Related Party Transactions.
The Company leases its 181,300 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 occupied 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 $2.0 million, $2.0 million and $1.9 million in Fiscal 2007, 2006 and 2005 respectively. Pursuant to the terms of the lease agreements, effective January 1, 2002 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 its term.
The Company leases oneof its retail stores from Mr. Higgins under an operating lease. Annual rental payments under this lease were $40,000 in Fiscal 2007, 2006 and 2005. 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 $3,800, $4,100 and $4,400 in Fiscal 2007, 2006 and 2005 respectively.
The Company occasionally utilizes privately chartered aircraft owned or partially owned by Mr. Higgins, for Company business. The Company charters an aircraft from Crystal Jet, a corporation wholly-owned by Mr. Higgins, for Company business. Payments to Crystal Jet aggregated approximately $0, $11,000 and $6,000 in Fiscal 2007, 2006 and 2005, respectively. The Company also charters an aircraft from Richmor Aviation, an unaffiliated corporation that leases an aircraft owned by Mr. Higgins, for Company business. Payments to Richmor Aviation, to charter the aircraft owned by Mr. Higgins, in Fiscal 2007, 2006 and 2005 were approximately $29,000, $526,000 and $276,000, respectively.
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: Merchandise inventory is stated at the lower of cost or market under 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 and distribution centers throughout the year and inventory records are adjusted accordingly.
Shrink expense, including obsolescence was $18.5 million, $14.9 million and $15.1 million, in Fiscal 2007, 2006 and 2005 respectively. As a rate to net sales, this equaled 1.5%, 1.0% and 1.2%, respectively. Shrink expense, including obsolescence, as a percentage of net sales was higher in Fiscal 2007 than in prior years due to the write down of obsolete inventory in the Company’s video game category due to the narrowing of stores offering video games. Presently, a 0.1% change in the rate of shrink and obsolescence provision would equal approximately $0.5 million in additional charge or benefit to cost of sales, based on Fiscal 2007 net sales since the last physical inventories.
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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. The Company incurred merchandise return charges in its Fiscal years 2007, 2006 and 2005 of $2.2 million, $3.6 million and $5.6 million, respectively. Return penalties have declined in recent years, consistent with the decline in the Company’s music business which generates the majority of merchandise return penalties.
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;
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. During Fiscal 2007, the Company recorded an asset impairment charge of $30.7 million related to the write down of certain long-lived assets at underperforming locations. There were no asset impairment charges recorded in Fiscal 2006 or 2005. 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 million, $2.2 million and $2.4 million in Fiscal 2007, 2006 and 2005, respectively, and is included in SG&A expenses in the Consolidated Statement of Operations and loss on disposal of fixed assets in the Consolidated Statement 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.
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. Historically, 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. In assessing the propriety of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income. Management considers the scheduled reversal of taxable temporary differences, projected future taxable income and tax planning strategies in making this assessment. As of February 2, 2008, the Company has incurred a cumulative three-year loss. Based on the cumulative three-year loss and other available objective evidence, management concluded that a full valuation allowance should be recorded against its net deferred tax assets in accordance with the provisions of SFAS No. 109,Accounting for Income Taxes. In Fiscal 2008 and in future years, the Company will continue to record a valuation allowance against recorded net deferred tax assets to a level deemed appropriate by management to ensure that any net deferred tax assets not allowed against will ultimately be realized.
Effective February 4, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”),Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109, which prescribes a financial statement recognition threshold and measurement attribute for tax positions taken or expected to be taken in a tax return. The accounting for tax positions in accordance with FIN 48 requires management to make estimates relative to the likelihood of realization upon ultimate settlement of uncertain tax positions. 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:The Company’s adoption of SFAS No. 123 (revised 2004), “Share-Based Payment”, or SFAS 123(R), during Fiscal 2006 required that it recognize stock-based compensation expense associated with the vesting of share based instruments in the statement of operations. Determining the amount of stock-based compensation to be recorded requires the Company to develop estimates to be used in calculating the grant-date fair value of stock options. The Company calculates the grant-date fair values using the Black-Scholes valuation model. The Black-Scholes model requires us 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.
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The amount of stock-based compensation recognized during a period is based on the value 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 the unvested portion of the surrendered option. The Company reviewed historical forfeiture data and determined the appropriate forfeiture rate based on that data. The Company will re-evaluate this analysis periodically and adjust the forfeiture rate as necessary. Ultimately, the Company will recognize the actual expense over the vesting period only for the shares that vest.
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 customers redeem cards, at which point the Company records revenue, or when 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 at the end of a reporting 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 December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141 (Revised 2007),Business Combinations, (“SFAS No. 141(R)”). This standard will significantly change the accounting for business combinations. Under SFAS No. 141(R), an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS No. 141(R) also includes a substantial number of new disclosure requirements. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.
In December 2007, the FASB issued SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51 (“SFAS No. 160”), which establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. This standard does not currently have a significant affect on the Company.
In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157,Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. SFAS No. 157 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 financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. However, the FASB issued FASB Staff Positions (“FSP”) 157-1 and 157-2. FSP 157-1 amends SFAS No. 157 to exclude FASB No. 13, Accounting for Leases, and its related interpretative accounting pronouncements that address leasing transactions, while FSP 157-2 delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis, until fiscal years beginning after November 15, 2008. The adoption of SFAS No. 157 is not expected to have a significant impact on the Company’s Consolidated Financial Statements.
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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 11 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 February 2, 2008.
The Company’s independent registered public accounting firm, KPMG LLP, has issued an audit report on the Company’s effectiveness of internal control over financial reporting as of February 2, 2008, 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 February 2, 2008 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, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
(a) Identification of Directors
Incorporated herein by reference is the information appearing under the captions “Election of Directors” and “Compensation of Directors” in the Company’s definitive Proxy Statement for the Registrant’s 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after February 2, 2008.
(b) Identification of Executive Officers
Incorporated herein by reference is the information appearing under the caption “Executive Compensation” in the Company’s definitive Proxy Statement for the Registrant’s 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after February 2, 2008.
(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, 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 Compensation” in the Company’s definitive Proxy Statement for the Registrant’s 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after February 2, 2008.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER 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 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after February 2, 2008.
Information on Trans World Entertainment Common Stock authorized for issuance under equity compensation plans is contained in our Proxy Statement for our 2008 Annual Meeting of Shareholders under the caption “Stock Option Plans” and is incorporated herein by reference. See Note 8 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for a description of the Company’s employee stock award 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 2, 2008:
| | | Number of Shares to be Issued | | Weighted Average Exercise | | Number of Shares Remaining |
| | | upon Exercise of Outstanding | | Price of Outstanding Options, | | Available for Future Issuance |
| Plan Category | | Options, Warrants and Rights | | Warrants and Rights | | Under Equity Compensation |
| | | | | | | Plans (Excluding Outstanding |
| | | | | | | Options, Warrants and Rights) |
| | | | | (Shares in thousands) | | |
| Equity Compensation Plan | | | | | | |
| Approved by Shareholders | | 9,020 | | $8.26 | | 3,925 |
| Equity Compensation Plans and | | | | | | |
| Agreements not Approved | | | | | | |
| by Shareholders | | --- | | --- | | --- |
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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 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after February 2, 2008.
Item 14. PRINCIPAL ACCOUNTANT 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 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after February 2, 2008.
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PART IV
Item 15. EXHIBITS,ANDFINANCIAL STATEMENT SCHEDULES
15(a) (1) Financial Statements
The Consolidated Financial Statements and Notes 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 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 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.
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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.
| | | | | TRANS WORLD ENTERTAINMENT CORPORATION |
| |
| |
| Date: April 17, 2008 | | | | | By: /s/ ROBERT J. HIGGINS |
| | | | | | Robert J. Higgins |
| | | | | | Chairman and Chief Executive Officer |
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
| Name | | Title | | Date |
| /s/ ROBERT J. HIGGINS | | Chairman and Chief Executive Officer | | April 17, 2008 |
| (Robert J. Higgins) | | (Principal Executive Officer) | | |
| |
| /s/ JOHN J. SULLIVAN | | Executive Vice President and Chief Financial Officer (Principal Financial | | April 17, 2008 |
| (John J. Sullivan) | | and Chief Accounting Officer) and Secretary | | |
| |
| /s/ BRETT BREWER | | Director | | April 17, 2008 |
| (Brett Brewer) | | | | |
| |
| /s/ MARK A. COHEN | | Director | | April 17, 2008 |
| (Mark A. Cohen) | | | | |
| |
| /s/ MARTIN E. HANAKA | | Director | | April 17, 2008 |
| (Martin E. Hanaka) | | | | |
| |
| /s/ ISAAC KAUFMAN | | Director | | April 17, 2008 |
| (Isaac Kaufman) | | | | |
| |
| /s/ DR. JOSEPH G. MORONE | | Director | | April 17, 2008 |
| (Dr. Joseph G. Morone) | | | | |
| |
| /s/ LORI SCHAFER | | Director | | April 17, 2008 |
| (Lori Schafer) | | | | |
| |
| /s/ MICHAEL B. SOLOW | | Director | | April 17, 2008 |
| (Michael B. Solow) | | | | |
| |
| /s/ EDMOND THOMAS | | Director | | April 17, 2008 |
| (Edmond Thomas) | | | | |
34
TRANS WORLD ENTERTAINMENT CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
| | | Form 10-K |
| | | Page No. |
| | | |
| Reports of Independent Registered Public Accounting Firm | | F-2 |
| | | |
| Consolidated Financial Statements | | |
| | | |
| Consolidated Balance Sheets at February 2, 2008 and February 3, 2007 | | F-4 |
| | | |
| Consolidated Statements of Operations - Fiscal years ended | | |
| February 2, 2008, February 3, 2007, and January 28, 2006 | | F-5 |
| | | |
| Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss) - Fiscal years ended | | |
| February 2, 2008, February 3, 2007, and January 28, 2006 | | F-6 |
| | | |
| Consolidated Statements of Cash Flows - Fiscal years ended | | |
| February 2, 2008, February 3, 2007, and January 28, 2006 | | F-7 |
| |
| Notes to Consolidated Financial Statements | | F-8 |
F-1
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Trans World Entertainment Corporation:
We have audited the accompanying consolidated balance sheets of Trans World Entertainment Corporation and subsidiaries (the “Company”) as of February 2, 2008 and February 3, 2007, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the fiscal years in the three-year period ended February 2, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
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 2, 2008 and February 3, 2007, and the results of their operations and their cash flows for each of the fiscal years in the three-year period ended February 2, 2008, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, effective February 4, 2007, the Company adopted Financial Accounting Standards Board Intepretation No. 48, “Accounting for Uncertainty in Income Taxes.” Effective February 3, 2007, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” In addition, effective January 29, 2006, the Company adopted SFAS No 123(R), “Share-Based Payment.”
We also have audited, in accordance with the standards of Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of February 2, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated April 17, 2008 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
/s/ KPMG LLP
Albany, New York
April 17, 2008
F-2
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
of Trans World Entertainment Corporation:
We have audited Trans World Entertainment Corporation and subsidiaries’ (the “Company”), internal control over financial reporting as of February 2, 2008, based on criteria established inInternal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
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 audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide a 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, the Company maintained, in all material respects, effective internal control over financial reporting as of February 2, 2008, based on criteria established inInternal Control – Integrated Framework issued by COSO.
