-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, WVWimcRjiKh/LsspBZOLuIzi1I8B/uqEx1RkWD80SnBCVBCGCvXP7qUL6PEqcFy9 F5l+h6N8TxI1DfbYh3BTuQ== 0000832995-00-000004.txt : 20000327 0000832995-00-000004.hdr.sgml : 20000327 ACCESSION NUMBER: 0000832995-00-000004 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000324 FILER: COMPANY DATA: COMPANY CONFORMED NAME: MUSICLAND STORES CORP CENTRAL INDEX KEY: 0000832995 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-RADIO TV & CONSUMER ELECTRONICS STORES [5731] IRS NUMBER: 411623376 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-11014 FILM NUMBER: 577239 BUSINESS ADDRESS: STREET 1: 10400 YELLOW CIRCLE DR CITY: MINNETONKA STATE: MN ZIP: 55343 BUSINESS PHONE: 6129318000 MAIL ADDRESS: STREET 1: 10400 YELLOW CIRCLE DR CITY: MINNETONKA STATE: MN ZIP: 55343 10-K 1 REPORT 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark one) X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES - --- EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1999 OR 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 1-11014 MUSICLAND STORES CORPORATION (Exact name of Registrant as specified in its charter) Delaware 41-1623376 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 10400 Yellow Circle Drive, Minnetonka, Minnesota 55343 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (952) 931-8000 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- Common stock, $.01 par value New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. --- The aggregate market value of the voting stock held by nonaffiliates of the Registrant on March 10, 2000 was approximately $213,243,536 based on the closing stock price of $6.9375 on the New York Stock Exchange on such date (only directors and executive officers of the Registrant are considered affiliates for this calculation). The Registrant had 33,078,941 shares of common stock outstanding on March 10, 2000. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held May 8, 2000 (the "Proxy Statement") are incorporated by reference into Part III. PART I ITEM 1. BUSINESS General The Company is the leading specialty retailer of home entertainment products in the United States and is one of the largest national full-media retailers of music, video, books, computer software, video games and other entertainment related products. The Company's stores operate in one segment under two principal strategies: (i) mall based music and video stores ("Mall Stores"), operating predominantly under the trade names Sam Goody and Suncoast Motion Picture Company ("Suncoast"), and (ii) non-mall based full-media superstores ("Superstores"), operating under the trade names Media Play and On Cue. At December 31, 1999, the Company operated 1,345 stores in 49 states, the District of Columbia, the Commonwealth of Puerto Rico and the Virgin Islands, with total store square footage of 8.6 million. The Company met its stated objectives for 1999 of (i) increasing profitability, (ii) improving net cash position, (iii) adding retail square footage and (iv) establishing an e-commerce presence. Total sales of $1.89 billion and net earnings of $58.4 million, or $1.60 per diluted share, set new records for the Company, exceeding the previous record sales and net earnings in 1998 by 2.4% and 53.5%, respectively. Operating performance continued to improve in all of the Company's retail store chains in 1999. These performance improvements contributed to increases in inventory turnover and cash flows during 1999. Cash and cash equivalents, which are generally highest at the end of December following the Christmas season, reached $335.7 million by year-end, while total debt, all of which is long-term, remained at approximately $259 million. Total store square footage increased 3.4% to 8.6 million in 1999, representing the first net increase in total square footage since 1995. The Company opened 39 new stores in 1999 and closed 40 stores, including the 14 remaining stores in the United Kingdom. Media Play and On Cue stores accounted for the majority of the total new store square footage and store count, respectively. In addition to new stores, the Company continued to remodel or relocate existing stores and established an e-commerce presence with the launch of four e-commerce sites in June of 1999. Capital expenditures in 1999 for these and other capital projects totaled approximately $45.0 million, net of landlord and other funding. The Company's board of directors has authorized the repurchase of up to six million shares of the Company's common stock on the open market. During 1999, the Company repurchased 2.0 million shares for an aggregate cost of $14.7 million. The Company's objectives in 2000 are to (i) strengthen its e-commerce presence through increased investment, (ii) begin the first phase in the development of new, web-enabled store systems, (iii) invest capital to remodel Mall Stores and expand Superstores and (iv) continue to improve the profitability of the base brick-and-mortar business. During 2000, the Company plans to open approximately 60 new stores and close 30 or more stores. The remodeling and closing of stores will occur primarily at the end of the lease term in connection with management's ongoing review of store profitability. Capital expenditures in 2000 for these programs and other capital projects are expected to be approximately $60 million. Musicland Stores Corporation ("MSC") was incorporated in Delaware in 1988 and acquired The Musicland Group, Inc. ("MGI") on August 25, 1988. MGI was incorporated in Delaware in 1977 as a successor corporation to a number of companies that participated in the music business as early as 1956. The principal asset of Musicland Stores Corporation is 100% of the outstanding common stock of MGI, and, since its formation, MSC has engaged in no independent business operations. MSC and MGI, together with MGI's subsidiaries, are collectively referred to as the "Company." 1 Mall Stores Sam Goody. Sam Goody is a leading specialty music retailer offering a broad product selection in an exciting, customer friendly shopping environment. Sam Goody stores specialize in providing music entertainment products, including compact discs, audiocassettes, music and movie videos, sheet music, music inspired apparel, posters and novelties and other music-related accessories. The music stores are predominantly found in mall locations and range in size from 1,000 to 30,000 square feet, averaging 4,500 square feet. The larger music stores are often in more prominent mall or downtown locations and carry a broader inventory of catalog product, including substantial classical and jazz offerings as well as deep video assortments. During 1999, the Company opened five new Sam Goody stores and closed 21 stores. In recent years, the Company has relocated several stores. Most of the relocations are part of an ongoing strategy to replace one or more smaller stores in a mall with a store in a more prominent location in the same mall. Many of the moves position Sam Goody as the exclusive music retailer in the mall. Sam Goody was the single music retailer in 301 malls at the end of 1999. Most of the music stores previously operated under the Musicland name have been converted to the Sam Goody name. As of December 31, 1999, the Company operated 680 music stores in 49 states, the District of Columbia, the Commonwealth of Puerto Rico and the Virgin Islands. The total square footage of music stores was approximately 3.1 million square feet, or 35.4% of the Company's total store square footage as of December 31, 1999. In 2000, the Company plans to open approximately ten new stores and close 20 or more stores. The Company also plans to remodel or relocate approximately 83 stores throughout the year. Suncoast. Suncoast is the dominant mall based video retailer in the United States, emphasizing a broad product selection and a high level of customer service in an entertaining atmosphere. Suncoast stores average 2,400 square feet in size and feature newly released and classic movies, special interest videos and episodes from popular TV shows. Complementary products include Hollywood inspired apparel, posters and other products, as well as blank videotapes, storage cases and other video-related accessories. Most movies on videocassette are priced at less than $20 and more than half sell for less than $15. Each store also offers a wide selection of feature films and videos for less than $10. Suncoast stores present DVD in a very visible display in the front of its stores. Although most of the DVD titles are priced at $20 to $30, an increasing number of titles are priced below $20. At December 31, 1999, there were 411 Suncoast stores in 46 states, the District of Columbia and the Commonwealth of Puerto Rico. The Company opened nine new Suncoast stores during 1999 and closed three stores. The total square footage of Suncoast stores was approximately 1.0 million square feet, or 11.7% of the Company's total store square footage as of December 31, 1999. The Company plans to open approximately 10 new stores and close 10 or more stores in 2000. The Company also plans to remodel or relocate approximately 30 stores during the year. Superstores Media Play Stores. Media Play is a full-media superstore retailer located in major metropolitan markets offering a superior assortment of home entertainment products at competitive prices. The family-oriented Media Play stores are operated primarily in freestanding and strip mall locations in urban and suburban areas. Media Play's extensive merchandise assortment provides customers with one-stop shopping for music, books, movie and specialty videos, computer software, video games, storage products, personal/portable electronics and licensed movie, music and sports apparel, as well as other media and related products including magazines, trading cards, posters and toys. Store features such as M.P. Kids, Game Zone and Jam Central provide a family oriented and exciting shopping environment appealing to customers of all ages. The vendor sponsored M.P. Kids 2 department functions as a play area for children and has a wide array of popular movies, books and interactive and educational toys for children. Game Zone is an interactive department in which customers can buy both new and used video games, sample product on one of two game stations and also sell or trade their used video games. The Jam Central area combines musical instruments, sheet music and accessories into an exciting in-store boutique. The Company opened four Media Play stores in 1999 and plans to open six Media Play stores in 2000. Media Play will enter the Pittsburgh market in 2000 with three of the planned new stores while the remainder of the new stores will be additions to existing markets. The new stores opened in 1999 and planned for 2000 average approximately 35,000 square feet. The Company also plans to downsize a select number of existing Media Play stores, which currently average 47,000 square feet, to the current prototype of 30,000 to 40,000 square feet. The smaller stores are part of the Company's strategy to create a smaller, more streamlined store format with enhanced departments and upgraded signage and graphics. At December 31, 1999, the Company operated 73 Media Play stores in 19 states with total square footage of approximately 3.4 million square feet, or 39.8% of the Company's total store square footage. On Cue Stores. On Cue is a full-media retailer located in small cities, generally with populations between 10,000 and 30,000 people, providing a wide assortment of entertainment products at competitive prices and superior customer service to encourage repeat business. On Cue stores average 6,200 square feet in size and offer customers a convenient local store to shop for music, books, videos, computer software, video games and related products. On Cue customers also have access to over 200,000 music and video titles as well as a comprehensive selection of book titles through the Company's special order program. The in-store boutique, Jam Central, is also in On Cue stores and features an expanded selection of musical instruments and accessories including keyboards, guitars, microphones, amps, starter drum sets and P.A. systems. The Company opened 21 On Cue stores and closed two stores in 1999. At December 31, 1999, the Company operated 181 On Cue stores in 31 states with total square footage of approximately 1.1 million square feet, or 13.1% of the Company's total store square footage. The Company plans to open approximately 35 On Cue stores in the Midwest, West Coast and Pacific Northwest during 2000. E-Commerce In June of 1999, the Company launched four e-commerce sites: SamGoody.com, Suncoast.com, MediaPlay.com and OnCue.com. The sites offer a diverse selection of products frequently cross-merchandised around entertainment personalities and themes. A full line of music and video (VHS and DVD) products are complemented by selected licensed apparel, electronics, accessories, toys, sheet music, entertainment books, video games and computer software. The e-commerce strategy integrates the Company's strong store brands and capitalizes on the Company's nationwide presence, broad fashion-forward merchandise and state-of-the-art inventory and distribution systems. E-commerce product orders are fulfilled from the Company's distribution facility in Franklin, Indiana. Customers accumulate Replay loyalty points for both online and in-store purchases. The Company's electronic gift card can be purchased and used in any of the Company's stores or e-commerce sites once it is activated. The gift cards allow younger buyers who do not have a credit card to shop online. During 2000, the Company plans to implement upgrades to the e-commerce sites that will increase online capacity and merchandise offerings. The e-commerce sites are ready to deliver direct music downloading as demand develops. 3 Products Sales and percentage of total sales attributable to each product group are as follows: Years Ended December 31, ------------------------------------------------------ 1999 1998 1997 --------------- ---------------- --------------- Sales % Sales % Sales % -------- ----- -------- ----- -------- ----- (dollars in millions) Music: Compact discs...... $ 832.8 44.0 % $ 781.7 42.3 % $ 707.0 40.0 % Audiocassettes and other............ 146.9 7.8 183.0 9.9 223.0 12.6 -------- ----- -------- ----- -------- ----- Total music... 979.7 51.8 964.7 52.2 930.0 52.6 Video: DVD................ 110.9 5.9 55.4 3.0 9.3 0.5 Videocassettes and other ........... 404.6 21.3 475.6 25.8 499.8 28.3 -------- ----- -------- ----- -------- ----- Total video... 515.5 27.2 531.0 28.8 509.1 28.8 Books and other entertainment products........... 396.6 21.0 351.2 19.0 329.2 18.6 -------- ----- -------- ----- -------- ----- Total...... $1,891.8 100.0 % $1,846.9 100.0 % $1,768.3 100.0 % ======== ===== ======== ===== ======== ===== Music. Sales of music in the U.S. market climbed 6.3% to $14.6 billion in 1999 from $13.7 billion in 1998 and are expected to grow at a compound annual rate of 5.5% through 2003, according to such sources as the Recording Industry Association of America. Sam Goody stores typically carry 6,000 to 10,000 compact disc titles, depending upon store size and location, while the largest Sam Goody stores carry up to 30,000 compact disc titles. Media Play and On Cue stores carry up to 40,000 and 9,000 compact disc titles, respectively. These titles include "hits," which are the best selling newer releases, and "catalog" items, which are older but still popular releases that customers purchase to build their collections. Video. The video sell-through market, including VHS and DVD, totaled an estimated $9.9 billion in 1999 and is expected to grow at a compound annual rate of 4.6% over the next ten years, according to Paul Kagan Associates, Inc. In 1999, the third year of DVD merchandising, the Company's DVD sales exceeded $100 million and were double that of the previous year. The Company expects the significant growth in DVD sales to continue over the next several years as more consumers purchase DVD players and more titles become available on the DVD format. The DVD Video Group reported that DVD players reached an installed base of nearly 5 million players by the end of 1999. Nearly all of the Company's stores carry DVD in addition to the videocassette format. Suncoast and Media Play stores, in particular, devote significant space and special displays to DVD product. Suncoast stores feature up to 12,000 titles, including 3,200 in the DVD format. Media Play stores carry up to 15,000 titles, including 3,200 DVD titles. Sam Goody stores typically carry 800 DVD titles and 3,000 video titles in total, while the largest Sam Goody stores carry up to 3,000 DVD titles out of a total of 12,000 video titles. On Cue stores carry up to 3,500 titles, including 800 DVD titles. Books and Other Entertainment Products. Media Play and On Cue stores carry up to 45,000 and 8,500 titles of books, respectively. Other entertainment products include computer software, video games, electronics, storage cases, educational toys, sheet music, instruments and brand name blank audio and video tapes, as well as entertainment related accessories, apparel, posters and various other trend related items. The Company's stores carry a limited variety of electronic equipment such as portable compact disc and audio cassette players, portable stereo systems and kids' electronic products 4 at retail prices under $200. DVD players are currently offered in all Media Play and On Cue stores. Movie and artist related accessories and apparel products are highly influenced by the trends and fads surrounding popular movies, TV shows, actors and artists. Computer software and video games are available primarily in Media Play and On Cue stores. All Media Play stores and a limited number of On Cue stores allow customers to buy, sell and trade used video games through the in-store boutique, Game Zone. The in-store boutique Jam Central is in all Media Play and On Cue stores and features a selection of guitars, basses, amps, keyboards, drums, accessories and sheet music. The Company introduced a private-label Fairmont guitar brand for the 1999 holiday season. Jam Central merchandise will be available through the Company's e-commerce sites in 2000. Suppliers Substantially all of the home entertainment products sold by the Company are purchased directly from manufacturers. The Company purchases inventory for its stores from approximately 1,100 suppliers, exclusive of consignment arrangements. In 1999, approximately 67% of all purchases, net of returns, were made from the 10 largest suppliers in terms of net purchase volume. The Company has no long-term contracts with its suppliers and transacts business principally on an order-by-order basis as is typical throughout the industry. The Company received confirmation from its major product vendors representing 93% of total purchase volume that their systems are Year 2000 ready. The Company made efforts by telephone and the Internet to obtain information from the remaining product vendors who had not responded to the Company's Year 2000 readiness inquiries. To date, the Company has not experienced delays in receiving product from its suppliers related to the Year 2000 issue. See "Management's Discussion and Analysis of Results of Operations and Financial Condition - Other Matters - Year 2000." Marketing The Company's major suppliers offer cooperative advertising support and provide funds for the placement and position of product. The Company's marketing programs are designed to build each store's brand image, encourage first-time visits and reinforce store loyalty among existing customers through a wide variety of traffic-driving special events and promotions. The Company has developed marketing and advertising partnerships with its vendors and nationally recognized corporations for cross promotions, events and sweepstakes that the Company believes are attractive to shoppers. For the fifth consecutive year, the Company has run a nationally televised/advertised unsigned band competition, or "Bandemonium" search, which appeals to its target customers. In addition to the Sam Goody stores, sponsors of the Bandemonium event in 1999 included the presenting sponsor PepsiCo, as well as Gibson and L'Oreal. Bandemonium was expanded in 1999 to include dedicated in-store space for the promotion of unsigned band product throughout the year. The product will be promoted on the Company's e-commerce sites in 2000. Nearly 900,000 customers are members of the Replay program, a frequent shopper program designed to promote customer loyalty and encourage repeat visits through special offers and targeted marketing. During 1999, customers of Suncoast and On Cue stores were added to the existing base of Sam Goody customers. The program will be expanded to Media Play customers in 2000. The Company publishes Request, a cutting-edge music and video entertainment newsmagazine for younger customers distributed in Sam Goody, Media Play and On Cue stores and also at limited magazine stands. The magazine has a pass-along readership estimated in the millions. The Request web site, requestmagazine.com, offers an online version of the music reviews from the magazine together with downloadable sound clips. 5 Store Operations Sam Goody, Suncoast and On Cue stores are typically managed by a store manager and an assistant manager. Media Play stores are typically managed by a general manager, an assistant general manager and three to five department managers. Most stores are open up to 80 hours per week, seven days a week. The Company does not extend credit to customers, but most major credit cards are accepted. In November of 1999, the Company launched a new electronic stored value card that can be purchased in any denomination and can be reloaded with additional value at any time. Once activated, the card can be purchased, used and reloaded at any of the Company's stores as well as its four e-commerce sites. The cards allow younger consumers who do not have a credit card to shop online. The Company has completed and tested the necessary Year 2000 remediations to all of its store systems. To date, the Company has not experienced any significant business disruption related to the Year 2000. See "Management's Discussion and Analysis of Results of Operations and Financial Condition - Other Matters - Year 2000." Industry and Competitive Environment The retail home entertainment industry is highly competitive. The Company competes with other brick-and-mortar retailers and a growing number of direct-to-consumer alternatives. Brick-and-Mortar Retailers. The Company competes with large, established music and video chains, such as those operated by Trans World Entertainment Corporation, The Wherehouse and Tower Records; consumer electronics superstores such as Best Buy and Circuit City; mass merchants such as Wal-Mart, Kmart and Target and other specialty retail stores such as Barnes & Noble and Borders. Some of these competitors may have greater financial or other resources than the Company. In addition, the Company also faces competition from video rental stores, variety discounters and warehouse clubs. Direct-to-Consumer. The Internet has become an established avenue for retailing. The purchase of music, video and books, in particular, through the Internet is increasing in popularity with consumers. The Company's e-commerce competitors include Amazon.com, CDnow.com, Barnesandnoble.com, mp3.com and others, most of which have one or more marketing alliances. In addition to the Internet, consumers receive television and mail order offers and have access to mail order clubs. The largest mail order clubs are affiliated with major manufacturers of prerecorded music and video and may have advantageous marketing relationships with their affiliates. Consumers also have access to cable television and digital satellite systems, including pay-per-view television. Many retailers as well as certain distributors are testing technology that allows for the purchase of music through a digital download via either the Internet in the home or from an in-store kiosk unit. Although sales to date have been minimal, consumer interest in this form of distribution could increase as the technology improves and the assortment of titles available for download widens. While consolidation of brick-and-mortar retailers slowed during 1999, significant consolidation is occurring elsewhere in the home entertainment industry. Time Warner Inc. recently agreed to be acquired by America Online, Inc. and also agreed to combine its music operation with Britain's EMI Group plc. The Sony Corporation of America and Time Warner Music Inc., two of the Company's largest suppliers, agreed to form a strategic alliance with CDnow, Inc. for music sales and delivery over the Internet. The Universal Music Group of Seagram Co. Ltd., another major supplier to the Company, agreed to purchase 50% of an Internet music retailing company operated by Bertelsmann AG, also a major supplier to the Company. The Company has adopted strategies to address these industry developments. The Company began Internet retailing in June of 1999 and plans to make investments during 2000 to strengthen its e- 6 commerce presence and to develop strategic alliances. Web technology will be utilized to enhance the interactive environment both online and in the stores. The Company participated in a limited test of digital delivery of music and is ready to offer music downloading on its e-commerce sites as demand develops. Seasonality The Company's business is highly seasonal, with sales peaking during the Christmas holiday season as is typical for most retailers. Because of the higher sales volume and extended payment terms generally provided by most product vendors for seasonal inventory purchases, the Company's cash position is generally highest at the end of December. Seasonal purchases of inventory typically begin during the third quarter and continue into the fourth quarter, while payment is typically due near the beginning of the following year. For the year ended December 31, 1999, 38.2% of the Company's sales and 93.8% of the Company's net earnings were generated in the fourth quarter. Quarterly results are affected by, among other things, the timing and strength of new product offerings, the timing of holidays, new store openings and sales performance of existing stores. See Note 15 of Notes to Consolidated Financial Statements for quarterly financial data. Trademarks and Service Marks The Company owns a number of trademarks, trade names and service marks, many of which have become key components of the Company's marketing and branding programs. The Company operates its Mall Stores under the names Sam Goody(registered), Musicland(registered) and Suncoast Motion Picture Company(registered) and operates its Superstores under the names Media Play(registered) and On Cue(registered). In addition, the Company operates five commercial Web sites using the trade names SamGoody.com-sm (http://www.samgoody.com), Suncoast.com-sm, Mediaplay.com-sm, OnCue.com-sm and Requestline.com-sm, and has trademark applications pending for them. The Company also uses the names REQUEST(registered) and REPLAY(registered) in its advertising and promotional activities. Personnel As of February 21, 2000, the Company employed approximately 5,900 full-time employees and 10,000 part-time employees. Unions represent hourly employees at 14 of the Company's stores. All other facilities are non-union and the Company believes that its employee relations are good. ITEM 2. PROPERTIES Corporate Headquarters and Distribution Facilities. The Company owns its corporate headquarters facility in Minneapolis, Minnesota, consisting of an office building with approximately 94,000 square feet of space on approximately 5.4 acres of land. Additional office, warehouse and storage space located in Minneapolis, Minnesota totaling approximately 150,000 square feet are under operating leases that expire at various dates through February 2002. The Company owns its distribution facilities located in Franklin, Indiana, consisting of a 715,000 square foot building on approximately 66.6 acres of land, with options on approximately 33.4 additional acres of land. The Company also has approximately 105,000 square feet of storage space in a building located in Indianapolis, Indiana, under an operating lease expiring in January 2001. Retail Stores. At December 31, 1999, the Company operated 1,345 retail stores, including 1,336 stores in the United States, seven stores in Puerto Rico and two stores in the Virgin Islands. The Company owns three Media Play stores and has operating leases for all other stores that expire in various years through 2016. The leases have noncancelable terms that generally range from three to 20 years and many include renewal options for additional periods. Certain store leases provide the Company with an early cancellation option if sales for a designated period do not reach a specified 7 level as defined in the lease. Most of the store leases contain escalation clauses and require payment of real estate taxes, utilities, common area maintenance costs and contingent rentals based on percentages of sales in excess of specified minimums. Certain store leases contain provisions restricting assignment, merger, change of control or transfer. The following table lists the number of store leases due to expire or terminate in each year based on the fixed lease term, giving effect to early cancellation options and excluding renewal options. 2000..................... 256 2005..................... 