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 2, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______ to _______
Commission File Number 0-24548
Movie Gallery, Inc.
(Exact name of registrant as specified in charter)
DELAWARE 63-1120122
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
900 West Main Street, Dothan, Alabama 36301
(Address of principal executive offices) (zip code)
(334) 677-2108
(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 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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]
The number of shares outstanding of the registrant's common stock as of
November 2, 2005 was 31,885,416.
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Movie Gallery, Inc.
Consolidated Balance Sheets
(In thousands, except per share amounts)
-------------------------
January 2, October 2,
2005 2005
----------- -----------
(Unaudited)
Assets
Current assets:
Cash and cash equivalents $ 25,518 $ 68,755
Extended viewing fees receivable, net - 1,110
Merchandise inventory, net 27,419 143,209
Prepaid expenses 12,712 42,457
Store supplies and other 9,493 29,757
Deferred income taxes 3,358 15,813
----------- -----------
Total current assets 78,500 301,101
Rental inventory, net 126,541 342,227
Property, furnishings and equipment, net 128,182 355,436
Goodwill, net 143,761 625,885
Other intangibles, net 7,741 190,706
Deferred income taxes, net - 13,203
Deposits and other assets 7,417 41,530
----------- -----------
Total assets $ 492,142 $ 1,870,088
=========== ===========
Liabilities and stockholders' equity
Current liabilities:
Current maturities of long-term obligations $ - $ 27,286
Current maturities of financing obligations - 7,973
Accounts payable 68,977 159,814
Accrued liabilities 30,570 137,578
Accrued interest - 29,233
Deferred revenue 10,843 31,687
----------- ----------
Total current liabilities 110,390 393,571
Long-term obligations, less current portion - 1,142,882
Deferred income taxes 50,618 -
Stockholders' equity:
Preferred stock, $.10 par value; 2,000
shares authorized, no shares issued
or outstanding - -
Common stock, $.001 par value; 65,000
shares authorized, 31,076 and 31,662
shares issued and outstanding, respectively 31 32
Additional paid-in capital 188,098 202,542
Unearned compensation - (4,830)
Retained earnings 136,750 128,592
Accumulated other comprehensive income 6,255 7,299
----------- -----------
Total stockholders' equity 331,134 333,635
----------- -----------
Total liabilities and stockholders' equity $ 492,142 $ 1,870,088
=========== ===========
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Consolidated Statements of Operations
(Unaudited, in thousands, except per share amounts)
Thirteen Weeks Ended Thirty-Nine Weeks Ended
--------------------- -----------------------
October 3, October 2, October 3, October 2,
2004 2005 2004 2005
--------- --------- --------- ---------
Revenue:
Rentals $ 176,058 $ 473,086 $ 538,054 $1,109,661
Product sales 13,797 99,356 44,694 201,301
--------- --------- --------- ---------
Total revenue 189,855 572,442 582,748 1,310,962
Cost of sales:
Cost of rental revenue 51,110 136,236 152,763 345,159
Cost of product sales 8,673 70,080 29,745 141,896
--------- --------- --------- ---------
Gross profit 130,072 366,126 400,240 823,907
Operating costs and expenses:
Store operating expenses 97,962 319,919 287,788 690,592
General and administrative 14,397 39,485 41,879 91,916
Amortization of intangibles 673 1,163 1,962 2,718
Stock compensation 755 535 795 1,098
-------- -------- -------- --------
Operating income 16,285 5,024 67,816 37,583
Interest expense, net (225) (24,427) (390) (41,430)
Write-off of bridge
financing costs - - - (4,234)
Equity in losses of
unconsolidated entities (955) - (4,891) (806)
-------- -------- -------- --------
Income (loss) before income
taxes 15,105 (19,403) 62,535 (8,887)
Income taxes (benefit) 5,891 (6,934) 24,435 (2,622)
-------- -------- -------- --------
Net income (loss) $ 9,214 $(12,469) $ 38,100 $ (6,265)
======== ======== ======== ========
Net income (loss) per share:
Basic $ 0.29 $ (0.39) $ 1.17 $ (0.20)
Diluted $ 0.29 $ (0.39) $ 1.16 $ (0.20)
Weighted average shares outstanding:
Basic 31,444 31,640 32,436 31,471
Diluted 31,807 31,640 32,933 31,471
Cash dividends per common share $ 0.03 $ - $ 0.09 $ 0.06
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Consolidated Statements of Cash Flows
(Unaudited, in thousands)
Thirty-Nine Weeks Ended
-----------------------
October 3, October 2,
2004 2005
--------- ----------
Operating activities:
Net income (loss) $ 38,100 $ (6,265)
Adjustments to reconcile net income (loss)
to net cash provided by operating activities:
Rental inventory amortization 107,690 206,134
Purchases of rental inventory (109,315) (174,251)
Depreciation and intangibles amortization 22,151 61,569
Amortization of debt issuance cost - 2,235
Stock based compensation 28 1,098
Tax benefit of stock options exercised 4,689 3,301
Deferred income taxes 12,496 (11,557)
Changes in operating assets and liabilities, net of
business acquisitions:
Extended viewing fees receivable, net - 20,259
Merchandise inventory 1,281 8,516
Other current assets 985 (3,948)
Deposits and other assets 897 (2,053)
Accounts payable (15,785) (82,258)
Accrued interest - 29,193
Accrued liabilities and deferred revenue (2,521) 13,336
--------- ---------
Net cash provided by operating activities 60,696 65,309
Investing activities:
Business acquisitions, net of cash acquired (9,599) (1,096,265)
Purchases of rental inventory-base stock (11,085) (16,569)
Purchase of property, furnishings and equipment (34,699) (48,873)
Proceeds from disposal of property,
furnishings and equipment - 2,107
Acquisition of construction phase assets, net - 2,154
--------- ---------
Net cash used in investing activities (55,383) (1,157,446)
Financing activities:
Repayment of capital lease obligations - (265)
Decrease in financing obligations - (2,412)
Net borrowings on credit facilities - 9,046
Long term debt financing fees - (32,452)
Proceeds from issuance of long-term debt 20,000 1,166,120
Principal payments on long-term debt - (8,367)
Proceeds from exercise of stock options 5,516 5,318
Proceeds from employee stock purchase plan 168 169
Purchases and retirement of common stock (47,390) -
Payment of dividends (2,958) (2,827)
--------- ---------
Net cash (used in) provided by
financing activities (24,664) 1,134,330
Effect of exchange rate changes on cash
and cash equivalents 579 1,044
--------- ---------
(Decrease) increase in cash and
cash equivalents (18,772) 43,237
Cash and cash equivalents at
beginning of period 38,006 25,518
--------- ---------
Cash and cash equivalents
at end of period $ 19,234 $ 68,755
========= =========
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (Unaudited)
October 2, 2005
1. Accounting Policies
Principles of Consolidation
The accompanying unaudited financial statements present the consolidated
financial position, results of operations and cash flows of Movie Gallery, Inc.
("Movie Gallery" or the "Company"), and subsidiaries. Investments in
unconsolidated subsidiaries where the Company has significant influence but
does not have control are accounted for using the equity method of accounting
for investments in common stock. All material intercompany accounts and
transactions have been eliminated.
Basis of Presentation
Movie Gallery completed the acquisition of Hollywood Entertainment Corporation
("Hollywood") on April 27, 2005. Movie Gallery is the nation's second largest
specialty home video retailer with approximately 4,800 retail stores located
throughout North America, operating under the Movie Gallery and Hollywood Video
trade names. In addition, the Company operates 650 Game Crazy departments
located within Hollywood Video stores and 20 free-standing Game Crazy stores
where game enthusiasts can buy, sell and trade new and used video game
hardware, software and accessories. The Company's common stock is traded on
The NASDAQ Stock Market under the symbol "MOVI".
The merger of Movie Gallery and Hollywood has been treated as a purchase
business combination for accounting purposes, with Movie Gallery designated as
the acquirer. The accompanying condensed consolidated statements of operations
and cash flows for the thirteen week and thirty-nine week periods ended October
2, 2005 include the results of operations of Hollywood since April 27, 2005,
the date of acquisition. Therefore, the results for the thirty-nine week period
ended October 2, 2005 include approximately 23 weeks of Hollywood's results and
39 weeks of Movie Gallery's results. Note 2 to the consolidated financial
statements provides summary unaudited pro forma information and details on the
purchase accounting.
These interim unaudited condensed consolidated financial statements have been
prepared in accordance with the rules and regulations of the Securities and
Exchange Commission ("SEC"). Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States of America for complete financial statements. In the
opinion of management, all adjustments (which include normal recurring
adjustments) considered necessary for a fair presentation have been included.
Operating results for the interim period are not necessarily indicative of the
results that may be expected for the full year. There is a distinct seasonal
pattern to the home video business. Compared to other months during the year,
we experience peak revenues during the months of November, December and January
due to the holidays in these months as well as inclement weather conditions.
Additionally, revenues generally rise in the months of June, July and August
when most schools are out of session, providing people with additional
discretionary time to spend on entertainment.
Readers of these interim period statements should refer to the audited
consolidated financial statements and notes thereto which are included in Movie
Gallery's Annual Report on Form 10-K for its fiscal year ended January 2, 2005.
For information relating to Hollywood prior to the merger, readers should refer
to the audited consolidated financial statements and notes thereto which are
included in Hollywood's Annual Report on Form 10-K for its fiscal year ended
December 31, 2004. Readers should also refer to Movie Gallery's 8-K/A filed on
July 11, 2005 that includes the annual and interim financial statements of
Hollywood and pro forma financial information.
Reclassifications
Certain reclassifications have been made to the prior year financial statements
to conform to the current year presentation. These reclassifications had no
impact on stockholders' equity or net income.
Rental Inventory Amortization Estimates
The Company manages its rental inventories of movies as two distinct
categories, new releases and catalog. New releases, which represent the
majority of all movies acquired, are those movies which are primarily purchased
on a weekly basis in large quantities to support demand upon their initial
release by the studios and are generally held for relatively short periods of
time. Catalog, or library, represents an investment in those movies the Company
intends to hold for an extended period of time and represents a historic
collection of movies which are maintained on a long-term basis for rental to
customers. In addition, the Company acquires catalog inventories to support new
store openings and to build-up its title selection, primarily as it relates to
changes in format preferences such as an increase in DVD from VHS.
Purchases of new release movies are amortized over six months on an accelerated
basis to current estimated average residual values of $1.00 for VHS and $4.00
for DVD. Purchases of DVD catalog are currently amortized on an accelerated
basis over twenty-four months to an estimated residual value of $4.00. VHS
catalog is amortized on an accelerated basis to an estimated $1.00 residual
value over twenty-four months for new store purchases and six months for all
other catalog purchases. Video games are currently amortized over twelve months
to an estimated residual value of $5.00.
For new release movies and games acquired under revenue sharing arrangements,
the studios' share of rental revenue is charged to cost of rental as revenue is
earned on the respective revenue sharing titles. Amortization periods,
carrying values and residual values are approximately equal to non-revenue
sharing purchases as outlined above.
Cooperative Advertising Credits
The Company receives cooperative credits from its inventory suppliers,
primarily studios, to promote their respective titles. The credits that
represent a reimbursement of specific, incremental, identifiable costs are
included in operating and selling expense on the consolidated statements of
operations, offsetting the related costs, in the period the promotion takes
place. Credits that exceed such costs are classified as a reduction of the cost
of product purchased, thereby reducing cost of revenue on the consolidated
statements of operations.
Change in Accounting Estimate for Rental Inventory
The Company regularly evaluates and updates rental amortization accounting
estimates. Effective April 4, 2005, the Company changed its estimated residual
value on VHS movies from $2.00 to $1.00 due to continued declines in the
average selling prices of older VHS product. The change was accounted for as a
change in accounting estimate, which decreased rental inventory and increased
amortization expense by approximately $10.1 million for the current year second
quarter. This reduced net income by $5.9 million (net of tax), or $0.19 per
diluted share for the thirty-nine weeks ended October 2, 2005. This change in
estimate reduces future cost of rental when the previously viewed VHS units are
sold.
Revenue Recognition
Movie Gallery recognizes extended viewing fee revenue when payment is received
from the customer. Hollywood historically recorded these fees on an accrual
basis and maintained an accounts receivable balance (net of estimated bad debt
reserve) for the extended viewing fee revenue expected to be collected. At the
time of the merger the receivable balance was $21.4 million. In order to
conform Hollywood's accounting process to Movie Gallery's accounting process,
in periods subsequent to the merger, the portion of the extended viewing fees
collected from Hollywood customers that relate to the acquired receivable will
reduce the receivable balance and extended viewing fee revenue will no longer
be accrued in advance of payment. As a result, revenue recorded by Hollywood
for extended viewing fees will be less than cash collected until the receivable
balance is depleted. In the thirteen and thirty-nine week periods ended October
2, 2005, this transition in accounting process reduced rental revenue by $7.5
million and $20.3 million, respectively, and reduced operating income by $6.6
million and $18.0 million, respectively, after adjusting accrued revenue
sharing on accrued extended viewing fees. This reduced net income by $4.7
million and $12.7 million, or $0.15 and $0.40 per diluted share, for the
thirteen and thirty-nine weeks ended October 2, 2005, respectively. The balance
sheet as of October 2, 2005, includes $1.1 million of accounts receivable for
acquired extended viewing fees in connection with Hollywood's former accrual
accounting process.
