MUSICLAND STORES CORP, 10-K405, 1997-04-11

MUSICLAND STORES CORP
10-K405, 1997-04-11
RADIO, TV & CONSUMER ELECTRONICS STORES

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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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, 1996

[ ] 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

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MUSICLAND STORES CORPORATION
(Exact name of Registrant as specified in its charter)

<TABLE>
<S> <C>
DELAWARE 41-1623376
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

10400 YELLOW CIRCLE DRIVE,
MINNETONKA, MINNESOTA 55343
(Address of principal executive (Zip Code)
offices)
</TABLE>

Registrant's telephone number, including area code: (612) 931-8000

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Securities registered pursuant to Section 12(b) of the Act:

<TABLE>
<CAPTION>
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
- ----------------------------------------------- -----------------------------------------------
<S> <C>
Common stock, $.01 par value New York Stock Exchange
</TABLE>

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. _X_

The aggregate market value of the voting stock held by nonaffiliates of the
Registrant on March 26, 1997 was $38,371,268.75, based on the closing price of
$1 1/4 per common share on the New York Stock Exchange on such date (only
members of the Management Investors Group are considered affiliates for this
calculation).

The number of shares outstanding of the Registrant's common stock on March 26,
1997 was 34,301,956.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Proxy Statement for the 1997 Annual Meeting of
Stockholders (the "Proxy Statement") are incorporated by reference into Part
III.

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PART I

ITEM 1. BUSINESS

GENERAL

The Company operates principally in the United States and is engaged in one
industry segment as a specialty retailer of home entertainment products,
including prerecorded music, prerecorded video, books, computer software and
related accessories. The Company's two principal business categories are
non-mall based full-media superstores operating under the names Media Play and
On Cue and mall based music and video sell-through stores operating under the
names Sam Goody, Musicland and Suncoast Motion Picture Company ("Suncoast"). At
December 31, 1996, the Company operated 1,466 stores in 49 states, the District
of Columbia, the Commonwealth of Puerto Rico, the Virgin Islands and the United
Kingdom. For the year ended December 31, 1996, the Company had consolidated
revenues of $1.8 billion, including $0.6 billion from non-mall stores and $1.2
billion from mall stores.

The market for prerecorded music and video, books, computer software and
related accessories continues to be highly competitive. The number of stores and
types of competitors have increased significantly over the past few years,
including non-mall discount stores, consumer electronics superstores and other
mall based music, video and book specialty retailers expanding into non-mall
multimedia superstores of their own. The low prices offered by these non-mall
stores create intense price competition and adversely impact the performance of
both the Company's non-mall and mall stores. Further, consumers have more home
entertainment options available with the increasing penetration of personal
computers into homes, while industry growth in prerecorded music sales has
slowed due to the lack of strong product releases. The Company anticipates that
the challenging retail sales environment will continue into the foreseeable
future.

Management implemented programs during 1996 to improve profitability, reduce
inventory levels and increase inventory turnover. More focused marketing and
advertising programs were instituted in late 1996. The Company slowed store
expansion to focus on improving performance in its existing stores and recorded
pretax restructuring charges totaling $75 million to reflect estimated costs
associated with the closing of 115 underperforming stores and the Company's
distribution facility in Minneapolis, Minnesota. The Company also evaluated
goodwill for impairment in 1995 and 1996 and recorded a write-down of $138
million in 1995 and a write-down of the remaining balance of $95.3 million in
1996. See "Management's Discussion and Analysis of Results of Operations and
Financial Condition."

During the year ended December 31, 1996, the Company opened 35 stores and
closed 65 stores, resulting in a net decrease in store count of 30 stores. At
December 31, 1996, the Company operated 245 non-mall stores with total square
footage of 5.2 million and 1,199 mall stores with total square footage of 4.3
million. After store closings under the restructuring programs are completed and
before consideration of other changes to store counts in 1997, the Company will
operate 225 non-mall stores with total square footage of 4.2 million and 1,157
mall stores with total square footage of 4.1 million. Store expansion in 1997
will be very limited.

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 herein as the "Company."

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NON-MALL STORES

MEDIA PLAY STORES. Media Play stores are full-media, low-price superstores
in freestanding and regional strip mall locations averaging 48,000 square feet
in size. These stores offer a broad merchandising assortment appealing to all
ages. During 1996, the merchandising strategy of Media Play stores was revised
to minimize slow-moving inventory and reduce working capital investment. The
streamlined Media Play stores have approximately 100,000 SKU's of merchandise
compared to 175,000 SKU's previously. In addition to prerecorded music, books
and prerecorded video, Media Play stores carry approximately 2,000 computer
software programs and video games and 1,500 magazine titles, as well as comic
books, greeting cards, licensed music, movie and sports apparel and other media
and related products.

Media Play stores provide a family oriented and exciting shopping
environment featuring easy access to all merchandise categories, lounge areas
for relaxed browsing, convenient customer service areas, live performances and
other entertainment activities, children's play areas, coffee carts and popcorn
stands. In-store events, such as musician appearances, book clubs and drawing
events, have been popular with customers and will be continued. In late 1996,
advertising and merchandising programs were upgraded as part of the Company's
strategy to increase store traffic and the average purchase per customer. The
Company plans to continue in-store merchandising tests to identify additional
product category opportunities. Currently, an expanded children's department is
being tested that will provide an interactive learning environment for children.

The first Media Play store opened in Rockford, Illinois in November 1992.
The Company opened nine Media Play stores in 1996 and closed 11 under the
restructuring programs. As part of the Company's effort to improve store
productivity, the new stores were smaller in size, averaging approximately
44,000 square feet. At December 31, 1996, the Company operated 87 Media Play
stores in 20 states with total square footage of approximately 4.2 million, or
44% of the Company's total store square footage. The Company plans to close an
additional 20 underperforming Media Play stores during 1997 under its
restructuring programs. After these closings are completed, the Company will
operate 67 Media Play stores in 19 states with total square footage of 3.2
million. In other efforts to improve store productivity, 10 to 20 existing
stores will be downsized to approximately 35,000 to 40,000 square feet. The
Company plans to sublease the vacated space.

ON CUE STORES. On Cue stores are full-media stores for smaller markets of
between 5,000 and 20,000 people and average 6,200 square feet in size. The
stores emphasize competitive prices on new releases and everyday low prices on
catalog titles. On Cue stores are promoted through highway billboards, direct
mail, cable television and local print and radio. Customer loyalty is rewarded
through such programs as in-store sweepstakes and unadvertised in-store
specials. The stores offer prerecorded music, books, prerecorded video, computer
software, accessories and entertainment related licensed products, such as
apparel and posters. Most stores carry approximately 25,000 SKU's of
merchandise. On Cue customers have access to over 100,000 home entertainment
titles through the Company's special order program.

The first On Cue store opened in February 1992. The Company opened 10 On Cue
stores in 1996 and closed five under the restructuring programs. At December 31,
1996, the Company operated 158 On Cue stores in 28 states with total square
footage of approximately 1.0 million, or 10% of the Company's total store square
footage.

MALL STORES

The Company's mall based music stores continue to experience increasing
competition from non-mall discount stores, consumer electronics superstores and
other mall based music, video and book specialty retailers that are expanding
into non-mall multimedia superstores of their own. These non-mall competitors
are expanding into new markets and offer low prices on prerecorded music and
video products.

MUSIC STORES. The majority of the mall based music stores are operated
under the name Sam Goody. At December 31, 1996, there were 777 music stores in
49 states, the District of Columbia, the Commonwealth of Puerto Rico and the
Virgin Islands. These stores offer a full line of music, video and home

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entertainment products through stores averaging 4,200 square feet and ranging
from 1,000 square feet to 30,000 square feet in size. The total square footage
of music stores was approximately 3.3 million, or 34% of the Company's total
store square footage at December 31, 1996.

In recent years, the Company has opened combo stores, principally in malls
and downtown locations. These combo stores combine a full line of both music and
video products and offer computer and entertainment software. When compared to
traditional mall based music stores, "combo" stores are larger and more
prominent in the mall and carry a broader inventory of catalog product,
including substantial classical offerings and sell-through video, to appeal to
the high volume purchaser.

The mall based music stores offer REPLAY, a frequent shopper program
designed to promote customer loyalty and enable targeted marketing. More than
500,000 mall based music store customers participate in the REPLAY program. A
music and video publication specially designed for adult REPLAY members was
introduced in 1996. In addition, the Company publishes "REQUEST," a cutting-edge
music and video entertainment news magazine for younger customers. "REQUEST" is
distributed in the music stores and at limited magazine stand outlets. The
magazine has an audited monthly circulation of 1,029,000 and an estimated
monthly readership of 2.5 million.

Expansion of mall based music stores has been curtailed in order to focus on
streamlining the existing store base and improving profitability. In 1996, the
Company opened three new stores and closed 46 stores. The closings included 36
stores under the restructuring programs and 10 stores that were generally non-
productive and at or near the end of their lease terms. Additionally, the
Company continued the conversion of store names from Musicland to Sam Goody and
plans to convert additional stores in 1997. The Company plans to close an
additional 33 underperforming music stores during 1997 under its restructuring
programs. After these closings are completed, the Company will operate 744 music
stores with total square footage of 3.1 million. The Company also plans to close
other nonproductive stores during 1997, the majority of which are at or near the
end of their lease terms.

SUNCOAST MOTION PICTURE COMPANY STORES. The mall based Suncoast stores
primarily offer sell-through video and average 2,440 square feet in size. The
prerecorded video categories include adventure, comedy, drama, family, animated,
musicals, music video, instructional and other special interest. The video
selection ranges from 6,000 to 13,000 titles and is complemented by movie and
Hollywood related apparel and gift products, accessories, blank video tapes,
laser discs and special order prerecorded video cassettes and laser discs. Most
of the movies 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's marketing programs include sweepstakes, instant rebates, phone
card promotions and exclusive merchandise events promoting recent video
releases. Suncoast stores utilize theme and cross-promotional merchandising that
coordinates the display and sale of licensed merchandise with the related movie
or genre to maximize total sales. "Producers' Club," a customer loyalty program,
is being tested in key targeted markets.

At December 31, 1996, there were 422 Suncoast stores in 46 states, the
District of Columbia and the Commonwealth of Puerto Rico. In 1996, the Company
opened 11 new Suncoast stores and closed one non-productive store. The total
square footage of Suncoast stores was approximately 1.0 million, or 11% of the
Company's total store square footage at December 31, 1996. The Company plans to
close an additional nine underperforming Suncoast stores during 1997 under its
restructuring programs. After these closings are completed, the Company will
operate 413 Suncoast stores.

INTERNATIONAL STORES

The Company operates music stores in the United Kingdom under the name Sam
Goody. The first two stores in the United Kingdom were opened in 1990. In 1996,
the Company opened two new stores and closed one store. At December 31, 1996,
the Company had 22 stores in operation averaging approximately 2,900 square feet
in size. The United Kingdom stores provide for their own corporate services,
including purchasing and distribution.

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PRODUCTS

The following table shows the sales and percentage of total sales
attributable to each product group.

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
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1996 1995 1994
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SALES % SALES % SALES %
--------- --------- --------- --------- --------- ---------
(DOLLARS IN MILLIONS)
<S> <C> <C> <C> <C> <C> <C>
Prerecorded music:
Compact discs...................................... $ 681.9 37.4% $ 610.1 35.4% $ 534.2 36.1%
Audio cassettes and other.......................... 249.2 13.7 284.9 16.5 314.7 21.3
--------- --------- --------- --------- --------- ---------
Total............................................ 931.1 51.1 895.0 51.9 848.9 57.4

Prerecorded video.................................... 531.2 29.2 505.9 29.4 413.5 28.0
Books................................................ 126.3 6.9 106.6 6.2 56.5 3.8
Computer software, accessories and apparel........... 233.0 12.8 215.1 12.5 159.9 10.8
--------- --------- --------- --------- --------- ---------
Total............................................ $ 1,821.6 100.0% $ 1,722.6 100.0% $ 1,478.8 100.0%
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</TABLE>

PRERECORDED MUSIC. Sales of compact discs are expected to continue to grow
and become a larger portion of total prerecorded music sales while sales of
prerecorded audio cassettes are expected to continue to decline. The Company's
non-mall based Media Play and On Cue stores and mall based music stores offer
assortments of compact discs and prerecorded audio cassettes purchased from all
major manufacturers. Media Play and On Cue stores typically carry approximately
30,000 and 5,000 titles of prerecorded music, respectively. Music stores
typically carry 6,000 titles, while combo stores carry up to 30,000 titles,
depending upon store size and location. 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. The Company
also produces and sells prerecorded music under its "Excelsior" label. Product
includes compilations of public domain classical, jazz, big band and reggae
music.

Several key suppliers of prerecorded music have more strictly enforced
minimum advertised price ("MAP") programs. Under the terms of these programs,
retailers which sell prerecorded music below the MAP lose the cooperative
advertising funding which they would normally receive from the supplier. The
severity of the penalty varies by supplier from losing advertising funding for
the life of the title to losing it for 30 days or losing advertising support on
the supplier's total offering. In the first quarter of 1997, two of the six
largest prerecorded music suppliers raised the MAP by $1.00. These MAP policies
are determined by the suppliers and compliance with them by retailers is at
their discretion. See "--Competition" and "Management's Discussion and Analysis
of Results of Operations and Financial Condition--Results of Operations--Sales"
and "--Gross Profit."

PRERECORDED VIDEO. The demand for movies and other prerecorded video has
increased in direct response to the penetration of video cassette recorders into
most homes in the United States, the lowering of prices and the growing consumer
acceptance of owning videos. Prerecorded video cassettes are for sale at all of
the Suncoast, Media Play and On Cue stores and at substantially all of the music
stores. Suncoast stores typically carry 8,000 title selections. Media Play
stores and On Cue stores typically carry 10,000 and 2,000 titles of prerecorded
video cassettes, respectively. Music stores carry approximately 2,000 title
selections; combo stores carry up to 11,000 title selections. Management, based
on industry information, believes the demand for video will continue to
increase, causing sales of prerecorded video to be a growing component of the
Company's total revenues.

