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 December 31, 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:
Title of Class Name of Each Exchange on which Registered
Common Stock, $0.001 par value The NASDAQ Global Market
(including associated rights to
purchase shares of Series A
Junior Participating Preferred
Stock or Common Stock)
Securities registered pursuant to Section 12(g) of the Act: None
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 2, 2006, was approximately $139,754,000 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
6th, 2007 was 31,838,901.
Documents incorporated by reference:
Portions of the Company's Proxy Statement for the 2007 Annual Meeting of
Stockholders filed with the Securities and Exchange Commission are incorporated
by reference in Part III of this Form 10-K.
Forward-Looking Statements
Some of the statements made under Item 1. "Business" and Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
elsewhere in this Annual Report on Form 10-K are 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
Movie Gallery, Inc., sometimes referred to herein as "we", "our", "us", "the
Company" or "Movie Gallery," is the second largest North American home
entertainment specialty retailer focused on urban, rural and suburban markets.
We currently own and operate approximately 4,600 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 completed our acquisition of Hollywood
Entertainment Corporation, or Hollywood. Movie Gallery's eastern-focused,
rural and secondary market presence 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 primarily located in small towns and
suburban areas of cities with populations between 3,000 and 20,000,
where the primary competitors are 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 approximately
15,000 movies and video games for rental, as well as new and used movies and
games for sale at competitive prices.
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 carries
approximately 25,000 movies and video games.
The Game Crazy branded locations are dedicated game retail departments where
game enthusiasts can buy, sell and trade new and used video game hardware,
software and accessories. The Game Crazy locations are located primarily
within Hollywood Video stores, and as of December 31, 2006, 634 Hollywood Video
stores included an in-store Game Crazy department. A typical Game Crazy
department carries approximately 9,000 new and used video games, as well as
hardware and accessories and occupies an area of approximately 700 to 900
square feet within the store. In addition, as of December 31, 2006, we had 17
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 negatively impact the rental market: weak title
lineup; weak box office revenues and declining attendance at movie theaters;
cannibalization of rentals by low-priced movies available for sale; growth of
the online 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 movies available through video-on-demand,
TIVO/DVR, digital cable, satellite TV, broadband, internet and broadcast
television.
In spite of these dynamics, we believe home video retail stores 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. We
also believe 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.
Although the movie rental industry is facing increased competition from other
forms of entertainment, we believe there will continue to be significant demand
in the movie rental industry for the following reasons:
Exclusive Rental Window
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 as 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 other channels.
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 45 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 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 have tested 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 the larger 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 revenue-sharing arrangements, we pay movie studios a significantly
reduced price per copy and, in return, share with the studios an agreed upon
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, which improves customer
satisfaction. We have revenue-sharing arrangements with a number of studios,
with more than two-thirds of our new movie release rental revenue in 2006
having been generated under revenue-sharing arrangements.
Video Game Industry
Consumer Spending
According to NPD Group, Inc., or NPD, a global provider of consumer and retail
market research information, the video game industry comprised an approximately
$12.6 billion market in the United States in 2006, with software accounting for
$6.5 billion and hardware and accessories accounting for $6.1 billion.
Hardware and Software
Video game hardware and software expansion has been driven by the 2005 release
of the Microsoft XBOX 360 and Sony Playstation Portable, or PSP, handheld
system. According to NPD, the video game software industry grew 6.4% to
approximately $6.5 billion in 2006, an increase of $0.4 billion compared to
2005. Hardware sales, according to NPD, were up 42.8% for 2006 due to the
release of the Nintendo Wii and Sony Playstation 3, or PS3, for the holiday
2006 season and the first full year of XBOX 360 sales. We expect that these
new hardware platforms will drive further growth in software sales and rentals
in 2007.
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
and Playstation 3 which have over 256-bit processing speeds. Advances in
processing speed and data storage have 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, released in November 2006, came equipped to play high definition Blu-
Ray DVD movies. We expect these advances will continue to 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 new-generation hardware platforms 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 Initiatives
During the first quarter 2007, we acquired substantially all of the assets,
technology, network operations, and customers of MovieBeam, Inc., an on-demand
movie service for cash consideration, the amount of which will be immaterial to
our fiscal 2007 consolidated financial statements. We believe the acquisition
of the MovieBeam service will provide us with a technology platform to enable
digital content delivery.
MovieBeam provides customers a convenient way to rent movies from home. The
MovieBeam content delivery network, which is available in 31 major metropolitan
areas across the United States, uses over-the-air datacasting technology to
provide access to new releases and popular movies-on-demand from virtually
every major movie studio. In addition to MovieBeam's proprietary set-top box
based content delivery network, we intend to use MovieBeam's existing
infrastructure to underpin the development of alternative digital delivery
capabilities.
We believe that the MovieBeam technology will contribute to our efforts to
digitize and deliver content to our customers in both standard definition and
high definition formats - via new mediums including downloading or streaming of
movies over the internet, internet protocol-based content delivery and other
developing channels.
We are also exploring other alternative delivery channels to improve revenue
growth, profitability and customer satisfaction. These efforts include an
online video rental channel, with an expected pilot phase implementation in
late 2007. We believe we can cost-effectively implement this strategy while
providing our customers with a quality service that will provide additional
convenience in obtaining movie rentals either in-store or through online
delivery.
We are also currently testing movie kiosks, which are completely automated
movie vending machines located in supermarkets, malls and other high traffic
areas. These units provide around-the-clock availability of movies with
minimal overhead and fixed costs. Currently there are approximately 74 kiosk
units in operation, and we plan to rollout approximately 200 additional units
during the course of 2007.
New Stores
We do not plan on significant store growth in the next several years as we
focusour resources on debt retirement, profitability within our existing store
base and alternative delivery methods. However, we may complete the transaction
to purchase 20 Hollywood Video stores and 17 Game Crazy stores currently owned
by Boards, Inc., pursuant to a put option contained in the license agreement
for these stores. See Item 7. "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Pending Acquisition."
The following table is a historical summary showing store openings,
acquisitions and store closings since the beginning of fiscal 2002.
Fiscal Year Ended
---------------------------------------------------------
January 5, January 4, January 2, January 1, December 31,
2003 2004 2005 2006(1)(2) 2006 (3)
----------------------------------------------------------
Opened 145 241 314 288 123
Acquired 265 170 74 2,138 -
Closed 41 37 64 159 230
--------------------------------------------------------
Total stores
at end of
period 1,784 2,158 2,482 4,749 4,642
========================================================
(1) Includes 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.
(2) Includes the closure of 64 Movie Gallery stores whose trade areas
overlapped with acquired Hollywood Video stores. See Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of Operations-
Operating Costs and Expenses."
(3) Includes the closure of 46 Movie Gallery stores whose trade areas primarily
overlapped with other stores in the Movie Gallery segment.
Rightsizing Opportunities
We believe future profitability can be enhanced by adjusting the square footage
of 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. We intend to achieve this objective through a three-pronged
strategy that includes allowing larger store leases for under-performing stores
to expire, returning portions of existing stores to landlords and subleasing
where possible.
Operating Segments
Upon our acquisition of Hollywood, we began to assess performance and operate
our business in three operating segments: Movie Gallery, Hollywood Video and
Game Crazy. For financial information for each reportable segment, refer to
Note 13, "Segment Reporting and Geographic Information" in our accompanying
consolidated financial statements.
Products
Movie Gallery and Hollywood Video Stores
Movie Gallery and Hollywood Video stores offer a wide selection of movies
and video games for rent and sale. Depending upon location, Movie Gallery
stores typically carry approximately 15,000 movies and video games, while
Hollywood Video stores carry approximately 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 2 & 3, Microsoft XBOX 360 and XBOX, and Nintendo Wii and
Game Cube.
Our video stores contributed 87% of total revenue in fiscal 2006. Revenue from
rental products, including rental and sale of previously viewed movies and
video games, represented approximately 80% of total revenue for fiscal 2006.
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 primarily resulted from the
sale of new DVDs and concessions such as popcorn, sodas, candy, and magazines.
Game Crazy
Game Crazy, which consists of 634 Hollywood Video in-store game departments and
17 free-standing stores where consumers buy, sell and trade new and used video
game software, hardware, and accessories, contributed 13% of our total revenue
for 2006. Each Game Crazy typically carries approximately 9,000 units of new
and used video games, as well as hardware, and accessories for all major new
and legacy game systems. We offer new and used Sony Playstation 2, PS3 and PSP,
Microsoft XBOX 360 and XBOX, and Nintendo Wii, Game Cube, Dual Screen, Game Boy
Advance, and Game Boy hardware systems, as well as a broad selection of used
legacy hardware systems. In addition, we offer new and used game accessories
including controllers, memory cards and game media such as strategy guides.
Revenue from new and used software represented approximately 70% of Game Crazy
revenue for 2006, while 30% of Game Crazy revenue came from new and used
hardware and accessories.
Our revenues by product category for the last three fiscal years were as
follows:
2004 2005 2006
---- ---- ----
DVD rentals 58% 54% 56%
VHS rentals 12% 7% 2%
Game rentals 8% 7% 7%
Previously viewed rental
sales (DVD, VHS and games) 14% 14% 15%
New and used game product sales 1% 11% 13%
Movie product sales 3% 3% 3%
Concessions, accessories and other 4% 4% 4%
Store Operations
The Movie Gallery and Hollywood Video brands are managed by separate store
operations management teams. In fiscal 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 considering future opportunities
to consolidate store operations management across the three brands.
Our video store managers report to district managers who supervise store
operations. District managers report to regional managers, who report to a Vice
President of Operations for each zone.
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, who provide attentive
customer service and possess knowledge of the industry for our Game Crazy
departments.
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 78 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, we periodically offer promotional and prepaid rental and
discount card programs that provide our customers greater discounts on
rentals. We have also conducted nationwide trivia games to generate traffic in
our stores, 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 (including Game Crazy) 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, with the
exception of used games, which we receive on trade directly from our customers,
we purchase a majority of our video games directly from video game publishers.
During 2006, we consolidated our primary movie and video game purchasing
function into our Oregon support center.
Inventory and Information Management
Inventory Management
We run separate point-of-sale, or POS, systems in the Movie Gallery stores,
Hollywood stores, and Game Crazy departments, each having been developed
specifically to address the needs of the separate brands. These POS systems
maintain up-to-date inventory levels in the stores and report those levels to
corporate systems.
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. The Movie Gallery POS system captures
rental history on movie titles for each store and uses the data to project or
estimate demand for future titles of a similar genre. 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 to our distribution centers, bar coded, and distributed to the stores.
Hollywood Video and Game Crazy
We also 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 to our distribution
centers, 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 POS 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. We are analyzing future opportunities to
consolidate POS and merchandising systems for the three brands.
Information Management
Movie Gallery
Movie Gallery stores utilize a proprietary 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.
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 support center. Data is processed and
reports are generated that allow management to monitor customer activity, 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 regular physical inventories during normal store
hours using bar code recognition, to process human resource and payroll
timekeeping information and to provide system-based training modules.
Hollywood Video and Game Crazy
Our Hollywood Video and Game Crazy stores also use proprietary POS systems.
Information regarding revenue, current and historical rental and sales
activity, store membership demographics, individual customer histories, and
DVD, videocassette and video game rental patterns are maintained and updated
daily. These POS systems allow us to measure our current performance, manage
inventory, make purchasing decisions and manage labor costs. They also provide
management the ability to monitor critical performance factors.
Systems Integration
We have made considerable efforts to integrate our financial systems, human
resources and payroll systems, operational reporting and inventory management
systems. We completely integrated financial and human resources and payroll
systems in 2006. In 2007, we intend to integrate inventory management systems
and operational reporting, which we began in 2006. Until each system's
integration is complete, separate systems will continue to operate to ensure
accurate reporting and appropriate management of the business.
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, downloading services, 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 retail 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
smaller, less competitive markets 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
household penetration. We estimate that cable or satellite television 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, and through the Internet and 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, inclement weather conditions and frequently the home
video release of the preceding summer's hit titles. September is typically the
lowest revenue period with schools back in session and the premiere of new fall
broadcast television programs. Seasonal patterns for our Game Crazy operating
segment are similar to traditional retail revenue peaks, which are
significantly weighted towards holiday periods and when schools are out of
session.
Intellectual Property
We own a number of U.S. 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 13, "Segment Reporting and Geographic Information," in our consolidated
financial statements.
Employees
As of December 31, 2006, we employed approximately 41,400 associates, including
approximately 39,800 in retail stores, with the remainder in our support
centers, field management staff and distribution facilities. Of our retail
associates, approximately 6,300 were full-time and 33,500 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 to 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. Periodically, we initiate other 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 overall company performance.
Available Information
We are subject to the reporting and information requirements of the Securities
Exchange Act of 1934, as amended, or the Exchange Act, and, as a result, we
file periodic reports, proxy statements and other information with the United
States Securities and Exchange Commission, or the SEC. We make these filings
available on our website free of charge, the URL of which is http://
www.moviegallery.com, as soon as reasonably practicable after we electronically
file such material with, or furnish it to, the SEC. The SEC maintains a website
(http://www.sec.gov) that contains our annual, quarterly and current reports,
proxy and information statements, and other information that we file
electronically with the SEC. You can read and copy any materials we file with
the SEC at the SEC's Public Reference Room at 100 F Street, N.E., Room 1850,
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. Information on our
website does not constitute part of this Annual Report on Form 10-K.
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, 2007:
Name Age Position(s) Held
- ----------------- --- -------------------------------------------------------
J.T. Malugen 55 Chairman of the Board, President and Chief Executive
Officer
H. Harrison 58 Vice Chairman of the Board and Senior Vice President -
Parrish Concessions
Jeffrey S. Stubbs 44 Executive Vice President and Chief Operating Officer -
Movie Gallery Division
Timothy A. Winner 42 Executive Vice President and Chief Operating Officer -
Hollywood Entertainment Division
S. Page Todd 45 Executive Vice President - Secretary, General Counsel
and Chief Compliance Officer
Mark S. Loyd 51 Executive Vice President and Chief Merchandising
Officer
Keith A. Cousins 38 Executive Vice President and Chief Development Officer
Thomas D. Johnson
Jr. 43 Executive Vice President and Chief Financial Officer
John J.
Jump (1)(2)(3) 55 Director
William B.
Snow (1)(2)(3) 75 Director
James C.
Lockwood (1)(2)(3) 69 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. Winner joined Hollywood in July 1993 and spent four years in field
management, rising from Store Manager to Regional Director. In 1997, Mr.
Winner was promoted to Director of Human Resources, and in 1999 he became a
Zone Vice President with Hollywood. Subsequent to the Hollywood acquisition,
Mr. Winner was named Executive Vice President and Chief Operating Officer for
the Hollywood Video Division in April 2006. He has an 18-year career in the
home entertainment industry and 16 years with Hollywood Entertainment.
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 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 Chief Administrative Officer. In April 2006,
Mr. Loyd was named Chief Merchandising 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. 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 was named Interim Chief
Financial Officer in June 2006 and in February 2007 was appointed as Executive
Vice President and Chief Financial Officer. Mr. Johnson has nearly 20 years of
experience in the securities industry and in April 2004 he joined Movie Gallery
from Russell Corporation in Atlanta, GA where he led their investor
relations program. Prior to Russell, Mr. Johnson directed 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 was 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. Since July 2006, he
has served as a Manager for Accent Marketing, Inc. Mr. Jump was a Managing
Partner for Foodservice Equipment Brokers of MO., Inc. from July 2004 until
July 2006. He served as Business Manager, Operations for Convergys Corporation
from August 2002 until July 2004. 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 served as
Vice President, General Counsel and Secretary of Keystone Automotive
Industries, Inc., a publicly held distributor of aftermarket collision
replacement parts from 1997 to February 2007 when he resigned as an officer.
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 December 31, 2006, we had approximately $1,092.5 million of indebtedness,
consisting primarily of borrowings under our senior credit facility prior to
its refinancing and our 11% Senior Notes due 2012, which we refer to as our
Senior Notes. After refinancing our senior credit facility and replacing it
with a new senior credit facility in March 2007, which we refer to as our March
2007 Credit Facility, we have approximately $1,100.5 million of indebtedness.
Our high level of indebtedness could have important consequences, 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;
- it may 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 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.
The March 2007 Credit Facility requires us to maintain certain financial ratios
and the March 2007 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 the Company's 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.
Any failure to comply with the restrictions of the March 2007 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 Item 7. "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 the March 2007 Credit Facility on making capital expenditures
may prevent us from pursuing new business initiatives, which may place us at a
competitive disadvantage.
The March 2007 Credit Facility limits the amount of money that we may spend on
capital expenditures to $45.0 million in 2007 and, subject to certain
exceptions, $45.0 million in subsequent years. We believe that successful
execution of our plan will require us to dedicate a significant portion of our
capital expenditures to the continuing integration of Hollywood and Movie
Gallery and required maintenance capital. Accordingly, we could 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.
Uncertainty concerning our ability to meet our financial obligations, coupled
with the continued declines and uncertainty in the rental industry generally,
has caused negative publicity surrounding our business. As a result, our
flexibility with our suppliers has been affected. Although we recently
refinanced our credit facility in order to provide greater financial
flexibility, we cannot assure you that our trade creditors will consider this a
sufficient basis on which to continue extending trade credit to us or that they
will offer more favorable terms than those available to us prior to the
refinancing. To the extent we are unable to obtain trade credit on acceptable
terms, the amount of operating cash flow, debt or equity financing that we will
need to operate our business may increase, and we may not be able to improve
our operating cash flows or obtain additional financing on acceptable terms
from lenders or equity investors.
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
has and could continue to require substantial time, effort, attention and
dedication of management resources and may distract management in unpredictable
ways from their other responsibilities. The integration process has and could
continue to 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 POS
and 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. See "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 so that we may 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 POS 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 impacted if we are unable to manage
our merchandise inventory effectively.
Our merchandise inventory carries risks associated with inventory management,
obsolescence and theft. While most of our retail movie product is returnable
to vendors, our investment in inventory 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 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, or VOD, services. 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 enable
consumers to conveniently view and control the movies they want to see and 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 as video stores. It could be further exacerbated by
the increasing popularity and availability of personal digital recording
systems (such as TiVo), which 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. Additionally, we
cannot assure you that our efforts to offer content through alternative
channels such as MovieBeam, will be successful.
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 purchasing
rather than renting movies continues.
Historically, studios offered the movies they distribute at prices 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 more likely to have a desire to purchase a certain title. The
penetration of DVD into the market at a significantly lower price point 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 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 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 the
copies 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 such programs are discontinued. Additionally, studio revenue-
sharing programs permit the studios, in the ordinary course of business, to
audit our records to determine whether we have complied with the terms of these
programs. We may be required to pay additional amounts, which may be material,
as a result of these audits. Further, some of our studio 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 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 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 priced for sell-through. As a result, there are no assurances
that we will be able to sell 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.
We could be adversely affected by conditions impacting the motion picture
industry, including variability in consumer appeal of the movie titles and game
software released for rental and sale.
The availability of new movies produced by the movie studios is vital to us and
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.
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 late 2006, Sony and Nintendo released their newest platforms. Consumer
demand for video games available in our stores could be adversely affected if
manufacturers fail to introduce new games for these platforms 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, inclement weather
conditions and frequently the home video release of the preceding summer's hit
titles. 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 and the
impact on our revenues and operating results of the strength of the home video
title slate, 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 our 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; 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 a material
weakness 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 December 31, 2006, and this
assessment identified one material weakness in our internal controls relating
to lease accounting matters. 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. This material weakness 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 an initial lease term of five to ten years, with
at least one renewal option for an additional two to five years. During the
fourth quarter of fiscal 2006, we closed our 9 stores in Mexico. The following
table provides information regarding the number of stores we operated in each
state and Canada as of December 31, 2006.
