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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                 --------------
                                    FORM 10-K
                                 --------------

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

                    FOR THE FISCAL YEAR ENDED JULY 31, 2001

                                       OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES 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                      (I.R.S. Employer
of Incorporation or Organization)                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

================================================================================

           SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

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     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. [ ]

        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 [X] NO [ ]

   As of July 31, 2001, 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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                                MTS, INCORPORATED
                                    FORM 10-K
                     FOR THE FISCAL YEAR ENDED JULY 31, 2001

                                      INDEX

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 Registrant's Common Stock 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 Disclosure About Market Risks
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

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K

SIGNATURES

                                     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 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

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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 exchange rates and economic and political
country 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 covenants as
prescribed by the Company's Amended and Restated Credit Agreement, as amended;
(xi) the ability of the Company to arrange for alternative debt or equity
financing commitments as required under the terms of the Company's Amended and
Restated Credit Agreement, as amended; (xii) the ability of the Company to meet
the mandatory commitment reductions under the Company's Amended and Restated
Credit Agreement, as amended; and (xiii) 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, 2001, the Company operated a total of 173 stores worldwide,
consisting of 106 U.S. stores in 20 states and 67 international stores in seven
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, software
titles, 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 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,


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including recent releases, older catalog releases and other various music
formats primarily in stand-alone 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, Osaka, Philadelphia, San Francisco, Seattle, Tokyo 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.

With the objective of increasing and diversifying its revenue base, Tower became
the first U.S.-based music retailer to implement an international growth
strategy. This expansion, which commenced in 1979, initially focused on the
Japanese market (which is currently the world's second largest market for
recorded music), and enabled Tower to become a market leader in Japan for
recorded music. Tower implemented a similar expansion strategy in the United
Kingdom beginning in 1986. The Company currently has more international
locations than any other U.S.-based music retailer, and for the 2001 fiscal
year derived approximately 42% of its total net revenues from international
sales. Tower currently operates 49 stores in Japan; eight in England; five in
Mexico, two in Ireland, one each in Singapore, Canada and Scotland. In addition,
the Company has entered into franchise agreements with local operators in
Colombia, Ecuador, Israel, Malaysia, The Philippines, Argentina, Hong Kong,
Taiwan, China and the United Arab Emirates.

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-year
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 up to nine under performing
domestic record, outlet and frame/gallery stores, and monitoring an additional
nine stores for possible future closure. The Restructuring Plan also contains
several initiatives intended to improve cash flow, including substantially
eliminating new store openings and remodeling plans, reducing overhead expenses,
reducing capital expenditures until internally generated cash flow will support
further growth, and reducing working capital. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Restructuring Plan."


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OPERATIONS

As of July 31, 2001, Tower operated a total of 173 stores worldwide, consisting
of 106 U.S. retail stores in 20 states and 67 international stores in seven
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. The Company's operations are directed by an Executive
Committee comprised of nine committee members.

UNITED STATES. As of July 31, 2001 the Company's U.S. operations consisted of
106 retail stores. In the United States, 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, 2001, Tower's Asian operations consisted of forty-nine
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 Asian store managers report to the
Director of Asian Operations located in Japan. Product is purchased through a
variety of sources worldwide.

UNITED KINGDOM AND IRELAND. As of July 31, 2001, the Company operated eight
stores in England, one in Scotland, 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.

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, Tower manages store operations, utilizing input from local
investors. The joint venture operation is managed from Tower's corporate
headquarters.

The Company has entered into franchise agreements to operate stores in Colombia,
Ecuador, Israel, Malaysia, The Philippines, Argentina, Hong Kong, Taiwan, China
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.


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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 web site 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 America Online and Yahoo.

STORE FORMAT AND LOCATIONS

Tower has differentiated itself from competing music retailers with its
strategic store 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 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. For the fiscal year ended July 31, 2001, the Company opened five
stores in the United States and ten stores internationally (including eight in
Japan), while closing 23 stores and converting six international stores to
franchises.

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, software titles, personal electronics
and accessories.

RECORDED MUSIC. The Company's primary source of revenue is the sale of recorded
music on compact discs and audiocassettes. For fiscal years 2001 and 2000,
recorded music sales accounted for approximately 86.3% and 87.8%, 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


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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, Osaka,
Philadelphia, San Francisco, Seattle, Tokyo 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 2001 and 2000, video sales
accounted for approximately 9.8% and 8.6%, 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 49% from fiscal 2000 to fiscal
2001.

COMPLEMENTARY PRODUCTS. To complement music buyers' interests, Tower stores also
sell books, magazines, blank tapes, software titles, personal electronics and
accessories. As of July 31, 2001, the Company operated four stand-alone
bookstores. For the fiscal years 2001 and 2000, sales of complementary products
accounted for approximately 3.9% and 3.6% 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, 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.


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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, and due to the Company's expanded
approach to co-op advertising, it receives substantial marketing support funds
from both its major and independent vendors, 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 enable 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 marketed through strategic alliances with well-known Internet
companies, such as America Online 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 the manufacturer 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 software titles 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
software titles may be returned to distributors for full refunds. Personal
electronics are generally not returnable for a full refund.


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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 managers to return the 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.

The Company uses its U.S. distribution operations 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, such as Japan. In
addition, the Company has an established export-wholesaling branch in Japan.
This enables the Company to export international catalog product to music
retailers, taking advantage of the economies of scale, while providing prompt
delivery.

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 America Online 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. Musicland recently agreed to be acquired by
Best Buy, both competitors of the Company. Time Warner Inc. was acquired by
America Online, Inc. Vivendi 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,

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acquired an interest in Napster. The Company believes that other major suppliers
of recorded music to the Company are exploring direct 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 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 or Virgin.

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

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


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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 prerecorded 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 2001 and
2000, 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 has
applications pending for a number of additional trademarks. 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.

EMPLOYEES

As of July 31, 2001, the Company employed approximately 6,795 persons, of whom
approximately 867 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 $297.7 million and the Company's shareholders' equity was $21.4
million at July 31, 2001. 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

<PAGE>

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 expires on April 23, 2002. At July 31, 2001 the
Company had $177 million outstanding. The Credit Facility is subject to maximum
borrowings, maximum leverage ratio tests and maintaining a minimum rolling
quarterly EBITDA. The Company is also required to reduce the outstanding balance
by $5 million in October 2001 and $10 million in December 2001. The Company's
future operating performance and ability to service or refinance the debt
outstanding under its senior subordinated notes and its Credit Facility will be
subject to the Company's ability to refinance its Credit Facility, future
economic conditions and to financial, business and other factors, many of which
are beyond the Company's control. There can be no assurance or guaranty that the
Company will be successful in refinancing or extending its Credit Facility or
that any renewal or extension will be on terms that are favorable to the
Company. In the event the Company is unable to refinance or extend its Credit
Facility, the Company's business, financial condition and results of operations
would be materially and adversely affected. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."

The Company's 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.

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


<PAGE>
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 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 "Business Competition--
Internet and Other." In addition, consolidation continues to occur in the home
entertainment industry. Musicland recently agreed to be acquired by Best Buy,
both competitors of the Company. Time Warner Inc. was acquired by America
Online, Inc. Vivendi 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. The Company believes
that other major suppliers of recorded music to the Company are exploring direct


<PAGE>

sales to the consumer via the Internet. These industry developments could
adversely impact the Company and its business, financial condition and results
of operations.

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 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. 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.


<PAGE>

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,
including its founder, Russell M. Solomon, 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's parent
corporation. 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 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, 2001, Tower's total leased space consisted of approximately 2.9
million square feet of space worldwide. As of July 31, 2001, the Company was a
party to approximately 228 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 2001 and 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-Electra-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 United States District Court for the Northern


<PAGE>

District of Illinois Eastern Division. The second action, filed on August 8,
2000, is entitled State of Florida et al vs. BMG et al, and 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 al, was 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 have been 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 January 2001, and the case is currently in
the discovery phase. At this stage in the litigation, it is difficult to assess
or predict potential outcome or risk to the Company, as these complaints do set
forth specific monetary damages claims. The Company intends to vigorously defend
itself against all charges.

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

No matters were submitted to a vote of the Company's shareholders during the
fourth quarter of fiscal 2001.

                                     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, 2001, Tower Records, Incorporated was the only shareholder
of record of the Company. See "Item 12. 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.

The Amended and Restated Credit Agreement governing the Company's existing
Credit Facility restricts the payment of dividends by the Company.


