<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------
FORM 10-K
----------
(Mark One)
/x/ Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 (no fee required)
FOR THE FISCAL YEAR ENDED JULY 31, 1998
OR
/ / Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 (no fee required)
MTS, INCORPORATED
------------------------------------------------------
(Exact name of Registrant as specified in its charter)
CALIFORNIA 94-1500342
---------------------------- -------------------
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
2500 DEL MONTE STREET
WEST SACRAMENTO, CA 95691
----------------------------------------
(Address of principal executive offices)
(916) 373-2500
----------------------------------------------------
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
<TABLE>
<CAPTION>
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
---------------------- ----------------------
<S> <C>
None None
</TABLE>
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
(TITLE OF CLASS)
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.
DOCUMENTS INCORPORATED BY REFERENCE
NONE.
This report is filed pursuant to Regulation 15d-2 of the Exchange Act of 1934
and contains financial statements for the fiscal years ended July 31, 1996, 1997
and 1998.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
MTS, INCORPORATED
(Registrant)
By: /s/ DEVAUGHN D. SEARSON
--------------------------------------------
EXECUTIVE VICE PRESIDENT, CHIEF FINANCIAL
OFFICER AND DIRECTOR
Pursuant to the Securities Exchanges Act of 1934, this report has been signed by
the following persons in the capacities and on the dates indicated:
<TABLE>
<S> <C> <C>
/s/ RUSSELL M. SOLOMON CHAIRMAN AND DIRECTOR OCTOBER 28, 1998
/s/ MICHAEL T. SOLOMON PRESIDENT, CHIEF EXECUTIVE OCTOBER 28, 1998
OFFICER AND DIRECTOR
/s/ DEVAUGHN D. SEARSON EXECUTIVE VICE PRESIDENT, OCTOBER 28, 1998
CHIEF FINANCIAL OFFICER AND
DIRECTOR
</TABLE>
<PAGE>
MTS, INCORPORATED
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Report of Independent Public Accountants................................................................... F-2
Report of Independent Accountants.......................................................................... F-3
Consolidated Balance Sheets as of July 31, 1997, and 1998.................................................. F-4
Consolidated Statements of Income for the fiscal years ended July 31, 1996, 1997, and 1998 ................ F-5
Consolidated Statements of Shareholders' Equity for the fiscal years ended July 31, 1996,
1997, and 1998 .......................................................................................... F-6
Consolidated Statements of Cash Flows for the fiscal years ended July 31, 1996, 1997, and 1998............. F-7
Notes to Consolidated Financial Statements................................................................. F-8
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To MTS, Incorporated and Subsidiaries:
We have audited the accompanying consolidated balance sheet of MTS,
INCORPORATED and Subsidiaries (a California corporation) as of July 31, 1998,
and the related consolidated statements of income, shareholders' equity and
cash flows for the year then ended. 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 audit. The financial
statements of MTS, Incorporated and Subsidiaries for the years ended July 31,
1997 and July 31, 1996, were audited by other auditors whose report dated
October 29, 1997, except for Notes 2 and 3 as to which the dates are April
20, 1998 and March 20, 1998, respectively, expressed an unqualified opinion
on those statements.
We conducted our audit 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 audit provides 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 MTS, Incorporated and
Subsidiaries as of July 31, 1998, and the consolidated results of its operations
and its cash flows for the year then ended in conformity with generally accepted
accounting principles.
ARTHUR ANDERSEN LLP
Sacramento, CA
October 23, 1998
F-2
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and
Shareholders of MTS, INCORPORATED
and Subsidiaries
West Sacramento, California
We have audited the accompanying consolidated balance sheet of MTS,
INCORPORATED and Subsidiaries as of July 31, 1997, and the related
consolidated statements of income, shareholders' equity and cash flows for
each of the two years in the period ended July 31, 1997. 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 audits 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 consolidated financial position of MTS,
INCORPORATED and Subsidiaries as of July 31, 1997, and the consolidated
results of their operations and their cash flows for each of the two years in
the period ended July 31, 1997, in conformity with generally accepted
accounting principles.
/s/ COOPERS & LYBRAND L.L.P.
Sacramento, California
October 29, 1997, except for
Notes 2 and 3 as to which the
dates are April 20, 1998 and
March 20, 1998, respectively
F-3
<PAGE>
MTS, INCORPORATED
CONSOLIDATED BALANCE SHEETS
AS OF JULY 31, 1997 AND 1998
<TABLE>
<CAPTION>
JULY 31,
------------------------
1997 1998
----------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents............................................... $ 6,607 $ 14,609
Receivables, net........................................................ 20,698 23,095
Merchandise inventories................................................. 282,015 261,003
Prepaid expenses........................................................ 9,085 6,619
Deferred tax assets..................................................... 425 4,184
----------- -----------
Total current assets................................................ 318,830 309,510
Fixed assets, net......................................................... 190,357 187,586
Deferred tax assets....................................................... 7,566 15,076
Other assets.............................................................. 27,825 33,219
----------- -----------
Total assets........................................................ $ 544,578 $ 545,391
----------- -----------
----------- -----------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
Current maturities of long-term debt.................................... $ 163,171 $ 2,540
Accounts payable........................................................ 163,956 157,443
Accrued liabilities..................................................... 28,876 30,422
Income taxes payable.................................................... 191 1,422
Deferred revenue, current portion....................................... 2,877 3,251
----------- -----------
Total current liabilities........................................... 359,071 195,078
Long-term Liabilities:
Long-term debt, less current maturities................................. 48,096 229,345
Deferred revenue, less current portion.................................. 184 170
----------- -----------
Total liabilities................................................... 407,351 424,593
----------- -----------
Minority equity in subsidiaries........................................... 3,196 --
----------- -----------
Commitments and contingencies (Notes 10 and 14)
Shareholders' Equity:
Common stock:
Class A, no par value; 5,000,000 shares authorized; 500 shares issued
and outstanding at July 31, 1997; none at July 31, 1998............. 3 --
Class B, no par value; 10,000,000 shares authorized; 500 shares issued
and outstanding at July 31, 1997; 1,000 issued and outstanding
July 31, 1998....................................................... 3 6
Additional paid-in capital.............................................. 780
Retained earnings....................................................... 133,245 120,792
----------- -----------
Total shareholders' equity.......................................... 134,031 120,798
----------- -----------
Total liabilities and shareholders' equity.......................... $ 544,578 $ 545,391
----------- -----------
----------- -----------
</TABLE>
The accompanying notes are an integral part of these statements.
