UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FOR THE TRANSITION PERIOD FROM             TO             

COMMISSION FILE NUMBER: 0-14818

(Exact name of registrant as specified in its charter)

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 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 ý  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 an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes ý  No o

As of July 31, 2004, 34,274,732 shares of the Registrant’s Common Stock, excluding 20,209,449 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 31, 2004 as reported on the National Market tier of The NASDAQ Stock Market, Inc. was $340,348,089.  Shares of Common Stock held by the Company’s controlling shareholder, who controls approximately 44.8% 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 26, 2005, there were 32,675,216 shares of Common Stock Issued and Outstanding.

PART I

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 our 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 our control, that could cause our 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 our forward-looking statements.

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:

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 four e-commerce sites and is one of the largest specialty retailers of entertainment software, including music, video, including DVD and VHS, and games and related products in the United States.

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 Web 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 to each) on its Web site as soon as practical after they 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.

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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 on the Saturday closest to January 31.

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.   The Company now owns 100% of the issued and outstanding shares of Second Spin. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations, the transaction was accounted for as a step acquisition with the excess of purchase price over the fair value reported as goodwill.  The Company recorded goodwill of $62,000 related to this transaction. 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, 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.

At January 29, 2005, the Company operated 810 stores totaling approximately 5.0 million square feet in 46 states, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands.

At January 29, 2005, the Company operated 560 mall-based stores in three concepts, predominantly under the FYE, For Your Entertainment, brand including:

Traditional FYE stores.   The traditional FYE mall store averages 5,700 square feet in size and carries a full complement of entertainment software, including music, DVD, games and related accessories.   These stores are often the exclusive provider of music in regional malls.   There were 529 traditional FYE stores at January 29, 2005.

Super FYE stores.  The super FYE concept carries the same merchandise categories as traditional FYE mall locations, but with a much broader and deeper assortment.  This concept is designed to be a semi-anchor or destination location in major regional malls.  There were 14 super FYE stores at January 29, 2005 that averaged 24,500 square feet in size.

Movie stores.  Saturday Matinee and FYE Movie stores specialize in the sale of DVD and related accessories.  They are located in large, regional shopping malls and average 2,200 square feet in size.  The Company operated 17 Movie stores at January 29, 2005.

At January 29, 2005, the Company operated 249 freestanding stores, which operate under the brand names of 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 products and are designed for freestanding, strip center and downtown locations.   The freestanding stores average approximately 6,200 square feet in size.

The Company also operates a single Planet Music store, a 31,400 square foot freestanding superstore in Virginia Beach, VA.   The store offers an extensive catalog of music, video, including DVD and VHS, games and related merchandise.

E-Commerce Sites

The Company has an online presence through various Web sites including, www.fye.com, www.coconuts.com, www.wherehouse.com, and www.secondspin.com.  These sites offer substantially the same complement of products in music, video, including DVD and VHS, and games, as offered in the Company’s stores.

The Company’s stores offer predominantly entertainment software, including music, video, including DVD and VHS, and games.  These categories represented 91% of the Company’s sales in 2004.  The balance of categories, including software accessories, boutique and electronic products, represented 9% of the Company’s sales in 2004.  Management believes there will be continued growth in its DVD and games businesses.  However, sales in music will continue to be the largest category in the foreseeable future.

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The entertainment software industry, including music, DVD and games, totaled approximately $38 billion in the United States in 2004.  This statistic is compiled from three sources: (1) the Recording Industry Association of America’s (“RIAA’s”) value of shipped units of CDs, music videos, cassettes and singles; (2) Rentrak Home Video Essentials (title revenues) including DVD and VHS, and (3) NPD Funworld’s estimate of retail games software sales.

According to statistics published by the RIAA, the number of Compact Discs (CDs) shipped domestically from record companies to retail distribution channels rose 5% in 2004 as compared to 2003. Counting all formats and all distribution channels, both retail and special markets (music clubs and mail order), overall shipments increased by 2% in 2004. This represents a 3% increase in value over 2003. Despite the first increase in CD sales in four years, the number of overall units shipped to retail in 2004 was down 21% as compared to 1999. The top 100 albums, often the most heavily pirated, sold 194.9 million units in 1999, compared to 153.3 million units in 2004 and 146.8 million units in 2003.  Consumers are also increasingly embracing legal digital music formats, with the popularity and acceptance of online music services continuing to expand.  In 2004, just under 140 million licensed digital tracks were sold in the United States.

