10-Q 1 a77921e10-q.txt FORM 10-Q -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM 10-Q --------------------- [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED OCTOBER 31, 2001 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER 0-22289 WHEREHOUSE ENTERTAINMENT, INC. (Exact name of registrant as specified in its charter)

~~Table~~DELAWARE 95-4608339 (State or other jurisdiction of ~~Contents~~(IRS Employer Identification Number) incorporation or organization)

19701 HAMILTON AVENUE, TORRANCE, CA 90502-1311 (Address of principal executive offices, including ZIP code) (310) 965-8300 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under the plan confirmed by a court. Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date: COMMON STOCK, $.01 PAR VALUE, 11,001,421 SHARES OUTSTANDING AS OF DECEMBER 10, 2001 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- WHEREHOUSE ENTERTAINMENT, INC. INDEX

~~________________________________________________________________________________~~ PAGE ---- FORWARD-LOOKING STATEMENTS........................................... 2 PART I. FINANCIAL INFORMATION Item 1. Financial Statements: Consolidated Condensed Balance Sheets -- October 31, 2001 (Unaudited) and January 31, 2001............................ 3 Consolidated Condensed Statements of Operations -- Three Months Ended October 31, 2001 and 2000 (Unaudited) and Nine Months Ended October 31, 2001 and 2000 (Unaudited).......... 4 Consolidated Condensed Statements of Cash Flows -- Nine Months Ended October 31, 2001 and 2000 (Unaudited).......... 5 Notes to Consolidated Condensed Financial Statements (Unaudited)................................................. 6 Item 2. Management's Discussion and Analysis of Financial Condition 8 and Results of Operations................................... Item 3. Quantitative and Qualitative Disclosures About Market 12 Risk........................................................ PART II. OTHER INFORMATION Item 1. Legal Proceedings........................................... 13 Item 5. Other Information........................................... 13 Item 6. Exhibits and Reports on Form 8-K............................ 13 SIGNATURES........................................................... 14

1 FORWARD-LOOKING STATEMENTS This Quarterly Report on Form 10-Q includes certain statements that may be deemed to be "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The sections of this Quarterly Report on Form 10-Q containing such forward-looking statements include "Management's Discussion and Analysis of Financial Condition and Results of Operations" under Item 2 of Part I below. Statements in this Quarterly Report on Form 10-Q which address activities, events or developments that the registrant expects or anticipates will or may occur in the future, including such things as future issuances of shares, future capital expenditures (including the amount and nature thereof), expansion and other developments and technological trends of industry segments in which the registrant is active, business strategy, expansion and growth of the registrant's and its competitors' business and operations and other such matters are forward-looking statements. You can find many of these statements by looking for words like "believes", "expects", "anticipates", or similar expressions in this Quarterly Report on Form 10-Q. Although the registrant believes the expectations expressed in such forward-looking statements are based on reasonable assumptions within the bounds of its knowledge of its business, a number of factors could cause actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of the registrant. The registrant's operations are subject to factors outside its control. Any one, or a combination, of these factors could materially affect the results of the registrant's operations. These factors include (a) changes in levels of competition from current competitors and potential new competition from both non-traditional retailers of the registrant's products and alternative methods or channels of distribution such as Internet and telephone shopping services and mail order; (b) loss of a significant vendor or prolonged disruption of product supply; (c) the presence or absence of popular new releases and products in the product categories the registrant represents; (d) changes in levels of consumer spending, especially during seasonally significant periods; (e) changes in Federal and state income tax rules and regulations or interpretations of existing legislation; (f) changes in the general economic conditions in the United States including, but not limited to, consumer sentiment about the economy in general; (g) regulatory changes which may adversely affect the business in which the registrant is engaged; (h) the ability to attract and retain key personnel; and (i) adverse results in significant litigation matters. The foregoing should not be construed as an exhaustive list of all factors which could cause actual results to differ materially from those expressed in forward-looking statements made by the registrant. You should consider the cautionary statements contained in this section when evaluating any forward-looking statements that we may make. We do not have any obligation to publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect the occurrence of unanticipated events. 2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS WHEREHOUSE ENTERTAINMENT, INC. CONSOLIDATED CONDENSED BALANCE SHEETS

~~UNITED~~OCTOBER ~~STATES~~31, ~~SECURITIES~~JANUARY 31, 2001 2001 ------------ ------------ (UNAUDITED) ASSETS Current assets: Cash and cash equivalents................................. $ 1,130,000 $ 2,457,000 Receivables, net.......................................... 4,951,000 1,343,000 Inventories, net.......................................... 193,695,000 197,147,000 Income taxes receivable................................... 1,568,000 9,825,000 Other current assets...................................... 1,650,000 2,401,000 Deferred taxes............................................ 1,429,000 5,983,000 ------------ ------------ Total current assets.............................. 204,423,000 219,156,000 Property, equipment and improvements, net................... 49,473,000 67,132,000 Deferred income taxes....................................... 19,886,000 Intangible assets, net...................................... 28,571,000 34,510,000 Other assets, net........................................... 4,735,000 1,007,000 ------------ ------------ Total assets...................................... $287,202,000 $341,691,000 ============ ============ LIABILITIES AND ~~EXCHANGE COMMISSION~~ SHAREHOLDERS' EQUITY Current liabilities: Accounts payable and bank overdraft....................... $124,334,000 $129,042,000 Accrued expenses.......................................... 32,548,000 35,468,000 Store closure reserves.................................... 7,624,000 8,421,000 Reorganization liabilities................................ 1,202,000 1,242,000 Current portion of long-term debt......................... 3,634,000 3,836,000 Current portion of leases in excess of fair market value.................................................. 3,270,000 3,270,000 Current portion of capital lease obligations.............. 4,986,000 6,090,000 ------------ ------------ Total current liabilities......................... 177,598,000 187,369,000 Line of credit.............................................. 57,228,000 35,123,000 Long-term debt.............................................. 202,000 224,000 Capital lease obligations................................... 12,311,000 16,293,000 Leases in excess of fair market value....................... 15,234,000 18,195,000 Deferred rent and other long-term liabilities............... 4,405,000 5,181,000 ------------ ------------ Total liabilities................................. 266,978,000 262,385,000 ------------ ------------ Shareholders' equity: Preferred stock, $.01 par value; shares authorized, 3,000,000; shares issued, none Common stock, $.01 par value; shares authorized, 24,000,000; shares issued, 11,026,421; shares outstanding, 11,001,421................................ 110,000 110,000 Additional paid-in-capital................................ 94,510,000 94,453,000 Retained earnings (deficit)............................... (66,943,000) (8,084,000) Treasury stock, 25,000 shares............................. (338,000) (338,000) Notes receivable.......................................... (7,115,000) (6,835,000) ------------ ------------ Total shareholders' equity........................ 20,224,000 79,306,000 ------------ ------------ Total liabilities and shareholders' equity........ $287,202,000 $341,691,000 ============ ============

See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements. 3 WHEREHOUSE ENTERTAINMENT, INC. CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

~~Washington~~THREE MONTHS ENDED NINE MONTHS ENDED --------------------------- --------------------------- OCTOBER 31, DOCTOBER 31, OCTOBER 31, OCTOBER 31, 2001 2000 2001 2000 ------------ ------------ ------------ ------------ (UNAUDITED) Sale merchandise revenue.C............ ~~20549~~ $128,554,000 $147,454,000 $427,519,000 $487,753,000 Rental revenue, net.................. 853,000 1,342,000 3,233,000 4,398,000 ------------ ------------ ------------ ------------ Total revenues..................... 129,407,000 148,796,000 430,752,000 492,151,000 Cost of sale merchandise revenue..... 85,002,000 93,882,000 281,694,000 315,430,000 ------------ ------------ ------------ ------------ Gross profit....................... 44,405,000 54,914,000 149,058,000 176,721,000 Selling, general and administrative expenses........................... 48,180,000 54,677,000 152,958,000 167,677,000 Depreciation and amortization........ 7,366,000 7,554,000 22,977,000 22,425,000 Loss on disposition of assets........ 3,261,000 108,000 3,411,000 773,000 ------------ ------------ ------------ ------------ Loss from operations............... (14,402,000) (7,425,000) (30,288,000) (14,154,000) Interest expense..................... 1,217,000 2,250,000 4,455,000 6,592,000 Interest income...................... (209,000) (95,000) (405,000) (313,000) Equity in loss from unconsolidated joint venture...................... 3,100,000 9,143,000 ------------ ------------ ------------ ------------ Loss before income taxes........... (15,410,000) (12,680,000) (34,338,000) (29,576,000) Income tax (expense) benefit......... (32,092,000) 5,097,000 (24,521,000) 11,889,000 ------------ ------------ ------------ ------------ Net loss........................... $(47,502,000) $ (7,583,000) $(58,859,000) $(17,687,000) ============ ============ ============ ============ Net loss per common share: Basic.............................. $ (4.32) $ (0.69) $ (5.35) $ (1.61) ============ ============ ============ ============ Diluted............................ $ (4.32) $ (0.69) $ (5.35) $ (1.61) ============ ============ ============ ============ Weighted average common shares outstanding -- Basic............... 11,001,421 11,001,421 11,001,421 10,984,538 ============ ============ ============ ============ Weighted average common shares and common equivalent shares outstanding -- Diluted............. 11,001,421 11,001,421 11,001,421 10,984,538 ============ ============ ============ ============