Merchandising of digital video discs ("DVD"), a new video technology, is
expected to begin in 1997. DVD offers the consumer laser technology in a smaller
disc format with superior picture quality and audio fidelity. The Company
believes that in the next few years, sales of DVD players will begin to replace
sales of laserdisc players and video cassette recorders as the new technology
becomes widely available. Management expects to capitalize on the release of DVD
players by offering software as soon as it is available. However, DVD demand
could accelerate faster or slower depending upon how consumers react

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to its technical superiority over the VHS format and the introductory price
points of the hardware and software.

BOOKS. The Company began selling books with the introduction of the
non-mall based full-media superstores in 1992. Media Play and On Cue stores
typically carry 29,000 and 4,000 titles of books, respectively.

COMPUTER SOFTWARE, ACCESSORIES AND APPAREL. This product category includes
computer and entertainment software, brand name blank audio and video tapes,
storage containers, carrying cases and guitar and piano sheet music, as well as
entertainment related apparel, posters and various other items. Movie and artist
related accessories and apparel are highly influenced by the trends and fads
surrounding popular movies, actors and artists. The Company's stores also carry
a limited variety of portable electronic equipment such as audio cassette
players, radios and stereo audio cassette/radios, generally sold at retail
prices of approximately $200 or less.

SUPPLIERS

Substantially all of the home entertainment products (other than computer
software) sold by the Company are purchased directly from manufacturers. The
Company purchases inventory for its stores from approximately 3,100 suppliers
and has consignment arrangements with approximately 1,800 of these suppliers.
Approximately 60% of purchases in 1996 were made from the eight largest
suppliers. 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.

During 1996, the Company experienced difficulty in obtaining shipments from
certain vendors in the books, computer software, video games and trend product
categories, primarily due to concerns about the Company's liquidity. In the
first quarter of 1997, the Company's largest vendors and a substantial majority
of the remaining vendors agreed to temporarily defer existing trade payables and
provide continued product supply, subject to payment terms reduced to 10 days or
less on new purchases. Because these understandings are voluntary on the part of
the vendors and will continue at their sole discretion, there can be no
assurance that the Company will continue to receive adequate product from its
vendors on acceptable credit terms. See "Management's Discussion and Analysis of
Results of Operations and Financial Condition--Liquidity and Capital Resources."

MARKETING

The Company uses a high level of advertising and promotions in marketing its
products. Marketing and advertising programs include special events, advertising
partnerships with vendors and corporate partnerships with nationally known
names. Additionally, frequent buyer programs in the Company's mall stores and
certain product specific programs in On Cue stores are designed to build
customer loyalty and encourage repeat visits. The Company has been sponsoring
nationally televised/advertised events such as ESPN's Xtreme Games and the
"UnVailed" battle of the bands, which appeal to its target customers. Other
advertising programs which are being created in conjunction with vendors include
television and billboard ads featuring specific albums or movies.

The Company's major suppliers offer cooperative advertising support and
provide funds for the placement and position of product. A significant portion
of the Company's total advertising costs have been funded by suppliers through
these programs. The Company advertises principally through newspaper inserts.
Because of the high concentration of its mall stores in major metropolitan areas
such as New York, Chicago and Los Angeles, the Company has been able to expand
its radio and local television advertising in those areas. The national
distribution of the Company's mall stores has made it practical to advertise in
certain national magazines and on nationally syndicated radio programs and cable
television, including MTV.

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STORE OPERATIONS

Media Play stores typically are managed by a general manager, an operations
manager and three to five department managers. On Cue, music and Suncoast stores
are typically managed by a store manager and one to three assistant 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.

COMPETITION

The market for prerecorded music and video, books, computer software and
related accessories continues to be highly competitive. Some or all of these
home entertainment products can be purchased or rented through other mall retail
chains, warehouse clubs, individual stores, video rental stores, grocery,
convenience and drug stores, television, telephone or Internet mail order offers
and mail order clubs. The number of stores and types of competitors have
increased significantly over the past few years, including non-mall discount
stores, consumer electronics superstores and other mall based music, video and
book specialty retailers expanding into non-mall multimedia superstores of their
own. The low prices offered by these non-mall stores create intense price
competition and adversely impact the performance of both the Company's non-mall
and mall stores. Further, consumers have more home entertainment options
available with the increasing penetration of personal computers into homes,
while industry growth in prerecorded music sales has slowed due to the lack of
strong product releases. The Company anticipates that the challenging retail
sales environment will continue into the foreseeable future. The Company
believes that its ability to compete successfully depends on its ability to
secure and maintain attractive and convenient locations, manage merchandise
efficiently, offer broad product selections at competitive prices, provide
effective management and control operating costs. See "Management's Discussion
and Analysis of Results of Operations and Financial Condition."

SEASONALITY

The Company's business is highly seasonal, with nearly 40% of the annual
revenues and all of the net earnings generated in the fourth quarter. Quarterly
results are affected by, among other things, the timing of holidays, new product
offerings and new store openings and sales performance of existing stores. See
Note 16 of Notes to Consolidated Financial Statements.

TRADEMARKS AND SERVICE MARKS

The Company operates its stores under various names, including "Media Play,"
"On Cue," "Sam Goody," "Musicland," and "Suncoast Motion Picture Company," which
have become important to the Company's business as a result of its advertising
and promotional activities. These names, along with a number of others,
including "Request," "REPLAY," "Excelsior" and "Channel 1000," have been or are
being registered with the U.S. Patent and Trademark Office. The Company intends
to continue to use these names and marks and may use new names for specific
stores depending on the type of store and its location.

PERSONNEL

As of March 25, 1997, the Company employed approximately 6,100 full-time
employees, 9,200 part-time employees and 600 temporary employees. Hourly
employees at 17 of the Company's stores are represented by unions. 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. In the third quarter of 1996, net proceeds of $11.6 million
were received from the sale of the 513,000 square foot building containing the
Company's distribution facilities

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and certain corporate office facilities in Minneapolis, Minnesota. The Company
leased back the entire building through January 1997 and thereafter will
continue to lease approximately 73,000 square feet of office and storage space
in the building through January 2002. In January 1997, the Company completed the
consolidation of its distribution facilities into one center in Franklin,
Indiana. The distribution facility is in a 715,000 square foot building and is
under an operating lease that expires in 1999 with a one year renewal option.
The lease contains purchase options at the end of the original and renewal
periods. See "Management's Discussion and Analysis of Results of Operations and
Financial Condition--Liquidity and Capital Resources" and Note 10 of Notes to
Consolidated Financial Statements .

STORE LEASES. Most of the Company's stores are under operating leases with
various remaining terms through the year 2017. The Company owns three Media Play
stores. The leases have terms ranging from 3 to 25 years. Certain store leases
contain provisions restricting assignment, merger, change of control or
transfer. In most instances, the Company pays, in addition to minimum rent, real
estate taxes, utilities, common area maintenance costs and percentage rentals
which are based upon sales volume. 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. The following table lists the number of
leases due to expire or terminate in each fiscal year, based on the fixed lease
term and excluding renewal options.

<TABLE>
<S> <C> <C> <C>
1997 181 2002 108
1998 124 2003 137
1999 182 2004 124
2000 200 2005 111
2001 185 2006 and thereafter 111
</TABLE>

The Company expects that, as these current leases expire, in most cases it
should be able to obtain either renewal leases, if desired, or new leases at
equivalent or better locations.

ITEM 3. LEGAL PROCEEDINGS

The Company is a party to various claims, legal actions and complaints
arising in the ordinary course of business. In the opinion of management, all
such matters are without merit or involve such amounts that unfavorable
disposition will not have a material impact 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 fiscal year covered by this report.

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 16 of Notes to
Consolidated Financial Statements. As of March 26, 1997, MSC had approximately
705 holders of record of its common stock.

MSC has never paid cash dividends on its capital stock and does not plan to
pay cash dividends in the foreseeable 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 credit agreement and the indenture for the 9% senior subordinated
notes restrict the amount of cash dividends that may be paid by MSC. See Note 4
of Notes to Consolidated Financial Statements.

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ITEM 6. SELECTED FINANCIAL DATA

The following table sets forth selected financial data for the periods
indicated. This information should be read in conjunction with the Consolidated
Financial Statements and related notes contained in Item 14 herein and
"Management's Discussion and Analysis of Results of Operations and Financial
Condition" contained in Item 7 herein. No cash dividends have ever been declared
on the common stock of MSC.

SELECTED CONSOLIDATED FINANCIAL DATA
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS AND STORE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------------------------------------------
1996 1995 1994 1993 1992
------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
STATEMENT OF EARNINGS DATA:
Sales......................................... $ 1,821,594 $ 1,722,572 $ 1,478,842 $ 1,181,658 $ 1,020,508
Gross profit.................................. 611,759 606,070 542,199 470,951 414,167
Selling, general and administrative
expenses.................................... 576,658 525,213 450,919 365,311 319,713
Depreciation and amortization................. 44,819 45,531 37,243 29,057 24,715
Goodwill write-down........................... 95,253 138,000 -- -- --
Restructuring charges......................... 75,000 -- -- -- --
Operating income (loss)....................... (179,971) (102,674) 54,037 76,583 69,739
Interest expense.............................. 32,967 27,881 19,555 19,831 24,418
Earnings (loss) before income taxes and
extraordinary charges....................... (212,938) (130,555) 34,482 56,752 45,321
Income taxes.................................. (19,200) 5,195 17,100 25,400 21,100
Earnings (loss) before extraordinary
charges(1).................................. (193,738) (135,750) 17,382 31,352 23,518
Earnings (loss) per common share(1)........... $ (5.80) $ (4.00) $ 0.51 $ 1.03 $ 0.83
Weighted average number of common shares
outstanding................................. 33,414 33,898 34,238 30,548 28,398

DECEMBER 31,
--------------------------------------------------------------------
1996 1995 1994 1993 1992
------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Total assets.................................. $ 996,915 $ 996,957 $ 1,079,632 $ 905,682 $ 689,349
Revolver...................................... 272,000 53,000 -- -- --
Long-term debt, including current
maturities.................................. 124,599 110,000 110,000 135,000 103,541
Stockholders' equity.......................... 2,619 195,811 340,276 322,594 223,646
Book value per common share(2)................ 0.08 5.71 9.94 9.42 7.42

STORE DATA:
Total store square footage (in millions)...... 9.5 9.9 7.2 4.9 3.8
Store count:
Media Play stores........................... 87 89 46 13 1
On Cue stores............................... 158 153 77 32 13
Music stores................................ 777 820 869 875 861
Suncoast stores............................. 422 412 378 320 252
Readwell's store............................ -- 1 1 1 --
United Kingdom stores....................... 22 21 15 10 8
------------ ------------ ------------ ------------ ------------
Total..................................... 1,466 1,496 1,386 1,251 1,135
------------ ------------ ------------ ------------ ------------
------------ ------------ ------------ ------------ ------------
</TABLE>

- ------------------------

(1) Amounts for the year ended December 31, 1992 are after dividends on senior
preferred stock of $703. Amounts for the years ended December 31, 1993 and
1992 are before extraordinary charges from early redemption of debt, net of
income tax benefit, of $3,900, or $0.13 per share, and $8,440, or $0.30 per
share, respectively. Net earnings applicable to common stockholders for the
years ended December 31, 1993 and 1992 were $27,452, or $0.90 per share, and
$15,078, or $0.53 per share, respectively.

(2) Based on the number of common shares outstanding at year end.

8
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION

GENERAL

The Company is engaged in one industry segment as a specialty retailer of
home entertainment products operating principally in two business categories:
non-mall based full-media, low-price superstores under the names Media Play and
On Cue and mall based music and video sell-through stores under the names Sam
Goody, Musicland and Suncoast. The market for prerecorded music and video,
books, computer software and related accessories continues to be highly
competitive. The number of stores and types of competitors have increased
significantly over the past few years, including non-mall discount stores,
consumer electronics superstores and other mall based music, video and book
specialty retailers expanding into non-mall multimedia superstores of their own.
The low prices offered by these non-mall stores create intense price competition
and adversely impact the performance of both the Company's non-mall and mall
stores. Further, consumers have more home entertainment options available with
the increasing penetration of personal computers into homes, while industry
growth in prerecorded music sales has slowed due to the lack of strong product
releases. The Company anticipates that the challenging retail sales environment
will continue into the foreseeable future.

The Company has experienced diminishing liquidity as a result of the
challenging retail sales environment and the negative impact of underperforming
existing stores and new Media Play stores opened in 1995 and 1996, particularly
those performing below expectations. During 1996, the Company experienced
difficulty in obtaining shipments from certain vendors, primarily due to
concerns about the Company's liquidity. In the first quarter of 1997, the
Company's largest vendors and a substantial majority of the remaining vendors
agreed to temporarily defer existing trade payables and provide continued
product supply, subject to reduced payment terms on new purchases. Because these
understandings are voluntary on the part of the vendors and will continue at
their sole discretion, there can be no assurance that the Company will continue
to receive adequate product from its vendors on acceptable credit terms. Should
any or all of these vendors demand payment of the deferred balances, there can
be no assurance that the Company will be able to obtain adequate financing to
make such payment.

In April and October of 1996, the Company obtained amendments to its credit
agreement. The April amendment modified certain existing covenants and added
financial covenants while the October amendment waived the additional financial
covenants and further modified certain existing covenants through March 30,
1997. In March 1997, the Company obtained waivers of certain financial covenants
and technical defaults under the credit agreement through May 29, 1997. Without
the waivers in October 1996 and March 1997, the Company would have been in
default under the credit agreement in the fourth quarter of 1996 and the first
quarter of 1997.

The Company is currently in negotiations with its banks to obtain an
amendment to its credit agreement that will modify or provide additional
flexibility in the covenants and provide additional financing under a term
facility. If an amendment is not obtained by May 29, 1997, when the waivers
under the credit agreement expire, the Company will be in default and the banks
could demand repayment of all amounts outstanding under the revolver. There can
be no assurance that debt or equity to repay the revolver, if necessary, will be
available or can be arranged on acceptable terms.