<PAGE>
ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>

                                                               FISCAL YEAR ENDED JULY 31,
                                              ----------------------------------------------------------
                                                2001         2000         1999         1998        1997
                                              --------     --------     --------     --------     ------
                                                                   (DOLLARS IN MILLIONS)
<S>                                           <C>          <C>          <C>          <C>          <C>
INCOME STATEMENT DATA:
  Net revenues .........................      $1,079.5     $1,099.9     $1,026.4     $1,008.1     $991.8
  Cost of sales (a) ....................         768.4        745.4        694.9        684.2      669.3
                                              --------     --------     --------     --------     ------
    Gross profit .......................         311.1        354.5        331.5        323.9      322.5
  Selling, general and
    administrative expenses(b) .........         294.7        301.4        276.3        269.3      267.6
  Restructuring and impairment costs ...          23.3          0.0          0.0          0.0        0.0
  Depreciation and
    amortization .......................          30.5         28.3         23.4         22.3       26.4
                                              --------     --------     --------     --------     ------
  (Loss)income from operations .........         (37.4)        24.8         31.8         32.3       28.5
  Other (income) expense:
  Interest expense .....................          25.2         21.0         17.6         14.9       14.3
  Foreign currency
    translation loss\(gain) ............           4.3          9.2         14.7         (1.1)       3.6
  Other expenses .......................           2.4          3.6          4.1          0.5        1.1
                                              --------     --------     --------     --------     ------
  (Loss)income before taxes,minority
    interest,extraordinary item,
    and cumulative effect of
    change in accounting principle .....         (69.3)        (9.0)        (4.6)        18.0        9.5
  Provision for income
    taxes ..............................          21.0          1.1          3.7          8.1        4.5
                                              --------     --------     --------     --------     ------
  (Loss)income before minority interest,
    extraordinary item, and
    cumulative effect of change
    in accounting principle ............         (90.3)       (10.1)        (8.3)         9.9        5.0
  Other items(c) .......................           0.0          0.0         (0.5)         0.0       (1.5)
                                              --------     --------     --------     --------     ------
  Net(loss)income ......................      $  (90.3)    $  (10.1)    $   (8.8)    $    9.9     $  3.5
                                              ========     ========     ========     ========     ======


BALANCE SHEET DATA (AT PERIOD END)
  Total assets .........................      $  527.0     $  627.3     $  586.2     $  545.4     $544.6
  Total debt (including
    current maturities) ................         297.7        311.6        283.1        231.9      211.3
  Shareholders' equity .................       $  21.4      $ 107.4      $ 115.7      $ 120.8     $134.0

</TABLE>

    (a) Includes $20.7 million of inventory write downs related to the
    Restructuring Plan in 2001 (See Note 2 to Consolidated Financial Statements)

    (b) Includes $2.7 million in professional fees related to the Restructuring
    Plan in 2001 (See Note 2 to Consolidated Financial Statements)

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


<PAGE>

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 discussion contains forward-looking
statements that involve known and unknown risks and uncertainties. Use of the
words "anticipates," "believes," "estimates," "expects," "intends," "plans" and
similar expressions are intended to identify forward-looking statements. 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 risks; (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 Credit
Agreement, as amended; (xi) the ability of the Company to meet the mandatory
commitment reductions under the Company's Amended and Restated Credit Agreement,
as amended; (xii) the ability of the Company to refinance or extend its Credit
Facility prior to the maturity thereof; and (xiii) 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 effect 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-year
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 up to nine under performing domestic record, outlet
and frame/gallery


<PAGE>
stores, and monitoring an additional nine stores for possible future closure.
The Restructuring Plan also contains several initiatives intended to improve
cash flow, including postponing new store openings and remodeling plans,
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. Since the plan was implemented, the Company has closed six 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. One store in Canada has
been closed and the remaining store is to be closed in the first quarter of
fiscal 2002. 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 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 is 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.

The Company expects to substantially complete implementation of the remainder of
the Restructuring Plan by the end of the first quarter of the Company's 2002
fiscal year. The Company will continue to record charges to operations for
restructuring costs, asset impairments and inventory reserves in the future. Due
to these additional restructuring charges, the Company anticipates that its
results of operations will be negatively impacted in the first quarter of 2002.

RESULTS OF OPERATIONS

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


<PAGE>
million internationally for the fiscal year ended July 31, 2000. Record and tape
sales for the period ended July 31, 2001 represented 86.3% of the Company's net
revenues versus 87.8% for the period ended July 31, 2000. Retail sales
represented 95.5% of the Company's net revenues for the twelve month period
ended July 31, 2001 versus 95.8% for the twelve month period 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, write-downs from closed operations
related to the restructuring initiatives, 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 and the liquidation of inventory from closed
operations associated with the Restructuring Plan.

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
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. The decrease was partly offset by
increases in distribution and store occupancy. As a percentage of net revenues,
selling, general and administrative expenses 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


<PAGE>

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 $32.0 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 $1.8 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 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 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 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 loss of $10.1 million for the fiscal year ended July 31, 2000. The
increase in 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 loss also includes an increase in
net operating losses related to international operations, which were closed
prior to July 31, 2001. The 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.


<PAGE>

FISCAL YEAR ENDED JULY 31, 2000 COMPARED TO FISCAL YEAR ENDED JULY 31, 1999

NET REVENUES. Net revenues were $1.1 billion for the fiscal year ended July 31,
2000, an increase of $73.5 million or 7.2% (or 3.0 % excluding the effects of
U.S. dollar foreign translation fluctuations) from $1.0 billion for the fiscal
year ended July 31, 1999. The Company's net revenues were derived from U.S.
revenues of $649.6 million and international revenues of $450.3 million for the
fiscal year ended July 31, 2000 compared to $616.1 million in the U.S. and
$410.3 million internationally for the fiscal year ended July 31, 1999. Record
and tape sales for the period ended July 31, 2000 represented 87.8% of the
Company's net revenues versus 86.1% for the period ended July 31, 1999. Retail
sales represented 95.8% of the Company's net revenues for the twelve month
period ended July 31, 2000 versus 96.6% for the twelve month period ended July
31, 1999. The increase in the Company's net revenues was primarily due to an
increase in new store expansion and same store sales growth. Comparable same
store sales growth was .6% which was predominately a reflection of gains in
domestic same store sales growth.

GROSS PROFIT. Gross profit was $354.5 million for the fiscal year ended July 31,
2000, an increase of $23.0 million or 6.9%, from $331.5 million for the fiscal
year ended July 31, 1999. Gross profit as a percentage of net revenues decreased
slightly to 32.2% for the fiscal year ended July 31, 2000 as compared to 32.3%
for the fiscal year ended July 31, 1999. The Company believes that the primary
factor contributing to the slight decline was competitive Internet pricing in
the United States associated with the Company's Internet growth and liquidation
losses associated with the closing of 22 VHS rental locations.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses were $301.4 million for the fiscal year ended July 31,
2000 an increase of $25.1 million or 9.1% from $276.3 million for the fiscal
year ended July 31, 1999. As a percentage of net revenues, selling, general and
administrative expenses increased .5% for the fiscal year ended July 31, 2000 as
compared to the fiscal year ended July 31, 1999, primarily due to moderate
increases in wages and rents in the United States and Japan, increased costs
resulting from the Company's Internet activities and increased overhead costs in
the United Kingdom and Latin America, resulting from decreasing sales.

DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense was $28.3
million for the fiscal year ended July 31, 2000 compared to $23.4 million for
the fiscal year ended July 31, 1999, an increase of approximately $4.9 million,
primarily due to a change in useful lives of its technology and intangible
assets, in compliance with SOP 98-5.

INCOME FROM OPERATIONS. Income from operations was $24.8 million for the fiscal
year ended July 31, 2000 a decrease of $7.0 million from $31.8 million for the
fiscal year ended July 31, 1999. As a percentage of net revenues, income from
operations decreased to 2.3% for the fiscal year ended July 31, 2000 from 3.1%
for the fiscal year ended July 31, 1999, due primarily from increased losses
associated with the Company's Latin American and Internet operations, the rise
in depreciation and amortization expense, and the increase in selling, general
and administrative costs.


<PAGE>
OTHER EXPENSE. Other expense net was $33.8 million for the fiscal year ended
July 31, 2000 compared to $36.4 million for the fiscal year ended July 31, 1999,
which represented a decrease of $2.6 million, primarily due to a reduction in
net non-cash foreign currency transaction loss of $9.2 million for the fiscal
year ended July 31, 2000 compared to a net foreign currency transaction loss of
$14.7 million for the fiscal year ended July 31, 1999. This non-cash loss
largely represented the translation back to U.S. dollars at the spot rate of the
Company's 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 yen and more recently the pound sterling as
well as other Asian currencies against the U.S. dollar. Additionally, net
interest expense increased to $21.0 million for the fiscal year ended July 31,
2000, as compared with $17.6 million for the fiscal year ended July 31, 1999.
This increase was largely due to an increase in borrowings under the Credit
Facility coupled with higher interest costs.

NET LOSS. As a result of the above, the Company reported a net loss of $10.1
million for the fiscal year ended July 31, 2000, an increase of $1.3 million
from a loss of $8.8 million for the fiscal year ended July 31, 1999.

LIQUIDITY AND CAPITAL RESOURCES

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.

Net cash provided by operating activities was $44.7 million and $30.2 million
for the fiscal years ended July 31, 2001 and 2000, respectively. In fiscal 2001,
net reduction in inventory was $23.6 million, which included a $20.7 million
write-down of inventory related to the Company's restructuring plan. Increase in
inventory was $21.7 million for fiscal 2000. The increase in cash flow from
operations for fiscal 2001 compared to fiscal 2000 were primarily due to more
aggressive management of working capital as part of the Company's restructuring
plan.