169 2001..................... 250 2006..................... 53 2002..................... 125 2007..................... 14 2003..................... 184 2008...................... 22 2004..................... 168 2009 and thereafter....... 101 Of the 506 leases expiring in 2000 and 2001, 123 have renewal options. In most cases, the Company expects that it should be able either to obtain renewal leases, if desired, or to obtain leases for other suitable locations. In 2000, the Company plans to close 30 or more stores and relocate 36 stores. Most of the relocations are part of a strategy to replace one or more smaller stores in a mall with a store in a more prominent location in the same mall. The relocation and closing of stores will occur primarily at the end of the lease term in connection with management's ongoing review of store profitability. ITEM 3. LEGAL PROCEEDINGS The Company is subject to various legal proceedings that arise in the course of conducting its business. It is management's opinion that the ultimate resolution of such proceedings is not likely to have a material adverse effect on the financial position or results of operations of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders by MSC during the fourth quarter of the year ended December 31, 1999. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock of MSC is traded on the New York Stock Exchange under the symbol MLG. For common stock price information, see Note 15 of Notes to Consolidated Financial Statements. As of March 10, 2000, MSC had approximately 484 holders of record of its common stock. MSC has never paid cash dividends on its capital stock and has no plans to pay cash dividends in the future. The current policy of the Board of Directors of MSC is to reinvest in the business of the Company. The terms of the Company's indentures for the 9% and 9 7/8% senior subordinated notes restrict the amount of cash dividends that may be paid by MSC. See Note 3 of Notes to Consolidated Financial Statements. 8 ITEM 6. SELECTED FINANCIAL DATA The following table presents selected financial data for the years indicated. This information should be read in conjunction with the Consolidated Financial Statements and related notes contained in Item 14 and "Management's Discussion and Analysis of Results of Operations and Financial Condition" contained in Item 7. SELECTED CONSOLIDATED FINANCIAL DATA (In thousands, except per share amounts and store data) Years Ended December 31, --------------------------------------------------------- 1999 1998 1997 1996 1995 ---------- ---------- ---------- ---------- ---------- Statement of Operations Data: Sales................ $1,891,828 $1,846,882 $1,768,312 $1,821,594 $1,722,572 Gross profit......... 690,835 656,300 614,829 611,759 606,070 Selling, general and administrative expenses............ 543,518 532,018 529,427 576,658 525,213 Depreciation and amortization........ 41,276 39,471 39,411 44,819 45,531 Goodwill write-down.. - - - 95,253 138,000 Restructuring charges............. - - - 75,000 - Operating income (loss).............. 106,041 84,811 45,991 (179,971) (102,674) Interest expense..... 22,661 30,478 31,720 32,967 27,881 Earnings (loss) before income taxes. 83,380 54,333 14,271 (212,938) (130,555) Income taxes......... 25,000 16,300 300 (19,200) 5,195 Net earnings (loss).. 58,380 38,033 13,971 (193,738) (135,750) Earnings (loss) per common share: Basic............. $ 1.65 $ 1.10 $ .42 $ (5.80)$ (4.00) Diluted........... 1.60 1.04 .41 (5.80) (4.00) December 31, --------------------------------------------------------- 1999 1998 1997 1996 1995 ---------- ---------- ---------- ---------- ---------- Balance Sheet Data: Total assets......... $1,063,574 $ 973,640 $ 733,895 $ 996,915 $ 996,957 Long-term debt, including current maturities.......... 258,950 258,871 193,087 396,599 163,000 Stockholders' equity. 109,358 63,982 18,770 2,619 195,811 Store Data: Total store square footage (in millions)........... 8.6 8.3 8.3 9.5 9.9 Store count: Sam Goody stores.... 680 696 713 777 820 Suncoast stores..... 411 405 409 422 412 Media Play stores... 73 69 68 87 89 On Cue stores....... 181 162 157 158 153 Other retail strategies......... - 14 16 22 22 ---------- ---------- ---------- ---------- ---------- Total.......... 1,345 1,346 1,363 1,466 1,496 ========== ========== ========== ========== ========== 9 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Results of Operations The Company's performance in 1999 set new sales and earnings records, surpassing the previous records achieved in 1998. Total sales rose 2.4% to $1.89 billion while operating income improved by $21.2 million to $106.0 million, an increase of 25.0%. Net earnings in 1999 increased 53.5% to $58.4 million, or $1.60 per diluted share, from $38.0 million, or $1.04 per diluted share, in 1998. The earnings improvements resulted primarily from comparable store sales increases, gross margin improvements and lower interest expense. The loss from e-commerce operations, net of tax benefit, reduced net earnings by $0.10 per share in 1999. The table below presents certain sales and store data for Mall Stores, Superstores and in total for the Company for the last three years. Because both Mall Stores and Superstores are supported by centralized corporate services and have similar economic characteristics, products, customers and retail distribution methods, the stores are reported as a single operating segment. The Company formed an e-commerce operation in 1998 and began online retailing in June of 1999. To date, the Company's e-commerce operations have not been significant. Years Ended December 31, ---------------------------------------- 1999 1998 1997 ---------- ---------- ------------ (dollars and square footage in millions) Sales Data: Sales: Mall Stores (1)..................... $ 1,222.1 $ 1,206.8 $ 1,165.0 Superstores (1)..................... 668.6 627.9 589.5 Total (2)........................ 1,891.8 1,846.9 1,768.3 Percentage change from prior year: Mall Stores (1)..................... 1.3 % 3.6 % 0.4 % Superstores (1)..................... 6.5 6.5 (8.4) Total (2)........................ 2.4 4.4 (2.9) Comparable store sales increase (3): Mall Stores......................... 2.0 % 6.5 % 4.7 % Superstores......................... 3.7 7.2 4.1 Total (2)........................ 2.6 6.7 4.5 Store Data: Number of stores open at year end: Mall Stores ........................ 1,091 1,101 1,122 Superstores......................... 254 231 225 Total (2)........................ 1,345 1,346 1,363 Total store square footage at year end: Mall Stores......................... 4.1 4.0 4.0 Superstores......................... 4.5 4.3 4.2 Total (2)........................ 8.6 8.3 8.3 - ------------------------------------- (1) Mall Store sales in 1999 include sales from SamGoody.com and Suncoast.com; Superstore sales in 1999 include sales from MediaPlay.com and OnCue.com. (2) The totals include other retail strategies. (3) Comparable store sales percentages are computed for stores open for a full year during each year. 10 Sales. The increases in total sales for the year ended December 31, 1999 were led by the comparable store sales increases and sales from 25 new superstores opened in 1999, which included four Media Play stores and 21 On Cue stores. The music product category continued as the main contributor to comparable store sales growth, generating comparable store sales increases of 2.4% on top of strong comparable store sales gains in 1998 and 1997. DVD sales in 1999 of $110.9 million were double the 1998 DVD sales of $55.4 million. The significant growth of DVD sales partially offset declines in consumer demand for videocassettes and the difficult comparisons against the record video sales of the blockbuster movie "Titanic" released in September 1998. The increases in total sales for the year ended December 31, 1998 were attributable primarily to the comparable store sales increases, partially offset by the decrease in sales from the closing of stores. The comparable store sales gains were attributable primarily to sales increases in music and video. Soundtracks from popular movies, led by the soundtrack from the movie "Titanic," as well as the diverse popularity of music titles, contributed to the growth in music sales. The movie "Titanic," released in September 1998, produced the strongest sales for a video title in the Company's history. In recent years, the Company has expanded product offerings of popular items such as musical instruments, educational toys, portable electronics and video games, which has enabled the Company to achieve sales growth outside of its core music and video product categories. As a result of this sales growth, combined sales in the trend, contemporary, electronics and other product categories increased to 21% of total sales in 1999 while music and video sales were 79% of total sales. The comparable store sales percentage increase (decrease) and the percentage of total sales attributable to the Company's music and video product categories for the last three years are presented below. Years Ended December 31, ----------------------------------- 1999 1998 1997 -------- -------- -------- Music........................... 2.4 % 6.4 % 7.5 % Video........................... (3.2) 5.7 0.2 Music and video as a percentage of total sales................. 79.0 81.0 81.4 The table below presents certain components of earnings as a percentage of sales for the last three years. Years Ended December 31, ------------------------------------ 1999 1998 1997 --------- --------- --------- Gross profit.................... 36.5 % 35.5 % 34.8 % Selling, general and administrative expenses........ 28.7 28.8 29.9 Depreciation and amortization... 2.2 2.1 2.2 Gross Profit. The gross margin improvement in 1999 was the result of the Company's ongoing strategy of selective price increases and conservatively managed promotional pricing. A decrease in inventory shrinkage added 0.1% to gross margin in 1999. Most of the gross margin improvement in 1998 was attributable to less promotional pricing and selective price increases made during the second half of 1997 and in 1998. Inventory shrinkage decreased in 1998 and accounted for 0.2% of the gross margin improvement. Selling, General and Administrative Expenses. Selling, general and administrative expenses in 1999 increased $11.5 million, or 2.2%, over 1998. Expenditures for the e-commerce operation totaled approximately $6 million, the majority of which related to marketing and infrastructure costs. This incremental expense in 1999 was offset by a decrease in the provision for store closings due to lower estimated closing costs, because most closings are planned to occur after the lease expiration. Excluding e-commerce expenses, selling, general and administrative expenses as a percentage of sales were 28.4%. The lower expense rate in 1999 compared with 1998 was primarily the result of comparable store sales growth. 11 Selling, general and administrative expenses in 1998 increased slightly over 1997, but decreased as a percentage of sales by 1.1%. The decrease in the expense rate was attributable to the comparable store sales increases and the continued benefit of cost saving initiatives that began in 1997. The consolidation of distribution facilities into a single facility, completed in January 1997, resulted in greater operating efficiency and lower distribution costs. Advertising effectiveness was improved while advertising expenditures were decreased by focusing resources on a wide range of traffic driving events and promotions and by partnering with vendors and nationally recognized corporations. As part of a strategy to build market share, the Company plans to significantly increase expenditures in 2000 for its e-commerce operations. Most of the expenditures will be reported as selling, general and administrative expenses and will focus on intensified marketing efforts as well as infrastructure and site enhancements. The Company expects these expenditures, net of tax benefit, to reduce earnings per share by up to $0.30 or more in 2000. Depreciation and Amortization. Capital spending for new stores and upgrades to existing stores caused depreciation and amortization to increase in 1999 over the prior year. This increase was partially offset by decreases to depreciation and amortization resulting from the closing of stores. Depreciation and amortization in 1998 was comparable to 1997. Increases to depreciation and amortization in 1998 resulting from capital expenditures and the Company's distribution facility in Franklin, Indiana were offset by decreases to depreciation and amortization resulting from store closings. Interest Expense. Components of interest expense for the last three years were as follows: Years Ended December 31, ------------------------------- 1999 1998 1997 ------- ------- ------- (in millions) Interest on revolver borrowings...... $ - $ 3.5 $ 19.0 Interest on term loan................ - 3.6 1.2 Interest on senior subordinated notes............................... 24.8 20.8 9.9 Other interest, net of interest income.............................. (2.1) 2.6 1.6 ------- ------- ------- Total............................. $ 22.7 $ 30.5 $ 31.7 ======= ======= ======= The decrease in interest expense in 1999 compared with 1998 and 1997 resulted from improvements in operating performance and the issuance of $150 million of 9 7/8% senior subordinated notes in April 1998, which enabled the Company to forgo revolver borrowings. During 1999, the Company had monthly average total cash and cash equivalents of $87.8 million, which generated $4.3 million of interest income. For the years ended December 31, 1998 and 1997, average daily revolver borrowings, based upon the number of days with outstanding borrowings, weighted average interest rates, based on the average daily revolver borrowings, and the highest balances outstanding under the revolving credit facility were as follows: Years Ended December 31, ------------------ 1998 1997 ------ ------ (dollars in millions) Average daily revolver borrowings............... $ 56.4 $238.5 Number of days with outstanding revolver borrowings..................................... 201 362 Weighted average interest rate, excluding facility costs................................. 7.8 % 7.4 % Highest level of revolver borrowings............ $152.0 $273.0 For the years ended December 31, 1999, 1998 and 1997, the Company incurred facility costs related to revolving credit facilities of $0.6 million, $1.1 million and $1.5 million, respectively. Most of the increase in the interest rate in 1998 over 1997 resulted from amendments to the Company's former credit agreement that increased the margin added to variable interest rates on revolver borrowings. 12 Income Taxes. The effective income tax rates of 30.0% in 1999 and 1998 and 2.1% in 1997 vary from the federal statutory rate as a result of deferred tax valuation allowances and state income taxes. Valuation allowances reduce deferred income tax balances to the approximate amount of recoverable income taxes based on assessments of taxable income within the carryback or carryforward periods for each year. Valuation allowances, established in 1996, were reduced by $8.9 million, $4.0 million and $7.5 million for the years ended December 31, 1999, 1998 and 1997, respectively. See Note 4 of Notes to Consolidated Financial Statements. Liquidity and Capital Resources The Company's financial position has strengthened in recent years as a result of increased profitability, operating improvements and the completion in April 1998 of an offering of $150 million of 9 7/8% senior subordinated notes due in 2008. The Company had no revolver borrowing activity during 1999 and had minimal revolver borrowing activity in 1998 after completion of the offering. At December 31, 1999 and 1998, the Company had no outstanding revolver borrowings and had cash and cash equivalents of $335.7 million and $257.2 million, respectively. In September 1999, the Company cancelled its revolving credit facility, which would have expired in October 1999, and replaced it with a standby $25 million secured facility with an initial term of three years. The maximum available under the facility requires a minimum inventory of $150 million at specified locations and is reduced by outstanding letters of credit. Management currently intends to have no more than minimal use of this revolving credit facility, relying on internally generated cash as the Company's primary source of capital. See "- Financing Activities" and Note 3 of Notes to Consolidated Financial Statements. Operating Activities. Net cash provided by operating activities (including the increase (decrease) in outstanding checks in excess of cash balances which primarily related to vendor payments) was $141.1 million in 1999, $215.6 million in 1998 and $86.7 million in 1997. The significant increases in operating cash flows since 1997 have been attributable to increased profitability and operating improvements achieved through better store performance and working capital management. More frequent purchases closer to the time of sale and better in-stock positions have enabled the Company to maintain lower inventory levels and increase inventory turnover. Inventories decreased slightly at December 31, 1999 versus the prior year while total store square footage increased in 1999 by 300,000 square feet. Inventory turnover improved to 2.33 in 1999 from 2.28 in 1998. Accounts payable at December 31, 1999 increased by $23.8 million over 1998 as a result of the improvement in inventory turnover. The increase in other current liabilities at December 31, 1999 was primarily due to increases in gift certificate deferred revenue and income taxes payable. The Company's introduction of a new electronic gift card in November 1999 contributed to higher Christmas season purchases versus the paper gift certificates in 1998, which increased approximately 23% over the November-December holiday period of the previous year. The increase in income taxes payable is due to the increase in earnings. For the year ended December 31, 1998, inventory turnover was 2.28 compared with 2.05 in 1997. The significant increase was a result of the inventory management programs discussed above as well as the closing of underperforming stores and the completion of the Company's restructuring programs in the first quarter of 1997. At December 31, 1998, although inventories remained comparable to the prior year, accounts payable increased by $107.3 million over December 31, 1997, reflecting normal extended payment terms for seasonal inventory purchases as well as later purchases of seasonal inventory. In addition, accounts payable at December 31, 1997 was impacted by the combination of earlier payments to product vendors for seasonal purchases and the completion in the fourth quarter of payment of certain accounts payable balances that had been temporarily deferred from the first quarter. The most significant increase in other current liabilities relates to the increase in income taxes payable as a result of higher earnings in 1998. 13 Investing Activities. Capital expenditures and store data for the last three years are as follows: Years Ended December 31, ---------------------------- 1999 1998 1997 ------- ------- ------- Capital expenditures (in millions)....... $ 48.3 $ 27.2 $ 10.9 Store openings: Mall Stores........................... 14 7 2 Superstores........................... 25 7 1 Total (1).......................... 39 14 3 Store closings: Mall Stores........................... (24) (28) (79) Superstores........................... (2) (1) (21) Total (1).......................... (40) (31) (106) Net increase (decrease) in store count: Mall Stores........................... (10) (21) (77) Superstores........................... 23 6 (20) Total (1).......................... (1) (17) (103) - ----------------- (1) The totals include other retail strategies. The most significant portion of the Company's capital expenditures in each year related to the remodeling, relocation and general upkeep of existing stores and, to a lesser extent, the opening of new stores. The number of stores closed in 1997 included 61 stores closed under restructuring programs. All other closings in 1997 and in 1999 and 1998 resulted from the Company's ongoing monitoring of store performance in conjunction with lease expirations. The Company used primarily internally generated cash to finance capital expenditures in 1999. In addition, the Company received landlord and other funding of $3.3 million, typically in the form of contributions and rent abatements for new stores and relocations of existing stores. In 1998, the Company used internally generated cash and, to a lesser extent, borrowings under the revolving credit facility to finance capital expenditures. The Company's planned capital expenditures for 2000 are expected to be approximately $60 million, the majority of which will include expenditures for existing stores as well as approximately 60 new stores. The Company's expenditures for existing stores include the remodel or relocation of over 100 stores as well as the general upkeep of both Mall Stores and Superstores. Media Play and On Cue stores will continue to account for the majority of the total new store square footage and store count, respectively. In addition to store spending, capital expenditures are planned for the improvement of the Company's e-commerce sites, the first phase in the development of new web-enabled store systems and the expansion of the Company's headquarters facilities. Management plans to use primarily internally generated cash to finance these capital expenditures. The Company anticipates closing 30 or more stores in 2000, primarily when the leases expire, as part of management's ongoing review of store profitability. Financing Activities. The Company's primary source of financing during 1999 was internally generated cash. During 1999, the Company used internally generated cash to purchase 2,015,700 shares of its common stock at a cost of $14.7 million. The stock purchase is part of a program authorized by the Company's board of directors to repurchase up to six million shares of common stock on the open market. The shares repurchased will be held as treasury stock until reissued for purposes to be determined by the board of directors. The Company plans to finance these purchases with internally generated cash. 14 Financing activities in 1998 include net proceeds of $144.3 million received by the Company from the offering of $150 million of 9 7/8% senior subordinated notes. The net proceeds were used to repay $32.1 million of outstanding mortgage notes payable and to reduce outstanding revolver borrowings. Excess cash generated from strong Christmas season sales in 1998 was used to repay the $50 million term loan in December 1998. Maturities of the senior subordinated notes are $110 million in 2003 and $150 million in 2008. The $110 million senior subordinated notes may be redeemed prior to maturity, at the Company's option, at 102.25% of par on and after June 15, 1999 and thereafter at prices declining annually to 100% of par on and after June 15, 2001. The $150 million senior subordinated notes may be redeemed prior to maturity, at the Company's option, at 104.938% of par on and after March 15, 2003 and thereafter at prices declining annually to 100% of par on and after March 15, 2006. The Company's board of directors has authorized the repurchase of up to $25 million of either of its outstanding issues of senior subordinated notes by redemption or through the market maker. The timing and amount of purchases will depend primarily on market conditions. Management expects to use internally generated cash for any such repurchases and believes it will be able to secure adequate financing to repay the senior subordinated notes when they mature. Other Matters Inflation, Economic Trends and Seasonality. Although its operations are affected by general economic trends, the Company does not believe that inflation has had a material effect on the results of its operations during the past three years. The Company's business is highly seasonal. See "Seasonality" and Note 15 of Notes to Consolidated Financial Statements for quarterly financial data. Year 2000. To date, the Company has not experienced any significant business disruptions and has had no delays in receiving product from its suppliers as a result of the Year 2000. While the risks associated with Year 2000 readiness peaked with the change of the date from December 31, 1999 to January 1, 2000, there is a risk that a Year 2000 related issue could surface within the year. The Company plans to continue to devote the necessary resources to resolve all significant Year 2000 issues in a timely manner. However, if third parties upon which the Company relies fail to adequately address any of their Year 2000 problems, it could disrupt the Company's business. In the most reasonably likely worst case scenarios the Company could experience delays in receiving product from vendors, shipping product to stores, accessing various types of information or communicating effectively with financial institutions or vendors. The Company's Year 2000 task force has developed a contingency plan, which generally follows an approach similar to the Company's disaster recovery plan should any significant business disruption related to the Year 2000 occur. The task force has also confirmed with the Company's major product vendors, representing 93% of total purchase volume, that their systems are Year 2000 ready. Efforts were made by telephone and the Internet to obtain information from the remaining product vendors who had not responded to the Company's Year 2000 readiness inquiries. The task force also received responses to Year 2000 readiness surveys from the majority of the Company's other business partners and service providers. The Company's Year 2000 readiness process for its internal systems was substantially complete by the third quarter of 1999. Incremental costs of addressing the Year 2000 issue, which have totaled approximately $3 million, were charged to expense as incurred. The Company primarily utilized internal resources for the completion of Year 2000 remediations. The cost for the purchase of any new, Year 2000 compliant system was capitalized in accordance with SOP 98-1. Forward-Looking Statements. This annual report on Form 10-K contains certain forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, relating to the Company's operations that are based on management's current expectations, estimates and projections about the Company and the home entertainment industry. Words such as "believes," "expects," "may," 15 "will," "should," "seeks," "anticipates," "intends" or "plans," either in the positive or negative, or discussions of strategy or intentions are used to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Further, some forward-looking statements are based upon assumptions as to future events that may not prove to be accurate. Examples of factors that could cause actual outcomes and results to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements are: general economic and market conditions; changes in consumer demand and demographics; increased or unanticipated costs or other effects associated with Year 2000 compliance by the Company or its service or supply providers; increases in labor costs; the ability to attract and retain qualified personnel; effects of competition, especially in the retailing of music and video products; possible disruptions or delays in the opening of new stores or the inability to obtain suitable sites for new stores; higher than anticipated store closing or relocation costs; unanticipated increases in merchandise or occupancy costs; the performance of the Company's e-commerce sites; possible increases in shipping rates or interruptions in shipping service; changes in prevailing interest rates and the availability of and terms of financing to fund the anticipated growth of the Company's business and other factors which may be outside of the Company's control. The Company's repurchase of its common stock is also dependent on the availability of excess cash, the attractiveness of prevailing market prices and restrictive covenants by which the Company is bound. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Management undertakes no obligation to update publicly any forward- looking statement for any reason, even if new information becomes available or other events occur in the future. 16 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company holds no derivative instruments and does not engage in hedging activities. Information about fair value of financial instruments is included in Note 12 of Notes to Consolidated Financial Statements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and related notes are included in Item 14 of this report. See Index to Consolidated Financial Statements contained in Item 14. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11. EXECUTIVE COMPENSATION ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by these items of Part III will be set forth in the Proxy Statement under similar captions and is incorporated by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as a part of this report: (1) Consolidated Financial Statements See Index to Consolidated Financial Statements on page 20. (2) Financial Statement Schedules Financial Statement Schedules have been omitted because they are not required or are not applicable, or because the information required either is not material or is included in the Consolidated Financial Statements or related notes. (3) Exhibits See Exhibit Index on pages 39 through 40. 