UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended January 1, 2006
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)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value (including associated rights to purchase shares
of Series A Junior Participating Preferred Stock or Common Stock)
(Title of class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes [ ] No [X]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes [ ] No [X]
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
The aggregate market value of the common stock held by non-affiliates of the
registrant as of July 3, 2005, was approximately $677,491,200 assuming solely
for purposes of this calculation that all directors and executive officers of
the registrant and all stockholders beneficially owning more than 10% of the
registrant's common stock are "affiliates." This determination of affiliate
status is not necessarily a conclusive determination for other purposes.
The number of shares outstanding of the registrant's common stock as of March
6, 2006 was 32,015,439.
Documents incorporated by reference:
1. Proxy Statement for the 2006 Annual Meeting of Stockholders filed with the
Securities and Exchange Commission (Part III of Form 10-K).
Forward-Looking Statements
This Annual Report on Form 10-K 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 below. In light of these risks, uncertainties and
assumptions, the forward-looking events discussed in this Form 10-K 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-
K that the factors listed in the section of this Form 10-K under the caption
"Item 1A-Risk Factors," 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. We assume no
obligation (and specifically disclaim any such obligation) to update the
following cautionary statements or any other forward-looking statements
contained in this Annual Report on Form 10-K to reflect actual results, changes
in assumptions or other factors affecting such forward-looking statements.
PART I
ITEM 1. BUSINESS
Our Business
We are the second largest North American home entertainment specialty retailer
focused on both rural and suburban markets. We currently own and operate
approximately 4,800 retail stores, located throughout North America, that rent
and sell DVDs, videocassettes and video games. Since our initial public
offering in August 1994, Movie Gallery has grown from 97 stores to our present
size through acquisitions and new store openings. In April 2005, we acquired
industry peer Hollywood Entertainment Corporation, or Hollywood, bringing total
annual revenue for the Company to over $2.6 billion on a pro-forma annual
basis. Movie Gallery's eastern focused rural and secondary market dominance
and Hollywood's western focused prime urban and suburban superstore locations
combine to form a strong nationwide geographical store footprint. We operate
three distinct brands, Movie Gallery, Hollywood Video and Game Crazy.
The Movie Gallery branded stores are located in primarily small towns and
suburban areas of cities with populations generally between 3,000 and 20,000,
where the primary competitors are typically independently owned stores and
small regional chains. The average size of a Movie Gallery store is
approximately 4,200 square feet and carries a broad selection of between 2,700
and 16,000 movies and video games for rental as well as new and used movies and
games for sale at competitive prices.
The Hollywood Video branded stores are typically located in high-traffic, high
visibility, urban and suburban locations with convenient access and parking.
Hollywood focuses on providing a superior selection of movies and games for
rent, as well as new and used movies and video games for sale. The average
Hollywood Video store is approximately 6,600 square feet and typically carries
more than 25,000 movies and video games.
The Game Crazy branded locations are dedicated game retail departments located
primarily within Hollywood Video stores. As of January 1, 2006, 648 Hollywood
Video stores included an in-store Game Crazy department where game enthusiasts
can buy, sell and trade new and used video game hardware, software and
accessories. A typical Game Crazy department carries over 9,000 new and used
video games, hardware and accessories and occupies an area of approximately 700
to 900 square feet within the store. In addition, as of January 1, 2006,
Hollywood has 20 free-standing Game Crazy stores.
Industry Overview
Home Video Industry
The home video retail industry includes the sale and rental of movies by
traditional video store retailers, online retailers, subscription rental
retailers, mass merchants and other retailers. A number of industry-wide
factors have combined to impact the rental market: weak title lineup; weak box
office revenues and declining attendance at movie theaters; cannibalization of
rental by low-priced movies available for sale; growth of the on-line rental
segment; the standard DVD format nearing the end of its life cycle; competing
high definition DVD formats delaying content release and consumer acceptance;
and the proliferation of alternative consumer entertainment options including
video-on-demand, TIVO/DVR, digital cable, satellite TV, broadband, internet and
broadcast.
In spite of these dynamics, we believe home video will remain a significant
business. The consolidation of independent operators has driven a growing
market share to industry leaders, a trend we believe will continue. Many
consumers continue to prefer the in-store retail shopping experience. Movie
rentals remain one of the least expensive forms of entertainment and offer a
significant value proposition. Accordingly, we believe a large segment of the
population prefers renting to purchasing home entertainment media.
The movie studios' current movie distribution practice provides an exclusive
window for movie retail channels before a movie is available to pay-per view,
video-on-demand and other distribution channels. Home video rental serves an
important role for the studios and is a key risk mitigation tool. On average,
box office receipts do not cover the production and marketing costs for the
studios. Because the home video retail industry represents the single largest
source of revenue to movie studios by a large margin, we expect studios to
continue to release movies to retail channels before they are available to
other distribution channels, which we believe reduces the threat to our
business posed by these channels.
Although the movie rental industry is facing increased competition from other
forms of entertainment, we believe there continue to be significant
opportunities in the industry for the following reasons:
Exclusive Rental Window
As a result of the importance of the video retail industry to the movie
studios' revenue base, the home video rental and sell-through markets enjoy a
period of time during which they have the exclusive rights to distribute a
movie. This period of exclusivity has been in place since the mid 1980s. The
period typically begins after a film finishes its domestic theatrical run
(usually four to six months after its debut), or upon its release to video in
the case of direct-to-video releases, and lasts for 30 to 60 days thereafter.
This period of exclusivity is intended to maximize revenue to the movie studio
prior to a movie being released to other less profitable distribution channels,
including pay-per-view, video-on-demand, premium or pay cable and other
television distribution, and provides what we believe is a significant
competitive advantage for the rental retail channel. Exclusive windows have
historically been used to protect each distribution channel from downstream
channels, principally protecting theaters from home video, home video from pay-
per-view or video-on-demand, and pay-per-view or video-on-demand from premium
cable and other television channels. The exclusive home video window protects
both mass merchants who sell videos and video retailers who rent videos. While
the studios are now testing concurrent theatrical and home video releases on an
experimental basis for certain "B" titles in selected genres, and while the
windows may compress further, we believe the studios remain opposed to broad
scale modifications to the release window in order to maximize their overall
economics. Therefore, we believe the studios will preserve the exclusive rental
window for the home video distribution channel.
New Release Movie Pricing to Home Video Retailers
In 1998, the major studios and several large home video retailers, including
Movie Gallery and Hollywood, began entering into revenue sharing arrangements
as an alternative to the historical rental pricing structures, which required
home video retailers to purchase all titles for rental or sell-through. Under
these arrangements, we pay movie studios a significantly reduced price per copy
and in return share with the studios an agreed percentage of our rental revenue
for a limited period of time, usually 26 weeks. We believe that there are
considerable advantages to revenue sharing, including the ability to improve
availability and thus customer satisfaction. We have revenue sharing
arrangements with a number of studios, with more than half of our new movie
release rental revenue in 2005 having been generated under revenue sharing
arrangements.
Video Game Industry
Consumer Spending
According to Kagan Research, LLC, or Kagan, the video game industry was an
approximately $11.3 billion market in the United States in 2005, with software
accounting for $6.5 billion and hardware and accessories accounting for $4.8
billion.
Hardware and Software
In 2000 and 2001, three new-generation hardware platforms, Nintendo's GameCube,
Sony's PlayStation 2 and Microsoft's XBOX, were introduced. The popularity of
these platforms has substantially increased the number of video game hardware
units in use and has driven significant growth in the video game software
segment in recent years. Further video game hardware and software expansion
has been driven by the 2005 release of the Microsoft XBOX 360 and Sony PSP
handheld system. According to Kagan, the video game software industry grew
4.9% to approximately $6.5 billion in 2005 compared to 2004. Hardware sales,
according to Kagan, were up 38.9% for 2005 due to the release of the Sony PSP
and Microsoft XBOX 360. We anticipate additional next generation hardware to be
introduced in 2006 with Sony's PS3 and Nintendo's Revolution consoles. We
expect that these new hardware platform introductions will drive further growth
in software sales and rentals.
Game Hardware Platform Technology
Hardware platform technology continues to evolve. The early products launched
in the 1980s had only 8-bit processing speeds compared to the hardware
available today, Sony Playstation 2, Microsoft XBOX and Nintendo Game Cube,
which have 128-bit processing speeds, and in the case of the Microsoft XBOX 360
have over 256-bit processing speeds. Advances in processing speed and data
storage significantly improved graphics and audio quality, which has led to the
creation of more exciting games. In addition, new hardware technology is
available with capabilities beyond gaming, such as playing DVD movies and
providing Internet connectivity. Sony's PS3 consoles, projected to be
introduced in 2006, will come equipped to play high definition Blu-Ray DVD
movies. We expect these advances will attract new game players and encourage
existing game players to upgrade their systems.
Viable and Growing Used Games Market
Video game retailers have benefited from the rapid growth of the used video
game market over the last few years. Used titles are more profitable because
margins on used video games are significantly higher than on new video games.
The introduction of the three new-generation hardware platforms has created a
greater supply and demand of used legacy games as some gamers switch to the new
platforms and trade in legacy games, while others seek to extend the lives of
legacy systems by purchasing used legacy games. At the same time, the high
price of new video games for the latest platforms has increased the perceived
value of used game software compatible with the new systems. As a result, we
believe the used video game market will increase as consumers increasingly look
to realize the trade-in value of products they already own when making new
purchases.
New Stores.
To enhance liquidity, we currently expect that we will open only our current
committed pipeline of approximately 140 new stores in 2006, primarily in rural
and suburban markets. We also expect to purchase 20 Hollywood Video stores and
17 Game Crazy stores currently owned by Boards Video Company LLC, pursuant to a
put option contained in the license agreement for these stores. See
Management's Discussion and Analysis of Financial Condition and Results of
Operations, "Other Acquistions." We do not plan to open any additional stores
in the next several years, as we focus our resources on debt retirement.
Pursuing Consolidation Opportunities.
Although we have grown from 97 stores to our present size through acquisitions
and new store openings, future profitability will be driven by moving
aggressively to adjust the size our existing real estate portfolio.
We believe that the size of our stores can be reduced for Hollywood from
approximately 6,600 square feet to approximately 4,000 square feet and for
Movie Gallery from approximately 4,200 square feet to approximately 3,000
square feet. This is a three-pronged strategy which includes allowing larger
store leases to expire, returning portions of existing stores to landlords and
subleasing wherever possible.
The following table is a historical summary showing store openings,
acquisitions and store closings since the beginning of fiscal 2001.
Fiscal Year Ended
------------------------------------------------------
January 6, January 5, January 4, January 2, January 1,
2002(1) 2003 2004 2005 2006(2)(3)
--------------------------------------------------------
Opened 77 145 241 314 288
Acquired 355 265 170 74 2,138
Closed 37 41 37 64 159
----------------------------------------------------
Total stores
at end of
period 1,415 1,784 2,158 2,482 4,749
====================================================
(1) Reflects the December 2001 acquisition of 324 Video Update stores.
(2) Reflects the April 2005 acquisition of 2,031 Hollywood Video stores and 20
freestanding Game Crazy stores; Reflects the May 2005 acquisition of 61 VHQ
stores; Reflects the acquisition of 26 stores in other acquisitions.
(3) Reflects the closure of 64 Movie Gallery stores whose trade areas
overlapped with acquired Hollywood Video stores. See Management's Discussion
and Analysis of Financial Condition and Results of Operations, "Operating Costs
and Expenses". We will continue to evaluate alternatives such as these as
market conditions warrant.
Operating Segments
Upon acquisition of Hollywood, we began to assess performance and operate our
business in 3 operating segments: Hollywood Video, Movie Gallery, and Game
Crazy. For financial information for each reportable segment, refer to Note 12
Segment Reporting and Geographic Information for the Notes to Consolidated
Financial Statements.
Products
Movie Gallery and Hollywood Video Stores
Our Movie Gallery and Hollywood Video stores offer a wide selection of movies
and video games for rent and sale. Depending upon location, our Movie Gallery
stores typically carry from 2,700 to 16,000 movies and video games, while our
Hollywood Video stores typically carry more than 25,000 movies and video games.
Our video stores contain a combination of new releases and older "catalog"
movies and games. Excluding new releases, movie titles are often classified
into categories, such as "Action," "Comedy," "Drama" and "Children," and are
displayed alphabetically within those categories. We rent video games primarily
for Sony Playstation 1 & 2, Microsoft XBOX 360 and XBOX and Nintendo Game Cube.
Our video stores contributed 89% of total revenue in 2005. Revenue from rental
products, including rental and sale of previously viewed movies and video
games, represented approximately 82% of total revenue for 2005. Rental revenue
is dominated by DVD rentals and the sale of previously viewed DVDs. Our ability
to sell previously viewed movies at lower prices than new movies provides a
competitive advantage over mass-market retailers. With the significant growth
in DVD player penetration over the past few years we believe DVD player
penetration has reached market saturation. The remaining approximately 7% of
total revenue from video stores was from the sale of new DVDs and
videocassettes and concessions such as popcorn, sodas, candy and magazines.
Game Crazy
Game Crazy, which consists primarily of our Hollywood Video in-store game
departments where consumers buy, sell and trade new and used video game
software, hardware and accessories, contributed 11% of our total revenue for
2005. Each Game Crazy typically carries over 9,000 units of new and used video
games, hardware and accessories for all major new and legacy game systems. We
offer new and used Sony Playstation 2 and PSP, Microsoft XBOX 360 and XBOX,
Nintendo Game Cube, Dual Screen, Game Boy Advance and Game Boy hardware systems
as well a broad selection of used legacy hardware systems. In addition, we
offer new and used game accessories such as controllers, memory cards and game
media such as strategy guides. Revenue from new and used software represented
64% of Game Crazy revenue for 2005, while 36% was from new and used hardware
and accessories. Beginning in November, 2005, we began exploring various
strategic alternatives for Game Crazy, which include a potential sale,
strategic partnership, or joint venture.
Our revenues by product category for the last three fiscal years were as
follows:
2003 2004 2005
---- ---- ----
DVD rentals 38% 58% 54%
VHS rentals 32% 12% 7%
Game rentals 9% 8% 7%
Previously view rental
sales (DVD, VHS and games) 12% 14% 14%
New and used game product sales 1% 1% 11%
Movie product sales 4% 3% 3%
Concessions, accessories and other 4% 4% 4%
Store Operations
Video store managers report to district managers, who supervise the operations
of the stores. The district managers report to regional managers, who report
directly to the Vice President of Operations for each zone. The corporate
support staff periodically has meetings with zone personnel, regional managers,
district managers and store managers to review operations.
The Game Crazy store level operators report to Game Crazy district managers,
who in turn report to regional managers with responsibility for both Hollywood
and Game Crazy brands. We have made a concerted effort through our established
recruiting and training process to hire sales associates who are game
enthusiasts. This is particularly important in the video game industry, which
requires product knowledge on a large and growing number of titles and hardware
platforms. We have attracted a staff of dedicated gamers for our Game Crazy
departments who provide attentive customer service and possess knowledge of the
industry.
The Movie Gallery and Hollywood Video brands are managed by separate store
operations management teams. In 2005, the Game Crazy regional managers and
Vice President of Operations were consolidated into the Hollywood Video store
operations management organization resulting in a reduction of management
headcount and cost savings. We are analyzing future opportunities to
consolidate store operations management across the three brands.
Marketing and Advertising
We use market development funds, cooperative allowances from our suppliers and
movie studios, and internal funds to purchase direct mail, newspaper
advertising, free-standing newspaper inserts, in-store visual merchandising and
in-store media. Through the use of market development funds, our trade name is
promoted along with a video or game title. Creative copy is prepared by us in
conjunction with the movie studios and is placed by our in-house media buyers
in the appropriate medium. We also prepare monthly consumer magazines, Video
Buzz, Movie Companion and Gamers Edge and a customized video program, MGTV, all
of which feature promotional programs and new releases for each brand. Along
with these traditional forms of advertising, we have developed and implemented
a customer loyalty program, Reel Players, in our Movie Gallery stores. The
program is based on a point system that provides customers the opportunity to
earn free rentals and discounts on movie purchases. We believe that our
current marketing strategy is the most productive and cost effective manner to
increase customer visits. We currently have a customer transaction database
containing information on over 74 million household member accounts, which
enables targeted marketing based on historical usage patterns.
From time to time we conduct special promotions in our stores to drive customer
visits. For example, periodically we offer promotional and prepaid rental and
discount card programs that provide our customers greater discounts on
rentals. We have also conducted nationwide trivia games and we occasionally
partner with other major businesses such as concession vendors, to help build
additional revenue and increase our brand awareness to potential customers.
The Movie Gallery and Hollywood marketing and advertising efforts are currently
managed by separate marketing departments in the Alabama and Oregon support
centers. We are analyzing future opportunities to consolidate these efforts
for the three brands.
Suppliers and Purchasing Agreements
We purchase the majority of our movies directly from the studios through
revenue sharing arrangements or other direct purchasing methods, and we
purchase a majority of our video games directly from video game publishers,
except for used games, which are received on trade directly from our customers.
We expect that in 2006, most movie and video game purchasing functions will be
consolidated into our Oregon support center.
Inventory and Information Management
Inventory Management
We are currently running separate legacy point-of-sale and merchandising
systems in the Movie Gallery and Hollywood stores. Each point-of-sale and
merchandising system was developed specifically to address the needs of the
brands when the companies were separate. The systems provide similar levels of
detail information for inventory management purposes.
Movie Gallery
New movies offered for sale are primarily hit titles promoted by the studios
for sell-through, as well as special interest and children's titles and
seasonal titles related to particular holidays.
New release movie and game products are allocated to individual Movie Gallery
stores through a system that considers the revenue levels and customer
demographic profiles of each store. Rental history on movie titles is captured
for each store and used as a comparison point for future titles of a similar
genre. During the fourth quarter of 2005, we completed the consolidation of
substantially all distribution functions to the Oregon and Tennessee
distribution centers, which were acquired in the Hollywood acquisition. Our
inventory of movies and video games for rental is prepared rental-ready for
merchandising in our stores. Each new movie and video game is shipped in a
locking case from the studio, bar coded and distributed to the stores.
Hollywood Video and Game Crazy
We maintain detailed information on inventory utilization in our Hollywood and
Game Crazy departments. Our information systems enable us to track rental
activity by individual movie and video game to determine appropriate buying,
distribution, pricing and disposition of inventory, including the sale of
previously viewed product. Our inventory of movies and video games for rental
is prepared rental-ready for merchandising in our stores. Each new movie and
video game is shipped in a locking case from the studio, bar coded and
distributed to the stores. Our Game Crazy departments utilize their own
independent inventory system with enhanced functionality that allows us to
manage used product trade-in credit values and retail pricing based upon
multiple factors such as age and current inventory levels. Game Crazy's point-
of-sale system provides us with sufficient detail to manage our breadth of
titles and maintain in-stock positions with frequent replenishment cycles. The
inventory system also permits us to match supply with demand title-by-title,
adjust ordering, transfer inventories from one store location to another and
manage new and used title pricing. As we integrate the purchasing and
distribution functions, we are analyzing future opportunities to consolidate
over time point-of-sale and merchandising systems for the three brands.
Information Management
Movie Gallery
Our Movie Gallery stores utilize a proprietary point-of-sale (POS) system
developed by us. Our POS system provides detailed information on store
operations, including the rental history of titles and daily operations for
each store, which is telecommunicated to our support center on a daily or
weekly basis. Our POS system is installed in all new stores prior to opening
and shortly after the closing date for acquired stores.
All rental and sale information upon customer checkout and return is recorded
using scanned bar code information. All transactional data is transmitted into
the management information system at the Alabama support center. The data is
processed and reports are generated that allow management to effectively
monitor store operations and inventory, to review rental history by title and
location and to assist in making purchasing decisions with respect to new
releases. Our POS system enables us to perform our regular physical
inventories during normal store hours using bar code recognition, to process
human resource information and to provide system-based training modules.
Hollywood Video and Game Crazy
We use a scalable client-server system and maintain an integrated point-of-sale
system for Hollywood Video and Game Crazy and a corporate information system.
The upgrade and integration of the Hollywood Video and Game Crazy point-of-sale
systems was completed in 2005. We maintain information, updated daily,
regarding revenue, current and historical rental and sales activity, store
membership demographics, individual customer histories, and DVD, videocassette
and video game rental patterns. This system allows us to measure our current
performance, manage inventory, make purchasing decisions and manage labor
costs; it also enables us to continue to improve customer service, operational
efficiency, and management's ability to monitor critical performance factors.
Competition
The video retail industry is highly competitive. We compete with local,
regional and national video retail stores, including Blockbuster; mail-delivery
video rental subscription services, such as Netflix and Blockbuster Online;
mass merchants, supermarkets, pharmacies, convenience stores, bookstores and
other retailers; and non-commercial sources such as libraries.
We believe that the principal competitive factors in the video rental industry
are price, title selection, rental period, the number of copies of popular
titles available, store location and visibility, customer service and employee
friendliness, and convenience of store access and parking. Substantially all of
our Hollywood brand stores compete with stores operated by Blockbuster, most in
very close proximity. Our Movie Gallery brand stores generally operate in a
less competitive environment against local and regional competitors.
We also compete with cable, satellite, and pay-per-view television systems.
Digital cable and digital satellite services have continued to increase
penetration; we estimate that cable or satellite is available in over 90
million households. These systems offer multiple channels dedicated to pay-per-
view and in some cases, video-on-demand, and allow some of our competitors to
transmit a significant number of movies to consumers' homes at frequent
intervals.
The video game industry is highly fragmented. With the possible exception of
Wal-Mart and GameStop, we believe no major player holds more than a 20% share
of the market. Video game software and hardware is typically sold through
retail channels, including specialty retailers, mass merchants, toy retail
chains, consumer electronic retailers, computer stores, regional chains,
wholesale clubs, via the Internet and through mail order. Specialty retail
chains that feature an educated game staff, such as GameStop, are our chief
competitors in the used game market
Seasonality
There is a distinct seasonal pattern to the home video and game retail
business. Compared to other months during the year, we typically 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 consumers with additional
discretionary time to spend on entertainment. September is typically the
lowest revenue period with schools back in session and the premiere of "new"
fall broadcast television programs. Game Crazy experiences more traditional
retail revenue peaks, which are more significantly weighted towards holiday
periods and when schools are out of session.
Intellectual Property
We own a number of United States and international service mark registrations,
including the marks "Movie Gallery," "Hollywood Video," and "Game Crazy." We
consider our service marks important to our continued success.
Foreign Operations
For disclosure of enterprise-wide financial information by geographic area, see
Note 12, "Segment Reporting and Geographic Information," of the Notes to
Consolidated Financial Statements.
Employees
As of February 28, 2006, we employed approximately 45,873 associates, including
approximately 44,017 in retail stores, with the remainder in our support
centers, field management staff and distribution facilities. Of our retail
associates, approximately 7,488 were full-time and 36,529 were part-time. None
of our associates are represented by a labor union, and we believe that our
relations with our associates are good.
We have developed internal hiring, training and retention programs designed to
enhance consistent and thorough communication of our operating policies and
procedures, as well as increase the rate of internal promotions. We also have
an incentive and discretionary bonus program under which retail management
associates receive quarterly bonuses when stores meet or exceed criteria
established under the program. Additionally, we have periodic sales and
marketing programs that provide our associates opportunities to earn
incremental bonus compensation based on relative performance to pre-established
goals and to actual performance compared to other associates. We believe our
bonus programs reward excellence in management, give associates an incentive to
improve operations and result in an overall reduction in the cost of
operations. In addition, certain associates are eligible to receive bonuses
based on individual and overall company performance.
Available Information
The address of our internet website is www.moviegallery.com. Through links on
the Investor Relations portion of our website, we make available free of charge
our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports
on Form 8-K, and any amendments to those reports, filed or furnished pursuant
to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. Such
material is made available through our website as soon as reasonably
practicable after we electronically file or furnish the material with the
Securities and Exchange Commission, or the SEC.
You may also read and copy any materials we file with the SEC at the SEC's
Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. You may
obtain information on the operation of the Public Reference Room by calling the
SEC at 1-800-SEC-0330. Additionally, the SEC maintains a website that contains
reports, proxy and information statements and other information regarding Movie
Gallery at www.sec.gov.
Directors and Executive Officers
The following table sets forth the name, age and position held by each of our
executive officers and directors, as of February 28, 2006:
Name Age Position(s) Held
- ----------------- --- -------------------------------------------------------
J.T. Malugen 54 Chairman of the Board, President and Chief Executive
Officer
H. Harrison 57 Vice Chairman of the Board and Senior Vice President -
Parrish Concessions
Jeffrey S. Stubbs 43 Executive Vice President and Chief Operating Officer -
Movie Gallery Division
S. Page Todd 44 Executive Vice President - Secretary, General Counsel
and Chief Compliance Officer
Mark S. Loyd 50 Executive Vice President and Chief Administrative
Officer - Movie Gallery Division
Keith A. Cousins 37 Executive Vice President and Chief Development Officer
Timothy R. Price 47 Executive Vice President and Chief Financial Officer
Silvio D. Piccini 43 Executive Vice President and Chief Merchandising
Officer
Thomas D. Johnson 42 Senior Vice President - Corporate Finance and Business
Jr. Development
John J.
Jump (1)(2)(3) 54 Director
William B.
Snow (1)(2)(3) 74 Director
James C.
Lockwood (1)(2)(3) 68 Director
(1) Member of Compensation Committee
(2) Member of Audit Committee
(3) Member of Nominating Committee
Mr. Malugen co-founded Movie Gallery in 1985 and has been our Chairman of the
Board and Chief Executive Officer since that time. Mr. Malugen was appointed
President effective January 4, 2002. Prior to our initial public offering in
August 1994, Mr. Malugen had been a practicing attorney in the states of
Alabama and Missouri since 1978 but spent a majority of his time managing the
operations of Movie Gallery beginning in early 1992. Mr. Malugen received a
B.S. degree in Business Administration from the University of Missouri-
Columbia, his J.D. from Cumberland School of Law, Samford University and his
LL.M.(in Taxation) from New York University School of Law.
Mr. Parrish co-founded Movie Gallery in 1985 and has served as a Director since
that time. He was elected Vice Chairman of the Board in June 2002. Mr.
Parrish served as President of Movie Gallery from 1985 until his resignation on
January 4, 2002, at which time Mr. Parrish assumed the position of Senior Vice
President - Concessions. Mr. Parrish received a B.A. degree in Business
Administration from The University of Alabama.
Mr. Stubbs joined Movie Gallery in November 1995 and served as Regional Manager
over Texas, Louisiana and Mississippi until being elected Senior Vice President
- - Operations in November 1997. He was elected Executive Vice President -
Operations in April 2001 and Chief Operating Officer in April 2004. Prior to
joining Movie Gallery, Mr. Stubbs served as Vice President and General Manager
of A.W.C. Corporation, a video specialty and restaurant retailer in east Texas,
from 1987 to 1995. He also has eight years of experience in grocery and
convenience store management. Mr. Stubbs attended Texas A&M University and
graduated from Southwest Texas State University, where he received a B.B.A.
degree in Business Administration and Marketing.
Mr. Todd was elected Senior Vice President, Secretary and General Counsel in
December 1994 and was promoted to Executive Vice President in April 2003. Mr.
Todd was named Movie Gallery's Chief Compliance Officer in April 2004. Prior
to joining Movie Gallery, Mr. Todd practiced tax and corporate law in Dothan,
Alabama. Mr. Todd received a B.S. degree in Business Administration from The
University of Alabama, his J.D. from The University of Alabama School of Law
and his LL.M. (in Taxation) from New York University School of Law.
Mr. Loyd joined Movie Gallery in August 1986 and has served as the retail store
coordinator as well as Vice President - Purchasing and Product Management. In
October 1996, he was elected Senior Vice President - Purchasing and Product
Management and was promoted to Executive Vice President in April 2003. In
April 2004, Mr. Loyd was named Movie Gallery's Chief Administrative Officer.
Mr. Loyd attended Southeast Missouri State University, where he majored in
Business Administration.
Mr. Cousins joined Movie Gallery in August 1998 as Senior Director of
Development, Planning and Analysis. Mr. Cousins was elected Senior Vice
President - Development in March 1999. He was promoted to Executive Vice
President - Development in April 2004 and was named Chief Development Officer
in February 2006. Prior to joining Movie Gallery, Mr. Cousins had four years
of management consulting experience with Computer Sciences Corporation as
Program Control Manager; Management Consulting and Research, Inc. as Cost
Analyst; and Telecolote Research, Inc. as Advanced Cost Estimator. He also has
seven years of real estate and property management experience as Senior
Director of Development for KinderCare Learning Centers, Inc. and as Senior
Accountant with Aronov Realty Management Co., Inc. Mr. Cousins received a B.S.
degree in Business Administration from Auburn University at Montgomery.
Mr. Price joined Movie Gallery in April 2005, retaining his position as Senior
Vice President and Chief Financial Officer of Hollywood Entertainment
Corporation. Mr. Price was elected Executive Vice President and Chief
Financial Officer for the combined company in July 2005. Mr. Price joined
Hollywood in January 2003 as Senior Vice President of Finance and was named
Chief Financial Officer in July 2003. Prior to joining Hollywood, Mr. Price was
with May Company for four years holding the positions of Chief Financial
Officer for Robinson's-May from 2000 to 2002 and Vice President and Controller
of Hecht's from 1998 to 2000. Prior to the May Company, Mr. Price served as
Vice President and Controller of Kohl's from 1996 to 1998 and held a variety of
financial executive positions at The Limited from 1988 to 1996.