Net cash used for investing activities was driven primarily by capital
expenditures on stores, including the opening of five stores in the United
States, ten stores internationally along with 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 2001 was $13.6 million, resulting
principally from proceeds from life insurance loans. Net borrowings under the
Company's Credit Facility increased $0.7 million during fiscal 2001. Net cash
provided by financing in fiscal 2000 was $18.2 million, which resulted primarily
from net borrowings under the Company's Credit Facility.

Interest payments on the senior subordinated notes and on the Credit Facility
will continue to impose significant liquidity demands upon the Company. 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

<PAGE>
2002 are expected to be approximately $15.0 million, of which approximately
$11.9 million will be related to maintenance, required technological and capital
improvements.

The Company's Senior Credit Facility (Credit Facility) expires April 23, 2002.
The Company intends to refinance the Credit Facility prior to expiration and
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
expected capital expenditures and other operating expenses for the next twelve
months.

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. 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 (Yen)15,596,828,718, which was equivalent to
$126.6 million at inception), with a maturity date of April 23, 2002. Maximum
borrowings under the Credit Facility are scheduled to decline during its
one-year term by $15.0 million in July 2001, $5.0 million in October 2001, and
$10 million in December 2001.

Maximum borrowings under the Credit Facility are subject to a borrowing base
formula, maximum leverage ratio tests and maintaining a minimum rolling
quarterly EBITDA. As of July 31, 2001, approximately $210.0 million was
available under the Senior Credit Facility, of which $177.1 million had been
drawn. The $177.1 million includes a decrease of $14.6 million due to yen debt
translated back to U.S. dollars at the spot rate on July 31, 2001.

The Company's future operating performance and ability to service or refinance
the notes and the Credit Facility will be subject to the Company's ability to
refinance its Credit Facility maturing April 23, 2002, future economic
conditions and financial, business and other factors, many of which are beyond
the Company's control. There can be no assurance or guaranty that the Company
will be successful in refinancing or extending its Senior Credit Facility or
that any renewal or extension will be on terms that are favorable to the
Company. In the event the Company is unable to refinance its Credit Facility,
the Company's business, financial condition and results of operations would be
materially and adversely affected.

The Credit Facility and the 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 Credit Facility and
the 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
leaseback transactions, make investments, loans or advances and make
acquisitions.

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,


<PAGE>

more specifically, the mall-based retailers rely heavily on the calendar fourth
quarter to achieve annual sales and profitability results. Tower's deep-catalog
approach to prerecorded 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 this reliance on the U.S. holiday shopping season.
Nevertheless, in each of fiscal 2001 and 2000, the second quarter (November 1
through January 31) accounted for approximately 30% of annual sales. See Note 15
to Consolidated Financial Statements.

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

The Company has 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 "Business Risk Factors--Foreign Currency Fluctuations
and Other Risks Related to the Company's International Operations Could
Adversely Affect the Company's Business" 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 impairment.
The previous accounting principles governing goodwill generated from a business
combination will cease upon adoption of SFAS 142.


<PAGE>

Currently, the Company is assessing but has not yet determined how the adoption
of SFAS 141 and SFAS 142 will impact its financial position and results of
operations.

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 Credit Facility are based
on variable rates. If the base borrowing rates (primarily a combination of LIBOR
and TIBOR) were to increase 1% in fiscal 2002 as compared to the rate at July
31, 2001, the Company's interest expense related to its Credit Facility for
fiscal 2002 would increase approximately $1.8 million based on the outstanding
balance of the Company's Credit Facility at July 31, 2001.

A substantial 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, primarily Japanese
yen. The Company uses forward exchange contracts to hedge intercompany
transactions with foreign subsidiaries and affiliates, and in connection with
certain of its 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
fluctuations on net income and shareholder's equity. At July 31, 2001, the
Company had outstanding forward exchange contracts maturing on dates through
October 2001, to buy approximately $1,500,000 in foreign currency (186 billion
yen at the contract rate). The fair value of the contracts as of July 31, 2001
was 188 billion yen.

To finance expansion and operations in Japanese markets, the Company has entered
into 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, but it may do so from time to time in the future.


<PAGE>

The Company engaged a third party to analyze the sensitivity of the Company's
operations to fluctuations in the exchange rate between U.S. dollars and
Japanese Yen. The analysis made various assumptions for exchange rates, and
assumed that the results of the Japanese operations would remain consistent with
recent history. According to this analysis, the Japanese operation provides a
natural hedge against any impact of changes in foreign exchange rates on the
company's Yen denominated debt. Based on the results of this analysis, the
Company concluded that a change in exchange rates from year-end levels would not
materially affect the Company's results of operations.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The following are included
herein:




Report of Independent Public Accountants

Consolidated Balance Sheets as of July 31, 2001, and 2000

Consolidated Statements of Operations for the fiscal years ended July 31, 2001,
2000, and 1999

Consolidated Statements of Shareholder's Equity for the fiscal years ended July
31, 2001, 2000 and 1999

Consolidated Statements of Cash Flows for the fiscal years ended July 31, 2001,
2000, and 1999

Notes to Consolidated Financial Statements


<PAGE>

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To MTS, Incorporated and Subsidiaries:

We have audited the accompanying consolidated balance sheets of MTS,
INCORPORATED (a California corporation) and Subsidiaries as of July 31, 2001 and
2000, and the related consolidated statements of operations, changes in
shareholder's equity and cash flows for the three years then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of MTS, Incorporated and
subsidiaries as of July 31, 2001 and 2000, and the results of their operations
and their cash flows for the three years then ended in conformity with
accounting principles generally accepted in the United States.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 2 to the
financial statements, the Company's Senior Revolving Credit Facility (Credit
Facility), which at July 31, 2001 has an outstanding balance of $177 million,
matures April 2002. The Company's future operating performance, ability to meet
the Credit Facility maturity and other obligations are dependent upon the
Company's ability to refinance the Credit Facility and other factors. In the
event that the Company is unable to refinance the Credit Facility, the Company's
financial position and results of operations would be materially and adversely
affected. These conditions raise substantial doubt about the Company's ability
to continue as a going concern. Management's plan in regard to this matter is
described in Note 2. The financial statements do not include any adjustments
that might result from the outcome of this uncertainty, except for the
valuation allowance on the Company's deferred tax assets described in Note 12.



/S/ Arthur Andersen LLP

Sacramento, CA
October 25, 2001


<PAGE>

                               MTS, INCORPORATED
                           CONSOLIDATED BALANCE SHEETS
                          AS OF JULY 31, 2001 AND 2000

                             (DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                July 31,
                                                                      ---------------------------
                                                                        2001               2000
                                                                      ---------         ---------
<S>                                                                   <C>               <C>
ASSETS
Current Assets:
   Cash and cash equivalents .................................        $  32,075         $  21,486
   Receivables, less allowance for doubtful accounts of $1,685
   and $2,185, respectively ..................................           31,805            31,457
   Merchandise inventories ...................................          249,128           293,429
   Prepaid expenses ..........................................            8,970            12,728
   Deferred tax assets .......................................               --            12,694
                                                                      ---------         ---------
      Total current assets ...................................          321,978           371,794
   Fixed assets, net .........................................          178,021           207,440
   Deferred tax assets .......................................               --             9,648
   Other assets ..............................................           26,976            38,396
                                                                      ---------         ---------
      Total assets ...........................................        $ 526,975         $ 627,278
                                                                      =========         =========
LIABILITIES AND SHAREHOLDER'S EQUITY
Current Liabilities:
   Current maturities of long-term debt ......................        $ 179,374         $ 191,325
   Accounts payable ..........................................          163,336           165,701
   Reserve for restructuring costs ...........................            2,225                --
   Accrued liabilities .......................................           39,399            39,456
   Income taxes payable ......................................               --                95
   Deferred revenue, current portion .........................            2,780             2,959
                                                                      ---------         ---------
      Total current liabilities ..............................          387,114           399,536
Long-term Liabilities:
   Long-term debt, less current maturities ...................          118,341           120,238
   Deferred revenue, less current portion ....................              131               144
                                                                      ---------         ---------
      Total liabilities ......................................          505,586           519,918
                                                                      ---------         ---------

Commitments and contingencies (Notes 11,16 and 17)

Shareholder's Equity:
   Common stock:
     Class B, no par value; 10,000,000 shares authorized;
        1,000 shares issued and outstanding at July 31,
        2001 and 2000 ........................................                6                 6
   Retained earnings .........................................           35,848           126,138
   Accumulated other comprehensive income ....................          (14,465)          (18,784)
                                                                      ---------         ---------
     Total shareholder's equity ..............................           21,389           107,360
                                                                      ---------         ---------
     Total liabilities and shareholder's equity ..............        $ 526,975         $ 627,278
                                                                      =========         =========

</TABLE>


   The accompanying notes are an integral part of these financial statements.


