UNITED STATES
WASHINGTON, D.C. 20549
FORM 10-K
| xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES | |
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FOR THE FISCAL YEAR ENDED FEBRUARY 3, 2007
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
FOR THE TRANSITION PERIOD FROM _______ TO _______
COMMISSION FILE NUMBER: 0-14818
TRANS WORLD ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in its charter)
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New York | 14-1541629 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification Number) |
38 Corporate Circle
Albany, New York 12203
(Address of principal executive offices, including zip code)
(518) 452-1242
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in the Rule 405 of the Securities Act. Yeso No No xý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yeso No No xý
Indicate by a check mark whether the Registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes xý No o
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 the Registrant’s Knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or an amendment to this Form 10-K.o
Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer or non-accelerated filer (as defined in Rule 12b-2 of the Act). Yes
ý No Large accelerated filero
Accelerated filerx Non-accelerated filero
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No xý
As of July 30, 2005, 32,184,02628, 2006, 30,838,399 shares of the Registrant’s Common Stock, excluding 23,404,54925,104,990 shares of stock held in Treasury, were issued and outstanding. The aggregate market value of the voting stock held by non-affiliates of the Registrant, based upon the closing sale price of the Registrant’s Common Stock on July 30, 200528, 2006 as reported on the National Market tier of The NASDAQ Stock Market, Inc. was $207,286,769.$103,569,030. Shares of Common Stock held by the Company’s controlling shareholder, who controls approximately 38.7%40.3% of the outstanding Common Stock, have been excluded for purposes of this computation. Because of such shareholder’s control, shares owned by other officers, directors and 5% shareholders have not been excluded from the computation. As of March 25, 2006,30, 2007, there were 30,620,30230,992,763 shares of Common Stock Issued and Outstanding.
Documents of Which Portions Are Incorporated by Reference |
| Parts of the Form 10-K into Which Portion of |
Proxy Statement for Trans World Entertainment Corporation’s June |
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1
PART I
Cautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995
This document includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to analyses and other information that are based on forecasts of future results and estimates of amounts not yet determinable. These statements also relate to the Company’s future prospects, developments and business strategies. The statements contained in this document that are not statements of historical fact may include forward-looking statements that involve a number of risks and uncertainties.
We have used the words “anticipate”, “believe”, “could”, “estimate”, “expect”, “intend”, “may”, “plan”, “predict”, “project”, and similar terms and phrases, including references to assumptions, in this document to identify forward-looking statements. These forward-looking statements are made based on management’s expectations and beliefs concerning future events and are subject to uncertainties and factors relating to our operations and business environment, all of which are difficult to predict and many of which are beyond the Company’s control, that could cause actual results to differ materially from those matters expressed in or implied by these forward-looking statements. The following factors are among those that may cause actual results to differ materially from the Company’s forward-looking statements.
•highly competitive nature of the retail entertainment business;
•competitive pricing (price and product changes);
•adverse publicity;
•interest rate fluctuations;
•dependence on key employees;
•change in laws;
•the Company’s level of debt and related restrictions and limitations;
•new product introductions (“hit releases”);
•future cash flows;
•availability of new real estate;
•new technology, including digital downloading; and
•product liability claims
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• | highly competitive nature of the retail entertainment business; | |
• | competitive pricing; | |
• | adverse publicity; | |
• | interest rate fluctuations; | |
• | dependence on key employees; | |
• | change in laws; | |
• | accelerated declines in music CD industry sales; | |
• | the Company’s level of debt and related restrictions and limitations; | |
• | new product introductions (“hit releases”); | |
• | future cash flows; | |
• | availability of new real estate; | |
• | new technology, including digital downloading; and | |
• | product liability claims. |
The reader should keep in mind that any forward-looking statement made by us in this document, or elsewhere, speaks only as of the date on which we make it. New risks and uncertainties come up from time-to-time, and it’s impossible for us to predict these events or how they may affect us. In light of these risks and uncertainties, you should keep in mind that any forward-looking statements made in this report or elsewhere might not occur.
In addition, the preparation of financial statements in accordance with accounting principles generally accepted in the United States (“GAAP”) requires us to make estimates and assumptions. These estimates and assumptions affect:
•the reported amounts and timing of revenue and expenses,
•the reported amounts and classification of assets and liabilities, and
•the disclosure of contingent assets and liabilities.
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• | the reported amounts and timing of revenue and expenses, | |
• | the reported amounts and classification of assets and liabilities, and | |
• | the disclosure of contingent assets and liabilities. |
Actual results may vary from our estimates and assumptions. These estimates and assumptions are based on historical results, assumptions that we make, as well as assumptions by third-parties.
Item 1. BUSINESS
Trans World Entertainment Corporation, which, together with its consolidated subsidiaries, is referred to herein as “the Company”, was incorporated in New York in 1972. It owns 100% of the outstanding common stock of Record Town, Inc., through which its principal operations are conducted. The Company operates retail stores and fourfive e-commerce sites and is one of the largest specialty retailers of entertainment software, including music, home video, and video games and related products in the United States.
2
During 2005, the Company acquired an 80% interest in a company that is fully consolidated for financial reporting purposes.
On July 22, 2004, the Company acquired the remaining 29% of the issued and outstanding shares of Second Spin Inc. (“Second Spin”), for cash of $2.0 million. Prior to the step acquisition, the Company had consolidated all of the net assets and operations of Second Spin in its Consolidated Balance Sheets and Consolidated Statements of Operations due to Second Spin’s accumulated operating losses, and accordingly, no minority interest had been reflected in the Consolidated Balance Sheets.
In October 2003,March 2006, the Company acquired substantially all of the net assets of 111 stores from Wherehouse Entertainment Inc. (“Wherehouse”), a specialty music retailer located primarily in the Western United States for $35.2 million in cash. The Company also acquired in October 2003 substantially all of the net assets of 13 specialty stores of CD World Inc. (“CD World”), located in New Jersey and Missouri for $1.9 million in cash. See Note 3 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for further information.
Recent Developments
Subsequent to fiscal 2005 year end, effective March 27, 2006, the Company acquired the net assets of Musicland Holding Corp. (“Musicland”). Musicland, an entertainment specialty retailer which operatesoperated retail stores and websites under the names Sam Goody (www.SamGoody.com)(samgoody.com), Suncoast Motion Picture Company (www.Suncoast.com)(suncoast.com), On Cue and www.MediaPlay.com,MediaPlay.com, filed a voluntary petition to restructure under Chapter 11 of the United States Bankruptcy Code in January 2006. The transaction representsrepresented total consideration of $104.2$78.8 million in cash and $18.1$16.3 million in assumed liabilities, including certain customer obligations, rent and occupancy liabilities and employee obligations. Under the terms of the Asset Purchase Agreement, the Company agreed to acquire 335 of Musicland’s 400 remaining stores, with the remainder of the stores being liquidated under an agency agreement with Hilco Merchant Resources, LLC. As of February 3, 2007 the Company operated 210 of the 335 acquired stores. See Note 133 of Notes to the Consolidated Financial Statements onof this Annual Report on Form 10-K for detail.
OnIn March 16, 2006, the Company acquired an 80% interest in Mix & Burn LLC, a company that will beis fully consolidated for financial reporting purposes.reporting. The Company has committed a total funding of $5.2 million, over two years, of which $1.2$4.0 million was funded as of March 25, 2006.February 3, 2007.
Stores and Store Concepts
At January 28, 2006,February 3, 2007, the Company operated 782992 stores totaling approximately 4.86.0 million square feet in 46 states,the United States, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands.
Mall Stores
At January 28, 2006,February 3, 2007, the Company operated 546737 mall-based stores, in four concepts, predominantly under the f.y.ef.y.e. (“For Your Entertainment”) brand, including:
Traditional stores. The Traditional store averages about 5,600 square feet and carries a full complement of entertainment software, including music, home video, video games and related accessories. There were 587 Traditional f.y.e. stores at the end of Fiscal 2006. | |
Superstores. The Superstores carry the same merchandise categories as Traditional locations, but with a much broader and deeper assortment. This concept is a semi-anchor or destination location in major regional malls. There were 13 f.y.e. mall Superstores at the end of Fiscal 2006 that averaged about 24,000 square feet. | |
Video only stores.At the end of Fiscal 2006, the Company operated 137 video only stores, under the Suncoast and Saturday Matinee brands. These stores specialize in the sale of home video and related accessories. They are located in large, regional shopping malls and average about 2,400 square feet. |
Freestanding Stores
The Company operated 255 freestanding stores, as of February 3, 2007, under the brand names of f.y.e. (“For Your Entertainment”), brand including:
Traditional f.y.e stores. The Traditional f.y.e mall store averages 5,700 square feet and carries a full complement of entertainment software, including music, video, video games and related accessories. There were 515 Traditional f.y.e stores at January 28, 2006.
f.y.e Games store. The Company operated one f.y.e Games store at January 28, 2006 occupying 2,300 square feet.
Freestanding Stores
At January 28, 2006, the Company operated 235 freestanding stores, under the brand names of f.y.e,Sam Goody, Coconuts Music and Movies, Strawberries, Wherehouse Music and Movies, CD World, Streetside Records, Spec’s Music, and Second Spin. They carry a full complement of entertainment productssoftware, including music, home video, video games and related accessories and are located in freestanding, strip center and downtown locations. The freestanding stores average approximately 6,2006,400 square feet.
feet (excluding f.y.e. Superstores and Planet Music). The Company also operates 6 freestanding f.y.e. Superstores that average about 53,000 square feet and a single 31,400 square foot Planet Music store a 31,400 square foot freestanding superstore in Virginia Beach, VA.
The store offers an extensive catalogCompany is in the process of music, DVD, video games and related merchandise.re-branding its freestanding stores to f.y.e. (“For Your Entertainment”). This initiative is expected to be completed during Fiscal 2007.
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E-Commerce Sites
The Company operates fourfive retail Webweb sites including,www.fye.com,, www.coconuts.com, www.wherehouse.com, www.secondspin.com, www.samgoody.com andwww.secondspin.comwww.suncoast.com.. These sites offer substantially the same complement of products as offered in the Company’s stores.
Sales by merchandise category as a percentage of total sales for Fiscal 2006, 2005 2004 and 2003,2004, and comparable store sales for 2005Fiscal 2006 and 2004,2005, were as follows:
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Music: |
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Compact discs |
| 53.0 | % | (8.5 | )% | 53.9 | % | (0.8 | )% | 53.9 | % |
Audio cassettes and singles |
| 0.6 |
| (42.5 | ) | 1.1 |
| (38.4 | ) | 1.8 |
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Total Music |
| 53.6 |
| (9.2 | ) | 55.0 |
| (2.0 | ) | 55.7 |
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Video: |
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DVD |
| 28.4 |
| 0.7 |
| 26.4 |
| 14.6 |
| 23.6 |
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VHS |
| 1.6 |
| (45.5 | ) | 2.8 |
| (35.3 | ) | 4.6 |
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Total Video |
| 30.0 |
| (3.7 | ) | 29.2 |
| 6.5 |
| 28.2 |
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Video games |
| 7.3 |
| 2.3 |
| 6.5 |
| 9.6 |
| 6.1 |
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Other |
| 9.1 |
| 4.4 |
| 9.3 |
| (5.6 | ) | 10.0 |
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Total |
| 100.0 | % | (5.7 | )% | 100.0 | % | 0.8 | % | 100.0 | % |
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| Comparable |
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| 2006 |
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| 2005 |
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Music |
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| 44.2 | % |
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| (14.0 | )% |
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| 53.6 | % |
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| (9.2 | )% |
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| 55.0 | % |
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Home Video |
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| 37.6 |
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| 1.2 |
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| 30.0 |
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| (3.7 | ) |
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| 29.2 |
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Video games |
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| 7.8 |
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| 4.0 |
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| 7.3 |
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| 2.3 |
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| 6.5 |
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Other |
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| 10.4 |
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| 7.9 |
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| 9.1 |
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| 4.4 |
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| 9.3 |
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Total |
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| 100.0 | % |
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| (6.2 | )% |
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| 100.0 | % |
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| (5.7 | )% |
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| 100.0 | % |
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The “Other” category includes electronics, accessories boutique, and othertrend item sales, none of which individually exceedsexceeded 5%. of total sales.
The Company’s stores offer predominantly entertainment software, including music,Music, home video and video games. These categoriesgames represent an approximately $38 billion industry nationwide, and represented 91%approximately 90% of the Company’s sales in 2005. The balance of categories, including electronics, boutique and software accessory products represented 9% of the Company’s sales in 2005. Management believes there will be continued growth in its DVD and video games businesses.
The entertainment software industry, including music, video, and video games, totaled approximately $38 billion in the United States inFiscal 2006. This statistic is compiled from three sources: (1) Recording Industry Association of America (“RIAA”); (2) Rentrak Home Video Essentials (title revenues), including DVD and VHS; and (3) NPD Funworld’s estimate of retail video game sales.
According to statistics obtained from Nielsen Soundscan, the RIAA, the overall approximate retail valuetotal number of the music industry in 2005 was $12.27 billion,albums sold, including shipments of physical products and value of various digital revenue streams. This compares with 2004 industry retail value of $12.34 billion. Overall album shipments, including both physicalCD, cassette, LP and digital albums, were 794.7was 588.2 million units in 2005,2006, a 3.9%4.9% decline from 2004. The number of overall physical2005. Excluding digital albums, total sales were 555.6 million units in all formats shipped to all distribution channels in 2005 decreased by 8.0% when compared to 2004 .
2006, a 7.8% decline from 2005.
According to statistics obtained from Rentrak Home Video Essentials, overall home video sales in 2006, including DVD and VHS, were $16.1$15.9 billion, a decrease of 0.1%0.9% from 2004.2005. DVD retail sales in 20052006 were $15.7 billion, an increase of 4.5% over 2004.
flat compared to 2005.
The NPD Group published that video games sales in 20052006 were $10.5$12.5 billion including portable and console hardware, software and accessories, an increase of 6%19% over 20042005 sales.
Music sales have suffered from the unauthorized duplicationlegal (e.g., iTunes) and illegal downloading of music and specialty retailers have been impacted by the proliferation of mass merchants (e.g., Wal-Mart and Target) and electronics superstores (e.g., Best Buy and Circuit City) that offer entertainment software and have gained a larger share of the market. The Company also competes with large specialty retail chains that offer similar products in similar style stores, including Tower Records, primarily in free-standing locations. However, the number of specialty and independent retailers has dramatically decreased due to their reliance on sales of recorded music. The Company has taken advantage of competitor exits from markets, made acquisitions, diversified its products and taken other measures to position itself competitively within its industry. The Company believes it effectively competes in the following ways:
• | Location and convenience: a strength of the Company is its convenient store locations that are often the exclusive retailer in centers offering a full complement of entertainment software; | |
• | Marketing: the Company uses newspaper, radio and television advertising and in-store visual displays to market to consumers; | |
• | Selection and assortment: the Company differentiates itself by maintaining a high in-stock position in a large assortment of product, particularly CDs and DVDs; | |
• | Customer service: the Company believes it offers personalized customer service at its stores; | |
• | Listening and Viewing Stations (“LVS”): the Company’s LVS is a sampling and selection tool designed to encourage customer purchases. The third generation of LVS (“LVS 3”) is currently installed in over 700 of the Company’s stores. LVS 3 enhances the customers’ in-store experience through improved product information displays and product search and suggestion capabilities; | |
• | In-store CD burning and digital downloading: The Company has begun offering CD burning and digital downloading stations in selected stores and plans on expanding these capabilities to a greater number of stores in Fiscal 2007. |
4
•Location and convenience: a strength of the Company is its convenient store locations that are often the exclusive retailers in centers offering a full complement of entertainment software;
•Marketing: the Company uses newspaper, radio and television advertising and in-store visual displays to market to consumers;
•Selection and assortment: the Company differentiates itself by maintaining a high in-stock position in a large assortment of product, particularly CDs and DVDs;
•Customer service: the Company believes it offers personalized customer service at its stores;
•Price perception: the Company communicates a value message by promoting value-priced merchandise, off-brand product and closeout merchandise and by offering a broad selection of used CDs, DVDs and video games;
•Listening and Viewing Stations (“LVS”): the Company’s LVS is a sampling and selection tool designed to encourage customer purchases. The third generation of LVS (“LVS 3”) is currently installed in 185 of the Company’s mall stores. The Company expects to complete the installation of LVS 3 in all stores during 2006. LVS 3 enhances the customers’ in-store experience through improved product information displays and product search and suggestion capabilities. It also supports in-store digital downloading.
The Company’s business is seasonal, with the fourth fiscal quarter constituting the Company’s peak selling period. In 2005,Fiscal 2006, the fourth quarter accounted for 37%approximately 40% of annual sales. In anticipation of increased sales activity during these months, the Company purchases additional inventory and hires additional temporary employees to supplement its permanentfull-time store sales staff. If, for any reason, the Company’s net sales were below seasonal norms during the fourth quarter, the Company’s operating results could be adversely affected. Quarterly sales can also be affected by the timing of new product releases, new store openings or closings and the performance of existing stores.
Advertising
The Company makes extensive use of visual displays. It uses a mass-media marketing program, including newspaper, radio, and television advertisements. The majority of vendors from whom the Company purchases merchandise offer advertising allowances to promote their merchandise that are accounted for as a reduction of the cost of inventory to the extent that such allowances exceed the cost incurred for the advertising.merchandise.
Suppliers and Purchasing
The Company purchases inventory from approximately 900990 suppliers. 71%In Fiscal 2006, 68% of purchases in 2005 were made from ten suppliers: EMD (EMIsuppliers including EMI Music Distribution), Sony/BMG (Sony-BertelsmannDistribution, Sony-Bertelsmann Music Group), WEA (Warner/Group, Warner/Electra/Atlantic Corp.), UMVD (UniversalUniversal Music and Video Distribution),Distribution, Fox Video Inc., Paramount Home Video, Buena Vista Home Video, Sony ComputerWarner Home Entertainment, Universal Studios Home Entertainment and Sony Pictures Home Entertainment. The Company does not have material long-term purchase contracts; rather, it purchases products from its suppliers on an order-by-order basis. Historically, the Company has not experienced difficulty in obtaining satisfactory sources of supply and management believes that it will retaincontinue to have access to adequate sources of supply.
Under current trade practices with large suppliers, retailers of music and home video products are generally entitled to return unsold merchandise they have purchased in exchange for other titles carried by the suppliers. Two of the four largest music suppliers charge a related merchandise return penalty and the remaining two largest suppliers charge a combination of return penalties and return handling fee.fees. Most manufacturers and distributors of home video products do not typically charge a return penalty or handling fee. Under current trade practices with large suppliers, retailers of video games and related products are generally entitled to markdown support from suppliers to help clear slow turning merchandise. Merchandise return policies and other trade practices have not changed significantly in recent years. The Company generally adapts its purchasing policies to changes in the policies of its largest suppliers.
As of January 28, 2006,February 3, 2007, the Company employed approximately 8,100 employees,9,600 people, of whom approximately 3,6704,400 were employed on a full-time basis. All other employees areothers were employed on a part-time or temporary basis. The Company hires seasonal sales employees during its fourth quarter peak selling season to ensure continued levels of customer service. Store managers, district managers and regional managers are eligible to receive incentive compensation based on the sales and profitability of stores for which they are responsible. Sales support managers are generally eligible to receive incentive compensation based on the sales and profitability of the Company as a whole. None of the Company’s employees are covered by collective bargaining agreements and management believes that the Company enjoys favorable relations with its employees.
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Information Systems
The Company continually assesses its information system needs to increase efficiency, improve decision-making and support growth. It utilizes primarily IBM AS400 technology to run its management information systems, including its merchandising, distribution and accountingfinancial systems. Management believes its systems contribute to enhanced customer service and operational efficiency, as well as provide the ability to monitor critical performance indicators versus plans and historical results.
