	31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934.

	32.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C Section 1350.

	32.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C Section 1350.

Signatures

Pursuant to the requirements 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~~the registrant has duly caused this report to be signed on its behalf by the fact that they do not relate strictly to historical information and may include words such as "believe," "anticipate," "expect," "intend," "plan," "will," "may," "estimate" or other similar expressions and variations thereof. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Our forward-looking statements are based on management's current intent, belief, expectations, estimates and projections regarding our company and our industry. Forward- looking statements are subject to known and unknown risks and uncertainties, including those described in our Annual Report on Form 10-K for the fiscal year ended January 1, 2006. Forward-looking statements include statements regarding our ability to comply with the covenants contained in our senior credit facility, our ability to make projected capital expenditures and our ability to achieve cost savings in connection with our acquisition of Hollywood Entertainment Corporation, as well as general market conditions, competition and pricing. Our forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially, including, but not limited to, risks and uncertainties that: - - revenues are less than projected; - - we are unable to comply with the revised financial covenants contained in our senior credit facility; - - our real estate subleasing program and other initiatives fail to generate anticipated cost reductions; - - the availability of new movie releases priced for sale negatively impacts consumers' desire to rent movies; - - unforeseen issues arise with the continued integration of the Hollywood Entertainment business; - - our actual expenses or liquidity requirements differ from estimates and expectations; - - consumer demand for movies and games is less than expected; - - the availability of movies and games is less than expected; or - - competitive pressures are greater than anticipated. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this quarterly report on Form 10-Q might not occur. In addition, actual results could differ materially from those suggested by the forward-looking statements, and therefore you should not place undue reliance on the forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. We desire to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, and, in that regard, we caution the readers of this quarterly report on Form 10-Q that the important factors described under Part II, Item 1A. Risk Factors in this quarterly report on Form 10-Q and under Item 1A. Risk Factors in our Annual Report on Form 10-K for the fiscal year ended January 1, 2006, among others, could affect our actual results of operations and may cause changes in our strategy with the result that our operations and results may differ materially from those expressed in any forward-looking statements made by us, or on our behalf. Item 1. Financial Statements Movie Gallery, Inc. Consolidated Balance Sheets (In thousands) ------------------------- January 1, October 1, 2006 2006 ----------- ----------- (Unaudited) Assets Current assets: Cash and cash equivalents $ 135,238 $ 19,634 Merchandise inventory, net 136,450 123,929 Prepaid expenses 41,393 51,226 Store supplies and other 24,194 20,564 ----------- ----------- Total current assets 337,275 215,353 Rental inventory, net 371,565 340,078 Property, furnishings and equipment, net 332,218 272,341 Goodwill, net 118,404 117,626 Other intangibles, net 184,671 182,803 Deposits and other assets 40,995 37,726 ----------- ----------- Total assets $ 1,385,128 $ 1,165,927 =========== =========== Liabilities and stockholders' deficit Current liabilities: Current maturities of long-term obligations $ 78,146 $ 781,559 Current maturities of financing obligations 4,492 982 Accounts payable 236,989 78,799 Accrued liabilities 88,460 78,511 Accrued payroll 38,624 42,726 Accrued interest 7,220 16,207 Deferred revenue 39,200 33,014 ----------- ---------- Total current liabilities 493,131 1,031,798 Long-term obligations, less current portion 1,083,083 322,371 Other accrued liabilities 21,662 32,570 Deferred income taxes 70 88 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 199,151 197,074 Unearned compensation (4,128) - Retained deficit (417,882) (428,541) Accumulated other comprehensive income 10,009 10,535 ----------- ----------- Total stockholders' deficit (212,818) (220,900) ----------- ----------- Total liabilities and stockholders' deficit $ 1,385,128 $ 1,165,927 =========== =========== The accompanying notes are an integral part of this financial statement. Movie Gallery, Inc. Consolidated Statements of Operations (Unaudited, in thousands, except per share amounts) Thirteen Weeks Ended Thirty-Nine Weeks Ended ----------------------- ----------------------- October 2, October 1, October 2, October 1, 2005 2006 2005 2006 --------- --------- ---------- ---------- Revenue: Rentals $ 473,086 $ 475,779 $1,109,661 $1,539,754 Product sales 99,356 107,210 201,301 338,888 --------- --------- --------- --------- Total revenue 572,442 582,989 1,310,962 1,878,642 Cost of sales: Cost of rental revenue 136,236 141,589 345,159 470,073 Cost of product sales 70,080 78,160 141,896 249,455 -------- --------- -------- --------- Gross profit 366,126 363,240 823,907 1,159,114 Operating costs and expenses: Store operating expenses 319,919 322,643 690,592 944,495 General and administrative 40,020 44,022 93,014 134,853 Amortization of intangibles 1,163 701 2,718 2,142 -------- -------- -------- -------- Operating income (loss) 5,024 (4,126) 37,583 77,624 Interest expense, net (24,427) (31,185) (41,430) (89,331) Write-off of bridge financing - - (4,234) - Equity in losses of unconsolidated entities - - (806) - -------- -------- -------- -------- Loss before income taxes (19,403) (35,311) (8,887) (11,707) Income taxes (benefit) (6,934) 800 (2,622) (1,048) -------- -------- -------- -------- Net loss $(12,469) $(36,111) $ (6,265) $(10,659) ======== ======== ======== ======== Net loss per share: Basic $ (0.39) $ (1.13) $ (0.20) $ (0.34) Diluted $ (0.39) $ (1.13) $ (0.20) $ (0.34) Weighted average shares outstanding: Basic 31,640 31,840 31,471 31,786 Diluted 31,640 31,840 31,471 31,786 Cash dividends per common share $ - $ - $ 0.06 $ - The accompanying notes are an integral part of this financial statement. Movie Gallery, Inc. Consolidated Statements of Cash Flows (Unaudited, in thousands) Thirty-Nine Weeks Ended ----------------------- October 2, October 1, 2005 2006 --------- --------- Operating activities: Net loss $ (6,265) $(10,659) Adjustments to reconcile net loss to net cash provided by (used in)operating activities: Rental inventory amortization 152,018 167,259 Purchases of rental inventory (120,135) (125,246) Purchases of rental inventory-base stock (16,569) (10,527) Depreciation and intangibles amortization 60,206 79,214 Accretion on asset retirement obligations - 3,022 Loss on disposal of property, furnishings and equipment 1,363 3,675 Stock-based compensation 1,098 2,073 Tax benefit of stock options exercised 3,301 - Amortization of debt issuance cost 2,235 4,952 Deferred income taxes (11,557) 18 Changes in operating assets and liabilities, net of business acquisitions: Extended viewing fees receivable, net 20,259 - Merchandise inventory 8,516 12,634 Other current assets (3,948) (7,075) Deposits and other assets (2,053) 2,567 Accounts payable (82,258) (157,454) Accrued interest 29,193 8,986 Accrued liabilities and deferred revenue 13,336 (8,508) --------- --------- Net cash provided by (used in) operating activities 48,740 (35,069) Investing activities: Business acquisitions, net of cash acquired (1,096,265) (319) Purchase of property, furnishings and equipment (48,873) (19,145) Proceeds from disposal of property, furnishings and equipment 2,107 1,320 Acquisition of construction phase assets, net 2,154 3,553 --------- --------- Net cash used in investing activities (1,140,877) (14,591) Financing activities: Repayment of capital lease obligations (265) (412) Decrease in financing obligations (2,412) (3,510) Net borrowings on credit facilities 9,046 13,142 Debt financing fees (32,452) (5,528) Proceeds from issuance of long-term debt 1,166,120 1,948 Principal payments on long-term debt (8,367) (72,392) Proceeds from exercise of stock options 5,318 - Proceeds from employee stock purchase plan 169 - Payment of dividends (2,827) - --------- --------- Net cash provided by (used in) financing activities 1,134,330 (66,752) Effect of exchange rate changes on cash and cash equivalents 1,044 808 --------- --------- Increase (decrease) in cash and cash equivalents 43,237 (115,604) Cash and cash equivalents at beginning of period 25,518 135,238 --------- --------- Cash and cash equivalents at end of period $ 68,755 $ 19,634 ========= ========= The accompanying notes are an integral part of this financial statement. Movie Gallery, Inc. Notes to Consolidated Financial Statements (Unaudited) October 1, 2006 1. Accounting Policies Principles of Consolidation The accompanying financial statements present the consolidated financial position, results of operations and cash flows of Movie Gallery, Inc. and its subsidiaries (the "Company"). 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. Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete consolidated financial statements. The balance sheet at January 1, 2006 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments and accruals) considered necessary for a fair presentation have been included. Operating results for the thirteen-week and thirty-nine week periods ended October 1, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2006. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the fiscal year ended January 1, 2006. 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' deficit or net loss. During the fourth quarter of fiscal year 2005, we began to classify purchases of rental inventory-base stock in operating activities rather than investing activities. The accompanying consolidated statements of cash flows for the thirty-nine weeks ended October 2, 2005 has been revised to reflect all purchases of rental inventory as operating cash uses. The statement of cash flows for the thirty-nine weeks ended October 2, 2005 has also been 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. On March 29, 2005, the SEC published Staff Accounting Bulletin No. 107 ("SAB 107"), which provides the Staff's views on a variety of matters relating to stock-based payments upon adoption of Statement of Financial Accounting Standard 123(R), "Share-Based Payment." SAB 107 requires that stock-based compensation be classified in the same expense line items as cash compensation. Accordingly, stock-based compensation for the thirteen and thirty-nine weeks ended October 2, 2005 has been reclassified in the statement of operations to correspond to current year presentation within the same operating expense line items as cash compensation paid to employees. Change in Accounting Estimate for Rental Inventory 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 by approximately $0 and $11.3 million for the thirteen and thirty-nine weeks ended October 1, 2006, respectively. This reduced net income by $0 and $12.2 million (net of tax), or $0.00 and $0.38 per diluted share, for the thirteen and thirty-nine weeks ended October 1, 2006, respectively. Earnings Per Share Basic earnings per share are computed based on the weighted average number of shares of common stock outstanding during the periods presented. Diluted earnings per share are 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. Due to our loss for the thirteen weeks and thirty-nine weeks ended October 2, 2005, securities consisting of options convertible into 215,000 and 319,000 shares of common stock and 0 and 8,000 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 the thirteen weeks and thirty-nine weeks ended October 1, 2006, securities consisting of options convertible into 66,000 and 68,000 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 In June 2003, our Board of Directors adopted, and our stockholders approved, the Movie Gallery, Inc. 2003 Stock Plan (the "2003 Plan"), which was subsequently amended in June 2005 (Second Amendment) to reserve an additional 3,500,000 shares of our common stock for future grants of awards. The plan provides for the award of stock options, restricted stock and stock appreciation rights to employees, directors and consultants. Prior to adoption of the 2003 Plan, stock option awards were subject to our 1994 Stock Plan, which expired in 2004. As of October 1, 2006, 5,261,168 shares are reserved for issuance under the plans. Options granted under the plans have a ten-year term and generally vest over four years. Prior to January 1, 2006, we accounted for stock-based compensation in accordance with Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"), and followed the disclosure-only provisions of Statement of Financial Accounting Standard ("SFAS") No. 123, "Accounting for Stock-Based Compensation" ("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, except for the variable options as described in our Annual Report on Form 10-K for the fiscal year ended January 1, 2006. Effective with our fiscal year beginning January 2, 2006, we adopted SFAS No. 123(R), "Share-Based Payment" ("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 1, 2006, as well as the unvested portion of previously granted options. 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. However, we expect to 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 year 2004 and 2005 and the thirty-nine weeks ended October 1, 2006 were as follows: Thirty-nine Weeks Fiscal Year Ended Ended ----------------------- ---------- January 2, January 1, October 1, 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. 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 Emerging Issues Task Force ("EITF") Issue No. 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) supersedes 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 the third quarter of fiscal 2006. Fair Value Disclosures - Prior to SFAS No. 123(R) Adoption Stock-based compensation for the thirteen and thirty-nine weeks ended October 2, 2005 was determined using the intrinsic value method. The following table provides supplemental information for the thirteen and thirty-nine weeks ended October 2, 2005 as if stock-based compensation had been computed under SFAS No. 123 (in thousands, except per share data): Thirteen Weeks Ended Thirty-nine Weeks Ended -------------------- ----------------------- October 2, October 2, 2005 2005 --------- ---------- Net loss, as reported $ (12,469) $ (6,265) Add: Stock based compensation included in reported net loss, net of tax 442 774 Deduct: Stock based compensation determined under fair value based methods for all awards, net of tax (1,087) (1,887) --------- --------- Pro forma loss $ (13,114) $ (7,378) ========= ========= Net loss per share, as reported: Basic $ (0.39) $ (0.20) Diluted $ (0.39) $ (0.20) Pro forma net loss, per share: Basic $ (0.41) $ (0.23) Diluted $ (0.41) $ (0.23) A summary of our stock option activity and related information is as follows: Weighted- Outstanding Average Exercise Options Price Per Share ------------ --------------- Outstanding at January 1, 2006 976,751 14.33 Granted 0.00 0.00 Exercised 0.00 0.00 Cancelled (100,563) 18.57 ------------ Outstanding at