<PAGE>




                                MTS, INCORPORATED
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                FOR THE YEARS ENDED JULY 31, 2001, 2000 AND 1999

              (DOLLARS IN THOUSANDS, EXCEPT PER SHARE INFORMATION)


<TABLE>
<CAPTION>
                                                                 FOR THE YEARS ENDED JULY 31,
                                                   ---------------------------------------------------
                                                       2001                2000               1999
                                                   -----------         -----------         -----------
<S>                                                <C>                 <C>                 <C>
Net revenue ...............................        $ 1,079,519         $ 1,099,931         $ 1,026,379
Cost of sales(a) ..........................            768,393             745,376             694,910
                                                   -----------         -----------         -----------
   Gross profit ...........................            311,126             354,555             331,469
Selling, general and administrative
   expenses(b) ............................            294,681             301,445             276,262
Restructuring and asset impairment costs ..             23,329                  --                  --
Depreciation and amortization .............             30,495              28,320              23,387
                                                   -----------         -----------         -----------
   (Loss) income from operations ..........            (37,379)             24,790              31,820
Other income and (expenses):
   Interest expense .......................            (25,234)            (20,993)            (17,596)
   Foreign currency translation loss ......             (4,306)             (9,204)            (14,713)
   Other expenses .........................             (2,430)             (3,585)             (4,068)
                                                   -----------         -----------         -----------
      Loss before taxes, minority interest
         and  cumulative effect of change
         in accounting principle ..........            (69,349)             (8,992)             (4,557)
Provision for income taxes ................             20,941               1,148               3,774
                                                   -----------         -----------         -----------
   Loss before cumulative effect of change
      in accounting principle .............            (90,290)            (10,140)             (8,331)
                                                   -----------         -----------         -----------

Cumulative effect of change in accounting
   principle, net of income taxes of $317..                 --                  --                (475)
                                                   -----------         -----------         -----------
   Net loss ...............................        $   (90,290)        $   (10,140)        $    (8,806)
                                                   ===========         ===========         ===========
Basic and diluted loss per share ..........        $(90,290.12)        $(10,139.85)        $ (8,805.57)
                                                   ===========         ===========         ===========

</TABLE>

(a)  Includes $20.7 million of inventory write downs related to Restructuring
     Plan in 2001 (See Note 2 to Consolidated Financial Statements)

(b)  Includes $2.7 million in professional fees related to the Restructuring
     Plan in 2001 (See Note 2 to Consolidated Financial Statements)

   The accompanying notes are an integral part of these financial statements.


<PAGE>




                                MTS, INCORPORATED
           CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY
                FOR THE YEARS ENDED JULY 31, 2001, 2000, AND 1999

                             (DOLLARS IN THOUSANDS)


<TABLE>
<CAPTION>
                                                  COMMON STOCK
                                 ------------------------------------------------                  ACCUMULATED
                                         SERIES A                SERIES B                             OTHER
                                 -----------------------    ----------------------    RETAINED    COMPREHENSIVE
                                  SHARES         AMOUNT       SHARES       AMOUNT     EARNINGS       INCOME         TOTAL
                                 ---------     ---------    ---------    ---------    ---------     ---------     ---------
<S>                              <C>           <C>          <C>          <C>          <C>           <C>           <C>
Balance, July 31, 1998 .........        --           $--        1,000         $  6    $ 145,084     $ (24,292)    $ 120,798
   Comprehensive income:
   Net income ..................        --            --           --           --       (8,806)           --        (8,806)
   Foreign translation
   adjustment, net of taxes ....        --            --           --           --           --         3,710         3,710
                                                                                                                  ---------
   Total comprehensive income ..                                                                                     (5,096)
                                 ---------     ---------    ---------    ---------    ---------     ---------     ---------
Balance, July 31, 1999 .........        --            --        1,000            6      136,278       (20,582)      115,702
   Comprehensive income:
   Net loss ....................        --            --           --           --      (10,140)           --       (10,140)
   Foreign translation
   adjustment, net of taxes ....        --            --           --           --           --         1,798         1,798
                                                                                                                  ---------
Total comprehensive income .....                                                                                     (8,342)
                                 ---------     ---------    ---------    ---------    ---------     ---------     ---------
Balance, July 31, 2000 .........        --            --        1,000            6      126,138       (18,784)      107,360
   Comprehensive income:
   Net loss ....................        --            --           --           --      (90,290)           --       (90,290)
   Foreign translation
   adjustment, net of taxes ....        --            --           --           --           --         4,319         4,319
                                                                                                                  ---------
Total comprehensive income .....                                                                                    (85,971)
                                 ---------     ---------    ---------    ---------    ---------     ---------     ---------
Balance, July 31, 2001 .........        --           $--        1,000          $ 6    $  35,848     $ (14,465)    $  21,389
                                 =========     =========    =========    =========    =========     =========     =========
</TABLE>

   The accompanying notes are an integral part of these financial statements.

<PAGE>

                                MTS, INCORPORATED
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                FOR THE YEARS ENDED JULY 31, 2001, 2000 AND 1999
                             (DOLLARS IN THOUSANDS)



<TABLE>
<CAPTION>
                                                                    FOR THE YEARS ENDED JULY 31,
                                                             ------------------------------------------
                                                               2001             2000             1999
                                                             --------         --------         --------
<S>                                                          <C>              <C>              <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net loss ............................................     $(90,290)        $(10,140)        $ (8,806)
   Adjustments to reconcile net loss to net cash
      provided by operating activities:
      Depreciation and amortization ....................       33,199           30,658           27,870
      Restructuring costs ..............................       42,083               --               --
      Provision for losses on accounts receivable ......         (500)             289              286
      Loss on disposal of assets .......................        6,199            7,076            5,547
      Exchange loss ....................................        6,130           12,556           14,096
      Other non-cash expense (income) ..................          448              176             (247)
      Provision (benefit) from deferred taxes ..........       26,932           (3,151)            (260)
      Cumulative effect of change in accounting
         principle .....................................           --               --              475
      (Decrease) increase in cash resulting
         from changes in:
         Accounts receivable ...........................         (348)          (5,079)          (3,283)
         Inventories ...................................       23,626          (21,716)         (10,710)
         Prepaid expenses ..............................        3,758           (1,516)          (4,593)
         Accounts payable ..............................       (6,218)          15,369           (7,111)
         Accrued liabilities and income taxes payable ..         (152)           5,823            1,884
         Deferred revenue ..............................         (192)            (152)            (166)
                                                             --------         --------         --------
            Net cash provided by operating activities ..       44,675           30,193           14,982
                                                             --------         --------         --------
CASH FLOWS FROM INVESTING ACTIVITIES:
   Acquisition of fixed assets .........................      (25,569)         (39,999)         (39,799)
   Acquisition of investments ..........................       (3,100)          (3,301)          (3,481)
   Increase in deposits ................................         (393)            (457)            (434)
   Refund of deposits ..................................          155               28              247
   Increase in intangibles .............................       (3,624)            (429)            (899)
                                                             --------         --------         --------
            Net cash used in investing activities ......      (32,531)         (44,158)         (44,366)
                                                             --------         --------         --------
CASH FLOWS FROM FINANCING ACTIVITIES:
   Loans to shareholder, officers and employees ........           --               --             (277)
   Proceeds from employee loan repayments ..............          373              280              292
   Proceeds from life insurance loans ..................       12,461               --               --
   Principal payments under long-term
      financing agreements .............................      (74,453)         (61,736)          (2,495)
   Proceeds from issuance of long-term
      financing agreements .............................       75,198           79,651           29,306
                                                             --------         --------         --------
            Net cash provided by financing activities ..       13,579           18,195           26,826
                                                             --------         --------         --------
Effect of exchange rate changes on cash ................      (15,134)          (7,449)          12,654
                                                             --------         --------         --------
            Net increase (decrease) in cash and
               cash equivalents ........................       10,589           (3,219)          10,096
Cash and cash equivalents, beginning of period .........       21,486           24,705           14,609
                                                             --------         --------         --------
Cash and cash equivalents, end of period ...............     $ 32,075         $ 21,486         $ 24,705
                                                             ========         ========         ========
Cash paid for interest .................................     $ 25,274         $ 21,094         $ 17,772
                                                             ========         ========         ========
Cash paid for income taxes .............................     $    605         $  6,581         $  5,709
                                                             ========         ========         ========
</TABLE>

   The accompanying notes are an integral part of these financial statements.



<PAGE>

                                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 7 to 10 years, and
equipment and vehicles over 5 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 non-capital nature incurred prior to opening
of new stores are expensed as incurred.


<PAGE>

INTANGIBLES--Intangibles primarily represent the excess of cost over the fair
value of businesses acquired and debt issuance costs. The Company amortizes
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, software
titles, 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 consolidation into
the financial statements is reported as a separate component of shareholder's
equity. Some transactions of the Company and its foreign subsidiaries are


<PAGE>

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 shareholder's 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.

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 ($10,319,000), ($9,060,000) and
($8,025,000) for the years ended July 31, 2001, 2000 and 1999, respectively.

USE OF ESTIMATES--The preparation of financial statements in conformity with
generally accepted accounting principles 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 The Company adopted Statement of Financial
Accounting Standards (SFAS) No. 130, REPORTING COMPREHENSIVE INCOME, and SFAS
No. 131, DISCLOSURE ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, in
fiscal year 1999, as reflected in the accompanying financial statements and
notes herein.