Stock Based Compensation
The Company accounts for stock-based employee compensation under the
recognition and measurement principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees, and related interpretations. Stock compensation is
reflected in net income for non-vested restricted stock granted and variable
options outstanding that were repriced in March 2001. No stock compensation is
reflected in net income for fixed options granted to employees, as the exercise
price was equal to the market value of the underlying common stock on the date
of grant.
The following table illustrates the effect on net income/(loss) and
earnings/(loss) per share if we had applied the fair value recognition
provision of FASB Statement No. 123, Accounting for Stock-Based Compensation,
as amended, to stock-based employee compensation.
Thirteen Weeks Ended Thirty-Nine Weeks Ended
-------------------- -----------------------
October 3, October 2, October 3, October 2,
2004 2005 2004 2005
--------- --------- --------- ---------
(in thousands, except per share data)
Net income (loss), as reported $ 9,214 $ (12,469) $ 38,100 $ (6,265)
Add: Stock based compensation
included in reported net income,
net of tax 461 442 $ 485 774
Deduct: Stock based compensation
determined under fair value based
methods for all awards, net of tax (426) (1,087) $ (1,013) (1,887)
--------- --------- --------- ---------
Pro forma net income/(loss) $ 9,249 (13,114) $ 37,572 $ (7,378)
========= ========= ========= =========
Net income/(loss) per share, as reported:
Basic $ 0.29 $ (0.39) $ 1.17 $ (0.20)
Diluted $ 0.29 $ (0.39) $ 1.16 $ (0.20)
Pro forma net income/(loss) per share:
Basic $ 0.29 $ (0.41) $ 1.16 $ (0.23)
Diluted $ 0.29 $ (0.41) $ 1.14 $ (0.23)
Recently Issued Accounting Pronouncements
In December 2004, the FASB issued a revised Statement No. 123, Share Based
Payment ("Statement 123R"), to address the accounting for stock-based employee
plans. The statement eliminates the ability to account for share-based
compensation transactions using APB 25 and instead requires that such
transactions be accounted for using a fair value based method of accounting.
The future impact of adoption of Statement 123R cannot be predicted at this
time because it will depend on levels of share-based payments granted in the
future. However, had we adopted Statement 123R in prior periods, the impact of
that standard would have approximated the impact of Statement 123 as shown in
the table above. Statement 123R also requires the benefits of tax deductions
in excess of recognized compensation cost to be reported as a financing cash
flow, rather than as an operating cash flow as required under current
literature. This requirement will reduce the amount of net operating cash
flows recognized in periods after adoption. While we cannot estimate what
those amounts will be in the future (because they depend on, among other
things, when employees exercise stock options, and the market price of our
common stock on the dates of future stock option exercises), the amount of
operating cash flows recognized for such excess tax deductions were $4.7
million and $3.3 million for the thirty-nine weeks ended October 3, 2004 and
October 2, 2005, respectively. We will adopt the requirements of
Statement 123R beginning January 2, 2006.
2. Business Combinations
Merger of Movie Gallery and Hollywood
On April 27, 2005, Movie Gallery and Hollywood completed their previously
announced merger pursuant to the Agreement and Plan of Merger, dated as of
January 9, 2005 (the "Merger Agreement"). Upon the consummation of the merger,
Hollywood became a wholly-owned subsidiary of Movie Gallery. As of the date of
the merger, Hollywood operated 2,031 specialty home video retail stores and 20
free-standing video game stores throughout the United States. The merger was
made as a strategic expansion of our geographic and urban markets in accordance
with our growth plans.
Under the terms of the Merger Agreement, Hollywood shareholders received $13.25
in cash for each Hollywood share owned. Approximately $862.1 million in cash
was paid in consideration for (i) all outstanding common stock of Hollywood and
(ii) all outstanding vested stock options of Hollywood. Existing Hollywood
indebtedness was repaid for a total of $381.5 million. $161.4 million was paid
by Hollywood with the remainder funded by Movie Gallery with proceeds from a
new credit facility and the issuance of $325.0 million principal amount of 11%
senior notes due 2012. The total consideration paid was approximately $1.1
billion, including transaction costs of $10.0 million.
The merger has been treated as a purchase business combination for accounting
purposes, and as such, Hollywood's assets acquired and liabilities assumed have
been recorded at their fair value. The purchase price for the acquisition,
including transaction costs, has been allocated to the assets acquired and
liabilities assumed based on estimated fair values at the date of acquisition,
April 27, 2005. The purchase price allocation is preliminary and further
adjustments are expected.
The purchase price allocation changed during the third quarter of 2005. The
revised preliminary purchase price allocation is as follows (in thousands):
April 27, 2005 Adjustment Amount
-------------- ---------- ----------
Current Assets:
Cash and cash equivalents $ 18,733 $ - $ 18,733
Extended viewing fees receivable, net 21,369 - 21,369
Merchandise inventory 122,468 - 122,468
Prepaid expenses 27,632 - 27,632
Store supplies and other 18,146 337 18,483
---------- --------- ----------
Total current assets 208,348 337 208,685
Rental inventory 227,800 - 227,800
Property, furnishings and equipment 238,279 (110) 238,169
Goodwill 474,990 (11,247) 463,743
Other intangibles 183,894 - 183,894
Deferred income taxes, net 64,944 - 64,944
Deposits and other assets 1,662 - 1,662
---------- --------- ----------
Total assets acquired $1,399,917 $ (11,020) $1,388,897
Liabilities
Current Liabilities:
Current maturities of long-term obligations $ 557 - $ 557
Current maturities of financing obligations 10,385 - 10,385
Accounts payable 182,963 (13,369) 169,594
Accrued liabilities 85,198 8,833 94,031
Accrued interest 39 - 39
Deferred revenue 27,552 (6,484) 21,068
---------- --------- ----------
Total current liabilities 306,694 (11,020) 295,674
Long-term obligations, less current portion 941 - 941
Total liabilities 307,635 (11,020) 296,615
---------- --------- ----------
Net Assets Acquired $1,092,282 $ - $1,092,282
========== ========= ==========
The Company has allocated approximately $183.9 million to identifiable
intangible assets, of which approximately $170.9 relates to the indefinite
lived trade name of Hollywood Video. The remaining intangible assets include
finite lived trade names and customer lists, which will be amortized over their
estimated useful lives which are 15 years and 5 years, respectively.
The unaudited pro forma financial information in the table below summarizes the
combined results of operations of Movie Gallery and Hollywood Entertainment for
the thirteen-week and thirty-nine week periods ended October 2, 2005 and
October 3, 2004 as though the companies had been combined as of the beginning
of those respective periods. The pro forma financial information is presented
for informational purposes only and is not indicative of the results of
operations that would have been achieved if the merger had taken place as of
the beginning of 2004, nor is it indicative of future results. In addition, the
following pro forma information has not been adjusted to reflect any operating
efficiencies that may be realized as a result of the merger, except for the
elimination of certain redundant executive compensation costs as a result of
departures of corporate personnel, substantially all of which occurred shortly
before or after the merger.
(unaudited, in thousands, except share data)
------------------------------------------------
Thirteen Weeks Ended Thirty-Nine Weeks Ended
---------------------- ------------------------
October 3, October 2, October 3, October 2,
2004 2005 2004 2005
---------- ---------- ---------- -----------
Total revenue $ 602,178 $ 579,934 $1,860,583 $1,926,705
Operating income 45,986(1) 12,517 174,630(2) 100,087(3)
Net income(loss) 14,548(1) (7,654) 64,634(2) 14,396(3)
Net income(loss) per share:
Basic 0.46 (0.24) 1.99 0.46
Diluted 0.46 (0.24) 1.96 0.45
(1) Includes $1.7 million (before taxes) of transaction costs and professional
services incurred by Hollywood related to merger activities.
(2) Includes $5.3 million (before taxes) of transaction costs and professional
services incurred by Hollywood related to merger activities.
(3) Includes $21.1 million (before taxes) of transaction costs and professional
services incurred by Hollywood related to merger activities which were recorded
prior to the merger and therefore are not included in the reported Movie
Gallery results. Includes $10.1 million in charges (before taxes) related to
the VHS residual value adjustment by Movie Gallery, $1.5 million (before taxes)
in transaction bonuses paid by Movie Gallery as a result of the completion of
the merger and net income also includes a $4.2 million (before taxes) write off
of bridge financing costs related to the acquisition financing by Movie
Gallery.
The Company has established reserves relating to employee separation costs
pursuant to the integration of certain functions. Costs associated with these
integration actions do not impact current earnings and are recognized as a
component of purchase accounting, resulting in an adjustment to goodwill.
During the second quarter of 2005, the Company notified 78 Hollywood employees
of the decision to eliminate their positions in connection with these
integration efforts. A $6.2 million reserve was recorded for costs associated
with severance and benefits for the impacted individuals. Payments to these
individuals will be made over the severance period in accordance with the
Company's severance agreements. Payments year-to-date of $1.6 million have
been made, leaving a $4.6 million reserve as of October 2, 2005. This reserve
may be adjusted in the future when more information becomes available.
The Company closed 50 Game Crazy departments since the acquisition date for a
total cash cost of $0.3 million. The costs associated with these department
closures do not impact current earnings and are recognized as a component of
the purchase accounting, resulting in an adjustment to goodwill.
Other Acquisitions
During the second quarter, the Company acquired VHQ Entertainment, Inc.
("VHQ"). VHQ currently operates 57 stores in Canada. VHQ's results of
operations have been included in our results since May 17, 2005. In addition
to the VHQ acquisition, during the thirty-nine weeks ended October 2, 2005,
Movie Gallery purchased 26 stores in 11 separate transactions for a total cash
consideration, including VHQ, of $22.7 million. The aggregate preliminary
purchase price allocation of these individually immaterial acquisitions is as
follows:
(in thousands)
-------------
Rental inventory $ 3,200
Other tangible assets 4,880
Goodwill (including $4,179 of tax deductible goodwill) 18,381
Other intangible assets 1,960
Liabilities assumed (5,705)
----------
Total purchase price $ 22,716
==========
The pro-forma effects on consolidated revenues and net income of these
acquisitions are not presented herein because they are not material.
By letter dated August 29, 2005, Boards Video Company LLC ("Boards"), an entity
controlled by Mark Wattles, the founder and former Chief Executive Officer of
Hollywood,, exercised a contractual right to require Hollywood to purchase all
of the 20 Hollywood Video stores and 17 Game Crazy stores owned and operated by
Boards pursuant to a "put" option contained in the license agreement for these
stores. In accordance with the terms of the license agreement, Hollywood and
Boards have agreed to the retention of a valuation expert and are proceeding
with the valuation of the stores. It is anticipated that the transaction will
close by the end of first quarter 2006.
3. Property, Furnishings and Equipment
Property, furnishings and equipment as of January 2, 2005 and October 2, 2005
consists of the following(in thousands):
----------- ----------
January 2, October 2,
2005 2005
----------- ----------
Land and buildings $ 13,578 $ 17,943
Fixtures and equipment 185,490 275,253
Leasehold improvements 69,904 247,334
Construction phase assets - 8,008
Equipment under capital lease - 1,786
----------- ----------
268,972 550,324
Less accumulated depreciation
and amortization (140,790) (194,888)
----------- ----------
$ 128,182 $ 355,436
=========== ==========
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $0.0 and $0.2
million at January 2, 2005 and October 2, 2005, respectively. Depreciation
expense related to property, furnishings and equipment was $30.3 million and
$57.5 million for the thirteen and thirty-nine weeks ended October 2, 2005,
respectively, compared to $6.9 million and $19.8 million for the corresponding
periods in 2004.
For the Hollywood operating segment, a change in estimate was recorded in the
thirteen weeks ended October 2, 2005, to conform the lives of Hollywood's long
lived assets to Movie Gallery's policy and to record the increase in
depreciation expense generated by recording Hollywood's long lived assets at
their increased fair value in the business combination accounting. A charge of
$7.1 million in depreciation expense was recorded in the thirteen weeks ended
October 2, 2005, of which $2.7 million related to the ten weeks ended July 3,
2005. This reduced net income by $1.9 million, or $0.06 per diluted share for
both the thirteen and thirty-nine weeks ended October 2, 2005. These changes
will continue to increase depreciation expense in future periods.
4. Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes," which requires that deferred assets and
liabilities be recognized using enacted tax rates for the effect of temporary
differences between the financial reporting and tax bases of recorded assets
and liabilities. SFAS No. 109 also requires that deferred tax assets be
reduced by a valuation allowance if it is more likely than not that some
portion of or all of the deferred tax asset will not be realized.
In the ordinary course of business, there may be many transactions and
calculations where the ultimate tax outcome is uncertain. The calculation of
tax liabilities involves dealing with uncertainties in the application of
complex tax laws. No assurance can be given that the final outcome of these
matters will not be different than what is reflected in the current and
historical income tax provisions and accruals.
The effective tax rate was a benefit of 35.7% and 29.5% for the thirteen and
thirty-nine weeks ended October 2, 2005, respectively, as compared to a
provision of 39.0% for both of the corresponding prior year periods. The
decrease in the effective rate is a result of several factors including a
decrease in book income and limitations on the recognition of the tax benefit
of a loss. It is anticipated that the effective rate should be more reflective
of historical effective tax rates in the future tax periods.