October 1, 2006 876,188 13.84 ============ Exercisable at January 1, 2006 976,751 14.33 Exercisable at October 1, 2006 876,188 13.84 The total intrinsic value of options exercised was $8.9 million and $0 for the fiscal year ended January 1, 2006 and for the thirty-nine weeks ended October 1, 2006, respectively. Options outstanding as of October 1, 2006 had a weighted-average remaining contractual life of approximately 5 years and exercise prices ranging from $1.00 to $22.00 as follows: Exercise price of ----------------------------------------------- $1.00 to $6.00 to $13.00 to $3.00 $12.00 $22.00 -------------- --------------- ---------------- Options outstanding 181,864 78,750 615,574 Weighted-average exercise price $1.64 $6.22 $18.42 Weighted-average remaining contractual life 3.2 years 0.1 years 6.6 years Options exercisable 181,864 78,750 615,574 Weighted-average exercise price of exercisable options $1.64 $6.22 $18.42 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 $1.6 million for the fiscal year ended January 1, 2006 and for the thirty-nine weeks ended October 1, 2006, respectively. The total grant date fair value of service- based share awards vested during the fiscal year ended January 1, 2006 and the thirty-nine weeks ended October 1, 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 (75,924) 22.72 --------- Outstanding at October 1, 2006 1,344,417 7.99 ========== 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 $0.5 million for performance-based stock grants was recognized for the fiscal year ended January 1, 2006 and for the thirty-nine weeks ended October 1, 2006, respectively, using the accelerated expense attribution method under SFAS Interpretation No. 28 (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 October 1, 2006 25,000 30.03 ========== The total grant date fair value of performance-based share awards vested during the fiscal year ended January 1, 2006 and the thirty-nine weeks ended October 1, 2006 was $0 and $1.5 million, respectively. Total compensation cost related to all non-vested awards that is not yet recognized was $9.2 million at October 1, 2006, and is expected to be recognized over a weighted-average period of approximately three years. Recently Issued Accounting Pronouncements On March 28, 2006, the Financial Accounting Standards Board ("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. 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 (FIN 48), "Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109," 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 April 2006, the FASB issued FSP FIN 46(R)-6 "Determining the Variability to be Considered in Applying FASB Interpretation No. 46(R)-6", or FSP FIN 46(R)-6, which addresses certain major implementation issues related to FASB Interpretation No. 46(R)6. FSP FIN 46(R)-6 is effective prospectively for all entities (including newly created entities) with which that enterprise first becomes involved and to all entities previously required to be analyzed under FIN 46(R). We are in the process of evaluating the effect of FSP FIN 46(R)-6 on our financial statements. In September 2006, the FASB issued FASB Statement No. 157 (SFAS 157), "Fair Value Measurements", 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 157 is effective for us for fiscal years beginning after November 15, 2007. We are in the process of evaluating the effect of SFAS 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" (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. We are in the process of evaluating the effect of SAB 108 on our financial statements. 2. Business Combinations Merger of Movie Gallery and Hollywood On April 27, 2005, Movie Gallery and Hollywood Entertainment Corporation ("Hollywood") completed their previously announced merger pursuant to the Agreement and Plan of Merger, dated as of January 9, 2005 (the "Merger Agreement"). Upon the consummation of the merger, Hollywood became a wholly- owned subsidiary of Movie Gallery. As of the date of the merger, Hollywood operated 2,031 specialty home video retail stores and 20 free-standing video game stores throughout the United States. The merger was made as a strategic expansion of our geographic and urban markets. Under the terms of the Merger Agreement, Hollywood shareholders received $13.25 in cash for each Hollywood share they owned. Approximately $862.1 million in cash was paid in exchange for (i) all outstanding common stock of Hollywood and (ii) all outstanding vested and unvested stock options of Hollywood. Hollywood's outstanding indebtedness was repaid at the time of the merger for a total of $381.5 million, of which $161.4 million was paid by Hollywood with the remainder funded by Movie Gallery with proceeds from a new credit facility ("Credit Facility") and the issuance of $325.0 million principal amount of 11% Senior notes due 2012 ("Senior Notes"). The total consideration paid was approximately $1.1 billion, including transaction costs of $10.0 million. The merger has been treated as a purchase business combination for accounting purposes, and, as such, Hollywood's assets acquired and liabilities assumed have been recorded at their estimated fair values. The purchase price for the acquisition, including transaction costs, 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 further adjustments may be required in 2006 as we complete the analysis of the acquired tax basis of certain assets and carryover tax attributes of Hollywood. The purchase price allocation has been revised in the periods following the acquisition in accordance with SFAS 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 our initial purchase price allocation, together with subsequent revisions and the resulting revised allocation reflected in the accompanying consolidated balance sheets (in thousands): As of Initial Subsequent October Allocation Revisions 1, 2006 Current Assets: Cash and cash equivalents $ 18,733 $ - $ 18,733 Extended viewing fees receivable, net 21,369 - 21,369 Merchandise inventory 122,468 - 122,468 Prepaid expenses 27,632 - 27,632 Store supplies and other 18,146 (5,107) 13,039 ---------- --------- ---------- Total current assets 208,348 (5,107) 203,241 Rental inventory 227,800 - 227,800 Property, furnishings and equipment 238,279 49 238,328 Goodwill 474,990 3,707 478,697 Other intangibles 183,894 - 183,894 Deferred income taxes 64,944 (13,708) 51,236 Deposits and other assets 1,662 - 1,662 ---------- --------- ---------- Total assets acquired 1,399,917 (15,059) 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 182,963 (14,728) 168,235 Accrued liabilities 65,507 6,984 72,491 Accrued payroll 19,691 (1,147) 18,544 Accrued interest 39 - 39 Deferred revenue 27,552 (6,168) 21,384 ---------- --------- ---------- Total current liabilities 306,694 (15,059) 291,635 Long-term obligations, less current portion 941 - 941 Total liabilities 307,635 (15,059) 292,576 ---------- --------- ---------- Net assets acquired $1,092,282 $ - $1,092,282 ========== ========= ========== The initial allocation shown above was based on the unaudited balance sheet as of April 27, 2005, and our preliminary estimates of fair value, which were revised and adjusted throughout fiscal 2005 and the third quarter of fiscal 2006 as we completed the analysis of various balance sheet accounts and refined the estimates of the fair values of assets acquired and liabilities assumed. For the thirty-nine weeks ended October 1, 2006, adjustments were made to the purchase price allocation for accrued liabilities, deferred income taxes, accounts receivable, and property, furnishings and equipment totaling $0.9 million. Following is a summary of the nature of the significant revisions and the facts and circumstances that required the revisions shown in the preceding table: - - Store supplies and other: We decreased the balance in store supplies by $5.4 million based on the results of subsequent physical inventories and revised estimates. We increased legal-related receivables by $0.3 million related to pre-acquisition legal contingencies and the related insurance coverage. - - Deferred income taxes: We wrote-off Hollywood's pre-acquisition deferred income tax balances and set-up new deferred income tax balances based on the differences between the financial reporting basis of assets and liabilities and their underlying tax basis, including amounts assigned to Hollywood's carryover tax attributes. The net impact of these adjustments decreased deferred tax assets by $13.7 million. - - Accounts payable: During fiscal 2005, we completed an analysis of accounts payable to our studio vendors based on detailed reconciliations and revised estimates, the net effect of which decreased accounts payable by $14.7 million as of April 27, 2005. - - Accrued liabilities: The revisions to the initial allocation included: - recorded a $6.6 million liability for employee separation costs for Hollywood employees who were terminated shortly before and after the merger in accordance with EITF 95-3, "Recognition of Liabilities in Connection with a Purchase Business Combination;" - adjusted Hollywood's favorable and unfavorable operating leases to net fair value of $2.9 million, based on a report received from an independent valuation consultant in the third quarter; - reduced Hollywood's pre-acquisition legal contingencies $0.6 million to the amount we concluded was probable based on management's assessment of the individual matters using all available information; - reduced accruals for Hollywood's pre-merger expenses by $2.0 million to reflect the actual amounts paid; - established $3.1 million in reserves for store closures in accordance with EITF 95-3 to reflect the cost of remaining lease obligations for closed stores and other costs associated with 50 Game Crazy departments that were closed shortly after the merger; and - recorded a reduction of $3.0 million in income tax and franchise tax liabilities based on subsequent analyses of Hollywood's tax accounts, after giving consideration to the effects of merger-related transactions. - - Accrued payroll: We reduced our estimate of Hollywood's accrued bonuses by $1.1 million to reflect actual amounts subsequently earned (considering the impact of employee separations and changes to the bonus plans implemented as of the transaction date by Movie Gallery). - - Deferred revenue: We decreased Hollywood's deferred revenue associated with stored value (gift) card by $6.2 million to reflect the estimated fair value associated with redemptions in accordance with EITF 01-3, "Accounting in a Business Combination for Deferred Revenue of an Acquiree." This adjustment was determined, in part, based on an analysis of the fair value completed by the valuation advisors in the third quarter of fiscal 2005. We allocated approximately $183.9 million of the purchase price to identifiable intangible assets, of which approximately $170.9 relates to the indefinite- lived trade name of Hollywood Video. The remaining intangible assets include finite-lived trade names and customer lists, which will be amortized over their estimated useful lives, which are 15 years and 5 years, respectively. The fair value of these intangible assets was determined by independent valuations advisors. After giving consideration to the effect of the revisions described above, we allocated a total of $478.7 million to goodwill, against which an impairment charge of $361.2 million was recorded in fiscal 2005. We paid a substantial premium to acquire Hollywood for several reasons, including: - - Expanded geographic footprint: The merger created a strong number two competitor in the specialty home video retail industry that combines Hollywood's prime urban superstore locations with Movie Gallery's substantial presence in rural and suburban markets. The two companies possessed minimal store overlap as a result of Movie Gallery's significant East Coast presence and focus on rural and suburban locations and Hollywood's significant West Coast presence and focus on urban locations. - - Cost savings: The combined operations of Movie Gallery and Hollywood are expected to achieve cost benefits resulting from the reduction of duplicative general and administrative costs and the realization of scale economies with respect to products and services purchased from studios and merchandisers. - - Operating efficiencies: The combined operations of Movie Gallery and Hollywood are expected to improve operational performance due to greater distribution density, consolidation of duplicative functions and the adoption of best practices at the 4,675 store locations for the combined company. In addition, in order to acquire Hollywood, we participated in a competitive bidding process against Leonard Green & Partners L.P. and Blockbuster, Inc. Our successful bid was $1.25 per share lower than Blockbuster, Inc.'s bid. However, Hollywood's stock (NASDAQ: HLYW) was trading at a significant premium to book value due, in part, to merger and acquisition speculation. The operations of Hollywood Entertainment have been included in our consolidated results of operations from April 27, 2005 forward. The following pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the merger had taken place as of the beginning of 2005, nor is it indicative of future results. In addition, the following pro forma information has not been adjusted to reflect any operating efficiencies that may be realized as a result of the merger, except for the elimination of certain redundant executive compensation costs for terminated corporate personnel, substantially all of which occurred shortly after the merger. The unaudited pro forma financial information in the table below summarizes the combined results of operations of Movie Gallery and Hollywood Entertainment for the thirty-nine weeks ended October 2, 2005 as though the companies had been combined as of the beginning of fiscal 2005. (unaudited) (in thousands, except per share data) Thirty-nine weeks ended October 2, 2005 --------------- Total revenue $ 1,926,705 Operating income 100,087 Net income 14,396 Net income per share: Basic 0.46 Diluted 0.45 The summary pro forma data includes adjustments to depreciation, amortization and lease expenses to reflect the allocation of purchase price to record Hollywood's assets and liabilities at their estimated fair values. In addition, pro forma net income reflects increases in interest expense related to the incremental borrowings under our bank credit facilities and Senior Notes as if such financing had taken place at the beginning of fiscal 2005. The historical financial data of Hollywood (not separately presented herein) for periods prior to the merger (included in the pro forma presentation above), includes $21.1 million (before taxes) of transactions costs and professional services related to merger activities. Merger Reserves We closed 50 Game Crazy departments shortly after the acquisition date for a total cash cost of $0.3 million. The costs associated with these department closures were not charged to current operations, but rather were recognized as acquired liabilities in purchase accounting, resulting in an increase to goodwill. 