SFAS No. 130 establishes standards for reporting and display of comprehensive
income and its components in a financial statement that is displayed with the
same prominence as other financial statements. Comprehensive income is a measure
of all changes in the equity of the Company as a result of recognized
transactions and other economic events of the period other than transactions
with shareholders in their capacity as shareholders. Comprehensive income is
reflected on the consolidated statements of changes in shareholders' equity.

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


<PAGE>

resources to segments.

The Company is a worldwide specialty retailer of prerecorded 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. Geographic presentation relating to the Company's foreign operations is
disclosed in Note 14.

SFAS No. 133. 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 reported adjustments to
fair value through income. The effects to the financial statements were
immaterial.

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 impairment.
The previous accounting principles governing goodwill generated from a business
combination will cease upon adoption of SFAS 142.

Currently, the Company is assessing but has not yet determined how the adoption
of SFAS 141 and SFAS 142 will impact its financial position and results of
operations.

RISKS RELATING TO INTERNATIONAL OPERATIONS--The Company has substantial
operations and assets located outside the United States, primarily in Japan and
the United Kingdom. With respect to international operations, principally all of
the Company's revenues and costs (including borrowing costs) are incurred in the
local


<PAGE>

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 adversely affect the Company's
business, financial position 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 they 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.

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-year 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 up to nine under performing domestic record, outlet
and frame/gallery stores, and monitoring an additional nine stores for possible
future closure. The Restructuring Plan also contains several initiatives
intended to improve cash flow, including postponing new store openings and
remodeling plans, reducing working capital, reducing overhead expenses and
reducing capital expenditures until internally generated cash flow will support
further growth.

The Company began implementing its Restructuring Plan shortly after its
adoption. Since the plan was implemented, the Company has closed six 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. One store in Canada has
been closed and the remaining store is to be closed in the first quarter of
fiscal 2002. 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 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


<PAGE>

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 is 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.

The Company expects to substantially complete implementation of the remainder of
the Restructuring Plan by the end of the first quarter of the Company's 2002
fiscal year. The Company will continue to record charges to operations for
restructuring costs, asset impairments and inventory reserves in the future.

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's Senior Credit Facility (Credit Facility) expires April 23, 2002.
The Company intends to refinance the Credit Facility prior to expiration. 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. 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
(Yen)15,596,828,718, which was equivalent to $126.6 million at inception), with
a maturity date of April 23, 2002. Maximum borrowings under the Credit Facility
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.

Maximum borrowings under the Credit Facility are subject to a borrowing base
formula, maximum leverage ratio tests and maintaining a minimum rolling
quarterly EBITDA. As of July 31, 2001, approximately $210.0 million was
available under the Senior Credit Facility, of which $177.1 million had been
drawn. The $177.1 million includes a decrease of $14.6 million due to yen debt
translated back to U.S. dollars at the spot rate on July 31, 2001, see Note 7.

The Company's future operating performance and ability to service or refinance
the notes and the Credit Facility will be subject to the Company's ability to
refinance its Credit Facility maturing April 23, 2002, the success of its
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 successful in refinancing or extending its Credit
Facility or that any renewal or extension will be on terms that are favorable to
the Company. In the event the Company is unable to refinance its Credit
Facility, the Company's business, financial position and results of operations
would be materially and adversely affected.


<PAGE>

Management's plans for addressing this uncertainty include focusing on cash flow
improvements and cost reductions related to the implementation of the
restructuring plan as well as refinancing the Credit Facility. 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 and is unable to refinance the Credit Facility,
the operations of the Company would be materially and adversely affected. These
conditions raise substantial doubt about the ability of the Company to continue
as a going concern. The accompanying financial statements do not include any
adjustment that might result from the outcome of these uncertainties.

NOTE 3--LOSS 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):


<TABLE>
<CAPTION>
                                                            FOR THE YEARS ENDED JULY 31,
                                               ---------------------------------------------------
                                                   2001               2000                1999
                                               -----------         -----------         -----------
  <S>                                            <C>                 <C>                 <C>
Loss available to common
   shareholder before cumulative effect
   of change in accounting principle ..        $(90,290)           $(10,140)           $ (8,331)
Cumulative effect of change in
   accounting principle ...............                 --                  --             (475)
                                               -----------         -----------         -----------
                                               $(90,290)           $(10,140)           $ (8,806)
                                               ===========         ===========         ===========
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 loss before cumulative
   effect of change in  accounting
   principle ..........................        $(90,290.12)        $(10,139.85)        $ (8,330.74)
   On cumulative effect of change in
   accounting principle ...............                 --                  --             (474.83)
                                               -----------         -----------         -----------
   On net loss ........................        $(90,290.12)        $(10,139.85)        $ (8,805.57)
                                               ===========         ===========         ===========

</TABLE>

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.

<PAGE>
NOTE 4--RECEIVABLES

Receivables consist of (in thousands):

<TABLE>
<CAPTION>
                                                             JULY 31,
                                                      ----------------------
                                                        2001           2000
                                                      -------        -------
<S>                                                   <C>         <C>
Trade receivables, less allowance for doubtful
 accounts of $1,257 and $1,597 for 2001 and
 2000, respectively ..........................        $23,333        $20,968
Officers and employee receivables, including
 notes, less allowance for doubtful accounts
 of $428 and $588 for 2001 and 2000,
 respectively ................................             83            870
Other receivables ............................          8,389          9,619
                                                      -------        -------
                                                      $31,805        $31,457
                                                      =======        =======
</TABLE>

The Company has receivables of approximately $11,835,000 and $9,141,000 from
sales of product for resale and supplies to foreign affiliates at July 31, 2001
and 2000 respectively, included in trade receivables.


NOTE 5--FIXED ASSETS

Fixed assets consist of (in thousands):

<TABLE>
<CAPTION>
                                                                JULY 31,
                                                       -------------------------
                                                         2001            2000
                                                       --------        ---------
<S>                                                    <C>             <C>
Land ..........................................        $  9,737        $  9,737
Buildings .....................................          19,101          19,118
Leasehold improvements ........................         144,630         169,859
Video rental ..................................           3,907           9,273
Store fixtures ................................          50,486          51,584
Equipment .....................................         141,623         139,765
Vehicles ......................................             461             516
                                                       --------        --------
                                                        369,945         399,852
Less: accumulated depreciation and amortization         191,924         192,412
                                                       --------        --------
                                                       $178,021        $207,440
                                                       ========        ========
</TABLE>

The cost to build new store fixtures and improvements includes a portion of
interest expense. Interest capitalized was $611,000 and $661,000 for the years
ended July 31, 2001 and 2000 respectively.

Depreciation and amortization of fixed assets was $32,452,000, $30,658,000 and
$27,280,000 for the years ended July 31, 2001, 2000 and 1999, respectively.

<PAGE>

NOTE 6--OTHER ASSETS

Other assets consist of (in thousands):

<TABLE>
<CAPTION>
                                                                  JULY 31,
                                                          ----------------------
                                                            2001           2000
                                                          -------        -------
<S>                                                       <C>            <C>
Notes receivable, officers and employees,
 less current portion ..............................      $ 1,084        $ 1,718
Investment in foreign joint ventures ...............        1,250          1,217
Securities and Artwork .............................           46             35
Cash surrender value of officers' life insurance ...        9,425         18,868
Deposits ...........................................        7,727          8,898
Goodwill, debt issuance costs and other intangible
 assets, net of accumulated amortization of
 11,096 for 2001 and $8,766 for 2000,
 respectively ......................................        7,444          7,660
                                                          -------        -------
                                                          $26,976        $38,396
                                                          =======        =======
</TABLE>

Cash surrender value of life insurance at July 31, 2001 includes $8,816,000, net
of loans, as to 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 $7,882,000 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 the Family Trusts. Premiums on these policies amount to
$3.6 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 $231,000, $282,000 and $280,000 in the years ended July 31,
2001, 2000, and 1999, respectively.

<PAGE>

NOTE 7--LONG-TERM DEBT

Long-term debt consists of (in thousands):

<TABLE>
<CAPTION>
                                                                JULY 31,
                                                         ------------------------
                                                           2001            2000
                                                         --------        --------
<S>                                                        <C>           <C>
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 (7.31% to 9.25% at July 31, 2001),
   principal due April 2002 .....................          61,000          74,000
 Yen-based, variable interest payable
   monthly (3.56% at July 31, 2001),
   principal due April 2002 .....................         116,069         114,055
Other obligations, 7.0% to 12.5%, principal
 and interest generally due in monthly
 installments, collateralized by certain
 real property, equipment and leasehold
 improvements ...................................          10,646          13,508
                                                         --------        --------
Total Long-term Debt ............................         297,715         311,563
Less Current Portion ............................         179,374         191,325
                                                         --------        --------
Non-current Debt ................................        $118,341        $120,238
                                                         ========        ========
</TABLE>

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
(Notes) and entering into a senior revolving Credit Facility (Credit Facility).
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
was $37,400,000 on July 31, 2001.