United States:
Alabama 184
Alaska 7
Arizona 90
Arkansas 83
California 360
Colorado 59
Connecticut 35
Delaware 16
District of Columbia 2
Florida 221
Georgia 167
Hawaii 4
Idaho 34
Illinois 119
Indiana 120
Iowa 48
Kansas 44
Kentucky 83
Louisiana 51
Maine 53
Maryland 57
Massachusetts 68
Michigan 122
Minnesota 89
Mississippi 76
Missouri 135
Montana 22
Nebraska 32
Nevada 37
New Hampshire 20
New Jersey 40
New Mexico 36
New York 131
North Carolina 171
North Dakota 9
Ohio 205
Oklahoma 74
Oregon 75
Pennsylvania 165
Rhode Island 15
South Carolina 95
South Dakota 14
Tennessee 112
Texas 361
Utah 51
Vermont 6
Virginia 150
Washington 114
West Virginia 29
Wisconsin 70
Wyoming 7
-----
Total United States 4,368
Canada:
Alberta 104
British Columbia 67
Manitoba 7
New Brunswick 5
Newfoundland 5
Nova Scotia 13
Ontario 48
Prince Edward Island 2
Saskatchewan 21
Yukon Territory 2
-----
Total Canada 274
-----
Total 4,642
=====
Support Centers and Distribution Facilities
We have a support center and limited inventory distribution facility located in
an approximately 116,000 square foot building in Dothan, Alabama, which we
own. We also lease approximately 48,000 square feet of off-site warehouse
space in Dothan to supplement distribution and to provide record storage.
In 2004, construction began on a new 190,000 square foot distribution center
located in Dothan, Alabama. This facility was funded through a loan from Movie
Gallery to the local area Industrial Development Board, or the IDB, partially
offset by funds provided by a bond fund from the State of Alabama. After the
acquisition of Hollywood, construction was stopped on this facility and we, the
local area IDB and the State of Alabama are evaluating alternatives, including
transferring the property to the IDB and repaying the amount loaned by Movie
Gallery.
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 also 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.
ITEM 3. LEGAL PROCEEDINGS
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 LGP. 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. Following mediation,
the parties agreed to settle the case and a memorandum of understanding was
recently executed. The settlement is subject to preliminary and final approval
of the court, and settlement papers are in the process of being prepared. The
settlement, if approved, will be immaterial to our consolidated financial
statements.
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 and each of the plaintiffs
have entered into a settlement agreement that will result in a complete
dismissal of the case. The terms of the settlement are confidential. However,
the settlement proceeds will be paid entirely by Hollywood's insurance carrier
providing coverage for this claim.
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, our legal contingencies reserve, net of expected recoveries
from insurance carriers, was $3.0 million of which $2.4 million relates to pre-
acquisition contingencies. At December 31, 2006, our legal contingencies
reserve, net of expected recoveries from insurance carriers, was $1.8 million
of which $1.3 million relates to pre-acquisition contingencies.
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 fiscal 2006.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
Market Information
Our common stock is listed on the Nasdaq Global Market, or NASDAQ, under the
symbol "MOVI". As of March 6, 2007, we had approximately 54 stockholders of
record. The following information sets forth the high and low closing prices
for our common stock as reported on the NASDAQ for each quarterly period within
the last two fiscal years.
High Low Dividend
-------- --------- ---------
2006:
Fourth Quarter $ 4.70 $ 1.90 $ -
Third Quarter 6.67 1.94 -
Second Quarter 7.50 2.57 -
First Quarter 5.78 2.01 -
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
Dividends
In December 2003, our Board of Directors instituted a dividend policy under
which it declared an initial quarterly cash dividend of $0.03 per share. In
September 2005, we announced that due to the challenging conditions currently
affecting the home video industry, we would not declare a quarterly cash
dividend for the third quarter of fiscal 2005. Our Board of Directors later
decided to suspend the payment of cash dividends indefinitely. Our new senior
credit facility entered into in March 2007 effectively prohibits payment of any
future dividends until the credit facility is repaid.
Securities Authorized for Issuance Under Equity Compensation Plans
Information relating to compensation plans under which equity securities of the
Company are authorized for issuance appears under the heading "Stock Option
Plans" in our definitive Proxy Statement filed for our 2007 Annual Meeting of
Stockholders, and is incorporated herein by reference.
ITEM 6. SELECTED FINANCIAL DATA
Fiscal Year Ended
----------------------------------------------------------
January 5, January 4, January 2, January 1, December 31,
2003 2004 2005 2006(5) 2006
---------- ---------- ---------- ---------- -----------
($ in thousands, except per share data)
Statements of Operations Data:
Revenues:
Rentals $ 490,836 $ 629,793 $ 729,167 $1,630,058 $2,030,251
Product sales 38,152 62,602 62,010 357,269 511,682
--------- ---------- ---------- --------- ----------
Total revenues 528,988 692,395 791,177 1,987,327 2,541,933
--------- ---------- ---------- --------- ----------
Cost of sales:
Cost of rental
revenues 164,818(1) 184,439 208,160 502,873 626,918
Cost of product
sales 29,852 50,143 41,942 271,900 384,933
-------- ---------- ---------- --------- ---------
Gross margin 334,318 457,813 541,075 1,212,554(6) 1,530,082
Operating costs and expenses:
Store operating
expenses 253,865(2) 324,466 395,425(4)1,027,119 1,250,799(12)
General and
administrative 43,274(3) 48,003 55,475 130,059 180,153
Amortization of
intangibles 1,298 2,003 2,601 3,865 2,838
Impairment of
goodwill - - - 522,950(7) -
Impairment of other
intangibles - - - 4,940(7) -
Other income - - - - (43)
-------- ---------- ---------- --------- ----------
Operating income
(loss) 35,881 83,341 87,574 (476,379) 96,335
-------- ---------- ---------- --------- ----------
Interest expense,
net (1,024) (468) (624) (68,529)(8) (120,410)(8)
Write off of bridge
financing - - - (4,234)(9) -
Equity in losses of
unconsolidated
entities - (1,450) (5,746) (806) -
--------- ---------- --------- --------- ----------
Income (loss) before
income taxes 34,857 81,423 81,204 (549,948) (24,075)
Income taxes 13,923 31,987 31,716 2,792(10) 1,645(13)
--------- ---------- ---------- --------- ----------
Net income (loss) $ 20,934 $ 49,436 $ 49,488 $(552,740) $ (25,720)
========= ========== ========== ========= ==========
Net income (loss) per share:
Basic $ 0.69 $ 1.53 $ 1.54 $ (17.53) $ (0.81)
========= ========== ========== ========== =========
Diluted $ 0.67 $ 1.48 $ 1.52 $ (17.53) $ (0.81)
========= ========== ========== ========== =========
Weighted average shares outstanding:
Basic 30,273 32,406 32,096 31,524 31,800
========= ========== ========== ========== =========
Diluted 31,436 33,370 32,552 31,524 31,800
========= ========== ========== ========== =========
Cash dividends per
common share $ - $ 0.03 $ 0.12 $ 0.06 $ -
========= ========== ========== ========== =========
Fiscal Year Ended
-----------------------------------------------------------
January 5, January 4, January 2, January 1, December 31,
2003 2004 2005 2006(5) 2006
---------- ---------- ---------- ---------- -----------
($ in thousands, except per share data)
Balance Sheet Data (at end of period):
Cash and cash
equivalents $ 29,555 $ 38,006 $ 25,518 $ 135,238 $ 32,953
Rental inventory,
net 82,880 102,479 126,541 371,565 339,981
Total assets 361,209 457,884 492,142 1,385,128 1,153,277(12)
Long-term debt less
current maturities - - - 1,083,083 1,087,875
Stockholders'
equity (deficit) 259,051 320,116 331,134 (212,818) (236,431)
Other Data:
Number of stores at
end of period 1,784 2,158 2,482 4,749(11) 4,642
Revenues per weighted
average store $ 337 $ 355 $ 341 $ 496 $ 538
Increase(decrease) in
same-store revenues 3.2% 7.0% (1.5)% (4.7)% (3.7)%
(1) Effective October 7, 2002, we revised the estimates used to amortize rental
inventory, resulting in a non-cash charge of approximately $27.9 million in the
fourth quarter of fiscal 2002, and $5.9 million throughout fiscal 2003.
(2) Includes a $1.6 million charge related to the amendment of our supply
agreement with Rentrak Corporation.
(3) Includes a $4.0 million charge related to a legal settlement in the second
quarter of fiscal 2002.
(4) 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
we accounted for as an immaterial cumulative correction. See Note 1,
"Accounting Policies," in our accompanying consolidated financial statements.
(5) Recognizes the consolidated results of Movie Gallery and Hollywood for the
period subsequent to our merger on April 27, 2005. See Note 2, "Business
Combinations," in our accompanying consolidated financial statements for
information on our acquisition of Hollywood.
(6) Includes $10.1 million in charges (before taxes)($0.21 per diluted share
after tax) related to the VHS residual value adjustment by the Movie Gallery
segment, 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.
(7) Recognizes 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 6, "Impairment of Goodwill and Other
Long-Lived Assets," in our accompanying consolidated financial statements for
information on 2005 impairment charges.
(8) Recognizes the interest expense related to the credit facility and Senior
Notes to finance the Hollywood acquisition.
(9) Recognizes the write-off of costs incurred to obtain an acquisition bridge
financing commitment that expired, unused, on the date of acquisition of
Hollywood.
(10) Effective tax rate for fiscal 2005 is adversely impacted by goodwill
impairment, of which $332.1 million is not tax deductible and which 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," in our accompanying consolidated
financial statements.
(11) Recognizes 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.
(12) Recognizes adjustments required to properly conform with the provisions of
SFAS No. 143, "Accounting for Asset Retirement Obligations," including an
increase to operating expenses of $7.3 million and an increase in property and
equipment of $1.4 million.
(13) Effective tax rate for fiscal 2006 is impacted by an increase in the
valuation allowance which was recorded for $12.1 million to reflect
management's determination that the deferred tax asset may not be realized. In
addition, the tax provision was impacted by prior year issues relating to the
statute of limitations of federal and state tax jurisdictions. See Note 4,
"Income Taxes," in our accompanying consolidated financial statements.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Overview
As of December 31, 2006, we operated approximately 4,600 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. We currently plan to maintain the Hollywood brand and store
format. We currently plan to open approximately 10 new stores for the full
fiscal year 2007 period, subject to market and industry conditions. Movie
Gallery's eastern-focused rural and secondary market presence 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 to 60 day period during which we can rent and
sell new releases before they are made available on pay-per-view or other
distribution channels. According to Adams Media Research, the domestic home
video industry accounted for approximately 60% of domestic studio movie revenue
in 2006. 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 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 12 full months, to
assess the performance of our business.
- - Product purchasing economics. In order to maintain the desired profit
margin in our business, we carefully manage purchases of inventory for both
rental and sale. 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 our models enable us 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. Our stores 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. We do not plan on significant
store growth plans in the next several years.
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 of
the notes were tendered. The Hollywood acquisition was financed using
Hollywood's cash on-hand of approximately $180.0 million, 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, or Senior Notes.
The combination of Movie Gallery and Hollywood created the second largest North
American video rental company. At the time of the acquisition, the combined
pro-forma annual revenue was in excess of $2.6 billion and included
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
did not overlap significantly with Movie Gallery's rural and suburban store
locations concentrated in the eastern half of the United States. In the fourth
quarter of fiscal 2005, we closed 64 Movie Gallery stores with trade areas that
overlapped with acquired Hollywood Video stores. An additional 46 overlapping
Movie Gallery stores were closed in fiscal 2006. We will continue to evaluate
the closure of stores with overlapping trade areas such as these as market
conditions warrant.
We maintain our 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
initially focused on consolidating the leadership functions in the brands. We
have completed most of our integration of the Human Resources, Real Estate,
Legal, Lease Administration, Finance, Loss Prevention and Distribution
functions.
During the fourth quarter of fiscal 2005, we notified 101 Movie Gallery
associates that their positions would 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. The affected individuals were required to render
service for a range of 10 to 49 weeks in order to receive termination benefits.
The total cost of providing severance, retention incentives and outplacement
services to the impacted associates was approximately $2.3 million.
Approximately $1.2 million and $1.1 million were recognized during fiscal 2005
and 2006, respectively, by establishing reserves for those amounts in
accordance with SFAS No. 146, "Accounting for Costs Associated with Disposal
and Exit Activities." Cash payments of $2.0 million were charged to the
reserve during fiscal 2006.
Our integration plan was amended in the second quarter of fiscal 2006 with
regard to the Human Resource Processing and Benefits functions within the Human
Resources department. We decided to consolidate substantially all of these
functions to our Dothan, Alabama corporate offices, and the affected Hollywood
employees were notified that their positions would be relocated.
We estimate that total savings, including new initiatives in 2006 combined with
the full year fiscal 2006 impact of the savings already achieved in 2005 were
approximately $50 million. These savings have been driven principally by
improvements in the supply chain for our Movie Gallery branded stores,
consolidation of our Real Estate and Architecture functions, inventory
utilization, and elimination of duplicative executive management. Since the
acquisition in April 2005, 482 corporate positions have been eliminated as the
result of our consolidation efforts.
We continue to evaluate opportunities to leverage both Movie Gallery's and
Hollywood's best practices and to generate general and administrative cost
savings. To date, we have identified and taken advantage of 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 are also 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 or that we
will achieve any further cost savings.
MovieBeam Acquisition - Subsequent Event
Subsequent to fiscal 2006, on March 5, 2007, we acquired substantially all of
the assets, technology, network operations, and customers of MovieBeam, Inc.,
an on-demand movie service for cash consideration, the amount of which will be
immaterial to our fiscal 2007 consolidated financial statements.
Pending Acquisition
By letter dated August 29, 2005, Boards, Inc., 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, including 17 Game Crazy stores owned and operated by
Boards, pursuant to a put option. The put option, and a related call option,
were contained in the license agreement between Hollywood and Boards that 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. 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. As of
December 31, 2006, the purchase price had not yet been determined. It is
possible that the transaction will close in fiscal 2007. On March 7, 2007,
Boards sent a demand for arbitration, which we refer to as the Demand, to us
seeking to determine the purchase price of these stores, along with accrued
interest. Additionally, Boards claims an additional $10.0 million in punitive
damages alleging that we have taken action to deliberately diminish the value
of the Boards stores in order to lower the purchase price. We believe the
allegations contained in the Demand are completely without merit and intend to
vigorously defend this matter.
Results of Operations
The following discussion of our results of operations, liquidity and capital
resources is intended to provide further insight into our performance over the
last three years.
Selected Financial Statement and Operational Data:
Fiscal Year Ended
------------------------------------
January 2, January 1, December 31,
2005 2006(1) 2006
---------- ---------- -----------
($ in thousands, except per share
and store data)
Rental revenue $ 729,167 $1,630,058 $2,030,251
Product sales 62,010 357,269 511,682
--------- ---------- ----------
Total revenue 791,177 1,987,327 2,541,933
Cost of rental revenue 208,160 502,873 626,918
Cost of product sales 41,942 271,900 384,933
--------- ---------- ----------
Total gross profit 541,075 1,212,554 1,530,082
Store operating expenses 395,425 1,027,119 1,250,799
General and administrative expenses 55,475 130,059 180,153
Impairment of goodwill - 522,950 -
Impairment of other intangibles - 4,940 -
Operating income (loss) 87,574 (476,379) 96,335
Interest expense, net (624) (68,529) (120,410)
Equity in losses of
unconsolidated entities 5,746 806 -
Net income (loss) $ 49,488 $ (552,740) $ (25,720)
Net income (loss) per diluted share $ 1.52 $ (17.53) $ (0.81)
Cash dividends per common share $ 0.12 $ 0.06 $ -
Rental margin 71.5% 69.1% 69.1%
Product sales margin 32.4% 23.9% 24.8%
Total gross margin 68.4% 61.0% 60.2%
Percent of total revenue:
Rental revenue 92.2% 82.0% 79.9%
Product sales 7.8% 18.0% 20.1%
Store operating expenses 50.0% 51.7% 49.2%
General and administrative expenses 7.0% 6.5% 7.1%
Impairment of goodwill 0.0% 26.3% 0.0%
Impairment of other intangibles 0.0% 0.2% 0.0%
Operating income (loss) 11.1% (24.0%) 3.8%
Interest expense, net 0.1% 3.4% 4.7%
Net income (loss) 6.3% (27.8%) (1.0%)
Total same-store revenues (1.5%) (4.7%) (3.7%)
Movie Gallery same-store revenues (1.5%) (5.7%) (0.1%)
Hollywood same-store revenues(1) 1.5% (4.3%) (5.4%)
Total same-store rental revenues (1.0%) (6.2%) (5.6%)
Movie Gallery same-store rental revenues (1.0%) (6.5%) (0.5%)
Hollywood same-store rental revenues(1) (4.3%) (6.0%) (8.3%)
Total same-store product sales (12.0%) 1.7% 4.1%
Movie Gallery same-store product sales (12.0%) 3.0% 4.2%
Hollywood same-store product sales(1) 29.4% 1.5% 4.1%
Store count:
Beginning of period 2,158 2,482 4,749
New store builds 314 288 123
Stores acquired 74 2,138(2) -
Stores closed (64) (159) (230)
--------- --------- --------
End of period 2,482 4,749 4,642
========= ========= ========
(1) Hollywood's results for periods prior to April 27, 2005 are not included in
the consolidated statements of operations but rather recognize 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," in our accompanying 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," in our accompanying consolidated financial statements.
Revenue. Consolidated total revenues increased 27.9% and 151.2% for fiscal
2006 and 2005, respectively, compared to fiscal 2005 and 2004. The increase in
revenues was primarily due to the acquisition of Hollywood, which added $1.7
billion and $1.1 billion in revenue for fiscal 2006 and 2005, respectively,
accounting for over 95% of the revenue increases. Same-store total revenues
were negative 3.7% for fiscal 2006, which consisted of a 5.6% decline in same-
store rental revenue and a 4.1% increase in same-store product revenue.
With the acquisition of Hollywood, our revenue mix has shifted more to product
revenue and away from rental revenue versus comparable periods prior to the
acquisition. The Game Crazy operating segment is the primary driver of this
shift in the revenue mix.
For fiscal 2006 and 2005, the Movie Gallery operating segment total revenues
increased 3.1% and 6.8%, respectively, from the prior years. The increase in
fiscal 2006 compared to 2005 was primarily driven by new stores outperforming
closed stores and a 1% increase in weighted-average stores operated. Same-store
total revenues were relatively flat at negative 0.1%, which consisted of a 0.5%
decline in same-store rental revenue and a 4.2% increase in same-store product
revenue. The increase in fiscal 2005 compared to 2004 was primarily due to a
13.5% increase in the average number of stores operated, partially offset by a
5.7% decline in same-store total revenue.
The Hollywood segment same-store total revenues decreased 5.4% for fiscal 2006,
which consisted of an 8.3% decline in same-store rental revenue and a 4.1%
increase in same-store product revenue. For fiscal 2005, to conform Hollywood's
extended viewing fees accounting policy to Movie Gallery's accounting policy,
we have recognized 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. 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. Excluding
the impact of the change in accounting policy, same-store total revenues
declined 4.3% for fiscal 2005.
We believe the following factors contributed to the decline in our rental same-
store revenues:
-The overabundance of DVD titles available for sale in the marketplace;
-The growth of online rental;
-The maturation of the DVD life cycle; and
-The widespread availability of other audio/video media such as recorded
television, pay-per-view movies and the Internet.