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 2, 2008 and February 3, 2007, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended February 2, 2008, and our report dated April 17, 2008 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Albany, New York
April 17, 2008
F-3
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
($ in thousands)
| | | | February 2, | | | | February 3, | |
| | | | 2008 | | | | 2007 | |
| ASSETS | | | | | | | | |
| CURRENT ASSETS | | | | | | | | |
| Cash and cash equivalents | | $ | 74,655 | | | $ | 118,630 | |
| Accounts receivable | | | 8,632 | | | | 7,874 | |
| Merchandise inventory | | | 440,241 | | | | 504,860 | |
| Income taxes receivable, net | | | 5,216 | | | | --- | |
| Prepaid expenses and other | | | 17,578 | | | | 5,953 | |
| Deferred taxes, net | | | --- | | | | 9,039 | |
| Total current assets | | | 546,322 | | | | 646,356 | |
| |
| FIXED ASSETS, net | | | 82,248 | | | | 138,252 | |
| |
| DEFERRED TAXES, net | | | --- | | | | 32,715 | |
| OTHER ASSETS | | | 10,423 | | | | 12,367 | |
| TOTAL ASSETS | | $ | 638,993 | | | $ | 829,690 | |
| |
| |
| LIABILITIES | | | | | | | | |
| CURRENT LIABILITIES | | | | | | | | |
| Accounts payable | | $ | 237,774 | | | $ | 306,378 | |
| Accrued expenses and other current liabilities | | | 53,540 | | | | 56,735 | |
| Income taxes payable, net | | | --- | | | | 13,646 | |
| Current portion of long-term debt | | | 537 | | | | 506 | |
| Current portion of capital lease obligations | | | 2,964 | | | | 2,887 | |
| Total current liabilities | | | 294,815 | | | | 380,152 | |
| |
| LONG –TERM DEBT, less current portion | | | 3,552 | | | | 4,085 | |
| CAPITAL LEASE OBLIGATIONS, less current portion | | | 9,036 | | | | 12,000 | |
| OTHER LONG-TERM LIABILITIES | | | 33,441 | | | | 40,248 | |
| TOTAL LIABILITIES | | | 340,844 | | | | 436,485 | |
| |
| SHAREHOLDERS’ EQUITY | | | | | | | | |
| Preferred stock ($0.01 par value; 5,000,000 shares authorized; | | | | | | | | |
| none issued) | | | --- | | | | --- | |
| Common stock ($0.01 par value; 200,000,000 shares authorized; | | | | | | | | |
| 56,288,637 shares and 55,998,109 shares issued , respectively) | | | 563 | | | | 560 | |
| Additional paid-in capital | | | 303,998 | | | | 301,526 | |
| Treasury stock at cost (25,102,990 and 25,103,990 shares , respectively) | | | (217,555 | ) | | | (217,560 | ) |
| Accumulated other comprehensive loss | | | (1,625 | ) | | | (1,888 | ) |
| Retained earnings | | | 212,768 | | | | 310,567 | |
| TOTAL SHAREHOLDERS’ EQUITY | | | 298,149 | | | | 393,205 | |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY | | $ | 638,993 | | | $ | 829,690 | |
See Accompanying Notes to Consolidated Financial Statements.
F-4
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
($ in thousands, except per share amounts)
| | | Fiscal Year Ended |
| | | | February 2, | | | | February 3, | | | | January 28, | |
| | | | 2008 | | | | 2007 | | | | 2006 | |
| |
| |
| Net sales | | $ | 1,265,658 | | | $ | 1,471,157 | | | $ | 1,238,486 | |
| Cost of sales | | | 819,911 | | | | | 951,935 | | | | 806,873 | |
| Gross profit | | | 445,747 | | | | | 519,222 | | | | 431,613 | |
| Selling, general and administrative expenses | | | 470,386 | | | | | 519,246 | | | | 426,854 | |
| Asset impairment charge | | | 30,731 | | | | | --- | | | | --- | |
| (Loss) income from operations | | | (55,370 | ) | | | | (24 | ) | | | 4,759 | |
| Interest expense | | | 6,519 | | | | | 5,504 | | | | 2,954 | |
| Other income | | | (429 | ) | | | | (4,435 | ) | | | (2,171 | ) |
| (Loss) income before income taxes, extraordinary gain – unallocated negative | | | | | | | | | | | | | |
| goodwill and cumulative effect of change in accounting principle | | | (61,460 | ) | | | | (1,093 | ) | | | 3,976 | |
| Income tax expense (benefit) | | | 37,975 | | | | | (2,041 | ) | | | 1,090 | |
| (Loss) income before extraordinary gain – unallocated negative goodwill | | | | | | | | | | | | | |
| and cumulative effect of a change in accounting principle | | | (99,435 | ) | | | | 948 | | | | 2,886 | |
| Extraordinary gain – unallocated negative goodwill, net of income | | | | | | | | | | | | | |
| taxes of $0, $6,739 and $0 in 2007, 2006 and 2005, respectively | | | --- | | | | | 10,721 | | | | --- | |
| Cumulative effect of a change in accounting principle, net of income taxes | | | | | | | | | | | | | |
| of $0, $0 and $1,505 in 2007, 2006 and 2005, respectively. | | | --- | | | | | --- | | | | (2,277 | ) |
| NET (LOSS) INCOME | | $ | (99,435 | ) | | $ | | 11,669 | | | $ | 609 | |
| BASIC (LOSS) EARNINGS PER SHARE: | | | | | | | | | | | | | |
| (Loss) earnings per share before extraordinary gain – unallocated | | | | | | | | | | | | | |
| negative goodwill and cumulative effect of a change in accounting principle | | $ | (3.20 | ) | | $ | | 0.03 | | | $ | 0.09 | |
| Extraordinary gain – unallocated negative goodwill | | | --- | | | | | 0.35 | | | | --- | |
| Cumulative effect of a change in accounting principle | | | --- | | | | | --- | | | | (0.07 | ) |
| Basic (loss) earnings per share | | $ | (3.20 | ) | | $ | | 0.38 | | | $ | 0.02 | |
| |
| Weighted average number of common shares outstanding – basic | | | 31,046 | | | | | 30,797 | | | | 31,962 | |
| |
| DILUTED (LOSS) EARNINGS PER SHARE: | | | | | | | | | | | | | |
| (Loss) earnings per share before extraordinary gain – unallocated | | | | | | | | | | | | | |
| negative goodwill and cumulative effect of a change in accounting principle | | $ | (3.20 | ) | | $ | | 0.03 | | | $ | 0.09 | |
| Extraordinary gain – unallocated negative goodwill | | | --- | | | | | 0.33 | | | | --- | |
| Cumulative effect of a change in accounting principle | | | --- | | | | | --- | | | | (0.07 | ) |
| Diluted (loss) earnings per share | | $ | (3.20 | ) | | $ | | 0.36 | | | $ | 0.02 | |
| |
| Weighted average number of common shares – diluted | | | 31,046 | | | | | 31,986 | | | | 32,132 | |
See Accompanying Notes to Consolidated Financial Statements.
F-5
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE (LOSS) INCOME
(Shares and $ in thousands)
| | | | | | | | | | | Unearned | | | | | | | | Accum. | | | | | | |
| | | | | | | | Additional | | Compensation | | | | | Treasury | | | Other | | | | | | |
| | | Common | | Common | | Paid-in | | Restricted | | Treasury | | | Stock | | | Comp. | | | Retained | | Shareholders’ |
| | | Shares | | Stock | | Capital | | Stock | | Shares | | | At Cost | | | Loss | | | Earnings | | Equity |
| Balance as of January 29, 2005 | | 55,015 | | $ | 550 | | $ | 292,922 | | $ | (46) | | (21,989) | | $ | (186,298) | | $ | (1,094) | | $ | 298,289 | | $ | 404,323 |
| Comprehensive loss: | | | | | | | | | | | | | | | | | | | | | | | | | |
| Net income | | --- | | | --- | | | --- | | | --- | | --- | | | --- | | | --- | | | 609 | | | 609 |
| Excess of additional minimum pension liability | | | | | | | | | | | | | | | | | | | | | | | | | |
| over unrecognized prior service cost, net of | | | | | | | | | | | | | | | | | | | | | | | | | |
| income taxes of $741 | | --- | | | --- | | | --- | | | --- | | --- | | | --- | | | (954) | | | --- | | | (954) |
| Total comprehensive loss | | | | | | | | | | | | | | | | | | | | | | | | | (345) |
| Repurchase of shares of treasury stock | | --- | | | --- | | | --- | | | --- | | (3,117) | | | (31,270) | | | --- | | | --- | | | (31,270) |
| Issuance of treasury stock under | | | | | | | | | | | | | | | | | | | | | | | | | |
| incentive stock programs | | --- | | | --- | | | 3 | | | --- | | 1 | | | 4 | | | --- | | | --- | | | 7 |
| Amortization of unearned compensation | | | | | | | | | | | | | | | | | | | | | | | | | |
| – restricted stock | | --- | | | --- | | | --- | | | 16 | | --- | | | --- | | | --- | | | --- | | | 16 |
| Stock compensation and related tax benefit | | 713 | | | 7 | | | 5,774 | | | --- | | --- | | | --- | | | --- | | | --- | | | 5,781 |
| Balance as of January 28, 2006 | | 55,728 | | $ | 557 | | $ | 298,699 | | $ | (30) | | (25,105) | | $ | (217,564) | | $ | (2,048) | | $ | 298,898 | | $ | 378,512 |
| Comprehensive income: | | | | | | | | | | | | | | | | | | | | | | | | | |
| Net income | | --- | | | --- | | | --- | | | --- | | --- | | | --- | | | --- | | | 11,669 | | | 11,669 |
| |
| Additional pension liability adjustment, | | | | | | | | | | | | | | | | | | | | | | | | | |
| net of income taxes of $1,771 | | --- | | | --- | | | --- | | | --- | | --- | | | --- | | | 2,445 | | | --- | | | 2,445 |
| Total comprehensive income | | | | | | | | | | | | | | | | | | | | | | | | | 14,114 |
| Adjustment to initially apply | | | | | | | | | | | | | | | | | | | | | | | | | |
| SFAS 158, net of income taxes of $1,623 | | --- | | | --- | | | --- | | | --- | | --- | | | --- | | | (2,285) | | | --- | | | (2,285) |
| Issuance of treasury stock under incentive stock | | | | | | | | | | | | | | | | | | | | | | | | | |
| programs | | --- | | | --- | | | 2 | | | --- | | 1 | | | 4 | | | --- | | | --- | | | 6 |
| Stock compensation and related tax benefit | | 270 | | | 3 | | | 2,842 | | | --- | | --- | | | --- | | | --- | | | --- | | | 2,845 |
| Reclassification of unearned compensation upon | | | | | | | | | | | | | | | | | | | | | | | | | |
| adoption of SFAS 123(R) | | --- | | | --- | | | (30) | | | 30 | | --- | | | --- | | | --- | | | --- | | | --- |
| Amortization of unearned compensation – restricted | | | | | | | | | | | | | | | | | | | | | | | | | |
| stock | | --- | | | --- | | | 13 | | | --- | | --- | | | --- | | | --- | | | --- | | | 13 |
| Balance as of February 3, 2007 | | 55,998 | | $ | 560 | | $ | 301,526 | | $ | --- | | (25,104) | | $ | (217,560) | | $ | (1,888) | | $ | 310,567 | | $ | 393,205 |
| Comprehensive loss: | | | | | | | | | | | | | | | | | | | | | | | | | |
| Net loss | | --- | | | --- | | | --- | | | --- | | --- | | | --- | | | --- | | | (99,435) | | | (99,435) |
| |
| Additional pension liability adjustment, | | | | | | | | | | | | | | | | | | | | | | | | | |
| net of income taxes of $107 | | --- | | | --- | | | --- | | | --- | | --- | | | --- | | | 263 | | | --- | | | 263 |
| Total comprehensive loss | | | | | | | | | | | | | | | | | | | | | | | | | (99,172) |
| Adjustment to initially apply FIN 48 | | --- | | | --- | | | --- | | | --- | | --- | | | --- | | | --- | | | 1,636 | | | 1,636 |
| Issuance of treasury stock under incentive stock | | | | | | | | | | | | | | | | | | | | | | | | | |
| programs | | --- | | | --- | | | 1 | | | --- | | 1 | | | 5 | | | --- | | | --- | | | 6 |
| Stock compensation and related tax benefit | | 291 | | | 3 | | | 2,532 | | | --- | | --- | | | --- | | | --- | | | --- | | | 2,535 |
| Unearned compensation – restricted stock | | --- | | | --- | | | (125) | | | --- | | --- | | | --- | | | --- | | | --- | | | (125) |
| Amortization of unearned compensation – restricted | | | | | | | | | | | | | | | | | | | | | | | | | |
| stock | | --- | | | --- | | | 54 | | | --- | | --- | | | --- | | | --- | | | --- | | | 54 |
| Reversal of unearned compensation – restricted stock | | | | | | | | | | | | | | | | | | | | | | | | | |
| associated with termination of a participant | | --- | | | --- | | | 10 | | | --- | | --- | | | --- | | | --- | | | --- | | | 10 |
| Balance as of February 2, 2008 | | 56,289 | | $ | 563 | | $ | 303,998 | | $ | --- | | (25,103) | | $ | (217,555) | | $ | (1,625) | | $ | 212,768 | | $ | 298,149 |
See Accompanying Notes to Consolidated Financial Statements.
