                               |   |          |         |      |   |         |        
|Non-current Debt                                                                                                                                                              |                                                                                                               | $ | 116,394  |         |      | $ | 118,341 |        
|                                                                                                                                                                              |                                                                                                               |   |          |         |      |   |         |        

In April 1998 the Company refinanced on a long-term basis certain obligations
outstanding under its revolving credit lines, senior notes and term notes by
consummating an offering of $110.0 million of 9.375% senior subordinated notes
(the Notes) and entering into the Credit Facility, which was collateralized by a
majority of the Companys inventory, accounts receivable and a pledge of 65% of
the capital stock of its Japanese subsidiary. The Notes have options to redeem
in part at various premiums throughout the duration of the indenture, which
mature in May 2005. The fair value of the notes

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approximated $35 million on July 31, 2002.

The Company refinanced the Credit Facility on October 11, 2002. In April 2001,
the Company extended and restated on a short-term basis its outstanding
obligations under its senior revolving credit facility. The Credit Facility
was further amended in October 2001, April 2002, June 2002, September 2002 and
October 2002. The extended Credit Facility provided for initial maximum
borrowings of up to $225.0 million, consisting of two sub-facilities (one for
an initial maximum of $98.4 million and one for an initial maximum Japanese Yen
of 15,596,828,718, which was equivalent to $126.6 million at inception), with a
maturity date, as amended, of October 11, 2002. Maximum borrowings under the
Credit Facility as amended were scheduled to decline during its one-year term
by $15 million in July 2001, $5 million in October 2001 and $10 million in
December 2001. The Company met all scheduled reductions under the Credit
Facility, as amended.

Subsequent to the end of fiscal 2002, on October 11, 2002, the Company
completed the sale of its Japanese operations to Nikko Principal Investments
Japan, Ltd. for an aggregate purchase price of 16 billion Japanese yen
(approximately $129 million at then-current exchange rates). Net proceeds from
the sale of $112.6 million were used to pay down the Credit Facility. In
connection with the sale of the Japanese subsidiary, the Company has refinanced
this obligation subsequent to July 31, 2002. (See Note 19). The balance of the
Credit Facility was refinanced on October 11, 2002, with an asset-based line of
credit and a term loan, each of which matures on April 1, 2005. The Company
entered into a Loan and Security Agreement with The CIT Group/Business Credit,
Inc. and other lenders providing for a line of credit of up to $110 million,
subject to achieving certain syndication requirements for the final
$35 million of the line of credit. On October 11, 2002, the line of
credit had an outstanding balance of $61.1 million, with an
additional $13.9 million available. The Company also
received a $26 million term loan pursuant to an Amended and Restated Term Loan
Agreement with JPMorgan Chase Bank and other lenders.

Maximum borrowings under both the Amended and Restated Term Loan Agreement and
the asset-based line of credit are subject to a borrowing base formula, certain
financial ratio tests and maintaining a minimum rolling quarterly EBITDA. Also,
the new line of credit requires that the Company maintain minimum cash
availability level of $15 million. Prior to its refinance, the Credit Facility
bore interest at various variable rates, including (as defined in the
agreements) a Money Market Rate, ABR Rate, Yen Base Rate and Euro Rate, plus an
annual facility fee payable by the Company. There were various restrictive
terms and covenants relating to the occurrence of material adverse financial
operating conditions, balance sheet coverage ratio, certain debt and certain
limitations on additional indebtedness, sale-leaseback transactions, liens or
encumbrances on substantially all of the Companys assets, cash management
arrangements, long-term transactions, capital expenditures, investments,
acquisitions and new retail locations, mandatory commitment reductions and
issuance of capital stock. At July 31, 2002 the Company was in compliance with
affirmative and negative covenants.

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Maturities of long-term debt obligations are as follows (in thousands):

|                     |       |            |         |         | 
|-------------------- | ----- | ---------- | ------- | ------- | 
|Year Ending July 31, |       | Maturities
|                     |       |           
|2003                 |       | $          | 195,783 |        
|2004                 |       |            | 1,564   |        
|2005                 |       |            | 111,387 |        
|2006                 |       |            | 199     |        
|2007                 |       |            | 104     |        
|Thereafter           |       |            | 3,140   |        
|                     |       |            |         |        
|                     | Total |            | $       | 312,177 | 
|                     |       |            |         |        

NOTE 8INTEREST RATE INSTRUMENTS

During 2000 the Company was party to an interest rate swap covering debt with a
total amount of $20.1 million (approximately Japanese Yen 2,200,000,000)
outstanding. This swap agreement expired in March 2001. At July 31, 2002 the
Company had no outstanding interest rate instruments.

NOTE 9DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

The estimated fair value of the Companys financial instruments approximates
the related carrying value. The following methods and assumptions were used to
estimate the fair value of each class of financial instruments:

Cash and Cash Equivalents, Accounts Receivable, Accounts Payable and Notes
Receivable  The carrying amount approximates fair value because of the
short-term maturity of these instruments.

Long-term Debt  The fair value of the Companys subordinated notes was
estimated based upon the global markets at which the bonds are traded as quoted
by the market. The carrying value of the Companys variable rate debt
approximates fair value due to the variable nature of interest rates.

Deposits  The fair value is not determinable since there is no market for
these deposits and the date of recovery of the amount on deposit depends on
future events.

NOTE 10SHAREHOLDERS EQUITY

COMMON STOCKThe Companys articles of incorporation authorize issuance of two
classes of common stock: Class A and Class B. Class A (5,000,000 authorized;
none outstanding) and Class B (10,000,000 shares authorized; 1,000 outstanding)
Common Stock have no par value and have the same rights and privileges except
that Class A common has ten votes per share on all matters while Class B common
has one vote per share on all matters and Class B common has priority voting
rights, as a separate class, to elect twenty-five percent of the total
membership of the Board of Directors.

PREFERRED STOCKPreferred stock (1,000,000 shares authorized; none
outstanding)

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may be issued from time to time in one or more series. The Board of Directors
is authorized to determine the rights, preferences, privileges and restrictions
granted to or imposed upon unissued series of preferred stock and to fix the
number of shares of any such series.

NOTE 11LEASES

OPERATING LEASESThe Company leases substantially all of its retail stores,
warehouses and administrative facilities. Those operating lease agreements
expire through 2024 and generally have renewal options of one to twenty years.
The terms of the leases provide for fixed or minimum payments plus, in some
cases, contingent rents based on the consumer price index, or percentages of
sales in excess of specified minimum amounts or other specified increases. The
Company is generally responsible for maintenance, insurance and property taxes.

Minimum future obligations on non-cancelable operating leases are as follows
(in thousands):

|                     |                                      |        |         |         | 
|-------------------- | ------------------------------------ | ------ | ------- | ------- | 
|Year Ending July 31, |                                      | Amount
|                     |                                      |       
|2003                 |                                      | $      | 45,385  |        
|2004                 |                                      |        | 38,091  |        
|2005                 |                                      |        | 36,134  |        
|2006                 |                                      |        | 32,299  |        
|2007                 |                                      |        | 28,116  |        
|Thereafter           |                                      |        | 117,478 |        
|                     |                                      |        |         |        
|                     | Total Minimum Future Rental Payments |        | $       | 297,503 | 
|                     |                                      |        |         |        

Total rental expense (including taxes and maintenance, when included in rent,
contingent rents and accruals to recognize minimum rents on the straight-line
basis over the term of the lease) relating to all operating leases for the
years ended July 31, 2002, 2001 and 2000 are as follows (in thousands):

|                   |  |                              |        |      |  |      |        |  |  |   |        | 
|------------------ |  | ---------------------------- | ------ | ---- |  | ---- | ------ |  |  | - | ------ | 
|                   |  | FOR THE YEARS ENDED JULY 31,
|                   |  |                             
|                   |  | 2002                         |        | 2001 |  | 2000
|                   |  |                              |        |      |  |     
|Minimum rentals    |  | $                            | 71,475 |      |  | $    | 74,072 |  |  | $ | 74,845 | 
|Contingent rentals |  |                              | 5,668  |      |  |      | 6,076  |  |  |   | 6,204  | 
|                   |  |                              |        |      |  |      |        |  |  |   |        | 
|                   |  | $                            | 77,143 |      |  | $    | 80,148 |  |  | $ | 81,049 | 
|                   |  |                              |        |      |  |      |        |  |  |   |        | 

NOTE 12INCOME TAXES

The (benefit) provision for income taxes on income from operations consists of
(in thousands):