See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements. 4 WHEREHOUSE ENTERTAINMENT, INC. CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

~~Form~~NINE MONTHS ENDED --------------------------- OCTOBER 31, OCTOBER 31, 2001 2000 ------------ ------------ (UNAUDITED) OPERATING ACTIVITIES: Net loss.................................................... $(58,859,000) $(17,687,000) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization............................. 22,977,000 22,425,000 Loss on disposition of assets............................. 3,411,000 773,000 Rental amortization included in cost of rentals........... 2,717,000 2,688,000 Book value of rental inventory dispositions, included in cost of rentals......................................... 314,000 477,000 Loss on investment in joint venture....................... 9,143,000 Stock option compensation................................. 57,000 37,000 Interest on notes receivable.............................. (280,000) (280,000) Deferred income taxes..................................... 24,440,000 (12,681,000) Changes in operating assets and liabilities: Receivables, net........................................ (250,000) 6,372,000 Inventories, net........................................ (18,932,000) (10,257,000) Rental inventory purchases.............................. (2,777,000) (2,967,000) Income taxes receivable/payable......................... 8,257,000 Other current assets.................................... 731,000 270,000 Accounts payable, accrued expenses and other current liabilities............................................ (7,656,000) (6,696,000) Store closure and leases in excess of FMV reserves...... (3,241,000) (4,633,000) Other long-Q term liabilities............................. (776,000) (5,000) ------------ ------------ Net cash used in operating activities................. (29,867,000) (13,021,000) ------------ ------------ INVESTING ACTIVITIES: Purchase of property, equipment and improvements............ (6,659,000) (10,120,000) Proceeds from sale of stores................................ 18,236,000 Investment in joint venture................................. (17,826,000) Decrease (increase) in other assets......................... 4,000 115,000 ------------ ------------ Net cash provided by (used in) investing activities... 11,581,000 (27,831,000) ------------ ------------ FINANCING ACTIVITIES: Net borrowings under line of credit......................... 22,105,000 40,959,000 Payments on capital lease obligations and long-term debt.... (5,106,000) (4,379,000) Proceeds from sale of common stock.......................... 5,000,000 Settlement of pre-petition claims........................... (40,000) (311,000) ------------ ------------ Net cash provided by financing activities............. 16,959,000 41,269,000 ------------ ------------ Net (decrease) increase in cash and cash equivalents........ (1,327,000) 417,000 Cash and cash equivalents at beginning of the period........ 2,457,000 4,531,000 ------------ ------------ Cash and cash equivalents at end of the period.............. $ 1,130,000 $ 4,948,000 ============ ============ Supplemental disclosures of cash flow information: Cash paid during the period for: Interest................................................ $ 4,059,000 $ 6,450,000 Income taxes, net....................................... $ (7,937,000) $ 367,000

Non-cash investing and financing activities: The Company incurred capital lease obligations of $377,000 and $853,000 for the purchase of certain equipment during the nine months ended October 31, 2001 and October 31, 2000, respectively. The Company recorded notes receivable which totaled $6,075,000 in connection with the sale of 64 Wherehouse Music stores during the nine months ended October 31, 2001. See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements. 5 WHEREHOUSE ENTERTAINMENT, INC. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The accompanying unaudited consolidated condensed financial statements include the accounts of Wherehouse Entertainment, Inc. and its wholly owned subsidiaries (collectively referred to as the "Company"). All material intercompany balances and transactions have been eliminated in consolidation. The interim unaudited consolidated condensed financial statements of the Company have been prepared in accordance with the instructions to Form 10-Q of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by Generally Accepted Accounting Principles ("GAAP") for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The Company's business is seasonal, so operating results for the nine months ended October 31, 2001 are not necessarily indicative of the results that may be expected for the Company's fiscal year ending January 31, 2002 ("Fiscal 2002"). For further information, refer to the financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the Company's fiscal year ended January 31, 2001 ("Fiscal 2001"). 2. DISPOSITION OF STORES On August 9, 2001, the Company completed the sale of sixty-four (64) Wherehouse Music stores to The Music Network ("TMN") for approximately $25.9 million which was comprised of $19.8 million in cash and $6.1 million in notes receivable less approximately $0.6 million in costs to complete the transaction. Approximately $0.9 million of the cash proceeds were in escrow and were received subsequent to October 31, 2001. In addition, the Company received warrants to purchase 90,440 shares or approximately 1.75% of TMN for $0.01 per share. Management has valued these warrants at a de minimus amount. The majority of the stores sold to TMN are located in Florida, North Carolina, South Carolina and Tennessee, with a few located in Georgia and Alabama. As part of the transaction, the Company also granted the rights to the Turtle's Music trade brand to TMN. The subject stores accounted for $63.6 million in total revenues for the fiscal year ended January 31, 2001 and $26.8 million in total revenues for the nine months ended October 31, 2001. The net tangible book value of the assets sold amounted to approximately $25.3 million. In addition, the Company also wrote off approximately $3.3 million of goodwill which was attributable to the sold stores. The Company is also obligated to fulfill lease commitments should TMN default on certain obligations. 3. E-COMMERCE For the nine-month period ended October 31, 2000, the Company recognized a loss of $9.1 million related to its equity investment in Checkout.com, an Internet content provider and e-commerce retailer of music, movies and games. As of October 31, 2000, the Company's investment in the joint venture amounted to $17.8 million. As a result of significant operating losses experienced by CheckOut.com, CheckOut.com ceased operation of its Internet site in February, 2001. For Fiscal 2001, a $20.6 million loss on investment in joint venture was recorded by the Company which included $11.1 million representing the Company's share in the joint venture's operating losses and $9.5 million representing a loss due to the impairment in value of the remaining investment. During November 2001, the Company re-launched its Internet e-commerce site, "Wherehousemusic.com". 4. INCOME TAXES During the quarter ended October 31, 2001, the Company recorded a valuation allowance for a significant portion of its total deferred income tax assets in the amount of $32.1 million as a result of recurring losses from operations. Such valuation allowance will be reversed when the Company returns to profitability at levels sufficient to realize such deferred income tax assets. 6 WHEREHOUSE ENTERTAINMENT, INC. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 5. LITIGATION In January, 2001, the Company was sued in the Los Angeles Superior Court by a former store manager, claiming alleged failure to pay overtime wages to herself and all similarly situated salaried store employees. The Complaint does not specify any amount of the claims, either individually or on behalf of the class. Thereafter, the Complaint was amended to add three additional named plaintiffs. The amended Complaint seeks relief on behalf of both store managers and assistant managers going back to 1997. The Company's motions to strike the class action allegations have been denied. A limited amount of discovery has been conducted to date. In October, 2001, a second class action suit was filed with respect to store managers and assistant managers by different named plaintiffs and different lawyers. It also seeks overtime pay and, in addition, asserts claims for meal break and rest break penalties. No case activity has taken place in the second case to date. The Company believes the allegations in both suits are without merit and intends to vigorously defend itself in these matters. However, no assurance can be provided as to its outcome. Management does not believe an adverse judgment against the Company would result in a material impact to the consolidated financial statements. On July 18, 2001, the Santa Clara County, California Superior Court entered a $7.6 million judgment against the Company in a personal injury lawsuit encaptioned Peterson, et al. v. Shapell Industries (the "Peterson Lawsuit"). While the Company was insured for this judgment, its insurer, Reliance Insurance Company, was ordered liquidated by the State of Pennsylvania on October 3, 2001. As such, it is unknown at present whether, and to what extent, assets of the insurer will be available to the Company subsequent to a formal liquidation proceeding. Pending this outcome, California's Insurance Guarantee Fund ("CIGA") has engaged appellate counsel on behalf of the Company. CIGA has also facilitated the posting of an appellate bond to stay execution of the Peterson judgment pending the outcome of the Company's appeal. The Company was required by the bonding company to provide an $11.4 million letter of credit as security for the appellate bond. Management, based on the advice of legal counsel, believes that it is reasonably possible that it will either prevail on appeal or be successful in an alternative legal strategy and accordingly has not recorded a liability for the judgment in the accompanying financial statements. In addition, the Company is a party to various other claims, legal actions and complaints arising in the ordinary course of its 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. 6. ACCOUNTING POLICY CHANGE In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets". SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method of accounting and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired in a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but will be tested at least annually for impairment. The Company is required to implement SFAS No. 142 on February 1, 2002 and, at that time, will stop amortizing goodwill that resulted from business combinations completed prior to the adoption of SFAS No. 141. Goodwill is currently being amortized at approximately $3.3 million annually. The Company is currently evaluating the provisions of SFAS No. 142 and has not yet determined any additional effects that adoption of these standards will have on its financial statements. 7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION This discussion should be read in conjunction with the financial statements, related notes and Management's Discussion and Analysis of Financial Condition and Results of Operations contained in the Company's Annual Report on Form 10-K for Fiscal 2001. RESULTS OF OPERATIONS FOR THE QUARTERS ENDED OCTOBER 31, 2001 AND OCTOBER 31, 2000 Revenues Total revenues were $129.4 million and $148.8 million for the quarters ended October 31, 2001 (the third quarter of Fiscal 2002) and October 31, 2000 (the third quarter of Fiscal 2001), respectively. The decrease of $19.4 million was primarily attributable to decreases in net revenues of $17.2 million due to the closure of 34 stores since August 1, 2000 and the sale of 64 stores sold during the three months ended October 31, 2001, same store sales decreases in net revenues of $1.9 million and the reduction of net rental revenue of $0.5 million. A summary of total sale merchandise and rental revenue by category is provided below: SALE MERCHANDISE AND RENTAL REVENUES BY CATEGORY

