UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED OCTOBER 29, 2005

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 0-14818

TRANS WORLD ENTERTAINMENT CORPORATION

(Exact name of registrant as specified in its charter)

New York		14-1541629
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer
		Identification Number)

38 Corporate Circle
Albany, New York 12203
(Address of principal executive offices, including zip code)

(518) 452-1242
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock, $.01 par value,

30,981,126 shares outstanding as of November 26, 2005

TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES

PART 1. FINANCIAL INFORMATION

Item 1 - Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

(unaudited)

	October 29, 2005			January 29, 2005			October 30, 2004
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	16,805		$	229,768		$	18,658
Merchandise inventory	477,732			431,246			459,246
Income taxes receivable	13,030			—			11,940
Deferred taxes	12,397			15,526			8,657
Other current assets	13,513			13,006			12,186
Total current assets	533,477			689,546			510,687

NET FIXED ASSETS	129,918			130,196			121,088
DEFERRED TAXES	27,640			25,039			31,386
OTHER ASSETS	13,876			14,872			14,063
TOTAL ASSETS	$	704,911		$	859,653		$	677,224

LIABILITIES
CURRENT LIABILITIES:
Accounts payable	$	252,014		$	358,396		$	224,777
Borrowings under line of credit	—			—			3,940
Income taxes payable	—			8,592			—
Accrued expenses and other current liabilities	35,550			43,712			35,965
Current portion of long-term debt	470			448			442
Current portion of capital lease obligations	3,108			332			431
Total current liabilities	291,142			411,480			265,555

LONG-TERM DEBT, less current portion	4,708			5,060			5,177
CAPITAL LEASE OBLIGATIONS, less current portion	15,668			6,977			7,137
DEFERRED RENT AND OTHER LIABILITIES	29,290			31,813			22,002
TOTAL LIABILITIES	340,808			455,330			299,871

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; 55,657,325, 55,014,598 and 54,559,643 shares issued, respectively)	557			550			546
Additional paid-in capital	299,016			292,922			289,672
Unearned compensation – restricted stock	(34		)	(46		)	(50		)
Accumulated other comprehensive loss	(1,094		)	(1,094		)	—
Treasury stock at cost (24,444,349, 21,988,949 and 21,149,849 shares, respectively)	(213,262		)	(186,298		)	(176,425		)
Retained earnings	278,920			298,289			263,610
TOTAL SHAREHOLDERS’ EQUITY	364,103			404,323			377,353
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	704,911		$	859,653		$	677,224

See Notes to Condensed Consolidated Financial Statements.

TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

	Thirteen Weeks Ended						Thirty-nine Weeks Ended
	October 29, 2005			October 30, 2004			October 29, 2005			October 30, 2004

Sales	$	241,395		$	270,013		$	779,923		$	851,678
Cost of sales	158,397			170,045			499,485			535,367
Gross profit	82,998			99,968			280,438			316,311
Selling, general and administrative expenses	102,325			108,863			311,337			327,458
Loss from operations	(19,327		)	(8,895		)	(30,899		)	(11,147		)
Other income	(152		)	(60		)	(1,607		)	(392		)
Interest expense	773			638			2,005			1,693
Loss before income taxes and extraordinary gain - unallocated negative goodwill	(19,948		)	(9,473		)	(31,297		)	(12,448		)
Income tax benefit	(8,480		)	(4,299		)	(11,928		)	(16,444		)
Income (loss) before extraordinary gain - unallocated negative goodwill	(11,468		)	(5,174		)	(19,369		)	3,996
Extraordinary gain - unallocated negative goodwill, net of income taxes of 0, $359 and 0, $1,979, respectively	—			570			—			3,166
Net income (loss)	$	(11,468	)	$	(4,604	)	$	(19,369	)	$	7,162

BASIC INCOME (LOSS) PER SHARE:
Income (loss) per share before extraordinary gain -unallocated negative goodwill	$	(0.36	)	$	(0.15	)	$	(0.60	)	$	0.11
Extraordinary gain - unallocated negative goodwill, net of income taxes	—			$	0.01		—			$	0.09
Basic income (loss) per share	$	(0.36	)	$	(0.14	)	$	(0.60	)	$	0.20

Weighted average number of common shares outstanding – basic	31,624			33,812			32,350			34,965

DILUTED INCOME (LOSS) PER SHARE:
Income (loss) per share before extraordinary gain -unallocated negative goodwill	$	(0.36	)	$	(0.15	)	$	(0.60	)	$	0.11
Extraordinary gain - unallocated negative goodwill, net of income taxes	—			$	0.01		—			$	0.09
Diluted income (loss) per share	$	(0.36	)	$	(0.14	)	$	(0.60	)	$	0.20

Weighted average number of common shares outstanding – diluted	31,624			33,812			32,350			36,653

See Notes to Condensed Consolidated Financial Statements.

TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Thirty-nine Weeks Ended
	October 29, 2005			October 30, 2004
Net cash used by operating activities	$	(172,792	)	$	(128,495	)

Cash flows from investing activities:
Purchases of fixed assets	(29,063		)	(22,602		)
Acquisition of interest in subsidiary, net of cash acquired	—			(2,000		)
Proceeds from sale of available for sale securities	813			—
Net cash used by investing activities	(28,250		)	(24,602		)

Cash flows from financing activities:
Proceeds from long-term debt	—			5,760
Proceeds from capital leases	12,863			(141		)
Payments of long-term debt	(332		)	3,940
Payments of capital lease obligations	(1,394		)	(292		)
Payments for purchases of treasury stock	(26,972		)	(30,362		)
Proceeds from the exercise of stock options	3,914			928
Net cash used by financing activities	(11,921		)	(20,167		)

Net decrease in cash and cash equivalents	(212,963		)	(173,264		)
Cash and cash equivalents, beginning of year	229,768			191,922
Cash and cash equivalents, end of period	$	16,805		$	18,658
Supplemental disclosure of non-cash investing and financing activities:
Income tax benefit resulting from exercises of stock options	$	2,187		$	383
Issuance of shares under restricted stock plan	—			51
Issuance of treasury stock under incentive stock programs	8			—

See Notes to Condensed Consolidated Financial Statements.

TRANS WORLD ENTERTAINMENT CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

October 29, 2005 and October 30, 2004

Note 1. Nature of Operations

Trans World Entertainment Corporation and its subsidiaries is one of the largest specialty retailers of music, video, including DVD and VHS, video games and related products in the United States. The Company operates retail entertainment stores and e-commerce sites, including www.fye.com, www.coconuts.com, www.wherehouse.com, and www.secondspin.com, in a single industry segment. As of October 29, 2005, the Company operated 800 stores totaling approximately 4.9 million square feet in 46 states, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands.

Note 2: Basis of Presentation

The accompanying unaudited condensed 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 (“the Company”). During the thirteen weeks ended October 29, 2005, the Company acquired an 80% interest in a Company that is fully consolidated for financial reporting purposes. All significant intercompany accounts and transactions have been eliminated.

The interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the United States Securities and Exchange Commission (“SEC”). The information furnished in these condensed consolidated financial statements reflects all normal, recurring adjustments which, in the opinion of management, are necessary for the fair presentation of such financial statements. 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. Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to rules and regulations applicable to interim financial statements.

The information presented in the accompanying unaudited condensed consolidated balance sheet as of January 29, 2005 has been derived from the Company’s fiscal year 2005 audited consolidated financial statements. All other information has been derived from the Company’s unaudited consolidated financial statements as of and for the thirteen and thirty-nine weeks ended October 29, 2005 and October 30, 2004. These unaudited condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2005. Certain reclassifications have been made to prior periods to conform to the current period presentation.

The Company’s significant accounting policies are the same as those described in Note 1 to the Company’s Consolidated Financial Statements on Form 10-K for the fiscal year ended January 29, 2005.

Note 3. Seasonality

The Company’s business is seasonal in nature, with the fourth fiscal quarter constituting the Company’s peak selling period. In 2004, the fourth fiscal quarter accounted for approximately 38% of annual sales. In anticipation of increased sales activity during these months, the Company purchases additional merchandise inventory and hires additional, temporary employees to supplement its permanent store sales staff. If, for any reason, the Company’s net sales are below seasonal norms during the fourth quarter, the Company’s operating results, particularly operating and net income, could be adversely affected. Additionally, quarterly sales results, in general, are affected by the timing of new releases, the performance of existing stores and new store openings or closings.

Note 4. Stock Based Compensation

The Company applies the intrinsic value-based method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including Financial Accounting Standards Board (“FASB”) Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation – An Interpretation of APB No. 25, in accounting for its fixed plan stock options. Under this method, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. Unearned compensation recognized for restricted stock awards is shown as a separate component of shareholders’ equity and is amortized to expense over the vesting period of the stock award using the straight-line method. Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123 and SFAS No.148. The following table illustrates the effect on net income (loss) and income (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation:

	Thirteen Weeks ended						Thirty-nine Weeks ended
	October 29, 2005			October 30, 2004			October 29, 2005			October 30, 2004
	(in thousands except per share amounts)						(in thousands except per share amounts)
Net income (loss), as reported	$	(11,468	)	$	(4,604	)	$	(19,369	)	$	7,162
Add: Stock-based employee compensation expense included in reported net income (loss), net of related income taxes	57			27			122			106
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related income taxes	(643		)	(819		)	(2,202		)	(2,614		)
Proforma net income (loss)	$	(12,054	)	$	(5,396	)	$	(21,449	)	$	4,654
Income (loss) per share:
Basic - as reported	$	(0.36	)	$	(0.14	)	$	(0.60	)	$	0.20
Basic– proforma	$	(0.38	)	$	(0.16	)	$	(0.66	)	$	0.13
Diluted – as reported	$	(0.36	)	$	(0.14	)	$	(0.60	)	$	0.20
Diluted – proforma	$	(0.38	)	$	(0.16	)	$	(0.66	)	$	0.13

Note 5. Defined Benefit Plan

The Company maintains a non-qualified Supplemental Executive Retirement Plan (“SERP”) for certain executives 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.

