MTS 10Q/A 2003 Q2 Quarterly report (amended)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q/A

(Amendment No. 1)


(Mark One)

(x)		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended January 31, 2003


( )		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Transition Period
from to

Commission File Number
333-54035

MTS, INCORPORATED

(Exact name of registrant as specified in its charter)


California (State or other jurisdiction of incorporation or organization)		94-1500342 (I.R.S. Employer Identification No.)

2500 Del Monte Street, West Sacramento, CA 95691
(Address of principal executive office)

916-373-2500
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (x) No ( )

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the exchange act). Yes ( ) No (x)

Shares outstanding of the Registrant’s common stock:


Class Class B Common Stock, no par value		Outstanding at January 31, 2003 1,000 shares

TABLE OF CONTENTS


PART I—FINANCIAL INFORMATION
	Item 1. Consolidated Financial Statements
		CONSOLIDATED BALANCE SHEETS AS OF JANUARY 31, 2003, 2002 AND JULY 31, 2002
		CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED JANUARY 31, 2003 AND 2002 AND THE SIX MONTHS ENDED JANUARY 31, 2003 AND 2002
		CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JANUARY 31, 2003 AND 2002
		CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS FOR THE SIX MONTHS ENDED JANUARY 31, 2003 AND 2002
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II — OTHER INFORMATION
	ITEM 1. LEGAL PROCEEDINGS
	ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
CERTIFICATION OF CHIEF FINANCIAL OFFICER
INDEX OF EXHIBITS

MTS, INCORPORATED
TABLE OF CONTENTS


			Page
Part I. Financial Information				4
	Item 1. Consolidated Financial Statements			4
		Consolidated Balance Sheets (unaudited) as of January 31, 2003, 2002 and July 31, 2002 )		4
		Consolidated Statements of Operations (unaudited) for the three months ended January 31, 2003 and 2002 and the six months ended January 31, 2003 and 2002		5
		Consolidated Statements of Cash Flows (unaudited) for the six months ended January 31, 2003 and 2002		6
		Consolidated Statements of Comprehensive Loss (unaudited) for the six months ended January 31, 2003 and 2002		7
		Notes to Consolidated Financial Statements (unaudited)		8-15
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			16-26
	Item 3. Quantitative and Qualitative Disclosures about Market Risk			27
	Item 4. Controls and Procedures			28
Part II. Other Information
	Item 1. Legal Proceedings			29
	Item 6. Exhibits and Reports on Form 8-K			29
Signatures				30
Certification of Chief Executive Officer				31
Certification of Chief Financial Officer				32
Index of Exhibits				33

Explanatory Note

The purpose of this Amendment No. 1 to Quarterly Report on Form 10-Q is to restate the unaudited consolidated financial statements of MTS, Incorporated and its subsidiaries (the “Company”) for the three months ended January 31, 2003 to reflect an adjustment related to the disposal of the Company’s Japanese subsidiary (see Note 1 to the consolidated financial statements).

This Amendment No. 1 to Quarterly Report on Form 10-Q does not reflect events occurring after the April 1, 2003 filing of the Company’s Quarterly Report on Form 10-Q for the three months ended January 31, 2003, or modify or update those disclosures as set forth in that Quarterly Report on Form 10-Q in any way, except to reflect the effect of the restatement as described above.

The items of the Company’s Quarterly Report on Form 10-Q for the three months ended January 31, 2003, which are amended and restated herein, are:

1.		Part I, Item 1 – Consolidated Financial Statements, have been restated.

2.		Part I, Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations, have been revised.

3.		The certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 have been refiled.

The remaining Items contained within this Amendment No. 1 to the Company’s Quarterly Report on Form 10-Q consist of all other Items originally contained in the Company’s Quarterly Report on Form 10-Q for the three months ended January 31, 2003 in the form filed with the Commission on April 1, 2003. These remaining Items are not amended hereby, but are included for the convenience of the reader. In order to preserve the nature and character of the disclosures set forth in such Items as originally filed, except as expressly noted herein, this report contains disclosures as of the date of the original filing, and the Company has not updated the disclosures in this report to reflect events subsequent to the original filing date, April 1, 2003. While this report primarily relates to the historical periods covered, events may have taken place since the original filing that might have been reflected in this report if they had taken place prior to the original filing date. All information contained in this Amendment No. 1 to Quarterly Report on Form 10-Q may be updated or supplemented by disclosures contained in the Company’s reports filed with the Commission subsequent to the date of the original filing of the Quarterly Report on Form 10-Q, including but not limited to the Company’s Quarterly Report on Form 10-Q for the three months ended April 30, 2003.

PART I—FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

MTS, INCORPORATED

CONSOLIDATED BALANCE SHEETS
AS OF JANUARY 31, 2003, 2002 AND JULY 31, 2002
(DOLLARS IN THOUSANDS)
(UNAUDITED)


				JANUARY 31,			JANUARY 31,			JULY 31,
				2003			2002			2002

				(AS RESTATED,
				SEE NOTE 1)
			Assets
Current assets:
	Cash and cash equivalents			$	8,409		$	9,058		$	7,477
	Receivables, net				6,098			22,545			21,710
	Merchandising inventories				159,571			166,854			167,609
	Prepaid expenses				8,330			5,421			8,055

		Total current assets			182,408			203,878			204,851
Fixed assets, net					101,822			135,964			114,894
Other assets					13,768			14,761			13,210
Assets of discontinued operations					—			127,920			145,049

		Total assets		$	297,998		$	482,523		$	478,004

			Liabilities and Shareholders’ (Deficit) Equity
Current liabilities:
	Current maturities of long-term debt			$	3,248		$	51,846		$	82,776
	Accounts payable				121,081			125,138			112,904
	Reserve for restructuring costs				16,786			274			6,839
	Accrued liabilities				33,590			31,221			28,664
	Deferred revenue, current portion				6,559			7,465			2,286

		Total current liabilities			181,264			215,944			233,469
	Long-term debt, less current maturities				176,609			116,641			115,771
	Deferred revenue, less current portion				112			125			118
	Liabilities of discontinued operations				—			148,195			169,433

		Total liabilities			357,985			480,905			518,791

Shareholders’ (deficit) equity:
	Class B common stock, no par value; 10,000,000 shares authorized;1,000 shares issued and outstanding at January 31, 2003, 2002 and July 31, 2002				6			6			6
	Retained (deficit) earnings				(47,334	)		15,203			(21,355	)
	Accumulated other comprehensive loss				(12,659	)		(13,591	)		(19,438	)

		Total shareholders’ (deficit) equity			(59,987	)		1,618			(40,787	)

		Total liabilities and shareholders’ (deficit) equity		$	297,998		$	482,523		$	478,004

See accompanying notes to consolidated financial statements

MTS, INCORPORATED

CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED JANUARY 31, 2003 AND 2002
AND THE SIX MONTHS ENDED JANUARY 31, 2003 AND 2002
(DOLLARS IN THOUSANDS)
(UNAUDITED)


			THREE MONTHS ENDED						SIX MONTHS ENDED
			JANUARY 31,						JANUARY 31,

			2003			2002			2003			2002

			(AS RESTATED,						(AS RESTATED,
			SEE NOTE 1)						SEE NOTE 1)
Net revenue			$	176,789		$	194,310		$	306,911		$	334,430
Cost of sales (a) (b)				127,907			142,324			217,693			238,759

		Gross profit		48,882			51,986			89,218			95,671
Operating expenses:
Selling, general and administrative expenses (c)				44,259			49,926			87,514			94,098
Restructuring and asset impairment costs, net				20,071			719			23,981			802
Depreciation and amortization				5,256			5,709			10,584			11,442

		Loss from operations		(20,704	)		(4,368	)		(32,861	)		(10,671	)
Other income and (expense):
	Interest expense			(5,309	)		(6,214	)		(11,157	)		(12,357	)
	Foreign currency translation gain (loss)			2,031			(785	)		2,059			(1,086	)
	Other			(844	)		(818	)		(1,172	)		(848	)

		Loss from continuing operations before taxes		(24,826	)		(12,185	)		(43,131	)		(24,962	)
Provision for income taxes				29			123			76			254

		Loss from continuing operations		(24,855	)		(12,308	)		(43,207	)		(25,216	)
Discontinued operations (Note 3):
		Income from operations of discontinued Japanese subsidiary (including gain on disposal of $15,847, net of U.S. income and foreign taxes of $6,512, for the six months ended January 31, 2003)		—			2,935			17,228			4,571

		Net loss	$	(24,855	)	$	(9,373	)	$	(25,979	)	$	(20,645	)

(a)		Includes $2.0 million and $9.7 million of inventory write-downs related to restructuring efforts for the three months ended January 31, 2003 and 2002, respectively; and $2.0 million and $11.2 million for the six months ended January 31, 2003 and 2002, respectively.