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 fiscal 2005 and
2006 was consistent at 69.1%. The gross margin for both fiscal 2005 and 2006
included charges due to changes in rental amortization estimates. In fiscal
2005, a charge of $10.1 million was recorded to reflect a change in estimate of
the residual value of VHS movies from $2.00 to $1.00. In fiscal 2006 we then
reduced to zero the remaining salvage value of VHS inventory and recorded a
corresponding charge which was immaterial to our consolidated financial
statements. Also in fiscal 2006, charges totaling $11.3 million were recorded
to recognize changes for the Movie Gallery segment in the estimate of the book
value associated with revenue-sharing DVD movies and to accelerate rental
amortization on games. Improvements in rental gross margins due to an increase
in the percentage of DVD movies acquired under revenue-sharing arrangements and
efficiencies in rental product distribution and processing were offset by an
increase in the percentage of rental revenue from promotionally discounted
sales of previously viewed movies.
The gross margin on rental revenue for fiscal 2004 was 71.5% compared to 69.1%
for fiscal 2005. The decrease was primarily a result of the acquisition of the
Hollywood Video stores. Gross margins in the Hollywood Video stores were
historically lower than those of Movie Gallery stores because Hollywood
generally invested more in rental inventory as a percentage of revenue to
compete effectively in urban markets.
Cost of product sales includes the costs of new and used video game merchandise
in the Game Crazy operating segment, and includes 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 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 fiscal 2004, 2005 and 2006 was 32.4%, 23.9% and
24.8%, respectively. The decrease in product sales margin from fiscal 2004
compared to 2005 and 2006 was primarily caused by higher penetration of new
movies and new game merchandise sales. The acquisition of Hollywood, including
the Game Crazy segment, was the primary driver of the change in sales mix.
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 were 50.0%, 51.7% and 49.2% in fiscal 2004, 2005 and 2006,
respectively.
The decrease in store operating expenses as a percentage of total revenue from
2005 to 2006 is primarily due to:
- A reduction of store labor expense as a percentage of revenue; store
labor decreased 1.1% compared to the prior year, due largely to
improvements in labor scheduling.
- A reduction of depreciation expense as a percentage of revenue; store
depreciation decreased 0.5% compared to the prior year due mainly to
assets, primarily leasehold improvements, acquired in conjunction with the
acquisition of Hollywood becoming fully depreciated during fiscal 2006, in
addition to a significant number of lease term expirations during 2006.
The reductions were partially offset in fiscal 2006 by a charge of $7.5
million, or 0.2% of revenue, to recognize asset retirement obligations in
accordance with SFAS No. 143.
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 fiscal 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, furnishings 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 fiscal 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.
General and administrative expenses. General and administrative expenses as a
percentage of revenue were 7.0%, 6.5% and 7.1% in 2004, 2005 and 2006,
respectively. The increase in general and administrative expenses as a
percentage of revenue from fiscal 2005 to 2006 is due to:
- - An increase in professional fees related to restructuring and
refinancing fees incurred during fiscal 2006 of $9.2 million, as well as
an increase in stock compensation expense of $1.5 million.
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, despite increases in severance for
integration and the impact of higher than anticipated same store revenue
decreases.
Fiscal 2006 Impairment Testing. Impairment charges include the impairment of
goodwill and intangible assets, including customer lists. 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," or SFAS No. 144. We have tested our long-lived
assets (other than goodwill and intangible assets) for impairment under SFAS
No. 144 and concluded that no impairment existed for fiscal 2006 other than
impairments recognized in conjunction with store closures.
Goodwill and indefinite-lived intangible assets are also subject to impairment
testing annually, or whenever indicators of impairment are present. In
accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," or SFAS
No. 142, we assess goodwill and intangible assets with indefinite lives for
impairment at the reporting unit level on an annual basis and between annual
tests if events occur or circumstances change that would more likely than not
reduce the fair value of these assets below their carrying amount. We
conducted our annual test of the valuation of goodwill and intangible assets
during the fourth quarter of fiscal 2006, in accordance with our policy and the
requirements as set forth in SFAS No. 142, and determined that no impairment
existed.
As part of our ongoing store profitability reviews, in the fourth quarter of
fiscal 2006 we closed our nine stores in Mexico which in the aggregate were
deemed to be underperforming. We recorded a charge against operating income of
approximately $1.5 million, consisting primarily of a write-off of property,
furnishings and equipment, and a write-down of movie product.
Fiscal 2005 Impairment Losses. The first quarter of fiscal 2005 results for
both Hollywood and Movie Gallery, prior to Movie Gallery's acquisition of
Hollywood, were significantly better than the expectations and plans of both
management groups. In the second and third quarters after the merger, our
results were significantly worse than 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 of fiscal 2005 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 fiscal 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 fiscal 2005:
- Goodwill - We tested goodwill and indefinite-lived intangibles at the
beginning of the fourth quarter of fiscal 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 online 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 above, we also
tested all other intangible assets for impairment as of the beginning of
the fourth quarter of fiscal 2005. Based on the results of this test, we
concluded that the customer list intangible assets of our Movie Gallery
operating segment were impaired. We estimated the value of our acquired
customer lists, basing this estimate primarily on observations of market
comparables for similar customer lists on a per thousand customer basis. As
a result of this analysis, we recorded a $4.9 million impairment charge in
the fourth quarter of fiscal 2005 to reduce the carrying value of Movie
Gallery's previously acquired customer lists to our revised 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,
furnishings and equipment, were impaired under the guidance in SFAS No.
144.
Stock Compensation Expense. Stock compensation expense primarily represents
non-cash charges associated with non-vested stock grants. Beginning in fiscal
2006, we adopted SFAS No. 123R, "Accounting for Stock-Based Compensation," or
SFAS No. 123R. Upon adoption of SFAS No. 123R, we are no longer permitted to
account for stock based compensation using the intrinsic value approach that we
had followed, in years prior to adoption of SFAS No. 123R under APB Opinion No.
25, "Accounting for Stock Issued to Employees."
Service-based non-vested share awards vest over periods ranging from one to
four years. Compensation expense, representing the excess of the fair market
value of the shares at the date of issuance over the nominal purchase price, if
any, of the shares, net of assumptions regarding estimated future forfeitures
is charged to earnings over the vesting period. Performance-based non-vested
share awards entitle participants to acquire shares of stock upon attainment of
specified performance goals. Compensation expense, representing the excess of
the fair market value of the shares at the date of issuance over the nominal
purchase price, if any, net of assumptions regarding future forfeitures and the
likelihood that the performance requirements will be attained, is charged to
earnings over the vesting period. In fiscal 2005 and 2006, we recognized $1.2
million and $2.5 million, respectively, in compensation expenses related to
service-based stock grants, and $0.4 million and $0.6 million, respectively, in
expenses related to performance-based stock grants.
Fiscal 2004 and 2005 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. In
addition, in fiscal 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 1, "Accounting
Policies," in our accompanying consolidated financial statements.
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 requires 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.
In November 2005, the FASB issued FASB Staff Position No. 123R-3, "Transition
Election Related to Accounting for the Tax Effects of Share-Based Payment
Awards." We have adopted the simplified method to calculate the beginning
balance of the additional paid-in-capital, or APIC, pool of the excess tax
benefit, and to determine the subsequent effect on the APIC pool and
Consolidated Statements of Cash Flows of the tax effects of stock-based
compensation awards that were outstanding upon our adoption of SFAS No. 123R.
Operating Income. As a result of the impact of the above factors on our
revenues and expenses, our operating income increased by $572.7 million for
fiscal 2006 to $96.3 million. The increase in operating income was principally
attributable to the non-recurrence of $522.9 million in goodwill impairment
charges and $4.9 million for the impairment of intangibles recorded in fiscal
2005. There were no similar charges in fiscal 2006. In addition, fiscal 2006
contained a full 52 weeks of results from Hollywood, while fiscal 2005
contained only 36 weeks.
For fiscal 2005, operating income decreased by $564.0 million to a loss of
$476.4 million. The decrease in operating income was principally attributable
to $522.9 million in goodwill impairment charges and $4.9 million for the
impairment of intangibles recorded in fiscal 2005. There were no similar
charges in fiscal 2004. The following factors contributed to the remaining
decline in operating income:
- 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 to our historical method in fiscal 2005,
which reduced operating income by $19.0 million after adjusting for
accrued revenue-sharing.
- Cost of sales 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.
Interest Expense, net. Net loss for fiscal 2006 includes $120.4 million pre-
tax, or $3.79 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 fiscal 2005 and 2004 amounted to $68.5
million and $0.6 million, respectively, a substantial portion of which related
to credit facility fees and expenses. We expect cash interest expense to
decrease by approximately $6.0 million annually as a result of the March 2007
refinancing of our senior credit facility.
Write-off of Bridge Financing. Concurrently with the acquisition of Hollywood
in the second quarter of fiscal 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 2006.
Equity in Losses of Unconsolidated Entities. During the last half of fiscal
2003, we began to make investments in various alternative delivery vehicles
(both retail and digital) for movie content. As of January 1, 2006, we had
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. In the future, we may make, subject to
limitations in the agreements governing our indebtedness, similar investments
that we will be required to account for as equity investments similar to the
investments we have made in the past.
Income Taxes. The effective tax rate was a provision of 6.8% for fiscal 2006,
compared to a provision of 39.1% and 0.5% for fiscal 2004 and 2005,
respectively. The change in the effective rate in 2006 is primarily a result
of an increase in the valuation allowance of $12.1 million for our deferred tax
assets and changes in prior year tax benefits due to statute of limitations
issues. 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 allowance in future periods and we
will not be able to recognize tax benefits in our statement of operations
related to future losses. 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
Summary
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,
borrowings under the revolving portion of our senior secured credit facility.
For fiscal 2006, net cash used in operating activities was $9.8 million,
resulting in an increased use of borrowings under our credit facility to fund
our capital needs.
On March 8, 2007, we entered into a new $900 million senior secured credit
facility, or the March 2007 Credit Facility. The March 2007 Credit Facility
refinanced a previous $829.9 million senior secured credit facility that we
entered into in April 2005 in connection with our acquisition of Hollywood, or
the April 2005 Credit Facility.
At December 31, 2006, we had cash and cash equivalents of $33.0 million and
$36.0 million in available borrowings under the April 2005 Credit Facility.
Prior to the refinancing, our projected operating results indicated we would
fail the financial covenant tests contained in the April 2005 Credit Facility,
effective as of April 1, 2007. If such a breach of the financial covenants
contained in the April 2005 Credit Facility had taken place, one or more events
of default, including cross-defaults between multiple components of our
indebtedness, could have resulted. Such an event of default would have
permitted our creditors to declare all amounts owing to be immediately due and
payable. However, because we executed the March 2007 refinancing prior to the
filing of this Form 10-K, and because the financial covenants, which we
describe below, contained in the March 2007 Credit Facility are significantly
less restrictive than those contained in the April 2005 Credit Facility,
pursuant to SFAS No. 6, "Classification of Short-Term Obligations Expected to
Be Refinanced," we classified all amounts outstanding under the April 2005
Credit Facility, less the current portion, as non-current liabilities as of
December 31, 2006. We currently expect to classify outstanding borrowings
under the March 2007 Credit Facility, less the current portion, as long-term
debt for the remainder of fiscal 2007.
We will continue to explore various alternative strategies to reduce our
outstanding indebtedness, including, among other things, raising additional
equity, sale/leaseback transactions, and subleasing and restructuring leases at
our stores. We cannot assure you that any of these actions will be successful.
We believe that cash flow available from operations and borrowings under the
March 2007 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 fiscal 2007.
Credit Facility
The March 2007 Credit Facility consists of:
- A $100 million revolving credit facility, which we refer to as the
revolver;
- A $25 million first lien synthetic letter of credit facility;
- A $600 million first lien term loan; and
- A $175 million second lien term loan.
We sometimes collectively refer to the revolver, the first lien term loan and
the letter of credit facility as the first lien facilities.
We did not incur any incremental indebtedness as a part of the refinancing,
except to pay fees and expenses associated with the refinancing. The following
table summarizes (in millions) the sources and uses of funds in connection with
the refinancing of the April 2005 Credit Facility with the March 2007 Credit
Facility:
Sources Uses
Revolver $ 0.0 Existing Bank Debt (1) $ 754.9
Cash on Hand 18.7 Fees and Expenses 23.2
First Lien Term Loan 600.0 Accrued Interest and
Second Lien Term Loan 175.0 Fees 15.6
---------- -------------
Total Sources $ 793.7 Total Uses $ 793.7
(1) Consists of $66.8 million of Term Loan A borrowings and $688.1 million of
Term Loan B borrowings under the April 2005 Credit Facility.
In the first quarter of fiscal 2007, we will account for the refinancing of the
April 2005 Credit Facility as an extinguishment of debt, and at that time we
will recognize a debt extinguishment charge of approximately $18.0 million to
write off the unamortized deferred financing fees related to the April 2005
Credit Facility.
Borrowings under the first lien term loan and the revolver bear interest at a
rate equal to LIBOR plus 3.50%, or 8.84%, and LIBOR plus 2.50%, or 7.84%,
respectively, as of March 8, 2007. After we deliver our financial statements
for the quarter ended September 30, 2007, the revolver will bear interest at a
rate equal to LIBOR plus a margin determined by reference to our secured
leverage ratio. Additionally, we are required to pay a commitment fee equal to
a percentage of the average amounts that are undrawn under the revolver, also
determined by reference to our secured leverage ratio. The LIBOR margin and
commitment fees for the revolver are set forth below:
Secured Leverage Ratio LIBOR Margin Commitment Fee
- ---------------------- ------------ --------------
Equal to or greater than 2.50 2.50% 0.50%
Less than 2.50 2.25% 0.375%
Borrowings under the revolver cannot cause the ratio of the value of our
inventory to total revolver usage to be less than 3.00 to 1.00 (or, in the
event we are not meeting the financial covenants described below, 3.50 to
1.00.)
The second lien term loan bears interest at a rate of LIBOR plus 6.50%, or
11.84% as of March 8, 2007. The second lien term loan includes an option,
which we refer to as the PIK option, for us to defer interest on all or 50% of
the second lien term loan and instead pay interest in-kind by increasing the
principal amount of the second lien term loan by up to $25 million. For any
period during which we elect to pay interest in-kind, the interest rate
applicable to that portion of the second lien term loan subject to the PIK
option will increase by 0.75%.
The maturity date of the first lien facilities is March 8, 2012. However, if
we do not refinance the Senior Notes by October 31, 2011, then the maturity
date of the first lien facilities is shortened to January 15, 2012.
The maturity date of the second lien term loan is September 8, 2012. However,
if we do not refinance the Senior Notes by October 31, 2011, then the maturity
date of the second lien term loan is shortened to January 15, 2012.
The first lien facilities require us to meet certain financial covenants,
including a secured leverage test, a total leverage test and an interest
coverage test. Each of these covenants is calculated based on trailing four
quarter results using specific definitions that are contained in the first lien
credit agreement. In general terms,
- the secured leverage test is a measurement of secured leverage, which
includes indebtedness under the first lien facilities, the second lien term
loan, amounts drawn under letters of credit and any other secured
indebtedness relative to operating cash flow;
- the leverage test is a measurement of total leverage, or all of our
indebtedness, including our Senior Notes, and amounts drawn under letters of
credit, relative to operating cash flow; and
- the interest coverage ratio is a measurement of operating cash flow
relative to interest expense.
The covenant levels under the March 2007 Credit Facility are as follows:
Secured Leverage Interest Coverage
Ratio Leverage Ratio Ratio
---------------- -------------- -----------------
2007 4.75 6.75 1.40
2008 4.25 6.25 1.50
2009 3.75 5.50 1.60
2010 3.00 4.75 1.75
Thereafter 2.50 4.00 2.00
The second lien credit facility contains no financial covenants.
The March 2007 Credit Facility also imposes certain other 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; acquire or sell 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 place
restrictions on the ability of subsidiaries to make distributions. These
restrictions in the first lien credit facility are substantially identical to
the restrictions in the second lien credit facility.
The first lien term loan requires annual prepayments equal to 1% of the
original principal balance. In addition to the regularly scheduled
prepayments, the first lien credit agreement, subject to certain exceptions,
also requires us to make mandatory prepayments in an amount equal to:
- 75% of any excess cash flow, which generally represents the amount of
cash generated by us but not used towards operations and debt service (and
subject to step-downs in this percentage based upon the then current secured
leverage ratio);
- 100% of the net proceeds from any asset sales, subject to certain
exceptions for reinvested proceeds;
- 100% of any insurance proceeds, subject to certain exceptions for
reinvested proceeds; and
- 50% of the net proceeds from any issuances of equity (subject to
exceptions for (i) up to $75 million of proceeds from issuances of equity
used to redeem our Senior Notes and (ii) proceeds of equity issuances to
finance certain permitted acquisitions).
The March 2007 Credit Facility is fully and unconditionally guaranteed on a
joint and several basis by all of our domestic subsidiaries. It is also
secured by (i) in the case of the first lien credit facility, first priority
security interests in, and liens on, substantially all of our direct and
indirect domestic subsidiaries' tangible and intangible assets (other than
leasehold mortgages on stores), first priority pledges of all the equity
interests owned by us in our existing and future direct and indirect wholly
owned domestic subsidiaries, and 65% of the equity interests owned by us in our
existing and future wholly owned non-domestic subsidiaries (ii) in the case of
the second lien credit facility, second priority security interests in, and
liens on, substantially all of our direct and indirect domestic subsidiaries'
tangible and intangible assets (other than leasehold mortgages on stores),
second priority pledges of all the equity interests owned by us in our existing
and future direct and indirect wholly owned domestic subsidiaries, and 65% of
the equity interests owned by us in our existing and future wholly owned non-
domestic subsidiaries.
11% Senior Notes due 2012
In connection with the Hollywood acquisition, we issued $325.0 million
aggregate principal amount of the Senior Notes. The indenture governing the
Senior Notes imposes 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.
Interest Rate Hedges
The March 2007 Credit Facility requires that no later than 90 days subsequent
to entering the March 2007 Credit Facility, 50% of our total outstanding debt
is to be converted to fixed rate debt for a period of three years subsequent to
March 8, 2007.
Our April 2005 Credit Facility required that for a period of two years
subsequent to entering into the April 2005 Credit Facility, a portion of our
floating-rate debt was to be converted to fixed-rate debt. In fiscal 2005 we
entered into two, two-year floating-to-fixed interest rate swaps for a total
amount of $280.0 million. Under the terms of both of the swap agreements, we
paid fixed interest on the $280.0 million at a rate of 4.06% and received
floating interest based on the three-month LIBOR. The scheduled termination
date for both of these swaps was June 29, 2007. On October 20, 2006, we
settled both of these interest rate swaps (prior to their scheduled termination
dates) and received $2.5 million in cash.
On October 20, 2006, we entered into a new floating-to-fixed interest rate swap
for an amount of $140.0 million. Under the terms of the new swap agreement, we
will pay fixed interest on the $140.0 million at a rate of 5.41% and receive
floating interest based on the three-month LIBOR. The termination date for the
new swap agreement is April 30, 2007.
Also on October 20, 2006, we entered into a new 5.50% interest rate cap
agreement for an amount of $140.0 million. Under the terms of the new cap
agreement, we will pay floating rate interest up to a maximum of 5.50% and
receive floating rate interest based on the three-month LIBOR. The termination
date for the new 5.50% cap agreement is April 27, 2007.
Contractual Obligations.
The following table discloses our contractual obligations and commercial
commitments as of December 31, 2006. We have presented this information based
on the recorded amounts contained in our December 31, 2006 consolidated balance
sheet consistent with the requirements under SFAS No. 47, "Disclosure of Long-
Term Obligations," or SFAS No. 47, absent consideration of the subsequent
refinancing of the April 2005 Credit Facility on March 8, 2007 except with
regard to the current maturities in year one which reflect the current portion
of long term debt under our March 2007 Credit Facility.