The Company's stores operate in a retail environment in which many factors
that are difficult to predict and outside the Company's control can have a
significant impact on store and Company sales and

9
<PAGE>
profits. These factors include the timing and strength of new product offerings,
pricing strategies of competitors, openings and closings of competitors' stores,
the Company's ability to continue to receive adequate product from its vendors
on acceptable credit terms and to obtain sufficient financing to meet its
liquidity needs, effects of weather and overall economic conditions, including
inflation, consumer confidence, spending habits and disposable income. Any of
these factors, alone or in combination, could affect the Company's ability to
meet its financial covenants and to continue as a going concern. See Note 1 of
Notes to Consolidated Financial Statements.

RESULTS OF OPERATIONS

The following table presents certain sales and store data for the Company's
two principal business categories and in total for the Company for the last
three years.

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1996 1995 1994
--------- --------- ---------
(DOLLARS AND SQUARE FOOTAGE IN
MILLIONS)
<S> <C> <C> <C>
SALES:
Non-mall stores.................................................. $ 643.8 $ 516.7 $ 247.9
Mall stores...................................................... 1,160.0 1,187.0 1,217.0
Total(1)....................................................... 1,821.6 1,722.6 1,478.8
PERCENTAGE CHANGE FROM PRIOR YEAR:
Non-mall stores.................................................. 24.6% 108.5% 355.6%
Mall stores...................................................... (2.3) (2.5) 9.0
Total(1)....................................................... 5.7 16.5 25.1
COMPARABLE STORE SALES CHANGE FROM PRIOR YEAR:
Non-mall stores.................................................. 2.0% 4.8% 33.3%
Mall stores...................................................... (1.7) (4.9) 3.1
Total(1)....................................................... (0.6) (3.2) 4.6
NUMBER OF STORES OPEN AT YEAR END:
Non-mall stores(2)............................................... 245 242 123
Mall stores(2)................................................... 1,199 1,232 1,247
Total(1)....................................................... 1,466 1,496 1,386
TOTAL STORE SQUARE FOOTAGE AT YEAR END:
Non-mall stores.................................................. 5.2 5.3 2.7
Mall stores...................................................... 4.3 4.5 4.4
Total(1)....................................................... 9.5 9.9 7.2
</TABLE>

- ------------------------

(1) The totals include other divisions which individually are not significant.

(2) After the remaining store closings under the restructuring programs are
completed in 1997, store counts will be 225 superstores and 1,157 mall
stores.

SALES. Sales from new non-mall stores opened since 1994 and comparable
store sales increases in non-mall stores open for one year or more accounted for
most of the sales increases in 1996 and 1995. Inventory liquidation sales held
late in the fourth quarter of 1996 in anticipation of the closing of certain
underperforming stores contributed approximately $9 million to the sales
increase in 1996. Comparable store sales in 1996 were adversely impacted by the
lack of strong product releases in music and video and the challenging retail
sales environment. In 1995, comparable store sales in both non-mall and mall
stores were adversely impacted by weak sales during the fourth quarter coupled
with aggressive price competition. Comparable store sales of mall stores in 1995
also were negatively impacted by increased competition from non-mall stores and
weak music sales.

10
<PAGE>
The following table shows the comparable store sales percentage increase
(decrease) attributable to the Company's two principal product categories for
the last three years.

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------
1996 1995 1994
----- -------- ------
<S> <C> <C> <C>
Prerecorded music......................................................... 1% (7)% 3%
Prerecorded video cassettes............................................... (1) 5 10
</TABLE>

The low prerecorded music comparable store sales increase in 1996 is a
reflection of the low overall sales volume in the music industry. According to
SOUNDSCAN, which collects and compiles retail store and rack sales data, unit
sales of music recordings in 1996 versus 1995 were flat. Sales of music product
were particularly soft in 1995 due to a lack of strong releases in the latter
part of the year. In prerecorded video, the top selling video titles in 1996 did
not attain the same level of sales volume as those released in 1995. Video sales
in 1995 benefited from the very successful LION KING video released in the first
quarter, FORREST GUMP released in the second quarter and STAR WARS TRILOGY
released in the third quarter.

COMPONENTS OF EARNINGS. The following table sets forth certain operating
results as a percentage of sales for the last three years.

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------
1996 1995 1994
----- ------ -----
<S> <C> <C> <C>
Gross profit............................................................. 33.6% 35.2% 36.7%
Selling, general and administrative expenses............................. 31.7 30.5 30.5
Operating income before depreciation, amortization and non-recurring
charges................................................................ 1.9 4.7 6.2
Operating income (loss).................................................. (9.9) (6.0) 3.7
</TABLE>

GROSS PROFIT. The increase in sales from the low-price non-mall stores
relative to total Company sales accounted for 0.5% of the decrease in gross
margin in 1996 and substantially all of the decrease in 1995. Inventory
shrinkage increased to 1.2% of sales in 1996 from 0.8% of sales in 1995, causing
a gross margin decline of 0.4% in 1996. The balance of the gross margin decrease
in 1996 was primarily attributable to increased promotional pricing in both mall
and non-mall stores and lower prices in mall stores in 1996 compared to 1995.

Sales in non-mall stores will further reduce gross margin in future periods
if their revenues increase at a faster rate than the Company's total sales. The
rate of decrease, however, is expected to slow because of the closing of
non-mall stores under the restructuring program and the curtailment of store
expansion. The Company may also potentially benefit from the continued
compliance by certain non-mall competitors with the more strictly enforced
minimum advertised price ("MAP") policies of certain of the largest prerecorded
music suppliers and the continued closing of stores by certain mall competitors.
See "Business--Products: Prerecorded Music" and "--Competition."

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses as a percentage of sales were 31.7% in 1996 compared to
30.5% in 1995 and 1994, an increase of 1.2%. Increased advertising in the Media
Play stores accounted for 0.5% of the percentage increase. Financial and legal
advisory services and related expenses, most of which were required or incurred
in conjunction

11
<PAGE>
with the Company's credit agreement, totaled approximately $4 million, or 0.2%
of sales in 1996. The remainder of the increase in selling, general and
administrative expenses as a percentage of sales in 1996 was attributable to the
impact of fixed costs, principally occupancy costs, both in underperforming
existing stores and in new Media Play stores opened in 1995 and 1996 that have
not achieved the sales level of a mature store. Some of these new Media Play
stores also performed below expectations in 1996, further impacting the expense
percentage. Many of these existing and recently opened underperforming stores
have been or will be closed under the Company's restructuring programs.

During 1996 and 1995, the Company consolidated its distribution facilities
into one center in Franklin, Indiana, which has more than double the combined
capacity of the Company's former facilities in Minneapolis, Minnesota and
Edison, New Jersey. The Minneapolis facility closed in January 1997 while the
Edison facility closed in May 1995. The Company incurred expense in 1996 of
approximately $1.5 million related to the closing of the Minneapolis facility
and transfer of operations to the Franklin facility. Expenses in 1995 included
approximately $1.6 million related to costs associated primarily with the
start-up of the new distribution center in Franklin, Indiana opened in March
1995 and, to a lesser extent, the closing of the Edison distribution facility.

Costs incurred related to store openings were approximately $4 million in
1996, $13 million in 1995 and $11 million in 1994. The lower level of expense in
1996 was due to the fewer number of store openings. Selling, general and
administrative expenses in 1995 included a net reduction to expense of $3.4
million related to two nonrecurring items. Income of $8.8 million from the
termination of certain service and business development agreements was partially
offset by a charge of $5.4 million for the closing of 35 mall based music
stores. Expenses in 1994 included a charge of approximately $3 million for the
cost of closing facilities and changing the name of certain Musicland stores to
Sam Goody.

Management believes that the closing of underperforming stores, the
consolidation of distribution facilities into a single facility in Franklin,
Indiana and other streamlining and profit improvement actions taken in 1996 and
1997 will reduce expenses in 1997. Additionally, store opening costs in 1997
will be minimal due to very limited store expansion plans. The Company also
anticipates improvements in expenses as a percentage of sales from the lower
cost structure of the non-mall stores as the existing, streamlined base of
stores matures and realizes comparable store sales growth. These reductions may
be offset by contingent rentals on the Franklin distribution facility, which
fluctuate based upon changes in certain interest rates.

DEPRECIATION AND AMORTIZATION. Goodwill amortization in 1996 was $3.0
million, or $0.09 per share in 1996 compared to $5.8 million, or $0.17 per share
in 1995, a decrease of $2.8 million. The write-down of goodwill in the third
quarter of 1995 decreased goodwill amortization by $4.2 million, or $0.13 per
share, in 1996 and by $1.4 million, or $0.04 per share, in 1995. Other
depreciation and amortization was $41.8 million, $39.7 million and $30.1 million
in 1996, 1995 and 1994, respectively, and primarily related to stores. The
increases over the prior years in 1996 and 1995 were attributable to store
expansion, net of the decreases related to store closings.

GOODWILL WRITE-DOWN AND ADOPTION OF NEW ACCOUNTING STANDARD. During the
third quarter of 1995, the Company adopted Financial Accounting Standards Board
Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of" ("Statement No. 121"), issued in March
1995. In August 1995, in connection with the adoption of Statement No. 121, the
Company recorded a goodwill write-down of $138 million, or $4.07 per share, for
the year ended December 31, 1995. An additional goodwill write-down of $95.3
million, or $2.85 per share, was recorded in December 1996, eliminating the
remaining goodwill balance and goodwill amortization for years after 1996.

Most of the goodwill was established in conjunction with the 1988 leveraged
buyout of MGI by MSC. At that time, nearly all of the Company's stores were mall
based music stores. The carrying values of long-lived assets, primarily goodwill
and property, of the music division were reviewed for recoverability and
possible impairment in both 1995 and 1996 because of sales declines that began
in 1995 and continued during 1996. These sales declines resulted from general
declines in customer traffic in malls, the increase in

12
<PAGE>
high-volume, low-price superstores and the lack of strong music product
releases. While the Company's mall based music stores have responded with
increased promotional pricing and lower prices, they are at a competitive
disadvantage to non-mall stores because of their higher cost structure,
principally related to occupancy costs. See "--Liquidity and Capital Resources"
and Note 2 of Notes to Consolidated Financial Statements.

RESTRUCTURING CHARGES. During 1996, the Company implemented programs
designed to improve profitability and increase inventory turnover. Pretax
restructuring charges of $75 million were recorded in 1996 to reflect estimated
costs associated with the closing of 115 underperforming stores and the
Company's distribution facility in Minneapolis, Minnesota. The store closings
include 79 mall stores and 36 non-mall stores. The Company completed 53 of these
store closings through December 31, 1996 and will have closed the distribution
facility and an additional 61 stores by March 31, 1997. The restructuring
charges include $41.1 million of estimated cash expenditures, primarily
consisting of estimated payments to landlords for the early termination of
operating leases and estimated legal and consulting fees, and $33.9 million for
estimated non-cash write-downs of leasehold improvements and certain equipment,
net of unamortized lease credits. In 1996, $41.0 million of the restructuring
reserve had been utilized, consisting of $24.1 million of cash payments and
$16.9 million of non-cash charges. See "--Liquidity and Capital
Resources--Investing Activities."

INTEREST EXPENSE. Components of interest expense for the last three years
were as follows:

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1996 1995 1994
--------- --------- ---------
(IN MILLIONS)
<S> <C> <C> <C>
Interest on revolver.................................................. $ 21.9 $ 17.0 $ 7.4
Interest on term loan................................................. -- -- 1.1
Interest on subordinated debt......................................... 9.9 9.9 9.9
Other interest, net................................................... 1.2 1.0 1.2
--------- --------- ---------
$ 33.0 $ 27.9 $ 19.6
--------- --------- ---------
--------- --------- ---------
</TABLE>

Interest expense on the revolver is impacted by the level of outstanding
borrowings during the year, interest rates, the Company's credit rating and the
number of days borrowings are outstanding during the year. Average daily
revolver borrowings outstanding, weighted average interest rates on the
revolver, based on the average daily borrowings, and the highest balances
outstanding under the revolving credit facility were as follows:

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1996 1995 1994
--------- --------- ---------
(DOLLARS IN MILLIONS)
<S> <C> <C> <C>
Average daily revolver borrowings................................. $ 289.7 $ 254.0 $ 128.6
Highest level of revolver borrowings.............................. 333.0 350.0 216.0

Weighted average interest rate.................................... 7.6% 7.1% 6.4%
</TABLE>

Higher outstanding borrowings on the revolver increased interest expense by
$2.4 million in 1996 and in 1995 by $6.2 million, net of the decrease in term
loan interest. Increases in the weighted average interest rates increased
revolver interest by $1.2 million in 1996 and $1.7 million in 1995. The
remainder of the increases in revolver interest in 1996 and 1995 were caused by
an increase in the number of days borrowings were outstanding. The term loan was
repaid in October 1994. Other interest expense consists primarily of
amortization of debt issuance costs.

During 1996 and in January 1997, Moody's Investor's Service, Inc. and
Standard & Poor's Corporation issued downgrades to the ratings of the Company's
revolving credit facility and its $110 million senior subordinated notes. These
downgrades occurred as a result of a number of factors including the continued
weak retailing environment, increased competition from nontraditional music
retailers, declining mall

13
<PAGE>
traffic and fundamental changes in the way recorded music is distributed, which,
along with high fixed costs from poorly performing stores and aggressive store
expansion in previous years, have negatively impacted the Company's financial
performance and limited the Company's financial flexibility. The downgrades
issued in January 1997 also cited diminishing liquidity due to the Company's
reliance upon waivers to continue access to its revolving credit facility. As a
result of the lower credit ratings and an amendment to the Company's credit
agreement in April 1996, the annual facility fee rate increased from 0.30% to
0.50% and the margin added to variable interest rates on revolver borrowings
increased by 0.93%. See
"--Liquidity and Capital Resources."

INCOME TAXES. The effective income tax rates of 9.0% in 1996, (4.0%) in
1995 and 49.6% in 1994 vary from the federal statutory rate principally as a
result of goodwill amortization and write-downs, which are nondeductible, and
state income taxes. The income tax benefit and the effective income tax rate in
1996 were also reduced by valuation allowances established in the fourth quarter
of $24.5 million. The valuation allowances were required because of the
uncertainty of future earnings and reduced the deferred income tax balances to
approximate the remaining recoverable income taxes after carryback of the 1996
taxable loss. Accordingly, the Company expects its tax provision for the year
ending December 31, 1997 to be minimal and no tax provision (benefit) will be
recorded on pretax earnings (loss) in interim periods during 1997. See Note 5
and Note 16 of Notes to Consolidated Financial Statements.