The Company’s point-of-sale and merchandising systems allow for the daily reporting of sales, inventory and gross margin by store and by item. The Company replaced its point-of-sale system in 2005, through a capital lease transaction at a cost of $12.0 million (see Note 5 of Notes to the Consolidated Financial Statements for detail).
The Company’s headquarters are located at 38 Corporate Circle, Albany, New York 12203, and its telephone number is (518) 452-1242. The Company’s corporate Webweb site address is www.twec.com. The Company makes available, free of charge, its Exchange Act Reports (Forms 10-K, 10-Q, 8-K and any amendments thereto) on its Webweb site as soon as practical after the reports are filed with the Securities and Exchange Commission (“SEC”). The public may read and copy any materials the Company files with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. This information can be obtained from the site http://www.sec.gov.
The Company’s Common Stock, $0.01 par value, is quoted on the NASDAQ National Market under the trading symbol “TWMC”. The Company’s fiscal year end is the Saturday closest to January 31. The fiscal 2006 (“2006”) year ended on February 3, 2007; fiscal 2005 (“2005”) year ended on January 28, 2006; and fiscal 2004 (“2004”) year ended on January 29, 2005; and fiscal 2003 (“2003”) year ended on January 31, 2004.2005.
Item 1A. RISK FACTORS
The following is a discussion of certain factors, which could affect the financial results of the Company.
The Company’s results of operations are affected by the availability of new products.
The Company’s business is affected by the release of “hit” music, home video and video game titles, which can create fluctuations in sales. It is not possible to determine the timing of these fluctuations or the future availability of hit titles. The Company does not control the content of new products and is dependent upon the major music and movie producers to continue to produce hit products. To the extent that new hitshit releases are not available, or not available at prices attractive to consumers, or, if manufacturers fail to introduce or delay the introduction of new products, the Company’s results of operations may be adversely affected.
The Company’s results of operations may suffer if the Company does not accurately predict consumer acceptance of new product or distribution technologies.
The entertainment industry is characterized by changing technology, evolving format standards, frequent new and enhanced product introductions and rapid product obsolescence. These characteristics require that the Company respond quickly to technological changes and understand the impact of these changes on customers’ preferences. If the Company is unable to participate in new product or distribution technologies, that consumers accept, its results of operations may suffer.
Increased competition from existing retailers and alternative distribution channels may adversely affect the Company’s results of operations.
The retail entertainment business is highly competitive. The Company competes with a wide variety of entertainment retailers, including regional and national mall-based music chains, deep-discount retailers, mass merchandisers, consumer electronics outlets, internet retailers, record clubs and independent operators, some of which have greater financial and other resources than the Company. 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. In particular, Internet and cable technologies coupled with high-quality digital recording technologies allows direct downloading of recorded music by consumers via the Internet.options. Some of these, technological enhancements, including the ability to download music, video and video games onto PCs or other devices, or the ability to play video games over the Internet through consoles, could reduce retail sales of CDs, DVDs and video games. A wide selection of music and video services can now be offered to consumers through:
•the Internet,
•cable companies,
•direct broadcast satellite companies,
•telephone companies, and
•other telecommunications companies.
If technological advances were to result in significant changes in existing distribution channels for pre-recorded music, home video and video games, the Company’s results of operations could be adversely affected.
A decline in general economic condition, including declines in current levels of consumer spending could adversely affect results of operations.
The Company’s results of operations isare affected by the level of consumer spending, which reflects the general state of local economies in which the Company operates. Changes in consumer preference or discretionary consumer spending could harm our business.
The Company’s operating results fluctuate from period to period.
As is the case with many retailers, a significant portion of the Company’s sales, and an even greater portion of the Company’s earnings, isare generated in the fourth fiscal quarter, which includes the holiday selling season. Less than satisfactory sales for such period could have an adverse effect on the Company’s results of operations.
Growth Strategy – the failure to grow the Company’s business may limit its earnings.
Historically, the Company’s growth has come from the opening of new stores and the acquisition of stores. The Company opens new stores if it finds desirable locations and is able to negotiate suitable lease terms. AnyA lack of availability of new stores or acquisition opportunitiesstore growth may impact the Company’s ability to increase sales and earnings.
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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 results of operations.
The majority of the Company’s purchases come from ten major suppliers. As is standard in the musicits industry, the Company does not maintain long-term contracts with its suppliers but instead makes purchases on an order-by-order basis. If the Company fails to maintain customary trade terms or enjoy positive vendor relations, it could have an adverse effect on the Company’s results of operations.
If the Company’s vendors fail to provide marketing and merchandising support at historical levels, the Company’s results of operations could be negatively impacted.adversely affected.
The manufacturers of entertainment products have typically provided retailers with significant marketing and merchandising support for their products. As part of this support, the Company receives cooperative advertising and market development paymentsallowances from these vendors. These cooperative advertising and market development paymentsallowances enable the Company to actively promote and merchandise the products that it sells and drive sales at the Company’sits stores and on its websites. If the Company’s vendors fail to provide this support at historical levels, the Company’s results of operations could be negatively impacted.
If the Company fails to successfully complete and integrate future acquisitions, the Company’s results of operationscould be negatively impacted.
As part of the Company’s efforts to grow and compete, the Company may engage in acquisitions. The Company’s pursuit of future acquisitions is subject to its ability to negotiate favorable terms for these acquisitions. Accordingly, the Company cannot be assured that future acquisitions will be completed. In addition, to facilitate future acquisitions, the Company may take actions that could dilute the equity interests of its stockholders, increase its debt or assume contingent liabilities, all of which may have a negative effect on the price of the Company’s common stock. Finally, if any acquisitions are not successfully integrated with its business, the Company’s ongoing operations and results of operations could be adversely affected.
Loss of Key Personnel could harmadversely affect the Company’s results of operations.
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 qualified key personnel. The loss of the services of certain of the Company’s executive officers and other key management personnel could harmadversely affect the Company’s results of operations.
Control by and Dependence on Key Personnel -Robert J. Higgins has a strongsignificant influence on the outcome of any vote of the Company’s Shareholders and if the Company were to lose his services, it may not be able to replace his skills and experience.
Robert J. Higgins serves as Chairman of the Board of Trans Worldthe Company and its Chief Executive Officer and owns approximately 40.6%40.3% of the outstanding common stock of Trans World,the Company, as of March 15, 2006.February 3, 2007. Further, if the Company were to lose Mr. Higgins’ services, it may not be able to replace his skills and experience, and this could have an adverse effect on the Company’s financial results.
If, in the future, the Company concludes that its internal controls over financial reporting are not adequate, or if the Company’s auditors conclude that the Company’s evaluation of internal controls over financial reporting is not adequate, investors could lose confidence in the reliability of the Company’s financial statements, which could result in a decrease in the value of the Company’s common stock. The effectiveness of the Company’s disclosure and internal controls may be limited.
As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted rules requiring public companies to include a report of management on the company’s internal control over financial reporting in their annual reports on Form 10-K. There is a risk that in the future, the Company may identify internal control deficiencies that suggest that the Company’s controls are no longer effective. This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of the Company’s financial statements, which could cause a decline in the market price of the Company’s common stock.
Disclosure controls and procedures and internal controls over financial reporting may not prevent all errors and intentional misrepresentations. In the event that there are errors or misrepresentations in the Company’s historical financial statements or the SEC disagrees with the Company’s accounting, the Company may need to restate its financial statements. There is no guarantee that existing controls will prevent or detect all material issues or be effective in future conditions, which could materially and adversely impact the Company’s financial results in the future.
Anti-takeover provisions – New York anti-takeover law provisions and the classified Board Amendment, may discourage unsolicited takeovers.
In August 2000, the Company’s Board of Directors adopted a Classified Board Amendment which together with anti-takeover provisions eschewed by New York State Law may discourage open market purchases or a non-negotiated tender or exchange offer for the stock of the Company. This may be adverse to the interests of a shareholder who might receive a premium in a transaction of this type.certain shareholders.
Item 1B. UNRESOLVED SEC COMMENTS
The Company has not received within 180 days or more before January 28, 2006,February 3, 2007, written comments from the Securities and Exchange Commission regarding its periodic or current reports under the Securities Exchange Act of 1934, as amended, that remain unresolved.
7
Item 2. PROPERTIES
Retail Stores
At January 28, 2006,February 3, 2007, the Company operated 781991 stores under operating leases, somemany of which have renewal options. Substantially all of the leases provide for the payment of fixed monthly rentals and expenses for maintenance, property taxes and insurance. Many leases provide for added rent based on store sales in excess of specified levels. The following table lists the leases due to expire as of the fiscal year-end in each of the years shown, assuming any renewal options are not exercised:
|
|
|
|
|
|
|
|
|
|
Year |
| No. of |
| Year |
| No. of |
| ||
|
|
|
| ||||||
2007 |
| 395 |
|
| 2011 |
| 54 |
|
|
|
|
|
|
|
|
|
|
|
|
2008 |
| 173 |
|
| 2012 |
| 40 |
|
|
|
|
|
|
|
|
|
|
|
|
2009 |
| 141 |
|
| 2013 |
| 19 |
|
|
|
|
|
|
|
|
|
|
|
|
2010 |
| 87 |
|
| 2014 and beyond |
| 82 |
|
|
Year |
| No. of |
| Year |
| No. of |
|
|
|
|
|
|
|
|
|
2006 |
| 186 |
| 2010 |
| 69 |
|
|
|
|
|
|
|
|
|
2007 |
| 135 |
| 2011 |
| 39 |
|
|
|
|
|
|
|
|
|
2008 |
| 132 |
| 2012 |
| 31 |
|
|
|
|
|
|
|
|
|
2009 |
| 118 |
| 2013 and beyond |
| 71 |
|
The Company expects that as mostAs leases expire, itthe Company will evaluate the decision to exercise renewal rights or obtain new leases for the same or similar locations.locations based on store profitability. The Company owns one store.
Corporate Offices and Distribution Center Facilities
The Company leases its Albany, New York, distribution facility and corporate office space from its largest shareholder and Chairman and Chief Executive Officer under three capital lease arrangements that extend through 2015. These leases are at fixed rentals with provisions for biennial increases based on increases in the Consumer Price Index. The Company incurs all property taxes, insurance and maintenance costs. The office portion of the facility is approximately 53,20039,800 square feet and the distribution center portion is approximately 128,100141,500 square feet. The Company owns a 236,600 square foot distribution center with 59,200 square feet of adjacent office space in North Canton, Ohio. The Company also leases a 198,200198,300 square foot distribution center in Carson, California; this lease includes two five-year renewal options and expires in December 2015.
The Company believes that its existing distribution facilities are adequate to meet the Company’s planned business needs. Shipments from the distribution facilities to the Company’s stores are made at least once a week and currently provide approximately 74%70% of all merchandise requirements.shipment requirements to stores. The balance of the stores’ requirements areis satisfied through direct shipments from vendors. Company operated trucks service approximately 8655 of its stores. The remaining stores are serviced by common carriers chosen on the basis of geography and rate considerations.
The Company leases a 43,500an 82,560 square foot facility in Johnstown, New York, where it manufactures many of its store fixtures. The operating lease expires in December 2006.2007. The Company believes that its costs of production are equal to or lower than purchasing the fixtures from outside suppliers.
The Company leases an additional 31,700 square feet of office space in Albany, New York. The operating lease expires in June 2014 and includes two, five-year options to renew.
Item 3. LEGAL PROCEEDINGS
The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of its business and have not been finally adjudicated. Although there can be no assurance as to the ultimate disposition of these matters, it is management’s opinion, based upon the information available at this time, that the expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on the results of operations and financial condition of the Company.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended January 28, 2006.
8February 3, 2007.
PART II
Item 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market InformationInformation.. The Company’s Common Stock trades on the NASDAQ Stock Market under the symbol “TWMC.” As of January 28, 2006,March 30, 2007, there were 535486 shareholders of record. The following table sets forth high and low last reported sale prices for each fiscal quarter during the period from January 31, 200430, 2005 through March 18, 2005.30, 2007.
|
| Closing Sales Prices |
| ||||
|
| High |
| Low |
| ||
2004 |
|
|
|
|
| ||
1st Quarter |
| $ | 10.79 |
| $ | 7.45 |
|
2nd Quarter |
| $ | 10.65 |
| $ | 9.38 |
|
3rd Quarter |
| $ | 11.54 |
| $ | 8.83 |
|
4th Quarter |
| $ | 12.77 |
| $ | 10.62 |
|
|
|
|
|
|
| ||
2005 |
|
|
|
|
| ||
1st Quarter |
| $ | 15.39 |
| $ | 12.55 |
|
2nd Quarter |
| $ | 14.91 |
| $ | 10.39 |
|
3rd Quarter |
| $ | 10.74 |
| $ | 6.39 |
|
4th Quarter |
| $ | 6.95 |
| $ | 4.74 |
|
|
|
|
|
|
| ||
2006 |
|
|
|
|
| ||
1st Quarter (through March 31, 2006) |
| $ | 6.17 |
| $ | 5.06 |
|
|
|
|
|
|
|
|
|
|
| Closing Sales Prices |
| ||||
|
|
|
| ||||
|
| High |
| Low |
| ||
2005 |
|
|
|
|
|
|
|
1st Quarter |
| $ | 15.39 |
| $ | 12.55 |
|
2nd Quarter |
| $ | 14.91 |
| $ | 10.39 |
|
3rd Quarter |
| $ | 10.74 |
| $ | 6.39 |
|
4th Quarter |
| $ | 6.95 |
| $ | 4.74 |
|
|
|
|
|
|
|
|
|
2006 |
|
|
|
|
|
|
|
1st Quarter |
| $ | 6.17 |
| $ | 5.06 |
|
2nd Quarter |
| $ | 7.35 |
| $ | 5.03 |
|
3rd Quarter |
| $ | 6.50 |
| $ | 5.50 |
|
4th Quarter |
| $ | 6.88 |
| $ | 5.45 |
|
|
|
|
|
|
|
|
|
2007 |
|
|
|
|
|
|
|
1st Quarter (through March 30, 2007) |
| $ | 5.82 |
| $ | 5.20 |
|
On March 31, 2006,30, 2007, the last reported sale price on the Common Stock on the NASDAQ National Market was $5.57.
Options for the Company’s Common Stock trade on the Chicago Board Options Exchange.
$5.68
On May 28, 2003, the Company’s Board of Directors authorized the repurchase of 10 million outstanding shares of the Company’s Common Stock from time to time on the open market. The Company had repurchased 15 million shares of common stock under previously announced programs. As of January 28, 2006, the Company had purchased all the 10 million shares outstanding under the stock repurchase program, at a total cost of $88.5 million. During 2005 the Company purchased 3.1 million shares at a total cost of $31.3 million. The following table shows the purchase of equity securities purchased under theThere are currently no share repurchase program as required by Item 703 of Regulation S-K.programs outstanding.
Period |
| Total Number of Shares |
| Average Price Paid per |
| Total Number of Shares |
| Maximum Number of |
| |
October 30, 2005 – November 26, 2005 |
| 226,100 |
| $ | 6.63 |
| 226,100 |
| 434,541 |
|
November 27, 2005 – December 31, 2005 |
| 434,541 |
| $ | 6.44 |
| 434,541 |
| — |
|
January 1, 2006 – January 28, 2006 |
| — |
| — |
| — |
| — |
| |
Total |
| 660,641 |
| $ | 6.51 |
| 660,641 |
| — |
|
9
The following table contains information about the Company’s Common Stock that may be issued upon the exercise of options, warrants and rights under all of the Company’s equity compensation plans as of January 28, 2006:
Plan Category |
| Number of Shares to be Issued |
| Weighted Average Exercise |
| Number of Shares Remaining |
| |
|
| (Shares in thousands) |
| |||||
Equity Compensation Plan Approved by Shareholders |
| 9,860 |
| $ | 8.94 |
| 5,451 |
|
Equity Compensation Plans and Agreements not Approved by Shareholders |
| — |
| — |
| — |
| |
Dividend Policy:The Company has never declared dividends on its Common Stock and does not plan to pay cash dividends on its Common Stock in the foreseeable future. The Company’s credit agreement does not restrict the payment of cash dividends so long as payment conditions per the agreement are met. Any future determination as to the payment of dividends will depend upon capital requirements, limitations imposed by the Company’s credit agreement and other factors the Company’s Board of Directors may consider.
Five-Year Performance Graph:
10The following line graph reflects a comparison of the cumulative total return of the Company’s Common Stock from January 31, 2002 through January 31, 2007 with the Nasdaq Index (U.S. Stocks) and with the Nasdaq National Market Retail Trade Stocks index. Because none of the Company’s leading competitors has been an independent publicly traded company over the period, the Company has elected to compare shareholder returns with the published index of retail companies compiled by NASDAQ. All values assume a $100 investment on January 31, 2002, and that all dividends were reinvested.