F-6
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)
| | | Fiscal Year Ended |
| | | February 2, | | February 3, | | January 28, |
| | | 2008 | | 2007 | | 2006 |
| OPERATING ACTIVITIES: | | | | | | |
| Net (loss) income | | $(99,435) | | $11,669 | | $609 |
| Adjustments to reconcile net (loss) income to net cash (used by) provided by operating activities: | | | | | | |
| Depreciation and amortization of fixed assets | | 39,900 | | 40,099 | | 37,216 |
| Asset impairment charge | | 30,731 | | --- | | --- |
| Amortization of intangible assets | | 297 | | 263 | | 94 |
| Amortization of lease valuations, net | | (1,146) | | (3,150) | | (428) |
| Stock compensation | | 1,906 | | 2,191 | | 319 |
| Loss on disposal of fixed assets | | 2,535 | | 2,243 | | 2,391 |
| Gain on sale of available for sale securities and other investments | | --- | | (3,528) | | (813) |
| Deferred tax expense (benefit) | | 42,475 | | (4,387) | | 4,186 |
| Cumulative effect of change in accounting principle, net of income taxes | | --- | | --- | | 2,277 |
| Extraordinary gain on acquisition of businesses, net of income taxes | | --- | | (10,721) | | --- |
| Changes in operating assets and liabilities, net of effects of acquisitions: | | | | | | |
| Accounts receivable | | (758) | | 819 | | (2,469) |
| Merchandise inventory | | 64,619 | | 10,520 | | 28,534 |
| Prepaid expenses and other | | (11,625) | | 146 | | 1,067 |
| Other assets | | 47 | | (490) | | 544 |
| Accounts payable | | (68,444) | | 3,804 | | (38,776) |
| Income taxes receivable/payable | | (17,280) | | 2,247 | | (7,863) |
| Accrued expenses and other current liabilities | | (3,457) | | (3,305) | | (2,831) |
| Other long-term liabilities | | (5,944) | | (1,152) | | 1,190 |
| Net cash (used by) provided by operating activities | | (25,579) | | 47,268 | | 25,247 |
| |
| INVESTING ACTIVITIES: | | | | | | |
| Purchases of fixed assets | | (15,949) | | (48,289) | | (41,330) |
| Acquisition of businesses | | --- | | (78,810) | | --- |
| Proceeds from sale of available-for-sale securities and other investments | | --- | | 4,228 | | 813 |
| Net cash used by investing activities | | (15,949) | | (122,871) | | (40,517) |
| |
| FINANCING ACTIVITIES: | | | | | | |
| Proceeds from capital lease obligations | | --- | | --- | | 12,877 |
| Payments of long-term debt | | (502) | | (473) | | (444) |
| Payments of capital lease obligations | | (2,887) | | (3,182) | | (2,117) |
| Payments of debt issue costs | | --- | | --- | | (495) |
| Payments for purchases of treasury stock | | --- | | --- | | (31,270) |
| Excess tax benefit from stock award exercises | | 3 | | 36 | | --- |
| Proceeds from exercise of stock awards | | 939 | | 643 | | 4,160 |
| Net cash used by financing activities | | (2,447) | | (2,976) | | (17,289) |
| |
| Net decrease in cash and cash equivalents | | (43,975) | | (78,579) | | (32,559) |
| Cash and cash equivalents, beginning of year | | 118,630 | | 197,209 | | 229,768 |
| Cash and cash equivalents, end of year | | $74,655 | | $118,630 | | $197,209 |
| Supplemental disclosures and non-cash investing and financing activities: | | | | | | |
| Issuance of treasury stock under incentive stock programs | | $6 | | $6 | | $7 |
| Issuance of deferred / restricted shares under deferred / restricted stock plans | | 160 | | 105 | | --- |
| Income tax benefit resulting from exercises of stock options | | --- | | --- | | 1,621 |
| Interest paid | | 6,534 | | 5,529 | | 2,901 |
| See Accompanying Notes to Consolidated Financial Statements. | | | | | | |
F-7
TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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, 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, www.wherehouse.com,www.secondspin.com, www.samgoody.comandwww.suncoast.com in a single industry segment. As of February 2, 2008, the Company operated 813 stores totaling approximately 5.1 million square feet in the United States, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands. The Company’s business is seasonal in nature, with the peak selling period being the holiday season in the Company’s fourth fiscal quarter.
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. All significant intercompany accounts and transactions have been eliminated. Certain amounts in previously issued consolidated financial statements were reclassified to conform to the Fiscal 2007 presentation. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Items Affecting Comparability:The Company’s fiscal year is a 52 or 53-week period ending the Saturday nearest to January 31. Fiscal 2007, 2006, and 2005 ended February 2, 2008, February 3, 2007, and January 28, 2006, respectively. Fiscal 2006 had 53 weeks and 2007 and 2005 had 52 weeks. The 53rd week of business in Fiscal 2006 contributed approximately $23.0 million in net sales.
Effective February 4, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”),Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109, which prescribes a financial statement recognition threshold and measurement attribute for tax positions taken or expected to be taken in a tax return. In particular, FIN 48 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 measurement of a tax position will be based on the largest amount that is determined to have greater than a 50% likelihood of realization upon ultimate settlement. Any resulting cumulative effect of adopting the provisions of FIN 48 are to be reported as an adjustment to the beginning balance of retained earnings in the period of adoption. As a result of adopting FIN 48, the Company recorded a $1.6 million decrease in its reserve for uncertain tax positions as an adjustment to retained earnings. See Note 6 in the Notes to Consolidated Financial Statements for detailed discussion.
The Company adopted the FASB’s Statement of Financial Accounting Standards (“SFAS”) No. 158 ,Employers’ Accounting for Defined Benefit and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R), effective February 3, 2007. In accordance with SFAS No. 158, the Company recorded a liability equal to the underfunded status of the Company sponsored Supplemental Executive Retirement Plan (“SERP”) and “Director Retirement Plan” as of the November 1, 2006 measurement date. See Note 8 in the Notes to Consolidated Financial Statements for detailed discussion.
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 and 2007 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 and 2007, 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.
The Company adopted FASB Interpretation No. 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.
Concentration of Business Risks:The Company purchases merchandise inventory for its stores from approximately 500 suppliers, with approximately 61% of purchases being made from ten suppliers including EMI Music Distribution, Sony-Bertelsmann Music Group, Warner/Electra/Atlantic Corp., Universal Music Group, Fox Video Inc., Paramount Video, Buena Vista Video, Warner Home Entertainment, Universal Studios Home Entertainment and Sony Pictures Home Entertainment. 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. However, a loss of a major supplier could cause a loss of sales, which would have an adverse effect on operating results.
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.
F-8
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.
Accounts Receivable:Accounts receivable are comprised of receivables and unbilled revenues from advertising services performed for third parties, and amounts due under operating or service agreements with unaffiliated entities, loans to related business ventures, and other, individually insignificant amounts. There are no provisions for uncollectible amounts from retail sales of merchandise inventory since payment is received at the time of sale.
Merchandise Inventory and Return Costs: Merchandise inventory is stated at the lower of cost or market under the average cost method. Inventory valuation requires significant judgment and estimates, including obsolescence, shrink and any adjustments to market value, if market value is lower than cost. 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 and distribution centers throughout the year, and inventory records are adjusted accordingly.
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 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:
| Leasehold improvements | | Lesser of estimated useful life of the asset or the lease term |
| Fixtures and equipment | | 3-7 years |
| Buildings and improvements | | 10-30 years |
Major improvements and betterments to existing facilities and equipment are capitalized. Expenditures for maintenance and repairs are expensed as incurred. A majority of the Company’s operating leases are ten years in term. Amortization of capital lease assets is included in depreciation and amortization expense.
Impairment of Long-Lived Assets:Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to undiscounted future net cash flows expected to be generated by the asset over its remaining useful life. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Fair value is generally measured based on discounted estimated future cash flows. Assets to be disposed of would be separately presented in the Consolidated Balance Sheets and reported at the lower of the carrying amount or fair value less disposition costs
During Fiscal 2007, the Company recorded an asset impairment charge of $30.7 million related to the write down of certain long-lived assets at underperforming locations. There were no asset impairment charges recorded in Fiscal 2006 or 2005. 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 million, $2.2 million and $2.4 million in Fiscal 2007, 2006 and 2005, respectively, and is included in selling, general and administrative (“SG&A”) expenses in the Consolidated Statements of Operations and loss on disposal of fixed assets in the Consolidated Statements 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.
Conditional Asset Retirement Obligations:The Company records the fair value of an asset retirement obligation (“ARO”) as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development, and/or normal use of the asset. The Company also records a corresponding asset that is depreciated over the life of the asset. Subsequent to the initial measurement of the ARO, the ARO is adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation.
Investments in Unconsolidated Affiliates:Investments in unconsolidated affiliates have been recorded on the cost basis, with any decline in the market value below cost that is deemed other than temporary charged to operations. Write-offs of investments in unconsolidated affiliates for
F-9
other than temporary decline in market value are reflected in SG&A expenses in the Consolidated Statements of Operations. There were no write-offs of investments in unconsolidated affiliates in Fiscal 2007, 2006 and 2005.
Commitments and Contingencies
The Company is subject to 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.