3. Property, Furnishings and Equipment Property, furnishings and equipment consists of the following (in thousands): ----------- ---------- January 1, October 1, 2006 (1) 2006 ----------- ---------- Land and buildings $ 19,372 $ 20,211 Fixtures and equipment 244,320 246,749 Leasehold improvements 284,737 281,482 Asset retirement obligation - 5,924 Construction phase assets 4,542 989 Equipment under capital lease 1,659 1,659 ----------- ---------- 554,630 557,014 Less accumulated depreciation and amortization (222,412) (284,673) ----------- ---------- $ 332,218 $ 272,341 =========== ========== (1) Amounts reflect an adjustment of $36.2 million to conform presentation between Movie Gallery and Hollywood segments from signage (fixtures and equipment) to leasehold improvements. Accumulated depreciation and amortization, as presented above, includes accumulated amortization of assets under capital leases of $0.3 and $0.6 million at January 1, 2006 and October 1, 2006, respectively. Depreciation expense related to property, furnishings and equipment was $28.2 million and $77.0 million for the thirteen and thirty-nine weeks ended October 1, 2006, respectively, compared to $30.3 million and $57.5 million for the corresponding periods in 2005. 4. Income Taxes In the ordinary course of business, there may be many transactions and calculations where the ultimate tax outcome is uncertain. The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax laws. No assurance can be given that the final outcome of these matters will not be different than what is reflected in the current and historical income tax provisions and accruals. The effective tax rate was an expense of 2.3% and a benefit of 8.9% for the thirteen and thirty-nine weeks ended October 1, 2006, respectively, as compared to a benefit of 35.7% and 29.5% for corresponding prior year periods. The projected annual effective tax rate is a benefit of 4.2% which differs from the expense of 2.3% for the quarter ended October 1, 2006 due to the interaction between valuation allowances against our deferred tax assets and net operating losses which have been incurred and changes to contingent liabilities and equity compensation. The low annual effective rate is primarily a result of changes in previously established valuation allowances for our deferred tax assets. Because of the existence of the valuation allowance against our deferred tax assets, we generally expect that our federal income tax provision will be low until such time as the valuation allowance is depleted through future taxable income or until we determine it is no longer necessary. Likewise, we do not currently expect that we will be able to recognize any significant federal income tax benefit on future net operating losses because those benefits would most likely cause us to increase the valuation allowance by a corresponding amount in the foreseeable future. 5. Goodwill and Other Intangible Assets The components of goodwill and other intangible assets are as follows (in thousands): January 1, 2006 October 1, 2006 Weighted- ------------------------ --------------------- Average Gross Gross Amortization Carrying Accumulated Carrying Accumulated Period Amount Amortization Amount Amortization ------------ -------- ------------ -------- ------------ Goodwill Segments: Movie Gallery - $ - $ - $ 147 $ - Hollywood Video - 118,404 - 117,479 - -------- ------------ -------- ------------ Total goodwill $118,404 $ - $117,626 $ - ======== ============ ======== ============ Other intangible assets: Non-compete agreements 8 years $ 12,205 $ (10,110) $ 12,293 $ (10,717) Trademarks: Hollywood Video Indefinite 170,959 - 171,159 - Game Crazy 15 years 4,000 (178) 4,000 (378) Customer lists 5 years 8,994 (1,199) 8,994 (2,548) -------- ------------ -------- ------------ $196,158 $ (11,487) $196,446 $ (13,643) ======== ============ ======== ============ Estimated amortization expense for other intangible assets for the remainder of fiscal 2006 and the five succeeding fiscal years is as follows (in thousands): 2006 696 2007 2,698 2008 2,476 2009 2,289 2010 958 2011 292 The changes in the carrying amounts of goodwill for the fiscal year ended January 1, 2006 and the thirty-nine weeks ended October 1, 2006, are as follows (in thousands): Net balance as of January 2, 2005 $ 143,761 Goodwill acquired (including revisions) 497,593 Impairment (522,950) ----------- Net balance as of January 1, 2006 118,404 Goodwill acquired 147 Change in goodwill (925) ----------- Net balance as of October 1, 2006 $ 117,626 =========== 6. Store Closure, Merger 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 stores. In addition to these closures, we continue to evaluate underperforming stores and stores that have overlap trade areas in our Movie Gallery, Hollywood and Game Crazy segments. We anticipate closing approximately 230 underperforming and overlap stores during fiscal 2006. For the thirty-nine weeks ended October 1, 2006, we have recognized $9.1 million in store closure expenses, of which $3.7 million is related to the loss on the disposal of fixed assets. Movie Hollywood Gallery Video Total ---------- --------- --------- Store closure reserve: Balance as of January 1, 2006 $ 10,112 $ 3,613 $ 13,725 Additions and adjustments 5,065 (216) 4,849 Reclassifications (1) (1,921) - (1,921) Payments (3,808) (564) (4,372) ---------- --------- -------- Balance as of October 1, 2006 $ 9,448 $ 2,833 $ 12,281 ========== ========= ======== (1) In the first quarter of fiscal 2006, $1.9 million of accrued estimated fixed assets disposals were reclassified from current liabilities into property, furnishings and equipment, net. Merger and 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 are required to render service for a range of 10 to 49 weeks in order to receive termination benefits. We currently estimate that the total cost of providing severance, retention incentives and outplacement services to all impacted associates will be approximately $2.5 million, of which approximately $1.2 million and $1.3 million was recognized during the fiscal year ended January 1, 2006 and the thirty-nine weeks ended October 1, 2006, respectively, in accordance with SFAS No. 146, "Accounting for Costs Associated with Disposal and Exit Activities." Severance, retention incentives and outplacement services costs are recognized in store operating expenses and general and administrative expense. Cash payments of $1.4 million were charged to the reserve during the thirty-nine weeks ended October 1, 2006. 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 the Dothan, Alabama corporate offices, and the affected Hollywood employees were notified that their positions will be relocated. We established merger 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. We recorded a $6.6 million reserve for costs associated with severance and benefits for the impacted individuals. Payments to these individuals will be made over the severance period in accordance with the severance agreements. Total payments of $2.5 million and $1.8 million were made for the fiscal year ended January 1, 2006 and the thirty-nine weeks ended October 1, 2006, respectively, leaving a $2.3 million reserve as of October 1, 2006. Movie Hollywood Gallery Video Total Termination benefits: ---------- --------- -------- Balance as of January 1, 2006 $ 1,190 $ 4,116 $ 5,306 Additions and adjustments 1,301 - 1,301 Payments (1,410) (1,825) (3,235) ---------- --------- -------- Balance as of October 1, 2006 $ 1,081 $ 2,291 $ 3,372 ========== ========= ======== Estimated future additions and adjustments $ 50 $ - $ 50 Total termination benefits cost $ 2,541 $ 6,655 $ 9,196 7. Long-Term Debt Long term debt consists of the following (in thousands): January 1, October 1, Instrument 2006 2006 - ----------------------------------- ---------- ---------- Movie Gallery senior notes $ 321,489 $ 321,905 Credit Facility: Term A Loan 85,500 71,447 Term B Loan 746,250 689,915 Revolving credit facility 6,862 20,004 Hollywood senior subordinated notes 450 450 Capital leases 678 209 ----------- ---------- Total 1,161,229 1,103,930 Less current portion (78,146) (781,559) ----------- ---------- $1,083,083 $ 322,371 =========== ========== As of October 1, 2006, we were in compliance with our Credit Facility financial covenants. We anticipate complying with the financial covenants contained in the Credit Facility, as