SEASONALITY. The Company's business is highly seasonal, with nearly 40% of
the annual revenues and all of the net earnings generated in the fourth quarter.
See Note 16 of Notes to Consolidated Financial Statements for quarterly
financial data.

RECENTLY ISSUED ACCOUNTING STANDARDS. Financial Accounting Standards Board
Statement No. 128, "Earnings per Share" ("Statement No. 128"), issued in
February 1997 and effective for fiscal years ending after December 15, 1997,
establishes and simplifies standards for computing and presenting earnings per
share ("EPS"). Implementation of this statement will not have a material impact
on the Company's computation or presentation of EPS, as the Company's common
stock equivalents have had no material effect on earnings per share amounts.

LIQUIDITY AND CAPITAL RESOURCES

The Company's primary sources of capital are borrowings under the revolving
credit facility pursuant to the terms of its bank credit agreement and
internally generated cash. Because of the seasonality of the retail industry,
the Company's cash needs fluctuate throughout the year and typically peak in
November as inventory levels build in anticipation of the Christmas selling
season. The Company's cash position is generally highest at the end of December
because of the higher sales volume during the Christmas season and extended
payment terms typically provided by most vendors for seasonal inventory
purchases. The Company's cash needs build during the first quarter as
inventories are replenished following the Christmas season and payments for
seasonal inventory purchases become due. The credit agreement, as amended in
October 1996 and in the absence of any default, provides for a revolving credit
facility and expires in October 1999. Borrowings under the revolving credit
facility are available up to $275 million (subject to certain limitations)
during the period from December 20, 1996 through September 11, 1997, and up to
$300 million (subject to certain limitations) thereafter. At December 31, 1996,
the maximum permitted borrowings under the revolver, based upon the lesser of a
percentage of inventory or the maximum available for the period, were $275
million. The Company had borrowings under the revolver of $272 million at
December 31, 1996; however cash and cash equivalents at December 31, 1996 were
$162.0 million. See "--Financing Activities" and Note 4 of Notes to Consolidated
Financial Statements.

14
<PAGE>
October of 1996, the Company obtained amendments to its credit agreement. The
April amendment modified certain existing covenants and added financial
covenants. The additional financial covenants required the Company to meet
certain debt and trade payables to eligible inventory ratios and to make an
annual one day clean-down of outstanding revolver borrowings. The October
amendment waived these additional financial covenants and further modified
certain existing covenants through March 30, 1997.

In March 1997, the Company obtained an agreement from its banks to waive
certain financial covenants and technical defaults through May 29, 1997. Without
the waivers in October 1996 and March 1997, the Company would have been in
default of the financial covenants related to the debt and trade payables to
eligible inventory ratio and the annual one day clean-down requirement during
the fourth quarter of 1996 and the first quarter of 1997. Additionally, the
terms of an amendment to an operating lease with a special purpose entity formed
for the purpose of purchasing land and constructing three of the Company's Media
Play stores using secured financing required consolidation of that entity as of
October 1996, the date of the amendment. This consolidation caused the Company
to be in technical default of the covenants of the credit agreement restricting
additional debt, liens and the amount of capital spending. The waiver in March
1997 permitted the additional debt and the related lien and capital spending.
See "--Investing Activities."

During the first quarter of 1997, the Company's largest vendors and a
substantial majority of the remaining vendors agreed to temporarily defer
existing trade payables and provide continued product supply, subject to reduced
payment terms on new purchases. Because these understandings are voluntary on
the part of the vendors and will continue at their sole discretion, there can be
no assurance that the Company will continue to receive adequate product from its
vendors on acceptable credit terms. Should any or all of these vendors demand
payment of the deferred balances, there can be no assurance that the Company
will be able to obtain adequate financing to make such payment.

The Company's Franklin distribution facility is under an operating lease
with a special purpose entity that contains certain financial covenants. The
write-down of goodwill in 1995 followed by an additional write-down of the
remaining goodwill balance on December 31, 1996 caused the Company to be in
default of the financial covenant related to the maximum total liabilities to
total stockholders' equity ratio on December 31, 1996. This covenant ratio did
not anticipate the impact on stockholders' equity of any goodwill write-down.
The Company is working with the parties to the operating lease to obtain a
waiver to adjust the covenant ratio for the effect of the goodwill write-downs.
However, there can be no assurance that the Company will be able to obtain such
a waiver or that alternative sources of financing for the distribution facility
would be available if the waiver is not obtained.

The Company is currently in negotiations with its banks to obtain an
amendment to its credit agreement that will modify or provide additional
flexibility in the covenants and provide additional financing under a term
facility. If an amendment is not obtained by May 29, 1997, when the waivers
under the credit agreement expire, the Company will be in default and the banks
could demand repayment of all amounts outstanding under the revolver. The
Company had been in negotiations with a potential equity investor; however,
those negotiations have terminated. There can be no assurance that debt or
equity to repay the revolver, if necessary, will be available or can be arranged
on acceptable terms.

The Company's stores operate in a retail environment in which many factors
that are difficult to predict and outside the Company's control can have a
significant impact on store and Company sales and profits. These factors include
the timing and strength of new product offerings, pricing strategies of
competitors, openings and closings of competitors' stores, the Company's ability
to continue to receive adequate product from its vendors on acceptable credit
terms and to obtain sufficient financing to meet its liquidity needs, effects of
weather and overall economic conditions, including inflation, consumer
confidence, spending habits and disposable income. Any of these factors, alone
or in combination, could affect the Company's ability to meet its financial
covenants and to continue as a going concern. See Note 1 of Notes to
Consolidated Financial Statements.

OPERATING ACTIVITIES. Net cash provided by (used in) operating activities
was $16.7 million in 1996, ($56.2) million in 1995 and $71.5 million in 1994.
The amounts in 1996 and 1995 were impacted by early

15
<PAGE>
payments made to certain vendors to obtain discounts. The payments near the end
of 1995 caused the amount of checks issued but not presented to the Company's
banks for payment to exceed the Company's bank balances by $69.3 million at
December 31, 1995. When netted with checks drawn in excess of bank balances,
cash provided by (used in) operating activities was ($52.6) million in 1996 and
$7.2 million in 1995.

Cash used in operating activities in 1996 included $24.1 million of cash
expenditures related to store closings under the Company's restructuring
programs. Cash used for inventory purchases, as reflected by the aggregate net
changes in inventories, accounts payable and checks drawn in excess of bank
balances, was $38.9 million in 1996 compared to $31.8 million in 1995. Although
inventories at December 31, 1996 of $506.1 million decreased $27.6 million from
$533.7 million at December 31, 1995, the amount of cash used for inventory
purchases increased because of early payments made to certain vendors to obtain
discounts and to ensure continued availability of product. Cash flow in 1997
will benefit from lower inventory levels as a result of the consolidation of
distribution centers into a single facility, store closings and other
initiatives designed by management to increase inventory turnover. Additionally,
the Company will receive income tax refunds in the first quarter of 1997
totaling approximately $20 million from the carryback of the 1996 taxable loss.
However, the cash expected to be generated in 1997 will be offset by
approximately $17 million of expected cash expenditures to complete the
restructuring programs.

The reduction in cash provided by operating activities in 1995 compared to
1994 was attributable to the inventory purchased for store expansion and weak
sales in the latter part of 1995. The Company reduced inventory levels at the
end of 1995 in response to the weak retailing environment.

INVESTING ACTIVITIES. Capital expenditures and store data for the last
three years are as follows:

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1996 1995 1994
--------- --------- ---------
<S> <C> <C> <C>
Capital expenditures, net of sale/leasebacks and other property sales (in
millions).......................................................................... $6.4 $87.0 $ 109.6
Store openings:
Non-mall stores.................................................................... 19 119 78
Mall stores........................................................................ 14 49 92
Total(1)........................................................................... 35 175 175
Store closings:
Non-mall stores.................................................................... (16) -- --
Mall stores........................................................................ (47) (64) (40)
Total(1)........................................................................... (65) (65) (40)
Net increase (decrease) in store count:
Non-mall stores.................................................................... 3 119 78
Mall stores........................................................................ (33) (15) 52
Total(1)........................................................................... (30) 110 135
</TABLE>

- ------------------------

(1) The totals include other divisions which individually are not significant.

Most of the Company's capital expenditures are for store expansion, and the
majority of the store expansion in the last three years consisted of new Media
Play stores. Financing for capital expenditures has generally been provided by
borrowings under the revolving credit facility and internally generated cash.
The Company typically receives financing from landlords in the form of
contributions and rent abatements for a portion of the capital expenditures,
primarily related to new stores. In the third quarter of 1996, net proceeds of
$11.6 million were received from the sale of the building containing the
Company's distribution facilities and certain corporate office facilities in
Minneapolis, Minnesota. The Company leased back the entire building through
January 1997 and thereafter will continue to lease a portion of the office
facilities. Approximately $14 million of capital expenditures for three new
Media Play stores opened in 1996 were financed under an operating lease with a
special purpose entity formed for the purpose of purchasing the land and
constructing the stores using secured long-term financing. The land, buildings
and

16
<PAGE>
certain fixtures, together with the related mortgage note payable, were recorded
on the Company's books after the terms of an amendment to the operating lease
required consolidation of the special purpose entity as of October 1996, the
date of the amendment.

A portion of the Media Play capital expenditures in 1995 and 1994 were
financed with proceeds from sale/leaseback transactions totaling $26.2 million
in 1995 and $10.0 million in 1994. The new Franklin distribution facility and
most of the related equipment, which together had an original cost of
approximately $30 million, were financed under an operating lease with a special
purpose entity. The Company financed a significant portion of capital
expenditures in 1994 with $70.7 million in net proceeds from a common stock
offering completed in December 1993.

The Company significantly reduced capital expenditures in 1996 in response
to the challenging retail environment, which is expected to continue into the
foreseeable future. Capital expenditures in 1997 will be limited to
approximately $20 million and will consist primarily of improvements to existing
stores. A portion of the capital spending is planned for the downsizing of Media
Play stores from approximately 50,000 square feet to approximately 35,000 to
40,000 square feet. The Company anticipates that these capital expenditures will
be financed by borrowings under its credit agreement and internally generated
cash. During 1997, the Company plans to close the remaining 62 stores under its
restructuring programs, of which 61 stores will have closed in the first
quarter. The Company also plans to close other nonproductive stores, the
majority of which are at or near the end of their lease terms. Inventories from
closed stores will be either redeployed to existing stores that are more
profitable, returned to vendors or sold in preclosing liquidation sales.

FINANCING ACTIVITIES. The Company's financing activities principally
consist of borrowings and repayments under its revolving credit facility. Cash
provided by (used in) financing activities was $149.7 million, $106.6 million
and ($19.0) million during the years ended December 31, 1996, 1995 and 1994,
respectively. At December 31, 1996, outstanding revolver borrowings were $272.0
million while cash and cash equivalents were $162.0 million. The Company had
$53.0 million of revolver borrowings and checks drawn in excess of bank balances
of $69.3 million outstanding at December 31, 1995. There were no revolver
borrowings outstanding at December 31, 1994 and checks drawn in excess of bank
balances were $5.9 million.

As the financial covenants related to the annual one day clean-down
requirement during the period from December 15, 1996 to February 15, 1997 and
the debt and trade payables to eligible inventory ratio were waived, the
revolver borrowings were not required to be paid down at December 31, 1996. For
purposes of comparison to the $53 million of outstanding revolver borrowings at
December 31, 1995, the revolver borrowings at December 31, 1996 would have been
$110 million when netted with the balance of cash and cash equivalents at year
end. The higher level of net revolver borrowings at December 31, 1996 compared
to December 31, 1995 is due primarily to the continued weak retailing
environment and the cash used under the restructuring programs in 1996 to close
underperforming stores. Because of the weak retailing environment in the latter
part of 1995 which continued through the Christmas season, $53 million of
borrowings remained outstanding under the revolving credit facility at December
31, 1995. Sufficient cash was generated from the Christmas season in 1994 to
repay all outstanding revolver borrowings at year end.

During the third quarter of 1995, the Company loaned $10.0 million to its
401(k) trust to finance the purchase of 1,042,900 shares of common stock of the
Company in the open market. The stock is used for a "KSOP" plan, which combines
features of a 401(k) plan and an employee stock ownership plan. See Note 6 of
Notes to Consolidated Financial Statements.

In October 1994, the Company replaced its $175 million revolving credit
facility and term loan with its current revolving credit facility. Borrowings
under the October 1994 revolving credit facility were used to repay all
outstanding borrowings under the former revolving credit facility and to make
the final $25 million principal payment on the term loan that was due on
December 31, 1994.

17
<PAGE>
The Company's revolving credit facility expires in October 1999. The
mortgage note payable requires a principal payment of $2.1 million in March 1997
with the balance due at the end of either the original term in May 2000 or the
one year renewal term in May 2001. The operating lease for the distribution
facility in Franklin, Indiana contains a residual value guarantee in an amount
not to exceed $24.9 million at the end of the original four year lease term in
March 1999 and $25.7 million at the end of the one year renewal term in March
2000. The lease also contains purchase options at the end of the original and
renewal periods. The Company plans to either sell and lease back these
properties or seek other sources of financing. As the challenging retail
environment is expected to continue into the foreseeable future, there can be no
assurance that the Company will be able to obtain adequate or alternative
sources of financing to meet its obligations under these agreements.

INFLATION AND ECONOMIC TRENDS

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 fiscal years.

Forward-looking statements herein are made pursuant to the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995. There are
certain important factors that could cause results to differ materially from
those anticipated by some of the statements made herein. Investors are cautioned
that all forward-looking statements involve risks and uncertainty. In addition
to the factors discussed above, among the factors that could cause actual
results to differ materially are the following: the timing and strength of new
product offerings, pricing strategies of competitors, openings and closings of
competitors' stores, the Company's ability to continue to receive adequate
product from its vendors on acceptable credit terms and to obtain sufficient
financing to meet its liquidity needs, effects of weather and overall economic
conditions, including inflation, consumer confidence, spending habits and
disposable income.

