UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended October 31, 2002
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 000-24381
HASTINGS ENTERTAINMENT, INC.
(Exact name of registrant as specified in its charter)
TEXAS 75-1386375
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
3601 PLAINS BOULEVARD, AMARILLO, TEXAS 79102
(Address of principal executive offices) (Zip Code)
(806) 351-2300
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes (X) No ( )
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes ( ) No (X)
Number of shares outstanding of the registrant's common stock, as of December 6,
2002:
Class Shares Outstanding
- --------------------------------------- ------------------------------------
Common Stock, $.01 par value per share 11,365,396
HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
FORM 10-Q FOR THE THREE AND NINE MONTHS ENDED OCTOBER 31, 2002
INDEX
<Table>
<Caption>
PAGE
----
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of October 31, 2002 (Unaudited),
October 31, 2001 (Unaudited) and January 31, 2002 3
Unaudited Consolidated Statements of Operations for the Three and
Nine Months Ended October 31, 2002 and 2001 4
Unaudited Consolidated Statements of Cash Flows for the Nine
Months Ended October 31, 2002 and 2001 5
Notes to Unaudited Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 11
Item 3. Quantitative and Qualitative Disclosures about Market Risk 21
Item 4. Controls and Procedures 21
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 22
Item 6. Exhibits and Reports on Form 8-K 22
SIGNATURE PAGE 23
CERTIFICATIONS 24
INDEX TO EXHIBITS 26
</Table>
2
PART 1
ITEM 1 - FINANCIAL STATEMENTS
HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
October 31, 2002 and 2001, and January 31, 2002
(Dollars in thousands, except par value)
<Table>
<Caption>
OCTOBER 31, OCTOBER 31, JANUARY 31,
2002 2001 2002
----------- ----------- -----------
ASSETS (UNAUDITED) (UNAUDITED)
Current assets:
Cash $ 3,421 $ 3,844 $ 4,319
Merchandise inventories, net 166,269 146,143 148,265
Income taxes receivable 24 6,756 5,377
Other current assets 4,635 5,347 5,331
----------- ----------- -----------
Total current assets 174,349 162,090 163,292
Property and equipment, net of accumulated depreciation
of $132,117, $120,184 and $124,644, respectively 76,163 65,061 64,811
Deferred income taxes, net 946 -- 1,091
Intangible assets, net 676 645 646
Other assets 37 11 11
----------- ----------- -----------
$ 252,171 $ 227,807 $ 229,851
=========== =========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities on capital lease obligations $ 169 $ 153 $ 169
Trade accounts payable 100,535 85,271 86,704
Accrued expenses and other current liabilities 30,342 27,347 26,507
----------- ----------- -----------
Total current liabilities 131,046 112,771 113,380
Long term debt, excluding current maturities on capital lease obligations 46,475 38,458 33,263
Other liabilities 4,925 6,391 5,864
Commitments and contingencies -- -- --
Shareholders' equity:
Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued -- -- --
Common stock, $.01 par value; 75,000,000 shares authorized;
11,944,544 shares issued and 11,363,729 shares outstanding at October 31, 2002
11,944,544 shares issued and 11,832,331 shares outstanding at October 31, 2001;
11,918,035 shares issued and 11,304,022 shares outstanding at January 31, 2002; 119 119 119
Additional paid-in capital 36,763 36,846 36,850
Retained earnings 35,688 33,848 43,368
Treasury stock, at cost; 580,815 shares, 112,213 shares and 614,013 shares at
October 31, 2002, and 2001 and January 31, 2002, respectively (2,845) (626) (2,993)
----------- ----------- -----------
69,725 70,187 77,344
----------- ----------- -----------
$ 252,171 $ 227,807 $ 229,851
=========== =========== ===========
</Table>
See accompanying notes to unaudited consolidated financial statements.
3
HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Unaudited Consolidated Statements of Operations
For the Three and Nine Months Ended October 31, 2002 and 2001
(Dollars in thousands, except per share amounts)
<Table>
<Caption>
THREE MONTHS ENDED OCTOBER 31, NINE MONTHS ENDED OCTOBER 31,
2002 2001 2002 2001
------------ ------------ ------------ ------------
Merchandise revenue $ 86,445 $ 82,373 $ 267,026 $ 255,864
Rental video revenue 24,191 20,802 71,493 66,524
------------ ------------ ------------ ------------
Total revenues 110,636 103,175 338,519 322,388
Merchandise cost of revenue 66,370 61,491 199,408 190,669
Rental video cost of revenue 10,222 9,615 29,387 30,510
------------ ------------ ------------ ------------
Total cost of revenues 76,592 71,106 228,795 221,179
------------ ------------ ------------ ------------
Gross profit 34,044 32,069 109,724 101,209
Selling, general and administrative expenses 40,117 37,064 117,030 105,107
Pre-opening expenses 150 47 331 81
------------ ------------ ------------ ------------
Operating loss (6,223) (5,042) (7,637) (3,979)
Other income (expense):
Interest expense (481) (514) (1,497) (1,656)
Interest income 24 -- 1,290 --
Other, net 53 39 164 133
------------ ------------ ------------ ------------
Loss before income taxes (6,627) (5,517) (7,680) (5,502)
Income tax expense -- -- -- --
------------ ------------ ------------ ------------
Net loss $ (6,627) $ (5,517) $ (7,680) $ (5,502)
============ ============ ============ ============
Basic and diluted loss per share $ (0.58) $ (0.46) $ (0.68) $ (0.47)
============ ============ ============ ============
Weighted-average common shares outstanding:
Basic and diluted 11,364 11,865 11,341 11,821
============ ============ ============ ============
</Table>
See accompanying notes to unaudited consolidated financial statements.
4
HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Unaudited Consolidated Statements of Cash Flows
For the Nine Months Ended October 31, 2002 and 2001
(Dollars in thousands)
<Table>
<Caption>
NINE MONTHS ENDED OCTOBER 31,
2002 2001
------------ ------------
Cash flows from operating activities:
Net loss $ (7,680) $ (5,502)
Adjustments to reconcile net loss to net cash provided by
operating activities:
Depreciation and amortization expense 29,048 25,054
Loss on rental videos lost, stolen and defective 4,001 3,940
Loss on disposal of non-rental video assets 253 293
Non-cash compensation 133 111
Changes in operating assets and liabilities:
Merchandise inventory (13,599) (13,108)
Other current assets 697 650
Trade accounts payable and accrued expenses 17,667 11,185
Income taxes receivable 5,497 1,003
Other assets and liabilities, net (966) (337)
------------ ------------
Net cash provided by operating activities 35,051 23,289
------------ ------------
Cash flows from investing activities:
Purchases of rental video assets (27,992) (18,351)
Purchases of property and equipment (21,100) (12,976)
Purchase of retail locations -- (1,167)
------------ ------------
Net cash used in investing activities (49,092) (32,494)
------------ ------------
Cash flows from financing activities:
Borrowings under revolving credit facility 372,911 349,116
Repayments under revolving credit facility (359,573) (340,006)
Payments under capital lease obligations (124) (108)
Purchase of treasury stock (355) (650)
Proceeds from exercise of stock options 284 440
------------ ------------
Net cash provided by financing activities 13,143 8,792
------------ ------------
Net decrease in cash (898) (413)
Cash at beginning of period 4,319 4,257
------------ ------------
Cash at end of period $ 3,421 $ 3,844
============ ============
</Table>
See accompanying notes to unaudited consolidated financial statements.