Prior to June 1, 2003, the Company provided the Board of Directors with a noncontributory, unfunded retirement plan (“Director Retirement Plan”) that paid 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 began at age 62 or retirement, whichever was later, and would continue for 10 years or the life of the director and his or her spouse, whichever period was shorter. Partial vesting in the retirement plan began after six years of continuous service. Participants became fully vested after 12 years of continuous service on the Board. As of June 1, 2003, new directors are no longer covered by the Director Retirement Plan. Current directors who were not yet vested in their retirement benefits had the present value of benefits already accrued as of the effective date converted to deferred shares under the Directors Stock Option 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 Directors Stock Option Plan as of the effective date.

The Company accounts for the SERP and the Director Retirement Plan in accordance with the provisions of SFAS No. 87, Employers’ Accounting for Pensions.

During the thirteen and thirty-nine weeks ended October 29, 2005, the Company did not make any cash contributions to the SERP or the Director Retirement Plan, and presently expects to pay $35,000 in benefits relating to SERP and $6,250 in benefits relating to the Director Retirement Plan during 2005. The following represents the components of the net periodic pension cost related to the Company’s SERP and Director Retirement Plan for the respective periods:

	Thirteen weeks ended					Thirty-nine weeks ended
	October 29, 2005			October 30, 2004		October 29, 2005		October 30, 2004
	(in thousands)					(in thousands)
Service cost	$		133	$	101	$	399	$	303
Interest cost	196			157		588		471
Amortization of prior service cost	85			85		255		255
Amortization of net loss	62			4		186		12
Net periodic pension cost	$	476		$	347	$	1,428	$	1,041

Note 6. Extraordinary Gain

The Company acquired substantially all the net assets of Wherehouse Entertainment Inc. and CD World Inc. in October 2003 for $35.2 million and $1.9 million, respectively. The purchase price was allocated on a preliminary basis using information available at the time. In accordance with SFAS No. 141, Business Combinations, the allocation of the purchase price to the assets and liabilities acquired were finalized during the thirteen weeks ended October 30, 2004, after obtaining more information regarding asset valuations and liabilities assumed.

During the thirteen and thirty-nine weeks ended October 30, 2004, the Company adjusted the purchase accounting in accordance with the provisions of SFAS No. 141, resulting in an extraordinary gain of $0.6 million and $3.2 million, respectively, net of income taxes of $0.3 million and $2.0 million respectively, related to unallocated negative goodwill. The gain represents the excess of the fair value of net assets acquired over the purchase price.

Note 7. Long-Term Debt and Capital Lease Obligations

During the thirty-nine weeks ended October 29, 2005, the Company financed the replacement of its point-of-sale system through a capital lease arrangement in the amount of $12.0 million. The lease arrangement bears an average interest rate of 5.76% and will be repaid in monthly installments of $229 thousand over 5 years. During the thirteen weeks ended October 29, 2005, the Company purchased software licenses through a capital lease arrangement for $0.9 million, bearing an average interest rate of 5.75%. The capital lease will be repaid in quarterly installments of $122 thousand over 2 years.

During 2004, the Company borrowed $5.8 million under a mortgage loan with South Trust Bank to finance the purchase of real estate. The mortgage loan is repayable in monthly installments of $64 thousand over 10 years with a fixed interest rate of 6.0% and is collateralized by the real estate. The mortgage loan contains a minimum net worth (shareholders’ equity) covenant of $290 million, excluding the impact, if any, of certain non-cash charges.

Note 8. Comprehensive Income (Loss)

The Company accounts for comprehensive income (loss) in accordance with SFAS No. 130, Reporting Comprehensive Income, which requires only additional disclosures in the consolidated financial statements. Items of other comprehensive income that the Company currently reports are the excess additional minimum pension liability over unrecognized prior service cost with respect to the SERP and unrealized gains (losses) on available-for-sale securities. The Company’s total comprehensive income (loss) for the thirteen and thirty-nine weeks ended October 29, 2005 and October 30, 2004 was as follows:

	Thirteen Weeks ended						Thirty-nine Weeks ended
	October 29, 2005			October 30, 2004			October 29, 2005			October 30, 2004
	($ in thousands)						($ in thousands)
Net income (loss)	$	(11,468	)	$	(4,604	)	$	(19,369	)	$	7,162

Other comprehensive income (loss), net of income taxes:
Change in unrealized gain on available-for-sale securities, net of income taxes of 0 and 0, and $306 and 0, respectively	—			—			442			—
Reclassification adjustment for realized gain on Available-for-sale securities included in income	—			—			(442		)	—
Total comprehensive income (loss)	$	(11,468	)	$	(4,604	)	$	(19,369	)	$	7,162

Note 9. Recently Issued Accounting Standards.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS No. 154 also provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The provisions of SFAS No. 154 are effective for accounting changes and corrections of errors made in fiscal periods beginning after December 15, 2005. The adoption of the provisions of SFAS No. 154 is not expected to have a material impact on the Company’s consolidated financial condition or results of operations.