F-4
<PAGE>
MTS, INCORPORATED
CONSOLIDATED STATEMENTS OF INCOME
FOR THE FISCAL YEARS ENDED JULY 31, 1996, 1997 AND 1998
<TABLE>
<CAPTION>
FOR THE YEARS ENDED JULY 31,
-----------------------------------------
1996 1997 1998
------------- ------------- -----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE INFORMATION)
<S> <C> <C> <C>
Net revenue............................... $ 1,001,035 $ 991,810 $ 1,008,146
Cost of sales............................. 676,155 669,279 684,201
------------- ------------- -----------
Gross profit.......................... 324,880 322,531 323,945
Selling, general and administrative
expenses................................ 270,353 267,620 269,263
Depreciation and amortization............. 20,938 26,365 22,287
------------- ------------- -----------
Income from operations................ 33,589 28,546 32,395
Other income and (expenses):
Interest expense........................ (14,905) (14,298) (14,921)
Foreign currency translation gain
(loss)................................ (1,425) (3,552) 1,082
Other income and (expenses)............. (62) (1,154) (455)
------------- ------------- -----------
Income before taxes, extraordinary
item and minority interest.......... 17,197 9,542 18,101
Provision for income taxes................ 7,013 4,543 8,096
------------- ------------- -----------
Income before extraordinary item and
minority interest................... 10,184 4,999 10,005
Minority interest in net income of
subsidiaries............................ 149 224 139
------------- ------------- -----------
Income before extraordinary item...... 10,035 4,775 9,866
Extraordinary loss on extinguishment of
debt, net of income taxes of $824....... -- 1,236 --
------------- ------------- -----------
Net income............................ $ 10,035 $ 3,539 $ 9,866
------------- ------------- -----------
------------- ------------- -----------
Basic and diluted earnings per share:
On income before extraordinary item..... $ 10,035.73 $ 4,774.83 $ 9,865.72
------------- ------------- -----------
------------- ------------- -----------
On net income........................... $ 10,035.73 $ 3,539.31 $ 9,865.72
------------- ------------- -----------
------------- ------------- -----------
</TABLE>
The accompanying notes are an integral part of these statements.
F-5
<PAGE>
MTS, INCORPORATED
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE FISCAL YEARS ENDED JULY 31, 1996, 1997, AND 1998
<TABLE>
<CAPTION>
COMMON STOCK
--------------------------------------------------
SERIES A SERIES B
------------------------ ------------------------
SHARES AMOUNT SHARES AMOUNT
----------- ----------- ----------- -----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE INFORMATION)
<S> <C> <C> <C> <C>
Balance, July 31, 1995............................. 500 $ 3 500 $ 3
Trust distributions.............................. -- -- -- --
Net income....................................... -- -- -- --
Translation adjustment, net of income taxes...... -- -- -- --
--- ----------- ----- -----------
Balance, July 31, 1996............................. 500 3 500 3
Trust distributions.............................. -- -- -- --
Net income....................................... -- -- -- --
Translation adjustment, net of income taxes...... -- -- -- --
--- ----------- ----- -----------
Balance, July 31, 1997............................. 500 3 500 3
Trust distribution (unaudited)................... -- -- -- --
Net income (unaudited)........................... -- -- -- --
Translation adjustment, net of income taxes
(unaudited).................................... -- -- -- --
Conversion of Class A to Class B common shares as
part of Reorganization (unaudited)............. (500) (3) 500 3
--- ----------- ----- -----------
Balance, July 31, 1998............................. -- $ -- 1,000 $ 6
--- ----------- ----- -----------
--- ----------- ----- -----------
<CAPTION>
RETAINED EARNINGS
-------------------------------------
BEFORE AFTER
ADDITIONAL CUMULATIVE CUMULATIVE CUMULATIVE
PAID-IN TRANSLATION TRANSLATION TRANSLATION
CAPITAL ADJUSTMENT ADJUSTMENT ADJUSTMENT TOTAL
------------- ----------- ----------- ----------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Balance, July 31, 1995............................. $ 780 $ 137,147 $ (10,469) $ 126,678 $ 127,464
Trust distributions.............................. -- (357) -- (357) (357)
Net income....................................... -- 10,035 -- 10,035 10,035
Translation adjustment, net of income taxes...... -- -- (1,995) (1,995) (1,995)
----- ----------- ----------- ----------- ---------
Balance, July 31, 1996............................. 780 146,825 (12,464) 134,361 135,147
Trust distributions.............................. -- (126) -- (126) (126)
Net income....................................... -- 3,539 -- 3,539 3,539
Translation adjustment, net of income taxes...... -- -- (4,529) (4,529) (4,529)
----- ----------- ----------- ----------- ---------
Balance, July 31, 1997............................. 780 150,238 (16,993) 133,245 134,031
Trust distribution............................... (780) (15,020) -- (15,020) (15,800)
Net income....................................... -- 9,866 -- 9,866 9,866
Translation adjustment, net of income taxes...... -- -- (7,299) (7,299) (7,299)
Conversion of Class A to Class B common shares as
part of Reorganization......................... -- -- -- -- --
----- ----------- ----------- ----------- ---------
Balance, July 31, 1998............................. $ 0 $ 145,084 $ (24,292) $ 120,792 $ 120,798
----- ----------- ----------- ----------- ---------
----- ----------- ----------- ----------- ---------
</TABLE>
The accompanying notes are an integral part of these statements.