Revenue Recognition:The Company’s revenue is primarily from retail sales of merchandise inventory. Revenue is recognized at the point-of-sale. Internet sales are recognized as revenue upon shipment. Shipping and handling fee income from the Company’s Internet operations is recognized as net sales. Loyalty card revenue is amortized straight-line over the life of the membership period. Net sales are recorded net of estimated amounts for sales returns and other allowances. The Company records shipping and handling costs in cost of goods sold. Net sales are recorded net of applicable sales taxes.
Cost of Sales: In addition to the cost of product, the Company includes in cost of sales those costs associated with purchasing, receiving, shipping, inspecting and warehousing product. Also included are costs associated with the return of product to vendors. Cost of sales further includes the cost of inventory shrink and obsolescence 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, store operating 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 3 of Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K). Selling, general and administrative expenses also include fixed asset write offs associated with store closures, if any, and miscellaneous items, other than interest.
Advertising Costs and Vendor Allowances:The Company often receives allowances from its vendors to fund in-store displays, print, radio and television advertising, and other promotional events. The Company accounts for vendor allowances in accordance with the provisions of 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. Vendor advertising allowances which exceed specific, incremental and identifiable costs incurred in relation to the advertising and promotions offered by the Company to its vendors are classified as a reduction in the purchase price of merchandise inventory. Accordingly, advertising and sales promotion costs are charged to operations, offset by direct vendor reimbursements, as incurred. Total advertising expense, excluding vendor allowances, was $29.7 million, $29.7 million, and $22.0 million in Fiscal 2007, 2006, and 2005, respectively. In the aggregate, vendor allowances supporting the Company’s advertising and promotion included as a reduction of SG&A expenses, as reimbursements of such costs in accordance with EITF No. 02-16, were $15.9 million, $10.7 million, and $9.6 million in Fiscal 2007, 2006, and 2005, respectively.
Lease Accounting:The Company’s calculation of straight-line rent expense includes the impact of escalating rents for periods in which it is reasonably assured of exercising lease options and includes in the lease term any period during which the Company is not obligated to pay rent while the store is being constructed (“rent holiday”). The Company accounts for step rent provisions, escalation clauses and other lease concessions by recognizing these amounts on a straight line basis over the initial lease term. The Company capitalizes leasehold improvements funded by tenant improvement allowances, depreciating them over the lives of the related leases. The tenant improvement allowances are recorded as deferred rent in the Consolidated Balance Sheet and are amortized as a reduction in rent expense over the life of the related leases.
Store Closing Costs: Management periodically considers the closing of underperforming stores. Reserves are established at the time a liability is incurred for the present value of any remaining lease obligations, net of estimated sublease income, and other exit costs, as prescribed by SFAS No. 146,Accounting for Costs Associated with Exit or Disposal Activities.
Gift Cards: The Company offers gift cards for sale. A deferred income account, which is included in accrued expenses and other current liabilities in the Consolidated Balance Sheets, is established for gift cards issued. The deferred income balance related to gift cards was $18.3 million and $21.0 million at the end of Fiscal 2007 and 2006, respectively When gift cards are redeemed at the store level, revenue is recorded and the related liability is reduced. Breakage is estimated based on the historical relationship of the redemption of gift cards redeemed to gift cards sold, over a certain period of time. The Company has the ability to reasonably and reliably estimate gift card liability based on historical experience with redemption rates associated with a large volume of homogeneous transactions, from a period of more than ten years. The Company’s estimate is not susceptible to significant external factors and the circumstances around purchases and redemptions have not changed significantly over time. The Company recorded breakage on its gift cards for Fiscal 2007, 2006 and 2005 in the amount of $3.4 million, $3.6 million and $2.9 million, respectively. Gift card breakage is recorded as a reduction of SG&A expenses.
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
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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. Deferred tax assets are subject to valuation allowances based upon management’s estimates of realizability. It is the Company’s practice to recognize interest and penalties related to income tax matters in income tax expense (benefit) in the Consolidated Statements of Operations.
Stock-Based Compensation:Effective January 29, 2006, the Company adopted SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123 (R)”), which amends SFAS No. 123 and supersedes APB No. 25in establishing standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, as well as transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. This Statement requires that the cost resulting from all share-based payment transactions be recognized in the financial statements based on the fair value of the share-based payment. This Statement establishes fair value as the measurement objective in accounting for share-based payment transactions with employees, except for equity instruments held by employee share ownership plans. As allowed under SFAS No. 123 (R), the Company elected the modified prospective method of adoption, under which compensation cost is recognized in the financial statements beginning with the effective date of SFAS No. 123 (R) for all share-based payments granted after that date, and for all unvested awards granted prior to the effective date of SFAS No. 123 (R). Accordingly, prior period amounts have not been restated.
In the fourth quarter of 2005, the Company’s Board of Directors approved the acceleration of vesting of previously granted unvested options awarded annually to employees and officers under the Company’s Stock Option Plans which had exercise prices greater than $10.00 per share. Options to purchase 2,273,057 shares of the Company’s common stock, representing approximately 24% of the total options outstanding, became immediately vested and exercisable as a result of this action. The number of shares and exercise prices of the options subject to the acceleration remained unchanged. Also, all of the other terms of the options remain the same. Based upon an analysis performed in accordance with SFAS No.123, the acceleration of vesting of these stock options resulted in compensation expense of $5.9 million, in the pro forma net income (loss) results. The decision to accelerate vesting of these stock options was made primarily to avoid recognizing compensation expense in the Consolidated Statements of Operations in future financial statements upon the adoption of SFAS No.123 (R),Share-Based Payment,which the Company adopted on January 29, 2006. The acceleration of the vesting of these stock options reduced the amounts recognized by the Company as share-based compensation expense, net of income taxes, by approximately $2.4 million in Fiscal 2006 and by approximately $1.9 million in Fiscal 2007, and will reduce compensation expense by approximately $1.2 million in Fiscal 2008, and $0.4 million in Fiscal 2009. The accelerated options included 1,355,000 options held by executive officers and 918,057 options held by other employees. Based on the Company’s closing stock price of $6.25 per share on the date of accelerated vesting, the exercise prices of all of the options were above the closing market price.
Total stock-based compensation expense recognized in the Consolidated Statements of Operations for Fiscal 2007 and Fiscal 2006 was $1.9 million and $2.2 million. The related total deferred tax benefit was approximately $0.8 million and $0.9 million in Fiscal 2007 and 2006, respectively. Prior to the adoption of SFAS No. 123(R), the Company presented all tax benefits for deductions resulting from the exercise of stock options as operating cash flows in the Consolidated Statements of Cash Flows. SFAS No. 123(R) requires the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options to be classified and reported as both an operating cash outflow and a financing cash inflow on a prospective basis upon adoption. As of February 2, 2008, there was $3.3 million of unrecognized compensation cost related to stock option awards that is expected to be recognized as expense over a weighted average period of 2.4 years.
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The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to its share-based payments for Fiscal 2005.
| ($ in thousands except for per share amounts) | | 2005 |
| |
| Net income, as reported | | | $ 609 |
| Add: Stock-based employee compensation expense | | | |
| included in reported net income, net of related tax | | | |
| effects | | | 180 |
| Deduct: Total stock-based employee compensation | | | |
| expense determined under fair value based method for | | | |
| all awards, net of related tax effects | | | |
| | | | (7,521) |
| Pro forma net (loss) income | | $ | (6,732) |
| Earnings (loss) per share: | | | |
| Basic - as reported | | $ | 0.02 |
| Basic– pro forma | | $ | (0.21) |
| Diluted – as reported | | $ | 0.02 |
| Diluted – pro forma | | $ | (0.21) |
The fair values of the options granted have been estimated at the date of grant using the Black - Scholes option pricing model with the following assumptions:
| | | Stock Option Plan |
| | | 2007 | | 2006 | | 2005 |
| Dividend yield | | 0% | | 0% | | 0% |
| Expected volatility | | 65.1% - 68.7% | | 65.9% - 71.2% | | 55% |
| Risk-free interest rate | | 3.57% - 4.94% | | 4.64% - 5.04% | | 3.71% - 4.34% |
| Expected option life in years | | 4.70 – 7.30 | | 4.93 – 7.12 | | 5 – 6.25 |
| Weighted average fair value per share | | | | | | |
| of options granted during the year | | $3.39 | | $3.42 | | $6.59 |
(Loss) Earnings Per Share: Basic (loss) earnings per share is calculated by dividing net income by the weighted average common shares outstanding for the period. Diluted (loss) earnings per share is calculated by dividing net income by the sum of the weighted average shares outstanding and additional common shares that would have been outstanding if the dilutive potential common shares had been issued for the Company’s common stock awards from the Company’s Stock Award Plans.
The following is a reconciliation of the basic weighted average number of shares outstanding to the diluted weighted average number of shares outstanding:
| | | Fiscal Year |
| | | 2007 | | 2006 | | 2005 |
| |
| Weighted average common shares outstanding – basic | | 31,046 | | 30,797 | | 31,962 |
| Dilutive effect of outstanding stock awards | | --- | | 1,189 | | 170 |
| Weighted average common shares outstanding – diluted | | 31,046 | | 31,986 | | 32,132 |
| |
| Antidilutive stock awards | | 6,413 | | 7,290 | | 4,756 |
As the Company recorded a net loss during Fiscal 2007, the impact of all outstanding stock awards was not considered as such impact would be antidilutive. Certain stock awards outstanding were excluded from the computation of diluted earnings per share for Fiscal 2006 and 2005 because the exercise price of the options was greater than the average market price of the common shares during the period.
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Fair Value of Financial Instruments:The carrying amounts reported in the Consolidated Balance Sheets for cash and cash equivalents, accounts receivable, accounts payable and other current liabilities approximate fair value because of the immediate or short-term maturity of these financial instruments. The carrying value of life insurance policies included in other assets approximates fair value based on estimates received from insurance companies. The carrying value of the Company’s long-term debt including current portion, approximates fair value based on estimated discounted future cash flows for remaining maturities and rates currently offered to the Company for similar debt instruments. The Company had outstanding product import letters of credit with a fair value of $0 and $36 thousand as of February 2, 2008 and February 3, 2007 respectively.
Segment Information:The Company has one reportable segment in accordance with the requirements of SFAS No. 131,Disclosures about Segments of an Enterprise and Related Information. The following table shows net sales by merchandise category:
| | | Fiscal year |
| | | 2007 | | 2006 | | 2005 |
| | | ($ in thousands) |
| Music | | $494,286 | | $676,091 | | $663,712 |
| Video | | 491,360 | | 529,900 | | 371,965 |
| Video games | | 114,431 | | 114,654 | | 90,408 |
| Other | | 165,581 | | 150,512 | | 112,401 |
| Total | | $1,265,658 | | $1,471,157 | | $1,238,486 |
The “Other” category includes electronics, accessories and trend items, none of which individually exceeds 10% of total net sales.
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Note 2. Business Combinations
On March 27, 2006, the Company acquired substantially all the net assets of Musicland Holding Corp. (“Musicland”). Under the terms of the Asset Purchase Agreement (“APA”), the Company acquired 335 of Musicland’s 400 stores, with the remainder of the stores being liquidated under an agency agreement with Hilco Merchant Resources LLC. Musicland, which operated retail stores and websites, filed a voluntary petition to restructure under Chapter 11 of the United States Bankruptcy Code in January 2006. The acquisition was accounted for using the purchase method of accounting. The Consolidated Statement of Operations for Fiscal 2006 includes the results of Musicland beginning March 27, 2006.