Mr. Piccini joined Movie Gallery in April 2005, retaining his position as
Senior Vice President Merchandising for the Hollywood brand. Mr. Piccini was
elected Executive Vice President and Chief Merchandising Officer for Movie
Gallery in July 2005. Mr. Piccini joined Hollywood in 1996 as Vice President
of Operations-Southern Region when Hollywood had 477 stores. Subsequently he
assumed the role of Vice President of Planning and Allocation and in 2000 was
promoted to Senior Vice President of Merchandising overseeing all product
merchandising. Prior to joining Hollywood, Mr. Piccini was a partner in Tex-
Chex, Inc., a restaurant franchise company. Prior to that, Mr. Piccini spent
seven years at Taco Bell, then a subsidiary of PepsiCo, in increasing roles of
responsibility including store operations, real estate development and
franchise operations. Mr. Piccini received his B.A. in Business and Languages
from the University of Notre Dame and his M.B.A. from the University of
Florida.
Mr. Johnson joined Movie Gallery in April 2004 as Senior Vice President
Investor Relations and was named Senior Vice President Corporate Finance and
Business Development in January 2005. Mr. Johnson has nearly 20 years of
experience in the securities industry and in April 2004 he joined Movie Gallery
from Russell Corporation (NYSE: RML) in Atlanta, GA where he led their investor
relations program. Prior to Russell, Mr. Johnson directed the investor
relations for Wolverine Tube, Inc., Blount International, Inc. and KinderCare
Learning Centers, Inc. In addition to his responsibilities for investor
relations, Mr. Johnson was the assistant treasurer at Wolverine Tube and while
at KinderCare Mr. Johnson also responsible for the Company's Marketing as
well as the Financial Planning and Analysis departments. Prior to that, Mr.
Johnson spent four years as a securities analyst with the Alabama Securities
Commission. Mr. Johnson holds a MBA from the University of Alabama and a
B.S. degree in business administration from Auburn University at Montgomery.
Mr. Jump became a director of Movie Gallery in June 2003. He is the President
and Owner of Jump Start Promotions, a specialty advertising business that he
founded in September 2000. Since August 2002, he has also served as Business
Manager, Operations for Convergys Corporation. Mr. Jump currently is a
Managing Partner for Foodservice Equipment Brokers of MO., Inc. Mr. Jump
served as Chairman of the Board of Directors of Video Update, Inc. from May
2001 until December 2001, and he served as its interim Chief Executive Officer
from November 2001 until December 2001. Mr. Jump served as Executive Vice
President, Sales and Marketing of Sight and Sound Distributors, Inc., a home
video distribution company, from 1985 to 2000. Mr. Jump received a B.A. degree
in Psychology from the University of Missouri at St. Louis.
Mr. Snow became a director of Movie Gallery in July 1994. He served as Vice
Chairman of the Board from July 1994 until June 2002, and served as Chief
Financial Officer from July 1994 until May 1996. Mr. Snow was the Executive
Vice President and Chief Financial Officer and a Director of Consolidated
Stores Corporation, a publicly held specialty retailer, from 1985 until he
retired in June 1994. Mr. Snow is a Certified Public Accountant, and he
received his Masters in Business Administration from the Kellogg Graduate
School of Management at Northwestern University and his Masters in Taxation
from DePaul University.
Mr. Lockwood became a director of Movie Gallery in June 2004. He has served as
Vice President, General Counsel and Secretary of Keystone Automotive
Industries, Inc., a publicly held distributor of aftermarket collision
replacement parts, since 1997. From 1985 until 1997, Mr. Lockwood was a member
of the law firm of Troy and Gould. Mr. Lockwood was an investment banker with
Montgomery Securities from 1984-1985. Mr. Lockwood received a B.S. degree in
Chemical Engineering from the Georgia Institute of Technology, and his J.D.
from the University of Michigan.
Directors are elected to serve until our next annual meeting of stockholders or
until their successors are elected and qualified. Officers serve at the
discretion of our Board of Directors, subject to any contracts of employment.
Director compensation was modified in 2005. Non-employee directors receive an
annual fee of $48,000, a fee of $2,000 for each Board meeting attended in
person and a $1,000 fee for each telephonic Board meeting in which the director
participates. Fees for each Audit committee meeting will be $2,500 for the
chairman of the committee and $1,500 for each other committee member. Fees for
each other committee meeting will be $2,000 for the chairman of the committee
and $1,000 for each other committee member. We have granted vested options to
purchase shares of our common stock to each of the non-employee directors, in
each case at the fair market value of the common stock on the date of grant.
In addition, we have granted restricted stock with a one-year vesting period to
each of the non-employee directors.
Item 1A. RISK FACTORS
We have a significant amount of indebtedness, which may limit our operating
flexibility.
As of January 1, 2006, we had approximately $1,161.2 million of indebtedness,
consisting primarily of borrowings under our senior credit facility and our 11%
Senior Notes due 2012, or the senior notes.
Our high level of indebtedness could have important consequences to you,
including the following:
- - it may be difficult for us to satisfy our obligations with respect to our
indebtedness;
- - our ability to obtain additional financing for working capital, capital
expenditures, or general corporate or other purposes may be impaired;
- - a substantial portion of our cash flow from operations must be dedicated to
the payment of principal and interest on our indebtedness, reducing the
funds available to us for other purposes;
- - cause our trade creditors to change their terms for payment on goods and
services provided to us, thereby negatively impacting our ability to
receive products and services on acceptable terms;
- - it may place us at a competitive disadvantage compared to our competitors
that have less debt or are less leveraged; and
- - we may be more vulnerable to economic downturns, may be limited in our
ability to respond to competitive pressures and may have reduced
flexibility in responding to changing business, regulatory and economic
conditions.
Our ability to pay interest on and to satisfy our other debt obligations will
depend upon, among other things, our future operating performance and our
ability to refinance indebtedness when necessary. Each of these factors is, to
a large extent, dependent upon economic, financial, competitive and other
factors beyond our control. If, in the future, we cannot generate sufficient
cash from operations to meet our debt obligations, we will need to refinance
our existing debt, obtain additional financing or sell assets. We cannot assure
you that our business will generate sufficient cash flows to satisfy our
existing indebtedness obligations or that funding sufficient to satisfy our
debt service requirements will be available on satisfactory terms, if at all.
We may be unsuccessful in executing our plan to reduce our level of
indebtedness and return to profitability.
Our plan to reduce our level of indebtedness and return to profitability
includes, among other things, taking advantage of synergies arising out of the
Hollywood acquisition, closing overlapping stores and reducing store sizes.
Our plan also involves our disposal of certain non-core assets in order to
generate proceeds to repay indebtedness. We may be unable to identify buyers
for these assets or negotiate for their sale on terms that are satisfactory, if
at all. If we are unable to successfully execute our plan to reduce our level
of indebtedness, the interest expense associated with this indebtedness will
adversely affect our results of operations.
We require a significant amount of cash, which may not be available to us.
Our ability to make payments on, repay or refinance our debt, to fund planned
capital expenditures and to generate sufficient working capital to operate our
business will depend largely upon our future operating performance. Our future
performance is subject to general economic, financial, competitive,
legislative, regulatory and other factors that are beyond our control. In
addition, our ability to borrow funds depends on the satisfaction of the
covenants in our senior credit facility and our other debt agreements,
including the indenture governing the senior notes, and other agreements we may
enter into in the future. Specifically, our senior credit facility requires us
to maintain certain financial ratios. Additionally, our working capital needs
may increase to the extent that our suppliers are unwilling to extend credit to
us on satisfactory terms. We cannot assure you that our business will generate
sufficient cash flow from operations or that future borrowings will be
available to us under our senior credit facility or from other sources in an
amount sufficient to enable us to pay our debt, fund capital expenditures or to
fund our working capital or other liquidity needs.
Our debt instruments include restrictive and financial covenants that limit our
operating flexibility.
Our senior credit facility requires us to maintain certain financial ratios and
our senior credit facility and the indenture governing the senior notes contain
covenants that, among other things, restrict our ability to take specific
actions, even if we believe such actions are in our best interest. These
include, among other things, restrictions on our ability to:
- - incur indebtedness or issue preferred stock;
- - pay dividends or make other distributions or repurchase or redeem our stock
or subordinated indebtedness or make investments;
- - sell assets and issue capital stock of our subsidiaries;
- - use the proceeds of permitted sales of assets;
- - create liens;
- - enter into agreements restricting our subsidiaries' ability to pay
dividends;
- - enter into transactions with affiliates;
- - engage in new lines of business;
- - consolidate, merge or sell all or substantially all of our assets; and
- - issue guarantees of debt.
While we were in compliance at the end of the fourth quarter 2005 with the
financial covenants contained in our senior credit facility, we obtained an
amendment to the senior credit facility on March 15, 2006 in order to remain in
compliance with those covenants in the near term. This amendment provides
covenant relief for the period ending on December 31, 2006. For the first
quarter of 2007, absent further amendment, the more restrictive financial
covenants contained in the original senior credit facility will apply to us.
Because the most restrictive covenants are computed on a trailing four quarter
basis, we do not expect that we will be in compliance with the first quarter
2007 covenants unless the covenants are further amended or we obtain additional
equity financing by that time. We are exploring several alternative strategies
to remain in compliance with the terms of our senior credit facility,
including, among other things, operational improvements through capitalizing on
merger integration synergy opportunities, raising additional equity, divesting
certain non-core assets and sale/leaseback transactions. We also may be
required to seek further amendments to our senior credit facility. We cannot
assure you that any of these actions will be successful, or that any sales of
assets, additional debt or equity financings or further debt amendments can be
obtained.
Any failure to comply with the restrictions of our senior credit facility, the
indenture governing the senior notes or any subsequent financing agreements may
result in an event of default. Such default may allow our creditors to
accelerate the related debt and may result in the acceleration of any other
debt to which cross-acceleration or cross-default provisions apply. In
addition, these creditors may be able to terminate any commitments they had
made to provide us with further funds. See Management's Discussion and Analysis
of Financial Condition and Results of Operations, "Liquidity and Capital
Resources," for more information on our restrictive and financial covenants.
Limitations in our senior credit facility on making capital expenditures may
prevent us from pursuing new business initiatives, which may place us at a
competitive disadvantage.
Our senior credit facility limits the amount of money that we may spend on
capital expenditures to $35.0 million in 2006 and, subject to certain
exceptions, $17.5 million in subsequent years. We believe that successful
execution of our plan will require us to dedicate substantially all of these
amounts to capital expenditures associated with the continuing integration of
Hollywood and Movie Gallery and required maintenance capital. Accordingly, we
will be unable to make capital expenditures in order to open or acquire a
significant number of new stores or pursue new business initiatives, including
investing in an online rental program or other alternative delivery vehicles.
Our inability to pursue new business initiatives may place us at a disadvantage
to our competitors who are not subject to these restrictions. If our
competitors successfully pursue new business initiatives, these restrictions
may limit our ability to react effectively, and our results of operations or
financial condition could be adversely affected.
Uncertainty surrounding our ability to meet our financial obligations has
adversely impacted and could continue to adversely impact our ability to obtain
sufficient product on favorable terms.
Since our acquisition of Hollywood in April 2005, we have entered into two
amendments of our senior credit facility pursuant to which certain covenants in
our senior credit facility were amended or waived. This, coupled with the
continued declines and uncertainty in the rental industry, has caused negative
publicity surrounding our business. As a result, our flexibility with our
suppliers has been affected. We cannot assure you that our trade creditors will
not further change their terms for payment on goods and services provided to us
or that we will continue to be able to receive products and services on
acceptable terms.
The continuing integration of Hollywood and Movie Gallery may strain our
resources and prove to be difficult and may subject us to liabilities.
On April 27, 2005, we completed our acquisition of Hollywood, which was
substantially larger than any of our previous acquisitions. The expansion of
our business and operations resulting from the acquisition of Hollywood,
including the differences in the cultures, strategies and infrastructures of
our operating segments, may strain our administrative, operational and
financial resources. The continuing integration of Movie Gallery and Hollywood
will require substantial time, effort, attention and dedication of management
resources and may distract management in unpredictable ways from their other
responsibilities. The integration process could create a number of potential
challenges and adverse consequences, including the possible unexpected loss of
key employees or suppliers, a possible loss of sales, an increase in operating
and other costs, possible difficulties in integrating the information
management systems, including point-of-sale, inventory control systems
previously maintained by Hollywood and Movie Gallery and the need to modify
operating accounting controls and procedures to comply with the Sarbanes-Oxley
Act of 2002. These types of challenges and uncertainties could have a
material adverse effect on our business, financial condition, liquidity and
results of operations.
Our business could be adversely affected by increased competition, including
new business initiatives by our competitors.
We compete with:
- - local, regional and national video retail stores, including stores operated
by Blockbuster, Inc., the largest video retailer in the United States;
- - internet-based, mail-delivery home video rental subscription services, such
as Netflix and, recently, Blockbuster Online;
- - mass merchants;
- - specialty retailers, including GameStop and Suncoast;
- - supermarkets, pharmacies, convenience stores, bookstores and other retailers
that rent or sell similar products as a component, rather than the focus, of
their overall business;
- - mail order operations and online stores, including Amazon.com; and
- - noncommercial sources, such as libraries.
Pricing strategies, including Blockbuster's "No Late Fees" program, for movies
and video games are a major competitive factor in the video retail industry and
we have fewer financial and marketing resources, lower market share and less
name recognition than Blockbuster.
Other types of entertainment, such as theaters, television, personal video
recorders, internet related activities, sporting events, and family
entertainment centers, also compete with our movie and video game businesses.
Some of our competitors, such as online stores, mass merchants and warehouse
clubs may operate at margins lower than we do and may be able to distribute and
sell movies at lower price points than we can. These competitors may even be
willing to sell movies below cost due to their broad inventory mix.
If any of our competitors were to substantially increase their presence in the
markets we serve, our revenues and/or profitability could decline, our
financial condition, liquidity, and results of operations could be harmed and
the continued success of our business could be challenged.
Our business could be adversely affected if we lost key members of our
executive management team.
We are highly dependent on the efforts and performance of our executive
management team. If we were to lose any key members of this team, our business
could be adversely affected. You should read the information under "Directors
and Executive Officers" for a detailed description of our executive management
team.
Our business could be adversely affected by the failure of our management
information systems to perform as expected.
We depend on our management information systems for the efficient operation of
our business. Our merchandise operations use our inventory utilization system
to track rental activity by format for each individual movie and video game
title to determine appropriate buying, distribution and disposition of our
inventory. We also rely on a scalable client-server system to maintain and
update information relating to revenue, rental and sales activity, movie and
video game rental patterns, store membership demographics, and individual
customer history. These systems, together with our point-of-sale and in-store
systems, allow us to control our cash flow, keep our in-store inventories at
optimum levels, move our inventory more efficiently and track and record our
performance. If our management information systems failed to perform as
expected, our ability to manage our inventory and monitor our performance could
be adversely affected, which, in turn, could harm our business and financial
condition.
Our financial results could be adversely affected if we are unable to manage
our merchandise inventory effectively.
Our merchandise inventory introduces risks associated with inventory
management, obsolescence and theft. While most of our retail movie product is
returnable to vendors, our investment in inventory necessary to operate our
business increases our exposure to excess inventories in the event anticipated
sales fail to materialize. In addition, returns of video game inventory, which
is prone to obsolescence because of the nature of the industry, are subject to
negotiation with vendors. The prevalence of multiple game platforms may make
it more difficult to accurately predict consumer demand with respect to video
games. The nature of and market for our products, particularly games and DVDs,
also makes them prone to risk of theft and loss.
Specifically, our operating results could suffer if we are unable to:
- - maintain the appropriate levels of inventory to support customer demand
without building excess inventories;
- - obtain or maintain favorable terms from our vendors with respect to payment
and product returns;
- - control shrinkage resulting from theft, loss or obsolescence; and
- - avoid significant inventory excesses that could force us to sell products at
a discount or loss.
Our business could be negatively impacted if movie studios significantly alter
the movie distribution windows.
Studios distribute movies in a specific sequence in order to maximize studio
revenues on each title they release. The order of distribution of movies is
typically: (1) movie theaters; (2) home video retailers; (3) pay-per-view; and
(4) all other sources, including cable and syndicated television. The length
of the movie rental window varies, but is typically 45 days prior to the pay-
per-view release date. The movie studios are not contractually obligated to
continue to observe these window periods. As a result, we cannot be certain
that movie studios will maintain this exclusive window in the future. We could
be adversely affected if the movie studios shorten or eliminate these exclusive
windows, or if the movie rental windows were no longer among the first windows
following the theatrical release, because newly released movies would be made
available earlier through other forms of non-theatrical movie distribution. As
a result, consumers would no longer need to wait until after the home video
distribution window to view these movies through other distribution channels.
Some studios have tested concurrent theatrical and home video releases on an
experimental basis for certain "B" titles in selected genres which could in
turn lead to further compression of the window period that home video retailers
currently enjoy. Changes like these could negatively impact the demand for our
products and reduce our revenues and could harm our business, financial
condition, liquidity, and results of operations.
Our business may be negatively impacted by new and existing technologies.
Advances in technologies that benefit our competitors may materially and
adversely affect our business. For example, advances in cable and direct
broadcast satellite technologies, including high definition digital television
transmissions offered through those systems, and the increasing ease of
downloading video content on the internet may adversely affect public demand
for video store rentals. Expanded content available through these media,
including movies, specialty programming and sporting events, could result in
fewer movies being rented. In addition, higher quality resolution and sound
offered through these services and technologies could require us to increase
capital expenditures, for example, to upgrade our DVD inventories to provide
movies in high definition.
Cable and direct broadcast satellite technologies offer both movie channels,
for which subscribers pay a subscription fee for access to movies selected by
the provider at times selected by the provider, and pay-per-view services, for
which subscribers pay a discrete fee to view a particular movie selected by the
subscriber. Historically, pay-per-view services have offered a limited number
of channels and movies and have offered movies only at scheduled intervals.
Over the past five years, however, advances in digital compression and other
developing technologies have enabled cable and satellite companies, and may
enable internet service providers and others, to transmit a significantly
greater number of movies to homes at more frequently scheduled intervals
throughout the day. Certain cable companies, internet service providers and
others are also testing or offering video-on-demand, (VOD) services. As a
concept, VOD provides a subscriber with the ability to view any movie included
in a catalog of titles maintained by the provider at any time of the day.
If pay-per-view, VOD or any other alternative movie delivery systems achieve
the ability to enable consumers to conveniently view and control the movies
they want to see, when they want to see them, such alternative movie delivery
systems could achieve a competitive advantage over the traditional home video
rental industry. This risk would be exacerbated if these competitors receive
the movies from the studios at the same time video stores do and by the
increased popularity and availability of personal digital recording systems
(such as TiVo) that allow viewers to record, pause, rewind, and fast forward
live broadcasts and create their own personal library of movies.
In addition, we may compete in the future with other distribution or
entertainment technologies that are either in their developmental or testing
phases now or that may be developed in the future. For example, some retailers
have begun to rent or sell DVDs through kiosks or vending machines.
Additionally, the technology exists to offer disposable DVDs, which would allow
a consumer to view a DVD an unlimited number of times during a specified period
of time, at the end of which the DVD becomes unplayable. We cannot predict the
impact that future technologies will have on our business.
If any of the technologies described above creates a competitive advantage for
our competitors, our business, financial condition, liquidity, and results of
operations could be harmed.
Our business could be adversely affected if the trend of consumers deciding to
purchase rather than rent movies continues.
Historically, studios priced a number of movies they distributed at pricing
which was typically too high to generate significant consumer demand to
purchase these movies. A limited number of titles were released at a lower
price point when consumers were believed to be more likely to have a desire to
purchase a certain title. The penetration of DVD into the market has resulted
in a significant increase in the quantity of newly released movies available
for purchase by the consumer. These movies are purchased to rent by home video
specialty retailers, and to sell by both home video specialty retailers and
mass merchants, among others. We believe that these changes in pricing have
led to an increasing number of consumers who decide to purchase, rather than
rent movies. Further changes in studio pricing and/or sustained or further
depressed pricing by competitors could further accelerate this trend and could
result in increased competition. If we are not able to derive most of our
revenues from our higher margin rental business, our profit levels would be
adversely impacted and we may not be able to compete with our competitors for
the consumer's sell-through dollar.
Our business could be adversely impacted if movie studios negatively altered
revenue sharing programs.
Prior to studio revenue sharing programs and the advent of DVD, we would
typically pay between $35 and $65 per videocassette for major theatrical
releases not priced as sell-through titles. Under studio revenue sharing
programs, we are able to pay a minimal up-front cost per unit and thereafter
pay a percentage of each revenue dollar earned for a specified period of time
to the studios. We currently utilize these types of programs for a significant
number of DVD and VHS movie releases. These programs have enabled us to
significantly increase the number of copies carried for each title, thereby
enabling us to better meet consumer demand. After a specified period of time,
we offer them for sale to our customers as "previously viewed movies" at lower
prices than new copies of the movie. We could be adversely affected if these
programs are changed to give the movie studios a greater percentage of each
revenue dollar or if they are discontinued. Further, some of our agreements
may be terminated on short notice.
Our gross margins may be adversely affected if the average sales price for our
previously viewed product is not at or above an expected price.
We earn rental revenues from video rentals and from the sale of previously
viewed movies to the public. We need to sell previously viewed movies at an
expected price in order to achieve our gross margin targets. Our gross margins
may be adversely affected if the number of rentals we expect to generate does
not materialize or if the average sales price for previously viewed movies is
not at or above our target price.
A consumer's desire to own a particular movie and the number of previously
viewed movies available for sale to the public by our competitors are factors
that affect our ability to sell previously viewed movies at our target price.
Additionally, sales of previously viewed movies also compete with newly
released movies that are priced for sell-through. As a result, there are no
assurances that we will be able to sell an appropriate quantity of previously
viewed movies at or above the expected price. If selling prices for previously
viewed movies or previously played games decline, we may be required to write-
down the carrying value of our rental inventory.
The video store industry could be adversely affected by conditions impacting
the motion picture industry.
The availability of new movies produced by the movie studios is vital to our
industry. The quality and quantity of new movies available in our stores could
be negatively impacted by factors that adversely affect the motion picture
industry, such as financial difficulties, regulatory requirements and work
disruptions involving key personnel such as writers or actors. Additionally,
we depend on the movie studios to produce new movies that appeal to consumer
tastes. A decrease in the quality and quantity of new movies available in our
stores could result in reduced consumer demand, which could negatively impact
our revenues and harm our business and financial position.
Our revenues could be adversely affected due to the variability in consumer
appeal of the movie titles and game software released for rental and sale.
The quality of movie titles and game software released for rental and sale is
not within our control, and our results of operations have from time to time
reflected the variability in consumer appeal for such items. We cannot assure
you that future releases of movie titles and game software will appeal to
consumers and, as a result, our revenues and profitability may be adversely
affected.
Our business could be adversely affected if video game software and hardware
manufacturers do not introduce new products in a timely manner.
The video game industry is characterized by the significant impact on consumer
spending that accompanies the introduction of new game software and hardware
platforms. Retail spending in the video game industry typically grows rapidly
with the introduction of new platforms but declines considerably prior to the
release of new platforms. In 2005, Microsoft introduced the XBOX-360 platform
and in 2006, we expect new platforms from Sony and Nintendo. Consumer demand
for video games available in our stores could be adversely affected if
manufacturers fail to introduce new games and systems in a timely manner or are
unable to make new games and systems available in sufficient quantities. A
decline in consumer demand for video games available in our stores could
negatively affect our revenues and harm our business and financial position.
Piracy of the products we offer may adversely affect our results of operations.
The development of the internet and related technologies increases the threat
of piracy by making it easier to duplicate and widely distribute pirated
content. We cannot assure you that movie studios and others with rights in the
product will take steps to enforce their rights against internet piracy or that
they will be successful in preventing the distribution of pirated content.
Technological developments and advances of products such as at-home DVD burners
also may increase piracy of movies and games. Increased piracy could
negatively affect our revenues and results of operations.
The value of our securities may be affected by variances in our quarterly
operating results that are unrelated to our long-term performance.
Historically, our quarterly operating results have varied, and we anticipate
that they will vary in the future. Factors that may cause our quarterly
operating results to vary, many of which we cannot control, include:
- - consumer demand for our products;
- - prices at which we can rent or sell our products;
- - timing, cost and availability of newly-released movies, new video games and
new video game systems;
- - competition from providers of similar products, other forms of entertainment,
and special events, such as the Olympics or ongoing major news events of
significant public interest;
- - seasonality;
- - weather patterns that can significantly increase business (inclement
conditions that prohibit outdoor activities) or decrease business (mild
temperatures and dry conditions that reduce the consumer's desire to relax
indoors); and
- - acts of God, or public authorities, war, civil unrest, hurricanes, fire,
floods, earthquakes, acts of terrorism, and other matters beyond our control.
Our revenues and operating results fluctuate on a seasonal basis and may suffer
if revenues during peak seasons do not meet expectations.
The home video retail industry generally experiences relative revenue declines
in April and May, due in part to the change in Daylight Savings Time and due to
improved weather, and in September and October, due in part to the start of the
traditional school year and the introduction of new television programs. The
industry typically experiences 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. The game sales
business is traditionally strongest in November and December, as title releases
are often clustered around the holiday shopping season.
In view of seasonal variations in our revenues and operating results,
comparisons of our revenues and operating results for any period with those of
the immediately preceding period or the same period of the preceding fiscal
year may be of limited relevance in evaluating historical financial performance
and predicting future financial performance. Our working capital, cash and
short-term borrowings also fluctuate during the year as a result of the factors
set forth above.
Our operating results may suffer if revenues during peak seasons do not meet
expectations. If revenues during these periods do not meet expectations, we may
not generate sufficient revenue to offset increased costs incurred in
preparation for peak seasons and operating results may suffer. Finally, the
operational risks described elsewhere in these risk factors may be exacerbated
if the events described therein were to occur during a peak season.
The market price for our common stock may fluctuate substantially.
We have experienced, and continue to expect, periodic fluctuations in our stock
price due to technological advancements, developments concerning our business,
our competitors or the home video specialty retail industry, including
fluctuations in our operating results, the introduction of new products, the
performance of other similar companies, changes in financial estimates by
financial analysts or our failure to meet these estimates and other factors.
In addition, in recent years the stock market has experienced a high level of
price and volume volatility, and market prices for the stock of many companies
have experienced wide fluctuations that have not necessarily been related to
the operating performance of these companies. These broad market fluctuations
could have a material adverse effect on the market price of our common stock,
business, and results of operations or financial condition. We cannot assure
you that our stock price will not experience significant fluctuations in the
future.
Historically, companies that have experienced market price volatility have been
the target of securities class action litigation. We could incur significant
costs and our management's time and resources could be diverted from the
operation of our business if we were the target of securities class action
litigation.
Terrorism, war or other acts of violence could have a negative impact on our
stock price or our business.
Terrorist attacks, as well as the on-going events in Iraq or other acts of
violence and civil unrest in the nation and throughout the world, could
influence the financial markets and the economy. Consumers' television viewing
habits may be altered as a result of these events such that the demand for home
video entertainment is reduced. These factors could have a negative impact on
our results of operations or our stock price.
Investor confidence may be adversely impacted as a result of the material
weaknesses in our internal controls.
We are required, pursuant to rules adopted by the SEC under Section 404 of the
Sarbanes-Oxley Act of 2002, to include a report of our management's assessment
of the effectiveness of our internal control over financial reporting in our
Annual Reports on Form 10-K. Our management assessed the effectiveness of our
internal control over financial reporting as of January 1, 2006, and this
assessment identified four material weaknesses in our internal controls. A
material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be
prevented or detected. These material weaknesses related to:
- - Ineffective management review of account analyses and reconciliations;
- - Ineffective communication of accounting policy for capitalizing costs and
lack of effective review process;
- - Inaccurate or lack of timely updating of accounting inputs for key
estimates and assumptions.
- - Ineffective procurement and receiving processes.
These material weaknesses could result in an adverse reaction in the financial
marketplace due to a loss of investor confidence in the reliability of our
financial statements, which ultimately could negatively impact market prices
for our securities.
Item 1B. Unresolved Staff Comments
None.
ITEM 2. PROPERTIES
Stores. Substantially all of our retail stores are leased. Our new store
leases generally provide for initial lease term of five to ten years, with at
least one renewal option for an additional two to five years. The following
table provides information regarding the number of stores we operated in each
state and country as of January 1, 2006.