amended, at each test date through the remainder of fiscal 2006. However, unless we are successful in obtaining an additional amendment to the financial covenants in our Credit Facility, our projected operating results indicate that we will fail the more restrictive financial covenant tests effective as of April 1, 2007. As a result, in accordance with EITF 86-30, "Classification of Obligations When a Violation is Waived by a Creditor," all amounts outstanding under the Credit Facility have been classified as current liabilities as of October 1, 2006. To the extent such a breach occurs, one or more events of default, including cross-defaults between multiple components of our indebtedness, could result. These events of default could permit our creditors to declare all amounts owing to be immediately due and payable and to terminate any commitments to make further extensions of credit. If we are unable to repay our indebtedness, our secured creditors could proceed against the collateral securing the indebtedness owed to them. If amounts outstanding under the Credit Facility were accelerated by the lenders due to a covenant violation, amounts under other agreements, such as the indenture governing our 11% Senior Notes and certain leases, could also become due and payable immediately. Should the amounts outstanding under the Credit Facility be accelerated and become due and payable because of our failure to comply with applicable debt covenants in the future, we would be required to search for alternative measures to finance current and ongoing obligations of our business. There can be no assurance that such financing would be available on acceptable terms, if at all. Our ability to obtain future financing or to sell assets to provide additional funding could be adversely affected because we have substantial indebtedness and substantially all of our assets have been secured as collateral under the Credit Facility. In addition, our financial results, our substantial indebtedness, and our reduced credit ratings could adversely affect the availability and terms of financing for us. Further, uncertainty surrounding our ability to finance our obligations has caused some of our trade creditors to impose increasingly less favorable terms, and continuing uncertainty could result in even more unfavorable terms from our trade creditors. Any of these scenarios could adversely impact our liquidity and results of operations. We are exploring several alternative strategies to facilitate further amendments to or a refinancing of our Credit Facility, 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, or that further debt amendments or additional debt or equity financings can be obtained on acceptable terms, if at all. Credit Facility The Credit Facility, which we entered into in connection with our acquisition of Hollywood Entertainment Corporation ("Hollywood"), provides for aggregate borrowings of $836.4 million, consisting of a five-year $75.0 million revolving credit facility due April 27, 2010 (the "Revolver") and two term loans in an aggregate principal amount of $761.4 million as of October 1, 2006. Term Loan A is a $71.5 million loan that matures on April 27, 2010, and Term Loan B is a $689.9 million loan that matures on April 27, 2011. At October 1, 2006, we had $43.8 million drawn under the Revolver, comprised of $23.8 million in letters of credit and $20.0 million in borrowings. On March 15, 2006, we executed a second amendment to the Credit Facility, effective through the fourth quarter of 2006 that relaxed financial covenants, increased restrictive operating covenants and increased interest rate margins. The quarterly financial covenants revert to the original covenants commencing with 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 $19.0 million of unamortized deferred financing costs associated with the Credit Facility. We incurred significant fees related to the second amendment totaling $5.5 million, which have been deferred in accordance with EITF 96-19 and will be amortized over the remaining term of the Credit Agreement. Borrowings under the Term Loan A and the Revolver bear interest at LIBOR plus the following margin based upon a leverage ratio described below: Leverage Ratio LIBOR Margin > 4.00 5.00% 3.25 - 4.00 3.50% 2.75 - 3.25 2.75% 2.25 - 2.75 2.50% 1.75 - 2.25 2.25% < 1.75 2.00% Borrowings under the Term Loan B bear interest at a rate of LIBOR plus 5.25% if our leverage ratio exceeds 4.00; otherwise the rate will be LIBOR plus 3.75%. As of October 1, 2006, the Revolver/Term Loan A and Term Loan B interest rates are 10.37% and 10.62%, respectively. When the leverage ratio is greater than or equal to 4.00, at our discretion, we can elect to defer payment of 0.50% of the Term Loan A, Term Loan B and Revolver interest as non-cash interest, which will be capitalized into the loans (with compounding interest). For the thirteen and thirty-nine weeks ended October 1, 2006, we have recapitalized $1.0 million and $2.0 million of interest, respectively. The Credit Facility is fully and unconditionally guaranteed on a joint and several basis by our domestic subsidiaries. The Credit Facility is secured by first priority security interests in, and liens on, substantially all of our direct and indirect subsidiaries' tangible and intangible assets (other than leasehold mortgages on stores) and first priority pledges of all the equity interests owned by us in our existing and future direct and indirect wholly owned domestic subsidiaries and 66 2 / 3 % of the equity interests owned by us in our existing and future wholly owned non-domestic subsidiaries. The Credit Facility requires us to meet certain financial covenants including a leverage ratio test, a fixed charge coverage ratio test and an interest coverage test. Each of these covenants is calculated on trailing four quarter results based on specific definitions that are contained in the credit agreement. In general terms, the leverage ratio is a measurement of total net indebtedness relative to operating cash flow. The fixed charge coverage ratio is a measurement of operating cash flow plus rent relative to total fixed charges including rent, scheduled principal payments, and cash interest. The interest coverage ratio is a measurement of operating cash flow relative to interest expense. The covenant levels under the Credit Facility are as follows: Leverage Fixed Charge Interest Coverage Ratio Coverage Ratio Ratio 2006 Q3 6.75 1.00 1.45 2006 Q4 6.50 1.00 1.45 2007 Q1 2.25 1.10 3.00 2007 Q2 2.25 1.10 3.00 The 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; 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. Term Loan A and Term Loan B require aggregate quarterly prepayments of principal in the amounts of 5.0% and 0.25%, respectively, of the outstanding balances through the first quarter of fiscal 2010, after which the mandatory Term Loan B prepayments escalate. In addition to these prepayments, the Credit Facility also requires us to make prepayments in an amount equal to 100% of any excess cash flow, which generally represents the amount of cash generated by the Company but not used towards operations, debt service, or investments. Based upon our operating results for the thirty-nine weeks ended October 1, 2006 and projected operating results for the remainder of fiscal 2006, we do not believe that we that we will be 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 (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. 