Contractual 2-3 4-5 More than
Obligations Total 1 Year Years Years 5 Years
- --------------- ---------- -------- -------- ---------- --------
Principal Payments
April 2005 Credit Facility $ 769,881 $ 4,500 $ 53,000 $ 712,381 $ -
Senior Notes 325,450 - - 450 325,000
Capital Leases 80 80 - - -
Interest
April 2005 Credit Facility(1) 316,628 81,399 157,327 77,902 -
Senior Notes 190,851 35,793 71,587 71,554 11,917
Capital Leases 1 1 - - -
Operating Leases 1,478,182 376,012 557,087 329,453 215,630
----------- -------- -------- ---------- --------
Total $ 3,081,073 $497,785 $839,001 $1,191,740 $552,547
----------- -------- -------- ---------- --------
(1) Interest rates based on current LIBOR rates as of December 31, 2006,
including margin, of 10.37% for Term Loan A and the 2005 Revolver, and 10.62%
for Term Loan B under our old April 2005 Credit Facility. We have assumed
these interest rates would stay the same for the remaining terms of the loans
for purposes of presenting future interest payments.
The following supplemental pro-forma table is provided to show our contractual
obligations and commercial commitments for the succeeding five years from
December 31, 2006, taking into consideration the refinancing of our April 2005
Credit Facility with our new March 2007 Credit Facility on March 8, 2007. We
believe that this presentation provides an enhanced understanding of our future
liquidity requirements.
Contractual 2-3 4-5 More than
Obligations Total 1 Year Years Years 5 Years
- --------------- ---------- -------- -------- -------- ----------
Principal Payments
March 2007 Credit Facility
First lien term loan $ 600,000 $ 4,500 $ 12,000 $ 12,000 $ 571,500
Second lien term loan 175,000 - - - 175,000
2007 Revolver - - - - -
Senior Notes 325,450 - - 450 325,000
Capital leases 80 80 - - -
Interest
First lien term loan (2) 259,623 43,178 104,356 102,235 9,854
Second lien term loan (2)114,188 16,906 41,440 41,440 14,402
April 2005 Credit
Facility (3) 15,856 15,856 - - -
Hedge agreement 27 27 - - -
Senior Notes 190,851 35,793 71,587 71,554 11,917
Capital leases 1 1 - - -
Operating leases 1,478,182 376,012 557,087 329,453 215,630
---------- -------- -------- -------- ----------
Total $3,159,259 $492,353 $786,470 $557,132 $1,323,303
---------- -------- -------- -------- ----------
(2) Interest rates based on current LIBOR rates plus margin. As of March 8,
2007, the first lien term loan and second lien term loan rates are 8.84% and
11.84%, respectively. We have assumed these interest rates will stay the same
for the remaining terms of the loans for purposes of presenting future interest
payments.
(3) Represents accrued interest through March 8, 2007 on the April 2005 Credit
Facility before it was refinanced by the March 2007 Credit Facility.
Statement of Cash Flow Data
Fiscal Year Ended
-----------------------------------
January 2, January 1, December 31,
2005 2006 2006
--------- --------- -----------
($ in thousands)
Statements of Cash Flow Data:
Net cash provided by (used in)
operating activities $ 89,873 $ 132,135 $ (9,779)
Net cash used in investing activities (59,469) (1,151,212) (14,912)
Net cash (used in) provided by
financing activities (45,353) 1,127,851 (77,765)
Operating Activities
The decrease in net cash provided by operating activities for fiscal 2006
compared to 2005 was primarily due to an increase in the use of cash for
accounts payable and interest, changes in accrued liabilities and the change in
accounting for extended viewing fees, offset by increased cash provided by
operations, excluding changes in working capital, from our Hollywood segment,
which we operated for approximately 36 weeks in fiscal 2005 compared to the
full fiscal year 2006. During fiscal 2006, we used $149.9 million of cash
toward payment of our accounts payable balances. This was driven by credit
restrictions on the part of certain vendors.
The increase in net cash provided by operating activities for fiscal 2005
compared to 2004 was primarily due to the acquisition of Hollywood, offset by
an increase in cash paid for interest.
Investing Activities
Net cash used in investing activities includes the cost of business
acquisitions, new store builds and other capital expenditures. For fiscal 2006,
our net cash used in investing activities was $14.9 million, which included 123
new store builds. For fiscal 2005, our net cash used in investing activities
was $1.2 billion, which included the purchases of Hollywood and VHQ
Entertainment and 288 new store builds. For fiscal 2004, our net cash used in
investing activities was $59.5 million, which included 314 new store builds and
74 stores acquired.
Capital expenditure requirements for fiscal 2007 are estimated at $38 million
to fund a limited number of store openings, maintenance on our existing store
base, and strategic investments. This estimate does not include capital
required to fund our acquisition of the Boards stores pursuant to a contractual
put provision. The Boards stores acquisition may occur in fiscal 2007; however,
a purchase price has yet to be negotiated.
Financing Activities
Net cash flow related to financing activities for fiscal 2006 was a use of cash
of $77.8 million, which included an excess cash flow payment of $56.9 million
made in the first quarter of fiscal 2006. Additionally, on March 15, 2006, we
paid lender fees of $5.5 million to complete the second amendment to the April
2005 Credit Facility. Net cash flow related to financing activities for fiscal
2005 was a source of cash of $1.1 billion, which included borrowings under the
April 2005 Credit Facility and the proceeds from the sale of the Senior Notes
used to fund the Hollywood acquisition. Net cash flow related to financing
activities for fiscal 2004 was a use of cash of $45.4 million, which included
$47.4 million to repurchase common stock and $3.9 million for payment of
dividends, offset by $5.5 million of proceeds from the exercise of stock
options.
At December 31, 2006, we had a working capital deficit of $28.8 million. This
is primarily 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 a majority 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.
Off-Balance Sheet Arrangements
As of December 31, 2006, we have derivative financial instruments, as defined
by SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities,
as amended." See Note 8, "Long Term Obligations" in our accompanying
consolidated financial statements.
We have no other off balance sheet arrangements or obligations.
Critical Accounting Policies and Estimates
Our significant accounting policies are described in Note 1, "Accounting
Policies" in our accompanying consolidated financial statements. 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 intangible
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
revenue and sales of previously viewed 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 as well as the residual
values established by competitors in our industry. Effective January 2, 2006,
we reduced the amount capitalized on DVD revenue-sharing units for the Movie
Gallery segment such that the carrying value of the units, when combined with
revenue-sharing expense on previously viewed sales, more closely approximates
the carrying value of non-revenue sharing units. We also began to amortize
games on an accelerated method for the Movie Gallery segment, effective January
2, 2006, in order to remain consistent with observed changes in rental patterns
for games. 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. In fiscal 2006, we stopped purchasing VHS product. We also
reduced to zero the remaining salvage value of VHS inventory and recorded a
corresponding charge which was immaterial to our consolidated financial
statements. 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 anticipated transition to high definition DVD movies and the recent 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 estimates.
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
1, 2006 and December 31, 2006, we had $371.6 million and $340.0 million,
respectively, in rental inventory on our balance sheet. As of December 31,
2006, the net book value of our VHS rental inventory was completely written
off.
Long-Lived Assets
We assess the fair value and recoverability of our long-lived assets, including
rental inventory, 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 in the future.
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 recorded goodwill impairment charges in fiscal 2005 in the amount of $522.9
million. As of December 31, 2006, we have $115.6 million in goodwill on our
balance sheet, which primarily relates to our Hollywood Video reporting unit.
The amount of the goodwill impairment charge we recognized in 2005 for the
Hollywood Video reporting unit represented our best estimate of the charge
based on the information available to us as of the date of our consolidated
financial statements. Although we completed the purchase price allocation in
2006, we may need to make further adjustments to goodwill upon resolution of
certain acquired income tax contingencies (see discussion of deferred tax
assets related to acquired assets and carryover tax attributes, below). See
Note 6, "Impairment of Goodwill and Other Long-Lived Assets," in our
accompanying consolidated financial statements for additional information on
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 in periods following the acquisition.
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 Hollywood acquisition, including transaction costs, was
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 final for all items except deferred income taxes and we expect
further adjustments may be required during fiscal 2007 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 basis of assets
and liabilities. We regularly review our deferred tax assets for recoverability
and establish a valuation allowance when we conclude that it is more likely
than not that all or a portion of deferred tax assets will not be realized
through reversals of existing taxable temporary differences, carrybacks to
prior years with taxable income, tax planning strategies, or offset to future
tax expense attributable to taxable income in future periods. 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 an
additional valuation allowance related to net operating loss carryforwards and
tax credit carryforwards that we have determined may not be realized. In 2006,
we established an additional valuation allowance for the same reasons. 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, or the IRS, interpretive
guidance and judicial rulings. If facts and circumstances in the future should
warrant elimination or reduction of our valuation allowance related to these
net operating losses and tax credits, our effective income tax rate, which was
39.1%, 0.5% and 6.8% for fiscal 2004, 2005 and 2006, 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 allowance 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 the federal tax 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 $3.2 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 allowance 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
of Hollywood was 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 still under review by the IRS.
RECENTLY ISSUED ACCOUNTING STANDARDS
In November 2004, the Financial Accounting Standards Board, or the FASB, issued
SFAS No. 151, "Inventory Costs-An Amendment of ARB No. 43, Chapter 4," or SFAS
No. 151. SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, Inventory
Pricing, or ARB 43, to clarify the accounting for abnormal amounts of idle
facility expense, freight, handling costs and wasted material. SFAS No. 151 is
effective for fiscal years beginning after September 15, 2005. The adoption of
SFAS No. 151 did not have a material impact on our consolidated financial
statements.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections," or SFAS No. 154. This new standard replaces APB Opinion No. 20,
Accounting Changes, and SFAS No. 3, "Reporting Accounting Changes in Interim
Financial Statements". Among other changes, SFAS No. 154 requires retrospective
application of a voluntary change in accounting principle with all prior period
financial statements presented on the new accounting principle, unless it is
impracticable to do so. SFAS No. 154 also requires that a change in method of
depreciating or amortizing a long-lived nonfinancial asset be accounted for
prospectively as a change in estimate, and correction of errors in previously
issued financial statements should be termed a restatement. The new standard is
effective for accounting changes and correction of errors made in fiscal years
beginning after December 15, 2005. The adoption of SFAS No. 154 did not have a
material impact on our consolidated financial statements.
In September 2005, the Emerging Issues Task Force, or EITF, reached a consensus
on Issue 04-13, "Accounting for Purchases and Sales of Inventory with the Same
Counterparty," or EITF 04-13. The FASB Task Force concluded that inventory
purchases and sales transactions with the same counterparty should be combined
for accounting purposes if they were entered into in contemplation of each
other. The Task Force provided indicators to be considered for purposes of
determining whether such transactions are entered into in contemplation of each
other. The Task Force also provided guidance on the circumstances under which
nonmonetary exchanges of inventory within the same line of business should be
recognized at fair value. EITF 04-13 is effective in reporting periods
beginning after March 15, 2006. The adoption of EITF 04-13 did not have a
material impact on our consolidated financial statements.
In October 2005, the FASB issued FASB Staff Position, or FSP, No. FAS 13-1,
"Accounting for Rental Costs Incurred during a Construction Period,' or FSP FAS
13-1. FSP FAS 13-1 requires rental costs associated with operating leases that
are incurred during a construction period to be recognized as rental expense.
FSP FAS 13-1 is effective for reporting periods beginning after December 15,
2005. The adoption of FSP FAS 13-1 did not have a material impact on our
consolidated financial statements.
On March 28, 2006, the FASB issued EITF 06-3, "How Taxes Collected from
Customers and Remitted to Governmental Authorities Should Be Presented in the
Income Statement (That is, Gross versus Net Presentation)," or EITF 06-3, which
clarifies how a company discloses its recording of taxes collected that are
imposed on revenue-producing activities. EITF 06-3 is effective for the first
interim reporting period beginning after December 31, 2006. Presently, we
record revenues net of applicable sales taxes collected from customers. We are
in the process of evaluating the effect of EITF 06-3 on our financial
statements.
On July 13, 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109," or
FIN 48, which clarifies the way companies account for uncertainty in income
taxes. FIN 48 is effective for the first fiscal year beginning after December
15, 2006. FIN 48 will be effective for us for the fiscal year beginning
January 1, 2007. We are in the process of evaluating the effect of FIN 48 on
our financial statements.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," or
SFAS No. 157, which provides enhanced guidance for using fair value to measure
assets and liabilities. The standard also responds to investors' requests for
expanded information about the extent to which companies measure assets and
liabilities at fair value, the information used to measure fair value, and the
effect of fair value measurements on earnings. The standard applies whenever
other standards require (or permit) assets or liabilities to be measured at
fair value. The standard does not expand the use of fair value in any new
circumstances. SFAS No. 157 is effective for us for fiscal years beginning
after January 1, 2007. We are in the process of evaluating the effect of SFAS
No. 157 on our financial statements.
In September 2006, the SEC staff released Staff Accounting Bulletin No. 108,
"Considering the Effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements," or SAB 108. SAB 108
provides for a "one-time" special transition provision for correcting certain
prior year misstatements that were uncorrected as of the beginning of the
fiscal year of adoption. SAB 108 permits existing public companies to initially
apply its provisions either by (i) restating prior financial statements as if
the dual approach had always been used or (ii) recording the cumulative effect
of initially applying the dual approach as adjustments recorded to the opening
balance of retained earnings. SAB 108 is effective for fiscal years ending
after November 15, 2006. The adoption of SAB 108 did not have a material
impact on our consolidated financial statements.
In February 2007, the FASB issued SFAS No.159, "The Fair Value Option for
Financial Assets and Financial Liabilities," or SFAS No. 159, which provides
guidance on applying fair value measurements on financial assets and
liabilities. SFAS No. 159 permits entities to choose to measure many financial
instruments and certain other items at fair value. The objective is to improve
financial reporting by providing entities with the opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. SFAS No. 159 is effective for us for fiscal years beginning after
January 1, 2007. We are in the process of evaluating the effect of SFAS No.
159 on our financial statements.
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 fluctuations in variable interest rates on our short-term and
long-term debt.
Interest payable on the March 2007 Credit Facility, which we entered into on
March 8, 2007, 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 March 2007 Credit Facility, we
will enter into hedge agreements to convert a portion of our variable rate debt
to a fixed rate of interest. If variable base rates were to increase 1% from
the three-month LIBOR at March 8, 2007, our interest expense on an annual basis
would increase by approximately $3.5 million on the non-hedged principal, based
on both the outstanding balance on the March 2007 Credit Facility as of March
8, 2007 and the March 2007 Credit Facility's mandatory principal payment
schedule.
We are exposed to foreign exchange risks associated with our Canadian
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
fiscal 2006 results, 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.
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 our disclosure controls and
procedures were not effective as of December 31, 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, or 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 December 31, 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 material weakness in internal
control over financial reporting as of December 31, 2006:
Ineffective controls over lease accounting. The Company's process related to
identifying, understanding, and properly accounting for lease terms that have
an accounting impact did not function to reduce to remote the likelihood that
material misstatements would not be prevented or detected in a timely manner.
The material weakness stems from the aggregation of control deficiencies
related to the identification of non-standard lease terms, insufficient
knowledge of GAAP accounting for leases, and an inadequate process in place to
review and identify all terms included in leases that impact the accounting for
leases. The material weakness resulted in us making adjustments to property,
furnishings, and equipment, asset retirement obligations, deferred rent,
depreciation and amortization expense, rent expense, and store closure reserve
accounts in both our annual and interim financial statements for the fiscal
year ended December 31, 2006.
As a result of the material weakness described above, management has concluded
that, as of December 31, 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 December 31, 2006 has been audited by Ernst & Young LLP,
independent registered public accounting firm, and their attestation report
appears below.
Remediation Efforts Related to Material Weakness in Internal Control Over
Financial Reporting
Management plans to put controls in place to ensure proper accounting for lease
issues during fiscal 2007 in order to remediate the material weakness noted as
of December 31, 2006.
Remediation of Material Weaknesses
As previously reported, there were four material weaknesses in our internal
control over financial reporting as of January 1, 2006. The remediation of
these material weaknesses during fiscal 2006 is described as follows:
Ineffective review of account analyses and reconciliations. Management
enhanced control activities and monitoring controls surrounding account
reconciliations. A systematic methodology for performing account
reconciliations was put in place. Additional qualified financial reporting
personnel were hired and trained, and turnover was reduced. Management has
determined that this material weakness was remediated.
Ineffective communication of accounting policy for capitalizing costs and lack
of effective review process. Management implemented improved policies and
control activities governing fixed asset additions which remediated the
material weakness surrounding improper capitalization of costs into fixed
assets.
Inaccurate or lack of timely updating of accounting inputs for key estimates
and assumptions. Management enhanced control activities and monitoring
controls surrounding the use of assumptions and estimates in accounts. A
systematic methodology for documenting and reviewing assumptions was
implemented, thereby remediating this material weakness.
Ineffective procurement and receiving processes. Improved information
collection procedures and standardization and enhancement of control activities
pertaining to procurement and receiving processes were implemented as a result
of consolidating substantially all of the procurement functions to our
corporate facilities in Wilsonville, Oregon during fiscal 2006. Management has
determined that this material weakness was remediated.
Changes in Internal Control over Financial Reporting
As described in the preceding section, management implemented changes in
internal control in 2006 to correct the material weaknesses as of January 1,
2006, described above, and substantially completed the consolidation of our
accounting and finance operations to our Wilsonville, Oregon support center.
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 December 31, 2006, because of the effect of the
material weakness 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 weakness has been identified and
included in management's assessment as of December 31, 2006:
Ineffective controls over lease accounting. The Company's process related to
identifying, understanding, and properly accounting for lease terms that have
an accounting impact did not function to reduce to remote the likelihood that
material misstatements would not be prevented or detected in a timely manner.
The material weakness stems from the aggregation of control deficiencies
related to the identification of non-standard lease terms, insufficient
knowledge of GAAP accounting for leases, and an inadequate process in place to
review and identify all terms included in leases that impact the accounting for
leases.
The material weakness resulted in the Company making adjustments to its
property, furnishings, and equipment, asset retirement obligations, deferred
rent, depreciation and amortization expense, rent expense, and store closure
reserve accounts in both its annual and interim financial statements for the
fiscal year ended December 31, 2006. This material weakness was considered in
determining the nature, timing, and extent of the audit tests applied in our
audit of the Company's 2006 consolidated financial statements, and this report
does not affect our report dated March 15, 2007 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 December 31,
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 weakness
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 December 31, 2006, based on the COSO control
criteria.