The purchase price for the acquired Musicland assets was $78.8 million, including acquisition-related costs of $1.8 million. The total purchase price was allocated to the assets acquired and liabilities assumed based on their estimated fair values as of February 3, 2007 as follows:
| | | | ($ in thousands) |
| Assets Acquired: | | | |
| Inventory | | $ | 112,612 |
| |
| Liabilities Assumed: | | | |
| Accrued expenses and other | | $ | 11,062 |
| Other long-term liabilities | | | 5,280 |
| Total liabilities assumed | | $ | 16,342 |
| Net assets acquired | | $ | 96,270 |
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 of $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 was 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 2, 2008 represented 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), an adjustment to occupancy related expenses ($1.5 million) and an adjustment to the cash purchase price ($2.9 million).
| Note 3. Fixed Assets | | | | | | | |
| Fixed assets consist of the following: | | | | | | | |
| |
| | | February 2, | | | | February 3, | |
| | | 2008 | | | | 2007 | |
| | | ($ in thousands) | |
| Buildings and improvements | $ | 26,513 | | | $ | 26,493 | |
| Fixtures and equipment | | 173,414 | | | | 229,115 | |
| Leasehold improvements | | 76,274 | | | | 157,935 | |
| | | 276,201 | | | | 413,543 | |
| Allowances for depreciation and amortization | | (193,953 | ) | | | (275,291 | ) |
| | $ | 82,248 | | | $ | 138,252 | |
Depreciation and amortization of fixed assets is included in the Consolidated Statements of Operations as follows:
| | | | Fiscal Year |
| | | | 2007 | | | 2006 | | | 2005 |
| | | | ($ in thousands) |
| Cost of sales | | $ | 2,670 | | $ | 3,108 | | $ | 3,076 |
| Selling, general and administrative expenses | | | 37,230 | | | 36,991 | | | 34,140 |
| Total | | $ | 39,900 | | $ | 40,099 | | $ | 37,216 |
Depreciation and amortization expense related to the Company’s distribution center facility and equipment is included in cost of sales. All other depreciation and amortization of fixed assets is included in SG&A expenses.
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Note 4. Impairment of Long-Lived Assets
During Fiscal 2007, the Company concluded, based on a significant decline in sales and earnings during the fourth quarter, that triggering events had occurred, pursuant to SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”)., requiring a test of long-lived assets for impairment at its retail stores and consolidated subsidiaries. Long-lived assets at locations where impairment was determined to exist were written down to their estimated fair values as of February 2, 2008, resulting in the recording of an asset impairment charge of $30.7 million. Estimated fair values for long-lived assets at these locations, including store fixtures and equipment, leasehold improvements and certain intangible assets, were determined based on a measure of discounted future cash flows over the remaining lease terms at the respective locations. Future cash flows were estimated based on store operating plans and were discounted at a rate approximating the Company’s cost of capital. Management believes its assumptions were reasonable and consistently applied.
Note 5. Debt
On January 5, 2006, the Company entered into a five year, $100 million revolving secured credit facility agreement (“Credit Agreement”) with Bank of America, N.A. At the election of the Company, loans under the Credit Agreement bear interest on the principal amount at a rate equal to either the Prime Rate or Adjusted LIBOR plus 0.75% . The principal amount of all outstanding loans under the Credit Agreement together with any accrued but unpaid interest, are due and payable on January 6, 2011, unless otherwise paid earlier pursuant to the terms of the Credit Agreement. Payments of amounts due under the Credit Agreement are secured by the assets of the Company.
The Credit Agreement includes customary provisions, including affirmative and negative covenants, which include representations, warranties and restrictions on additional indebtedness and acquisitions. The Credit Agreement also includes customary events of default, including, among other things, bankruptcy, and certain changes of control. The Company was in compliance with terms and conditions of the Credit Agreement as of February 2, 2008.
On March 23, 2006, the Company entered into a First Amendment of the Credit Agreement with Bank of America, N.A. which increased the maximum amount available for borrowing under the revolving secured credit facility to $130 million, under the same terms and conditions.
On October 20, 2006, the Company entered into a Second Amendment of the Credit Agreement with Bank of America, N.A. which increased the maximum amount available for borrowing under the revolving secured credit facility to $150 million, under the same terms and conditions.
During Fiscal 2007, 2006 and 2005, the highest aggregate balances outstanding under the revolving credit facility were $111.5 million, $107.5 million and $27.2 million, respectively. As of February 2, 2008 and February 3, 2007, the Company had $0 and $36 thousand, respectively, in outstanding letter of credit obligations under the Credit Agreements with Bank of America, N.A. The Company had $150 million available for borrowing as of February 2, 2008 and February 3, 2007.
During Fiscal 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. As of February 2, 2008, the outstanding balance on the loan was $4.1 million. The following table presents principal cash payments of long-term debt by expected maturity dates as of February 2, 2008:
| | | | Long-term debt |
| | | | ($ in thousands) |
| 2008 | | $ | 537 |
| 2009 | | | 570 |
| 2010 | | | 606 |
| 2011 | | | 643 |
| 2012 | | | 683 |
| Thereafter | | | 1,050 |
| Total | | | 4,089 |
| Less: current portion | | | 537 |
| Long –term debt obligation | | $ | 3,552 |
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Note 6. Income Taxes
Income tax expense (benefit) consists of the following:
| | | | Fiscal Year | |
| | | | 2007 | | | | 2006 | | | | 2005 | |
| | | | ($ in thousands) | |
| Federal – current | | $ | (4,864 | ) | | $ | 2,090 | | | $ | (3,887 | ) |
| State – current | | | 364 | | | | 256 | | | | 791 | |
| Deferred | | | 42,475 | | | | (4,387 | ) | | | 4,186 | |
| | | $ | 37,975 | | | $ | (2,041 | ) | | $ | 1,090 | |
A reconciliation of the Company’s effective income tax rate with the Federal statutory rate is as follows:
| | | Fiscal Year |
| | | 2007 | | 2006 | | 2005 |
| Federal statutory rate | | 35.0 | % | | 35.0 | % | | 35.0 | % |
| State income taxes, net of | | | | | | | | | |
| federal tax effect | | (15.9 | )% | | 17.9 | % | | 52.2 | % |
| Change in federal valuation allowance | | (78.1 | )% | | 99.3 | % | | (5.9 | )% |
| Corporate-owned life insurance | | | | | | | | | |
| payment settlement, net | | (0.4 | )% | | (21.4 | )% | | 5.9 | % |
| Cash surrender value – insurance/ benefit | | | | | | | | | |
| programs | | (0.1 | )% | | 10.7 | % | | (4.2 | )% |
| Executive compensation | | (0.2 | )% | | (13.1 | )% | | 3.3 | % |
| Tax exempt income | | --- | | | 17.7 | % | | (3.2 | )% |
| Closing of tax periods | | --- | | | 18.1 | % | | (8.8 | )% |
| Tax credits | | (0.1 | )% | | 27.6 | % | | (7.8 | )% |
| Recognized deferred tax asset | | --- | | | --- | | | (43.3 | )% |
| Other | | (2.0 | )% | | (5.1 | )% | | 4.2 | % |
| Effective income tax rate | | (61.8 | )% | | 186.7 | % | | 27.4 | % |
During Fiscal 2005, the Company recognized a tax benefit of $2.0 million attributable to the effect of additional deductible temporary differences. The Other category is comprised of various items, including the impacts of non deductible meals, dues, penalties, amortization, uncertain tax positions, tax attribute carryback limitations and graduated rate brackets.
Under the final payment terms of a 2003 agreement between the Company and the IRS regarding an earlier audit, the Company made a final principal payment of $7.1 million in 2007.
F-16
| Significant components of the Company’s deferred tax assets are as follows: | | | | | | | |
| | February 2, | | | February 3, | |
| | 2008 | | | 2007 | |
| | ($ in thousands) | |
| DEFERRED TAX ASSETS | | | | | | | |
| Accrued expenses | $ | 1,643 | | | $ | 1,888 | |
| Inventory | | 4,690 | | | | 5,459 | |
| Retirement and compensation related accruals | | 8,033 | | | | 7,172 | |
| Fixed assets, including impairment charge | 18,949 | | | | 3,532 | |
| Federal and state net operating loss and credit carryforwards | 19,011 | | | | 10,381 | |
| Real estate leases, including deferred rent | | 9,799 | | | | 11,839 | |
| Losses on investments | | 1,683 | | | | 2,475 | |
| Goodwill | | 5,525 | | | | 6,251 | |
| Other | | 1,263 | | | | 493 | |
| Gross deferred tax assets before valuation allowance | 70,596 | | | | 49,490 | |
| Less: valuation allowance | (70,596 | ) | | | (7,736 | ) |
| Total deferred tax assets | $ | --- | | | $ | 41,754 | |
| |
| DEFERRED TAX LIABILITIES | | --- | | | | --- | |
| |
| NET DEFERRED TAX ASSET | $ | --- | | | $ | 41,754 | |
| |
| The net deferred tax asset is classified on the Company’s Consolidated Balance Sheets as follows: | | | | | | | |
| |
| | February 2, | | | February 3, | |
| | 2008 | | | 2007 | |
| | ($ in thousands) | |
| Current deferred tax asset, net | $ | --- | | | $ | 9,039 | |
| Non-current deferred tax asset, net | | --- | | | | 32,715 | |
| | $ | --- | | | $ | 41,754 | |
The net deferred tax asset as of February 3, 2007 reflects the tax effect ($1.2 million) of the reduction of deductible temporary differences related to the extraordinary gain – unallocated negative goodwill associated with the Musicland acquisition and the tax effect ($0.2 million) of the combined reductions in deductible temporary differences related to the exercise and cancellation of stock options accounted for under SFAS No. 123(R),Share-Based Payment, charged to Additional Paid-In Capital and to changes in the Company’s pension liability accounted for under SFAS No. 158,Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, charged to Accumulated Other Comprehensive Loss.
The Company has a net operating loss carryforward of $19.7 million for federal income tax purposes and approximately $155 million for state income tax purposes as of the end of Fiscal 2007 that expire at various times through 2025 and are subject to certain limitations and statutory expiration periods. The state net operating loss carryforwards are subject to various business apportionment factors and multiple jurisdictional requirements when utilized. The Company has federal tax credit carryforwards of $0.9 million, of which $0.2 million will expire in 2026, with the remainder available indefinitely. The Company has state tax credit carryforwards of $1.1 million, of which $0.3 million will expire in 2027.
In assessing the propriety of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income. Management considers the scheduled reversal of taxable temporary differences, projected future taxable income and tax planning strategies in making this assessment. As of February 2, 2008, the Company has incurred a cumulative three-year loss. Based on the cumulative three-year loss and other available objective evidence, management concluded that a full valuation allowance should be recorded against its deferred tax assets. As of February 2, 2008, the valuation allowance increased to $70.6 million from $7.7 million at February 3, 2007, because management believes that it is more likely than not that the tax benefit will not be realized. The increase in the valuation allowance includes approximately $11.6 million associated with the impairment of long-lived assets, pursuant to SFAS No. 144, and approximately $14.3 million associated with the increase in valuation allowance against federal and state net operating loss and credit carryforwards during Fiscal 2007. The remaining change is consistent with the Company’s decision to record a full valuation allowance against deferred tax assets that have been recorded in the normal course of business, as described above.