18
<PAGE>
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 herein.

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 herein by reference.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) Documents filed as part of this report:

(1) Consolidated Financial Statements

See Index to Consolidated Financial Statements on page 21.

(2) Financial Statement Schedules

Financial Statement Schedules have been omitted because they are not
required or are not applicable or because the information required to be
set forth therein either is not material or is included in the
Consolidated Financial Statements or notes thereto.

(3) Exhibits

See Exhibit Index on pages 42 through 44.

(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, 1996.

See Exhibit Index on pages 42 through 44.

(d) Other Financial Statements

Not applicable.

19
<PAGE>
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: April 11, 1997
--------------------------------------------

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

SIGNATURE CAPACITY DATE
- ------------------------------ -------------------------- ---------------

Chairman of the Board,
/s/ JACK W. EUGSTER President, Chief
- ------------------------------ Executive Officer and April 11, 1997
Jack W. Eugster Director (principal
executive officer)

Executive Vice President
/s/ REID JOHNSON and Chief Financial
- ------------------------------ Officer (principal April 11, 1997
Reid Johnson financial and accounting
officer)

/s/ KEITH A. BENSON
- ------------------------------ Director April 11, 1997
Keith A. Benson

/s/ KENNETH F. GORMAN
- ------------------------------ Director April 11, 1997
Kenneth F. Gorman

/s/ WILLIAM A. HODDER
- ------------------------------ Director April 11, 1997
William A. Hodder

/s/ LLOYD P. JOHNSON
- ------------------------------ Director April 8, 1997
Lloyd P. Johnson

/s/ JOSIAH O. LOW, III
- ------------------------------ Director April 11, 1997
Josiah O. Low, III

/s/ TOM F. WEYL
- ------------------------------ Director April 11, 1997
Tom F. Weyl

/s/ MICHAEL W. WRIGHT
- ------------------------------ Director April 11, 1997
Michael W. Wright

20
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
-----

<S> <C>
Report of Independent Public Accountants................................................................... 22

Consolidated Statements of Operations...................................................................... 23

Consolidated Balance Sheets................................................................................ 24

Consolidated Statements of Cash Flows...................................................................... 25

Consolidated Statements of Stockholders' Equity............................................................ 26

Notes to Consolidated Financial Statements................................................................. 27
</TABLE>

21
<PAGE>
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,
1996 and 1995, and the related consolidated statements of operations, cash flows
and stockholders' equity for each of the three years in the period ended
December 31, 1996. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. 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 financial statements referred to above present fairly,
in all material respects, the financial position of Musicland Stores Corporation
and Subsidiaries as of December 31, 1996 and 1995, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1996, in conformity with generally accepted accounting principles.

The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in Note
1 to the consolidated financial statements, the Company has experienced
declining operating results and liquidity constraints that raise substantial
doubt about its ability to continue as a going concern. Management's plans in
regard to these matters are also described in Note 1. The consolidated financial
statements do not include any adjustments relating to the recoverability and
classification of asset carrying amounts or the amount and classification of
liabilities that might result should the Company be unable to continue as a
going concern.

ARTHUR ANDERSEN LLP

Minneapolis, Minnesota,
February 25, 1997

22
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------------
1996 1995 1994
------------ ------------ ------------
<S> <C> <C> <C>
Sales................................................................... $ 1,821,594 $ 1,722,572 $ 1,478,842
Cost of sales........................................................... 1,209,835 1,116,502 936,643
------------ ------------ ------------
Gross profit.......................................................... 611,759 606,070 542,199
Selling, general and administrative expenses............................ 576,658 525,213 450,919
Depreciation and amortization........................................... 44,819 45,531 37,243
Goodwill write-down..................................................... 95,253 138,000 --
Restructuring charges................................................... 75,000 -- --
------------ ------------ ------------
Operating income (loss)............................................... (179,971) (102,674) 54,037
Interest expense........................................................ 32,967 27,881 19,555
------------ ------------ ------------
Earnings (loss) before income taxes................................... (212,938) (130,555) 34,482
Income taxes............................................................ (19,200) 5,195 17,100
------------ ------------ ------------
Net earnings (loss)................................................... $ (193,738) $ (135,750) $ 17,382
------------ ------------ ------------
------------ ------------ ------------
Net earnings (loss) per common share.................................. $ (5.80) $ (4.00) $ 0.51
------------ ------------ ------------
------------ ------------ ------------
Weighted average number of common shares outstanding.................... 33,414 33,898 34,238
------------ ------------ ------------
------------ ------------ ------------
</TABLE>

See accompanying Notes to Consolidated Financial Statements.

23
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1996 1995
---------- ----------
<S> <C> <C>
ASSETS

Current assets:
Cash and cash equivalents............................................................... $ 161,976 $ 1,971
Inventories............................................................................. 506,093 533,694
Deferred income taxes................................................................... 11,800 17,400
Other current assets.................................................................... 31,492 20,840
---------- ----------
Total current assets.................................................................. 711,361 573,905

Property, at cost......................................................................... 430,116 446,100
Accumulated depreciation and amortization................................................. (152,120) (127,783)
---------- ----------
Property, net........................................................................... 277,996 318,317

Goodwill.................................................................................. -- 98,258
Deferred income taxes..................................................................... 1,200 --
Other assets.............................................................................. 6,358 6,477
---------- ----------
Total Assets.......................................................................... $ 996,915 $ 996,957
---------- ----------
---------- ----------
LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Checks drawn in excess of bank balances................................................. $ -- $ 69,321
Current maturities of long-term debt.................................................... 2,060 --
Revolver................................................................................ 272,000 53,000
Accounts payable........................................................................ 406,642 403,848
Restructuring reserve................................................................... 33,963 --
Other current liabilities............................................................... 100,866 108,455
---------- ----------
Total current liabilities............................................................. 815,531 634,624
Long-term debt............................................................................ 122,539 110,000
Other long-term liabilities............................................................... 56,226 52,622
Deferred income taxes..................................................................... -- 3,900
Commitments and contingent liabilities

Stockholders' equity:
Preferred stock ($.01 par value; authorized: 5,000,000 shares; issued and outstanding:
none)................................................................................. -- --
Common stock ($.01 par value; authorized: 75,000,000 shares; issued and outstanding:
December 31, 1996, 34,301,956 shares; December 31, 1995, 34,296,956 shares)........... 343 343
Additional paid-in capital.............................................................. 253,896 254,350
Accumulated deficit..................................................................... (238,649) (44,911)
Deferred compensation................................................................... (7,998) (8,998)
Common stock subscriptions.............................................................. (4,973) (4,973)
---------- ----------
Total stockholders' equity............................................................ 2,619 195,811
---------- ----------
Total Liabilities and Stockholders' Equity............................................ $ 996,915 $ 996,957
---------- ----------
---------- ----------
</TABLE>

See accompanying Notes to Consolidated Financial Statements.

24
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------
1996 1995 1994
----------- ----------- -----------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net earnings (loss)...................................................... $ (193,738) $ (135,750) $ 17,382
Adjustments to reconcile net earnings (loss) to net cash provided by
(used in) operating activities:
Depreciation and amortization.......................................... 44,819 45,531 37,243
Goodwill write-down.................................................... 95,253 138,000 --
Disposal of property................................................... 1,733 7,587 3,475
Amortization of debt issuance and other costs.......................... 658 516 872
Other amortization..................................................... 234 364 1
Restructuring charges.................................................. 75,000 -- --
Deferred income taxes.................................................. 500 (3,400) (6,100)
Changes in operating assets and liabilities:
Inventories............................................................ 27,601 (41,866) (155,026)
Other current assets................................................... (10,353) (11,172) (1,991)
Accounts payable....................................................... 2,794 (53,388) 154,196
Restructuring reserve.................................................. (24,092) -- --
Other current liabilities.............................................. (6,767) (11,445) 16,829
Other assets........................................................... (590) (1,079) (1,333)
Other long-term liabilities............................................ 3,637 9,875 5,914
----------- ----------- -----------
Net cash provided by (used in) operating activities.................. 16,689 (56,227) 71,462
----------- ----------- -----------
INVESTING ACTIVITIES:
Capital expenditures..................................................... (17,970) (113,983) (119,608)
Sale/leasebacks and other property sales................................. 11,594 26,969 10,000
----------- ----------- -----------
Net cash used in investing activities................................ (6,376) (87,014) (109,608)
----------- ----------- -----------
FINANCING ACTIVITIES:
Increase (decrease) in checks drawn in excess of bank balances........... (69,321) 63,435 5,886
Borrowings under revolver................................................ 219,000 53,000 --
Principal payments on long-term debt..................................... -- -- (25,000)
Loan to KSOP............................................................. -- (9,997) --
Net proceeds from sale of common stock................................... 13 196 72
----------- ----------- -----------
Net cash provided by (used in) financing activities.................. 149,692 106,634 (19,042)
----------- ----------- -----------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS....................... 160,005 (36,607) (57,188)

CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR............................. 1,971 38,578 95,766
----------- ----------- -----------

CASH AND CASH EQUIVALENTS AT END OF YEAR................................... $ 161,976 $ 1,971 $ 38,578
----------- ----------- -----------
----------- ----------- -----------

CASH PAID DURING THE YEAR FOR:
Interest................................................................. $ 31,677 $ 27,268 $ 19,666
Income taxes............................................................. 9,010 17,884 29,394
</TABLE>

See accompanying Notes to Consolidated Financial Statements.

25
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(IN THOUSANDS)

<TABLE>
<CAPTION>
RETAINED
COMMON STOCK ADDITIONAL EARNINGS COMMON TOTAL
---------------------- PAID-IN (ACCUMULATED DEFERRED STOCK STOCKHOLDERS'
SHARES AMOUNT CAPITAL DEFICIT) COMPENSATION SUBSCRIPTIONS EQUITY
--------- ----------- ---------- ------------ ------------- ------------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
January 1, 1994.................... 34,230 $ 342 $ 253,768 $ 73,457 $ $ (4,973) $ 322,594
Net earnings....................... 17,382 17,382
Other, including exercise of stock
options and related tax
benefit.......................... 17 -- 300 300
--------- ----- ---------- ------------ ------------- ------------- ------------
December 31, 1994.................. 34,247 342 254,068 90,839 (4,973) 340,276

Net loss........................... (135,750) (135,750)
Other, including exercise of stock
options and related tax
benefit.......................... 50 1 670 671
Loan to KSOP....................... (9,997) (9,997)
Amortization of deferred
compensation and adjustment to
fair market value of KSOP shares,
net of related tax benefit....... (388) 999 611
--------- ----- ---------- ------------ ------------- ------------- ------------
December 31, 1995.................. 34,297 343 254,350 (44,911) (8,998) (4,973) 195,811

Net loss........................... (193,738) (193,738)
Other, including exercise of stock
options and related tax
benefit.......................... 5 -- 13 13
Amortization of deferred
compensation and adjustment to
fair market value of KSOP shares,
net of related tax benefit....... (467) 1,000 533
--------- ----- ---------- ------------ ------------- ------------- ------------
December 31, 1996.................. 34,302 $ 343 $ 253,896 $ (238,649) $ (7,998) $ (4,973) $ 2,619
--------- ----- ---------- ------------ ------------- ------------- ------------
--------- ----- ---------- ------------ ------------- ------------- ------------
</TABLE>

See accompanying Notes to Consolidated Financial Statements.

26
<PAGE>
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 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 and is
engaged in one industry segment as a specialty retailer of home entertainment
products, including prerecorded music, prerecorded video, books, computer
software and related accessories. The Company's two principal business
categories are non-mall based full-media low-price superstores operating under
the names Media Play and On Cue and mall based music and video sell-through
stores operating under the names Sam Goody, Musicland and Suncoast Motion
Picture Company. At December 31, 1996, the store count consisted of 245 non-mall
stores and 1,199 mall stores, with 5.2 million total store square footage in
non-mall stores and 4.3 million total store square footage in mall stores. The
Company operated 1,466 stores in 49 states, the District of Columbia, the
Commonwealth of Puerto Rico, the Virgin Islands and the United Kingdom at
December 31, 1996.

SUMMARY OF SIGNIFICANT RISKS AND UNCERTAINTIES AND GOING CONCERN
ASSESSMENT. The market for prerecorded music and video, books, computer
software and related accessories continues to be highly competitive. The number
of stores and types of competitors have increased significantly over the past
few years, including non-mall discount stores, consumer electronics superstores
and other mall based music, video and book specialty retailers expanding into
non-mall multimedia superstores of their own. The low prices offered by these
non-mall stores create intense price competition and adversely impact the
performance of both the Company's non-mall and mall stores. Further, consumers
have more home entertainment options available with the increasing penetration
of personal computers into homes, while industry growth in prerecorded music
sales has slowed due to the lack of strong product releases. The Company
anticipates that the challenging retail sales environment will continue into the
foreseeable future.

27
<PAGE>
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)
through March 30, 1997. In March 1997, the Company obtained waivers of certain
financial covenants and technical defaults under the credit agreement through
May 29, 1997. Without the waivers in October 1996 and March 1997, the Company
would have been in default under the credit agreement in the fourth quarter of
1996 and the first quarter of 1997. See Note 4 and Note 10.

Management implemented programs during 1996 to improve profitability, reduce
inventory levels and increase inventory turnover. More focused marketing and
advertising programs were instituted in late 1996. The Company slowed store
expansion to focus on improving performance in its existing stores and recorded
pretax restructuring charges totaling $75,000 to reflect estimated costs
associated with the closing of 115 underperforming stores and the Company's
distribution facility in Minneapolis, Minnesota. The Company also evaluated
goodwill for impairment in 1995 and 1996 and recorded a write-down of $138,000
in 1995 and a write-down of the remaining balance of $95,253 in 1996. See Note 2
and Note 3.