|
|
|
|
|
|
|
|
|
|
|
|
| 2002 |
| 2003 |
| 2004 |
| 2005 |
| 2006 |
| 2007 |
|
|
|
|
|
| ||||||
Trans World Entertainment Corporation | 100 |
| 40 |
| 94 |
| 157 |
| 66 |
| 70 |
NASDAQ (U.S. Stocks) | 100 |
| 69 |
| 107 |
| 107 |
| 121 |
| 130 |
NASDAQ Retail Trade Stocks | 100 |
| 80 |
| 118 |
| 143 |
| 153 |
| 166 |
Item 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected income statementStatement of Operations and balance sheetBalance Sheet data for the five fiscal years ended January 28, 2006February 3, 2007 from the Company’s audited consolidated financial statements. EachConsolidated Financial Statements. The fiscal year ended February 3, 2007 consisted of 53 weeks while all the other fiscal years of the Company presented consisted of 52 weeks. The information should be read in conjunction with the Company’s audited consolidated financial statementsConsolidated Financial Statements and related notes and other financial information included herein, including Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
|
| Fiscal Year Ended |
| |||||||||||||
|
| January 28, |
| January 29, |
| January 31, |
| February 1, |
| February 2, |
| |||||
|
| ($ in thousands, except per share and store data) |
| |||||||||||||
INCOME STATEMENT DATA: |
|
|
|
|
|
|
|
|
|
|
| |||||
Sales |
| $ | 1, 238,486 |
| $ | 1,365,133 |
| $ | 1,330,626 |
| $ | 1,281,869 |
| $ | 1,388,032 |
|
Cost of sales |
| 806,873 |
| 869,999 |
| 842,726 |
| 815,071 |
| 935,256 |
| |||||
Gross profit |
| 431,613 |
| 495,134 |
| 487,900 |
| 466,798 |
| 452,776 |
| |||||
Selling, general and administrative expenses |
| 426,854 |
| 450,162 |
| 459,441 |
| 465,893 |
| 422,737 |
| |||||
Goodwill impairment charge (1) |
| — |
| — |
| — |
| 40,914 |
| — |
| |||||
Income (loss) from operations |
| 4,759 |
| 44,972 |
| 28,459 |
| (40,009 | ) | 30,039 |
| |||||
Interest expense |
| 2,954 |
| 2,444 |
| 2,147 |
| 2,349 |
| 2,477 |
| |||||
Other income |
| (2,171 | ) | (1,039 | ) | (718 | ) | (1,231 | ) | (2,120 | ) | |||||
Income (loss) before income taxes, extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
| 3,976 |
| 43,567 |
| 27,030 |
| (41,127 | ) | 29,682 |
| |||||
Income tax expense (benefit) |
| 1,090 |
| 4,892 |
| 8,302 |
| (9,341 | ) | 12,891 |
| |||||
Income (loss) before extraordinary gain – unallocated negative goodwill and cumulative effect of change in accounting principle |
| 2,886 |
| 38,675 |
| 18,728 |
| (31,786 | ) | 16,791 |
| |||||
Extraordinary gain – unallocated negative goodwill , net of income taxes (2) |
| — |
| 3,166 |
| 4,339 |
| — |
| — |
| |||||
Cumulative effect of change in accounting principle, net of income taxes (3)(4) |
| (2,277 | ) | — |
| — |
| (13,684 | ) | — |
| |||||
Net income (loss) |
| $ | 2,922 |
| $ | 41,841 |
| $ | 23,067 |
| $ | (45,470 | ) | $ | 16,791 |
|
Basic earnings (loss) per share: |
|
|
|
|
|
|
|
|
|
|
| |||||
Earnings (loss) per share before extraordinary gain – unallocated negative goodwill and cumulative effect of change in accounting principle |
| $ | 0.09 |
| $ | 1.12 |
| $ | 0.50 |
| $ | (0.79 | ) | $ | 0.40 |
|
Extraordinary gain – unallocated negative goodwill |
| — |
| 0.09 |
| 0.12 |
| — |
| — |
| |||||
Cumulative effect of change in accounting principle |
| (0.07 | ) | — |
| — |
| (0.34 | ) | — |
| |||||
Basic earnings (loss) per share |
| $ | 0.02 |
| $ | 1.21 |
| $ | 0.62 |
| $ | (1.13 | ) | $ | 0.40 |
|
Weighted average number of shares outstanding - basic |
| 31,962 |
| 34,531 |
| 37,422 |
| 40,224 |
| 41,938 |
| |||||
Diluted earnings (loss) per share: |
|
|
|
|
|
|
|
|
|
|
| |||||
Earnings (loss) per share before extraordinary gain – unallocated negative goodwill and cumulative effect of change in accounting principle |
| $ | 0.09 |
| $ | 1.06 |
| $ | 0.49 |
| $ | (0.79 | ) | $ | 0.39 |
|
Extraordinary gain – unallocated negative goodwill |
| — |
| 0.09 |
| 0.11 |
| — |
| — |
| |||||
Cumulative effect of change in accounting principle |
| (0.07 | ) | — |
| — |
| (0.34 | ) | — |
| |||||
Diluted earnings (loss) per share |
| $ | 0.09 |
| $ | 1.15 |
| $ | 0.60 |
| $ | (1.13 | ) | $ | 0.39 |
|
Weighted average number of shares outstanding – diluted |
| 32,124 |
| 36,297 |
| 38,209 |
| 40,224 |
| 42,553 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Pro forma amounts assuming new accounting principle was applied retroactively: |
|
|
|
|
|
|
|
|
|
|
| |||||
Income before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle, as reported |
| $ | 2,886 |
| $ | 38,675 |
| $ | 18,728 |
| $ | (31,786 | ) | $ | 16,791 |
|
Pro forma income before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
| 2,922 |
| 38,946 |
| 18,533 |
| (32,115 | ) | 17,283 |
| |||||
Pro forma net income |
| 2,922 |
| 42,112 |
| 22,872 |
| (45,799 | ) | 17,283 |
| |||||
Per share amounts: |
|
|
|
|
|
|
|
|
|
|
| |||||
Basic earnings per share before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle, as reported |
| $ | 0.09 |
| $ | 1.12 |
| $ | 0.50 |
| $ | (0.79 | ) | $ | 0.40 |
|
Pro forma basic earnings per share before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
| $ | 0.09 |
| $ | 1.13 |
| $ | 0.50 |
| $ | (0.80 | ) | $ | 0.41 |
|
Pro forma basic earnings per share |
| $ | 0.09 |
| $ | 1.22 |
| $ | 0.61 |
| $ | (1.14 | ) | $ | 0.41 |
|
Diluted earnings per share before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle, as reported |
| $ | 0.09 |
| $ | 1.06 |
| $ | 0.49 |
| $ | (0.79 | ) | $ | 0.39 |
|
Pro forma diluted earnings per share before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
| $ | 0.09 |
| $ | 1.07 |
| $ | 0.49 |
| $ | (0.80 | ) | $ | 0.40 |
|
Pro forma diluted earnings per share |
| $ | 0.09 |
| $ | 1.16 |
| $ | 0.60 |
| $ | (1.14 | ) | $ | 0.40 |
|
11
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Fiscal Year Ended |
| |||||||||||||
|
| |||||||||||||||
|
| February 3, |
| January 28, |
| January 29, |
| January 31, |
| February 1, |
| |||||
|
| |||||||||||||||
STATEMENT OF OPERATIONS DATA: |
| ($ in thousands, except per share and store data) |
| |||||||||||||
|
|
|
| |||||||||||||
Sales |
| $ | 1,471,157 |
| $ | 1,238,486 |
| $ | 1,365,133 |
| $ | 1,330,626 |
| $ | 1,281,869 |
|
Cost of sales |
|
| 951,935 |
|
| 806,873 |
|
| 869,999 |
|
| 842,726 |
|
| 815,071 |
|
|
| |||||||||||||||
Gross profit |
|
| 519,222 |
|
| 431,613 |
|
| 495,134 |
|
| 487,900 |
|
| 466,798 |
|
Selling, general and administrative expenses |
|
| 519,246 |
|
| 426,854 |
|
| 450,162 |
|
| 459,441 |
|
| 465,893 |
|
Goodwill impairment charge (1) |
|
| — |
|
| — |
|
| — |
|
| — |
|
| 40,914 |
|
|
| |||||||||||||||
(Loss) income from operations |
|
| (24 | ) |
| 4,759 |
|
| 44,972 |
|
| 28,459 |
|
| (40,009 | ) |
Interest expense |
|
| 5,504 |
|
| 2,954 |
|
| 2,444 |
|
| 2,147 |
|
| 2,349 |
|
Other income |
|
| (4,435 | ) |
| (2,171 | ) |
| (1,039 | ) |
| (718 | ) |
| (1,231 | ) |
|
| |||||||||||||||
(Loss) income before income taxes, extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
|
| (1,093 | ) |
| 3,976 |
|
| 43,567 |
|
| 27,030 |
|
| (41,127 | ) |
Income tax (benefit) expense |
|
| (2,041 | ) |
| 1,090 |
|
| 4,892 |
|
| 8,302 |
|
| (9,341 | ) |
|
| |||||||||||||||
Income (loss) before extraordinary gain – unallocated negative goodwill and cumulative effect of change in accounting principle |
|
| 948 |
|
| 2,886 |
|
| 38,675 |
|
| 18,728 |
|
| (31,786 | ) |
Extraordinary gain – unallocated negative goodwill, net of income taxes (2),(6) |
|
| 10,721 |
|
| — |
|
| 3,166 |
|
| 4,339 |
|
| — |
|
Cumulative effect of a change in accounting principle, net of income taxes (3)(4) |
|
| — |
|
| (2,277 | ) |
| — |
|
| — |
|
| (13,684 | ) |
|
| |||||||||||||||
Net income (loss) |
| $ | 11,669 |
| $ | 609 |
| $ | 41,841 |
| $ | 23,067 |
| $ | (45,470 | ) |
|
| |||||||||||||||
Basic earnings (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earnings (loss) per share before extraordinary gain – unallocated negative goodwill and cumulative effect of change in accounting principle |
| $ | 0.03 |
| $ | 0.09 |
| $ | 1.12 |
| $ | 0.50 |
| $ | (0.79 | ) |
Extraordinary gain – unallocated negative goodwill |
|
| 0.35 |
|
| — |
|
| 0.09 |
|
| 0.12 |
|
| — |
|
Cumulative effect of change in accounting principle |
|
| — |
|
| (0.07 | ) |
| — |
|
| — |
|
| (0.34 | ) |
|
| |||||||||||||||
Basic earnings (loss) per share |
| $ | 0.38 |
| $ | 0.02 |
| $ | 1.21 |
| $ | 0.62 |
| $ | (1.13 | ) |
|
| |||||||||||||||
Weighted average number of shares outstanding - basic |
|
| 30,797 |
|
| 31,962 |
|
| 34,531 |
|
| 37,422 |
|
| 40,224 |
|
|
| |||||||||||||||
Diluted earnings (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earnings (loss) per share before extraordinary gain – unallocated negative goodwill and cumulative effect of change in accounting principle |
| $ | 0.03 |
| $ | 0.09 |
| $ | 1.06 |
| $ | 0.49 |
| $ | (0.79 | ) |
Extraordinary gain – unallocated negative goodwill |
|
| 0.33 |
|
| — |
|
| 0.09 |
|
| 0.11 |
|
| — |
|
Cumulative effect of change in accounting principle |
|
| — |
|
| (0.07 | ) |
| — |
|
| — |
|
| (0.34 | ) |
|
| |||||||||||||||
Diluted earnings (loss) per share |
| $ | 0.36 |
| $ | 0.02 |
| $ | 1.15 |
| $ | 0.60 |
| $ | (1.13 | ) |
|
| |||||||||||||||
Weighted average number of shares outstanding – diluted |
|
| 31,986 |
|
| 32,124 |
|
| 36,297 |
|
| 38,209 |
|
| 40,224 |
|
|
| |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Proforma amounts assuming new accounting principles were applied retroactively: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle, as reported |
| $ | 948 |
| $ | 2,886 |
| $ | 38,675 |
| $ | 18,728 |
| $ | (31,786 | ) |
Proforma income (loss) before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
|
| 948 |
|
| 2,922 |
|
| 38,946 |
|
| 18,533 |
|
| (32,115 | ) |
Pro forma net income |
|
| 11,669 |
|
| 2,922 |
|
| 42,122 |
|
| 22,872 |
|
| (45,799 | ) |
Per share amounts: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic earnings (loss) per share before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle, as reported |
| $ | 0.03 |
| $ | 0.09 |
| $ | 1.12 |
| $ | 0.50 |
| $ | (0.79 | ) |
Proforma basic earnings (loss) per share before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
| $ | 0.03 |
| $ | 0.09 |
| $ | 1.13 |
| $ | 0.50 |
| $ | (0.80 | ) |
Pro forma basic earnings per share |
| $ | 0.38 |
| $ | 0.09 |
| $ | 1.22 |
| $ | 0.61 |
| $ | (1.14 | ) |
Diluted earnings (loss) per share before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle, as reported |
| $ | 0.03 |
| $ | 0.09 |
| $ | 1.06 |
| $ | 0.49 |
| $ | (0.79 | ) |
Proforma diluted earnings (loss) per share before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
| $ | 0.03 |
| $ | 0.09 |
| $ | 1.07 |
| $ | 0.49 |
| $ | (0.80 | ) |
Pro forma diluted earnings per share |
| $ | 0.36 |
| $ | 0.09 |
| $ | 1.16 |
| $ | 0.60 |
| $ | (1.14 | ) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Fiscal Year Ended |
| |||||||||||||
|
| |||||||||||||||
|
| February 3, |
| January 28, |
| January 29, |
| January 31, |
| February 1, |
| |||||
|
| |||||||||||||||
|
| ($ in thousands, except per share and store data) |
| |||||||||||||
|
|
|
| |||||||||||||
BALANCE SHEET DATA (at the end of the period): |
|
|
| |||||||||||||
| ||||||||||||||||
Total assets |
| $ | 829,690 |
| $ | 799,657 |
| $ | 859,653 |
| $ | 817,758 |
| $ | 803,396 |
|
Current portion of long-term debt and capital lease obligations |
|
| 3,393 |
|
| 3,659 |
|
| 780 |
|
| 395 |
|
| 1,640 |
|
Long-term obligations |
|
| 16,085 |
|
| 19,474 |
|
| 12,037 |
|
| 7,465 |
|
| 7,860 |
|
Shareholders’ equity |
| $ | 393,205 |
| $ | 378,512 |
| $ | 404,323 |
| $ | 399,184 |
| $ | 392,104 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
OPERATING DATA: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Store count (open at end of period): |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Mall stores |
|
| 737 |
|
| 546 |
|
| 560 |
|
| 595 |
|
| 650 |
|
Freestanding stores |
|
| 255 |
|
| 236 |
|
| 250 |
|
| 286 |
|
| 205 |
|
Total stores |
|
| 992 |
|
| 782 |
|
| 810 |
|
| 881 |
|
| 855 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Comparable store sales (decrease) / increase(5) |
|
| (6.2 | %) |
| (5.7 | %) |
| 0.8 | % |
| 1.3 | % |
| (5.0 | %) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total square footage (in thousands) |
|
| 5,950 |
|
| 4,824 |
|
| 5,002 |
|
| 5,484 |
|
| 4,944 |
|
1. | The Company recorded a non-cash goodwill impairment charge in fiscal 2002 related to SFAS No. 142, “Goodwill and Other Intangible Assets”. |
2. | The Company’s acquisition of substantially all of net assets of Wherehouse Entertainment Inc. and CD World Inc. stores in fiscal 2003 resulted in extraordinary gains recorded in 2003 and 2004 in accordance with SFAS No. 141, “Business Combinations”. The gains represent the excess of fair value of net assets acquired over the purchase price of the acquired assets. |
3. | The Company adopted Financial Accounting Standards Board’s (“FASB’s”) Emerging Issues Task Force (“EITF”) Statement No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor”, effective as of the beginning of 2002, resulting in a one-time, non-cash, after-tax charge of $13.7 million, which was classified as a “cumulative effect of a change in accounting principle” in 2002. |
4. | The Company adopted FASB Interpretation No. (“FIN”) 47, “Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143”, effective January 28, 2006 resulting in a one-time, non-cash, after tax charge of $2.3 million, which was classified as a “cumulative effect of a change in accounting principle” in 2005. For additional discussion regarding the cumulative effect of the change in accounting principle, refer to Note 2 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K. |
5. | A store is included in comparable store sales calculations at the beginning of its thirteenth full month of operation. Mall stores relocated in the same shopping center after being open for at least thirteen months are considered comparable stores. Closed stores that were open for at least thirteen months are included in comparable store sales through the month immediately preceding the month of closing. |
6. | The Company’s acquisition of substantially all of the net assets of Musicland Holding Corp. stores in fiscal 2006 resulted in an extraordinary gain recorded in 2006 in accordance with SFAS No. 141, “Business Combinations”. The gain represents the excess of fair value of net assets acquired over the purchase price of the acquired assets. For additional discussion regarding the extraordinary gain, refer to Note 3 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K. |
|
| Fiscal Year Ended |
| |||||||||||||
|
| January 28, |
| January 29, |
| January 31, |
| February 1, |
| February 2, |
| |||||
|
| ($ in thousands, except per share and store data) |
| |||||||||||||
BALANCE SHEET DATA: (at the end of the period) |
|
|
|
|
|
|
|
|
|
|
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Total assets |
| $ | 800,323 |
| $ | 859,653 |
| $ | 817,758 |
| $ | 803,396 |
| $ | 935,418 |
|
Current portion of debt and capital lease obligations |
| 3,659 |
| 780 |
| 395 |
| 1,640 |
| 4,711 |
| |||||
Long-term obligations |
| 19,474 |
| 12,037 |
| 7,465 |
| 7,860 |
| 9,500 |
| |||||
Shareholders’ equity |
| $ | 378,512 |
| $ | 404,323 |
| $ | 399,184 |
| $ | 392,104 |
| $ | 448,066 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
OPERATING DATA: |
|
|
|
|
|
|
|
|
|
|
| |||||
Store count (open at end of period): |
|
|
|
|
|
|
|
|
|
|
| |||||
Mall stores |
| 546 |
| 560 |
| 595 |
| 650 |
| 686 |
| |||||
Freestanding stores |
| 236 |
| 250 |
| 286 |
| 205 |
| 216 |
| |||||
Total stores |
| 782 |
| 810 |
| 881 |
| 855 |
| 902 |
| |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Comparable store sales increase/(decrease) (5) |
| (5.7 | )% | 0.8 | % | 1.3 | % | (5.0 | )% | (2.7 | )% | |||||
|
|
|
|
|
|
|
|
|
|
|
| |||||
Total square footage (in thousands) |
| 4,824 |
| 5,002 |
| 5,484 |
| 4,944 |
| 5,076 |
|
(1)The Company recorded a non-cash goodwill impairment charge in fiscal 2002 related to SFAS No. 142, “Goodwill and Other Intangible Assets” concerning the accounting for goodwill.
(2)The Company’s acquisition of the net assets of Wherehouse Entertainment Inc. and CD World Inc. stores in fiscal 2003 resulted in extraordinary gains recorded in 2003 and 2004 in accordance with SFAS No. 141, “Business Combinations” . The gain represents the excess of fair value of net assets acquired over the purchase price of the acquired assets. For additional discussion regarding the extraordinary gain, refer to Note 3 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.
(3)The Company adopted guidance relating to the Financial Accounting Standards Board’s (“FASB’s”) Emerging Issues Task Force (“EITF”) Statement No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor”, effective as of the beginning of 2002, resulting in a one-time, non-cash, after-tax charge of $13.7 million, which was classified as a “cumulative effect of a change in accounting principle” in 2002.
(4)The Company adopted FASB Interpretation No. (“FIN”) 47, “Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143”, effective January 28, 2006 resulting in a one-time, non-cash, after tax charge of $2.3 million, which was classified as a “cumulative effect of a change in accounting principle” in 2005. For additional discussion regarding the cumulative effect of the change in accounting principle, refer to Note 2 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.
(5)A store is included in comparable store sales calculations at the beginning of its thirteenth full month of operation. Mall stores relocated in the same shopping center after being open for at least thirteen months are considered comparable stores. Closed stores that were open for at least thirteen months are included in comparable store sales through the month immediately preceding the month of closing.
12
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Management’s Discussion and Analysis of Financial Condition and Results of Operations provides information that the Company’s management believes necessary to achieve an understanding of its financial condition and results of operations. To the extent that such analysis contains statements which are not of a historical nature, such statements are forward-looking statements, which involve risks and uncertainties. These risks include, but are not limited to, changes in the competitive environment for the Company’s merchandise, including the entry or exit of non-traditional retailers of the Company’s merchandise to or from its markets; releases by the music, DVD,home video, and video gamesgame industries of an increased or decreased number of “hit releases”; general economic factors in markets where the Company’s merchandise is sold; and other factors discussed in the Company’s filings with the Securities and Exchange Commission. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with “Selected Consolidated Financial Data” and the consolidated financial statementsConsolidated Financial Statements and related notes included elsewhere in this report.
Subsequent to the fiscal year ended January 28, 2006 and effectiveIn March, 27, 2006, the Company acquired substantially all of the net assets of Musicland Holding Corp. (“Musicland”). Musicland, an entertainment specialty retailer, which operatesoperated retail stores and Web siteswebsites under the names Sam Goody (www.SamGoody.com)(samgoody.com), Suncoast Motion Picture Company (www.Suncoast.com)(suncoast.com), On Cue and www.MediaPlay.com,MediaPlay.com, and filed a voluntary petition to restructure under Chapter 11 of the United States Bankruptcy Code in January 2006. See Note 133 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for further detail.
OnIn March 16, 2006, the Company acquired an 80% interest in Mix & Burn LLC, a company that will beis fully consolidated for financial reporting purposes.reporting. The Company has committed a total funding of $5.2 million, over two years, of which $1.2$4.0 million was funded as of March 25, 2006.
February 3, 2007.
At January 28, 2006,February 3, 2007, the Company operated 782992 stores totaling approximately 4.86.0 million square feet in 46 states,the United States, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands. In the fiscal year ended February 3, 2007 (referred to herein as “2006”), the Company’s sales increased as compared to the fiscal year ended January 28, 2006, (referred to herein as “2005”), the Company’s sales decreased as compared to the fiscal year ended January 29, 2005, (referred to herein as “2004”) as a result of lowerincreased store count related to the Musicland acquisition, partially offset by a decrease in comparable sales and from operating fewer stores during the year. Earningsstore sales. Income before extraordinary items decreased in 20052006 as a result of lowergreater overall sales and gross margins,margin were not able to offset increased SG&A expenses associated with the higher average store count and integration costs associated with the Musicland acquisition. Comparable store sales decreased 6.2% during Fiscal 2006 as double digit comparable store sale declines in music were partially offset by lower selling, generalpositive comparable store sales in home video, video games and administrative expenses.
accessories and related products.