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.

The NPD Group, which tracks games sales in the United States, noted that software sales for the games industry were $6.2 billion, up 8% over 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.

The Company’s stores offer predominantly entertainment software, including music, video, including DVD and VHS, and games. Other categories include electronics, accessories and boutique products. Management believes there will be continued growth in its DVD and games businesses.

Sales by merchandise category as a percentage of total sales for the three years ended January 29, 2005, January 31, 2004 and February 1, 2003  and comparable store sales for the years ended January 29, 2005 and January 31, 2004, were as follows:

The “Other” category includes electronics, accessories, boutique, and other sales, none of which individually exceeds 5%.

The Company competes with large specialty retail chains that offer similar products in similar style stores, including the Musicland Group Inc., primarily in malls, and Tower Records, primarily in free-standing locations.  However, the number of specialty and independent retailers has decreased due to their reliance on sales of recorded music.  Music sales have suffered from the unauthorized duplication of music and specialty retailers have been impacted by the proliferation of mass merchants (Wal-Mart and Target) and electronics superstores (Best Buy and Circuit City) that offer entertainment software and gained a larger share of the market.  This has similarly impacted the Company’s sales, yet the Company has taken advantage of competitor exits from markets, made acquisitions, diversified its products and taken other measures to position itself competitively in this market and has improved its recent results.  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 retailers in centers offering a full complement of entertainment software;

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•                  Marketing: the Company uses primarily newspaper inserts, radio and television advertising and 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 its customer service levels exceed that of its competition;

•                  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 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 is currently in design and after implementation, will enhance the customers’ in-store experience through improved product information displays and product search and suggestion capabilities.  It will also support in-store digital downloading.

The Company’s business is seasonal, with the fourth fiscal quarter constituting the Company’s peak selling period.  In 2004, the fourth quarter accounted for 38% 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 permanent 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.

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.

The Company purchases inventory from approximately 840 suppliers.  55% of purchases in 2004 were made from four suppliers: EMD (EMI Music Distribution), Sony – BMG (Sony-Bertelsmann Music Group), WEA (Warner/Electra/Atlantic Corp.) and UMVD (Universal Music and Video Distribution).  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 retain access to adequate sources of supply.

Under current trade practices with large suppliers, retailers of music and video products are generally entitled to return merchandise they have purchased for other titles carried by the suppliers.  This practice permits the Company to carry a wider selection of titles by reducing the risk of inventory obsolescence.  Two of the four largest music suppliers charge a related merchandise return penalty and the remaining two suppliers charge a handling fee.  Most manufacturers and distributors of video products do not typically charge a return penalty.  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 29, 2005, the Company employed approximately 7,400 employees, of whom approximately 2,800 were employed on a full-time basis.   All other employees are 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.  None of the Company’s employees are covered by collective bargaining agreements and management believes that the Company enjoys mostly favorable relations with its employees.

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 accounting 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.

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The Company’s point-of-sale and merchandising systems allow for and utilize the daily reporting of sales, inventory and gross margin by store and by item. The Company uses a broadband communication network in its stores to provide data transmission to centralized computer operations, streamline customer checkout procedures (i.e. credit authorization) and transmit content for its in-store listening and viewing stations.   It further provides the capability to implement digital distribution in stores. The Company anticipates replacing its point-of-sale system in fiscal 2005, which will require between $11 million and $12 million in capital spending.  The Company has signed a commitment letter for $12 million at an average interest rate of 5.76% to finance this expenditure through a capital lease transaction during 2005.

At January 29, 2005, the Company operated 809 stores under operating leases, some of which have renewal options.  Substantially all of the leases provide for payment of fixed monthly rentals and expenses for maintenance, property taxes, insurance and utilities.  Many leases provide for added rent based on store receipts 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:

The Company expects that as most leases expire it will exercise renewal rights or obtain new leases for the same or similar locations.  The Company owns one store.