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. SFAS No. 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of SFAS No. 151 are effective for fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151 is not expected to have a significant impact on the Company’s consolidated financial condition or results of operations.

In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment: an amendment of FASB Statements No. 123 and 95. SFAS No.123(R) requires an enterprise to measure the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award at the grant date (with limited exceptions) and recognize the compensation cost over the period during which an employee is required to provide service in exchange for the award. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”), which expresses views of the SEC staff regarding the application of SFAS No. 123(R). Among other things, SAB 107 provides interpretive guidance related to the interaction between SFAS No. 123(R) and certain SEC rules and regulations, and provides the SEC staff’s views regarding the valuation of share-based payment arrangements for public companies. The Company is required to adopt SFAS No. 123(R) in its first quarter of 2006 and is currently evaluating the potential effects of this standard on its stock compensation arrangements and related effects on the Company’s consolidated financial condition and results of operations. If the Company had applied the provisions of SFAS No. 123(R) to the condensed consolidated financial statements for the thirteen and thirty-nine weeks ended October 29, 2005, the net loss would have been higher by approximately $0.6 million, or $0.02 per share, and $2.1 million, or $0.06 per share, respectively.

In June 2005, the Emerging Issues Task Force (“EITF”) issued EITF No. 05-6, Determining the Amortization Period of Leasehold Improvements (purchased after lease inception) or Acquired in a Business Combination (“EITF 05-6”). EITF 05-6 provides that the amortization period for leasehold improvements acquired in a business combination or purchased after the inception of a lease be the shorter of (a) the useful life of the assets or (b) a term that includes required lease periods and renewals that are reasonably assured upon the acquisition of the purchase. The provisions of EITF 05-6 are effective on a prospective basis for leasehold improvements purchased or acquired beginning July 1, 2005. The adoption of EITF 05-6 did not have a material effect on the Company’s condensed consolidated financial statements for the thirteen and thirty-nine weeks ended October 29, 2005.

Note 10. Depreciation and Amortization

Depreciation and amortization of fixed assets included in the condensed consolidated statements of operations is as follows:

	Thirteen Weeks Ended					Thirty-nine Weeks Ended
	October 29, 2005			October 30, 2004		October 29, 2005		October 30, 2004
	(in thousands)					(in thousands)
Cost of sales	$		778	$	603	$	2,328	$	1,789
Selling, general & administrative expenses	8,585			7,945		25,171		24,904
Total	$	9,363		$	8,548	$	27,499	$	26,693

Note 11. Earnings Per Share

Weighted average shares are calculated as follows:

	Thirteen Weeks Ended		Thirty-nine Weeks Ended
	October 29, 2005	October 30, 2004	October 29, 2005	October 30, 2004
	(in thousands)		(in thousands)
Weighted average common shares outstanding – basic	31,624	33,812	32,350	34,965
Dilutive effect of employee stock options	—	—	—	1,688
Weighted average common shares outstanding – diluted	31,624	33,812	32,350	36,653

Anti-dilutive stock options	9,947	9,625	9,851	4,012

For the thirteen and thirty-nine week periods ended October 29, 2005, the impact of outstanding stock options was not considered because the Company reported a net loss and such impact would be anti-dilutive.

Note 12. Income Taxes

The Company recorded an income tax charge of $1.1 million resulting from changes in the Ohio state income tax law enacted during the thirty-nine weeks ended October 29, 2005. The legislation phases out state corporation franchise tax, which is based on income. The tax charge represents a write-off of the state deferred tax assets allocated to Ohio, principally net operating losses that, based on management’s estimates, will not be realized during the phase-out period.

The Company recorded an income tax benefit of $10.5 million in the thirty-nine weeks ended October 30, 2004. The benefit was the result of closing a federal income tax examination, including all matters not previously settled in relation to Company Owned Life Insurance (“COLI”) policies, which were part of the Company’s acquisition of Camelot in 1999. The original income tax payable amounts relating to the years covered by the examination were reversed subsequent to the final settlement resulting in the income tax benefit. With the closing of the tax examination, the Company has surrendered the remaining COLI policies.

Item 2 - Management’s Discussion and Analysis of Financial Condition and

Results of Operations

October 29, 2005 and October 30, 2004

Overview

Management’s Discussion and Analysis of Financial Condition and Results of Operations provides information that the Company’s management believes necessary to achieve an understanding of its financial condition and results of operations. To the extent that such analysis contains statements which are not of a historical nature, such statements are forward-looking statements, which involve risks and uncertainties. These risks include, but are not limited to, changes in the competitive environment for the Company’s merchandise, including the entry or exit of non-traditional retailers of the Company’s merchandise to or from its markets; releases by the music, video, including DVD and VHS, and video games industries of an increased or decreased number of “hit releases”; general economic factors in markets where the Company’s merchandise is sold; and other factors discussed in the Company’s filings with the SEC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and related notes included elsewhere in this report and the audited financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2005.