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|                                     |                 |   |                              |        |      |   |        |        |   |   |        |        |  
|------------------------------------ | --------------- | - | ---------------------------- | ------ | ---- | - | ------ | ------ | - | - | ------ | ------ | -
|                                     |                 |   | FOR THE YEARS ENDED JULY 31,
|                                     |                 |   |                             
|                                     |                 |   | 2002                         |        | 2001 |   | 2000  
|                                     |                 |   |                              |        |      |   |       
|Current:                             |                 |   |                              |        |      |   |        |        |   |   |        |       
|                                     | U.S. Federal    |   | $                            | (4,533 | )    |   | $      | (4,829 | ) |   | $      | 942    |  
|                                     | State and Local |   |                              | 598    |      |   |        | 1,115  |   |   |        | 1,786  |  
|                                     | Foreign         |   |                              | 2,639  |      |   |        | 1,366  |   |   |        | 1,571  |  
|                                     |                 |   |                              |        |      |   |        |        |   |   |        |       
|                                     |                 |   | (1,296                       | )      |      |   | (2,348 | )      |   |   | 4,299  |       
|                                     |                 |   |                              |        |      |   |        |        |   |   |        |       
|Deferred:                            |                 |   |                              |        |      |   |        |        |   |   |        |       
|                                     | U.S. Federal    |   |                              | (3,849 | )    |   |        | 25,366 |   |   |        | (1,328 | )
|                                     | State and Local |   |                              | 0      |      |   |        | 1,567  |   |   |        | (682   | )
|                                     | Foreign         |   |                              | 3,849  |      |   |        | (3,644 | ) |   |        | (1,141 | )
|                                     |                 |   |                              |        |      |   |        |        |   |   |        |       
|                                     |                 |   | 0                            |        |      |   | 23,289 |        |   |   | (3,151 | )     
|                                     |                 |   |                              |        |      |   |        |        |   |   |        |       
|(Benefit) provision for income
taxes |                 | $ | (1,296                       | )      |      | $ | 20,941 |        |   | $ | 1,148  |       
|                                     |                 |   |                              |        |      |   |        |        |   |   |        |       

The effective tax rates (i.e. provision for income taxes as a percent of income
before income taxes) differs from the statutory federal income tax rate as
follows (in thousands, except percentages):

|                                                                |  |                              |         |         |  |        |       |         |  |        |         |         |  |  |       |   |  |   |        |   |  |  |       |  
|--------------------------------------------------------------- |  | ---------------------------- | ------- | ------- |  | ------ | ----- | ------- |  | ------ | ------- | ------- |  |  | ----- | - |  | - | ------ | - |  |  | ----- | -
|                                                                |  | FOR THE YEARS ENDED JULY 31,
|                                                                |  |                             
|                                                                |  | 2002                         |         | 2001    |  | 2000  
|                                                                |  |                              |         |         |  |       
|                                                                |  | Amount                       |         | Percent |  | Amount |       | Percent |  | Amount |         | Percent
|                                                                |  |                              |         |         |  |        |       |         |  |        |         |        
|Federal income tax, at
statutory rate                           |  | $                            | (20,474 | )       |  |        | 35.0  | %       |  | $      | (22,849 | )       |  |  | 35.0  | % |  | $ | (3,147 | ) |  |  | -35.0 | %
|State and local income taxes,
net of
federal income tax benefit |  |                              | (1,519  | )       |  |        | 2.6   | %       |  |        | (1,108  | )       |  |  | 1.7   | % |  |   | (352   | ) |  |  | -3.9  | %
|Change in federal tax law                                       |  |                              | (5,475  | )       |  |        | 9.4   | %       |  |        | 0       |         |  |  | 0     |   |  |   | 0      |   |  |  | 0     |  
|State franchise and capital tax                                 |  |                              | 598     |         |  |        | -1.0  | %       |  |        | 958     |         |  |  | -1.5  | % |  |   | 540    |   |  |  | 6.0   | %
|Change in valuation allowance                                   |  |                              | 26,137  |         |  |        | -44.7 | %       |  |        | 42,213  |         |  |  | -64.7 | % |  |   | 3,012  |   |  |  | 33.5  | %
|Foreign taxes                                                   |  |                              | 3,009   |         |  |        | -5.1  | %       |  |        | 2,485   |         |  |  | -3.8  | % |  |   | 1,571  |   |  |  | 17.5  | %
|Foreign tax credit recognized                                   |  |                              | (3,009  | )       |  |        | 5.1   | %       |  |        | (1,330  | )       |  |  | 2.0   | % |  |   | (1,244 | ) |  |  | -13.8 | %
|Other, principally permanent
differences                        |  |                              | (563    | )       |  |        | 1.0   | %       |  |        | 572     |         |  |  | -0.9  | % |  |   | 768    |   |  |  | 8.5   | %
|                                                                |  |                              |         |         |  |        |       |         |  |        |         |         |  |  |       |   |  |   |        |   |  |  |       |  
|Provision for income taxes                                      |  | $                            | (1,296  | )       |  |        | 2.3   | %       |  | $      | 20,941  |         |  |  | -32.2 | % |  | $ | 1,148  |   |  |  | 12.8  | %
|                                                                |  |                              |         |         |  |        |       |         |  |        |         |         |  |  |       |   |  |   |        |   |  |  |       |  

Deferred income tax assets and liabilities consist of the tax effects of
temporary differences related to the following (in thousands):

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|                          |                                                                                       |                                |                                                    |        |          |        |        |        |        |        | 
|------------------------- | ------------------------------------------------------------------------------------- | ------------------------------ | -------------------------------------------------- | ------ | -------- | ------ | ------ | ------ | ------ | ------ | 
|                          |                                                                                       |                                |                                                    |        | July 31,
|                          |                                                                                       |                                |                                                    |        |         
|                          |                                                                                       |                                |                                                    |        | 2002     |        | 2001  
|                          |                                                                                       |                                |                                                    |        |          |        |       
|Deferred tax assets:      |                                                                                       |                                |                                                    |        |          |        |        |       
|                          | Foreign translation                                                                   |                                | $                                                  | 7,833  |          |        | $      | 8,495  |       
|                          | Foreign and other tax credits                                                         |                                |                                                    | 4,108  |          |        |        | 5,105  |       
|                          | Cumulative translation adjustments to shareholders
equity                            |                                |                                                    | 19,438 |          |        |        | 13,504 |       
|                          | Tax, but not book, gain on transactions between MTS
and the Family Trusts             |                                |                                                    | 2,308  |          |        |        | 2,636  |       
|                          | Net operating losses                                                                  |                                |                                                    | 30,209 |          |        |        | 19,218 |       
|                          | Vacation accrual                                                                      |                                |                                                    | 1,059  |          |        |        | 1,003  |       
|                          | Capitalized inventory costs                                                           |                                |                                                    | 554    |          |        |        | 583    |       
|                          | Differences between tax and accounting in inclusion of
income from foreign operations |                                |                                                    | 4,538  |          |        |        | 738    |       
|                          | Other nondeductible expenses and accelerated
income items                             |                                |                                                    | 10,545 |          |        |        | 526    |       
|                          |                                                                                       |                                |                                                    |        |          |        |        |       
|                          |                                                                                       | Total deferred tax assets      |                                                    |        | 80,592   |        |        |        | 51,808 |       
|                          |                                                                                       |                                |                                                    |        |          |        |        |       
|Deferred tax liabilities: |                                                                                       |                                |                                                    |        |          |        |        |       
|                          | Depreciation and amortization                                                         |                                |                                                    | 3,212  |          |        |        | 1,280  |       
|                          | Other accelerated deductions and deferred income items                                |                                |                                                    | 1,099  |          |        |        | 1,099  |       
|                          | State tax                                                                             |                                |                                                    | 1,413  |          |        |        | 698    |       
|                          |                                                                                       |                                |                                                    |        |          |        |        |       
|                          |                                                                                       | Total deferred tax liabilities |                                                    |        | 5,724    |        |        |        | 3,077  |       
|                          |                                                                                       |                                |                                                    |        |          |        |        |       
|                          |                                                                                       |                                | Net deferred tax assets before valuation allowance |        |          | 74,868 |        |        |        | 48,731 | 
|Valuation allowance       |                                                                                       |                                | 74,868                                             |        |          |        | 48,731 |       
|                          |                                                                                       |                                |                                                    |        |          |        |        |       
|Net deferred tax assets   |                                                                                       | $                              | 0                                                  |        |          | $      | 0      |       
|                          |                                                                                       |                                |                                                    |        |          |        |        |       

Deferred tax assets and liabilities are reflected in the Companys consolidated
balance sheets as follows (in thousands):

|                                |                         |   |          |   |      |   |   |   | 
|------------------------------- | ----------------------- | - | -------- | - | ---- | - | - | - | 
|                                |                         |   | July 31,
|                                |                         |   |         
|                                |                         |   | 2002     |   | 2001
|                                |                         |   |          |   |     
|Current deferred tax assets     |                         | $ | 0        |   |      | $ | 0 |  
|Non-current deferred tax assets |                         |   | 0        |   |      |   | 0 |  
|                                |                         |   |          |   |      |   |   |  
|                                | Net deferred tax assets |   | $        | 0 |      |   | $ | 0 | 
|                                |                         |   |          |   |      |   |   |  

During 2000, the Company established a valuation allowance against deferred
tax assets. During 2001, the Company increased the valuation allowance by $42.2
million to $48.7 million as of July 31, 2001. During 2002, the Company
increased the valuation allowance by $26.2 to $74.9 million as of July 31,
2002. This increase was recorded to account for the uncertain recoverability of
the deferred tax assets caused by the questions regarding the Companys ability
to achieve profitable operations and generate taxable income.