/s/ Ernst & Young LLP
Portland, Oregon
March 15, 2007
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 2007 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 2007 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 2007 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 2007 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 2007 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 2007 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 2007 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 December 31,
2006:
(1) FINANCIAL STATEMENTS
The following financial statements of the Registrant, together with the Report
of Independent Registered Public Accounting Firm dated March 15, 2007, are
filed herewith:
Consolidated Balance Sheets as of January 1, 2006 and December 31, 2006
Consolidated Statements of Operations for the fiscal years ended January 2,
2005, January 1, 2006, and December 31, 2006
Consolidated Statements of Stockholders' Equity (Deficit) and Comprehensive
Income (Loss) for the fiscal years ended January 2, 2005, January 1, 2006, and
December 31, 2006
Consolidated Statements of Cash Flows for the fiscal years ended January 2,
2005, January 1, 2006, and December 31, 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
3.1 Certificate of Incorporation of Movie Gallery, Inc. (1)
3.1.1 Certificate of Amendment of Certificate of Incorporation of
Movie Gallery, Inc. dated June 6, 1996. (2)
3.1.2 Certificate of Amendment of Certificate of Incorporation of
Movie Gallery, Inc. dated July 1, 1999. (2)
3.1.3 Certificate of Amendment of Certificate of Incorporation of
Movie Gallery, Inc. dated March 27, 2003. (3)
3.2 Amended and Restated Bylaws of Movie Gallery, Inc. (3)
4.1 Specimen Common Stock Certificate. (4)
10.1 Form of Indemnity Agreement. (1)
10.2 Employment Agreement between M.G.A., Inc. and Joe Thomas
Malugen. (1)
10.2.1 First Amendment to Employment Contract between M.G.A., Inc. and
J.T. Malugen, dated April 3, 2000. (5)
10.3 Executive Employment Agreement between M.G.A., Inc. and S. Page
Todd, dated November 14, 1997. (6)
10.4 Executive Employment Agreement between M.G.A., Inc. and Jeffrey
S. Stubbs, dated November 30, 1999. (7)
10.5 Executive Employment Agreement between Hollywood Entertainment
Corporation and Timothy A. Winner, dated July 11, 2006. (8)
10.6 Executive Employment Agreement between Movie Gallery US, LLC and
Mark S. Loyd, dated July 18, 2006. (9)
10.7 Executive Employment Agreement between Movie Gallery US, LLC and
Keith A. Cousins, dated August 23, 2006. (10)
10.8 Movie Gallery, Inc. 2003 Stock Plan, effective June 11, 2003. (11)
10.8.1 Amendment to the Movie Gallery, Inc. 2003 Stock Plan, dated
August 20, 2003. (11)
10.8.2 Second Amendment to the Movie Gallery, Inc. 2003 Stock Plan,
dated June 10, 2005. (12)
10.9 Movie Gallery, Inc. 1994 Stock Plan. (13)
10.9.1 Amendment to the Movie Gallery, Inc. 1994 Stock Plan, dated
June 13, 2000. (14)
10.9.2 Amendment to the Movie Gallery, Inc. 1994 Stock Plan, dated
September 12, 2002. (15)
10.9.3 Amendment to the Movie Gallery, Inc. 1994 Stock Plan, dated
June 11, 2003.
10.10 Indenture, dated April 27, 2005, by and among Movie Gallery,
Inc., the Guarantors named therein and SunTrust Bank, as
Trustee. (16)
10.11 First Lien Credit and Guaranty Agreement, dated March 8, 2007,
by and among Movie Gallery, Inc., certain Subsidiaries of Movie
Gallery, Inc. as Guarantors, the several banks and other
financial institutions from time to time parties to the Credit
Agreement as Lenders, including Goldman Sachs Credit Partners
L.P. as Lead Arranger, Syndication Agent and Administrative
Agent, and Wachovia Bank, National Association as Collateral
Agent and Documentation Agent. (17)
10.12 Second Lien Credit and Guaranty Agreement, dated March 8, 2007,
by and among Movie Gallery, Inc., certain Subsidiaries of Movie
Gallery, Inc. as Guarantors, the several banks and other
financial institutions from time to time parties to the Credit
Agreement as Lenders, including Goldman Sachs Credit Partners
L.P. as Lead Arranger and Syndication Agent, CapitalSource
Finance LLC as Administrative Agent and Collateral Agent. (18)
10.13 Summary of Non-Employee Director Compensation. (19)
10.14 Form of Employee Restricted Stock Purchase Agreement (service-
based vesting for employees). (20)
10.15 Form of Non-Employee Director Restricted Stock Purchase
Agreement (for non-employee directors). (21)
10.16 Form of Employee Restricted Stock Purchase Agreement (one-year
performance based on vesting for employees). (22)
10.17 Form of Employee Restricted Stock Purchase Agreement (two-year
performance based vesting for employees). (23)
10.18 Offer Letter, dated February 2, 2004, between the Company and
Thomas D. Johnson, Jr. (24)
10.19 Movie Gallery, Inc. Performance Bonus Plan. (25)
14 Amended and Restated Movie Gallery, Inc. Code of Business
Conduct and Ethics. (26)
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
18U.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 June 10, 1994, as an exhibit to the Company's
Registration Statement on Form S-1 (File No. 033-80120), and
incorporated herein by reference.
(2) 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 (File No. 000-24548), and incorporated herein by reference.
(3) 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.
(4) 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. 033-80120),
and incorporated herein by reference.
(5) 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 (File
No. 000-24548), and incorporated herein by reference.
(6) 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
(File No. 000-24548), and incorporated herein by reference.
(7) 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,
(File No. 000-24548) and incorporated herein by reference.
(8) Previously filed on July 20, 2006, as Exhibit 10.1 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(9) Previously filed on July 20, 2006, as Exhibit 10.2 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(10) Previously filed on March 14, 2007, as Exhibit 10.1 to Amendment No. 1
to the Company's Quarterly Report on Form 10-Q for the quarter ended
October 1, 2006, 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, and incorporated herein by
reference.
(12) Previously filed on July 27, 2005, as Exhibit 10.1 to the Company's
Current Report on Form 8-K/A, and incorporated herein by reference.
(13) Previously filed on April 7, 1997, as Exhibit 10.1 to the Company's
Annual Report on Form 10-K (File No. 000-24548), and incorporated herein
by reference.
(14) Previously filed on April 7, 2003, as Exhibit 10.1.1 to the Company's
Annual Report on Form 10-K, and incorporated herein by reference.
(15) Previously filed on November 20, 2002, as Exhibit 10.1 to the Company's
Quarterly Report on Form 10-Q, and incorporated herein by reference.
(16) 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.
(17) Previously filed on March 14, 2007, as Exhibit 10.1 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(18) Previously filed on March 14, 2007, as Exhibit 10.2 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(19) 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.
(20) Previously filed on October 21, 2005, as Exhibit 10.1 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(21) Previously filed on October 21, 2005, as Exhibit 10.2 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(22) Previously filed on October 21, 2005, as Exhibit 10.3 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(23) Previously filed on October 21, 2005, as Exhibit 10.4 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(24) Previously filed on March 24, 2006 as Exhibit 10.15 to the Company's
Annual Report on Form 10-K, and incorporated herein by reference.
(25) Previously filed on June 14, 2006, as Exhibit 10.1 to the Company's
Current Report on Form 8-K, and incorporated herein by reference.
(26) Previously filed on August 3, 2005, as Exhibit 14 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 16, 2007 /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 16, 2007
- ---------------- and Chief Executive Officer
J.T. Malugen (Principal Executive Officer)
/s/ Harrison Parrish Vice Chairman of the Board March 16, 2007
- --------------------
H. Harrison Parrish
/s/ William B. Snow Director March 16, 2007
- -------------------
William B. Snow
/s/ John J. Jump Director March 16, 2007
- ----------------
John J. Jump
/s/ James C. Lockwood Director March 16, 2007
- ---------------------
James C. Lockwood
/s/ Thomas D. Johnson Jr. Executive Vice President and March 16, 2007
- ------------------------- Chief Financial Officer
Thomas D. Johnson Jr. (Principal Financial and
Accounting Officer)
FINANCIAL STATEMENTS
Movie Gallery, Inc.
Consolidated Balance Sheets
(in thousands, except per share amounts)
-------------------------
January 1, December 31,
2006 2006
----------- -----------
Assets
Current assets:
Cash and cash equivalents $ 135,238 $ 32,953
Merchandise inventory, net 136,450 140,614
Prepaid expenses 41,393 45,324
Store supplies and other 24,194 20,211
Deferred income taxes - 209
----------- -----------
Total current assets 337,275 239,311
Rental inventory, net 371,565 339,981
Property, furnishings and equipment, net 332,218 242,935
Goodwill 118,404 115,569
Other intangibles, net 184,671 181,912
Deposits and other assets 40,995 33,569
----------- -----------
Total assets $ 1,385,128 $ 1,153,277
=========== ===========
Liabilities and stockholders' deficit
Current liabilities:
Current maturities of long-term obligations $ 78,146 $ 4,580
Current maturities of financing obligations 4,492 -
Accounts payable 236,989 86,380
Accrued liabilities 88,460 80,432
Accrued payroll 38,624 47,896
Accrued interest 7,220 6,774
Deferred revenue 39,200 42,055
----------- ----------
Total current liabilities 493,131 268,117
Long-term obligations, less current portion 1,083,083 1,087,875
Other accrued liabilities 21,662 33,716
Deferred income taxes 70 -
----------- ----------
1,597,946 1,389,708
----------- ----------
Commitments and contingencies
Stockholders' deficit:
Preferred stock, $.10 par value; 2,000
shares authorized, no shares issued
or outstanding - -
Common stock, $.001 par value; 65,000
shares authorized, 31,686 and 31,840
shares issued and outstanding, respectively 32 32
Additional paid-in capital 199,151 197,961
Unearned compensation (4,128) -
Accumulated deficit (417,882) (443,602)
Accumulated other comprehensive income 10,009 9,178
----------- -----------
Total stockholders' deficit (212,818) (236,431)
----------- -----------
Total liabilities and stockholders' deficit $ 1,385,128 $ 1,153,277
=========== ===========
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 2, January 1, December 31,
2005 2006 2006
---------- ---------- -----------
Revenue:
Rentals $ 729,167 $1,630,058 $2,030,251
Product sales 62,010 357,269 511,682
--------- ---------- ----------
Total revenue 791,177 1,987,327 2,541,933
Cost of sales:
Cost of rental revenue 208,160 502,873 626,918
Cost of product sales 41,942 271,900 384,933
--------- --------- ----------
Gross profit 541,075 1,212,554 1,530,082
Operating costs and expenses:
Store operating expenses 395,425 1,027,119 1,250,799
General and administrative 55,475 130,059 180,153
Amortization of intangibles 2,601 3,865 2,838
Impairment of goodwill - 522,950 -
Impairment of other intangibles - 4,940 -
Other income - - (43)
--------- -------- ----------
Operating income (loss) 87,574 (476,379) 96,335
Non-operating expenses:
Interest expense, net (624) (68,529) (120,410)
Write-off of bridge
financing costs - (4,234) -
Equity in losses of
unconsolidated entities (5,746) (806) -
--------- -------- ----------
Income (loss) before income
taxes 81,204 (549,948) (24,075)
Income taxes 31,716 2,792 1,645
--------- ---------- ----------
Net income (loss) $ 49,488 $ (552,740) $ (25,720)
========= ========== ==========
Net income (loss) per share:
Basic $ 1.54 $ (17.53) $ (0.81)
========= ========== ==========
Diluted $ 1.52 $ (17.53) $ (0.81)
========= ========== ==========
Weighted average shares outstanding:
Basic 32,096 31,524 31,800
Diluted 32,552 31,524 31,800
Cash dividends per common share $ 0.12 $ 0.06 $ -
========= ========= ==========
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Consolidated Statements of Stockholders' Equity (Deficit)
and Comprehensive Income (Loss)
(In thousands, except per share amounts)
Accumulated
Retained Other Total
Earnings/ Un- Compre- Stock-
Additional (Accum- earned hensive holders'
Common Paid-in ulated Compen- Income Equity
Stock Capital Deficit) sation (Loss) (Deficit)
------ -------- -------- ------- --------- --------
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 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)
Comprehensive income (loss):
Net loss (25,720) - - (25,720)
Foreign currency
translation - - - - 171 171
Change in fair value of
interest rate swap - - - - (1,002) (1,002)
------
Total comprehensive
Loss (26,551)
Stock based compensation -
restricted stock , net of
tax - 2,938 - - - 2,938
Post APB 25 adoption
of SFAS No. 123R - (4,128) - 4,128 - -
------ -------- --------- ------- ------- ---------
Balance at
December 31, 2006 $ 32 $197,961 $(443,602)$ - $ 9,178 $ (236,431)
====== ======== ========= ======= ======= =========
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 2, January 1, December 31,
2005 2006 2006
--------- ---------- -----------
(Revised) (Revised)
Operating activities:
Net income (loss) $ 49,488 $ (552,740) $ (25,720)
Adjustments to reconcile net income (loss)
to net cash provided by (used in) operating
activities:
Rental inventory amortization 144,521 213,141 222,751
Purchases of rental inventory, net (150,924) (202,085) (179,954)
Purchases of rental inventory - base
stock (15,616) (20,367) (11,213)
Depreciation and intangibles amortization 36,185 92,655 108,304
Accretion on asset retirement obligations - - 3,102
Gain on sale of property, furnishings
and equipment, net - (494) (952)
Stock based compensation 64 1,618 3,082
Amortization of debt issuance cost - 3,659 6,661
Impairment of goodwill - 522,950 -
Impairment of other intangibles - 4,940 -
Tax benefit of stock options exercised 4,305 - -
Deferred income taxes 19,106 5,156 (279)
(Increase) decrease in assets,
net of business acquisitions:
Extended viewing fees receivable, net - 21,369 -
Merchandise inventory (491) 11,044 (4,051)
Other current assets (500) (3,092) (355)
Deposits and other assets 1,336 9 5,739
(Decrease) increase in liabilities,
net of acquisitions:
Accounts payable (1,962) (4,135) (149,871)
Accrued interest - 6,910 2,511
Accrued liabilities and deferred revenue 4,361 31,597 10,466
--------- --------- ---------
Net cash provided by (used in) operating
activities 89,873 132,135 (9,779)
--------- --------- ---------
Investing activities:
Business acquisitions, net of cash
acquired (12,962) (1,096,686) (319)
Purchases of property, furnishings
and equipment (46,507) (58,198) (19,620)
Proceeds from disposal of property,
furnishings and equipment - 3,672 5,027
--------- --------- ---------
Net cash used in investing activities (59,469) (1,151,212) (14,912)
--------- --------- ---------
Financing activities:
Repayment of capital lease obligations - (426) (541)
Net borrowings on credit facilities - 6,862 8,163
Long term debt financing fees - (32,484) (5,528)
Proceeds from issuance of long-term debt - 1,166,120 -
Principal payments on long-term debt - (15,093) (79,859)
Proceeds from exercise of stock options 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 (45,353) 1,127,851 (77,765)
--------- --------- ---------
Effect of exchange rate changes on cash
and cash equivalents 2,461 946 171
--------- --------- ---------
Increase (decrease) in cash and
cash equivalents (12,488) 109,720 (102,285)
Cash and cash equivalents at
beginning of period 38,006 25,518 135,238
--------- --------- ---------
Cash and cash equivalents
at end of period $ 25,518 $ 135,238 $ 32,953
========= ========= =========
Supplemental disclosures of cash flow information:
Cash paid for interest $ 694 $ 61,782 $ 112,109
Cash paid for income taxes 6,826 1,918 1,453
Supplemental noncash investing and financing
activities:
Change in construction phase assets $ - $ 5,621 $ 4,541
Establishment of asset retirement obligations - - 6,724
Payment-in-kind interest - - 2,910
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Notes to Consolidated Financial Statements
January 2, 2005, January 1, 2006 and December 31, 2006
1. Accounting Policies
Nature of the Business
Movie Gallery, Inc. is a home video specialty retailer primarily focused on the
rental and sale of DVD and VHS movies and video games. The Company owns and
operates approximately 4,600 retail stores located throughout North America
which operate under the Movie Gallery, Hollywood Video and Game Crazy brand
names.
References herein to "Movie Gallery", the "Company", "we", "our", or "us" refer
to Movie Gallery, Inc. and its subsidiaries unless the context specifically
indicates otherwise. References herein to "Hollywood" refer to Hollywood
Entertainment Corporation.
Principles of Consolidation
The accompanying financial statements present the consolidated financial
position, results of operations and cash flows of Movie Gallery 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 residual values and useful lives of rental
inventory, useful lives of fixed assets and other intangibles, estimated
accruals related to revenue-sharing titles subject to performance guarantees,
revenues generated by customer programs and incentives, valuation allowances
for deferred tax assets, estimated cash flows used to test goodwill and long-
lived assets for impairment, the allocation of the purchase price to the fair
value of net assets of acquired businesses, share-based compensation, and
contingencies. Actual results could differ materially from these estimates and
assumptions.
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 2, 2005, January 1, 2006 and December 31, 2006 reflect 52-week
years.
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 (deficit) or net income (loss).
The statement of cash flow was revised to reclassify the book cost of
previously viewed movie sales from rental inventory amortization as a reduction
of purchases of rental inventory to be consistent with the presentation in the
current year.
Cash and 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 sheets for cash and cash equivalents approximate those assets' fair
values.
Merchandise Inventory
Merchandise inventory consists primarily of new and used video game software,
hardware and accessories, new DVD 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.
Merchandise inventory is carried at the lower of cost or its estimated market
value. 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.
We and certain of our vendors enter into cooperative advertising programs and
other promotional programs in which the vendors provide us with cash
consideration in exchange for marketing and advertising of the vendor's
products. In accordance with Emerging Issues Task Force, or the EITF, 02-16,
Accounting by a Customer (Including a Reseller) for Certain Consideration
Received from a Vendor, vendor allowances are recorded as a reduction in the
cost of the applicable vendor's products and recognized in cost of sales when
the related product is sold, unless the allowances represent reimbursement of
specific incremental and identifiable costs incurred to promote the vendor's
product. If the allowance represents a reimbursement of cost, it is recorded as
an offset to the associated expense incurred. Any reimbursement greater than
the costs incurred is recognized as a reduction to the cost of the product.
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 that 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 that 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 DVD movies are amortized over six months on an
accelerated basis to an average residual value of $4.00. Purchases of DVD
catalog inventory units are currently amortized on an accelerated basis over
twenty-four months to an average residual value of $4.00. Video games are
amortized over twelve months on an accelerated basis to an average residual
value of $5.00.
For new release movies and games acquired under revenue-sharing arrangements,
the studios' share of rental revenue is charged to cost of rental as revenue is
earned on the respective revenue-sharing titles. Amortization periods, carrying
values and residual values of movies purchased under revenue-sharing
arrangements are approximately equal to the estimates we apply to non-revenue
sharing purchases outlined above.
We regularly review, evaluate and update our rental amortization accounting
estimates. Effective January 2, 2006, we reduced the amount capitalized on DVD
revenue-sharing units for the Movie Gallery segment such that the carrying
value of the units, when combined with revenue-sharing expense on previously
viewed sales, more closely approximates the carrying value of non-revenue
sharing units. We also began to amortize games on an accelerated method for the
Movie Gallery segment, effective January 2, 2006, in order to remain consistent
with observed changes in rental patterns for games. These changes were
accounted for as a change in accounting estimate, which increased cost of
rental revenue through the second quarter of fiscal 2006 by approximately $11.3
million, reducing net income by $12.2 million (net of tax), or $0.38 per
diluted share. During the second quarter of fiscal 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 fiscal 2005, reducing net income by $6.6 million (net of tax), or
$0.21 per diluted share. In fiscal 2006 we stopped purchasing VHS product. We
also reduced to zero the remaining salvage value of VHS inventory and recorded
a corresponding charge which was immaterial to our consolidated financial
statements.
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 39 years. Leasehold
improvements are amortized over the lesser of the assets' economic life or the
contractual term of the lease, usually five to ten 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 and indefinite-lived intangible assets are not amortized, but are
subject to impairment testing annually or whenever indicators of impairment are
present. Finite-lived intangible assets are amortized on a straight-line basis
over their estimated useful lives.
In accordance with Statement of Financial Accounting Standard, or the SFAS,
No. 142, "Goodwill and Other Intangible Assets," or SFAS No. 142, we assess
goodwill and intangible assets with indefinite lives for impairment at the
reporting unit level on an annual basis and between annual tests if events
occur or circumstances change that would more likely than not reduce the fair
value of these assets below their carrying amount.