United States:
Alabama 193
Alaska 7
Arizona 89
Arkansas 87
California 359
Colorado 60
Connecticut 35
Delaware 21
District of Columbia 2
Florida 233
Georgia 167
Hawaii 4
Idaho 31
Illinois 127
Indiana 122
Iowa 49
Kansas 43
Kentucky 88
Louisiana 54
Maine 53
Maryland 60
Massachusetts 76
Michigan 124
Minnesota 93
Mississippi 75
Missouri 128
Montana 22
Nebraska 30
Nevada 36
New Hampshire 22
New Jersey 40
New Mexico 36
New York 135
North Carolina 175
North Dakota 8
Ohio 206
Oklahoma 79
Oregon 78
Pennsylvania 170
Rhode Island 15
South Carolina 100
South Dakota 14
Tennessee 118
Texas 363
Utah 50
Vermont 5
Virginia 157
Washington 115
West Virginia 27
Wisconsin 69
Wyoming 6
-----
Total United States 4,456
Canada:
Alberta 113
British Columbia 70
Manitoba 9
New Brunswick 6
Newfoundland 3
Nova Scotia 13
Ontario 44
Prince Edward Island 2
Saskatchewan 22
Yukon Territory 2
-----
Total Canada 284
Mexico 9
-----
TOTAL 4,749
=====
Support Centers and Distribution Facility.
We have a support center and limited inventory distribution facility that are
located in an approximately 116,000 square foot building in Dothan, Alabama,
which we own. We are also leasing approximately 48,000 square feet of off-site
warehouse space to supplement distribution and to provide record storage.
In 2004, we began construction on a new 190,000 square foot distribution center
located in Dothan, Alabama. After the acquisition of Hollywood, construction
was stopped on this facility and we are evaluating alternatives, including the
sale of this facility.
Our Oregon support center is located in Wilsonville, Oregon, and consists of
approximately 123,000 square feet of leased space. The lease expires in
November 2008. We currently lease space in two distribution centers, to
primarily support Movie Gallery, Hollywood Video and Game Crazy. The
distribution centers are located in Wilsonville, Oregon (approximately 175,000
square feet) and in LaVergne, Tennessee (approximately 98,000 square feet).
These facilities are leased pursuant to agreements that expire in December
2011 and June 2010, respectively. A third facility, formerly used to support
Game Crazy, is located in Wilsonville, Oregon (approximately 84,000 square
feet). This facility is no longer in use as of March 2006 and the lease
expires in June 2006.
ITEM 3. LEGAL PROCEEDINGS
Hollywood was named as a defendant in several purported class action lawsuits
asserting various causes of action, including claims regarding its membership
application and additional rental period charges. Hollywood vigorously defended
these actions and maintains that the terms of its additional rental charge
policy are fair and legal. Hollywood obtained dismissal of three of the actions
filed against it. A statewide class action entitled George Curtis v. Hollywood
Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8 SEA was
certified on June 14, 2002 in the Superior Court of King County, Washington. On
May 20, 2003, a nationwide class action entitled George DeFrates v. Hollywood
Entertainment Corporation, No. 02 L 707 was certified in the Circuit Court of
St. Clair County, Twentieth Judicial Circuit, State of Illinois. Hollywood
reached a nationwide settlement with the plaintiffs on all of the various
claims asserted in each of the related actions. Preliminary approval of
settlement was granted on August 10, 2004. Hollywood agreed not to oppose
plaintiffs' application for an award of $2.7 million for fees and costs to
class counsel and plaintiffs counsel and up to $50,000 in class representative
incentive awards. Class members received rent-one-get-one coupons on a claims-
made basis with a guaranteed total redemption of $9 million along with other
remedial relief. The court granted final approval of the settlement on June 24,
2005. An appeal of the final approval was filed on July 25, 2005. A settlement
with the appellants was reached and the matter was fully and finally resolved
on December 9, 2005.
Hollywood and the members of its former board of directors (including
Hollywood's former chairman Mark Wattles) were named as defendants in several
lawsuits in the Circuit Court in Clackamas County, Oregon. The lawsuits, filed
between March 31, 2004 and April 14, 2004, asserted breaches of duties
associated with the merger agreement executed with a subsidiary of Leonard
Green & Partners, L.P., or LPG. The Clackamas County actions were later
consolidated, and the plaintiffs filed an Amended Consolidated Complaint
alleging four claims for relief against Hollywood's former board members
arising out of the merger of Hollywood with Movie Gallery. The purported four
claims for relief are breach of fiduciary duty, misappropriation of
confidential information, failure to disclose material information in the proxy
statement in support of the Movie Gallery merger, and a claim for attorneys'
fees and costs. The Amended Consolidated Complaint also names UBS Warburg and
LGP as defendants. Following the merger with Movie Gallery, the plaintiffs
filed a Second Amended Consolidated Complaint. The plaintiffs restated their
causes of action and generally allege that the defendants adversely impacted
the value of Hollywood through the negotiations and dealings with LGP.
Hollywood and the former members of its board have also been named as
defendants in a separate lawsuit entitled JDL Partners, L.P. v. Mark J. Wattles
et al. filed in Clackamas County, Oregon, Circuit Court on December 22, 2004.
This lawsuit, filed before Hollywood's announcement of the merger agreement
with Movie Gallery, alleges breaches of fiduciary duties related to a bid by
Blockbuster Inc. to acquire Hollywood, as well as breaches related to a loan to
Mr. Wattles that Hollywood forgave in December 2000. On April 25, 2005, the JDL
Partners action was consolidated with the other Clackamas County lawsuits. The
plaintiffs seek damages and attorneys' fees and costs. Hollywood denies these
allegations and is vigorously defending this lawsuit.
Hollywood was named as a defendant in a sexual harassment lawsuit filed in the
Supreme Court of the State of New York, Bronx County on April 17, 2003. The
action, filed by eleven former female employees, alleges that an employee, in
the course of his employment as a store director for Hollywood, sexually
harassed and assaulted certain of the plaintiffs, and that Hollywood and its
members of management failed to prevent or respond adequately to the employee's
alleged wrongdoing. The plaintiffs seek unspecified damages, pre-judgment
interest and attorneys' fees and costs. Hollywood denies these allegations and
is vigorously defending this lawsuit.
In addition, we have been named to various other claims, disputes, legal
actions and other proceedings involving contracts, employment and various other
matters. We believe we have provided adequate reserves for contingencies and
that the outcome of these matters should not have a material adverse effect on
our consolidated results of operations, financial condition or liquidity. At
January 1, 2006, the legal contingencies reserve, net of expected recoveries
from insurance carriers was $3.0 million of which $2.4 million is related to
pre-acquisition contingencies of Hollywood. At January 2, 2005, the legal
contingencies reserve was $0.3 million.
A negative outcome in certain of the ongoing litigation 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no submissions of matters to a vote of security holders in the
fourth quarter of 2005.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
Market Information
Our common stock is listed on the Nasdaq National Market under the symbol
"MOVI". As of March 6, 2006, we had approximately 56 stockholders of record.
The following information sets forth the high and low closing prices for our
common stock as reported on the Nasdaq National Market for each quarterly
period within the last two fiscal years.
High Low Dividend
-------- --------- ---------
2005:
Fourth Quarter $ 9.75 $ 4.60 $ -
Third Quarter 26.52 9.86 -
Second Quarter 33.43 26.26 0.03
First Quarter 29.45 18.29 0.03
2004:
Fourth Quarter $ 19.30 $ 15.30 $ 0.03
Third Quarter 18.54 16.43 0.03
Second Quarter 20.50 18.29 0.03
First Quarter 20.25 18.38 0.03
Dividends
In December 2003, our Board of Directors instituted a dividend policy under
which it declared an initial quarterly cash dividend of $0.03 per share. In
September 2005, we announced that due to the challenging conditions currently
affecting the home video industry, we would not declare a quarterly cash
dividend for the third quarter of 2005. Our Board of Directors later decided
to suspend the payment of cash dividends indefinitely. The March 15, 2006
amendment to our credit facility prohibits payment of any future dividends
until the credit facility is repaid.
Securities Authorized for Issuance Under Equity Compensation Plans
Information relating to compensation plans under which equity securities of the
Company are authorized for issuance appears under the heading "Stock Option
Plans" in our definitive Proxy Statement filed for our 2006 Annual Meeting of
Stockholders, and is incorporated herein by reference.
ITEM 6. SELECTED FINANCIAL DATA
Fiscal Year Ended
---------------------------------------------------------
January 6, January 5, January 4, January 2, January 1,
2002(1) 2003 2004 2005 2006(7)
---------- ---------- ---------- ---------- ----------
($ in thousands, except per share data)
Statements of Operations Data:
Revenues:
Rentals $ 347,464 $ 490,836 $ 629,793 $ 729,167 $1,630,058
Product sales 21,667 38,152 62,602 62,010 357,269
--------- ---------- ---------- --------- ----------
Total revenues 369,131 528,988 692,395 791,177 1,987,327
--------- ---------- ---------- --------- ----------
Cost of sales:
Cost of rental
revenues 108,732 164,818(2) 184,439 208,160 502,873
Cost of product
sales 17,715 29,852 50,143 41,942 271,900
-------- ---------- ---------- --------- ----------
Gross margin 242,684 334,318 457,813 541,075 1,212,554(8)
Operating costs and expenses:
Store operating
expenses 171,409 253,865(3) 324,466 395,425(5)1,027,119
General and
administrative 29,288 40,995(4) 46,522 54,644 128,441
Amortization of
intangibles (6) 6,656 1,298 2,003 2,601 3,865
Impairment of
goodwill - - - - 522,950(9)
Impairment of other
intangibles - - - - 4,940(9)
Stock option
compensation 8,161 2,279 1,481 831 1,618
-------- ---------- ---------- --------- ----------
Operating income
(loss) 27,170 35,881 83,341 87,574 (476,379)
-------- ---------- ---------- --------- ----------
Interest expense,
net (3,026) (1,024) (468) (624) (68,529)(10)
Write off of bridge
financing - - - - (4,234)(11)
Equity in losses of
unconsolidated
entities - - (1,450) (5,746) (806)
--------- ---------- --------- -------- ----------
Income (loss) before
Income taxes 24,144 34,857 81,423 81,204 (549,948)
Income taxes 9,788 13,923 31,987 31,716 2,792(12)
--------- ---------- ---------- --------- ---------
Net income (loss) $ 14,356 $ 20,934 $ 49,436 $ 49,488 $(552,740)
========= ========== ========== ========= =========
Net income (loss) per share:
Basic $ 0.56 $ 0.69 $ 1.53 $ 1.54 $ (17.53)
========= ========== ========== ========== =========
Diluted $ 0.53 $ 0.67 $ 1.48 $ 1.52 $ (17.53)
========= ========== ========== ========== =========
Weighted average shares outstanding:
Basic 25,837 30,273 32,406 32,096 31,524
========= ========== ========== ========== =========
Diluted 27,220 31,436 33,370 32,552 31,524
========= ========== ========== ========== =========
Cash dividends per
common share $ - $ - $ 0.03 $ 0.12 $ 0.06
========= ========== ========== ========== =========
Fiscal Year Ended
---------------------------------------------------------
January 6, January 5, January 4, January 2, January 1,
2002(1) 2003 2004 2005 2006(7)
---------- ---------- ---------- ---------- ----------
($ in thousands, except per share data)
Balance Sheet Data (at end of period):
Cash and cash
equivalents $ 16,349 $ 29,555 $ 38,006 $ 25,518 $ 135,238
Rental inventory,
net 88,424 82,880 102,479 126,541 371,565
Total assets 270,132 361,209 457,884 492,142 1,385,128
Long-term debt less
current maturities 26,000 - - - 1,083,083
Stockholders'
Equity (deficit) 162,182 259,051 320,116 331,134 (212,818)
Other Data:
Number of stores at
end of period 1,415 1,784 2,158 2,482 4,749(13)
Revenues per weighted
average store $ 342 $ 337 $ 355 $ 341 $ 496
Increase(decrease) in
same-store revenues 2.7% 3.2% 7.0% (1.5)% (4.7)%
(1) Results for 2001 reflect a 53-week year and include 17 days of operations
for Video Update, Inc., which we acquired out of bankruptcy on December 21,
2001. All other years presented reflect 52-week years.
(2) Effective October 7, 2002, we changed the estimates used to amortize rental
inventory resulting in a non-cash charge of approximately $27.9 million in the
fourth quarter of 2002, and $5.9 million throughout 2003.
(3) Includes a $1.6 million charge related to the amendment of our supply
agreement with Rentrak Corporation.
(4) Includes a $4.0 million charge related to a legal settlement in the second
quarter of 2002.
(5) Includes a pre-tax charge of $6.3 million to correct our accounting for
leasehold improvements, including $2.9 million related to prior periods, which
was accounted for as an immaterial prior period correction. See Note 1,
"Accounting Policies," of the Notes to Consolidated Financial Statements.
(6) Reflects adoption of Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets," as of the beginning of 2002. Under
Statement 142, goodwill and indefinite lived intangible assets are no longer
amortized. Application of the non-amortization provisions of Statement 142 as
of the beginning of 2001 would have increased net income by approximately
$3.4 million, or $0.65 per diluted share, for 2001.
(7) Reflects the consolidated results of Movie Gallery and Hollywood for the
period subsequent to the merger on April 27, 2005. See Note 2, "Business
Combinations," of the Notes to Consolidated Financial Statements for
information on our acquisition of Hollywood.
(8) Includes $10.1 million in charges (before taxes)($0.21 per diluted share
after tax) related to the VHS residual value adjustment by Movie Gallery and
the reduction of extended viewing fee revenue of $21.4 million and the
corresponding $19.0 million gross margin impact of conforming Hollywood's
extended viewing fee revenue accounting method to Movie Gallery's method.
(9) Reflects goodwill impairment of the Movie Gallery and Hollywood Video
reporting units. Reflects impairment charge for customer lists to reduce
carrying value to fair value. See Note 5, "Goodwill and Other Intangible
Assets," to the Notes to Consolidated Financial Statements for information on
2005 impairment charges.
(10) Reflects the interest expense related to the credit facility and senior
notes to finance the Hollywood acquisition.
(11) Reflects the write-off of costs incurred to obtain acquisition bridge
financing commitment that expired, unused, on the date of acquisition of
Hollywood.
(12) Effective tax rate for 2005 is adversely impacted by goodwill
impairment of which $332.1 million is not tax deductible and therefore
generated an abnormally low effective tax rate. In addition, a valuation
allowance was recorded for $85.2 million on our net deferred tax asset to
reflect management's determination that the deferred tax asset may not be
realized. See Note 4, "Income Taxes," to the Notes to Consolidated Financial
Statements.
(13) Reflects the April 2005 acquisition of 2,031 Hollywood Video stores and 20
freestanding Game Crazy stores; Reflects the May 2005 acquisition of 61 VHQ
stores; Reflects the acquisition of 26 stores in other acquisitions.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Overview
As of January 1, 2006, we operated approximately 4,800 home video retail stores
that rent and sell movies and video games in urban, rural and suburban markets.
We operate three distinct brands: Movie Gallery, Hollywood Video and Game
Crazy. On April 27, 2005, we completed our acquisition of Hollywood
Entertainment Corporation, or Hollywood. Our acquisition of Hollywood was
accounted for as a purchase business combination. Accordingly, our results of
operations for 2005 include the operating results of Hollywood only since the
date of the acquisition and are not indicative of annualized results of the
combined companies. This acquisition increased our total revenues to over $2.6
billion on a pro-forma annual basis with a store count of over 4,700 stores and
substantially increased our urban market presence. We currently plan to
maintain the Hollywood brand and store format. We currently plan to open
approximately 140 new stores for the full year 2006 period, subject to market
and industry conditions and the integration of Hollywood. Movie Gallery's
eastern focused rural and secondary market dominance and Hollywood's western
focused prime urban and suburban superstore locations combine to form a strong
nationwide geographical store footprint.
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 (DVDs and video
cassettes available for rental and sale), 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 domestic home video
industry accounts for approximately 51% of domestic studio movie revenue in
2005. 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. 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 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 staffing
requirements 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 closely monitors same-store revenues, which we define
as revenues at stores that we have operated for at least twelve 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 benefit from the reduced labor and real estate
costs the Movie Gallery brand stores enjoy by being located in rural markets
versus the higher costs associated with the larger urban markets. We are
also able to adjust store hours and staffing levels to specific market
conditions as well as leverage best practices from both Movie Gallery and
Hollywood to reduce expense and increase operating efficiency.
- - 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 teams. 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 significant long-term debt.
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 using 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 principal 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 $2.6 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.
In the fourth quarter of 2005, we closed 64 Movie Gallery stores with trade
areas that overlapped with acquired Hollywood Video stores. We will continue
to evaluate the closure of stores with overlapping trade areas such as these as
market conditions warrant.
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 brands. 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
continue to evaluate opportunities to leverage both Movie Gallery's and
Hollywood's best practices and generate general and administrative cost
savings. To date, we have identified cost savings opportunities in both Movie
Gallery's and Hollywood's cost structures and we anticipate that we will
identify additional opportunities 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 any further cost savings.
As of October 25, 2005, we notified 92 Movie Gallery associates that their
positions will be relocated or eliminated as part of our integration plan
through the consolidation of Finance, Accounting, Treasury, Product, Logistics,
Human Resources and Payroll at our Wilsonville, Oregon support center.
Subsequently, as of January 1, 2006, an additional 9 Movie Gallery associates
were notified that their positions were being eliminated. 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
affected individuals are required to render service for a range of 10 to 49
weeks in order to receive termination benefits. We estimate that the total
cost of providing severance, retention incentives and outplacement services to
these associates will be approximately $3.3 million, of which $1.2 million was
recognized in 2005, with the remainder to be expensed over the remaining
retention service period for the impacted associates in 2006 in accordance with
SFAS No. 146, "Accounting for Costs Associated with Disposal and Exit
Activities."
We estimate the integration-related efficiencies and savings achieved during
2005 to be in excess of $20 million. These savings have been driven
principally by improvements in the supply chain for Movie Gallery branded
stores, consolidation of our Real Estate and Architecture functions, inventory
utilization, and elimination of duplicative executive management. We continue
to identify and implement additional savings opportunities. We expect that
total savings, including new projects in 2006 combined with the full year 2006
impact of the savings already achieved in 2005 will be in excess of $50
million.
Other Acquisitions
During the second quarter of 2005, we acquired VHQ Entertainment, Inc., or VHQ.
VHQ operated 61 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 2005, Movie Gallery purchased 26 stores in 11 separate
transactions for a total cash consideration, including VHQ, of $23.1 million.
These acquisitions had an immaterial impact on our operating results in 2005.
By letter dated August 29, 2005, Boards Video Company LLC, or 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. The put option, and a related call option, were contained in the
license agreement between Hollywood and Boards which was effective January 25,
2001. On a change of control (as defined in the license agreement) Hollywood
had an option to purchase the stores within six months. Likewise, on a change
of control, Boards had the option to require Hollywood to purchase the stores
within six months. In both cases, the process by which the price would be
determined was detailed in the license agreement and was at fair value as
determined by an appraisal process. We concluded that the put/call option
features of the license agreement were not a derivative (or embedded
derivative) under SFAS No. 133 "Accounting for Derivative Instruments and
Hedging Activities," because the put and call features were not net settleable,
as there was no provision for net cash settlement, there was no market for the
option features, and the underlying asset (the stores) were not readily
convertible to cash. 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 in 2006.
The following discussion of our results of operations, liquidity and capital
resources is intended to provide further insight into our performance over the
last three years.
Results of Operations
Selected Financial Statement and Operational Data:
Fiscal Year Ended
-----------------------------------
January 4, January 2, January 1,
2004 2005 2006(1)
---------- ---------- ----------
($ in thousands, except per share
and store data)
Rental revenue $ 629,793 $ 729,167 $1,630,058
Product sales 62,602 62,010 357,269
--------- --------- ----------
Total revenue 692,395 791,177 1,987,327
Cost of rental revenue 184,439 208,160 502,873
Cost of product sales 50,143 41,942 271,900
--------- --------- ----------
Total gross profit $ 457,813 $ 541,075 $1,212,554
========= ========= ==========
Store operating expenses $ 324,466 $ 395,425 $1,027,119
General and administrative
expenses $ 46,522 $ 54,644 $ 128,441
Impairment of goodwill $ - $ - $ 522,950
Impairment of other intangibles $ - $ - $ 4,940
Stock compensation expense $ 1,481 $ 831 $ 1,618
Operating income (loss) $ 83,341 $ 87,574 $ (476,379)
Interest expense, net $ (468) $ (624) $ (68,529)
Equity in losses of
unconsolidated entities $ 1,450 $ 5,746 $ 806
Net income (loss) $ 49,436 $ 49,488 $ (552,740)
Net income (loss) per diluted share $ 1.48 $ 1.52 $ (17.53)
Cash dividends per common share $ .03 $ 0.12 $ 0.06
Rental margin 70.7% 71.5% 69.1%
Product sales margin 19.9% 32.4% 23.9%
Total gross margin 66.1% 68.4% 61.0%
Percent of total revenue:
Rental revenue 91.0% 92.2% 82.0%
Product sales 9.0% 7.8% 18.0%
Store operating expenses 46.9% 50.0% 51.7%
General and administrative expenses 6.7% 6.9% 6.5%
Impairment of goodwill 0.0% 0.0% 26.3%
Impairment of other intangibles 0.0% 0.0% 0.2%
Stock compensation expense 0.2% 0.1% 0.1%
Operating income (loss) 12.0% 11.1% (24.0%)
Interest expense, net 0.1% 0.1% 3.4%
Net income (loss) 7.1% 6.3% (27.8%)
Total same-store revenues 7.0% (1.5%) (4.7%)
Movie Gallery same-store revenues 7.0% (1.5%) (5.7%)
Hollywood same-store revenues(1) 10.7% 1.5% (4.3%)
Total same-store rental revenues 5.0% (1.0%) (6.2%)
Movie Gallery same-store revenues 5.0% (1.0%) (6.5%)
Hollywood same-store revenues(1) 2.5% (4.3%) (6.0%)
Total same-store product sales 35.0% (12.0%) 1.7%
Movie Gallery same-store sales 35.0% (12.0%) 3.0%
Hollywood same-store sales(1) 76.2% 29.4% 1.5%
Store count:
Beginning of period 1,784 2,158 2,482
New store builds 241 314 288
Stores acquired 170 74 2,138(2)
Stores closed (37) (64) (159)
--------- --------- ----------
End of period 2,158 2,482 4,749
========= ========= ==========
(1) Hollywood's results for periods prior to April 27, 2005 are not included in
the consolidated statements of operations, but rather reflect the historical
statistics previously reported by Hollywood Entertainment. Hollywood same-
store revenues are presented for the full year periods and are inclusive of the
Game Crazy operating segment. Hollywood same-store revenues exclude the
effects of the accounting change for extended viewing fees recognition
described in Note 1 Accounting Policies of the Notes to Consolidated Financial
Statements.
(2) Includes 2,031 Hollywood Video stores and 20 free-standing Game Crazy
stores acquired in the acquisition of Hollywood in April 2005 and 61 stores
acquired in our acquisition of VHQ in May 2005. See Note 2, "Business
Combinations," of the Notes to Consolidated Financial Statements.
Revenue. Consolidated total revenues increased 151.2% and 14.3% for 2005 and
2004, respectively, compared to the years 2004 and 2003. The increase in
revenues for 2005 was primarily due to the acquisition of Hollywood, which
added $1.1 billion in revenue. Same-store total revenues for fiscal 2005 were
negative 4.7%. Same-store rental revenue, including sales of previously viewed
rental inventory, declined 6.2% while same-store product revenue increased
1.7%. The increase in 2004 revenue compared to 2003 was primarily due to a
19.0% increase in the average number of stores operated during the year
partially offset by a same-store revenue decrease of 1.5%.
With the acquisition of Hollywood, our revenue mix has shifted more to product
revenue and away from rental revenue versus comparative periods last year. The
Game Crazy operating segment is the primary driver of this shift in the revenue
mix. We believe this trend will continue for two to three years due to the
introduction of new game platforms.
For 2004 and 2005, the Movie Gallery operating segment total revenues increased
14.3% and 6.8%, respectively, from the prior years. The increases were
primarily due to increases of approximately 19.0% and 13.5% in the average
number of stores operated, respectively. This increase was partially offset by
same-store revenue decreases of 1.5% and 5.7% for 2004 and 2005, respectively.
Same-store rental revenue declined 6.5% for 2005, while same-store product
sales increased 3.0%.
The addition of the Hollywood operating segment revenue for 2005 accounted for
95.5% of the total revenue increase. The Hollywood segment total same-store
revenues decreased 4.3% for 2005 (all same store revenue statistics for
Hollywood include periods prior to our acquisition). Same-store rental revenue
declined 6.0%, while same-store product revenue increased 1.5%. To conform
Hollywood's extended viewing fees accounting policy to Movie Gallery's
accounting policy, we have reflected the portion of extended viewing fees
collected that relate to receivables from customers at the date of our merger
as a reduction of the receivable balance, and extended viewing fees are no
longer being recognized in advance of collection. As a result of conforming
this accounting policy following the merger, Hollywood's extended viewing fees
recognized as revenue in 2005 was $21.4 million less than the actual amounts
collected from customers. The same-store total revenue and same-store rental
revenue statistics for Hollywood have been presented excluding the impact of
conforming Hollywood's historical accounting method to Movie Gallery's method.
The following factors contributed to a decrease in our total same-store
revenues for 2005 versus 2004:
- - Movie rental revenue, including previously viewed sales, declined and
was adversely impacted by the weak home video release schedule, the
overabundance of DVD titles available for sale in the marketplace, the
growth of on-line rental and the maturation of the DVD life cycle.
- - Game rental revenue declined reflecting the weakness of new game titles
released during the year and the industry softness that traditionally
occurs before the introduction of new game platforms. Microsoft's XBOX
360 was released late in 2005 and new platforms from Sony and Nintendo
are anticipated in 2006.
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 2003, 2004 and
2005 was 70.7%, 71.5% and 69.1%, respectively. A charge of $10.1 million was
recorded against cost of rental revenues in the second quarter of fiscal 2005
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 70.0% for 2005. 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 informed 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. We also
changed our estimate of the percentage of total rental inventory purchases
allocated to catalog or "base stock" inventory in the fourth quarter for our
Movie Gallery segment to reflect recent trends in retention patterns of catalog
inventory, which resulted in a charge of $1.7 million in rental amortization
($0.03 per share net of tax).
In addition to the negative impact on rental gross margin caused by the
accounting adjustments noted above, rental gross margins also decreased as a
result of the acquisition of the Hollywood Video stores, as their gross margins
have historically been 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 historical discount
and promotional activity related to previously viewed products also contributed
to the reduced rental gross margins.
Cost of product sales includes the costs of new and used video game merchandise
in the Game Crazy operating segment, new movies, concessions and other products
sold in our Hollywood and Movie Gallery stores. New movies and new game
merchandise typically have a much lower margin than previously viewed movies,
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 2003, 2004 and 2005 was 19.9%, 32.4% and
23.9%, respectively. The decrease in product sales margin in 2005 compared to
2004 was primarily caused by higher penetration of new movies and new game
merchandise sales. We expect that the acquisition of the Game Crazy operating
segment acquired with Hollywood will continue to increase the percentage of
total revenues from new game merchandise sales (versus comparable prior year
periods). We expect this trend to continue for two to three years due to the
introduction of new game platforms.
Operating Costs and Expenses. Store operating expenses include store-level
expenses such as lease payments, in-store payroll and start-up costs associated
with new store openings. Store operating expenses as a percentage of total
revenue was 46.9%, 50.0% and 51.7% in 2003, 2004 and 2005, respectively.
The increase in store operating expenses as a percentage of total revenue from
2004 to 2005 is primarily due to:
- - A 4.7% decrease in same-store revenues for the combined company in 2005
versus a decrease of 1.5% in 2004, as certain operating expenses are
fixed and increase as a percentage of revenue when revenues decline.
- - The decrease in same-store revenues in 2005 was more significant than
anticipated thereby limiting our ability to reduce variable expenses in
response to the revenue decrease.
- - Our decision to close 64 Movie Gallery stores that overlapped trade
areas with Hollywood stores required the establishment of a store closure
reserve for the remaining lease obligations and the write-off of
remaining property, fixtures and equipment of $9.6 million
- - A significant number of new store openings generating store opening and
start-up costs for immature stores in the revenue base (our store base
has increased by 10% or more in each of 2005, 2004 and 2003). New stores
typically do not perform as well as mature stores in their first year of
operations, because a substantial portion of store operating expenses are
fixed.
The increase in store operating expenses as a percentage of total revenue in
from 2003 to 2004 is primarily due to:
- - An increase to depreciation expense in the fourth quarter of $6.3
million (of which $2.9 million relates to prior years) related to the
correction of errors in our historical amortization practice for
leasehold improvements;
- - The 1.5% decrease in same-store revenues in 2004, as certain operating
expenses are fixed and result in an increase as a percentage of revenue
when revenues decline; and
- - Continued growth in the number of new store openings generating store
opening and start-up costs for a larger number of immature stores in the
revenue base versus the prior year (our store base has increased by 15%
or more in each of 2004, 2003 and 2002).
General and administrative expenses. General and administrative expenses as a
percentage of revenue were 6.7%, 6.9% and 6.5% in 2003, 2004 and 2005,
respectively. The decrease in general and administrative expenses as a
percentage of revenue from fiscal 2004 to 2005 is due to:
- - The acquisition of Hollywood and its lower general and administrative
costs as a percentage of revenue reduced our percentage of revenue
despite increases in severance for integration and the impact of higher
than anticipated same store revenue decreases.