5
Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
October 31, 2002 and 2001
(Tabular amounts in thousands, except per share data or as otherwise noted)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of Hastings
Entertainment, Inc. and its subsidiaries (the "Company", "We", "Our", "Us") have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with instructions in Form 10-Q and Article 10
of Regulation S-X. Certain information and footnote disclosures normally
included in annual financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to such
principles and regulations of the Securities and Exchange Commission. All
adjustments, consisting only of normal recurring adjustments, have been made
which, in the opinion of management, are necessary for a fair presentation of
the results of the interim periods. The results of operations for such interim
periods are not necessarily indicative of the results that may be expected for a
full year because of, among other things, seasonality factors in the retail
business. The unaudited consolidated financial statements contained herein
should be read in conjunction with the audited consolidated financial statements
and notes thereto included in the Company's annual report on Form 10-K for the
fiscal year 2001.
Certain prior year amounts have been reclassified to conform with the fiscal
2002 presentation.
Our fiscal year ends on January 31 and is identified as the fiscal year for the
immediately preceding calendar year. For example, the fiscal year that will end
on January 31, 2003 is referred to as fiscal 2002.
2. CONSOLIDATION POLICY
The unaudited consolidated financial statements present the results of Hastings
Entertainment, Inc. and its subsidiaries. All significant intercompany
transactions and balances have been eliminated in consolidation.
3. STORE CLOSING RESERVE
From time to time and in the normal course of business, we evaluate our store
base to determine if a need to close a store(s) is present. Such evaluations
include, among other factors, current and future profitability, market trends,
age of store and lease status.
Included in accrued expenses and other liabilities are accruals for the net
present value of future minimum lease payments and other costs attributable to
closed or relocated stores, net of estimated sublease income.
A charge of approximately $0.8 million was recorded in the third quarter of
fiscal 2002 for the net present value of minimum lease payments relating to one
underperforming superstore to be closed during the fourth quarter of fiscal
2002. Offsetting this charge was a change in estimate during the third quarter
of fiscal 2002 of approximately $0.3 million, as a result of negotiating an
early buy-out of lease liability on one closed superstore.
Additions to the provision during the third quarter of fiscal 2001 included
charges totaling approximately $0.3 million related to the net present value of
minimum lease payments on certain closed and relocated superstores. In addition,
a charge of approximately $0.3 million was recorded resulting from changes in
estimates primarily related to sublease activity on certain closed superstores.
6
Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
October 31, 2002 and 2001
(Tabular amounts in thousands, except per share data or as otherwise noted)
3. STORE CLOSING RESERVE (CONT'D)
The following tables provide a rollforward of reserves that were established for
these charges for the nine months ended October 31, 2002 and 2001.
<Table>
<Caption>
Future Lease
Payments Other Costs Total
------------ ----------- -------
Balance at January 31, 2001 $ 6,350 $ 255 $ 6,605
Changes in estimates 263 -- 263
Additions to provision 369 -- 369
Cash outlay (764) (123) (887)
------------ ----------- -------
Balance at October 31, 2001 $ 6,218 $ 132 $ 6,350
============ =========== =======
</Table>
<Table>
<Caption>
Future Lease
Payments Other Costs Total
------------ ----------- -------
Balance at January 31, 2002 $ 5,919 $ 13 $ 5,932
Changes in estimates (224) -- (224)
Additions to provision 946 134 1,080
Cash outlay (1,178) (117) (1,295)
------------ ----------- -------
Balance at October 31, 2002 $ 5,463 $ 30 $ 5,493
============ =========== =======
</Table>
Payments during the next five years that are to be charged against the reserve
are expected to be approximately $1.6 million per year.
4. AMENDMENT TO CREDIT FACILITY
On August 23, 2002, we executed an amendment to our Revolving Credit Facility
agreement with Fleet Retail Finance and The CIT Group/Business Credit, Inc.
Under the amendment, the borrowing limit ceiling was increased from $70 million
to $80 million and the maturity date was extended by an additional two years to
August 20, 2005. All other terms and conditions of the Revolving Credit Facility
in place at July 31, 2002 remain essentially the same.
5. INTEREST INCOME
During the second quarter of fiscal 2002, we recorded interest income of
approximately $1.3 million as a result of interest earned on income tax refunds
for amended returns filed for fiscal years 1995 through 1998. The Company was
notified in July 2002 that the payment of the refunds, which totaled
approximately $5.4 million, would be processed in August 2002 and would be
accompanied by interest payments. All refunds, including interest, were received
by October 31, 2002.
6. LOSS PER SHARE
Options to purchase 1,784,784 and 1,594,755 shares of common stock at exercise
prices ranging from $1.27 per share to $14.03 per share outstanding at October
31, 2002 and 2001, respectively, were not included in the computation of diluted
income per share because their inclusion would have been antidilutive.
7
Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
October 31, 2002 and 2001
(Tabular amounts in thousands, except per share data or as otherwise noted)
7. LITIGATION AND CONTINGENCIES
In 2000, the Company restated its consolidated financial statements for the
first three quarters of fiscal 1999 and the prior four fiscal years. Following
the Company's initial announcement in March 2000 of the requirement for such
restatements, nine purported class action lawsuits were filed in the United
States District Court for the Northern District of Texas against the Company and
certain of the current and former directors and officers of the Company
asserting various claims under Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934. Although four of the lawsuits were originally filed in the
Dallas Division of the Northern District of Texas, all of the five pending
actions have been transferred to the Amarillo Division of the Northern District
and have been consolidated. One of the Section 10(b) and 20(a) lawsuits filed in
the Dallas Division was voluntarily dismissed. On May 15, 2000, a lawsuit was
filed in the United States District Court for the Northern District of Texas
against the Company, its current and former directors and officers at the time
of the Company's June 1998 initial public offering and three underwriters,
Salomon Smith Barney, A.G. Edwards & Sons, Inc. and Furman Selz, LLC asserting
various claims under Sections 11, 12(2) and 15 of the Securities Act of 1933.
Motions to dismiss these actions were filed by the Company and, on September 25,
2001, were denied by the Court.