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During Fiscal 2007, the Company paid income taxes, net of refunds, of approximately $12.4 million. For Fiscal 2006, the Company received a net income tax refund of approximately $0.1 million. For Fiscal 2005, the Company paid income taxes, net of refunds, of approximately $4.7 million.
On February 4, 2007, the Company adopted Financial Interpretation No. 48 (“FIN 48”),Accounting for Uncertainties in Income Taxes – An Interpretation of FASB Statement No. 109, which prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. Under FIN 48, the tax benefit from an uncertain tax position may be recognized only if it is more likely than not that the tax position will be sustained, based on its technical merits, on examination by taxing authorities. The amount of the tax benefit recognized is measured as the largest amount that is determined to have a greater than 50% likelihood of realization upon ultimate settlement. Upon adoption of FIN 48 on February 4, 2007, the Company reduced the total reserve for uncertain tax positions by $1.6 million.
As of February 2, 2008, the liability for uncertain tax positions reflected in the Company’s Consolidated Balance Sheets was $2.4 million, including accrued interest of $1.0 million.
A reconciliation of the beginning and ending amounts of unrecognized tax benefits is provided below. Amounts presented excluded interest and penalties, where applicable, on unrecognized tax benefits:
| (Amounts in thousands) | | | |
| Unrecognized tax benefits at February 4, 2007 | | $3,169 | |
| Increases in tax positions from prior years | | 95 | |
| Decreases in tax positions from prior years | | (10 | ) |
| Increases in tax positions for current year | | - | |
| Settlements | | - | |
| Lapse of applicable statute of limitations | | (97 | ) |
| |
| Unrecognized tax benefits at February 2, 2008 | | $3,157 | |
As of February 2, 2008, the Company had $3.2 million of gross unrecognized tax benefits, $2.4 million of which would affect the Company’s tax rate if recognized. While it is reasonably possible that the amount of unrecognized tax benefits will increase or decrease within the next twelve months, the Company does not expect the change to have a significant impact on its results of operations or financial position.
The Company is subject to U.S. federal income tax as well as income tax of multiple state jurisdictions. The Company has substantially concluded all federal income tax matters through Fiscal 2000 and all material state and local income tax matters through Fiscal 2003.
The Company’s practice is to recognize interest and penalties associated with its unrecognized tax benefits as a component of income tax expense in the Company’s Consolidated Statement of Operations. During Fiscal 2007, the Company accrued a provision for interest and penalties of $0.2 million. As of February 2, 2008, the Company had accrued interest and penalties of $1.0 million related to uncertain tax positions.
F-18
Note 7. Leases
As more fully discussed in Note 10 in the Notes to Consolidated Financial Statements, the Company leases its Albany, NY distribution center and administrative offices under three capital lease arrangements with its Chief Executive Officer and largest shareholder.
Fixed assets recorded under capital leases, which are included in fixed assets on the accompanying Consolidated Balance Sheets, are as follows:
| | | | February 2, | | | February 3, | |
| | | | 2008 | | | 2007 | |
| | | | ($ in thousands) | |
| Buildings | | $ | 9,342 | | | $ | 9,342 | |
| Fixtures and equipment | | | 12,824 | | | | 12,824 | |
| | | | 22,166 | | | | 22,166 | |
| Allowances for depreciation | | | | | | | | |
| and amortization | | | (13,120 | ) | | | (10,325 | ) |
| | | $ | 9,046 | | | $ | 11,841 | |
At February 2, 2008, the Company leased 812 stores under operating leases, many of which contain renewal options, for periods ranging from five to twenty-five years, with the majority being ten years. Most leases also provide for payment of operating expenses and real estate taxes. Some also provide for additional rent based on a percentage of sales.
Net rental expense was as follows:
| | | Fiscal Year |
| | | | 2007 | | | 2006 | | | 2005 |
| | | ($ in thousands) |
| Minimum rentals | | $ | 123,303 | | $ | 130,802 | | $ | 108,581 |
| Contingent rentals | | | 849 | | | 1,453 | | | 1,226 |
| | | $ | 124,152 | | $ | 132,255 | | $ | 109,807 |
Future minimum rental payments required under all leases that have initial or remaining non-cancelable lease terms in excess of one year at February 2, 2008 are as follows:
| | | | Operating | | Capital |
| | | | Leases | | Leases |
| | | | ($ in thousands) |
| 2008 | | $ | 96,977 | | $ | 4,841 |
| 2009 | | | 67,891 | | | 4,841 |
| 2010 | | | 45,726 | | | 2,841 |
| 2011 | | | 29,325 | | | 2,095 |
| 2012 | | | 21,155 | | | 2,095 |
| Thereafter | | | 36,130 | | | 5,794 |
| Total minimum payments required | | $ | 297,204 | | $ | 22,507 |
| Less: amounts representing interest | | | | | | | 10,507 |
| Present value of minimum lease payments | | | | | | 12,000 |
| Less: current portion | | | | | | 2,964 |
| Long-term capital lease obligations | | | | | $ | 9,036 |
Interest rates on capital leases were between 5.65% and 31.5% per annum.
F-19
Note 8. Benefit Plans
401(k) Savings Plan
The Company offers a 401(k) Savings Plan to eligible employees meeting certain age and service requirements. This plan permits participants to contribute up to 80% of their salary, including bonuses, up to the maximum allowable by IRS regulations. Participants are immediately vested in their voluntary contributions plus actual earnings thereon. Participant vesting of the Company’s matching and profit sharing contribution is based on the years of service completed by the participant. Participants are fully vested upon the completion of four years of service. All participant forfeitures of non-vested benefits are used to reduce the Company’s contributions in future years. Total expense related to the Plan was approximately $1,042,000, $1,003,000 and $957,000 in Fiscal 2007, 2006 and 2005, respectively.
Stock Award Plans
The Company has five employee stock award plans, the 1994 Stock Option Plan, the 1998 Stock Option Plan, the 1999 Stock Option Plan and the 2002 Stock Option Plan (the “Old Plans”); and the 2005 Long Term Incentive Share Plan (the “New Plan”). Additionally, the Company has a stock award plan for non-employee directors (the “1990 Plan”). The Company no longer issues stock options under the Old Plans. Under the New Plan, the Company generally issues Stock-Settled Appreciation Rights (“SSARS”) that become exercisable in 50% increments commencing three years from the date of grant and have a maximum term of ten years from issuance. Under the 1990 Plan, awards generally become exercisable commencing one year from the date of grant in increments of 25% per year with a maximum term of ten years. In addition, directors of the Company receive annual grants of deferred shares of Common Stock (“Deferred Shares”) issued under the 1990 Plan which vest equally in three years from date of grant.
Stock options and SSARS authorized for issuance under the Old Plans, New Plan and 1990 Plan total 20.6 million. As of February 2, 2008, of the awards authorized for issuance under the Old Plans, New Plan and 1990 Plan, 9.0 million were granted and are outstanding, 6.7 million of which were vested and exercisable. Options available for future grants at February 2, 2008 and February 3, 2007 were 3.3 million and 3.7 million, respectively.
The following table summarizes information about the stock awards outstanding under the Old Plans, New Plan and 1990 Plan as of February 2, 2008:
| | | Outstanding | | | | Exercisable | | |
| | | | | | | Weighted | | | | | | Weighted | | |
| | | | | Average | | Average | | Aggregate | | | | Average | | Aggregate |
| Exercise | | | | Remaining | | Exercise | | Intrinsic | | | | Exercise | | Intrinsic |
| Price Range | | Shares | | Life | | Price | | Value | | Shares | | Price | | Value |
| $0.00-$2.66 | | 355,400 | | 7.9 | | $0.00 | | $1,492,680 | | 79,460 | | $0.00 | | $333,732 |
| 2.67-5.33 | | 2,481,041 | | 6.3 | | 4.11 | | 224,534 | | 1,145,191 | | 3.50 | | 801,634 |
| 5.34-8.00 | | 883,575 | | 8.4 | | 6.19 | | --- | | 155,000 | | 7.02 | | --- |
| 8.01-10.00 | | 1,852,859 | | 3.7 | | 8.45 | | --- | | 1,852,859 | | 8.45 | | --- |
| 10.01-13.33 | | 2,028,100 | | 4.1 | | 10.84 | | --- | | 2,020,600 | | 10.83 | | --- |
| 13.34-16.00 | | 1,265,370 | | 5.3 | | 14.57 | | --- | | 1,265,370 | | 14.57 | | --- |
| 16.01-18.67 | | 154,050 | | 0.2 | | 17.79 | | --- | | 154,050 | | 17.79 | | --- |
| Total | | 9,020,395 | | 5.3 | | $8.26 | | $1,717,214 | | 6,672,530 | | $9.56 | | $1,135,366 |
The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value based on the Company’s closing stock price of $4.20 as of February 1, 2008, which would have been received by the award holders had all award holders under the Old Plans, New Plan and 1990 Plan exercised their awards as of that date. The total number of in-the-money awards exercisable as of February 2, 2008 was 1,224,651.
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The following table summarizes activity under the Stock Award Plans:
| | | Employee and Director Stock Award Plans |
| | | Number of | | Stock Award | | Weighted |
| | | Shares Subject | | Exercise Price | | Average |
| | | To Option | | Range Per Share(1) | | Exercise Price |
| Balance January 29, 2005 | | 9,298,096 | | $1.21-$23.75 | | $8.16 |
| Granted | | 1,420,241 | | 7.10-14.32 | | 12.45 |
| Exercised | | (712,977) | | 1.21-12.44 | | 5.84 |
| Canceled* | | (145,548) | | 3.50-17.79 | | 8.79 |
| Balance January 28, 2006 | | 9,859,812 | | $1.58-$23.75 | | $8.94 |
| Granted | | 1,092,675 | | 5.32-7.29 | | 4.86 |
| Exercised | | (267,262) | | 1.58-3.96 | | 2.40 |
| Canceled* | | (626,371) | | 2.80-17.79 | | 8.58 |
| Balance February 3, 2007 | | 10,058,854 | | $3.16-$23.75 | | $8.70 |
| Granted | | 654,716 | | 4.80-5.50 | | 4.43 |
| Exercised | | (272,802) | | 3.16-3.96 | | 3.45 |
| Canceled* | | (1,420,373) | | 3.50-23.75 | | 10.51 |
| Balance February 2, 2008 | | 9,020,395 | | $3.50-$17.79 | | $8.26 |
(1) Exercise price ranges do not include the impact of deferred or restricted shares that were granted at an exercise price of $0.
* During Fiscal 2007, 900,000 of the stock awards that were cancelled represented stock options that were granted in Fiscal 1997 and expired out-of-the-money. No stock awards expired in Fiscal 2006 and 2005.
During Fiscal 2007, 2006 and 2005, the Company recognized expenses of approximately $526,000, $477,000 and $296,000, respectively, for deferred shares issued to non-employee directors at an exercise price below the closing stock price on the date of grant.
Restricted Stock Plan
Under the 1990 Restricted Stock Plan, the Compensation Committee of the Board of Directors is authorized to grant awards for up to 900,000 restricted shares of Common Stock to executive officers and other key employees of the Company. The shares are issued as restricted stock and are held in the custody of the Company until all vesting restrictions are satisfied. If conditions or terms under which an award is granted are not satisfied, the shares are forfeited. Shares vest under these grants over a period of two to five years, with vesting criteria that includes continuous employment until applicable vesting dates have expired. As of February 2, 2008, a total of 330,000 shares have been granted, of which 240,000 shares have vested and 90,000 shares had been forfeited. Unearned compensation is recorded at the date of award, based on the market value of the shares, and is amortized over the applicable vesting period. The amount amortized to expense in Fiscal 2007, 2006 and 2005, net of the impact of forfeitures, was approximately $54,000, $13,000 and $16,000, respectively. As of February 2, 2008, there were no outstanding awards and shares available for grant totaled 660,000.