17 (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the fourth quarter of the year ended December 31, 1999. (c) Exhibits See Exhibit Index on pages 39 through 40. (d) Other Financial Statements Not applicable. 18 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MUSICLAND STORES CORPORATION (Registrant) By: /s/ Jack W. Eugster ---------------------------------------- Jack W. Eugster, Chairman of the Board, President and Chief Executive Officer Date: March 24, 2000 -------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Signature Capacity Date --------- -------- ---- Chairman of the Board, President and Chief Executive Officer /s/ Jack W. Eugster (principal executive officer) March 24, 2000 - ------------------------- Jack W. Eugster Vice Chairman, Chief Financial Officer and Director (principal financial and /s/ Keith A. Benson accounting officer) March 24, 2000 - ------------------------- Keith A. Benson /s/ Gilbert L. Wachsman Vice Chairman and Director March 24, 2000 - ------------------------- Gilbert L. Wachsman /s/ Kenneth F. Gorman Director March 24, 2000 - ------------------------- Kenneth F. Gorman /s/ William A. Hodder Director March 24, 2000 - ------------------------- William A. Hodder /s/ Josiah O. Low III Director March 24, 2000 ------------------------ Josiah O. Low III /s/ Terry T. Saario Director March 24, 2000 - ------------------------- Terry T. Saario /s/ Tom F. Weyl Director March 24, 2000 - ------------------------- Tom F. Weyl /s/ Michael W. Wright Director March 24, 2000 - ------------------------- Michael W. Wright 19 MUSICLAND STORES CORPORATION AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page ---- Report of Independent Public Accountants 21 Consolidated Statements of Earnings 22 Consolidated Balance Sheets 23 Consolidated Statements of Cash Flows 24 Consolidated Statements of Stockholders' Equity 25 Notes to Consolidated Financial Statements 26 20 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Musicland Stores Corporation: We have audited the accompanying consolidated balance sheets of Musicland Stores Corporation (a Delaware Corporation) and Subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of earnings, cash flows and stockholders' equity for each of the three years in the period ended December 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Musicland Stores Corporation and Subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. ARTHUR ANDERSEN LLP Minneapolis, Minnesota, January 21, 2000 21 MUSICLAND STORES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS (In thousands, except per share amounts) Years Ended December 31, ------------------------------------------- 1999 1998 1997 ------------- ------------- ------------ Sales............................... $ 1,891,828 $ 1,846,882 $ 1,768,312 Cost of sales....................... 1,200,993 1,190,582 1,153,483 ------------- ------------- ------------ Gross profit.................... 690,835 656,300 614,829 Selling, general and administrative expenses............ 543,518 532,018 529,427 Depreciation and amortization....... 41,276 39,471 39,411 ------------- ------------- ------------ Operating income................ 106,041 84,811 45,991 Interest expense.................... 22,661 30,478 31,720 ------------- ------------- ------------ Earnings before income taxes.... 83,380 54,333 14,271 Income taxes........................ 25,000 16,300 300 ------------- ------------- ------------ Net earnings.................... $ 58,380 $ 38,033 $ 13,971 ============= ============= ============ Basic earnings per common share..... $ 1.65 $ 1.10 $ 0.42 ============= ============= ============ Diluted earnings per common share... $ 1.60 $ 1.04 $ 0.41 ============= ============= ============ See accompanying Notes to Consolidated Financial Statements. 22 MUSICLAND STORES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share amounts) December 31, -------------------------- 1999 1998 ------------ ----------- ASSETS Current assets: Cash and cash equivalents........................ $ 335,693 $ 257,218 Inventories...................................... 444,792 446,710 Deferred income taxes............................ 27,300 15,800 Other current assets............................. 9,162 10,395 ------------ ----------- Total current assets........................... 816,947 730,123 Property, net....................................... 236,550 233,424 Other assets........................................ 10,077 10,093 ------------ ----------- Total Assets................................... $ 1,063,574 $ 973,640 ============ =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable................................. $ 476,191 $ 452,410 Other current liabilities........................ 179,171 154,743 ------------ ----------- Total current liabilities...................... 655,362 607,153 Long-term debt...................................... 258,950 258,871 Other long-term liabilities......................... 39,904 43,634 Commitments and contingent liabilities Stockholders' equity: Preferred stock ($.01 par value; shares authorized: 5,000,000; shares issued and outstanding: none).......................... - - Common stock ($.01 par value; shares authorized: 75,000,000; shares issued: December 31, 1999, 36,187,454; December 31, 1998, 36,041,934)...... 362 360 Additional paid-in capital....................... 261,534 260,608 Accumulated deficit.............................. (128,265) (186,645) Deferred compensation............................ (5,237) (5,998) Common stock subscriptions....................... (4,303) (4,343) Treasury stock, at cost (2,015,700 shares)....... (14,733) - ------------ ----------- Total stockholders' equity..................... 109,358 63,982 ------------ ----------- Total Liabilities and Stockholders' Equity..... $ 1,063,574 $ 973,640 ============ =========== See accompanying Notes to Consolidated Financial Statements. 23 MUSICLAND STORES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Years Ended December 31, ---------------------------------------- 1999 1998 1997 ------------ ------------ ------------ OPERATING ACTIVITIES: Net earnings......................... $ 58,380 $ 38,033 $ 13,971 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization...... 41,276 39,471 39,411 Disposal of property............... 3,886 4,287 4,112 Amortization of debt issuance costs and other................... 1,411 2,630 1,234 Other amortization................. 1,021 986 1,022 Deferred income taxes.............. (11,500) (2,800) - Changes in operating assets and liabilities: Inventories...................... 1,918 3,548 55,835 Other current assets............. 1,233 (1,627) 22,724 Accounts payable................. 23,781 107,288 (61,520) Restructuring reserve............ - - (12,231) Other current liabilities........ 24,768 41,919 14,843 Other assets..................... (1,320) (492) (1,483) Other long-term liabilities...... (3,730) (5,557) (3,305) ------------ ------------ ------------ Net cash provided by operating activities.......... 141,124 227,686 74,613 ------------ ------------ ------------ INVESTING ACTIVITIES: Capital expenditures................. (48,284) (27,153) (10,940) ------------ ------------ ------------ Net cash used in investing activities.......... (48,284) (27,153) (10,940) ------------ ------------ ------------ FINANCING ACTIVITIES: Increase (decrease) in outstanding checks in excess of cash balances... - (12,061) 12,061 Net repayments under revolver........ - - (272,000) Net proceeds from issuance of long-term debt...................... - 144,317 49,500 Principal payments on long-term debt. - (82,933) (11,487) Purchase of treasury stock........... (14,733) - - Proceeds from sale of common stock... 368 3,420 219 ------------ ------------ ------------ Net cash provided by (used in) financing activities...... (14,365) 52,743 (221,707) ------------ ------------ ------------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS...................... 78,475 253,276 (158,034) CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR..................... 257,218 3,942 161,976 ------------ ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF YEAR........................... $ 335,693 $ 257,218 $ 3,942 ============ ============ ============ CASH PAID (RECEIVED) DURING THE YEAR FOR: Interest............................. $ 25,533 $ 24,517 $ 33,035 Income taxes, net.................... 23,845 855 (22,908) See accompanying Notes to Consolidated Financial Statements. 24 MUSICLAND STORES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (In thousands)
Retained Common Total Common Stock Additional Earnings Deferred Stock Treasury Stock- -------------- Paid-in (Accumulated Compen- Sub- Stock, holders' Shares Amount Capital Deficit) sation scriptions At Cost Equity ------ ------ ---------- ------------ --------- ----------- --------- ------------ January 1, 1997............ 34,302 $ 343 $ 253,896 $ (238,649) $ (7,998) $ (4,973) $ 2,619 Net earnings............... 13,971 13,971 Stock options exercised and related tax benefit..... 71 1 275 276 Issuance of warrants....... 890 890 Amortization of deferred compensation and adjustment to fair market value of KSOP shares, net of tax...... 14 1,000 1,014 ------ ------ ---------- ------------ --------- ----------- --------- ------------ December 31, 1997.......... 34,373 344 255,075 (224,678) (6,998) (4,973) 18,770 Net earnings............... 38,033 38,033 Stock options exercised and related tax benefit..... 475 4 3,576 3,580 Net proceeds from exercise of warrants............. 1,194 12 790 802 Amortization of deferred compensation and adjustment to fair market value of KSOP shares, net of tax...... (9) 1,000 991 Common stock subscriptions paid and related tax benefit................. 1,176 630 1,806 ------ ------ ---------- ------------ --------- ----------- --------- ------------ December 31, 1998.......... 36,042 360 260,608 (186,645) (5,998) (4,343) 63,982 Net earnings............... 58,380 58,380 Stock options exercised and related tax benefit..... 91 1 548 549 Net proceeds from exercise of warrants............. 24 - 38 38 Issuance of restricted stock................... 30 1 307 (308) - Amortization of deferred compensation and adjustment to fair market value of KSOP shares, net of tax...... (29) 1,069 1,040 Common stock subscriptions paid and related tax benefit................. 62 40 102 Purchase of treasury stock. (14,733) (14,733) ------ ------ ---------- ------------ --------- ----------- --------- ------------ December 31, 1999.......... 36,187 $ 362 $ 261,534 $ (128,265) $ (5,237) $ (4,303) $(14,733) $ 109,358 ====== ====== ========== ============ ========= =========== ========= ============
See accompanying Notes to Consolidated Financial Statements. 25 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share amounts) 1. Summary of Significant Accounting Policies Basis of Presentation. The consolidated financial statements include the accounts of Musicland Stores Corporation ("MSC") and its wholly-owned subsidiary, The Musicland Group, Inc. ("MGI") and MGI's wholly-owned subsidiaries, after elimination of all material intercompany balances and transactions. MSC and MGI are collectively referred to as the "Company." The Company's foreign operations in the United Kingdom, which were discontinued in 1999, and resulting foreign currency translation adjustments have not been material. The preparation of the accompanying consolidated financial statements required management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates. Business. The Company operates principally in the United States as a specialty retailer of home entertainment products, including prerecorded music and video, books, computer software, video games and related products. The Company's stores operate under two principal strategies: (i) mall based music and video stores ("Mall Stores"), operating predominantly under the trade names Sam Goody and Suncoast Motion Picture Company, and (ii) non-mall based full-media superstores ("Superstores"), operating under the trade names Media Play and On Cue. Because both Mall Stores and Superstores are supported by centralized corporate services and have similar economic characteristics, products, customers and retail distribution methods, the stores are reported as a single operating segment. The Company operates stores in 49 states, the District of Columbia, the Commonwealth of Puerto Rico and the Virgin Islands. At December 31, 1999, the Company operated a total of 1,345 stores, consisting of 1,091 Mall Stores with 4.1 million of total store square footage and 254 Superstores with 4.5 million of total store square footage. The Company formed an e-commerce operation in 1998 and began online retailing in June of 1999. The Company's e-commerce operations have not been significant. Cash and Cash Equivalents. Cash equivalents consist principally of short-term investments with original maturities of three months or less and are recorded at cost, which approximates market value. Restricted cash amounts are not material. The Company maintains cash and cash equivalents at various high quality financial institutions and limits the amount of credit exposure at any one institution. Inventories. Inventories are valued at the lower of cost or market. Cost is determined using the retail inventory method, on the first-in, first-out (FIFO) basis. Property. Buildings and improvements, store fixtures and other property are depreciated using the straight-line method over the estimated useful lives of the respective assets. Leasehold improvements are amortized on a straight-line basis over an estimated useful life of 10 years, which is generally equal to or less than the lease term. Accelerated depreciation methods are used for income tax purposes. When assets are sold or retired, the costs and related accumulated depreciation are removed from the accounts and the resulting gain or loss is included in operations. Depreciation and amortization expense for property was $41,272, $39,459 and $39,370 for the years ended December 31, 1999, 1998 and 1997, respectively. In the event that facts and circumstances indicate that the carrying amount of property may not be recoverable, an evaluation would be performed using such factors as recent operating results, projected cash flows and management's plans for future operations. 26 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 1. Summary of Significant Accounting Policies (Continued) Debt Issuance Costs. Debt issuance costs are amortized over the terms of the related financing using the interest method. Store Opening and Advertising Costs. Store opening and advertising costs are charged to expense as they are incurred. Stock-Based Compensation. Compensation expense for employee and director stock options is measured based on the excess, if any, of the quoted market price of the Company's stock on the date of grant over the amount that must be paid to acquire the stock. Income Taxes. Deferred income taxes are provided for temporary differences between the financial reporting and tax basis of assets and liabilities at currently enacted tax rates. A valuation allowance for deferred income tax assets is recorded when it is more likely than not that some portion or all of the deferred income tax assets will not be realized. Derivative Instruments, Hedging Activities and Other Comprehensive Income. The Company holds no derivative instruments, engages in no hedging activities and has no significant items of other comprehensive income. Earnings Per Common Share. Basic earnings per common share is computed by dividing net earnings by the weighted average number of common shares outstanding during each year. Diluted earnings per common share is computed by dividing net earnings by the weighted average number of common shares outstanding during each year, increased by the effect of the assumed exercise of dilutive stock options and warrants. For purposes of earnings per share computations, shares of common stock under the Company's employee stock ownership plan, established in the third quarter of 1995, are not considered outstanding until they are committed to be released. 2. Weighted Average Common Shares Outstanding A reconciliation of weighted average common shares used in the computation of basic and diluted earnings per common share is as follows: Years Ended December 31, ---------------------------------------- 1999 1998 1997 ------------ ------------ ------------ Weighted average common shares outstanding - basic.......... 35,316,000 34,485,000 33,528,000 Dilutive effect of stock options...................... 686,000 856,000 299,000 Dilutive effect of warrants... 442,000 1,105,000 342,000 ------------ ------------ ------------ Weighted average common shares outstanding - diluted........ 36,444,000 36,446,000 34,169,000 ============ ============ ============ Antidilutive stock options.... 1,969,000 831,000 1,803,000 ============ ============ ============ Antidilutive stock options had an exercise price greater than the average market price during the year. 27 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 3. Long-term Debt Long-term debt consists of the following: December 31, -------------------------- 1999 1998 ------------ ------------ Revolver borrowings, variable rates........ $ - $ - 9% senior subordinated notes, unsecured, due 2003.................................. 110,000 110,000 9 7/8% senior subordinated notes, unsecured, due 2008....................... 148,950 148,871 ------------ ------------ Total long-term debt...................... $ 258,950 $ 258,871 ============ ============ In September 1999, the Company cancelled its revolving credit facility, which would have expired in October 1999, and replaced it with a standby $25,000 secured facility. The new facility is collateralized by inventory in the Company's Media Play stores and distribution facility in Franklin, Indiana, which had an aggregate carrying value, net of certain valuation reserves, of $172,663 at December 31, 1999. The maximum available under the facility requires a minimum inventory in the aggregate of $150,000 at the specified locations and is reduced by outstanding letters of credit. The facility expires in September 2002 and is renewable annually thereafter. The Company is required to pay facility costs including an unused line fee and charges for outstanding letters of credit. The Company also paid facility costs on the former revolving credit facility. The Company had no revolver borrowing activity during 1999 under either facility. For the years ended December 31, 1998 and 1997, the weighted average interest rates, excluding facility costs, on revolver borrowings were 7.78% and 7.37%, respectively. Total facility costs incurred for the years ended December 31, 1999, 1998 and 1997 were $576, $1,099 and $1,549, respectively. In April 1998, the Company completed an offering of $150,000 of 9 7/8% senior subordinated notes with an original issue discount of $1,183. The net proceeds to the Company from the offering, after discounts, commissions and other offering costs were $144,317 and were used to repay $32,076 of outstanding mortgage notes payable and $112,241 of outstanding revolver borrowings. The Company has options to redeem the senior subordinated notes prior to maturity. The 9% issue may be redeemed at 102.25% of par on and after June 15, 1999 and thereafter at prices declining annually to 100% of par on and after June 15, 2001. The 9 7/8% issue may be redeemed at 104.938% of par on and after March 15, 2003 and thereafter at prices declining annually to 100% of par on and after March 15, 2006. The Company's board of directors has authorized the repurchase of up to $25,000 of either of its outstanding issues of senior subordinated notes by redemption or through the market maker. The indentures related to the senior subordinated notes contain financial covenants which limit, among other things, the ability of the Company to pay dividends, make certain other restricted payments or investments, incur additional indebtedness, dispose of assets, create liens and enter into certain transactions with related parties. The Company was in compliance with all covenants at December 31, 1999. 28 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 4. Income Taxes Income taxes consist of: Years Ended December 31, --------------------------------------- 1999 1998 1997 ----------- ----------- ----------- Current: Federal................... $ 30,600 $ 16,700 $ 100 State, local and other.... 5,900 2,400 200 ----------- ----------- ----------- 36,500 19,100 300 ----------- ----------- ----------- Deferred: Federal................... (10,300) (1,800) 1,400 State, local and other.... (1,200) (1,000) (1,400) ----------- ----------- ----------- (11,500) (2,800) - ----------- ----------- ----------- Total income taxes........... $ 25,000 $ 16,300 $ 300 =========== =========== =========== The Company's effective income tax rates differ from the federal statutory rate as follows: Years Ended December 31, --------------------------------------- 1999 1998 1997 ----------- ----------- ----------- Federal statutory tax rate... 35.0% 35.0% 35.0% State and local income taxes, net of federal benefit.... 5.0 1.7 (5.5) Valuation allowance.......... (10.7) (7.0) (32.6) Other........................ .7 .3 5.2 ----------- ----------- ----------- Effective income tax rate. 30.0% 30.0% 2.1% =========== =========== =========== Components of deferred income taxes are as follows: December 31, ------------------------- 1999 1998 ----------- ----------- Net current deferred tax asset: Capitalized inventory costs............. $ 5,410 $ 5,540 Inventory valuation..................... 10,774 9,609 Compensation related.................... 4,399 3,542 Store closings.......................... 2,524 3,877 Other accruals.......................... 2,675 2,388 Other, net.............................. 1,518 644 ----------- ----------- Total current deferred income taxes ....... 27,300 25,600 Valuation allowance..................... - (9,800) ----------- ----------- Net current deferred income taxes.......... $ 27,300 $ 15,800 =========== =========== 29 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 4. Income Taxes (Continued) December 31, --------------------------- 1999 1998 ------------ ------------ Net noncurrent deferred tax asset: Depreciation.......................... $ (10,106) $ (12,453) Rent expense.......................... 14,721 16,418 Amortization of intangible assets..... (1,960) (2,010) Net pension liability................. 1,162 1,042 Other, net............................ 283 203 ------------ ------------ Total noncurrent deferred income taxes... 4,100 3,200 Valuation allowance................... (4,100) (3,200) ------------ ------------ Net noncurrent deferred income taxes..... $ - $ - ============ ============ The Company's management believes it is more likely than not that the deferred income tax assets, net of valuation allowances, will be realized based on current income tax laws and assessments of taxable income within the carryback or carryforward periods for each year. However, the amount of deferred tax assets considered realizable could be adjusted in the future if estimates of taxable income are revised. 5. Employee Benefit Plans The Company has a non-contributory, defined benefit pension plan covering certain employees. Retirement benefits are a function of both years of service and the level of compensation. The Company's funding policy is to make an annual contribution equal to or exceeding the minimum required by the Employee Retirement Income Security Act of 1974. Effective December 31, 1991, participation in the pension plan was frozen for employees hired on or after July 1, 1990. The Company has been evaluating on a year to year basis the continuation of benefit accruals under the pension plan. Accordingly, the projected benefit obligation approximated the accumulated benefit obligation at December 31, 1999 and 1998. In October 1998, the Company established a non-qualified, unfunded Supplemental Executive Retirement Plan ("SERP") to provide certain executives with pension benefits in excess of limits imposed by federal tax law. The annual benefit amount is a function of both years of service and the level of compensation. For the years ended December 31, 1999 and 1998, pension expense for the SERP was $310 and $136, respectively. The benefit obligation for the SERP at December 31, 1999 and 1998 was $838 and $1,366, respectively. Changes in actuarial assumptions in 1999 reduced the benefit obligation at December 31, 1999 by $789. 30 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 5. Employee Benefit Plans (Continued) The funded status of the pension plans and the related accrued pension cost, using a measurement date of September 30, are as follows: December 31, ----------------------- 1999 1998 ---------- ---------- Change in benefit obligation: Benefit obligation at beginning of year... $ 13,931 $ 10,457 Service cost.............................. 755 513 Interest cost............................. 982 847 Effect of assumption change............... (2,240) 1,099 Unrecognized prior service cost from inception of the SERP................... - 1,366 Actuarial loss (gain)..................... (524) 175 Benefits paid............................. (549) (526) ---------- ---------- Benefit obligation at end of year............ 12,355 13,931 ---------- ---------- Change in plan assets: Fair value of plan assets at beginning of year................................. 9,979 10,925 Actual return on plan assets.............. 919 (972) Employer contribution..................... 562 552 Benefits paid............................. (549) (526) ---------- ---------- Fair value of plan assets at end of year..... 10,911 9,979 ---------- ---------- Funded status................................ (1,444) (3,952) Unrecognized gains........................ (2,889) (22) Unamortized prior service cost............ 1,180 1,278 ---------- ---------- Accrued pension cost......................... $ (3,153) $ (2,696) ========== ========== The components of net pension expense are as follows: Years Ended December 31, ------------------------------------- 1999 1998 1997 ----------- ---------- ---------- Service cost.................... $ 755 $ 513 $ 411 Interest cost................... 982 847 748 Expected return on plan assets.. (835) (916) (754) Amortization of prior service cost and gain................. 68 (6) (5) ----------- ---------- ---------- Net pension expense.......... $ 970 $ 438 $ 400 =========== ========== ========== Assumptions used in computing pension data are as follows: December 31, ----------------------- 1999 1998 ---------- ---------- Discount rate for benefit obligations....... 8.00 % 7.00 % Expected long-term rate of return on plan assets.................................... 8.50 8.50 Rate of compensation increase for the SERP obligation................................ 5.50 5.50 31 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 5. Employee Benefit Plans (Continued) The Company established a defined contribution plan in 1992 for employees not covered by the pension plan. The Company has a 401(k) plan, which is based on contributions made through payroll deductions and partially matched by the Company, covering substantially all employees. The Company's matching contribution to the 401(k) plan is paid in stock of MSC under an employee stock ownership plan ("KSOP"). The Company may also, at its discretion, make a supplemental cash matching contribution. In 1995, to establish the KSOP, the Company made a loan to the KSOP trust for the purchase of 1,042,900 shares of the Company's common stock in the open market. In exchange, the Company received a note, the balance of which is recorded as deferred compensation and is reflected as a reduction of stockholders' equity. The Company recognizes compensation expense during the period the match is earned equal to the expected market value of the shares to be released to settle the match liability. The number of KSOP shares committed to be released was 104,290 at December 31, 1999 and 1998. At December 31, 1999 and 1998, the number of shares held in suspense was 521,450 and 625,740, respectively, and the market value of the shares held in suspense was $4,400 and $9,621, respectively. Expenses for the defined contribution and 401(k) plans for the years ended December 31, 1999, 1998 and 1997 totaled $1,529, $1,332 and $1,749, respectively. Expenses for postemployment benefits were not material. The Company does not offer or provide postretirement benefits other than pensions to its employees. 6. Stock Plans The Company's stock plans authorize the grant of stock options and other stock awards to officers, other employees and outside directors. Stock options are generally exercisable over a period not to exceed 10 years after the grant date. As stock options have been granted at exercise prices not less than the fair market value of the Company's common stock on the date of the grant, no compensation expense has been recognized in connection with the grant of stock options. In 1999, the Company issued a restricted stock award of 30,000 shares to one of its officers. The shares are restricted from sale or transfer, with such restrictions lapsing in three equal annual installments beginning in 2001. The issuance of the restricted stock resulted in compensation expense equal to the fair market value of the common stock at the date of the award, which is being amortized over the period the restricted shares vest. The unamortized deferred compensation expense is a reduction of stockholders' equity. 