The Company's stores operate in a retail environment in which many factors
that are difficult to predict and outside the Company's control can have a
significant impact on store and Company sales and profits. These factors include
the timing and strength of new product offerings, pricing strategies of
competitors, openings and closings of competitors' stores, the Company's ability
to continue to receive adequate product from its vendors on acceptable credit
terms and to obtain sufficient financing to meet its liquidity needs, effects of
weather and overall economic conditions, including inflation, consumer
confidence, spending habits and disposable income. Any of these factors, alone
or in combination, could affect the Company's ability to meet its financial
covenants and to continue as a going concern. The consolidated financial
statements do not include any adjustments relating to the recoverability and
classification of asset carrying amounts or the amount and classification of
liabilities that might result should the Company be unable to continue as a
going concern.

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.

CASH MANAGEMENT. The Company's cash management system provides for the
reimbursement of all major bank disbursement accounts on a daily basis. Checks
issued but not presented for payment to the bank are reflected as checks drawn
in excess of bank balances in the accompanying consolidated financial
statements.

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. Property consists principally of store leasehold improvements,
fixtures and other equipment and is stated at cost. Leasehold improvements are
amortized on a straight-line basis over an estimated useful life of ten years,
which is generally equal to or less than the lease term. Store fixtures and
other equipment are depreciated on a straight-line basis over their estimated
useful lives. When assets are

28
<PAGE>
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)
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 $41,763, $39,653 and
$29,816 for the years ended December 31, 1996, 1995 and 1994, respectively.

GOODWILL. Goodwill represents the cost in excess of fair value of net
assets of businesses acquired and primarily resulted from the acquisition of MGI
by MSC in 1988. The carrying amount of goodwill is evaluated if facts and
circumstances indicate that it may be impaired. If an evaluation is required,
the estimated future undiscounted cash flows of the entity acquired over the
remaining amortization period would be compared to the carrying amount of
goodwill to determine if a write-down is required. In December 1996, the Company
recorded a write-down of $95,253, which represented the remaining carrying
amount of goodwill. In August 1995, the Company recorded a write-down of
$138,000. Prior to the August 1995 write-down, goodwill was amortized using the
straight-line method over a forty year period. During 1996, goodwill was
amortized using the straight-line method over the remaining life of 33 years.
Accumulated amortization at December 31, 1995 was $1,002.

DEBT ISSUANCE COSTS. Debt issuance costs are amortized over the terms of
the related financing using the interest method.

STORE OPENING AND ADVERTISING COSTS. Costs associated with store openings
are amortized over expected sales to the end of the fiscal year in which the
store opens. Advertising costs are charged to expense as they are incurred.

STOCK-BASED COMPENSATION. Compensation for employee stock options is
recognized based on the difference, if any, between the quoted market price of
the stock on the date of grant and the amount an employee must pay to acquire
the stock. The Company's plans are fixed stock option plans and, accordingly,
the Company has not recognized compensation expense. See Note 7 for pro forma
disclosures as if the fair value method of accounting for stock options had been
used.

INCOME TAXES. The provision for deferred income taxes represents the tax
effects of differences in the timing of income and expense recognition for tax
and financial reporting purposes under the liability method of accounting. A
valuation allowance reduces deferred tax assets when it is more likely than not
that some portion or all of the deferred tax assets will not be realized.

EARNINGS (LOSS) PER COMMON SHARE. Earnings (loss) per common share amounts
are computed by dividing net earnings (loss) by the weighted average number of
common shares outstanding. For purposes of earnings (loss) 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. Common stock equivalents
related to stock options are anti-dilutive in 1996 and 1995 due to the net
losses. Common stock equivalents related to stock options which would have a
dilutive effect based upon current market prices had no material effect on net
earnings per common share in 1994.

29
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

2. WRITE-DOWN OF GOODWILL

During the third quarter of 1995, the Company adopted Financial Accounting
Standards Board Statement No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of" ("Statement No. 121"),
issued in March 1995. Goodwill primarily resulted from the acquisition of MGI by
MSC in a leveraged buyout in 1988, when nearly all of the Company's stores were
mall based music stores. In connection with the adoption of Statement No. 121,
the carrying values of long-lived assets, primarily goodwill and property, of
the music division were reviewed for recoverability and possible impairment
because of recent developments.

Since the beginning of 1995, the music division has been experiencing sales
declines. These sales declines resulted from general declines in customer
traffic in malls, the increase in high-volume, low-price superstores and the
lack of strong music product releases. While the Company's mall based music
stores have responded with increased promotional pricing and lower prices, they
are at a competitive disadvantage to non-mall stores because of their higher
cost structure, principally related to occupancy costs. The Company updated its
operating projections for the music division during the third quarter of 1995
and again in the fourth quarter of 1996 to reflect the continued weak retail
environment and competitive pricing. An analysis of the projected undiscounted
future cash flows indicated impairment had occurred. A goodwill write-down of
$138,000 was recorded in August 1995 based on an estimated fair value of the
music division determined primarily from a range of valuations based on the
operating projections and future discounted cash flows. In December 1996, a
write-down of the remaining goodwill of $95,253 was recorded and was based on an
estimated fair value determined from updated future discounted cash flows of the
music division and other significant market factors related to the Company.

3. RESTRUCTURING CHARGES

During 1996, the Company implemented programs designed to improve
profitability and increase inventory turnover. Pretax restructuring charges of
$35,000 and $40,000 were recorded in the first and fourth quarters of 1996,
respectively. These charges reflect estimated costs associated with the closing
of 115 underperforming stores and the Company's distribution facility in
Minneapolis, Minnesota. The store closings include 79 mall stores and 36
non-mall stores. The Company completed 53 of these store closings through
December 31, 1996 and will have closed the distribution facility and an
additional 61 stores by March 31, 1997. The restructuring charges include
$41,100 of estimated cash expenditures, primarily consisting of estimated
payments to landlords for the early termination of operating leases and
estimated legal and consulting fees, and $33,900 for estimated non-cash
write-downs of leasehold improvements and certain equipment, net of unamortized
lease credits. In 1996, $41,000 of the restructuring reserve had been utilized,
consisting of $24,100 of cash payments and $16,900 of non-cash charges.

30
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

4. REVOLVING CREDIT FACILITY AND LONG-TERM DEBT

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------
1996 1995 1994
---------- ---------- ----------
<S> <C> <C> <C>
REVOLVER DATA IS AS FOLLOWS:
Revolver borrowings at year end.................................... $ 272,000 $ 53,000 $ --
Average daily revolver borrowings.................................. 289,700 254,000 128,600
Highest total revolver borrowings.................................. 333,000 350,000 216,000
Weighted average interest rates:
Based on average daily borrowings................................ 7.56% 7.13% 6.38%
At year end, excluding facility fee rate......................... 7.26 7.12 N/A
</TABLE>

The Company's bank credit agreement, as amended in October 1996 and in the
absence of any default, provides for a revolving credit facility and expires in
October 1999. Borrowings under the revolving credit facility are at variable
interest rates and are available up to a maximum of the lesser of 50% to 60% of
eligible inventory or $275,000 during the period from December 20, 1996 through
September 11, 1997, or $300,000 thereafter. The credit agreement also requires
payment of a facility fee at an annual rate of 0.15% to 0.50% on the maximum
credit amount available, subject to adjustment based on the Company's credit
rating. The Company is currently at the maximum facility fee rate of 0.50 %
based on its current credit rating. The Company has pledged the common stock of
certain of its wholly owned subsidiaries as collateral for borrowings under the
credit agreement.

The Company's credit agreement contains covenants that limit additional
indebtedness, liens, capital expenditures and cash dividends. Additionally, the
Company must meet financial covenants relating to fixed charge coverage,
consolidated tangible net worth and debt to total capitalization. In April and
October of 1996, the Company obtained amendments to its credit agreement. The
April amendment modified certain existing covenants and added financial
covenants. The additional financial covenants required the Company to meet
certain debt and trade payables to eligible inventory ratios and to make an
annual one day clean-down of outstanding revolver borrowings. The initial one
day clean-down was to occur during the period from December 15, 1996 to February
15, 1997. The October amendment waived these additional financial covenants and
further modified certain existing covenants through March 30, 1997.

31
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

4. REVOLVING CREDIT FACILITY AND LONG-TERM DEBT (CONTINUED)
the credit agreement expire, the Company will be in default and the banks could
demand repayment of all amounts outstanding under the revolver. The Company had
been in negotiations with a potential equity investor; however, those
negotiations have terminated. There can be no assurance that debt or equity to
repay the revolver, if necessary, will be available or can be arranged on
acceptable terms.

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1996 1995
---------- ----------
<S> <C> <C>
LONG-TERM DEBT CONSISTS OF THE FOLLOWING:
Mortgage note payable, variable interest rates.................................. $ 14,599 $ --
9% senior subordinated notes, unsecured, due 2003............................... 110,000 110,000
---------- ----------
Total......................................................................... 124,599 110,000
Less current maturities......................................................... 2,060 --
---------- ----------
Total long-term debt.......................................................... $ 122,539 $ 110,000
---------- ----------
---------- ----------
</TABLE>

The mortgage note payable is collateralized by land, buildings and certain
fixtures of three of the Company's Media Play stores with an aggregate carrying
value, including additional building improvements, of $14,537 at December 31,
1996. The mortgage note payable and related agreements, as amended in October
1996, require a principal payment of $2,060 in March 1997 with the balance due
at the end of either the original term in May 2000 or the one year renewal term
in May 2001. Interest and facility fees are payable monthly. The interest rate,
inclusive of the facility fee rate, was 7.92% at December 31, 1996.

The senior subordinated notes are subordinate to borrowings under the credit
agreement, with interest payable semi-annually. The debt agreement for the
senior subordinated notes contains financial covenants and the Company was in
compliance with such covenants at December 31, 1996.

32
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

5. INCOME TAXES

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------
1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>
INCOME TAXES CONSIST OF:
Current:
Federal............................................................. $(18,300) $ 7,395 $ 18,900
State, local and other.............................................. (1,400) 1,200 4,300
-------- -------- --------
(19,700) 8,595 23,200
-------- -------- --------
Deferred:
Federal............................................................. (1,000) (3,200) (5,000)
State, local and other.............................................. 1,500 (200) (1,100)
-------- -------- --------
500 (3,400) (6,100)
-------- -------- --------
Total............................................................. $(19,200) $ 5,195 $ 17,100
-------- -------- --------
-------- -------- --------
THE COMPANY'S EFFECTIVE INCOME TAX RATE DIFFERED FROM THE FEDERAL
STATUTORY RATE AS FOLLOWS:
Federal statutory tax rate............................................ (35.0)% (35.0)% 35.0%
Goodwill amortization and write-down.................................. 16.2 38.5 7.3
State and local income taxes, net of federal benefit.................. -- 0.5 6.0
Valuation allowance................................................... 9.3 -- --
Other items, net*..................................................... 0.5 -- 1.3
-------- -------- --------
Effective income tax rate........................................... (9.0)% 4.0% 49.6%
-------- -------- --------
-------- -------- --------
</TABLE>

- --------------------------

* None of which individually exceeds 5% of federal tax at the statutory rate on
earnings (loss) before income taxes.

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1996 1995
---------- ----------
<S> <C> <C>
COMPONENTS OF DEFERRED INCOME TAXES ARE AS FOLLOWS:
Net current deferred tax asset:
Capitalized inventory costs.................................................... $ 5,880 $ 5,877
Inventory valuation............................................................ 5,564 5,012
Compensation related........................................................... 2,601 2,264
Restructuring charges.......................................................... 14,388 --
Facility closings.............................................................. 1,883 2,251
Other accruals................................................................. 2,103 1,562
Other, net..................................................................... 581 434
---------- ----------
Total current deferred income taxes.......................................... 33,000 17,400
Valuation allowance............................................................ (21,200) --
---------- ----------
Net current deferred income taxes............................................ $ 11,800 $ 17,400
---------- ----------
---------- ----------
</TABLE>

33
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

5. INCOME TAXES (CONTINUED)

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1996 1995
---------- ----------
<S> <C> <C>
Net noncurrent deferred tax asset (liability):
Depreciation................................................................... $ (20,901) $ (25,096)
Rent expense................................................................... 17,651 19,572
Amortization of intangible assets.............................................. (2,011) (2,034)
Net pension liability.......................................................... 881 807
Other, net..................................................................... (49) 551
Alternative minimum tax credit................................................. 8,929 2,300
---------- ----------
Total noncurrent deferred income taxes....................................... 4,500 (3,900)
Valuation allowance............................................................ (3,300) --
---------- ----------
Net noncurrent deferred income taxes......................................... $ 1,200 $ (3,900)
---------- ----------
---------- ----------
</TABLE>

Due to the loss incurred in 1996 and uncertainty of future earnings, current
deferred income taxes and the noncurrent alternative minimum tax credit have
been reduced by valuation allowances at December 31, 1996 to approximate the
remaining recoverable income taxes after carryback of the 1996 taxable loss.

6. 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 established a defined contribution plan in 1992 for
those employees.

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1996 1995
--------- ---------
<S> <C> <C>
PENSION DATA HAVE BEEN COMPUTED BASED ON THE FOLLOWING ASSUMPTIONS:
Discount rate for benefit obligations............................................... 7.75% 7.50%
Rate of increase for future compensation levels..................................... 5.50 5.50
Expected long-term rate of return on plan assets.................................... 8.50 8.50

THE FUNDED STATUS OF THE PENSION PLAN AND THE RELATED AMOUNTS RECOGNIZED IN THE
CONSOLIDATED BALANCE SHEETS WERE AS FOLLOWS:
Funded assets at fair value (primarily listed stocks and U.S. bonds)................ $ 9,468 $ 9,289
Projected benefit obligation:
Vested benefits................................................................... (9,604) (9,141)
Non-vested benefits............................................................... -- (142)
--------- ---------
Accumulated benefit obligation.................................................... (9,604) (9,283)
Projected future salary increases................................................. -- (47)
--------- ---------
Projected benefit obligation...................................................... (9,604) (9,330)
--------- ---------
Projected benefit obligation in excess of assets.................................... (136) (41)
Net unamortized gains............................................................... (2,273) (1,983)
--------- ---------
Net pension liability............................................................. $ (2,409) $ (2,024)
--------- ---------
--------- ---------
</TABLE>

34
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

6. EMPLOYEE BENEFIT PLANS (CONTINUED)
The increase in the discount rate at December 31, 1996 decreased the
accumulated benefit obligation and the projected benefit obligation by $456. 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, 1996 and 1995.