At October 29, 2005, the Company operated 800 stores totaling approximately 4.9 million square feet in 46 states, the District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin Islands. The Company’s stores offer predominantly entertainment software, including music, video, including DVD and VHS, and video games. In total, these categories represented 91% and 92% of the Company’s total sales in the thirteen weeks and thirty-nine weeks ended October 29, 2005, respectively. The balance of categories, including software accessories, boutique and electronic products represented 9% and 8% of the Company’s total sales in the thirteen weeks and thirty-nine weeks ended October 29, 2005, respectively.

The Company strives to understand general economic and business trends and to manage the business in response to those trends, and monitors a number of key performance indicators in this regard, including:

Sales: The Company measures the rate of comparable store sales change. A store is included in comparable store sales calculations at the beginning of its thirteenth full month of operation. Mall stores relocated in the same shopping mall after being open for at least thirteen months are considered comparable stores. Closed stores that were open for at least thirteen months are included in comparable store sales through the month immediately preceding the month of closing. The Company further analyzes sales by store format (i.e., mall versus freestanding) and by product category.

Cost of Sales and Gross Profit: Gross profit is a function of the cost of product in relation to its retail selling value. Changes in gross profit are impacted primarily by the mix of products sold and by allowances negotiated with vendors. The Company records its distribution and product shrink expenses in cost of sales. Distribution expenses include those costs associated with purchasing, receiving, inspecting and warehousing merchandise and costs associated with product returns to vendors. Cost of sales also includes obsolescence costs and is reduced by the benefit of vendor allowances.

Selling, General and Administrative (“SG&A”) expenses: Included in SG&A expenses are payroll and related costs, occupancy charges, professional and service fees, general operating and overhead expenses and depreciation and amortization charges (excluding those related to cost of sales, as discussed in Note 10 to the Condensed Consolidated Financial Statements). SG&A expenses also include asset impairment charges and write-offs, if any, and miscellaneous items, other than interest.

Balance Sheet and Ratios: The Company views cash, net inventory investment (merchandise inventory less accounts payable) and working capital (current assets less current liabilities) as indicators of its financial condition. See Liquidity and Capital Resources for discussion of items related to liquidity.

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 and income taxes. 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 Notes to the Consolidated Financial Statements on Form 10-K for the year ended January 29, 2005 includes a summary of the significant accounting policies and methods used by the Company in the preparation of its condensed 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 Charges: Merchandise inventory is stated at the lower of cost or market as determined by the average cost method. Merchandise inventory valuation requires significant judgment and estimates regarding 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 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 a period. Shrink estimates are based on historical results and trends. Physical inventories are taken at least annually for all stores, and inventory records are adjusted accordingly.

The Company is entitled to return merchandise purchased from major vendors for credit against other purchases from these vendors. Select vendors reduce the credit with a merchandise return charge ranging from 0% to 20% of the original merchandise purchase price depending on the type of merchandise being returned. The Company records merchandise return charges in cost of sales.

RESULTS OF OPERATIONS

Thirteen and Thirty-nine Weeks Ended October 29, 2005

Compared to the Thirteen and Thirty-nine Weeks Ended October 30, 2004

The following table sets forth a period over period comparison of the Company’s sales for the thirteen and thirty-nine weeks ended October 29, 2005 and October 30, 2004, by category:

	Thirteen weeks ended													Thirty-nine weeks ended
	October 29, 2005			October 30, 2004			Change			%		Comp Store Sales		October 29, 2005			October 30, 2004			Change			%		Comp Store Sales
	(in thousands)													(in thousands)
Sales	$	241,395		$	270,013		$	(28,618	)	-10.6	%	-7.5	%	$	779,923		$	851,678		$	(71,755	)	-8.4	%	-4.5	%
As a % of sales
Music	58		%	58		%						-8.0	%	58		%	59		%						-6.5	%
Video	27		%	27		%						-7.6	%	27		%	27		%						-4.7	%
Video Games	6		%	7		%						-13.3	%	7		%	6		%						7.1	%
Other	9		%	8		%						-1.0	%	8		%	8		%						3.1	%

Store Count:
Mall	556			585
Freestanding	244			267
Total	800			852

Sales. The decrease in sales resulted from a comparable store sales decrease of 7.5% and 4.5%, respectively for the thirteen and thirty-nine weeks ended October 29, 2005, respectively. The decrease in sales was also due to the operation of fewer stores. The Company operated 800 stores as of October 29, 2005 compared to 852 stores as of October 30, 2004.