5. Goodwill and Other Intangible Assets
The components of goodwill and other intangible assets are as follows (in
thousands):
January 2, 2005 October 2, 2005
Weighted- ------------------------ ---------------------
Average Gross Gross
Amortization Carrying Accumulated Carrying Accumulated
Period Amount Amortization Amount Amortization
------------ -------- ------------ -------- ------------
Goodwill --- $175,172 $ (31,411) $657,296 $ (31,411)
======== ============ ======== ============
Other intangible assets:
Non-compete
agreements 8 years $ 7,426 $ (4,937) $ 6,146 $ (3,842)
Trademarks:
Hollywood Video --- - - 170,942 -
Game Crazy 15 years - - 4,000 (111)
Customer lists 5 years 7,628 (2,376) 17,771 (4,200)
-------- ------------ -------- ------------
$ 15,054 $ (7,313) $198,859 $ (8,153)
======== ============ ======== ============
Estimated amortization expense for other intangible assets for the remainder of
2005 and the five succeeding fiscal years is as follows (in thousands):
2005 (remainder) $ 1,147
2006 4,364
2007 4,221
2008 3,679
2009 2,806
2010 1,025
The changes in the carrying amounts of goodwill for the fiscal year ended
January 2, 2005 and the thirty-nine weeks ended October 2, 2005, are as follows
(in thousands):
Net balance as of January 4, 2004 $ 136,008
Goodwill acquired 7,753
-----------
Net balance as of January 2, 2005 143,761
Goodwill acquired (including revised
estimates) 482,124
-----------
Net balance as of October 2, 2005 $ 625,885
===========
6. Long-Term Debt
On April 27, 2005, the Company completed its cash acquisition of Hollywood,
refinanced substantially all of the existing indebtedness of Hollywood, and
replaced its existing unsecured revolving credit facility. To effect this
transaction, the Company obtained a new senior secured credit facility ("Credit
Facility") from a lending syndicate led by Wachovia and Merrill Lynch and
issued $325.0 million of 11% senior unsecured notes ("Senior Notes"), due 2012.
On September 21, 2005, the Company executed an amendment to the Credit Facility
that relaxed certain financial covenants for a one-year period, provided for an
additional $50.0 million of borrowings under the Term Loan B tranche, and
increased the letter of credit sub-limit under the revolving credit facility
from $30.0 million to $40.0 million.
The Credit Facility is in an aggregate amount of $913.4 million, consisting of
a five-year, $75.0 million revolving credit facility ("Revolver") currently
bearing floating rate interest of London Interbank Offered Rate ("LIBOR") plus
3.50%, and two term loan facilities in an aggregate principal amount of $838.4
million. Term Loan A is a $90.3 million, five-year facility currently bearing
floating rate interest of LIBOR plus 3.50%. Term Loan B is a $748.1 million,
six-year facility currently bearing floating interest of LIBOR plus 3.75%.
Term Loan A and Term Loan B require aggregate quarterly prepayments in the
amounts of 5% and 0.25%, respectively, of the outstanding balances beginning
September 30, 2005 through the first fiscal quarter of 2010, after which the
mandatory Term Loan B prepayments escalate. The Credit Facility is fully and
unconditionally guaranteed on a joint and several basis by Movie Gallery's
domestic subsidiaries. The Credit Facility is secured by first priority
security interests in, and liens on, substantially all of Movie Gallery's and
its direct and indirect subsidiaries' tangible and intangible assets (other
than leasehold mortgages on stores) and first priority pledges of all the
equity interests owned by Movie Gallery in its existing and future direct and
indirect wholly-owned domestic subsidiaries and 66 2 / 3 % of the equity
interests owned by Movie Gallery in its existing and future wholly-owned non-
domestic subsidiaries.
As required by the Credit Facility, the Company has entered into a two-year
floating-to-fixed interest rate swap with Wachovia and Merrill Lynch for an
amount of $280.0 million. Under the terms of the swap agreement, the Company
pays fixed interest on the $280.0 million at a rate of 4.06% and receives
floating interest based on three-month LIBOR. The termination date for the
swap is June 29, 2007.
As of October 2, 2005, the Company had $9.0 million and $19.1 million in
borrowings and letters of credit, respectively, drawn against the Revolver.
The 11% Senior Unsecured Notes Due 2012 were sold at 98.806% of their face
amount and were issued pursuant to an indenture dated April 27, 2005 between
Movie Gallery, the subsidiary guarantors named in the indenture, and SunTrust
Bank. The Senior Notes (i) have interest payment dates of May 1 and November 1
of each year; (ii) are redeemable in cash at the Company's option after the
dates and at the prices (expressed in percentages of principal amount on the
redemption date) as set forth below:
Year Percentage
------------------------ ----------
May 1, 2008 105.500%
May 1, 2009 103.667%
May 1, 2010 101.833%
May 1, 2011 & thereafter 100.000%
And (iii) are senior unsecured obligations and are senior in right of payment
to any of our future subordinated obligations.
Long term debt consists of the following (in thousands):
Instrument January 2, 2005 October 2, 2005
- ---------- --------------- ---------------
11% Senior Unsecured Notes
Due 2012 (net of discount $3,650) $ - $ 321,350
Term A loan - 90,250
Term B loan - 748,125
Revolving credit facility - 9,046
Hollywood 9.625% senior notes - 450
VHQ debt - 95
Capital leases - 852
--------------- ------------
Subtotal $ - $ 1,170,168
Less: Current Portion - (27,286)
--------------- ------------
$ - $ 1,142,882
=============== ============
The current portion of long term debt included on the balance sheet as of
October 2, 2005 is based on maturities of debt for the following twelve fiscal
periods.
Calender year maturities for the next five years and thereafter are as follows
(in thousands):
Year Total
----------- ---------
2005 $ 6,804
2006 27,149
2007 26,619
2008 26,500
2009 35,546
Thereafter 1,051,200
----------
Total $1,173,818
Discount on
senior notes (3,650)
----------
Net $1,170,168
==========
The Credit Facility and Indenture governing the Company's 11% notes impose
certain restrictions, including restrictions on the Company's ability to: incur
debt; grant liens; provide guarantees in respect of obligations of any other
person; pay dividends; make loans and investments; sell the Company's assets;
make redemptions and repurchases of capital stock; make capital expenditures;
prepay, redeem or repurchase debt; engage in mergers or consolidations; engage
in sale/leaseback transactions and affiliate transactions; change the business;
amend certain debt and other material agreements; issue and sell capital stock
of subsidiaries; and make distributions from subsidiaries.
The Credit Facility also requires the Company to meet certain financial
covenants including a leverage ratio test, a fixed charge coverage ratio test
and an interest coverage test. Each of these covenants is calculated on
trailing four quarter results based on specific definitions that are contained
in the credit agreement. In general terms, the leverage ratio is a measurement
of total net indebtedness relative to operating cash flow. The fixed charge
coverage ratio is a measurement of operating cash flow plus rent relative to
total fixed charges including rent, scheduled principal payments, and cash
interest. The interest coverage ratio is a measurement of operating cash flow
relative to interest expense.
7. Earnings (Loss) Per Share
Basic earnings (loss) per share is computed based on the weighted average
number of shares of common stock outstanding during the periods presented.
Diluted earnings (loss) per share is computed based on the weighted average
number of shares of common stock outstanding during the periods presented,
increased by the effects of non-vested restricted stock and shares that could
be issued from the exercise of dilutive common stock options (363,000 for the
thirteen weeks ended October 3, 2004; 497,000 for the thirty-nine weeks ended
October 3, 2004). No adjustments were made to net income in the computation of
basic or diluted earnings (loss) per share.
Due to the Company's loss for the thirteen weeks and thirty-nine weeks ended
October 2, 2005, securities consisting of options convertible into 982,000
shares of common stock and 216,000 shares of non-vested restricted stock were
excluded from the calculation of diluted earnings (loss) per share, as their
inclusion in the diluted earnings (loss) per share calculation would have been
anti-dilutive.
8. Comprehensive Income
Comprehensive income is as follows (in thousands):
Thirteen Weeks Ended Thirty-Nine Weeks Ended
--------------------- ------------------------
October 3, October 2, October 3, October 2,
2004 2005 2004 2005
--------- --------- --------- ---------
Net income (loss) $ 9,214 $ (12,469) $ 38,100 $ (6,265)
Foreign currency
translation adjustment 1,663 2,398 579 1,044
--------- --------- --------- ----------
Comprehensive income (loss) $ 10,877 $ (10,071) $ 38,679 $ (5,221)
========= ========= ========= ==========
9. Commitments and Contingencies
Certain of the Company's subsidiaries have been named in various claims,
disputes, legal actions and other proceedings involving contracts, employment
and various other matters. The Company believes that it has provided adequate
reserves for contingencies and that the outcome of these matters should not
have a material adverse effect on the Company's future consolidated results of
operations, financial condition or liquidity. At October 2, 2005, the legal
contingencies reserve was $8.9 million of which $8.5 million relates to pre-
acquisition contingencies. The recorded reserves for some matters may require
adjustment in future periods and those adjustments could be material. Under
FASB Statement 141, some or all of any future revisions to the recorded
reserves for pre-acquisition contingencies may be required to be treated as
revisions to the preliminary purchase price allocation (described in Note 2)
which generally would be recorded as adjustments to goodwill. All other
adjustments related to matters existing as of the date of acquisition of
Hollywood will be recognized in the income statement in the period when such
revisions are made. At January 2, 2005, the legal contingencies reserve was
$0.3 million.
A negative outcome in certain of the ongoing litigation could harm the
Company's business, financial condition, liquidity or results of operations.
In addition, prolonged litigation, regardless of which party prevails, could be
costly, divert management attention or result in increased costs of doing
business.
10. Segment Reporting
As of April 27, 2005, management began evaluating the operating results of the
Company based on three segments, Movie Gallery, Hollywood Video, and Game
Crazy. Movie Gallery represents 2,714 video stores, Hollywood Video represents
2,051 video stores and Game Crazy represents 650 in-store departments and 20
free-standing stores. The Company measures segment profit as operating income
(loss), which is defined as income (loss) before interest, and other financing
costs, equity in losses of unconsolidated entities and income taxes.
Information on segments and reconciliation to operating income (loss) are as
follows (unaudited, in thousands):
Thirteen Weeks Ended
October 2, 2005
-------------------------------------------
Movie Hollywood Game
Gallery Video Crazy Total
---------- --------- -------- ----------
Revenues $ 197,185 $ 316,115 $ 59,142 $ 572,442
Depreciation and
amortization 10,291 19,728 2,278 32,297
Rental amortization 40,632 34,687 - 75,319
Operating income(loss) (652) 10,508 (4,832) 5,024
Total assets 523,108 1,230,589 116,391 1,870,088
Purchases of property,
furnishings and
equipment, net 11,672 4,351 400 16,423
Thirty-Nine Weeks Ended
October 2, 2005
-------------------------------------------
Movie Hollywood Game
Gallery(1) Video Crazy Total
---------- --------- -------- ----------
Revenues $ 630,038 $ 572,650 $108,274 $1,310,962
Depreciation and
amortization 28,675 27,493 5,401 61,569
Rental amortization 138,983 67,151 - 206,134
Operating income(loss) 18,462 25,873 (6,752) 37,583
Total assets 523,108 1,230,589 116,391 1,870,088
Purchases of property,
furnishings and
equipment, net 40,403 7,874 596 48,873
(1) Rental amortization includes $10.1 million of VHS residual value
adjustment.
For the comparable periods ending October 3, 2004, there was only one
reportable segment, which was Movie Gallery. Last year's consolidated results
are the Movie Gallery segment totals.
11. Subsequent Events
As of October 25, 2005, Movie Gallery notified 92 Movie Gallery associates that
their positions will be relocated or eliminated as part of integration efforts
through the consolidation of the primary functions of Finance, Accounting,
Treasury, Product, Logistics, Human Resources and Payroll at the Company's
Wilsonville, Oregon office. As this action impacts the acquiring Company's
associates, these costs are charged to the condensed consolidated statement of
operations as they are incurred. The Company estimates that the total cost of
providing severance, retention incentives and outplacement services to these
associates will be approximately $1.9 million and will be expensed within the
condensed consolidated statement of operations in future periods over the
retention service period for the impacted associates in accordance with
Statement of Financial Accounting Standards, ("SFAS") No. 146, "Accounting for
Costs Associated with Disposal and Exit Activities".
The consolidation of these corporate functions will allow the Company to reduce
its salaried and administrative office staff by approximately 10% over the next
twelve months, primarily in the Dothan office. The Company expects to realize
annualized pre-tax savings of approximately $2.1 million.
12. Consolidating Financial Statements
The following tables present condensed consolidating financial information for:
(a) Movie Gallery, Inc. (the "Parent") on a stand-alone basis; (b) on a
combined basis, the guarantors of the 11% Senior Notes ("Subsidiary
Guarantors"), which include Movie Gallery US, Inc.; Hollywood Entertainment
Corporation; Hollywood Management Company; Movie Gallery Finance, Inc.; Movie
Gallery Licensing, Inc.; Movie Gallery Services, Inc.; M.G.A. Realty I, LLC;
M.G. Digital, LLC; Movie Gallery Asset Management, Inc., and (c) on a combined
basis, the Non-Guarantor Subsidiaries, which include Movie Gallery Canada,
Inc., VHQ Entertainment, Inc., Movie Gallery Mexico, Inc., S. de R.L. de C.V.,
and MG Automation, Inc. Each of the Subsidiary Guarantors is wholly-owned by
Movie Gallery, Inc. The guarantees issued by each of the Subsidiary Guarantors
are full, unconditional, joint and several. Accordingly, separate financial
statements of the wholly-owned Subsidiary Guarantors are not presented because
the Subsidiary Guarantors are jointly, severally and unconditionally liable
under the guarantees, and we believe separate financial statements and other
disclosures regarding the Subsidiary Guarantors are not material to investors.