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the quarterly period ended July 31, 2001
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

A. Sale merchandise revenue. Sale merchandise revenue includes prerecorded music, new videocassettes, DVDs, and video game software and hardware (collectively referred to as "sale merchandise"). Management defines same-store sales as sales from stores that were open for the full period in both periods of comparison. On a same-store basis, excluding the 34 stores closed since August 1, 2000 and the 64 stores sold during the three months ended October 31, 2001, sale merchandise revenue decreased by approximately 1.5% during the third quarter of Fiscal 2002 as compared to the third quarter of Fiscal 2001. Same-store sales for the three months ended October 31, 2001 were trending positively prior to the events of September 11, 2001. Since September 11, 2001, sales have been adversely impacted by the general economic downturn. Also contributing to the decrease in same-store sales is continuing competition from certain "big-box" retailers selling selected new music releases at or below cost. Partially offsetting these decreases were increased sales of DVD and used music. B. Rental revenue, net. Rental revenue, net includes the proceeds from the rental of videocassettes, DVDs, video games and game players, and from the sale of previously viewed videocassettes and previously played video games, net of cost of rentals. Rental revenue, net was $0.8 million in the third quarter of Fiscal 2002 and $1.3 million in the third quarter of Fiscal 2001, representing a decrease due to the Company's de-emphasis of the rental portion of its business. 8 C. Competition and Economic Factors. The Company believes that, in the future, its business and same-store revenues may be impacted by various competitive and economic factors. These factors include, but are not limited to, consumer tastes, new releases of music, DVD, videocassette and video game titles available for sale or rental, the increasing popularity of the Internet as an avenue for retailing and other direct-to-consumer alternatives, and technological developments such as digital downloading and the use of CD "burners" to copy, as well as general economic trends impacting retailers and consumers. In addition, in recent years the Company's sale merchandise and rental revenues have been impacted by increased competition from other music and video specialty chains, consumer electronics superstores, discounters and mass merchandisers. Consolidation continues to occur in the home entertainment industry and the Company continues to study industry developments in developing its own strategies. Cost of Sale Merchandise Revenue Cost of sale merchandise revenue was $85.0 million for the third quarter of Fiscal 2002, as compared with $93.9 million for the same period last year, a decrease of $8.9 million. As a percentage of sale merchandise revenue, cost of sale merchandise revenue was 66.1% for the third quarter of Fiscal 2002 as compared with 63.7% for the third quarter of Fiscal 2001. As a percentage of total revenues for the third quarter of Fiscal 2002, sales of higher margin new music product continued to decrease and sales of lower margin DVD product continued to increase, which offset the benefit from an increase of higher margin used music product. In addition, decreases in sales prices related to several mid-line new music promotional events also caused downward pressure on gross profit margins. Operating Expenses Selling, general and administrative ("SG&A") expenses for the third quarter of Fiscal 2002 were $48.2 million, compared to $54.7 million for the third quarter of Fiscal 2001, a decrease of $6.5 million. The decrease is primarily attributable to a reduction of $8.0 million in operating expenses at the Company's stores due to the sale of 64 stores. In addition, improvements in operating efficiencies and expense reductions partially offset cost of living increases in payroll, CPI increases in occupancy costs and similar inflationary increases in utility and other costs. SG&A expenses were 37.2% of revenue in the third quarter of Fiscal 2002, compared to 36.8% of revenue in the third quarter of Fiscal 2001, an increase of 0.4%. Depreciation and amortization expense was $7.4 million in the third quarter of Fiscal 2002 compared to $7.6 million in the third quarter of Fiscal 2001, an decrease of $0.2 million. The decrease is principally related to the sale of certain assets to TMN (see Note 2 to Item 1 above). Interest Expense Interest expense for the third quarter of Fiscal 2002 was $1.2 million, compared to $2.3 million for the third quarter of Fiscal 2001, a decrease of $1.1 million. This decrease was primarily attributable to a reduction in the average interest rates paid by the Company on its borrowings under the Company's revolving line of credit with Congress Financial Corporation (Western) (the "Congress Facility") of approximately 340 basis points in the third quarter of Fiscal 2002 as compared to the third quarter of Fiscal 2001. Also contributing to the decline was lower average borrowings under the Congress Facility during the third quarter of Fiscal 2002. Borrowings under the Congress Facility were used mainly for the funding of working capital and, in the third quarter of Fiscal 2001, to fund the investment in CheckOut.com. Interest Income Interest income for the third quarter of Fiscal 2002 was $0.2 compared to $0.1 for the third quarter of Fiscal 2001. The increase in interest income is attributable to the notes receivable related to the sale of certain assets to TMN. Interest income also includes notes receivable from shareholders. 9 Loss from Investment in Joint Venture The Company had a 49% interest in the CheckOut.com joint venture and accounted for this investment under the equity method of accounting. For the third quarter of Fiscal 2001, the Company recognized a $3.1 million loss related to its share of the losses of CheckOut.com. CheckOut.com continued to experience significant operating losses and ceased operations of its Internet site in February 2001. Income Taxes The income tax expense of $32.1 million for the quarter ended October 31, 2001, represents the valuation allowance provided against a significant portion of the Company's deferred income tax assets due to recurring losses from the Company's operations. Such valuation allowance will be reversed when the Company returns to profitability at levels sufficient to realize such deferred income tax assets. FOR THE NINE MONTHS ENDED OCTOBER 31, 2001 AND OCTOBER 31, 2000 Revenues Total revenues were $430.8 million and $492.2 million for the nine months ended October 31, 2001 and October 31, 2000, respectively. The decrease of $61.4 million was primarily attributable to decreases in net revenues of $34.9 million due to the closure of 54 stores since February 1, 2000 and the sale of 64 stores during the three months ended October 31, 2001, same store sales decreases in net revenues of $26.3 million and the reduction of net rental revenue of $1.2 million A summary of total sale merchandise and rental revenue by category is provided below: SALE MERCHANDISE AND RENTAL REVENUES BY CATEGORY