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 40,300 square feet and the distribution center portion is approximately 128,100 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 198,200 square foot distribution center in Carson, California, that expires in December 2005 and contains two five-year options to extend.

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 78% of all merchandise requirements.  The balance of the stores’ requirements are satisfied through direct shipments from vendors.  Company operated trucks service approximately 129 of its stores.  The remaining stores are serviced by common carriers chosen on the basis of geography and rate considerations.  The Company’s shipment volume allows it to take advantage of transportation economies.

The Company leases a 43,500 square foot facility in Johnstown, New York, where it manufactures the majority of its store fixtures. The operating lease expires in December 2006.  The Company believes that its costs of production are equal to or lower than purchasing the fixtures from outside suppliers.

The Company leases 15,100 square feet of office space in Albany, New York. The operating lease expires in December 2005 and includes an option to renew for 6 months.

The Company also leases 31,700 square feet of office space in Albany, New York. The operating lease expires in June 2014 and includes two options to renew for additional consecutive five year periods.

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Item 3.  LEGAL PROCEEDINGS

On October 16, 2000, the United States District Court for the District of Delaware issued an opinion in favor of the IRS in the case IRS vs. CM Holdings Inc., a wholly-owned subsidiary of the Company, upholding the IRS’ disallowance of deductions of interest expense related to corporate-owned life insurance policies through fiscal 1994. The original accrual for additional income taxes resulting from disallowed interest expense deductions was recorded following the October 2000 court decision. The remaining accrued liabilities attributable to this matter are $8.7 million and $8.1 million which are included in deferred rent and other long-term liabilities in the Consolidated Balance Sheets as of January 29, 2005 and January 31, 2004, respectively.  During the second fiscal quarter of 2003, the Company and the IRS agreed on final computation and payment terms (including bankruptcy provision interpretations, an interest holiday and interest compounding) for an amount less than previously accrued, which resulted in an income tax benefit of $2.1 million in fiscal 2003.  Under the final payment terms, the Company has agreed to make annual interest payments and a final principal payment of approximately $7.1 million in 2007.

The Company is subject to other 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.

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended January 29, 2005.

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PART II

Market Information.  The Company’s Common Stock trades on the NASDAQ Stock Market under the symbol “TWMC.”  As of January 29, 2005, there were 535 shareholders of record.  The following table sets forth high and low last reported sale prices for each fiscal quarter during the period from February 1, 2003 through March 18, 2005.

On March 18, 2005, the last reported sale price on the Common Stock on the NASDAQ National Market was $14.66

Options for the Company’s Common Stock trade on the Chicago Board Options Exchange.

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 program has no expiration date.  The Company had repurchased 15 million shares of common stock under previously announced programs. As of January 29, 2005, the Company had purchased 6.9 million shares, at a total cost of $57.2 million, and 3.1 million shares remained to be purchased under the current program. During fiscal 2004, the Company purchased 3.8 million shares at a total cost of $40.2 million. As of March 18, 2005, the Company had completed the purchase of an additional 0.4 million shares for $5.9 million under the current program. The following table shows the purchase of equity securities purchased under the repurchase program as required by Item 703 of Regulation S-K.

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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 29, 2005:

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 currently allows the Company to pay a cash dividend once in each calendar year.  Any dividend would be restricted to 10% of the most recent fiscal year’s consolidated net income and could only be paid if, after any payment of dividends, the Company maintains $25 million in availability under the credit agreement.  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.

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Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth selected income statement and balance sheet data for the five fiscal years ended January 29, 2005 from the Company’s audited consolidated financial statements.  Each fiscal year of the Company consisted of 52 weeks, except the fiscal year ended February 3, 2001, which consisted of 53 weeks. The information should be read in conjunction with the Company’s audited consolidated 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”.

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(1)       The Company recorded a non-cash goodwill impairment charge in fiscal 2002 related to Statement of Financial Accounting Standard (SFAS) No. 142, “Goodwill and Other Intangible Assets” concerning the accounting for goodwill. For additional discussion regarding the impairment charge, refer to Note 1 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K .

(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 fiscal 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. 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.

(4)       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.