On September 12, 2002, the Company announced that an agreement in principle to
settle the actions described above had been reached. The settlement requires a
payment of $5.75 million ($3.25 million of which the Company estimates will be
funded from amounts remaining under the Company's director and officer insurance
policy after the payment of litigation expenses) and the assignment to the
plaintiff settlement class of any claims the Company may have had against KPMG
Peat Marwick, LLP, the Company's outside auditors at the time of the March 7,
2000 announcement. The settlement resolves all claims against the Company, its
current and former defendant officers and directors and the defendant
underwriters. Based on the foregoing, the Company recorded a loss contingency of
$2.5 million, or $0.22 per share, during the second quarter of fiscal 2002.
Before completion of the settlement agreements, plaintiffs' counsel informed the
Company that the plaintiff settlement class had settled all claims against KPMG,
including the claims assigned by the Company. Amended settlement agreements that
added the terms of the KPMG settlement with the plaintiff settlement class are
expected to be filed in mid December 2002. The settlement is subject to Court
approval.
The Company is also involved in various other claims and legal actions arising
in the ordinary course of business. In the opinion of management, the ultimate
disposition of these matters will not have a material adverse effect on the
Company's financial position, results of operations and cash flows.
8
Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
October 31, 2002 and 2001
(Tabular amounts in thousands, except per share data or as otherwise noted)
8. SEGMENT DISCLOSURES
The Company has two operating segments, retail stores and Internet operations.
Our chief operating decision maker, as that term is defined in the relevant
accounting standard, regularly reviews financial information about each of the
above operating segments for assessing performance and allocating resources.
Revenue for retail stores is derived from the sale of merchandise and rental of
videocassettes, video games and DVDs. Revenue for Internet operations is derived
solely from the sale of merchandise. Segment information regarding our retail
stores and Internet operations for the three and nine months ended October 31,
2002 and 2001 is presented below.
<Table>
<Caption>
For the three months ended October 31, 2002: Retail Internet
Stores Operations Total
--------- ---------- ---------
Total revenue $ 110,598 $ 38 $ 110,636
Depreciation and amortization 10,111 61 10,172
Operating loss (5,890) (333) (6,223)
Total assets 251,931 240 252,171
Capital expenditures $ 19,659 $ -- $ 19,659
</Table>
<Table>
<Caption>
For the three months ended October 31, 2001: Retail Internet
Stores Operations Total
--------- ---------- ---------
Total revenue $ 103,135 $ 40 $ 103,175
Depreciation and amortization 7,959 69 8,028
Operating loss (4,802) (240) (5,042)
Total assets 227,252 555 227,807
Capital expenditures $ 13,843 $ -- $ 13,843
</Table>
<Table>
<Caption>
For the nine months ended October 31, 2002: Retail Internet
Stores Operations Total
--------- ---------- ---------
Total revenue $ 338,388 $ 131 $ 338,519
Depreciation and amortization 28,853 195 29,048
Operating loss (6,823) (814) (7,637)
Total assets 251,931 240 252,171
Capital expenditures $ 49,090 $ 2 $ 49,092
</Table>
<Table>
<Caption>
For the nine months ended October 31, 2001: Retail Internet
Stores Operations Total
--------- ---------- ---------
Total revenue $ 322,275 $ 113 $ 322,388
Depreciation and amortization 24,846 208 25,054
Operating loss (3,261) (718) (3,979)
Total assets 227,252 555 227,807
Capital expenditures $ 32,494 $ -- $ 32,494
</Table>
9
Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
October 31, 2002 and 2001
(Tabular amounts in thousands, except per share data or as otherwise noted)
9. RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statements of Financial Accounting Standards ("SFAS") No. 141, Business
Combinations, and No. 142, Goodwill and Other Intangible Assets (the
"Statements"), effective for fiscal years beginning after December 15, 2001.
Under the new rules, goodwill is no longer amortized but is subject to annual
impairment tests in accordance with the Statements. Other intangible assets
continue to be amortized over their useful lives. The Company applied the new
rules on accounting for goodwill and other intangible assets as of February 1,
2002 and adoption did not have a material impact on its consolidated financial
position or results of operations.
In July 2001, the FASB issued Statement No. 143, "Accounting for Asset
Retirement Obligations" ("SFAS 143"), effective for fiscal years beginning after
June 15, 2002. SFAS 143 addresses the financial accounting and reporting for
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. SFAS 143 requires the capitalization of any
retirement costs as part of the total cost of the related long-lived asset and
the subsequent allocation of the total expense to future periods using a
systematic and rational method. The Company is required to implement SFAS 143 on
February 1, 2003, and it has not determined the impact that this statement will
have on its consolidated financial position or results of operations.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, which addresses financial accounting and
reporting for the impairment or disposal of long-lived assets and supersedes
SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions
of APB Opinion No. 30, Reporting the Results of Operations for a disposal of a
segment of a business. SFAS 144 is effective for fiscal years beginning after
December 15, 2001. The Company adopted SFAS 144 as of February 1, 2002 and such
adoption did not have a significant impact on the Company's financial position
or results of operations.
In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities. This statement changes certain aspects of financial
accounting and reporting for costs associated with exit or disposal activities.
This statement is effective for exit or disposal activities that are initiated
after December 31, 2002. We do not expect the adoption of this statement to have
a material effect on our consolidated financial position or results of
operations.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-looking Statements
Certain written and oral statements set forth below or made by Hastings or with
the approval of an authorized executive officer of the company constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. The words "believe," "expect," "intend,"
"anticipate," "project," "will" and similar expressions identify forward-looking
statements, which generally are not historical in nature. All statements which
address operating performance, events or developments that we expect or
anticipate will occur in the future including statements relating to the impact
on our financial statements of any adjustment to fair value of interest rate
swaps, inflation, effect of critical accounting policies including lower of cost
or market for inventory adjustments, the returns process, rental video
amortization and our store closing reserve and statements expressing general
optimism about future operating results are forward-looking statements. Such
statements are based upon our management's current estimates, assumptions and
expectations, which are based on information available at the time of the
disclosure, and are subject to a number of factors and uncertainties, including,
but not limited to, whether our assumptions turn out to be correct, our
inability to attain such estimates and expectations, a downturn in market
conditions in any industry relating to the products we inventory, sell or rent,
the effects of or changes in economic conditions in the U.S. and or the markets
in which we operate our superstores, our success in forecasting customer demand
for products, and whether or not the court approves the settlement of the
securities litigation (see the discussion of Legal Proceedings in Part II, Item
1 of this Form 10-Q for the three and nine months ended October 31, 2002 and
subsequent SEC filings) any of which could cause actual results to differ
materially from those described herein. We undertake no obligation to affirm,
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise.
The following discussion should be read in conjunction with the unaudited
consolidated financial statements of the Company and the related notes thereto
appearing elsewhere in the report.