F-6
<PAGE>
MTS, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED JULY 31, 1996, 1997, AND 1998
<TABLE>
<CAPTION>
FOR THE YEARS ENDED JULY 31,
----------------------------------
1996 1997 1998
--------- ------------ ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income...................................... $ 10,035 $ 3,539 $ 9,866
Adjustments to reconcile net income to net cash
provided by operating actvities:
Depreciation and amortization................. 26,784 32,127 28,558
Provision (recovery) for losses on accounts
receivable.................................. (95) 23 1,087
Loss on disposal of depreciable assets........ 2,432 2,678 3,011
Exchange (gain) loss.......................... 763 1,902 (2,626)
Other non-cash expense........................ 249 834 348
Provision for deferred taxes.................. 789 360 (3,425)
Minority interests in net income of
subsidiaries................................ 149 223 139
Extraordinary loss on extinguishment of
debt........................................ -- 1,236 --
(Decrease) increase in cash resulting from
changes in:
Accounts receivable......................... 3,960 1,551 (10,421)
Inventories................................. (26,624) (8,290) 22,394
Prepaid expenses............................ 287 3,711 2,740
Accounts payable............................ 19,260 15,183 (21,238)
Accrued liabilities......................... 10,140 (3,549) 2,697
Deferred revenue............................ 77 635 360
--------- ------------ ---------
Net cash provided by operating
activities.............................. 48,206 52,163 33,490
--------- ------------ ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of fixed assets..................... (48,730) (45,012) (30,686)
Acquisition of investments and artwork.......... (7,025) (5,467) (6,179)
Increase in deposits............................ (835) (1,701) (2,165)
Refund of deposits.............................. 791 121 170
Increase in intangibles......................... (3,080) (681) (6,410)
--------- ------------ ---------
Net cash used in investing activities..... (58,879) (52,740) (45,270)
--------- ------------ ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Loans to shareholders, officers and employees... (345) (223) (90)
Proceeds from employee loan repayments.......... 520 572 106
Trust distributions............................. (357) (126) (240)
Principal payments under long-term financing
agreements.................................... (32,523) (93,672) (220,499)
Proceeds from issuance of long-term financing
agreements.................................... 38,941 102,169 249,493
--------- ------------ ---------
Net cash provided by financing
activities.............................. 6,236 8,720 28,770
--------- ------------ ---------
Effect of exchange rate changes on cash........... (7,289) (9,789) (8,988)
--------- ------------ ---------
Net increase (decrease) in cash and cash
equivalents............................. (11,726) (1,646) 8,002
Cash and cash equivalents, beginning of period.... 19,979 8,253 6,607
--------- ------------ ---------
Cash and cash equivalents, end of period.......... $ 8,253 $ 6,607 $ 14,609
--------- ------------ ---------
--------- ------------ ---------
Cash paid for interest expense.................... $ 13,562 $ 17,434 $ 12,872
--------- ------------ ---------
--------- ------------ ---------
Cash paid for income taxes........................ $ 4,057 $ 5,440 $ 8,366
--------- ------------ ---------
--------- ------------ ---------
</TABLE>
The accompanying notes are an integral part of these statements.
F-7
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION POLICY--The consolidated financial statements include the
accounts of MTS, INCORPORATED and its majority and wholly owned subsidiaries
(Company). As the result of a reorganization in April 1998 of the retail
business assets of the shareholder and his family, the financial statements
include, on a retroactive basis for the periods prior to the reorganization,
the accounts of businesses previously held by two trusts for the benefit of
the shareholder's sons (Trusts) as well as the accounts of two S corporations
owned by the shareholder's sons (S Corporations) (Note 2).
The Company has 50% investments in certain foreign joint ventures that
are accounted for using the equity method. In June, 1998, the Company
acquired the remaining stock of a joint venture from its former partner;
consequently, income or loss of this operation is included in the
consolidated statement of income from the date that the Company acquired a
controlling interest.
All material intercompany balances and transactions have been eliminated in
consolidation.
GENERAL--The Company operates retail stores under the name Tower offering a
diversified line of recorded music products and other complementary products
throughout the United States, Japan, the United Kingdom and other parts of the
world.
CASH AND CASH EQUIVALENTS--The Company considers all highly liquid
temporary cash investments with original maturities of three months or less
when purchased to be cash equivalents for purposes of the statement of cash
flows. The Company's bank deposits generally exceed the federally insured
limit.
INVENTORIES--Inventories are stated at the lower of cost or market. Cost is
determined principally by the first-in, first-out method. The Company does not
provide an allowance for inventory markdowns, due to music industry return
policies which generally provide for full recovery of cost upon return.
PROPERTY AND EQUIPMENT--Property and equipment are carried at cost.
Depreciation is computed using the straight-line method. Depreciation is
computed on all fixed assets with the exception of land. Buildings are
depreciated over 40 years, leasehold improvements over an average of 15 years,
store fixtures over 7 to 10 years, and equipment and vehicles over 5 years.
Leasehold improvements are amortized using the straight-line method over the
shorter of their estimated useful lives or the lease term. When assets are
retired or otherwise disposed of, the cost and related accumulated depreciation
are removed from the accounts and any resulting gain or loss is reflected in
income for the period. The cost of maintenance and repairs is charged to income
as incurred; significant renewals and betterments are capitalized.
Amortization of video rental cassettes is calculated based on a straight
line method over three years. When the popularity of renting the new release
declines (usually after approximately six months)
F-8
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
redundant copies are transferred from rental stock to merchandise inventories
for sale to customers at net realizable value. A write down to net realizable
value is recorded in cost of sales at the time of the transfer from rental to
held-for-sale classification.
STORE PREOPENING COSTS--Costs of a noncapital nature incurred prior to
opening of new stores are expensed as incurred.
INTANGIBLES--Intangibles primarily represent the excess of cost over the
fair value of businesses acquired and debt issuance costs. The Company amortizes
goodwill using the straight-line method over 40 years. Debt issuance costs are
amortized over the term of the related debt using the effective interest rate
method.
INCOME TAXES--The Company accounts for income taxes under the liability
method. Deferred taxes are recorded based on the difference between the
financial statement and tax basis of assets and liabilities. A valuation
allowance would be established to reduce deferred tax assets if it is more
likely than not that all, or a portion, of the deferred tax asset will not be
realized. No allowance against deferred tax assets was provided at July 31,
1997 nor 1998.
EARNINGS PER SHARE--Effective January 31, 1998, the Company adopted the
provisions of SFAS No. 128, EARNINGS PER SHARE, which was effective for
accounting periods ending after December 15, 1997. SFAS No. 128 changed the
method of calculating earnings per share and requires a dual presentation of
basic and diluted earnings per share. In accordance with the provisions of SFAS
No. 128, earnings per share information for all periods presented have been
stated under the methodology and disclosures specified in SFAS No. 128.
REVENUE RECOGNITION--The Company's revenue is primarily from retail sales
comprised of recorded music (including compact discs and audio cassettes), video
sales (including recorded video cassettes, laser discs and DVD) and other
complementary products (including books, magazines, blank tapes, software titles
and accessories) through the Company's stores and are recognized at the point of
the retail transaction. Reductions of revenues for returns by customers are
generally provided at the point of the return due to infrequency and occurrence
within short intervals of the sale.
TRANSLATION OF FOREIGN CURRENCY--The value of the U.S. dollar rises and
falls day-to-day on foreign currency exchanges. Since the Company does
business in several foreign countries, these fluctuations affect the
Company's financial position and results of operations. In accordance with
SFAS No. 52, FOREIGN CURRENCY TRANSLATION, all foreign assets and liabilities
have been translated at the exchange rates prevailing at the respective
balance sheet dates, and all income statement items have been translated
using the weighted average exchange rates during the respective years. The
net gain or loss resulting from translation upon consolidation into the
financial statements is reported as a separate component of retained
earnings. Some transactions of the Company and its foreign subsidiaries are
made in currencies different from their functional currency. Gains and losses
from these transactions are included in income as they occur.