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
1996 1995 1994
--------- --------- ---------
<S> <C> <C> <C>
THE COMPONENTS OF NET PENSION EXPENSE WERE AS FOLLOWS:
Service cost for benefits earned........................................ $ 446 $ 260 $ 407
Interest cost on projected benefit obligation........................... 715 631 648
Actual return on plan assets............................................ (597) (1,814) 512
Net amortization and deferred amounts................................... (179) 1,130 (1,225)
--------- --------- ---------
Net pension expense................................................... $ 385 $ 207 $ 342
--------- --------- ---------
--------- --------- ---------
</TABLE>

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. Beginning in 1996, 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, 1996 and 1995. At December 31, 1996
and 1995, the number of shares held in suspense was 834,320 and 938,610,
respectively, and the market value of the shares held in suspense was $1,251 and
$3,989, respectively.

Expenses for the 401(k) and defined contribution plans for the years ended
December 31, 1996, 1995 and 1994 totalled $354, $570 and $591, respectively.
Expenses for postemployment benefits were not material. The Company does not
offer or provide postretirement benefits other than pensions to its employees.

7. STOCK PLANS

The Company's 1994, 1992 and 1988 Stock Option Plans authorize the grant of
stock options and stock appreciation rights to officers and other key employees.
The Company's Directors Stock Option Plan authorizes the grant of stock options
to its directors who are not employees of the Company or its affiliates. The
number of shares of common stock that may be issued to employees and directors
under each of these plans is 950,000 shares, 1,500,000 shares, 1,000,000 shares
and 200,000 shares, respectively. The stock options become exercisable over a
period not to exceed ten years after the date they are granted. Exercise prices
are based upon the stock's market price at the grant date. The employee and
director stock options generally vest over a period of four to five years. No
stock appreciation rights were outstanding as of December 31, 1996. In 1996, the
Company adopted Financial Accounting Standards board Statement No. 123,
"Accounting for Stock-Based Compensation" ("Statement No. 123"), for disclosure
purposes only.

35
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

7. STOCK PLANS (CONTINUED)

A SUMMARY OF THE STATUS OF THE COMPANY'S EMPLOYEE STOCK OPTION PLANS AS OF
DECEMBER 31, 1996, 1995 AND 1994 AND CHANGES DURING THE YEARS THEN ENDED IS
PRESENTED BELOW:

<TABLE>
<CAPTION>
1996 1995 1994
------------------------- ------------------------- -------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
------------ ----------- ------------ ----------- ------------ -----------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning
of year.............................. 1,847,984 $ 10.49 1,708,916 $ 11.89 1,588,250 $ 11.65
Granted................................ 1,023,973 2.30 393,350 7.82 215,000 14.37
Exercised.............................. (5,000) 2.50 (50,100) 3.93 (17,206) 4.20
Cancelled.............................. (230,663) 11.26 (204,182) 18.73 (77,128) 15.41
------------ ------------ ------------
Outstanding at end
of year.............................. 2,636,294 7.25 1,847,984 10.49 1,708,916 11.89
------------ ------------ ------------
------------ ------------ ------------
Options exercisable
at year end.......................... 958,916 800,838 605,762
------------ ------------ ------------
------------ ------------ ------------
Options available for
future grant......................... 631,750 1,425,060 1,612,046
------------ ------------ ------------
------------ ------------ ------------
Weighted average fair
value of options granted
during the year...................... $ 1.32 $ 4.37
------------ ------------
------------ ------------
</TABLE>

THE FOLLOWING TABLE SUMMARIZES INFORMATION ABOUT EMPLOYEE STOCK OPTIONS
OUTSTANDING AT DECEMBER 31, 1996:

<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
--------------------------------------- OPTIONS EXERCISABLE
WEIGHTED ----------------------
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
RANGE OF EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE
- ------------------------------------------ ----------- --------------- --------- ----------- ---------
<S> <C> <C> <C> <C> <C>
$ 1.500 to $ 2.5625....................... 820,299 7.35 $ 2.073 287,384 $ 2.500
3.000 to 4.5000....................... 691,350 7.47 3.454 257,850 4.500
6.625 to 9.8750....................... 352,195 8.68 7.664 17,198 6.625
12.875 to 21.7500....................... 772,450 6.36 15.965 396,484 15.321
----------- -----------
2,636,294 958,916
----------- -----------
----------- -----------
</TABLE>

36
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

7. STOCK PLANS (CONTINUED)
A SUMMARY OF THE STATUS OF THE COMPANY'S DIRECTORS STOCK OPTION PLANS AS OF
DECEMBER 31, 1996, 1995 AND 1994 AND CHANGES DURING THE YEARS THEN ENDED IS
PRESENTED BELOW:

<TABLE>
<CAPTION>
1996 1995 1994
---------------------- ---------------------- ----------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
--------- ----------- --------- ----------- --------- -----------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning
of year....................................... 45,000 $ 11.90 40,000 $ 12.22 40,000 $ 12.22
Granted......................................... -- 5,000 --
--------- --------- ---------
Outstanding at end
of year....................................... 45,000 11.90 45,000 11.90 40,000 12.22
--------- --------- ---------
--------- --------- ---------
Options exercisable
at year end................................... 45,000 11.90 40,000 12.22 40,000 12.22
--------- --------- ---------
--------- --------- ---------
Options available for
future grant.................................. 35,000 35,000 40,000
--------- --------- ---------
--------- --------- ---------
</TABLE>

Exercise prices under the director stock option plan range from $9.375 to
$12.50 and the weighted average remaining contractual life of the outstanding
options is 6.36 years. The weighted average fair value of options granted in
1995 was $5.34.

PRO FORMA DISCLOSURES OF NET LOSS AND NET LOSS PER COMMON SHARE AS IF THE
FAIR VALUE BASED METHOD OF ACCOUNTING FOR STOCK OPTIONS UNDER STATEMENT NO. 121
HAD BEEN APPLIED ARE AS FOLLOWS:

<TABLE>
<CAPTION>
1996 1995
----------- -----------
<S> <C> <C> <C>
Net loss As reported............................... $ (193,738) $ (135,750)
Pro forma................................. $ (194,394) $ (135,850)
Net loss per common share As reported............................... $ (5.80) $ (4.00)
Pro forma................................. $ (5.82) $ (4.01)
</TABLE>

The fair value of the employee and director options granted was estimated on
the date of the grant using the Black-Scholes option pricing model with the
following assumptions for 1996 and 1995, respectively: risk-free interest rates
of 6.17% and 6.31%; expected volatility of 45% and 49%; expected life of seven
years for both years; and no dividend yields for either year.

Statement No. 123 does not apply to option grants prior to 1995.
Additionally, options vest over several years and additional stock option grants
are anticipated in the future. Accordingly, the pro forma disclosures may not be
representative of the effects on net earnings (loss) in future years.

37
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

8. COMMON STOCK SUBSCRIPTIONS

Certain members of management of the Company own 1,991,308 shares of common
stock with restrictions ("Restricted Stock") at $0.0025 per share. The
Restricted Stock is not transferable until the Company is paid the balance of
the subscription price of $2.4975 or $4.4975 per share. The amount of
subscriptions due from the holders of Restricted Stock upon transfer is
reflected as a reduction of stockholders' equity.

9. PREFERRED STOCK PURCHASE RIGHTS

In March 1995, the Company's Board of Directors adopted a stockholder rights
plan and declared a dividend of one preferred share purchase right ("Right") per
share for each outstanding share of common stock. 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.

10. COMMITMENTS

The Company leases most of its retail stores and certain office and
warehouse facilities under operating leases for terms ranging from three to
twenty-five years. 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. In most instances, the Company pays, in addition
to minimum rent, real estate taxes, utilities, common area maintenance costs and
percentage rentals which are based upon sales volume. Certain store leases
contain provisions restricting assignment, merger, change of control or
transfer. The Company also leases certain store fixtures and equipment,
computers, and automobiles under operating leases.

The Company's distribution facility in Franklin, Indiana is under an
operating lease with a special purpose entity that contains an original term of
four years, a one year renewal option and purchase options at the end of the
original and renewal periods. The lease contains a residual value guarantee in
an amount not to exceed $24,900 at the end of the original lease term in March
1999 and $25,650 at the end of the renewal term in March 2000. The lease also
contains certain financial covenants. The write-down of goodwill in 1995
followed by an additional write-down of the remaining goodwill balance on
December 31, 1996 caused the Company to be in default of the financial covenant
related to the maximum total liabilities to total stockholders' equity ratio on
December 31, 1996. The operating lease was executed in March 1994 and,
accordingly, this covenant ratio did not anticipate the impact on stockholders'
equity of any goodwill write-down. The Company is working with the parties to
the operating lease to obtain a waiver to adjust the covenant ratio for the
effect of the goodwill write-downs taken in 1996 and 1995. However, there can

38
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

10. COMMITMENTS (CONTINUED)
be no assurance that the Company will be able to obtain such a waiver or that
alternative sources of financing for the distribution facility would be
available if the waiver is not obtained.

<TABLE>
<S> <C>
AT DECEMBER 31, 1996, FUTURE ANNUAL MINIMUM RENTALS FOR
NONCANCELLABLE OPERATING LEASES WITH REMAINING FIXED TERMS
GREATER THAN ONE YEAR ARE:
1997..................................................... $ 145,525
1998..................................................... 142,907
1999..................................................... 155,748
2000..................................................... 116,400
2001..................................................... 93,075
Thereafter............................................... 343,609
---------
Total.................................................. $ 997,264
---------
---------
</TABLE>

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------
1996 1995 1994
---------- ---------- ----------
<S> <C> <C> <C>
TOTAL RENT EXPENSE CONSISTS OF THE FOLLOWING:
Minimum cash rents....................................... $ 166,308 $ 148,736 $ 120,118
Straight-line recognition of leases with scheduled rent
increases.............................................. 3,152 7,304 4,892
Percentage rents......................................... 1,733 2,000 3,408
---------- ---------- ----------
Total rent expense..................................... $ 171,193 $ 158,040 $ 128,418
---------- ---------- ----------
---------- ---------- ----------
</TABLE>

11. RELATED PARTY TRANSACTIONS

Donaldson, Lufkin & Jenrette, Inc. ("DLJ") and certain of its affiliates,
excluding DLJ employees, owned approximately 6.9% of the Company's common stock
at December 31, 1996. DLJ acts as a market maker in the Company's senior
subordinated notes.

12. FAIR VALUE OF FINANCIAL INSTRUMENTS

The carrying amounts reported in the consolidated balance sheets at December
31, 1996 and 1995 for cash and cash equivalents, other current assets, checks
drawn in excess of bank balances, accounts payable and other current liabilities
approximate fair value because of the immediate or short-term maturity of these
financial instruments. As the interest rate on the long-term debt is reset
monthly based on current market rates, the carrying value of the mortgage note
payable approximates fair value. The fair value of the revolver at December 31,
1996 and 1995, based on current market rates, was $217,600 and $45,050,
respectively. The fair value of the senior subordinated notes at December 31,
1996 and 1995, based on the last quoted price on those dates, was $50,600 and
$66,000, respectively.

39
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

13. SUPPLEMENTARY BALANCE SHEET INFORMATION

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1996 1995
---------- ----------
<S> <C> <C>
OTHER CURRENT LIABILITIES CONSIST OF THE FOLLOWING:
Income taxes(1)....................................................... $ -- $ 10,351
Payroll and related taxes and benefits................................ 19,598 18,183
Gift certificates payable............................................. 32,792 28,716
Sales taxes payable................................................... 19,924 19,694
Accrued store expenses and other...................................... 28,552 31,511
---------- ----------
Total............................................................. $ 100,866 $ 108,455
---------- ----------
---------- ----------

OTHER LONG-TERM LIABILITIES CONSIST OF THE FOLLOWING:
Straight-line recognition of leases with scheduled rent increases..... $ 36,442 $ 35,915
Deferred rent credits................................................. 14,651 11,882
Other................................................................. 5,133 4,825
---------- ----------
Total............................................................. $ 56,226 $ 52,622
---------- ----------
---------- ----------
</TABLE>

- ------------------------

(1) Other current assets at December 31, 1996 include net income taxes
refundable of $18,657.

14. SUPPLEMENTAL CASH FLOW INFORMATION

In May 1995, the Company entered into an operating lease with a special
purpose entity for the purpose of purchasing land and constructing three of the
Company's Media Play stores using secured long-term financing. The land,
buildings and certain fixtures, which had an aggregate cost of $14,395 at
December 31, 1996, together with the related mortgage note payable and deferred
financing credits totaling $14,599 at December 31, 1996, were recorded on the
Company's books after the terms of an amendment to the operating lease required
consolidation of the special purpose entity as of October 1996, the date of the
amendment.

15. LITIGATION

40
<PAGE>
MUSICLAND STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

16. QUARTERLY FINANCIAL DATA (UNAUDITED)

<TABLE>
<CAPTION>
EARNINGS COMMON STOCK PRICE
NET (LOSS) PER
GROSS EARNINGS COMMON --------------------
SALES PROFIT (LOSS) SHARE HIGH LOW
------------ ---------- ----------- ----------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
1996:
First................... $ 383,570 $ 129,833 $ (52,636) $ (1.58) $ 4 3/4 $ 2
Second.................. 372,410 126,582 (24,080) (0.72) 5 1/4 3 1/8
Third................... 366,634 127,702 (24,201) (0.72) 3 5/8 1 3/8
Fourth.................. 698,980 227,642 (92,821) (2.77) 2 1 1/4
------------ ---------- ----------- -----------
Total................. $ 1,821,594 $ 611,759 $ (193,738) $ (5.80)
------------ ---------- ----------- -----------
------------ ---------- ----------- -----------

1995:
First................... $ 346,360 $ 122,244 $ (6,314) $ (0.18) $ 10 3/4 $ 6 3/4
Second.................. 331,720 123,372 (7,531) (0.22) 10 5/8 8 7/8
Third................... 357,585 131,317 (144,550) (4.28) 11 8 1/4
Fourth.................. 686,907 229,137 22,645 0.68 10 3 3/4
------------ ---------- ----------- -----------
Total................. $ 1,722,572 $ 606,070 $ (135,750) $ (4.00)
------------ ---------- ----------- -----------
------------ ---------- ----------- -----------
</TABLE>

The three months ended December 31, 1996 and September 30, 1995 include
goodwill write-downs of $95,253, or $2.85 per share, and $138,000, or $4.09 per
share, respectively.