General
Hastings Entertainment is a leading multimedia entertainment retailer that
combines the sale of books, music, software, periodicals, videocassettes, video
games and DVDs with the rental of videocassettes, video games and DVDs in a
superstore and Internet Web site format. As of October 31, 2002, we operated 145
superstores averaging approximately 20,000 square feet in small to medium-sized
markets located in 21 states, primarily in the Western and Midwestern United
States. Each of our superstores is company-operated under the name of Hastings.
Our operating strategy is to enhance our position as a multimedia entertainment
retailer by expanding existing superstores, opening new superstores in selected
markets and expanding our offering of products through our Internet Web site.
References herein to fiscal years are to the twelve-month periods that end in
January of the following calendar year. For example, the twelve-month period
ending January 31, 2003 is referred to as fiscal 2002.
Critical Accounting Policies
Our financial statements are prepared in accordance with accounting principles
generally accepted in the United States, which require management to make
estimates and assumptions that affect the reported amounts of assets,
liabilities at the date of the financial statements, the disclosure of
contingent assets and liabilities and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. We believe the following critical accounting policies affect our more
significant estimates and assumptions used in the preparation of our financial
statements. Our significant estimates and assumptions are reviewed, and any
required adjustments are recorded, on a monthly basis.
Lower of Cost or Market for Merchandise Inventory. Our merchandise inventories
are recorded at the lower of standard cost or market. As with any retailer,
economic conditions, cyclical customer demand and changes in purchasing or
distribution can affect the carrying value of inventory. As circumstances
warrant, we record lower of
11
cost or market ("LCM") inventory adjustments. In some instances, these
adjustments can have a material effect on the financial results of an annual or
interim period. In order to determine such adjustments, we evaluate the age,
inventory turns and estimated fair value of merchandise inventory by product
category and record any adjustment if estimated fair value is below cost.
Through merchandising and an automated-progressive markdown program, we quickly
take the steps necessary to increase the sell-off of slower moving merchandise
to eliminate or lessen the effect of any LCM adjustment.
Returns Process. In general, merchandise inventory owned by us is returnable
based upon return agreements with our merchandise vendors. We continually return
merchandise to vendors based on, among other factors, current and projected
sales trends, overstock situations, authorized return timelines or change in
product offerings. At the end of any reporting period, there is inventory that
has been returned to vendors, or is in the process of being returned to vendors,
or has been identified to be returned to vendors, for which cost accruals are
required. These costs can include freight, valuation and quantity differences,
and other fees charged by a vendor. In order to appropriately match the costs
associated with the return of merchandise with the process of returning such
merchandise, we utilize an allowance for cost of inventory returns (the
"Allowance"). To accrue for such costs and estimate the Allowance, we utilize
historical experience adjusted for significant estimated or contractual
modifications. Certain adjustments to the Allowance can have a material effect
on the financial results of an annual or interim period. We continually evaluate
the returns process and initiate improvements as needed.
Rental Video Cost Amortization. We have a series of direct revenue-sharing
agreements with major studios and we anticipate that our future involvement in
revenue-sharing agreements will be similar to that of the current fiscal year.
Revenue sharing allows us to acquire rental video assets at a lower up-front
capital cost than traditional buying arrangements. We then share with studios a
percentage of the actual net rental revenues generated over a contractually
determined period of time. The increased access to additional copies of new
releases under revenue-sharing agreements allows customer demand for new
releases to be satisfied over a shorter period of time at a time when the new
releases are most popular. We expense revenue-sharing payments through rental
video cost of revenue, under the terms of the specific contracts with supplying
studios, as revenues are recognized. The capitalized cost of all rental video
assets acquired for a fixed price is being amortized on an accelerated basis
over six months to a salvage value of $4 per unit, except for rental video
assets purchased for the initial stock of a new superstore, which are being
amortized on a straight line basis over 36 months to a salvage value of $4.
Certain events, including a downturn in the rental video industry as a whole or
in the markets within which we operate our superstores, further consolidation of
rental video retailers, substantial change in customer demand and change in the
mix of rental video revenues, could affect the salvage value we have assigned to
our rental video assets. The effect could result in a material reduction of the
carrying value of our rental video assets and have a material impact on the
financial results of an annual or interim period. In particular, the growth of
the DVD market and the shift of consumer purchases from VHS (videocassettes) to
DVD could result in a decrease in the salvage value of rental videos. At some
point during the rental cycle, a VHS item, as with DVD and games, is available
for purchase by a customer as a previously viewed tape ("PVT"). Our current
experience is that the amount received for the PVT is higher than our salvage
value of that item in our rental inventory. Based in part on this factor and
sales of PVTs, we believe our estimate of salvage value is appropriate.
Store Closing Reserve. On a quarterly basis, and in the normal course of
business, we evaluate our store base to determine if a need to close or relocate
a store(s) is present. Management will evaluate, among other factors, current
and future profitability, market trends, age of store and lease status. Upon the
appropriate executive approval to close a location, we record charges related to
the costs of store closings or relocations. The primary expense items associated
with these charges relate to the net present value of minimum lease payments
(the present value of remaining lease payments under an active lease) and the
write-off of leasehold improvements and other assets not remaining in our
possession at the time the location is closed or relocated. The amount recorded
can fluctuate based on the age of the closing location, term and remaining years
of the lease and the number of stores being closed or relocated. These charges
can have a material effect on the financial results of an annual or interim
period. Although we actively pursue sublease tenants on all closed or relocated
locations, we do not record any estimated sublease income as an offset to any
closing or relocation charges until a sublease agreement is executed.
12
Revenue Recognition. The Company's revenue is primarily from retail sales and
rental of our products. Merchandise and rental revenues are recognized at the
point of sale or rental or at the time merchandise is shipped to the customer.
Revenues are presented net of returns and exclude all taxes. Customers may
return certain merchandise for exchange or refund within the Company's policies,
and an allowance has been established to provide for projected returns. There
are no provisions for uncollectible amounts since payment is received at the
time of sale. The Company, as with most retailers, also offers gift cards for
sale. Deferred revenue, a current liability, is recognized at the time a gift
card is sold with the costs of designing, printing and distributing the cards
recorded as an expense as incurred. The deferred revenue liability is relieved
and revenue is recognized upon the redemption of the gift cards. From time to
time the Company will offer sales incentives, in the form of customer rebates,
to its customers. Revenue is reduced by the amount of estimated redemptions,
based on experience of similar types of rebate offers, and a deferred revenue
liability is established. The deferred revenue liability is relieved when the
customer has completed all criteria necessary to file a valid rebate claim. Any
remaining portion of deferred revenue is recorded as revenue following the
termination of the extended redemption period and following completion of all
outstanding rebate claims.
13
Results of Operations
The following tables present our statement of operations data, expressed as a
percentage of revenue, and the number of superstores open at the end of the
periods presented herein.