32 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 6. Stock Plans (Continued) Stock option activity is as follows: 1999 1998 1997 --------------------- ------------------- ------------------ Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price ----------- -------- ---------- -------- ---------- -------- Outstanding at beginning of year............ 3,513,414 $ 8.86 2,935,908 $ 6.20 2,681,294 $ 7.33 Granted........... 677,350 10.60 1,193,775 13.65 734,650 3.16 Exercised......... (91,227) 3.18 (475,292) 4.19 (70,636) 3.10 Canceled.......... (86,272) 8.37 (140,977) 9.57 (409,400) 8.67 ----------- ----------- ----------- Outstanding at end of year..... 4,013,265 9.29 3,513,414 8.86 2,935,908 6.20 =========== =========== =========== Options exercisable at year end..... 1,383,106 955,997 1,084,642 =========== =========== =========== Options available for future grant.... 370,641 966,052 341,500 =========== =========== =========== Stock options outstanding and exercisable at December 31, 1999 are as follows: Stock Options Stock Options Outstanding Exercisable ------------------------------ --------------------- Weighted Average Remaining Weighted Weighted Contractual Average Average Number Life Exercise Number Exercise Range of Exercise Prices Outstanding (Years) Price Exercisable Price - ------------------------- ----------- ------- -------- ----------- --------- $ 1.5000 to $ 2.5625.... 899,504 6.9 $ 1.947 358,524 $ 2.069 3.0000 to 4.5000.... 344,866 4.6 3.564 269,534 3.716 6.0625 to 10.3125.... 536,077 7.3 7.647 185,311 7.993 10.5625 to 14.8125.... 1,347,118 7.3 11.822 429,537 13.696 15.0625 to 21.7500.... 885,700 7.8 16.124 140,200 21.750 ----------- ----------- 4,013,265 1,383,106 =========== =========== Pro forma data using the fair value of stock options is as follows: 1999 1998 1997 ------------------ ----------------- ---------------- As Pro As Pro As Pro Reported Forma Reported Forma Reported Forma --------- -------- -------- -------- -------- ------- Net earnings........... $58,380 $56,030 $38,033 $37,002 $13,971 $13,168 Earnings per common share: Basic......... $ 1.65 $ 1.59 $ 1.10 $ 1.07 $ .42 $ .39 Diluted....... 1.60 1.54 1.04 1.02 .41 .39 33 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 6. Stock Plans (Continued) The fair value of each stock option was estimated on the date of grant using the Black-Scholes option pricing model. The pro forma data may not be representative of the effects on net earnings in future years because pro forma compensation expense related to grants made prior to 1996 is not considered, stock options vest over several years and additional stock options may be granted in the future. Fair value and assumptions were as follows: 1999 1998 1997 ----------- ----------- ----------- Weighted average fair value of options granted....................... $7.37 $9.53 $2.00 Risk-free interest rate................ 6.0% 5.2% 6.3% Expected stock price volatility........ 66% 69% 56% Expected dividend yield................ - - - Expected life of stock options......... 7 years 7 years 7 years 7. Common Stock On August 25, 1988, certain members of current and former management of the Company purchased common stock with restrictions ("Restricted Stock") at $0.0025 per share. Although holders of Restricted Stock have voting and dividend rights, no Restricted Stock is transferable until the holder has paid the Company the balance of the subscription price of $2.4975 or $4.4975 per share. After August 25, 2003, the Company may, at its option, buy back the outstanding shares of Restricted Stock for $0.0025 per share. At December 31, 1999 and 1998, the amount of subscriptions due for Restricted Stock outstanding of 1,724,204 shares and 1,740,204 shares, respectively, is reflected as a reduction of stockholders' equity. In connection with a term loan agreement completed in June 1997, the Company issued warrants for the purchase of 1,822,087.16 shares of common stock at $1.5625 per share. The fair value of the warrants at the time of issuance of $890 was recorded as additional debt issuance costs and an increase to additional paid-in capital. During 1999 and 1998, 24,293 and 1,194,050 shares of common stock, respectively, were issued in connection with the exercise of warrants and a total of 0.97 and 84,660.70 warrants, respectively, were canceled for cashless exercises and fractional shares. In January 2000, 417,220 shares of common stock were issued in connection with the cashless exercise of the remaining warrants. A total of 101,862.49 warrants were canceled for the cashless exercise and fractional shares. The Company's board of directors has authorized the repurchase of up to 6,000,000 shares of common stock on the open market. The shares repurchased will be held as treasury stock until reissued for purposes to be determined by the board of directors. During 1999, the Company purchased 2,015,700 shares at an aggregate cost of $14,733. 34 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 8. Preferred Stock Purchase Rights In March 1995, the Company's Board of Directors declared a dividend of one preferred share purchase right ("Right") per share for each outstanding share of common stock pursuant to a stockholder rights plan. The Rights will be distributed 20 days after a person or group (an "Acquiring Person") either acquires beneficial ownership of, or commences a tender or exchange offer for, 17.5% or more of the Company's outstanding common stock. Each Right then may be exercised to purchase one one-hundredth of a share of Series A Junior Participating Preferred Stock, $0.01 par value (the "Preferred Shares"), at an exercise price of $70.00 per one-hundredth Preferred Share. Thereafter, upon the occurrence of certain events, the Rights entitle holders other than the Acquiring Person to acquire common stock having a value of twice the exercise price of the Rights. Alternatively, upon the occurrence of certain other events, the rights would entitle holders other than the Acquiring Person to acquire common stock of the Acquiring Person having a value of twice the exercise price of the Rights. The Rights may be redeemed by the Company at a redemption price of $.001 per Right at any time until the 20th day after a public announcement of an acquisition of 17.5% or more of the common stock of the Company. The Rights expire on March 20, 2005. 9. Commitments Most of the Company's retail stores are under operating leases with various remaining terms through 2016. The leases have noncancelable terms that generally range from three to 20 years and many include renewal options for additional periods. Certain store leases provide the Company with an early cancellation option if sales for a designated period do not reach a specified level as defined in the lease. Most of the store leases contain escalation clauses and require payment of real estate taxes, utilities, common area maintenance costs and contingent rentals based on percentages of sales in excess of specified minimums. Certain store leases contain provisions restricting assignment, merger, change of control or transfer. The Company also leases certain office and storage facilities, store fixtures and equipment, computers and automobiles under operating leases. Future minimum payments under operating leases with noncancelable terms in excess of one year at December 31, 1999 are: 2000, $125,994; 2001, $111,526; 2002, $96,179; 2003, $80,999; 2004, $62,679 and thereafter, $235,968. Total rent expense consists of the following: Years Ended December 31, --------------------------------------- 1999 1998 1997 ----------- ----------- ----------- Minimum cash rents............ $ 151,918 $ 149,432 $ 152,343 Straight-line recognition of leases with scheduled rent increases.............. (2,936) (2,676) (910) Percentage rents.............. 2,231 2,169 2,143 ----------- ----------- ----------- Total rent expense......... $ 151,213 $ 148,925 $ 153,576 =========== =========== =========== 35 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 10. Litigation The Company is a party to various claims, legal actions and complaints arising in the ordinary course of business. It is the opinion of management that the ultimate resolution of these matters will not have a material adverse effect on the financial position or results of operations of the Company. 11. Related Party Transactions Donaldson, Lufkin & Jenrette Securities Corporation ("DLJSC"), a wholly owned subsidiary of Donaldson, Lufkin & Jenrette, Inc. ("DLJ"), acts as a market maker for the Company's senior subordinated notes. A Managing Director of DLJSC is a member of the Company's board of directors. In 1998, DLJSC received compensation as underwriter of approximately $2,322 in connection with the Company's offering of the 9 7/8% senior subordinated notes. 12. Fair Value of Financial Instruments The carrying amounts reported in the consolidated balance sheets at December 31, 1999 and 1998 for cash and cash equivalents, other current assets, accounts payable and other current liabilities approximate fair value because of the immediate or short-term maturity of these financial instruments. The carrying amount of long-term debt and the related fair value, based on quoted market prices, are as follows: December 31, 1999 December 31, 1998 ------------------ ------------------ Carrying Fair Carrying Fair Amount Value Amount Value -------- -------- -------- -------- 9% senior subordinated notes.. $110,000 $105,600 $110,000 $104,885 9 7/8% senior subordinated notes........................ 148,950 138,945 148,871 139,860 13. Supplemental Balance Sheet Information Property consists of the following, at cost: December 31, --------------------------- 1999 1998 ------------ ------------ Land and land improvements............... $ 10,003 $ 10,003 Buildings................................ 32,568 32,242 Leasehold improvements................... 250,064 237,596 Store fixtures and other property........ 174,891 157,508 ------------ ------------ 467,526 437,349 Less accumulated depreciation and amortization........................... (230,976) (203,925) ------------ ------------ Property, net......................... $ 236,550 $ 233,424 ============ ============ 36 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 13. Supplemental Balance Sheet Information (Continued) Other current liabilities consist of the following: December 31, --------------------------- 1999 1998 ------------ ------------ Payroll and related taxes and benefits.... $ 31,157 $ 29,003 Gift certificates payable................. 57,613 46,384 Sales taxes payable....................... 20,380 19,823 Accrued store expenses and other.......... 37,733 39,559 Income taxes payable...................... 32,288 19,974 ------------ ------------ Total other current liabilities........ $ 179,171 $ 154,743 ============ ============ Other long-term liabilities consist of the following: December 31, --------------------------- 1999 1998 ------------ ------------ Straight-line recognition of leases with scheduled rent increases................ $ 25,893 $ 29,193 Deferred rent credits..................... 10,482 11,165 Other..................................... 3,529 3,276 ------------ ------------ Total other long-term liabilities...... $ 39,904 $ 43,634 ============ ============ 14. Supplemental Cash Flow Information Investing and financing activities for the year ended December 31, 1997 exclude the addition of certain distribution facility property, which had an original cost of approximately $30,000, and the related mortgage note payable. The Company had an operating lease for the distribution facility property that provided secured financing to the lessor, a special purpose entity, through a third party lender. The property and related mortgage note payable, which was repaid in 1998, were recorded on the Company's Consolidated Balance Sheet in 1997 after an amendment to the lease required consolidation of the special purpose entity. 37 MUSICLAND STORES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except per share amounts) 15. Quarterly Financial Data (Unaudited) Basic Diluted Earnings Earnings (Loss) (Loss) Net per per Common Stock Price Gross Earnings Common Common ------------------ Sales Profit (Loss) Share Share High Low ---------- --------- --------- ------- ------- --------- ------- 1999: First.... $ 401,797 $ 143,577 $ 1,374 $ .04 $ .04 $15.2500 $8.7500 Second... 381,059 143,128 1,499 .04 .04 12.0625 8.3750 Third.... 386,337 145,971 728 .02 .02 11.1875 8.5000 Fourth... 722,635 258,159 54,779 1.58 1.53 9.5625 6.7500 ---------- --------- --------- ------- ------- Total.. $1,891,828 $ 690,835 $ 58,380 $ 1.65 $ 1.60 ========== ========= ========= ======= ======= 1998: First.... $ 392,405 $ 136,753 $ (3,551) $(0.11) $(0.11) $12.0625 $6.5000 Second... 367,203 135,805 (4,662) (0.14) (0.14) 15.1250 9.8750 Third.... 387,368 137,795 (3,779) (0.11) (0.11) 16.1875 9.1250 Fourth... 699,906 245,947 50,025 1.42 1.36 18.0000 8.5000 ---------- --------- --------- ------- ------- Total.. $1,846,882 $ 656,300 $ 38,033 $ 1.10 $ 1.04 ========== ========= ========= ======= ======= The totals of basic and diluted earnings (loss) per common share by quarter may not equal the totals for the year as there are changes in the weighted average number of common shares outstanding each quarter and basic and diluted earnings (loss) per common share are calculated independently for each quarter. 38 EXHIBIT INDEX Exhibit No. Description - ----------- --------------------------------------------------------------- 3.1 - Restated Certificate of Incorporation of MSC, as amended (incorporated by reference to Amendment No. 1 to MSC's Form S-1 Registration Statement covering common stock filed with the Commission on July 20, 1990, File No. 33-35774) 3.2 - By-laws of MSC, as amended (incorporated by reference to MSC's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998 filed with the Commission on November 13, 1998, File No. 1-11014) 4.1(a) - Senior Subordinated Note Indenture, including form of Note, dated as of June 15, 1993 among MGI, MSC and Bank One Columbus, N.A. as Successor Trustee to Harris Trust and Savings Bank (incorporated by reference to Amendment No. 1 to MGI's Registration Statement covering 9% Senior Subordinated Notes filed with the Commission on June 3, 1993, File No. 33-62928) 4.1(b) - First Supplemental Indenture dated as of June 13, 1997 to the Senior Subordinated Note Indenture (incorporated by reference to MSC's Quarterly report on Form 10-Q for the quarterly period ended June 30, 1997 filed with the Commission on August 13, 1997, File No. 1-11014) 4.2 - Amended and Restated Rights Agreement dated as of March 13, 2000, between MSC and Norwest Bank Minnesota, National Association, Rights Agent (incorporated by reference to Amendment No. 1 to MSC's Form 8-A Exchange Act Registration Statement covering Preferred Share Purchase Rights filed with the Commission on March 15, 2000) 4.3 - Indenture including Form of Note dated as of April 6, 1998 between MGI, as Issuer, MSC, as Guarantor, and Bank One, N.A., as Trustee (incorporated by reference to MGI's Registration Statement on Form S-4 covering 9 7/8% Senior Subordinated Notes initially filed with the Commission on April 24, 1998, File No. 333-50951) 4.4(a) - Loan and Security Agreement dated as of September 29, 1999 by and between Congress Financial Corporation (Central) as Lender and The Musicland Group, Inc. as Borrower (incorporated by reference to MSC's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1999 filed with the Commission on November 12, 1999, File No. 1-11014) 4.4(b) - Form of Guarantee on behalf of Musicland Stores Corporation, Musicland Retail, Inc. and Media Play, Inc. dated as of September 29, 1999 in favor of Congress Financial Corporation (Central) (incorporated by reference to MSC's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1999 filed with the Commission on November 12, 1999, File No. 1-11014) 4.4(c) - Form of General Security Agreement on behalf of Musicland Retail, Inc. and Media Play, Inc. dated as of September 29, 1999 in favor of Congress Financial Corporation (Central) (incorporated by reference to MSC's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1999 filed with the Commission on November 12, 1999, File No. 1-11014) *10.1(a) - Form of Subscription Agreement among MSC and the Management Investors (incorporated by reference to Amendment No. 2 to MSC's Form S-1 Registration Statement covering Senior Subordinated Notes filed with the Commission on August 17, 1988, File No. 33-22058) *10.1(b) - Form of amendment to Management Subscription Agreement (incorporated by reference to Amendment No. 1 to MSC's Form S-1 Registration Statement covering common stock filed with the Commission on July 20, 1990, File No. 33-35774) *10.2 - Form of Registration Rights Agreement among MSC, DLJ and the Management Investors (incorporated by reference to MSC's Annual Report on Form 10-K for the year ended December 31, 1993 filed with the Commission on March 25, 1994, File No. 1-11014) 39 Exhibit No. Description - ----------- --------------------------------------------------------------- *10.3 - 1988 Stock Option Plan, as amended (incorporated by reference to Amendment No. 1 to MSC's Form S-1 Registration Statement covering common stock filed with the Commission on July 20, 1990, File No. 33-35774) *10.4 - Stock Option Plan for Unaffiliated Directors of MSC, as amended (incorporated by reference to MSC's Quarterly report on Form 10-Q for the quarterly period ended June 30, 1997 filed with the Commission on August 13, 1997, File No. 1-11014) *10.5 - 1992 Stock Option Plan (incorporated by reference to Amendment No. 4 to MSC's Form S-1 Registration Statement covering common stock filed with the Commission on January 27, 1992, File No. 33-35774) *10.6 - Musicland Stores Corporation 1994 Employee Stock Option Plan (incorporated by reference to MSC's Annual Report on Form 10-K for the year ended December 31, 1994 filed with the Commission on March 27, 1995, File No. 1-11014) *10.7 - Musicland Stores Corporation 1998 Stock Incentive Plan (incorporated by reference to MSC's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1998 filed with the Commission on August 12, 1998, File No. 1-11014) *10.8(a) - Management Incentive Plan dated as of January 1, 1999 (incorporated by reference to MSC's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 filed with the Commission on May 13, 1999, File No. 1-11014) *10.8(b) - Alternate Incentive Plan for Designated Senior Officers (incorporated by reference to MSC's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1999 filed with the Commission on August 12, 1999, File No. 1-11014) *10.9 - Three-Year Cycle Long Term Incentive Plan (incorporated by reference to MSC's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1999 filed with the Commission on May 13, 1999, File No. 1-11014) *10.10 - Executive Officer Salary Continuation Plan dated as of March 10, 1997 (incorporated by reference to MSC's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1997 filed with the Commission on May 14, 1997, File No. 1-11014) *10.11 - The Musicland Group, Inc. Supplemental Executive Retirement Plan adopted as of October 26, 1998 (incorporated by reference to MSC's Annual Report on Form 10-K for the year ended December 31, 1998 filed with the Commission on March 25, 1999, File No. 1-11014) *10.12 - Form of Employment Agreement for Chief Executive Officer, as of July 26, 1999 *10.13 - Form of Employment Agreement for Other Senior Executive Officers, as of July 26, 1999 11 - Statement re computation of per share earnings (requirements met by Note 1 and Note 2 of Notes to Consolidated Financial Statements) 21 - Subsidiaries of MSC 23 - Consent of Arthur Andersen LLP 27 - Financial Data Schedule 99 - Form 11-K for The Musicland Group's Capital Accumulation Plan (to be filed by amendment) - -------------------------------------------- * Indicates Management Contract or Compensatory Plan or Agreement required to be filed as an Exhibit to this form 40 EX-10.12 2 FORM OF EMPLOYMENT AGREEMENT FOR CEO FORM OF EMPLOYMENT AGREEMENT FOR CHIEF EXECUTIVE OFFICER This Agreement is made as of July 26, 1999 by and between The Musicland Group, Inc., a Delaware corporation (the "Company"), Musicland Stores Corporation, a Delaware corporation (the "Parent") and _______________ (the "Executive"). WHEREAS the Company and the Parent have employed Executive pursuant to the terms of Employment and Change of Control Agreements dated August 25, 1988, as amended January 22, 1992 and November 27, 1995 (the "Prior Agreements"); WHEREAS the Company and the Parent desire to continue to employ Executive in accordance with the terms and conditions stated in this Agreement, which shall replace and supersede the Prior Agreements; and WHEREAS Executive desires to continue employment pursuant to the terms and conditions of this Agreement and acknowledges that this Agreement replaces and supersedes the Prior Agreements; NOW, THEREFORE, for the consideration described below, the parties agree as follows: I. EMPLOYMENT 1.1 Employment As Executive. During the Period of Employment described in Section 1.3 below, the Company and the Parent hereby agree to employ Executive as Chairman and Chief Executive Officer of the Company and the Parent, unless terminated earlier pursuant to Article III of this Agreement. Executive accepts such employment pursuant to the terms of this Agreement. Executive shall be responsible for managing the Company and the Parent and shall perform such duties and responsibilities as may be determined from time to time by the Boards of Directors of the Company and the Parent, which shall be consistent with his position as a Chief Executive Officer of the Company and the Parent. The Company and the Parent shall nominate and use their best efforts to secure the election of Executive as a member of the Boards of Directors of the Company and the Parent, and Executive shall serve as Director of the Company and the Parent without additional compensation other than as provided herein. Executive shall not be required to perform his duties hereunder for more than 60 working days in any year, or for more than 21 consecutive days at any one time, at any office located in any place other than the Minneapolis, Minnesota metropolitan area. 1.2 Exclusive Services. Executive agrees to devote his full time, attention, and energy to performing his duties and responsibilities to the Company and the Parent 1 under this Agreement during the period that this Agreement is in effect, except for reasonable vacations, illness, or incapacity, provided that nothing in this Agreement shall preclude Executive from devoting time during reasonable periods required for (i) serving as a director or member of a committee of any organization or company involving no conflict of interest with the Company or the Parent; (ii) delivering lectures, fulfilling speaking engagements; (iii) engaging in charitable and community activities; and (iv) managing personal or family finances and investments; provided that such activities do not materially interfere with the performance of his duties hereunder. 1.3 Period of Employment. The Period of Employment shall be determined as follows: (a) Except as provided in subsection (b) in the event of a Change of Control as defined in Section 4.1, the Period of Employment hereunder shall be from July 26, 1999 through July 26, 2002, subject to extension or termination as hereinafter provided. The then-existing Period of Employment shall be automatically extended by one additional year (to the next subsequent July 26, but in no event shall the Period of Employment extend beyond the first day of the month next succeeding the month in which Executive attains age 65) unless the Company shall deliver to Executive or Executive shall deliver to the Company written notice at least 30 months prior to the expiration of the then-existing Period of Employment that the Period of Employment will not be extended. In such case, the Period of Employment will end at the expiration of the then-existing Period of Employment hereunder, including any previous extension, and shall not be further extended except by agreement of the Company and Executive. (For example, in order to avoid the automatic extension of the expiration of the Period of Employment from July 26, 2002 to July 26, 2003, notice must be given by January 26, 2000.) (b) If upon an event constituting a Change of Control the remaining period in the then-existing Period of Employment (as determined under subsection (a) above) is less than 36 months, the Period of Employment shall be extended so that the expiration is on the last business day of the 36th calendar month following such Change of Control. No adjustment will be made if the remaining period is more than 36 months at the time of the Change in Control. In either case, the automatic one year extensions shall continue to apply as provided in subsection (a) above. (For example, if a Change in Control occurs January 1, 2000, the remaining period in the Period of Employment (ending July 26, 2002) is less than 36 months and would be extended to expire January 1, 2003. In order to avoid automatic extension of the adjusted Period of Employment to January 1, 2004, notice must be given by July 1, 2000.) 2 (c) The Period of Employment shall continue until the expiration of all automatic extensions effected as aforesaid, unless and until it sooner ceases or is terminated as provided in Article III. II. COMPENSATION, BENEFITS, AND PERQUISITES 2.1 Salary. During the Period of Employment, the Company shall pay Executive a base salary at the annual rate of $___________ commencing January 1, 1999. The base salary shall be payable in equal bi-weekly installments. The Compensation Committee of the Board of Directors of the Company may review the salary periodically and may in its sole discretion increase it to reflect performance and other factors in accordance with the Company's customary procedures and practices regarding the salaries of senior officers. 2.2 Disability Pay. In the event of the disability of Executive (within the meaning of the Company's disability benefit plans in effect at the time of Executive's disability), the obligation of the Company to make payments of salary under Section 2.1 shall cease as of the date Executive begins receiving benefits under the Company's short-term salary continuation plan, and Executive shall be entitled to benefits under the Company's disability benefit plans in accordance with the terms of such plans. Notwithstanding the terms of this Agreement, the Company retains the right to amend, reduce or terminate its disability benefit plans at any time so long as such amendments, reductions or terminations apply equally to all senior officers. 2.3 Employee Benefits. Executive shall be entitled to the benefits and perquisites which the Company generally provides to its other senior officers under the applicable Company plans and policies. Executive's participation in such benefit plans shall be on the same basis as applies to other senior officers of the Company and subject to the terms of applicable law, plan documents, and insurance policies. Executive shall pay contributions, if any, which are generally required of the Company's senior officers in order to receive any such benefits. Specifically, Executive shall: (a) participate in the Company's Management Incentive Plan and Long-Term Incentive Plan, or, if applicable, the shareholder approved Alternate Incentive Plan for Designated Senior Officers (the "Alternate Plan"); (b) be considered by the Compensation Committee of the Board of Directors for possible grants of stock options, stock appreciation rights, restricted stock and deferred stock awards, under the Company's stock option plans, stock incentive plans, or any similar plan adopted by the Company or the Parent during the Period of Employment; (c) participate to the permitted extent he wishes in the Company's Capital Accumulation Plan; 3 (d) participate in the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan; (e) participate in the Company's death benefit plans (consisting of its Group Life Insurance Plan, and accidental death and dismemberment insurance); (f) participate in the Company's disability benefit plans (consisting of its short-term salary continuation, short-term disability and long-term disability plans); (g) participate in its senior officer medical, dental, health and welfare plans; (h) participate in equivalent successor plans of the Company for which officers are eligible; and (i) be provided with one golf membership paid for by the Company regardles if any other senior officers are provided such perquisite. Notwithstanding the foregoing, nothing in this agreement shall preclude any amendment or termination by the Company of any employee benefit plan or practice (other than (i) above), provided such amendment or termination is applicable to all of the Company's senior officers generally; provided, however, that in the event of a Change of Control as defined in Section 4.1 and through the Period of Employment described in Section 1.3(b), Executive shall be entitled to perquisites and benefits at least as favorable as those to which Executive was entitled immediately prior to the Change of Control, and to the extent such perquisites or benefits are not payable or provided under any such plan of the Company by reason of the amendment or termination thereof, the Company itself shall pay or provide therefor. 