(b)		Excludes depreciation and amortization related to retail and distribution assets of $3.3 and $3.9 million for the three months ended January 31, 2003 and 2002, respectively, and $6.7 and $7.6 million for the six months ended January 31, 2003 and 2002, respectively, which have been included below in operating expenses.

(c)		Includes $0.7 million and $1.3 million in professional fees related to restructuring efforts for the three months ended January 31, 2003 and 2002, respectively; and $1.5 million and $2.7 million for the six months ended January 31, 2003 and 2002, respectively.

See accompanying notes to consolidated financial statements.

MTS, INCORPORATED

CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JANUARY 31, 2003 AND 2002
(DOLLARS IN THOUSANDS)
(UNAUDITED)


					SIX MONTHS ENDED
					JANUARY 31,
					2003			2002

					(AS RESTATED,
					SEE NOTE 1)
Cash flows from operating activities:
	Net loss				$	(25,979	)	$	(20,645	)
	Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
		Income from discontinued operations, net of tax				(17,228	)		(4,571	)
		Depreciation and amortization				11,137			12,047
		Restructuring and asset impairment costs, net				23,981			802
		Allowance for doubtful accounts				(178	)		2
		Inventory write-downs due to restructuring				1,965			11,156
		Loss on disposal of depreciable assets				312			436
		Foreign exchange loss (gain)				2,039			(957	)
		Other non-cash expense				217			268
		Increase (decrease) in cash resulting from changes in operating assets and liabilities, net of effect from sale of subsidiary:
			Receivables			9,697			3,402
			Merchandising inventories			6,073			4,683
			Prepaid expenses			(275	)		(303	)
			Accounts payable			8,177			5,268
			Reserve for restructuring costs			(4,063	)		(2,254	)
			Accrued liabilities			4,926			1,332
			Deferred revenue			4,267			4,770

				Net cash provided by operating activities		25,068			15,436

Cash flows from investing activities:
	Net proceeds from sale of Japanese subsidiary					109,532			—
	Acquisition of fixed assets					(2,038	)		(3,725	)
	Acquisition of investments					(175	)		(983	)
	Change in deposits, net					(478	)		(443	)
	Change in intangibles, net					(99	)		(246	)

				Net cash provided by (used in) investing activities		106,742			(5,397	)

Cash flows from financing activities:
	Proceeds from life insurance loans					—			3,526
	Proceeds from employee loan payments					3			107
	Change in debt issuance costs, net					(4,674	)		(994	)
	Net proceeds from long-term line of credit					37,506			—
	Repayments on other long-term debt					(172,655	)		(51,925	)
	Proceeds from other long-term debt					7,600			40,000

				Net cash used in financing activities		(132,220	)		(9,286	)

Net cash and cash equivalents from discontinued operations						157			(6,834	)
Effect of exchange rate changes on cash and cash equivalents						1,185			4,495

				Net decrease in cash and cash equivalents		932			(1,586	)
Cash and cash equivalents, beginning of period						7,477			10,644

Cash and cash equivalents, end of period					$	8,409		$	9,058

Cash paid for interest					$	11,460		$	12,504

Cash paid for income taxes					$	4,504		$	37

See accompanying notes to consolidated financial statements.

MTS, INCORPORATED

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
FOR THE SIX MONTHS ENDED JANUARY 31, 2003 AND 2002
(DOLLARS IN THOUSANDS)
(UNAUDITED)


			SIX MONTHS ENDED
			JANUARY 31,
			2003			2002

			(AS RESTATED,
			SEE NOTE 1)
Net loss			$	(25,979	)	$	(20,645	)

Other comprehensive income, net of tax:
	Reclassification adjustment to net loss from the sale of Japanese subsidiary			9,029			—
	Foreign currency translation			(2,250	)		874

		Other comprehensive income		6,779			874

Comprehensive loss			$	(19,200	)	$	(19,771	)

See accompanying notes to consolidated financial statements.

MTS, INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

NOTE 1- RESTATEMENT

As part of the review and preparation of its Quarterly Report on Form 10-Q for the three months ended January 31, 2003, MTS, Incorporated and its subsidiaries (the “Company”) identified an adjustment related to the disposal of the Company’s Japanese subsidiary in October 2002. The gain on the sale of the Company’s Japanese subsidiary was originally reported as $36.0 million, net of tax, in the Company’s Quarterly Report on Form 10Q for the three months ended October 31, 2002, as filed on December 16, 2002. However, the Company has determined that the gain should have been $15.8 million, net of tax, after reclassification of the Japanese subsidiary’s accumulated other comprehensive loss. This restatement has also been reflected in the Company’s Amendment No. 2 to Quarterly Report on Form 10Q for the three months ended October 31, 2002.

The effects of the restatement on the unaudited consolidated statements of operations and other comprehensive loss for the six months ended January 31, 2003 are presented below (dollars in thousands):


		Six Months Ended January 31, 2003

		As
		Previously			As
		Reported*			Restated

Statement of Operations:
	Income from operations of discontinued Japanese subsidiary	$	37,400		$	17,228
	Net loss		(5,807	)		(25,979	)
Statement of Comprehensive Loss:
	Net loss		(5,807	)		(25,979	)
	Comprehensive income		972			(19,200	)

*As previously reported in the Company’s Quarterly Report on Form 10-Q for the three months ended January 31, 2003, filed on April 1, 2003.

NOTE 2- BASIS OF PRESENTATION

The unaudited consolidated financial statements include the accounts of MTS, Incorporated and its majority and wholly owned subsidiaries (the “Company”). In the opinion of the Company’s management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary to present fairly its consolidated financial position, the consolidated results of its operations and the consolidated cash flows for each of the periods presented. The consolidated results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year or any future period.

The significant accounting policies and certain financial information that are normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America, but which are not required for interim reporting purposes, have

been omitted. The accompanying unaudited consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2002.

Certain reclassifications have been made to conform prior periods’ financial statements to the current period’s presentation.

NOTE 3 – DISCONTINUED OPERATIONS

On October 11, 2002, the Company completed the sale of its Japanese subsidiary, Tower Records Kabushiki Kaisha (“TRKK”), to Nikko Principal Investments Japan, Ltd. The Company sold all authorized and issued capital stock of TRKK for an aggregate purchase price of 16 billion Japanese Yen, which was approximately $129 million at then-current exchange rates. As discussed in Note 7, net proceeds were used to pay down the Credit Facility (as defined in Note 7). The Company recorded a $15.8 million gain, net of $6.5 million in U.S. income and foreign taxes, from the sale of TRKK, which is included in income from discontinued operations on the accompanying statement of operations for the six months ended January 31, 2003. In accordance with the Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” TRKK’s current year operating results have been presented as discontinued operations. Additionally, all prior period consolidated financial statements presented have been reclassified to present TRKK as discontinued operations.