The increase in general and administrative expenses as a percentage of revenue
from 2003 to 2004 is due to:
- - The same-store revenue decrease of 1.5% in fiscal 2004; and
- - Overhead increases to support our expanding store base and growth
strategy, which included continued expansion in geographic areas where
our market penetration was lower.
Impairment Losses. Impairment charges include the impairment of goodwill and
intangible assets, and customer lists. The first quarter 2005 results for both
Hollywood and Movie Gallery were significantly better than management's
expectations and plans. Our results after the integration in the second and
third quarters were worse than management's expectations, but were believed to
be primarily driven by a weak title line-up in the second and third quarters.
Management expected a recovery in the fourth quarter primarily from improving
title content. This recovery did not materialize. Because the fourth quarter
results failed to meet our expectations, we revised our outlook for 2006 and
beyond and reflected these updated forecasts in our determination and
measurement of the fourth quarter impairment charges. Following is a
description of the impairment charges recorded in the fourth quarter of 2005:
- - Goodwill - Goodwill and indefinite-lived intangible assets are tested
for impairment on an annual basis in accordance with SFAS No. 142.
Additionally, goodwill and indefinite lived intangibles are tested for
impairment between annual tests if an event occurs or changes in
circumstances indicate the fair value of a reporting unit is below its
carrying value. We tested goodwill and indefinite lived intangibles at
the beginning of the fourth quarter of 2005 in accordance with our normal
accounting policy and pursuant to SFAS No. 142.
Goodwill is tested at a reporting unit level. Our reporting units for
this purpose are Movie Gallery, Hollywood Video and Game Crazy. Goodwill
is impaired if the fair value of a reporting unit is less than the
carrying value of its assets. The estimated fair value of each of the
reporting units was computed using the present value of estimated future
cash flows, which included the impact of trends in the business and
industry noted in 2005, including the accelerated decline in the in-store
rental industry, increased competition in the video sell-through markets
and the growth of the on-line movie rental segment in which neither Movie
Gallery nor Hollywood has a presence. Impairments of goodwill were
recorded for the Movie Gallery and Hollywood reporting units in the
amounts of $161.7 million and $361.2 million respectively.
- - Intangible assets - As a result of the impairment indicators that
contributed to the goodwill impairment charges described in the preceding
paragraph, we also tested all other intangible assets for impairment as
of the beginning of the fourth quarter of 2005. Based on the results of
this test, we concluded that customer list intangible assets of our Movie
Gallery operating segment were impaired. Based on the estimated value of
the acquired customer lists, which were based primarily on observations
of market comparables for similar customer lists on a per thousand
customer basis, we recorded a $4.9 million impairment charge in the
fourth quarter of 2005 to reduce the carrying value of Movie Gallery's
previously acquired customer lists to our estimate of their fair value.
We also tested the indefinite-lived Hollywood trademark for impairment
and determined that it was not impaired. Likewise, we determined that
the finite-lived carrying value of the Game Crazy trademark was not
impaired. No other long-lived assets, including rental inventory and
property, fixtures and equipment, were impaired under the guidance in
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets."
Stock Compensation Expense. Stock compensation expense primarily represents
non-cash charges associated with non-vested stock grants. In accordance with
APB Opinion No. 25, compensation expense, representing the intrinsic value of
the stock granted on the grant date, is recognized over the vesting period for
service based awards. Compensation expense for performance based stock grants
is recognized based on the amounts we believe are probable of achievement and
is periodically adjusted (remeasured) based on the current stock price, which
is consistent with accounting for variable stock based compensation. In 2005,
we recognized $1.2 million in compensation expenses related to service based
stock grants and $0.4 million in expenses related to performance based stock
grants. Fiscal 2005 and 2004 also included nominal amounts of non-cash expense
associated with certain stock options that were repriced during the first
quarter of fiscal 2001 and accounted for as variable stock options. The
majority of stock compensation expense in 2003 related to the remaining options
outstanding that were repriced in 2001. In addition in 2004, stock
compensation expense also included $0.8 million in cash expenses related to our
decision to repurchase 145,900 shares of common stock from current and former
executives, which represented the intrinsic value of those options on the date
of the buy-out. See Note 9, "Stockholders' Equity," of the Notes to
Consolidated Financial Statements.
Beginning in fiscal 2006, we will be required to adopt SFAS No. 123R
"Accounting for Stock-Based Compensation." Upon adoption of SFAS 123R, we will
no longer be permitted to account for stock based compensation using the
intrinsic value approach that we have followed under APB Opinion No. 25
"Accounting for Stock Issued to Employees." We may, from time to time, decide
to issue stock based compensation in the form of stock grants and stock options,
which under SFAS No. 123R will require a fair value recognition approach and
will be expensed in income from continuing operations. As a result, the amount
of compensation expense we recognize over the vesting period will generally not
be affected by subsequent changes in the trading value of our common stock.
Operating Income. As a result of the impact of the above factors on revenues
and expenses, operating income/(loss) decreased by $564.0 million for fiscal
2005 to ($476.4) million. The decrease in operating income was principally
attributable to $523.0 million in goodwill impairment charges and $4.9 million
for the impairment of intangibles. There were no similar charges in 2004.
Excluding the one-time effects of the impairment charges, operating income
declined from $87.6 million (11% of revenues) in 2004 to $51.5 million (2.6% of
revenues) in 2005. The following factors contributed to the remaining decline
in operating income as a percentage of total revenues:
- - The Hollywood segment's revenues were $21.4 million lower than the
actual cash collected from customers due to conforming Hollywood's
accounting method for extending viewing fees in 2005, which reduced
operating income by $19.0 million after adjusting for accrued revenue
sharing.
- - Cost of sales has increased as a percentage of revenues due to the
acquisition of Hollywood and the historically lower margins generated by
the Hollywood Video stores and Game Crazy departments.
- - The greater than anticipated decreases in same store revenues limited
our ability to reduce operating costs and expenses due to the fact that
many of our store level expenses are fixed.
The factors described above in revenue, cost of sales, operating costs and
expenses and general and administrative expenses also contributed to an
increase of operating income by 5.1% in 2004 as compared to 2003.
Interest Expense, net. Net loss for fiscal 2005 includes $68.5 million pre-
tax, or $2.17 per diluted share in interest expense, principally related to
borrowings used to fund the acquisitions of Hollywood and VHQ. We expect to
incur significant interest expense for the foreseeable future. Immediately
prior to the acquisition of Hollywood, we had no debt outstanding and had
carried minimal amounts of outstanding indebtedness for the preceding two
fiscal years. Interest expense in 2004 and 2003 amounted to $0.6 and $0.5
million, respectively, a substantial portion of which related to credit
facility fees and expenses.
Write-off of Bridge Financing. Concurrently with the acquisition of Hollywood
in the second quarter of 2005, we wrote-off $4.2 million, or $0.09 per diluted
share (net of tax), of fees and expenses associated with the bridge commitment
feature of our senior credit facility. The bridge facility was entered into in
connection with the Hollywood acquisition but was never drawn upon. Therefore,
the associated fees were expensed concurrently with the expiration of the
bridge loan commitment at the closing of the acquisition and related financing
transactions. There were no similar transactions in 2003 or 2004.
Equity in Losses of Unconsolidated Entities. During the last half of 2003, we
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. As of January 1,
2006 we have completely written off our investments in these unconsolidated
entities, either through recognizing our proportionate share of the investee
losses under the equity method, by disposing of the related interests, or
through write-offs for investments we deemed to be worthless. Although we have
no present intentions to do so, in the future we may make, subject to covenant
limitations, similar investments that we will be required to account for as
equity investments similar to the investments we have made in the past. The
write-offs of our share of investee losses were lower in 2005 versus 2004
because the majority of these write-offs were recorded in 2004 and only a small
remaining balance was written off in 2005.
Income Taxes. The effective tax rate was a provision of 0.5% for fiscal 2005,
compared to a provision of 39.3% and 39.1% for fiscal 2003 and 2004,
respectively. The decrease in the effective rate in 2005 is primarily a result
of the goodwill impairment charges recognized in 2005, a substantial portion of
which was non-deductible goodwill, and the establishment of a valuation
allowance of $88.5 million for our deferred tax assets, a portion of which
relates to net operating loss carryforwards that our management determined may
not be realized through reversal of temporary differences, tax strategies and
future taxable income. As a result of the establishment of the valuation
allowance on our net deferred tax assets, including net operating loss
carryforwards, we expect our effective tax rate will be lower in future periods
to the extent we are profitable, due to the potential reversal of the valuation
allowance. Likewise, if we continue to report net losses before income taxes,
we may be required to increase our valuation allowances in future periods.
Therefore, we are unable to predict with certainty whether our effective tax
rate in the near term will be reflective of our historical pattern.
Liquidity and Capital Resources
Our primary capital needs are for seasonal working capital, debt service, new
store investment, and remodeling and relocating existing stores. We fund our
capital needs primarily by cash flow from operations and, as necessary, loans
under our senior secured credit facility (the "Credit Facility"). The Credit
Facility, which we entered into in connection with the acquisition of Hollywood
and the refinancing of Hollywood's existing indebtedness, is in an aggregate
amount of $906.8 million, consisting of a five-year $75.0 million revolving
credit facility (the "Revolver") and two term loan facilities in an aggregate
principal amount of $831.8 million. Term Loan A is a $85.5 million five-year
facility that matures in April 27, 2010 and Term Loan B is a $746.3 million
six-year facility that matures on April 27, 2011. Also in connection with the
Hollywood acquisition and refinancing, we issued $325.0 million in aggregate
principal amount of 11% senior unsecured notes due 2012 ("the Senior Notes").
At January 1, 2006, we had cash and cash equivalents of $135.2 million and
$41.9 million in available borrowings under our Credit Facility. We also had
$33.1 million drawn under the revolving portion of the Credit Facility,
comprised of $6.9 million and $26.2 million in borrowings and letters of
credit, respectively. Although there can be no assurances, we believe that cash
flow available from operations and availability under the $75.0 million
Revolver of the Credit Facility will be sufficient to operate our business,
satisfy our working capital and capital expenditure requirements, and meet our
foreseeable liquidity requirements, including debt service for the next twelve
months.
Our ability to fund our current plan of operations will depend upon our future
performance, which is subject to general economic, financial, competitive,
industry 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, remain in compliance with the financial
covenants contained in the Credit Facility, 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 our available cash resources, we may be
required to sell assets or to obtain additional financing.
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 our debt service obligations under the Credit Facility or the Senior
Notes, described below, our secured creditors could proceed against the
collateral securing the indebtedness owed to them.
On September 21, 2005, we 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; increased the
letter of credit sub-limit under the Revolver from $30.0 million to $40.0
million; and increased the percentage of Excess Cash Flow, as defined in the
Credit Facility, required to be applied toward principal repayment to 100% from
75%.
On March 15, 2006, we executed a second amendment effective through the fourth
quarter 2006 that further relaxed the financial covenants and restricted our
ability to fund capital expenditures, perform asset sales, and use equity
proceeds. We will incur significant fees related to this amendment including a
50 basis point upfront fee totaling $4.5 million and various professional fees.
While we were in compliance at the end of the fourth quarter 2005 with the
financial covenants contained in our Credit Facility, we obtained the second
amendment in order to remain in compliance with those covenants in the near
term. For the first quarter of 2007, absent further amendment, the more
restrictive financial covenants contained in the original Credit Facility will
apply to us. Because the most restrictive covenants are computed on a trailing
four quarter basis, we do not expect that we will be in compliance with the
first quarter 2007 covenants unless the covenants are further amended or we
obtain additional equity financing by that time. We are exploring several
alternative strategies to remain in compliance with the terms of our Credit
Facility, including, among other things, operational improvements through
capitalizing on merger integration synergy opportunities, raising additional
equity, divesting certain non-core assets and sale/leaseback transactions. We
also may be required to seek further amendments to our Credit Facility. We
cannot assure you that any of these actions will be successful, or that any
sales of assets, additional debt or equity financings or further debt
amendments can be obtained.
During the fourth quarter 2005 and first quarter 2006, the Term Loan A and
Revolver bear interest rates of London Interbank Offered Rate ("LIBOR"), plus
3.50%, and the Term Loan B bears an interest rate of LIBOR plus 3.75%. We also
incur a 0.50% commitment fee on the unused balance of the Revolver. The March
2006 amendment to the Credit Facility specifies new pricing for the interest
rates on the Term Loans and Revolver. For the period starting April 1, 2006
until we deliver to the administrative agent under the Credit Facility our
financial results for the first quarter of 2006, the interest rate for the Term
Loan A and Revolver will be set at LIBOR plus 5.00%. After submission of the
covenant package, the pricing grid is as follows:
Leverage Ratio LIBOR Margin
---------------- --------------
> 4.00 5.00%
3.25 - 4.00 3.50%
2.75 - 3.25 2.75%
2.25 - 2.75 2.50%
1.75 - 2.25 2.25%
< 1.75 2.00%
The Term Loan B pricing was revised to reflect a rate of LIBOR plus 5.25%
starting April 1, 2006 until we deliver to the administrative agent under the
Credit Facility our financial results for the first quarter of 2006. After
then, the interest rate will be LIBOR plus 5.25% if our leverage ratio exceeds
4.00; otherwise the rate will be LIBOR plus 3.75%, as was the case during the
fourth quarter 2005 and first quarter 2006.
At our discretion, we can elect to defer payment of 0.50% of the Term Loan A,
Term Loan B and Revolver interest as non-cash interest, that will be added to
the principal amount of the loans (with compounding interest).
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. In addition to these prepayments,
the Credit Facility also requires us to make prepayments in an amount equal to
100% of any Excess Cash Flow, which generally represents the amount of cash
generated by the Company but not used towards operations, debt service, or
investments. The Excess Cash Flow payment for fiscal 2005 is $56.9 million due
on March 31, 2006, which is shown separately on the Contractual Obligations
table below as a Credit Facility principal repayment.
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.
The Credit Facility, as amended, 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 less capital
expenditures 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 cash interest expense.
The covenant levels contained in the Credit Facility, as amended, are as
follows:
Leverage Fixed Charge Interest Coverage
Ratio Coverage Ratio Ratio
---------- ---------------- -------------------
2006 Q1 5.00 1.05 2.00
2006 Q2 5.75 1.05 1.75
2006 Q3 6.75 1.00 1.45
2006 Q4 6.50 1.00 1.45
2007 Q1 2.25 1.10 3.00
2007 Q2 2.25 1.10 3.00
2007 Q3 2.25 1.10 3.00
2007 Q1 2.00 1.10 3.00
The Credit Facility and indenture governing our 11% Senior 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.
As required by the Credit Facility, we have entered into a two-year floating-
to-fixed interest rate swap 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.
The interest rate swap is a cash flow hedge. The hedge is structured such that
all of the terms match exactly to the hedged debt and there is no hedge
ineffectiveness. The terms of the debt and the fixed rate payments to be
received on the swap coincide (notional amounts, payment dates, terms and
rates), and the hedge is considered perfectly effective. We designated the
swap, at inception, as a cash flow hedge and documented the hedge designation
contemporaneously. At the end of each reporting period, we assess hedge
effectiveness by making sure that the terms match exactly the designated hedged
debt instrument. On each reset date after the variable rate has been
determined, the ultimate payment or receipt is calculated and recorded as an
increase or decrease of interest expense on a weighted average basis over the
period in accordance with SFAS 133 paragraph 132.
Contractual Obligations. The following table discloses our contractual
obligations and commercial commitments as of January 1, 2006 (in thousands):
Contractual 2-3 4-5 More than
Obligations Total 1 Year Years Years 5 Years
- --------------- ---------- -------- -------- -------- ----------
Principal Payments
Credit Facility
Term Loan A $ 79,650 $ 13,150 $ 38,000 $ 28,500 $ -
Term Loan B 695,193 7,500 15,000 367,500 305,193
Revolver 6,862 - - 6,862 -
Excess Cash
Flow Sweep (1)
Term A 5,850 5,850 - - -
Term B 51,057 51,057 - - -
Senior Notes 325,450 - - - 325,450
Capital leases 678 589 89 - -
Interest
Term Loan A (2) 16,248 6,294 8,010 1,944 -
Term Loan B (2) 306,718 61,557 121,250 115,118 8,793
Hedge agreement (2,016) (1,344) (672) - -
Senior Notes 226,691 35,793 71,587 71,587 47,724
Capital leases 20 19 1 - -
Operating leases 1,612,492 367,033 578,443 356,577 310,439
---------- -------- -------- -------- ----------
Total $3,324,893 $547,498 $831,708 $948,088 $ 997,599
---------- -------- -------- -------- ----------
(1) Future prepayments of indebtedness under the Credit Facility will be
required in an amount equal to our excess cash flow, as defined in the Credit
Facility. The amount of these prepayments cannot be estimated at this time.
(2)Interest rates based on current LIBOR rates plus margin. As of January 1,
2006, the Term Loan A and Term Loan B rates are 8.03% and 8.28%, respectively.
We have assumed these interest rates will stay the same for the remaining terms
of the loans for purposes of presenting future interest payments.
Fiscal Year Ended
-----------------------------------
January 4, January 2, January 1,
2004 2005 2006
--------- --------- ----------
($ in thousands)
Statements of Cash Flow Data:
Net cash provided by operating
activities $ 78,853 $ 89,873 $ 132,406
Net cash used in investing activities (77,788) (59,469) (1,145,591)
Net cash (used in) provided by
financing activities 3,333 (45,353) 1,121,959
The increase in net cash provided by operating activities in 2005 versus 2004
was primarily attributable to: (1) increased sources of cash from rental
amortization, accrued liabilities, and depreciation and amortization; and (2)
reduced uses of cash for merchandise inventory, other current assets, and
deposits and other assets. These improvements to cash are offset by: (1)
increased uses of cash for purchases of rental inventory and accounts payable;
and (2) reduced sources of cash for deferred income taxes for fiscal 2005
versus fiscal 2004. The detail contained in the cash provided by operating
activities section reflects the offsetting impact of (1) the reduction of net
income caused by the non-cash impairment of goodwill and other intangibles and
(2) the source of cash generated by these non-cash charges.
The increase in net cash provided by operating activities in 2004 versus 2003
was primarily attributable to the revenue growth as a result of the continued
expansion of our store base, offset partially in fiscal 2004 by a 1.5% decline
in same-store revenues.
Net cash used in investing activities includes the costs of business
acquisitions, new store builds, and purchases of property, furnishings and
equipment. The increase in cash used in investing activities in 2005 versus
2004 was primarily due to the acquisitions of Hollywood and VHQ, which amounted
to $1.1 billion in the aggregate, versus much smaller acquisitions during 2004.
During 2005, we grew our store base through both internally developed and
acquired stores. We opened 288 internally developed stores, acquired 2,138
stores which include the acquisitions of Hollywood and VHQ and closed 159
stores during the year-to-date period ended January 1, 2006. We expect the
majority of our planned 2006 new stores will be internally developed. Capital
requirements to fund new store growth of 140 stores for fiscal 2006 are
estimated at $16 million. Additionally in fiscal 2006, we estimate $19 million
in other on-going capital expenditure requirements for the existing store base.
These estimates do not include capital required to fund our acquisition of the
Boards stores pursuant to a contractual put provision.
The decrease in net cash used in investing activities during fiscal 2004 versus
2003 was primarily due to declining levels of business acquisitions, offset
partially by increased new store openings and, in fiscal 2003, by the purchase
of a corporate aircraft and lighting retrofits in many of our stores to achieve
savings in the cost of utilities.
Net cash flow related to financing activities for fiscal 2005 includes the
proceeds from the Credit Facility and the issuance of the Senior Notes. These
new financing sources contributed to the significant increase in financing cash
flows as compared to 2004, when we used cash of $47.4 million to repurchase
2,624,712 shares of our common stock at an average price of $18.06 per share
and paid dividends to shareholders of $3.9 million, offset by proceeds from the
exercise of stock options and our employee stock purchase plan.
In June 2004, our Board of Directors declared a quarterly cash dividend of
$0.03 per share to be paid under our dividend policy instituted in December
2003. In September 2005 we announced that due to the challenging conditions
currently affecting the home video industry we would not declare a quarterly
cash dividend for the third quarter of 2005. Our Board of Directors later
decided to suspend the payment of cash dividends indefinitely. Under the terms
of our amended Credit Facility, we are precluded from paying dividends until
the Credit Facility is repaid.
Net cash flow related to financing activities for fiscal 2004 includes the
repurchase of 2,624,712 shares of our common stock at an average price of
$18.06 per share and dividends paid to shareholders of $3.9 million, offset by
proceeds from the exercise of stock options and our employee stock purchase
plan. The only financing activity in fiscal 2003 was proceeds from the exercise
of stock options of $3.3 million.
At January 1, 2006, we had a working capital deficit of $155.9 million, due to
the accounting treatment of rental inventory. Rental inventory is treated as a
non-current 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 non-current 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.
Recently, Blockbuster, the industry leader, has announced that it intends to
restate its financial statements to classify its rental inventory as a current
asset. We will evaluate and reconsider our accounting treatment in the future
when we are able to fully assess differences between Blockbuster's facts and
circumstances and ours.
Critical Accounting Policies and Estimates
Our significant accounting policies are described in Note 1 to our consolidated
financial statements elsewhere in this Annual Report on Form 10-K. 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 and tangible assets, including goodwill, estimating the fair value
of acquired assets and assumed liabilities in purchase accounting, and
determining the need for valuation allowances for deferred tax assets.
Rental Inventory
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
consider the actual historical performance trends of our rental inventory and
expectations of future trends and patterns. We develop our estimates of
amortization rates and useful lives to approximate the pattern of rental turns
and sales of previously viewed (used) items in our rental inventory. Our
established residual values are based on an evaluation of the selling prices we
expect to realize from our customers on used inventory, prices observed in bulk
sale transactions 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 transition to new formats, including ongoing VHS transition
to DVD, anticipated transition to high definition DVD within one to three
years, and release of new video game formats, this could necessitate revisions
to our current rental amortization rates, further revisions to our estimated
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 and games. However, we cannot assure you that we will
be able to fully anticipate the impact of ongoing or future format transitions
and we could incur losses on sales of previously viewed movies in the future.
As of January 2, 2005 and January 1, 2006, we had $126.5 million and $371.6
million, respectively, in rental inventory on our balance sheet. As of January
1, 2006, the net book value of our VHS rental inventory was approximately 7.3%
of the net book value of our total rental inventory.
Long-Lived Assets
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
their use and eventual disposition. In order to do this, we make assumptions
and estimates regarding the amount and timing of future cash flows 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 their fair values. If we do not meet our operating
forecasts, which could result in decreases to the undiscounted cash flows we
use to determine whether impairment exists, and then to measure the amount of
any resulting impairment, we may have to record impairment charges not
previously recognized.
Intangible Assets
We test goodwill for impairment on an annual basis. Additionally, goodwill is
tested for impairment between annual tests if an event occurs or changes in
circumstances 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 recorded goodwill impairment charges in fiscal 2005 in the amount of
$523.0 million. As of January 1, 2006, we have $118.4 million in goodwill on
our balance sheet, all of which relates to our Hollywood Video reporting unit.
The amount of the goodwill impairment charge we recognized in 2005 for the
Hollywood Video reporting unit represents our best estimate of the charge based
on the information available to us as of the date of our consolidated financial
statements. Because some aspects of the purchase price allocation have not
been completed, we may need to make further adjustments to the purchase price
allocation (see discussion of deferred tax assets related to acquired assets
and carryover tax attributes below). Some of the further revisions to the
purchase price could impact our estimate of the goodwill impairment charge
reflected in our 2005 consolidated financial statements. Any revisions to the
amount we recorded based on our best estimate as of January 1, 2006 will be
reflected in our statement of operations in future periods. See Note 5,
"Goodwill and Other Intangible Assets," of the Notes to Consolidated Financial
Statements for additional information on our 2005 goodwill and other intangible
asset impairment charges.
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, in part, on
a 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 substantially final for all items except deferred income taxes
and we expect further adjustments may be required in 2006 as we complete our
analysis of the acquired tax basis of certain assets and carryover tax
attributes of Hollywood.
Deferred Income Taxes
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, in prior years we
established a valuation allowance against our deferred tax assets related to
net operating loss carryforwards that we acquired in the 2001 acquisition of
Video Update. In 2005, we established additional valuation allowances related
to net operating loss carryforwards and tax credit carryforwards that we have
determined may not be realized. In forming our conclusion about the future
recoverability of the net operating losses and tax credits, we considered,
among other things, the applicable provisions of the federal income tax code,
which place certain limitations on the deductibility of acquired net operating
loss carryforwards and tax credit carryforwards, as well as other limitations
that may apply to the future deductibility of these net operating losses and
tax credits. We also considered the availability of reversing taxable
temporary differences during the carryforward period, the length of the
available carryforward period, recent operating results, our expectations of
future taxable income during the carryforward period, Internal Revenue Service
(IRS) interpretive guidance and judicial rulings. If facts and circumstances
in the future should warrant elimination or reduction of our valuation
allowances related to these net operating losses and tax credits, our effective
income tax rate, which was 39%, 39% and 0.5% for fiscal 2003, 2004 and 2005,
respectively, could be substantially lower than the statutory federal income
tax rate. Likewise, if our future operating results are not consistent with our
expectations, or changes in tax law have adverse consequences on us, we may be
required to further increase our valuation allowances in future periods. Any
such changes could cause our effective tax rate to differ materially from
historical trends.
Federal tax laws impose restrictions on the utilization of net operating loss
carryforwards and tax credit carryforwards 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. In
addition, previous ownership changes occurred with respect to Hollywood (prior
to our acquisition) and an ownership change also occurred upon our 2001
acquisition of Video Update. Our ability to utilize our net operating loss
carryforwards and tax credit carryforwards 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. If our estimates of the amount of net
operating loss and tax credit carryforwards that will not be fully realized
change, further revisions to our valuation allowance may be necessary.
Depending on the circumstances, some of these revisions may have an impact on
our future income tax expense, while other revisions may be charged or credited
to goodwill.
There is a reasonable possibility that an exposure to the amount of net
operating loss carryforwards available on the ownership change dates exists due
to subjectivity in the calculation of the limitations. The range of the
potential exposure is between $0.6 million and $46 million on a tax effected
basis. Pursuant to the provisions of EITF 93-7, "Uncertainties Related to
Income Taxes in a Purchase Business Combination," any adjustments to deferred
tax assets recorded at the date of acquisition, due to resolution of this
uncertainty (which may not occur for many years) will be recorded as an
adjustment to increase or decrease goodwill, regardless of the time that has
elapsed since the acquisition date. The effect of a decrease in tax reserves
and related valuation allowances established in purchase accounting will be
applied (1) first to reduce to zero any goodwill related to the acquisition,
(2) second to reduce to zero other noncurrent intangible assets related to the
acquisition, and (3) third, to reduce income tax expense.
As part of our accounting for business combinations, some of the purchase price
is allocated to goodwill and intangible assets. A portion of any 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. The remainder will be allocated to tax deductible goodwill acquired
in the Hollywood acquisition. To the extent any future impairment charges are
attributed to tax deductible goodwill, we would record deferred tax benefits or
reduce deferred tax liabilities, and this portion would not have an impact on
our income tax expense or effective tax rate. Amortization expense associated
with separately identified, finite-lived intangible assets, such as the Game
Crazy trademark, is likewise not tax deductible, but the tax effects of any
future impairment charges or amortization associated with these assets would be
offset by deferred taxes created in purchase accounting, and therefore, will
not affect our income tax expense or effective tax rate going forward.
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 was
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.
ITEM 7A. 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 to
hedge against fluctuation in variable interest rates on our 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 $5.4 million on the non-hedged principal, based on
both the outstanding balance on the Credit Facility as of January 1, 2006 and
the Credit Facility's mandatory principal 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 2005 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 nine locations, which we do not believe to
be significant enough to result in a material impact from fluctuations in
currency exchange rates.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item is included in Part IV, Item 15 of this
Annual Report on Form 10-K and is incorporated by reference into this Item 8.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures designed to ensure information
required to be disclosed in our reports filed under the Securities and Exchange
Act of 1934, as amended, or the Exchange Act, is recorded, processed,
summarized, and reported within the time periods specified in the SEC's rules
and forms. Disclosure controls and procedures are designed to provide
reasonable assurance that information required to be disclosed in our Exchange
Act reports is accumulated and communicated to management, including our Chief
Executive Officer and Chief Financial Officer, as appropriate, to allow timely
decisions regarding required disclosure.
In accordance with Exchange Act Rules 13a-15 and 15a-15, we carried out an
evaluation, under the supervision and with the participation of management,
including our Chief Executive Officer and Chief Financial Officer, of the
effectiveness of our disclosure controls and procedures as of the end of the
period covered by this report. Based on that evaluation, our Chief Executive
Officer and Chief Financial Officer concluded that, because of the material
weaknesses in our internal control over financial reporting described below,
our disclosure controls and procedures were not effective as of January 1,
2006.
Management's Annual Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining an adequate
system of internal control over our financial reporting, as such term is
defined in Exchange Act Rule 13a-15(f). Our internal control over financial
reporting is a process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of our financial
statements for external reporting purposes in accordance with accounting
principles generally accepted in the United States (GAAP). Because of its
inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Further, because of changes in conditions,
effectiveness of internal control over financial reporting may vary over time.