Furthermore, there are no significant legal restrictions on the Parent's
ability to obtain funds from its subsidiaries by dividend or loan.
The Parent is a Delaware holding company and has no independent operations
other than investments in subsidiaries and affiliates.
Consolidating Statement of Operations
Thirteen weeks ended October 3, 2004
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- --------- --------- ---------
Revenue:
Rentals $ - $ 162,507 $ 13,551 $ - $ 176,058
Product sales - 12,511 1,286 - 13,797
--------- --------- --------- --------- ---------
Total revenue - 175,018 14,837 - 189,855
Cost of sales:
Cost of rental revenue - 47,697 3,413 - 51,110
Cost of product sales - 7,730 943 - 8,673
--------- --------- --------- --------- ---------
Gross profit - 119,591 10,481 - 130,072
Operating costs and expenses:
Store operating expenses - 91,335 6,627 - 97,962
General and administrative 33 12,983 1,381 - 14,397
Amortization of intangibles - 634 39 - 673
Stock compensation - 755 - - 755
-------- -------- -------- -------- ---------
Operating income(loss) (33) 13,884 2,434 - 16,285
Interest expense, net - (229) 4 - (225)
Equity in losses of
unconsolidated entities (955) - - - (955)
Equity in earnings of
subsidiaries 9,831 1,454 - (11,285) -
-------- -------- -------- -------- ---------
Income before income
taxes 8,843 15,109 2,438 (11,285) 15,105
Income taxes (benefit) (371) 5,278 984 - 5,891
-------- -------- -------- -------- ---------
Net income $ 9,214 $ 9,831 $ 1,454 $(11,285) $ 9,214
======== ======== ======== ======== =========
Consolidating Statement of Operations
Thirteen weeks ended October 2, 2005
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- --------- --------- --------
Revenue:
Rentals $ - $ 452,502 $ 20,584 $ - $ 473,086
Product sales - 96,679 2,677 - 99,356
--------- --------- --------- --------- --------
Total revenue - 549,181 23,261 - 572,442
Cost of sales:
Cost of rental revenue - 131,161 5,075 - 136,236
Cost of product sales - 68,465 1,615 - 70,080
--------- ---------- --------- --------- --------
Gross profit - 349,555 16,571 - 366,126
Operating costs and expenses:
Store operating expenses - 307,766 12,153 - 319,919
General and administrative 171 38,026 1,288 - 39,485
Amortization of intangibles - 1,070 93 - 1,163
Stock compensation - 535 - - 535
-------- -------- -------- -------- ---------
Operating income(loss) (171) 2,158 3,037 - 5,024
Interest expense, net (24,052) (241) (134) - (24,427)
Equity in earnings(loss) of
subsidiaries 3,194 1,745 - (4,939) -
-------- -------- -------- -------- --------
Income (loss) before income
taxes (21,029) 3,662 2,903 (4,939) (19,403)
Income taxes (benefit) (8,560) 468 1,158 - (6,934)
-------- -------- -------- -------- --------
Net income (loss) $(12,469) $ 3,194 $ 1,745 $ (4,939) $(12,469)
======== ======== ======== ======== ========
Consolidating Statement of Operations
Thirty-Nine weeks ended October 3, 2004
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- --------- --------- ---------
Revenue:
Rentals $ - $ 500,479 $ 37,575 $ - $ 538,054
Product sales - 40,678 4,016 - 44,694
--------- --------- --------- --------- ---------
Total revenue - 541,157 41,591 - 582,748
Cost of sales:
Cost of rental revenue - 142,286 10,477 - 152,763
Cost of product sales - 26,973 2,772 - 29,745
--------- --------- --------- --------- ---------
Gross profit - 371,898 28,342 - 400,240
Operating costs and expenses:
Store operating expenses - 267,964 19,824 - 287,788
General and administrative 79 38,307 3,493 - 41,879
Amortization of intangibles - 1,850 112 - 1,962
Stock compensation - 795 - - 795
--------- -------- --------- --------- ---------
Operating income(loss) (79) 62,982 4,913 - 67,816
Interest expense, net - (404) 14 - (390)
Equity in losses of
unconsolidated entities (4,891) - - - (4,891)
Equity in earnings of
subsidiaries 41,203 2,945 - (44,148) -
--------- -------- -------- --------- ---------
Income before income
taxes 36,233 65,523 4,927 (44,148) 62,535
Income taxes (benefit) (1,867) 24,320 1,982 - 24,435
--------- -------- -------- -------- --------
Net income $ 38,100 $ 41,203 $ 2,945 $(44,148) $ 38,100
========= ======== ======== ======== ========
Consolidating Statement of Operations
Thirty-Nine weeks ended October 2, 2005
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- ---------- --------- ------- ----------
Revenue:
Rentals $ - $1,056,278 $ 53,383 $ - $1,109,661
Product sales - 195,300 6,001 - 201,301
--------- --------- --------- ------- ---------
Total revenue - 1,251,578 59,384 - 1,310,962
Cost of sales:
Cost of rental revenue - 328,867 16,292 - 345,159
Cost of product sales - 137,981 3,915 - 141,896
--------- --------- --------- ------- ---------
Gross profit - 784,730 39,177 - 823,907
Operating costs and expenses:
Store operating expenses - 659,461 31,131 - 690,592
General and administrative 372 88,027 3,517 - 91,916
Amortization of intangibles - 2,544 174 - 2,718
Stock compensation - 1,098 - - 1,098
-------- -------- -------- ------ ---------
Operating income(loss) (372) 33,600 4,355 - 37,583
Interest expense, net (40,606) (669) (155) - (41,430)
Write-off of bridge
financing costs (4,234) - - - (4,234)
Equity in losses of
unconsolidated entities (806) - - - (806)
Equity in earnings of
subsidiaries 23,118 2,543 - (25,661) -
-------- -------- -------- -------- --------
Income (loss) before income
taxes (22,900) 35,474 4,200 (25,661) (8,887)
Income taxes (benefit) (16,635) 12,356 1,657 - (2,622)
-------- -------- -------- -------- --------
Net income (loss) $ (6,265) $ 23,118 $ 2,543 $(25,661) $ (6,265)
======== ======== ======== ======== ========
Condensed Consolidating Balance Sheet
January 2, 2005
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- -------- --------- ---------
Assets
Current assets:
Cash and cash equivalents $ 1 $ 15,711 $ 9,806 $ - $ 25,518
Merchandise inventory, net - 24,806 2,613 - 27,419
Prepaid expenses - 11,607 1,105 - 12,712
Store supplies and other 23 8,344 1,126 - 9,493
Deferred income taxes, net - 2,994 364 - 3,358
--------- --------- -------- --------- ---------
Total current assets 24 63,462 15,014 - 78,500
Rental inventory, net - 113,939 12,602 - 126,541
Property, furnishings and
equipment, net - 116,462 11,720 - 128,182
Goodwill, net - 133,292 10,469 - 143,761
Other intangibles, net - 7,144 597 - 7,741
Deposits and other assets 806 6,028 583 - 7,417
Investments in subsidiaries 328,494 30,644 - (359,138) -
--------- --------- -------- --------- ---------
Total assets $ 329,324 $ 470,971 $ 50,985 $(359,138) $ 492,142
========= ========= ======== ========= =========
Liabilities and stockholders' equity:
Current liabilities:
Accounts payable - 63,465 5,512 - 68,977
Accrued liabilities (1,810) 27,323 5,057 - 30,570
Deferred revenue - 10,415 428 - 10,843
--------- --------- -------- --------- ---------
Total current liabilities (1,810) 101,203 10,997 - 110,390
Deferred income taxes - 47,468 3,150 - 50,618
Payable to affiliate - (6,194) 6,194 - -
Stockholders' equity 331,134 328,494 30,644 (359,138) 331,134
--------- --------- -------- --------- ---------
Total liabilities and
Stockholders' equity $ 329,324 $ 470,971 $ 50,985 $(359,138) $ 492,142
========= ========= ======== ========= =========
Condensed Consolidating Balance Sheet
October 2, 2005
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- -------- --------- ---------
Assets
Current assets:
Cash and cash equivalents $ - $ 67,338 $ 1,417 $ - $ 68,755
Extended viewing fees
receivable, net - 1,110 - - 1,110
Merchandise inventory,net - 139,334 3,875 - 143,209
Prepaid expenses 33 40,477 1,947 - 42,457
Store supplies and other - 28,410 1,347 - 29,757
Deferred income taxes, net - 15,633 180 - 15,813
--------- --------- -------- --------- --------
Total current assets 33 292,302 8,766 - 301,101
Rental inventory, net - 326,450 15,777 - 342,227
Property, furnishings and
equipment, net - 338,937 16,499 - 355,436
Goodwill, net - 601,213 24,672 - 625,885
Other intangibles, net - 189,361 1,345 - 190,706
Deferred income taxes 18,398 (475) (4,720) - 13,203
Deposits and other assets 30,761 10,058 711 - 41,530
Investments in
subsidiaries 1,441,318 41,336 - (1,482,654) -
--------- --------- -------- --------- ---------
Total assets $1,490,510 $1,799,182 $ 63,050$(1,482,654)$1,870,088
========= ========= ======= ========= =========
Liabilities and stockholders' equity:
Current liabilities:
Current maturities of
long-term obligations 26,500 652 134 - 27,286
Current maturities of
financing obligations - 7,973 - - 7,973
Accounts payable - 155,456 4,358 - 159,814
Accrued liabilities (731) 131,389 6,920 - 137,578
Accrued interest 29,168 38 27 - 29,233
Deferred revenue - 31,297 390 - 31,687
---------- --------- -------- --------- ---------
Total current liabilities 54,937 326,805 11,829 - 393,571
Long-term obligations,less
current portion 1,133,225 581 9,076 - 1,142,882
Deferred income taxes - - - - -
Payable to(receivable
from)affiliate (31,287) 30,478 809 - -
Stockholders' equity 333,635 1,441,318 41,336 (1,482,654) 333,635
--------- --------- -------- --------- ---------
Total liabilities and
stockholders' equity $1,490,510 $1,799,182 $63,050$(1,482,654)$1,870,088
========= ========= ======== ========= =========
Consolidating Condensed Statement of Cash Flow
Thirty-Nine weeks ended October 3, 2004
(unaudited, in thousands)
-------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
-------- --------- -------- -------- ---------
Operating Activities:
Net income $ 38,100 $ 41,203 $ 2,945 $ (44,148) $ 38,100
Equity earnings in
subsidiary (41,203) (2,945) - 44,148 -
Adjustments to reconcile
net income to cash
provided by operating
activities:
Rental inventory
amortization - 99,371 8,319 - 107,690
Purchases of rental
inventory - (100,194) (9,121) - (109,315)
Depreciation and
intangibles amortization - 20,605 1,546 - 22,151
Stock based compensation 28 - - - 28
Tax benefit of stock
options exercised 4,689 - - - 4,689
Deferred income taxes - 9,028 3,468 - 12,496
Changes in operating
assets and liabilities, net
of business acquisitions:
Merchandise inventory - 1,106 175 - 1,281
Other current assets - 1,117 (132) - 985
Deposits and other assets 700 (137) 334 - 897
Accounts payable - (14,743) (1,042) - (15,785)
Accrued liabilities and
deferred revenue (2,144) 557 (934) - (2,521)
Intercompany payables/
receivables - (1,084) 1,084 - -
-------- --------- -------- -------- ---------
Net cash provided by
operating activities 170 53,884 6,642 - 60,696
Investing Activities:
Business acquisitions,
net of cash acquired - (9,346) (253) - (9,599)
Purchases of rental
inventory-base stock - (10,212) (873) - (11,085)
Purchase of property,
furnishings and equipment - (31,317) (3,382) - (34,699)
Investment in subsidiaries (31,397) (2,079) - 33,476 -
-------- --------- -------- -------- ---------
Net cash used in investing
activities (31,397) (52,954) (4,508) 33,476 (55,383)
Financing Activities:
Proceeds from issuance of
long-term debt 20,000 - - - 20,000
Proceeds from exercise
of stock options 5,516 - - - 5,516
Proceeds from employee
stock purchase plan 168 - - - 168
Purchases and retirement
of common stock (47,390) - - - (47,390)
Capital contribution
from parent - 31,397 2,079 (33,476) -
Dividend to parent 55,891 (55,891) - - -
Payment of dividends (2,958) - - - (2,958)
-------- --------- -------- -------- ---------
Net cash (used in)
provided by financing
activities 31,227 (24,494) 2,079 (33,476) (24,664)
Effect of exchange rate
changes on cash and
cash equivalents - 579 - - 579
-------- --------- -------- -------- ---------
Increase (decrease) in
cash and cash equivalents - (22,985) 4,213 - (18,772)
Cash and cash equivalents at
beginning of period - 34,849 3,157 - 38,006
-------- --------- -------- -------- ---------
Cash and cash equivalents
at end of period $ - $ 11,864 $ 7,370 $ - $ 19,234
======== ========= ======== ======== =========
Consolidating Condensed Statement of Cash Flow
Thirty-Nine Weeks ended October 2, 2005
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
-------- --------- --------- -------- ---------
Operating Activities:
Net income $ (6,265) $ 23,118 $ 2,543 $(25,661) $ (6,265)
Equity earnings in
subsidiary (23,118) (2,543) - 25,661 -
Adjustments to reconcile
net income to cash
provided by operating
activities:
Rental inventory
amortization - 192,740 13,394 - 206,134
Purchases of rental
inventory - (161,581) (12,670) - (174,251)
Depreciation and
intangibles amortization - 58,633 2,936 - 61,569
Amortization of debt
issuance cost 2,235 - - - 2,235
Stock based compensation 705 393 - - 1,098
Tax benefit of stock
options exercised 3,301 - - - 3,301
Deferred income taxes (18,398) 5,313 1,528 - (11,557)
Changes in operating
assets and liabilities, net
of business acquisitions:
Extended viewing fees
receivable, net - 20,259 - - 20,259
Merchandise inventory - 8,658 (142) - 8,516
Other current assets (10) (3,098) (840) - (3,948)
Deposits and other assets 493 (2,418) (128) - (2,053)
Accounts payable - (77,603) (4,655) - (82,258)
Accrued interest 29,168 (2) 27 - 29,193
Accrued liabilities and
deferred revenue 2,013 9,498 1,825 - 13,336
--------- --------- -------- -------- ---------
Net cash provided by
operating activities (9,876) 71,367 3,818 - 65,309
Investing Activities:
Business acquisitions,
net of cash acquired (1,092,282) 12,142 (16,125) - (1,096,265)
Purchases of rental
inventory-base stock - (15,136) (1,433) - (16,569)
Purchase of property,
furnishings and equipment - (44,156) (4,717) - (48,873)
Proceeds from disposal of
Property, furnishings and
Equipment - 2,107 - - 2,107
Acquisition of construction
phase assets, net - 2,154 - - 2,154
Investment in subsidiaries (354) (8,149) - 8,503 -
--------- --------- -------- -------- ---------
Net cash used in investing
activities (1,092,636) (51,038) (22,275) 8,503 (1,157,446)
Financing Activities:
Repayment of capital
lease obligations - (265) - - (265)
Intercompany payable/
receivable (31,165) 36,550 (5,385) - -
Decrease in financing
obligations - (2,412) - - (2,412)
Net borrowings on credit
facilities - - 9,046 - 9,046
Long term debt financing
fees (32,452) - - - (32,452)
Proceeds from issuance of
long-term debt 1,166,120 - - - 1,166,120
Principal payments on
long-term debt (6,625) - (1,742) - (8,367)
Proceeds from exercise
of stock options 5,318 - - - 5,318
Proceeds from employee
stock purchase plan 169 - - - 169
Capital contribution from
parent - 354 8,149 (8,503) -
Dividend to parent 3,973 (3,973) - - -
Payment of dividends (2,827) - - - (2,827)
-------- -------- -------- -------- ---------
Net cash (used in)
provided by financing
activities 1,102,511 30,254 10,068 (8,503) 1,134,330
Effect of exchange rate
changes on cash and
cash equivalents - 1,044 - - 1,044
-------- -------- -------- -------- ---------
Increase (decrease) in
cash and cash equivalents (1) 51,627 (8,389) - 43,237
Cash and cash equivalents at
beginning of period 1 15,711 9,806 - 25,518
-------- --------- -------- -------- ---------
Cash and cash equivalents
at end of period $ - $ 67,338 $ 1,417 $ - $ 68,755
======== ========= ======== ======== =========
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
Overview
As of October 2, 2005, we operated approximately 4,800 home video retail stores
that rent and sell movies and video games in urban, rural and suburban markets.