~~Commission~~NINE ~~File~~MONTHS ~~Number~~ENDED 0OCTOBER 31, -~~22289~~ -------------------- 2001 2000 -------- -------- (DOLLARS IN MILLIONS) Sale merchandise revenue: Music..................................................... $354.4 $420.6 Other, principally sales of new videocassettes, DVDs, video game software and hardware, general merchandise and ticket commissions................................. 73.1 67.2 ------ ------ Total sale merchandise revenue.................... 427.5 487.8 Rental revenue, net......................................... 3.2 4.4 ------ ------ Total revenue..................................... $430.8 $492.2 ====== ======

A. Sale merchandise revenue. On a same-store basis, excluding the 54 stores closed since February 1, 2000 and the 64 stores sold during the during the three months ended October 31, 2001, sale merchandise revenue decreased by approximately 6.2% during the nine months ended October 31, 2001 as compared to the same period last year. The primary reasons for the decrease were a weak new release schedule for music products that continued during most of the nine month period ended October 31, 2001, and competition from certain "big-box" retailers selling selected new music releases at or below cost. Partially offsetting these decreases were increased sales of DVD and used music. B. Rental revenue, net. Rental revenue, net was $3.2 million in the nine months ended October 31, 2001 and $4.4 million in the nine months ended October 31, 2000, representing a decrease of $1.2 million or 27.3% due to the Company's de-emphasis of the rental portion of its business. 10 Cost of Sale Merchandise Revenue Cost of sale merchandise revenue was $281.7 million for the nine months ended October 31, 2001, as compared with $315.4 million for the same period last year, a decrease of $33.7 million. As a percentage of sale merchandise revenue, cost of sale merchandise revenue was 65.9% for the nine months ended October 31, 2001 as compared with 64.7% for the nine months ended October 31, 2000. As a percentage of total revenues for the nine months ended October 31, 2001, sales of higher margin new music product continued to decrease and sales of lower margin DVD product continued to increase, which offset the benefit from an increase of higher margin used music product In addition, decreases in sales prices related to several mid-line new music promotional events also caused pressure on gross profit margins. Operating Expenses SG&A expenses for the nine months ended October 31, 2001 were $153.0 million, compared to $167.7 million for the nine months ended October 31, 2000, a decrease of $14.7 million. The decrease includes a reduction of $12.9 million in operating expenses at the Company's stores due to store closures and the sale of 64 of the Company's stores. In addition, cost of living increases in payroll, CPI increases in occupancy costs and similar inflationary increases in utility and other costs were more than offset by improvements in operating efficiencies and expense reductions. SG&A expenses were 35.5% of revenue in the nine months ended October 31, 2001, compared to 34.1% of revenue in the nine months ended October 31, 2000, an increase of 1.4%. Depreciation and amortization expense was $23.0 million in the nine months ended October 31, 2001 compared to $22.4 million in the nine months ended October 31, 2000, an increase of $0.6 million. The increase is principally related to capital expenditures over the last twelve months for the acquisition of property, equipment and system improvements. Interest Expense Interest expense for the nine months ended October 31, 2001 was $4.5 million, compared to $6.6 million for the nine months ended October 31, 2000, a decrease of $2.1 million. This decrease was partially attributable to lower average borrowings under the Congress Facility. Also contributing to the decline was a reduction in the average interest rates paid by the Company on its borrowings under the Congress Facility of approximately 210 basis points in the nine months ended October 31, 2001 as compared to the nine months ended October 31, 2000. Interest Income Interest income for the nine months ended October 31, 2001 was $0.4 compared to $0.3 for the nine months ended October 31, 2000. The increase in interest income is attributable to the notes receivable related to the sale of certain assets to TMN. Loss from Investment in Joint Venture For the nine months ended October 31, 2000, the Company recognized a $9.1 million loss related to its share of the losses of CheckOut.com. CheckOut.com continued to experience significant operating losses and ceased operations of its Internet site in February 2001. Income Taxes The income tax expense of $24.5 million for the nine months ended October 31, 2001, reflects the $32.1 valuation allowance provided against a significant portion of the Company's deferred income tax assets due to losses from the Company's operations in the quarter ended October 31, 2001. Such valuation allowance will be reversed when the Company returns to profitability at levels sufficient to realize such deferred income tax assets. 11 LIQUIDITY AND CAPITAL RESOURCES During the nine months ended October 31, 2001 and the nine months ended October 31, 2000, the Company's net cash used in operating activities was $29.9 million and $13.0 million, respectively. The most significant use of cash during this period was related to seasonal and non-seasonal inventory purchases as evidenced by higher inventory levels, $18.9 million and a decrease in accounts payable, accrued expenses and other current liabilities, $7.7 million. Seasonal inventory purchases typically begin during the third quarter and continue into the fourth quarter, while payment is typically due in the first quarter of the fiscal year. Non-seasonal inventory purchases are made throughout the year and fluctuate with the timing and strength of new releases. Net cash provided by investing activities during the nine months ended October 31, 2001 was $11.6 million primarily due to $18.2 million in proceeds received from the sale of assets to TMN, partially offset by capital expenditures totaling $6.7 million for the acquisition of property, equipment and improvements. Financing of capital expenditures has generally been provided by cash by operations and borrowings under the Congress Facility. During the nine months ended October 31, 2000, net cash used in investing activities included $17.8 million invested in the Company's joint venture with CheckOut.com. Net cash provided by financing activities for the nine months ended October 31, 2001 was $17.0 million due to net borrowings under the Congress Facility of $22.1 million, offset partially by payments of $5.1 million on capital lease obligations and long-term debt. As of October 31, 2001, there was an outstanding loan balance of $57.2 million and there were no outstanding letters of credit under the Congress Facility. The Company estimates that its availability under its revolving line of credit at October 31, 2001 was $51.2 million. On November 29, 2001, the Company was required to post a letter of credit of $11.4 million as security for an appellate bond issued to stay execution of the judgment in the Peterson Lawsuit, discussed above, pending the outcome of the Company's appeal. As of December 17, 2001, the Company estimates that its availability under its revolving line of credit was $63.0 after giving effect to the $11.4 million letter of credit. The Company believes that cash on hand, cash flow from operations, including planned inventory reductions during Fiscal 2002, and the availability of lease financing, together with borrowings available under the Congress Facility, will be adequate to support existing operations and the planned capital expenditures of the Company for Fiscal 2002. SEASONALITY AND INFLATION The Company's business is seasonal, and revenues and operating income are highest during the fourth quarter of the Company's fiscal year. Working capital and related bank borrowings in prior years were usually lowest during the period beginning with the end of the Christmas holiday season and ending with the close of the Company's fiscal year. Beginning in February, working capital and related bank borrowings have historically trended upward during the year until the fourth quarter. Borrowings have historically been highest in October and November due to capital expenditures and the building of inventory for the holiday season. The Company believes that, except for changes in the minimum wage mandated by the Federal government, inflation has not had a material effect on its operations and its internal and external sources of liquidity and working capital. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is subject to risks resulting from interest rate fluctuations since interest on the Company's borrowings under the Congress Facility are based on variable rates. If the Eurodollar rate were to increase 1% in Fiscal 2002 as compared to the rate at October 31, 2001, the Company's interest expense for Fiscal 2002 would increase $0.6 million based on the outstanding balance of the Congress Facility at October 31, 2001. The Company does not hold any derivative instruments and does not engage in hedging activities. 12 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS As discussed above, in January, 2001, the Company was sued in the Los Angeles Superior Court by a former store manager, claiming alleged failure to pay overtime wages to herself and all similarly situated salaried store employees. The Complaint does not specify any amount of the claims, either individually or on behalf of the class. Thereafter, the Complaint was amended to add three additional named plaintiffs. The amended Complaint seeks relief on behalf of both store managers and assistant managers going back to 1997. The Company's motions to strike the class action allegations have been denied. A limited amount of discovery has been conducted to date. In October 2001, a second class action suit was filed with respect to store managers and assistant managers by different named plaintiffs and lawyers. It also seeks overtime pay and, in addition, asserts claims for meal break and rest break penalties. No case activity has taken place in the second case to date. The Company believes the allegations in both suits are without merit and intends to vigorously defend itself in these matters. However, no assurance can be provided as to its outcome. Management does not believe an adverse judgment against the Company would result in a material impact to the consolidated financial statements. On July 18, 2001, the Santa Clara County, California Superior Court entered a $7.6 million judgment against the Company in a personal injury lawsuit encaptioned Peterson, et al. v. Shapell Industries (the "Peterson Lawsuit"). While the Company was insured for this judgment, its insurer, Reliance Insurance Company, was ordered liquidated by the State of Pennsylvania on October 3, 2001. As such, it is unknown at present whether, and to what extent, assets of the insurer will be available to the Company subsequent to a formal liquidation proceeding. Pending this outcome, California's Insurance Guarantee Fund ("CIGA") has engaged appellate counsel on behalf of the Company. CIGA has also facilitated the posting of an appellate bond to stay execution of the Peterson judgment pending the outcome of the Company's appeal. The Company was required by the bonding company to provide an $11.4 million letter of credit as security for the appellate bond. Management, based on the advice of legal counsel, believes that it is reasonably possible that it will either prevail on appeal or be successful in an alternative legal strategy and accordingly has not recorded a liability for the judgment in the accompanying financial statements. In addition, the Company is a party to various other claims, legal actions and complaints arising in the ordinary course of its 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 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits None. (b) Reports on Form 8-K None. 13 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. WHEREHOUSE ENTERTAINMENT, INC. /s/ ANTONIO C. ALVAREZ, II -------------------------------------- Antonio C. Alvarez, II Chairman of the Board and Chief Executive Officer, and Director (Principal Executive Officer) Date: December 21, 2001 /s/ MARK A. VELARDE -------------------------------------- Mark A. Velarde Executive Vice President, Chief Financial Officer and Chief Administrative Officer (Principal Financial Officer) Date: December 21, 2001 /s/ MEHDI MAHDAVI -------------------------------------- Mehdi Mahdavi Vice President, Controller (Principal Accounting Officer) Date: December 21, 2001 14