As of January 1, 2006, our management has assessed the effectiveness of our
internal control over financial reporting. In making its assessment of internal
control over financial reporting, management used the criteria issued by the
Committee of Sponsoring Organizations of the Treadway Commission, or COSO, in
Internal Control-Integrated Framework. A material weakness is a significant
deficiency, or combination of significant deficiencies, that results in more
than a remote likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. In performing the
assessment, management identified the following control deficiencies that we
have concluded are material weaknesses in internal control over financial
reporting as of January 1, 2006:
Ineffective management review of account analyses and reconciliations.
Management's ineffective review of significant account analyses and
reconciliations prepared as part of the financial reporting process, arising
from a shortage of, and turnover in qualified personnel, did not function to
reduce to remote the likelihood that material misstatement of certain accrued
liability accounts in the financial statements would not be prevented or
detected in a timely manner. This material weakness resulted in adjustments to
several accrued liability accounts and related expenses and could affect
substantially all of our significant accounts.
Ineffective communication of accounting policy for capitalizing costs and lack
of effective review process. Controls related to capitalization of property,
furnishings and equipment, including invoice approval, coding and review
processes, did not function to reduce to remote the likelihood that material
misstatements of property, furnishings and equipment and store operating
expenses would not be prevented or detected in a timely manner. This material
weakness resulted in adjustments to property, furnishings and equipment,
depreciation expense, accumulated depreciation, and store operating expenses.
Inaccurate or lack of timely updating of accounting inputs for key estimates
and assumptions. Controls that reasonably assure the accurate and timely
updating of accounting data used in making estimates for financial reporting
purposes did not function to reduce to remote the likelihood that errors in
accounts affected by estimation processes could result in material
misstatements that would not be prevented or detected in a timely manner. This
deficiency is due, in part, to a lack of, and turnover in, qualified people
with sufficient skills and experience, and in part to ineffective or incomplete
policies and procedures surrounding periodic review and updating of key
estimates and assumptions. This material weakness resulted in adjustments to
rental inventory amortization, store supplies, merchandise inventory, and
accrued liabilities.
Ineffective procurement and receiving processes. Several key controls did not
function effectively to provide reasonable assurance that rental and
merchandise inventory transferred to stores from Company-operated distribution
centers are appropriately accumulated, processed and recorded in the proper
period. This combination of control deficiencies resulted in adjustments to
accounts payable, rental inventory, merchandise inventory, costs of product
sales, and rental inventory.
As a result of the material weaknesses described above, management has
concluded that, as of January 1, 2006, our system of internal control over
financial reporting was not effective based on the COSO criteria.
Our assessment of the effectiveness of internal control over financial
reporting as of January 1, 2006 has been audited by Ernst & Young LLP,
independent registered public accounting firm, and their attestation
report, which appears below.
Remediation of Material Weaknesses
As discussed above, as of January 1, 2006, there were four material weaknesses
in our internal control over financial reporting. In 2006, management plans to
implement improved policies and control activities governing fixed asset
additions, enhanced control activities and monitoring controls surrounding
account reconciliations and management's use of assumptions and estimates in
its accounts, and improved information and control activities surrounding
integrated procurement and receiving processes. In addition, we intend to
evaluate our current staffing and training needs in light of the control
deficiencies identified herein and in preparation for the completion of the
transition of accounting and finance operations to our corporate facilities in
Wilsonville, Oregon, which began in 2005 and which we expect to complete during
2006.
Changes in Internal Control over Financial Reporting
During the fourth quarter of 2005, we completed the consolidation of
substantially all distribution functions to the Oregon and Tennessee
distribution centers acquired in the Hollywood acquisition. This change
contributed to the material weakness relating to ineffective procurement and
receiving processes noted above. Beyond this, there were no changes in our
internal control over financial reporting during the most recently completed
fiscal quarter that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting. However, as
described in the preceding paragraph, we plan to implement changes in internal
control in 2006 to correct the material weaknesses described above and to
complete the consolidation of our accounting and finance operations.
Report of Independent Registered Public Accounting Firm on Internal Control
Over Financial Reporting
The Board of Directors and Stockholders
Movie Gallery, Inc.
We have audited management's assessment, included in the accompanying
"Management's Annual Report on Internal Control Over Financial Reporting", that
Movie Gallery, Inc. (the Company) did not maintain effective internal control
over financial reporting as of January 1, 2006, because of the effect of the
material weaknesses identified in management's assessment and described below,
based on criteria established in Internal Control--Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (the
COSO criteria). The Company's management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our
responsibility is to express an opinion on management's assessment and an
opinion on the effectiveness of the Company's internal control over financial
reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control
over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately
and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and expenditures of
the company are being made only in accordance with authorizations of management
and directors of the company; and (3) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition
of the company's assets that could have a material effect on the financial
statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be
prevented or detected. The following material weaknesses have been identified
and included in management's assessment as of January 1, 2006:
- - Ineffective management review of account analyses and reconciliations.
Management's ineffective review of significant account analyses and
reconciliations prepared as part of the financial reporting process,
arising from a shortage of, and turnover in qualified financial reporting
personnel, did not function to reduce to remote the likelihood that
material misstatement of certain accrued liability accounts in the
financial statements would not be prevented or detected in a timely
manner. This material weakness resulted in adjustments to several
accrued liability accounts and related expenses, and if not remediated,
could result in future misstatements.
- - Ineffective communication of accounting policy for capitalizing costs and
lack of effective review process. Controls related to capitalization of
property, furnishings and equipment, including invoice approval, coding,
and review processes, did not function to reduce to remote the likelihood
that material misstatements of property, furnishings and equipment and
store operating expenses would not be prevented or detected in a timely
manner. This material weakness resulted in adjustments to property,
furnishings and equipment, depreciation expense, accumulated depreciation
and store operating expenses, and if not remediated, could result in
future misstatements.
- - Inaccurate or lack of timely updating of accounting inputs for key
estimates and assumptions. Controls that reasonably assure the accurate
and timely updating of accounting data used in making estimates for
financial reporting purposes did not function to reduce to remote the
likelihood that material errors in accounts affected by estimation
processes could result in material misstatements that would not be
prevented or detected in a timely manner. This deficiency is due, in
part, to a lack of, and turnover in, qualified financial reporting
personnel with sufficient skills and experience, and in part to
ineffective or incomplete policies and procedures surrounding periodic
review and updating of key accounting estimates and assumptions. This
material weakness resulted in adjustments to rental inventory
amortization, store supplies, merchandise inventory and accrued
liabilities and if not remediated, could result in future misstatements.
- - Ineffective procurement and receiving processes. Several key controls
did not function effectively to provide reasonable assurance that rental
and merchandise inventory transferred to stores from Company-operated
distribution centers are appropriately accumulated, processed and recorded in
the proper period. This combination of control deficiencies resulted in
adjustments to accounts payable, rental inventory, merchandise inventory,
costs of product sales, and rental inventory amortization and if not
remediated, could result in future misstatements.
These material weaknesses affected substantially all of the Company's
significant accounts and required the Company to record adjustments to both its
annual and interim 2005 financial statements. These material weaknesses were
considered in determining the nature, timing, and extent of the audit tests
applied in our audit of the Company's 2005 consolidated financial statements,
and this report does not affect our report dated March 22, 2006 on those
financial statements.
In our opinion, management's assessment that Movie Gallery, Inc. did not
maintain effective internal control over financial reporting as of January 1,
2006, is fairly stated, in all material respects, based on the COSO control
criteria. Also, in our opinion, because of the effect of the material
weaknesses described above on the achievement of the objectives of the
control criteria, Movie Gallery, Inc. has not maintained effective internal
control over financial reporting as of January 1, 2006, based on the COSO
control criteria.
/s/ Ernst & Young LLP
Birmingham, Alabama
March 22, 2006
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item (other than the information regarding
directors and executive officers set forth in Part 1, Item 1 of this Annual
Report on Form 10-K under the heading "Directors and Executive Officers")
appears in our definitive Proxy Statement for our 2006 Annual Meeting of
Stockholders, and is incorporated herein by reference.
The information required by this Item in regards to a Code of Business Conduct
and Ethics appears in our definitive Proxy Statement for our 2006 Annual
Meeting of Stockholders under the heading "Code of Ethics" and is incorporated
herein by reference.
The information required by this Item in regards to an "audit committee
financial expert" appears in our definitive Proxy Statement for our 2006 Annual
Meeting of Stockholders under the heading "Audit Committee" and is incorporated
herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item appears in our definitive Proxy Statement
for our 2006 Annual Meeting of Stockholders, and is incorporated herein by
reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item appears in our definitive Proxy Statement
for our 2006 Annual Meeting of Stockholders, and is incorporated herein by
reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item appears in our definitive Proxy Statement
for our 2006 Annual Meeting of Stockholders, and is incorporated herein by
reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this Item appears in our definitive Proxy Statement
for our 2006 Annual Meeting of Stockholders, and is incorporated herein by
reference.
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Listed below are all financial statements, notes, schedules and exhibits
filed as part of our Annual Report on Form 10-K for the year ended January 1,
2006:
(1) FINANCIAL STATEMENTS
The following financial statements of the Registrant, together with the Report
of Independent Registered Public Accounting Firm dated March 22, 2006, are
filed herewith:
Consolidated Balance Sheets as of January 2, 2005 and January 1, 2006
Consolidated Statements of Operations for the fiscal years ended January 4,
2004, January 2, 2005, and January 1, 2006
Consolidated Statements of Stockholders' Equity for the fiscal years ended
January 4, 2004, January 2, 2005, and January 1, 2006
Consolidated Statements of Cash Flows for the fiscal years ended January 4,
2004, January 2, 2005, and January 1, 2006
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
(2) FINANCIAL SCHEDULES
All financial schedules are omitted, as the required information is
inapplicable or the information is presented in the respective Consolidated
Financial Statements or related notes.
(3) EXHIBITS
The following exhibits are filed with or incorporated by reference into this
Annual Report on Form 10-K:
EXHIBIT TABLE
2.1 Agreement and Plan of Merger by and among the Movie Gallery,
Inc., TG Holdings, Inc. and Hollywood Entertainment Corporation,
dated January 9, 2005.(1)
3.1 Certificate of Incorporation of Movie Gallery, Inc.(2)
3.1.1 Certificate of Amendment of Certificate of Incorporation of
Movie Gallery, Inc. dated June 6, 1996.(3)
3.1.2 Certificate of Amendment of Certificate of Incorporation of
Movie Gallery, Inc. dated July 1, 1999.(3)
3.1.3 Certificate of Amendment of Certificate of Incorporation of
Movie Gallery, Inc. dated June 27, 2002.(4)
3.2 Amended and Restated Bylaws of Movie Gallery, Inc.(4)
4.1 Specimen Common Stock Certificate.(5)
10.1 Form of Indemnity Agreement.(2)
10.2 Employment Agreement between M.G.A., Inc. and Joe Thomas
Malugen.(2)
10.2.1 First Amendment to Employment Contract between M.G.A., Inc. and
J.T. Malugen, dated April 3, 2000.(6)
10.3 Executive Employment Agreement between M.G.A., Inc. and S. Page
Todd, dated November 14, 1997.(7)
10.4 Executive Employment Agreement between M.G.A., Inc. and Jeffrey
S. Stubbs, dated November 30, 1999.(8)
10.5 2003 Stock Plan.(9)
10.5.1 Amendment to the Movie Gallery, Inc. 2003 Stock Plan, dated
August 20, 2003.(9)
10.5.2 Second Amendment to the Movie Gallery, Inc. 2003 Stock Plan,
dated June 10, 2005.(10)
10.6 2003 Employee Stock Purchase Plan.(11)
10.6.1 Amendment to Movie Gallery, Inc. 2003 Employee Stock Purchase
Plan, dated December 16, 2004.(12)
10.7 Purchase Agreement, dated April 25, 2005, by and among Movie
Gallery, Inc., the Guarantors named therein, Wachovia Capital
Markets, LLC, Merrill Lynch, Pierce, Fenner & Smith Incorporated
and CIBC World Markets Corp.(13)
10.8 Indenture, dated April 27, 2005, by and among Movie Gallery,
Inc., the Guarantors named therein and SunTrust Bank, as
Trustee.(14)
10.9 Credit Agreement, dated April 27, 2005, by and among Movie
Gallery, Inc., Movie Gallery Canada, Inc., the Initial Lenders
and Initial Issuing Banks named therein, Wachovia Bank, N.A. as
U.S. Administrative Agent, Congress Financial Corporation
(Canada), as Canadian Administrative Agent, Merrill Lynch,
Pierce, Fenner & Smith Incorporated as Syndication Agent and
Bank of America, N.A., Calyon New York Branch and Canadian
Imperial Bank of Commerce as Co-Documentation Agents.(15)
10.9.1 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.(16)
10.9.2 Second Amendment, dated March 15, 2006, 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. (17)
10.10 Summary of Non-Employee Director Compensation.(18)
10.11 Form of Employee Restricted Stock Purchase Agreement (service-
based vesting for employees).(19)
10.12 Form of Non-Employee Director Restricted Stock Purchase
Agreement (for non-employee directors).(20)
10.13 Form of Employee Restricted Stock Purchase Agreement (one-year
performance based on vesting for employees).(21)
10.14 Form of Employee Restricted Stock Purchase Agreement (two-year
performance based vesting for employees).(22)
10.15 Offer Letter, dated February 2, 2004, between the Company and
Thomas D. Johnson, Jr.
14 Amended and Restated Movie Gallery, Inc. Code of Business
Conduct and Ethics.(23)
21 List of Subsidiaries.
23 Consent of Independent Registered Public Accounting Firm.
31.1 Certification of Chief Executive Officer pursuant to Rule 13a-
14(a)/15d-14(a) of the Securities Exchange Act of 1934.
31.2 Certification of Chief Financial Officer pursuant to Rule 13a-
14(a)/15d-14(a) of the Securities Exchange Act of 1934.
32.1 Certification of Chief Executive Officer pursuant to Rule 13a-
14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18
U.S.C Section 1350.
32.2 Certification of Chief Financial Officer pursuant to Rule 13a-
14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18
U.S.C. Section 1350.
(1) Previously filed on January 11, 2005, as exhibit of the same number to
the Company's Current Report on Form 8-K, and incorporated herein by
reference.
(2) Previously filed on June 10, 1994, as an exhibit to the Company's
Registration Statement on Form S-1 (File No. 33-80120), and incorporated
herein by reference.
(3) Previously filed on August 17, 1999, as exhibit of the same number to
the Company's Quarterly Report on Form 10-Q for the quarter ended July
4, 1999, and incorporated herein by reference.
(4) Previously filed on April 7, 2003, as exhibit of the same number to the
Company's Annual Report on Form 10-K for the fiscal year ended January
5, 2003, and incorporated herein by reference.
(5) Previously filed on August 1, 1994, as an exhibit to Amendment No. 2 to
the Company's Registration Statement on Form S-1 (File No. 33-80120),
and incorporated herein by reference.
(6) Previously filed on May 17, 2000, as Exhibit 10.2 to the Company's
Quarterly Report on Form 10-Q for the quarter ended April 2, 2000, and
incorporated herein by reference.
(7) Previously filed on April 6, 1998, as Exhibit 10.7 to the Company's
Annual Report on Form 10-K for the fiscal year ended January 4, 1998,
and incorporated herein by reference.
(8) Previously filed on April 2, 2001, as Exhibit 10.7 to the Company's
Annual Report on Form 10-K for the fiscal year ended December 31, 2000,
and incorporated herein by reference.
(9) Previously filed on September 29, 2003, as Exhibit 4.4 to the Company's
Registration Statement on Form S-8 (File No. 333-109240), and
incorporated herein by reference.
(10) Previously filed on July 26, 2005, as Exhibit 10.1 to the Company's
Current Report on Form 8-K/A, and incorporated herein by reference.
(11) Previously filed on September 29, 2003, as Exhibit 4.4 to the Company's
Registration Statement on Form S-8 (File No. 333-109241), and
incorporated herein by reference.
(12) Previously filed on December 20, 2004, as Exhibit 10.1 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(13) Previously filed on April 29, 2005, as Exhibit 10.1 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(14) Previously filed on April 29, 2005, as Exhibit 10.2 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(15) Previously filed on April 29, 2005, as Exhibit 10.4 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(16) Previously filed on September 28, 2005, as Exhibit 10.1 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(17) Previously filed on March 17, 2006, as Exhibit 10.1 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(18) Previously filed on June 15, 2005, as Exhibit 10.2 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(19) Previously filed on October 20, 2005, as Exhibit 10.1 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(20) Previously filed on October 20, 2005, as Exhibit 10.2 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(21) Previously filed on October 20, 2005, as Exhibit 10.3 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(22) Previously filed on October 20, 2005, as Exhibit 10.4 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(23) Previously filed on August 3, 2005, as Exhibit 10.2 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
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: March 23, 2006 /s/ J.T. Malugen
----------------------------
J.T. Malugen
Chairman of the Board, President
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
- --------------------- -------------------------------- --------------
/s/ J.T. Malugen Chairman of the Board, President March 23, 2006
- ---------------- and Chief Executive Officer
J.T. Malugen (Principal Executive Officer)
/s/ Harrison Parrish Vice Chairman of the Board March 23, 2006
- --------------------
H. Harrison Parrish
/s/ William B. Snow Director March 23, 2006
- -------------------
William B. Snow
/s/ John J. Jump Director March 23, 2006
- ----------------
John J. Jump
/s/ James C. Lockwood Director March 23, 2006
- ---------------------
James C. Lockwood
/s/ Timothy R. Price Executive Vice President and March 23, 2006
- -------------------- Chief Financial Officer
Timothy R. Price (Principal Financial and
Accounting Officer)
FINANCIAL STATEMENTS
Movie Gallery, Inc.
Consolidated Balance Sheets
(In thousands, except per share amounts)
-------------------------
January 2, January 1,
2005 2006
----------- -----------
Assets
Current assets:
Cash and cash equivalents $ 25,518 $ 135,238
Merchandise inventory, net 27,419 136,450
Prepaid expenses 12,712 41,393
Store supplies and other 9,493 24,194
Deferred income taxes 3,358 -
----------- -----------
Total current assets 78,500 337,275
Rental inventory, net 126,541 371,565
Property, furnishings and equipment, net 128,182 332,218
Goodwill, net 143,761 118,404
Other intangibles, net 7,741 184,671
Deposits and other assets 7,417 40,995
----------- -----------
Total assets $ 492,142 $ 1,385,128
=========== ===========
Liabilities and stockholders' equity (deficit)
Current liabilities:
Current maturities of long-term obligations $ - $ 78,146
Current maturities of financing obligations - 4,492
Accounts payable 68,977 236,989
Accrued liabilities 17,164 88,460
Accrued payroll 11,098 38,624
Accrued interest - 7,220
Deferred revenue 10,843 39,200
----------- ----------
Total current liabilities 108,082 493,131
Long-term obligations, less current portion - 1,083,083
Other accrued liabilities 2,308 21,662
Deferred income taxes 50,618 70
Commitments and contingencies (Note 6
and Note 10) - -
Stockholders' equity (deficit):
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 31,686
shares issued and outstanding, respectively 31 32
Additional paid-in capital 188,098 199,151
Unearned compensation - (4,128)
Retained earnings (deficit) 136,750 (417,882)
Accumulated other comprehensive income 6,255 10,009
----------- -----------
Total stockholders' equity (deficit) 331,134 (212,818)
----------- -----------
Total liabilities and stockholders' equity $ 492,142 $ 1,385,128
=========== ===========
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Consolidated Statements of Operations
(in thousands, except per share amounts)
Fiscal Year Ended
------------------------------------
January 4, January 2, January 1,
2004 2005 2006
---------- ---------- -----------
Revenue:
Rentals $ 629,793 $ 729,167 $1,630,058
Product sales 62,602 62,010 357,269
--------- -------- ----------
Total revenue 692,395 791,177 1,987,327
Cost of sales:
Cost of rental revenue 184,439 208,160 502,873
Cost of product sales 50,143 41,942 271,900
--------- -------- ----------
Gross profit 457,813 541,075 1,212,554
Operating costs and expenses:
Store operating expenses 324,466 395,425 1,027,119
General and administrative 46,522 54,644 128,441
Amortization of intangibles 2,003 2,601 3,865
Impairment of goodwill - - 522,950
Impairment of other intangibles - - 4,940
Stock compensation expense 1,481 831 1,618
--------- -------- ----------
Operating income (loss) 83,341 87,574 (476,379)
Non-operating expenses:
Interest expense, net (468) (624) (68,529)
Write-off of bridge
financing costs - - (4,234)
Equity in losses of
unconsolidated entities (1,450) (5,746) (806)
--------- -------- ----------
Income (loss) before income
taxes 81,423 81,204 (549,948)
Income taxes 31,987 31,716 2,792
--------- ---------- ----------
Net income (loss) $ 49,436 $ 49,488 $ (552,740)
========= ======== ==========
Net income (loss) per share:
Basic $ 1.53 $ 1.54 $ (17.53)
========= ======== ==========
Diluted $ 1.48 $ 1.52 $ (17.53)
========= ======== ==========
Weighted average shares outstanding:
Basic 32,406 32,096 31,524
Diluted 33,370 32,552 31,524
Cash dividends per common share $ 0.03 $ 0.12 $ 0.06
========= ======== ==========
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Consolidated Statements of Stockholders' Equity (Deficit)
(In thousands, except per share amounts)
Accumulated
Other Total
Un- Compre- Stock-
Additional earned hensive holders'
Common Paid-in Retained Compen- Income Equity
Stock Capital Earnings sation (Loss) (Deficit)
------ -------- -------- ------- --------- --------
Balance at January 3, 2003$ 32 $216,631 $ 42,647 $ - $ (259) $259,051
Comprehensive income:
Net income 49,436 49,436
Foreign currency
translation - - 4,053 4,053
------
Total comprehensive
income 53,489
Exercise of stock options
for 779 shares 1 3,332 - - - 3,333
Tax benefit of stock
options exercised - 3,747 - - - 3,747
Non-cash stock option
compensation - 1,481 - - - 1,481
Dividends declared, $0.03
per share - - (985) - - (985)
----- -------- -------- ------- ----- --------
Balance at January 4, 2004 33 225,191 91,098 - 3,794 320,116
Comprehensive income:
Net income 49,488 - 49,488
Foreign currency
translation - - 2,461 2,461
------
Total comprehensive
income 51,949
Exercise of stock options
for 876 shares 1 5,522 - - - 5,523
Tax benefit of stock
options exercised - 4,305 - - - 4,305
Non-cash stock option
compensation - 64 - - - 64
Issuance of 26 shares of
Common stock pursuant
to employee stock
purchase plan - 403 - - - 403
Purchase and retirement of
2,625 shares of common
stock (3) (47,387) - - - (47,390)
Dividends declared, $0.12
per share - - (3,836) - - (3,836)
----- -------- -------- ------- ----- --------
Balance at January 2, 2005 31 188,098 136,750 - 6,255 331,134
Comprehensive income (loss):
Net loss (552,740) - - (552,740)
Foreign currency
translation - - - - 946 946
Change in fair value of
interest rate swap - - - - 2,808 2,808
------
Total comprehensive
(loss) (548,986)
Exercise of stock options
for 575 shares 1 5,318 - - - 5,319
Non-cash stock option
compensation - 67 - - - 67
Issuance of 35 shares of
common stock pursuant
to employee stock
purchase plan - 379 - - - 379
Dividends declared, $0.06
per share - - (1,892) - - (1,892)
Issuance of nonvested
stock award and
amortization of
unearned compensation - 5,289 - (4,128) - 1,161
------ -------- --------- ------- ------- ---------
Balance at January 1, 2006 $ 32 $199,151 $(417,882)$(4,128)$10,009 $(212,818)
====== ======== ========= ======= ======= =========
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Consolidated Statements of Cash Flows
(in thousands)
Fiscal Year Ended
------------------------------------
January 4, January 2, January 1,
2004 2005 2006
--------- --------- ---------
(Revised) (Revised)
Operating activities:
Net income (loss) $ 49,436 $ 49,488 $(552,740)
Adjustments to reconcile net income (loss)
to net cash provided by operating
activities:
Rental inventory amortization 132,978 144,521 288,084
Purchases of rental inventory (130,503) (150,924) (277,028)
Purchases of rental inventory - base
stock (16,702) (15,616) (20,367)
Depreciation and intangibles amortization 23,569 36,185 92,655
Gain on disposal of property, furnishings
and equipment - - (494)
Stock based compensation (non-cash) 1,481 64 1,618
Amortization of debt issuance cost - - 3,659
Impairment of goodwill - - 522,950
Impairment of other intangibles - - 4,940
Tax benefit of stock options exercised 3,747 4,305 -
Deferred income taxes 24,036 19,106 5,156
Changes in operating assets and liabilities,
net of business acquisitions:
Extended viewing fees receivable, net - - 21,369
Merchandise inventory (7,232) (491) 11,044
Other current assets (4,905) (500) (3,092)
Deposits and other assets (5,085) 1,336 9
Accounts payable 6,308 (1,962) (4,135)
Accrued interest - - 7,181
Accrued liabilities and deferred revenue 1,725 4,361 31,597
--------- --------- ---------
Net cash provided by operating activities 78,853 89,873 132,406
Investing activities:
Business acquisitions, net of cash
acquired (30,672) (12,962) (1,096,686)
Purchases of property, furnishings
and equipment (47,116) (46,507) (58,198)
Proceeds from disposal of property,
furnishings and equipment - - 3,672
Acquisition of construction phase assets,
net (non cash) - - 5,621
--------- --------- ---------
Net cash used in investing activities (77,788) (59,469) (1,145,591)
Financing activities:
Repayment of capital lease obligations - - (426)
Decrease in financing obligations (non cash) - - (5,892)
Net borrowings (repayments) on credit
facilities - - 6,862
Long term debt financing fees - - (32,484)
Proceeds from issuance of long-term debt - - 1,166,120
Principal payments on long-term debt - - (15,093)
Proceeds from exercise of stock options 3,333 5,523 5,319
Proceeds from employee stock purchase plan - 403 379
Purchases and retirement of common stock - (47,390) -
Payment of dividends - (3,889) (2,826)
--------- -------- ---------
Net cash (used in) provided by
financing activities 3,333 (45,353) 1,121,959
Effect of exchange rate changes on cash
and cash equivalents 4,053 2,461 946
--------- -------- ---------
Increase (decrease) in cash and
cash equivalents 8,451 (12,488) 109,720
Cash and cash equivalents at
beginning of period 29,555 38,006 25,518
--------- -------- ---------
Cash and cash equivalents
at end of period $ 38,006 $ 25,518 $ 135,238
========= ======== =========
Supplemental disclosures of cash flow information:
Cash paid for interest $ 254 $ 694 $ 61,782
Cash paid for income taxes 4,974 6,826 1,918
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Notes to Consolidated Financial Statements
January 4, 2004, January 2, 2005 and January 1, 2006
1. Accounting Policies
Nature of the Business
Movie Gallery is the second largest North American home video rental company
with annual revenue of approximately $2.6 billion on a pro forma basis and
nearly 4,800 stores located throughout the United States, Mexico and Canada.
We operate three distinct brands, Movie Gallery, Hollywood Video and Game
Crazy. In addition we operate 648 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. Our common stock is traded on the NASDAQ Stock Market under
the symbol "MOVI".
Since our initial public offering in August 1994, we have grown from 97 stores
to our present size through acquisitions and new store openings.
We acquired Hollywood Entertainment Corporation ("Hollywood") on April 27,
2005. 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 consolidated statements of operations and cash
flows for the fiscal year ended January 1, 2006 include the results of
operations of Hollywood since April 27, 2005, the date of acquisition. See
Note 2 for a summary of unaudited pro forma information and additional details
on the purchase of Hollywood.
Principles of Consolidation
The accompanying 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 we have significant influence but do not have control are
accounted for using the equity method of accounting. We account for
investments in entities where we do not have significant influence using the
cost method. All material intercompany accounts and transactions have been
eliminated.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires us to make
estimates and assumptions that affect the amounts reported in the consolidated
financial statements and accompanying notes. The most significant estimates
and assumptions relate to the amortization methods and useful lives of rental
inventory, fixed assets and other intangibles, valuation allowances for
deferred tax assets, estimated cash flows used to test goodwill and long-lived
assets for impairment, and the allocation of the purchase price to the fair
value of net assets of acquired businesses. These estimates and assumptions
could change if actual results differ from these estimates, and these
differences could be material.
Fiscal Year
Our fiscal year ends on the first Sunday following December 30, which
periodically results in a fiscal year of 53 weeks. Results for the fiscal year
ended January 4, 2004, January 2, 2005 and January 1, 2006 reflect 52-week
years. The fiscal year includes revenues and certain costs and expenses, such
as revenue sharing, payroll and other miscellaneous expenses, on a daily basis.
All other expenses, primarily depreciation, amortization, rent and utilities,
are calculated and recorded monthly, with twelve months included in each fiscal
year.
Reclassifications and Revisions
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.
The accompanying consolidated statements of cash flows for 2003 and 2004 have
been revised to reflect all purchases of rental inventory as operating cash
flows. In our previously filed 2004 and 2003 statements of cash flows,
purchases of base stock rental inventory were reflected as investing
activities. After recent consultations with the Securities and Exchange
Commission, we decided to classify these purchases, which amounted to $16.7
million and $15.6 million, in 2003 and 2004, respectively, as operating cash
flows.