NOTE 13EMPLOYEE BENEFITS

PROFIT SHARINGSubstantially all full-time domestic employees with
24 months of service who have attained age 21 participate in
the Companys profit sharing retirement programs. The plans provide for
discretionary contributions as determined annually by

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the Board of Directors of up to 15% of all eligible compensation. Costs under
the plans are funded on an annual basis.

The Company also maintains a plan for employees of its Japanese subsidiary. The
plan covers substantially all employees of the Japanese operations. The plan
provides for a lump sum payment upon termination without cause based on term of
service and compensation level. A liability for plan payments is accrued equal
to the amount that would result from termination of all employees based on
service to date and current compensation levels. As permitted by Japanese law,
the plan is not funded. On October 11, 2002, this liability was sold in the
sale of the Japanese operations.

SALARY DEFERRALIn October 1998, the Company established a salary deferral
plan (401(K) Plan). All employees with 12 months of service who have
attained age 18 may join the 401 (K) Plan quarterly each year. All
eligible employees may contribute up to 15% or $10,500 of their annual
compensation on a pre-tax basis. The plan provides for a discretionary match
determined annually by the Board of Directors.

Pension expense under the pension plans and salary deferral plan amounted to
$729,000, $1,705,000 and $2,516,000 for the years ended July 31, 2002, 2001 and
2000, respectively.

NOTE 14SEGMENT AND GEOGRAPHIC INFORMATION:

SFAS No. 131 requires that the Company report financial and descriptive
information about its reportable operating segments using the management
approach model. Under the management approach model, segments are defined
based on the way the Companys management internally evaluates segment
performance and decides how to allocate resources to segments. The Company
has defined its only segment as retail sales of pre-recorded music and
evaluates this based on geographic area.

The Company is a worldwide specialty retailer of pre-recorded music, video,
books and other related products. Certain of the Companys stores offer video
and other products for rental. The Company is supported by centralized
corporate services and the stores have similar economic characteristics,
products, customers, and retail distribution methods, and as such are reported
as a single segment.

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Financial information relating to the Companys principal foreign operations is
as follows (in thousands):

|                         |                            |                             |         |         |                              |         |         |         |         |           |         |        |         |           | 
|------------------------ | -------------------------- | --------------------------- | ------- | ------- | ---------------------------- | ------- | ------- | ------- | ------- | --------- | ------- | ------ | ------- | --------- | 
|                         |                            |                             |         |         | FOR THE YEARS ENDED JULY 31,
|                         |                            |                             |         |         |                             
|                         |                            |                             |         |         | 2002                         |         | 2001    |         | 2000   
|                         |                            |                             |         |         |                              |         |         |         |        
|Net Revenue              |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         | United States:             |                             |         |         |                              |         |         |         |         |           |         |        |        
|                         |                            | Unaffiliated customer sales |         | $       | 529,783                      |         |         | $       | 611,588 |           |         | $      | 627,405 |          
|                         |                            | Interarea transfers         |         |         | 23,533                       |         |         |         | 19,678  |           |         |        | 22,233  |          
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         |                            |                             | 553,316 |         |                              |         | 631,266 |         |         |           | 649,638 |       
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         | Japan:                     |                             |         |         |                              |         |         |         |         |           |         |        |        
|                         |                            | Unaffiliated customer sales |         |         | 371,995                      |         |         |         | 365,116 |           |         |        | 359,909 |          
|                         |                            | Interarea transfers         |         |         |                             |         |         |         |        |           |         |        |        |          
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         |                            |                             | 371,995 |         |                              |         | 365,116 |         |         |           | 359,909 |       
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         | Great Britain and Ireland: |                             |         |         |                              |         |         |         |         |           |         |        |        
|                         |                            | Unaffiliated customer sales |         |         | 52,305                       |         |         |         | 54,669  |           |         |        | 57,805  |          
|                         |                            | Interarea transfers         |         |         |                             |         |         |         |        |           |         |        | 1,447   |          
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         |                            |                             | 52,305  |         |                              |         | 54,669  |         |         |           | 59,252  |       
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         | Other:                     |                             |         |         |                              |         |         |         |         |           |         |        |        
|                         |                            | Unaffiliated customer sales |         |         | 5,188                        |         |         |         | 28,468  |           |         |        | 31,132  |          
|                         |                            | Interarea transfers         |         |         |                             |         |         |         |        |           |         |        |        |          
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         |                            |                             | 5,188   |         |                              |         | 28,468  |         |         |           | 31,132  |       
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         |                            |                             | TOTAL   |         | $                            | 982,804 |         |         | $       | 1,079,519 |         |        | $       | 1,099,931 | 
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|Operating income (loss): |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         | United States              |                             | $       | (23,160 | )                            |         | $       | (53,764 | )       |           | $       | 17,526 |        
|                         | Japan                      |                             |         | 15,632  |                              |         |         | 11,274  |         |           |         | 13,850 |        
|                         | Great Britain and Ireland  |                             |         | (28,333 | )                            |         |         | (4,107  | )       |           |         | (1,279 | )      
|                         | Other                      |                             |         | 4,636   |                              |         |         | 9,218   |         |           |         | (5,307 | )      
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       
|                         |                            | $                           | (31,225 | )       |                              | $       | (37,379 | )       |         | $         | 24,790  |       
|                         |                            |                             |         |         |                              |         |         |         |         |           |         |       

|                     |                           |   |          |         |      |   |         |         | 
|-------------------- | ------------------------- | - | -------- | ------- | ---- | - | ------- | ------- | 
|                     |                           |   | July 31,
|                     |                           |   |         
|                     |                           |   | 2002     |         | 2001
|                     |                           |   |          |         |     
|Identifiable assets: |                           |   |          |         |      |   |         |        
|                     | United States             |   | $        | 320,933 |      |   | $       | 359,903 | 
|                     | Japan                     |   |          | 145,048 |      |   |         | 135,612 | 
|                     | Great Britain and Ireland |   |          | 10,208  |      |   |         | 28,764  | 
|                     | Other                     |   |          | (95     | )    |   |         | 2,696   | 
|                     |                           |   |          |         |      |   |         |        
|                     |                           | $ | 476,094  |         |      | $ | 526,975 |        
|                     |                           |   |          |         |      |   |         |        

United States net revenue includes export sales to non-affiliated customers of
$61,000, $517,000 and $1,435,000 for the years ended July 31, 2002, 2001 and
2000, respectively.

Interarea transfers relate to the Companys distribution operations.