In April 2001, the Company extended and restated on a short-term basis its
outstanding obligations under its senior revolving Credit Facility. 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 (Yen)15,596,828,718, which was
equivalent to $126.6 million at inception), with a maturity date of April 23,
2002. Maximum borrowings under the Credit Facility were scheduled to decline
during its one-year term by $15 million in each of July and October 2001, and an
additional $95 million in December 2001. Maximum borrowings under the Credit
Facility are subject to a borrowing base formula, maximum leverage ratio tests
and maintaining a minimum rolling quarterly EBITDA. Borrowings are
collateralized by substantially all of the Company's assets and the capital
stock of its subsidiaries. The Credit Facility bears 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 are 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

<PAGE>

reductions and issuance of capital stock. At July 31, 2001 the Company was in
compliance with affirmative and negative covenants required to be met at July
31, 2001.

Subsequent to year-end, the Company completed an additional Amendment (the
Amendment) dated as of October 5, 2001, and effective September 2001 as to the
conditions set forth within the Amendment. Pursuant to the Amendment, the
maximum borrowings under the Credit Facility and are required to be reduced by
$5 million in October 2001 and $10 million in December 2001, instead of $15
million in October 2001 and $95 million in December 2001. The Amendment also
eliminates certain provisions of the Credit Facility, specifically those
requiring the Company to (1) provide firm commitments by October 1, 2001 for
financing or sale of assets that will reduce the commitments to $100,000,000 by
December 31, 2001 and (2) receiving proceeds of such financing or sale that
actually reduce the commitments to $100,000,000 by December 31, 2001. In
addition, the Amendment reduces the EBITDA and leverage ratio amounts that the
Company is required to meet. The Company paid a 0.0375% amendment fee to the
lenders. The recorded value of the Credit Facility approximates fair value at
July 31, 2001 due to the variable nature of rates.

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

<TABLE>
<CAPTION>
YEAR ENDING JULY 31,                                             MATURITIES
--------------------                                             ----------
<S>                                                              <C>
2002 ........................................................     $179,374
2003 ........................................................        2,176
2004 ........................................................        1,178
2005 ........................................................      111,121
2006 ........................................................           64
Thereafter ..................................................        3,802
                                                                  --------
     Total...................................................     $297,715
                                                                  ========
</TABLE>

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 Yen 2.200.000.000) outstanding.
This swap agreement expired in March 2001.

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 fixed rate long-term debt was
estimated based upon the discounted amount of future cash flows using rates
offered to

<PAGE>

the Company for debt of a similar nature using remaining average maturities and
taking into account the global markets in which funds are available to the
Company 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.

Risk Management Instruments - Foreign exchange and interest rate risk management
instruments are recorded at their estimated value based on quoted market prices
of comparable contracts.

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--SHAREHOLDER'S EQUITY

COMMON STOCK--The Company's articles of incorporation authorized 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)
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):

<TABLE>
<CAPTION>
YEAR ENDING JULY 31,                                               AMOUNT
--------------------                                              --------
<S>                                                              <C>
2002 .......................................................      $ 38,603
2003 .......................................................        37,637
2004 .......................................................        30,717
2005 .......................................................        28,884
2006 .......................................................        25,237
Thereafter .................................................       130,404
                                                                  --------
     Total Minimum Future Rental Payments ..................      $291,482
                                                                  ========
</TABLE>

<PAGE>

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, 2001, 2000 and 1999 are as follows (in thousands):

<TABLE>
<CAPTION>
                                       FOR THE YEARS ENDED JULY 31,
                                    --------------------------------
                                      2001        2000        1999
                                    -------     -------      -------
<S>                                 <C>         <C>          <C>
Minimum rentals ..............      $74,072     $74,845      $68,507
Contingent rentals ...........        6,076       6,204        5,392
                                    -------     -------      -------
                                    $80,148     $81,049      $73,899
                                    =======     =======      =======
</TABLE>

NOTE 12--INCOME TAXES

The provision for income taxes is allocated between income from operations,
cumulative effect of change in accounting principle, extraordinary loss on
extinguishment of debt and cumulative translation adjustments to shareholders'
equity. The provision for income taxes on income from operations consists of (in
thousands):

<TABLE>
<CAPTION>
                                         FOR THE YEARS ENDED JULY 31,
                                    --------------------------------------
                                      2001           2000           1999
                                    --------       --------       --------
<S>                                 <C>            <C>            <C>
Current:
 U.S. Federal ................      $ (4,829)      $    942       $  1,216
 State and Local .............         1,115          1,786          1,462
 Foreign .....................         1,366          1,571          1,356
                                    --------       --------       --------
                                      (2,348)         4,299          4,034
                                    --------       --------       --------
Deferred:
 U.S. Federal ................        25,366         (1,328)          (761)
 State and Local .............         1,567           (682)          (416)
 Foreign .....................        (3,644)        (1,141)           917
                                    --------       --------       --------
                                      23,289         (3,151)          (260)
                                    --------       --------       --------
Provision for income taxes ...      $ 20,941       $  1,148       $  3,774
                                    ========       ========       ========
</TABLE>

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):

<PAGE>

<TABLE>
<CAPTION>
                                                         FOR THE YEARS ENDED JULY 31,
                                         -------------------------------------------------------------
                                                 2001                 2000                 1999
                                         -------------------    -----------------    -----------------
                                          Amount     Percent    Amount    Percent    Amount    Percent
                                         -------     -------    ------    -------    ------    -------
<S>                                      <C>         <C>        <C>       <C>        <C>       <C>
Federal income tax, at statutory rate    (22,849)      35.0%    (3,147)    -35.0%    (1,595)    -35.0%
State and local income taxes, net of
 federal income tax benefit .........     (1,108)       1.7%      (352)     -3.9%      (169)     -3.7%
State franchise and capital tax .....        958       -1.5%       540       6.0%       513      11.3%
Change in valuation allowance .......     42,213      -64.7%     3,012      33.5%     3,507      76.9
Foreign taxes .......................      2,485       -3.8%     1,571      17.5%     1,710      37.5
Foreign tax credit recognized .......     (1,330)       2.0%    (1,244)    -13.8%      (903)    -19.8%
Other, principally permanent
 differences ........................        572       -0.9%       768       8.5%       711      15.6
                                         -------     -------    ------    -------    ------    -------
Provision for income taxes ..........     20,941      -32.2%     1,148      12.8%     3,774      82.8
                                         =======     =======    ======    =======    ======    =======
</TABLE>


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

<TABLE>
<CAPTION>
                                                                2001      2000
                                                              -------    -------
<S>                                                           <C>        <C>
Deferred tax assets:
 Foreign translation .....................................    $ 8,495    $ 7,758
 Foreign and other tax credits ...........................      5,105      3,688
 Cumulative translation adjustment to shareholders' equity     13,504     13,504
 Tax, but not book, gain on transactions between MTS
  and Trusts .............................................      2,636      2,964
 Net operating losses ....................................     19,218          0
 Vacation accrual ........................................      1,003        895
 Capitalized inventory costs .............................        583        629
 Differences between tax and accounting in
  inclusion of income from foreign operations ............        738      3,964
 Other nondeductible expenses and accelerated
  income items ...........................................        526        555
                                                              -------    -------
  Total deferred tax assets ..............................     51,808     33,957
                                                              -------    -------
Deferred tax liabilities:
 Depreciation and amortization ...........................      1,280      4,146
 Other accelerated deductions and deferred
  income items ...........................................      1,099        811
 State tax ...............................................        698        140
                                                              -------    -------
 Total deferred tax liabilities ..........................      3,077      5,097
                                                              -------    -------
  Net deferred tax assets before valuation allowance .....     48,731     28,860

Valuation allowance ......................................     48,731      6,518
                                                              -------    -------
Net deferred tax asset ...................................    $     0    $22,342
                                                              =======    =======
</TABLE>

<PAGE>

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

<TABLE>
<CAPTION>
                                                 July 31,
                                            ------------------
                                              2001       2000
                                            -------    -------
<S>                                         <C>        <C>
Current deferred tax assets ............    $     0    $12,694
Non-current deferred tax assets ........          0      9,648
                                            -------    -------
 Net deferred tax assets ...............    $     0    $22,342
                                            =======    =======
</TABLE>

During 2000, the Company established a valuation allowance in the amount of $6.5
million 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. 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
refinance its Credit Facility discussed in Note 2.

NOTE 13--EMPLOYEE BENEFITS

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

Pension expense under the pension plans amounted to $1,705,000, $2,516,000 and
$2,329,000 for the years ended July 31, 2001, 2000 and 1999, respectively.

SALARY DEFERRAL-- In October 1998, the Company established a salary deferral
plan (401(K) Plan). All employees with twelve months of service who have
attained age eighteen 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.

<PAGE>

NOTE 14--SEGMENT AND GEOGRAPHIC INFORMATION:

The Company operates predominantly in the recorded music retail industry.