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Item 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 statements 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, video, including DVD and VHS, and games 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 statements and related notes included elsewhere in this report.

At January 29, 2005, the Company operated 810 stores totaling approximately 5.0 million square feet in 46 states, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands.  In the fiscal year ended January 29, 2005 (referred to herein as “2004”), the Company improved its sales over the year ended January 31, 2004, (referred to herein as “2003”) primarily as a result of the acquisition of the Wherehouse stores and CD World stores in 2003 and positive comparable store sales.  Comparable store sales in 2004 increased in the DVD and games categories and declined slightly in the CD category.  Earnings increased in 2004 as a result of increased sales and a decrease in selling, general and administration expenses and a tax benefit recorded during the year (see Note 6 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K).

The Company focuses on the following areas in its effort to improve its business:

The Company strives to increase consumer awareness of its various branded stores and internet sites.  Particular attention is paid to its national mall-based brand FYE (“For Your Entertainment”), since its launch in 2001.  The FYE brand initiative is aimed at broadening the Company’s customer base by creating a more relevant entertainment shopping experience and differentiating FYE 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.

The Company edits the product mix of its stores toward regional tastes in order to increase the productivity of its stores, seeking to serve key customer segments within each store.  This involves tailoring the overall music inventory and square footage allocation in line with a store’s trend, and increasing inventory and square footage allocations for other, growing categories, particularly DVD and games.  The Company also continually evaluates new products to complement its core entertainment software businesses.  Further, the Company in recent years has increased its business in used product.  With the acquisition of the Wherehouse stores in 2003, the Company has established this category as a competitive advantage by providing further value to customers.

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.  The digital music market was about $330 million in 2004, or about 1% of all music sales, a figure that is expected to double in 2005 according to research firm Jupiter.  In 2004 the Company introduced the FYE Download Zone, a subscription-based digital music service, where customers can access over one million songs for $14.95 per month.  FYE Download Zone is available within Microsoft’s Windows Media Player 10.

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 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, 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 acquired stores represent an excellent fit both strategically and operationally with the Company’s freestanding stores and provide the unique opportunity to expand its presence on the West Coast.  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.

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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.

During 2004, the Company closed 95 stores, opened 24 stores and repositioned 15 stores.  Management believes it will close approximately 25 stores in 2005 and open about 35 stores. The Company anticipates that its store growth will continue in the future.

Management monitors a number of key performance indicators to evaluate its performance, including:

Revenues:  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 impacted primarily by the mix of products sold and by discounts negotiated with vendors.  The Company records its distribution and product shrink expenses in cost of sales. In addition to the cost of product, cost of sales includes those costs associated with purchasing, receiving, inspecting and warehousing product.  Also included are costs associated with product returns to vendors.  Cost of sales further includes obsolescence costs and the benefit of vendor allowances and discounts.

Selling, General and Administrative (“SG&A”) 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 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.

On February 7, 2005, the Office of the Chief Accountant of the U.S. Securities and Exchange Commission issued a clarification of their interpretation of certain accounting issues and their application under U.S. generally accepted accounting principles, relating to operating leases.  After an internal review and discussion with its independent auditors, the Company determined its then current method of accounting for allowances provided by landlords to fund leasehold improvements needed to be revised.  Historically, the Company accounted for these allowances as reductions to the related leasehold improvements on its balance sheet and as a reduction of related investing activities on its cash flow statement.  Management revised its method of accounting for these allowances to record them as deferred credits (“deferred rent”) on its balance sheet and as a component of operating activities on its cash flow statement.  See Note 4 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for detailed discussion.

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.   The Company now owns 100% of the issued and outstanding shares of Second Spin. In accordance with SFAS No. 141, Business Combinations, the transaction was accounted for as a step acquisition with the excess of purchase price over the fair value reported as goodwill.  The Company recorded goodwill of $62,000 related to this transaction. 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 Statements of Operations due to Second Spin’s accumulated operating losses, and accordingly no minority interest had been reflected in the financial statements.

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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:

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, excluding 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 for the years ended January 29, 2005 and January 31, 2004 were as follows:

The “Other” category includes electronics, accessories, boutique and other sales, none of which individually exceeds 5%.