<Table>
<Caption>
Three Months Ended Nine Months Ended
October 31, October 31,
2002 2001 2002 2001
---------- ---------- ---------- ----------
Merchandise revenue 78.1 % 79.8 % 78.9 % 79.1 %
Rental video revenue 21.9 20.2 21.1 20.9
---------- ---------- ---------- ----------
Total revenues 100.0 100.0 100.0 100.0
Merchandise cost of revenue 76.8 74.6 74.7 74.5
Rental video cost of revenue 42.3 46.2 41.1 45.9
---------- ---------- ---------- ----------
Total cost of revenues 69.2 68.9 67.6 68.6
---------- ---------- ---------- ----------
Gross profit 30.8 31.1 32.4 31.4
Selling, general and administrative expenses 36.3 35.9 34.6 32.6
Pre-opening expenses 0.1 0.0 0.1 0.0
---------- ---------- ---------- ----------
Operating loss (5.6) (4.8) (2.3) (1.2)
Other income (expense):
Interest expense (0.4) (0.5) (0.4) (0.5)
Interest income 0.0 -- 0.4 --
Other, net 0.0 0.0 0.0 0.0
---------- ---------- ---------- ----------
Loss before income taxes (6.0) (5.3) (2.3) (1.7)
Income tax expense (benefit) -- -- -- --
---------- ---------- ---------- ----------
Net loss (6.0)% (5.3)% (2.3)% (1.7)%
========== ========== ========== ==========
</Table>
Summary of Superstore Activity
<Table>
<Caption>
Three Months Ended Nine Months Ended Year Ended
October 31, October 31, January 31,
2002 2001 2002 2001 2002
-------- ---------- -------- ---------- -----------
Beginning number of stores 143 139 142 142 142
Openings 3 2 5 3 5
Closings 1 -- (2) (4) (5)
-------- ---------- -------- ---------- -----------
Ending number of stores 145 141 145 141 142
======== ========== ======== ========== ===========
</Table>
14
Three months ended October 31, 2002 compared to October 31, 2001
Revenues. Total revenues increased $7.5 million, or 7.2%, for the third quarter
of fiscal 2002 to $110.6 million compared to $103.1 million a year ago due
primarily to an increase in total comparable store revenues ("Comps") of 6.1%.
Elements of total Comps were as follows:
<Table>
Merchandise Comps 4.0%
Rental video Comps 14.2%
Total Comps 6.1%
</Table>
Total merchandise revenue for the third quarter increased $4.0 million, or 4.9%,
to $86.4 million compared to $82.4 million last year. Contributing to the
increase in total merchandise revenue were increases in DVD and video game
revenues of 67% and 171%, respectively, and book revenues of 5.6% for the three
months ended October 31, 2002 over the same period in the prior year. Book Comps
increased 4.7% over the comparable period in the prior year resulting from
improved inventory selection and programs initiated over the past year to grow
revenue and improve inventory turns. Partially offsetting these Comp increases
was a decline in music Comps resulting primarily from a (12.2%) decrease in new
release compact disc revenues for the current quarter, which we believe is the
result of the continuing downturn of the music industry. Partially offsetting
this decline were higher revenues generated from other music related products
resulting in our overall music Comps decreasing (8.4%) for the current quarter
when compared to the same period last year.
Total rental video revenue for the quarter grew $3.4 million, or 16.3%, to $24.2
million, up from $20.8 million a year earlier. This increase was primarily
driven by a 109% increase in DVD rentals over the same period last year and was
partially offset by a 16% decline in VHS rentals. The acceptance of DVD by the
consumer is the primary reason for the decline in VHS rental revenue, but part
of the decline resulted from studios increasing the percentage of rental titles
released simultaneously for sale at a lower price-point, which entices the
consumer to purchase a title on VHS instead of renting.
Gross Profit. Total gross profit of $34.0 million in the third quarter of fiscal
2002 increased $2.0 million, or 6.2%, from $32.0 million in the third quarter of
fiscal 2001. Total gross profit as a percent of total revenue decreased slightly
for the three months ended October 31, 2002 to 30.8% compared to 31.1% for the
same period last year. Merchandise gross profit as a percent of merchandise
revenue decreased to 23.2% for the current quarter compared to 25.4% for the
same quarter last year. Significant changes in the components of merchandise
gross profit were:
(i) an increase in our product cost from 65.2% of merchandise revenue for
the three months ended October 31, 2001 to 68.1% for the three months
ended October 31, 2002. Factoring in the increase in revenues, this
higher cost percentage resulted in lower merchandise gross profit of
approximately $1.1 million for the current quarter and was due
primarily to reduced margins in music and sale video, resulting from
lowering sales prices to meet competitor prices. Partially offsetting
these declines was an increase in book gross profit due primarily to a
planned move toward higher margin products in this category;
(ii) an increase in inventory markdowns during the third quarter of fiscal
2002 of approximately $0.5 million compared to the same period last
year due primarily to a higher level of non-returnable, non-saleable
book items being disposed of during the third quarter;
(iii) an increase in net freight expense of approximately $0.2 million,
caused primarily by an earlier build-up of inventory for the holiday
season when compared to the prior year; and
(iv) an increase of approximately $0.1 million in the costs associated with
the returning of merchandise inventory. The volume of returns shipped
from our returns facility increased approximately 27.4% for the three
months ended October 31, 2002 compared to the same period in the prior
year, which resulted in an increase of approximately $0.6 million in
overhead and variable labor costs. Those increases were partially
offset by a decrease in total returns fees of approximately $0.5
million as a result of improved efficiency and accuracy of the product
return process.
15
Partially offsetting these decreases in gross profit was:
(i) a decrease of approximately $0.7 million in the costs associated with
distributing merchandise inventory due primarily to lower markdowns on
certain products being purchased through our distribution facility; and
(ii) a decrease in merchandise shrinkage of approximately $0.2 million.
Rental video gross profit as a percent of rental video revenue increased to
57.7% for the current quarter from 53.8% for the same quarter last year. This
increase was due primarily to non-revenue sharing titles, which have
historically reflected higher margins, representing a higher percentage of total
rental video revenue for the third quarter of fiscal 2002 compared to the third
quarter of fiscal 2001 and a decline in rental video shrinkage of approximately
$0.1 million.
Selling, General and Administrative Expenses. Selling, general and
administrative ("SG&A") expenses as a percent of total revenues increased to
36.3% for the quarter ended October 31, 2002 from 35.9% for the same period last
year. The increase was primarily the result of:
(i) an increase in store variable human resource expenses, excluding group
healthcare costs, of approximately $1.0 million for the three months
ended October 31, 2002 compared to the same period in the prior year.
Store human resource productivity remained constant at 13.7% of total
revenues for the quarterly periods presented.