The Company focuses on the following areas in its effort to improve its business:
Developing its Brands – f.y.e. brand
The Company strives to increase consumer awareness of its various branded stores and Internet sites. Particular attention is paid to itscreating a recognized national mall-based brand f.y.eunder the name f.y.e. (“For Your Entertainment”), since its launch in 2001.. The f.y.ef.y.e. brand initiative is aimed at broadening the Company’s customer base by creating a more relevant entertainment shopping experience and differentiating f.y.ef.y.e. from its competition. It is centered on an engaging and personalized approach in marketing and merchandising, an interactive in-store and on-line entertainment experience and a best-in-retail-class customer service level – all designed to draw customers into stores and enhance long-term customer loyalty. As of February 3, 2007, the Company had over 650 f.y.e. stores and is in the process of re-branding the remaining of its freestanding stores to f.y.e. during 2007. The video only Suncoast brand will be retained. There were 118 Suncoast stores at February 3, 2007. During 2005, the Company also introduced its customer loyalty program, f.y.e. Backstage Pass, which is designed to build stronger connections with each customer.drive repeat business.
Improving Merchandise Assortment and Product Mix
The Company editstailors the product mix of its stores toward regional tastes in order to increaseoptimize the productivity of its stores, seeking to serve key customer segments within each store. This involves tailoring the overall CD inventory and square footage allocation in line with a store’s trend, and increasing inventory and square footage allocations for other, growinggrowth categories. The Company is also evaluating introduction of new productsAs music sales have continued to complement its core categories of CD, DVD and video games. In particular,decline on an industry wide basis, the Company has been able to offset the impact by shifting square footage allocations from music to home video, video game, and other product categories. In addition, the acquisition of the video only Suncoast stores in March 2006 has helped diversify the product mix and lower music as a percentage of the total business. This is seeing growthevident as music has decreased to 44.2% of total sales in Fiscal 2006 compared to 53.6% in Fiscal 2005.
The acquisition of Mix and positive results with the introduction of new products including portable DVD players, mobile phones, MP3 players and accessories in the electronics, accessories and boutique categories and will continue to refine that mix. In 2005, an area of success was the 20% growth over 2004 in the Company’s used product business and this growth is expected to continueBurn in 2006 aswill allow the Company expands into the underdeveloped DVD business as well as increase promotionsto offer customers CD burning and in-store merchandising.
The Company is embracing new digital media sales in its stores and on its e-commerce sites and regards digital downloading as a means to grow sales. With the introduction of its third generation Listening and Viewing Stations (“LVS 3”)stations in allselected stores in 2006, the Company will pursue growth in this category. LVS 3 will support the digital download of music and videos in the future.during 2007.
Growing Store CountOpenings
The Company has historically grown its sales by opening new stores and by acquiring specialty retailers in its business. The Company continues to assess and evaluate the expansion of its national store network, seeking prudent additions, as competitors abandon locations and where
13
economics are compelling. Management believes there are opportunities to expand into new markets, fill-in existing markets, and reposition stores in its current portfolio, particularly with its freestanding formats.
In October 2003,During 2006, the Company acquired substantially all335 stores and closed 189 stores, including 125 of the net assets of 111 stores from Wherehouse Entertainment Inc. (“Wherehouse”), a specialty music retailer located primarily in the Western United States, for $35.2 million in cash. The acquired stores, have been an excellent fit both strategically and operationally with the Company’s freestandingopened 64 stores and provided an intelligent opportunity to expand its West Coast presence. Therepositioned 15 stores. In 2007, the Company also acquired in October 2003 substantially all of the net assets of 13 specialty stores of CD World Inc. (“CD World”), located in New Jersey and Missouri, for $1.9 million in cash. See Note 3 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for further information.
will open very few new stores.
Historically, about 10% of the Company’s stores are being evaluated at any time for closure. The composition of these stores changes from time-to-time as the result of competitive changes and other factors. The Company aggressively closes stores when minimum operating thresholds are not achieved. In recent years, the Company has experienced a net store decline, as closings have outnumbered openings and acquisitions.
During 2005, the Company closed 47 stores, opened 19 stores and repositioned 16 stores. Management believes it will close approximately 35 stores in 2006 and open about 50 new stores. The Company anticipates that its store growth will continue in the future. Subsequent to the fiscal year ended January 28, 2006 and effective March 27, 2006, the Company acquired theexperienced a significant net assets of 335 stores from Musicland Holding Corp. (“Musicland”). Musicland, an entertainment specialty retailer which operates retailstore increase, as acquired stores and websites under the names Sam Goody (SamGoody.com), Suncoast Motion Picture Company (Suncoast.com), On Cue and MediaPlay.com. The acquisition of the Musicland stores provides the Company with the ability to leverage theirnew store locations, and strategically increase its national presence and provide further growth opportunities. See Note 13 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for detail.openings outpaced store closings.
Key Performance Indicators
Management monitors a number of key performance indicators to evaluate its performance, including:
Sales:The Company measures the rate of comparable store sales change. A store is included in comparable store sales calculations at the beginning of its thirteenth full month of operation. Mall stores relocated in the same shopping center after being open for at least thirteen months are considered comparable stores. Closed stores that were open for at least thirteen months are included in comparable store sales through the month immediately preceding the month of closing. The Company further analyzes sales by store format (i.e. mall versus freestanding) and by product category.
Cost of Sales and Gross Profit: Gross profit is a function of the cost of product in relation to its retail selling value. Changes in gross profit are impacted primarily by sales levels, mix of products sold, vendor discounts and allowances and distribution costs. The Company records its distribution and product shrink expenses in cost of sales. Distribution expenses include those costs associated with purchasing, receiving, inspecting and warehousing merchandise and costs associated with product returns to vendors. Cost of sales also includes obsolescence costs and is reduced by the benefit of vendor allowances.
Selling, General and Administrative (“SG&A”) Expenses:expenses: Included in SG&A expenses are payroll and related costs, occupancy charges, professional and service fees, general operating and overhead expenses and depreciation charges (excluding those related to distribution operations, as discussed in Note 4 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K). SG&A expenses also include asset impairment charges and write-offs, if any, and miscellaneous items, other than interest.
Balance Sheet and Ratios:The Company views cash, net inventory investment (inventory(merchandise inventory less accounts payable) and working capital (current assets less current liabilities) as indicators of its financial position. See Liquidity and Capital Resources for further discussion of these items.
14
Compared to Fiscal Year Ended January 28, 2006 (“2005”)
Compared to Fiscal Year Ended January 29, 2005 (“2004”)Sales.
Sales. The following table sets forth a year-over-year comparison of the Company’s total sales:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| 2006 vs. 2005 |
| |||||
|
|
|
|
|
|
|
|
| |||||
($ in thousands) |
| 2006 |
| 2005 |
| $ |
| % |
| ||||
|
|
|
|
| |||||||||
Sales |
| $ | 1,471,157 |
| $ | 1,238,486 |
| $ | 232,671 |
|
| 18.8 | % |
Sales increased in 2006 due to an increase in the average store count. Due to the Musicland acquisition, average store count increased from 801 in Fiscal 2005 to 1,044 in Fiscal 2006. Additionally, the 53rd week in Fiscal 2006 contributed approximately $23.0 million in sales. These factors were partially offset by a comparable store sales decrease of 6.2%. Non-comparable store sales for Fiscal 2006 and 2005 were $349.5 million and $37.6 million, respectively. Total product units sold in Fiscal 2006 increased 13.4% over Fiscal 2005, and the average retail price for units sold increased 3.8% as a larger portion of the Company’s total units sold represented DVDs, video games and electronics which, in general, sell at higher average retail unit prices than CDs.
|
|
|
|
|
| 2005 vs. 2004 |
| |||||
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| % |
| |||
Sales |
| $ | 1,238,486 |
| $ | 1,365,133 |
| $ | (126,647 | ) | (9.3 | )% |
Sales and percentage of total by merchandise category for Fiscal 2006 and 2005, sales change by category for Fiscal 2006 and comparable store sales by category for Fiscal 2006 were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||||||||||||||
($ in thousands) |
| 2006 |
| % |
| 2005 |
| % |
| Total % |
| Comparable |
| ||||||
|
| ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Music |
| $ | 650,352 |
|
| 44.2 | % | $ | 663,712 |
|
| 53.6 | % |
| (2.0 | )% |
| (14.0 | )% |
Home Video |
|
| 552,722 |
|
| 37.6 |
|
| 371,965 |
|
| 30.0 |
|
| 48.6 |
|
| 1.2 |
|
Video games |
|
| 114,514 |
|
| 7.8 |
|
| 90,408 |
|
| 7.3 |
|
| 26.7 |
|
| 4.0 |
|
Other |
|
| 153,569 |
|
| 10.4 |
|
| 112,401 |
|
| 9.1 |
|
| 36.6 |
|
| 7.9 |
|
|
| ||||||||||||||||||
Total |
| $ | 1,471,157 |
|
| 100.0 | % | $ | 1,238,486 |
|
| 100.0 | % |
| 18.8 | % |
| (6.2 | )% |
|
|
The “Other” category includes electronics, accessories and trend item sales, none of which individually exceed 5% of total sales.
Music
The Company’s stores offer a wide range of new and used CDs across most music genres, including new releases from current artists as well as an extensive catalog of music from past periods and artists. The music category represented 44.2% of the Company’s sales in Fiscal 2006 compared to 53.6% in Fiscal 2005. The music category has declined as a percentage of total sales due to a shift in square footage allocations to higher growth categories and due to the acquisition of over 160 video only Suncoast stores in March 2006 (118 remain open at February 3, 2007) which has shifted a larger portion of total sales into the home video category.
Total sales in the music category declined 2.0% from $663.7 million in Fiscal 2005 to $650.4 million in Fiscal 2006. The Company’s annual CD unit sales decreased 2.7% in Fiscal 2006. This decrease in total music sales is due to lower comparable store sales, partially offset by increased average store count.
On a comparable store basis, music sales declined 14.0% due to continued industry sales declines and the aforementioned shift in store square footage allocations. According to Soundscan, total CD unit sales in the United States declined 6.2% during the period corresponding with the Company’s Fiscal 2006.
Home Video
The Company offers DVDs in all its stores. The home video category represented 37.6% of the Company’s sales in Fiscal 2006 compared to 30.0% in Fiscal 2005. The majority of the increase is due to the addition of the video only Suncoast stores in March 2006. The increase is also partially due to the increase in store square footage to support the home video category.
Total sales for Fiscal 2006 in the home video category, including DVD and VHS, increased 48.6% from $372.0 million in Fiscal 2005 to $552.7 million in Fiscal 2006. Total sales in the DVD category increased 55.5% in 2006 and represented 99.1% of total home video sales in 2006. The total sales increase in home video is due the addition of the Suncoast stores, a greater average store count and an increase in comparable store sales.
Comparable store sales, during Fiscal 2006, increased 5.5% in the DVD category. Comparable store sales in the total home video category, including VHS, increased only 1.2% due to the declining VHS category as the Company has discontinued carrying VHS during Fiscal 2006.
The increase in DVD comparable store sales reflects the increase in inventory and floor space to support growth in this category. According to statistics obtained from Rentrak Home Video Essentials, overall home video sales in calendar year 2006, including DVD and VHS, were $15.9 billion, a decrease of 0.9% from 2005. DVD retail sales in calendar year 2006 were $15.7 billion, flat compared to 2005.
Video games
The Company offers video game hardware and software in most of its stores. Total sales in the video game category increased 26.7% from $90.4 million in Fiscal 2005 to $114.5 million in Fiscal 2006 and represented 7.8% of the Company’s total sales in Fiscal 2006 compared to 7.3% in Fiscal 2005.
Comparable store sales in the video games category increased 4.0% in 2006. The increase was due to the release of Sony’s Play Station 3 and Nintendo’s Wii in November 2006 and Microsoft’s Xbox 360 which was released in November 2005. According to the NPD Group, video games sales during calendar year 2006, including portable and console hardware, software and accessories increased 19% over calendar year 2005 sales.
Other
The “Other” category consists of electronics, accessories and trend items and represented 10.4% of total sales in Fiscal 2006 compared to 9.1% in Fiscal 2005. Total sales in this category increased 36.6% to $153.6 million in Fiscal 2006 compared to $112.4 million in Fiscal 2005. This increase is due to the increase in average store count and a comparable store sale increase of 7.9%.
Gross Profit. The following table sets forth a year-over-year comparison of the Company’s Gross Profit:
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| 2006 vs. 2005 |
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| |||||
($ in thousands) |
| 2006 |
| 2005 |
| $ |
| % |
| ||||
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|
|
|
| |||||||||
Gross Profit |
| $ | 519,222 |
| $ | 431,613 |
| $ | 87,609 |
|
| 20.3 | % |
| |||||||||||||
As a percentage of sales |
|
| 35.3 | % |
| 34.9 | % |
|
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|
|
|
|
Gross profit as a percentage of sales increased 40 basis points in Fiscal 2006 as compared to Fiscal 2005 due to higher overall product margins (20 basis points) and the leveraging of distribution expenses over the total sales increase (20 basis points).
Selling, General and Administrative Expenses. The following table sets forth a year-over-year comparison of the Company’s SG&A expenses:
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| 2006 vs. 2005 |
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| |||||
($ in thousands) |
| 2006 |
| 2005 |
| $ |
| % |
| ||||
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|
|
|
| |||||||||
Selling, general and administrative expenses |
| $ | 519,246 |
| $ | 426,854 |
| $ | 92,392 |
|
| 21.6 | % |
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|
|
As a percentage of sales |
|
| 35.3 | % |
| 34.5 | % |
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|
|
The Company’s SG&A expenses increased in Fiscal 2006 due to the operation of a greater number of stores. The Company operated an average of 1,044 stores in 2006 compared to an average of 801 stores in 2005, an increase of 30%. SG&A expenses as a percentage of sales increased 80 basis points, due to the recording of $7.9 million in transition costs related to the Musicland acquisition and a comparable store sales decrease of 6.2%.
Interest Expense. Interest expense in Fiscal 2006 was $5.5 million compared to $3.0 million in Fiscal 2005. The increase is due to increased borrowings on the Company’s line of credit to fund the Musicland acquisition, along with higher variable interest rates.
Other Income. For Fiscal 2006, other income includes a $3.5 million gain on the sale of an investment. For Fiscal 2005, other income includes a realized gain of $0.8 million on the sale of available-for-sale securities. Other income also includes interest income, which was $0.9 million and $1.4 million in Fiscal 2006 and 2005, respectively.
Income Tax (Benefit) Expense. The following table sets forth a year-over-year comparison of the Company’s income tax (benefit) expense:
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| 2006 vs. 2005 |
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($ in thousands) |
| 2006 |
| 2005 |
| $ |
| |||
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| ||||||
| ||||||||||
Income tax expense (benefit) |
| $ | (2,041 | ) | $ | 1,090 |
| $ | (3,131 | ) |
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|
|
|
|
|
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Effective tax rate |
|
| 186.7 | % |
| 27.4 | % |
|
|
|
The 2006 income tax benefit is attributable to a tax favored gain from the sale of an investment, which resulted in a $1.4 million reduction of the valuation allowance attributable to losses on investments, favorable settlements of income tax examinations ($0.9 million) and federal income tax credits ($0.3 million), partially offset by unfavorable state tax legislation enacted during the year and changes in management’s estimates of the realization of state net operating losses. For a reconciliation of the federal statutory tax rate to the Company’s effective income tax rate, see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.
For Fiscal 2005, the Company’s effective tax rate was negatively impacted by changes in Ohio State tax legislation. The legislation phased out state corporation franchise taxes which are based on income. The impact of the Ohio tax legislation resulted in an increase in the state valuation allowance of $1.9 million, associated with deferred tax assets, principally net operating losses that, based on management’s estimates, will not be realized during the phase-out period. Additionally, the valuation allowance was increased by $0.9 million to reserve for deferred tax assets attributable to state net operating losses impacted as a result of projected lower future taxable income within certain states’ expiration periods. During Fiscal 2005, the Company recognized a tax benefit of $2.0 million attributable to the effect of additional deductible temporary differences.
Cumulative Effect of a Change in Accounting Principle. The Company adopted FIN 47,Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143, effective January 28, 2006. In accordance with FIN 47, the Company recorded an asset and a corresponding liability for the present value of the estimated asset retirement obligations associated with the fixed assets and leasehold improvements at its store locations that arise under the terms of operating leases. The Company recognized an expense for the cumulative effect of this change in accounting principle in the fourth quarter of Fiscal 2005 of $2.3 million, net of income taxes of $1.5 million.
Extraordinary Gain. In Fiscal 2006, the Company recorded an extraordinary gain as a result of acquiring substantially all of the net assets of Musicland Holding Corp. on March 27, 2006. From March 27, 2006 to February 3, 2007, the Company allocated the purchase price in accordance with the provisions of SFAS No. 141,Business Combinations, resulting in an extraordinary gain – unallocated negative goodwill of $10.7 million, net of income taxes $6.7 million. The extraordinary gain represents the excess of the fair value of net assets acquired over the purchase price. The purchase price was allocated on a preliminary basis during the thirteen weeks ended April 29, 2006 using information available at the time. The extraordinary gain recorded as of April 29, 2006 was $0.9 million, which was net of income taxes of $0.7 million. In accordance with SFAS No.141, the allocation of the purchase price to the assets and liabilities acquired must be finalized within twelve months following the date of acquisition. Accordingly, the purchase price allocation has been adjusted between April 29, 2006 and February 3, 2007, resulting in an adjustment to the extraordinary gain of $9.8 million, which is net of income taxes of $6.0 million. The pre-tax increase in the extraordinary gain from April 29, 2006 to February 3, 2007 represents adjustments to the value of acquired inventory ($1.9 million), an adjustment to customer liabilities related to the former Musicland loyalty program ($3.4 million), an adjustment to customer liabilities related to gift cards based on the redemption experience since acquisition ($6.1 million) and an adjustment to occupancy related expenses ($1.5 million) and an adjustment to the cash purchase price ($2.9 million).
Net Income. The following table sets forth a year-over-year comparison of the Company’s net income:
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| 2006 vs. 2005 |
| |||||
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| |||||
($ in thousands) |
| 2006 |
| 2005 |
| $ |
| % |
| ||||
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| ||||||
Income before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
| $ | 948 |
| $ | 2,886 |
| $ | (1,938 | ) |
| (67.2 | %) |
Extraordinary gain – unallocated negative goodwill, net of income taxes of $6,739 and $0 for 2006 and 2005, respectively |
|
| 10,721 |
|
| — |
|
|
|
|
|
|
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| |||||||||||||
Cumulative effect of a change in accounting principle, net of income taxes of $0 and $1,505 for 2006 and 2005, respectively |
|
| — |
|
| (2,277 | ) |
|
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|
|
|
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| ||||
Net income |
| $ | 11,669 |
| $ | 609 |
| $ | 11,060 |
|
| 1,816.1 | % |
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Net income as a percentage of sales |
|
| 0.8 | % |
| 0.1 | % |
|
|
|
|
|
|
Income before extraordinary items decreased to $0.9 million in Fiscal 2006 as increased sales and gross profit associated with the increased average store count was not enough to offset a 6.2% decline in comparable store sales and the increase in SG&A expenses, including integration expenses of $7.9 million related to the Musicland acquisition. Income before extraordinary items in Fiscal 2006 was positively impacted by an income tax benefit of $2.0 million. The increase in net income in Fiscal 2006 is due to the extraordinary gain, net of tax, of $10.7 million recorded in relation to the Musicland acquisition.