RISK MANAGEMENT INSTRUMENTS--The Company enters into foreign exchange
contracts as a hedge against variations in exchange rates on accounts and notes
payable due in foreign currency.
F-9
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Market value gains and losses related to foreign exchange contracts are
recognized and offset foreign exchange gains and losses on foreign accounts and
notes payable. Counterparties to risk management instruments are major financial
institutions. Credit loss from counterparty nonperformance is not anticipated.
ADVERTISING EXPENSE--Advertising expenses are recorded as an expense when
incurred. Cooperative advertising rebates and supplier promotional and
in-store advertising reimbursements earned are recognized as reductions to
advertising expense in the period the advertisements are run or the
merchandising programs are provided. Certain other rebates and listening
station fees from media vendors are also credited to advertising expense in
the period the related advertising expenses are incurred. Such rebates and
reimbursements are in consideration for ad production and placement
activities performed by the Company, and are negotiated under contractual
agreements on a case-by-case basis. Net advertising and marketing expense
(revenue) was $3,306,000 ($1,469,000) and ($4,721,000) for the years ended
July 31, 1996, 1997 and 1998, respectively.
ACCOUNTING ESTIMATES--The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
GIFT CERTIFICATES--The Company offers gift certificates for sale. A deferred
income account is established for gift certificates issued. When gift
certificates are redeemed at the store level, the deferred income account is
charged and revenue is credited.
NEW ACCOUNTING PRONOUNCEMENTS--Statement of Financial Accounting Standards
(SFAS) No. 130, REPORTING COMPREHENSIVE INCOME, and SFAS No. 131, DISCLOSURE
ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, were issued in June
1997. The Company will adopt both of the statements on their effective date,
which will be in the Company's fiscal year ending July 31, 1999.
SFAS No. 130 establishes standards for reporting and display of
comprehensive income and its components in a financial statement that is
displayed with the same prominence as other financial statements.
Comprehensive income is a measure of all changes in the equity of the Company
as a result of recognized transactions and other economic events of the
period other than transactions with shareholders in their capacity as
shareholders. Had the provisions of SFAS No. 130 been applied for the years
ended July 31, 1996, 1997 and 1998, comprehensive income would have consisted
primarily of net income and foreign currency translation adjustments.
SFAS No. 131 requires that the Company report financial and descriptive
information about its reportable operating segments using the "management
approach" model. Under the management approach model, segments are defined based
on the way the Company's management internally evaluates segment performance and
decides how to allocate resources to segments. The Company is in the process of
evaluating the impact of this pronouncement on its segment disclosures.
In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No.133, Accounting for Derivative
Instruments and Hedging Activities. The Statement establishes accounting and
reporting standards requiring that every derivative instrument (including
certain derivative instruments embedded in other contracts) be recorded in
the balance sheet as either an asset or liability measured at its fair value.
The Statement requires that changes in the derivative's fair value be
recognized currently in earnings unless specific hedge accounting criteria are
met. Special accounting for qualifying hedges allows a derivative's gains and
losses to offset related results on the hedged item in the income statement,
and requires that a company must formally document, designate, and assess the
effectiveness of transactions that receive hedge accounting.
Statement 133 is effective for fiscal years beginning after June 15,
1999. A company may also implement the Statement as of the beginning of any
fiscal quarter after issuance (that is, fiscal quarters beginning June 16,
1998 and thereafter). Statement 133 cannot be applied retroactively.
Statement 133 must be applied to (a) derivative instruments and (b) certain
derivative instruments embedded in hybrid contracts that were issued,
acquired, or substantively modified after December 31, 19997 (and, at the
company's election, before January 1, 1998).
The Company has not yet quantified the impacts of adopting Statement 133
on its financial statements nor determined the timing of or method of our
adoption of Statement 133. However, the Statement could increase volatility
in earnings and other comprehensive income.
F-10
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECLASSIFICATIONS. Certain reclassifications have been made to conform
prior years' financial statements to the current year's presentation.
RISKS RELATING TO INTERNATIONAL OPERATIONS--The Company has substantial
operations and assets located outside the United States, primarily in Japan
and the United Kingdom. With respect to international operations, principally
all of the Company's revenues and costs (including borrowing costs) are
incurred in the local currency, except that certain inventory purchases are
tied to US dollars. The Company's financial performance on a U.S.
dollar-denominated basis has historically been significantly affected by
changes in currency exchange rates. Changes in certain exchange rates could
adversely affect the Company's business, financial position and results of
operations.
International operations are also subject to a number of other special
risks, including trade barriers, exchange controls, governmental
expropriation, political risks and risks of increases in taxes. In addition,
the laws of certain foreign countries do not protect the Company's trademark,
trade name, copyright and other intellectual property rights to the same
extent as they do the laws of the United States. Also, various jurisdictions
outside the United States have laws limiting the right and ability of
non-U.S. subsidiaries and affiliates to pay dividends and remit earnings to
affiliated companies unless specified conditions are met. Earnings of
international subsidiaries are subject to income taxes of non-U.S.
jurisdictions that reduce cash flow available to meet required debt service
and other obligations of the Company.
NOTE 2--REORGANIZATION
In April 1998, the Company consummated certain transactions designed to
consolidate substantially all of the business operations into the Company
(such transactions collectively, the "Reorganization") as a result of which the
Company became a wholly owned subsidiary of TOWER RECORDS, INCORPORATED
(Parent). The Company also, prior to the Reorganization, transferred certain
assets to the Trusts in April 1998.
The Reorganization included an exchange by the Company's shareholders of
their common shares in the Company for a controlling equity interest in the
Parent. As part of the Reorganization, two irrevocable trusts established by
the Company's principal shareholder for the benefit of his sons (the Trusts)
and the shareholders of two S corporations (the S Corporations), contributed
certain assets, liabilities and equity ownership interests in businesses to
the Parent in exchange for the remaining equity interest in the Parent. The
assets, liabilities and businesses contributed by the Trusts and the
shareholders of the S Corporations consist of one Tower store, land used in
the Tower business, trademark rights to the Tower name in Japan and all
royalties accrued in connection therewith on and after February 1, 1998, a
recorded music wholesale operation, intercompany receivables and payables,
bank debt and the cash surrender value as of April 1998 of certain
second-to-die split value life insurance policies on the lives of the
Parent's principal shareholder and his wife. The Parent then contributed to
the Company the assets and liabilities it received from the Trusts and the
shareholders of the S corporations.