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NOTE 15SELECTED UNAUDITED QUARTERLY INFORMATION (in thousands, except per
share)

|              |  |             |         |             |  |           |         |          |  |        |         |   |  |   |         |   |  |   |         |  
|------------- |  | ----------- | ------- | ----------- |  | --------- | ------- | -------- |  | ------ | ------- | - |  | - | ------- | - |  | - | ------- | -
|              |  | October 31, |         | January 31, |  | April 30, |         | July 31, |  | Fiscal
|              |  | 2001        |         | 2002        |  | 2002      |         | 2002     |  | 2002  
|              |  |             |         |             |  |           |         |          |  |       
|Sales         |  | $           | 226,694 |             |  | $         | 293,665 |          |  | $      | 225,217 |   |  | $ | 237,228 |   |  | $ | 982,804 |  
|Gross profits |  |             | 70,513  |             |  |           | 80,479  |          |  |        | 70,459  |   |  |   | 69,121  |   |  |   | 290,572 |  
|Net loss      |  |             | (11,272 | )           |  |           | (9,373  | )        |  |        | (8,623  | ) |  |   | (27,935 | ) |  |   | (57,203 | )

|              |  |             |         |             |  |           |         |          |  |        |         |   |  |   |         |   |  |   |           |  
|------------- |  | ----------- | ------- | ----------- |  | --------- | ------- | -------- |  | ------ | ------- | - |  | - | ------- | - |  | - | --------- | -
|              |  | October 31, |         | January 31, |  | April 30, |         | July 31, |  | Fiscal
|              |  | 2000        |         | 2001        |  | 2001      |         | 2001     |  | 2001  
|              |  |             |         |             |  |           |         |          |  |       
|Sales         |  | $           | 255,388 |             |  | $         | 322,988 |          |  | $      | 255,098 |   |  | $ | 246,045 |   |  | $ | 1,079,519 |  
|Gross profits |  |             | 84,377  |             |  |           | 94,805  |          |  |        | 70,923  |   |  |   | 61,021  |   |  |   | 311,126   |  
|Net loss      |  |             | (733    | )           |  |           | (5,461  | )        |  |        | (34,378 | ) |  |   | (49,718 | ) |  |   | (90,290   | )

NOTE 16FORWARD EXCHANGE CONTRACTS

At July 31, 2002, the Company did not have any outstanding forward exchange
contracts. These contracts are for the purpose of hedging liabilities
denominated in U.S. Dollars. Market value gains and losses on these contracts
are recognized in the statement of operations and offset foreign exchange gains
and losses recognized on the liabilities denominated in U.S. Dollars.

NOTE 17CONTINGENCIES

The Company is the subject of litigation arising in the normal course of
business. In the opinion of management, the Companys ultimate liability, if
any, related to pending or threatened litigation would not materially affect
its financial position or results of operations.

As a codefendant the Company is subject to three antitrust cases, which allege
that, the named defendants were engaged in a conspiracy to fix the prices of
CDs in violation of federal and state antitrust, unfair trade practices, and
consumer protection statuses. These three antitrust complaints were filed
following the May 10, 2000 announcement that the major music distributors had
entered into a settlement agreement with the Federal Trade Commission.
Subsequent to year-end, a settlement agreement was finalized and the Companys
portion of the settlement was for $275,000, which was accrued for at July 31,
2002.

The Company entered into a consulting contract with Chilmark Partners, LLC
(Chilmark) on May 18, 2001. By letter to Chilmark dated June 12, 2002, the
Company terminated the contract. On July 29, 2002, Chilmark filed suit against
the Company in the U.S. District Court for the Northern District of Illinois,
alleging breach of contract and seeking other remedies under the contract and
attachment of proceeds of the Companys sale of its Japan operations. In
August 2002, Chilmarks request for such an attachment was denied. The
litigation continues with respect to Chilmarks breach of contract claim and
its request for damages under the terms of the contract. As of October 11,
2002, Chilmarks total damage request was approximately $2.6 million. The

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Company believes it has meritorious defenses with respect to each of Chilmarks
claims and intends to defend against the claims vigorously; however, the
litigation is in the preliminary stage and there can be no assurance that the
Company will prevail in this action. If Chilmark receives a favorable judgment
for all or a substantial portion of the total $2.6 million in damages Chilmark
is seeking, such an outcome could have a material adverse effect on the
Companys financial condition, results of operations and cash flows.

NOTE 18RELATED PARTIES

The Company accrued royalty fees payable to certain of the trusts established
for the benefit of Russell Solomon, Michael Solomon and their family members
(the Trusts) for royalties charged to them for the use of the Trusts
trademarks and logos. The Company was charged interest on the unpaid balance at
current six month U.S. Treasury Bill Rates, plus 250 basis points, or 7.04% at
July 31, 2002. The outstanding payable to the Trusts at July 31, 2002 and 2001
was approximately $15,491,000 and $12,966,000, respectively and was included in
accounts payable. All such accrued royalty fees were paid to the Trusts on
October 11, 2002.

Additional related-party transactions include lease expense to an affiliate of
$567,000, $616,000 and $667,000 for the years ended July 31, 2002, 2001 and
2000, respectively.

As of July 31, 2002, the Chairman of the Companys Board of Directors owed the
Company $287,000 under an interest-free loan and a merchandise account with the
Company.

As of July 31, 2002, the Chief Executive Officer of the Company, owed the
Company $37,000 under an interest-free merchandise account with the Company.

As of July 31, 2002, the Chief Operating Officer of the Company, owed the
Company $71,000 under an interest-bearing loan and an interest-free merchandise
account with the Company.

In fiscal 2002, the Company contracted Searson & Company, Inc., Certified
Public Accountants, Inc., in the amount of $165,000 in consulting fees for
assistance in the corporate finance department related to year-end activities
and accrued an additional $23,261 in advisory services and cost reimbursement
related to the sale of the Companys Japan operations. Karen Searson, the
spouse of DeVaughn D. Searson, the Companys Chief Financial Officer, is the
majority owner of Searson & Co. In addition, the Company paid $172,382 to
Complete Data Services, Inc. for custodial and retrieval services related to
the Companys credit card transactions and chargebacks. Complete Data
Services, Inc. is owned by Karen Searson.

NOTE 19SUBSEQUENT EVENTS

On October 11, 2002, the Company completed the sale of its Japanese operations
to Nikko Principal Investments Japan, Ltd. for an aggregate purchase price of
16 billion Japanese Yen (approximately $129 million at then-current exchange
rates). Estimated gain on the sale is approximately $38 million. Net proceeds
from the sale were used to pay down the principal balance of the Japanese Yen
denominated sub-facility which was approximately 13.5 billion Japanese Yen
(approximately $112.6 million at then-current exchange rates).

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The balance of the Companys credit facility was refinanced on October 11,
2002, into an asset-based line of credit and a term loan, each of which has a
maturity of April 1, 2005. The Company entered into a Loan and Security
Agreement with The CIT Group/Business Credit, Inc. and other lenders providing
for a line of credit of up to $110 million, subject to achieving certain
syndication requirements for the final $35 million of the line
of credit. The Company also received a $26 million term loan
pursuant to an Amended and Restated Term Loan Agreement with JPMorgan Chase
Bank and other lenders.

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

None




PART III




ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth the name, age, position and years of service of
the individuals who were serving as directors and executive officers of the
Company, as of October 15, 2002. Executive officers are appointed by the Board
of Directors and serve at the discretion of the Board.

|                    |  |     |    |          |  |                                                                                      |  |       |    | 
|------------------- |  | --- | -- | -------- |  | ------------------------------------------------------------------------------------ |  | ----- | -- | 
|                    |  |     |    |          |  |                                                                                      |  | Years
|                    |  |     |    |          |  |                                                                                      |  | with 
|Name                |  | Age |    | Position |  | Tower                                                                               
|                    |  |     |    |          |  |                                                                                     
|Russell M. Solomon  |  |     | 77 |          |  | Chairman and Board Member                                                            |  |       | 42 | 
|Michael T. Solomon  |  |     | 54 |          |  | President and Chief Executive Officer                                                |  |       | 15 | 
|DeVaughn D. Searson |  |     | 58 |          |  | Chief Financial Officer, Executive Vice
President, Secretary, Treasurer and Director |  |       | 14 | 
|Keith Cahoon        |  |     | 46 |          |  | Senior Vice President  Far East Operations                                          |  |       | 24 | 
|Andy D. Lown        |  |     | 37 |          |  | Senior Vice President  European Operations                                          |  |       | 17 | 
|Robert Lorber       |  |     | 55 |          |  | Director                                                                             |  |       | 4  | 

RUSSELL M. SOLOMON, Founder, serves as Chairman and as a Director of the
Company, and is a member of the Companys Executive Committee. Mr. Solomon has
served as President of the National Association of Recording Merchandisers
(NARM) and as a Board member of the Video Software Dealers Association. Mr.
Solomon is also a member of the Board of Directors of The Good Guys! Mr.
Solomon is the father of Michael T. Solomon.

MICHAEL T. SOLOMON serves as President, Chief Executive Officer and as a
Director of the Company and is a member of the Companys Executive Committee.
Mr. Solomon was appointed President and CEO of the Company in September 1998.
From 1987 to the date of this appointment, Mr. Solomon was the Companys
General Counsel. Mr. Solomon presently serves on the NARM Board of Directors,
has served on several NARM subcommittees and is a member of the California Bar
Association. Mr. Solomon is the son of Russell M. Solomon.