Cash Equivalents
We consider all highly liquid investments with a maturity of three months or
less when purchased to be cash equivalents. The carrying amounts reported in
the balance sheet for cash and cash equivalents approximate those assets' fair
value.
Merchandise Inventory
Merchandise inventory consists primarily of new and used video game software,
hardware and accessories, new DVD and VHS movies, video accessories and
concessions. Merchandise inventory is stated at the lower of cost or market.
Used video game inventory includes games accepted as trade-ins from customers.
Games are accepted from customers primarily in exchange for in-store credit.
At the time of trade-in, the inventory is recorded as well as the corresponding
liability for the trade credit. The liability is relieved when the trade
credit is redeemed.
The Movie Gallery segment determines the cost of merchandise inventory using
the retail method. The other segments determine the cost of inventory using
the weighted average cost method.
Rental Inventory Amortization Estimates
We manage our movie rental inventories 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,
purchases represent an investment in those movies we intend 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, we
purchase catalog inventories to support new store openings and to build-up
title selection, for formats preferred by our customers.
Purchases of new release movies are amortized over six months on an accelerated
basis to average residual values of $1.00 for VHS format (changed from $2.00 in
2005) and $4.00 for DVDs. Purchases of DVD catalog inventory units are
currently amortized on an accelerated basis over twenty-four months to an
estimated average residual value of $4.00. VHS catalog is amortized on an
accelerated basis to an estimated $1.00 residual value (changed from $2.00 in
2005) over twenty-four months for new store purchases and six months for all
other catalog purchases. Video games have been amortized over twelve months to
an estimated residual value of $5.00 for all periods presented herein.
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 of movies purchased under revenue sharing
arrangements are approximately equal to the estimates we apply to non-revenue
sharing purchases outlined above.
Change in Accounting Estimate for Rental Inventory
We regularly review, evaluate and update our rental amortization accounting
estimates. Effective April 4, 2005, we changed our estimated residual value on
VHS movies from $2.00 to $1.00 per unit due to continued declines in the
average selling prices of older VHS product. We accounted for this change as a
change in accounting estimate, which decreased rental inventory and increased
amortization expense by approximately $10.1 million in the second quarter. This
reduced net income by $6.6 million (net of tax), or $0.21 per diluted share for
the fiscal year ended January 1, 2006.
Property, Furnishings and Equipment
Property, furnishings and equipment are stated at cost and are depreciated on a
straight-line basis for financial reporting purposes over the estimated useful
life of the assets, which range from approximately five to forty years.
Leasehold improvements are amortized over the lesser of the assets' economic
life or the contractual term of the lease, usually 5 to 10 years at the
inception of the lease. Optional renewal periods are included in the
contractual term of the lease only if renewal is reasonably assured at the time
the asset is placed in service.
Additions to property, furnishings and equipment are capitalized and include
acquisitions of property, furnishings and equipment, costs incurred in the
development and construction of new stores, including in some cases the fair
value of lessor development in accordance with EITF 97-10 "The Effect of Lessee
Involvement in Asset Construction,", major improvements to existing property
and major improvements in management information systems including certain
costs incurred for internally developed computer software. Maintenance and
repair costs are charged to expense as incurred, while improvements that extend
the useful life of the assets are capitalized. When property and equipment are
sold or retired, the applicable cost and accumulated depreciation and
amortization are removed from the accounts and any gain or loss is recognized
on the disposition.
Goodwill and Other Intangible Assets
Goodwill is recorded at historical cost and is tested for impairment annually
or more frequently if events or changes in circumstances indicate that goodwill
might be impaired in accordance with SFAS No. 142, "Goodwill and Other
Intangible Assets." We recognized impairment losses on goodwill of $0, $0, and
$523.0 million for fiscal 2003, 2004, and 2005, respectively. See Note 5 for
additional information on the goodwill impairment charges in 2005.
Other intangible assets consist primarily of trademarks, non-compete agreements
and customer lists. We amortize finite-lived intangible assets on a straight-
line basis over their estimated useful lives. The Game Crazy trademark was
acquired with the acquisition of Hollywood and was determined to have a finite
life of 15 years. Indefinite-lived intangible assets are not amortized, but
are subject to impairment testing annually or whenever indicators of impairment
are present. The Hollywood Video trademark was acquired with the acquisition
of Hollywood Entertainment and was determined to have an indefinite life. The
Hollywood trademark is tested for impairment annually, or more frequently, if
events or changes in circumstances indicate that the asset might be impaired,
in accordance with SFAS No. 142. We also test other finite-lived intangible
assets for impairment annually, or whenever impairment indicators are present.
In 2005, we recognized impairment charges on customer lists. The $4.9 million
impairment was recorded to reduce the carrying value of acquired customer lists
to the estimated fair value based on a comparison of the carrying value to
observed market comparables. See Note 5 for additional information on the 2005
impairment charges related to customer lists intangible assets.
Impairment of Long-Lived Assets
Long-lived assets, including rental inventory, property, furnishings and
equipment and intangible assets with finite lives, are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount
may not be recoverable, in accordance with SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. We primarily use discounted cash
flow methods to estimate the fair value of long-lived assets.
Store Closure Reserves
When stores are closed before the end of the lease term, a liability for costs
that will continue to be incurred under the lease is recorded at the "cease
use" date by calculating the present value of the remaining lease obligations,
less actual or probable sublease revenues.
Store Opening and Start-up Costs
Store opening and other start-up costs, which consist primarily of payroll,
advertising and other pre-opening costs are expensed as incurred.
Contingencies Reserves
Legal and other contingencies, which are determined to be both probable and
estimable, are recorded as liabilities in the Consolidated Financial Statements
in amounts equal to our best estimates of the costs of resolution or settlement
of the underlying claims. These estimates are based upon judgments and
assumptions. We regularly monitor our estimates in light of subsequent
developments and changes in circumstances and adjust our estimates when
additional information causes us to believe that they are no longer
appropriate. If we cannot determine a best estimate for a particular
contingency, the amount representing the low end of the range of probable loss
is recorded. If material, possible loss contingencies in excess of the amounts
accrued are disclosed. See Note 10 for additional information on the estimates
of contingent liabilities. Legal costs are expensed as incurred.
Self-Insurance
We are self-insured for workers' compensation, general liability costs, group
medical, and certain other self-insurance plans, with per occurrence and
aggregate limits on losses provided by third party insurance carriers. The
self-insurance liabilities recorded in the financial statements are based on
internal and third party actuarial estimates considering claims filed and
actuarial development factors, including an estimate of claims incurred but not
yet reported.
Leases and Leasehold Improvements
Our new store leases generally provide for an initial lease term of five to ten
years, with at least one renewal option for an additional two to five years.
We account for leases in accordance with SFAS No. 13, "Accounting for Leases,"
and other related guidance. SFAS No. 13 requires lease expense to be
recognized on a straight-line basis over the lease term (as defined within the
guidance), including amortization of any lease incentives received from the
lessor. SFAS 13 also requires that leasehold improvements be depreciated over
the shorter of the lease term or the estimated useful life of the leasehold
improvement.
Subsequent to the end of fiscal 2004, we completed a comprehensive review of
our accounting for leases and leasehold improvements, including the recognition
of incentive payments received from landlords. We determined that leasehold
improvements were, in some cases, depreciated over a longer period than the
lease term. As a result, we recorded a cumulative fourth quarter adjustment to
correct depreciation expense of $6.3 million ($3.9 million after-tax or $0.12
per diluted share) as an increase in store operating expenses in 2004.
Approximately $2.9 million ($1.8 million after-tax or $0.05 per diluted share)
of the adjustment was related to years prior to 2004 and was not considered
material to any of the prior period financial statements to warrant a
restatement of those financial statements.
Deferred Rent
Many of our operating leases contain predetermined fixed increases in the
minimum rental rate during the initial lease term and/or rent holiday periods.
For these leases, we recognize the related rental expense on a straight-line
basis beginning on the date the property is delivered to us. We record the
difference between the amount charged to expense and the rent paid as deferred
rent, which is included in other liabilities.
Financing Obligations
In accordance with EITF 97-10, "The Effect of Lessee Involvement in Asset
Construction," for some build-to-suit lease arrangements (where we have
construction period risk or where we are involved in the construction of
structural improvements prior to the commencement of the lease), we are
considered the owner of the assets during the construction period under
generally accepted accounting principles. As a result, the assets and
corresponding financing obligation are recorded on our consolidated balance
sheet. Once the construction is completed, if the lease meets certain "sale-
leaseback" criteria, we remove the asset and related financing obligation from
the balance sheet in accordance SFAS No. 98 "Accounting for Leases." If upon
completion of construction the project does not meet the "sale-leaseback"
criteria in SFAS No. 98, the leased property is treated as a capital lease for
financial reporting purposes.
Revenue Recognition
We recognize rental revenue when a movie or video game is rented by the
customer. We recognize product sales revenue and the sale of previously viewed
inventory at the time of sale. Previously viewed sales revenue was $81.7
million, $109.6 million and $284.3 million in fiscal 2003, 2004 and 2005,
respectively.
We also sell stored value cards in the form of electronic gift cards and
discount rental cards. We record deferred revenue from the sale of stored
value cards at the time of sale to the customer. The liability is relieved and
revenue is recognized when the cards are redeemed by the customer.
Revenue for unredeemed gift cards estimated using historical redemption
rates is recognized in proportion to actual gift card redemptions, generally
over a period of 18 months.
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
uncollectible amounts) for the extended viewing fee revenue expected to be
collected. At the time of the merger, Hollywood's receivable balance was $21.4
million. In order to conform Hollywood's accounting to Movie Gallery's
accounting method, subsequent to the merger, the portion of the extended
viewing fees collected from Hollywood customers that related to the acquired
receivable was not recognized as revenue, but rather reduced the receivable
balance. As a result, revenue recorded by the Hollywood segment was less than
cash collected in 2005 until the receivable balance was depleted. For fiscal
year 2005, this transition reduced extended viewing fees recognized by the
Hollywood Video segment by $21.4 million as compared to the amount that would
have been recognized by that segment if it had continued its prior accounting
method. This transition reduced operating income by $19.0 million, ($0.39 per
share after tax), after adjusting for accrued revenue sharing on accrued
extended viewing fees versus the amount that would have been reported in 2005
under the historical treatment used by Hollywood prior to the merger.
The Movie Gallery segment offers a point-based loyalty program, Reel Players,
to its customers. The program provides customers the opportunity to earn free
rentals or discounts on previously viewed inventory purchases. The Reel
Players coupon is issued to a customer upon accumulation of a predefined number
of points that are earned for previous rental or sale transactions. Rental
revenue is recognized when the coupon is redeemed by the customer for the
current rental price of the movie or game or the current sale price of the
previously viewed movie or game. A corresponding promotional credit is
recorded against rental revenue to offset the value of the transaction in
accordance with the terms of the coupon.
The Hollywood Video segment offers several rental subscription programs to its
customers. We offer nationally the Movie Value Pass (MVP), an in-store movie
rental subscription service. Subscription fees are paid up-front and recognized
as rental product revenue on a straight-line basis over the applicable term of
the subscription, typically one month.
The Game Crazy segment offers a Most Valuable Player (MVP) program to its
customers. The MVP program allows customers a game magazine subscription,
discounted used game merchandise prices and higher trade-in values for used
game merchandise in exchange for an up-front payment that is recognized as
revenue on a straight-line basis over the time period the customer receives the
benefit, typically one year.
The Movie Gallery, Hollywood Video and Game Crazy stores also offer return
privileges on certain products, including guarantees on previously viewed
inventory. The sales returns and allowances under these programs are
immaterial.
The Hollywood Video segment recognizes the franchise fee revenue received from
20 franchise stores operated by the Boards Video Company LLC ("Boards") based
on a percentage of Boards' revenue. The revenue from Boards' stores is
not included in Movie Gallery's results from operations.
Cooperative Advertising Credits
Advertising costs are expensed as incurred. We receive cooperative credits
from certain inventory suppliers, primarily studios, to promote their
respective movie and game titles. Cooperative credits that represent a
reimbursement of specific, incremental, identifiable costs are included in
expense 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. Advertising expense, exclusive of cooperative
reimbursements from vendors accounted for as cost reimbursements, for fiscal
2003, 2004, and 2005 totaled $7.8 million, $9.5 million, and $43.7 million,
respectively.
Fair Value of Financial Instruments
In accordance with SFAS No. 107, "Disclosure about Fair Value of Financial
Instruments," we have disclosed the fair value, related carrying value and
methods of determining the fair value for the following financial instruments
in the accompanying notes as referenced: cash and cash equivalents (see above),
and long-term obligations (see Note 7).
Foreign Currency Translation
Our foreign subsidiaries record transactions using the local currency as the
functional currency. In accordance with SFAS No. 52, "Foreign Currency
Translation," the assets and liabilities of the foreign subsidiary are
translated into U.S. dollars using either the exchange rates in effect at the
balance sheet dates or historical exchange rates, depending upon the account
translated. Income and expenses are translated at average exchange rates each
fiscal period. The translation adjustments that result from translating the
balance sheet at different rates from those used to translate accounts in the
income statement are included in accumulated other comprehensive income or
loss, which is a separate component of consolidated stockholders' equity.
Earnings Per Share
Basic earnings per share are computed based on the weighted average number of
shares of common stock outstanding during the periods presented. Diluted
earnings 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 shares to be issued from the exercise of dilutive common stock
options (964,000, 456,000 and none in 2003, 2004 and 2005, respectively). No
adjustments were made to net income in the computation of basic or diluted
earnings per share. Because their inclusion would be anti-dilutive, 977,000
options convertible into shares of common stock and 206,000 shares of non-
vested restricted stock for 2005 were excluded from the computation of the
weighted average shares outstanding for purposes of computing diluted earnings
per share.
Stock Based Compensation
We account 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 expense is
reflected in net income for restricted stock granted to employees and for
certain variable options outstanding that were repriced in March 2001 and for
certain stock option redemptions involving current and former executives (in
2004 only). No stock compensation expense is reflected in net income for fixed
options granted to employees when the exercise price equals the market value of
the underlying common stock on the date of grant (See Note 9).
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 SFAS No. 123, "Accounting for Stock-Based Compensation," as amended, to
stock-based employee compensation (in thousands, except per share data).
Fiscal Year Ended
-------------------------------------
January 4, January 2, January 1,
2004 2005 2006
---------- ---------- ----------
Net income(loss), as reported $ 49,436 $ 49,488 $(552,740)
Add: Stock based compensation expense
included in reported net income,
net of tax 903 507 1,052
Deduct: Stock based compensation expense
determined under fair market value based
methods for all awards, net of tax (1,099) (1,301) (4,377)
--------- --------- ---------
Pro forma net income(loss) $ 49,240 $ 48,694 $(556,065)
========= ========= =========
Earnings(loss) per share, as reported:
Basic $ 1.53 $ 1.54 $ (17.53)
========= ========= =========
Diluted $ 1.48 $ 1.52 $ (17.53)
========= ========= =========
Pro forma earnings(loss) per share:
Basic $ 1.52 $ 1.52 $ (17.64)
========= ========= =========
Diluted $ 1.47 $ 1.49 $ (17.64)
========= ========= =========
Recently Issued Accounting Pronouncements
In December 2004, the FASB issued a revised SFAS No. 123, "Share Based
Payment," 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 SFAS 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 SFAS 123R in prior periods, the impact of that standard would have
approximated the impact of SFAS 123 as shown in the table above. SFAS 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. In 2003 and 2004, we
recognized $3.7 million and $4.3 million, respectively, in tax benefits from
stock options exercises as operating cash flows in our consolidated statements
of cash flows. This requirement will reduce the amount of net cash flows from
operations recognized in periods after adoption.
On December 2, 2005, the Board of Directors approved a resolution to accelerate
the vesting of all unvested stock options outstanding as of December 2, 2005.
The Board decided to fully vest these underwater options, as there was no
perceived value in these options to the employee, little retention
ramifications, and to minimize the future stock option compensation expense to
our consolidated financial statements upon adoption of SFAS 123R. This
acceleration of the original vesting schedules affected 716,000 unvested stock
options. No incremental stock-based compensation expense was recognized in
2005 (either in our statement of operations or in our pro forma disclosure)
except, the remaining unvested compensation expense previously measured for
purposes of our FAS 123 pro forma disclosure included in the pro forma amounts
presented herein.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an amendment
of ARB No. 43, Chapter 4." SFAS 151 clarifies that abnormal inventory expenses
such as excess freight and handling costs, excessive spoilage, and idle
facilities costs, are required to be recognized as current period charges. The
provisions of SFAS 151 are effective for inventory costs incurred during fiscal
years beginning after June 15, 2005. We do not expect that this new standard
will have a significant impact on our results of operations or financial
condition because we are not engaged in manufacturing activities.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections," a replacement of APB Opinion No. 20, Accounting Changes, and SFAS
No. 3, "Reporting Accounting Changes in Interim Financial Statements." SFAS
154 replaces the provisions of SFAS 3 with respect to reporting accounting
changes in interim financial statements. SFAS 154 is effective for accounting
changes and corrections of errors made in fiscal years beginning after December
15, 2005.
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.
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 exchange for (i) all outstanding common stock of Hollywood and
(ii) all outstanding vested and unvested stock options of Hollywood.
Hollywood's outstanding indebtedness was repaid at the time of the merger for a
total of $381.5 million, of which $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 estimated fair values. 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 substantially
final for all items except deferred income taxes, and further adjustments may
be required in 2006 as we complete the analysis of the acquired tax basis of
certain assets and carryover tax attributes of Hollywood.
The purchase price allocation has been revised in the periods following the
acquisition in accordance with SFAS 141, "Business Combinations," to reflect
revisions in our estimates of the fair values of assets acquired and
liabilities assumed to correct certain accounts in Hollywood's acquisition date
balance sheet. The table below presents a summary of our initial purchase price
allocation, together with subsequent revisions and the resulting revised
allocation reflected in the accompanying 2005 consolidated balance sheet (in
thousands):
Initial Subsequent As
Allocation Revisions Adjusted
----------- ---------- ---------
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 (5,434) 12,712
---------- --------- ----------
Total current assets 208,348 (5,434) 202,914
Rental inventory 227,800 - 227,800
Property, furnishings and equipment 238,279 (83) 238,196
Goodwill 474,990 4,633 479,623
Other intangibles 183,894 - 183,894
Deferred income taxes 64,944 (13,104) 51,840
Deposits and other assets 1,662 - 1,662
---------- --------- ----------
Total assets acquired 1,399,917 (13,988) 1,385,929
Liabilities
Current Liabilities:
Current maturities of long-term obligations 557 - 557
Current maturities of financing obligations 10,385 - 10,385
Accounts payable 182,963 (14,728) 168,235
Accrued liabilities 65,507 6,908 72,415
Accrued payroll 19,691 - 19,691
Accrued interest 39 - 39
Deferred revenue 27,552 (6,168) 21,384
---------- --------- ----------
Total current liabilities 306,694 (13,988) 292,706
Long-term obligations, less current portion 941 - 941
Total liabilities 307,635 (13,988) 293,647
---------- --------- ----------
Net assets acquired $1,092,282 $ - $1,092,282
========== ========= ==========
The initial allocation shown above was based on the unaudited balance sheet as
of April 27, 2005, and our preliminary estimates of fair value, which were
revised and adjusted throughout the second, third and fourth quarters as we
completed the analysis of various balance sheet accounts and refined the
estimates of the fair values of assets acquired and liabilities assumed.
Following is a summary of the nature of the significant revisions and the facts
and circumstances that required the revisions shown in the preceding table:
- - Store supplies and other: We adjusted the balance in store supplies by $5.4
million based on the results of subsequent physical inventories and revised
estimates.
- - Deferred income taxes: We wrote-off Hollywood's pre-acquisition deferred
income tax balances and set-up new deferred income tax balances based on the
differences between the financial reporting basis of assets and liabilities and
their underlying tax basis, including amounts assigned to Hollywood's carryover
tax attributes The net impact of these adjustments decreased deferred tax
assets by $13.1 million.
- - Accounts payable: During the third quarter, we completed an analysis of
accounts payable to our studio vendors based on detailed reconciliations and
revised estimates, the net effect of which decreased accounts payable by $14.7
million as of April 27, 2005.
- - Accrued liabilities: The revisions to the initial allocation included:
- recorded a $6.6 million liability for employee separation costs for
Hollywood employees who were terminated shortly before and after the
merger in accordance with EITF 95-3, "Recognition of Liabilities in
Connection with a Purchase Business Combination."
- adjusted Hollywood's favorable and unfavorable operating leases to net
fair value of $4.2 million, based on a report received from an independent
valuation consultant in the third quarter.
- reduced Hollywood's pre-acquisition legal contingencies $1.4 million to
the amount we concluded was probable based on management's assessment of
the individual matters using all available information.
- reduced our estimate of Hollywood's accrued bonuses by $1.1 million to
reflect actual amounts subsequently earned (considering the impact of
employee separations and changes to the bonus plans implemented as of the
transaction date by Movie Gallery).
- reduced accruals for Hollywood's pre-merger expenses by $1.8 million to
reflect the actual amounts paid.
- established $3.4 million in reserves for store closures in accordance with
EITF 95-3 to reflect the cost of remaining lease obligations for closed
stores and other costs associated with 50 Game Crazy departments that were
closed shortly after the merger.
- recorded a reduction of $3.0 million in income tax and franchise tax
liabilities based on subsequent analyses of Hollywood's tax accounts,
after giving consideration to the effects of merger related transactions.
- - Deferred revenue: We decreased Hollywood's deferred revenue associated with
stored value (gift) card by $6.2 million to reflect the estimated fair value
associated with redemptions in accordance with EITF 01-3, "Accounting in a
Business Combination for Deferred Revenue of an Acquiree" This adjustment was
determined, in part, based on an analysis of the fair value completed by the
valuation advisors in the third quarter.
We allocated approximately $183.9 million of the purchase price 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 fair
value of these intangible assets was determined by independent valuations
advisors.
After giving consideration to the effect of the revisions described above, we
allocated a total of $479.6 million to goodwill. We paid a substantial premium
to acquire Hollywood for several reasons, including:
- - Expanded geographic footprint: The merger created a strong number two
competitor in the specialty home video retail industry that combines
Hollywood's prime urban superstore locations with Movie Gallery's substantial
presence in rural and suburban markets. The two companies possessed minimal
store overlap as a result of Movie Gallery's significant East Coast presence
and focus on rural and suburban locations and Hollywood's significant West
Coast presence and focus on urban locations.
- - Cost savings: The combined operations of Movie Gallery and Hollywood are
expected to achieve cost benefits resulting from the reduction of duplicative
general and administrative costs and the realization of scale economies with
respect to products and services purchased from studios and merchandisers.
- - Operating efficiencies: The combined operations of Movie Gallery and
Hollywood are expected to improve operational performance due to greater
distribution density, consolidation of duplicative functions and the adoption
of best practices at the 4,749 store locations for the combined company.
In addition, in order to acquire Hollywood, we participated in a competitive
bidding process against Leonard Green & Partners L.L.P. and Blockbuster, Inc.
Our successful bid was $1.25 per share lower than Blockbuster, Inc.'s bid.
However, Hollywood's stock (NASDAQ: HLYW) was trading at a significant premium
to book value due, in part, to merger and acquisition speculation.
The operations of Hollywood Entertainment have been included in our
consolidated results of operations from April 27, 2005 forward. The following
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 for terminated corporate personnel,
substantially all of which occurred shortly after the merger. The unaudited
pro forma financial information in the table below summarizes the combined
results of operations of Movie Gallery and Hollywood Entertainment for the
fiscal years ended January 2, 2005 and January 1, 2006 as though the companies
had been combined as of the beginning of those respective periods. (in
thousands, except per share data).
(unaudited)
2004 2005
---------- ----------
Total revenue $2,571,821 $2,604,181
Operating income(loss) 223,606 (412,765)
Net income(loss) 82,468 (530,969)
Net income(loss) per share:
Basic 2.57 (16.84)
Diluted 2.53 (16.84)
The summary pro forma data for 2004 and 2005 includes adjustments to
depreciation, amortization and lease expenses to reflect the allocation of
purchase price to record Hollywood's assets and liabilities at their estimated
fair values. In addition, pro forma net income in 2004 and 2005 reflects
increases in interest expense related to the incremental borrowings under our
bank credit facilities and Senior Notes as if such financing had taken place at
the beginning of each respective period shown.
The historical financial data of Hollywood (not presented herein) for periods
prior to the merger (included in the pro forma presentation above), reflects
the following non-recurring charges:
- - In 2004, Hollywood recognized $9.5 million (before taxes) of transaction
costs and professional services incurred by Hollywood related to merger
activities.
- - In 2005, Hollywood incurred $21.1 million (before taxes) of transaction
costs and professional services related to merger activities.
Merger Reserves
We established merger reserves, which were treated as liabilities of the
acquired business at the date of acquisition, relating to executives and other
employees that were terminated shortly after the merger, including some that
were terminated as part of our integration efforts, in accordance with EITF 95-
3, "Recognition of Liabilities in Connection with a Purchase Business
Combination." During the second quarter of 2005, we notified 92 Hollywood
employees of the decision to eliminate their positions in connection with these
integration efforts. We recorded a $6.6 million reserve 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 our
severance agreements. Payments year-to-date of $2.5 million have been made,
leaving a $4.1 million reserve as of January 1, 2006.
We closed 50 Game Crazy departments shortly after the acquisition date for a
total cash cost of $0.3 million. The costs associated with these department
closures were not charged to current operations, but rather were recognized as
acquired liabilities in purchase accounting, resulting in an increase to
goodwill.
Write-off of Bridge Financing. Concurrently with the acquisition of Hollywood
in the second quarter of 2005, we wrote-off $4.2 million, or $0.09 per diluted
share (net of tax), of fees and expenses associated with the bridge commitment
feature of our senior credit facility. The bridge facility was entered into in
connection with the Hollywood acquisition but was never drawn upon. Therefore,
the associated fees were expensed concurrently with the expiration of the
bridge loan commitment at the closing of the acquisition and related financing
transactions.
Other Acquisitions
During the second quarter, we acquired VHQ Entertainment, Inc. ("VHQ"). At the
time of the acquisition VHQ operated 61 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 fiscal 2005, Movie Gallery purchased 26 stores
in 11 separate transactions for a total cash consideration, including VHQ, of
$23.1 million. The aggregate purchase price allocation of these individually
immaterial acquisitions is as follows: (in thousands)
Rental inventory $ 3,190
Other tangible assets 4,937
Goodwill (including $4,208 of tax deductible goodwill) 17,970
Other intangible assets 2,501
Liabilities assumed (5,461)
----------
Total purchase price $ 23,137
==========
The pro-forma effects on consolidated revenues and net income of these
acquisitions are not presented herein because they are not material.
3. Property, Furnishings and Equipment
Property, furnishings and equipment as of January 2, 2005 and January 1, 2006
consists of the following(in thousands):
----------- ----------
January 2, January 1,
2005 2006
----------- ----------
Land and buildings $ 13,578 $ 19,372
Fixtures and equipment 185,490 280,532
Leasehold improvements 69,904 248,525
Construction phase assets - 4,542
Equipment under capital lease - 1,659
----------- ----------
268,972 554,630
Less accumulated depreciation
and amortization (140,790) (222,412)
----------- ----------
$ 128,182 $ 332,218
=========== ==========
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $0.0 and $0.3
million at January 2, 2005 and January 1, 2006, respectively. Depreciation
expense related to property, furnishings and equipment was $21.6 million, $33.6
million, and $88.2 million for fiscal 2003, 2004, 2005, respectively.
4. Income Taxes
We account for income taxes in accordance with SFAS No. 109, "Accounting for
Income Taxes," which requires that deferred tax 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 or all of
the deferred tax asset will not be realized. We generally consider the
earnings of our foreign subsidiaries to be permanently reinvested for use in
those operations and, consequently, deferred federal income taxes, net of
applicable foreign tax credits, are not provided on the undistributed earnings
of foreign subsidiaries.
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 provision of 0.5% for fiscal 2005, compared to a
provision of 39.1% and 39.3% for fiscal 2003 and 2004, respectively. The
decrease in the effective rate in 2005 is primarily a result of the goodwill
impairment charges recognized in 2005, a substantial portion of which were non-
deductible, and an increase in the valuation allowance on the net deferred tax
assets of $88.5 million, a portion of which relates to net operating loss
carryforwards and tax credit carryforwards that we have determined may not be
realized through reversal of temporary differences, tax strategies and future
taxable income.