Fiscal Year Ended January 28, 2006 (“2005”)
Compared to Fiscal Year Ended January 29, 2005 (“2004”)
Sales. The following table sets forth a year-over-year comparison of the Company’s total Sales:
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| 2005 vs. 2004 |
| ||||
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| |||||
| ($ in thousands) |
| 2005 |
| 2004 |
| $ |
| % |
| ||||
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|
|
|
| ||||||||
| Sales |
| $ | 1,238,486 |
| $ | 1,365,133 |
| $ | (126,647 | ) |
| (9.3)% |
|
Sales decreased in 2005 due to a decrease in the average store count from 810 at the end of853 during 2004 to 782 at the end of801 during 2005. The decrease in sales was also the result of a comparable store sales decrease of 5.7%. In 2005, comparable store sales decreased 5.4% for mall-based stores and decreased 6.3% for freestanding stores. A store is included in comparable store sales calculations at the beginning of its thirteenth full month of operation. Not including comparable store sales, sales from new and acquired stores, sales from stores closed during the year and Internet sales, for 2005 and 2004 were $37.6 million and $145.8 million, respectively. Product units sold in 2005 decreased 9.0% over 2004, and average retail for units sold decreased 0.5%.
Sales by merchandise category for 2005 and 2004 and comparable store sales by category for 2005 were as follows:
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|
|
| Total Comparable |
| ||
|
| 2005 |
| 2004 |
| Store Sales |
| ||
|
| ($ in thousands) |
|
|
| ||||
Music: |
|
|
|
|
|
|
| ||
Compact discs |
| $ | 655,806 |
| $ | 736,149 |
| (8.5 | )% |
Audio cassettes and singles |
| 7,906 |
| 14,463 |
| (42.5 | ) | ||
Total Music |
| 663,712 |
| 750,612 |
| (9.2 | ) | ||
Video: |
|
|
|
|
|
|
| ||
DVD |
| 352,184 |
| 360,262 |
| 0.7 |
| ||
VHS |
| 19,781 |
| 37,781 |
| (45.5 | ) | ||
Total Video |
| 371,965 |
| 398,043 |
| (3.7 | ) | ||
Video games |
| 90,408 |
| 89,297 |
| 2.3 |
| ||
Other |
| 112,401 |
| 127,181 |
| 4.4 |
| ||
Total |
| $ | 1,238,486 |
| $ | 1,365,133 |
| (5.7 | )% |
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| ||||||||||||||||||
($ in thousands) |
| 2005 |
| % |
| 2004 |
| % |
| Total % |
| Comparable |
| ||||||
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| ||||||||||||||||||
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Music |
| $ | 663,712 |
|
| 53.6 | % | $ | 750,612 |
|
| 55.0 | % |
| (11.6 | ) % |
| (9.2 | )% |
Home Video |
|
| 371,965 |
|
| 30.0 |
|
| 398,043 |
|
| 29.2 |
|
| (6.6 | ) |
| (3.7 | ) |
Video games |
|
| 90,408 |
|
| 7.3 |
|
| 89,297 |
|
| 6.5 |
|
| 1.2 |
|
| 2.3 |
|
Other |
|
| 112,401 |
|
| 9.1 |
|
| 127,181 |
|
| 9.3 |
|
| (11.6 | ) |
| 4.4 |
|
|
| ||||||||||||||||||
Total |
| $ | 1,238,486 |
|
| 100.0 | % | $ | 1,365,133 |
|
| 100.0 | % |
| (9.3 | ) % |
| (5.7 | )% |
|
|
The “Other” category includes electronics, accessories boutique and other sales,trend items, none of which individually exceeds 5%. of total sales.
Music
The Company’s stores offer a wide range of new and used CDs across most music genres, including new releases from current artists as well as an extensive catalog of music from past periods and artists. The music category represented 53.6% of the Company’s sales in 2005.
The Company’s annual CD unit sales decreased 12.4% in 2005. This decrease is due to a lower store count, weak industry new releases and increased digital downloading. According to Soundscan, total CD unit sales in the United States declined 7.2%. during the same period.
Home Video
The Company is working to introduce digital distribution channels in its stores and through its e-commerce sites. The Company has rolled-out the third generation of LVS, or LVS 3, in over 185 mall stores at the end of 2005 and expects to install it in all stores in 2006. This next generation of technology for the customers enhances overall in-store and online experience through new product information displays and full catalog search capabilities. It is also positioned to deliver in-store digital downloading in the future. Management believes that music will be the category with the highest sales for the foreseeable future.
Video
The Company offers DVDs in all its stores. Total sales for 2005 in the home video category decreased 6.6%. Total sales in the DVD category decreased 2.2% in 2005, due to a lower store count,and were partially offset by a comparable store sales increase of 0.7%. The increase in DVD comparable store sales reflectsreflected the continued industry growth in this category offset by a lack of strong new releases and increased competition. The Company plans to continue to grow market share in this category by adding more product and increasing square footage allocations. Thehome video category, including DVD and VHS, represented 30.0% of the Company’s total sales in 2005. According to statistics obtained from Rentrak Home Video Essentials, DVD industry retail sales in 2005 were $15.7 billion, an increase of 4.5% over 2004.
Video games
The Company offers video game hardware and software in most of its stores, with a mix that favors software. Comparable sales in the video games category increased 2.3% in 2005. The results in this category were positively impacted by Microsoft’s Xbox 360 which was released in
15
November 2005. The comparable store sales increase in this category was partially offset by hardware shortages, delays in releasereleases of highly anticipated software titles and consumer anticipation of next-generation hardware. Video games represented 7.3% of the Company’s total sales in 2005. According to the NPD Group, industry sales for 2005 were $10.5 billion including portable and console hardware, software and accessories, an increase of 6% over 2004.
Other
The “Other” category predominantly consists of electronics, accessories and trend items and represented 9.1% of total sales in Fiscal 2005 compared to 9.3% in Fiscal 2004. Total sales in these categories decreased 11.6% to $112.4 million in Fiscal 2005 compared to $127.2 million in Fiscal 2004. This decrease is due to the decrease in average store count, partially offset by a comparable store sale increase of 4.4%.
Gross Profit.The following table sets forth a year-over-year comparison of the Company’s Gross Profit:
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|
|
|
| 2005 vs. 2004 |
| |||||
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| % |
| |||
Gross Profit |
| $ | 431,613 |
| $ | 495,134 |
| $ | (63,521 | ) | (12.8 | )% |
|
|
|
|
|
|
|
|
|
|
|
|
|
As a percentage of sales |
| 34.9 | % | 36.3 | % |
|
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| 2005 vs. 2004 |
| ||||
|
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|
|
|
|
|
|
| |||||
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| % |
| ||||
|
|
|
|
|
| ||||||||
Gross Profit |
| $ | 431,613 |
| $ | 495,134 |
| $ | (63,521 | ) |
| (12.8) % |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As a percentage of sales |
|
| 34.9 | % |
| 36.3 | % |
|
|
|
|
|
|
Gross profit as a percentage of sales decreased in 2005 as compared to 2004 due to an increase in the Company’s distribution center costs by 30 basis points, a shift in the mix of sales from music to DVD and video games categories of 30 basis points and more competitive pricing in DVD, video games and accessories categories of 50 basis points.
Selling, General and Administrative Expenses.The following table sets forth a year-over-year comparison of the Company’s SG&A expenses:
|
|
|
|
|
| 2005 vs. 2004 |
| |||||
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| % |
| |||
Selling, general and administrative expenses |
| $ | 426, 854 |
| $ | 450,162 |
| $ | (23,308 | ) | (5.2 | )% |
|
|
|
|
|
|
|
|
|
|
|
|
|
As a percentage of sales |
| 34.5 | % | 33.0 | % |
|
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|
| 2005 vs. 2004 |
| ||||
|
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|
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|
|
|
| |||||
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| % |
| ||||
|
|
|
|
|
| ||||||||
Selling, general and administrative expenses |
| $ | 426,854 |
| $ | 450,162 |
| $ | (23,308 | ) |
| (5.2) % |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As a percentage of sales |
|
| 34.5 | % |
| 33.0 | % |
|
|
|
|
|
|
The Company’s SG&A expenses decreased in 2005 due to the operation of fewer stores. The Company operated an average of 796801 stores in 2005 compared to an average of 846853 stores in 2004, a decrease of 6%. The increase in the SG&A expenses rate as a percentage of sales was due to lower sales.
Interest Expense. Interest expense was $3.0 million during 2005 compared to $2.4 million during 2004. The increase was due to a full year of interest being recorded on the real estate mortgaged in 2004 (See Footnote 4 in the Notes to the Consolidated Financial Statements) and interest expense recorded on the $12.0 million capital lease financing of the Company’s point of sale system in 2005 (See Footnote 8 in the Notes to the Consolidated Financial Statements).
Other Income.Other income includes interest income.income of $1.4 million. For 2005, other income also includesincluded a realized gain of $0.8 million on the sale of available-for-sale securities.
Income Tax Expense.The following table sets forth a year-over-year comparison of the Company’s provision for income taxes:
|
|
|
|
|
| 2005 vs. 2004 |
| |||
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| |||
Income tax expense |
| $ | 1,090 |
| $ | 4,892 |
| $ | (3,802 | ) |
|
|
|
|
|
|
|
|
|
|
|
Effective tax rate |
| 27.4 | % | 11.2 | % |
|
|
|
|
|
|
|
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|
|
|
|
|
|
|
|
| 2005 vs. 2004 |
|
|
|
|
|
|
|
|
|
| |
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| ||
|
|
|
|
| |||||
| |||||||||
Income tax expense |
| $ | 1,090 |
| $ | 4,892 |
| $ (3,802) |
|
|
|
|
|
|
|
|
|
|
|
Effective tax rate |
|
| 27.4 | % |
| 11.2 | % |
|
|
For 2005, the Company’s effective tax rate was negatively impacted by changes in Ohio State tax legislation. The legislation phasesphased out state corporation franchise taxes which are based on income. The impact of the Ohio tax legislation resulted in an increase in the state valuation allowance of $1.9 million, associated with deferred tax assets, principally net operating losses that, based on management’s estimates, will not be realized during the phase-out period. Additionally, the valuation allowance was increased by $0.9 million to reserve for deferred tax assets attributable to state net operating losses impacted as a result of projected lower future taxable income within certain states’ expiration periods. During 2005, the Company recognized a tax benefit of $2.0 million attributable to the effect of additional deductible temporary differences. For a reconciliation of the federal statutory tax rate to the Company’s effective income tax rate, see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.
The effective tax rate for 2004 was positively impacted by a benefit arising from the closing of a federal income tax examination and a decrease in the valuation allowance. The benefit of $10.5 million was recorded in the second fiscal quarter and included the closing of all matters not previously settled in relation to corporate-owned life insurance (“COLI”) policies, which were part of the Company’s acquisition of Camelot in 1999 (see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K).1999. The original income tax payable amounts which were recorded during the years covered by the examination were reversed subsequent to the final settlement resulting in the tax benefit. With the closing of the tax examination, the Company has surrendered the remaining COLI policies. In addition, the valuation allowance was decreased by $2.2 million to account for the planned utilization of federal and state net operating loss carryforwards during the
16
expiration periods previously considered uncertain (see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K).uncertain.
Cumulative Effect of a Change in Accounting Principle.The Company adopted FIN 47,Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143, effective January 28, 2006. In accordance with FIN 47, the Company recorded an asset and a corresponding liability for the present value of the estimated asset retirement obligations associated with the fixed assets and leasehold improvements at its store locations that arise under the terms of operating leases. The Company recognized an expense for the cumulative effect of this change in accounting principle in the fourth quarter of Fiscal 2005 of $2.3 million, net of income taxes of $1.5 million.
Extraordinary Gain.In Fiscal 2004, the Company recorded an extraordinary gain as the result of acquiring substantially all the net assets of Wherehouse Entertainment Inc. and CD World Inc. in October 2003 for $35.2 million and $1.9 million, respectively. The purchase price was allocated on a preliminary basis using information available at the time. The gain represents the excess of the fair value of net assets acquired over the purchase price. In accordance with SFAS No.141,Business Combinations, the allocation of the purchase price to the assets and liabilities acquired was finalized and adjusted in 2004, resulting in an extraordinary gain of $3.2 million, which is net of income taxes of $2.0 million, related to unallocated negative goodwill. The extraordinary gain represents adjustments to the value of liquidated inventory ($2.5 million), an adjustment to customer liabilities related to gift cards based on the redemption experience since acquisition ($2.1 million) and occupancy related expenses ($0.6 million).
Net Income.The following table sets forth a year-over-year comparison of the Company’s net income:
|
|
|
|
|
| 2005 vs. 2004 |
| |||||
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| % |
| |||
Income before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
| $ | 2,886 |
| $ | 38,675 |
| $ | (35,789 | ) | (92.5 | )% |
Extraordinary gain –unallocated negative goodwill, net of income taxes of $0 and $1,979 for 2005 and 2004, respectively |
| — |
| 3,166 |
|
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| |||
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|
| |||
Cumulative effect of a change in accounting principle, net of income taxes of $1,505 and $0 for 2005 and 2004 , respectively |
| (2,277 | ) | — |
|
|
|
|
| |||
|
|
|
|
|
|
|
|
|
| |||
Net income |
| $ | 609 |
| $ | 41,841 |
| $ | (41,232 | ) |
|
|
|
|
|
|
|
|
|
|
|
| |||
Net income as a percentage of sales |
| 0.1 | % | 3.1 | % |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| 2005 vs. 2004 |
| ||||
|
|
|
|
|
|
|
|
| |||||
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| % |
| ||||
|
|
|
|
|
| ||||||||
Income before extraordinary gain – unallocated negative goodwill and cumulative effect of a change in accounting principle |
| $ | 2,886 |
| $ | 38,675 |
| $ | (35,789 | ) |
| (92.5)% |
|
Extraordinary gain – unallocated negative goodwill, net of income taxes of $0 and $1,979 for 2005 and 2004, respectively |
|
| — |
|
| 3,166 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cumulative effect of a change in accounting principle, net of income taxes of $1,505 and $0 for 2005 and 2004, respectively |
|
| (2,277 | ) |
| — |
|
|
|
|
|
|
|
|
|
|
|
|
| ||||||||
| |||||||||||||
Net income |
| $ | 609 |
| $ | 41,841 |
| $ | (41,232 | ) |
|
|
|
|
|
|
|
|
| ||||||||
| |||||||||||||
Net income as a percentage of sales |
|
| 0.1 | % |
| 3.1 | % |
|
|
|
|
|
|
The decrease in income before extraordinary gain and cumulative effect of a change in accounting principle, and net income in 2005 as compared to 2004 is due to the decrease in income from operations driven by lower sales and resulting lower gross profit, partially offset by lower SG&A expenses, and a lower income tax benefit of $2.0 million recorded in 2005 compared to a benefit of $10.5 million, which was recorded in the second fiscal quarter of 2004 (see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K).
172004.
Fiscal Year Ended January 29, 2005 (“2004”)
Compared to Fiscal Year Ended January 31, 2004 (“2003”)
Sales. The following table sets forth a year-over-year comparison of the Company’s total Sales:
|
|
|
|
|
| 2004 vs. 2003 |
| |||||
($ in thousands) |
| 2004 |
| 2003 |
| $ |
| % |
| |||
Sales |
| $ | 1,365,133 |
| $ | 1,330,626 |
| $ | 34,507 |
| 2.6 | % |
Sales increased in 2004 despite a decrease in the store count from 881 at the end of 2003 to 810 at the end of 2004. The increase in sales resulted from a comparable store sales increase of 0.8%. In 2004, comparable store sales increased 1.9% for mall-based stores and decreased 1.3% for freestanding stores. A store is included in comparable store sales calculations at the beginning of its thirteenth full month of operation. Sales from new and acquired stores and stores closed during the year, excluded from comparable store sales, for 2004 and 2003 are $145.8 million and $121.2 million, respectively. Product units sold in 2004 increased 3.4% over 2003, and average retail for units sold decreased 0.6%.
Sales by merchandise category and comparable store sales for 2004 and 2003 were as follows:
|
| 2004 |
| 2003 |
| Comparable |
| ||
|
| ($ in thousands) |
|
|
|
|
| ||
Music: |
|
|
|
|
|
|
| ||
Compact discs |
| $ | 736,149 |
| $ | 717,145 |
| (0.8 | )% |
Audio cassettes and singles |
| 14,463 |
| 23,819 |
| (38.4 | ) | ||
Total Music |
| 750,612 |
| 740,964 |
| (2.0 | ) | ||
Video: |
|
|
|
|
|
|
| ||
DVD |
| 360,262 |
| 313,977 |
| 14.6 |
| ||
VHS |
| 37,781 |
| 60,891 |
| (35.3 | ) | ||
Total Video |
| 398,043 |
| 374,868 |
| 6.5 |
| ||
Video games |
| 89,297 |
| 80,888 |
| 9.6 |
| ||
Other |
| 127,181 |
| 133,906 |
| (5.8 | ) | ||
Total |
| $ | 1,365,133 |
| $ | 1,330,626 |
| 0.8 | % |
The “Other” category includes electronics, accessories, boutique and other sales, none of which individually exceeds 5%.
Music
The Company’s stores offer a wide range of CDs across most music genres, including new releases from current artists as well as an extensive catalog of music from past periods and artists. This category represented 55% of the Company’s sales in 2004.
The Company’s annual CD unit sales increased 4.0% in 2004. Despite positive comparable store sales during the first and second quarters of 2004, annual comparable store sales in the CD category declined in 2004. The decrease is largely due to weak industry new releases and effects of the much publicized unauthorized duplication of music. The Company’s annual CD unit sales compared favorably with the Soundscan reported industry increase of 1.9% in 2004. The industry increase marked the first rise in four years. Despite the growing popularity of legal digital music downloads, the CD format accounts for 98% of the 666 million albums sold, according to Soundscan.
The Company is actively embracing digital media in its stores and through its e-commerce activities and regards digital downloading as yet another format for selling media products. In the fourth quarter of 2004, the Company unveiled the f.y.e Download Zone, a subscription-based digital music service, where customers can have access to over a million songs for a monthly fee of $14.95.
Video
The Company offers DVDs and VHS in all of its stores. The growth in the DVD format has more than offset the corresponding decline in VHS for the Company. The increase in the Company’s comparable store sales for video was driven by DVD comparable store sales which increased 14.6%. The Company plans to continue to grow its business and market share in this category by adding more product and increasing square footage allocations. The video category, including DVD and VHS, represented 29% of the Company’s total sales in 2004.
According to statistics obtained from Rentrak Home Video Essentials, video sales, including DVD and VHS, increased 15% to $16.1 billion in 2004, as compared to 2003. The increase in 2004 was driven by a 27% increase in DVD sales. VHS sales declined by 57% during the same period.
18
Video games
The Company offers game hardware and software in most of its stores, with a mix that favors software. The Company’s video games business improved steadily during the second half of 2004, reversing first half results. The Company’s comparable sales in this category increased 9.6% in 2004. The results in the video games category were driven by the Company’s initiatives to improve product selection and increase the category’s visibility in its stores. The video games category was also positively impacted by the success of new releases, including Grand Theft Auto – San Andreas and Halo2. The category represented 7% of the Company’s total sales in 2004.
Software sales for the game industry were $6.2 billion, up 8%, or $400 million over sales in 2003. Industry sales for 2004 of $9.9 billion including portable and console hardware, software and accessories, decreased by less than 1% over 2003 sales, according to The NPD Group, which tracks video games sales in the United States. For 2004, console software, portable game software and portable game hardware also experienced unit sales increases of 8%, 13% and 9%, respectively.