Net income from discontinued operations, excluding the gain on sale, is as follows (dollars in thousands):


		Six Months Ended		Six Months Ended
		January 31, 2003		January 31, 2002

Total revenue		$	66,313	$	185,929
Total expense			64,932		181,358

	Net income	$	1,381	$	4,571

Assets and liabilities of discontinued operations primarily consist of the following (dollars in thousands):


			January 31, 2002		July 31, 2002

Assets:
	Cash and cash equivalents		$	20,917	$	29,876
	Merchandising inventories			63,281		68,763
	Fixed assets, net			29,966		31,873
	Other			13,756		14,537

		Assets of discontinued operations	$	127,920	$	145,049

Liabilities:
	Current maturities of long-term debt		$	100,595	$	113,007
	Accounts payable and accrued liabilities			36,520		39,918
	Other			11,080		16,508

		Liabilities of discontinued operations	$	148,195	$	169,433

NOTE 4 - TRANSLATION OF FOREIGN CURRENCY

The value of the U.S. dollar rises and falls day-to-day on foreign currency exchanges. Since the Company does business in several foreign countries, these fluctuations affect the Company’s financial position and results of operations. In accordance with SFAS No. 52,“Foreign Currency Translation,” all foreign assets and liabilities have been translated at the exchange rates prevailing at the respective balance sheets dates, and all statement of operations items have been translated using the weighted average exchange rates during the respective periods. The net gain or loss resulting from translation upon consolidation into the financial statements is included in accumulated other comprehensive loss, which is reported as a separate component of shareholders’ equity. Some transactions of the Company and its foreign subsidiaries are made in currencies different from their functional currency. Translation gains and losses from these transactions are included in the consolidated statement of operations as they occur. The Company recorded a net transaction gain of approximately $2.1 million for the six months ended January 31, 2003 and a net translation loss of approximately $1.1 million for the six months ended January 31, 2002. These amounts primarily represent the volatility of currencies in foreign countries in which the Company does business.

NOTE 5 - INCOME TAXES

The effective income tax rates for the six months ended January 31, 2003 and 2002 are based on the federal statutory income tax rate, increased for the effect of state income taxes, net of federal benefit, and foreign taxes resulting from the sale of TRKK. The Company has reserved all of its net deferred tax assets at January 31, 2003 and 2002 and July 31, 2002 due to the uncertainty of future utilization.

NOTE 6 – RESTRUCTURING PLANS AND SUBSEQUENT EVENT

2001 RESTRUCTURING PLAN

During the third quarter of fiscal 2001, the Company commenced a business plan and restructuring process and retained a consulting firm to assist the Company in its efforts to improve its operations and financial performance. These efforts produced a restructuring plan that was adopted by the Company in February 2001 (the “2001 Restructuring Plan”).

The 2001 Restructuring Plan contains several store-related initiatives designed to improve the Company’s profitability, including closing and liquidating most stand-alone and combination bookstores; disposing of most of the Company’s foreign operations by direct sale, franchise or closure; closing under-performing domestic record, outlet and frame/gallery stores; and monitoring the performance of additional stores. The 2001 Restructuring Plan also contains several operational initiatives designed to improve the Company’s cash flow position, including reducing corporate work force and overhead expenses, reducing working capital requirements and reducing capital expenditures until internally generated cash flow will support future needs.

FISCAL 2001 AND 2002 ACTIVITY

In fiscal 2001, the Company began efforts to dispose of its Argentina, Hong Kong, Taiwan, Singapore and Canadian operations, close under-performing domestic stores and make certain reductions in work force. As a result, the Company recorded pre-tax restructuring and asset impairment charges of $23.3 million during the 12 months of fiscal year 2001, which included $1.6 million of severance costs, $1.9 million of lease termination costs, $14.2 million of non-

cash asset impairment charges and $5.6 million of other closure costs. In fiscal 2001, the Company also recorded $2.7 million of professional fees incurred in connection with the 2001 Restructuring Plan in selling, general and administrative expenses, and $20.7 million of inventory write-downs in cost of sales. At July 31, 2001, the reserve for restructuring costs was $2.2 million, which was comprised mainly of accruals for store closures and severance.

In the fourth quarter of fiscal 2002, the Company began efforts to dispose of its United Kingdom and Ireland operations, close additional under-performing domestic stores and further reduce the domestic corporate in work force. As a result, the Company recorded pre-tax restructuring and asset impairment charges of $21.8 million during the 12 months of fiscal year 2002, which included $2.9 million of severance costs, $4.7 million of lease termination costs, $13.6 million of non-cash asset impairment charges and $0.6 million of other closure costs. In fiscal 2002, the Company also recorded $5.9 million of professional fees incurred in connection with the 2001 Restructuring Plan in selling, general and administrative expenses, and $14.2 million of inventory write-downs in cost of sales. At July 31, 2002, the reserve for restructuring costs was $6.8 million, which was comprised mainly of accruals for the closing of the United Kingdom and Ireland operations and two domestic store closures.

SUBSEQUENT EVENT

In February 2003, the Company entered into a Leasing and Employee Transfer Agreement with Virgin Retail Group Limited and Piccadilly Entertainment Store Limited (collectively, “Virgin”). Under this agreement, the Company will assign leases, sell store fixtures and transfer certain employees for two of the Company’s stores in the United Kingdom to Virgin in exchange for 1.5 million British Sterling (approximately $2.5 million at the then-current exchange rates) payable at the closing of the transaction. In addition, Virgin shall obtain the non-exclusive right to use the business name of “Tower Records” for the operation of these two stores for a period not to exceed one year from date of closing. The Company anticipates that the assignment and transfer pursuant to this agreement will be completed in April 2003.

2003 RESTRUCTURING PLAN

During the second quarter of the Company’s 2003 fiscal year, the Company commenced another restructure and turnaround plan and retained a consulting firm to assist the Company in its efforts. These efforts produced a restructuring plan that was adopted by the Company in December 2002 (the “2003 Restructuring Plan”).

The 2003 Restructuring Plan contains several additional initiatives designed to improve the Company’s operations, including closing and liquidating 13 under-performing stores, selling its Mexico investment, making cost cutting efforts focused on overhead reduction, right-sizing inventory with centralized purchasing and automatic replenishment, and suspending the Pulse! magazine publication. The 2003 Restructuring Plan also contains other cash flow improvement initiatives, including sales and marketing, gross margin enhancement, and inventory management. The Company began implementing its restructuring plan shortly after its adoption and has since closed two of the 13 under-performing stores through January 31, 2003. The Company closed an additional three stores in February 2003.

The Company expects to substantially complete implementation of the remainder of the 2001 Restructuring Plan by the end of the third quarter of fiscal 2003, and expects to substantially complete implementation of the 2003 Restructuring Plan by the end of the second quarter of fiscal 2004.

SECOND QUARTER FISCAL 2002 AND 2003 ACTIVITY

In the second quarter of fiscal 2003, the Company recorded restructuring and asset impairment charges of $21.4 million under the 2003 Restructuring Plan and decreased its estimated restructuring costs under the 2001 Restructuring Plan by $1.3 million, which resulted in net pre-tax restructuring and asset impairment charges of $20.1 million. The $21.4 million of restructuring and asset impairment charges under the 2003 Restructuring Plan included restructuring charges of $4.7 million for accrual of lease termination costs, $5.7 million of involuntary termination benefits and $1.0 million of other costs, which have been recorded in reserve for restructuring costs; and asset impairment charges of $4.1 million for the write-down of fixed assets and leasehold improvements in stores to be closed and $5.9 million for the disposal of the Company’s joint venture investment in Mexico. The involuntary termination benefits include amounts that have been either paid or accrued for and cover approximately 114 employees in both retail and corporate locations. As a result of the Leasing and Employee Transfer Agreement with Virgin, the Company had revised its 2001 Restructuring plan estimates and decreased its reserve for restructuring costs and restructuring costs as of and for the three months ended January 31, 2003 by $1.3 million, which comprised of $0.9 million of accrued lease termination costs and $0.4 million of accrued severance costs. In connection with the 2003 Restructuring Plan, the Company also recorded $0.7 million of professional fees incurred as a result of the Company’s restructuring efforts in selling, general and administrative expenses, and $2.0 million of inventory write-downs in cost of sales.