2.4 Incentive Compensation Following Change of Control. In the event of a Change of Control as defined in Section 4.1 and through the Period of Employment described in Section 1.3(b), Executive shall receive an annual award under the Company's Management Incentive Plan, or, if applicable, the Alternate Plan, or a plan with substantially equivalent incentives and benefits that may be adopted by the Company, for each calendar year, or portion thereof, during the Period of Employment, which shall be payable as soon as practicable after the end of such calendar year and shall be equal to a percentage of Executive's base salary for such calendar year. Such percentage shall be the greater of (i) 60% or (ii) the average of the percentages, for each of the three preceding calendar years (or such lesser number of years that the Executive has been a participant in the plan), that result from dividing Executive's annual award under the Management Incentive Plan (or its successor) for such year by Executive's annual base salary for that year. Furthermore, Executive shall continue to be a full participant in the performance awards of the Company's Long-Term Incentive Plan, or, if applicable, the Alternate Plan, and any other long-term incentive plans of the Company, and any and all executive incentive plans in which executives of the 4 Company participate that are in effect immediately prior to a Change of Control, or any amended or successor plans with at least as favorable terms that may be substituted and that may hereafter be adopted, including, without limitation, any plan relating to stock options, stock appreciation rights, restricted stock and deferred stock awards, or equivalent successor plans that may be adopted by the Company with at least the same reward opportunities that have heretofore been provided and with such improvements in such plans or other plans as may from time to time be made in accordance with the present practices of the Company. 2.5 Employment Taxes and Withholding. Executive recognizes that the compensation, benefits, and other amounts provided by the Company under this Agreement may be subject to federal, state, or local income taxes. All such taxes shall be the responsibility of the Executive. To the extent that federal, state, or local law requires withholding of taxes on compensation, benefits, or other amounts provided under this Agreement, the Company shall withhold the necessary amounts from the amounts payable to Executive under this Agreement. 2.6 Company Not Responsible for Insured Benefits. In this Article II, the Company is agreeing to provide certain benefits in the form of premiums for insurance coverage. The Company and the Parent are not themselves promising to pay the benefit an insurance company is obligated to pay under the policy the insurance company has issued. If an insurance company does not or cannot pay benefits it owes to Executive or his beneficiaries under the insurance policy, neither Executive nor his personal representative or beneficiary shall have any claim for benefits against the Company or the Parent. 2.7 Expenses. Executive shall be entitled to receive reimbursement from the Company (in accordance with the policies and procedures then in effect for the Company's employees) for all reasonable travel and other expenses incurred by him in connection with his services under this Employment Agreement. III.TERMINATION OF EXECUTIVE'S EMPLOYMENT 3.1 Termination of Employment. Notwithstanding any other provision of this Agreement, Executive's employment and the Period of Employment may be terminated pursuant to the following: (a) Executive's employment may be terminated by the Company or the Parent, on not less than 60 days' notice in writing, for Cause as defined in Section 3.2. After payment of all amounts accrued to Executive hereunder through the date of such notice, the Company and the Parent shall have no further obligation to the Executive hereunder except for the payment of benefits under the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan and Capital Accumulation Plan vested on such date. 5 (b) Executive's employment may be terminated by the Company at any time for any reason other than Cause as defined in Section 3.2, or Executive may terminate his employment with the Company and the Parent for Good Reason as defined in Section 3.3. In the event of termination of employment by the Company without Cause, or termination by the Executive for Good Reason, the Company shall pay to Executive, as liquidated damages or severance pay or both, the amounts described in Section 3.4. (c) Executive may terminate his employment with the Company and the Parent for other than Good Reason. In such event, the Executive's employment shall terminate as of the 90th day following the giving of written notice by the Executive to the Company of his decision to terminate other than for Good Reason, or such earlier date as the Company may specify in written notice to Executive, and the Company shall pay to Executive, as severance pay, the amounts described in Section 3.5. 3.2 Termination for Cause. (a) For purposes of this Article III, "Cause" shall mean only the following: (1) an intentional act or acts of dishonesty by the Executive constituting a felony and resulting or intended to result directly or indirectly in gain to or personal enrichment of the Executive at the Company's expense; (2) a deliberate and intentional refusal by the Executive to comply with Sections 1.1 and 1.2 of this Agreement (other than any such failure to comply resulting from the Executive's incapacity due to illness or accident) and which failure to comply results in demonstrably material injury to the Company, provided, however, that the Executive shall have either failed to remedy such failure to comply within 30 days from his receipt of written notice from the Secretary of the Company demanding that he remedy such failure to comply, or shall have failed to take all reasonable steps to that end during such 30-day period and thereafter; or (3) failure by the Executive, on at least three separate occasions (each occurring less than 24 months apart), to comply with Sections 1.1 and 1.2 of this Agreement for a significant period of time (other than any such failure to comply resulting from the Executive's incapacity due to illness or accident), and provided that the Company has, on each such occasion, promptly advised the Executive of such failure to comply by a written notice which sets forth the details of such failure to comply. 6 (b) Termination shall not be for Cause pursuant to the foregoing unless there shall be delivered to Executive, along with the termination notice, a certified copy of a resolution of the Board of Directors of the Company finding that Executive was guilty of conduct set forth in subsections (a)(1), (2) or (3) above and specifying the particulars thereof in detail. The resolution must be adopted by the affirmative vote of not less than that number of directors equal to the greater of (i) 4 directors or (ii) two-thirds of the entire membership (whether or not present) of the Board of Directors (other than Executive and directors who are employees of the Company or the Parent) at a meeting called and held for that purpose and at which Executive was given an opportunity to be heard. For purposes of the minimum number of directors required in the preceding sentence, any fraction shall be rounded up to the next higher whole number of directors. (c) Anything herein to the contrary notwithstanding, the employment of Executive shall not be considered to have been terminated by the Company for Cause if termination of his employment took place solely because of one or more of the following: (1) as a result of bad judgment of negligence on the part of Executive, or (2) as the result of an act or omission without intent of gaining therefrom directly or indirectly a profit to which Executive was not legally entitled; provided, however, that this subsection (c)(2) shall not apply to a termination pursuant to subsection (a)(3) above, or (3) because of an act or omission believed by Executive in good faith to have been in or not opposed to the interests of the Company, or (4) as the result of an act or omission which occurred more than 12 calendar months prior to Executive's having been given notice of the termination of his employment for such act or omission unless the commission of such act or such omission could not at the time of such commission or omission have been known to a member of the Board of Directors of the Company (other than Executive), in which case more than 12 calendar months prior to the date that the commission of such act or such omission was or could reasonably have been so known; provided, however, that this subsection (c)(4) shall not apply to a termination pursuant to subsection (a)(3) above; or (5) as a result of a continuing course of action which commenced and was or could reasonably have been known to a member of the 7 Board of Directors of the Company (other than Executive) more than 12 calendar months prior to notice having been given to the Executive of the termination of his employment; provided, however, that this subsection (c)(5) shall not apply to a termination pursuant to subsection (a)(3) above. 3.3 Good Reason (a) For the purposes of this Article III, "Good Reason" shall mean: (1) the authority, powers, functions, responsibilities or duties assigned to Executive pursuant to this Agreement are materially and adversely diminished without his written consent (except any diminution that occurs solely as a result of the fact that the Company or Parent ceases to be a public company); (2) Executive is removed as a director of the Company and Parent (or any successor thereto); (3) a breach of Article II of this Agreement with respect to the salary, incentive compensation and benefits of Executive; or (4) after a Change of Control (as defined in Section 4.1), Executive is required, without his written consent, to locate his office more than 35 miles distant by public highway from his office immediately prior to the Change of Control (but only if the distance between the Executive's residence and such new office is greater than the distance between his residence and office immediately prior to the Change in Control) or to travel on business more than 60 working days in any year or more than 21 consecutive days at any one time. (b) Executive shall give written notice to the Company of termination for Good Reason within six months of the event giving rise to such notice and allow the Company 30 days after the Company's receipt of such notice to cure such breach. If the Company disputes any contention by Executive that there has been Good Reason, such dispute shall be resolved by binding arbitration held in Minneapolis, Minnesota in accordance with the Employment Dispute Resolution Rules of The American Arbitration Association then in effect. The arbitrator shall be an attorney with experience in employment disputes who is mutually selected by the parties. Judgment may be entered on the arbitration award in any court having jurisdiction. (c) In the event of the liquidation, dissolution, consolidation or merger of the Company or transfer (in one transaction or a series of transactions) of 70% or more of its assets (regardless of whether such event is not a 8 Change of Control within the meaning of Section 4.1(c) because it is approved by the Continuing Directors), and the successor entity does not assume all duties and obligations of the Company under this Agreement or otherwise make arrangements with Executive satisfactory to Executive for employment of the Executive by the successor, then Executive may within 90 days following such event give written notice to the Company of his termination of employment (effective as of 90 days following such notice or such earlier date as specified by the Company in written notice to Executive), which shall be deemed termination for Good Reason. 3.4 Severance Benefits. In the event of termination of Executive's employment by the Company without Cause, or termination by the Executive for Good Reason, the Company shall provide Executive with the following compensation and benefits: (a) Salary. The Company shall pay Executive during the remainder of the Period of Employment as in effect immediately prior to such termination, as if such termination had not occurred, an amount equal to the base salary provided in Section 2.1, including any increases therein provided, at the times therein stated, for the month in which termination shall have occurred and for each month thereafter during such Period, less in respect of each such month the amounts, if any, paid to him pursuant to the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan and the amounts the Executive would have paid in cash in respect of employee benefits provided for in Section 2.3, if Executive were still employed. Notwithstanding the foregoing, in the event of a termination following a Change of Control, the salary amount described above shall be (i) determined based on a remaining Period of Employment of not less than 36 months (even if the actual Period of Employment is shorter) and (ii) paid in a single lump sum within 20 days after such termination. (b) Annual Incentive. The Company shall pay the Executive during the remainder of the Period of Employment as in effect immediately prior to such termination, as if such termination had not occurred, in full substitution for his rights under the Company's Management Incentive Plan, or, if applicable, the Alternate Plan, or any successor plan then in effect, a substitute incentive award, for the year in which termination occurred and for each subsequent calendar year, or portion thereof (in which case such substitute award shall be only in proportion to such portion), during such Period which shall be equal to the greater of: (1) 60% of Executive's base salary for the applicable calendar year as described in Section 2.1 (including any increases therein provided), or 9 (2) the average percentage (of salary) of the awards received by Executive in respect of the three calendar years next preceding the year in which the first such substitute incentive award is paid times such base salary. The substitute incentive award shall be paid in a single lump sum on the first day of February of each year, except that a pro rata award for that portion of the calendar year in which the Period of Employment ends shall be paid in a single lump sum on the last day of the Period of Employment. Notwithstanding the foregoing, in the event of a termination following a Change of Control, the substitute incentive awards described above shall be (i) determined based on a remaining Period of Employment of not less than 36 months (even if the actual Period of Employment is shorter) and (ii) paid at one time within 20 days after such termination in an amount equal to the aggregate lump sum value of such substitute awards. (c) Long-Term Incentive. The Company shall pay Executive in full substitution for any rights under all outstanding performance awards under the Long-Term Incentive Plan, or, if applicable, the Alternate Plan, or any successor plan then in effect, held by Executive at the time of such termination, for each year during the remainder of the Period of Employment a substitute long-term award as follows: (1) If the termination occurs after the completion of any performance cycle under the applicable plan but before the award for such cycle has been paid, the substitute award for the year in which termination occurs will equal the percentage of Executive's base salary actually earned under the terms of the applicable plan for such completed cycles and will be paid at the same time other participants are paid for such completed cycles. Otherwise, a substitute long-term award will not be paid in the year of termination if Executive has already received in such year a long-term incentive payment pursuant to the applicable plan. (2) The substitute long-term award for all other years will equal the greater of (i) 50% of Executive's then current annual base salary as provided in subsection (a) above or (ii) the average percentage (of salary) of the two most recent long-term awards paid to the Executive times such base salary and will be paid by February 1st of the year for which the payment is being made. (3) If the final year of the Period of Employment is a partial year, the substitute long-term award for such year (determined as in 10 subparagraph (2) above) will be prorated based on the number of days in such partial year. For example: If the Executive is terminated in January 2001 before payment is made for the completed 1999 - 2000 performance cycle, the Executive's substitute long-term award for the year of termination (2001) will be equal to the award earned by the Executive under such completed cycle and will be paid at the same time as other participants are paid. If the Executive is terminated in the year 2001 after the payment for the 1999-2000 performance cycle has been made, the first substitute long-term award will be paid in the year 2002. In either case, the Executive's substitute long-term award for the year 2002 will be paid by February 1, 2002 and will equal the greater of (i) 50% of Executive's then current annual base salary or (ii) the average percentage (of salary) of the long-term awards paid to the Executive in 2000 and 2001 times such base salary. Notwithstanding the foregoing, in the event of a termination following a Change of Control, the substitute long term incentive awards described above shall be (i) determined based on a remaining Period of Employment of not less than 36 months (even if the actual Period of Employment is shorter) and (ii) paid at one time within 20 days after such termination in an amount equal to the aggregate lump sum value of such substitute awards. (d) Stock Awards. Each outstanding stock option to purchase shares of the Company's or the Parent's common stock and any stock appreciation right that is held by Executive at the time of such termination shall become vested and exercisable in full. Each stock option to purchase shares of the Company's or the Parent's common stock granted to Executive on or after the date hereof shall contain the following provision: In the event that the Optionee's Period of Employment under his Employment Agreement with the Company dated as of July 26, 1999 is terminated pursuant to Section 3.1(b) thereof, this Option shall become exercisable in full. In addition, all restrictions upon any restricted stock previously granted to Executive by the Company or the Parent shall be deemed to have lapsed and Executive shall be entitled to receive all such shares of restricted stock. Similarly, Executive shall be entitled to receive all shares covered by outstanding deferred stock awards previously granted to Executive by the Company or the Parent as if the deferral period and all conditions pertaining thereto had expired or been satisfied, as the case may be. 11 (e) Death, Disability and Medical Benefits. During the remainder of the Period of Employment as in effect immediately prior to such termination, as if such termination had not occurred, the Executive shall continue to be entitled to all employee benefits provided for in Section 2.3(f), (g), and (h), as if Executive were still employed during such period under this Agreement, with benefits based upon the compensation and increases provided in subsection (a), and upon the assumption that Executive was continuing to pay or continued to be deemed to have paid in cash in respect of such benefits the amounts (and only the amounts) by which the payments otherwise due Executive under subsection (a) were reduced in respect to such benefits, and if and to the extent the said benefits shall not be payable or provided under any plan by reason of Executive no longer being an employee of the Company as a result of Executive's termination, the Company itself shall pay or provider therefor. Notwithstanding the foregoing, if Executive is entitled to death, disability or medical benefit coverage of the kind described in Section 2.3(f), (g) or (h) from other employment or a consulting position during the Period of Employment, such benefits provided under this Agreement shall be reduced or coordinated as provided in subsection (g) below. (f) Retirement Benefits. The Company shall pay to Executive during the remainder of his life following the expiration of the Period of Employment as in effect immediately prior to such termination, and, after his death, to his surviving spouse (subject to such optional method of payment election as may be made under the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan and as further described below), a supplemental retirement benefit which shall be equal to the excess of: (1) an aggregate benefit at least equal to the benefit that would have been paid under the Employees' Retirement Plan and Supplemental Executive Retirement Plan, subject to any plan amendments or terminations generally applicable to all of the Company's senior officers which are adopted prior to the date of such termination, if the Executive had continued to be employed and to be entitled to service credit for benefits during the remainder of such Period of Employment at an annual rate of compensation equal to his compensation and increases provided in subsections (a) and (b) (unless during such remainder the Executive dies or becomes disabled, in which event such benefit shall be reduced to reflect application of the last two sentences of subsection(e), over (2) the aggregate benefit actually payable to the Executive under the Employees' Retirement Plan and Supplemental Executive Retirement Plan. 12 In clarification of the foregoing paragraph (1), in determining whether any actuarial reduction would apply (and the amount of such reduction, if any) under the early retirement provisions of the Employees' Retirement Plan and Supplemental Executive Retirement Plan (to reflect the early commencements of benefits), the age which the Executive would have attained at the expiration of such Period, and the accredited service he would have had at such time, shall be used. An election made by Executive under the Employees' Retirement Plan and Supplemental Executive Retirement Plan as to a joint and survivor or other optional method of payment and as to the time for commencement of payments shall be applicable to such supplemental retirement benefit, with application of discount factors no less favorable to Executive than those in effect under the Employees' Retirement Plan and Supplemental Executive Retirement Plan on the date of such termination. Notwithstanding the foregoing, Executive may, by a notice in writing filed with the Plan Administrator for the Employees' Retirement Plan and Supplemental Executive Retirement Plan, designate any person as the payee of amounts due hereunder after his death (in the manner, and with the effect, described in the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan). Notwithstanding the foregoing, in the event of a termination following a Change of Control, the supplemental retirement benefit described above shall be (i) calculated based upon the Executive's years of service at the time of the termination plus an additional five years and disregarding the requirement of five years of participation in the Supplemental Executive Retirement Plan, and (ii) paid in a single sum within 20 days after such termination in an amount equal to the lump sum value of such benefit. (g) Subsequent Employment. Notwithstanding the foregoing, to the extent that the Executive shall receive cash compensation that is subject to federal income taxation in respect of other employment or a consulting position with another company and that is payable to Executive solely in respect of the remainder of the Period of Employment as in effect immediately prior to such termination, or a portion thereof, the payments to be made by the Company under subsections (a), (b), and (c) for the remainder of the Period of Employment as in effect immediately prior to such termination or such portion thereof, as the case may be, shall be correspondingly reduced, and any supplemental retirement benefit payments pursuant to subsection (f) shall be calculated after taking such reduction into account. In the event Executive has received lump sum payments following a Change of Control as provided above, Executive agrees to re-pay the Company in quarterly payments the reductions described in the foregoing sentence. 13 Furthermore, to the extent that benefits of the kind provided for in Section 2.3 (f), (g) and (h) are payable in respect of such other employment or consulting position, any death or disability benefits so payable under subsequent employment shall reduce benefits of such kind otherwise payable under subsection (e) above and any medical/dental/ welfare benefits so payable under subsequent employment shall be deemed the primary coverage for purposes of coordination of benefits under subsection (e) above and avoiding duplication of benefits. Notwithstanding the foregoing, Executive shall not be required to minimize damages or severance payments under this Agreement by seeking or accepting other employment or a consulting position. (h) After Death or Disability. Upon the death of Executive during the period that payment of the amounts specified in subsection (a) above are required to be made, the obligation of the Company to make payments to the Executive under this Section 3.4 shall cease as of the date of death and the benefits described in Section 3.7 shall become payable. In the event of the disability of the Executive during such Period, the obligation to make payments under subsections (a) and (b) above shall be suspended as of the date specified in Section 2.2 for the cessation of payments of salary and Executive shall be entitled to the benefits described in Section 3.6, and such obligation shall be reinstated again only if during such period Executive ceases to be disabled. 3.5 Severance Pay Upon Voluntary Termination. In the event Executive terminates employment with the Company other than for Good Reason, the Company shall provide Executive with the following compensation and benefits: (a) Executive shall receive monthly an amount equal to his monthly salary (at his annual rate of salary in effect on the date of such termination) for the month in which termination shall have occurred and for each month thereafter during the period ending the earlier of (1) the expiration of the 12 months immediately following the date of such termination, or (2) the end of the Period of Employment under Section 1.3, less in respect of each such month the amount, if any, paid to him pursuant to the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan and the amounts Executive would have paid in cash in respect of employee benefits provided for in Section 2.3 if the executive were still employed. 