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. Accordingly, prior to filing this Quarterly Report on Form 10-Q, the Company was in violation of this covenant. We believe that with this filing the violation was cured. In addition, the senior notes may be accelerated if an event of default occurs under our Credit Facility. Because no events of default have occurred under the Credit Facility as of October 1, 2006 and through the date of our filing of the Form 10-Q no events of acceleration have occurred. Therefore, we believe that the Senior Notes continue to be appropriately classified as long-term as of October 1, 2006. Interest Rate Hedge Our Credit Facility requires 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 three-month LIBOR. The scheduled termination date for both of these swaps was June 29, 2007. Subsequent to the thirty-nine weeks ended October 1, 2006, 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 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 three-month LIBOR. The termination date for the new 5.50% cap agreement is April 27, 2007. 8. Comprehensive Income Comprehensive income is as follows (in thousands): Thirteen Weeks Ended Thirty-nine Weeks Ended ---------------------- ---------------------- October 2, October 1, October 2, October 1, 2005 2006 2005 2006 --------- --------- --------- --------- Net loss $ (12,469) $ (36,111) $ (6,265) $(10,659) Foreign currency translation adjustment 2,398 (523) 1,044 808 Change in value of interest rate swap - (135) - (282) --------- --------- --------- --------- Comprehensive loss $ (10,071) $ (36,769) $ (5,221) $ (10,133) ========= ========= ========= ========= 9. Commitments and Contingencies Hollywood and the members of its former board of directors (including Hollywood's former chairman, Mark Wattles) were named as defendants in several lawsuits in the Circuit Court in Clackamas County, Oregon. The lawsuits, filed between March 31, 2004 and April 14, 2004, asserted breaches of duties associated with the merger agreement executed by Hollywood with a subsidiary of Leonard Green & Partners, L.P., or 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. Hollywood denies these allegations and is vigorously defending this lawsuit. Hollywood was named as a defendant in a sexual harassment lawsuit filed in the Supreme Court of the State of New York, Bronx County on April 17, 2003. The action, filed by eleven former female employees, alleges that an employee, in the course of his employment as a store director for Hollywood, sexually harassed and assaulted certain of the plaintiffs, and that Hollywood and its members of management failed to prevent or respond adequately to the employee's alleged wrongdoing. The plaintiffs seek unspecified damages, pre-judgment interest and attorneys' fees and costs. Hollywood denies these allegations and is vigorously defending this lawsuit. In addition, we have been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. A negative outcome in certain of the ongoing litigation could harm our business, financial condition, liquidity or results of operations. In addition, prolonged litigation, regardless of which party prevails, could be costly, divert management attention or result in increased costs of doing business. We believe we have provided adequate reserves for contingencies and that the outcome of these matters should not have a material adverse effect on our consolidated results of operation, financial condition or liquidity. At October 1, 2006, the legal contingencies reserve, net of expected recoveries from insurance carriers, was $1.6 million, of which $1.1 million relates to pre-acquisition contingencies. Adjustments related to pre-acquisition contingencies made after the anniversary date of the acquisition will be recognized in the income statement in the period when such revisions are made. All other adjustments related to matters existing as of the date of acquisition of Hollywood will be recognized in the income statement in the period when such revisions are made. Boards, Inc. By letter dated August 29, 2005, Boards, Inc. ("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 contained in the license agreement for these stores. In accordance with the terms of the license agreement, Hollywood and Boards have agreed to the retention of a valuation expert and are proceeding with the valuation of the stores. As of October 1, 2006 the purchase price has not yet been determined. We anticipate that the transaction could close in 2007. 10. Segment Reporting With the acquisition of Hollywood as of April 27, 2005, management began evaluating the operating results of the Company based on three segments, Movie Gallery, Hollywood Video, and Game Crazy. The segments are based on store branding. Movie Gallery represents 2,609 video stores serving mainly rural markets in the United States, Canada, and Mexico, Hollywood Video represents 2,049 video stores serving predominantly urban markets, and Game Crazy represents 643 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): Thirteen Weeks Ended October 2, 2005 (1) ------------------------------------------- Movie Hollywood Game Gallery Video Crazy Total ---------- --------- -------- ---------- Revenues $ 197,185 $ 316,115 $ 59,142 $ 572,442 Depreciation and amortization 9,448 19,701 2,278 31,427 Rental amortization 25,803 34,687 - 60,490 Operating income(loss) (652) 10,508 (4,832) 5,024 Goodwill, net 162,142 463,743 - 625,885 Total assets 523,108 1,230,589 116,391 1,870,088 Purchases of property, furnishings and equipment 11,672 4,351 400 16,423 (1) Rental amortization includes $10.1 million of VHS residual value adjustment Thirteen Weeks Ended October 1, 2006 ------------------------------------------- Movie Hollywood Game Gallery Video Crazy Total ---------- --------- -------- ---------- Revenues $ 202,577 $ 312,270 $ 68,142 $ 582,989 Depreciation and amortization 10,545 15,320 2,280 28,145 Rental amortization 21,854 25,655 - 47,509 Operating income(loss) (14,799) 10,990 (317) (4,126) Goodwill, net 147 117,479 - 117,626 Total assets 353,110 717,262 95,555 1,165,927 Purchases of property, furnishings and equipment 1,455 2,545 54 4,054 Thirty-nine Weeks Ended October 2, 2005 (2) ------------------------------------------- Movie Hollywood Game Gallery(3) Video Crazy Total ---------- --------- -------- ---------- Revenues $ 630,038 $ 572,650 $ 108,274 $ 1,310,962 Depreciation and amortization 27,342 27,463 5,401 60,206 Rental amortization 84,867 67,151 - 152,018 Operating income(loss) 18,462 25,873 (6,752) 37,583 Goodwill, net 162,142 463,743 - 625,885 Total assets 523,108 1,230,589 116,391 1,870,088 Purchases of property, furnishings and equipment 40,403 7,874 596 48,873 (2) Hollywood Video and Game Crazy from April 27, 2005 through October 2, 2005. (3) Rental amortization includes $10.1 million of VHS residual value adjustment. Thirty-nine Weeks Ended October 1, 2006 ------------------------------------------- Movie Hollywood Game Gallery Video Crazy Total ---------- --------- -------- ---------- Revenues $ 656,205 $1,016,881 $205,556 $1,878,642 Depreciation and amortization 28,930 42,855 7,429 79,214 Rental amortization 74,524 92,735 - 167,259 Operating income(loss) (1,256) 82,097 (3,217) 77,624 Goodwill, net 147 117,479 - 117,626 Total assets 353,110 717,262 95,555 1,165,927 Purchases of property, furnishings and equipment 12,164 6,834 147 19,145 11. Asset Retirement Obligation 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 FASB Statement No. 143, "Accounting for Asset Retirement Obligations." 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 preparation and review of our Quarterly Report on Form 10-Q for the thirteen and thirty-nine week periods ended October 1, 2006, we realized that we had not properly applied the guidance as set out above. As a result of this review, certain errors were identified and were corrected in the third quarter of 2006. 