(ii) a planned increase of approximately $0.9 million in advertising
expenditures designed to drive Comp sales and customer traffic;
(iii) an increase of approximately $0.5 million primarily related to
increases in depreciation and consultant fees in connection with the
implementation of new financial software and upgrades in our human
resource systems;
(iv) an increase in occupancy related costs of approximately $0.4 million
due to the increase in operating a greater number of superstore units
during the current quarter when compared to last year;
(v) an increase of approximately $0.3 million in the costs associated with
expanding or relocating four superstores and the write-off of fixed
assets related to the closing of one superstore during the third
quarter of fiscal 2002;
(vi) an unplanned increase of approximately $0.2 million in the costs
associated with our group healthcare plan due primarily to higher than
anticipated claims activity; and
(vii) a planned increase in corporate human resource expenses, excluding
group healthcare costs, of approximately $0.2 million.
Partially offsetting these increases in SG&A were lower estimated legal fees of
approximately $0.3 million relating to our exposure to various claims and legal
actions arising in the ordinary course of business and a reduction of
approximately $0.2 million in other SG&A expenses.
Also included in SG&A during the third quarter of fiscal 2002 were net charges
of approximately $0.5 million related to the net present value of future minimum
lease payments for one superstore to be closed during the fourth quarter 2002
and the effect of a negotiated early buy-out of the lease liability on one
closed superstore. These charges compare to net charges of approximately $0.6
million during the third quarter of fiscal 2001 related to the net present value
of minimum lease payments on certain closed and relocated superstores and
changes in estimates primarily related to sublease activity on certain closed
superstores.
16
Pre-opening Expenses. Pre-opening expenses were $0.1 million for the three
months ended October 31, 2002, as the Company opened three new superstores
during the period. Pre-opening expenses include human resource costs, travel,
rent, advertising, supplies and certain other costs incurred prior to a
superstore's opening.
Interest Expense. Interest expense remained unchanged at $0.5 million for the
three months ended October 31, 2002, compared to the three months ended October
31, 2001.
Income Taxes. We did not record any income tax benefit for the three months
ended October 31, 2002 or 2001 due to application of valuation allowances
related to the net deferred tax asset.
Nine months ended October 31, 2002 compared to October 31, 2001
Revenues. Total revenues increased $16.1 million, or 5.0%, for the nine months
to $338.5 million compared to $322.4 million a year ago due primarily to an
increase in total Comps of 5.4%. Elements of total Comps were as follows:
<Table>
Merchandise Comps 5.3%
Rental video Comps 5.9%
Total Comps 5.4%
</Table>
Total merchandise revenue for the nine months increased $11.2 million, or 4.4%,
to $267.0 million compared to $255.8 million last year. Contributing to the
increase in gross merchandise revenue were increases in DVD and video game
revenues of 57% and 167%, respectively, for the nine months ended October 31,
2002 over the same period in the prior year. On a percentage basis, Comp
merchandise revenue increases were higher than gross merchandise revenue
increases primarily because of increased revenue generated from
"going-out-of-business" sales for the closing of four stores during the nine
months ended October 31, 2001, that were excluded from the Comp calculation.
Book Comps increased 4.9% over the comparable period last year resulting from
improved inventory selection and programs initiated over the past year to grow
revenue and improve inventory turns. The music industry recorded a decline in
shipments of (10.5%) for the year as of the end of October 2002, which sustains
a downward pressure on retail sales for the industry. In comparison, our revenue
generated from the sale of new release compact discs decreased (9.1%) for the
nine months ended October 31, 2002; however, with our diverse music product
offering including used CDs, music accessories and musical instruments, our
overall music category decreased only (5.2%) for the nine-month period.
Total rental video revenue for the nine months ended October 31, 2002 grew $5.0
million, or 7.5%, to $71.5 million, up from $66.5 million a year earlier driven
primarily by a 105% increase in DVD rentals over the same period last year and
was partially offset by a 21% decline in VHS rentals.
Gross Profit. Total gross profit of $109.7 million for the nine months ended
October 31, 2002 increased $8.5 million, or 8.4%, from $101.2 million for the
nine months ended October 31, 2001. Total gross profit as a percent of total
revenues increased for the nine months ended October 31, 2002 to 32.4% compared
to 31.4% for the same period last year. Merchandise gross profit as a percent of
merchandise revenue decreased slightly to 25.3% for the current nine months from
25.5% for the same period last year due primarily to:
(i) a slight increase in our product cost of approximately 60 basis points
from 66.3% of merchandise revenue for the nine months ended October 31,
2001 to 66.9% for the nine months ended October 31, 2002. However, with
the increases in revenue as detailed above, merchandise gross profit
dollars increased approximately $2.2 million for the current nine
months;
(ii) an increase of approximately $1.6 million in the costs associated with
returning merchandise inventory primarily related to an increase of
approximately $16.0 million, or 30%, in the volume of product returned
to vendors during the first nine months of fiscal 2002 compared to the
same period last year. The higher level of returns was mainly
attributable to a planned reduction in inventory levels;
17
(iii) an increase in net freight expense of approximately $1.0 million, which
was primarily caused by the increases in shipments from our
distribution and returns facilities of approximately 21% for the nine
months ended October 31, 2002 compared to the same period in the prior
year; and
(iv) higher occupancy related costs of approximately $0.9 million due to the
increase in operating a greater number of superstore units during the
nine months ended October 31, 2002 when compared to last year.
Partially offsetting these decreases in gross profit was:
(i) a decline in inventory markdowns of approximately $1.5 million compared
to the same period last year due primarily to our automated-progressive
markdown programs, which improve our sell-through on slower moving
merchandise;
(ii) an increase of approximately $0.4 million in the amount of income from
certain trade and purchase discounts primarily resulting from volume
rebates related to merchandise inventory purchases; and
(iii) a decrease in merchandise shrinkage of approximately $0.3 million.
Rental video gross profit increased as a percent of rental video revenue to
58.9% for the nine months ended October 31, 2002 from 54.1% for the same period
last year. This increase was due primarily to non-revenue sharing titles, which
generally reflect higher margins, representing a higher percentage of total
rental revenues. In addition, rental video shrinkage decreased by approximately
$0.5 million for the nine months ended October 31, 2002 when compared to the
nine months ended October 31, 2001.
Selling, General and Administrative Expenses. SG&A expenses as a percent of
total revenues increased to 34.6% for the nine months ended October 31, 2002
from 32.6% for the same period last year. The increase was primarily the result
of:
(i) a $2.5 million charge, recorded at July 31, 2002, for the settlement
of the shareholder class action lawsuits (See the discussion of legal
proceedings in Part II, Item 1 of this Form 10-Q);
(ii) an increase of approximately $2.9 million in store variable human
resource expenses, excluding group healthcare costs, for the nine
months ended October 31, 2002 compared to the same period last year.