In the second quarter of fiscal 2002, the Company recorded pre-tax restructuring and asset impairment charges of $0.7 million, which was comprised of $0.5 million for write-down of fixed assets and leasehold improvements and $0.2 million in other costs. In connection with the 2001 Restructuring Plan, the Company also recorded $1.3 million of professional fees in selling, general and administrative expenses, and $9.7 million of inventory write-downs in cost of sales.

A summary of the restructuring reserve activities in fiscal 2002 and for the six months ended January 31, 2003 is approximately as follows (dollars in millions):


											Fiscal 2003 Six
		Restructuring		Fiscal 2002		Fiscal 2002			Restructuring		Month		Fiscal 2003 Six			Restructuring
		Reserve at		Restructuring		Cash			Reserve at		Restructuring		Month Cash			Reserve at
		July 31, 2001		Charges		Payments			July 31, 2002		Charges		Payments			January 31, 2003

Severance costs		$	0.2	$	2.9	$	(1.2	)	$	1.9	$	9.3	$	(3.6	)	$	7.6
Lease termination costs			0.8		4.7		(0.7	)		4.8		3.8		—			8.6
Other			1.2		0.6		(1.7	)		0.1		1.0		(0.5	)		0.6

	Total	$	2.2	$	8.2	$	(3.6	)	$	6.8	$	14.1	$	(4.1	)	$	16.8

NOTE 7 – LONG-TERM DEBT

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

In April 2001, the Company extended and restated on a short-term basis its outstanding obligations under the Credit Facility. The Credit Facility was further amended in October 2001, April 2002, June 2002, September 2002 and October 2002. The extended Credit Facility provided for initial maximum borrowings of up to $225.0 million, consisting of two sub-facilities (one for an initial maximum of $98.4 million and one for an initial maximum 15.6 billion Japanese Yen, which was equivalent to $126.6 million at inception), with a maturity date, as amended, of October 11, 2002. Maximum borrowings under the Credit Facility, as amended, were scheduled to decline by $15 million in July 2001, $5 million in October 2001 and $10 million in December 2001. The Company met all scheduled reductions under the Credit Facility, as amended.

On October 11, 2002, the Company completed the sale of TRKK to Nikko Principal Investments Japan, Ltd. for an aggregate purchase price of 16 billion Japanese Yen (approximately $129 million at then-current exchange rates). Of the proceeds from the sale of TRKK, $108.8 million were used to pay down the Credit Facility. The balance of the Credit Facility was refinanced on October 11, 2002, with an asset-based line of credit and a term loan, each of which matures on April 1, 2005. The asset-based borrowings as described in the Company’s Loan and Security Agreement with The CIT Group/Business Credit, Inc. and other lenders provide for a line of credit of up to $110 million. The Company has successfully syndicated $100 million of the line of credit. The Company anticipates that the line of credit at $100 million will be sufficient to meet its liquidity requirements. Interest is based on a formula of prime plus a premium based upon excess availability levels achieved each month. As of January 31, 2003, the line of credit had an outstanding balance of $37.5 million, with an additional $62.5 million available. The Company has received a $26 million term loan pursuant to an Amended and Restated Term Loan Agreement with JPMorgan Chase Bank and other lenders, which had an outstanding balance of $25 million at January 31, 2003.

Maximum borrowings under both the Amended and Restated Term Loan Agreement and the Loan and Security Agreement are subject to a borrowing base formula, certain financial ratio tests and maintaining a minimum rolling quarterly EBITDA. Also, the new line of credit requires that the Company maintain a minimum collateral reserve level of $15 million. Prior to its refinancing, the Credit Facility bore interest at various variable rates, including (as defined in the agreements) a Money Market Rate, ABR Rate, Yen Base Rate and Euro Rate, plus an annual facility fee payable by the Company. Under the Company’s long-term financing agreements, there were various restrictive terms and covenants relating to the occurrence of material adverse financial operating conditions, balance sheet coverage ratio, certain debt and certain limitations on additional indebtedness, sale-leaseback transactions, liens or encumbrances on substantially all of the Company’s assets, cash management arrangements, long-term transactions, capital expenditures, investments, acquisitions and new retail locations, mandatory commitment reductions and issuance of capital stock. The Company obtained a waiver from its lenders approving the sale of TRKK in October 2002.

NOTE 8 – RECENT ACCOUNTING PRONOUNCEMENTS

In November 2002, and as amended in March 2003, the Financial Accounting Standards Board (the “FASB”) issued Emerging Issues Task Force Issue No. 02-16 (“EITF No. 02-16”), “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” EITF No. 02-16 provides guidance on how a reseller of a vendor’s products should account for cash consideration received from that vendor. The Task Force reached a consensus that cash consideration received from a vendor is presumed to be a reduction of the prices of the vendor’s products or services and should, therefore, be characterized as a reduction of cost of

sales unless certain restrictive criteria are met. EITF No. 02-16 is effective for vendor reimbursement arrangements entered into after December 31, 2002. Accordingly, the Company will record amounts received from vendors for cooperative advertising and slotting arrangements as reductions to cost of sales. Vendor reimbursements from arrangements entered into prior to December 31, 2002 were recorded as reductions to selling, general and administrative expense. The Company’s accounting for promotional and volume related allowances was already consistent with the new EITF No. 02-16 requirements, and therefore will not require a change in policy. The adoption of EITF No. 02-16 did not have an impact on stockholders’ equity or net loss as of and for the three and six months ended January 31, 2003.

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The Company’s adoption of SFAS 143 on August 1, 2002 did not materially impact its financial position or results of operations.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement is effective for financial statements issued for fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 144 on August 1, 2002, on a prospective basis, and has recorded the sale of TRKK in accordance with this statement.

In May 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” which rescinded SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt,” and SFAS No. 64, “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements.” As a result, gains and losses from extinguishment of debt will no longer be aggregated and classified as an extraordinary item, net of related income tax effect, in the statement of operations. Instead, such gains and losses will be classified as extraordinary items only if they meet the criteria of unusual or infrequently occurring items. SFAS No. 145 also requires that gains and losses from debt extinguishments, which were classified as extraordinary items in prior periods, be reclassified to continuing operations if they do not meet the revised criteria for extraordinary items. The adoption of SFAS No. 145 on August 1, 2002 did not have a material impact on the Company’s financial position or results of operations.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Exit or Disposal Activities.” SFAS No. 146 addresses significant issues regarding the recognition, measurement and reporting of costs associated with exit and disposal activities, including restructuring activities that are currently accounted for pursuant to the guidance that the Emerging Issues Task Force (the “EITF”) set forth in EITF Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”). The scope of SFAS No. 146 also includes (i) costs related to terminating a contract that is not a capital lease and (ii) termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement, or an individual deferred compensation contract. SFAS No. 146 will be effective for exit or disposal activities initiated after December 31, 2002. Accordingly, with the Company’s continued restructuring efforts, the Company can only determine prospectively the impact that SFAS No. 146 may have on the Company’s financial position and results of operations.

NOTE 9 - SEGMENT AND GEOGRAPHIC INFORMATION

The Company reports financial and descriptive information about its reportable operating segments using the “management approach” model. Under the management approach model, segments are defined based on the way the Company’s management internally evaluates segment performance and decides how to allocate resources to segments. The Company has defined its only reportable segment as retail sales of pre-recorded music and related products and evaluates this reportable segment based on geographic area.