Music:

The Company’s stores offer a wide range of compact discs (“CDs”), audio cassettes and singles across most music genres, including new releases from current artists as well as an extensive catalog of music from past periods and artists. During the thirteen and thirty-nine weeks ended October 29, 2005, CD sales which constituted 99% of music sales, decreased 7.3% and 5.6% on a comparable store basis, respectively, as compared to the thirteen and thirty-nine weeks ended October 30, 2004. The decrease in CD sales was consistent with the decline in industry sales during the period, characterized generally by lack of strong new releases. The Company’s music sales also decreased due to lower store count.

Video:

The Company offers DVDs and videocassettes, in all of its stores. Comparable store sales in the DVD category decreased 3.0% in the thirteen weeks ended October 29, 2005 and was flat during the thirty-nine weeks ending October 29, 2005. DVD sales constituted 93% and 92% of total video sales in the thirteen and thirty-nine weeks ended October 29, 2005 respectively. The Company’s decrease in DVD sales was due to lower store count and a decrease in comparable store sales consistent with the decline in industry sales during the period, characterized generally by lack of strong new releases.

Video Games:

The Company offers video game hardware and software in most of its stores, with a mix that favors software. Comparable store sales decreased 13.3% and increased 7.1%, respectively, in the thirteen and thirty-nine weeks ended October 29, 2005. During the thirteen weeks ended October 29, 2005, sales in the video games category slowed due to lower sales of new releases. For the thirty-nine week period ended October 29, 2005, lower sales of new releases in the third quarter was offset by strong sales of Sony’s PSP game system which was released in the first quarter.

Other:

The Company offers items relating to the use, care and storage of entertainment software, along with boutique and electronic products. Comparable store sales decreased 1.0% and increased 3.1%, respectively in the thirteen and thirty-nine weeks ended October 29, 2005. The increase in the thirty-nine weeks ended October 29, 2005 is due to the Company’s merchandising initiatives to improve this category, including the expansion of product lines and adding new items to complement the core merchandise categories of music, video and video games.

Gross Profit. The following table sets forth a period over period comparison of the Company’s gross profit:

	Thirteen weeks ended											Thirty-nine weeks ended
	(in thousands)						Change					(in thousands)						Change
	October 29, 2005			October 30, 2004			$			%		October 29, 2005			October 30, 2004			$			%
Gross Profit	$	82,998		$	99,968		$	(16,970	)	(17.0	)%	$	280,438		$	316,311		$	(35,873	)	(11.3	)%

As a % of sales	34.4		%	37.0		%						36.0		%	37.1		%

For the thirteen weeks ended October 29, 2005, gross margin as a percentage of sales declined by 260 basis points, resulting from a decrease in margin in music and DVD due to a more competitive pricing environment (90 basis points), higher distribution costs as a rate to sales (70 basis points) and a decrease in vendor allowances and other miscellaneous items (100 basis points).

For the thirty-nine weeks ended October 29, 2005, the gross margin rate as a percentage of sales declined by 110 basis points, resulting from higher distribution costs as a rate to sales (70 basis points) and a decrease in vendor allowances and other miscellaneous items (40 basis points).

Selling, General & Administrative Expenses (“SG&A”). The following table sets forth a period over period comparison of the Company’s SG&A:

	Thirteen weeks ended											Thirty-nine weeks ended
	(in thousands)						Change					(in thousands)						Change
	October 29, 2005			October 30, 2004			$			%		October 29, 2005			October 30, 2004			$			%
SG&A	$	102,325		$	108,863		$	(6,538	)	(6.0	)%	$	311,337		$	327,458		$	(16,121	)	(4.9	)%

As a % of sales	42.4		%	40.3		%						39.9		%	38.4		%

Although variable SG&A expenses decreased due to fewer stores in operation, fixed SG&A expenses remained consistent in the thirteen and thirty-nine weeks ended October 29, 2005 as compared to the thirteen and thirty-nine weeks ended October 30, 2004, resulting in the reduction of expense leverage due to the decline in sales.

Other Income. Other income includes interest income. For the thirty-nine weeks ended October 29, 2005, other income also includes a realized gain of $0.8 million on the sale of available-for-sale securities during the second quarter.

Income Tax Benefit. The following table sets forth a period over period comparison of the Company’s income tax benefit:

	Thirteen weeks ended (in thousands)						Thirty-nine weeks ended (in thousands)
	October 29, 2005			October 30, 2004			October 29, 2005			October 30, 2004
Income tax benefit before IRS settlement benefit in 2004	$	(8,480	)	$	(4,299	)	$	(11,928	)	$	(5,899	)

Effective tax rate before IRS settlement benefit in 2004	42.5		%	45.4		%	38.1		%	47.4		%

IRS settlement benefit	—			—			—			(10,545		)

Income tax benefit	$	(8,480	)	$	(4,299	)	$	(11,928	)	$	(16,444	)

The Company recorded a lower tax benefit on a rate basis in the thirty-nine weeks ended October 29, 2005, due to an income tax charge of $1.1 million recorded in the thirty-nine weeks ended October 29, 2005 (see Note 12 of Notes to the Condensed Financial Statements).