Wherehouse Entertainment, Inc.

(Exact name of registrant as specified in its charter)

Delaware		95-4608339
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)
19701 Hamilton Avenue, Torrance, CA 90502-1311 (Address of principal executive offices, including ZIP code)		(310) 965-8300 (Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under the plan confirmed by a court. Yes þ No o

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

Common Stock, $.01 par value,

11,001,421 shares outstanding as of September 7, 2001

TABLE OF CONTENTS

INDEX
FORWARD-LOOKING STATEMENTS
PART I.FINANCIAL INFORMATION
	Item 1.Financial Statements
		CONSOLIDATED CONDENSED BALANCE SHEETS
		WHEREHOUSE ENTERTAINMENT, INC. CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (Unaudited)
		WHEREHOUSE ENTERTAINMENT, INC. CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (Unaudited)
		NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
	Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.Quantitative and Qualitative Disclosures About Market Risk
PART II.OTHER INFORMATION
Item 1.Legal Proceedings
	Item 5.Other Information
	Item 6.Exhibits and Reports on Form 8-K
SIGNATURES

INDEX

WHEREHOUSE ENTERTAINMENT, INC.

		Page
FORWARD-LOOKING STATEMENTS			2
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Condensed Balance Sheets — July 31, 2001 (Unaudited) and January 31, 2001		3
	Consolidated Condensed Statements of Operations — Three Months Ended July 31, 2001 and 2000 (Unaudited) and Six Months Ended July 31, 2001 and 2000 (Unaudited)		4
	Consolidated Condensed Statements of Cash Flows — Six Months Ended July 31, 2001 and 2000 (Unaudited)		5
	Notes to Consolidated Condensed Financial Statements (Unaudited)		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		8
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		12
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings		12
Item 5.	Other Information		13
Item 6.	Exhibits and Reports on Form 8-K		13
SIGNATURES			14

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q includes certain statements that may be deemed to be “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. The sections of this Quarterly Report on Form 10-Q containing such forward-looking statements include “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Item 2 of Part I below. Statements in this Quarterly Report on Form 10-Q which address activities, events or developments that the registrant expects or anticipates will or may occur in the future, including such things as future issuances of shares, future capital expenditures (including the amount and nature thereof), expansion and other developments and technological trends of industry segments in which the registrant is active, business strategy, expansion and growth of the registrant’s and its competitors’ business and operations and other such matters are forward-looking statements. You can find many of these statements by looking for words like “believes”, “expects”, “anticipates”, or similar expressions in this Quarterly Report on Form 10-Q. Although the registrant believes the expectations expressed in such forward-looking statements are based on reasonable assumptions within the bounds of its knowledge of its business, a number of factors could cause actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of the registrant.

The registrant’s operations are subject to factors outside its control. Any one, or a combination, of these factors could materially affect the results of the registrant’s operations. These factors include (a) changes in levels of competition from current competitors and potential new competition from both non-traditional retailers of the registrant’s products and alternative methods or channels of distribution such as Internet and telephone shopping services and mail order; (b) loss of a significant vendor or prolonged disruption of product supply; (c) the presence or absence of popular new releases and products in the product categories the registrant represents; (d) changes in levels of consumer spending, especially during seasonally significant periods; (e) changes in Federal and state income tax rules and regulations or interpretations of existing legislation; (f) changes in the general economic conditions in the United States including, but not limited to, consumer sentiment about the economy in general; (g) regulatory changes which may adversely affect the business in which the registrant is engaged; (h) the ability to attract and retain key personnel; (i) adverse results in significant litigation matters; and (j) shortages of electricity in California, where the registrant has a large number of retail stores, its corporate office and its distribution center. Such electricity shortages may, in the near term, subject these locations to rolling blackouts which could interrupt the registrant’s business as well as increase utility costs.

The foregoing should not be construed as an exhaustive list of all factors which could cause actual results to differ materially from those expressed in forward-looking statements made by the registrant. You should consider the cautionary statements contained in this section when evaluating any forward-looking statements that we may make. We do not have any obligation to publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect the occurrence of unanticipated events.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

WHEREHOUSE ENTERTAINMENT, INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

			July 31,			January 31,
			2001			2001
			(Unaudited)
ASSETS
Current assets:
	Cash and cash equivalents		$	2,565,000		$	2,457,000
	Receivables, net			1,664,000			1,343,000
	Inventories, net			184,438,000			197,147,000
	Income taxes receivable			9,825,000			9,825,000
	Other current assets			1,511,000			2,401,000
	Deferred taxes			8,726,000			5,983,000
		Total current assets		208,729,000			219,156,000
Property, equipment and improvements, net				56,769,000			67,132,000
Deferred taxes				24,795,000			19,886,000
Intangible assets, net				32,728,000			34,510,000
Other assets, net				750,000			1,007,000
		Total assets	$	323,771,000		$	341,691,000
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
	Accounts payable and bank overdraft		$	110,102,000		$	129,042,000
	Accrued expenses			32,327,000			35,468,000
	Store closure reserves			7,865,000			8,421,000
	Reorganization liabilities			1,203,000			1,242,000
	Current portion of long-term debt			3,820,000			3,836,000
	Current portion of leases in excess of fair market value			3,270,000			3,270,000
	Current portion of capital lease obligations			5,958,000			6,090,000
		Total current liabilities		164,545,000			187,369,000
Line of credit				56,284,000			35,123,000
Long-term debt				208,000			224,000
Capital lease obligations				13,244,000			16,293,000
Leases in excess of fair market value				16,560,000			18,195,000
Deferred rent and other long-term liabilities				5,128,000			5,181,000
		Total liabilities		255,969,000			262,385,000
Shareholders’ equity:
	Preferred stock, $.01 par value; shares authorized, 3,000,000; shares issued, none
	Common stock, $.01 par value; shares authorized, 24,000,000; shares issued, 11,026,421; shares outstanding, 11,001,421.			110,000			110,000
	Additional paid-in-capital			94,491,000			94,453,000
	Retained earnings (deficit)			(19,441,000	)		(8,084,000	)
	Treasury stock, 25,000 shares			(338,000	)		(338,000	)
	Notes receivable			(7,020,000	)		(6,835,000	)
		Total shareholders’ equity		67,802,000			79,306,000
		Total liabilities and shareholders’ equity	$	323,771,000		$	341,691,000

See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

WHEREHOUSE ENTERTAINMENT, INC.