DEVAUGHN D. SEARSON has served as the Companys Chief Financial Officer since
1988 and was appointed Executive Vice President in 1998. Mr. Searson is a
member of the Companys Executive Committee. Mr. Searson has also served as a
Director of the Company since May 1998. Prior to joining the Company, Mr.
Searson was President and Managing Partner of Searson & Company, CPAs, the
Companys outside accounting firm at the time, and served as the Companys
outside accountant for 11 years. Mr. Searson is a certified public accountant.

KEITH CAHOON has served as Managing Director of the Companys Far East

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Operations since 1984. Mr. Cahoon is a member of the Companys Executive
Committee.

ANDY D. LOWN has been an employee of the Company since 1986 and currently
serves as Managing Director of the Companys European operations. Mr. Lown is a
senior vice president of the Company. He also serves on the Board of the
British Association of Record Dealers, the UK Charts Supervisory Committee, and
the BPI Liaison Committee.

ROBERT LORBER became a director of the Company in 1998. Since 1976, Mr. Lorber
has been President of Lorber-Kamai Consulting Group, which advises Fortune 500
clients on productivity improvement. He is also a professor at the Graduate
School of Management at UC Davis.

On September 16, 2002, the Company entered into a consulting arrangement with
BETSY BURTON to serve as a retail operations turnaround specialist. Ms. Burton
has led retail turnarounds as chief executive officer of companies including
Supercuts, a division of the Regis Corporation, PIP Printing Inc. and Cosmetic
Center Inc. In addition, Ms. Burton currently serves on the Board of Directors
of Staples, Inc., The Sports Authority Inc., Rent-A-Center, Inc. and
Aeropostale, Inc.




ITEM 11. EXECUTIVE COMPENSATION

The following table sets forth compensation paid by the Company during each of
the Companys 2002, 2001 and 2000 fiscal years to the Companys Chief Executive
Officer and the next four highest-earning executive officers of the company for
the fiscal year ended July 31, 2002 (the Named Executive Officers):

|                          |                     |      |                     |        |     |       |         |         |  |          |         |         |  |           |         |           |       |   |       |       | 
|------------------------- | ------------------- | ---- | ------------------- | ------ | --- | ----- | ------- | ------- |  | -------- | ------- | ------- |  | --------- | ------- | --------- | ----- | - | ----- | ----- | 
|                          |                     |      | Annual Compensation
|                          |                     |      |                    
|                          |                     |      |                     |        |     |       |         |         |  |          |         |         |  |           | Other   |           | All  
|                          |                     |      |                     |        |     |       |         |         |  |          |         |         |  |           | Annual  |           | Other
|Name and Principal        |                     |      |                     |        |     |       |         |         |  |          |         |         |  | Compensa- |         | Compensa-
|Position                  |                     | Year |                     | Salary |     | Bonus |         | tion    |  | tion (a)
|                          |                     |      |                     |        |     |       |         |         |  |         
|Russell M. Solomon        |                     |      | 2002                |        |     | $     | 632,780 |         |  | $        | 300,000 |         |  | $         | 18,000  |           |       | $ | 0     |      
|Chairman                  |                     |      | 2001                |        |     |       | 632,780 |         |  |          | 300,000 |         |  |           | 36,000  |           |       |   | 0     |      
|                          |                     |      | 2000                |        |     |       | 632,780 |         |  |          | 447,000 |         |  |           | 39,000  |           |       |   | 7,872 |      
|                         
|Michael T. Solomon        |                     |      | 2002                |        |     | $     | 360,400 |         |  | $        | 100,000 |         |  | $         | 18,000  |           |       | $ | 0     | (f)  
|President and CEO         |                     |      | 2001                |        |     |       | 360,400 |         |  |          | 100,000 |         |  |           | 36,000  |           |       |   | 0     |      
|                          |                     |      | 2000                |        |     |       | 360,400 |         |  |          | 100,000 |         |  |           | 39,000  |           |       |   | 7,872 |      
|                         
|DeVaughn D. Searson       |                     |      | 2002                |        |     | $     | 228,106 |         |  | $        | 100,000 |         |  | $         | 18,000  |           |       | $ | 0     |      
|EVP and Chief Financial   |                     |      | 2001                |        |     |       | 222,378 |         |  |          | 100,000 |         |  |           | 36,000  |           |       |   | 0     |      
|                          | Officer             |      |                     | 2000   |     |       |         | 201,916 |  |          |         | 100,000 |  |           |         | 39,000    |       |   |       | 7,872 | 
|                         
|Stanley L. Goman (b)      |                     |      | 2002                |        |     | $     | 243,095 |         |  | $        | 100,000 |         |  | $         | 18,000  |           |       | $ | 0     |      
|EVP and Chief Operating   |                     |      | 2001                |        |     |       | 222,349 |         |  |          | 100,000 |         |  |           | 27,000  |           |       |   | 0     |      
|                          | Officer             |      |                     | 2000   |     |       |         | 210,900 |  |          |         | 100,000 |  |           |         | 11,437    |       |   |       | 7,872 | 
|                         
|Ronald Nugent (b)         |                     |      | 2002                |        |     | $     | 220,000 |         |  | $        | 106,250 |         |  | $         | 0       |           |       | $ | 0     |      
|EVP and Chief Marketing   |                     |      | 2001                |        |     |       | 220,000 |         |  |          | 34,629  |         |  |           | 67,057  |           |       |   | 0     |      
|                          | Officer             |      |                     | 2000   |     |       |         | 0       |  |          |         | 0       |  |           |         | 0         |       |   |       | 0     | 
|                         
|Keith Cahoon              |                     |      | 2002                | (c)    |     | $     | 199,917 |         |  | $        | 0       |         |  | $         | 170,993 |           |       | $ | 0     |      
|SVP and Managing
Director |                     |      | 2001                | (d)    |     |       | 165,120 |         |  |          | 0       |         |  |           | 73,968  |           |       |   | 0     |      
|                          | Far East Operations |      |                     | 2000   | (e) |       |         | 189,358 |  |          |         | 0       |  |           |         | 101,152   |       |   |       | 7,872 | 

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|(a) |  | Represents Company contributions to the Companys retirement plan.                                                                                                                                                                       
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(b) |  | Mr. Gomans and Mr. Nugents employment with the Company was terminated
on October 14, 2002.                                                                                                                                             
|   
|   
|   
|   
|(c) |  | Calculated at an exchange rate of 120 Japanese Yen per U.S. Dollar, the
rate on the spot market at July 31, 2002.                                                                                                                        
|   
|   
|   
|   
|(d) |  | Calculated at an exchange rate of 125 Japanese Yen per U.S. Dollar, the
rate on the spot market at July 31, 2001.                                                                                                                        
|   
|   
|   
|   
|(e) |  | Calculated at an exchange rate of 109 Japanese Yen per U.S. Dollar, the
rate on the spot market at July 31, 2000.                                                                                                                        
|   
|   
|   
|   
|(f) |  | Does not include split-dollar life insurance premiums paid on the lives of
Russell M. Solomon and Doris E. Solomon for the benefit of certain Family
Trusts described in Certain Relationships and Related Transactions-Life
Insurance.

EMPLOYMENT AGREEMENTS

The Company entered into a letter agreement with Ron Nugent as the Companys
Chief Marketing Officer. The letter agreement provided for Mr. Nugent to
receive an annual base salary of $220,000 per year, subject to discretionary
annual increases, and an annual target bonus of up to $75,000. Mr. Nugent
received a relocation allowance pursuant to the agreement and is entitled to
receive other standard employee benefits in accordance with the Companys
benefit plans. Under the agreement, Mr. Nugents employment could be terminated
by either the Company or Mr. Nugent at any time, provided that, in the event
that the Company terminated Mr. Nugents employment without cause, Mr. Nugent
would receive severance pay in an amount equal to up to four months salary for
each full year that he was employed by the Company and would be entitled to
participate in certain future severance plans if adopted by the Company. Mr.
Nugents employment was terminated by the Company on October 14, 2002.

In connection with the Companys efforts to sell its Japan operations, the
Company entered into a retention agreement with Keith Cahoon dated October 11,
2002, pursuant to which the Company agreed to pay Mr. Cahoon Japanese Yen
95,480,000 (approximately $797,000 at current exchange rates). One half the
amount was paid upon the sale of the Companys Japan operations and the
remainder is payable six months after October 11, 2002.