On April 27, 2005, we completed our acquisition of Hollywood Entertainment
Corporation ("Hollywood"). This acquisition increased our store count to over
4,700 stores and substantially increased our urban market presence. We
currently plan to maintain the Hollywood brand and store format. However, we
believe the most significant expansion opportunities continue to be in the
rural and suburban markets. We estimate that there are approximately 2,500 to
3,500 markets still available for expansion in rural America, where there is
less competition from other national and regional chains, as well as additional
opportunities throughout Canada and Mexico. We currently plan to open
approximately 300 new stores for the full year 2005 period, subject to market
and industry conditions and the integration of Hollywood.
We believe the most significant dynamic in our industry is the relationship our
industry maintains with the movie studios. The studios have historically
maintained an exclusive window for home video distribution (packaged goods),
which provides the home video industry with an approximately 45 day period
during which they can rent and sell new releases before they are made available
on pay-per-view or other distribution channels. According to Kagan Research,
the percentage of domestic studio movie revenue provided by the domestic home
video industry has increased substantially in recent years, from approximately
50% in 1998 to approximately 57% in 2004. For this reason, we believe movie
studios have a significant interest in maintaining a viable home video
business.
Our strategies have been designed to achieve reasonable, moderate and
consistent growth in same-store revenues and profitability in a mature
industry. We strive to minimize the operating and overhead costs associated
with our business, which allows us to maximize profitability and which has
proven to be a successful operating model for us. Our compound annual growth
rate for consolidated revenue and operating income from 2000 to 2004 was 25.5%
and 45.2% respectively. We intend to apply these same disciplines to the
Hollywood brand where appropriate.
In addition to the relationship between our industry and the movie studios, our
operating results are driven by revenue, inventory, rent and payroll. Given
those key factors, we believe that by monitoring the five operating performance
indicators described below, we can continue to be successful in executing our
operating plans and our growth strategy.
- - Revenues. Our business is a cash business with initial rental fees paid
upfront by the customer. Our management teams continuously review inventory
levels, marketing and sales promotions, real estate strategies, and
personnel issues in order to maximize profitable revenues at each location.
Additionally, our teams monitor revenue performance on a daily basis to
quickly identify trends or issues in our store base or in the industry as a
whole. Our management relies heavily on same-store revenues, which we
define as revenues at stores that we have operated for at least 12 full
months, to assess the performance of our business.
- - Product purchasing economics. In order to maintain the desired profit
margin in our business, purchases of inventory for both rental and sale must
be carefully managed. Our purchasing models are designed to analyze the
impact of the economic factors inherent in the various pricing strategies
employed by the studios. We believe that we are able to achieve purchasing
levels tailored for the customer demographics of each of our markets and to
maximize the return on investment of our inventory purchase dollars.
- - Store level cost control. The most significant store expenses are payroll
and rent, followed by other supply and service expenditures. We attempt to
control these expenses primarily through budgeting systems and
centralization of purchases into our corporate support centers. This
enables us to measure performance against expectations and to leverage our
purchasing power. We also have the benefit in that a significant portion of
our store base is in rural markets where we enjoy reduced labor and real
estate costs versus the higher costs associated with the larger urban
markets.
- - Leverage of overhead expenses. We apply the same principles of budgeting,
accountability and conservatism in our overhead spending that we employ in
managing our store operating costs. Our general and administrative expenses
include the costs to maintain our corporate support centers as well as the
overhead costs of our field management team. Our integration strategy is
focused on eliminating duplication, leveraging best practices and reaping
the financial benefits of economies of scale to reduce costs.
- - Operating cash flows. We have generated significant levels of cash flow
for several years. We have historically been able to fund the majority of
our store growth and acquisitions, as well as ongoing inventory purchases,
from cash flow generated from operations. An exception to this was the
acquisition of Hollywood which we funded through a combination of cash on
hand and long-term debt.
The following discussion of our results of operations, liquidity and capital
resources is intended to provide further insight into our performance for the
third quarter and year-to-date period of 2005 versus the comparable periods of
2004.
Hollywood Acquisition
On April 27, 2005, we completed our cash acquisition of Hollywood, refinanced
substantially all of the existing indebtedness of Hollywood, and replaced our
existing unsecured revolving credit facility. We paid $862.1 million to
purchase all of Hollywood's outstanding common stock and $384.7 million to
refinance Hollywood's debt. As part of the refinancing of Hollywood's debt,
Hollywood executed a tender offer for its $225.0 million principal amount
9.625% senior subordinated notes due 2011, pursuant to which $224.6 million
were tendered. The Hollywood acquisition was financed by Movie Gallery and
Hollywood's cash on-hand of approximately $180.0 million and a senior secured
credit facility guaranteed by all of our domestic subsidiaries in an aggregate
amount of $870.0 million, and an issuance of $325.0 million of 11% senior
unsecured notes.
The combination of Movie Gallery and Hollywood created the second largest North
American video rental company with pro-forma combined annual revenue in excess
of $2.5 billion and approximately 4,800 stores located in all 50 U.S. states,
Canada and Mexico. The acquisition substantially increased our presence on the
West Coast and in urban areas. Hollywood's predominantly West Coast urban
superstore locations present little overlap with Movie Gallery's rural and
suburban store locations concentrated in the eastern half of the United States.
We will maintain the Hollywood store format and brand separately from our Movie
Gallery business because of Hollywood's distinct operational model and to
ensure customer continuity. There has been a conscious effort not to interrupt
the field management organizations at Movie Gallery and Hollywood to ensure
they remain focused on revenue and customer service. Integration efforts to
date have primarily focused on consolidating the leadership functions in all
three operating segments. This is complete for the Human Resources, Real
Estate, Legal, Lease Administration, Finance, Information Systems, Loss
Prevention and Distribution functions. The respective leaders of these support
organizations are evaluating opportunities to leverage both Movie Gallery's and
Hollywood's best practices and generate general and administrative cost
savings. To date, these savings have been found in both Movie Gallery's and
Hollywood's cost structures which we anticipate will continue in the future.
The combined companies also are evaluating opportunities to reap the benefits
of increased purchasing leverage to reduce costs. However, we can make no
assurances that we will successfully integrate Hollywood's business with our
business or that we will achieve the anticipated cost savings.
As of October 25, 2005, we notified 92 Movie Gallery associates that their
positions will be relocated or eliminated as part of integration efforts
through the consolidation of the primary functions of Finance, Accounting,
Treasury, Product, Logistics, Human Resources and Payroll at our Wilsonville,
Oregon office. As this action impacts the acquiring company's associates,
these costs are charged to the condensed consolidated statement of operations
as they are incurred. We estimate that the total cost of providing severance,
retention incentives and outplacement services to these associates will be
approximately $1.9 million and will be expensed within the condensed
consolidated statement of operations in future periods over the retention
service period for the impacted associates in accordance with Statement of
Financial Accounting Standards, ("SFAS") No. 146, "Accounting for Costs
Associated with Disposal and Exit Activities".
The consolidation of these corporate functions will allow us to reduce our
salaried and administrative office staff by approximately 10% over the next
twelve months, primarily in the Dothan office. We expect to realize annualized
pre-tax savings of approximately $2.1 million.
During our integration of the operations of Hollywood, we will evaluate our
operational, growth, dividend and other strategies and policies discussed in
this report and will modify our strategies and policies as appropriate or
required by industry and operating conditions.
Other Acquisitions
During the second quarter of 2005, we acquired VHQ Entertainment, Inc.,
("VHQ"). VHQ operates 57 stores in Canada. VHQ's results of operations have
been included in our results since May 17, 2005. In addition to the VHQ
acquisition, during the thirty-nine weeks ended October 2, 2005, Movie Gallery
purchased 26 stores in 11 separate transactions for a total cash consideration,
including VHQ, of $22.7 million.
By letter dated August 29, 2005, Boards Video Company LLC ("Boards"), an entity
controlled by Mark Wattles, the founder and former Chief Executive Officer of
Hollywood,, exercised a contractual right to require Hollywood to purchase all
of the 20 Hollywood Video stores and 17 Game Crazy stores owned and operated by
Boards pursuant to a "put" option contained in the license agreement for these
stores. In accordance with the terms of the license agreement, Hollywood and
Boards have agreed to the retention of a valuation expert and are proceeding
with the valuation of the stores. It is anticipated that the transaction will
close by the end of first quarter 2006.