Gross Profit. The following table sets forth a year-over-year comparison of the Company’s Gross Profit:
|
|
|
|
|
| 2004 vs. 2003 |
| |||||
($ in thousands) |
| 2004 |
| 2003 |
| $ |
| % |
| |||
Gross Profit |
| $ | 495,134 |
| $ | 487,900 |
| $ | 7,234 |
| 1.5 | % |
|
|
|
|
|
|
|
|
|
|
|
|
|
As a percentage of sales |
| 36.3 | % | 36.7 | % |
|
|
|
|
The decrease in the gross profit rate as a percentage of sales was due to a continued shift in the mix of the Company’s sales toward DVD and video games, and higher markdowns in the electronics, accessories and boutique categories due to fourth quarter promotions and clearance activity. The Company also incurred higher product shrink expenses and distribution costs associated with bringing its Carson, California distribution facility into full production during the year.
Selling, General and Administrative Expenses. The following table sets forth a year-over-year comparison of the Company’s SG&A expenses:
|
|
|
|
|
| 2004 vs. 2003 |
| |||||
($ in thousands) |
| 2004 |
| 2003 |
| $ |
| % |
| |||
Selling, general and administrative expenses |
| $ | 450,162 |
| $ | 459,441 |
| $ | (9,279 | ) | (2.0 | )% |
|
|
|
|
|
|
|
|
|
|
|
|
|
As a percentage of sales |
| 33.0 | % | 34.5 | % |
|
|
|
|
The Company’s SG&A expenses were lower in 2004 due to the absence of non-recurring charges including the write-off of long-lived assets of $3.7 million related to the outsourcing of its Internet operations, and transition costs of $2.3 million associated with the Wherehouse acquisition in 2003. The Company also recognized approximately $5.0 million lower incentive bonuses in 2004 as compared to 2003. The improvement in the SG&A expenses rate as a percentage of sales was also due to the increase in 2004 sales.
Income Tax Expense. The following table sets forth a year-over-year comparison of the Company’s provision for income taxes:
|
|
|
|
|
| 2004 vs. 2003 |
| |||
($ in thousands) |
| 2004 |
| 2003 |
| $ |
| |||
Income tax expense |
| $ | 4,892 |
| $ | 8,302 |
| $ | (3,410 | ) |
|
|
|
|
|
|
|
| |||
Effective tax rate |
| 11.2 | % | 30.7 | % |
|
| |||
For 2004, the Company’s effective tax rate of 11.2% was positively impacted by a benefit arising from the closing of a federal income tax examination and a decrease in the valuation allowance. The benefit of $10.5 million was recorded in the second fiscal quarter and included the closing of all matters not previously settled in relation to corporate-owned life insurance (“COLI”) policies, which were part of the Company’s acquisition of Camelot in 1999 (see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K). The original income tax payable amounts which were recorded during the years covered by the examination were reversed subsequent to the final settlement resulting in the tax benefit. With the closing of the tax examination, the Company has surrendered the remaining COLI policies. In addition, the valuation allowance was decreased by $2.2 million to account for the planned utilization of federal and state net operating loss carryforwards during the expiration periods previously considered uncertain.
For 2003, the Company’s effective tax rate of 30.7% was positively impacted by improved earnings before taxes and the settlement of its COLI litigation with the IRS. An increase in earnings improves the rate due to the rate leverage on fixed-base state taxes recorded in income tax
19
expense. The Company recorded an additional tax benefit of $2.1 million as a result of the COLI settlement payment terms with the IRS that it recorded in the second quarter (see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K). For a reconciliation of the federal statutory tax rate to the Company’s effective income tax rate, see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.
Extraordinary Gain. In 2004, the Company recorded an extraordinary gain as the result of acquiring substantially all the net assets of Wherehouse Entertainment Inc. and CD World Inc. in October 2003 for $35.2 million and $1.9 million, respectively. The purchase price was allocated on a preliminary basis using information available at the time. The gain represents the excess of the fair value of net assets acquired over the purchase price. In accordance with SFAS No.141, Business Combinations, the allocation of the purchase price to the assets and liabilities acquired was finalized and adjusted in 2004, resulting in an extraordinary gain of $3.2 million, which is net of income taxes of $2.0 million, related to unallocated negative goodwill. The extraordinary gain represents adjustments to the value of liquidated inventory ($2.5 million), an adjustment to customer liabilities related to gift cards based on the redemption experience since acquisition ($2.1 million) and occupancy related expenses ($0.6 million).
Net Income. The following table sets forth a year-over-year comparison of the Company’s net income:
|
|
|
|
|
| 2004 vs. 2003 |
| |||||
($ in thousands) |
| 2004 |
| 2003 |
| $ |
| % |
| |||
Income before extraordinary gain |
| $ | 38,675 |
| $ | 18,728 |
| $ | 19,947 |
| 106.5 | % |
Extraordinary gain – unallocated negative goodwill, net of income taxes of $1,979 and $2,437 for 2004 and 2003, respectively |
| 3,166 |
| 4,339 |
|
|
|
|
| |||
|
|
|
|
|
|
|
|
|
| |||
Net income |
| $ | 41,841 |
| $ | 23,067 |
| $ | 18,774 |
| 81.4 | % |
|
|
|
| �� |
|
|
|
|
| |||
Net income as a percentage of sales |
| 3.1 | % | 1.7 | % |
|
|
|
|
The increase in income before extraordinary gain and net income in 2004 as compared to 2003 is due to increased sales and resulting gross profit, lower SG&A expenses and the income tax benefit recorded in the second fiscal quarter of 2004 (see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K).
20
LIQUIDITY AND CAPITAL RESOURCES
Liquidity and Cash Flows: The Company’s primary sources of working capital are cash provided by operations and borrowing capacity under its revolving credit facility. The Company’s cash flows fluctuate from quarter to quarter due to various items, including seasonality of sales and earnings, merchandise inventory purchases and the related terms on the purchases, store openings, tax payments and capital expenditures and stock repurchase activity.expenditures. Management believes it will have adequate resources to fund its cash needs for the foreseeable future, and anticipates that cash flows from operations will be sufficient to fund its capital spending, its seasonal increase in merchandise inventory, income tax payments and other operating cash requirements and commitments. Management anticipates any cash requirements due to an unanticipated shortfall in cash from operations, willwould be funded by the Company’s revolving credit facility, discussed hereafter. Management believes its reported cash flows for Fiscal 2006 are indicative of cash flow for Fiscal 2007, with the foreseeable futureexception of cash usage associated with the acquisition of Musicland, and is not currently aware of any trends, uncertainties or other significant events that would cause liquidity to increase or decrease in a material way except as discussed under Subsequent Events - Note 13 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.way. However, there can be no assurance that the Company will continue to generate cash flows at or above current levels or that we will be able to maintain the Company’s ability to borrow under the revolving credit facility. The Company does not expect any material changes in the mix (between equity and debt) or the relative cost of capital resources.
The following table sets forth a three year summary of key components of cash flow and working capital:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| 2006 vs. 2005 |
|
|
|
| 2005 vs. 2004 |
| ||||||||
|
|
|
|
|
|
|
|
|
| |||||||||||||
($ in thousands) |
| 2006 |
| 2005 |
| $ |
| % |
| 2004 |
| $ |
|
| % |
| ||||||
|
|
|
|
|
| |||||||||||||||||
Operating Cash Flows |
| $ | 47,268 |
| $ | 25,247 |
| $ | 22,021 |
|
| 87 | % | $ | 105,931 |
| $ | (80,684 | ) |
| (76 | )% |
Investing Cash Flows |
|
| (122,871 | ) |
| (40,517 | ) |
| (82,354 | ) |
| (203 | )% |
| (35,398 | ) |
| (5,119 | ) |
| (14 | )% |
Financing Cash Flows |
|
| (2,976 | ) |
| (17,289 | ) |
| 14,313 |
|
| 83 | % |
| (32,687 | ) |
| 15,398 |
|
| 47 | % |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Capital Expenditures |
|
| (48,289 | ) |
| (41,330 | ) |
| (6,959 | ) |
| (17 | )% |
| (33,398 | ) |
| (7,932 | ) |
| (24 | )% |
Acquisition of Business |
|
| (78,810 | ) |
| — |
|
| (78,810 | ) |
| — |
|
| (2,000 | ) |
| 2,000 |
|
| — |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash and Cash Equivalents |
|
| 118,630 |
|
| 197,209 |
|
| (78,579 | ) |
| (40 | )% |
| 229,768 |
|
| (32,559 | ) |
| (14 | )% |
Merchandise Inventory |
|
| 504,860 |
|
| 402,712 |
|
| 102,148 |
|
| 25 | % |
| 431,246 |
|
| (28,534 | ) |
| (7 | )% |
Working Capital |
|
| 266,204 |
|
| 273,623 |
|
| (7,419 | ) |
| (3 | )% |
| 289,999 |
|
| (16,376 | ) |
| (6 | )% |
Inventory turns |
|
| 1.8 |
|
| 1.9 |
|
|
|
|
|
|
|
| 2.0 |
|
|
|
|
|
|
|
Cash from operating activities increased by approximately $22.0 million in Fiscal 2006. The most significant factor driving the increase was the decrease (cash source) in net merchandise inventory (merchandise inventory less accounts payable) as compared to Fiscal 2005, excluding the merchandise inventory acquired in the Musicland acquisition. The change in net inventory provided cash of approximately $14.3 million in Fiscal 2006, compared to a cash use of approximately $10.2 million in Fiscal 2005, resulting in a $24.5 million increase in cash from operating activities. This was partially offset by a decrease in income before depreciation, amortization, stock compensation and gains and losses for which proceeds are presented in investing activities of approximately $2.6 million. Additional cash uses of approximately $2.9 million for accrued expenses and changes in prepaid expenses and other assets resulting in decreases in cash from operating activities of approximately $2.0 million, as compared to Fiscal 2005, were offset by changes in accounts receivable resulting in an increase in cash from operating activities of approximately $3.3 million and changes in current and deferred taxes resulting an increase in cash from operating activities of approximately $1.5 million.
|
|
|
|
|
| 2005 vs. 2004 |
|
|
| 2004 vs. 2003 |
| |||||||||
($ in thousands) |
| 2005 |
| 2004 |
| $ |
| % |
| 2003 |
| $ |
| % |
| |||||
Operating Cash Flows |
| $ | 25,247 |
| $ | 105,931 |
| $ | (80,684 | ) | (76 | )% | $ | 66,883 |
| $ | 39,048 |
| 58 | % |
Investing Cash Flows |
| (40,517 | ) | (35,398 | ) | (5,119 | ) | (14 | )% | (54,033 | ) | 18,635 |
| 34 | % | |||||
Financing Cash Flows |
| (17,289 | ) | (32,687 | ) | 15,398 |
| 47 | % | (17,978 | ) | (14,709 | ) | (82 | )% | |||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |||||
Capital Expenditures |
| (41,330 | ) | (33,398 | ) | (7,932 | ) | (24 | )% | (16,989 | ) | (16,409 | ) | 97 | % | |||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| |||||
Cash and Cash Equivalents |
| 197,209 |
| 229,768 |
| (32,559 | ) | (14 | )% | 191,922 |
| 37,846 |
| 20 | % | |||||
Merchandise Inventory |
| 402,712 |
| 431,246 |
| (28,534 | ) | (7 | )% | 424,783 |
| 6,463 |
| 2 | % | |||||
Working Capital |
| 257,467 |
| 278,066 |
| (20,599 | ) | (7 | )% | 253,475 |
| 24,591 |
| 10 | % | |||||
Inventory turns |
| 1.9 |
| 2.0 |
|
|
|
|
| 2.1 |
|
|
|
|
| |||||
The Company monitors various statistics to measure its management of inventory, including inventory turn (annual cost of sales divided by average merchandise inventory balances), inventory investment per square foot and inventory leverage (accounts payable divided by merchandise inventory). Inventory turn in Fiscal 2006 was 1.8 compared to 1.9 in Fiscal 2005. Inventory investment per square foot was $85 per square foot at the end of Fiscal 2006 as compared to $83 per square foot at the end of Fiscal 2005. Inventory leverage was 62% as of February 3, 2007 compared with 76% as of January 28, 2006. Management considers these results to be in a normal operating range. Management does not anticipate large fluctuations in merchandise inventory or accounts payable balances in the foreseeable future.
Cash used in investing activities was $122.9 million in Fiscal 2006, as compared to $40.5 million in Fiscal 2005. In Fiscal 2006, the primary uses of cash in investing activities were $48.3 million for capital expenditures and $78.8 million for the acquisition of the net assets of Musicland Holding Corp. These uses were partially offset by proceeds from the sale of an investment of approximately $4.2 million. The Company had capital expenditures in 2006 of $16.7 million for new store openings, relocations and store improvements. An additional $5.3 million was invested in the expansion of LVS 3 (Listening and Viewing Stations) to a greater number of stores. Another $13.5 million was invested in general MIS software and equipment. An investment of $8.4 million was made in store visual displays and other store related projects. Other capital expenditures totaled $4.4 million.
Capital expenditures were $41.3 million in Fiscal 2005. Included in Fiscal 2005 capital expenditures was $16.0 million for new store openings, relocations and other store improvements. The Company further made investments in its store technology and upgraded its LVS (in-store Listening and Viewing Stations) for $10.7 million. The Company also replaced its store point-of-sale system for $12.0 million.
The Company typically finances its capital expenditures through cash generated from operations. It may also receive landlord allowances or concessions for store openings, relocations or improvements. The Company anticipates capital spending of approximately $35 million in 2007.
In March, 2006, the Company acquired 335 Musicland stores for a total cash consideration of $78.8 million, and $16.3 million in assumed liabilities including certain customer obligations, rent and occupancy liabilities and other employee obligations. See Note 3 of Notes to the Consolidated Financial Statements of this Annual Report on Form 10-K.
Cash used in financing activities was $3.0 million in Fiscal 2006, as compared to a $17.3 million use of cash in Fiscal 2005. In Fiscal 2006, the primary uses of cash were payments of long-term debt and capital lease obligations of $0.5 million and $3.2 million, respectively, partially offset by $0.7 million in proceeds and excess tax benefits received from the exercise of stock awards. In Fiscal 2005, the primary use of cash in financing activities was $31.3 million to repurchase outstanding shares of the Company’s Common Stock under programs authorized by the Board of Directors. There are currently no open share repurchase programs.
The decrease in cash from operating activities in Fiscal 2005 compared to Fiscal 2004 was the result of lower net income of $0.6 million as compared to net income of $41.8 million in 2004. It was further due to a net $7.0$10.2 million cash use in Fiscal 2005 in net merchandise inventory (inventory(merchandise inventory less accounts payable) as compared to a $48.1$44.1 million net cash source in Fiscal 2004. The net $7.0 million cash use in 2005 was the result of larger than usual inventory payments in early 2005 for inventory received in the fourth quarter of 2004.
The Company used less cash in Fiscal 2005 for the payment of accrued expenses ($2.8 million cash use in Fiscal 2005 as compared to $10.4 million cash use in Fiscal 2004) and taxes ($7.9 million cash use in Fiscal 2005 as compared to $15.1 million cash use in Fiscal 2004). compared to Fiscal 2004. All other operating cash sources in Fiscal 2005, net, were approximately $10.7 million.
The Company monitors various statistics to measure its management of inventory, including inventory turn (annual cost of sales divided by average inventory balances), inventory investment per square foot and inventory leverage (accounts payable divided by inventory). Inventory turn for 2005 was 1.9 compared to 2.0 in 2004. Inventory investment per square foot was $83 per square foot at the end of 2005 as compared to $86 per square foot at the end of 2004. Inventory leverage was 80% as of January 28, 2006 compared with 83% as of January 29, 2005. Management considers these results to be in a normal operating range. Management does not anticipate large fluctuations in inventory or accounts payable balances for its existing stores in the foreseeable future.
Cash used in investing activities was $40.5 million in Fiscal 2005, as compared to $35.4 million in Fiscal 2004. In Fiscal 2005, the primary use of cash used in investing activities was $41.3 million for capital expenditures. The Company had capital expenditures in Fiscal 2005 of $16.0 million for new store openings and relocations and for store improvements. The Company further made investments in its store technology and upgraded its LVS (in-store Listening and Viewing Stations) for $10.7 million. The Company also replaced its store point-of-sale system for $12.0 million, as discussed hereafter.
The Company had capital expenditures in 2004 of $24.5 million for new store openings and relocations and for store improvements. The Company further made investments in its store technology and upgraded its LVS for $5.2 million. The remainder for 2004 was for other technology upgrades.
The Company typically finances its capital expenditures through cash generated from operations. It may also receive landlord allowances or concessions for store openings, relocations or improvements. The Company anticipates capital spending of $45.0 million in 2006.
Cash used in financing activities was $17.3 million in 2005, as compared to $32.7 million in 2004. In 2005, the primary sources of cash were $12.9 million through capital lease transactions and $4.2 million from the exercise of stock options. In 2005 and 2004, the primary use of cash in financing activities was $31.3 million and $40.2 million, respectively, to repurchase outstanding shares of the Company’s Common Stock under
21
programs authorized by the Board of Directors. The most recent share repurchase program was authorized by the Company’s Board of Directors in May 2003. As of January 28, 2006, the Company had purchased all the 10 million shares authorized under this program at a cost of $88.5 million.
The increase in operating cash flows in 2004 was due to increased earnings and the increase in accounts payable, offset by decreases in accrued expenses and income taxes payable in 2004. Inventory increased $4.0 million (net of adjustments related to extraordinary gain) in 2004 as compared to a decrease of $5.3 million in 2003. The rate of inventory turn (which is a measure of how fast inventory is sold and is calculated by dividing current year’s cost of sales by average inventory) for 2004 was 2.0 comparing with 2.1 in 2003. Inventory was $86 per square foot at the end of 2004 as compared to $77 per square foot at the end of 2003. The increase in inventory can be attributed to the fact that the Company anticipated greater sales than actually realized in the fourth quarter of 2004. Management does not anticipate significant changes to its inventory turn rates and inventory investment per square foot for the foreseeable future. Income taxes payable decreased $15.2 million due to the recording of a tax benefit of $10.5 million in the second quarter of 2004 and tax payments of $12.5 million compared to a provision of $8.5 million in 2004. The seasonality of the Company’s earnings results in substantially all of income tax payments to be made subsequent to year-end. Accounts payable leveraging (the percentage of merchandise inventory financed by vendor credit terms, e.g., accounts payable divided by merchandise inventory) increased to 83.1% as ofIn January, 29, 2005 compared with 72.0% as of January 31, 2004. The increase in leverage was due to the absence of last year’s inventory related to the acquired Wherehouse stores, which was funded in October 2003 without the corresponding accounts payable, and of which a significant amount was on hand at prior year-end. The decrease in accrued expenses in 2004 of $10.4 million was due to lower accruals for gift cards ($2.7 million), lower accruals for employee incentive costs ($4.1 million) and the absence of accruals for acquisition related costs in 2003 ($1.8 million). See Note 3 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for detail.
Cash used in investing activities was $35.4 million in 2004, as compared to $54.0 million in 2003. In 2004, the primary uses of cash were $33.4 million for capital expenditures and $2.0 million for the acquisition of businesses (see Note 3 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for further detail). The majority of the Company’s capital expenditures in 2004 were spent on store improvements, relocations and new store openings. The Company also made investments in technology in its stores including upgrading and maintenance of LVS. The investment in technology was $5.2 million. The remainder of the Company’s capital expenditures in 2004 related to miscellaneous MIS (Management Information Systems) projects. In 2003, primary uses of cash were $37.0 million for the acquisition of businesses (see Note 3 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K) and store improvements, relocations and new store openings. In 2003, the Company made investments of $4.0 million in technology in its stores including upgrading and maintenance of LVS and continued enhancement of the Company’s Web site www.fye.com.