In connection with the Companys efforts to restructure its operations in the
United Kingdom and Ireland, the Company entered into a retention agreement with
Andy Lown dated August 9, 2002, pursuant to which the Company agreed to pay Mr.
Lown British Pound Sterling 30,000 (approximately $47,000 at current exchange
rates) immediately upon execution of the agreement and a maximum payment of up
to British Pound Sterling 450,000 (approximately $704,000 at current exchange
rates) upon the occurrence

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of specified events relating to the restructuring of the Companys operations
in the United Kingdom and Ireland.

LIMITATION OF LIABILITY AND INDEMNIFICATION MATTERS

The Companys Articles of Incorporation contain provisions that eliminate the
personal liability of its directors for monetary damages to the fullest extent
permitted by law and authorize the Company to indemnify its directors and
officers to the fullest extent permitted by law. Such limitation of liability
does not affect the availability of equitable remedies such as injunctive
relief or rescission.

The Company has entered into indemnification agreements with its officers and
directors containing provisions which are in some respects broader than the
specific indemnification provisions contained in the California Corporations
Code, including advancement of expenses to the indemnities, the indemnities
right to select counsel and continuation of indemnification after indemnities
separation from the Company. The indemnification agreements may require the
Company, among other things, to indemnify such officers and directors against
certain liabilities arising from willful misconduct of a culpable nature and to
advance their expenses incurred as a result of any proceeding against them as
to which they could be indemnified.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

All matters concerning executive compensation in fiscal 2002 were addressed by
the full Board of Directors of the Company, the members of which were Russell
M. Solomon, Michael T. Solomon, DeVaughn D. Searson, and Robert Lorber.
Russell Solomon was also the Companys Chairman of the Board in fiscal 2002.
Michael T. Solomon was also the Companys President and Chief Executive Officer
in fiscal 2002 and DeVaughn D. Searson was also the Companys Chief Financial
Officer in fiscal 2002. None of the executive officers of the Company served
as a member of the compensation committee of any other entity during the fiscal
year ended July 31, 2002.

Russell Solomon and Michael Solomon entered into certain transactions with the
Company in fiscal 2002. As of July 31, 2002, Russell Solomon, the Chairman
and a director of the Company, owed the Company $18,672 and $268,772 under
loans from and a merchandise account, respectively, with the Company, both of
which are interest-free. As of July 31, 2002, Michael Solomon, President, Chief
Executive Officer and a director of the Company, owed the Company $36,956 under
a merchandise account with the Company, which is interest-free.

The Company accrued royalty fees payable to certain of the trusts established
for the benefit of Russell Solomon, Michael Solomon and their family members
(the Trusts) for royalties charged to them for the use of the Trusts
trademarks and logos. The Company is charged interest on the unpaid balance at
current six month U.S. Treasury Bill Rates, plus 250 basis points, or 7.04% at
July 31, 2002. The outstanding payable to the Trusts was approximately
$15,491,000 at July 31, 2002 and was included in accounts payable at fiscal
2002 year-end. All accrued royalty fees payable to the Trusts were paid on
October 11, 2002.

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The Company made lease payments to Solomon Properties LLC, an affiliate of the
Trusts, of $567,000 in fiscal 2002.

REPORT ON EXECUTIVE COMPENSATION

The Board of Directors of the Company is principally responsible for
establishing and administering the executive compensation program of the
Company, including approving salary increases for the Companys key executives
and administering the Companys annual bonus plan. The following report
addresses the Board of Directors objectives and its actions and decisions with
respect to executive compensation for the fiscal year ended July 31, 2002.

Compensation Philosophy and Objectives

The components of the executive compensation program are salary and annual
bonus awards. The program is designed to attract and retain competent people
with competitive salaries and to compensate executive officers for individual
and Company performance that contribute to achievement of the Companys
objectives.

Base Salary. Annual salary recommendations for the Companys executive
officers (other than the Chief Executive Officer) were made to the Board by the
Chief Executive Officer. The Board of Directors reviewed the recommendations,
taking into consideration the competitive level of salaries in the industry,
the absence of equity-based compensation, the performance of the department
under the executive officers management control, achievement of operational
objectives and the individual executive officers responsibilities,
contribution and performance. Following its review, the Board of Directors then
approved, with any modifications it deemed appropriate, or disapproved the
recommendations made by the Chief Executive Officer. Because of the Companys
performance in fiscal 2001, with the exception of a limited number of
individuals, the salaries of the Companys executive officers generally were
not increased in fiscal 2002 from fiscal 2001 levels.

Annual Bonus. The Companys Chief Executive Officer, Chief Operating Officer,
Chief Marketing Officer and Chief Financial Officer are eligible for annual
bonus awards based on the Companys bonus plan, which was established during
1998. Awards under the plan are granted to compensate key executive officers
for increases in their management responsibility, achievement of operational
objectives and the absence of equity-based compensation. In light of the
Companys performance in fiscal 2001, the Board did not increase bonus awards
in fiscal 2002 from fiscal 2001 levels.

Chief Executive Officers Compensation

The Companys Chief Executive Officers base annual compensation for fiscal
2002 was determined by evaluating the factors discussed above in connection
with reviewing salary recommendations for executive officers of the Company,
assessing the overall performance of the Chief Executive Officer, comparing the
base salary of the Chief Executive Officer to that of other chief executive
officers in the music retail industry and evaluating the performance of the
Company. The Chief Executive Officers base annual

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compensation for fiscal 2002 was not increased from his base annual
compensation in fiscal 2001.

The foregoing Report on Executive Compensation shall not be deemed to be
incorporated by reference by any general statement incorporating by reference
this Form 10-K into any filings of the Company pursuant to the Securities Act
of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except
to the extent the Company specifically incorporates the Report on Executive
Compensation by reference therein, and shall not be deemed filed under either
such Act.



|The Board of Directors                                                 
|-----------------------------------------------------------------------
|                                                                       
|Russell M. Solomon
Michael T. Solomon
DeVaughn D. Searson
Robert Lorber

COMPENSATION OF DIRECTORS

Each member of the Board of Directors has been elected to serve until his
successor has been elected and qualified. The Companys employees who serve as
directors receive $3,000 as separate compensation for their services as
directors for each Board of Directors meeting attended. Because of the
Companys performance in fiscal 2001, this compensation was suspended after the
January 2002 Board meeting. Robert Lorber, the Companys only non-employee
director, received $69,000 plus expenses for his service as a director and
consultant to the Company during the Companys 2002 fiscal year, which included
$3,000 for each Board of Directors meeting attended.




ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth certain information regarding ownership of the
Companys Common Stock as of October 15, 2002 by (i) each person who is known
by the Company to own beneficially more than five percent of the Companys
Common Stock, (ii) each of the Companys directors, (iii) The Named Executive
Officers, and (iv) all directors and Named Executive Officers as a group.
Except as otherwise indicated, the Company believes that the beneficial owners
of the Companys Common Stock listed below have sole investment and voting
power with respect to such shares, subject to community property laws.

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|                                                  |  |                  |     |            |  |  |       |  
|------------------------------------------------- |  | ---------------- | --- | ---------- |  |  | ----- | -
|                                                  |  | Amount and       |     |            |  | 
|                                                  |  | Nature of        |     |            |  | 
|                                                  |  | Beneficial       |     | Percentage
|Name and Address of Beneficial Owner (a)          |  | Ownership (b)(c) |     | Ownership 
|                                                  |  |                  |     |           
|Russell M. Solomon (d)                            |  |                  | 620 |            |  |  | 62.00 | %
|Michael T. Solomon (e)                            |  |                  | 372 |            |  |  | 37.20 | %
|DeVaughn D. Searson                               |  |                  |    |            |  |  |      |  
|Stanley L. Goman (f)                              |  |                  |    |            |  |  |      |  
|Ronald Nugent (f)                                 |  |                  |    |            |  |  |      |  
|Keith Cahoon                                      |  |                  |    |            |  |  |      |  
|Andy Lown                                         |  |                  |    |            |  |  |      |  
|Robert Lorber                                     |  |                  |    |            |  |  |      |  
|                                                  |  |                  |     |            |  |  |       |  
|All directors and officers as a group (7
persons) |  |                  | 992 |            |  |  | 99.20 | %

(a)  The address of each named individual is the address of the principal
executive office of the Company as set forth herein.

(b)  The numbers presented indicate the number of shares beneficially owned.
Beneficial ownership is determined in accordance with the rules of the
Securities Exchange Commission and generally includes voting or investment
power with respect to securities. Shares of Common Stock subject to options or
warrants currently exercisable or exercisable within 60 days are deemed to be
beneficially owned by the person holding such option or warrant for computing
the percentage ownership of such person, but are not treated as outstanding for
computing the percentage of any other person. As of October 15, 2002, the
Company had no such options or warrants outstanding.