The Company’s stores offer a wide range of CDs, audio cassettes and singles 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 FYE 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.  Management believes that music will continue to have the highest sales by category for the foreseeable future.

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. Management believes there will be continued growth in its video business.

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.

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The Company offers game hardware and software in most of its stores, with a mix that favors software.  The Company’s games business improved steadily during the second half of the year, reversing first half results. The Company’s comparable sales in this category increased 9.6% in 2004. The results in the games category were driven by the Company’s initiatives to improve product selection and increase the category’s visibility in its stores. The 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. Management believes there will be continued growth in its games business.

Software sales for the game industry were $6.2 billion, an increase of 8% 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 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:

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 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. Management believes that it can maintain its gross profit rate in the foreseeable future. However, if its competitors begin offering lower prices, and the Company has to lower its prices in response, it will negatively impact the gross profit rate.

Selling, General and Administrative Expenses.   The following table sets forth a year-over-year comparison of the Company’s SG&A expenses:

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 annual sales.

Income Tax Expense.    The following table sets forth a year-over-year comparison of the Company’s provision for income taxes:

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. 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.

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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 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.  The Company acquired substantially all the net assets of Wherehouse Entertainment Inc. (“Wherehouse”) and CD World Inc. (“CD World”) in October 2003 for $35.2 million and $1.9 million, respectively. The purchase price was allocated on a preliminary basis during 2003 using information available at the time. Extraordinary gain for 2003 was $4.3 million, which is net of income taxes of $2.4 million, related to unallocated negative goodwill. The gain represents the excess of the fair value of net assets acquired in excess of the purchase price of the acquired assets.  In accordance with Statement of Financial Accounting Standards (“SFAS”) No.141, Business Combinations, the allocation of the purchase price to the assets and liabilities acquired was finalized and adjusted during 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:

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).

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Fiscal Year Ended January 31, 2004 (“2003”)

Compared to Fiscal Year Ended February 1, 2003 (“2002”)

Sales.  The following table sets forth the year-over-year comparison of the Company’s sales:

The increase in sales resulted from a comparable store sales increase of 1.3% and an increase in the average number of stores in operation due to the acquisition of stores in the third quarter.  The store count increased from 855 at the end of 2002 to 881 at the end of 2003.  In 2003, comparable store sales increased 1.9% for mall-based stores and decreased 0.2% for freestanding stores.  The amount of sales not accounted for as comparable sales, including sales from new and acquired stores and sales from stores closed during the year, for fiscal years 2003 and 2002 are $121.3 million and $84.3 million, respectively. Product units sold in 2003 versus 2002 increased 3.8%, while the average retail for units sold remained the same.

Sales by merchandise category for the two years ended January 31, 2004 and February 1, 2003 were as follows:

The “Other” category includes electronics, boutique, accessories and other sales, none of which individually exceeds 5%.

Comparable store sales for music declined in fiscal 2003, following industry trends.  However, comparable store sales for CD sales improved during the third and fourth quarters of 2003 as compared to the first and second quarters, with an improvement in new release performance. The Company’s annual CD sales declined in fiscal 2003 for the third straight year.  The decreases followed industry trends that have been much publicized by the RIAA and are largely due to the unauthorized duplication of music and weak industry new releases.  According to the RIAA, industry sales of CDs were down 7% in 2003. It is widely believed that it was further helped by measures undertaken by the RIAA to reduce piracy, including legal actions taken against those who abuse on-line file-sharing services to illegally distribute product.

The Company believes that the paid digital downloading of music will garner more market share in the coming years and has developed plans to introduce an in-store test in the fourth quarter of 2004.

The Company offers DVDs and VHS in all of its stores.  Since the introduction of the DVD format in 1997, the video industry has experienced significant growth which is consistent with the Company’s increase in comparable store sales.   The growth in the DVD format has more than offset the corresponding decline in VHS for the Company. 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 category represented 28% of the Company’s sales in 2003.

According to The Digital Entertainment Group, consumer spending on video, including DVD and VHS, was up 18% in 2003, with DVD representing 72% of all video transactions.  Overall, DVD retail sales in the United States in the calendar year 2003 grew by 33% over 2002.   The increase in comparable store sales for video was driven by increased DVD sales.