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

Financial information relating to the Company’s principal geographic areas of continuing operations is as follows (dollars in thousands):


			For the Six Months Ended
			January 31,			January 31,
			2003			2002

Net Revenue
	United States		$	284,147		$	302,426
	Great Britain and Ireland			21,274			28,748
	Other foreign operations			1,490			3,256

		TOTAL	$	306,911		$	334,430

Loss from operations:
	United States		$	(31,081	)	$	(12,372	)
	Great Britain and Ireland			(1,765	)		(3,402	)
	Other foreign operations			(15	)		5,103

			$	(32,861	)	$	(10,671	)


		January 31,
		2003			2002

Identifiable assets:
	United States	$	292,399		$	328,045
	Great Britain and Ireland		6,032			27,916
	Other foreign operations		(433	)		126,562

		$	297,998		$	482,523

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following information should be read in conjunction with the unaudited interim consolidated financial statements and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q, and in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended July 31, 2002 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

FORWARD-LOOKING STATEMENTS

The following discussion should be read in conjunction with historical consolidated financial information and the consolidated financial statements of the Company and the notes thereto included elsewhere in this Form 10-Q. The results shown herein are not necessarily indicative of the results to be expected in any future period. The following discussion contains forward-looking statements that involve known and unknown risks and uncertainties. Use of the words “anticipates,” “believes,�� “estimates,” “expects,” “intends,” “plans,” “potential” and similar expressions are intended to identify forward-looking statements. A variety of factors could cause the Company’s actual results to differ materially from the anticipated results expressed in such forward-looking statements, including among other things: (i) consumer demand for the Company’s products, which is believed to be related to a number of factors, including overall consumer spending patterns, weather conditions and new releases available from suppliers; (ii) an increase in competition, including Internet competition and competition resulting from electronic or other alternative methods of delivery of music and other products to consumers, or unanticipated margin or other disadvantages relative to competitors; (iii) the continued availability and cost of adequate capital to fund the Company’s operations; (iv) higher than anticipated interest, occupancy, labor, distribution and inventory shrinkage costs; (v) the ability of the Company to successfully defend itself in ongoing and future litigation and the expenses associated with such litigation; (vi) higher than anticipated costs associated with the implementation of the Company’s restructuring plans and/or lower than anticipated resulting operations and cash flow benefits; (vii) unanticipated increases in the cost of merchandise sold by the Company; (viii) changes in foreign currency exchange rates and economic and political risks; (ix) the adverse effects of acts or threats of war, terrorism or other armed conflict on the United States and international economies; (x) the ability of the Company to comply with the ongoing monthly affirmative and negative covenants as prescribed by the Company’s Amended and Restated Term Loan Agreement with JPMorgan Chase and other lenders and by the Company’s Loan and Security Agreement with The CIT Group/Business Credit Inc., and other lenders; and (xi) the ability of the Company to continue to service its senior subordinated notes. All forward-looking statements included in this Form 10-Q are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements. Please refer to the Risk Factors section of the Company’s Annual Report Form 10-K for further information on other factors, which could affect the financial results of the Company and such forward-looking statements.

RESTATEMENT

The Company restated its consolidated financial statements for the six months ended January 31, 2003 for an overstatement of the gain from the disposal of the Company’s Japanese subsidiary (see Note 1 to Notes to Consolidated Financial Statements). The following discussion of the financial condition and results of operations of the Company has been amended in its entirety to reflect changes resulting from this restatement.

OVERVIEW

Founded in 1960, the Company is one of the largest specialty retailers of recorded music headquartered in the United States in terms of revenues and is one of the largest and most widely recognized music retailers in the world. As of January 31, 2003, the Company operated a total of 105 stores worldwide, consisting of 99 U.S. stores in 21 states and six stores in three countries.

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

On October 11, 2002, the Company sold its Japanese subsidiary, Tower Records, Kabushiki Kaisha (“TRKK”). Prior to its sale, TRKK represented a significant portion of the Company’s revenues, and the revenues accounted for by TRKK increased annually in each of the most recent two fiscal years. In addition, Japan was the only geographic region in which the Company generated net operating income in each of fiscal 2002 and fiscal 2001. For the fiscal year ended July 31, 2002, TRKK accounted for 38% of the Company’s revenues and provided $15.6 million of operating income, which is included in the Company’s net operating loss of $31.2 million.

The Company also faces declining sales with the emerging digital download of music by consumers and mass market competition. According to industry statistics provided by Billboard Magazine, unit shipments of all music formats have decreased by 11% in 2002, and a major cause of the decline in 2002 is the ongoing problem of online and physical music piracy. However, the Company’s sales decline over the six months of fiscal year 2003 has been lower than the industry’s sales decline. The Company attributes its lower-than-industry sales decline to its deep catalog competitive advantage as well as efforts to market products other than pre-recorded music such as DVDs, accessories, and other complementary products.

The Company’s management attempts to manage business risks on a daily basis by analyzing sales trends, industry trends and monitoring costs in order to maintain sales and gross profits for the domestic operations. In September 2002, the Company hired a turn-around specialist to focus efforts in the domestic market and improve financial results. These turn-around efforts are focused principally on gross margin improvement, sales and marketing, cost reduction and store management restructuring.

CRITICAL ACCOUNTING POLICIES

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

REVENUE RECOGNITION

The Company generates revenue primarily from retail sales comprised of pre-recorded music

(including compact discs and audio cassettes), video sales (including recorded video cassettes, laser discs and DVD) and other complementary products (including books, magazines, blank tapes, video games, personal electronics and accessories) through the Company’s stores and is recognized at the point of the retail transaction. Reductions of revenue for returns by retail customers are provided at the point of the return. Additionally, the Company generates revenue from distribution to outside customers and recognizes revenue based upon the shipment of merchandise to those distribution customers. The Company’s distribution arrangements with these customers generally give them the right to return titles. The Company reduces gross sales and direct product costs for returns at the time of the returns. The Company continuously monitors collections and payments from its wholesale distribution customers and maintains a provision for estimated credit losses based upon its historical experience and any specific distribution customer collection issues that the Company has identified.

INVENTORY VALUATION

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

RESTRUCTURING CHARGES

Since the adoption of the 2001 Restructuring Plan and the 2003 Restructuring Plan (the “Restructuring Plans”), the Company has closed seven out of ten of its stand-alone bookstores and has liquidated most of its book inventories. The Company has also closed six domestic under-performing record and outlet stores and sold two of its frame/gallery stores. It has successfully converted the Argentina, Hong Kong and Taiwan operations to franchises and closed its Canadian operations. Additionally, five out of eight stores in the United Kingdom were closed during the six months ended January 31, 2003. In addition, the Company has entered into an agreement in February 2003 with Virgin Retail Group Limited and Piccadilly Entertainment Store Limited regarding the assignment of leases and the transfer of certain employees of two stores in the United Kingdom. The Company believes that it is being more selective in the number of new store openings and remodels. Management has implemented several rounds of reductions in workforce related to store closures and to reduce operating costs. Since the adoption of the Restructuring Plans, the Company has terminated approximately 795 employees at both the retail and corporate level, from clerks to management. Capital expenditures and working capital have also been closely managed under the Restructuring Plans. In accordance with the Restructuring Plans, the Company continues to monitor additional stores for possible future closure.

Management expects to substantially complete the final phase of the 2001 Restructuring Plan by the end of the third quarter of fiscal 2003. Nearing completion of the 2001 Restructuring Plan and in conjunction with the hiring of a retail operations turnaround specialist, the Company adopted the 2003 Restructuring Plan in December 2002 aimed at further improving operations, monitoring and closing additional under-performing stores and assets, and evaluating its ongoing working capital investments. The 2003 Restructuring Plan will likely require the Company to

implement various restructuring initiatives, which could result in additional restructuring costs, asset impairment charges and inventory write-downs in future periods. The Company expects to complete the 2003 Restructuring Plan by the end of the second quarter of fiscal 2004.

The Company has estimated and recorded restructuring and asset impairment charges and inventory write-downs in fiscal 2003 and 2002 related to the Restructuring Plans. These costs and charges required judgments about, among other things, employee severance costs, contract and lease terminations, related consulting and litigation fees, long-lived assets and inventory valuation and other contingent liabilities. The ability to obtain agreements with lessors to terminate leases or with other parties to assign leases can also affect the accuracy of current estimates.

IMPAIRMENT OF LONG-LIVED ASSETS

It is the Company’s policy to review its long-lived assets for possible impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. The Company recognizes impairment losses when the carrying value of the long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the future undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group). An impairment loss is measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value. Assumptions and estimates used in the evaluation of impairment, including current and future economic trends in the many geographic regions that the Company’s stores are located, are subject to a high degree of judgment and complexity and changes in the assumptions and estimates may affect the carrying value of long-lived assets, and could result in additional impairment charges in future periods.