The Reorganization was a combination of businesses under common control and,
accordingly, has been accounted for in a manner similar to a
pooling-of-interests. Accordingly, the assets and liabilities the Company
received from the Parent in the Reorganization and the historical results of
operations of such business assets are included, on a retroactive basis, in the
Company's consolidated balance sheets and statements of income for all periods
presented at the previous accounting basis of the Trusts and shareholders of the
S corporations.
Subsequent to July 31, 1998, the Company eliminated by upstream merger
the subsidiary of T.R. Services. Additionally, the Company recently
reacquired all minority interests in certain subsidiaries of MTS,
INCORPORATED which the Company eliminated through upstream mergers into the
Company. The Company also eliminated Tower Domestic, Inc. and Queen Anne
Record Sales, subsidiaries of the Company, through upstream mergers into the
Company.
Prior to and apart from the Reorganization, the Company transferred to
the Trusts certain assets valued at $2,860,000 in exchange for inventory with
an equal value. The sale price of these assets was determined based on
independent appraisals or estimates of the fair market value of the assets
that the Company believes to be reasonable.
F-11
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--REORGANIZATION (CONTINUED) In the Reorganization, the Trusts
transferred to the Parent certain business assets, liabilities, intercompany
accounts, and the cash surrender value of certain life insurance policies and
retained their cash, certain receivables and other assets and liabilities
with an aggregate net book value of $15,800,000, net of related deferred
taxes. The principal asset retained is a noninterest bearing trademark
royalty receivable from the Company amounting to $12,891,000, offset by a
related deferred tax liability of $5,801,000. Since the Company's
consolidated financial statements include the Trust's assets and liabilities
on a retroactive basis, the net assets retained by the Trusts are reflected
as non cash distributions of retained earnings on the date of the
Reorganization.
In accordance with the Company's articles of incorporation, each outstanding
share of its Class A common stock automatically converted to one share of Class
B common stock upon exchange of the Company's common shares by the shareholders
for shares of the Parent as part of the Reorganization.
F-12
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 3--EARNINGS PER SHARE
A reconciliation of the numerators and denominators of the basic and diluted
earnings per share computations under SFAS No. 128 is as follows (in thousands,
except per share information):
<TABLE>
<CAPTION>
FOR THE YEAR ENDED JULY 31,
------------------------------------------
<S> <C> <C> <C>
1996 1997 1998
------------- ------------- ------------
<CAPTION>
<S> <C> <C> <C>
Income available to common shareholders
before extraordinary item............. $ 10,035 $ 4,775 $ 9,866
Extraordinary item...................... -- (1,236) --
------------- ------------- ------------
$ 10,035 $ 3,539 $ 9,866
------------- ------------- ------------
------------- ------------- ------------
Weighted average shares outstanding for
determination of:
Basic earnings per share.............. 1,000 1,000 1,000
------------- ------------- ------------
------------- ------------- ------------
Diluted earnings per share............ 1,000 1,000 1,000
------------- ------------- ------------
------------- ------------- ------------
Basic earnings per share:
On income before extraordinary item... $ 10,035.73 $ 4,774.83 $ 9,865.72
On extraordinary item................. -- (1,235.52) --
------------- ------------- ------------
On net income......................... $ 10,035.73 $ 3,539.31 $ 9,865.72
------------- ------------- ------------
------------- ------------- ------------
</TABLE>
Diluted earnings per share is the same as basic earnings per share since the
Company has a simple capital structure with only common shares outstanding.
F-13
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 4--RECEIVABLES
Receivables consist of (in thousands):
<TABLE>
<CAPTION>
JULY 31,
--------------------
1997 1998
--------- ---------
<S> <C> <C>
Trade receivables, less allowance for doubtful accounts
of $420 and $1,060..................................... $ 16,914 $ 13,095
Officers and employee receivables, including notes, less
allowance for doubtful accounts of $98 and $550........ 1,736 461
Notes receivable, shareholders and family members,
current portion........................................ 371 --
Other receivables........................................ 1,677 9,539
--------- ---------
$ 20,698 $ 23,095
--------- ---------
--------- ---------
</TABLE>
The Company has receivables of approximately $4,930,000 and
$4,556,000 from sales of product for resale and supplies to unconsolidated
foreign joint ventures at July 31, 1997, and 1998 respectively.
NOTE 5--FIXED ASSETS
Fixed assets consist of (in thousands):
<TABLE>
<CAPTION>
JULY 31,
-------------------------
1997 1998
----------- ------------
<S> <C> <C>
Land.................................................. $ 9,876 $ 9,730
Buildings............................................. 19,708 19,049
Leasehold improvements................................ 134,876 142,856
Video rental cassettes................................ 20,241 20,043
Store fixtures........................................ 41,910 46,434
Equipment............................................. 115,982 118,298
Vehicles.............................................. 581 505
----------- -----------
343,174 356,915
Less: accumulated depreciation and amortization....... 152,817 169,329
----------- -----------
$ 190,357 $ 187,586
----------- -----------
----------- -----------
</TABLE>
The cost to build new store fixtures and improvements includes a portion of
the interest expense. Interest capitalized was $192,000 and $30,000 for the
years ended July 31, 1997 and 1998 respectively.
F-14
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 5--FIXED ASSETS (CONTINUED)
Depreciation and amortization of fixed assets was $26,330,000,
$31,479,000 and $27,113,000 for the years ended July 31, 1996, 1997 and 1998,
respectively.
NOTE 6--OTHER ASSETS
Other assets consist of (in thousands):
<TABLE>
<CAPTION>
JULY 31,
--------------------
1997 1998
--------- ---------
<S> <C> <C>
Notes receivable, shareholders and family members,
less current portion................................ $ 785 $ --
Notes receivable, officers and employees, less current
portion............................................. 2,280 2,392
Investment in foreign joint ventures.................. 1,962 894
Securities and artwork................................ 994 2
Cash surrender value of officers' life insurance...... 8,956 12,129
Deposits.............................................. 7,298 6,864
Goodwill, debt issuance costs and other intangible
assets, net of accumulated amortization of
$3,336 and $4,781................................... 5,550 10,938
--------- ---------
$ 27,825 $ 33,219
--------- ---------
--------- ---------
</TABLE>
Cash surrender value of life insurance at July 31, 1998 includes
$9,361,000 as to split value life insurance policies on the lives of the
Company's Parent's principal shareholder and his wife for the benefit of
certain family trusts. Under the terms of the policies, the Company will
receive the first proceeds of the policies up to the aggregate premiums paid
by the Company, except for one group of policies as to which the Company will
receive the first proceeds of the policies up to the sum of the aggregate
premiums paid by the Company plus $8,917,000 representing the cash surrender
value of the policies when received by the Company in April 1998 as part of
the Reorganization. The balance of the proceeds will be paid to the Trusts.