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

<TABLE>
<CAPTION>
                                               FOR THE YEARS ENDED JULY 31,
                                       -------------------------------------------
                                           2001            2000            1999
                                       -----------     -----------     -----------
<S>                                    <C>             <C>             <C>
Net Revenue:
 United States:
  Unaffiliated customer sales .....    $   611,588     $   627,405     $   591,946
  Interarea transfers .............         19,678          22,233          24,136
                                       -----------     -----------     -----------
                                           631,266         649,638         616,082
                                       -----------     -----------     -----------
 Japan:
  Unaffiliated customer sales .....        365,116         359,909         313,204
  Interarea transfers .............             --              --              --
                                       -----------     -----------     -----------
                                           365,116         359,909         313,204
                                       -----------     -----------     -----------
 Great Britain and Ireland:
  Unaffiliated customer sales .....         54,669          57,805          62,273
  Interarea transfers .............              0           1,447           3,308
                                       -----------     -----------     -----------
                                            54,669          59,252          65,581
                                       -----------     -----------     -----------
 Other:
  Unaffiliated customer sales .....         28,468          31,132          31,512
  Interarea transfers .............             --              --              --
                                       -----------     -----------     -----------
                                            28,468          31,132          31,512
                                       -----------     -----------     -----------
  TOTAL ...........................    $ 1,079,519     $ 1,099,931     $ 1,026,379
                                       ===========     ===========     ===========
Operating income (loss):
 United States ....................    $   (53,764)         17,526     $    21,657
 Japan ............................         11,274          13,850          11,988
 Great Britain and Ireland ........         (4,107)         (1,279)            676
 Other ............................          9,218          (5,307)         (2,501)
                                       -----------     -----------     -----------
                                       $   (37,379)    $    24,790     $    31,820
                                       ===========     ===========     ===========
</TABLE>

<TABLE>
<CAPTION>
                                             July 31,
                                       --------------------
                                         2001        2000
                                       --------    --------
<S>                                    <C>         <C>
Identifiable assets:
 United States ....................    $359,903    $431,825
 Japan ............................     135,612     135,329
 Great Britain and Ireland ........      28,764      27,277
 Other ............................       2,696      32,847
                                       --------    --------
                                       $526,975    $627,278
                                       ========    ========
</TABLE>

United States net revenue includes export sales to non-affiliated customers of
$517,000, $1,435,000 and $2,107,000 for the years ended July 31, 2001, 2000 and
1999, respectively.

<PAGE>

NOTE 15--SELECTED UNAUDITED QUARTERLY INFORMATION (IN
THOUSANDS, EXCEPT PER SHARE)

<TABLE>
<CAPTION>
                             October 31,    January 31,      April 30,        July 31,        Fiscal
                                2000           2001            2001             2001           2001
                            -----------     -----------     -----------     -----------     -----------
<S>                         <C>             <C>             <C>             <C>             <C>
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)
  Loss per share .......    $   (732.78)    $ (5,461.72)    $(34,377.57)    $(49,718.05)    $(90,290.12)
</TABLE>

<TABLE>
<CAPTION>
                             October 31,    January 31,      April 30,        July 31,        Fiscal
                                1999           2000            2000             2000           2000
                            -----------     -----------     -----------     -----------     -----------
<S>                         <C>             <C>             <C>             <C>             <C>
Sales ..................    $   251,470     $   335,639    $   255,042     $   257,780     $ 1,099,931
Gross profits ..........         84,832          98,737         85,441          85,545         354,555
Net income (loss) ......         (1,429)          2,007         (4,253)         (6,465)        (10,140)
Income (loss)
  per share ............    $ (1,429.18)    $  2,007.34    $ (4,253.50)    $ (6,464.51)    $(10,139.85)
</TABLE>

NOTE 16--FORWARD EXCHANGE CONTRACTS

At July 31, 2001, the Company had outstanding forward exchange contracts
maturing on dates through October 2001, to buy approximately $1,500,000 in
foreign currency (186 billion yen at the contract rate). The fair value of the
contracts as of July 31, 2001 is 188 billion yen. 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 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 co-defendant 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.

<PAGE>

NOTE 18--RELATED PARTIES

The Company has accrued royalty fees payable to the Family 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 of 7.04% at July 31, 2001. The outstanding payable
to the Family Trust is approximately $12,966,000 and is included in accounts
payable.

In addition the Company had a note receivable at July 31, 1998 from the Trusts
for the purchase of the Japanese corporate headquarters office. The note was for
approximately 620 million yen ($4,283,247 at July 31, 1998) and was included in
other current receivables. The note was paid in full during the year ended July
31, 2000.

Additional related-party transactions include lease expense to an affiliate of
$616,000, $667,000 and $609,000 for the years ended July 31, 2001, 2000 and
1999, respectively.

As of July 31, 2001, the Chairman of the Company's Board of Directors owed the
Company $207,038 under an interest-free loan and a merchandise account with the
Company.

As of July 31, 2001, the Chief Executive Officer of the Company, owed the
Company $36,943 under an interest-free merchandise account with the Company.

As of July 31, 2001, the Chief Operating Officer of the Company, owed the
Company $126,821 under an interest-bearing loan and an interest-free merchandise
account with the Company.

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 July 31, 2001. Executive officers are appointed by the Board of
Directors and serve at the discretion of the Board.

<PAGE>

<TABLE>
<CAPTION>
                                                                                                           Years
                                                                                                           with
       Name                                 Age                      Position                              Tower
----------------------------------------    ---   ------------------------------------------------------   -----
<S>                                         <C>   <C>                                                      <C>
Russell M. Solomon .....................    76    Chairman and Board Member                                 41
Michael T. Solomon .....................    53    President and Chief Executive Officer                     14
DeVaughn D. Searson ....................    57    Chief Financial Officer, Executive Vice                   13
                                                  President, Secretary, Treasurer and Director
Stanley L. Goman .......................    53    Chief Operating Officer and Executive Vice President      34
Ronald Nugent ..........................    52    Chief Advertising Officer and Executive Vice President     1
Keith Cahoon ...........................    45    Senior Vice President--Far East Operations                23
Andy D. Lown ...........................    36    Senior Vice President--European Operations                16
Robert Lorber ..........................    54    Director                                                   3
</TABLE>

RUSSELL M. SOLOMON 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 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.

STANLEY L. GOMAN has been an employee of the Company since 1967 and currently
serves as Chief Operating Officer and Executive Vice President. Mr. Goman is a
member of the Company's Executive Committee. Mr. Goman has served as Chairman of
NARM's Board of Directors, and has also served as Chairman of the NARM Retail
Advisory Committee. Currently Mr. Goman serves on the Retail Advisory Committee.
Mr. Goman has also served on the Country Music Association's Board of Directors.

RONALD NUGENT joined the Company in 2000 as Executive Vice President, Chief
Marketing Officer. He is responsible for overseeing the development of
comprehensive marketing plans to support corporate branding, sales, revenue and
profit objectives of the Company. Previously Mr. Nugent has held executive
marketing positions at Breuners Home Furnishings Corporation, Lechmere and
Montgomery Ward. Mr. Nugent has over 27 years of retail experience in the areas
of strategic planning, advertising, consumer and market research, direct
marketing, merchandise presentation, event marketing and

<PAGE>

database marketing.

KEITH CAHOON has served as Managing Director of the Company's Far East
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 member
of the Company's Executive Committee. Mr. Lown also serves on the Executive
Committee, Operations Committee and Supervisory Committee of the British
Association of Record Dealers and on the Board of the British Phonographic
Association.

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.

<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

The following table sets forth compensation paid by the Company during each of
the Company's 2001, 2000, and 1999 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, 2001 (the" Named Executive Officers"):

<TABLE>
<CAPTION>
                                                            ANNUAL COMPENSATION
                                 -----------------------------------------------------------------------
                                                                                 OTHER            ALL
                                                                                ANNUAL           OTHER
 NAME AND PRINCIPAL                                                            COMPENSA-       COMPENSA-
      POSITION                   YEAR            SALARY           BONUS           TION          TION (a)
                                 ----           --------        --------       ---------       ---------
<S>                              <C>            <C>             <C>             <C>             <C>
Russell M. Solomon ......        2001           $632,780        $300,000        $ 36,000        $      0
Chairman                         2000            632,780         447,000          39,000           7,872
                                 1999            602,780         467,774           6,000           7,521

Michael T. Solomon ......        2001           $360,400        $100,000        $ 36,000        $      0(e)
President and CEO                2000            360,400         100,000          39,000           7,872
                                 1999            428,550         100,000           6,000           7,521

DeVaughn D. Searson .....        2001           $222,378        $100,000        $ 36,000        $      0
EVP and Chief Financial          2000            201,916         100,000          39,000           7,872
  Officer                        1999            221,977         255,000           6,000           7,521

Stanley L. Goman ........        2001           $222,349        $100,000        $ 27,000        $      0
EVP and Chief Operating          2000            210,900         100,000          11,437           7,872
  Officer                        1999            208,500         107,950          11,437           7,521

Ronald Nugent ...........        2001           $220,000        $ 34,629        $ 67,057        $      0
EVP and Chief Marketing          2000                  0               0               0               0
  Officer                        1999                  0               0               0               0

Keith Cahoon ............        2001(b)        $165,120        $      0        $ 73,968        $      0
SVP and Managing Director        2000(c)         189,358               0         101,152           7,872
  Far East Operations            1999(d)         181,053           7,544          85,743           7,521

</TABLE>


(a) Represents Company contributions to the Company's retirement plan.