Results of Operations
Selected Financial Statement and Operational Data:
Thirteen Weeks Ended Thirty-Nine Weeks Ended
--------------------- -----------------------
October 3, October 2, October 3, October 2,
2004 2005 2004 2005
--------- --------- --------- ----------
(unaudited)
($ in thousands, except per share and store data)
Rental revenue $ 176,058 $ 473,086 $ 538,054 $1,109,661
Product sales 13,797 99,356 44,694 201,301
--------- --------- --------- ----------
Total revenue 189,855 572,442 582,748 1,310,962
Cost of rental revenue 51,110 136,236 152,763 345,159
Cost of product sales 8,673 70,080 29,745 141,896
--------- --------- --------- ----------
Total gross profit $ 130,072 $ 366,126 $ 400,240 $ 823,907
========= ========= ========= ==========
Store operating expenses $ 97,962 $ 319,919 $ 287,788 $ 690,592
General and administrative
expenses $ 14,397 $ 39,485 $ 41,879 $ 91,916
Stock compensation $ 755 $ 535 $ 795 $ 1,098
Equity in losses of
unconsolidated entities $ 955 $ - $ 4,891 $ 806
Operating income $ 16,285 $ 5,024 $ 67,816 $ 37,583
Interest expense, net $ 225 $ 24,427 $ 390 $ 41,430
Net income (loss) $ 9,214 $ (12,469) $ 38,100 $ (6,265)
Net income (loss)
per diluted share $ 0.29 $ (0.39) $ 1.16 $ (0.20)
Cash dividends per
common share $ 0.03 $ - $ 0.09 $ 0.06
Rental margin 71.0% 71.2% 71.6% 68.9%
Product sales margin 37.1% 29.5% 33.4% 29.5%
Total gross margin 68.5% 64.0% 68.7% 62.8%
Percent of total revenue:
Rental revenue 92.7% 82.6% 92.3% 84.6%
Product sales 7.3% 17.4% 7.7% 15.4%
Store operating expenses 51.6% 55.9% 49.4% 52.7%
General and administrative
expenses 7.6% 6.9% 7.2% 7.0%
Stock compensation 0.4% 0.1% 0.1% 0.1%
Operating income 8.6% 0.9% 11.6% 2.9%
Interest expense, net 0.1% 4.3% 0.1% 3.2%
Net income (loss) 4.9% (2.2%) 6.5% (0.5%)
Total same-store revenues (2.3%) (9.0%) (0.3%) (3.1%)
Movie Gallery same-store revenues(2.3%) (9.8%) (0.3%) (5.3%)
Hollywood same-store revenues (2.4%) (8.6%) 1.3% (2.2%)
Total same-store rental revenues (2.1%) (10.3%) (0.1%) (5.2%)
Movie Gallery same-store revenues(2.1%) (10.8%) (0.1%) (5.5%)
Hollywood same-store revenues (8.0%) (10.1%) (4.8%) (5.1%)
Total same-store product sales (4.5%) (2.2%) (2.3%) 7.8%
Movie Gallery same-store sales (4.5%) 2.5% (2.3%) (3.1%)
Hollywood same-store sales 26.8% (3.0%) 37.6% 10.0%
Store count:
Beginning of period 2,331 4,730 2,158 2,482
New store builds 65 80 221 234
Stores acquired 5 - 60 2,138
Stores closed (18) (25) (56) (69)
--------- --------- --------- ----------
End of period 2,383 4,785 2,383 4,785
========= ========= ========= ==========
Hollywood same-store revenues are presented for full thirteen and thirty-nine
week periods and are inclusive of the Game Crazy operating segment. Hollywood
same-store revenues exclude the effects of the process change for extended
viewing fees recognition described in Note 1 to the accompanying consolidated
financial statements.
Revenue. For the thirteen weeks and thirty-nine weeks ended October 2, 2005,
consolidated total revenues increased 201.5% and 125.0% from the comparable
periods in 2004. Same-store total revenues were negative 9.0% for the third
quarter and negative 3.1% for the year-to-date period in 2005. Same-store
rental revenue declined 10.3% in the third quarter of 2005 and declined 5.2%
year-to-date in 2005. Product same-store revenue declined 2.2% in the third
quarter and grew 7.8% for the year-to-date period in 2005.
With the acquisition of Hollywood our revenue has shifted more to product
revenue and away from rental revenues versus comparative periods last year.
The Game Crazy operating segment is the primary driver of this shift in the
revenue mix. We expect this trend to continue.
For the thirteen weeks and thirty-nine weeks ended October 2, 2005, the Movie
Gallery operating segment total revenues increased 3.9% and 8.1% from the
comparable periods in 2004. The increases were due to an increase of
approximately 14.5% in the average number of stores operated during both the
quarter and year-to-date period of 2005. These increases were partially offset
by same-store revenue decreases of 9.8% for the third quarter and 5.3% for the
year-to-date period of 2005. Same-store rental revenue declined 10.8% in the
third quarter of 2005 and declined 5.5% year-to-date in 2005. Same-store
product sales increased 2.5% in the third quarter and declined 3.1% for the
year-to-date period in 2005.
The addition of Hollywood operating segment revenue for the thirteen weeks and
thirty-nine weeks ended October 2, 2005 accounted for 98.1% and 93.5%,
respectively, of the total revenue increases. Hollywood total same-store
revenues were negative 8.6% for the third quarter and negative 2.2% for the
year-to-date period. Same-store rental revenue declined 10.1% in the third
quarter of 2005 and declined 5.1% year-to-date in 2005. To conform Hollywood's
extended viewing fees accounting process to Movie Gallery's accounting process,
Hollywood's rental revenue was reduced by $7.5 million and $20.3 million in the
thirteen weeks and thirty-nine weeks ended October 2, 2005. The same-store
total revenue and rental revenue have been presented excluding this process
change. The same-store product sales decreased 3.0% in the third quarter and
increased 10.0% for the year-to-date period in 2005. The year-to-date growth in
Hollywood same-store product sales is primarily driven by the results of the
in-store Game Crazy departments. The year-to-date same-store revenue percentage
changes provided for Hollywood are for the full thirty-nine weeks.
The following factors contributed to a decrease in our total same-store
revenues for the third quarter of 2005 versus 2004:
- -Movie rental revenue, including previously viewed sales, declined and
was adversely impacted by the weak home video release schedule, the
maturation of the DVD life cycle and the overabundance of DVD titles
available in the marketplace.
- -Game rental revenue declined reflecting the weakness of the new game
titles currently being released and the industry softness that occurs in
anticipation of the introduction of new game platforms currently
scheduled for late 2005 and early 2006 release.
Cost of Sales. The cost of rental revenues includes the amortization of rental
inventory, revenue sharing expenses incurred and the cost of previously viewed
rental inventory sold. The gross margin on rental revenue for the third quarter
and year-to-date period of 2005 was 71.2% and 68.9%, respectively, versus 71.0%
and 71.6% for the comparable quarter and year-to-date period of 2004. A charge
of $10.1 million was recorded against rental margins in the second quarter to
reflect a change in estimate of the residual value of VHS movies from $2.00 to
$1.00. Excluding the extended viewing fees adjustment for Hollywood and the VHS
residual value adjustment in the second quarter for Movie Gallery, gross margin
on rental revenue would have been 71.5% and 70.1% for the thirteen and thirty-
nine weeks ending October 2, 2005, respectively. We have presented gross
margins on rental revenue adjusted to exclude charges related to the extended
viewing fee and VHS residual value adjustments because we believe it provides
our investors a more accurate view of the current period operating results and
our management uses this information to analyze our results from continuing
operations and to view trends and changes in these results.
The remaining decrease in the year-to-date period compared to the corresponding
period last year is primarily the result of the acquisition of the Hollywood
Video stores as their gross margins are historically lower than those of Movie
Gallery stores because Hollywood generally invests more in rental inventory as
a percentage of revenue to compete effectively in urban markets. Higher than
expected same-store revenue declines for movie rental revenue, and higher than
normal promotional activity of previously viewed products also contributed to
the reduced rental gross margins.
Cost of product sales includes the costs of new video and used video game
merchandise taken in on trade for the Game Crazy operating segment, new movies,
concessions and other goods sold. New movies and new game merchandise typically
have a much lower margin than used game merchandise and concessions. The gross
margin on product sales is subject to fluctuations in the relative mix of the
products that are sold. The gross margin on product sales for the thirteen
weeks and thirty-nine weeks ended October 2, 2005 was 29.5%, compared to 37.1%
and 33.4% for the comparable quarter and year-to-date periods of 2004. The
decrease in product sales margin was primarily caused by the higher penetration
of new movies and new game merchandise sales. The acquisition of the Game Crazy
operating segment acquired with Hollywood will continue to increase the percent
to total revenue of new game merchandise sales versus comparable periods last
year.
Operating Costs and Expenses. Store operating expenses include store-level
expenses such as lease payments, in-store payroll, utilities, repair and
maintenance costs and start-up costs associated with new store openings. Store
operating expenses as a percentage of total revenue was 55.9% and 52.7% for the
thirteen weeks and thirty-nine weeks ended October 2, 2005, respectively, in
comparison to 51.6% and 49.4% for the comparable periods in 2004. Store
operating expense increased 226.6% for the third quarter and 140.0% for the
year-to-date period versus comparable periods. The acquisition of Hollywood is
the primary reason for the increase in total store operating expenses, however
the Hollywood stores generally have lower operating expense as a percentage of
revenue than do the Movie Gallery stores. The Movie Gallery operating segment
store operating expenses as a percentage of total revenue was 58.7% and 53.3%
for the thirteen weeks and thirty-nine weeks ended October 2, 2005,
respectively, in comparison to 51.6% and 49.4% for the comparable periods in
2004.
For the Movie Gallery operating segment, the increases in operating expense as
a percentage of revenue are attributable to higher total spending based on a
14.5% increase in year-over-year store counts, and declines in same-store
revenues. For the thirteen weeks ended October 2, 2005, store operating
expenses were higher due to market increases in rent expense, higher salaries
and wages, higher depreciation related to lease accounting changes made in the
fourth quarter of 2004 as disclosed in Movie Gallery's Annual Report on Form
10-K for the fiscal year ended January 2, 2005, and increased store closure
related write-offs. A charge of $0.4 million was recorded in the third quarter
to account for three stores destroyed by Hurricane Katrina. These increases
were partially offset by reductions in the cost of store supplies.
For the thirty-nine weeks ended October 2, 2005, store operating expenses as a
percentage of revenues were higher due to the increase in year-over-year store
counts, market increases in rent expense, higher depreciation related to lease
accounting changes made in the fourth quarter of 2004 as disclosed in Movie
Gallery's Annual Report on Form 10-K for the fiscal year ended January 2, 2005,
increased repair and maintenance expense, higher store closure and hurricane
damage related write-offs. Marketing expense increased due to a reduction in
the amount of vendor rebates versus the prior year allowed to be offset against
marketing expense and which will be offset against the cost of rental revenue
in accordance with our rental inventory amortization policy. These increases
were partially offset by a decrease in salaries and wages due to reductions in
store hours and a reduction in supplies expense.
For the Hollywood operating segment, a change in estimate was recorded in the
thirteen weeks ended October 2, 2005, to conform the lives of Hollywood's long
lived assets to Movie Gallery's policy and to record the increase in
depreciation expense generated by recording Hollywood's long lived assets at
their increased fair value in the business combination accounting. A charge of
$7.1 million in depreciation expense was recorded in the thirteen weeks ended
October 2, 2005, of which $2.7 million related to the ten weeks ended July 3,
2005. These changes will continue to increase depreciation expense in future
periods.
General and Administrative Expenses. General and administrative expenses
include the costs to maintain our corporate support centers as well as the
overhead costs of our field management team. General and administrative
expenses as a percentage of total revenue were 6.9% and 7.0% for the thirteen
weeks and thirty-nine weeks ended October 2, 2005, respectively, in comparison
to 7.6% and 7.2% for the comparable periods in 2004. General and
administrative expenses increased 174.3% for the third quarter and 119.5% for
the year-to-date period primarily as the result of the acquisition of
Hollywood. General and administrative expenses as a percentage of total
revenue has decreased versus comparable periods last year due to the addition
of the Hollywood revenue and reductions in duplicate general and administrative
functions.
General and administrative expenses for the thirty-nine week period include
$1.5 million in transaction bonuses paid to certain employees who were
instrumental in completing the Hollywood merger. Excluding transaction
bonuses, general and administrative expense as a percentage of revenue would
have been 6.9% for the thirty-nine weeks ended October 2, 2005. We have
presented general and administrative expense as a percentage of revenues
adjusted to exclude transaction bonuses related to the Hollywood merger because
we believe it provides our investors a more accurate view of the current period
operating results, and our management uses this information to analyze our
results from continuing operations and to view trends and changes in these
results.
Stock Compensation Expense. Stock compensation expense represents the non-cash
charge associated with non-vested stock grants. Time based stock grants are
amortized over the vesting period. Performance based stock grants are accrued
based on predicted achievement and the current stock price. The thirty-nine
week period ended October 2, 2005 also includes the non-cash charge associated
with certain stock options that were repriced during the first quarter of
fiscal 2001 and accounted for as variable stock options.
Operating Income. As a result of the impact of the above factors on revenues
and expenses, operating income decreased by 69.1% and 44.6% for the third
quarter and year-to-date period of 2005 to $5.0 million and $37.6 million,
respectively. The reported operating income was reduced by $6.6 million and
$18.0 million for the third quarter and year-to-date period of 2005,
respectively, to conform Hollywood's extended viewing fees accounting process
to Movie Gallery's accounting process after adjusting accrued revenue sharing
on accrued extended viewing fees.
Interest Expense, net. Net income for the thirteen and thirty-nine weeks ended
October 2, 2005 includes $24.4 million and $41.4 million pre-tax, or $0.54 and
$0.93 per diluted share in interest expense, respectively, related to the
financing agreements used to fund the acquisitions of Hollywood and VHQ.
Write-off of Bridge Financing. Reflects the write-off of $4.2 million, or
$0.09 per diluted share of fees and expenses associated with the bridge
commitment feature of the senior credit facility in the second quarter of 2005.
The bridge facility was never used and therefore the associated fees did not
qualify to be deferred and amortized. The fees were expensed in the third
quarter.
Equity in Losses of Unconsolidated Entities. During the last half of 2003,
Movie Gallery began to make investments in various alternative delivery
vehicles (both retail and digital) for movie content. We do not anticipate
that any of these alternatives will replace our base video rental business.
However, we do believe it is appropriate to make selective investments in
synergistic opportunities that could potentially provide ancillary sources of
revenue and profitability to our base rental business. As of October 2, 2005,
the company has completely written off the equity in unconsolidated entities.
In the future, we may make additional investments in existing or new
unconsolidated entities that may require adjustments. The expenses associated
with our investments in alternative delivery vehicles are reflected as equity
in losses of unconsolidated entities on our statements of income.