As a percent of total revenues, store human resource productivity
decreased slightly to 13.1% of total revenues for the current nine
month period compared to 12.8% for the same period in the prior year;
(iii) a planned increase of approximately $2.3 million in advertising
expenditures designed to increase Comp sales and customer traffic;
(iv) an increase of approximately $1.4 million primarily related to
increase in depreciation and consultant fees in connection with the
implementation of new financial software and upgrades in our human
resource systems;
(v) an unplanned increase of approximately $0.7 million in the costs
associated with our group healthcare plan, the majority of which was
the result of two large medical claims incurred at the end of July
2002;
(vi) an increase in corporate human resource expenses, excluding group
healthcare costs, of approximately $0.5 million;
(vii) an increase of approximately $0.4 million in the costs associated with
expanding or relocating seven superstores and the write-off of fixed
assets related to the closing of one superstore; and
(viii) an increase of approximately $0.3 million in other SG&A costs.
18
Also included in SG&A for the nine months ended October 31, 2002 were net
charges of approximately $0.8 million primarily related to the net present value
of future minimum lease payments for the closing of two superstores, one of
which was closed during the third quarter of fiscal 2002 and the other to be
closed during the fourth quarter 2002, and the effect of a negotiated early
buy-out of lease liability on one closed superstore. These charges compare to
net charges of approximately $0.6 million for the nine months ended October 31,
2001 related to the net present value of minimum lease payments on certain
closed and relocated superstores and changes in estimates primarily related to
sublease activity on certain closed superstores.
Pre-opening Expenses. Pre-opening expenses were $0.3 million for the nine months
ended October 31, 2002, as the Company opened five new superstores during the
period. Pre-opening expenses include human resource costs, travel, rent,
advertising, supplies and certain other costs incurred prior to a superstore's
opening.
Interest Expense. Interest expense was $1.5 million, or 0.4% of revenues, for
the nine months ended October 31, 2002, compared to $1.7 million, or 0.5% of
revenues, in the nine months ended October 31, 2001. The slight decrease was due
to a decline in interest rates period over period, despite a higher average loan
balance outstanding.
Interest Income. During the second quarter, we recorded interest income of $1.3
million as a result of interest earned on income tax refunds for amended returns
filed for fiscal years 1995 through 1998. The Company was notified in July 2002
that the payment of the refunds, which totaled approximately $5.4 million, would
be processed in August 2002 and would be accompanied by interest payments. All
refunds, including interest, were received by October 31, 2002.
Income Taxes. We did not record any income tax benefit for the nine months ended
October 31, 2002 or 2001 due to application of valuation allowances related to
the net deferred tax asset.
Liquidity and Capital Resources
We generate cash from operations exclusively from the sale of merchandise and
the rental of video products and we have substantial operating cash flow because
most of our revenue is received in cash and cash equivalents. Other than our
principal capital requirements arising from the purchase, warehousing and
merchandising of inventory and rental videos, opening new superstores and
expanding existing superstores and updating existing and implementing new
information systems technology, we have no anticipated material capital
commitments. Our primary sources of working capital are cash flow from operating
activities, trade credit from vendors and borrowings under our amended revolving
credit facility (the "Facility"). We believe our cash flow from operations and
borrowings under the Facility will be sufficient to fund our ongoing operations,
new superstores and superstore expansions through fiscal 2005.
Consolidated Cash Flows
Operating Activities. Net cash flows from operating activities increased
$11.8 million, from $23.3 million for the nine months ended October 31,
2001 to $35.1 million for the nine months ended October 31, 2002.
Offsetting the increase in our net loss for the nine-month period was a
greater increase in trade accounts payable and accrued expenses for the
current year-to-date period of approximately $6.5 million associated with
extended dating on our trade payables for our seasonal build-up of
merchandise inventory. In addition, we recorded a greater decline in income
taxes receivable of approximately $4.5 million relating to the receipt of
federal income tax refunds during the third quarter of fiscal 2002.
Investing Activities. Net cash used in investing activities increased $16.6
million, or 51.1%, to $49.1 million for the nine months ended October 31,
2002 from $32.5 million for the nine months ended October 31, 2001. This
increase was the result of opening five superstores, growth in remodeling
and expansion activity of certain existing superstores compared to the
prior year, and higher procurement of rental video assets relating to the
growth of DVD and a higher percentage of purchases of non-revenue sharing
titles, which generally cost more per unit than revenue sharing titles.
19
Financing Activities. Cash provided by financing activities is primarily
associated with net borrowings under debt agreements. For the nine months
ended October 31, 2002, such net borrowings increased $4.2 million compared
to the nine months ended October 31, 2001. The increase for fiscal 2002
primarily resulted from items described under Operating Activities and
Investing Activities above.
Capital Structure. On August 23, 2002, we executed an amendment to our
syndicated secured Loan and Security Agreement with Fleet Retail Finance, Inc.
and The CIT Group/Business Credit, Inc, (the "Facility"). The amount outstanding
under the Facility is limited by a borrowing base predicated on eligible
inventory, as defined, and certain rental video assets, net of accumulated
depreciation less specifically defined reserves and is limited to a ceiling of
$80 million, less a $10 million availability reserve. The Facility's interest
rate is based on the prevailing prime rate or LIBOR plus a margin percentage, at
our option. The borrowing base under the Facility is limited to an advance rate
of 65% of eligible inventory and certain rental video assets net of accumulated
amortization less specifically defined reserves, which can be adjusted to reduce
availability under the Facility. The Facility contains no financial covenants,
restricts the payment of dividends and includes certain other debt and
acquisition limitations, allows for the repurchase of up to $7.5 million of our
common stock and requires a minimum availability of $10 million at all times.
The Facility is secured by substantially all of the assets of the company and
our subsidiaries and is guaranteed by each of our three consolidated
subsidiaries. The Facility matures on August 20, 2005. At October 31, 2002, we
had $19.5 million in excess availability, after the $10 million availability
reserve, under the Facility. At October 31, 2002 and January 31, 2002,
respectively, we had borrowings outstanding of $45.6 million and $32.2 million
under the Facility. The average rate of interest being charged under the
Facility was 4.2% and 6.1% at October 31, 2002 and January 31, 2002,
respectively.
From time to time, we enter into interest rate swap agreements in order to
obtain a fixed interest rate on a portion of our outstanding floating rate debt
thereby reducing our exposure to interest rate volatility. On October 4, 2002,
we cancelled, at no cost, two swap agreements entered into in November and
December of 2001 for $10 million each and replaced those agreements with one
interest rate swap agreement with a financial institution. The notional value of
the swap is $20 million of our revolving credit facility at a fixed interest
rate of 2.45% for two years. We have designated the interest rate swap as a
hedging instrument. At October 31, 2002, the fair value of the interest rate
swap was not significant.
At October 31, 2002, the Company's minimum operating lease commitments remaining
for fiscal 2002 were approximately $4.6 million. The present value of total
existing minimum operating lease commitments for fiscal years 2003 through 2019
discounted at 9.0% was approximately $69.7 million as of October 31, 2002.