SFAS No. 142 requires that the impairment test be performed through the
application of a two-step fair value test. The first step of the test compares
the book value of our reporting units to their estimated fair values at the
respective test dates. The estimated fair values of the reporting units are
computed using the present value of estimated future cash flows. If fair value
does not exceed carrying value 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. The implied fair value of goodwill is calculated as the excess of
the estimated fair value of the reporting unit being tested over the fair value
of its tangible assets and liabilities as well as existing recorded and
unrecorded identifiable intangible assets. The estimated implied fair value of
goodwill and the estimated fair value of identified intangibles are compared to
their respective carrying values and any excess carrying value is recorded as a
charge to operating income.
See Note 5 and Note 6 below for a discussion of goodwill, other intangible
assets and impairment charges.
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," or SFAS No. 144. We primarily
use discounted cash flow methods to estimate the fair value of long-lived
assets.
Asset Retirement Obligations
We record certain obligations associated with the requirement to restore leased
premises to their original condition for the removal of certain long-lived
assets under the guidance in SFAS No. 143, "Accounting for Asset Retirement
Obligations," or SFAS No. 143. Under this standard, we recognize the fair
value of a liability for an asset retirement obligation in the period in which
the obligation is incurred if we can make a reasonable estimate of the
liability's fair value. The associated asset retirement cost is capitalized as
part of the carrying amount of the long-lived asset and depreciated over the
remaining life of the underlying asset, and the associated liability is
accreted to the estimated fair value of the obligation at the settlement date
through periodic accretion charges to the consolidated statement of operations.
When the obligation is settled, any difference between the final cost and the
recorded amount is recognized as income or loss on settlement.
During the third quarter of fiscal year 2006, we determined that we had not
properly applied the guidance as set out above. As a result of this review, we
increased our property and equipment by $1.4 million, other long-term
liabilities by $8.7 million, and operating expenses by $7.3 million.
Store Closure Reserves
In accordance with SFAS No. 146 "Accounting for Costs Associated with Exit or
Disposal Activities," or SFAS No. 146, 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 that 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, reasonably possible loss contingencies in excess of
the amounts accrued are disclosed. See Note 11 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,"
or SFAS No. 13, 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 No. 13 also requires that leasehold improvements be
depreciated over the shorter of the lease term or the estimated useful life of
the leasehold improvement. Some of our stores have provisions for contingent
rentals based upon a percentage of defined sales volume or changes in the
Consumer Price Index. We recognize contingent rental expense when achievement
of specified sales targets are considered probable.
During fiscal 2004 we recorded an adjustment to correct depreciation expense
related to our depreciating certain leasehold improvements over a longer period
than the lease term. The adjustment of $6.3 million ($3.9 million after-tax,
or $0.12 per diluted share) resulted in an increase in store operating expenses
in fiscal 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 fixed or reasonably assured 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 accrued liabilities.
Financing Obligations
In accordance with Emerging Issues Task Force, or the EITF, Issue No. 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 financial 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
financial obligation from the balance sheet in accordance SFAS No. 98
"Accounting for Leases," or SFAS No. 98. 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 $109.6
million, $284.3 million and $378.3 million in fiscal 2004, 2005 and 2006,
respectively.
We also sell stored value cards in the form of electronic gift cards and
discount rental cards. We record the proceeds from the sale of stored value
cards as deferred revenue until the card is redeemed by the customer, thereby
resulting in revenue recognition and a reduction in the corresponding deferred
revenue liability. Revenue for the estimated amount of non-redeemed gift cards
is recognized in proportion to actual gift card redemptions, which is generally
over a period of 18 months.
We recognize extended viewing fee revenue when payment is received from the
customer.
Movie Gallery stores offer a point-based loyalty program, Reel Players, to
their 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.
Hollywood Video stores offer several rental subscription programs to their
customers, including the Movie Value Pass, an in-store movie rental
subscription service offered nationally. 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.
Game Crazy stores offer a Most Valuable Player, or MVP, program to their
customers. The MVP program provides customers a game magazine subscription,
discounts on used game merchandise 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.
We also recognize licensee fee revenue received from 20 licensed Hollywood
Video stores which are operated by Boards, Inc., or Boards, an unrelated third
party. Licensee fee revenue is based on a percentage of the Boards' stores
video rental and other revenue. Boards' stores revenue is not included in
Movie Gallery's results of operations.
Cooperative Advertising Credits
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 2004, 2005, and 2006 totaled $9.5 million, $43.7 million, and $45.1
million, respectively.
Income Taxes
Income taxes are provided based on the liability method of accounting. Deferred
taxes are recorded to reflect the tax benefit and consequences of future years'
differences between the tax basis of assets and liabilities and their financial
reporting basis. We record a valuation allowance to reduce deferred tax assets
if it is more likely than not that some portion or all of the deferred tax
assets 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. It is not practicable
to determine the amount of taxes which have been deferred under this approach.
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. We recognize potential liabilities for anticipated tax audit
issues in the United States and other tax jurisdictions based on an estimate of
the ultimate resolution of whether, and the extent to which, additional taxes
will be due. Although we believe the estimates are reasonable, no assurance can
be given that the final outcome of these matters will not be different than
what is reflected in the historical income tax provisions and accruals.
Fair Value of Financial Instruments
In accordance with SFAS No. 107, "Disclosure about Fair Value of Financial
Instruments," we disclose the fair value, related carrying value and methods of
determining the fair value for cash and cash equivalents (see above), and long-
term obligations (see Note 8).
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
(deficit). Net foreign currency gains and losses were not significant for any
of the years presented.
Comprehensive Income (Loss)
Comprehensive income (loss) is defined as the change in equity (net assets) of
a business enterprise during a period from transactions and other events and
circumstances from non-owner sources. It consists of net income (loss) and
other gains and losses affecting stockholders' equity (deficit) that, under
accounting principles generally accepted in the United States, are excluded
from net income (loss). Our accumulated comprehensive income (loss) is
comprised of foreign currency translation gains and losses, and gains and
losses on qualified cash flow hedging instruments.
Earnings / Loss Per Share
Basic earnings / loss per share is computed based on the weighted average
number of shares of common stock outstanding during the periods presented.
Diluted earnings per share is computed based on the weighted average number of
shares of common stock outstanding during the periods presented, increased by
the effects of non-vested stock and shares to be issued from the exercise of
dilutive common stock options, of which there were 456,000 in fiscal 2004. Due
to our loss in fiscal 2005, securities consisting of options convertible into
251,000 shares of common stock and 6,000 shares of non-vested stock,
respectively, were excluded from the calculation of diluted loss per share, as
their inclusion in the diluted loss per share calculation would have been anti-
dilutive. Due to our loss in fiscal 2006, securities consisting of options
convertible into 63,000 shares of common stock were excluded from the
calculation of diluted loss per share, as their inclusion in the diluted loss
per share calculation would have been anti-dilutive.
Stock-Based Compensation
Prior to January 2, 2006, we accounted for stock-based compensation in
accordance with Accounting Principles Board Opinion, or the APB, No. 25,
"Accounting for Stock Issued to Employees," or APB No. 25, and followed the
disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based
Compensation," or SFAS No. 123, as amended by SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure." Accordingly,
compensation expense was not recognized in our consolidated statement of
operations in connection with stock options that were granted under our stock-
based compensation plan prior to January 2, 2006, except for the variable
options as described in our Annual Report on Form 10-K for fiscal 2006.
Effective January 2, 2006, we adopted SFAS No. 123(R), "Share-Based Payment,"
or SFAS No. 123(R), which no longer permits use of the intrinsic value method
under APB No. 25. We used the modified prospective method to adopt SFAS No.
123(R), which requires that compensation expense be recorded for all stock-
based compensation granted on or after January 2, 2006, as well as the unvested
portion of previously granted options.
Recently Issued Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board, or the FASB, issued
SFAS No. 151, "Inventory Costs-An Amendment of ARB No. 43, Chapter 4," or SFAS
No. 151. SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, Inventory
Pricing, or ARB 43, to clarify the accounting for abnormal amounts of idle
facility expense, freight, handling costs and wasted material. SFAS No. 151 is
effective for fiscal years beginning after September 15, 2005. The adoption of
SFAS No. 151 did not have a material impact on our consolidated financial
statements.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections," or SFAS No. 154. This new standard replaces APB Opinion No. 20,
Accounting Changes, and SFAS No. 3, "Reporting Accounting Changes in Interim
Financial Statements". Among other changes, SFAS No. 154 requires retrospective
application of a voluntary change in accounting principle with all prior period
financial statements presented on the new accounting principle, unless it is
impracticable to do so. SFAS No. 154 also requires that a change in method of
depreciating or amortizing a long-lived nonfinancial asset be accounted for
prospectively as a change in estimate, and correction of errors in previously
issued financial statements should be termed a restatement. The new standard is
effective for accounting changes and correction of errors made in fiscal years
beginning after December 15, 2005. The adoption of SFAS No. 154 did not have a
material impact on our consolidated financial statements.
In September 2005, the Emerging Issues Task Force, or EITF, reached a consensus
on Issue 04-13, "Accounting for Purchases and Sales of Inventory with the Same
Counterparty," or EITF 04-13. The FASB Task Force concluded that inventory
purchases and sales transactions with the same counterparty should be combined
for accounting purposes if they were entered into in contemplation of each
other. The Task Force provided indicators to be considered for purposes of
determining whether such transactions are entered into in contemplation of each
other. The Task Force also provided guidance on the circumstances under which
nonmonetary exchanges of inventory within the same line of business should be
recognized at fair value. EITF 04-13 is effective in reporting periods
beginning after March 15, 2006. The adoption of EITF 04-13 did not have a
material impact on our consolidated financial statements.
In October 2005, the FASB issued FASB Staff Position, or FSP, No. FAS 13-1,
"Accounting for Rental Costs Incurred during a Construction Period,' or FSP FAS
13-1. FSP FAS 13-1 requires rental costs associated with operating leases that
are incurred during a construction period to be recognized as rental expense.
FSP FAS 13-1 is effective for reporting periods beginning after December 15,
2005. The adoption of FSP FAS 13-1 did not have a material impact on our
consolidated financial statements.
On March 28, 2006, the FASB issued EITF 06-3, "How Taxes Collected from
Customers and Remitted to Governmental Authorities Should Be Presented in the
Income Statement (That is, Gross versus Net Presentation)," or EITF 06-3, which
clarifies how a company discloses its recording of taxes collected that are
imposed on revenue-producing activities. EITF 06-3 is effective for the first
interim reporting period beginning after December 31, 2006. Presently, we
record revenues net of applicable sales taxes collected from customers. We are
in the process of evaluating the effect of EITF 06-3 on our financial
statements.
On July 13, 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109," or
FIN 48, which clarifies the way companies account for uncertainty in income
taxes. FIN 48 is effective for the first fiscal year beginning after December
15, 2006. FIN 48 will be effective for us for the fiscal year beginning
January 1, 2007. We are in the process of evaluating the effect of FIN 48 on
our financial statements.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," or
SFAS No. 157, which provides enhanced guidance for using fair value to measure
assets and liabilities. The standard also responds to investors' requests for
expanded information about the extent to which companies measure assets and
liabilities at fair value, the information used to measure fair value, and the
effect of fair value measurements on earnings. The standard applies whenever
other standards require (or permit) assets or liabilities to be measured at
fair value. The standard does not expand the use of fair value in any new
circumstances. SFAS No. 157 is effective for us for fiscal years beginning
after January 1, 2007. We are in the process of evaluating the effect of SFAS
No. 157 on our financial statements.
In September 2006, the SEC staff released Staff Accounting Bulletin No. 108,
"Considering the Effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements," or SAB 108. SAB 108
provides for a "one-time" special transition provision for correcting certain
prior year misstatements that were uncorrected as of the beginning of the
fiscal year of adoption. SAB 108 permits existing public companies to initially
apply its provisions either by (i) restating prior financial statements as if
the dual approach had always been used or (ii) recording the cumulative effect
of initially applying the dual approach as adjustments recorded to the opening
balance of retained earnings. SAB 108 is effective for fiscal years ending
after November 15, 2006. The adoption of SAB 108 did not have a material
impact on our consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities," or SFAS No. 159, which provides
guidance on applying fair value measurements on financial assets and
liabilities. SFAS No. 159 permits entities to choose to measure many financial
instruments and certain other items at fair value. The objective is to improve
financial reporting by providing entities with the opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. SFAS No. 159 is effective for us for fiscal years beginning after
January 1, 2007. We are in the process of evaluating the effect of SFAS No.
159 on our financial statements.
2. Business Combinations
Merger of Movie Gallery and Hollywood
On April 27, 2005, Movie Gallery and Hollywood merged pursuant to the Agreement
and Plan of Merger, dated as of January 9, 2005, or 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.
The merger was treated as a purchase business combination for accounting
purposes. The purchase price for the acquisition, including transaction costs,
was 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 2007 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 No. 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 the adjusted purchase
price allocation as of January 1, 2006, together with subsequent revisions and
the resulting revised allocation reflected in the accompanying consolidated
balance sheet as of December 31, 2006 (in thousands):
January 1, December 31,
2006 Subsequent 2006
As Adjusted Revisions As 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 12,712 327 13,039
---------- ---------- -----------
Total current assets 202,914 327 203,241
Rental inventory 227,800 - 227,800
Property, furnishings and equipment 238,196 132 238,328
Goodwill 479,622 (2,982) 476,640
Other intangibles 183,894 - 183,894
Deferred income taxes 51,841 1,452 53,293
Deposits and other assets 1,662 - 1,662
---------- ---------- -----------
Total assets acquired 1,385,929 (1,071) 1,384,858
Liabilities
Current Liabilities:
Current maturities of long-term
obligations 557 - 557
Current maturities of financing
obligations 10,385 - 10,385
Accounts payable 168,235 - 168,235
Accrued liabilities 73,562 (1,071) 72,491
Accrued payroll 18,544 - 18,544
Accrued interest 39 - 39
Deferred revenue 21,384 - 21,384
---------- --------- -----------
Total current liabilities 292,706 (1,071) 291,635
Long-term obligations,
less current portion 941 - 941
---------- --------- -----------
Total liabilities 293,647 (1,071) 292,576
---------- --------- -----------
Net assets acquired $1,092,282 $ - $ 1,092,282
========== ========= ===========
For fiscal 2006, adjustments were made to the purchase price allocation for
accrued liabilities, deferred income taxes, store supplies and other, and
property, furnishings and equipment totaling $3.0 million.
3. Property, Furnishings and Equipment
Property, furnishings and equipment consists of the following (in thousands):
----------- -----------
January 1, December 31,
2006 2006
----------- -----------
Land and buildings $ 19,372 $ 19,716
Fixtures and equipment 244,320 240,075
Leasehold improvements 284,737 279,009
Asset removal obligation - 5,860
Construction phase assets 4,542 -
Equipment under capital lease 1,659 1,659
----------- -----------
554,630 546,319
Less accumulated depreciation
and amortization (222,412) (303,384)
----------- -----------
$ 332,218 $ 242,935
=========== ===========
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $0.3 million and
$0.8 million at January 1, 2006 and December 31, 2006, respectively.
Depreciation expense related to property, furnishings and equipment was $33.6
million, $88.2 million, and $100.3 million for fiscal 2004, 2005, and 2006,
respectively.
4. Income Taxes
The components of income (loss) before income taxes are as follows (in
thousands):
Fiscal Year Ended
-------------------------------------
January 2, January 1, December 31,
2005 2006 2006
---------- --------- ----------
U.S. Federal $ 72,042 $(530,711) $ (21,260)
Foreign 9,162 (19,237) (2,815)
--------- --------- ----------
Total $ 81,204 $(549,948) $ (24,075)
========= ========= ==========
The following reflects the components of income tax expense (in thousands):
Fiscal Year Ended
-------------------------------------
January 2, January 1, December 31,
2005 2006 2006
---------- --------- ----------
Current tax expense:
U.S. Federal $ 9,811 $ 541 $ (101)
State 2,799 775 15
Foreign - 1,121 (585)
--------- --------- ----------
Total current tax expense 12,610 2,437 (671)
Deferred tax expense:
U.S. Federal 14,315 2,583 2,283
State 3,468 (374) 664
Foreign 1,323 (1,854) (631)
--------- --------- ----------
Total deferred tax expense 19,106 355 2,316
--------- --------- ----------
Total income tax expense $ 31,716 $ 2,792 $ 1,645
========= ========= ==========
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 2, January 1, December 31,
2005 2006 2006
---------- --------- ----------
Income tax expense (benefit) at
statutory rate $ 28,422 $(192,482) $ (8,427)
State income tax expense, net of federal
income tax benefit 2,679 (7,450) (1,393)
US permanent items - - 872
US credits generated - - (1,788)
Increase in contingency reserve - - 516
Non-deductible impairment charges - 116,212 -
Increase in valuation allowance,
net of amount attributable to
equity - 85,233 12,097
Other, net 615 1,279 (232)
--------- --------- ----------
$ 31,716 $ 2,792 $ 1,645
========= ========= ==========
The effective tax rate was a provision of 6.8% for fiscal 2006, compared to a
provision of 39.1% and 0.5% for fiscal 2004 and 2005, respectively. The
increase in the effective rate in 2006 is primarily a result of an increase in
the valuation allowance of $12.1 million and changes in prior year tax
contingencies due to statute of limitations considerations. The decrease in
the effective rate in fiscal 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 of $88.5 million on the
net deferred tax assets, 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.
Fiscal Year Ended
-------------------------
January 1, December 31,
2006 2006
----------- -----------
Deferred tax assets:
Non-compete agreements $ 3,451 $ 2,934
Tax credit carryforwards 11,703 14,977
Net operating loss carryforwards 159,833 160,627
Equity investments 1,880 1,880
Accrued bonus 2,654 5,822
Property, furnishings and equipment 17,139 33,227
Accrued liabilities 14,591 13,586
Other 5,114 5,277
----------- -----------
Total deferred tax assets 216,365 238,330
Valuation allowance (121,176) (126,444)
----------- -----------
Net deferred tax assets 95,189 111,886
Deferred tax liabilities
Rental inventory amortization (81,511) (87,105)
Goodwill (10,638) (23,353)
Other (3,110) (1,219)
----------- -----------
Total deferred tax liabilities (95,259) (111,677)
Net deferred tax assets (liabilities) $ (70) $ 209
============ ===========
We had federal and state net operating loss carryforwards at December 31, 2006
of approximately $409 million and $332 million, respectively. The loss
carryforwards resulted primarily from the Video Update acquisition in fiscal
2001 and the Hollywood acquisition during fiscal 2005. These losses will
expire in years 2007 through 2027. We have federal Alternative Minimum Tax, or
AMT, credit carryforwards of $6.6 million at December 31, 2006 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 $8.4 million at December 31, 2006 which are available to
reduce future taxes. The carryforward periods expire in years 2012 through
2027.
During fiscal 2005, we increased the valuation allowance for U.S. deferred tax
assets from $32.6 million to $121.2 million because we determined that it was
more likely than not that 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
fiscal 2005, was charged to stockholders' equity. During 2006, we increased
the valuation allowance from $121.2 million to $126.4 million because we
determined again that it was more likely than not that deferred tax assets
would not be realized.
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 fiscal 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,
described below, apply) may be charged or credited to goodwill.