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The Company offers games hardware and software in most of its stores, with a mix that favors software.  The Company’s sales in this category increased 3.5% in 2003. The Company expects a modest increase in sales in this category until new hardware platforms, and related software, are introduced.  The category represented 6% of total company sales in 2003. Management believes there will be continued growth in its games business.

According to a leading market information provider, The NPD Group, the games market in 2003, including portable and console hardware, software and accessories, was impacted by price cuts from console manufacturers as well as declines in retail software prices. Overall industry revenues declined by 4% to $11.2 billion in 2003, while sales of games software increased 2% in 2003 as compared to 2002.

Gross Profit.   The following table sets forth a year-over-year comparison of the Company’s Gross Profit:

The increase in the gross profit rate as a percentage of sales was due to improvement in margin rate across most product categories. The Company also recorded lower costs related to distribution and product shrink expenses, as a rate of sales, which are recorded in cost of sales.  Management believes that it can maintain its margin rate in the foreseeable future. However, if its competitors lower prices, and the Company has to lower its prices in response, it will negatively impact the margin rate.

Selling, General and Administrative Expenses.   The following table sets forth a year-over-year comparison of the Company’s SG&A expenses:

The decrease in selling, general and administrative expenses was the result of lower overhead expenses, including depreciation, as non-recurring charges in 2003 were partially offset by non-recurring charges in 2002.  In 2003, the Company recorded additional employee incentive costs of $8.7 million based on its improved performance, and recorded transition costs of $2.3 million associated with the acquisition of the Wherehouse stores.  The Company further wrote-off long-lived assets of $3.7 million related to its Internet operations.  These additional charges were partially offset by charges of $9.3 million taken in 2002 for the write down of certain investments deemed impaired.  The improvement in the selling, general and administrative expenses rate as a percentage of sales was due largely to the increase in 2003 annual sales.

Goodwill Impairment Charge. In 2002, the Company performed its annual review of its goodwill balances in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, and determined that the entire recorded goodwill of $40.9 million was impaired. The impairment charge resulted from operating profits and cash flows being lower than expected during the second half of 2002.  Based on this trend, the earnings forecasts of the Company were revised. The current fair values of the Company’s reporting units were based on the present expectations for these businesses in light of sales trends and the business environment at that time, including a slowdown in the retail music industry.   A discounted cash flow model based upon the Company’s weighted average cost of capital, and other widely accepted valuation techniques, including market multiple analyses, were used to determine the fair value of the Company’s reporting units for purposes of testing goodwill impairment. Accordingly, the Company took a non-cash impairment charge to operations of $40.9 million. For additional discussion regarding the impairment charge, refer to Note 1 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.

Income Tax Expense (Benefit).   The following table sets forth a year-over-year comparison of the Company’s provision for income taxes:

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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 expense.  The Company received 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).  The effective income tax benefit rate for 2002 was impacted significantly by an increase of $6.6 million in the valuation allowance for deferred taxes related to the write-off of goodwill balances (see Note 1 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K), losses from the write down of certain investments deemed impaired and the realizability of state operating loss carryforwards.  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.

Extraordinary Gain.  The Company acquired 111 Wherehouse and 13 CD World stores in October 2003 (see Note 3 of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K), resulting in an extraordinary gain of $4.3 million, which is net of income taxes of $2.4 million related to unallocated negative goodwill. The gain represents the excess of the fair value of net assets acquired in excess of the purchase price of the assets.

Cumulative Effect of Change in Accounting Principle.  The Company adopted a new method of accounting for cooperative advertising and certain other vendor allowances effective from the beginning of fiscal 2002 in accordance with the FASB’s EITF No. 02-16, Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, resulting in a one-time, non-cash charge of $13.7 million, net of income taxes of $8.9 million. For additional discussion regarding the charge, refer to Note 2 in Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K.

In adopting the guidance of EITF No. 02-16, the Company changed its previous method of accounting for cooperative advertising and other vendor allowances. This new practice changed the timing of recognizing allowances in net earnings and had the effect of reducing inventory and related cost of sales.

Net Income (Loss).   The following table sets forth a year-over-year comparison of the Company’s net income (loss):