For a detailed discussion of the Company’s accounting policies and related estimates and judgments, see the Notes to the Consolidated Financial Statements for the fiscal year ended July 31, 2002 filed on Form 10-K with the Securities and Exchange Commission. While the Company believes that the historical experience and other factors considered provide a meaningful basis for the accounting policies applied in the preparation of the consolidated financial statements, there can be no assurance that its estimates and assumptions will be accurate, which could require the Company to make adjustments to these estimates in future periods.

LIQUIDITY AND CAPITAL RESOURCES

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

Net cash provided by operating activities was $25.1 million for the six months ended January 31, 2003, and was $15.4 million for the six months ended January 31, 2002. For the six months ended January 31, 2003, net increase in inventory was $6.1 million. For the six months ended January 31, 2002, net increase in inventory was $4.7 million.

Net cash provided by investing activities was $106.7 million for the six months ended January 31, 2003 and net cash used in investing activities was $5.4 million for the six months ended January 31, 2002. Net cash provided by investing activities for the six months ended January 31, 2003 was primarily from proceeds received from sale of the Company’s Japanese subsidiary,

TRKK, and was offset by store leasehold improvements and capital expenditure requirements, including refurbishment and technology investments totaling approximately $1.4 million and $0.6 million used for video rental acquisition. Net cash used in investing activities for the six months ended January 31, 2002 was primarily due to store leasehold improvements and capital expenditure requirements, including store relocations, refurbishment and technology investments totaling approximately $5.5 million and $0.6 million used for video rental acquisition.

Net cash used in financing activities for the six months ended January 31, 2003 was $132.2 million, resulting principally from pay-down of long-term financing agreements from proceeds received from the sale of TRKK, offset by borrowings under the Company’s line of credit and changes in debt issuance costs. Net borrowings under the Company’s line of credit were $37.5 million for the six months ended January 31, 2003. Net cash used in financing activities for the six months ended January 31, 2002 was $9.3 million, which resulted primarily from net borrowings under the Credit Facility (as defined in Note 7 to the Consolidated Financial Statements).

Total funded debt decreased to $179.9 million as of January 31, 2003 from $269.4 million as of January 31, 2002, which included the funded debt of TRKK of $100.9 million at January 31, 2002. On January 31, 2003, outstanding debt consisted primarily of $110.0 million of 9.375% senior subordinated notes, $37.5 million under the asset-based line of credit agreement with The CIT Group/Business Credit, Inc. and $25.0 million under a term loan with JPMorgan Chase Bank. On January 31, 2002 outstanding debt consisted primarily of $110.0 million of 9.375% senior subordinated notes and $150.3 million under the Credit Facility.

Interest payments on the Company’s senior subordinated notes and under the asset-based line of credit and term loan will continue to impose significant liquidity demands upon the Company. In fiscal 2003, the Company made an interest payment on November 1, 2002, and is obligated to make another interest payment on its subordinated notes on May 1, 2003, each in the amount of $5.2 million. The Company must continue to make the semi-annual payments through the maturity date of the senior subordinated notes in May 2005. In addition to its debt service obligations, the Company will require liquidity for capital expenditures, lease obligations and general working capital needs.

During the six months ended January 31, 2003, the Company terminated a total of 114 employees in the United States, including certain senior executives, in accordance with its Restructuring Plans. As a result, the Company has estimated and accrued for $7.6 million of severance obligations in reserve for restructuring costs on the accompanying January 31, 2003 consolidated balance sheet, $4.5 million of which will be payable to senior executives over terms ranging from twelve to thirty-five months. New restructuring efforts include closure of under-performing domestic stores, closure of the Company’s Pulse! Magazine office and suspension of the Pulse! publication.

On October 11, 2002, the Company completed the sale of its Japanese subsidiary, TRKK, to Nikko Principal Investments Japan, Ltd. for an aggregate purchase price of 16 billion Japanese Yen (approximately $129 million at then-current exchange rates). Of the proceeds from the sale of TRKK, $108.8 million were used to pay down the Credit Facility. The balance of the Credit Facility was refinanced on October 11, 2002, with an asset-based line of credit and a term loan, each of which matures on April 1, 2005. For its asset-based borrowings, the Company entered into a Loan and Security Agreement with The CIT Group/Business Credit, Inc. and other lenders providing for a line of credit of up to $110 million. The Company has successfully achieved the syndication requirements for a line of credit up to $100 million. Interest is based on a formula of

prime plus a premium based upon excess availability levels achieved each month. As of January 31, 2003, the line of credit had an outstanding balance of $37.5 million, with an additional $62.5 million available. The Company also received a $26 million term loan pursuant to an Amended and Restated Term Loan Agreement with JPMorgan Chase Bank and other lenders, with an outstanding balance of $25 million at January 31, 2003.

The Company believes that the cash flow generated from its operations, together with amounts available from existing financing sources, will be sufficient to fund its debt service requirements, lease obligations, working capital needs, its currently anticipated capital expenditures and other operating expenses for at least the next 12 months. However, the Company’s ability to service its senior subordinated notes, asset-based line of credit and term loan, which mature in May 2005, April 2005 and April 2005, respectively, is subject to future economic conditions and financial, business and other factors.

The Company’s asset-based line of credit, term loan and senior subordinated notes impose certain restrictions on the Company’s ability to make capital expenditures and limit the Company’s ability to incur additional indebtedness. In addition, the Company’s cash balances are transferred nightly to pay down its outstanding debt and the daily management of cash needs and availability determine the next day’s draw on the line of credit. Such restrictions and cash balance transfers could limit the Company’s ability to respond to market conditions, to provide for unanticipated capital investments or to take advantage of business or acquisition opportunities. The debt covenants also, among other things, limit the ability of the Company to dispose of assets, repay indebtedness or amend other debt instruments, pay distributions to its shareholders, create liens on assets, make investments, loans or advances and make acquisitions.

The Company leases substantially all of its retail stores, warehouses and administrative facilities pursuant to operating leases that expire on dates through 2024 and generally have renewal options of one to 20 years. The terms of the leases provide for fixed or minimum payments plus, in some cases, contingent rents based on the consumer price index, or percentages of sales in excess of specified minimum amounts or other specified increases. The Company is generally responsible for maintenance, insurance and property taxes. Total rental expense (including taxes and maintenance, when included in rent, contingent rents and accruals to recognize minimum rents on the straight-line basis over the term of the lease) relating to all operating leases for the twelve months ending January 31, 2004 is expected to be approximately $45.2 million.

CONTRACTUAL OBLIGATIONS

The Company’s contractual obligations as of January 31, 2003 are as follows: (dollars in thousands):


		Payments due by period

				Less						More
				than 1		1-3		3-5		than 5
Contractual Obligations		Total		year		years		years		years

Long-term debt		$	179,857	$	3,248	$	153,328	$	4,269	$	19,012
Operating leases			253,258		33,695		61,294		49,737		108,532

	Total	$	433,115	$	36,943	$	214,622	$	54,006	$	127,544

SEASONALITY

Retail music sales in the United States are typically higher during the calendar fourth quarter as a result of consumer purchasing patterns due to increased store traffic and impulse buying by holiday shoppers. As a result, the majority of domestic music retailers and, more specifically, the mall-based retailers rely heavily on the calendar fourth quarter to achieve annual sales and profitability results. The Company’s deep-catalog approach to pre-recorded music appeals to customers who purchase music on a year-round basis. Consequently, the Company has historically experienced less seasonal reliance than other domestic music retailers. In each of fiscal 2002 and 2001, the second fiscal quarter (November 1 through January 31), excluding the sales of the Japanese subsidiary, accounted for approximately 32% and 31%, respectively, of the Company’s annual sales. Management expects to maintain this same seasonal trend as the Company continues to emphasize its year-round specialized entertainment shopping experience.