(b) Calculated at an exchange rate of 125 Japanese yen per U.S. dollar.

(c) Calculated at an exchange rate of 109 Japanese yen per U.S. dollar.

(d) Calculated at an exchange rate of 114 Japanese yen per U.S. dollar.

(e) 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 Item 13. Certain Relationships and Related
    Transactions-Life Insurance.
<PAGE>

EMPLOYMENT AGREEMENTS

The Company has entered into a letter agreement with Ron Nugent as the Company's
Chief Marketing Officer. The letter agreement provides 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.
Although Mr. Nugent's employment may be terminated by either the Company or Mr.
Nugent at any time, in the event that the Company terminates Mr. Nugent's
employment without cause, Mr. Nugent will receive severance pay in an amount
equal to up to four months' salary for each full year that he is employed by the
Company and will be entitled to participate in certain future severance plans if
adopted by the Company.

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 that 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 2001 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 2001. Michael T.
Solomon was also the Company's President and Chief Executive Officer in fiscal
2001 and DeVaughn D. Searson was also the Company's Chief Financial Officer in
fiscal 2001.

<PAGE>

Russell Solomon and Michael Solomon entered into certain transactions with the
Company in fiscal 2001. As of July 31, 2001, Russell Solomon owed the Company
the $46,906 and $160,132 under loans from and a merchandise account,
respectively, with the Company, both of which are interest-free.

As of July 31, 2001, Michael Solomon owed the Company $36,943 under a
merchandise account with the Company, which is interest-free.

The Company has accrued royalty fees payable to the Michael Solomon 1994 Trust
and the David Solomon 1994 Trust (collectively, the "Trusts") for royalties
charged to them for the use of the Trust's 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, 2001. The outstanding payable
to the trust is approximately $12,966,000 and is included in accounts payable.

The Company made lease payments to Solomon Properties LLC, an affiliate of the
Trusts, of $616,000 in fiscal 2001.

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, 2001.

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 2000, with the exception of a limited number of individuals, the salaries
of the Company's executive officers generally were not increased in fiscal 2001
from fiscal 2000 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

<PAGE>

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 from fiscal 2000 levels.

CHIEF EXECUTIVE OFFICER'S COMPENSATION

The Company's Chief Executive Officer's base annual compensation for fiscal 2001
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 compensation for fiscal 2001
was not increased from his base annual compensation in fiscal 2000.

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. Robert Lorber, the
Company's only non-employee director, received $156,000 plus expenses for his
service as a director and consultant to the Company during the Company's 2001
fiscal year, which included $3,000 for each Board of Directors meeting attended.

<PAGE>

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 31, 2001 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.

<TABLE>
<CAPTION>
                                                           AMOUNT AND
                                                            NATURE OF
                                                           BENEFICIAL      PERCENTAGE
NAME AND ADDRESS OF BENEFICIAL OWNER(a)                  OWNERSHIP(b)(c)   OWNERSHIP
---------------------------------------                  ---------------   ----------
<S>                                                      <C>               <C>
Russell M. Solomon(d) .................................         620          62.00%
Michael T. Solomon(e) .................................         372          37.20%
DeVaughn D. Searson ...................................
Stanley L. Goman ......................................
Ronald Nugent .........................................
Keith Cahoon ..........................................
Andy Lown .............................................
Robert Lorber .........................................
                                                                ---          -----
All directors and officers as a group (7 persons) .....         992          99.20%
</TABLE>

(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 July 31, 2001, 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

<PAGE>

shares as Trustee of the Michael 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 1994 Trust.

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 certain family trusts. The
aggregate annual premiums on such policies paid by the Company are approximately
$3.6 million. The Company will receive the first proceeds of 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.

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 million. The Company is the beneficiary of
the key-man policies.

CERTAIN INDEBTNESS OF MANAGEMENT AND AFFILIATES

As of July 31, 2001, Russell Solomon, the Chairman and a director of the
Company, owed the Company the $46,906 and $160,132 under loans from and a
merchandise account, respectively, with the Company, both of which are
interest-free.

As of July 31, 2001, Michael Solomon, President, Chief Executive Officer and a
director of the Company, owed the Company $36,943 under a merchandise account
with the Company, which is interest-free.

As of July 31, 2001, Stanley Goman, the Chief Operating Officer of the Company,
owed the Company $56,214 under a loan from the Company bearing interest at 9.5%
per annum and $70,607 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 Trust's 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, 2001. The outstanding payable to the
trust is approximately $12,966,000 and is included in accounts payable.

The Company had a note receivable from the Trust for the purchase of the
Japanese corporate headquarters office. The note was for approximately 620
million yen ($4,283,247 as July 31, 1998) and was included in other current
receivables. The note was paid in full during the year ended July 31, 2000. The

Company made lease payments to Solomon Properties LLC, an affiliate of the
Trust, of $616,000 in fiscal 2001.

<PAGE>

EMPLOYMENT AND OTHER AGREEMENTS

For information regarding employment and other agreements between the Company
and two of its executive officers, please see "Executive Compensation-Employment
Agreements" and "Executive Compensation - Limitation of Liability and
Indemnification Matter".

CERTAIN BUSINESS RELATIONSHIPS

In fiscal 2001, the Company contracted and paid Searson & Company, Inc.,
Certified Public Accountants, $185,000 in consulting fees for assistance in the
corporate finance department related to year end activities. Karen Searson the
spouse of DeVaughn D. Searson, the Company's Chief Financial Officer, is the
majority owner of Searson & Co.


                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

Report of Independent Public Accountants

Consolidated Balance Sheets as of July 31, 2001, and July 31, 2000

Consolidated Statements of Operations for the fiscal years ended July 31, 2001,
2000, and 1999

Consolidated Statements of Shareholder's Equity for the fiscal years ended July
31, 2001, 2000, and 1999

Consolidated Statements of Cash Flows for the fiscal years ended July 31, 2001,
2000, and 1999

Notes to Consolidated Financial Statements



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

            (a) REPORTS ON FORM 8-K

            There were no reports on Form 8-K filed during the fourth quarter of
            the Company's last fiscal year.

<PAGE>

            (b) EXHIBITS

            Reference is made to the index of exhibits immediately preceding the
            exhibits hereto, which index is incorporated herein by reference.

<PAGE>

                                   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.

<TABLE>
<CAPTION>
Signatures                         Title                              Date
<S>                                <C>                                <C>
/s/ RUSSELL M. SOLOMON             Chairman and Director              October 29, 2001

Russell M. Solomon

/s/ MICHAEL T. SOLOMON             President, Chief Executive         October 29, 2001
                                   Officer and Director
Michael T. Solomon

/s/ DEVAUGHN D. SEARSON            Executive Vice President, Chief    October 29, 2001
                                   Financial Officer and Director
DeVaughn D. Searson
</TABLE>



                         MTS, INCORPORATED



                         (Registrant)



                     By: /s/ DEVAUGHN D. SEARSON




                         DeVaughn D. Searson

                         Executive Vice President, Chief Financial Officer and
                         Director

                         (Principal Financial and Accounting Officer)

<PAGE>

                                INDEX OF EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT                                    DESCRIPTION
<S>         <C>     <C>
3.1         +++     Restated Articles of Incorporation of MTS, Incorporated
                    filed with the California Secretary of State on September
                    22, 1994

3.2         +++     Bylaws of MTS, Incorporated

4.1         +       Purchase Agreement dated as of April 23, 1998 between the
                    Registrant, Chase Securities, Inc. and Merrill Lynch,
                    Pierce, Fenner & Smith Incorporated

4.2         +       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         +       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         +       Form of 9 3/8% Senior Subordinated Note due 2005

10.1        +       Credit Agreement dated as of April 23, 1998 by and among the
                    Company, Tower Records Kabushiki Kaisha, the Lenders party
                    thereto, and The Chase Manhattan Bank as Administrative
                    Agent

10.2        +++     Japanese Security Agreement dated as of April 23, 1998

10.3        +++     MTS, Incorporated Security Agreement dated as of April 23,
                    1998

10.4        x       Agreement between the Company and Christopher Hopson dated
                    as of August 10, 2000.

10.5        xx      Amended and Restated Credit Agreement dated as of April 27,
                    2001 by and among the Company, Tower Records Kabushiki
                    Kaisha, the Lenders party thereto, and The Chase Manhattan
                    Bank as Administrative Agent.

1.1         +       List of Subsidiaries

5.12        +++     Statement of Eligibility on Form T-1 for State Street Bank
                    and Trust Company of California, N.A., as Trustee under the
                    Indenture
</TABLE>

+   Previously filed with the Company's Form S-4 Registration Statement on 1998

++  Previously filed with Amendment No. 1 to the S-4 Registration Statement on
July 1, 1998.

+++ Previously filed with the Amendment No. 2 to the S-4 Registration Statement
on July 23, 1998.

x   Previously filed with the Company's Report on Form 10-K for the fiscal year
ended July 31, 2000.

xx  Previously filed with the Company's Report on Form 10-Q for the quarter
ended April 30, 2001.