Cash used in financing activities was $32.7 million in 2004, as compared to $18.0 million in 2003. In 2004 and 2003, the primary use of cash used in financing activities was $40.2 million and $17.0 million, respectively, to repurchase outstanding shares of the Company’s Common Stock under programs authorized by the Board of Directors. The current share repurchase program was authorized by the Company’s Board of Directors in May 2003, and allows the Company to repurchase up to 10 million shares of Common Stock from time to time on the open market. As of January 2004, the Company had completed the purchase of 15 million shares of common stock under previously announced programs. As of January 29, 2005, the Company had purchased 6.9 million shares under this plan, at a total cost of $57.2 million, and 3.1 million shares were available for purchase under the current program. In 2004, the Company purchased 3.8 million shares.
Effective March 27, 2006, the Company acquired 335 Musicland stores for a total cash consideration of $104.2 million and $18.1 million in assumed liabilities including certain customer obligations, rent and occupancy liabilities and other employee obligations. See Note 13 of Notes to the Consolidated Financial Statements on this Annual Report on Form 10-K.
On January 5, 2006, the Company entered into a new five year,five-year, $100 million revolving secured Credit Agreement with Bank of America, N.A that expires in January 2010. The revolving credit facility contains provisions governing additional indebtedness and acquisitions and is secured by the Company’s eligible inventory, proceeds from the sale of inventory and by the stock of the Company’s subsidiaries. PriorIn March, 2006, the Company and Bank of America N.A., entered into a First Amendment to the new credit agreementCredit Agreement which increased the amount available for borrowing by the Company hadunder the Credit Agreement to $130 million and in October, 2006, the Company and Bank of America N.A. entered into a three year, $100 million secured revolving credit facility with Congress Financial Corporation that would have expired in July 2006. SubsequentSecond Amendment to the Credit Agreement increasing the amount available to the Company for borrowing to $150 million. The terms and conditions under the aforementioned amendments were the same as the original Credit Agreement.
As of February 3, 2007 and January 28, 2006, the Company entered into a First Amendment of the Credit Agreement with Bank of America N.A on March 26, 2006, which increases the maximum amount available for borrowing under the revolving secured credit facility to $130 million.
As of January 28, 2006had $36 thousand and January 29, 2005, the Company had $0.5 million and $0.3 million, respectively, in outstanding letter of credit obligations under the credit agreements with Bank of America, N.A and Congress Financial Corporation, respectively.N.A. The Company had $99.5$150.0 million and $99.7$99.5 million, available for borrowing as of February 3, 2007 and January 28, 2006, and January 29, 2005, respectively. Interest expense in Fiscal 2006 was $5.5 million, of which $2.1 million was incurred for capital leases. Interest expense in Fiscal 2005 was $3.0 million, of which $1.5 million was incurred for capital leases. Interest expense in 2004 was $2.4 million, of which $2.0 million was incurred for capital leases.
22
During Fiscal 2005, the Company financed the replacement of its point-of-sale system through a capital lease arrangement in the amount of $12.0 million. The lease arrangement has an average interest rate of 5.76% and will be repaid in monthly installments of approximately $229,000 over 5 years.through June 2010. As of January 28, 2006,February 3, 2007, the outstanding balance on the lease was $10.4$8.2 million.
During 2005, the Company purchased software licenses through a capital lease arrangement for $0.9 million, with an interest rate of 5.75%. The capital lease will be repaid in quarterly installments of $122,000 over 2 years. As of January 28, 2006, the outstanding balance on the lease was $0.5 million.
During 2005, the Company acquired an 80% interest in a company that is fully consolidated for financial reporting purposes. The Company has committed funding of $3.0 million over a period of three years, of which $1.0 million was funded as of January 28, 2006.
DuringFiscal 2004, the Company borrowed $5.8 million under a mortgage loan to finance the purchase of real estate. The mortgage loan is repayable in monthly installments of $64,000 over 10 years with a fixed interest rate of 6.0% and is collateralized by the real estate. The mortgage loan contains a minimum net worth (shareholders’ equity) covenant of $290 million, excluding the impact, if any, of certain non-cash charges. As of January 28, 2006,February 3, 2007, the outstanding balance on the loan was $5.1$4.6 million.
Contractual Obligations and Commitments. The following table summarizes the Company’s contractual obligations at January 28, 2006,as of February 3, 2007, and the effect that such obligations are expected to have on liquidity and cash flows in future periods.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Contractual |
| 2007 |
| 2008- |
| 2010 - |
| 2012 and |
| Total |
| |||||
$ in thousands |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating lease obligations |
| $ | 116,934 |
| $ | 163,132 |
| $ | 70,000 |
| $ | 48,293 |
| $ | 398,359 |
|
Capital lease obligations |
|
| 4,831 |
|
| 9,418 |
|
| 4,672 |
|
| 7,392 |
|
| 26,313 |
|
Long-term debt (principal) |
|
| 506 |
|
| 1,107 |
|
| 1,252 |
|
| 1,726 |
|
| 4,591 |
|
Long-term debt (interest) |
|
| 261 |
|
| 427 |
|
| 286 |
|
| 132 |
|
| 1,106 |
|
Purchase obligations (1) |
|
| — |
|
| — |
|
| — |
|
| — |
|
| — |
|
IRS Settlement (3) |
|
| 7,435 |
|
| — |
|
| — |
|
| — |
|
| 7,435 |
|
Deferred rent and other long-term liabilities (2) |
|
| 3,890 |
|
| 1,961 |
|
| 978 |
|
| 938 |
|
| 7,767 |
|
Pension benefits |
|
| 50 |
|
| 115 |
|
| 244 |
|
| 6,091 |
|
| 6,500 |
|
|
| |||||||||||||||
Total |
| $ | 133,907 |
| $ | 176,160 |
| $ | 77,432 |
| $ | 64,572 |
| $ | 452,071 |
|
|
|
(1) | For the purposes of this table, contractual obligations for purchase of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. The Company’s purchase orders are based on its current inventory needs and are fulfilled by its suppliers within short time periods. |
(2) | Included in deferred rent and other long-term liabilities in the Consolidated Balance Sheet as of February 3, 2007 are unfavorable lease valuations of $3.0 million and the long-term portion of deferred rent of $7.1 million which are not reflected in the table above as these amounts do not represent contractual obligations. Also included in long-term liabilities is the long-term portion of the straight line rent liability of $8.9 million, which is included in operating lease obligations in the table above. |
Included in deferred rent and other long term liabilities in the table above are the estimated asset retirement obligations associated with the fixed assets and leasehold improvements at the Company’s store locations that arise under the terms of operating leases. | |
In March, 2006, the Company acquired an 80% interest in Mix & Burn, LLC which is fully consolidated for financial reporting purposes. The Company has committed funding of $5.2 million of which $4.0 million was funded as of February 3, 2007. | |
(3) | During 2000, the United States District Court for the District of Delaware issued an opinion upholding the IRS’ disallowance of deductions of interest expense related to corporate-owned life insurance policies through fiscal 1994. During 2003, the Company and the IRS reached a settlement agreement on this issue. Under the final payment terms, the Company has agreed with the IRS to make annual interest payments and a final principal payment of approximately $7.1 million in June 2007. This amount and accrued interest is recorded in income taxes payable in the Consolidated Balance Sheets. The total payment of $7.4 million due in June 2007 includes the final principal payment of approximately $7.1 million and approximately $0.3 million related to annual interest. |
(4) | The Company offers a 401(k) Savings Plan to eligible employees (see also Note 9 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K). Total expense related to the Company’s matching contribution was approximately $1,003,000, $957,000 and $897,000 in 2006, 2005 and 2004 respectively. The Company expects to expense and fund an amount in 2007 that is comparable to these historical amounts, however, is not contractually obligated to do so and, as such, no amount is recorded in the table above. |
Contractual |
| 2006 |
| 2007 - |
| 2009 - |
| 2011 and |
| Total |
| ||||||
$ | in thousands |
|
|
|
|
|
|
|
|
|
|
| |||||
Operating lease obligations |
| $ | 101,583 |
| $ | 156,691 |
| $ | 83,373 |
| $ | 50,596 |
| $ | 392,243 |
| |
Capital lease obligations |
| 5,195 |
| 9,539 |
| 7,418 |
| 9,356 |
| 31,508 |
| ||||||
Long-term debt (principal) |
| 477 |
| 1,043 |
| 1,176 |
| 2,368 |
| 5,064 |
| ||||||
Long-term debt (interest) |
| 291 |
| 491 |
| 358 |
| 257 |
| 1,397 |
| ||||||
Purchase obligations (1) |
| — |
| — |
| — |
| — |
| — |
| ||||||
Deferred rent and other long-term liabilities (2) |
| 1,637 |
| 9,797 |
| 1,649 |
| 1,550 |
| 14,633 |
| ||||||
Pension benefits |
| 50 |
| 2,362 |
| 2,426 |
| 7,101 |
| 11,939 |
| ||||||
Total |
| $ | 109,233 |
| $ | 179,923 |
| $ | 96,400 |
| $ | 71,228 |
| $ | 456,784 |
| |
(1)Purchase obligations include all legally binding contracts such as software acquisition/license commitments and legally binding service contracts or other commitments. Purchase orders for inventory and other services are not included in the table above. Purchase orders represent authorization to purchase rather than binding agreements. For the purposes of this table, contractual obligations for purchase of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current inventory needs and are fulfilled by our suppliers within short time periods.
(2)As part of a settlement agreement with the IRS, the Company is required to pay interest of approximately $180,000 every six months, through fiscal year 2007, and a final principal payment of $7.1 million in 2007. These payments are pursuant to the settlement of matters with regard to corporate owned life insurance polices and the principal portion is reported in other long-term liabilities in the Consolidated Balance Sheets as of January 28, 2006. Included in deferred rent and other long-term liabilities are unfavorable lease valuations of $1.0 million and the long-term portion of deferred rent of $8.7 million which are not reflected in the table above as the underlying agreements are not legally binding. Also included in long-term liabilities is the long-term portion of the straight line rent liability of $10.6 million, which is included in operating lease obligations in the table above.
Included in deferred rent and other long term liabilities above, is the long-term liability corresponding to the present value of the estimated asset retirement obligations associated with the fixed assets and leasehold improvements at the Company’s store locations that arise under the terms of operating leases.
During 2005, the Company acquired an 80% interest in a Company that is fully consolidated for financial reporting purposes. The Company has committed funding of $3.0 million over a period of three years, of which $1.0 million was funded as of January 28, 2006 and the remaining obligations are included in deferred rent and other long term liabilities above.
Subsequent to January 28, 2006, the Company acquired an 80% interest in a company that will be fully consolidated for financial reporting purposes in 2006. The Company has committed funding of $5.2 million over a period of two years of which $1.2 million was committed as of March 25, 2006. This commitment has not been included in the table above as it does not represent a contractual obligation as of January 28, 2006.
The Company offers a 401(k) Savings Plan to eligible employees (see also Note 9 of Notes to the Consolidated Financial Statements in
23
this Annual Report on Form 10-K). Total expense related to the Company’s matching contribution was $957,000, $897,000 and $858,000 in 2005, 2004 and 2003, respectively. The Company expects to expense and fund an amount in 2006 that is comparable to these historical amounts.
Related Party Transactions.
The Company leases its 181,000181,300 square foot distribution center/office facility in Albany, New York from Robert J. Higgins, its Chairman, Chief Executive Officer and largest shareholder, under three capital leases that expire in the year 2015. The original distribution center/office facility was constructedoccupied in 1985.
Under the three capital leases, dated April 1, 1985, November 1, 1989 and September 1, 1998 (the “Leases”), the Company paid Mr. Higgins an annual rent of $1.9$2.0 million, $1.8$1.9 million and $1.8 million in Fiscal 2006, 2005 2004 and 20032004 respectively. Pursuant to the terms of the lease agreements, effective January 1, 2006 and every two years thereafter, rental payments will increase in accordance with the biennial increase in the Consumer Price Index. Under the terms of the lease agreements, the Company is responsible for property taxes, insurance and other operating costs with respect to the premises. Mr. Higgins’ obligation for principal and interest on his underlying indebtedness relating to the real property is approximately $1.1 million per year. None of the leases contain any real property purchase options at the expiration of their terms.
The Company leases oneof its retail stores from Mr. Higgins under ana long-term operating lease. Annual rental payments under this lease were $40,000 in Fiscal 2006, 2005 2004 and 2003.2004. Under the terms of the lease, the Company pays property taxes, maintenance and a contingent rental if a specified sales level is achieved. Total additional charges for the store, including contingent rent, were approximately $4,100, $4,400 and $14,500 in Fiscal 2006, 2005 and $4,600 in 2005, 2004 and 2003 respectively.
The Company regularly utilizes privately chartered aircraft owned or partially owned by Mr. Higgins. Under an unwritten agreement with Quail Aero Services of Syracuse, Inc., a corporation in which Mr. Higgins, holds a 47.5% share, thefor Company paid $0, $1,000, and $60,000 for chartered aircraft services in 2005, 2004, and 2003, respectively.business. The Company also charters an aircraft from Crystal Jet, a corporation wholly-owned by Mr. Higgins.Higgins, for Company business. Payments to Crystal Jet aggregated approximately $11,000, $6,000 and $10,000 in Fiscal 2006, 2005 and $13,000 in 2005, 2004, and 2003, respectively. The Company also charters an aircraft from Richmor Aviation, an unaffiliated corporation that leases an aircraft owned by Mr. Higgins.Higgins, for Company business. Payments to Richmor Aviation, to charter the aircraft owned by Mr. Higgins, in Fiscal 2006, 2005 and 2004 were approximately $526,000, $276,000 and 2003 were $276,000, $314,000, and $235,000, respectively. The Company believes that the charter rates and terms are as favorable to the Company as those generally available to it from other commercial charters.
Michael Solow, a member of the Company’s Board of Directors, is a partner of the law firm Kaye Scholer LLP, which rendered legal services to the Company in Fiscal 2004 and 2003 for which the Company incurred fees of $115,000 and $202,000 respectively.approximately $115,000. Kaye Scholer concluded its representation of the Company in Fiscal 2004.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires that management apply accounting policies and make estimates and assumptions that affect results of operations and the reported amounts of assets and liabilities in the financial statements. Management continually evaluates its estimates and judgments including those related to merchandise inventory and return costs, valuation of long-lived assets, income taxes, stock-based compensation, and accounting for gift card liability. Management bases its estimates and judgments on historical experience and other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Note 1 of the Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K includes a summary of the significant accounting policies and methods used by the Company in the preparation of its consolidated financial statements. Management believes that of the Company’s significant accounting policies, the following may involve a higher degree of judgment or complexity:
Merchandise Inventory and Return Costs: Inventory Merchandise inventory is stated at the lower of cost or market as determined by the average cost method. The average cost method attaches a cost to each item and is a blended average of the original purchase price and those of subsequent purchases or other cost adjustments throughout the life cycle of that item.
Inventory valuation requires significant judgment and estimates, including obsolescence, shrink and any adjustments to market value, if market value is lower than cost. Inherent in the entertainment software industry is the risk of obsolete inventory. Typically, newer releases generate a higher product demand. Some vendors offer credits to reduce the cost of products that are selling more slowly, thus allowing for a reduction in the selling price and reducing the possibility for items to become obsolete. The Company records obsolescence and any adjustments to market value (if lower than cost) based on current and anticipated demand, customer preferences, and market conditions. The provision for inventory shrink is estimated as a percentage of sales for the period from the last date a physical inventory was performed to the end of the fiscal year. Such estimates are based on historical results and trends and the shrink results from the last physical inventory. Physical inventories are taken at least annually for all stores throughout the year and inventory records are adjusted accordingly.
Shrink expense, including obsolescence was $14.9 million, $15.1 million and $17.2 million, in Fiscal 2006, 2005 and $14.0 million, in 2005, 2004 and 2003 respectively. As a rate to sales, this equaled 1.2%1.0%, 1.3%1.2% and 1.0%1.3%, respectively. The Company expects to realize approximately the same rate of shrink and obsolescence
24
for the foreseeable future as recorded in 2005.Fiscal 2006. Presently, a 0.1% change in the rate of shrink and obsolescence provision would equal approximately $1.2$0.7 million in additional charge or benefit to cost of sales, based on 2005 sales.Fiscal 2006 sales since the last physical inventories.
The Company is generally entitled to return merchandise purchased from major vendors for credit against other purchases from these vendors. Certain vendors reduce the credit with a per unit merchandise return charge ranging from 0% to 20% of the original merchandise purchase pricewhich varies depending on the type of merchandise being returned. Certain other vendors charge a handling fee based on units returned. The Company records merchandise return charges in cost of sales. The Company incurred merchandise return charges in its fiscal years 2006, 2005 and 2004 and 2003 of $3.6 million, $5.6 million and $12.4 million, and $13.5 million, respectively. Merchandise returns decreased 11% in 2005. Return penalties were lower in 2005Fiscal 2006 than in prior years as the major vendors have decreased the up-front incentives and in turn, lowered the back-end penalty rate. The level of merchandise return charges incurred is directly related to the level of merchandise returns.
Valuation of Long-Lived Assets:The Company assesses the impairment of long-lived assets to determine if any part of the carrying value may not be recoverable. Factors that the Company considers to be important when assessing impairment include:
• | significant underperformance relative to historical or projected future operating results; | |
• | significant changes in the manner of the use of acquired assets or the strategy for the Company’s overall business; | |
• | significant negative industry or economic trends; |
•significant underperformance relative to historical or projected future operating results;
•significant changes in the manner of the use of acquired assets or the strategy for the Company’s overall business;
•significant negative industry or economic trends;
If the Company determines that the carrying value of a long-lived asset may not be recoverable, it tests for impairment to determine if an impairment charge is needed. ImpairmentThere were no impairment losses recorded in Fiscal 2006, 2005 2004 and 2003 were $0, $0 and $3.7 million, respectively. The 2003 amount which is reflected in SG&A expenses in the Consolidated Statement of Operations represents the write-down of the fixed assets of www.fye.com pursuant to the Company’s decision to outsource the operation of its f.y.e. Web site.or 2004. Losses for store closings in the ordinary course of business represent the write down of the net book value of abandoned fixtures and leasehold improvements. The loss on disposal of fixed assets related to store closings was $2.5$2.2 million, $2.4 million and $2.8 million in Fiscal 2006, 2005 and $2.5 million in 2005, 2004, and 2003, respectively, and is included in SG&A expenses. Losses due toexpenses in the write downConsolidated Statement of fixed assets related to store closings are included in LossOperations and loss on disposal of fixed assets in the Consolidated StatementsStatement of Cash Flows. Store closings usually occur at the expiration of the lease, at which time leasehold improvements, which constitute a majority of the abandoned assets, are fully depreciated. Also, actual store closures usually occur within three to six months of the planned store closure date. As a result, changes in depreciation estimates as required by Accounting Principles Board, Opinion No. 20, Accounting Changes (“APB 20”), do not have a material impact on financial results.
Income Taxes:Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax operating loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date.
Accounting for income taxes requires management to make estimates and judgments regarding interpretation of various taxing jurisdictions, laws and regulations as well as the ultimate realization of deferred tax assets. These estimates and judgments include the generation of future taxable income, viable tax planning strategies and support of tax filings. Valuation allowances are recorded against deferred tax assets if, based upon management’s estimates of realizability, it is more likely than not that some portion or all of these deferred tax assets will not be realized. For additional discussion regarding income taxes, refer to Note 6 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.
Stock-based Compensation:For periods 2005 and prior, The Company’s adoption of SFAS No. 123 (revised 2004), “Share-Based Payment”, or SFAS 123(R), in the first quarter of 2006 required that the Company appliedrecognize stock-based compensation expense associated with the intrinsic value-based methodvesting of accounting prescribed by Accounting Principles Board (“APB”) Opinion No.25, Accounting for Stock Issuedshare based instruments in the statement of operations. Determining the amount of stock-based compensation to Employees,and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation – An Interpretationbe recorded requires the Company to develop estimates to be used in calculating the grant-date fair value of APB No.25, in accounting for its fixed plan stock options. Under this method,The Company calculate the grant-date fair values using the Black-Scholes valuation model. The Black-Scholes model requires the Company to make estimates of the following assumptions:
Expected volatility—The estimated stock price volatility was derived based upon the Company’s actual historic stock prices over the expected life of the options, which represents the Company’s best estimate of expected volatility.