14 (b) During the period that the payments of the amounts specified in subsection (a) are required to be made, Executive shall continue to be entitled to all employee benefits provided for in Section 2.3(f), (g), and (h) as if Executive were still employed during such period under this Agreement, with benefits based upon the compensation provided in subsection (a) and upon the assumption that Executive was continuing to pay or continued to be deemed to have paid in cash in respect to such benefits the amounts (and only the amounts) by which the payments otherwise due Executive under subsection (a) were reduced in respect of such benefits, and if and to the extent that such benefits shall not be payable or provided under any such plan by reason of Executive no longer being an employee of the Company as a result of Executive's termination, the Company itself shall pay or provide therefor. Notwithstanding the foregoing, if Executive is entitled to disability or medical benefit coverage of the kind described in Section 2.3(g) or (h) from other employment or a consulting position during the Period of Employment, such benefits provided under this Agreement shall be coordinated as provided in subsection (d) below. (c) The Company shall pay to the Executive during the remainder of his life following the expiration of the period specified in subsection (a) and, after his death, to his surviving spouse (subject to such optional method of payment election as may be made under the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan and as further described below), a supplemental retirement benefit which shall be equal to the excess of (1) an aggregate benefit at least equal to the benefit that would have been paid under the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan, subject to any plan amendments or terminations generally applicable to all of the Company's senior officers which are adopted prior to the date of such termination, if the Executive had continued to be employed and to be entitled to service credit for benefits during such period specified in subsection (a) at an annual rate of compensation equal to his compensation provided in subsection (a) (unless during such remainder the Executive dies or becomes disabled, in which event such benefit shall be reduced to reflect application of the last two sentences of subsection (b)), over (2) the aggregate benefit actually payable to Executive under the Employees' Retirement Plan and Supplemental Executive Retirement Plan . In clarification of the foregoing paragraph (1), in determining whether any actuarial reduction would apply (and the amount of such reduction, if any, 15 under the early retirement provisions of the Employees' Retirement Plan and Supplemental Executive Retirement Plan (to reflect the early commencement of benefits), the age which Executive would have attained at the expiration of such period, and the accredited service he would have had at such time, shall be used. An election made by Executive under the Employees' Retirement Plan and Supplemental Executive Retirement Plan as to a joint and survivor or other optional method of payment and as to the time for commencement of payments shall be applicable to such supplemental retirement benefit, with application of discount factors no less favorable to Executive than those in effect under the Employees' Retirement Plan and Supplemental Executive Retirement Plan on the date of such termination. Notwithstanding the foregoing, Executive may, by a notice in writing filed with the Plan Administrator for the Employees' Retirement Plan and Supplemental Executive Retirement Plan, designate any person as the payee of amounts due hereunder after his death (in the manner, and with the effect, described in the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan). (d) Notwithstanding the foregoing, to the extent that Executive shall receive cash compensation that is subject to federal income taxation in respect of other employment or a consulting position with another company and that is payable to Executive solely in respect to the period specified in subsection (a) or a portion thereof, the payments to be made by the Company under subsection (a) for such period or such portion thereof, as the case may be, shall be correspondingly reduced, and any supplemental retirement benefit payments pursuant to subsection (c) shall be calculated after taking such reduction into account. Furthermore, to the extent that benefits of the kind provided for in Section 2.3(g) and (h) are payable in respect of such other employment or consulting position, disability benefits of the kind described in Section 2.3(g) so payable shall reduce benefits of such kind otherwise payable under subsection(b) and medical and dental benefits of the kind described in Section 2.3(h) so payable shall be deemed the primary coverage for purposes of coordination of benefits and avoiding duplication of benefits. Notwithstanding the foregoing, the Executive shall not be required to minimize payments of benefits under this Agreement by seeking or accepting other employment or a consulting position. (e) Upon the death of the Executive during the period that payments of the amounts specified in subsection (a) are required to be made, the obligation of the Company to make payments to the Executive under this Section 3.5 shall cease as of the date of death and the benefits described in Section 3.7 shall become payable. In the event of the disability of the Executive during the period that payments of the amounts specified in subsection (a) are required to be made, the obligation to make payments 16 under subsection (a) shall be suspended as of the date specified in Section 2.2 and Executive shall be entitled to the benefits described in Section 3.6, and such obligation shall be reinstated again only if during such period Executive ceases to be disabled. 3.6 Disability. If Executive has become disabled from performing his duties under this Agreement and the disability has continued for a period of six consecutive months or for an aggregate of 180 days during nine consecutive months, the Period of Employment under this Agreement shall terminate. Such termination shall not result in payments pursuant to Sections 3.4 or 3.5 above, the disability benefits provided by the Company being in full satisfaction of the Company's obligation to Executive. 3.7 Death. Upon the death of Executive during the Period of Employment, the Period of Employment and the obligation of the Company to make payments under Section 2.1 shall cease as of the date of death, and benefits shall become payable under the death benefit plans described in Section 2.3(f) in accordance with their terms, exclusive of any plan amendments that reduce or terminate benefits thereunder not generally applicable to all of the Company's senior officers. 3.8 Non-Competition and Confidentiality. In consideration for the payments and benefits to be provided to Executive under this Agreement, Executive agrees to comply with the following requirements: (a) Agreement Not to Compete. Executive agrees that, on or before the first anniversary of the date Executive's employment under this Agreement terminates under Section 3.1, he will not, unless he receives the prior written approval of the Chairman of the Board of the Parent, directly or indirectly engage in any of the following actions: (1) Own an interest in (except as provided below), manage, operate, join, control, lend money or render financial or other assistance to, or participate in or be connected with, as an officer, director, employee, partner, stockholder, consultant or otherwise, any entity that is a competitor of the Company if the amount of competition is significant, i.e., the competition is in a line of business or products that constitute more than five percent of the gross revenues of both the Company and its consolidated subsidiaries and the competitor. However, nothing in this subsection (a) shall preclude Executive from (i) holding less than one percent of the outstanding capital stock of any corporation required to file periodic reports with the Securities and Exchange Commission under Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the securities of which are listed on any securities exchange, quoted on the National Association of Securities Dealers Automated Quotation System or traded in the over-the-counter market or (ii) continuing to engage in any activities or investments that the Executive 17 participated in prior to his termination of employment if such activities or investments did not violate Company policy. (2) Intentionally solicit, endeavor to entice away from the Parent or the Company, or any of their subsidiaries, or otherwise interfere with the relationship of the Parent or the Company, or any of their subsidiaries with, any person who is employed by or otherwise engaged to perform services for the Parent or the Company, or any of their subsidiaries (including, but not limited to, any independent sales representatives or organizations), or any persons or entity who is, or was within the then most recent 12-month period, a customer or client of the Parent or the Company, or any of their subsidiaries, whether for Executive's own account or for the account of any other individual, partnership, firm corporation or other business organization. If the scope of the restrictions in this subsection are determined by a court of competent jurisdiction to be too broad to permit enforcement of such restrictions to their full extent, then such restrictions shall be construed or rewritten (blue-lined) so as to be enforceable to the maximum extent permitted by law, and Executive hereby consents, to the extent he may lawfully do so, to the judicial modification of the scope of such restrictions in any proceeding brought to enforce them. (b) Non-Disclosure of Information. During the period of his employment hereunder, and at all times thereafter, Executive shall not, without the written consent of the Chief Executive Officer of the Parent, disclose to any person, other than an employee of the Parent or the Company, or any of their subsidiaries or a person to whom disclosure is reasonably necessary or appropriate in connection with the performance by Executive of his duties as an executive of the Parent or the Company, except where such disclosure may be required by law, any material confidential information obtained by him while in the employ of the Parent or the Company with respect to any of their products, technology, know-how or the like, services, customers, methods or future plans, all of which Executive acknowledges are valuable, special and unique assets the disclosure of which Executive acknowledges may be materially damaging to the Parent or the Company. (c) Remedies. Executive acknowledges that the Parent's or the Company's remedy at law for any breach or threatened breach by Executive of subsection (a) or (b) will be inadequate. Therefore, the Parent or the Company shall be entitled to injunctive and other equitable relief restraining Executive from violating those requirements, in addition to any other remedies that may be available to the Parent or the Company under this Agreement or applicable law. 18 IV. CHANGE OF CONTROL 4.1 Change of Control Defined. For purposes of this Agreement, "Change of Control" means the occurrence of any of the following: (a) The acquisition by any person, entity or "group" within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended ("the 1934 Act"), other than the Company, the Parent or any of their affiliates, or any employee benefit plan of the Company and/or its affiliates, of beneficial ownership (within the meaning of Rule 13(d)-3 under the 1934 Act) of shares of stock of the Company or the Parent having twenty five percent (25%) or more of the total number of votes that may be cast for election of the Directors of the Company or the Parent in a transaction or series of transactions not approved in advance by a vote of at least three-quarters of the Continuing Directors (as defined below). (b) A change in the composition of the Board of Directors of the Company or the Parent such that at any time a majority of the Board are not Continuing Directors. "Continuing Directors" refers to the individuals who serve as Directors at the effective date of this Agreement and any individual whose term of office as a Director begins thereafter if the nomination or election of such Director was approved in advance by a vote of at least three-quarters of the then serving Continuing Directors (other than a nomination of an individual whose initial assumption of office is in connection with an actual or threatened solicitation with respect to the election or removal of the Directors, as such terms are used in Rule 14a-11 of Regulation 14A under the 1934 Act). (c) The approval by the shareholders of the Company or the Parent of a reorganization, merger, consolidation, liquidation or dissolution of the Company or the Parent, or of the sale (in one transaction or a series of transactions) of all or substantially all of the assets of the Company or the Parent other than a reorganization, merger, consolidation, liquidation, dissolution or sale approved in advance by a vote of at least three-quarters of the Continuing Directors. (d) Any other occurrence if at least a majority of the Continuing Directors determine in their discretion that there has been a Change of Control of the Company or the Parent. 4.2 Vesting of Stock Options and Restricted Stock. Upon a Change of Control, the right of Executive to exercise any and all stock options to purchase shares of the Company's or the Parent's stock and any stock appreciation rights held by Executive shall, to the extent that such options and rights shall not theretofore have been exercised, become fully vested and exercisable immediately, all restrictions upon any restricted stock previously granted to Executive shall be deemed to have lapsed 19 and the deferral period and all conditions pertaining to any deferred stock awards previously granted to Executive shall be deemed to have expired or have been satisfied, as the case may be, and Executive shall be entitled to receive all such shares of restricted or deferred stock. All restricted stock and all deferred stock awards granted to Executive on or after the date hereof shall be awarded subject to the conditions described in the immediately preceding sentence. All options issued or awarded to the Executive on or after the date hereof shall contain the following provision: Notwithstanding anything herein contained to the contrary, in the event that a Change of Control, as defined in Section 4.1 of the Optionee's Employment Agreement with the Company dated as of July 26, 1999 should occur, this Option shall immediately thereafter become exercisable in full. 4.3 Trust Requirement After Change of Control. To assure the performance of the Company and the Parent of their obligations under this Agreement in the event of a Change of Control, the Company or the Parent shall, upon the request of Executive immediately prior to a Change of Control, deposit in an irrevocable trust with a trustee designated by Executive, an amount of liquid assets equal to the present value of the maximum amount of all lump amounts which could be paid to Executive under Section 3.4 in the event of a termination of employment of Executive without Cause following a Change of Control. Such trust shall be established and funded only if and to the extent that the establishment of such trust does not contravene the provisions of any loan agreement under which the Company or the Parent is obligated; provided, however, that the Company and Parent (as opposed to the lender under any such loan agreement) may not seek to preclude the establishment of such trust by initiating the entering into, renegotiating or amending of any such loan agreement, a principal purpose which entering into, renegotiating or amendment is such preclusion. The trust shall be reasonably satisfactory in form and substance to the Executive, with no greater rights in Executive than an unsecured creditor of the Company and Parent. To the extent there are not amounts in trust sufficient to pay Executive under this Agreement, the Company and Parent shall be and remain liable therefore. V. MISCELLANEOUS 5.1 Amendment. This Agreement may be amended only in a writing that is signed by all parties. 5.2 Entire Agreement. This Agreement contains the entire understanding of the parties with regard to the employment of the Executive by the Company and the Parent. There are no other agreements, conditions, or representations, oral or written, expressed or implied, with regard thereto. This Agreement supersedes all prior agreements, promises, and representations relating to the employment of Executive by the Company and the Parent. 20 5.3 Assignment. The Company may in its sole discretion assign this Agreement to any entity which succeeds to some or all of the business of the Company through merger, consolidation, a sale of some or all of the assets of the Company, or any similar transaction. Executive acknowledges that the services to be rendered by him are unique and personal. Accordingly, Executive may not assign any of his rights or obligations under this Agreement. 5.4 Successors. Subject to Section 5.3, the provisions of this Agreement shall be binding upon the parties hereto, upon any successor to or assign of the Company and the Parent, and upon Executive's heirs and the personal representative of Executive or Executive's estate. 5.5 Notices. Any notice required to be given under this Agreement shall be in writing and shall be delivered either in person or by certified or registered mail, return receipt requested. Any notice by mail shall be addressed as follows: If to the Company, to: The Musicland Group, Inc. 10400 Yellow Circle Drive Minnetonka, Minnesota 55343 Attention: Secretary If to Executive, to: The Musicland Group, Inc. 10400 Yellow Circle Drive Minnetonka, Minnesota 55343 Attention: _________________ With an additional copy to (home address): ---------------------- ---------------------- ---------------------- or to such other addresses as either party may be designate in writing to the other party from time to time. 5.6 Waiver of Breach. Any waiver by either party of compliance with any provision of this Agreement by the other party shall not operate or be construed as a waiver of any other provision of this Agreement or of any subsequent breach by such party of a provision of this Agreement. 21 5.7 Potential Excise Taxes. (a) Gross-Up Payment. Anything to the contrary notwithstanding, in the event it shall be determined that any payment, distribution or benefit made or provided by or on behalf of the Company or Parent to or for the benefit of the Executive (whether pursuant to this Agreement or otherwise) (a "Payment"), would be subject to the excise tax imposed by Section 4999 of the Internal Revenue Code of 1986. as amended (the "Code"), or any interest or penalties with respect to such excise tax (such excise tax, together with any such interest and penalties, being, collectively referred to as the "Excise Tax"), then the Company shall pay the Executive in cash an additional amount (the "Gross-Up Payment") such that, after payment by the Executive of all taxes (including any interest or penalties imposed with respect to such taxes), including but not limited to income taxes (and any interest and penalties imposed with respect thereto) and the Excise Tax imposed upon the Gross-Up Payment, the Executive retains an amount of the Gross-Up Payment equal to the Excise Tax imposed on the Payments. Notwithstanding the foregoing, no amount shall be paid under this Section 5.7, and the amounts payable to Executive under this Agreement shall be reduced to the amount at which no such Excise Tax is payable, if the result of such reduction is to place Executive in the same or a better after-tax position than would result from making the additional payments provided under this Section. (b) Determination of Gross-Up Payment. Subject to sub-paragraph (c) below, all determinations required to be made under this Section 5.7, including whether a Gross-Up Payment is required and the amount of the Gross-Up Payment, shall be made by the firm of independent public accountants selected by the Company to audit its financial statements for the year immediately preceding the Change of Control (the "Accounting Firm") which shall provide detailed supporting calculations to the Company and the Executive within 30 days after the date of the Executive's termination of employment. In the event that the Accounting Firm is serving as accountant or auditor for the individual, entity or group affecting the Change of Control, the Executive may appoint another nationally recognized accounting firm to make the determinations required under this Section 5.7 (which accounting firm shall then be referred to as the "Accounting Firm"). All fees and expenses of the Accounting Firm in connection with the work it performs pursuant to this Section 5.7 shall be promptly paid by the Company. Any Gross-Up Payment shall be paid by the Company to the Executive within 5 days of the receipt of the Accounting Firm's determination. If the Accounting Firm determines that no Excise Tax is payable by the Executive, it shall furnish the Executive 22 with a written opinion that failure to report the Excise Tax on the Executive's applicable federal income tax return would not result in the imposition of a penalty. Any determination by the Accounting Firm shall be binding upon the Company and the Executive. As a result of the uncertainty in the application of Section 4999 of the Code at the time of the initial determination by the Accounting Firm, it is possible that Gross-Up Payments which will not have been made by the Company should have been made ("Underpayment"). In the event that the Company exhausts its remedies pursuant to sub-paragraph (c) below, and the Executive is thereafter required to make a payment of Excise Tax, the Accounting Firm shall promptly determine the amount of the Underpayment that has occurred and any such Underpayment shall be paid by the Company to the Executive within 5 days after such determination. (c) Contest. The Executive shall notify the Company in writing of any claim made by the Internal Revenue Service that if successful, would require the Company to pay a Gross-Up Payment. Such notification shall be given as soon as practicable but no later than 10 business days after the Executive knows of such claim and shall apprise the Company of the nature of such claim and the date on which such claim is requested to be paid. The Executive shall not pay such claim prior to the expiration of the 30-day period following the date on which the Executive gives such notice to the Company (or such shorter period ending on the date that any payment of taxes with respect to such claim is due). If the Company notifies the Executive in writing prior to the expiration of such period that it desires to contest such claim, the Employee shall: (1) give the Company any information reasonably requested by the Company relating to such claim; (2) take such action in connection with contesting such claim as the Company shall reasonably request in waiting from time to time, without limitation, accepting legal representation with respect to such claim by an attorney selected by the Company and reasonably acceptable to the Executive; (3) cooperate with the Company in good faith in order to effectively contest such claim; and (4) permit the Company to participate in any proceedings relating to such claim, provided that the Company shall bear and pay directly all costs and expenses (including interest and penalties) incurred in connection with such contest and shall indemnify and hold the Executive harmless, on an after-tax basis, for any Excise Tax or income tax, including interest and penalties with respect thereto, 23 imposed as a result of such representation and payment of costs and expenses. Without limitation on the foregoing provisions of this subparagraph (c), the Company shall control all proceedings taken in connection with such contest. At its sole option, the Company may pursue or forego any and all administrative appeals, proceedings, hearings and conferences with the taxing authority in respect of such claim and may either direct the Executive to pay the tax claimed and sue for a refund or contest the claim in any permissible manner. The Executive agrees to prosecute such contest to a determination before any administrative tribunal, in a court of initial jurisdiction and in one or more appellate courts, as the Company shall determine, provided that any extension of the statute of limitations relating to payment of taxes for the taxable year of the Executive with respect to which such contested amount is claimed to be due is limited solely to such contested amount. The Company's control of the contest shall be limited to issues with respect to which a Gross-Up Payment would be payable hereunder, and the Executive shall be entitled to settle or contest, as the case may be, any other issue raised by the Internal Revenue Service or any other taxing authority. Furthermore, the Company agrees to hold in confidence and not to disclose, without Executive's prior written consent, any information with regard to Executive's tax position which the Company obtains pursuant to this Section 5.7. (d) Suit for Refund. If the Company directs the Executive to pay any claim and sue for a refund, the Company shall advance the amount of such payment to the Executive, on an interest-free basis. If the Executive becomes entitled to receive any refund with respect to such claim, the Executive shall promptly pay to the Company the amount of such refund (together with any interest paid or credited thereon after taxes applicable thereto). If a determination is made that the Executive shall not be entitled to any refund with respect to such claim and the Company does not notify the Executive in writing of its intent to contest such denial of refund prior to the expiration of 30 days after such determination, then such advance shall be forgiven and shall not be required to be repaid and the amount of such advance shall offset, to the extent thereof, the amount of Gross-Up Payment required to be paid. 5.8 Indemnification. The Company will indemnify Executive (and his legal representatives or other successors) to the fullest extent permitted (including payment of expenses in advance of final disposition of a proceeding) by the laws of the State of Delaware, as in effect at the time of the subject act or omission, or by the Restated Certificate of Incorporation and By-Laws of the Company, as in effect at such time or on the effective date of this Agreement, or by the terms of any indemnification agreement between the Company and Executive, whichever affords or afforded greater protection 24 to Executive, and the Executive shall be entitled to the protection of any insurance policies the Company may elect to maintain generally for the benefit of its directors and officers (and to the extent the Company maintains such an insurance policy or policies, Executive shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage affordable for any Company officer or director), against all costs, charges and expenses whatsoever incurred or sustained by him or his legal representatives at the time such costs, charges and expenses are incurred or sustained, in connection with any actions, suit or proceeding to which he (or his legal representatives or their successors) may be made a party by reason of his being or having been a director, officer or employee of the Company, the Parent or any subsidiary of either of them, or his serving or having served any other enterprise as a director, officer or employee at the request of the Company. 5.9 Attorney's Fees. In the event of any litigation, arbitration, or other proceeding between the Company and Executive with respect to this Agreement or the enforcement of Executive's rights hereunder, the Company shall periodically reimburse Executive for all of the reasonable costs and expenses relating to such litigation, arbitration or proceeding (including, without limitation, reasonable attorneys' fees), regardless of outcome. In no event shall Executive be required to reimburse the Company or the Parent for any of the costs or expenses relating to such litigation, arbitration, or proceeding. 5.10 Joint and Several Liability. All duties, undertakings, obligations, and liabilities of the Company and the Parent arising under this Agreement shall be the joint and several liability of the Company and the Parent. 5.11 Severability. If any one or more of the provisions (or portions thereof) of this Agreement shall for any reason be held by a final determination of a court of competent jurisdiction to be invalid, illegal, or unenforceable in any respect, such invalidity, illegality, or unenforceability shall not affect any other provisions (or portions of the provisions) of this Agreement, and the invalid, illegal, or unenforceable provision shall be deemed replaced by a provision that is valid, legal, and enforceable and that comes closest to expressing intention of the parties. 5.12 Governing Law. This Agreement shall be interpreted and enforced in accordance with the laws of the State of Minnesota, without giving effect to conflict of law principles. 5.13 Headings. The headings of articles and sections herein are included solely for convenience and reference and shall not control the meaning of interpretation of any of the provisions of this Agreement. 5.14 Counterparts. This Agreement may be executed by either of the parties in counterparts, each of which shall be deemed to be an original, but all such counterparts shall constitute a single instrument. 25 IN WITNESS WHEREOF, the parties have executed this Agreement effective as of the date set forth above. MUSICLAND STORES CORPORATION THE MUSICLAND GROUP, INC. By: ----------------------------------- William A. Hodder Chairman, Compensation Committee EXECUTIVE -------------------------------------- 26 EX-10.13 3 FORM OF EMPLOYMENT AGREEMENT FOR OTHER SEN EXEC'S FORM OF EMPLOYMENT AGREEMENT FOR OTHER SENIOR EXECUTIVE OFFICERS This Agreement is made as of July 26, 1999 by and between The Musicland Group, Inc., a Delaware corporation (the "Company"), Musicland Stores Corporation, a Delaware corporation (the "Parent") and _______________ (the "Executive"). WHEREAS the Company and the Parent have employed Executive pursuant to the terms of Employment and Change of Control Agreements dated August 25, 1988, as amended December 3, 1996 (the "Prior Agreements"); WHEREAS the Company and the Parent desire to continue to employ Executive in accordance with the terms and conditions stated in this Agreement, which shall replace and supersede the Prior Agreements; and WHEREAS Executive desires to continue employment pursuant to the terms and conditions of this Agreement and acknowledges that this Agreement replaces and supersedes the Prior Agreements; NOW, THEREFORE, for the consideration described below, the parties agree as follows: I. EMPLOYMENT 1.1 Employment As Executive. During the Period of Employment described in Section 1.3 below, the Company and the Parent hereby agree to employ Executive as ____________________ or in such other executive officer position as the Board of Directors of the Company and the Parent may from time to time determine, unless terminated earlier pursuant to Article III of this Agreement. Executive accepts such employment pursuant to the terms of this Agreement. Executive shall perform such duties and responsibilities as may be determined from time to time by the Board of Directors of the Company and the Parent, which shall be consistent with his position as an executive officer. Executive shall not be required to perform his duties hereunder for more than 60 working days in any year, or for more than 21 consecutive days at any one time, at any office located in any place other than the Minneapolis, Minnesota metropolitan area. 1.2 Exclusive Services. Executive agrees to devote his full time, attention, and energy to performing his duties and responsibilities to the Company and the Parent under this Agreement during the period that this Agreement is in effect, except for reasonable vacations, illness, or incapacity, provided that nothing in this Agreement shall preclude Executive from devoting time during reasonable periods required for (i) serving as a director or member of a committee of any organization or company involving no conflict of interest with the Company or the Parent; (ii) delivering lectures, 1 fulfilling speaking engagements; (iii) engaging in charitable and community activities; and (iv) managing personal or family finances and investments; provided that such activities do not materially interfere with the performance of his duties hereunder. 