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

		Three Months Ended						Six Months Ended
		July 31,			July 31,			July 31,			July 31,
		2001			2000			2001			2000
Sale merchandise revenue		$	149,709,000		$	165,062,000		$	298,965,000		$	340,299,000
Rental revenue, net			1,079,000			1,526,000			2,380,000			3,056,000
	Total revenues		150,788,000			166,588,000			301,345,000			343,355,000
Cost of sale merchandise revenue			99,419,000			108,266,000			196,692,000			221,548,000
	Gross profit		51,369,000			58,322,000			104,653,000			121,807,000
Selling, general and administrative expenses			52,232,000			54,883,000			104,778,000			113,000,000
Depreciation and amortization			7,743,000			7,471,000			15,611,000			14,871,000
Loss on disposition of assets			189,000			191,000			150,000			665,000
	Loss from operations		(8,795,000	)		(4,223,000	)		(15,886,000	)		(6,729,000	)
Interest expense			1,453,000			2,019,000			3,238,000			4,342,000
Interest income			(101,000	)		(97,000	)		(196,000	)		(218,000	)
Equity in loss from unconsolidated joint venture						2,971,000						6,043,000
	Loss before income taxes		(10,147,000	)		(9,116,000	)		(18,928,000	)		(16,896,000	)
Benefit for income taxes			4,059,000			3,680,000			7,571,000			6,792,000
	Net loss	$	(6,088,000	)	$	(5,436,000	)	$	(11,357,000	)	$	(10,104,000	)
Net loss per common share:
	Basic	$	(0.55	)	$	(0.49	)	$	(1.03	)	$	(0.92	)
	Diluted	$	(0.55	)	$	(0.49	)	$	(1.03	)	$	(0.92	)
Weighted average common shares outstanding — Basic			11,001,421			11,001,421			11,001,421			10,976,004
Weighted average common shares and common equivalent shares outstanding — Diluted			11,001,421			11,001,421			11,001,421			10,976,004

See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

WHEREHOUSE ENTERTAINMENT, INC.

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

				Six Months Ended
				July 31,			July 31,
				2001			2000
Operating activities:
Net loss				$	(11,357,000	)	$	(10,104,000	)
Adjustments to reconcile net loss to net cash used in operating activities:
	Depreciation and amortization				15,611,000			14,871,000
	Loss on disposition of assets				150,000			665,000
	Rental amortization included in cost of rentals				1,832,000			1,849,000
	Book value of rental inventory dispositions, included in cost of rentals				217,000			368,000
	Loss on investment in joint venture							6,043,000
	Stock option compensation				38,000
	Interest on notes receivable				(185,000	)		(186,000	)
	Deferred taxes				(7,652,000	)		(7,515,000	)
	Changes in operating assets and liabilities:
		Receivables, net			(321,000	)		4,766,000
		Inventories, net			12,587,000			35,432,000
		Rental inventory purchases			(1,927,000	)		(1,885,000	)
		Other current assets			890,000			471,000
		Accounts payable, accrued expenses and other current liabilities			(22,081,000	)		(44,327,000	)
		Store closure and leases in excess of FMV reserves			(2,191,000	)		(3,010,000	)
		Other long-term liabilities			(53,000	)		356,000
			Net cash used in operating activities		(14,442,000	)		(2,206,000	)
Investing Activities:
Purchase of property, equipment and improvements					(3,726,000	)		(7,073,000	)
Investment in joint venture								(14,896,000	)
Decrease (increase) in other assets					367,000			(21,000	)
			Net cash used in investing activities		(3,359,000	)		(21,990,000	)
Financing Activities:
Net borrowings under line of credit					21,161,000			22,422,000
Payments on capital lease obligations and long-term debt					(3,213,000	)		(2,992,000	)
Proceeds from sale of common stock								5,000,000
Settlement of pre-petition claims					(39,000	)		(163,000	)
			Net cash provided by financing activities		17,909,000			24,267,000
Net increase in cash and cash equivalents					108,000			71,000
Cash and cash equivalents at beginning of the period					2,457,000			4,531,000
Cash and cash equivalents at end of the period				$	2,565,000		$	4,602,000
Supplemental disclosures of cash flow information:
	Cash paid during the period for:
		Interest		$	2,962,000		$	4,249,000
		Income taxes, net		$	389,000		$	138,000

See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

WHEREHOUSE ENTERTAINMENT, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The accompanying unaudited consolidated condensed financial statements include the accounts of Wherehouse Entertainment, Inc. and its wholly owned subsidiaries (collectively referred to as the “Company”). All material intercompany balances and transactions have been eliminated in consolidation.

The interim unaudited consolidated condensed financial statements of the Company have been prepared in accordance with the instructions to Form 10-Q of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by Generally Accepted Accounting Principles (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The Company’s business is seasonal, so operating results for the six months ended July 31, 2001 are not necessarily indicative of the results that may be expected for the Company’s fiscal year ending January 31, 2002 (“Fiscal 2002”). For further information, refer to the financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the Company’s fiscal year ended January 31, 2001 (“Fiscal 2001”).

2. Disposition of Stores

On August 9, 2001, the Company completed the sale of sixty-four (64) Wherehouse Music stores to The Music Network (“TMN”) for approximately $26 million in cash and notes. The majority of the stores sold to TMN are located in Florida, North Carolina, South Carolina and Tennessee, with a few located in Georgia and Alabama. As part of the transaction, the Company also granted the rights to the Turtle’s Music trade brand to TMN. The subject stores accounted for $63.6 million in total revenues for the year ended January 31, 2001 and $26.8 million in total revenues for the six months ended July 31, 2001. The net book value of the assets sold amounted to approximately $26 million.

3. E-Commerce

In response to the growth in electronic commerce for prerecorded music and video product, the Company launched its own Internet commerce site, “Wherehousemusic.com,” on May 10, 1999. In November of 1999, the Company agreed to enter into an equity investment and strategic partnership agreement (the “Agreement”) with CheckOut.com, LLC (“CheckOut.com”), an Internet content provider and e-commerce retailer of music, movies and games. This Agreement was finalized on February 16, 2000. In exchange for a 49% interest in CheckOut.com, the Company contributed $9.8 million in February of 2000. In addition, commencing March 2000, amounts of up to $1.568 million per month were contributed for a total investment of approximately $20.0 million. Under the terms of the Agreement, CheckOut.com was the Company’s exclusive Internet website partner for music, movies and games. As a result, the Company merged the operation of its own Internet website, Wherehousemusic.com, with that of CheckOut.com. CheckOut.com was integrated into all of the Company’s marketing and advertising associated with the Company’s stores nationwide. As a part of the CheckOut.com transaction, the Company sold 250,000 shares of its common stock to affiliates of its partner in CheckOut.com for $5.0 million in cash. In addition, during the year ended January 31, 2000 the Company loaned CheckOut.com $5.0 million. The loan was repaid by Checkout.com in Fiscal 2001.

For the six-month period ended July 31, 2000, the Company recognized a loss of $6.0 million related to the joint venture. As of July 31, 2000, the Company’s investment in the joint venture amounted to $14.9 million. As a result of significant operating losses experienced by CheckOut.com subsequent to February, 2000, CheckOut.com ceased operation of its Internet site in February, 2001. For Fiscal 2001, a $20.6 million loss on investment in joint venture was recorded by the Company which included $11.1 million representing the Company’s share in the joint venture’s operating losses and $9.5 million representing a loss due to the impairment in value of the remaining investment.

WHEREHOUSE ENTERTAINMENT, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

4. Litigation

In January, 2001, the Company was sued in the Los Angeles Superior Court by a former store manager, claiming alleged failure to pay overtime wages to herself and all similarly situated salaried store employees. The Complaint does not specify any amount of the claims, either individually or on behalf of the class. The Company’s motion to strike the class action allegations was denied. The plaintiff’s motion to file an amended complaint was recently granted in part to allow for the addition of three new named plaintiffs and to expand the plaintiffs’ legal theory. However, the amended complaint has not yet been filed. The Company believes the allegations are without merit and intends to vigorously defend itself in this matter. However, no assurance can be provided as to its outcome. Management does not believe an adverse judgment against the Company would result in a material impact to the consolidated financial statements.