Income Taxes. The effective tax rate was a benefit of 35.7% and 29.5% for the
thirteen and thirty-nine weeks ended October 2, 2005, respectively, as compared
to a provision of 39.0% for both of the corresponding prior year periods. The
decrease in the effective rate is a result of several factors including a
decrease in book income and limitations on the recognition of the tax benefit
of a loss. It is anticipated that the effective rate should be more reflective
of historical effective tax rates in the future tax periods.
Liquidity and Capital Resources
Our primary capital needs are for debt service, opening and acquiring new
stores and for purchasing inventory. Other capital needs include refurbishing,
remodeling and relocating existing stores and refreshing, re-branding and
supplying new computer hardware for acquired stores. We fund our capital needs
primarily by cash flow from operations and, as necessary, loans under our new
senior secured credit facility ("Credit Facility").
At October 2, 2005, we had cash and cash equivalents of $68.8 million and $46.9
million in available borrowings under our Credit Facility. Although there can
be no assurances, we believe that cash flow available from operations and
availability under the $75.0 million revolving portion of the Credit Facility
(the "Revolver") will be sufficient to operate our business, satisfy our
working capital and capital expenditure requirements, and meet our foreseeable
liquidity requirements, including debt service on our $325.0 million principal
amount, 11% senior notes due 2012 (the "Senior Notes") and the Credit Facility.
The Credit Facility and Indenture governing our 11% notes impose certain
restrictions on us, including restrictions on our ability to: incur debt; grant
liens; provide guarantees in respect of obligations of any other person; pay
dividends; make loans and investments; sell our assets; make redemptions and
repurchases of capital stock; make capital expenditures; prepay, redeem or
repurchase debt; engage in mergers or consolidations; engage in sale/leaseback
transactions and affiliate transactions; change our business; amend certain
debt and other material agreements; issue and sell capital stock of
subsidiaries; and make distributions from subsidiaries.
The Credit Facility also requires us to meet certain financial covenants
including a leverage ratio test, a fixed charge coverage ratio test and an
interest coverage test. Each of these covenants is calculated on trailing four
quarter results based on specific definitions that are contained in the credit
agreement. In general terms, the leverage ratio is a measurement of total net
indebtedness relative to operating cash flow. The fixed charge coverage ratio
is a measurement of operating cash flow plus rent relative to total fixed
charges including rent, scheduled principal payments, and cash interest. The
interest coverage ratio is a measurement of operating cash flow relative to
interest expense.
On September 21, 2005, the Company executed an amendment to the Credit Facility
that relaxed certain financial covenants for a one-year period, provided for an
additional $50.0 million of borrowings under the Term Loan B tranche, and
increased the letter of credit sub-limit under the revolving credit facility
from $30.0 million to $40.0 million.
The instruments governing any future indebtedness may impose similar or other
restrictions and may require us to meet similar or other financial ratios and
tests. Our ability to comply with covenants contained in the instruments
governing our existing and future indebtedness may be affected by events and
circumstances beyond our control. If we breach any of these covenants, one or
more events of default, including cross-defaults between multiple components of
our indebtedness, could result. These events of default could permit our
creditors to declare all amounts owing to be immediately due and payable, and
to terminate any commitments to make further extensions of credit. If we were
unable to repay indebtedness owed to our secured creditors, they could proceed
against the collateral securing the indebtedness owed to them.
Contractual Obligations. The following table discloses our contractual
obligations and commercial commitments as of October 2, 2005. The operating
lease information presented is as of January 2, 2005, however, these amounts
are believed to approximate the obligations as of October 2, 2005 (in
thousands):
Contractual 2-3 4-5 More than
Obligations Total 1 Year Years Years 5 Years
- --------------- ---------- -------- -------- -------- ----------
Term Loan A $ 90,250 $ 19,000 $ 38,000 $ 33,250 $ -
Term Loan B 748,125 7,500 15,000 191,250 534,375
Senior Notes 325,450 - - - 325,450
VHQ debt 95 95 - - -
Interest Term
Loan A (1) 15,720 5,810 7,637 2,273 -
Interest Term
Loan B (1) 281,733 53,961 106,292 104,120 17,360
Interest on Hedge
Agreement 2,744 1,568 1,176 - -
Interest payment
on Senior Notes 235,639 35,793 71,587 71,587 56,672
Capital leases 852 650 202 - -
Interest payment
on capital
leases 31 28 3 - -
Revolver borrowings 9,046 - - 9,046 -
Operating leases 1,678,195 268,983 687,944 369,158 352,110
---------- -------- -------- -------- ----------
Total $3,387,880 $393,388 $927,841 $780,684 $1,285,967
---------- -------- -------- -------- ----------
(1)Interest rates based on current Libor rates plus margin. As of October 2,
2005, the Term Loan A and Term Loan B rates are 6.99% and 7.24%, respectively.
Thirty-Nine Weeks Ended
------------------------
October 3, October 2,
2004 2005
---------- ----------
($ in thousands)
Statements of Cash Flow Data:
Net cash provided by operating activities $ 60,696 $ 65,309
Net cash used in investing activities (55,383) (1,157,446)
Net cash (used in) provided by
financing activities (24,664) 1,134,330
The increase in net cash provided by operating activities was primarily
attributable to increases in rental amortization, accrued liabilities,
depreciation and amortization and extended viewing fees offset by lower net
income and increased uses of cash for purchases of rental inventory, accounts
payable and deferred income taxes for the first three quarters of 2005 versus
the comparable periods in 2004.
Net cash used in investing activities includes the costs of business
acquisitions, new store builds and investment in base stock rental inventory.
The increase in cash used in investing activities was primarily due to the
acquisitions of Hollywood and VHQ which amounted to $1.1 billion in the
aggregate, versus much smaller acquisitions during the first three quarters of
2004.
Net cash flow related to financing activities for the thirty-nine weeks ended
October 2, 2005 includes the proceeds from the Credit Facility and the issuance
of the Senior Notes. The Credit Facility is in an aggregate amount of $913.4
million, consisting of a five-year, $75.0 million revolving credit facility
("Revolver") currently bearing floating rate interest of London Interbank
Offered Rate ("LIBOR") plus 3.50%, and two term loan facilities in an aggregate
principal amount of $845.0 million. The Term Loan A is a $95.0 million, five-
year facility currently bearing floating rate interest of LIBOR plus 3.50%.
Term Loan B is a $750.0 million, six-year facility currently bearing floating
rate interest of LIBOR plus 3.75%. The Term Loan A and Term Loan B require
aggregate quarterly prepayments in the amounts of 5% and 0.25%, respectively,
of the outstanding balances beginning September 30, 2005 through the first
fiscal quarter of 2010, after which the mandatory Term Loan B prepayments
escalate. This new financing source is compared to a use of cash towards our
$25 million stock buyback program that was completed in the second quarter of
2004 with the Company repurchasing 1,336,312 shares of common stock at an
average price of $18.71 per share.
As required by the Credit Facility, we have entered into a two-year floating-
to-fixed interest rate swap with Wachovia and Merrill Lynch for an amount of
$280.0 million. Under the terms of the swap agreement, we pay fixed interest
on the $280.0 million at a rate of 4.06% and receive floating interest based on
three-month LIBOR. The termination date for the swap is June 29, 2007.
In June 2004, our board of directors declared a quarterly cash dividend of
$0.03 per share be paid under our dividend policy instituted in December 2003.
On September 26, 2005, we announced that our board of directors would not
declare a quarterly cash dividend for the third quarter of 2005 due to the
challenging conditions currently affecting the home video industry. The
payment of future dividends is subject to the discretion of our board of
directors. Future dividends may be increased, decreased or suspended from time
to time based on a number of factors, including changes in tax laws related to
dividends, our financial condition, capital requirements, future business
prospects, the restrictive covenants governing our indebtedness and any other
factors that our board of directors considers relevant.
At October 2, 2005, we had a working capital deficit of $92.5 million, due to
the accounting treatment of rental inventory. Rental inventory is treated as a
noncurrent asset under accounting principles generally accepted in the United
States because it is a depreciable asset and a portion of this asset is not
reasonably expected to be completely realized in cash or sold in the normal
business cycle. Although the rental of this inventory generates the major
portion of our revenue, the classification of this asset as noncurrent results
in its exclusion from working capital. The aggregate amount payable for this
inventory, however, is reported as a current liability until paid and,
accordingly, is reflected as a reduction in working capital. Consequently, we
believe that working capital is not an appropriate measure of our liquidity and
we anticipate that we will continue to operate with a working capital deficit.
We grow our store base through both internally developed and acquired stores.
We opened 234 internally developed stores, acquired 2,138 stores which include
the acquisitions of Hollywood and VHQ and closed 69 stores during the
year-to-date period ended October 2, 2005. We plan on opening another 42
internally developed stores during the last quarter of 2005. We will continue
to evaluate acquisition opportunities in 2005 as they arise although we
anticipate the majority of our future growth will most likely occur through new
store development. To the extent available, new stores and future acquisitions
may be completed using cash on-hand, funds available under our credit facility,
financing provided by sellers or alternative financing arrangements such as
funds raised in public or private debt or equity offerings. However, we cannot
assure you that financing will be available to us on terms which will be
acceptable, if at all.
We believe our projected cash flow from operations, cash on hand, borrowing
capacity under our credit facility and trade credit will provide the necessary
capital to service our debt and fund our current plan of operations, including
our anticipated new store openings and acquisition program, through fiscal
2005. Capital requirements to fund new store growth for fiscal 2005, including
the new store build-out costs and our rental and merchandise inventory
investment are estimated at $55 million. Additionally in fiscal 2005, we
estimate $35 million in other on-going capital expenditure requirements for the
existing store base. However, to fund a major acquisition, or to provide funds
in the event that our need for funds is greater than expected, or if the
financing sources identified above are not available to the extent anticipated
or if we increase our growth plan, we may need to seek additional or
alternative sources of financing. This financing may not be available on
satisfactory terms. Failure to obtain financing to fund our expansion plans or
for other purposes could have a material adverse effect on our operating
results.
Our ability to fund our current plan of operations and our growth plan will
depend upon our future performance, which is subject to general economic,
financial, competitive and other factors that are beyond our control. We
cannot assure you that our business will continue to generate sufficient cash
flow from operations in the future to fund capital resource needs, cover the
ongoing costs of operating the business and service our current level of
indebtedness or any debt we may incur in the future. If we are unable to
satisfy these requirements with cash flow from operations and cash on hand, we
may be required to sell assets or to obtain additional financing. We cannot
assure you that any such sales of assets or additional financing could be
obtained.
Critical Accounting Policies and Estimates
Our significant accounting policies are described in Note 1 to the consolidated
financial statements of Movie Gallery as filed in our Annual Report on Form 10-
K for the fiscal year ended January 2, 2005. Our discussion and analysis of
financial condition and results of operations is based upon our consolidated
financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States. The preparation of the
financial statements requires us to make estimates and judgments that affect
the reported amounts of assets, liabilities, revenues, expenses, and related
disclosure of contingent assets and liabilities. On an on-going basis, we
evaluate the estimates that we have made. These estimates have been based upon
historical experience and on various other assumptions that we believe to be
reasonable under the circumstances. Actual results may differ from these
estimates under different conditions or using different assumptions. We believe
our most critical accounting estimates include our policies with respect to
rental inventory amortization, impairment of long-lived assets, purchase price
allocation of acquired businesses and deferred income taxes.
A major component of our cost structure is the amortization of our rental
inventory. Rental inventory is amortized to an estimated residual value over an
estimated useful life of up to two years. We amortize the cost of rental
inventory using an accelerated method designed to approximate the rate of
revenue recognition. This method is based on historical customer demand patterns
from "street date" (the date studios release various titles for distribution to
our stores) through the end of the average useful life. In order to determine
the appropriate useful lives and residual values, we analyzed the actual
historical performance trends of our rental inventory. We quantified the average
rate of revenue recognition on our products and developed amortization rates and
useful lives that approximate the rental turns of our inventory. Our established
residual values are based on an evaluation of the sale prices we are able to
realize from our customers on used inventory, prices observed in bulk sale
transactions and prices observed in other open market purchases of used
inventory, as well as the residual values established by competitors in our
industry. Effective April 4, 2005, we changed our estimated residual value on
VHS movies from $2.00 to $1.00 due to continued declines in the market value of
VHS product. We believe our updated estimated useful lives and residual values
are appropriately matched to our current rental business and are consistent with
industry trends. However, should rental patterns of consumers change or should
market values of previously viewed inventory continue to decline due to the
acceptance of new formats (e.g., ongoing VHS transition to DVD, anticipated
transition to high definition DVD within one to three years, release of new
video game formats, etc.), this could necessitate an acceleration in our current
rental amortization rates, a reduction in residual values or a combination of
both courses of action. We believe that any acceleration in the rental
amortization rates would not have a long-lasting impact as the majority of our
current rental purchases are substantially depreciated within the first two to
three months after "street date" under our existing policy. In the past we have
generally been able to anticipate the rate of transition from one format to
another and manage our purchases, as well as inventory mix, to avoid significant
losses on the ultimate disposition of previously viewed movies. However, we
cannot assure you that we will be able to fully anticipate the impact of
continued transition to DVD or any other formats in the future and we could
incur losses on sales of previously viewed movies in the future. As of January
2, 2005 and October 2, 2005, we had $126.5 million and $342.2 million,
respectively, in rental inventory on our balance sheet. As of October 2, 2005,
the net book value of our VHS rental inventory is approximately 8.5% of the net
book value of our total rental inventory.