The three months ended March 31, 1996 and December 31, 1996 include pretax
restructuring charges of $35,000 and $40,000, respectively.

The total of earnings (loss) per common share by quarter may not equal the
total for the year as there are changes in the weighted average number of common
shares outstanding each quarter and earnings (loss) per common share is
calculated independently for each quarter.

Quarterly financial data for 1996 has been adjusted to reflect the effect of
the deferred tax valuation allowance in each quarter. See Note 5.

41
<PAGE>
EXHIBIT INDEX

The following documents are filed as part of this Annual Report on Form 10-K
for the year ended December 31, 1996.

<TABLE>
<CAPTION>
SEQUENTIAL
EXHIBIT NO. DESCRIPTION PAGE NO.
- ------------ ----------------------------------------------------------------------------------------- -------------
<C> <S> <C>
3.1 Restated Certificate of Incorporation of MSC, as amended................................. [i]

3.2 By-laws of MSC, as amended............................................................... [ii]

4.1 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........................................................................... [iii]

4.2(a) Credit Agreement dated as of October 7, 1994 (the "Credit Agreement") among MGI, MSC, the
banks listed therein and Morgan Guaranty Trust Company of New York, as agent........... [iv]

4.2(b) Amendment No. 1 dated as of February 28, 1995 to the Credit Agreement.................... [viii]

4.2(c) Amendment No. 2 dated as of April 9, 1996 to the Credit Agreement........................ [xi]

4.2(d) Amendment No. 3 dated as of October 18, 1996 to the Credit Agreement..................... [xii]

4.2(e) Waiver and Agreements under Credit Agreement dated as of March 7, 1997 to the Credit
Agreement.............................................................................. --

4.3 Rights Agreement dated as of March 14, 1995, between MSC and Norwest Bank Minnesota,
National Association, as Rights Agent.................................................. [v]

9 Voting Trust Agreement among DLJ, certain of its affiliates, the Equitable Investors and
Meridian Trust Company................................................................. [i]

10.1(a) Lease Agreement dated March 31, 1994 between Shawmut Bank Connecticut, N.A. as Owner
Trustee and Musicland Retail, Inc., as Lessee.......................................... [viii]

10.1(b) Participation Agreement dated March 31, 1994 among Musicland Retail, Inc., as Lessee,
Shawmut Bank Connecticut, N.A. as Owner Trustee, Kleinwort Benson Limited, as Owner
Participant, Lender and Agent and The Long-Term Credit Bank of Japan, Ltd. Chicago
Branch, Credit Lyonnais Cayman Island Branch, The Fuji Bank, Limited, as Lenders....... [viii]

10.1(c) Guaranty of MGI dated March 31, 1994..................................................... [viii]

10.2(a) Master Lease dated May 12, 1995 between Media Play Trust, as Landlord, and Media Play,
Inc., as Tenant........................................................................ [ix]

10.2(b) Participation Agreement dated May 12, 1995 among Natwest Leasing Corporation, as Owner
Participant, Media Play Trust, As Trust, Yasuda Bank and Trust Company (U.S.A.), as
Owner Trustee, National Westminster Bank PLC, as Agent and Lender, Media Play, Inc., as
Tenant and the Long-Term Credit Bank of Japan, Ltd. Chicago Branch and The Yasuda Trust
& Banking Company, Ltd., Chicago Branch, as Other Lenders.............................. [ix]

10.2(c) Amendment No. 1 dated as of April 9, 1996 to the Participation Agreement................. [xi]

10.2(d) Lease Guaranty dated May 12, 1995 between MGI, as Guarantor, and Media Play Trust, as
Landlord............................................................................... [ix]

10.2(e) Amendment No. 1 dated as of April 9, 1996 to the Lease Guaranty.......................... [xi]

*10.3(a) Subscription Agreement among MSC and the Management Investors............................ [vi]

*10.3(b) Form of amendment to Management Subscription Agreement................................... [i]
</TABLE>

42
<PAGE>
<TABLE>
<CAPTION>
SEQUENTIAL
EXHIBIT NO. DESCRIPTION PAGE NO.
- ------------ ----------------------------------------------------------------------------------------- -------------
<C> <S> <C>
*10.4 Form of Registration Rights Agreement among MSC, DLJ and the Management Investors........ [vii]

*10.5(a) Employment Agreement with Mr. Eugster.................................................... [vi]

*10.5(b) Form of amendment to Employment Agreement with Mr. Eugster............................... [i]

*10.5(c) Amendment No. 2 to Employment Agreement with Mr. Eugster................................. [x]

*10.6(a) Form of Employment Agreement with Messrs. Benson and Ross................................ [vi]

*10.6(b) Amendment to Employment Agreement with Mr. Benson........................................ --

*10.6(c) Amendment to Employment Agreement with Mr. Ross.......................................... --

*10.7(a) Form of Employment Agreement with Messrs. Bausman and Henderson.......................... [vi]

*10.7(b) Form of amendment to Employment Agreements with Messrs. Bausman and Henderson............ [i]

*10.7(c) Amendment No. 2 to Employment Agreement with Mr. Bausman................................. [x]

*10.7(d) Amendment No. 2 to Employment Agreement with Mr. Henderson............................... [x]

*10.8(a) Change of Control Agreement with Mr. Eugster............................................. [vi]

*10.8(b) Form of amendment to Change of Control Agreement with Mr. Eugster........................ [i]

*10.8(c) Amendment No. 2 to Change of Control Agreement with Mr. Eugster.......................... [x]

*10.8(d) Amendment No. 3 to Change of Control Agreement with Mr. Eugster.......................... --

*10.9 Management Incentive Plan dated as of January 1, 1996.................................... --

*10.10 1988 Stock Option Plan, as amended....................................................... [i]

*10.11 Stock Option Plan for Unaffiliated Directors of MSC, as amended.......................... [i]

*10.12 1992 Stock Option Plan................................................................... [i]

*10.13 Musicland Stores Corporation 1994 Employee Stock Option Plan............................. [viii]

*10.14 Employment Letter Agreement with Mr. Johnson............................................. [viii]

*10.15 (a) Change of Control Agreement with Mr. Johnson............................................. [x]

*10.15 (b) Amendment No. 1 to Change of Control Agreement with Mr. Johnson.......................... --

*10.16 (a) Change of Control Agreement with Messrs. Benson and Ross................................. [vi]

*10.16 (b) Amendment No. 1 to Change of Control Agreement with Mr. Benson........................... --

*10.16 (c) Amendment No. 1 to Change of Control Agreement with Mr. Ross............................. --

*10.17 Form of Executive Severance Agreement with Mr. Wachsman.................................. --

*10.18 Long Term Incentive Plan dated as of January 1, 1996..................................... --

*10.19 Executive Officer Short Term Incentive Plan dated as of November 15, 1996................ --

11 Statement re computation of per share earnings........................................... [xiii]

21 Subsidiaries of MSC...................................................................... [ii]

23 Consent of Arthur Andersen LLP........................................................... --

27 Financial Data Schedules................................................................. --

99 Form 11-K for The Musicland Group's Capital Accumulation Plan............................ [xiv]
</TABLE>

- ------------------------

[i] Incorporated by reference to MSC's Form S-1 Registration Statement covering
common stock initially filed with the Commission on July 6, 1990 (Commission
File No. 33-35774).

43
<PAGE>
[ii] Incorporated by reference to MSC's Annual Report on Form 10-K for the year
ended December 31, 1992 filed with the Commission on March 2, 1993
(Commission File No. 1-11014).

[iii] Incorporated by reference to MGI's Registration Statement covering 9%
Senior Subordinated Notes initially filed with the Commission on May 19,
1993 (Commission File No. 33-62928).

[iv] Incorporated by reference to MSC's Quarterly Report on Form 10-Q for the
quarterly period ended September 30, 1994 filed with the Commission on
November 11, 1994 (Commission File No. 1-11014).

[v] Incorporated by reference to MSC's Form 8-A Exchange Act Registration
Statement covering Preferred Share Purchase Rights filed with the Commission
on March 16, 1995.

[vi] Incorporated by reference to MSC's Form S-1 Registration Statement
covering Senior Subordinated Notes initially filed with the Commission on
May 20, 1988 (Commission File No. 33-22058).

[vii] 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
(Commission File No. 1-11014).

[viii] 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
(Commission File No. 1-11014).

[ix] Incorporated by reference to MSC's Quarterly Report on Form 10-Q for the
quarter period ended June 30, 1995 filed with the Commission on August 11,
1995 (Commission File No. 1-11014).

[x] Incorporated by reference to MSC's Annual Report on Form 10-K for the year
ended December 31, 1995 filed with the Commission on April 12, 1996
(Commission File No. 1-11014.

[xi] Incorporated by reference to MSC's Quarterly Report on Form 10-Q for the
quarter period ended March 31, 1996 filed with the Commission on May 10,
1996 (Commission File No. 1-11014).

[xii] Incorporated by reference to MSC's Quarterly Report on Form 10-Q for the
quarter period ended September 30, 1996 filed with the Commission on
November 13, 1996 (Commission File No. 1-11014).

[xiii] Earnings (loss) per common share amounts are computed by dividing net
earnings (loss) by the weighted average number of common shares outstanding.
For purposes of earnings (loss) 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. Common stock equivalents related to stock options
are anti-dilutive in 1996 and 1995 due to the net losses. Common stock
equivalents related to stock options which would have a dilutive effect
based upon current market prices had no material effect on net earnings per
common share in years prior to 1995. Accordingly, this exhibit is not
applicable to the Company.

[xiv] To be filed by amendment.

* Indicates Management Contract or Compensatory Plan or Agreement required to
be filed as an Exhibit to this form.

<PAGE>

March 7, 1997

The Musicland Group, Inc.
Musicland Stores Corporation
10400 Yellow Circle Drive
Minnetonka, Minnesota 55343

Re: Waivers and Agreements under Credit Agreement

Ladies/Gentlemen:

Please refer to the Credit Agreement dated as of October 7, 1994 (as
previously amended, the "Credit Agreement") among The Musicland Group, Inc.,
Musicland Stores Corporation, various financial institutions and Morgan
Guaranty Trust Company of New York, as Agent. Terms defined in the Credit
Agreement are, unless otherwise defined herein, used herein as so defined.

Pursuant to the Borrower's request, the Required Banks agree as follows:

1. The Required Banks hereby waive through May 29, 1997 any Default or
Event of Default which now or hereafter may exist under Section 5.7, 5.8, 5.9
or 5.23 of the Credit Agreement; it being understood that upon the expiration
of such waiver on May 30, 1997, the Agent and the Banks may exercise any or
all of their rights with respect to any such Default or Event of Default.

2. The Borrower and certain of its Subsidiaries have incurred obligations
under (a) the Participation Agreement dated as of May 12, 1995 among NatWest
Leasing Corporation, Media Play Trust, Yasuda Bank and Trust Company,
National Westminster Bank Plc, various other lenders and Media Play, Inc.,
and the Master Lease and other documents referred to therein and (b) the
Participation Agreement dated as of March 31, 1994 among Musicland Retail,
Inc., Shawmut Bank Connecticut, National Association, Kleinwort Benson
Limited, The Long Term Credit Bank of Japan, Ltd., Chicago Branch, Credit
Lyonnais Cayman Island Branch and The Fuji Bank, Limited, and the Master
Lease and other documents referred to therein. The transactions contemplated
by the documents described in the foregoing sentence are

Page 1
<PAGE>

collectively called the "Synthetic Lease Transactions".

As a result of certain payments which have been or may be made under the
Synthetic Lease Transactions, the Synthetic Lease Transactions have been or
may be required to be classified for accounting purposes as financing leases
(rather than operating leases). Such reclassification would result in
technical defaults under the Credit Agreement because the existing
obligations of the Borrower and its Subsidiaries under the Synthetic Lease
Transactions would be recharacterized as Debt, the existing interest of the
lessors under the Synthetic Lease Transactions would be recharacterized as
Liens and certain payments under the Synthetic Lease Transactions would be
recharacterized as Capital Expenditures.

Accordingly, the Required Banks hereby agree that (i) to the extent that
the existing obligations of the Company and its Subsidiaries under the
Synthetic Lease Transactions constitute Debt, such existing Debt shall be
permitted under Section 5.11 of the Credit Agreement; (ii) to the extent that
the property subject to the Synthetic Lease Transactions is deemed to be
owned by the Company or any Subsidiary and subject to existing Liens arising
under the Synthetic Lease Transactions, such existing Liens shall be
permitted under Section 5.14 of the Credit Agreement; and (iii) for purposes
of computing Capital Expenditures under Section 5.16 of the Credit Agreement,
payments under the Synthetic Lease Transactions shall continue to be deemed
to be operating lease payments and shall not constitute Capital Expenditures.
Without limiting the foregoing, the Required Banks waive any Default or
Event of Default arising solely from the recharacterization of the Synthetic
Lease Transactions as financing leases.

3. The Required Banks further agree that subclauses (i) and (ii) of clause
(b) of the definition of "Eligible Inventory Limit" set forth in the Credit
Agreement are amended in their entirety to read as follows:

"(i) during the fiscal months of May, June, July, August, September
and October of each year, and during November and December of 1996 and
January, February, March and April of 1997, 60%;

(ii) during the fiscal months of March and April of 1996, 55%;".

The waivers and agreements set forth above shall become effective when the
Agent has received counterparts of this letter

Page 2
<PAGE>

executed by the Required Banks (it being understood that the Agent may rely
upon facsimile confirmation of the execution of a counterpart hereof by any
Bank for purposes of determining such effectiveness).

This letter may be executed in any number of counterparts and by the
different parties on separate counterparts, and each such counterpart shall
be deemed to be an original but all such counterparts shall together
constitute one and the same letter. This letter shall be a contract made
under and governed by the internal laws of the State of New York applicable
to contracts made and to be performed within such State.

MORGAN GUARANTY TRUST COMPANY OF
NEW YORK