RESULTS OF OPERATIONS

Three months ended January 31, 2003 compared to three months ended January 31, 2002

REVENUES

For the three months ended January 31, 2003, the Company’s consolidated net revenues decreased 9.0% to $176.8 million from $194.3 million for the three months ended January 31, 2002, a decrease of $17.5 million. The Company’s net revenues were comprised of domestic revenues of $164.5 million and international revenues of $12.3 million for the three months ended January 31, 2003, compared to $176.0 million domestically and $18.3 million internationally for the three months ended January 31, 2002. The overall decrease in total Company revenues for the three months ended January 31, 2003 was driven primarily by the closing of seven domestic stores associated with the Restructuring Plans as well as an industry-wide 11% reduction in pre-recorded music sales in the United States, which the Company believes is primarily due to the increased digital downloading of music, online and physical music piracy, and the effects of other competition. The decrease in the Company’s revenues during the three months ended January 31, 2003 was offset by revenue increases from Internet sales of $1.2 million as compared to the three months ended January 31, 2002. Same store sales for the three months ended January 31, 2003 decreased by 4.1% when compared to the three months ended January 31, 2002.

GROSS PROFIT

For the three months ended January 31, 2003, gross profit decreased $3.1 million to $48.9 million from $52.0 million for the three months ended January 31, 2002. The decline in gross profit is principally attributable to the decrease in revenues as a result of the closure of seven domestic stores and the industry-wide reduction in pre-recorded music sales in the United States. Gross profit as a percentage of net revenues was 27.6% for the three months ended January 31, 2003, or 28.8% excluding the effects of the Restructuring Plans. Gross profit as a percentage of net revenues was 26.8% for the three months ended January 31, 2002, or 31.8% excluding the effects of the Restructuring Plans. The decrease in gross profit as a percentage of net revenues, excluding the effects of the Restructuring Plans, is attributable to weaker margins associated with competitive pricing pressures in the United States, partially offset by an increase in the Company’s warehouse distribution sales margin.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSE

Selling, general and administrative expenses decreased by $5.6 million to $44.3 million for the three months ended January 31, 2003 from $49.9 million for the three months ended January 31, 2002. Excluding the effects of the $0.7 million and $1.3 million in professional fees related to the Restructuring Plans for the three months ended January 31, 2003 and 2002, respectively, selling, general and administrative expenses decreased by $5.0 million to $43.6 million during the three months ended January 31, 2003 from $48.6 million for the three months ended January 31, 2002. Excluding the effect of professional fees related to the Restructuring Plans, decreases in personnel, occupancy and other administrative expenses are due to cost savings from initiatives resulting from the Company’s Restructuring Plans. As a percentage of net revenues, selling, general and administrative expenses, excluding the effects of the professional fees related to the Restructuring Plans, remained relatively level at 24.7% for the three months ended January 31, 2003 as compared to 25.0% for the three months ended January 31, 2002.

RESTRUCTURING AND IMPAIRMENT COSTS

Pre-tax restructuring and asset impairment charges increased by $19.4 million to $20.1 million for the three months ended January 31, 2003, from $0.7 million for the three months ended January 31, 2002. The increase of $19.4 million was comprised of new restructuring and asset impairment charges of $21.4 million under the 2003 Restructuring Plan, partially offset by changes in estimates made under the 2001 Restructuring Plan for accrued lease termination and severance costs of $1.3 million related to the Leasing and Employee Transfer Agreement with Virgin. In connection with the Restructuring Plans and for the three months ended January 31, 2003 and 2002, the Company also recorded $2.0 million and $9.7 million, respectively, of inventory write-downs in cost of sales, and $0.7 million and $1.3 million, respectively, of professional fees incurred in connection with the Restructuring Plans in selling, general and administrative expenses on the accompanying consolidated statements of operations.

DEPRECIATION AND AMORTIZATION

Depreciation and amortization expense was $5.3 million for the three months ended January 31, 2003, compared to $5.7 million for the three months ended January 31, 2002. The decrease of $0.4 million was primarily due to the closing of under-performing stores identified in the Restructuring Plans.

LOSS FROM CONTINUING OPERATIONS

The Company’s consolidated operating loss for the three months ended January 31, 2003 increased $16.3 million to $20.7 million from $4.4 million for the three months ended January 31, 2002. Excluding the effects of the Restructuring Plans, operating income decreased $5.2 million, which was primarily attributable to the decrease in revenues and gross profit as described above, partially offset by cost savings for the three-month period.

INTEREST EXPENSE

Net interest expense decreased to $5.3 million for the three months ended January 31, 2003 from $6.2 million for the three months ended January 31, 2002. The decrease of $0.9 million was due primarily to the reduction of the variable interest rate components as specified in the Company’s financing agreements.

FOREIGN CURRENCY TRANSLATION GAIN (LOSS)

A non-cash foreign currency translation gain of $2.0 million was recognized for the three months ended January 31, 2003, compared to a non-cash foreign currency translation loss of $0.8 million for the three months ended January 31, 2002. The gain (loss) primarily represents the foreign exchange fluctuations against the U.S. dollar in the foreign countries in which the Company does business.

INCOME TAXES

Pre-tax losses resulted in an income tax provision in the amount of $0.1 million for the three months ended January 31, 2003 and $0.1 million for the three months ended January 31, 2002. Tax provisions and benefits are based upon management’s estimate of the Company’s annualized effective tax rates.

Six months ended January 31, 2003 compared to six months ended January 31, 2002

REVENUES

For the six months ended January 31, 2003, the Company’s consolidated net revenues decreased 8.2% to $306.9 million from $334.4 million for the six months ended January 31, 2002, a decrease of $27.5 million. The Company’s net revenues were comprised of domestic revenues of $284.1 million and international revenues of $22.8 million for the six months ended January 31, 2003, compared to $302.4 million domestically and $32.0 million internationally for the six months ended January 31, 2002. The overall decrease in total Company revenues for the six months ended January 31, 2003 was driven primarily by the closing of seven domestic stores associated with the Restructuring Plans as well as the industry-wide reduction in pre-recorded music sales in the United States, which the Company believes is primarily due to the increased digital downloading of music, online and physical music piracy, and the effects of other competition. The decrease in the Company’s revenues during the six months ended January 31, 2003 was offset by revenue increases from Internet sales in the amount of $2.1 million as compared to the six months ended January 31, 2002. Same store sales for the six months ended January 31, 2003 decreased by 5.1% when compared to the six months ended January 31, 2002.

GROSS PROFIT

For the six months ended January 31, 2003, gross profit decreased $6.5 million to $89.2 million from $95.7 million for the six months ended January 31, 2002. The decrease in the gross profit is principally due to the decrease in revenues as described above. Gross profit as a percentage of net revenues, was 29.1% for the six months ended January 31, 2003, or 29.7% excluding the effects of the Restructuring Plans. Gross profit as a percentage of net revenues was 28.6% for the six months ended January 31, 2002, or 32.0% excluding the effects of the Restructuring Plans. Management attributes the percentage decrease, excluding the effects of the Restructuring Plans, primarily to weaker margins associated with the competitive pricing pressures in the United States, partially offset by an increase in the Company’s warehouse distribution sales margin.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSE

Selling, general and administrative expenses decreased by $6.6 million to $87.5 million for the six months ended January 31, 2003 from $94.1 million for the six months ended January 31, 2002. Excluding the effects of the $1.5 million and $2.7 million in professional fees related to

the Restructuring Plans for the six months ended January 31, 2003 and 2002, respectively, selling, general and administrative expenses decreased by $5.4 million to $86.0 million during the six months ending January 31, 2003 from $91.4 million during the six months ending January 31, 2002. Excluding the effect of professional fees related to the Restructuring Plans, decreases in personnel, occupancy and other administrative expenses are due to cost savings from initiatives resulting from the Restructuring Plans. As a percentage of net revenues, selling, general and administrative expenses, excluding the effects of the professional fees related to the Restructuring Plans, was 28.0% for the six months ended January 31, 2003 as compared to 27.3% for the six months ended January 31, 2002. This increase of 0.7% is attributable to the decrease in net revenues as described above.