On June 4, 2001, the Company received a copy of an Order entered by a Pennsylvania state court with respect to Reliance Insurance Company (“Reliance”). Reliance was the Company’s general and umbrella liability insurance carrier for the one-year period ended August 1, 1998. The Order stated that Reliance was placed in “Rehabilitation” under Pennsylvania’s Insurance Department Act. The Company is one of several named defendants in a personal injury lawsuit, Peterson v. Shappel Industries, Inc., et al., which relates to an event that occurred during the period the Company was insured by Reliance. On July 18, 2001, a $7.4 million judgment was entered against the Company in this lawsuit. The Company is in the process of appealing this decision. This judgment is within the scope of the insurance policy issued by Reliance. While it is not possible to predict the outcome of Reliance’s Rehabilitation, it is the Company’s understanding that, at the present time, Reliance is continuing to honor its obligations and pay its claims. The Company believes that liability, if any, under this lawsuit will be funded by Reliance.

5. Accounting Policy Change

In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method of accounting and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired in a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but will be tested at least annually for impairment. The Company is required to implement SFAS No. 141 and 142 on February 1, 2002 and, at that time, will stop amortizing goodwill that resulted from business combinations completed prior to the adoption of SFAS No. 141. Goodwill is currently being amortized at approximately $3.5 million annually. The Company is currently evaluating the provisions of SFAS No. 141 and 142 and has not yet determined any additional effects that adoption of these standards will have on its financial statements.

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

Introduction

This discussion should be read in conjunction with the financial statements, related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for Fiscal 2001.

Results of Operations

For the Quarters Ended July 31, 2001 and July 31, 2000

Revenues

Total revenues were $150.8 million and $166.6 million for the quarters ended July 31, 2001 (the second quarter of Fiscal 2002) and July 31, 2000 (the second quarter of Fiscal 2001), respectively. The decrease of $15.8 million was primarily attributable to decreases in net revenues of $6.4 million due to the closure of 34 stores since July 31, 2000, same store sales decreases in net revenues of $9.0 million and the reduction of net rental revenue of $0.4 million.

A summary of total sale merchandise and rental revenue by category is provided below:

Sale Merchandise and Rental Revenues

By Category

(Dollars in millions)

			Quarter Ended
			July 31,
			2001		2000
Sale merchandise revenue:
	Music		$	125.0	$	143.6
	Other, principally sales of new videocassettes, DVDs, video game software and hardware, general merchandise and ticket commissions			24.7		21.5
		Total sale merchandise revenue		149.7		165.1
Rental revenue, net				1.1		1.5
		Total revenue	$	150.8	$	166.6

B. Rental revenue, net. Rental revenue, net includes the proceeds from the rental of videocassettes, DVDs, video games and game players, and from the sale of previously viewed videocassettes and previously played video games, net of cost of rentals. Rental revenue, net was $1.1 million in the second quarter of Fiscal 2002 and $1.5 million in the second quarter of Fiscal 2001, representing a decrease due to the Company’s de-emphasis of the rental portion of its business.

C. Competition and Economic Factors. The Company believes that, in the future, its business and same-store revenues may be impacted by various competitive and economic factors. These factors include, but

are not limited to, consumer tastes, new releases of music, videocassette and video game titles available for sale or rental, the increasing popularity of the Internet as an avenue for retailing and other direct-to-consumer alternatives, and technological developments such as digital downloading, as well as general economic trends impacting retailers and consumers. In addition, in recent years the Company’s sale merchandise and rental revenues have been impacted by increased competition from other music and video specialty chains, consumer electronics superstores, discounters and mass merchandisers. Consolidation continues to occur in the home entertainment industry and the Company continues to study industry developments in developing its own strategies.

Cost of Sale Merchandise Revenue

Cost of sale merchandise revenue was $99.4 million for the second quarter of Fiscal 2002, as compared with $108.3 million for the same period last year, a decrease of $8.9 million. As a percentage of sale merchandise revenue, cost of sale merchandise revenue was 66.4% for the second quarter of Fiscal 2002 as compared with 65.6% for the second quarter of Fiscal 2001. As a percentage of total revenues for the second quarter of Fiscal 2002, sales of higher margin new music product continued to decrease and sales of lower margin DVD product continued to increase, which offset the benefit from an increase of higher margin used music product. In addition, decreases in sales prices related to several mid-line new music promotional events also caused pressure on gross profit margins.

Operating Expenses

Selling, general and administrative (“SG&A”) expenses for the second quarter of Fiscal 2002 were $52.2 million, compared to $54.9 million for the second quarter of Fiscal 2001, a decrease of $2.7 million. The decrease is primarily attributable to a reduction of $2.5 million in operating expenses at the Company’s stores due to store closures. In addition, cost of living increases in payroll, CPI increases in occupancy costs and similar inflationary increases in utility and other costs were more than offset by improvements in operating efficiencies and expense reductions. SG&A expenses were 34.6% of revenue in the second quarter of Fiscal 2002, compared to 32.9% of revenue in the second quarter of Fiscal 2001, an increase of 1.7%.

Depreciation and amortization expense was $7.7 million in the second quarter of Fiscal 2002 compared to $7.5 million in the second quarter of Fiscal 2001, an increase of $0.2 million. The increase is principally related to capital expenditures over the last twelve months for the acquisition of property, equipment and system improvements.

Interest Expense

Interest expense for the second quarter of Fiscal 2002 was $1.5 million, compared to $2.0 million for the second quarter of Fiscal 2001, a decrease of $0.5 million. This decrease was primarily attributable to a reduction in the average interest rates paid by the Company on its borrowings under the Company’s revolving line of credit with Congress Financial Corporation (Western) (the “Congress Facility”) of approximately 230 basis points in the second quarter of Fiscal 2002 as compared to the second quarter of Fiscal 2001. Also contributing to the decline was lower average borrowings under the Congress Facility during the second quarter of Fiscal 2002. Borrowings under the Congress Facility were used mainly for the funding of working capital and, in the second quarter of Fiscal 2001, to fund the investment in CheckOut.com.

Interest Income

Interest income for both the second quarter of Fiscal 2002 and the second quarter of Fiscal 2001 was $0.1 million. Interest income is related to notes receivable from shareholders.

Loss from Investment in Joint Venture

The Company had a 49% interest in the CheckOut.com joint venture and accounted for this investment under the equity method of accounting. For the second quarter of Fiscal 2001, the Company recognized a

$3.0 million loss related to its share of the losses of CheckOut.com. CheckOut.com continued to experience significant operating losses and ceased operations of its Internet site in February 2001.

Income Taxes

The Company recorded a tax benefit of $4.1 million for the second quarter of Fiscal 2002 compared to $3.7 million for the second quarter of Fiscal 2001. The tax benefit is commensurate with the increase in loss before income tax.

For the Six Months Ended July 31, 2001 and July 31, 2000

Revenues

Total revenues were $301.3 million and $343.4 million for the six months ended July 31, 2001 and July 31, 2000, respectively. The decrease of $42.1 million was primarily attributable to decreases in net revenues of $12.4 million due to the closure of 34 stores since July 31, 2000, same store sales decreases in net revenues of $29.0 million and the reduction of net rental revenue of $0.7 million. Total revenues for the sixty four (64) stores sold to TMN on August 9, 2001 were $26.8 million and $31.1 million for the six months ended July 31, 2001 and July 31, 2000, respectively.

A summary of total sale merchandise and rental revenue by category is provided below:

Sale Merchandise and Rental Revenues

By Category

(dollars in millions)

			Six Months Ended
			July 31,
			2001		2000
Sale merchandise revenue:
	Music		$	249.2	$	295.0
	Other, principally sales of new videocassettes, DVDs, video game software and hardware, general merchandise and ticket commissions			49.7		45.3
		Total sale merchandise revenue		298.9		340.3
Rental revenue, net				2.4		3.1
		Total revenue	$	301.3	$	343.4

A. Sale merchandise revenue. On a same-store basis, excluding the 19 stores closed during the six months ended July 31, 2001, sale merchandise revenue decreased by approximately 8.9% during the six months ended July 31, 2001 as compared to the same period last year. The primary reasons for the decrease were a weak new release schedule for music products that continued during most of the six month period ended July 31, 2001, and competition from certain “big-box” retailers selling selected new music releases at or below cost. Partially offsetting these decreases were increased sales of DVD and used music.