Defined Benefit Plans
The Company maintains a non-qualified Supplemental Executive Retirement Plan (“SERP”) for certain Executive Officers of the Company. The SERP, which is unfunded, provides eligible executives defined pension benefits that supplement benefits under other retirement arrangements. The annual benefit amount is based on salary and bonus at the time of retirement and number of years of service.
The Company provides the Board of Directors with a noncontributory, unfunded retirement plan (“Director Retirement Plan”) that pays a retired director an annual retirement benefit equal to 60% of the annual retainer at the time of retirement plus a 3% annual increase through the final payment. Payments begin at age 62 or retirement, whichever is later, and continue for 10 years or the life of the director and his or her spouse, whichever period is shorter. Partial vesting in the retirement plan begins after six years of continuous service. Participants become fully vested after 12 years of continuous service on the Board. After June 1, 2003, new directors were not covered by the Director Retirement Plan. Directors who were not yet vested in their retirement benefits as of June 1, 2003 had the present value of benefits already accrued as of the effective date converted to Deferred Shares under the 1990 Plan. Directors that were fully or partially vested in their retirement benefits were given a one time election to continue to participate in the current retirement program or convert the present value of benefits already accrued to Deferred Shares under the 1990 Plan as of the effective date.
The Company accounts for the SERP and the Director Retirement Plan in accordance with SFAS No 158,Employers’ Accounting for Defined Benefit and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R). SFAS No. 158 requires that the funded status of defined benefit pension plans, or the difference between the fair value of plan assets and the projected benefit obligation, be
F-21
recognized in the Consolidated Balance Sheets. This differs from the accounting under SFAS No. 87, which required the difference between the fair value of plan assets and the accumulated benefit obligation to be recorded in the Consolidated Balance Sheets. SFAS No. 158 also requires that defined benefit plan assets and obligations be measured as of the date of the employer’s fiscal year-end statement of financial position; however, this requirement of the statement is effective for fiscal years ending after December 15, 2008. Accordingly, the Company has not adopted this provision of SFAS No. 158 for the year ended February 2, 2008;however this provision will be adopted in accordance with the aforementioned requirements.For Fiscal 2007 and 2006, the measurement date for the plans is November 1.
For Fiscal 2007, 2006 and 2005, net periodic benefit cost recognized under both plans totaled approximately $1.3 million, $2.2 million, and $1.9 million, respectively. The accrued pension liability for both plans was approximately $14.2 million and $13.3 million at February 2, 2008 and February 3, 2007, respectively. The accumulated benefit obligation for both plans was approximately $13.5 million and $12.8 million as of February 2, 2008 and February 3, 2007, respectively.
The following is a summary of the Company’s defined benefit pension plans as of the most recent actuarial calculations:
| Obligation and Funded Status: | | | | | | | | |
| | | February 2, | | | February 3, | |
| | | 2008 | | | 2007 | |
| Change in Projected Benefit Obligation: | | ($ in thousands) |
| Benefit obligation at beginning of year | | $ | 13,276 | | | $ | 16,108 | |
| Service cost | | | 216 | | | | 679 | |
| Interest cost | | | 763 | | | | 885 | |
| Actuarial gain | | | (30 | ) | | | (4,346 | ) |
| Benefits paid | | | (50 | ) | | | (50 | ) |
| Projected Benefit obligation at end of year | | $ | 14,175 | | | $ | 13,276 | |
| |
| Fair value of plan assets at end of year | | $ | - | | | $ | - | |
| |
| Reconciliation of Funded Status: | | | | | | | | |
| Funded status | | $ | (14,175 | ) | | $ | (13,276 | ) |
| Unrecognized prior service cost | | | 3,058 | | | | 3,400 | |
| Unrecognized net actuarial gain | | | (199 | ) | | | (171 | ) |
| Accrued benefit cost | | | (11,316 | ) | | | (10,047 | ) |
| Additional liability | | | (2,859 | ) | | | (3,229 | ) |
| Accrued pension liability | | $ | (14,175 | ) | | $ | (13,276 | ) |
* The actuarial gain of $4.3 million in Fiscal 2006 was due to the non-vested termination of two plan participants, an increase in the discount rate from 5.50% to 5.75% and a 5 year extension of the assumed retirement age for the Company’s Chief Executive Officer.
| Amounts recognized in the Consolidated Balance Sheets consist of: | | | | | | | | |
| | | | February 2, | | | February 3, | |
| | | | 2008 | | | | 2007 | |
| | | | ($ in thousands) | |
| |
| Accrued pension liability | | $ | (14,175 | ) | | $ | (13,276 | ) |
| Accumulated other comprehensive loss | | | 1,625 | | | | 1,888 | |
| Deferred tax asset | | | 1,234 | | | | 1,341 | |
| Net amount recognized | | $ | (11,316 | ) | | $ | (10,047 | ) |
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Components of Net Periodic Benefit Cost and Other Amounts Recognized in
Other Comprehensive (Income) Loss:
($ in thousands) | | | |
| Net Periodic Benefit Cost: | Fiscal Year |
| | 2007 | | 2006 | | 2005 |
| Service cost | $ 216 | | $ 679 | | $ 531 |
| Interest cost | 763 | | 885 | | 782 |
| Amortization of prior service cost | 342 | | 343 | | 342 |
| Amortization of net (gain) loss | (2) | | 275 | | 243 |
| Net periodic benefit cost | $ 1,319 | | $ 2,182 | | $ 1,898 |
| |
| Other Changes in Benefit Obligations Recognized in Other | | | | | |
| Comprehensive (Income) Loss: | | | | | |
| Net prior service cost recognized as a component of net periodic benefit | | | | | |
| cost | $(342) | | $(343) | | |
| Net actuarial gain (loss) recognized as a component of net periodic | | | | | |
| benefit cost | 2 | | (275) | | |
| Net actuarial (gain) loss arising during the period | (30) | | (3,598) | | |
| | (370) | | (4,216) | | |
| Income tax effect | 107 | | 1,771 | | |
| Total recognized in other comprehensive (income) loss | $(263) | | $(2,445) | | |
| Total recognized in net periodic benefit cost | | | | | |
| and other comprehensive (income) loss | $1,056 | | $(263) | | |
The pre-tax components of accumulated other comprehensive loss, which have not yet been recognized as components of net periodic benefit cost as of February 2, 2008 and February 3, 2007 are summarized below.
| ($ in thousands) | | February 2, | | February 3, |
| | | 2008 | | 2007 |
| Net unrecognized actuarial gain | | $ (199) | | $ (171) |
| Net unrecognized prior service cost | | 3,058 | | 3,400 |
| Accumulated other comprehensive loss | | $2,859 | | $3,229 |
In Fiscal 2008, approximately $427,000 of net unrecognized prior service cost and approximately $3,000 of the net unrecognized actuarial gain, recorded as components of accumulated other comprehensive loss at February 2, 2008, will be recognized as components of net periodic benefit cost.
| Assumptions: | | | | | | |
| | | Fiscal Year | | |
| | | 2007 | | 2006 | | |
| Weighted-average assumptions used to determine | | | | | | |
| benefit obligation: | | | | | | |
| Discount rate | | 6.25% | | 5.75% | | |
| Salary increase rate | | 4.00% | | 4.00% | | |
| Measurement date | | Nov 1, 2007 | | Nov 1, 2006 | | |
| |
| | | Fiscal Year |
| | | 2007 | | 2006 | | 2005 |
| Weighted-average assumptions used to determine | | | | | | |
| net periodic benefit cost: | | | | | | |
| Discount rate | | 6.25% | | 5.75% | | 5.50% |
| Salary increase rate | | 4.00% | | 4.00% | | 4.00% |
F-23
The discount rate is based on the rates implicit in high-quality fixed-income investments currently available as of the measurement date. The Citigroup Pension Discount Curve (CPDC) rates are intended to represent the spot rates implied by the high quality corporate bond market in the U.S. The projected benefit payments attributed to the projected benefit obligation have been discounted using the CPDC mid-year rates and the discount rate is the single constant rate that produces the same total present value.
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid:
| Year | | Pension Benefits |
| | | ($ in thousands) |
| 2008 | | $51 |
| 2009 | | 64 |
| 2010 | | 101 |
| 2011 | | 143 |
| 2012 | | 1,356 |
| 2013 and thereafter | | $6,749 |
Note 9. Shareholders’ Equity
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 (see Note 5 to the Consolidated Financial Statements) and other factors the Company’s Board of Directors may consider.
Note 10. Related Party Transactions
The Company leases its 181,300 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 occupied 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 $2.0 million, $2.0 million and $1.9 million in Fiscal 2007, 2006 and 2005 respectively. Pursuant to the terms of the lease agreements, effective January 1, 2002 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 its term.
The Company leases oneof its retail stores from Mr. Higgins under an operating lease. Annual rental payments under this lease were $40,000 in Fiscal 2007, 2006 and 2005. 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 $3,800, $4,100 and $4,400 in Fiscal 2007, 2006 and 2005 respectively.
The Company occasionally utilizes privately chartered aircraft owned or partially owned by Mr. Higgins, for Company business. The Company charters an aircraft from Crystal Jet, a corporation wholly-owned by Mr. Higgins, for Company business. Payments to Crystal Jet aggregated approximately $0, $11,000 and $6,000 in Fiscal 2007, 2006 and 2005, respectively. The Company also charters an aircraft from Richmor Aviation, an unaffiliated corporation that leases an aircraft owned by Mr. Higgins, for Company business. Payments to Richmor Aviation, to charter the aircraft owned by Mr. Higgins, in Fiscal 2007, 2006 and 2005 were approximately $29,000, $526,000 and $276,000, respectively.