1.3 Period of Employment. The Period of Employment shall be determined as follows: (a) Except as provided in subsection (b) in the event of a Change of Control as defined in Section 4.1, the Period of Employment hereunder shall be from July 26, 1999 through July 26, 2001, subject to extension or termination as hereinafter provided. The then-existing Period of Employment shall be automatically extended by one additional year (to the next subsequent July 26, but in no event shall the Period of Employment extend beyond the first day of the month next succeeding the month in which Executive attains age 65) unless the Company shall deliver to Executive or Executive shall deliver to the Company written notice at least 18 months prior to the expiration of the then-existing Period of Employment that the Period of Employment will not be extended. In such case, the Period of Employment will end at the expiration of the then-existing Period of Employment hereunder, including any previous extension, and shall not be further extended except by agreement of the Company and Executive. (For example, in order to avoid the automatic extension of the expiration of the Period of Employment from July 26, 2001 to July 26, 2002, notice must be given by January 26, 2000.) (b) If upon an event constituting a Change of Control the remaining period in the then-existing Period of Employment (as determined under subsection (a) above) is less than 24 months, the Period of Employment shall be extended so that the expiration is on the last business day of the 24th calendar month following such Change in Control. No adjustment will be made if the remaining period is more than 24 months at the time of the Change in Control. In either case, the automatic one year extensions shall continue to apply as provided in subsection (a) above. (For example, if a Change of Control occurs January 1, 2000, the remaining period in the Period of Employment (ending July 26, 2001) is less than 24 months and would be extended to expire January 1, 2002. In order to avoid automatic extension of the adjusted Period of Employment to January 1, 2003, notice must be given by July 1, 2000.) (c) The Period of Employment shall continue until the expiration of all automatic extensions effected as aforesaid, unless and until it sooner ceases or is terminated as provided in Article III. 2 II. COMPENSATION, BENEFITS, AND PERQUISITES 2.1 Salary. During the Period of Employment, the Company shall pay Executive a base salary at the annual rate of $__________ commencing February 21, 1999. The base salary shall be payable in equal bi-weekly installments. The Compensation Committee of the Board of Directors of the Company may review the salary periodically and may in its sole discretion increase it to reflect performance and other factors in accordance with the Company's customary procedures and practices regarding the salaries of senior officers. 2.2 Disability Pay. In the event of the disability of Executive (within the meaning of the Company's disability benefit plans in effect at the time of Executive's disability), the obligation of the Company to make payments of salary under Section 2.1 shall cease as of the date Executive begins receiving benefits under the Company's short-term salary continuation plan, and Executive shall be entitled to benefits under the Company's disability benefit plans in accordance with the terms of such plans. Notwithstanding the terms of this Agreement, the Company retains the right to amend, reduce or terminate its disability benefit plans at any time so long as such amendments, reductions or terminations apply equally to all senior officers. 2.3 Employee Benefits. Executive shall be entitled to the benefits and perquisites which the Company generally provides to its other senior officers under the applicable Company plans and policies. Executive's participation in such benefit plans shall be on the same basis as applies to other senior officers of the Company and subject to the terms of applicable law, plan documents, and insurance policies. Executive shall pay contributions, if any, which are generally required of the Company's senior officers in order to receive any such benefits. Specifically, Executive shall: (a) participate in the Company's Management Incentive Plan and Long-Term Incentive Plan, or, if applicable, the shareholder approved Alternate Incentive Plan for Designated Senior Officers (the "Alternate Plan"); (b) be considered by the Compensation Committee of the Board of Directors for possible grants of stock options, stock appreciation rights, restricted stock and deferred stock awards, under the Company's stock option plans, stock incentive plans, or any similar plan adopted by the Company or the Parent during the Period of Employment; (c) participate to the permitted extent he wishes in the Company's Capital Accumulation Plan; (d) participate in the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan; 3 (e) participate in the Company's death benefit plans (consisting of its Group Life Insurance Plan, and accidental death and dismemberment insurance); (f) participate in the Company's disability benefit plans (consisting of its short-term salary continuation, short-term disability and long-term disability plans); (g) participate in its senior officer medical, dental, health and welfare plans; and (h) participate in equivalent successor plans of the Company for which officers are eligible. Notwithstanding the foregoing, nothing in this agreement shall preclude any amendment or termination by the Company of any employee benefit plan or practice, provided such amendment or termination is applicable to all of the Company's senior officers generally; provided, however, that in the event of a Change of Control as defined in Section 4.1 and through the Period of Employment described in Section 1.3(b), Executive shall be entitled to perquisites and benefits at least as favorable as those to which Executive was entitled immediately prior to the Change of Control, and to the extent such perquisites or benefits are not payable or provided under any such plan of the Company by reason of the amendment or termination thereof, the Company itself shall pay or provide therefor. 2.4 Incentive Compensation Following Change of Control. In the event of a Change of Control as defined in Section 4.1 and through the Period of Employment described in Section 1.3(b), Executive shall receive an annual award under the Company's Management Incentive Plan, or, if applicable, the Alternate Plan, or a plan with substantially equivalent incentives and benefits that may be adopted by the Company, for each calendar year, or portion thereof, during the Period of Employment, which shall be payable as soon as practicable after the end of such calendar year and shall be equal to a percentage of Executive's base salary for such calendar year. Such percentage shall be no less than the percentage at plan target in effect preceding the Change of Control. Furthermore, Executive shall continue to be a full participant in the performance awards of the Company's Long-Term Incentive Plan, or if applicable, the Alternate Plan, and any other long-term incentive plans of the Company, and any and all executive incentive plans in which executives of the Company participate that are in effect immediately prior to a Change of Control, or any amended or successor plans with at least as favorable terms that may be substituted and that may hereafter be adopted, including, without limitation, any plan relating to stock options, stock appreciation rights, restricted stock and deferred stock awards, or equivalent successor plans that may be adopted by the Company with at least the same reward opportunities that have heretofore been provided and with such improvements in such plans or other plans as may from time to time be made in accordance with the present practices of the Company. 4 2.5 Employment Taxes and Withholding. Executive recognizes that the compensation, benefits, and other amounts provided by the Company under this Agreement may be subject to federal, state, or local income taxes. All such taxes shall be the responsibility of the Executive. To the extent that federal, state, or local law requires withholding of taxes on compensation, benefits, or other amounts provided under this Agreement, the Company shall withhold the necessary amounts from the amounts payable to Executive under this Agreement. 2.6 Company Not Responsible for Insured Benefits. In this Article II, the Company is agreeing to provide certain benefits in the form of premiums for insurance coverage. The Company and the Parent are not themselves promising to pay the benefit an insurance company is obligated to pay under the policy the insurance company has issued. If an insurance company does not or cannot pay benefits it owes to Executive or his beneficiaries under the insurance policy, neither Executive nor his personal representative or beneficiary shall have any claim for benefits against the Company or the Parent. 2.7 Expenses. Executive shall be entitled to receive reimbursement from the Company (in accordance with the policies and procedures then in effect for the Company's employees) for all reasonable travel and other expenses incurred by him in connection with his services under this Employment Agreement. III.TERMINATION OF EXECUTIVE'S EMPLOYMENT 3.1 Termination of Employment. Notwithstanding any other provision of this Agreement, Executive's employment and the Period of Employment may be terminated pursuant to the following: (a) Executive's employment may be terminated by the Company or the Parent, on not less than 60 days' notice in writing, for Cause as defined in Section 3.2. After payment of all amounts accrued to Executive hereunder through the date of such notice, the Company and the Parent shall have no further obligation to the Executive hereunder except for the payment of benefits under the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan and Capital Accumulation Plan vested on such date. (b) Executive's employment may be terminated by the Company at any time for any reason other than Cause as defined in Section 3.2, or Executive may terminate his employment with the Company and the Parent for Good Reason as defined in Section 3.3. In the event of termination of employment by the Company without Cause, or termination by the Executive for Good Reason, the Company shall pay to Executive, as liquidated damages or severance pay or both, the amounts described in Section 3.4. 5 (c) Executive may terminate his employment with the Company and the Parent for other than Good Reason. In such event, the Executive's employment shall terminate as of the 90th day following the giving of written notice by the Executive to the Company of his decision to terminate other than for Good Reason, or such earlier date as the Company may specify in written notice to Executive. After such termination, the Company and the Parent shall have no further obligation to the Executive hereunder except for the payment of benefits under the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan and Capital Accumulation Plan vested on such date. 3.2 Termination for Cause. (a) For purposes of this Article III, "Cause" shall mean only the following: (1) an intentional act or acts of dishonesty by the Executive or an act or acts by him resulting or intended to result directly or indirectly in gain to or personal enrichment of the Executive at the Company's expense; (2) a conviction of the Executive or an admission by the Executive of committing a felony or any crime involving moral turpitude, or any other criminal activity or unethical conduct which, in the good faith opinion of the Company, would impair Executive's ability to perform his duties or impair the business reputation of the Company; (3) a deliberate and intentional refusal by the Executive to comply with Sections 1.1 and 1.2 of this Agreement (other than any such failure to comply resulting from the Executive's incapacity due to illness or accident) and which failure to comply results in demonstrably material injury to the Company, provided, however, that the Executive shall have either failed to remedy such failure to comply within 30 days from his receipt of written notice from the Secretary of the Company demanding that he remedy such failure to comply, or shall have failed to take all reasonable steps to that end during such 30-day period and thereafter; or (4) a determination by the Chief Executive Officer or an affirmative vote of at least a majority of the entire membership (whether present or not) of the Company's Board of Directors (other than the Executive if also a director) at a meeting called and held for that purpose and at which the Executive is given an opportunity to be heard, that, in the judgment of the Chief Executive Officer or the Board, the Executive has, over an extended period of time, consistently failed to satisfactorily perform the material duties of his 6 office assigned to him, and such failure has had an adverse impact upon the Company; provided, however, that such determination may be made only after a period of at least 90 days following the last of two formal reviews (which are at least six months apart) of the Executive's performance by the Chief Executive Officer, at which the Executive was informed of the most significant deficiencies in performance, and during such 90-day period the Executive shall have failed to correct, or failed to take all reasonable steps to correct, such significant deficiencies. For purposes of the minimum number of directors required in the preceding sentence, any fraction shall be rounded up to the next higher whole number of directors. (b) Anything herein to the contrary notwithstanding, the employment of Executive shall not be considered to have been terminated by the Company for Cause if termination of his employment took place solely because of one or more of the following: (1) as a result of bad judgment or negligence on the part of Executive, or (2) as the result of an act or omission without intent of gaining therefrom directly or indirectly a profit to which Executive was not legally entitled; provided, however, that this subsection (b)(2) shall not apply to a termination pursuant to subsection (a)(3) above, or (3) because of an act or omission believed by Executive in good faith to have been in or not opposed to the interests of the Company, or (4) as the result of an act or omission which occurred more than 12 calendar months prior to Executive's having been given notice of the termination of his employment for such act or omission unless the commission of such act or such omission could not at the time of such commission or omission have been known to a member of the Board of Directors of the Company (other than Executive), in which case more than 12 calendar months prior to the date that the commission of such act or such omission was or could reasonably have been so known; provided, however, that this subsection (b)(4) shall not apply to a termination pursuant to subsection (a)(3) above, or (5) as a result of a continuing course of action which commenced and was or could reasonably have been known to a member of the Board of Directors of the Company (other than Executive) more than 12 calendar months prior to notice having been given to the Executive of the termination of his employment; provided, however, 7 that this subsection (b)(5) shall not apply to a termination pursuant to subsection (a)(3) above. 3.3 Good Reason. (a) For the purposes of this Article III, "Good Reason" shall mean: (1) the authority, powers, functions, responsibilities or duties assigned to Executive pursuant to this Agreement are materially and adversely diminished without his written consent (except any diminution that occurs solely as a result of the fact that the Company or Parent ceases to be a public company); (2) a breach of Article II of this Agreement with respect to the salary, incentive compensation and benefits of Executive; or (3) after a Change of Control (as defined in Section 4.1), Executive is required, without his written consent, to locate his office more than 35 miles distant by public highway from his office immediately prior to the Change in Control (but only if the distance between Executive's residence and such new office is greater than the distance between his residence and office immediately prior to the Change of Control) or to travel on business more than 60 working days in any year or more than 21 consecutive days at any one time. (b) Executive shall give written notice to the Company of termination for Good Reason within six months of the event giving rise to such notice and allow the Company 30 days after the Company's receipt of such notice to cure such breach. If the Company disputes any contention by Executive that there has been Good Reason, such dispute shall be resolved by binding arbitration held in Minneapolis, Minnesota in accordance with the Employment Dispute Resolution Rules of The American Arbitration Association then in effect. The arbitrator shall be an attorney with experience in employment disputes who is mutually selected by the parties. Judgment may be entered on the arbitration award in any court having jurisdiction. (c) In the event of the liquidation, dissolution, consolidation or merger of the Company or transfer (in one transaction or a series of transactions) of 70% or more of its assets (regardless of whether such event is not a Change of Control within the meaning of Section 4.1(c) because it is approved by the Continuing Directors), and the successor entity does not assume all duties and obligations of the Company under this Agreement or otherwise make arrangements with Executive satisfactory to Executive for employment of the Executive by the successor, then Executive may 8 within 90 days following such event give written notice to the Company of his termination of employment (effective as of 90 days following such notice or such earlier date as specified by the Company in written notice to Executive), which shall be deemed termination for Good Reason. 3.4 Severance Benefits. In the event of termination of Executive's employment by the Company without Cause, or termination by the Executive for Good Reason, the Company shall provide Executive with the following compensation and benefits; provided, that, the Company shall not be obligated to provide any severance benefits unless and until the Executive (if he is then so serving) resigns as a director of the Parent or the Company or any subsidiaries: (a) Salary. The Company shall pay Executive during the remainder of the Period of Employment as in effect immediately prior to such termination, as if such termination had not occurred, an amount equal to the base salary provided in Section 2.1, including any increases therein provided, at the times therein stated, for the month in which termination shall have occurred and for each month thereafter during such Period, less in respect of each such month the amounts, if any, paid to him pursuant to the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan and the amounts the Executive would have paid in cash in respect of employee benefits provided for in Section 2.3, if Executive were still employed. Notwithstanding the foregoing, in the event of a termination following a Change of Control, the salary amount described above shall be (i) determined based on a remaining Period of Employment of not less than 24 months (even if the actual Period of Employment is shorter) and (ii) paid in a single lump sum within 20 days after such termination. (b) Annual Incentive. The Company shall pay the Executive during the remainder of the Period of Employment as in effect immediately prior to such termination, as if such termination had not occurred, in full substitution for his rights under the Company's Management Incentive Plan, or, if applicable, the Alternate Plan, or any successor plan then in effect, a substitute incentive award, for the year in which termination occurred and for each subsequent calendar year, or portion thereof (in which case such substitute award shall be only in proportion to such portion), during such Period which shall be equal to the then current percentage at plan target of Executive's base salary for the applicable calendar year as described in Section 2.1 (including any increases therein provided). The substitute incentive award shall be paid in a single lump sum on the first day of February of each year, except that a pro rata award for that 9 portion of the calendar year in which the Period of Employment ends shall be paid in a single lump sum on the last day of the Period of Employment. Notwithstanding the foregoing, in the event of a termination following a Change of Control, the substitute incentive awards described above shall be (i) determined based on a remaining Period of Employment of not less than 24 months (even if the actual Period of Employment is shorter) and (ii) paid at one time within 20 days after such termination in an amount equal to the aggregate lump sum value of such substitute awards. (c) Long-Term Incentive. The Company shall pay Executive in full substitution for any rights under all outstanding performance awards under the Long-Term Incentive Plan, or, if applicable, the Alternate Plan, or any successor plan then in effect, held by Executive at the time of such termination, for each year during the remainder of the Period of Employment a substitute long-term award as follows: (1) If the termination occurs after the completion of any performance cycle under the applicable plan but before the award for such cycle has been paid, the substitute award for the year in which termination occurs will equal the percentage of Executive's base salary actually earned under the terms of the applicable plan for such completed cycles and will be paid at the same time other participants are paid for such completed cycles. Otherwise, a substitute long-term award will not be paid in the year of termination if Executive has already received in such year a long-term incentive payment pursuant to the applicable plan. (2) The substitute long-term award for all other years will equal the then current percentage (of salary) at plan target times Executive's then current annual base salary as provided in subsection (a) above and will be paid by February 1st of the year for which the payment is being made. (3) If the final year of the Period of Employment is a partial year, the substitute long-term award for such year (determined as in subparagraph (2) above) will be prorated based on the number of days in such partial year. For example: If the Executive is terminated in January 2001 before payment is made for the completed 1999 - 2000 performance cycle, the Executive's substitute long-term award for the year of termination (2001) will be equal to the award earned by the Executive under such completed cycle and will be paid at the same time as other participants are paid. If the Executive is terminated in the year 2001 after the payment for the 1999-2000 performance 10 cycle has been made, the first substitute long-term award will be paid in the year 2002. In either case, the Executive's substitute long-term award for the year 2002 will be paid by February 1, 2002 and will equal the then current percentage (of salary) at plan target times Executive's then current annual base. Notwithstanding the foregoing, in the event of a termination following a Change of Control, the substitute long term incentive awards described above shall be (i) determined based on a remaining Period of Employment of not less than 24 months (even if the actual Period of Employment is shorter) and (ii) paid at one time within 20 days after such termination in an amount equal to the aggregate lump sum value of such substitute awards. (d) Stock Awards. Each outstanding stock option to purchase shares of the Company's or the Parent's common stock and any stock appreciation right that is held by Executive at the time of such termination shall become vested and exercisable in full. Each stock option to purchase shares of the Company's or the Parent's common stock granted to Executive on or after the date hereof shall contain the following provision: In the event that the Optionee's Period of Employment under his Employment Agreement with the Company dated as of July 26, 1999 is terminated pursuant to Section 3.1(b) thereof, this Option shall become exercisable in full. In addition, all restrictions upon any restricted stock previously granted to Executive by the Company or the Parent shall be deemed to have lapsed and Executive shall be entitled to receive all such shares of restricted stock. Similarly, Executive shall be entitled to receive all shares covered by outstanding deferred stock awards previously granted to Executive by the Company or the Parent as if the deferral period and all conditions pertaining thereto had expired or been satisfied, as the case may be. (e) Death, Disability and Medical Benefits. During the remainder of the Period of Employment as in effect immediately prior to such termination, as if such termination had not occurred, the Executive shall continue to be entitled to all employee benefits provided for in Section 2.3(f), (g), and (h), as if Executive were still employed during such period under this Agreement, with benefits based upon the compensation and increases provided in subsection (a), and upon the assumption that Executive was continuing to pay or continued to be deemed to have paid in cash in respect of such benefits the amounts (and only the amounts) by which the payments otherwise due Executive under subsection (a) were reduced in respect to such benefits, and if and to the extent the said benefits shall 11 not be payable or provided under any plan by reason of Executive no longer being an employee of the Company as a result of Executive's termination, the Company itself shall pay or provider therefor. Notwithstanding the foregoing, if Executive is entitled to death, disability or medical benefit coverage of the kind described in Section 2.3(f), (g) or (h) from other employment or a consulting position during the Period of Employment, such benefits provided under this Agreement shall be reduced or coordinated as provided in subsection (g) below. (f) Retirement Benefits. The Company shall pay to Executive during the remainder of his life following the expiration of the Period of Employment as in effect immediately prior to such termination, and, after his death, to his surviving spouse (subject to such optional method of payment election as may be made under the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan and as further described below), a supplemental retirement benefit which shall be equal to the excess of: (1) an aggregate benefit at least equal to the benefit that would have been paid under the Employees' Retirement Plan and Supplemental Executive Retirement Plan, subject to any plan amendments or terminations generally applicable to all of the Company's senior officers which are adopted prior to the date of such termination, if the Executive had continued to be employed and to be entitled to service credit for benefits during the remainder of such Period of Employment at an annual rate of compensation equal to his compensation and increases provided in subsections (a) and (b) (unless during such remainder the Executive dies or becomes disabled, in which event such benefit shall be reduced to reflect application of the last two sentences of subsection (e), over (2) the aggregate benefit actually payable to the Executive under the Employees' Retirement Plan and Supplemental Executive Retirement Plan. In clarification of the foregoing paragraph (1), in determining whether any actuarial reduction would apply (and the amount of such reduction, if any) under the early retirement provisions of the Employees' Retirement Plan and Supplemental Executive Retirement Plan (to reflect the early commencements of benefits), the age which the Executive would have attained at the expiration of such Period, and the accredited service he would have had at such time, shall be used. An election made by Executive under the Employees' Retirement Plan and Supplemental Executive Retirement Plan as to a joint and survivor or other optional method of payment and as to the time for commencement of payments shall be applicable to such supplemental retirement benefit, with application of discount factors no less favorable to Executive than those in 12 effect under the Employees' Retirement Plan and Supplemental Executive Retirement Plan on the date of such termination. Notwithstanding the foregoing, Executive may, by a notice in writing filed with the Plan Administrator for the Employees' Retirement Plan and Supplemental Executive Retirement Plan, designate any person as the payee of amounts due hereunder after his death (in the manner, and with the effect, described in the Company's Employees' Retirement Plan and Supplemental Executive Retirement Plan). Notwithstanding the foregoing, in the event of a termination following a Change of Control, the supplemental retirement benefit described above shall be (i) calculated based upon the Executive's years of service at the time of the termination plus an additional five years and disregarding the requirement of five years of participation in the Supplemental Executive Retirement Plan, and (ii) paid in a single sum within 20 days after such termination in an amount equal to the lump sum value of such benefit. (g) Subsequent Employment. Executive shall be required to minimize damages or severance payments under this Agreement by seeking and accepting other executive employment or a comparable consulting position. To the extent that the Executive shall receive cash compensation that is subject to federal income taxation in respect of other employment or a consulting position with another company and that is payable to Executive solely in respect of the remainder of the Period of Employment as in effect immediately prior to such termination, or a portion thereof, the payments to be made by the Company under subsections (a), (b), and (c) for the remainder of the Period of Employment as in effect immediately prior to such termination or such portion thereof, as the case may be, shall be correspondingly reduced, and any supplemental retirement benefit payments pursuant to subsection (f) shall be calculated after taking such reduction into account. In the event Executive has received lump sum payments following a Change in Control as provided above, Executive agrees to re-pay the Company in quarterly payments the reductions described in the foregoing sentence. Furthermore, to the extent that benefits of the kind provided for in Section 2.3 (f), (g) and (h) are payable in respect of such other employment or consulting position, any death or disability benefits so payable under subsequent employment shall reduce benefits of such kind otherwise payable under subsection (e) above and any medical/dental/ welfare benefits so payable under subsequent employment shall be deemed the primary coverage for purposes of coordination of benefits under subsection (e) above and avoiding duplication of benefits. 