Extraordinary Gain – Unallocated Negative Goodwill. In October 2003, the Company acquired substantially all of the net assets of Wherehouse Entertainment Inc. and CD World Inc. During the thirteen and thirty-nine weeks ended October 30, 2004, the Company adjusted the purchase accounting in accordance with the provisions of SFAS No. 141, resulting in an extraordinary gain of $0.6 million and $3.2 million, respectively, net of income taxes of $0.3 million and $2.0 million respectively, related to unallocated negative goodwill. The gain represents the excess of the fair value of net assets acquired over the purchase price.

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

	Thirteen weeks ended (in thousands)						Thirty-nine weeks ended (in thousands)
	October 29, 2005			October 30, 2004			October 29, 2005			October 30, 2004

Income (loss) before extraordinary gain	$	(11,468	)	$	(5,174	)	$	(19,369	)	$	3,996

Extraordinary gain – unallocated negative goodwill, net of income taxes of 0, $359 and 0, $1,979, respectively	—			570			—			3,166

Net income (loss)	$	(11,468	)	$	(4,604	)	$	(19,369	)	$	7,162

The decline in net income in the thirteen and thirty-nine weeks ended October 29, 2005 was due to the lower sales and gross profit, the recording of a tax charge for the change in Ohio state laws which was included in income (loss) for the thirty-nine weeks ended October 29, 2005 and the absence of a tax benefit recorded in the thirty-nine weeks ended October 30, 2004 (See Note 12 of Notes to the Condensed Consolidated Financial Statements).

LIQUIDITY AND CAPITAL RESOURCES

Liquidity. The Company’s primary sources of working capital are cash provided by operations and borrowings under its revolving credit facility. The Company’s cash flows fluctuate from quarter to quarter due to various items, including seasonality of sales and results from operations, merchandise inventory purchases and the related terms on the purchases, tax payments, capital expenditures and stock repurchase activity. Management believes the Company will have adequate resources to fund its cash needs for the foreseeable future. The following table sets forth a summary of key components of cash flow and working capital for the thirty-nine weeks ended October 29, 2005 and October 30, 2004:

	Thirty-nine weeks ended						Change
(in thousands)	October 29, 2005			October 30, 2004			$
Operating Cash Flows	$	(172,792	)	$	(128,495	)	$	(44,297	)
Financing Cash Flows	(11,921		)	(20,167		)	8,246

Capital Expenditures	(29,063		)	(22,602		)	(6,461		)

Cash and Cash Equivalents	16,805			18,658			(1,853		)
Inventories	477,732			459,246			18,486
Working Capital	242,335			245,132			(2,797		)

The Company had cash balances of $16.8 million at October 29, 2005, compared to $229.8 million at January 29, 2005 and $18.7 million at October 30, 2004. Inventory was $97 per square foot at October 29, 2005, compared to $88 per square foot at October 30, 2004. The increase in inventory is due to an expansion of the Company’s portable electronics category carrying a broader assortment of MP3 players and portable DVD players. The increase is also due to an earlier build up of inventory for the holiday selling season.

Cash used by operating activities was $172.8 million for the thirty-nine weeks ended October 29, 2005. The primary uses of cash were a $106.4 million seasonal reduction of accounts payable, a $21.6 million reduction in income taxes payable, and a $46.5 million increase in merchandise inventory. The Company’s inventory and accounts payable are heavily influenced by the seasonality of its business. A significant reduction of accounts payable occurs annually in the fiscal first quarter, reflecting payments for merchandise inventory sold during the prior year’s holiday season. Similarly, merchandise inventory increases each year throughout the fall season and peaks during the holiday selling season. The seasonality of the Company’s earnings in its fiscal fourth quarter also results in the timing of substantially all income tax payments to be made subsequent to year end. These cash uses are offset by a significant cash source in the fiscal fourth quarter from the seasonal increase in sales during the holiday season (see Note 3 of Notes to the Condensed Financial Statements).

Cash used by financing activities was $11.9 million for the thirty-nine weeks ended October 29, 2005. The primary use of cash was $27.0 million for the purchase of approximately 2.5 million shares of common stock under a stock repurchase program authorized by the Company’s Board of Directors in May 2003. The primary source of cash was through a capital lease borrowings of $12.9 million (See Note 7 of Notes to the Condensed Financial Statements) and the exercise of stock options of $3.9 million.

The authorized stock repurchase program allows the Company to repurchase 10 million shares of Common Stock from time to time on the open market and has no expiration date. As of October 29, 2005, the Company had 660 thousand remaining shares authorized under the current program.