RESTRUCTURING AND IMPAIRMENT COSTS

The Company recorded pre-tax restructuring and asset impairment charges of $24.0 million for the six months ended January 31, 2003 and $0.8 million for the six months ended January 31, 2002. In connection with the Restructuring Plans and for the six months ended January 31, 2003 and 2002, the Company also recorded $2.0 million and $11.2 million, respectively, of inventory write-downs in cost of sales, and $1.5 million and $2.7 million, respectively, of professional fees in selling, general and administrative expenses.

DEPRECIATION AND AMORTIZATION

Depreciation and amortization expense was $10.6 million for the six months ended January 31, 2003, compared to $11.4 million for the six months ended January 31, 2002. The decrease of $0.8 million was primarily due to the closing of under-performing stores identified in the Restructuring Plans.

LOSS FROM CONTINUING OPERATIONS

The Company’s consolidated operating loss for the six months ended January 31, 2003 was $32.9 million compared to $10.7 million for the six months January 31, 2002. The increase of $22.2 million, or $9.4 million excluding the effects of the Restructuring Plans, was primarily attributable to costs associated with the Restructuring Plans and decreases in revenues and gross profit as described above.

DISCONTINUED OPERATIONS

On October 11, 2002, the Company completed the sale of its Japanese subsidiary, TRKK, to Nikko Principal Investments Japan, Ltd. The Company sold all authorized and issued capital stock of TRKK for an aggregate purchase price of 16 billion Japanese Yen, which was approximately $129 million at then-current exchange rates. As discussed in Notes 3 and 7 to the Consolidated Financial Statements, net proceeds were primarily used to pay down the Credit Facility. The Company recorded a $15.8 million gain, net of $6.5 million in U.S. income and foreign taxes, from the sale of TRKK, which is included in income from discontinued operations on the accompanying statement of operations for the six months ended January 31, 2003. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” TRKK’s current year operating results have been presented as discontinued operations. Additionally, all prior period consolidated financial statements presented have been reclassified to present TRKK as discontinued operations.

INTEREST EXPENSE

Net interest expense decreased to $11.2 million for the six months ended January 31, 2003 from $12.4 million for the six months ended January 31, 2002. The decrease of $1.2 million was due primarily to the reduction of the variable interest rate components as specified in the Company’s financing agreements.

FOREIGN CURRENCY TRANSLATION GAIN (LOSS)

A non-cash foreign currency translation gain of $2.1 million was recognized for the six months ended January 31, 2003, compared to a non-cash foreign currency loss of $1.1 million for the six months ended January 31, 2002. The gain (loss) primarily represents the volatility of foreign currency fluctuations against the U.S. Dollar in foreign countries in which the Company does business.

INCOME TAXES

Pre-tax losses resulted in an income tax provision in the amount of $0.1 million for the six months ended January 31, 2003 and $0.3 million for the six months ended January 31, 2002. Tax provisions and benefits are based upon management’s estimate of the Company’s annualized effective tax rates.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

The Company is subject to risks resulting from interest rate fluctuations because interest on the Company’s asset-based line of credit borrowings is based on variable rates. If the base borrowing rates (primarily LIBOR) were to increase 1% above current rates as of January 31, 2003, the Company’s interest expense under the line of credit in fiscal 2003 would increase approximately $0.5 million.

A majority of the Company’s revenues, expenses and capital purchasing activities are transacted in U.S. Dollars. However, before the sale of TRKK, the Company had significant transactions in foreign currencies, primarily in Japanese Yen. The Company had used forward exchange contracts to hedge intercompany transactions with foreign subsidiaries and affiliates, and their vendors. Such instruments were short-term in nature and entered into in the ordinary course of the Company’s business, in order to reduce the impact of exchange rate fluctuation on net income and shareholders’ equity. At January 31, 2003, the Company did not have any outstanding forward exchange contracts. The Company has not entered into any Euro hedging contracts because the Company believes that the Company’s volume of transactions denominated in the Euro is not significant.

To finance expansion and operations in Japanese markets prior to the sale of TRKK, the Company entered into Japanese Yen-denominated borrowing arrangements. Unrealized gains and losses resulting from the impact of foreign exchange rate movements on these debt instruments were recognized as other income or expense in the period in which the exchange rates change. These borrowing arrangements were ultimately repaid with the proceeds received from the sale of TRKK.

Item 4. Controls and Procedures

(a) Under the supervision and with the participation of the Company’s management, including the Company’s principal executive officer and principal financial officer, the Company conducted an evaluation of its disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended, within 90 days of the filing date of this report. Based on their evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective.

(b) There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced in paragraph (a) above.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company entered into a consulting contract with Chilmark Partners, LLC (“Chilmark”) on May 18, 2001. By letter to Chilmark dated June 12, 2002, the Company terminated the contract. On July 29, 2002, Chilmark filed suit against the Company in the U.S. District Court for the Northern District of Illinois, alleging breach of contract and seeking other remedies under the contract and attachment of proceeds of the Company’s sale of its Japanese subsidiary. In August 2002, Chilmark’s request for such an attachment was denied. The litigation continues with respect to Chilmark’s breach of contract claim and its request for damages under the terms of the contract. As of January 31, 2003, Chilmark’s total damage request was approximately $2.6 million. The Company believes it has meritorious defenses with respect to each of Chilmark’s claims and intends to defend against the claims vigorously; however, the litigation is in the preliminary stage and there can be no assurance that the Company will prevail in this action. If Chilmark receives a favorable judgment for all or a substantial portion of the total $2.6 million in damages Chilmark is seeking, such an outcome could have a material adverse effect on the Company’s financial condition, results of operations and cash flows.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)

Exhibits


	Exhibit		Description
	10.26*		DeVaughn D. Searson Severance Agreement

	10.27*		Amended and Restated Revolving Loan Promissory Note

	10.28*		First Amendment to Loan and Security Agreement

	10.29*		Second Amendment to Loan and Security Agreement

	10.30*		James Bain Retention Agreement

	10.31*		William Baumann Retention Agreement

	10.32*		Kevin Cassidy Retention Agreement

	10.33*		Michael Solomon Retention Agreement

	* Previously filed

	(b)		Reports on Form 8-K.

			None

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

June 16, 2003
MTS, INCORPORATED
(Registrant)


		By:		/s/ DeVaughn D. Searson


				DeVaughn D. Searson
				Executive Vice President and Chief Financial Officer
				(Principal Financial and Accounting Officer)

CERTIFICATION OF CHIEF EXECUTIVE OFFICER

		I, E.Allen Rodriguez, Chief Executive Officer of MTS, Incorporated, certify that:

1.		I have reviewed this quarterly report on Form 10-Q of MTS, Incorporated.

2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.		The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.


Dated: June 16, 2003		/s/ E. Allen Rodriguez

		E. Allen Rodriguez
		Chief Executive Officer

CERTIFICATION OF CHIEF FINANCIAL OFFICER

		I, DeVaughn D. Searson, Chief Financial Officer of MTS, Incorporated, certify that:

1.		I have reviewed this quarterly report on Form 10-Q of MTS, Incorporated.

2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.		The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


Dated: June 16, 2003		/s/ DeVaughn D. Searson

		DeVaughn D. Searson
		Chief Financial Officer

INDEX OF EXHIBITS


	Exhibit		Description
	10.26*		DeVaughn D. Searson Severance Agreement

	10.27*		Amended and Restated Revolving Loan Promissory Note

	10.28*		First Amendment to Loan and Security Agreement

	10.29*		Second Amendment to Loan and Security Agreement

	10.30*		James Bain Retention Agreement

	10.31*		William Baumann Retention Agreement

	10.32*		Kevin Cassidy Retention Agreement

	10.33*		Michael Solomon Retention Agreement

* Previously filed

MTS Inactive 10-Q/A2003 Q2 Quarterly report (amended)

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