Seasonality and Inflation
As is the case with many retailers, a significant portion of the Company's
revenues, and an even greater portion of its operating profit, is generated in
the fourth fiscal quarter, which includes the Christmas selling season. As a
result, a substantial portion of the Company's annual earnings has been, and
will continue to be, dependent on the results of the fourth fiscal quarter. The
Company experiences reduced rentals of video activity in the spring because
customers spend more time outdoors. Major world or sporting events, such as the
Super Bowl, the Olympic Games or the World Series, also have a temporary adverse
effect on revenues. Future operating results may be affected by many factors,
including variations in the number and timing of store openings, the number and
popularity of new book, music and videocassette titles, the cost of the new
release or "best renter" titles, changes in comparable-store revenues,
competition, marketing programs, increases in the minimum wage, weather, special
or unusual events, and other factors that may affect retailers in general and
the Company in particular.
The Company does not believe that inflation has materially impacted operating
results during the past three years. Substantial increases in costs and expenses
could have a significant impact on the Company's operating results to the extent
such increases are not passed along to customers.
20
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In the ordinary course of our business, we are exposed to certain market risks,
primarily changes in interest rates. Our exposure to interest rate risk consists
of variable rate debt based on the lenders base rate or LIBOR plus a specified
percentage at our option. The annual impact on our results of operations of a
100 basis point interest rate change on the October 31, 2002 outstanding balance
of the variable rate debt would be approximately $0.3 million, including the
effect of our interest rate swap. After an assessment of these risks to our
operations, we believe that the primary market risk exposures (within the
meaning of Regulation S-K Item 305) are not material and are not expected to
have any material adverse impact on our financial position, results of
operations or cash flows for the next fiscal year. In addition, we do not
believe changes in the fair value of our interest rate swap entered into in
October of 2002 with a notional amount of $20 million will be material.
ITEM 4. CONTROLS AND PROCEDURES
Within 90 days prior to the date of the filing date of this Quarterly Report on
Form 10-Q, our Chief Executive Officer and Chief Financial Officer conducted an
evaluation of the effectiveness of our disclosure controls and procedures (as
defined in Rule 13a-14(c) under the Securities Exchange Act of 1934, as
amended). Based on that evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are
effective to ensure that information required to be disclosed by us in reports
that we file or submit under the Exchange Act is recorded, processed, summarized
and reported within the time periods specified in the SEC's rules and forms.
Subsequent to the date of their evaluation, we did not make any significant
changes in, nor take any corrective actions regarding, our internal controls or
other factors that could significantly affect these controls.
21
PART II
ITEM 1. LEGAL PROCEEDINGS
In 2000, the Company restated its consolidated financial statements for the
first three quarters of fiscal 1999 and the prior four fiscal years. Following
the Company's initial announcement in March 2000 of the requirement for such
restatements, nine purported class action lawsuits were filed in the United
States District Court for the Northern District of Texas against the Company and
certain of the current and former directors and officers of the Company
asserting various claims under Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934. Although four of the lawsuits were originally filed in the
Dallas Division of the Northern District of Texas, all of the five pending
actions have been transferred to the Amarillo Division of the Northern District
and have been consolidated. One of the Section 10(b) and 20(a) lawsuits filed in
the Dallas Division was voluntarily dismissed. On May 15, 2000, a lawsuit was
filed in the United States District Court for the Northern District of Texas
against the Company, its current and former directors and officers at the time
of the Company's June 1998 initial public offering and three underwriters,
Salomon Smith Barney, A.G. Edwards & Sons, Inc. and Furman Selz, LLC asserting
various claims under Sections 11, 12(2) and 15 of the Securities Act of 1933.
Motions to dismiss these actions were filed by the Company and, on September 25,
2001, were denied by the Court.
On September 12, 2002, the Company announced that an agreement in principle to
settle the actions described above had been reached. The settlement requires a
payment of $5.75 million ($3.25 million of which the Company estimates will be
funded from amounts remaining under the Company's director and officer insurance
policy after the payment of litigation expenses) and the assignment to the
plaintiff settlement class of any claims the Company may have had against KPMG
Peat Marwick, LLP, the Company's outside auditors at the time of the March 7,
2000 announcement. The settlement resolves all claims against the Company, its
current and former defendant officers and directors and the defendant
underwriters. Based on the foregoing, the Company recorded a loss contingency of
$2.5 million, or $0.22 per share, during the second quarter of fiscal 2002.
Before completion of the settlement agreements, plaintiffs' counsel informed the
Company that the plaintiff settlement class had settled all claims against KPMG,
including the claims assigned by the Company. Amended settlement agreements that
added the terms of the KPMG settlement with the plaintiff settlement class are
expected to be filed in mid December 2002. The settlement is subject to Court
approval.
The Company is also involved in various other claims and legal actions arising
in the ordinary course of business. In the opinion of management, the ultimate
disposition of these matters will not have a material adverse effect on the
Company's financial position, results of operations and cash flows.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a. List of Exhibits
99.1 Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
b. Reports on Form 8-K
On September 12, 2002, the Company filed a current report on Form 8-K
reporting, under "Item 5. Other Information," that an agreement in
principle had been reached with respect to the shareholder class action
lawsuits filed against the Company in fiscal 2000.
On September 12, 2002, the Company filed a current report on Form 8-K
reporting, under "Item 9. Regulation FD Disclosure," that in connection
with the filing of the quarterly report on Form 10-Q of the Company that
John H. Marmaduke, President and Chief Executive Officer (Principal
Executive Officer) and Dan Crow, Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer) had provided certifications
pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
22
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized:
HASTINGS ENTERTAINMENT, INC.
Date: December 09, 2002 /s/ Dan Crow
---------------------------
Dan Crow
Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
23
CERTIFICATIONS
I, John H. Marmaduke, President and Chief Executive Officer (Principal Executive
Officer) of Hastings Entertainment, Inc., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Hastings
Entertainment, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a. designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b. evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures
based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and audit
committee of registrant's board of directors (or persons performing
the equivalent function):
a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and
report financial data and have identified for the
registrant's auditors any material weaknesses in internal
controls; and
b. any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: December 09, 2002 /s/ John H. Marmaduke
--------------------------
John H. Marmaduke
President and Chief Executive Officer
(Principal Executive Officer)
24
I, Dan Crow, Vice President and Chief Financial Officer (Principal Financial and
Accounting Officer) of Hastings Entertainment, Inc., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Hastings
Entertainment, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a. designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b. evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures
based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and audit
committee of registrant's board of directors (or persons performing
the equivalent function):
a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and
report financial data and have identified for the
registrant's auditors any material weaknesses in internal
controls; and
b. any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: December 09, 2002 /s/ Dan Crow
---------------------------
Dan Crow
Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
25
INDEX TO EXHIBITS
<Table>
<Caption>
Exhibit
Number Description of Documents
------- ------------------------
99.1 Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
</Table>
26