There is a reasonable possibility that tax 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 tax liability is between $3.2 million and $46 million. 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 allowance 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 1, 2006 December 31, 2006
Weighted- ------------------------ ---------------------
Average Gross Gross
Amortization Carrying Accumulated Carrying Accumulated
Period Amount Amortization Amount Amortization
------------ -------- ------------ -------- ------------
Goodwill
Segments:
Movie Gallery - $ - $ - $ 147 $ -
Hollywood Video - 118,404 - 115,422 -
-------- ------------ -------- ------------
Total goodwill $118,404 $ - $115,569 $ -
======== ============ ======== ============
Other intangible assets:
Non-compete
agreements 8 years $ 12,205 $ (10,110) $ 12,263 $ (10,880)
Trademarks:
Hollywood Video Indefinite 170,959 - 170,977 -
Game Crazy 15 years 4,000 (178) 4,000 (444)
Customer lists 5 years 8,994 (1,199) 8,994 (2,998)
-------- ------------ -------- ------------
$196,158 $ (11,487) $196,234 $ (14,322)
======== ============ ======== ============
Estimated amortization expense for other intangible assets for the five
succeeding fiscal years is as follows (in thousands):
2007 $ 2,698
2008 2,476
2009 2,289
2010 958
2011 292
The changes in the carrying amounts of goodwill for fiscal 2005 and 2006
follows (in thousands):
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 acquired 147
Change in goodwill (2,982)
-----------
Net balance as of December 31, 2006 $ 115,569
===========
We recorded impairment charges of approximately $527.9 million related to
intangible assets in fiscal 2005, which have been included in "Impairment of
goodwill" and "Impairment of other intangible assets" in the consolidated
statement of operations.
Goodwill deductible for tax purposes as of December 31, 2006 is $126 million,
net of accumulated amortization.
6. Impairment of Goodwill and Other Long-Lived Assets
Goodwill
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. It also considered market prices of our debt and equity securities,
the accelerated decline in the in-store rental industry, increased competition
in the video sell-through markets and the growth of the online movie rental
segment in which we do not have a presence.
We performed the annual impairment test as of the beginning of the fourth
quarter of fiscal 2006 in accordance with our normal policy pursuant to SFAS
No. 142, which resulted in the estimated fair values of each of the reporting
units exceeding their book values.
When we performed the annual test as of the beginning of the fourth quarter in
fiscal 2005, the first step of the impairment test indicated that 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 determined to be 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.
Other Intangibles
We performed the annual impairment test as of the beginning of the fourth
quarter of fiscal 2006 for indefinite-lived intangibles in accordance with our
normal policy which resulted in no indication of impairment.
When we performed the annual impairment test as of the beginning of the fourth
quarter of fiscal 2005, which was impacted by the impairment indicators
contributing to the goodwill impairment charges discussed above, we concluded
that customer list intangible assets of our Movie Gallery operating segment
were impaired. The estimated fair 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.
The fiscal 2005 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, or 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
in fiscal 2005.
Other Long-Lived Assets
We have tested our long-lived assets (other than goodwill and intangible
assets) for impairment under SFAS No. 144 and concluded that no impairment
existed for fiscal 2005 and 2006 other than impairments recognized in
conjunction with store closures.
As part of our ongoing store profitability reviews, in the fourth quarter of
fiscal 2006 we closed all nine of our stores in Mexico because they were
underperforming. We recorded a charge against operating income of
approximately $1.5 million consisting primarily of a writeoff of property,
furnishings and equipment, and a writedown of movie product to fair value less
cost to sell in accordance with SFAS No. 144.
7. Store Closure and Restructuring Reserves
Store Closure
In the fourth quarter of fiscal 2005, we decided to close 64 Movie Gallery
stores that overlapped trade areas served by competing Hollywood Video stores.
In addition to these closures, we continue to evaluate underperforming stores
and stores that have overlap trade areas in our Movie Gallery, Hollywood Video
and Game Crazy segments. During fiscal 2006, we closed 230 underperforming and
overlap stores. For fiscal 2006, we have recognized $10.1 million in store
closure expenses, of which $5.0 million is related to the loss on the disposal
of fixed assets.
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)
---------- --------- ------ ---------
Balance as of January 1, 2006 10,112 3,613 - 13,725
Additions and adjustments 3,344 (145) - 3,199
Payments (5,474) (773) - (6,247)
---------- --------- ------ ---------
Balance as of December 31, 2006 $ 7,982 $ 2,695 $ - $ 10,677
========== ========= ====== =========
Restructuring
During the fourth quarter of fiscal 2005 we notified 101 Movie Gallery
associates that their positions would be relocated or eliminated as part of our
integration plan to consolidate Finance, Accounting, Treasury, Product,
Logistics, Human Resources and Payroll functions at our Wilsonville, Oregon
support center. The affected individuals were required to render service for a
range of 10 to 49 weeks in order to receive termination benefits.
The integration plan was amended in the second quarter of fiscal 2006 with
regard to the Human Resource Processing and Benefits functions within the Human
Resources department. We decided to consolidate substantially all of these
functions to our Dothan, Alabama corporate offices, and the affected Hollywood
employees were notified that their positions would be relocated.
We established restructuring reserves, which were treated as liabilities of the
acquired Hollywood 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 fiscal 2005, we notified
92 Hollywood employees of the decision to eliminate their positions in
connection with these integration efforts.
A summary of our restructuring reserve activity is as follows:
Movie Hollywood
Gallery Video Total
Termination benefits: ---------- --------- --------
Beginning balance $ - $ - $ -
Additions and adjustments 1,190 6,655 7,845
Payments - (2,539) (2,539)
---------- --------- --------
Balance as of January 1, 2006 1,190 4,116 5,306
Additions and adjustments 1,135 - 1,135
Payments (1,985) (3,034) (5,019)
---------- --------- --------
Balance as of December 31, 2006 $ 340 $ 1,082 $ 1,422
========== ========= ========
Estimated future
additions and
adjustments $ 17 $ - $ 17
Total termination
benefits cost $ 2,342 $ 6,655 $ 8,997
8. Long Term Obligations
Long term debt consists of the following (in thousands):
January 1, December 31,
Instrument 2006 2006
- ----------------------------------- ---------- ------------
Movie Gallery Senior Notes $ 321,489 $ 322,044
April 2005 Credit Facility
Term A Loan 85,500 66,787
Term B Loan 746,250 688,070
Revolving credit facility 6,862 15,024
Hollywood senior subordinated notes 450 450
Capital leases 678 80
----------- ------------
Total 1,161,229 1,092,455
Less current portion (78,146) (4,580)
----------- ------------
$ 1,083,083 $ 1,087,875
=========== ============
The scheduled maturities on our debt for the next five years are as
follows (in thousands):
Year Total
------------- ------------
2007 $ 4,580
2008 26,500
2009 26,500
2010 401,561
2011 311,270
Thereafter 325,000
------------
Total 1,095,411
Discount on
Senior Notes (2,956)
------------
Net $ 1,092,455
============
The scheduled maturities presented in this table include total borrowings under
our April 2005 Credit Facility on our consolidated balance sheet as of December
31, 2006. We refinanced the April 2005 Credit Facility on March 8, 2007 by our
March 2007 Credit Facility. The current portion of long term debt as shown
represents the amount due within one year of the balance sheet date under our
March 2007 Credit Facility pursuant to the criteria as set forth in SFAS No. 6,
"Classification of Short-Term Obligations Expected to be Refinanced", or SFAS
No. 6, and EITF 86-30 "Classification of Obligations When a Violation Is Waived
by the Creditor", or EITF 86-30.
The April 2005 Credit Facility
The credit facility that we entered into in connection with our acquisition of
Hollywood in April 2005, or the April 2005 Credit Facility, provided for
aggregate borrowings of $829.9 million, consisting of a five-year $75.0 million
revolving credit facility due April 27, 2010, or the 2005 Revolver, and two
term loans in an aggregate principal amount of $754.9 million as of December
31, 2006. Term Loan A is a $66.8 million loan that matures on April 27, 2010,
and Term Loan B is a $688.1 million loan that matures on April 27, 2011. At
December 31, 2006, we had $39.0 million drawn under the 2005 Revolver,
comprised of $24.0 million in letters of credit and $15.0 million in
borrowings. On March 15, 2006, we executed a second amendment to the April
2005 Credit Facility, effective through the fourth quarter of 2006, that
relaxed financial covenants, increased restrictive operating covenants and
increased interest rate margins. Had we not been able to refinance our April
2005 Credit Facility with our new March 2007 Credit Facility (discussed below),
the quarterly financial covenants under the April 2005 Credit Facility were
scheduled to revert to the original covenants commencing in the first quarter
of 2007.
We accounted for the second amendment as a modification pursuant to EITF No.
96-19, "Debtor's Accounting for a Modification or Exchange of Debt
Instruments," and accordingly have continued to defer approximately $18.0
million of unamortized deferred financing costs associated with the April 2005
Credit Facility (inclusive of $5.5 million in fees incurred in obtaining the
second amendment).
Under the terms of our April 2005 Credit Facility, when the leverage ratio is
greater than or equal to 4.0, we could elect to defer payment of the Term Loan
A, Term Loan B and 2005 Revolver interest as non-cash interest, which could be
recapitalized into the loans (with compounding interest). For the fiscal year
2006, we have recapitalized $2.9 million of interest. The April 2005 Credit
Facility also required us to make prepayments in an amount equal to 100% of any
excess cash flow, which generally represents the amount of cash generated by
us but not used towards operations, debt service or investments. Based upon
our operating results for the 52 weeks ended December 31, we were not required
to make an excess cash flow prepayment for fiscal 2006.
11% Senior Notes due 2012
Also in connection with the Hollywood acquisition, we issued $325.0 million in
an aggregate principal amount of 11% Senior Notes due 2012, or Senior Notes.
The Senior Notes 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 US 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.
The indenture governing the Senior Notes imposes certain restrictions on us,
including restrictions on our ability to: incur debt; grant liens; provide
guarantees in respect of obligations of any other person; pay dividends; make
loans and investments; sell our assets; make redemptions and repurchases of
capital stock; make capital expenditures; prepay, redeem or repurchase debt;
engage in mergers or consolidations; engage in sale/leaseback transactions and
affiliate transactions; change our business; amend certain debt and other
material agreements; issue and sell capital stock of subsidiaries; and make
distributions from subsidiaries.
The indenture governing the Senior Notes also contains a covenant requiring us
to file on a timely basis the periodic reports required by the Exchange Act.
Interest Rate Hedges
Our April 2005 Credit Facility required that for a period of two years
subsequent to entering into the Credit Facility, a portion of our floating rate
debt is to be converted to fixed rate debt. In fiscal 2005, we entered into
two, two-year floating-to-fixed interest rate swaps for a total amount of
$280.0 million. Under the terms of both of the swap agreements, we paid fixed
interest on the $280.0 million at a rate of 4.06% and received floating
interest based on the three-month LIBOR. They were both designated as cash
flow hedging instruments in accordance with SFAS No. 133 "Accounting for
Derivative Instruments and Hedging Activities" given that the fixed rate
payment terms of the swaps coincided with the terms of the underlying debt.
Changes in their fair value were recognized in accumulated other comprehensive
income in our consolidated balance sheets. The scheduled termination date for
both of these swaps was June 29, 2007. On October 20, 2006, we settled both of
them, prior to their scheduled termination dates, and received $2.5 million in
cash. This gain was recorded to accumulated other comprehensive income and is
being amortized into interest expense over the original terms of the swap
agreements.
On October 20, 2006, we entered into a new floating-to-fixed interest rate swap
for an amount of $140.0 million. Under the terms of the new swap agreement, we
will pay fixed interest on the $140.0 million at a rate of 5.41% and receive
floating interest based on the three-month LIBOR. The termination date for the
new swap agreement is April 30, 2007.
Also on October 20, 2006, we entered into a new 5.50% interest rate cap
agreement for an amount of $140.0 million. Under the terms of the new cap
agreement we will pay floating rate interest up to a maximum of 5.50% and
receive floating rate interest based on the three-month LIBOR. The termination
date for the new 5.50% cap agreement is April 27, 2007.
The new interest rate swap and interest rate cap do not qualify as hedging
instruments pursuant to SFAS No. 133, therefore changes in the fair value of
these derivatives are recognized in interest expense.
Fair Value of Debt
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 borrowing arrangements (if known),
or quoted market prices. The fair value of our long-term borrowings was $1,054
million as of January 1, 2006 and $1,015 million as of December 31, 2006.
Subsequent Event - New March 2007 Credit Facility
On March 8, 2007, we entered into a new $900 million senior secured credit
facility, or the March 2007 Credit Facility. The March 2007 Credit Facility
refinanced the April 2005 Credit Facility. Prior to the refinancing, our
projected operating results indicated we would fail the financial covenant
tests contained in the April 2005 Credit Facility, effective as of April 1,
2007. If such a breach of the financial covenants contained in the April 2005
Credit Facility had taken place, one or more events of default, including
cross-defaults between multiple components of our indebtedness, could have
resulted. Such an event of default would have permitted our creditors to
declare all amounts owing to be immediately due and payable. However, because
we executed the March 2007 refinancing prior to the filing of this Form 10-K,
and because the financial covenants, which are described in Item 7.
"Management's Discussion and Analysis - Liquidity and Capital Resources,"
contained in the March 2007 Credit Facility are significantly less restrictive
than those contained in the April 2005 Credit Facility, pursuant to SFAS No. 6,
we classified all amounts outstanding under the April 2005 Credit Facility,
less the current portion, as non-current liabilities as of December 31, 2006.
In the first quarter of fiscal 2007, we will account for the refinancing of the
April 2005 Credit Facility as an extinguishment of debt, and at that time we
will recognize a debt extinguishment charge of approximately $18.0 million to
write off the unamortized deferred financing fees related to the April 2005
Credit Facility.
The March 2007 Credit Facility consists of:
- A $100 million revolving credit facility, which we refer to as the
revolver;
- A $25 million first lien synthetic letter of credit facility;
- A $600 million first lien term loan; and
- A $175 million second lien term loan.
We sometimes collectively refer to the revolver, the first lien term loan and
the letter of credit facility as the first lien facilities.
The March 2007 Credit Facility requires that no later than 90 days subsequent
to entering the March 2007 Credit Facility, 50% of our total outstanding debt
is to be converted to fixed rate debt for a period of three years subsequent to
March 8, 2007.
9. Stock Based Compensation
In fiscal 2003, our Board of Directors adopted, and our stockholders approved,
the Movie Gallery, Inc. 2003 Stock Plan, or the 2003 Plan,, which was
subsequently amended in June 2005, or the Second Amendment, to reserve an
additional 3,500,000 shares of our common stock for future grants of awards.
The 2003 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 fiscal 2004. As of December 31, 2006, 5,260,808 shares
are reserved for issuance under the plans. Options granted under the plans
have a ten-year term and generally vest over four years.
On December 2, 2005, our 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 out-of-the-money options, as there was no perceived value
in these options to the employee, there were few retention ramifications, and
to minimize the expense to our consolidated financial statements upon adoption
of SFAS No. 123(R). This acceleration of the original vesting schedules
affected 716,000 unvested stock options. As a result, there is no compensation
expense associated with stock options granted prior to January 2, 2006 in the
consolidated statements of operations. No assumptions regarding the underlying
value of these previously granted stock options were changed upon adoption of
SFAS No. 123(R).
Under SFAS No. 123(R), the modified prospective method requires measurement of
compensation cost for all stock awards at fair value on the date of grant and
recognition of compensation over the service period for awards expected to
vest. The fair value of non-vested share grants is based on the number of
shares granted and the quoted price of our common stock. No stock options were
granted in fiscal 2006. We use the Black-Scholes valuation model for future
stock option grants in order to determine fair value. This is consistent with
the valuation techniques that were previously utilized for options in footnote
disclosures required under SFAS No. 123. The estimation of stock awards that
will ultimately vest requires significant estimates, and to the extent that
actual results or updated estimates differ from current estimates, such amounts
will be recorded as a cumulative adjustment in the period that estimates are
revised. Actual results and future changes in estimates may differ
substantially from the current estimates. Because we implemented SFAS No.
123(R), there are no longer any employee stock awards subject to variable
accounting treatment.
The weighted-average assumptions used and weighted-average grant-date fair
values of options for fiscal 2004, 2005 and 2006 were as follows:
Fiscal Year Ended
-------------------------------------
January 2, January 1, December 31,
2005 2006 2006
---------- ---------- ------------
Expected volatility 0.632 0.626 -
Risk-free interest rate 2.97% 3.05% -%
Expected life of option in years 3.4 3.0 -
Expected dividend yield 0.6% 5.7% -%
Weighted average grant date
fair value per share $ 8.70 $ 7.43 $ -
The adoption of SFAS No. 123(R) did not result in any changes in our
assumptions regarding estimated future forfeitures for grants outstanding as of
January 1, 2006; therefore, no cumulative adjustment from accounting change is
included in our consolidated statement of operations.
Valuation of awards of service-based non-vested shares was accounted for
similarly under APB No. 25, SFAS No. 123 and SFAS No. 123(R), in that all three
methods required the use of the grant date fair value as the basis for future
expense recognition. Treatment of performance-based non-vested share awards,
however, differs between APB No. 25 and SFAS No. 123(R). APB No. 25 required
quarterly revaluation of outstanding shares granted based on the quoted market
price of our stock, thus resulting in quarterly cumulative adjustments to the
extent that prior periods' expense was restated to reflect the new underlying
value of the non-vested shares. SFAS No. 123(R), however, values performance-
based non-vested shares at the quoted market price of our stock as of the grant
date, with no re-measurement.
In November 2005, the FASB issued FASB Staff Position No. 123R-3, "Transition
Election Related to Accounting for the Tax Effects of Share-Based Payment
Awards". We have adopted the simplified method to calculate the beginning
balance of the additional paid-in-capital, or APIC, pool of the excess tax
benefit, and to determine the subsequent effect on the APIC pool and
Consolidated Statements of Cash Flows of the tax effects of stock-based
compensation awards that were outstanding upon our adoption of SFAS No. 123R.
Prior to the adoption of SFAS No. 123(R), cash retained as the result of tax
deductions relating to stock-based compensation was presented in operating cash
flows, along with other tax cash flows, in accordance with the provisions of
the EITF 00-15, "Classification in the Statement of Cash Flows of the Income
Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee
Stock Option." SFAS No. 123(R) nullifies EITF 00-15, amends SFAS No. 95,
"Statement of Cash Flows," and requires tax benefits relating to excess stock-
based compensation deductions to be prospectively presented in the statement of
cash flows as financing cash inflows. There were no significant tax benefits
resulting from stock-based compensation deductions in excess of amounts
reported for financial reporting purposes for fiscal 2006.
Fair Value Disclosures - Prior to SFAS No. 123(R) Adoption
Stock-based compensation for fiscal 2004 and 2005 was determined using the
intrinsic value method. The following table provides supplemental information
for fiscal 2004 and 2005 as if stock-based compensation had been computed under
SFAS No. 123 (in thousands, except per share data):
Fiscal Year Ended
------------------------
January 2, January 1,
2005 2006
--------- ----------
Net income (loss), as reported $ 49,488 $(552,740)
Add: Stock based compensation expense
included in reported net income,
net of tax 507 1,052
Deduct: Stock based compensation expense
determined under fair market value based
methods for all awards, net of tax (1,301) (4,377)
--------- ---------
Pro forma net income (loss) $ 48,694 $(556,065)
========= =========
Earnings (loss) per share, as reported:
Basic $ 1.54 $ (17.53)
========= =========
Diluted $ 1.52 $ (17.53)
========= =========
Pro forma earnings (loss) per share:
Basic $ 1.52 $ (17.64)
========= =========
Diluted $ 1.49 $ (17.64)
========= =========
A summary of our stock option activity and related information is as follows:
Weighted-
Outstanding Average Exercise
Options Price Per Share
------------ ----------------
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
Granted - -
Exercised (360) 4.51
Cancelled (196,563) 13.78
------------
Outstanding at December 31, 2006 779,828 $ 14.47
============
Exercisable at January 2, 2005 1,024,181 $ 9.34
Exercisable at January 1, 2006 976,751 14.33
Exercisable at December 31, 2006 779,828 14.47
The total intrinsic value of stock options exercised was $12.3 million, $8.9
million and $0 for fiscal 2004, 2005, and 2006, respectively.