The Company has a three-year, $100 million secured revolving credit facility with Congress Financial Corporation that expires in July 2006 and renews on a year-to-year basis thereafter with the consent of both parties. The facility contains certain restrictive provisions, including provisions governing cash dividends and acquisitions and is collateralized by merchandise inventory and other assets. The Company anticipates the amount of the revolving credit facility being fully available to the Company through its term, and anticipates obtaining a similar, replacement facility upon its expiration. As of October 29, 2005, the Company had $1.2 million in outstanding letter of credit obligations under the revolving credit facility and $98.8 million was available for borrowing. As of October 30, 2004, the Company had $3.9 million outstanding in borrowings and $1.2 million in outstanding letter of credit obligations under the revolving credit facility.

During 2004, the Company borrowed $5.8 million under a mortgage loan with South Trust Bank to finance the purchase of real estate. The mortgage loan is repayable in monthly installments of $64 thousand over 10 years with a fixed interest rate of 6.0% and is secured by the real estate. As of October 29, 2005, the Company had a loan balance of $5.2 million outstanding.

The revolving credit facility restricts the amount of dividends that the Company can declare up to 10% of its annual net income, excluding certain non-cash gains. Payment of any dividends is further subject to levels of availability on the Company’s revolving credit facility. The mortgage loan and the revolving credit facility contain a minimum net worth (shareholders’ equity) covenant of $290 million, excluding the impact, if any, of certain non-cash charges.

During 2005, the Company financed the replacement of its point-of-sale system through a capital lease arrangement in the amount of $12.0 million. The lease arrangement bears an average interest rate of 5.76% and will be repaid in monthly installments of $229 thousand over 5 years. As of October 29, 2005, the outstanding balance on the lease was $10.9 million. During the thirteen weeks ended October 29, 2005, the Company purchased software licenses through a capital lease arrangement for $0.9 million, bearing an average interest rate of 5.75%. The capital lease will be repaid in quarterly installments of $122 thousand over 2 years. As of October 29, 2005, the outstanding balance on the lease was $0.8 million.

During the thirteen weeks ended October 29, 2005, the Company acquired an 80% interest in a Company that is fully consolidated for financial reporting purposes. The Company’s has committed funding of $3.0 million over a period of three years, of which $500 thousand has been funded as of October 29, 2005.

Capital Resources. During the thirty-nine weeks ended October 29, 2005, the Company made capital expenditures of $29.1 million. During the thirty-nine weeks ended October 29, 2005, the Company opened 8 new stores, relocated 12 stores and closed 18 stores. The Company plans to spend approximately $37 million for capital expenditures in 2005.

PART II - OTHER INFORMATION

Item 2 – Changes in Securities and Use of Proceeds

On May 28, 2003, the Company’s Board of Directors authorized the repurchase of 10 million outstanding shares of the Company’s Common Stock from time to time on the open market. The program has no expiration date. The Company had repurchased 15 million shares of common stock under previously announced programs. As of October 29, 2005 the Company had purchased 9.3 million shares, at a total cost of $84.1 million, and 660 thousand shares remained to be purchased under the current program. The following table shows the purchase of equity securities purchased under the repurchase program as required by Regulation 229.703 Item 703:

Period	Total Number of Shares Purchased	Average Price Paid per Share	Total Number of Shares Purchased as Part of Publicly Announced Programs	Maximum Number of Shares that May Yet Be Purchased Under the Plan
July 31, 2005 – August 27, 2005	352,700	8.10	352,700	1,348,741
August 28, 2005 – September 24, 2005	488,200	7.77	488,200	860,541
September 25, 2005 – October 29, 2005	199,900	7.83	199,900	660,641
Total	1,040,800	7.89	1,040,800	660,641

PART 1. FINANCIAL INFORMATION

Item 1 - Financial Statements

Condensed Consolidated Balance Sheets (unaudited) at October 29, 2005, January 29, 2005 and October 30, 2004 (unaudited)

Condensed Consolidated Statements of Operations (unaudited) – Thirteen Weeks and Thirty-nine Weeks Ended October 29, 2005 and October 30, 2004

Condensed Consolidated Statements of Cash Flows (unaudited)–Thirty-nine Weeks Ended October 29, 2005 and October 30, 2004

Notes to Condensed Consolidated Financial Statements (unaudited)

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 2 – Changes in Securities and Use of Proceeds

Item 6 - Exhibits and Reports on Form 8-K

Signatures

Exhibit No.		Description
31.1		Chief Executive Officer certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Chief Financial Officer certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certification pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

December 8, 2005	By: /s/ ROBERT J. HIGGINS
	Robert J. Higgins
	Chairman and Chief Executive Officer
	(Principal Executive Officer)

December 8, 2005	By: /s/ JOHN J. SULLIVAN
	John J. Sullivan
	Executive Vice President and Chief Financial Officer (Principal Financial and Chief Accounting Officer)

38 Corporate Circle

Results of Operations

The authorized stock repurchase program allows the Company to repurchase 10 million shares of Common Stock from time to time on the open market and has no expiration date. As of October 29, 2005, the Company had 660 thousand remaining shares authorized under the current program.

Item 2 – Changes in Securities and Use of Proceeds