The components of income (loss) before income taxes are as follows (in
thousands):
Fiscal Year Ended
-------------------------------------
January 4, January 2, January 1,
2004 2005 2006
---------- --------- ----------
U.S. Federal $ 76,873 $ 72,042 $ (530,711)
Foreign 4,550 9,162 (19,237)
--------- --------- ----------
Total $ 81,423 $ 81,204 $ (549,948)
========= ========= ==========
The following reflects the components of income tax expense (in thousands):
Fiscal Year Ended
-------------------------------------
January 4, January 2, January 1,
2004 2005 2006
---------- --------- ----------
Current payable:
U.S. Federal $ 5,537 $ 9,811 $ 541
State 2,415 2,799 775
Foreign - - 1,121
--------- --------- ----------
Total current 7,952 12,610 2,437
Deferred:
U.S. Federal 20,589 14,315 2,583
State 2,011 3,468 (374)
Foreign 1,435 1,323 (1,854)
--------- --------- ----------
Total deferred 24,035 19,106 355
--------- --------- ----------
$ 31,987 $ 31,716 $ 2,792
========= ========= ==========
Following are reconciliations of income tax expense at the federal statutory
income tax rate of 35% to the provision for income taxes (in thousands):
Fiscal Year Ended
-------------------------------------
January 4, January 2, January 1,
2004 2005 2006
---------- --------- ----------
Income tax expense(benefit) at
statutory rate $ 28,499 $ 28,422 $ (192,482)
State income tax expense, net of federal
income tax benefit 2,503 2,679 (7,450)
Non-deductible impairment charges - - 116,212
Increase in valuation allowance,
net of amount attributable to
stock option exercises - - 85,233
Other, net 985 615 1,279
--------- --------- ----------
$ 31,987 $ 31,716 $ 2,792
========= ========= ==========
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income taxes. Components of our deferred tax
assets and liabilities are as follows (in thousands):
Fiscal Year Ended
-------------------------
January 2, January 1,
2005 2006
----------- -----------
Deferred tax assets:
Non-compete agreements $ 3,853 $ 3,451
Tax credit carryforwards - 11,703
Net operating loss carryforwards 38,717 159,833
Equity investments 1,558 1,880
Accrued bonus 2,205 2,654
Property, furnishings and equipment - 17,139
Accrued liabilities - 14,591
Other 5,197 5,114
----------- -----------
Total deferred tax assets 51,530 216,365
Valuation allowance (32,642) (121,176)
----------- -----------
Net deferred tax assets 18,888 95,189
Deferred tax liabilities
Property, furnishings and equipment (24,028) -
Rental inventory amortization (31,525) (81,511)
Goodwill (9,666) (10,638)
Other (929) (3,110)
----------- -----------
Total deferred tax liabilities (66,148) (95,259)
----------- -----------
Net deferred tax liabilities $ (47,260) $ (70)
=========== ===========
We had federal and state net operating loss carryforwards at January 1, 2006 of
approximately $429 million and $359 million, respectively. The loss
carryforwards resulted primarily from the Video Update acquisition in 2001 and
the Hollywood Video acquisition during 2005. These losses will expire in years
2006 through 2026. We have federal Alternative Minimum Tax ("AMT") credit
carryforwards of $4.7 million which are available to reduce future regular
taxes in excess of AMT. These credits have no expiration date. We also have
other federal and state tax credit carryforwards of $7.0 million which are
available to reduce future taxes. The carryforward periods expire in years
2012 through 2025.
During 2005, management increased the valuation allowance for U.S. deferred tax
assets from $32.6 million to $121.2 million because it was determined that it
was more likely than not that these deferred tax assets would not be realized.
Of this increase, $85.2 million resulted in a charge to operations and the
remainder, which was attributable to excess tax deductions for stock option
exercises in 2005, was charged to stockholders' equity. Additions and
deductions to our valuation allowance for deferred tax assets are as follows
(in thousands):
Additions
----------------------
Balance at Charged to Charged to
Beginning Costs and Other Balance at End
of Period Expenses Accounts Deductions of Period
--------- ---------- ---------- ---------- --------------
Fiscal Year ended
January 4, 2004 $ 24,953 $ - $ 9,491(1) $ - $ 34,444
Fiscal Year ended
January 2, 2005 34,444 - - 1,802(2) 32,642
Fiscal Year ended
January 1, 2006 32,642 85,233 3,301 - 121,176
(1) Revision of allowance to offset true-up of preliminary estimated net
operating loss carryforwards to actual (not charged to income tax expense).
(2) Includes $1.3 million reduction to true-up preliminary estimated state net
operating losses to actual and $0.4 million reduction for utilization of net
operating losses.
Federal tax laws impose restrictions on the utilization of net operating loss
carryforwards and tax credit carryforwards 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. In
addition, previous ownership changes occurred with respect to Hollywood (prior
to our acquisition) and an ownership change also occurred upon our 2001
acquisition of Video Update. Our ability to utilize our net operating loss
carryforwards and tax credit carryforwards 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 carryforwards that apply to the 2005 ownership change
and prior ownership changes pertaining to Hollywood ranges between $13.5
million and $17.5 million and varies due to the fact there were several
ownership changes. If our estimates of the amount of net operating loss and
other tax credit carryforwards that will not be fully realized change, further
revisions to our valuation allowance may be necessary. Depending on the
circumstances, some of these revisions may have an impact on our future income
tax expense, while other revisions, (to the extent the provisions of EITF 93-7
apply) may be charged or credited to goodwill.
There is a reasonable possibility that an exposure to the amount of net
operating loss carryforwards available on the ownership change dates exists due
to subjectivity in the calculation of the limitations. The range of the
potential exposure is between $0.6 million and $46 million on a tax effected
basis. Pursuant to the provisions of EITF 93-7, "Uncertainties Related to
Income Taxes in a Purchase Business Combination," any adjustments to deferred
tax assets recorded at the date of acquisition, due to resolution of this
uncertainty (which may not occur for many years) will be recorded as an
adjustment to increase or decrease goodwill, regardless of the time that has
elapsed since the acquisition date. The effect of a decrease in tax reserves
and related valuation allowances established in purchase accounting will be
applied (1) first to reduce to zero any goodwill related to the acquisition,
(2) second to reduce to zero other noncurrent intangible assets related to the
acquisition, and (3) third, to reduce income tax expense.
5. Goodwill and Other Intangible Assets
The components of goodwill and other intangible assets are as follows (in
thousands):
January 2, 2005 January 1, 2006
Weighted- ------------------------ ---------------------
Average Gross Gross
Amortization Carrying Accumulated Carrying Accumulated
Period Amount Amortization Amount Amortization
------------ -------- ------------ -------- ------------
Goodwill
Segments:
Movie Gallery - $175,172 $ (31,411) $ - $ -
Hollywood Video - - - 118,404 -
-------- ------------ -------- ------------
Total goodwill $175,172 $ (31,411) $118,404 $ -
======== ============ ======== ============
Other intangible assets:
Non-compete
agreements 8 years $ 7,426 $ (4,937) $ 12,205 $ (10,110)
Trademarks:
Hollywood Video Indefinite - - 170,959 -
Game Crazy 15 years - - 4,000 (178)
Customer lists 5 years 7,628 (2,376) 8,994 (1,199)
-------- ------------ -------- ------------
$ 15,054 $ (7,313) $196,158 $ (11,487)
======== ============ ======== ============
Estimated amortization expense for other intangible assets for the five
succeeding fiscal years is as follows (in thousands):
2006 2,824
2007 2,682
2008 2,463
2009 2,277
2010 946
The changes in the carrying amounts of goodwill for the fiscal year ended
January 2, 2005 and January 1, 2006, 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) 497,593
Impairment (522,950)
-----------
Net balance as of January 1, 2006 $ 118,404
===========
Goodwill deductible for tax purposes as of January 1, 2006 is $55 million, net
of accumulated amortization.
Goodwill and Other Intangible Assets Impairment
Goodwill and indefinite lived intangibles are tested for impairment on an
annual basis in accordance with SFAS 142. Additionally, goodwill and
indefinite lived intangibles are 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. We tested goodwill and indefinite-
lived intangibles at the beginning of the fourth quarter of 2005 in accordance
with our normal policy pursuant to SFAS No. 142, "Goodwill and Other Intangible
Assets," and concluded that certain of our intangible assets, including
goodwill, were impaired.
Goodwill Impairment
Goodwill is tested at a reporting unit level. Our reporting units for this
purpose are Movie Gallery and Hollywood Video (our Game Crazy segment has no
goodwill). Goodwill is impaired if the fair value of a reporting unit is less
than the carrying value of its assets. The estimated fair value of each of the
reporting units was computed using the present value of estimated future cash
flows, which included the impact of trends in the business and industry noted
in 2005, and considering market prices of our debt and equity securities,
including the accelerated decline in the in-store rental industry, increased
competition in the video sell-through markets and the growth of the on-line
movie rental segment in which we do not have a presence. Impairments of
goodwill were recorded for the Movie Gallery and Hollywood reporting units in
the amounts of $161.7 million and $361.2 million, respectively.
The first step of the goodwill impairment test compares the book value of the
reporting units to their estimated fair values. The estimated fair values of
the reporting units are computed using the present value of estimated future
cash flows. This analysis utilizes a multi-year forecast of estimated cash
flows and a terminal value at the end of the cash flow period. The forecast
period growth assumptions consist of internal projections that are based on our
budget and long-range strategic plan. The discount rate used at the testing
date is our weighted-average cost of capital, modified as necessary to
reconcile the sum of the enterprise values of our reporting units to the market
value of our debt and equity securities outstanding. If fair values of the
reporting units do not exceed their carrying values then the second step must
be performed to quantify the amount of the impairment.
The second step of the goodwill impairment test compares the implied fair value
of goodwill to the book value of goodwill for each reporting unit. To determine
the implied fair value of goodwill, we allocated the estimated fair value of
each reporting unit to the estimated fair value of the existing tangible assets
and liabilities, as well as existing identified intangible assets and
previously unidentified intangible assets. The estimated implied fair value of
goodwill was compared to its respective carrying value and any excess carrying
value was recorded as a goodwill impairment charge to operating income.
In the first step of the impairment test the fair value of both the Movie
Gallery and Hollywood Video reporting units were lower than their carrying
values, and therefore the goodwill of those reporting units was impaired.
The second step of the impairment test indicated that the implied fair value of
goodwill for the Movie Gallery reporting unit was completely impaired, and
therefore a goodwill impairment charge was recorded for $161.7 million. The
implied fair value of goodwill for the Hollywood Video reporting unit was
$118.4 million, and therefore a goodwill impairment charge was recorded for
$361.2 million.
The amount of the goodwill impairment charge we recognized in 2005 for the
Hollywood Video reporting unit represents our best estimate of the charge based
on the information available to us. Because some aspects of the allocation of
purchase price to the acquired assets and liabilities of Hollywood have not
been completed, we may need to make further adjustments to the allocation.
Although the purchase price allocation is complete with respect to most
accounts, we have not completed our analyses of the tax basis of certain assets
and carryover tax basis attributes of Hollywood. We may need to revise these
estimates in future periods. Some of these revisions could impact our estimate
of the goodwill impairment charge that we recorded in 2005. Any such revisions
will be reflected in our statement of operations in 2006.
Impairment of Other Intangible Assets
As a result of the impairment indicators which contributed to the goodwill
impairment charges, we also tested all other significant intangible assets for
impairment as of the beginning of the fourth quarter of 2005. Based on the
results of these tests, we concluded that customer list intangible assets of
our Movie Gallery operating segment were impaired. The estimated value of the
acquired customer lists, which we determined primarily by reference to
observations of market comparables for similar customer lists on a per thousand
customer basis, was less than the historical carrying value of customer list
intangible assets. Accordingly, we recorded a $4.9 million impairment charge
in the fourth quarter of 2005 to reduce the carrying value of Movie Gallery's
previously acquired customer lists to our estimate of the fair value.
We also tested the indefinite-lived Hollywood trademark for impairment. The
annual test of the indefinite-lived Hollywood trademark compared the fair value
of the trademark with its carrying value. The fair value was determined by the
Relief from Royalty method, a specific discounted cash flow (DCF) approach, to
analyze cash flows attributable to the Hollywood trademark. The fair value of
the Hollywood trademark was higher than the carrying value and therefore it was
not impaired.
Likewise, using a similar approach to estimate fair value, we determined that
the finite-lived carrying value of the Game Crazy trade name was not impaired.
No other long-lived assets, including rental inventory and property, fixtures
and equipment were impaired under the guidance in SFAS No. 144, "Accounting for
the Impairment or Disposal of Long-Lived Assets."
6. Store Closure and Restructuring Reserves
As of October 25, 2005, we notified 92 Movie Gallery associates that their
positions will be relocated or eliminated as part of our integration plan
through the consolidation of Finance, Accounting, Treasury, Product, Logistics,
Human Resources and Payroll functions at our Wilsonville, Oregon support
center. Subsequently, as of January 1, 2006, an additional 9 Movie Gallery
associates were notified that their positions were being eliminated. As this
action impacted Movie Gallery's associates, these costs will be charged to
earnings generally over the retention periods, as employees render services.
The affected individuals are required to render service for a range of 10 to 49
weeks in order to receive termination benefits. We estimate that the total
cost of providing severance, retention incentives and outplacement services to
these associates will be approximately $3.3 million, of which approximately
$1.2 million was recognized in 2005, with the remainder to be expensed over the
remaining retention service period for the impacted associates in 2006 in
accordance with SFAS No. 146, "Accounting for Costs Associated with Disposal
and Exit Activities." There were no cash payments charged to the reserve in
2005.
In the fourth quarter of 2005, we decided to close 64 Movie Gallery stores that
overlapped trade areas served by competing Hollywood stores. We recorded store
closure costs of $9.6 million related to these store closures, which included
$1.8 million in non-cash write-offs of store fixtures and equipment and $7.6
million of reserves for operating lease obligations payable through the end of
the lease terms, net of probable sublease income, and $0.3 million for other
cash costs associated with these store closures, all of which were closed in
the fourth quarter. Cash payments charged to the reserve were $0 in 2005. The
remaining reserves for future lease payments are expected to be paid in 2006
through 2012.
We established merger reserves, which were treated as liabilities of the
acquired business at the date of acquisition, relating to executives and other
employees that were terminated shortly after the merger, including some that
were terminated as part of our integration efforts, in accordance with EITF 95-
3, "Recognition of Liabilities in Connection with a Purchase Business
Combination." During the second quarter of 2005, we notified 92 Hollywood
employees of the decision to eliminate their positions in connection with these
integration efforts. We recorded a $6.6 million reserve 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 our
severance agreements. Payments year-to-date of $2.5 million have been made,
leaving a $4.1 million reserve as of January 1, 2006.
Movie Hollywood Game
Gallery Video Crazy Total
---------- --------- -------- ----------
Store closure reserve:
Beginning balance $ 711 $ - $ - $ 711
Reserve established
upon merger - 2,875 295 3,170
Additions and adjustments 11,595 1,126 - 12,721
Payments (2,194) (388) (295) (2,877)
---------- ---------- ------- ----------
Ending balance $ 10,112 $ 3,613 $ - $ 13,725
========== ========= ======= ==========
Termination benefits:
Beginning balance $ - $ - $ - $ -
Additions and
adjustments 1,190 6,655 - 7,845
Payments - (2,539) - (2,539)
---------- --------- ------- ----------
Ending balance $ 1,190 $ 4,116 $ - $ 5,306
========== ========= ======= ==========
Estimated future
additions and
adjustments $ 2,140 $ - $ - $ 2,140
Total termination
benefits cost $ 3,330 $ 6,655 $ - $ 9,985
7. Long Term Obligations
Long term debt consists of the following (in thousands):
Fiscal Year Ended
-------------------------
January 2, January 1,
Instrument 2005 2006
- ----------------------------------- -------------------------
11% Senior notes
Due 2012 (net of discount $3,511) $ - $ 321,489
Credit Facility:
Term A Loan - 85,500
Term B Loan - 746,250
Revolving credit facility - 6,862
Hollywood 9.625% senior notes - 450
Capital leases - 678
----------- ----------
Total - 1,161,229
Less current portion - (78,146)
----------- ----------
$ - $1,083,083
=========== ==========
Expected maturities on long term obligations for the next five years are as
follows (in thousands):
Term Term Senior Capital
January 1, Loan A(1) Loan B(1) Notes Leases Revolver Total
- ---------- ------- -------- ------- ------- -------- ---------
2006 $19,000 $ 58,557 $ - $ 589 $ - $ 78,146
2007 19,000 7,500 - 89 - 26,589
2008 19,000 7,500 - - - 26,500
2009 19,000 7,500 - - 6,862 33,362
2010 9,500 360,000 - - - 369,500
Thereafter - 305,193 325,450 - - 630,643
------- --------- -------- ------ ------- ---------
Total 85,500 746,250 325,450 678 6,862 1,164,740
Discount on
Senior Notes - - (3,511) - - (3,511)
------- -------- -------- ------ ------- ----------
Net $85,500 $746,250 $321,939 $ 678 $ 6,862 $1,161,229
======= ======== ======== ====== ======= ==========
(1) Future prepayments of indebtedness under the Credit Facility will be
required in an amount equal to our "Excess Cash Flow", as defined in the Credit
Facility. The amount of these prepayments for fiscal years beyond 2006 cannot
be estimated at this time.
On April 27, 2005, we completed our 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, we
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.
Credit Facility
The Credit Facility, as amended, is in an aggregate amount of $906.8 million,
consisting of a five-year $75.0 million revolving credit facility ("Revolver")
and two term loan facilities in an aggregate principal amount of $831.8
million. Term Loan A is an $85.5 million facility that matures on April 27,
2010 and Term Loan B is a $746.3 million six-year facility that matures on
April 27, 2011.
On September 21, 2005, we 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; increased the
letter of credit sub-limit under the revolving credit facility from $30.0
million to $40.0 million; and increased the percentage of Excess Cash Flow, as
defined in the Credit Facility, required to be applied toward principal
repayment from 75% to 100%.
On March 15, 2006, we executed a second amendment effective through the fourth
quarter 2006 that further relaxed the financial covenants, modified certain
mandatory prepayment provisions, and restricted our ability to incur
indebtedness, pay dividends, redeem capital stock, make capital expenditures,
sell assets in other than the ordinary course of business, and make
acquisitions. Additional information on provisions of the amendment pertaining
to financial covenants and interest rates is discussed below. We incurred
significant fees related to the second amendment, including a 50 basis point
upfront fee totaling $4.5 million and various professional fees. The second
amendment also requires us to provide monthly financial reporting and cash flow
forecasts to the bank group. Effective the first quarter 2007, the financial
covenants revert to levels contained in the original agreement.
During the fourth quarter 2005 and first quarter 2006, the Term Loan A and
Revolver bear interest rates of London Interbank Offered Rate ("LIBOR") plus
3.50% and the Term Loan B bears an interest rate of LIBOR plus 3.75%. We also
incur a 0.50% commitment fee on the unused balance of the Revolver. The March
2006 amendment to the Credit Facility specifies new pricing for the interest
rates on the Term Loans and Revolver. For the period starting April 1, 2006,
through the submission of the first quarter 2006 covenant package to Wachovia,
the interest rate for the Term Loan A and Revolver will be set at LIBOR plus
5.00%. After submission of the covenant package, the pricing grid is as
follows:
Leverage Ratio LIBOR Margin
--------------- --------------
> 4.00 5.00%
3.25 - 4.00 3.50%
2.75 - 3.25 2.75%
2.25 - 2.75 2.50%
1.75 - 2.25 2.25%
< 1.75 2.00%
The Term Loan B pricing was revised to reflect a rate of LIBOR plus 5.25%
starting April 1, 2006 through the submission of the first quarter covenant
package. After submission of the covenant package, the interest rate will be
LIBOR plus 5.25% if our leverage ratio exceeds 4.00, otherwise the rate will be
LIBOR plus 3.75%, as was the case during the fourth quarter 2005 and first
quarter 2006.
When the leverage ratio is greater than or equal to 4.00, at our discretion, we
can elect to defer payment of 0.50% of the Term Loan A, Term Loan B and
Revolver interest as non-cash interest, which will be capitalized into the
loans (with compounding interest).
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 also requires
us to pay an Excess Cash Flow sweep, which, in broad terms, represents the
amount of cash generated by us but not used towards operations, debt service,
or investments since the date of the merger with Hollywood. The Excess Cash
Flow payment for fiscal year 2005 will be $56.9 million, which is estimated due
on or about March 31, 2006, and is classified as a component of the current
maturities of long-term debt in the 2005 consolidated balance sheet.
At January 1, 2006, we had $33.1 million drawn under the revolving portion of
the Credit Facility, comprised of $6.9 million and $26.2 million in borrowings
and letters of credit, respectively. The letters of credit are in place to
secure workers compensation, lease and trade liabilities.
The Credit Facility is fully and unconditionally guaranteed on a joint and
several basis by Movie Gallery's domestic subsidiaries. The Credit Facility
also is secured by first priority security interests in, and liens on,
substantially all of our 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.
The Credit Facility, as amended, 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 less capital
expenditures 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 cash interest expense.
The covenant levels contained in the March 2006 amendment are as follows:
Leverage Fixed Charge Interest Coverage
Ratio Coverage Ratio Ratio
-------- -------------- -----------------
2006 Q1 5.00 1.05 2.00
2006 Q2 5.75 1.05 1.75
2006 Q3 6.75 1.00 1.45
2006 Q4 6.50 1.00 1.45
2007 Q1 2.25 1.10 3.00
2007 Q2 2.25 1.10 3.00
2007 Q3 2.25 1.10 3.00
2007 Q1 2.00 1.10 3.00
Our ability to comply with these covenants may be affected by events and
circumstances beyond management's 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 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 our debt service
obligations under the Credit Facility or the Senior Notes, described
below, our secured creditors could proceed against the collateral securing
the indebtedness owed to them.
The Credit Facility and Indenture governing our 11% Senior Notes impose certain
restrictions, 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.
Interest Rate Hedge
As required by the Credit Facility, we have entered into a two-year floating-
to-fixed interest rate swap 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.
The interest rate swap is a cash flow hedge. The hedge is structured such that
all of the terms match exactly to the hedged debt and there is no hedge
ineffectiveness. The terms of the debt and the fixed rate payments to be
received on the swap coincide (notional amounts, payment dates, terms and
rates) and the hedge is considered perfectly effective. We designated the
swap, at inception, as a cash flow hedge and documented the hedge designation
contemporaneously. At the end of each reporting period, we assess hedge
effectiveness by making sure that the terms match exactly the designated hedged
debt instrument. The gain or loss on the effective portion of the hedge (i.e.,
change in fair value) is initially reported as a component of other
comprehensive income. The remaining gain or loss, if any, is recognized
currently in earnings. On each reset date after the variable rate has been
determined, the ultimate payment or receipt is calculated and recorded as an
increase or decrease in interest.
11% Senior Notes
The 11% Senior 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 our 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.
Fair Value of Debt and Interest Rate Swap
The fair value of short-term borrowings approximates their carrying values in
the balance sheets. The fair value of long-term borrowings, including current
maturities, are estimated using discounted cash flow analysis based on our
current borrowing rates for similar types of borrowings arrangements (if
known), or quoted market prices. The fair value of our long-term borrowings
was $1.1 billion as of January 1, 2006.
The fair value of the interest rate swap is based on a quoted settlement price,
which at January 1, 2006, was $2.8 million and is recorded as other assets
and as a component of accumulated other comprehensive income in the 2005
consolidated balance sheet.
8. Accumulated Comprehensive Income
Accumulated comprehensive income is as follows (in thousands):
January 4, January 2, January 1,
2004 2005 2006
---------- ---------- ----------
Foreign currency cumulative
translation adjustment $ 3,794 $ 6,255 $ 7,201
Change in value of interest rate swap - - 2,808
--------- --------- ----------
Balance, end of year $ 3,794 $ 6,255 $ 10,009
========= ========= ==========
9. Stockholders' Equity
Common Stock
During the second and third quarters of 2004, we completed two $25 million
common stock repurchase programs. Under the common stock repurchase programs,
we repurchased 2,624,712 shares of our common stock at an average price of
$18.06 per share.
Stock Option Plan
In June 2003, our Board of Directors adopted, and our stockholders approved,
the Movie Gallery, Inc. 2003 Stock Plan, which was subsequently amended in June
2005 (Second Amendment) to reserve an additional 3,500,000 shares of our common
stock for future grants of awards. The plan provides for the award of stock
options, restricted stock and stock appreciation rights to employees, directors
and consultants. Prior to adoption of the 2003 plan, stock option awards were
subject to our 1994 Stock Plan which expired in 2004. As of January 1, 2006,
5,373,658 shares are reserved for issuance under the plans. Options granted
under the plans have a ten-year term and generally vest over four years.
In accordance with the provisions of SFAS No. 123, we apply Accounting
Principles Board Opinion No. 25 and related Interpretations in accounting for
the plans and, accordingly, have not recognized compensation cost in connection
with the plans, except for the variable options and the transactions with
current and former executives, as described below. If we had elected to
recognize compensation cost based on the fair value of options granted at the
grant date as prescribed by SFAS 123, net income and earnings per share would
have been adjusted to the pro forma amounts indicated in Note 1. The effect on
net income and earnings per share is not expected to be indicative of the
effects on net income and earnings per share in future years.
The fair value of each option grant was estimated at the date of the grant
using the Black-Scholes option pricing model. The weighted-average assumptions
used and weighted-average grant-date fair values of options were as follows:
Fiscal Year Ended
-----------------------------------
January 4, January 2, January 1,
2004 2005 2006
---------- ---------- ----------
Expected volatility 0.700 0.632 0.626
Risk-free interest rate 4.81% 2.97% 3.05%
Expected life of option in years 4.9 3.4 3.0
Expected dividend yield 0.0% 0.6% 5.7%
Weighted average grant date
fair value per share $ 9.84 $ 8.70 $ 7.43
The Black-Scholes option valuation model was developed for use of estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. The Black-Scholes option valuation model also requires the
input of highly subjective assumptions, including the expected term of the
option and the expected stock price volatility.
In the third quarter of fiscal 2004, we repurchased 145,900 shares of our
common stock from current and former executives at an average price of $17.89
under our stock repurchase program. Since these individuals obtained these
shares through the exercise of stock options, we accounted for these
transactions as a repurchase of stock options resulting in compensation expense
of approximately $0.8 million.
We repriced 864,000 stock options in March 2001, and reduced the exercise price
to $1.78 per share. The repriced stock options are accounted for as variable
until the stock options are exercised, forfeited or expire unexercised.
Assuming all repriced stock options are exercised, we will ultimately receive
$0.6 million less than if no repricing had occurred. The total variable
compensation expense recognized under these repriced options was $1.5 million,
$0.1 million and $0.1 million in fiscal 2003, 2004 and 2005, respectively. As
of January 1, 2006, approximately 3,000 of these options remained outstanding
and they will expire, if not exercised or forfeited, in 2008 and 2009.
On December 2, 2005, the Board of Directors approved a resolution to vest all
stock options outstanding as of December 2, 2005. The Board decided to fully
vest these specific underwater options, as there was no perceived value in
these options to the employee, little retention ramifications, and to minimize
the expense to our consolidated financial statements upon adoption of SFAS No.
123R. This acceleration of the original vesting schedules affected 716,000
unvested stock options.
A summary of our stock option activity and related information is as follows:
Weighted-
Outstanding Average Exercise
Options Price Per Share
------------ ---------------
Outstanding at January 5, 2003 2,911,293 $ 6.90
Granted 537,500 20.30
Exercised (778,978) 4.29
Cancelled (33,722) 10.50
------------
Outstanding at January 4, 2004 2,636,093 10.36
Granted 102,000 19.36
Exercised (875,884) 6.31
Cancelled (268,653) 13.71
------------
Outstanding at January 2, 2005 1,593,556 12.59
Granted 29,500 17.33
Exercised (575,148) 9.25
Cancelled (71,157) 17.83
------------
Outstanding at January 1, 2006 976,751 14.33
------------
Exercisable at January 4, 2004 1,643,236 7.74
Exercisable at January 2, 2005 1,024,181 9.34
Exercisable at January 1, 2006 976,751 14.33
Options outstanding as of January 1, 2006 had a weighted-average remaining
contractual life of 7 years and exercise prices ranging from $1.00 to $22.00 as
follows:
Exercise price of
-----------------------------------------------
$1.00 to $6.00 to $13.00 to
$3.00 $12.00 $22.00
-------------- --------------- ----------------
Options outstanding 181,864 78,750 716,137
Weighted-average exercise price $1.64 $6.22 $18.44
Weighted-average remaining
contractual life 3.9 years 0.8 years 7.4 years
Options exercisable 181,864 78,750 716,137
Weighted-average exercise price
of exercisable options $1.64 $6.22 $18.44
Service-based nonvested share awards vest over periods ranging from 1 to 4
years. Compensation expense, representing the excess of the fair market value
of the shares at the date of issuance over the nominal purchase price of the
shares, is charged to earnings over the vesting period. During 2005,
compensation expense charged to operations related to these stock grants was
$1.2 million. As of January 1, 2006, there was $4.1 million of total
unrecognized compensation cost related to nonvested share-based compensation
arrangements granted under the plan. No service-based nonvested shares vested
during 2005. Performance-based nonvested share awards entitle participants to
acquire shares of stock upon attainment of specified performance goals.
Compensation cost of $390,000 for performance-based stock grants were
recognized in 2005 using the accelerated expense attribution method under SFAS
Interpretation No. 28 (EITF 00-23). No performance-based nonvested shares
vested during 2005.