(c)  Such share amounts solely reflect indirect ownership of the Class B Common
Stock of the Company, the only outstanding class of capital stock of the
Company. There are 1,000 shares of Class B Common Stock of the Company
outstanding, all of which are owned by the Companys parent corporation, Tower
Records, Incorporated, and Russell Solomon beneficially owns 620 shares, or 62%
and Michael Solomon, beneficially owns 372 shares, or 37.2%, of the outstanding
Common Stock of Tower Records, Incorporated.

(d)  Russell Solomon has sole voting and investment power with respect to such
shares as Trustee of the Russell Solomon Trust.

(e)  Michael Solomon has sole voting and investment power with respect to 364 of
such shares as Trustee of the Michael T. Solomon 1994 Trust (the Michael
Solomon Trust), the David Solomon 1994 Trust (the David Solomon Trust), the
Andrew Solomon Trust, and the Aaron O. Solomon Trust, which own 180, 180, 2 and
2 of such shares, respectively. Michael Solomon is also the beneficiary of the
Michael Solomon Trust.

(f)  Mr. Gomans and Mr. Nugents employment with the Company was terminated on
October 14, 2002.




ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

LIFE INSURANCE

The Company maintains split-dollar insurance policies on the lives of Russell
M. Solomon and Doris E. Solomon for the benefit of the Michael Solomon Trust
and the David Solomon Trust. The aggregate annual premiums on such policies
paid by the Company are approximately $3.6 million. The Company will receive
the first proceeds of

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the policies up to the aggregate premiums paid by the Company after the
reorganization date plus $14,874,000 representing the cash value of the
policies when received by the Company in April 1998. The split-dollar life
insurance agreement was terminated as of October 11, 2002.

In addition, the Company maintains key-man life insurance policies on the
lives of certain executive officers of the Company. Aggregate annual premiums
on such policies are approximately $300,000. The Company is the beneficiary of
the key-man policies.

CERTAIN INDEBTEDNESS OF MANAGEMENT AND AFFILIATES

As of July 31, 2002, Russell Solomon, the Chairman and a director of the
Company, owed the Company $18,672 and $268,772 under loans from and a
merchandise account, respectively, with the Company, both of which are
interest-free.

As of July 31, 2002, Michael Solomon, President, Chief Executive Officer and a
director of the Company, owed the Company $36,956 under a merchandise account
with the Company, which is interest-free.

As of July 31, 2002, Stanley Goman, the Chief Operating Officer of the Company,
owed the Company $71,327 under an interest-free merchandise account, with the
Company.

The Company has accrued royalty fees payable to the Trusts for royalties
charged to them for the use of the Trusts trademarks and logos. The Company is
charged interest on the unpaid balance at current six month U.S. Treasury Bill
Rates, plus 250 basis points, or 7.04% at July 31, 2002. As of July 31, 2002,
the outstanding payable to the Trusts was approximately $15,491,000 and was
included in accounts payable. All such accrued royalty fees were paid to the
Trusts on October 11, 2002.

The Company made lease payments to Solomon Properties LLC, an affiliate of the
Trusts, of $567,000 in fiscal 2002.

EMPLOYMENT AND OTHER AGREEMENTS

For information regarding employment and other agreements between the Company
and its executive officers, please see Executive
CompensationEmployment
Agreements and Executive CompensationLimitation of Liability and
Indemnification Matters.

CERTAIN BUSINESS RELATIONSHIPS

In fiscal 2002, the Company contracted Searson & Company, Inc., Certified
Public Accountants, Inc., in the amount of $165,000 in consulting fees for
assistance in the corporate finance department related to year-end activities
and accrued an additional $23,261 in advisory services and cost reimbursement
related to the sale of the Companys Japan operations. Karen Searson, the
spouse of DeVaughn D. Searson, the Companys Chief Financial Officer, is the
majority owner of Searson & Co. In addition, the Company paid $172,382 to
Complete Data Services, Inc. for custodial and retrieval services related to
the Companys credit card transactions and chargebacks. Complete Data
Services, Inc. is owned by Karen Searson.

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ITEM 14. CONTROLS AND PROCEDURES

Not applicable.

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PART IV




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

(a)     1.       Financial Statements.

The financial statements listed in the accompanying index to financial
statements and financial statement schedules are filed or incorporated by
reference as part of this annual report.

2.     Financial Statement Schedules.

All financial statement schedules have been omitted because they are not
required or are not applicable, or the information is otherwise included.

3.     Exhibits.

The exhibits listed in the accompanying index to exhibits are filed or
incorporated by reference as part of this annual report.



|(a) |  | Reports on Form 8-K.                                                                                                                                                                                                                                                                                                                                    
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|    |  | On June 24, 2002, the Company filed a Form 8-K relating to the completion
of the Fourth Amendment dated as of June 23, 2002, to the Amended and
Restated Credit Agreement dated as of April 27, 2001, as amended, among
the Company, Tower Records Kabushiki Kaisha (TRKK), the lenders party
thereto and JPMorgan Chase Bank as administrative agent.
|   
|    |  | On July 23, 2002, the Company filed a Form 8-K relating to an agreement
on terms to refinance the Companys then-existing credit facility.                                                                                                                                                                                                              

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SIGNATURES

Pursuant to the requirements 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.

|                                           |  |                                                                |  |                 
|------------------------------------------ |  | -------------------------------------------------------------- |  | ----------------
|Signatures                                 |  | Title                                                          |  | Date            
|                                          
|/s/ RUSSELL M. SOLOMONRussell M. Solomon   |  | Chairman and Director                                          |  | November 5, 2002
|                                          
|/s/ MICHAEL T. SOLOMONMichael T. Solomon   |  | President and Director                                         |  | November 5, 2002
|                                          
|/s/ DEVAUGHN D. SEARSONDeVaughn D. Searson |  | Executive Vice President, Chief Financial
Officer and Director |  | November 5, 2002

| |  |     |  |                                                                                                                               
| |  | --- |  | ------------------------------------------------------------------------------------------------------------------------------
| |  |     |  | MTS, INCORPORATED                                                                                                             
| |  |     |  |                                                                                                                               
| |  |     |  | (Registrant)                                                                                                                  
| |  |     |  |                                                                                                                               
| |  | By: |  | /s/ DEVAUGHN D. SEARSON                                                                                                       
| |  |     |  |                                                                                                                               
| |  |     |  | DeVaughn D. SearsonExecutive Vice President, Chief Financial Officer and Director
(Principal Financial and Accounting Officer)

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CERTIFICATIONS

I, Michael T. Solomon, Chief Executive Officer of MTS, Incorporated, (the
Registrant), do hereby certify, pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, that:



|(1) |  | I have reviewed this Annual Report on Form 10-K of the Registrant (the
Report)                                                                                                                                                                                                                        
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Based on my knowledge, the Report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by the
Report.
|   
|(3) |  | Based on my knowledge, the financial statements, and other financial
information included in the Report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the Registrant, as of, and for, the periods presented in the Report.                  



|Dated:   November 5, 2002 | /s/ Michael T. SolomonMichael T. Solomon, Chief Executive Officer
|------------------------- | -----------------------------------------------------------------

I, DeVaughn D. Searson, Chief Financial Officer of MTS, Incorporated, (the
Registrant), do hereby certify, pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, that:



|(1) |  | I have reviewed this Annual Report on Form 10-K of the Registrant (the
Report)                                                                                                                                                                                                                        
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Based on my knowledge, the Report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by the
Report.
|   
|(3) |  | Based on my knowledge, the financial statements, and other financial
information included in the Report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the Registrant, as of, and for, the periods presented in the Report.                  



|Dated:   November 5, 2002 | /s/ DeVaughn D. SearsonDeVaughn D. Searson, Chief Financial Officer
|------------------------- | -------------------------------------------------------------------