Options outstanding as of December 31, 2006 had a weighted-average remaining
contractual life of approximately six years and exercise prices ranging from
$1.00 to $22.00 as follows:
Exercise price of
-----------------------------------------------
$1.00 to $8.00 to $15.00 to
$7.00 $14.00 $22.00
-------------- --------------- ----------------
Options outstanding 181,504 176,699 421,625
Weighted-average exercise price $1.64 $14.49 $19.98
Weighted-average remaining
contractual life 2.9 years 5.2 years 6.9 years
Options exercisable 181,504 176,699 421,625
Weighted-average exercise price
of exercisable options $1.64 $14.49 $19.98
Service-based non-vested share awards vest over periods ranging from one to
four years. Compensation expense, representing the excess of the fair market
value of the shares at the date of issuance over the nominal purchase price, if
any, of the shares, net of assumptions regarding estimated future forfeitures
is charged to earnings over the vesting period. Compensation expense charged
to operations related to these stock grants was $1.2 million and $2.5 million
for fiscal 2005 and 2006, respectively. The total grant date fair value of
service-based share awards vested during fiscal 2005 and 2006 was $0 and $1.5
million, respectively.
Following is a summary of our service-based non-vested share activity:
Weighted-Average
Grant-Date Fair
Shares Value
---------- ------------------
Outstanding at January 2, 2005 - $ -
Granted 219,431 25.85
Cancelled (13,000) 29.45
----------
Outstanding at January 1, 2006 206,431 25.62
Granted 1,275,900 6.82
Vested (61,990) 24.55
Cancelled (89,274) 20.36
----------
Outstanding at December 31, 2006 1,331,067 $ 8.00
==========
Performance-based non-vested share awards entitle participants to acquire
shares of stock upon attainment of specified performance goals. Compensation
expense, representing the excess of the fair market value of the shares at the
date of issuance over the nominal purchase price, if any, net of assumptions
regarding future forfeitures and the likelihood that the performance
requirements will be attained, is charged to earnings over the vesting period.
Compensation cost of $0.4 million and $0.6 million for performance-based stock
grants was recognized for fiscal 2005 and 2006, respectively, using the
accelerated expense attribution method under SFAS Interpretation No. 28, or
EITF 00-23.
Following is a summary of our performance-based non-vested share activity:
Weighted-Average
Grant-Date Fair
Shares Value
---------- ------------------
Outstanding at January 2, 2005 - $ -
Granted 113,000 23.79
Cancelled (6,250) 12.83
----------
Outstanding at January 1, 2006 106,750 24.43
Granted - -
Vested (50,500) 28.84
Cancelled (31,250) 12.83
----------
Outstanding at December 31, 2006 25,000 $ 30.03
==========
The total grant date fair value of performance-based share awards vested during
fiscal 2005 and 2006 was $0 and $1.5 million, respectively.
Total compensation cost related to all non-vested awards that is not yet
recognized was $8.1 million at December 31, 2006, and is expected to be
recognized over a weighted-average period of approximately two years.
10. Accumulated Other Comprehensive Income
Accumulated other comprehensive income is as follows (in thousands):
January 2, January 1, December 31,
2005 2006 2006
---------- ---------- -----------
Cumulative translation adjustment
Balance, beginning of year $ 3,794 $ 6,255 $ 7,201
Change in foreign currency
cumulative translation adjustment,
net of taxes 2,461 946 171
---------- ---------- -----------
Balance, end of year $ 6,255 $ 7,201 $ 7,372
Qualified cash flow hedging instruments
Balance, beginning of year $ - $ - $ 2,808
Change in fair value of interest
rate swaps, net of taxes - 2,808 (1,002)
---------- ---------- -----------
Balance, end of year $ - $ 2,808 $ 1,806
Accumulated other comprehensive income
Balance, end of year $ 6,255 $ 10,009 $ 9,178
========== ========== ===========
11. Commitments and Contingencies
Operating Leases
Rent expense, including lease termination costs, for fiscal 2004, 2005, and
2006 totaled $126.1 million, $366.8 million and $474.7 million, respectively.
Total sublease income for fiscal 2004, 2005, and 2006 was $0.4 million, $3.7
million and $5.3 million, respectively.
At December 31, 2006, the future minimum annual rental commitments and sublease
income under non-cancelable operating leases were as follows (in thousands):
-------------------------------------------
Operating Sublease
Fiscal Year Leases Income
-------------------------------------------
2007 $376,012 $3,644
2008 306,644 2,794
2009 250,443 2,117
2010 186,960 1,722
2011 142,493 1,275
Thereafter 215,630 830
Litigation
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 LGP. 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. Following mediation,
the parties agreed to settle the case and a memorandum of understanding was
recently executed. The settlement is subject to preliminary and final approval
of the court, and settlement papers are in the process of being prepared. The
settlement, if approved, will be immaterial to our consolidated financial
statements.
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 and each of the plaintiffs
have entered into a settlement agreement that will result in a complete
dismissal of the case. The terms of the settlement are confidential. However,
the settlement proceeds will be paid entirely by Hollywood's insurance carrier
providing coverage for this claim.
By letter dated August 29, 2005, Boards, Inc., 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, including 17 Game Crazy stores owned and operated by
Boards, pursuant to a put option. The put option, and a related call option,
were contained in the license agreement between Hollywood and Boards that 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. 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. As of
December 31, 2006, the purchase price had not yet been determined. It is
possible that the transaction will close in fiscal 2007. On March 7, 2007,
Boards sent a demand for arbitration, or the Demand, to us seeking to determine
the purchase price of these stores, along with accrued interest. Additionally,
Boards claims an additional $10.0 million in punitive damages alleging that we
have taken action to deliberately diminish the value of the Boards stores in
order to lower the purchase price. We believe the allegations contained in the
Demand are completely without merit and intend to vigorously defend this
matter.
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. At December 31, 2006, the legal contingencies
reserve, net of expected recoveries from insurance carriers, was $1.8 million
of which $1.3 million relates to pre-acquisition contingencies.
12. Related Party Transactions
We hold a one-third interest in ECHO, LLC, or ECHO, a supply sales and
distribution company. We purchase office and store supplies and other business
products from ECHO.
Fiscal Year Ended
-------------------------------------
January 2, January 1, December 31,
2005 2006 2006
---------- ---------- ------------
(in thousands)
Purchases from ECHO $ 13,962 $ 16,858 $ 13,601
Distributions from ECHO 151 27 89
Interest from ECHO 5 - -
Note receivable from ECHO - - -
Accounts payable to ECHO 193 704 38
13. Segment Reporting and Geographic Information
With the acquisition of Hollywood in fiscal 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 2,580 video stores serving mainly rural markets in the
United States, Canada, and Mexico (in the fourth quarter of fiscal 2006 we
closed our nine stores in Mexico); Hollywood Video represents 2,045 video
stores serving predominantly urban markets; and Game Crazy represents 634 in-
store departments and 17 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
---------- --------- -------- ----------
Rental revenue $ 772,463 $ 857,595 $ - $1,630,058
Product sales 72,906 75,537 208,826 357,269
Depreciation and
amortization 40,466 43,939 8,250 92,655
Rental amortization 107,670 105,471 - 213,141
Impairment of goodwill 161,731 361,219 - 522,950
Impairment of other
intangible assets 4,940 - - 4,940
Operating income(loss) (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
Fiscal Year Ended
December 31, 2006
-------------------------------------------
Movie Hollywood Game
Gallery Video Crazy Total
---------- --------- -------- ----------
Rental revenue $ 793,763 $1,236,488 $ - $2,030,251
Product sales 77,641 109,257 324,784 511,682
Depreciation and
amortization 42,198 56,187 9,919 108,304
Rental amortization 101,071 121,680 - 222,751
Impairment of goodwill - - - -
Impairment of other
intangible assets - - - -
Operating income(loss) (18,425) 116,823 (2,063) 96,335
Goodwill, net 147 115,422 - 115,569
Total assets 347,709 702,500 103,068 1,153,277
Purchases of property,
furnishings and
equipment 13,145 6,323 152 19,620
For fiscal 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 2, January 1, December 31,
2005 2006 2006
---------- ------------ ------------
(in thousands)
Revenues:
United States $ 731,851 $ 1,903,125 $ 2,445,698
Canada 58,931 83,295 94,822
Mexico 395 907 1,413
---------- ------------ ------------
Total revenues $ 791,177 $ 1,987,327 $ 2,541,933
========== ============ ============
Assets (at end of fiscal year)
United States $ 441,519 $ 1,341,137 $ 1,115,220
Canada 49,390 42,209 37,562
Mexico 1,233 1,782 495
---------- ------------ ------------
Total assets $ 492,142 $ 1,385,128 $ 1,153,277
========== ============ ============
14. 401(k) Plans
Movie Gallery has established the Movie Gallery Retirement Savings Plan, or 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, or the Hollywood Plan, a defined contribution 401(k) plan for the
benefit of employees meeting certain eligibility requirements. We incurred
savings plan expenses of $115,000, $412,000, and $683,000 for fiscal 2004, 2005
and 2006, respectively. The fiscal 2005 expenses include $244,000 of savings
plan expenses incurred for the Hollywood Plan since April 27, 2005. In January
2007, the Movie Gallery Plan and Hollywood Plan merged into the Amended
Restated Movie Gallery/Hollywood 401(k) Retirement Savings Plan for the benefit
of employees meeting certain eligibility requirements.
15. 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 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) (12,469) (546,475)(2)
Basic earnings per share 0.59 (0.39) (0.39) (17.25)
Diluted earnings per share 0.58 (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) 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 6 for additional information on 2005
impairment charges.
Thirteen Weeks Ended
------------------------------------------------
April 2, July 2, October 1, December 31,
2006 2006 2006 2006
--------- --------- --------- ------------
Revenues $ 694,365 $ 601,285 $ 582,989 $ 663,294
Gross profit 426,909 368,968 363,240 370,965
Net income 40,347 (14,898) (36,111) (15,058)
Basic earnings per share 1.27 (0.47) (1.13) (0.47)
Diluted earnings per share 1.27 (0.47) (1.13) (0.47)
16. Consolidating Financial Information
The following tables present condensed consolidating financial information for:
(a) Movie Gallery, Inc., or the Parent, on a stand-alone basis; (b) on a
combined basis, the guarantors of the 11% Senior Notes, or the Subsidiary
Guarantors, which include Movie Gallery US, LLC; 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 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 51,209 4,156 - 55,475
Amortization of intangibles - 2,448 153 - 2,601
--------- -------- --------- --------- ---------
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 (loss) $ 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 454 124,715 4,890 - 130,059
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
--------- --------- -------- ------- ---------
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)
========= ========= ======== ========= =========
Consolidating Statement of Operations
Fiscal Year Ended December 31, 2006
(in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- ---------- --------- ------- ---------
Revenue:
Rentals $ - $1,944,036 $ 86,215 $ - $2,030,251
Product sales - 501,662 10,020 - 511,682
--------- ---------- --------- ------- ---------
Total revenue - 2,445,698 96,235 - 2,541,933
Cost of sales:
Cost of rental revenue - 594,617 32,301 - 626,918
Cost of product sales - 376,472 8,461 - 384,933
--------- ---------- --------- ------- ---------
Gross profit - 1,474,609 55,473 - 1,530,082
Operating costs and expenses:
Store operating expenses - 1,196,561 54,238 - 1,250,799
General and administrative 8,832 165,951 5,370 - 180,153
Amortization of intangibles - 2,696 142 - 2,838
Other (income)/expenses - - (43) - (43)
--------- --------- --------- ------- ---------
Operating income (loss) (8,832) 109,401 (4,234) - 96,335
Interest expense, net (81,066) (38,591) (753) - (120,410)
Equity in earnings(losses)
of subsidiaries 64,409 (3,772) - (60,637) -
--------- --------- -------- ------- --------
Income(loss) before income
taxes (25,489) 67,038 (4,987) (60,637) (24,075)
Income taxes (benefit) 231 2,629 (1,215) - 1,645
--------- --------- -------- ------- ---------
Net income (loss) $ (25,720) $ 64,409 $ (3,772) $(60,637) $ (25,720)
========= ========= ======== ========= =========
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
--------- --------- ------- ----------- ----------
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
Deposits and other assets 32,292 8,127 576 - 40,995
Investments in subsidiaries 902,135 19,790 - (921,925) -
---------- --------- ------- ----------- ----------
Total assets $ 934,446$1,328,617 $43,990 $ (921,925)$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) (212,818) 902,135 19,790 (921,925) (212,818)
---------- --------- ------- ----------- ----------
Total liabilities and
stockholders' equity
(deficit) $ 934,446$1,328,617 $43,990 $ (921,925)$1,385,128
========== ========= ======= =========== ==========
Condensed Consolidating Balance Sheet
December 31, 2006
(in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- -------- --------- ----------
Assets
Current assets:
Cash and cash equivalents $ - $ 29,274 $ 3,679 $ - $ 32,953
Merchandise inventory, net - 136,887 3,727 - 140,614
Prepaid expenses - 43,683 1,641 - 45,324
Store supplies and other - 18,764 1,447 - 20,211
Deferred income taxes, net - - 209 - 209
--------- --------- ------ ----------- --------
Total current assets - 228,608 10,703 - 239,311
Rental inventory, net - 326,183 13,798 - 339,981
Property, furnishings and
equipment, net - 230,146 12,789 - 242,935
Goodwill, net - 115,556 13 - 115,569
Other intangibles, net - 181,646 266 - 181,912
Deferred income taxes, net - - - - -
Deposits and other assets 28,906 4,175 488 - 33,569
Investments in subsidiaries 878,144 16,833 - (894,977) -
---------- --------- ------- ----------- ----------
Total assets $ 907,050 $1,103,147 $38,057 $ (894,977)$1,153,277
========== ========= ======= =========== ==========
Liabilities and stockholders' equity (deficit):
Current liabilities:
Current maturities of
long-term obligations $ 4,500 $ 80 $ - $ - $ 4,580
Accounts payable - 81,007 5,373 - 86,380
Accrued liabilities 858 79,262 312 - 80,432
Accrued payroll 534 45,568 1,794 - 47,896
Accrued interest 6,567 13 194 - 6,774
Deferred revenue - 41,362 693 - 42,055
--------- --------- ------- ---------- ----------
Total current liabilities 12,459 247,292 8,366 - 268,117
Long-term obligations, less
current portion 1,087,425 450 - - 1,087,875
Other accrued liabilities - 31,346 2,370 - 33,716
Intercompany promissory note
(receivable) (384,200) 384,200 - - -
Payable to (receivable from)
affiliate 427,797 (438,285) 10,488 - -
Stockholders' equity
(deficit) (236,431) 878,144 16,833 (894,977) (236,431)
---------- --------- ------- ----------- -----------
Total liabilities and
stockholders' equity
(deficit) $ 907,050$1,103,147 $38,057 $ (894,977)$ 1,153,277
========== ========= ======= =========== ===========
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 (loss) $ 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 - 201,156 11,985 - 213,141
Purchases of rental inventory - (189,551) (12,534) - (202,085)
Purchases of rental inventory
base stock - (18,502) (1,865) - (20,367)
Depreciation and
intangibles amortization - 89,170 3,485 - 92,655
Gain on sale 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 (252) 32 - 6,910
Accrued liabilities and
deferred revenue (10,248) 42,223 (378) - 31,597
--------- --------- -------- -------- ---------
Net cash provided by
(used in) operating
activities (34,700) 165,784 1,051 - 132,135
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
Investment in subsidiaries (335) (8,192) - 8,527 -
--------- --------- -------- -------- ---------
Net cash used in investing
activities (1,092,616) (45,549) (21,574) 8,527 (1,151,212)
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 - - -
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 (2,991) 12,054 (8,527) 1,127,851
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
========= ========= ======== ======== =========
Consolidating Condensed Statement of Cash Flow
Fiscal Year Ended December 31, 2006
(in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
-------- --------- --------- -------- ---------
Operating Activities:
Net income (loss) $ (25,720)$ 64,409 $ (3,772) $(60,637) $ (25,720)
Equity in earnings of
subsidiaries (64,409) 3,772 - 60,637 -
Adjustments to reconcile
net income (loss) to cash
provided by operating
activities:
Rental inventory
amortization - 206,616 16,135 - 222,751
Purchases of rental inventory - (167,769) (12,185) - (179,954)
Purchases of rental inventory
base stock - (10,939) (274) - (11,213)
Depreciation and
intangibles amortization - 102,592 5,712 - 108,304
Accretion of asset retirement
Obligations - 3,031 71 - 3,102
Gain on sale of property,
furnishings and equipment - (981) 29 - (952)
Amortization of debt
issuance cost 6,661 - - - 6,661
Impairment of goodwill - - - - -
Impairment of other
intangibles - - - - -
Stock based compensation (non
cash) 2,693 389 - - 3,082
Deferred income taxes 2 343 (624) - (279)
Changes in operating
assets and liabilities, net
of business acquisitions:
Merchandise inventory - (4,018) (33) - (4,051)
Other current assets 19 (1,181) 807 - (355)
Deposits and other assets 1,805 3,846 88 - 5,739
Accounts payable - (148,690) (1,181) - (149,871)
Accrued interest 2,346 3 162 - 2,511
Accrued liabilities and
deferred revenue 14,143 (3,073) (604) - 10,466
--------- --------- -------- -------- ---------
Net cash (used in) provided by
(used in) operating
activities (62,460) 48,350 4,331 - (9,779)
Investing Activities:
Business acquisitions,
net of cash acquired - (300) (19) - (319)
Purchases of property,
furnishings and equipment - (18,299) (1,321) - (19,620)
Proceeds from disposal of
property, furnishings and
equipment - 5,027 - - 5,027
Investment in subsidiaries 88,572 (815) - (87,757) -
--------- --------- -------- -------- ---------
Net cash provided by
(used in) investing
activities 88,572 (14,387) (1,340) (87,757) (14,912)
Financing Activities:
Repayment of capital
lease obligations - (541) - - (541)
Intercompany payable/
receivable 44,194 (49,648) 5,454 - -
Net borrowings on credit
facilities 15,024 - (6,861) - 8,163
Long term debt financing
fees (5,528) - - - (5,528)
Principal payments on
long-term debt (79,802) - (57) - (79,859)
Capital contribution from
parent - - 815 (815) -
Dividend to parent - (88,572) - 88,572 -
-------- -------- -------- -------- ---------
Net cash (used in)
provided by financing
activities (26,112) (138,761) (649) 87,757 (77,765)
Effect of exchange rate
changes on cash and
cash equivalents - 171 - - 171
-------- -------- -------- -------- ---------
Increase (decrease) in
cash and cash equivalents - (104,627) 2,342 - (102,285)
Cash and cash equivalents at
beginning of period - 133,901 1,337 - 135,238
-------- --------- -------- -------- ---------
Cash and cash equivalents
at end of period $ - $ 29,274 $ 3,679 $ - $ 32,953
======== ========= ======== ======== =========
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 December 31, 2006 and January 1, 2006, and the related consolidated
statements of operations, stockholders' equity (deficit), and cash flows for
each of the three years in the period ended December 31, 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 December 31, 2006, and January 1, 2006, and the consolidated results of
its operations and its consolidated cash flows for each of the three years in
the period ended December 31, 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 December 31, 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 15, 2007, expressed an unqualified opinion on management's
assessment of, and an adverse opinion on the effectiveness of, internal control
over financial reporting.
/s/ Ernst & Young LLP
Portland, Oregon
March 15, 2007