A summary of the status of our nonvested shares as of January 1, 2006, and
changes during the fiscal year 2005, is presented below:
Weighted-Average
Grant-Date Fair
Shares Value
---------- ------------------
Outstanding at January 2, 2005 - $ -
Granted 332,431 25.15
Exercised - -
Cancelled (19,250) 24.05
----------
Outstanding at January 1, 2006 313,181 25.21
==========
Employee Stock Purchase Plan
Under the 2003 Employee Stock Purchase Plan, 250,000 shares of our common stock
were made available for purchase through a series of six month offering periods
commencing on or about April 1 and October 1 of each year. The first offering
period commenced on October 1, 2003. Currently Movie Gallery employees are
eligible to participate in the plan; the plan is not yet available to Hollywood
employees. The purchase price of each share is 85% of the fair market value of
a share of common stock on the offering date or on the purchase date, whichever
is lower. Employees purchased approximately 26,000 and 35,000 shares of stock
under the plan in fiscal 2004 and 2005, respectively. We account for this plan
as non-compensatory under our current accounting policy for stock-based
compensation (APB 25). Upon adoption of the fair value approach to recognizing
stock-based compensation under SFAS 123(R) in 2006, we will recognize a nominal
amount of compensation expense related to stock purchases under this plan.
10. Commitments and Contingencies
Operating Leases
Rent expense for 2003, 2004, and 2005 totaled $103.2 million; $126.1 million
and $366.8 million, respectively. Total sublease income for 2003, 2004, 2005
was $0.3 million; $0.4 million and $3.7 million; respectively.
At January 1, 2006, the future minimum annual rental commitments and sublease
income under non-cancelable operating leases were as follows (in thousands):
-------------------------------------------
Operating Sublease
Year Leases Income
-------------------------------------------
2006 $367,033 $2,852
2007 318,766 2,287
2008 259,677 1,555
2009 207,381 1,044
2010 149,196 675
Thereafter 310,439 698
Litigation
Hollywood was named as a defendant in several purported class action lawsuits
asserting various causes of action, including claims regarding its membership
application and additional rental period charges. Hollywood vigorously defended
these actions and maintains that the terms of its additional rental charge
policy are fair and legal. Hollywood obtained dismissal of three of the actions
filed against it. A statewide class action entitled George Curtis v. Hollywood
Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8 SEA was
certified on June 14, 2002 in the Superior Court of King County, Washington. On
May 20, 2003, a nationwide class action entitled George DeFrates v. Hollywood
Entertainment Corporation, No. 02 L 707 was certified in the Circuit Court of
St. Clair County, Twentieth Judicial Circuit, State of Illinois. Hollywood
reached a nationwide settlement with the plaintiffs on all of the various
claims asserted in each of the related actions. Preliminary approval of
settlement was granted on August 10, 2004. Hollywood agreed not to oppose
plaintiffs' application for an award of $2.7 million for fees and costs to
class counsel and plaintiffs counsel and up to $50,000 in class representative
incentive awards. Class members received rent-one-get-one coupons on a claims-
made basis with a guaranteed total redemption of $9 million along with other
remedial relief. The court granted final approval of the settlement on June 24,
2005. An appeal of the final approval was filed on July 25, 2005. A settlement
with the appellants was reached and the matter was fully and finally resolved
on December 9, 2005.
Hollywood and the members of its former board of directors (including
Hollywood's former chairman Mark Wattles) were named as defendants in several
lawsuits in the Circuit Court in Clackamas County, Oregon. The lawsuits, filed
between March 31, 2004 and April 14, 2004, asserted breaches of duties
associated with the merger agreement executed by Hollywood with a subsidiary of
Leonard Green & Partners, L.P. or LPG. The Clackamas County actions were later
consolidated and the plaintiffs filed an Amended Consolidated Complaint
alleging four claims for relief against Hollywood's former board members
arising out of the merger of Hollywood with Movie Gallery. The purported four
claims for relief are breach of fiduciary duty, misappropriation of
confidential information, failure to disclose material information in the proxy
statement in support of the Movie Gallery merger, and a claim for attorneys'
fees and costs. The Amended Consolidated Complaint also names UBS Warburg and
LGP as defendants. Following the merger with Movie Gallery, the plaintiffs
filed a Second Amended Consolidated Complaint. The plaintiffs restated their
causes of action and generally allege that the defendants adversely impacted
the value of Hollywood through the negotiations and dealings with LGP.
Hollywood and the former members of its board have also been named as
defendants in a separate lawsuit entitled JDL Partners, L.P. v. Mark J. Wattles
et al. filed in Clackamas County, Oregon, Circuit Court on December 22, 2004.
This lawsuit, filed before Hollywood's announcement of the merger agreement
with Movie Gallery, alleges breaches of fiduciary duties related to a bid by
Blockbuster Inc. to acquire Hollywood, as well as breaches related to a loan to
Mr. Wattles that Hollywood forgave in December 2000. On April 25, 2005, the JDL
Partners action was consolidated with the other Clackamas County lawsuits. The
plaintiffs seek damages and attorneys' fees and costs. Hollywood denies these
allegations and is vigorously defending this lawsuit.
Hollywood was named as a defendant in a sexual harassment lawsuit filed in the
Supreme Court of the State of New York, Bronx County on April 17, 2003. The
action, filed by eleven former female employees, alleges that an employee, in
the course of his employment as a store director for Hollywood, sexually
harassed and assaulted certain of the plaintiffs, and that Hollywood and its
members of management failed to prevent or respond adequately to the employee's
alleged wrongdoing. The plaintiffs seek unspecified damages, pre-judgment
interest and attorneys' fees and costs. Hollywood denies these allegations and
is vigorously defending this lawsuit.
In addition, we have been named to various other claims, disputes, legal
actions and other proceedings involving contracts, employment and various other
matters. A negative outcome in certain of the ongoing litigation 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. We believe we have provided adequate reserves for contingencies and
that the outcome of these matters should not have a material adverse effect on
our consolidated results of operation, financial condition or liquidity.
At January 1, 2006, the legal contingencies reserve, net of expected recoveries
from insurance carriers, was $3.0 million of which $2.4 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
SFAS No. 141 "Business Combinations," 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.
Boards Inc.
By letter dated August 29, 2005, 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. We anticipate that the transaction will close in
fiscal 2006.
11. Related Party Transactions
We hold a one-third interest in ECHO, LLC ("ECHO"), a supply sales and
distribution company. We purchase office and store supplies and other business
products from ECHO.
Fiscal Year Ended
-----------------------------------
January 4, January 2, January 1,
2004 2005 2006
---------- ---------- ----------
(in thousands)
Purchases from ECHO $ 13,056 $ 13,962 $ 16,858
Distributions from ECHO 161 151 27
Interest from ECHO 5 5 -
Note receivable from ECHO 125 - -
Accounts payable to ECHO 309 193 704
12. Segment Reporting and Geographic Information
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. The segments are based on store branding. Movie Gallery represents
2,675 video stores serving mainly rural markets in the U.S, Canada, and Mexico,
Hollywood Video represents 2,054 video stores serving predominantly urban
markets, and Game Crazy represents 648 in-store departments and 20 free-
standing stores serving the game market in urban locations. We measure 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 our reportable operating segments is
as follows (in thousands):
Fiscal Year Ended
January 1, 2006
-------------------------------------------
Movie Hollywood Game
Gallery Video Crazy Total
---------- --------- -------- ----------
Revenues $ 845,369 $ 933,131 $208,827 $1,987,327
Depreciation and
amortization 40,466 43,939 8,250 92,655
Rental amortization(1) 182,613 105,471 - 288,084
Impairment of goodwill 161,731 361,219 - 522,950
Impairment of other
intangible assets 4,940 - - 4,940
Operating income(loss)(2) (161,528) (303,349) (11,502) (476,379)
Goodwill, net - 118,404 - 118,404
Total assets 412,890 863,879 108,359 1,385,128
Purchases of property,
furnishings and
equipment 47,725 9,866 607 58,198
(1) Rental amortization includes $10.1 million charge in the second quarter to
reflect a decrease in estimate of VHS residual value adjustment.
(2) Operating income(loss) for the Movie Gallery and Hollywood Video segments
includes impairment of goodwill and other intangible assets.
For 2003 and 2004, there was only one reportable segment, which was Movie
Gallery. Prior year consolidated results are the Movie Gallery segment totals
for those periods.
All intercompany transactions are accounted for at book cost basis.
The following table sets forth our consolidated revenues and assets by
geographic area. All intercompany balances and transactions have been
eliminated.
Fiscal Year Ended
-----------------------------------
January 4, January 2, January 1,
2004 2005 2006
---------- ---------- ----------
(in thousands)
Revenues:
United States $ 648,428 $ 731,851 $1,903,125
Canada 43,967 58,931 83,295
Mexico - 395 907
---------- ---------- ----------
Total revenues $ 692,395 $ 791,177 $1,987,327
========== ========== ==========
Assets (at end of fiscal year)
United States $ 423,118 $ 441,519 $1,341,137
Canada 34,766 49,390 42,209
Mexico - 1,233 1,782
---------- ---------- ----------
Total assets $ 457,884 $ 492,142 $1,385,128
========== ========== ==========
13. Summary of Quarterly Results of Operations (Unaudited)
The following is a summary of our unaudited quarterly results of operations (in
thousands, except per share data):
Thirteen Weeks Ended
-------------------------------------------
April 4, July 4, October 3, January 2,
2004 2004 2004 2005
--------- --------- --------- ----------
Revenues $ 203,302 $ 189,591 $ 189,855 $ 208,429
Gross profit 140,617 129,551 130,072 140,835
Net income 18,252 10,634 9,214 11,388(1)
Basic earnings per share 0.55 0.32 0.29 0.37(1)
Diluted earnings per share 0.54 0.32 0.29 0.36(1)
(1) Includes a pre-tax charge of $6.3 million ($3.9 million after-tax or $0.12
per diluted share) to correct our accounting for leasehold improvements,
including $2.9 million ($1.8 million after-tax or $0.05 per diluted share)
related to prior annual periods, which was accounted for as an immaterial prior
period correction (See Note 1).
Thirteen Weeks Ended
---------------------------------------------
April 3, July 3, October 2, January 1,
2005 2005(1) 2005(1) 2006(1)
--------- --------- --------- ----------
Revenues $ 233,791 $ 504,729 $ 572,442 $ 676,365
Gross profit 155,241 302,539 366,126 388,647
Net income 18,393 (12,189)(2) (12,469)(2) (546,475)(3)
Basic earnings per share 0.59 (0.39) (0.39) (17.25)
Diluted earnings per share 0.59 (0.39) (0.39) (17.25)
(1) Reflects the consolidated results of Movie Gallery and Hollywood for the
period subsequent to the merger on April 27, 2005.
(2) For the Hollywood and Game Crazy operating segments, a change in estimate
was recorded in the third quarter of 2005, to change the useful lives of
Hollywood's and Game Crazy's long lived assets. A charge of $7.1 million in
depreciation expense was recorded in the third quarter 2005, of which $2.7
million related to the ten weeks ended July 3, 2005. This reduced net
income by $1.8 million, or $0.06 per diluted share for the third quarter
2005, but had no effect on the full year operating results.
(3) Reflects goodwill impairment of Movie Gallery and Hollywood Video
reporting units. Reflects impairment charge for customer lists to reduce
carrying value to fair value. See Note 5 for additional information on 2005
impairment charges.
14. 401(k) Plans
Movie Gallery has established the Movie Gallery Retirement Savings Plan (the
"Movie Gallery Plan"), a defined contribution 401(k) plan for the benefit of
employees meeting certain eligibility requirements. On April 27, 2005, Movie
Gallery assumed sponsorship of the Hollywood Entertainment 401(k) Retirement
Savings Plan (the "Hollywood Plan"), a defined contribution 401(k) plan for the
benefit of employees meeting certain eligibility requirements. The Company
incurred savings plan expenses of $148,000, $115,000 and $412,000 for the years
2003, 2004 and 2005. The fiscal 2005 expenses include $244,000 of savings plan
expenses incurred for the Hollywood Plan since April 27, 2005.
15. Consolidating Financial Information
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; M.G.A. Realty I, LLC; M.G. Digital, LLC; and (c) on a combined
basis, the Non-Guarantor Subsidiaries, which include Movie Gallery Canada,
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
Fiscal Year Ended January 4, 2004
(in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- --------- --------- ---------
Revenue:
Rentals $ - $ 591,498 $ 38,295 $ - $ 629,793
Product sales - 56,929 5,673 - 62,602
--------- --------- --------- --------- ---------
Total revenue - 648,427 43,968 - 692,395
Cost of sales:
Cost of rental revenue - 172,774 11,665 - 184,439
Cost of product sales - 45,796 4,347 - 50,143
--------- --------- --------- --------- ---------
Gross profit - 429,857 27,956 - 457,813
Operating costs and expenses:
Store operating expenses - 303,771 20,695 - 324,466
General and administrative 104 43,795 2,623 - 46,522
Amortization of intangibles - 1,911 92 - 2,003
Stock compensation - 1,481 - - 1,481
--------- -------- --------- --------- ---------
Operating income(loss) (104) 78,899 4,546 - 83,341
Interest expense, net 3 (476) 5 - (468)
Equity in losses of
unconsolidated entities (1,450) - - - (1,450)
Equity in earnings of
subsidiaries 50,444 2,540 - (52,984) -
--------- -------- -------- --------- ---------
Income before income
taxes 48,893 80,963 4,551 (52,984) 81,423
Income taxes (benefit) (543) 30,519 2,011 - 31,987
--------- -------- -------- -------- --------
Net income $ 49,436 $ 50,444 $ 2,540 $(52,984) $ 49,436
========= ======== ======== ======== ========
Consolidating Statement of Operations
Fiscal Year Ended January 2, 2005
(in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- --------- --------- ---------
Revenue:
Rentals $ - $ 675,754 $ 53,413 $ - $ 729,167
Product sales - 56,096 5,914 - 62,010
--------- --------- --------- --------- ---------
Total revenue - 731,850 59,327 - 791,177
Cost of sales:
Cost of rental revenue - 193,229 14,931 - 208,160
Cost of product sales - 37,993 3,949 - 41,942
--------- --------- --------- --------- ---------
Gross profit - 500,628 40,447 - 541,075
Operating costs and expenses:
Store operating expenses - 367,991 27,434 - 395,425
General and administrative 110 50,378 4,156 - 54,644
Amortization of intangibles - 2,448 153 - 2,601
Stock compensation - 831 - - 831
--------- -------- --------- --------- ---------
Operating income(loss) (110) 78,980 8,704 - 87,574
Interest expense, net 9 (660) 27 - (624)
Equity in losses of
unconsolidated entities (5,746) - - - (5,746)
Equity in earnings of
subsidiaries 53,139 5,263 - (58,402) -
--------- -------- -------- --------- ---------
Income before income
taxes 47,292 83,583 8,731 (58,402) 81,204
Income taxes (benefit) (2,196) 30,444 3,468 - 31,716
--------- -------- -------- -------- --------
Net income $ 49,488 $ 53,139 5,263 $(58,402) $ 49,488
========= ======== ======== ======== ========
Consolidating Statement of Operations
Fiscal Year Ended January 1, 2006
(in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- ---------- --------- ------- ---------
Revenue:
Rentals $ - $1,555,141 $ 74,917 $ -$1,630,058
Product sales - 347,985 9,284 - 357,269
--------- ---------- -------- ------- ---------
Total revenue - 1,903,126 84,201 - 1,987,327
Cost of sales:
Cost of rental revenue - 480,254 22,619 - 502,873
Cost of product sales - 265,535 6,365 - 271,900
--------- ---------- -------- ------- ---------
Gross profit - 1,157,337 55,217 - 1,212,554
Operating costs and expenses:
Store operating expenses - 982,671 44,448 - 1,027,119
General and administrative 454 123,097 4,890 - 128,441
Amortization of intangibles - 3,602 263 - 3,865
Impairment of goodwill - 498,718 24,232 - 522,950
Impairment of other
intangibles - 4,086 854 - 4,940
Stock compensation - 1,618 - - 1,618
--------- --------- -------- ------- ---------
Operating loss (454) (456,455) (19,470) - (476,379)
Interest expense, net (46,363) (21,853) (313) - (68,529)
Write off of bridge
financing (4,234) - - - (4,234)
Losses of
unconsolidated entities (806) - - - (806)
Equity in earnings of
subsidiaries (515,948) (19,048) - 534,996 -
--------- --------- ------- ------- ---------
Loss before income
taxes (567,805) (497,356) (19,783) 534,996 (549,948)
Income taxes (benefit) (15,065) 18,592 (735) - 2,792
--------- --------- -------- -------- ---------
Net loss $(552,740) $(515,948)$(19,048) $ 534,996 $(552,740)
========= ========= ======== ========= =========
Condensed Consolidating Balance Sheet
January 2, 2005
(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) 14,997 3,977 - 17,164
Accrued payroll - 10,354 744 - 11,098
Deferred revenue - 10,415 428 - 10,843
--------- --------- -------- --------- ---------
Total current liabilities (1,810) 99,231 10,661 - 108,082
Other accrued liabilities - 1,972 336 - 2,308
Deferred income taxes - 47,468 3,150 - 50,618
Payable to (receivable from)
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
January 1, 2006
(in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- -------- --------- ---------
Assets
Current assets:
Cash and cash equivalents $ - $ 133,901 $ 1,337 $ $ 135,238
Merchandise inventory, net - 132,757 3,693 136,450
Prepaid expenses 19 39,495 1,879 41,393
Store supplies and other - 22,177 2,017 24,194
Deferred income taxes, net - - - -
--------- --------- ------- ----------- ----------
Total current assets 19 328,330 8,926 - 337,275
Rental inventory, net - 354,091 17,474 - 371,565
Property, furnishings and
equipment, net - 315,604 16,614 - 332,218
Goodwill, net - 118,404 - - 118,404
Other intangibles, net - 184,271 400 - 184,671
Deferred income taxes, net - - - - -
Deposits and other assets 32,292 8,127 576 - 40,995
Investments in subsidiaries 1,302,111 19,788 - (1,321,899) -
---------- --------- ------- ----------- ----------
Total assets $1,334,422$1,328,615 $43,990 $(1,321,899)$1,385,128
========== ========= ======= =========== ==========
Liabilities and stockholders' equity (deficit):
Current liabilities:
Current maturities of
Long-term obligations $ 77,557 $ 533 $ 56 $ - $ 78,146
Current maturities of
financing obligations - 4,492 - - 4,492
Accounts payable - 230,436 6,553 - 236,989
Accrued liabilities (13,378) 99,608 2,230 - 88,460
Accrued payroll 386 37,164 1,074 - 38,624
Accrued interest 7,130 58 32 - 7,220
Deferred revenue - 38,709 491 - 39,200
--------- --------- ------- ---------- ---------
Total current liabilities 71,695 411,000 10,436 - 493,131
Long-term obligations, less
current portion 1,075,682 538 6,863 - 1,083,083
Other accrued liabilities - 20,209 1,453 - 21,662
Deferred income taxes - (345) 415 - 70
Intercompany promissory note
(receivable) (384,200) 384,200 - - -
Payable to (receivable from)
affiliate 384,087 (389,120) 5,033 - -
Stockholders' equity
(deficit) 187,158 902,133 19,790 (1,321,899) (212,818)
---------- --------- ------- ----------- ----------
Total liabilities and
stockholders' equity
(deficit) $1,334,422$1,328,615 $43,990 $(1,321,899)$1,385,128
========== ========= ======= =========== ==========
Consolidating Condensed Statement of Cash Flows
Fiscal Year Ended January 4, 2004
(in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
-------- --------- --------- -------- ---------
Operating Activities:
Net income $ 49,436 $ 50,444 $ 2,540 $(52,984) $ 49,436
Equity in earnings of
subsidiaries (50,444) (2,540) - 52,984 -
Adjustments to reconcile
net income to cash
provided by operating
activities:
Rental inventory
amortization - 122,663 10,315 - 132,978
Purchases of Rental inventory - (118,579) (11,924) - (130,503)
Purchases of rental inventory -
base stock - (15,883) (819) - (16,702)
Depreciation and
intangibles amortization - 22,111 1,458 - 23,569
Stock based compensation (non
cash) 1,481 - - - 1,481
Tax benefit of stock
options exercised 3,747 - - - 3,747
Deferred income taxes - 24,718 (682) - 24,036
Changes in operating
assets and liabilities, net
of business acquisitions:
Merchandise inventory - (5,739) (1,493) - (7,232)
Other current assets - (4,456) (449) - (4,905)
Deposits and other assets (3,150) (1,747) (188) - (5,085)
Accounts payable - 4,578 1,730 - 6,308
Accrued liabilities and
deferred revenue (534) (416) 2,675 - 1,725
Intercompany payables/
receivables - (2,946) 2,946 - -
--------- --------- -------- -------- ---------
Net cash provided by
operating activities 536 72,208 6,109 - 78,853
Investing Activities:
Business acquisitions,
net of cash acquired - (26,505) (4,167) - (30,672)
Purchases of property,
furnishings and equipment - (41,507) (5,609) - (47,116)
Investment in subsidiaries (10,485) (4,743) - 15,228 -
--------- --------- -------- -------- ---------
Net cash used in investing
activities (10,485) (72,755) (9,776) 15,228 (77,788)
Financing Activities:
Proceeds from exercise
of stock options 3,333 - - - 3,333
Capital contribution from
parent - 10,485 4,743 (15,228) -
Dividend to parent 6,611 (6,611) - - -
-------- -------- -------- -------- ---------
Net cash provided by
financing activities 9,944 3,874 4,743 (15,228) 3,333
Effect of exchange rate
changes on cash and
cash equivalents - 4,053 - - 4,053
-------- -------- -------- -------- ---------
Increase (decrease) in
cash and cash equivalents (5) 7,380 1,076 - 8,451
Cash and cash equivalents at
beginning of period 5 27,469 2,081 - 29,555
-------- --------- -------- -------- ---------
Cash and cash equivalents
at end of period $ - $ 34,849 $ 3,157 $ - $ 38,006
======== ========= ======== ======== =========
Consolidating Condensed Statement of Cash Flow
Fiscal Year Ended January 2, 2005
(in thousands)
-------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
-------- --------- --------- -------- ---------
Operating Activities:
Net income $ 49,488 $ 53,139 $ 5,263 $(58,402) $ 49,488
Equity in earnings of
subsidiaries (53,139) (5,263) - 58,402 -
Adjustments to reconcile
net income to cash
provided by operating
activities:
Rental inventory
amortization - 132,691 11,830 - 144,521
Purchases of rental inventory - (137,022) (13,902) - (150,924)
Purchases of rental inventory
base stock - (13,757) (1,859) - (15,616)
Depreciation and
intangibles amortization - 34,035 2,150 - 36,185
Stock based compensation (non
cash) 64 - - - 64
Tax benefit of stock
options exercised 4,305 - - - 4,305
Deferred income taxes - 15,638 3,468 - 19,106
Changes in operating
assets and liabilities, net
of business acquisitions:
Merchandise inventory - (315) (176) - (491)
Other current assets - 124 (624) - (500)
Deposits and other assets 2,344 (708) (300) - 1,336
Accounts payable - (2,304) 342 - (1,962)
Accrued liabilities and
deferred revenue (2,191) 5,995 557 - 4,361
Intercompany payable/
receivable - (1,948) 1,948 - -
--------- --------- -------- -------- ---------
Net cash provided by
operating activities 871 80,305 8,697 - 89,873
Investing Activities:
Business acquisitions,
net of cash acquired - (12,186) (776) - (12,962)
Purchases of property,
furnishings and equipment - (40,960) (5,547) - (46,507)
Investment in subsidiaries (11,408) (4,275) - 15,683 -
--------- --------- -------- -------- ---------
Net cash used in investing
activities (11,408) (57,421) (6,323) 15,683 (59,469)
Financing Activities:
Proceeds from exercise
of stock options 5,523 - - - 5,523
Proceeds from employee
stock purchase plan 403 - - - 403
Purchases and retirement
of common stock (47,390) - - - (47,390)
Capital contribution from
parent - 11,408 4,275 (15,683) -
Dividend to parent 55,891 (55,891) - - -
Payment of dividends (3,889) - - - (3,889)
-------- -------- -------- -------- ---------
Net cash (used in)
provided by financing
activities 10,538 (44,483) 4,275 (15,683) (45,353)
Effect of exchange rate
changes on cash and
cash equivalents - 2,461 - - 2,461
-------- -------- -------- -------- ---------
Increase (decrease) in
cash and cash equivalents 1 (19,138) 6,649 - (12,488)
Cash and cash equivalents at
beginning of period - 34,849 3,157 - 38,006
-------- --------- -------- -------- ---------
Cash and cash equivalents
at end of period $ 1 $ 15,711 $ 9,806 $ - $ 25,518
======== ========= ======== ======== =========
Consolidating Condensed Statement of Cash Flow
Fiscal Year Ended January 1, 2006
(in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
-------- --------- --------- -------- ---------
Operating Activities:
Net income (loss) $(552,740)$(515,948)$ (19,048) $534,996 $(552,740)
Equity in earnings of
subsidiaries 515,948 19,048 - (534,996) -
Adjustments to reconcile
net income (loss) to cash
provided by operating
activities:
Rental inventory
amortization - 270,010 18,074 - 288,084
Purchases of rental inventory - (258,405) (18,623) - (277,028)
Purchases of rental inventory
base stock - (18,502) (1,865) - (20,367)
Depreciation and
intangibles amortization - 89,170 3,485 - 92,655
Gain on disposal of property,
furnishings and equipment - (494) - - (494)
Amortization of debt
issuance cost 3,659 - - - 3,659
Impairment of goodwill - 498,718 24,232 - 522,950
Impairment of other
intangibles - 4,086 854 - 4,940
Stock based compensation (non
cash) 1,030 588 - - 1,618
Deferred income taxes - 7,021 (1,865) - 5,156
Changes in operating
assets and liabilities, net
of business acquisitions:
Extended viewing fees
receivable, net - 21,369 - - 21,369
Merchandise inventory - 11,009 35 - 11,044
Other current assets 4 (1,653) (1,443) - (3,092)
Deposits and other assets 517 (516) 8 - 9
Accounts payable - (1,688) (2,447) - (4,135)
Accrued interest 7,130 19 32 - 7,181
Accrued liabilities and
deferred revenue (10,248) 42,223 (378) - 31,597
--------- --------- -------- -------- ---------
Net cash provided by
(used in) operating
activities (34,700) 166,055 1,051 - 132,406
Investing Activities:
Business acquisitions,
net of cash acquired (1,092,281) 12,005 (16,410) - (1,096,686)
Purchases of property,
furnishings and equipment - (53,034) (5,164) - (58,198)
Proceeds from disposal of
property, furnishings and
equipment - 3,672 - - 3,672
Acquisition of construction
phase assets, net (non cash) - 5,621 - - 5,621
Investment in subsidiaries (335) (8,192) - 8,527 -
--------- --------- -------- -------- ---------
Net cash used in investing
activities (1,092,616) (39,928) (21,574) 8,527 (1,145,591)
Financing Activities:
Repayment of capital
lease obligations - (426) - - (426)
Intercompany payable/
receivable 384,285 (383,124) (1,161) - -
Change in intercompany
promissory note (384,200) 384,200 - - -
Decrease in financing
obligations (non cash) - (5,892) - - (5,892)
Net borrowings on credit
facilities - - 6,862 - 6,862
Long term debt financing
fees (32,484) - - - (32,484)
Proceeds from issuance of
long-term debt 1,166,120 - - - 1,166,120
Principal payments on
long-term debt (13,251) - (1,842) - (15,093)
Proceeds from exercise
of stock options 5,319 - - - 5,319
Proceeds from employee
stock purchase plan 379 - - - 379
Capital contribution from
parent - 332 8,195 (8,527) -
Dividend to parent 3,973 (3,973) - - -
Payment of dividends (2,826) - - - (2,826)
-------- -------- -------- -------- ---------
Net cash (used in)
provided by financing
activities 1,127,315 (8,883) 12,054 (8,527) 1,121,959
Effect of exchange rate
changes on cash and
cash equivalents - 946 - - 946
-------- -------- -------- -------- ---------
Increase (decrease) in
cash and cash equivalents (1) 118,190 (8,469) - 109,720
Cash and cash equivalents at
beginning of period 1 15,711 9,806 - 25,518
-------- --------- -------- -------- ---------
Cash and cash equivalents
at end of period $ - $ 133,901 $ 1,337 $ - $ 135,238
======== ========= ======== ======== =========
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Movie Gallery, Inc.
We have audited the accompanying consolidated balance sheets of Movie Gallery,
Inc. as of January 1, 2006, and January 2, 2005 and the related consolidated
statements of operations, stockholders' equity (deficit), and cash flows for
each of the three years in the period ended January 1, 2006. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Movie Gallery,
Inc. at January 1, 2006, and January 2, 2005, and the consolidated results of
its operations and its consolidated cash flows for each of the three years in
the period ended January 1, 2006, in conformity with U.S. generally accepted
accounting principles.
We also have audited, in accordance with the standards
of the Public Company Accounting Oversight Board (United States), the
effectiveness of Movie Gallery, Inc.'s internal control over financial
reporting as of January 1, 2006, based on criteria established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission, and our report dated March 22, 2006,
expressed an unqualified opinion on management's assessment of the
effectiveness of internal control over financial reporting and an adverse
opinion on the effectiveness of internal control over financial reporting.
/s/ Ernst & Young LLP
Birmingham, Alabama
March 22, 2006