Premiums on the policies amount to $3.6 million per year which are recorded
as expense, net of increases in the cash surrender value of the policies.
Life insurance expense related to these policies amounted to $352,000, $274,000
and $279,000 in the years ended July 31, 1996, 1997, and 1998, respectively.
F-15
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7--LONG-TERM DEBT
Long-term debt consists of (in thousands):
<TABLE>
<CAPTION>
JULY 31,
------------------------
1997 1998
----------- -----------
<S> <C> <C>
9.375% Senior Subordinated Notes, uncollateralized, interest payable
semiannually, principal due May 2005.................................... $ -- $ 110,000
Senior Revolving Credit Facility, collateralized:
Dollar-based, variable interest payable monthly (6.10% to 6.38%
at July 31, 1998)..................................................... 33,500
Yen-based, variable interest payable monthly (1.17% to 1.63%
at July 31, 1998)..................................................... 76,314
Revolving credit line, uncollateralized, variable interest payable
monthly (6.63% at July 31, 1997), retired in April 1998................. 102,000 --
1.88% Senior note, uncollateralized, interest payable quarterly, retired
in April 1998........................................................... 49,374 --
1.42% Senior note, uncollateralized, interest payable quarterly, retired
in April 1998........................................................... 29,175 --
2.40% to 2.50% term loan notes, uncollateralized, principal and interest
payable quarterly, retired in April 1998................................ 17,017 --
Other obligations, 8.21% to 12.5%, principal and interest generally due in
monthly installments, collateralized by certain real property, equipment
and leasehold improvements.............................................. 13,701 12,071
----------- -----------
Total Long-term Debt...................................................... 211,267 231,885
Less Current Portion...................................................... 163,171 2,540
----------- -----------
Noncurrent Debt........................................................... $ 48,096 $ 229,345
----------- -----------
----------- -----------
</TABLE>
In April 1998, the Company refinanced on a long-term basis certain
obligations outstanding under its revolving credit lines, senior notes and
term notes by consummating an offering of $110.0 million of 9.375% senior
subordinated notes (Notes) and entering into a new senior revolving credit
facility (New Credit Facility) of up to $275.0 million.
F-16
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7--LONG-TERM DEBT (CONTINUED)
The Notes have options to redeem in part at various premiums throughout the
duration of the indenture. The New Credit Facility consists of two
sub-facilities (one for a maximum of $125.0 million and one for a maximum of
Japanese yen of 19,810,500,000, which amounted to $150.0 million at inception)
and matures in April 2001 with two provisions to extend for an additional
one-year period subject to certain terms and conditions. Maximum borrowings
under the New Credit Facility are subject to a borrowing base formula and are
collateralized by a majority of the Company's inventory, accounts receivable and
a pledge of 65% of the capital stock of its Japanese subsidiary. The New Credit
Facility bears interest at various variable rates, including (as defined in the
agreements) a Money Market Rate, ABR rate, Yen Base Rate and Euro Rate, plus an
annual facility fee. The amount included in the outstanding balance on July
31, 1998, under this agreement, drawn down in yen was 11,046,500,000
translated to $76,314,000.
There are various restrictive terms and covenants under the senior
subordinated notes and revolving credit facility relating to occurrence of
material adverse financial or operating conditions, minimum levels of net
worth, minimum fixed charge ratios, balance sheet coverage ratios, and
leverage ratios. Certain limitations on additional indebtedness, liens or
encumbrances on assets, long-term lease transactions, capital expenditures,
and issuance of capital stock.
In connection with retirement of Senior Notes in January 1997, the Company
recorded an extraordinary loss consisting of prepayment penalties.
Maturities of long-term debt obligations are as follows (in thousands):
<TABLE>
<CAPTION>
YEAR ENDING
------------
JULY 31,1998
------------
<S> <C>
1999.............................................................. $ 2,540
2000.............................................................. 2,132
2001.............................................................. 111,733
2002.............................................................. 829
2003.............................................................. 481
Thereafter........................................................ 114,170
------------
Total......................................................... $ 231,885
------------
------------
</TABLE>
NOTE 8--DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value of the Company's financial instruments approximates
the related carrying value. The following methods and assumptions were used to
estimate the fair value of each class of financial instruments:
CASH AND CASH EQUIVALENTS AND NOTES RECEIVABLE--The carrying amount
approximates fair value because of the short-term maturity of these instruments.
F-17
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 8--DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
LONG-TERM DEBT--The fair value of the Company's fixed rate long-term debt
was estimated based upon the discounted amount of future cash flows using rates
offered to the Company for debt of a similar nature using remaining average
maturities and taking into account the global markets in which funds are
available to the Company. The carrying value of the Company's variable rate debt
approximates fair value due to the variable nature of interest rates.
RISK MANAGEMENT INSTRUMENTS--Foreign exchange and interest rate risk
management instruments are recorded at their estimated value based on quoted
market prices of comparable contracts.
DEPOSITS--The fair value is not determinable since there is no market for
these deposits and the date of recovery of the amount on deposit depends on
future events.
NOTE 9--SHAREHOLDERS' EQUITY
COMMON STOCK--The Company's articles of incorporation authorize issuance of
two classes of common stock: Class A and Class B. Class A and Class B Common
Stock have no par value and have the same rights and privileges except that
Class A common has ten votes per share on all matters while Class B common has
one vote per share on all matters and Class B common has priority voting rights,
as a separate class, to elect twenty-five percent of the total membership of the
Board of Directors.
In accordance with the Company's Articles of Incorporation, each share of
Class A common automatically converted into one share of Class B common stock
upon the exchange by the shareholders of the Company's common shares for shares
of the Parent as part of the Reorganization (see Note 2).
PREFERRED STOCK--Preferred stock (1,000,000 shares authorized) may be issued
from time to time in one or more series. The Board of Directors is authorized to
determine the rights, preferences, privileges and restrictions granted to or
imposed upon unissued series of preferred stock and to fix the number of shares
of any such series.
NOTE 10--LEASES
OPERATING LEASES--The Company leases substantially all of its retail stores,
warehouses and administrative facilities. Those operating lease agreements
expire through 2023 and generally have renewal options of one to twenty years.
The terms of the leases provide for fixed or minimum payments plus, in some
cases, contingent rents based on the consumer price index, or percentages of
sales in excess of specified minimum amounts or other specified increases. The
Company is generally responsible for maintenance, insurance and property taxes.