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INDEX OF EXHIBITS

|        |  |  |     |  |  |                                                                                                                                                                                                                                             
|------- |  |  | --- |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |  |     |  |  | Description                                                                                                                                                                                                                                 
|       
|3.1     |  |  | (1) |  |  | Restated Articles of Incorporation of MTS, Incorporated filed
with the California Secretary of State on September 22, 1994                                                                                                                  
|       
|3.2     |  |  | (1) |  |  | Bylaws of MTS, Incorporated                                                                                                                                                                                                                 
|       
|4.1     |  |  | (2) |  |  | Purchase Agreement dated as of April 23, 1998 between the
Registrant, Chase Securities, Inc. and Merrill Lynch, Pierce,
Fenner & Smith Incorporated                                                                                         
|       
|4.2     |  |  | (2) |  |  | Indenture dated as of April 23, 1998 by and between the
Registrant and State Street Bank and Trust Company of
California, N.A., as Trustee                                                                                                  
|       
|4.3     |  |  | (2) |  |  | Exchange and Registration Rights Agreement dated as of April
20, 1998 by and among the Registrant and Chase Securities Inc.
and Merrill Lynch, Pierce, Fenner & Smith Incorporated as the
initial purchases                                 
|       
|4.4     |  |  | (2) |  |  | Form of 9 3/8% Senior Subordinated Note due 2005                                                                                                                                                                                            
|       
|10.1    |  |  | (2) |  |  | Credit Agreement dated as of April 23, 1998 by and among the
Company, Tower Records Kabushiki Kaisha (TRKK), the Lenders
party thereto, and The Chase Manhattan Bank as Administrative
Agent                                              
|       
|10.2    |  |  | (1) |  |  | Japanese Security Agreement dated as of April 23, 1998                                                                                                                                                                                      
|       
|10.3    |  |  | (1) |  |  | MTS, Incorporated Security Agreement dated as of April 23, 1998                                                                                                                                                                             
|       
|10.4    |  |  | (3) |  |  | Agreement between the Company and Christopher Hopson dated as
of August 10, 2000                                                                                                                                                            
|       
|10.5    |  |  | (4) |  |  | Amended and Restated Credit Agreement dated as of April 27,
2001 by and among the Company, TRKK, the Lenders party
thereto, and The Chase Manhattan Bank as Administrative Agent                                                            
|       
|10.6    |  |  | (5) |  |  | First Amendment, dated as of October 5, 2001, to the Amended
and Restated Credit Agreement dated as of April 27, 2001 by
and among the Company, TRKK, the Lenders party thereto, and
The Chase Manhattan Bank as Administrative Agent       
|       
|10.7    |  |  | (6) |  |  | Stock Purchase Agreement, dated as of April 11, 2002, by and
between the Company and Valtona Holding B.V. (Valtona)                                                                                                                       
|       
|10.8    |  |  | (6) |  |  | Second Amendment, dated as of April 1, 2002, to the Amended
and Restated Credit Agreement dated as of April 27, 2001, as
amended, by and among the Company, TRKK, the Lenders party
thereto, and JPMorgan Chase Bank as Administrative Agent
|       
|10.9    |  |  | (7) |  |  | Letter Amendment dated May 21, 2002 to Stock Purchase
Agreement, dated as of April 11, 2002, by and between the
Company and Valtona                                                                                                         

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|        |  |  |      |  |  |                                                                                                                                                                                                                                                            
|------- |  |  | ---- |  |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |  |      |  |  | Description                                                                                                                                                                                                                                                
|       
|10.10   |  |  | (7)  |  |  | Third Amendment and Waiver, dated as of April 30, 2002, to the
Amended and Restated Credit Agreement dated as of April 27,
2001, as amended, by and among the Company, TRKK, the Lenders
party thereto, and JPMorgan Chase Bank as Administrative Agent    
|       
|10.11   |  |  | (8)  |  |  | Fourth Amendment, dated as of June 23, 2002, to the Amended
and Restated Credit Agreement dated as of April 27, 2001, as
amended, by and among the Company, TRKK, the Lenders party
thereto, and JPMorgan Chase Bank as Administrative Agent               
|       
|10.12   |  |  | (9)  |  |  | Letter Agreement dated as of August 14, 2002 between the
Company and Vespasianus Co., Ltd. (Vespasianus) amending
that certain Stock Purchase Agreement dated as of April 11,
2002 between the Company and Valtona, as assigned to
Vespasianus by Valtona
|       
|10.13   |  |  | (10) |  |  | Letter Agreement dated as of August 30, 2002 between the
Company and Vespasianus amending that certain Stock Purchase
Agreement dated as of April 11, 2002 between the Company and
Valtona, as assigned to Vespasianus by Valtona                          
|       
|10.14   |  |  | (11) |  |  | Letter Agreement dated as of September 13, 2002 between the
Company and Vespasianus amending that certain Stock Purchase
Agreement dated as of April 11, 2002 between the Company and
Valtona, as assigned to Vespasianus by Valtona                       
|       
|10.15   |  |  | (12) |  |  | Fifth Amendment, dated as of September 12, 2002, to the
Amended and Restated Credit Agreement dated as of April 27,
2001, as amended, by and among the Company, TRKK, the Lenders
party thereto, and JPMorgan Chase Bank as Administrative Agent           
|       
|10.16   |  |  | (13) |  |  | Sixth Amendment, dated as of September 30, 2002, to the
Amended and Restated Credit Agreement dated as of April 27,
2001, as amended, by and among the Company, TRKK, the Lenders
party thereto, and JPMorgan Chase Bank as Administrative Agent           
|       
|10.17   |  |  | (13) |  |  | Letter Agreement dated as of September 27, 2002 between the
Company and Vespasianus amending that certain Stock Purchase
Agreement dated as of April 11, 2002 between the Company and
Valtona, as assigned to Vespasianus by Valtona                       
|       
|10.18   |  |  | (14) |  |  | Seventh Amendment and Consent, dated as of October 4, 2002, to
the Amended and Restated Credit Agreement dated as of April
27, 2001, as amended, by and among the Company, TRKK, the
Lenders party thereto, and JPMorgan Chase Bank as
Administrative Agent
|       
|10.19   |  |  | (15) |  |  | Loan and Security Agreement, dated October 9, 2002, by and
among the Company, Three As Holdings, L.L.C., the lenders
party thereto and The CIT Group/Business Credit, Inc., as
administrative and collateral agent                                        
|       
|10.20   |  |  | (15) |  |  | Amended and Restated Term Loan Agreement, dated as of October
9, 2002, among the Company, the lenders party thereto and
JPMorgan Chase Bank, as                                                                                                            

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|        |  |  |  |  |  |                                                                                      
|------- |  |  |  |  |  | -------------------------------------------------------------------------------------
|Exhibit |  |  |  |  |  | Description                                                                          
|       
|        |  |  |  |  |  | administrative agent and collateral agent                                            
|       
|10.21   |  |  |  |  |  | Retention agreement
between the Company and Keith Cahoon dated as of October 11, 2002
|       
|10.22   |  |  |  |  |  | Retention agreement
between the Company and Andy Lown dated as of August 9, 2002     
|       
|99.1    |  |  |  |  |  | Certification of Chief Executive Officer                                             
|       
|99.2    |  |  |  |  |  | Certification of Chief Financial Officer                                             



|(1)  |  | Previously filed with the Amendment No. 2 to the S-4 Registration
Statement on July 23, 1998   
|---- |  | -----------------------------------------------------------------------------------------------
|    
|    
|    
|    
|(2)  |  | Previously filed with the Companys Form S-4 Registration Statement on
June 1, 1998            
|    
|    
|    
|    
|(3)  |  | Previously filed with the Companys Report on Form 10-K for the fiscal
year ended July 31, 2000
|    
|    
|    
|    
|(4)  |  | Previously filed with the Companys Report on Form 10-Q for the quarter
ended April 30, 2001   
|    
|    
|    
|    
|(5)  |  | Previously filed with the Companys Report on Form 8-K dated October 8,
2001                   
|    
|    
|    
|    
|(6)  |  | Previously filed with the Companys Report on Form 8-K dated April 11,
2002                    
|    
|    
|    
|    
|(7)  |  | Previously filed with the Companys Report on Form 10-Q for the quarter
ended April 30, 2002   
|    
|    
|    
|    
|(8)  |  | Previously filed with the Companys Report on Form 8-K dated June 24,
2002                     
|    
|    
|    
|    
|(9)  |  | Previously filed with the Companys Report on Form 8-K dated August 16,
2002                   
|    
|    
|    
|    
|(10) |  | Previously filed with the Companys Report on Form 8-K dated September 3,
2002                 
|    
|    
|    
|    
|(11) |  | Previously filed with the Companys Report on Form 8-K dated September
13, 2002                
|    
|    
|    
|    
|(12) |  | Previously filed with the Companys Report on Form 8-K dated September
20, 2002                
|    
|    
|    
|    
|(13) |  | Previously filed with the Companys Report on Form 8-K dated October 3,
2002                   
|    
|    
|    
|    
|(14) |  | Previously filed with the Companys Report on Form 8-K dated October 9,
2002                   
|    
|    
|    
|    
|(15) |  | Previously filed with the Companys Report on Form 8-K dated October 18,
2002                  

72