B. Rental revenue, net. Rental revenue, net was $2.4 million in the six months ended July 31, 2001 and $3.1 million in the six months ended July 31, 2000, representing a decrease of $0.7 million or 22.6% due to the Company’s de-emphasis of the rental portion of its business.

Cost of Sale Merchandise Revenue

Cost of sale merchandise revenue was $196.7 million for the six months ended July 31, 2001, as compared with $221.5 million for the same period last year, a decrease of $24.8 million. As a percentage of sale merchandise revenue, cost of sale merchandise revenue was 65.8% for the six months ended July 31, 2001 as compared with 65.1% for the six months ended July 31, 2000. As a percentage of total revenues for the six months ended July 31, 2001, sales of higher margin new music product continued to decrease and sales of

lower margin DVD product continued to increase, which offset the benefit from an increase of higher margin used music product In addition, decreases in sales prices related to several mid-line new music promotional events also caused pressure on gross profit margins.

Operating Expenses

SG&A expenses for the six months ended July 31, 2001 were $104.8 million, compared to $113.0 million for the six months ended July 31, 2000, a decrease of $8.2 million. The decrease includes a reduction of $5.4 million in operating expenses at the Company’s stores due to store closures. In addition, cost of living increases in payroll, CPI increases in occupancy costs and similar inflationary increases in utility and other costs were more than offset by improvements in operating efficiencies and expense reductions. SG&A expenses were 34.8% of revenue in the six months ended July 31, 2001, compared to 32.9% of revenue in the six months ended July 31, 2000, an increase of 1.9%.

Depreciation and amortization expense was $15.6 million in the six months ended July 31, 2001 compared to $14.9 million in the six months ended July 31, 2000, an increase of $0.7 million. The increase is principally related to capital expenditures over the last twelve months for the acquisition of property, equipment and system improvements.

Interest Expense

Interest expense for the six months ended July 31, 2001 was $3.2 million, compared to $4.3 million for the six months ended July 31, 2000, a decrease of $1.1 million. This decrease was partially attributable to lower average borrowings under the Congress Facility. Also contributing to the decline was a reduction in the average interest rates paid by the Company on its borrowings under the Congress Facility of approximately 125 basis points in the six months ended July 31, 2001 as compared to the six months ended July 31, 2000.

Interest Income

Interest income for both the six months ended July 31, 2001 and the six months ended July 31, 2000 was $0.2 million. Interest income is related to notes receivable from shareholders.

Loss from Investment in Joint Venture

For the three months ended July 31, 2000, the Company recognized a $6.0 million loss related to its share of the losses of CheckOut.com. CheckOut.com continued to experience significant operating losses and ceased operations of its Internet site in February 2001.

Income Taxes

The Company recorded a tax benefit of $7.6 million for the six months ended July 31, 2001, compared to $6.8 million for the six months ended July 31, 2000. The tax benefit is commensurate with the increase in loss before income tax.

Liquidity and Capital Resources

During the six months ended July 31, 2001 and the six months ended July 31, 2000, the Company’s net cash used in operating activities was $14.4 million and $2.2 million, respectively. The most significant use of cash during this period was related to the reduction of accounts payable, accrued expenses and other current liabilities of $22.1 million which was partially offset by a reduction in inventories, net of $12.6 million. Seasonal inventory purchases typically begin during the third quarter and continue into the fourth quarter, while payment is typically due in the first quarter of the fiscal year. Non-seasonal inventory purchases are made throughout the year and fluctuate with the timing and strength of new releases.

Net cash used in investing activities during the six months ended July 31, 2001 was $3.4 million primarily due to capital expenditures totaling $3.7 million for the acquisition of property, equipment and improvements. Financing of capital expenditures has generally been provided by cash by operations and borrowings under the

Congress Facility. During the six months ended July 31, 2000, net cash used in investing activities included $14.9 million invested in the Company’s joint venture with CheckOut.com.

Net cash provided by financing activities for the six months ended July 31, 2001 was $17.9 million due to net borrowings under the Congress Facility of $21.2 million, offset partially by payments of $3.2 million on capital lease obligations and long-term debt.

As of July 31, 2001, there was an outstanding loan balance of $56.3 million and there were no outstanding letters of credit under the Congress Facility. The Company estimates that its availability under its revolving line of credit at July 31, 2001 was $47.3 million. Subsequent to the sale of the 64 stores to TMN discussed above, the outstanding balance under the Congress Facility was $34.9 million on August 31, 2001 and the availability under the Company’s revolving line of credit was $58.6 million.

The Company believes that cash on hand, cash flow from operations, including planned inventory reductions during Fiscal 2002, and the availability of lease financing, together with borrowings available under the Congress Facility, will be adequate to support existing operations and the planned capital expenditures of the Company for Fiscal 2002.

Seasonality and Inflation

The Company’s business is seasonal, and revenues and operating income are highest during the fourth quarter of the Company’s fiscal year. Working capital and related bank borrowings in prior years were usually lowest during the period beginning with the end of the Christmas holiday season and ending with the close of the Company’s fiscal year. Beginning in February, working capital and related bank borrowings have historically trended upward during the year until the fourth quarter. Borrowings have historically been highest in October and November due to capital expenditures and the building of inventory for the holiday season. The Company believes that, except for changes in the minimum wage mandated by the Federal government, inflation has not had a material effect on its operations and its internal and external sources of liquidity and working capital.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company is subject to risks resulting from interest rate fluctuations since interest on the Company’s borrowings under the Congress Facility are based on variable rates. If the Eurodollar rate were to increase 1% in Fiscal 2002 as compared to the rate at July 31, 2001, the Company’s interest expense for Fiscal 2002 would increase $0.6 million based on the outstanding balance of the Congress Facility at July 31, 2001. The Company does not hold any derivative instruments and does not engage in hedging activities.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

As discussed above, in January 2001, the Company was sued in the Los Angeles Superior Court by a former store manager, claiming alleged failure to pay overtime wages to herself and all salaried similarly situated store employees. The Complaint does not specify any amount of the claims, either individually or on behalf of the class. The Company’s motion to strike the class action allegations was denied. The plaintiff’s motion to file an amended complaint was recently granted in part to allow for the addition of three new named plaintiffs and to expand the plaintiffs’ legal theory. However, the amended complaint has not yet been filed. The Company believes the allegations are without merit and intends to vigorously defend itself in this matter. However, no assurance can be provided as to its outcome. Management does not believe an adverse judgment against the Company would result in a material impact to the consolidated financial statements.

named defendants in a personal injury lawsuit, Peterson v. Shappel Industries, Inc., et al., which relates to an event that occurred during the period the Company was insured by Reliance. On July 18, 2001, a $7.4 million judgment was entered against the Company in this lawsuit. The Company is in the process of appealing this decision. This judgment is within the scope of the insurance policy issued by Reliance. While it is not possible to predict the outcome of Reliance’s Rehabilitation, it is the Company’s understanding that, at the present time, Reliance is continuing to honor its obligations and pay its claims. The Company believes that liability, if any, under this lawsuit will be funded by Reliance.

In addition, the Company is a party to various other claims, legal actions and complaints arising in the ordinary course of its 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 5. Other Information

None.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

Exhibit Number Description None.

(b) Reports on Form 8-K

None.

SIGNATURES

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

WHEREHOUSE ENTERTAINMENT, INC. /s/ ANTONIO C. ALVAREZ, II Antonio C. Alvarez, II Chairman of the Board and Chief Executive Officer, and Director (Principal Executive Officer)

Date: September 14, 2001

/s/ MARK A. VELARDE Mark A. Velarde Executive Vice President, Chief Financial Officer and Chief Administrative Officer (Principal Financial Officer)

Date: September 14, 2001

/s/ MEHDI MAHDAVI Mehdi Mahdavi Vice President, Controller (Principal Accounting Officer)

Date: September 14, 2001

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