F-18
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 10--LEASES (CONTINUED)
Minimum future obligations on noncancelable operating leases are as follows
(in thousands):
<TABLE>
<CAPTION>
YEAR ENDING JULY 31, 1998
- ------------------------------------------------------------------------------- -----------
<S> <C>
1999........................................................................... $ 38,781
2000......................................................................... 36,715
2001......................................................................... 32,160
2002......................................................................... 30,628
2003......................................................................... 29,807
Thereafter................................................................... 166,359
-----------
Total Minimum Future Rental Payments....................................... $ 334,450
-----------
-----------
</TABLE>
Total rental expense (including taxes and maintenance, when included in
rent, contingent rents and accruals to recognize minimum rents on the
straight-line basis over the term of the lease) relating to all operating leases
for the years ended July 31, 1996, 1997 and 1998 are as follows (in thousands):
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
-------------------
JULY 31,
--------
<S> <C> <C> <C>
1996 1997 1998
--------- --------- ---------
Minimum rentals.................................... $ 62,318 $ 64,808 $ 63,772
Contingent rentals................................. 4,211 5,141 5,136
--------- --------- ---------
$ 66,529 $ 69,949 $ 68,908
--------- --------- ---------
--------- --------- ---------
</TABLE>
F-19
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 11--INCOME TAXES
The provision for income taxes is allocated between income from operations,
extraordinary loss on extinguishment of debt and cumulative translation
adjustments to retained earnings. The provision for income taxes on income from
operations consists of (in thousands):
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
---------------------
JULY 31,
--------
<S> <C> <C> <C>
1996 1997 1998
--------- --------- ---------
Current:
U.S.
Federal................................................................... $ 4,220 $ 843 $ 10,055
State and Local................................................................ (185) 424 1,215
Foreign........................................................................ 2,189 2,916 251
--------- --------- ---------
6,224 4,183 11,521
--------- --------- ---------
Deferred:
U.S. Federal................................................................... (3,467) 1,106 124
State and Local................................................................ 773 237 (226)
Foreign........................................................................ 3,483 (983) (3,323)
--------- --------- ---------
789 360 (3,425)
--------- --------- ---------
Provision for income taxes....................................................... $ 7,013 $ 4,543 $ 8,096
--------- --------- ---------
--------- --------- ---------
</TABLE>
The effective tax rates (i.e. provision for income taxes as a percent of
income before income taxes) differs from the statutory federal income tax rate
as follows (in thousands, except percentages):
<TABLE>
<CAPTION>
FOR THE YEAR ENDED JULY 31,
-------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
1996 % 1997 % 1998 %
------- -------- --------- --------- --------- --------
Federal income tax, at statutory rate.................... $ 6,019 35.0% $ 3,339 35.0% $ 6,335 35.0%
Trust taxes in excess of (less than) C corporation rate.. 170 0.8 229 2.4 246 1.4
State and local income taxes, net of federal benefit..... 871 5.2 362 3.8 1,023 5.7
Foreign taxes............................................ 5,672 32.7 1,933 20.3 (3,073) (17.0)
Foreign tax credit recognized............................ (5,672) (32.7) (1,933) (20.3) 3,073 17.0
Other, principally permanent differences................. (47) (0.2) 613 6.4 492 2.7
------- -------- --------- --------- --------- --------
Provision for income taxes............................... $ 7,013 40.8% $ 4,543 47.6% $ 8,096 44.8%
------- -------- --------- --------- --------- --------
------- -------- --------- --------- --------- --------
</TABLE>
The effective tax rate prior to the Reorganization in April 1998 was
influenced by higher statutory tax rates applicable to trust income than to C
corporation income and deductibility of distributions of trust income within
certain time frames of when earned.
F-20
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 11--INCOME TAXES (CONTINUED)
Deferred income tax assets and liabilities consist of the tax effects of
temporary differences related to the following (in thousands):
<TABLE>
<CAPTION>
JULY 31,
--------------------
<S> <C> <C>
1997 1998
--------- ---------
Deferred tax assets:
Foreign tax credits.................................................. $ 11,816 $ 5,403
Cumulative translation adjustment to retained earnings............... 12,896 15,353
Tax, but not book, gain on transactions between MTS and Trusts....... 3,626 3,690
California state franchise tax....................................... 1,792 689
Vacation Accrual..................................................... 632 777
Capitalized inventory costs.......................................... 383 485
Other nondeductible expenses and accelerated income items............ 1,483 562
--------- ---------
Total deferred tax assets.......................................... 32,628 26,959
--------- ---------
Deferred tax liabilities:
Depreciation and amortization........................................ 15,293 4,108
Differences between tax and accounting in inclusion of income from
foreign operations................................................. 3,413 1,734
Cash to accrual difference on Trusts................................. 4,264 --
Other accelerated deductions and deferred income items............... 1,667 1,857
--------- ---------
Total deferred tax liabilities..................................... 24,637 7,699
--------- ---------
Net deferred tax assets.......................................... $ 7,991 $ 19,260
--------- ---------
--------- ---------
</TABLE>
Deferred tax assets and liabilities are reflected in the Company's
consolidated balance sheets as follows (in thousands):
<TABLE>
<CAPTION>
JULY 31,
--------------------
<S> <C> <C>
1997 1998
--------- ---------
Current deferred tax assets............................................. $ 425 $ 4,184
Non-current deferred tax assets......................................... 7,566 15,076
--------- ---------
Net deferred tax assets............................................. $ 7,991 $ 19,260
--------- ---------
--------- ---------
</TABLE>
F-21
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 12--PENSION PLAN
PROFIT SHARING--Substantially all full-time domestic employees with
twenty-four months of service who have attained age twenty-one participate in
the Company's profit sharing retirement programs. The plans provide for
discretionary contributions as determined annually by the Board of Directors
of up to 15% of all eligible compensation. Costs under the plans are funded
on an annual basis. The trustee of the plan is also an officer of the Company.
The Company also maintains a plan for employees of their Japanese
subsidiary. The plan covers substantially all employees of the Japanese
operations. The plan provides for a lump sum payment upon termination without
cause based on term of service and compensation level. A liability for plan
payments is accrued equal to the amount that would result from termination of
all employees based on service to date and current compensation levels. As
permitted by Japanese law, the plan is not funded.
Pension expense under the pension plans amounted to $1,792,000, $1,719,000
and $2,383,000 for the years ended July 31, 1996, 1997 and 1998, respectively.
F-22
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 13--SEGMENT AND GEOGRAPHIC INFORMATION:
The Company operates predominantly in the recorded music retail industry.