F-24
Note 11. Quarterly Financial Information (Unaudited)
| | | | Fiscal 2007 Quarter Ended | |
| | | | 2007 | | | | 2/02/08 | | | | 11/03/07 | | | | | 8/04/07 | | | | 5/05/07 | |
| | | | ($ in thousands, except for per share amounts) | |
| Net sales | | $ | 1,265,658 | | | $ | 451,476 | | | $ | 260,570 | | | $ | | 267,305 | | | $ | 286,307 | |
| Gross profit | | | 445,747 | | | | 152,072 | | | | 91,332 | | | | | 97,962 | | | | 104,381 | |
| Net loss | | $ | (99,435 | ) | | $ | (66,029 | ) | | $ | (14,263 | ) | | $ | | (10,074 | ) | | $ | (9,069 | ) |
| |
| Basic and diluted loss per share | | $ | (3.20 | ) | | $ | (2.12 | ) | | $ | (0.46 | ) | | $ | | (0.32 | ) | | $ | (0.29 | ) |
During the fourth quarter of Fiscal 2007, the Company recorded an asset impairment charge of $30.7 million related to the write down of certain long-lived assets at underperforming locations. In addition, during the fourth quarter, the Company recorded a full valuation allowance against its net deferred tax assets. See Note 4 and Note 6, respectively in the Notes to Consolidated Financial Statements for further detail regarding the impairment charge and valuation allowance.
| | | | Fiscal 2006 Quarter Ended | |
| | | | 2006 | | | 2/03/07 | | | 10/28/06 | | | | 7/29/06 | | | | 4/29/06 | |
| | | | ($ in thousands, except for per share amounts) | |
| Net sales | | $ | 1,471,157 | | $ | 586,680 | | $ | 297,679 | | | $ | 298,261 | | | $ | 288,537 | |
| Gross profit | | | 519,222 | | | 203,755 | | | 108,811 | | | | 106,212 | | | | 100,444 | |
| Income (loss) before extraordinary | | | | | | | | | | | | | | | | | | |
| gain - unallocated negative goodwill | | | 948 | | | 32,461 | | | (13,305 | ) | | | (10,217 | ) | | | (7,991 | ) |
| Extraordinary gain – unallocated negative goodwill, | | | | | | | | | | | | | | | | | | |
| net of income taxes | | | 10,721 | | | 5,387 | | | 1,925 | | | | 2,475 | | | | 934 | |
| Net income (loss) | | $ | 11,669 | | $ | 37,848 | | $ | (11,380 | ) | | $ | (7,742 | ) | | $ | (7,057 | ) |
| |
| Basic earnings (loss) per share before extraordinary | | | | | | | | | | | | | | | | | | |
| gain – unallocated negative goodwill | | $ | 0.03 | | $ | 1.05 | | $ | (0.43 | ) | | $ | (0.33 | ) | | $ | (0.26 | ) |
| Extraordinary gain – unallocated negative goodwill, | | | | | | | | | | | | | | | | | | |
| net of income taxes | | | 0.35 | | $ | 0.18 | | $ | 0.06 | | | $ | 0.08 | | | $ | 0.03 | |
| Basic earnings (loss) per share | | $ | 0.38 | | $ | 1.23 | | $ | (0.37 | ) | | $ | (0.25 | ) | | $ | (0.23 | ) |
| Diluted earnings (loss) per share before extraordinary | | | | | | | | | | | | | | | | | | |
| gain – unallocated negative goodwill | | $ | 0.03 | | $ | 1.00 | | $ | (0.43 | ) | | $ | (0.33 | ) | | $ | (0.26 | ) |
| Extraordinary gain – unallocated negative goodwill, | | | | | | | | | | | | | | | | | | |
| net of income taxes | | | 0.33 | | | 0.17 | | | 0.06 | | | | 0.08 | | | | 0.03 | |
| Diluted earnings (loss) per share | | $ | 0.36 | | $ | 1.17 | | $ | (0.37 | ) | | $ | (0.25 | ) | | $ | (0.23 | ) |
F-25
Index to Exhibits
Document Number and Description
Exhibit No.
| 2.1 | Asset Acquisition Agreement dated February 17, 2006, between Trans World Entertainment Corporation and Musicland Holding Corp.- incorporated by reference to Exhibit 99.2 to the Company’s Current Report on Form 8-K filed February 22, 2006. Commission File No. 000-14818. |
| |
| 3.1 | Restated Certificate of Incorporation -- incorporated herein by reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the year ended January 29, 1994. Commission File No. 0-14818. |
| |
| 3.2 | Certificate of Amendment to the Certificate of Incorporation -- incorporated herein by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended October 29, 1994. Commission File No. 0-14818. |
| |
| 3.3 | Certificate of Amendment to the Certificate of Incorporation -- incorporated herein by reference to Exhibit 3.4 to the Company’s Annual Report on Form 10-K for the year ended January 31, 1998. Commission File No. 0-14818. |
| |
| 3.4 | *3.4 Amended By-Laws -- incorporated herein by reference to Exhibit 3.4 to the Company’s Annual Report on Form 10-K for the year ended January 29, 2000. Commission File No. 0-14818. |
| |
| 3.5 | Certificate of Amendment to the Certificate of Incorporation—incorporated herein by reference to Exhibit 3.5 to the Company’s Registration Statement on Form S-4, No. 333-75231. |
| |
| 3.6 | Certificate of Amendment to the Certificate of Incorporation—incorporated herein by reference to Exhibit 3.6 to the Company’s Registration Statement on Form S-4, No. 333-75231. |
| |
| 3.7 | Certificate of Amendment to the Certificate of Incorporation—incorporated herein by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K filed August 11, 2000. Commission File No. 0-14818. |
| |
| 3.8 | Certificate of Amendment to the Certificate of Incorporation of Trans World Entertainment Corporation - incorporated herein by reference to Exhibit 2 to the Company’s Current Report on Form 8-A filed August 11, 2000. Commission File No. 0-14818. |
| |
| 4.1 | Credit Agreement dated January 5, 2006, between Trans World Entertainment Corporation and Bank of America N.A. - incorporated by reference to Exhibit 99.2 to the Company’s Current Report on Form 8-K filed January 10, 2006. Commission File No. 0-14818. |
| |
| 4.2 | First Amendment to Credit Agreement between Trans World Entertainment Corporation and Bank of America N.A – incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed March 23, 2006. Commission File No. 0-14818. |
| |
| 4.3 | Second Amendment to Credit Agreement between Trans World Entertainment Corporation and Bank of America N.A – incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed October 23, 2006. Commission File No. 0-14818. |
| |
| 4.4 | Rights Agreement, between Trans World Entertainment Corporation and ChaseMellon Shareholder Services, L.L.C., as Rights Agent – incorporated herein by reference to Exhibit 1 to the Company’s Current Report on Form 8-A filed August 11, 2000. Commission File No. 0-14818. |
| |
| 4.5 | Amendment No. 1 to the Rights Agreement, dated as of August 11, 2000, between Trans World Entertainment Corporation and Mellon Investor Services LLC (as successor in interest to ChaseMellon Shareholder Services, L.L.C.) – incorporated herein by reference to Exhibit 4.2 to the Company’s Form 8-A12G/A filed November 27, 2007. Commission File No. 0-14818. |
| |
| 10.1 | Lease, dated April 1, 1985, between Robert J. Higgins, as Landlord, and Record Town, Inc. and Trans World Music Corporation, as Tenant and Amendment thereto dated April 28, 1986 -- incorporated herein by reference to Exhibit 10.3 to the Company’s Registration Statement on Form S-1, No. 33-6449. |
| |
| 10.2 | Second Addendum, dated as of November 30, 1989, to Lease, dated April 1, 1985, among Robert J. Higgins, and Trans World Music Corporation, and Record Town, Inc., exercising five year renewal option -- incorporated herein by reference to Exhibit 10.2 to the Company’s Annual Report on Form 10-K for the year ended February 3, 1990. Commission File No. 0-14818. |
| |
| 10.3 | Lease, dated November 1, 1989, between Robert J. Higgins, as Landlord, and Record Town, Inc. and Trans World Music Corporation, as Tenant -- incorporated herein by reference to Exhibit 10.3 to the Company’s Annual Report on Form 10-K for the year ended February 2, 1991. Commission File No. 0-14818. |
| |
F-26
| 10.5 | Lease dated September 1, 1998, between Robert J. Higgins, as Landlord, and Record Town, Inc. and Trans World Music Corporation, as Tenant, for additional office space at 38 Corporate Circle -- incorporated herein by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended October 31, 1998. Commission File No. 0-14818. |
| |
| 10.6 | Trans World Music Corporation 1986 Incentive and Non-Qualified Stock Option Plan, as amended and restated, and Amendment No. 3 thereto -- incorporated herein by reference to Exhibit 10.5 of the Company’s Annual Report on Form 10-K for the year ended February 2, 1991. Commission File No. 0-14818. |
| |
| 10.7 | Trans World Music Corporation 1990 Stock Option Plan for Non-Employee Directors, as amended and restated -- incorporated herein by reference to Annex A to Trans World’s Definitive Proxy Statement on Form 14A filed as of May 19, 2000. Commission File No. 0- 14818. |
| |
| 10.8 | Trans World Entertainment Corporation Amended 1990 Restricted Stock Plan -- incorporated herein by reference to Annex B to Trans World’s Definitive Proxy Statement on Form 14A filed as of May 17, 1999. Commission File No. 0-14818. |
| |
| 10.9 | Trans World Entertainment Corporation 1994 Stock Option Plan -- incorporated herein by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended July 30, 1994. Commission File No. 0-14818. |
| |
| 10.10 | Trans World Entertainment Corporation 1998 Stock Option Plan -- incorporated herein by reference to Annex B to Trans World’s Definitive Proxy Statement on Form 14A filed as of May 7, 1998. Commission File No. 0-14818. |
| |
| 10.11 | Trans World Entertainment Corporation 1999 Stock Option Plan -- incorporated herein by reference to Annex A to Trans World’s Definitive Proxy Statement on Form 14A filed as of May 7, 1998. Commission File No. 0-14818. |
| |
| 10.12 | Form of Indemnification Agreement dated May 1, 1995 between the Company and its officers and directors incorporated herein by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended April 29, 1995. Commission File No. 0-14818. |
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| 10.13 | Trans World Entertainment Corporation 1997 Supplemental Executive Retirement Plan -- incorporated herein by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended May 3, 1997. Commission File No. 0-14818. |
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| 10.14 | Employment Agreement, dated as of May 1, 2003, between the Company and Robert J. Higgins. Incorporated herein by reference to Exhibit 10.17 to the Company’s Annual Report on Form 10-K for the year ended February 1, 2003. Commission File No. 0-14818. |
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| 10.15 | Agreement dated September 19, 2003 by and between a joint venture composed of Trans World Entertainment Corporation, Hilco Merchant Resources, LLC, Hilco Real Estate, LLC Gordon Brothers Retail Partners, LLC and The Ozer Group LLC as Agent and Wherehouse Entertainment, Inc., as Merchant to acquire certain assets of Wherehouse Entertainment Inc. -- incorporated herein by reference to Exhibit 10.18 to the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended November 1, 2003. Commission File No. 0-14818. |
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| 10.16 | Amendment No.1 dated October 1, 2003 to the agency agreement dated September 19, 2003 -- incorporated herein by reference to Exhibit 10.19 to the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended November 1, 2003. Commission File No. 0-14818. |
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| 10.17 | Trans World Entertainment Corporation 2005 Long Term Incentive and Share Award Plan incorporated herein by reference to Appendix A to Trans World Entertainment Corporation’s Definitive Proxy Statement on Form 14A filed as of May 11, 2005. Commission File No. 0-14818. |
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| * 21 | Significant Subsidiaries of the Registrant. |
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| * 23 | Consent of KPMG LLP. |
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| *31.1 | Certification of Chief Executive Officer dated April 17, 2008, relating to the Registrant’s Annual Report on Form 10-K for the year ended February 2, 2008. |
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| *31.2 | Certification of Chief Financial Officer dated April 17, 2008, relating to the Registrant’s Annual Report on Form 10-K for the year ended February 2, 2008. |
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| *32 | Certification of Chief Executive Officer and Chief Financial Officer of Registrant, dated April 17, 2008, pursuant to 18 U. S. C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 relating to the Registrant’s Annual Report on Form 10-K for the year ended February 2, 2008. |
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| 99.1 | Consent and Agreement, dated as of November 20, 2007, by and among Robert J. Higgins, Riley Investment Management LLC and Trans World Entertainment Corporation—incorporated herein by reference to Exhibit 99.1 to the Company’s Current Report on Form 8- K filed November 27, 2007. Commission File No. 0-14818. |
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*Filed herewith.
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