Expected option life—The Company’s estimate of an expected option life was calculated based on actual historical data relating to grants, exercises and cancellations.
Risk-free interest rate—The Company used the yield on zero-coupon U.S. Treasury securities for a period that is commensurate with the expected life assumption as the risk-free interest rate.
The amount of stock-based compensation expense would be recordedrecognized during a period is based on the datevalue of the portion of the awards that are ultimately expected to vest. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct from “cancellations” or “expirations” and represents only if the current market priceunvested portion of the underlying stock exceededsurrendered option. The Company reviewed historical forfeiture data and determined the exercise price. Unearned compensation recognized for restricted stock awards is shownappropriate forfeiture rate based on that data. The Company will re-evaluate this analysis periodically and adjust the forfeiture rate as a separate component of shareholders’ equity and is amortized tonecessary. Ultimately, the Company will recognize the actual expense over the vesting period ofonly for the stock award using the straight-line method. SFAS No.123, Accounting for Stock-Based Compensation, as amended by SFAS No.148, Accounting for Stock-Based Compensation – Transition and Disclosure, established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No.123, the Company elected to continue to apply the intrinsic value-based method of accounting described above, and adopted the disclosure requirements of SFAS No.123 and SFAS No.148. The Company adopted the expense recognition provisions of SFAS No.123(R), effective for fiscal 2006shares that began on January 29, 2006.
vest.
In December 2005, the Company’s Board of Directors approved the acceleration of vesting of previously granted unvested annual options awarded to employees and officers under the Company’s Stock Option Plans which had exercise prices greater than $10.00 per share. Options to purchase 2.3 million shares became exercisable immediately, representing 24% of total options outstanding, as a result of the vesting acceleration. The decision to accelerate vesting of these stock options was made primarily to avoid recognizing compensation expense in the Consolidated Statement of Operations in future financial statements upon the adoption of SFAS No.123 (R), Share-Based Payment, which the
25
Company will adopt on January 29, 2006. The acceleration of vesting of these stock options resulted in compensation expenses of $5.9 million, in the pro forma net income (loss) results (see Note 1 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K).
Accounting for Gift Card Liability:The Company sells gift cards that are redeemable only for merchandise and have no expiration date. The Company derecognizes card liability when either cu stomerscustomers redeem cards, at which point the Company records revenue; or the Company determines it does not have a legal obligation to remit unredeemed cards to the relevant jurisdictions and the likelihood of the cards being
redeemed becomes remote, at which point the Company records breakage as a credit to SG&A expenses. The Company’s accounting for gift cards is based on estimating the Company’s liability for future card redemptions asat the end of a reporting period end.period. Estimated liability is equal to two years of unredeemed cards, plus an amount for outstanding cards that may possibly be redeemed for the cumulative look-back period, exclusive of the last two years. The Company’s ability to reasonably and reliably estimate the liability is based on historical redemption experience with gift cards and similar types of arrangements and the existence of a large volume of relatively homogeneous transactions. The Company’s estimate is not susceptible to significant external factors and the circumstances around gift card sales and redemptions have not changed significantly over time.
Recently Issued Accounting Pronouncements.
In February 2006,2007, the FASBFinancial Accounting Standards Board (FASB) issued SFASStatement of Financial Accounting Standards (SFAS) No. 155, 159,AccountingThe Fair Value Option for Certain Hybrid Financial Instruments -Assets and Financial Liabilities – including an amendment of FASB StatementsStatement No. 133 and 140115, to simplify and make more consistent the accounting for certain financial instruments. Specifically,. SFAS No. 155 amends159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective of the statement is to provide entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, to permit fair value remeasurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided that the whole instrument159 is accounted for on a fair value basis. SFAS No. 155 amends SFAS No. 140, Accounting for Transfers and Servicingeffective as of Financial Assets and Extinguishment of Liabilities, to allow a qualifying special-purpose entity to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 applies to all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that beginsbeginning after SeptemberNovember 15, 2006, with earlier application allowed.2007. The adoption of SFAS No.155No. 159 is not expected to have a significant impact on the Company’s consolidated financial position or results of operations.Consolidated Financial Statements.
In May 2005,September 2006, the FASB issued SFASStatement of Financial Accounting Standards (SFAS) No. 154, 157,Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial StatementsFair Value Measurements. SFAS No. 154 provides guidance on the157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting forprinciples (GAAP), and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle.expands disclosures about fair value measurements. SFAS No. 154 also provides guidance157 applies under other accounting pronouncements that require or permit fair value measurements, however, does not require any new fair value measurements. SFAS No. 157 is effective for determining whether retrospective application of a change in accounting principle is impracticablefinancial statements issued for fiscal years beginning after November 15, 2007, and for reporting a change when retrospective application is impracticable.interim periods within those fiscal years. The provisionsadoption of SFAS No. 154 are effective for accounting changes and corrections of errors made in fiscal periods beginning after December 15, 2005. The adoption of the provisions of SFAS No. 154157 is not expected to have a materialsignificant impact on the Company’s consolidated financial condition or results of operations.Consolidated Financial Statements.
In June 2005,July 2006, the Emerging Issues Task ForceFASB issued Interpretation No. (“EITF”FIN”) issued EITF48,Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 05-6, Determining109, which prescribes a recognition threshold and measurement attribute for the Amortization Periodfinancial statement recognition and measurement of Leasehold Improvements (purchased after lease inception)a tax position taken or Acquiredexpected to be taken in a Business Combination (“EITF 05-6”). EITF 05-6 provides thattax return. In particular, this interpretation requires uncertain tax positions to be recognized only if they are “more-likely-than-not” to be upheld based on their technical merits. Additionally, the amortization period for leasehold improvements acquired in a business combination or purchased after the inception of a lease be the shorter of (a) the useful lifemeasurement of the assets or (b)tax position will be based on the largest amount that is determined to have greater than a term that includes required lease periods and renewals that are reasonably assured50% likelihood of realization upon the acquisitionultimate settlement. Any resulting cumulative effect of applying the purchase. The provisions of EITF 05-6 areFIN 48 upon adoption would be reported as an adjustment to the beginning balance of retained earnings in the period of adoption. FIN 48 will be effective on a prospective basis for leasehold improvements purchased or acquiredthe Company’s fiscal year beginning July 1, 2005.February 4, 2007. The adoptionCompany is currently evaluating the impact of EITF 05-6 did not have a material effectthis interpretation on the Company’s consolidated financial position or results of operations.Consolidated Financial Statements.
In December 2004, the FASB issued SFAS No.123(R), Share-Based Payment: an amendment of FASB Statements No. 123 and 95. SFAS No.123(R) requires an enterprise to measure the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award at the grant date (with limited exceptions) and recognize the compensation cost over the period during which an employee is required to provide service in exchange for the award. In March 2005, the SEC issued Staff Accounting Bulletin No.107 (“SAB 107”), which expresses views of the SEC staff regarding the application of SFAS No.123(R). Among other things, SAB 107 provides interpretive guidance related to the interaction between SFAS No.123(R) and certain SEC rules and regulations, and provides the SEC staff’s views regarding the valuation of share-based payment arrangements for public companies. In February 2006, the FASB published FASB Staff Position No. FAS 123(R)-4 (“FSP No.123(R)-4”), Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event, to amend guidance in SFAS No.123(R), on classifying options and similar instruments issued as part of employee compensation arrangements. As amended, SFAS No.123(R) requires options issued as compensation to employees to be classified as liabilities if the cash settlement feature can be exercised only upon the occurrence of a contingent event that is outside the employee’s control, and such event is deemed probable to occur. The Company will adopt the expense recognition provisions of SFAS No.123(R) in its first quarter of fiscal 2006 which began on January 29, 2006. If the Company had applied the provisions of SFAS No.123(R) to the financial statements for the period ended January 28, 2006, net loss would have been greater by approximately $7.3 million or $(0.23) per share.
26
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company does not hold any financial instruments that expose it to significant market risk and does not engage in hedging activities. To the extent the Company borrows under its revolving credit facility, the Company is subject to risk resulting from interest rate fluctuations since interest on the Company’s borrowings under its revolving credit facility can be variable. If interest rates on the Company’s revolving credit facility were to increase by 25 basis points, and to the extent borrowings were outstanding, for every $1,000,000 outstanding on the facility, income before income taxes would be reduced by $2,500 per year. Information about the fair value of financial instruments is included in Note 1of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The index to the Company’s Consolidated Financial Statements is included in Item 15, and the Consolidated Financial Statements follow the signature page to this Annual Report on Form 10-K and are incorporated herein by reference.
The quarterly results of operations are included herein in Note 12 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
Item 9A. CONTROLS AND PROCEDURES
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures:Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act). Based on this evaluation, our principal executive officer and our principal financial officer concluded that, as of the end of the period covered by this annual report, our disclosure controls and procedures were effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports we file or submit, under the Exchange Act, is recorded, processed, summarized and reported within the time period specified in the Securities and Exchange Commission’s rules and forms.
Management’s Report on Internal Control Over Financial Reporting: Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15d – 15(f) under the Securities Exchange Act of 1934, as amended). Under the supervision and with the participation of the Company’s management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) inInternal Control-Integrated Framework. Based on our evaluation under the framework inInternal Control- Integrated Framework, our management concluded that our internal control over financial reporting was effective as of January 28, 2006.February 3, 2007.
The Company’s independent registered public accounting firm, KPMG LLP, havehas issued an audit report on the Company’s assessment of the effectiveness of internal control over financial reporting as of January 28, 2006,February 3, 2007, which is included in Item 8 of this Annual Report on Form 10-K and incorporated herein by reference.
Changes in Controls and Procedures:No change in our internal control over financial reporting occurred during the quarterly period ended January 28, 2006February 3, 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B. Other Information
No events have occurred which would require disclosure under this Item.
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PART III
Item 10. DIRECTORS, AND EXECUTIVE OFFICERS OF THE REGISTRANTAND CORPORATE GOVERNANCE
(a) Identification of Directors
Incorporated herein by reference is the information appearing under the captions “Election of Directors” and “Board“Compensation of Directors Meetings and Its Committees”Directors” in the Company’s definitive Proxy Statement for the Registrant’s 20062007 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after January 28, 2006.
February 3, 2007.
(b) Identification of Executive Officers
Incorporated herein by reference is the information appearing under the caption “Executive Officers and Compensation” in the Company’s definitive Proxy Statement for the Registrant’s 20062007 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after January 28, 2006.
February 3, 2007.
(c) Code of Ethics
We have adopted the Trans World Entertainment Corporation Code of Ethics that applies to all officers, directors, employees and consultants of the Company. The Code of Ethics is intended to comply with Item 406 of Regulation S-K of the Securities Exchange Act of 1934 and with applicable rules of The NASDAQ Stock Market, Inc. Our Code of Ethics is posted on our Internet website under the “Corporate” page. Our Internet website address is www.twec.com. To the extent required or permitted by the rules of the SEC and Nasdaq,NASDAQ, we will disclose amendments and waivers relating to our Code of Ethics in the same place as our website.
Item 11. EXECUTIVE COMPENSATION
Incorporated herein by reference is the information appearing under the caption “Executive Officers and Compensation” in the Company’s definitive Proxy Statement for the Registrant’s 20062007 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after January 28, 2006.February 3, 2007.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERSHAREHOLDER MATTERS
Incorporated herein by reference is the information appearing under the captions “Equity Ownership of Directors and Executive Officers” and “Principal Shareholders” in the Company’s definitive Proxy Statement for the Registrant’s 20062007 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after January 28, 2006.
February 3, 2007.
Information on Trans World Entertainment Common Stock authorized for issuance under equity compensation plans is contained in our Proxy Statement for our 20062007 Annual Meeting of Shareholders under the caption “Stock Option Plans” and is incorporated herein by reference. See Note 9 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for a description of the Company’s employee stock optionaward plans.
The following table contains information about the Company’s Common Stock that may be issued upon the exercise of options, warrants and rights under all of the Company’s equity compensation plans as of February 3, 2007:
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Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Incorporated herein by reference is the information appearing under the caption “Related Party Transactions” in the Company’s definitive Proxy Statement for the Registrant’s 20062007 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after January 28, 2006.February 3, 2007.
Item 14. PRINCIPAL ACCOUNTINGACCOUNTANT FEES AND SERVICES
Incorporated herein by reference is the information appearing under the caption “Other Matters” in the Company’s definitive Proxy Statement for the Registrant’s 20062007 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after January 28, 2006.
28February 3, 2007.
PART IV
Item 15. EXHIBITS, AND FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
15(a) (1) Financial Statements
The consolidated financial statementsConsolidated Financial Statements and notesNotes are listed in the Index to Consolidated Financial Statements on page F-1 of this report.
15(a) (2) Financial Statement Schedules
Consolidated financial statement schedulesFinancial Statement Schedules not filed herein have been omitted as they are not applicable or the required information or equivalent information has been included in the consolidated financial statementsConsolidated Financial Statements or the notes thereto.
15(a) (3) Exhibits
Exhibits are as set forth in the “Index to Exhibits” which follows the Notes to the Consolidated Financial Statements and immediately precedes the exhibits filed.
15(b) Reports on Form 8-K
A Form 8-K was filed on November 10, 2005, incorporating by reference Trans World Entertainment’s November 10, 2005 press release announcing the Company’s financial results for its third quarter ended October 29, 2005.
A Form 8-K/A was filed on December 21, 2005, incorporating by reference Trans World Entertainment’s press release dated December 20, 2006, announcing the acceleration of vesting of “underwater” unvested stock options held by employees and executive officers.
A Form 8-K was filed on January 4, 2006, incorporating be reference Trans World Entertainment’s January 4, 2006 press release announcing the Company’s financial results for the five and nine-week periods ending December 31, 2005.
A Form 8-K was filed on January 10, 2006, incorporating be reference Trans World Entertainment’s January 5, 2006 press release announcing the Company’s new five year, $100 million revolving secured credit facility agreement (“Credit Agreement”) with Bank of America, N.A.
A Form 8-K was filed on February 22, 2006, incorporating by reference Trans World Entertainment’s February 17, 2006 entry into an Asset Purchase Agreement with Musicland Holding Corp. and the related press release announcing the same event.
A Form 8-K was filed on March 9, 2006, incorporating by reference Trans World Entertainment’s March 9, 2006 press release announcing the Company’s financial results for its fourth quarter and year ended January 28, 2006.
A Form 8-K was filed on March 23, 2006, incorporating by reference Trans World Entertainment’s March 22, 2006 press release announcing the approval by the United States Bankruptcy Court for the Southern District of New York of the Company’s bid to acquire all of the assets of Musicland Holding Corp.
A Form 8-K was filed on March 29, 2006, incorporating by reference Trans World Entertainment’s March 29, 2006 press release announcing the completion of the Company’s acquisition of Musicland stores and the First Amendment to the Company’s Credit Agreement with Bank of America N.A.
A Form 8-K was filed on March 30, 2006, incorporating by reference Trans World Entertainment’s March 30, 2006 press release announcing the Company’s acquisition of a majority interest in Mix and Burn LLC, a provider of digital content services.
15(c) Exhibits
Exhibits are as set forth in the “Index to Exhibits” which follows the Notes to the Consolidated Financial Statements and immediately precedes the exhibits filed.
15(d) Other Financial Statements
Not applicable.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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Date: April 19, 2007 | By: /s/ ROBERT J. HIGGINS | ||||
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Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
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30
TRANS WORLD ENTERTAINMENT CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders
We have audited the accompanying consolidated balance sheets of Trans World Entertainment Corporation and subsidiaries (the Company) as of February 3, 2007 and January 28, 2006, We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Trans World Entertainment Corporation and subsidiaries as of February 3, 2007 and January 28, 2006, As discussed in and for share-based compensation. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Trans World Entertainment Corporation’s internal control over financial reporting as of /s/ KPMG LLP
Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Trans World Entertainment Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that Trans World Entertainment Corporation and subsidiaries maintained effective internal control over financial reporting as of We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Trans World Entertainment Corporation and subsidiaries as of February 3, 2007 and January 28, 2006, and /s/ KPMG LLP
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
See Accompanying Notes to Consolidated Financial Statements.
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
See Accompanying Notes to Consolidated Financial Statements.
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
See Accompanying Notes to Consolidated Financial Statements.
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
See Accompanying Notes to Consolidated Financial Statements.
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
Note 1. Nature of Operations and Summary of Significant Accounting Policies Nature of Operations: Trans World Entertainment Corporation and subsidiaries (“the Company”) is one of the largest specialty retailers of entertainment software, including music, home video, video games and related products in the United States. The Company operates a chain of retail entertainment stores and e-commerce sites,www.fye.com, Basis of Presentation: The consolidated financial statements consist of Trans World Entertainment Corporation, its wholly-owned subsidiary, Record Town, Inc. (“Record Town”), and Record Town’s subsidiaries, all of which are wholly-owned. During Fiscal 2006 and 2005, the Company acquired Items Affecting Comparability:The Company’s fiscal year is a 52 or 53-week period ending the Saturday nearest to January 31. Fiscal 2006, 2005, and 2004
Effective January 29, 2006, the Company adopted SFAS No. 123(R),Share-Based Payment, using the modified prospective transition method. Under this transition method, compensation cost recognized during 2006 includes compensation expense for all stock-based awards granted prior to, but not yet vested as of January 29, 2006 as well as awards granted in Fiscal 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123. Results for prior periods have not been restated, as allowed for under the modified prospective transition method. For periods 2005 and prior, the Company applied the intrinsic value-based method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25,Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation – An Interpretation of APB No. 25, in accounting for its fixed plan stock options. Under this method, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. Unearned compensation recognized for restricted stock awards is amortized to expense over the vesting period of the stock award using the straight-line method. SFAS No. 123,Accounting for Stock-Based Compensation, as amended by SFAS No. 148,Accounting for Stock-Based Compensation – Transition and Disclosure, established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, prior to 2006, the Company elected to continue to apply the intrinsic value-based method of accounting described above, and adopted the disclosure requirements of SFAS No. 123 and SFAS No.148. The Company adopted FASB Interpretation No. (“FIN”) 47Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143, effective January 28, 2006. In accordance with FIN 47, the Company recorded an asset and a corresponding liability for the present value of the estimated asset retirement obligations associated with the fixed assets and leasehold improvements at its store locations that arise under the terms of operating leases. See Note 2 to the Consolidated Financial Statements for detailed discussion.
Cash and Cash Equivalents: The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
Concentration of Credit Risks: The Company maintains centralized cash management and investment programs whereby excess cash balances are invested in short-term money market funds and instruments considered to be cash equivalents. The Company’s investment portfolio is diversified and consists of short-term investment grade securities consistent with its investment guidelines. These guidelines include the provision that sufficient liquidity will be maintained to meet anticipated cash flow needs. The Company maintains investments with various financial institutions. These amounts often exceed the FDIC insurance limits. The Company limits the amount of credit exposure with any one financial institution and believes that no significant concentration of credit risk exists with respect to cash investments.
Merchandise Inventory and Return Costs: The Company is generally entitled to return merchandise purchased from major vendors for credit against other purchases from these vendors. Certain vendors reduce the credit with a per unit merchandise return charge
which varies depending on the type of merchandise being returned. Certain other vendors charge a handling fee based on units returned. The Company records merchandise return charges in cost of sales. Fixed Assets and Depreciation: Fixed assets are recorded at cost and depreciated or amortized over the estimated useful life of the asset using the straight-line method. The estimated useful lives are as follows:
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