Financial information relating to the Company's principal foreign operations
is as follows (in thousands):
<TABLE>
<CAPTION>
FOR THE YEAR ENDED JULY 31,
---------------------------
<S> <C> <C>
1996 1997 1998
---------- ----------- --------------
Net Revenue:
United States:
Unaffiliated customer sales.............. $ 520,960 $ 553,292 $ 587,565
Interarea transfers...................... 63,392 44,092 37,901
----------- ----------- -------------
584,352 597,384 625,466
----------- ----------- -------------
Japan:
Unaffiliated customer sales.............. 334,586 304,630 288,876
Interarea transfers...................... 0 0 0
----------- ----------- -------------
334,586 304,630 288,876
----------- ----------- -------------
Great Britain and Ireland:
Unaffiliated customer sales.............. 56,590 59,774 64,419
Interarea transfers...................... 1,045 1,858 1,215
----------- ----------- -------------
57,635 61,632 65,634
----------- ----------- -------------
Other:
Unaffiliated customer sales.............. 24,462 28,164 28,170
Interarea transfers...................... 0 0 0
----------- ----------- -------------
24,462 28,164 28,170
----------- ----------- -------------
TOTAL $ 1,001,035 $ 991,810 $ 1,008,146
----------- ----------- -------------
----------- ----------- -------------
Operating income (loss):
United States.............................. $ 13,747 $ 12,831 $ 23,310
Japan...................................... 19,605 14,825 10,135
Great Britain and Ireland.................. 440 1,081 951
Other...................................... (203) (191) (2,001)
----------- ----------- -------------
$ 33,589 $ 28,546 $ 32,395
----------- ----------- -------------
----------- ----------- -------------
</TABLE>
F-23
<PAGE>
MTS, INCORPORATED
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 13--SEGMENT AND GEOGRAPHIC INFORMATION: (CONTINUED)
<TABLE>
<CAPTION>
JULY 31,
-------------------------------------
1996 1997 1998
----------- ----------- -----------
<S> <C> <C> <C>
Identifiable assets:
United States.............................................. $ 359,735 $ 373,273 $ 395,785
Japan...................................................... 122,952 121,778 96,996
Great Britain and Ireland.................................. 30,077 29,937 29,977
Other...................................................... 16,006 19,590 22,633
----------- ----------- -----------
$ 528,770 $ 544,578 $ 545,391
----------- ----------- -----------
----------- ----------- -----------
</TABLE>
United States net revenue includes export sales to non-affiliated
customers of $ 0, $3,856,000, and $2,583,000 for the years ended July 31,
1996, 1997 and 1998, respectively.
NOTE 14--FORWARD EXCHANGE CONTRACTS
At July 31, 1998, the Company had outstanding forward exchange contracts
maturing on dates through July 1998, to buy approximately $6,000,000 in
foreign currency (701 million yen at the contract rate). The fair value of
the contracts as of July 31, 1998 is 869 million yen. The contracts are for
the purpose of hedging foreign currency exposure on specific commitments and
a net exposed liability position of the Company's operations in Japan, as
well as to take advantage of expected changes in exchange rates.
NOTE 15--YEAR 2000 COMPLIANCE
Many currently installed information technology and non-information
technology systems and products are coded to accept only two digit entries in
the date code field. Beginning in the year 2000, these date code fields will
need to accept and recognize four digit entries to distinguish 21st century
dates from 20th century dates. As a result, within the next two years
computer systems and/or software used by many companies may need to be
upgraded to comply with such "Year 2000" requirements. The Company has
developed an overall plan to assist with the Year 2000 problem resolution
process. This plan is being used for both information technology (mainly
financial programs) and non-information technology programs (stereos, tv's,
vcr's, escalators, elevators, etc.). The main components of the plan are as
follows: awareness of the problem, preparation of an inventory check list,
assessment of complexity, remediation, validation testing and implementation.
With respect to information technology systems, the Company has already
finished all phases through implementation for the majority of its financial
systems and expects to have 100% compliance by late 1998. The non-information
technology systems and products have been completed through the assessment of
complexity phase and MTS expects to have 100% compliance by the middle of
1999. MTS is still in the process of obtaining year 2000 compliance
certificates from its third parties but due to the fact the Company does not
have a material relationship with any one vendor it does not anticipate any
possible business interruption due to non-compliance with third parties. As
of July 31, 1998 the Company has incurred $166,000 in remediation cost and
estimates it will require an additional $1,034,000 to complete all year 2000
compliance work. These costs include but are not limited to costs directly
related to fixing year 2000 issues, such as modifying software and hiring
year 2000 solution providers. Although it is not certain what the worst case
Year 2000 scenario would be, management believes that any computer generated
work (i.e. inventory tracking, point of sale at cash register) could be
performed manually as had been the case before the in-store processing
programs were implemented in 1994. In the unlikely event that a contingency
plan is needed due to a year 2000 system failure, the Company would revert
back to manual "offline" processing of its sales and inventory systems until
the problem is resolved.
NOTE 16--RELATED PARTIES
The Company has a note receivable from the Trusts for the purchase of the
Japanese corporate headquarters office. The note is for approximately 620
million yen ($4,283,247 at July 31, 1998) and is included in other current
receivables. In addition, the Company has accrued royalty fees payable to the
Trusts for royalties charged to them for the use of the Trusts trademarks and
logos. This payable is for approximately $12,262,000 included in at July 31,
1998.
F-24
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> JUL-31-1998
<PERIOD-START> AUG-01-1997
<PERIOD-END> JUL-31-1998
<CASH> 14,609
<SECURITIES> 0
<RECEIVABLES> 24,705
<ALLOWANCES> 1,610
<INVENTORY> 261,003
<CURRENT-ASSETS> 309,510
<PP&E> 356,915
<DEPRECIATION> 169,329
<TOTAL-ASSETS> 545,391
<CURRENT-LIABILITIES> 195,078
<BONDS> 231,885
0
0
<COMMON> 6
<OTHER-SE> 120,792
<TOTAL-LIABILITY-AND-EQUITY> 545,391
<SALES> 1,008,146
<TOTAL-REVENUES> 1,008,146
<CGS> 684,201
<TOTAL-COSTS> 291,550
<OTHER-EXPENSES> 14,294
<LOSS-PROVISION> 1,087
<INTEREST-EXPENSE> 14,921
<INCOME-PRETAX> 18,101
<INCOME-TAX> 8,096
<INCOME-CONTINUING> 18,101
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 9,866
<EPS-PRIMARY> 9,865.72
<EPS-DILUTED> 9,865.72
</TABLE>