13 (h) After Death or Disability. Upon the death of Executive during the period that payment of the amounts specified in subsection (a) above are required to be made, the obligation of the Company to make payments to the Executive under this Section 3.4 shall cease as of the date of death and the benefits described in Section 3.6 shall become payable. In the event of the disability of the Executive during such Period, the obligation to make payments under subsections (a) and (b) above shall be suspended as of the date specified in Section 2.2 for the cessation of payments of salary and Executive shall be entitled to the benefits described in Section 3.5, and such obligation shall be reinstated again only if during such period Executive ceases to be disabled. 3.5 Disability. If Executive has become disabled from performing his duties under this Agreement and the disability has continued for a period of six consecutive months or for an aggregate of 180 days during nine consecutive months, the Period of Employment under this Agreement shall terminate. Such termination shall not result in payments pursuant to Section 3.4 above, the disability benefits provided by the Company being in full satisfaction of the Company's obligation to Executive. 3.6 Death. Upon the death of Executive during the Period of Employment, the Period of Employment and the obligation of the Company to make payments under Section 2.1 shall cease as of the date of death, and benefits shall become payable under the death benefit plans described in Section 2.3(f) in accordance with their terms, exclusive of any plan amendments that reduce or terminate benefits thereunder not generally applicable to all of the Company's senior officers. 3.7 Non-Competition and Confidentiality. In consideration for the payments and benefits to be provided to Executive under this Agreement, Executive agrees to comply with the following requirements: (a) Agreement Not to Compete. Executive agrees that, on or before the first anniversary of the date Executive's employment under this Agreement terminates under Section 3.1, he will not, unless he receives the prior written approval of the Chief Executive Officer of the Company, directly or indirectly engage in any of the following actions: (1) Own an interest in (except as provided below), manage, operate, join, control, lend money or render financial or other assistance to, or participate in or be connected with, as an officer, director, employee, partner, stockholder, consultant or otherwise, any entity that is a competitor of the Company if the amount of competition is significant, i.e., the competition is in a line of business or products that constitute more than five percent of the gross revenues of both the Company and its consolidated subsidiaries and the competitor. However, nothing in this subsection (a) shall preclude Executive from (i) holding less than one percent of the outstanding capital stock of any corporation required 14 to file periodic reports with the Securities and Exchange Commission under Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the securities of which are listed on any securities exchange, quoted on the National Association of Securities Dealers Automated Quotation System or traded in the over-the-counter market or (ii) continuing to engage in any activities or investments that the Executive participated in prior to his termination of employment if such activities or investments did not violate Company policy. (2) Intentionally solicit, endeavor to entice away from the Parent or the Company, or any of their subsidiaries, or otherwise interfere with the relationship of the Parent or the Company, or any of their subsidiaries with, any person who is employed by or otherwise engaged to perform services for the Parent or the Company, or any of their subsidiaries (including, but not limited to, any independent sales representatives or organizations), or any persons or entity who is, or was within the then most recent 12-month period, a customer or client of the Parent or the Company, or any of their subsidiaries, whether for Executive's own account or for the account of any other individual, partnership, firm, corporation or other business organization. If the scope of the restrictions in this subsection are determined by a court of competent jurisdiction to be too broad to permit enforcement of such restrictions to their full extent, then such restrictions shall be construed or rewritten (blue-lined) so as to be enforceable to the maximum extent permitted by law, and Executive hereby consents, to the extent he may lawfully do so, to the judicial modification of the scope of such restrictions in any proceeding brought to enforce them. (b) Non-Disclosure of Information. During the period of his employment hereunder, and at all times thereafter, Executive shall not, without the written consent of the Chief Executive Officer of the Parent, disclose to any person, other than an employee of the Parent or the Company, or any of their subsidiaries or a person to whom disclosure is reasonably necessary or appropriate in connection with the performance by Executive of his duties as an executive of the Parent or the Company, except where such disclosure may be required by law, any material confidential information obtained by him while in the employ of the Parent or the Company with respect to any of their products, technology, know-how or the like, services, customers, methods or future plans, all of which Executive acknowledges are valuable, special and unique assets the disclosure of which Executive acknowledges may be materially damaging to the Parent or the Company. (c) Remedies. Executive acknowledges that the Parent's or the Company's remedy at law for any breach or threatened breach by Executive of subsection (a) or (b) will be inadequate. Therefore, the Parent or the 15 Company shall be entitled to injunctive and other equitable relief restraining Executive from violating those requirements, in addition to any other remedies that may be available to the Parent or the Company under this Agreement or applicable law. IV. CHANGE OF CONTROL 4.1 Change of Control Defined. For purposes of this Agreement, "Change of Control" means the occurrence of any of the following: (a) The acquisition by any person, entity or "group" within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended ("the 1934 Act"), other than the Company, the Parent or any of their affiliates, or any employee benefit plan of the Company and/or its affiliates, of beneficial ownership (within the meaning of Rule 13(d)-3 under the 1934 Act) of shares of stock of the Company or the Parent having twenty five percent (25%) or more of the total number of votes that may be cast for election of the Directors of the Company or the Parent in a transaction or series of transactions not approved in advance by a vote of at least three-quarters of the Continuing Directors (as defined below). (b) A change in the composition of the Board of Directors of the Company or the Parent such that at any time a majority of the Board are not Continuing Directors. "Continuing Directors" refers to the individuals who serve as Directors at the effective date of this Agreement and any individual whose term of office as a Director begins thereafter if the nomination or election of such Director was approved in advance by a vote of at least three-quarters of the then serving Continuing Directors (other than a nomination of an individual whose initial assumption of office is in connection with an actual or threatened solicitation with respect to the election or removal of the Directors, as such terms are used in Rule 14a-11 of Regulation 14A under the 1934 Act). (c) The approval by the shareholders of the Company or the Parent of a reorganization, merger, consolidation, liquidation or dissolution of the Company or the Parent, or of the sale (in one transaction or a series of transactions) of all or substantially all of the assets of the Company or the Parent other than a reorganization, merger, consolidation, liquidation, dissolution or sale approved in advance by a vote of at least three-quarters of the Continuing Directors. (d) Any other occurrence if at least a majority of the Continuing Directors determine in their discretion that there has been a Change of Control of the Company or the Parent. 16 4.2 Vesting of Stock Options and Restricted Stock. Upon a Change of Control, the right of Executive to exercise any and all stock options to purchase shares of the Company's or the Parent's stock and any stock appreciation rights held by Executive shall, to the extent that such options and rights shall not theretofore have been exercised, become fully vested and exercisable immediately, all restrictions upon any restricted stock previously granted to Executive shall be deemed to have lapsed and the deferral period and all conditions pertaining to any deferred stock awards previously granted to Executive shall be deemed to have expired or have been satisfied, as the case may be, and Executive shall be entitled to receive all such shares of restricted or deferred stock. All restricted stock and all deferred stock awards granted to Executive on or after the date hereof shall be awarded subject to the conditions described in the immediately preceding sentence. All options issued or awarded to the Executive on or after the date hereof shall contain the following provision: Notwithstanding anything herein contained to the contrary, in the event that a Change of Control, as defined in Section 4.1 of the Optionee's Employment Agreement with the Company dated as of July 26, 1999 should occur, this Option shall immediately thereafter become exercisable in full. 4.3 Trust Requirement After Change of Control. To assure the performance of the Company and the Parent of their obligations under this Agreement in the event of a Change of Control, the Company or the Parent shall, upon the request of Executive immediately prior to a Change of Control, deposit in an irrevocable trust with a trustee designated by Executive, an amount of liquid assets equal to the present value of the maximum amount of all lump amounts which could be paid to Executive under Section 3.4 in the event of a termination of employment of Executive without Cause following a Change of Control. Such trust shall be established and funded only if and to the extent that the establishment of such trust does not contravene the provisions of any loan agreement under which the Company or the Parent is obligated; provided, however, that the Company and Parent (as opposed to the lender under any such loan agreement) may not seek to preclude the establishment of such trust by initiating the entering into, renegotiating or amending of any such loan agreement, a principal purpose which entering into, renegotiating or amendment is such preclusion. The trust shall be reasonably satisfactory in form and substance to the Executive, with no greater rights in Executive than an unsecured creditor of the Company and Parent. To the extent there are not amounts in trust sufficient to pay Executive under this Agreement, the Company and Parent shall be and remain liable therefore. V. MISCELLANEOUS 5.1 Amendment. This Agreement may be amended only in a writing that is signed by all parties. 17 5.2 Entire Agreement. This Agreement contains the entire understanding of the parties with regard to the employment of the Executive by the Company and the Parent. There are no other agreements, conditions, or representations, oral or written, expressed or implied, with regard thereto. This Agreement supersedes all prior agreements, promises, and representations relating to the employment of Executive by the Company and the Parent. 5.3 Assignment. The Company may in its sole discretion assign this Agreement to any entity which succeeds to some or all of the business of the Company through merger, consolidation, a sale of some or all of the assets of the Company, or any similar transaction. Executive acknowledges that the services to be rendered by him are unique and personal. Accordingly, Executive may not assign any of his rights or obligations under this Agreement. 5.4 Successors. Subject to Section 5.3, the provisions of this Agreement shall be binding upon the parties hereto, upon any successor to or assign of the Company and the Parent, and upon Executive's heirs and the personal representative of Executive or Executive's estate. 5.5 Notices. Any notice required to be given under this Agreement shall be in writing and shall be delivered either in person or by certified or registered mail, return receipt requested. Any notice by mail shall be addressed as follows: If to the Company, to: The Musicland Group, Inc. 10400 Yellow Circle Drive Minnetonka, Minnesota 55343 Attention: Secretary If to Executive, to: The Musicland Group, Inc. 10400 Yellow Circle Drive Minnetonka, Minnesota 55343 Attention: ______________ With an additional copy to (home address): ----------------------- ----------------------- ----------------------- 18 or to such other addresses as either party may be designate in writing to the other party from time to time. 5.6 Waiver of Breach. Any waiver by either party of compliance with any provision of this Agreement by the other party shall not operate or be construed as a waiver of any other provision of this Agreement or of any subsequent breach by such party of a provision of this Agreement. 5.7 Potential Excise Taxes. (a) Gross-Up Payment. Anything to the contrary notwithstanding, in the event it shall be determined that any payment, distribution or benefit made or provided by or on behalf of the Company or Parent to or for the benefit of the Executive (whether pursuant to this Agreement or otherwise) (a "Payment"), would be subject to the excise tax imposed by Section 4999 of the Internal Revenue Code of 1986. as amended (the "Code"), or any interest or penalties with respect to such excise tax (such excise tax, together with any such interest and penalties, being, collectively referred to as the "Excise Tax"), then the Company shall pay the Executive in cash an additional amount (the "Gross-Up Payment") such that, after payment by the Executive of all taxes (including any interest or penalties imposed with respect to such taxes), including but not limited to income taxes (and any interest and penalties imposed with respect thereto) and the Excise Tax imposed upon the Gross-Up Payment, the Executive retains an amount of the Gross-Up Payment equal to the Excise Tax imposed on the Payments. Notwithstanding the foregoing, no amount shall be paid under this Section 5.7, and the amounts payable to Executive under this Agreement shall be reduced to the amount at which no such Excise Tax is payable, if the result of such reduction is to place Executive in the same or a better after-tax position than would result from making the additional payments provided under this Section. (b) Determination of Gross-Up Payment. Subject to sub-paragraph (c) below, all determinations required to be made under this Section 5.7, including whether a Gross-Up Payment is required and the amount of the Gross-Up Payment, shall be made by the firm of independent public accountants selected by the Company to audit its financial statements for the year immediately preceding the Change in Control (the "Accounting Firm") which shall provide detailed supporting calculations to the Company and the Executive within 30 days after the date of the Executive's termination of employment. In the event that the Accounting Firm is serving as accountant or auditor for the individual, entity or group affecting the Change in Control, the Executive may appoint another nationally recognized accounting firm to make the determinations required under this Section 5.7 (which accounting firm shall then be referred to as the 19 "Accounting Firm"). All fees and expenses of the Accounting Firm in connection with the work it performs pursuant to this Section 5.7 shall be promptly paid by the Company. Any Gross-Up Payment shall be paid by the Company to the Executive within 5 days of the receipt of the Accounting Firm's determination. If the Accounting Firm determines that no Excise Tax is payable by the Executive, it shall furnish the Executive with a written opinion that failure to report the Excise Tax on the Executive's applicable federal income tax return would not result in the imposition of a penalty. Any determination by the Accounting Firm shall be binding upon the Company and the Executive. As a result of the uncertainty in the application of Section 4999 of the Code at the time of the initial determination by the Accounting Firm, it is possible that Gross-Up Payments which will not have been made by the Company should have been made ("Underpayment"). In the event that the Company exhausts its remedies pursuant to sub-paragraph (c) below, and the Executive is thereafter required to make a payment of Excise Tax, the Accounting Firm shall promptly determine the amount of the Underpayment that has occurred and any such Underpayment shall be paid by the Company to the Executive within 5 days after such determination. (c) Contest. The Executive shall notify the Company in writing of any claim made by the Internal Revenue Service that if successful, would require the Company to pay a Gross-Up Payment. Such notification shall be given as soon as practicable but no later than 10 business days after the Executive knows of such claim and shall apprise the Company of the nature of such claim and the date on which such claim is requested to be paid. The Executive shall not pay such claim prior to the expiration of the 30-day period following the date on which the Executive gives such notice to the Company (or such shorter period ending on the date that any payment of taxes with respect to such claim is due). If the Company notifies the Executive in writing prior to the expiration of such period that it desires to contest such claim, the Employee shall: (1) give the Company any information reasonably requested by the Company relating to such claim; (2) take such action in connection with contesting such claim as the Company shall reasonably request in waiting from time to time, without limitation, accepting legal representation with respect to such claim by an attorney selected by the Company and reasonably acceptable to the Executive; (3) cooperate with the Company in good faith in order to effectively contest such claim; and 20 (4) permit the Company to participate in any proceedings relating to such claim, provided that the Company shall bear and pay directly all costs and expenses (including interest and penalties) incurred in connection with such contest and shall indemnify and hold the Executive harmless, on an after-tax basis, for any Excise Tax or income tax, including interest and penalties with respect thereto, imposed as a result of such representation and payment of costs and expenses. Without limitation on the foregoing provisions of this subparagraph (c), the Company shall control all proceedings taken in connection with such contest. At its sole option, the Company may pursue or forego any and all administrative appeals, proceedings, hearings and conferences with the taxing authority in respect of such claim and may either direct the Executive to pay the tax claimed and sue for a refund or contest the claim in any permissible manner. The Executive agrees to prosecute such contest to a determination before any administrative tribunal, in a court of initial jurisdiction and in one or more appellate courts, as the Company shall determine, provided that any extension of the statute of limitations relating to payment of taxes for the taxable year of the Executive with respect to which such contested amount is claimed to be due is limited solely to such contested amount. The Company's control of the contest shall be limited to issues with respect to which a Gross-Up Payment would be payable hereunder, and the Executive shall be entitled to settle or contest, as the case may be, any other issue raised by the Internal Revenue Service or any other taxing authority. Furthermore, the Company agrees to hold in confidence and not to disclose, without Executive's prior written consent, any information with regard to Executive's tax position which the Company obtains pursuant to this Section 5.7. (d) Suit for Refund. If the Company directs the Executive to pay any claim and sue for a refund, the Company shall advance the amount of such payment to the Executive, on an interest-free basis. If the Executive becomes entitled to receive any refund with respect to such claim, the Executive shall promptly pay to the Company the amount of such refund (together with any interest paid or credited thereon after taxes applicable thereto). If a determination is made that the Executive shall not be entitled to any refund with respect to such claim and the Company does not notify the Executive in writing of its intent to contest such denial of refund prior to the expiration of 30 days after such determination, then such advance shall be forgiven and shall not be required to be repaid and the amount of such advance shall offset, to the extent thereof, the amount of Gross-Up Payment required to be paid. 21 5.8 Indemnification. The Company will indemnify Executive (and his legal representatives or other successors) to the fullest extent permitted (including payment of expenses in advance of final disposition of a proceeding) by the laws of the State of Delaware, as in effect at the time of the subject act or omission, or by the Restated Certificate of Incorporation and By-Laws of the Company, as in effect at such time or on the effective date of this Agreement, or by the terms of any indemnification agreement between the Company and Executive, whichever affords or afforded greater protection to Executive, and the Executive shall be entitled to the protection of any insurance policies the Company may elect to maintain generally for the benefit of its directors and officers (and to the extent the Company maintains such an insurance policy or policies, Executive shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage affordable for any Company officer or director), against all costs, charges and expenses whatsoever incurred or sustained by him or his legal representatives at the time such costs, charges and expenses are incurred or sustained, in connection with any actions, suit or proceeding to which he (or his legal representatives or their successors) may be made a party by reason of his being or having been a director, officer or employee of the Company, the Parent or any subsidiary of either of them, or his serving or having served any other enterprise as a director, officer or employee at the request of the Company. 5.9 Attorney's Fees. In the event of any litigation, arbitration, or other proceeding between the Company and Executive with respect to this Agreement or the enforcement of Executive's rights hereunder, if the Executive prevails on any issue which is a material part of such litigation, arbitration or other proceeding, the Company shall periodically reimburse Executive for all of the reasonable costs and expenses relating to such litigation, arbitration or proceeding (including, without limitation, reasonable attorneys' fees). In no event shall Executive be required to reimburse the Company or the Parent for any of the costs or expenses relating to such litigation, arbitration, or proceeding. 5.10 Joint and Several Liability. All duties, undertakings, obligations, and liabilities of the Company and the Parent arising under this Agreement shall be the joint and several liability of the Company and the Parent. 5.11 Severability. If any one or more of the provisions (or portions thereof) of this Agreement shall for any reason be held by a final determination of a court of competent jurisdiction to be invalid, illegal, or unenforceable in any respect, such invalidity, illegality, or unenforceability shall not affect any other provisions (or portions of the provisions) of this Agreement, and the invalid, illegal, or unenforceable provision shall be deemed replaced by a provision that is valid, legal, and enforceable and that comes closest to expressing intention of the parties. 5.12 Governing Law. This Agreement shall be interpreted and enforced in accordance with the laws of the State of Minnesota, without giving effect to conflict of law principles. 22 5.13 Headings. The headings of articles and sections herein are included solely for convenience and reference and shall not control the meaning of interpretation of any of the provisions of this Agreement. 5.14 Counterparts. This Agreement may be executed by either of the parties in counterparts, each of which shall be deemed to be an original, but all such counterparts shall constitute a single instrument. IN WITNESS WHEREOF, the parties have executed this Agreement effective as of the date set forth above. MUSICLAND STORES CORPORATION THE MUSICLAND GROUP, INC. By:-------------------------------------- Jack W. Eugster Chairman and CEO EXECUTIVE ----------------------------------------- 23 EX-21 4 SUBSIDIARY INFORMATION SUBSIDIARY INFORMATION EXHIBIT 21 UPDATED AS OF DECEMBER 31, 1999 I. SUBSIDIARIES OF MUSICLAND STORES CORPORATION State of Name(s) Under Which Name Of Corporation Incorporation Corporation Does Business - ------------------- ------------- ------------------------- The Musicland Group, Inc. Delaware Discount Records Excelsior Musicland Musicland/Suncoast Motion Picture Company On Cue Replay Sam Goody Sam Goody's Music & Video Sam Goody's Musicland Sam Goody/Suncoast Motion Picture Company II. SUBSIDIARIES OF THE MUSICLAND GROUP, INC. State of Name(s) Under Which Name Of Corporation Incorporation Corporation Does Business - ------------------- ------------- ------------------------- Media Play, Inc. Delaware Media Play MG Financial Services, Inc. Delaware MLG Internet, Inc. Delaware mediaplay.com oncue.com samgoody.com suncoast.com Musicland Retail, Inc. Delaware Musicland Musicland/Suncoast Motion Picture Company Replay Sam Goody Sam Goody/Suncoast Motion Picture Company On Cue, Inc. Delaware On Cue Request Media, Inc. Delaware Request requestline.com Suncoast Group, Inc. Delaware Producers Club Suncoast Motion Picture Company Suncoast Pictures Suncoast Motion Picture Company, Inc. Delaware Suncoast Retail, Inc. Delaware Producers Club Suncoast Motion Picture Company TMG Caribbean, Inc. Delaware Musicland Sam Goody Suncoast Motion Picture Company TMG-Virgin Islands, Inc. Delaware Sam Goody EX-23 5 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS Exhibit 23 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report dated January 21, 2000, included in this form 10-K, into the Company's previously filed Registration Statement File Nos. 33-50520, 33-50522, 33-50524, 33-82130, 33-99146, 333-51401 and 333-68275. ARTHUR ANDERSEN LLP Minneapolis, Minnesota, March 24, 2000 EX-27 6 FINANCIAL DATA SCHEDULE
5 This schedule contains summary financial information extraced from the consolidated balance sheet of Musicland Stores Corporation and subsidiaries as of December 31, 1999, and the related consolidated statement of operations for the year then ended, and is qualified in its entirety by reference to such financial statements. 1000 Year Dec-31-1999 Jan-01-1999 Dec-31-1999 335,693 0 0 0 444,792 816,947 467,526 230,976 1,063,574 655,362 258,950 0 0 362 108,996 1,063,574 1,891,828 1,891,828 1,200,993 1,200,993 584,794 0 22,661 83,380 25,000 58,380 0 0 0 58,380 1.65 1.60
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