We assess the fair value and recoverability of our long-lived assets, including
property, furnishings and equipment and intangible assets with finite lives,
whenever events and circumstances indicate the carrying value of an asset may
not be recoverable from estimated future cash flows expected to result from its
use and eventual disposition. In doing so, we make assumptions and estimates
regarding future cash flows and other factors in order to make our
determination. The fair value of our long-lived assets is dependent upon the
forecasted performance of our business, changes in the video retail industry
and the overall economic environment. When we determine that the carrying value
of our long-lived assets may not be recoverable, we measure any impairment based
upon the excess of the carrying value over the estimated fair value of the
assets. If we do not meet our operating forecasts, we may have to record
impairment charges not previously recognized.
We test goodwill for impairment on an annual basis. Additionally, goodwill is
tested for impairment between annual tests if an event occurs or circumstances
change that indicate the fair value of a reporting unit is below its carrying
value. With the acquisition of Hollywood, the reporting units for Movie
Gallery are as follows: Movie Gallery, Hollywood Video and Game Crazy.
These events or circumstances would include a significant change in the
business climate, legal factors, operating performance indicators, competition,
sale or disposition of a significant portion of the business or other factors.
We have not recorded any impairment losses on goodwill since a fiscal 2001
impairment charge of $700,000. If we do not meet our operating forecasts we
may have to record additional impairment charges not previously recognized. As
of October 2, 2005, we have $625.9 million in goodwill on our balance sheet of
which the Hollywood acquisition accounts for $463.7 million.
We estimate the fair value of assets and liabilities of acquired businesses
based on historical experience and available information at the acquisition
date. We engage independent valuation specialists to assist when necessary.
If information becomes available subsequent to the acquisition date that would
materially impact the valuation of assets acquired or liabilities assumed in
business combinations, we may be required to adjust the purchase price
allocation. With the exception of the Video Update acquisition in 2001 and the
Hollywood acquisition, we have not experienced any significant adjustments to
the valuation of assets or liabilities acquired in business combinations in the
last seven years. Prior to the Hollywood acquisition our acquisitions have
typically been small businesses for which we generally do not assume
liabilities and for which the assets acquired consist primarily of inventory,
fixtures, equipment and intangibles.
We treated the acquisition of Hollywood as a purchase business combination for
accounting purposes, and as such, Hollywood's assets acquired and liabilities
assumed have been recorded at their fair value as determined based on a
preliminary valuation report performed by an independent valuation specialist.
The purchase price for the acquisition, including transaction costs, has been
allocated to the assets acquired and liabilities assumed based on estimated
fair values at the date of acquisition, April 27, 2005. The purchase price
allocation is preliminary and we expect further adjustments.
We recognize deferred tax assets and liabilities based on the differences
between the financial statement carrying amounts and the tax bases of assets
and liabilities. We regularly review our deferred tax assets for recoverability
and establish a valuation allowance based upon historical losses, projected
future taxable income and the expected timing of the reversals of existing
temporary differences. As a result of this review, we have established a
valuation allowance against our deferred tax assets related to net operating
loss carry forwards that we acquired in the 2001 acquisition of Video Update.
In forming our conclusion about the future recoverability of the net operating
losses from our 2001 acquisition of Video Update, we considered, among other
things, the applicable provisions of the federal income tax code, which limit
the deductibility of net operating loss carry forwards to the post-acquisition
taxable income (cumulative basis) of the acquired subsidiary on a separate
return basis, as well as other limitations that may apply to the future
deductibility of these net operating losses. We also considered the
availability of reversing taxable temporary differences during the carry
forward period, the length of the available carry forward period, recent
operating results, our expectations of future taxable income during the carry
forward period, changes in tax law, Internal Revenue Service (IRS) interpretive
guidance and judicial rulings. If facts and circumstances in the future should
warrant elimination or reduction of the valuation allowance related to these
net operating losses, our effective income tax rate, which was 40%, 39% and 39%
for fiscal 2002, 2003 and 2004, respectively, could be reduced.
Federal tax laws impose restrictions on the utilization of net operating loss
carry forwards and tax credit carry forwards in the event of an "ownership
change," as defined by the federal income tax code. Such an ownership change
occurred on April 27, 2005 concurrent with our acquisition of Hollywood. Our
ability to utilize our net operating loss carry forwards and tax credit carry
forwards is subject to restrictions pursuant to these provisions. Utilization
of the federal net operating loss and tax credits will be limited annually and
any unused limitation in a given year may be carried forward to the next year.
The annual limitation on utilization of the net operating loss carry forwards
is currently being determined. If we determine it is more likely than not that
we will not fully realize all net operating loss carry forwards and tax credit
carry forwards a valuation allowance may be necessary.
As part of our accounting for business combinations, some of the purchase price
is allocated to goodwill and intangible assets. Future impairment charges
associated with goodwill will not be tax deductible and will result in an
increased income tax expense in the quarter the impairment is recorded.
Amortization expense associated with separately identified, finite-lived
intangible assets is likewise not tax deductible, but the tax will be offset by
deferred taxes created in purchase accounting, and therefore, will not affect
our income tax expense.
In the fourth quarter of 2003 Hollywood applied for a change in accounting
method with the IRS to accelerate the deduction of store pre-opening supplies
and the amortization of DVD and VHS movies and video games. Permission has been
granted for the change in accounting method to accelerate the deduction of
store pre-opening supplies. The application for the accelerated deduction of
DVD and VHS movies and video games is under review by the IRS.
Forward Looking Statements
This quarterly report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, which represent
our expectations or beliefs about future events and financial performance.
Forward-looking statements are identifiable by the fact that they do not relate
strictly to historical information and may include words such as "believe,"
"anticipate," "expect," "intend," "plan," "will," "may," "estimate" or other
similar expressions and variations thereof. In addition, any statements that
refer to expectations, projections or other characterizations of future events
or circumstances are forward-looking statements. Our forward-looking
statements are based on management's current intent, belief, expectations,
estimates and projections regarding our company and our industry. Forward-
looking statements are subject to known and unknown risks and uncertainties,
including those described in our Annual Report on Form 10-K for the fiscal year
ended January 2, 2005. Forward-looking statements include statements regarding
our ability to continue our expansion strategy, our ability to make projected
capital expenditures and our ability to achieve cost savings in connection with
our acquisition of Hollywood, as well as general market conditions, competition
and pricing.
Our forward-looking statements are subject to risks and uncertainties that
could cause actual results to differ materially, including that:
- - we may not successfully integrate the operations of Hollywood into our
operations and may be subjected to liabilities as a result of our acquisition
of Hollywood;
- - our management information systems may fail to perform as expected;
- - we may fail to manage merchandise inventory effectively;
- - movie studios may alter their current movie distribution practices or
revenue sharing programs;
- - advances in technologies may adversely affect our business;
- - customers may choose to purchase, rather than rent, movies in greater
proportion than anticipated;
- - video game hardware and software manufacturers may fail to introduce new
products in a timely manner; and
- - the other risks described in "Risk Factors" in our Annual Report on Form 10-
K for the fiscal year ended January 2, 2005 and the Registration Statement Form
S-4 filed on July 26, 2005.
In light of these risks, uncertainties and assumptions, the forward-looking
events discussed in this Form 10-Q might not occur. In addition, actual
results could differ materially from those suggested by the forward-looking
statements, and therefore you should not place undue reliance on the forward-
looking statements. We undertake no obligation to publicly update or revise
any forward-looking statements, whether as a result of new information, future
events or otherwise. We desire to take advantage of the "safe harbor"
provisions of the Private Securities Litigation Reform Act of 1995 and in that
regard we caution the readers of this Form 10-Q that the important factors
described in our Annual Report on Form 10-K for the fiscal year ended January
2, 2005, among others, could affect our actual results of operations and may
cause changes in our strategy with the result that our operations and results
may differ materially from those expressed in any forward-looking statements
made by us, or on our behalf.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk represents the risk of loss that may impact our financial position,
operating results, or cash flows due to adverse changes in financial and
commodity market prices and rates. We have entered into certain market-risk-
sensitive financial instruments for other than trading purposes, principally
short-term and long-term debt.
The interest payable on the Credit Facility is based on variable interest rates
equal to a specified Eurodollar rate or base rate and is therefore affected by
changes in market interest rates. However, as required by the Credit Facility,
we have entered into a two-year interest rate swap to exchange $280 million of
the variable-rate Credit Facility debt for 4.06% fixed rate debt. If variable
base rates were to increase 1%, our interest expense on an annual basis would
increase by approximately $5.7 million on the non-hedged principal based on
both the outstanding balance on the Credit Facility as of October 2, 2005 and
the Credit Facility's mandatory principle payment schedule.
We are exposed to foreign exchange risks associated with our Canadian and
Mexican operations. Historically, Canadian exchange rates have been relatively
stable, and we believe the impact of fluctuations in the currency exchange
rates will be immaterial to our financial position and results of operations.
Based on pro-forma fiscal 2004 results including VHQ, a hypothetical 10% change
in the Canadian exchange rate would not have a significant effect on either our
consolidated financial position or results of operations. Our Mexican
operations are currently limited to six locations. Growth in Mexico in 2005 is
not expected to be significant enough to result in a material impact from
fluctuations in currency exchange rates.
Item 4. Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief
Financial Officer, has evaluated the effectiveness of our disclosure controls
and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under
the Securities Exchange Act of 1934, as amended (the "Exchange Act" )) as of
the end of the period covered by this report. Based on that evaluation, our
Chief Executive Officer and Chief Financial Officer have concluded that, as of
the end of such period, our disclosure controls and procedures are effective.
On April 27, 2005, the Company completed the acquisition of Hollywood, which
the Company believes is material to its results of operations, financial
position and cash flows. Management continues to assess the internal controls
of Hollywood. Other than changes arising out of the Hollywood acquisition,
including the transition of certain financial reporting functions from the
Company's headquarters in Dothan, Alabama to Portland, Oregon, there has been
no significant change in the Company's internal control over financial
reporting during the most recent fiscal quarter that has materially affected,
or are likely to materially affect, the Company's internal control over
financial reporting.
The Company does not expect that its disclosure controls and procedures will
prevent all errors and all fraud. A system of controls and procedures, no
matter how well conceived and operated, can provide only reasonable, not
absolute, assurance that the objectives of the system are met. Because of the
limitations in all such systems, no evaluation can provide absolute assurance
that all control issues and instances of fraud, if any, within the Company have
been detected. Furthermore, the design of any system of controls and procedures
is based in part upon certain assumptions about the likelihood of future
events, and there can be no assurance that any design will succeed in achieving
its stated goals under all potential future conditions, regardless of how
unlikely. Because of these inherent limitations in a cost-effective system of
controls and procedures, misstatements or omissions due to error or fraud may
occur and not be detected.
Part II - Other Information
Item 1. Legal Proceedings
Certain of our subsidiaries have been named in various claims, disputes, legal
actions and other proceedings involving contracts, employment and various other
matters. We believe that we have provided adequate reserves for contingencies
and that the outcome of these matters should not have a material future adverse
effect on our consolidated results of operation, financial condition or
liquidity. At October 2, 2005, the legal contingencies reserve was $8.9 million
of which the acquisition of Hollywood added $8.5 million. At January 2, 2005,
the legal contingencies reserve was $0.3 million.
A negative outcome in certain of the ongoing actions could harm our business,
financial condition, liquidity or results of operations. In addition,
prolonged litigation, regardless of which party prevails, could be costly,
divert management attention or result in increased costs of doing business.
Item 6. Exhibits
a) Exhibits
10.1 First Amendment, dated September 21, 2005 by and among Movie
Gallery, Inc., Movie Gallery Canada, Inc., Wachovia Bank, N.A.,
and Congress Financial Corporation (Canada), to the Credit
Agreement dated April 27, 2005. (Incorporated by Reference from
the Registrant's Current Report on Form 8-K, dated September 21,
2005)
10.2 Second Amendment to the Movie Gallery, Inc. 2003 Stock Plan
(Incorporated by Reference from the Registrant's Current Report
on Form 8-K/A, dated June 9, 2005)
10.3 Form of Employee Restricted Stock Purchase Agreement (service-
based vesting for employees)(Incorporated by Reference from the
Registrant's Current Report on Form 8-K, dated June 9, 2005)
10.4 Form of Non-Employee Director Restricted Stock Purchase
Agreement (for non-employee directors)(Incorporated by Reference
from the Registrant's Current Report on Form 8-K, dated June 9,
2005)
10.5 Form of Employee Restricted Stock Purchase Agreement (one-year
performance based on vesting for employees)(Incorporated by
Reference from the Registrant's Current Report on Form 8-K,
dated June 9, 2005)
10.6 Form of Employee Restricted Stock Purchase Agreement (two-year
performance based vesting for employees)(Incorporated by
Reference from the Registrant's Current Report on Form 8-K,
dated June 9, 2005)
31.1 Certification of Chief Executive Officer Pursuant to Rule 13a-
14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934,
as amended
31.2 Certification of Chief Financial Officer Pursuant to Rule 13a-
14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934,
as amended
32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C
1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C.
1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
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.
Movie Gallery, Inc.
-------------------
(Registrant)
Date: November 11, 2005 /s/ Timothy R. Price
----------------------------
Timothy R. Price,
Executive Vice President and
Chief Financial Officer