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. The impact of these corrections on our financial position, results of operations, and cash flows for the fiscal years ended January 4, 2004, January 2, 2005, and January 1, 2006, were not material. Although the correction of the errors is material to the third quarter of 2006 it is not material to fiscal 2006 taken as a whole. The following is an analysis of our asset retirement obligation if we would have properly implemented FASB Statement No. 143 as of January 4, 2003 for the fiscal years ended 2003, 2004, 2005, and the quarters ended April 2, 2006, July 2, 2006, and October 1, 2006 (in thousands): Amount ------- Asset retirement obligation as of January 4, 2003 $2,462 Liability accrued upon lease commencement 554 Liability settled (73) Accretion of discount 104 ------- Asset retirement obligation as of January 4, 2004 3,047 Liability accrued upon lease commencement 529 Liability settled (125) Accretion of discount 126 ------- Asset retirement obligation as of January 2, 2005 3,577 Liability accrued upon lease commencement/acquisition 5,219 Liability settled (322) Accretion of discount 276 ------- Asset retirement obligation as of January 1, 2006 8,750 Liability accrued upon lease commencement 61 Liability settled (96) Accretion of discount 87 ------- Asset retirement obligation as of April 2 2006 8,802 Liability accrued upon lease commencement 25 Liability settled (106) Accretion of discount 86 ------- Asset retirement obligation as of July 2, 2006 8,807 Liability accrued upon lease commencement 17 Liability settled (203) Accretion of discount 85 ------- Asset retirement obligation as of October 1, 2006 $8,706 The following table illustrates the effect on net income or loss and related per share amounts as if we had properly applied the guidance of FASB Statement No. 143 on January 4, 2003 on each of the fiscal years ended 2003, 2004, and 2005 and the first and second quarters of 2006: Fiscal Year -------------------------------------------- (Amounts in thousands, except per share amounts) 2003 2004 2005 -------------- -------------- -------------- Net income (loss) as reported $49,436 $49,488 $(552,740) Pro forma net income $48,453 $49,209 $(557,649) Basic earnings per share: Net income (loss) per share as reported $1.53 $1.54 $(17.53) Pro forma net income per share $1.50 $1.53 $(17.69) Diluted earnings per share: Net income per share as reported $1.48 $1.52 $(17.53) Pro forma net income per share $1.45 $1.51 $(17.69) Quarter Ended ---------------------------- (Amounts in thousands, except per share amounts) April 2, July 2, 2006 2006 -------------- ------------- Net income (loss) as reported $40,347 $(14,898) Pro forma net income $40,198 $(15,045) Basic earnings per share: Net income (loss) per share as reported $1.27 $(0.47) Pro forma net income per share $1.27 $(0.47) Diluted earnings per share: Net income per share as reported $1.27 $(0.47) Pro forma net income per share $1.27 $(0.47) 12. Consolidating Financial Statements The following tables present condensed consolidating financial information for: (a) Movie Gallery, Inc. (the "Parent") on a stand-alone basis; (b) on a combined basis, the guarantors of the 11% Senior Notes ("Subsidiary Guarantors"), which include Movie Gallery US, 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 Thirteen weeks ended October 2, 2005 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- --------- --------- -------- Revenue: Rentals $ - $ 452,502 $ 20,584 $ - $ 473,086 Product sales - 96,679 2,677 - 99,356 --------- --------- --------- --------- --------- Total revenue - 549,181 23,261 - 572,442 Cost of sales: Cost of rental revenue - 131,161 5,075 - 136,236 Cost of product sales - 68,465 1,615 - 70,080 --------- --------- --------- --------- --------- Gross profit - 349,555 16,571 - 366,126 Operating costs and expenses: Store operating expenses - 307,766 12,153 - 319,919 General and administrative 171 38,561 1,288 - 40,020 Amortization of intangibles - 1,070 93 - 1,163 -------- -------- -------- -------- --------- Operating income(loss) (171) 2,158 3,037 - 5,024 Interest expense, net (24,052) (241) (134) - (24,427) Equity in earnings (loss) of subsidiaries 3,194 1,745 - (4,939) - -------- -------- -------- -------- --------- Income (loss) before income taxes (21,029) 3,662 2,903 (4,939) (19,403) Income taxes (benefit) (8,560) 468 1,158 - (6,934) -------- -------- -------- -------- --------- Net income (loss) $(12,469) $ 3,194 $ 1,745 $ (4,939)$ (12,469) ======== ======== ======== ======== ========= Consolidating Statement of Operations Thirteen weeks ended October 1, 2006 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- --------- --------- --------- Revenue: Rentals $ - $ 454,002 $ 21,777 $ - $ 475,779 Product sales - 104,858 2,352 - 107,210 --------- --------- --------- --------- --------- Total revenue - 558,860 24,129 - 582,989 Cost of sales: Cost of rental revenue - 133,701 7,888 - 141,589 Cost of product sales - 76,347 1,813 - 78,160 --------- --------- --------- --------- --------- Gross profit - 348,812 14,428 - 363,240 Operating costs and expenses: Store operating expenses - 309,103 13,540 - 322,643 General and administrative 3,167 39,133 1,722 - 44,022 Amortization of intangibles - 665 36 - 701 -------- -------- -------- -------- --------- Operating income(loss) (3,167) (89) (870) - (4,126) Interest expense, net (21,063) (10,014) (108) - (31,185) Equity in earnings (loss) of subsidiaries (11,022) (361) - 11,383 - -------- -------- -------- -------- --------- Income (loss) before income taxes (35,252) (10,464) (978) 11,383 (35,311) Income taxes (benefit) 859 558 (617) - 800 -------- -------- -------- -------- --------- Net income (loss) $(36,111) $(11,022) $ (361) $11,383 $(36,111) ======== ======== ======== ======== ========= Consolidating Statement of Operations Thirty-nine weeks ended October 2, 2005 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- ---------- --------- --------- --------- Revenue: Rentals $ - $1,056,278 $ 53,383 $ - $1,109,661 Product sales - 195,300 6,001 - 201,301 --------- ---------- --------- --------- --------- Total revenue - 1,251,578 59,384 - 1,310,962 Cost of sales: Cost of rental revenue - 328,867 16,292 - 345,159 Cost of product sales - 137,981 3,915 - 141,896 --------- ---------- --------- --------- --------- Gross profit - 784,730 39,177 - 823,907 Operating costs and expenses: Store operating expenses - 659,461 31,131 - 690,592 General and administrative 372 89,125 3,517 - 93,014 Amortization of intangibles - 2,544 174 - 2,718 -------- --------- -------- -------- --------- Operating income(loss) (372) 33,600 4,355 - 37,583 Interest expense, net (40,606) (669) (155) - (41,430) Write-off bridge financing (4,234) - - - (4,234) Equity in losses of unconsolidated entities (806) - - - (806) Equity in earnings (loss) of subsidiaries 23,118 2,543 - (25,661) - -------- --------- -------- -------- --------- Income (loss) before income taxes (22,900) 35,474 4,200 (25,661) (8,887) Income taxes (benefit) (16,635) 12,356 1,657 - (2,622) -------- --------- -------- -------- --------- Net income (loss) $ (6,265) $ 23,118 $ 2,543 $(25,661) $ (6,265) ======== ========= ======== ======== ========= Consolidating Statement of Operations Thirty-nine weeks ended October 1, 2006 (unaudited, in thousands) --------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- ---------- --------- --------- ---------- Revenue: Rentals $ - $1,475,068 $ 64,686 $ - $1,539,754 Product sales - 331,422 7,466 - 338,888 --------- ---------- --------- --------- --------- Total revenue - 1,806,490 72,152 - 1,878,642 Cost of sales: Cost of rental revenue - 444,442 25,631 - 470,073 Cost of product sales - 243,097 6,358 - 249,455 --------- ---------- --------- --------- --------- Gross profit - 1,118,951 40,163 - 1,159,114 Operating costs and expenses: Store operating expenses - 903,956 40,539 - 944,495 General and administrative 6,065 124,762 4,026 - 134,853 Amortization of intangibles - 2,034 108 - 2,142 -------- --------- -------- -------- --------- Operating income(loss) (6,065) 88,199 (4,510) - 77,624 Interest expense, net (61,209) (27,898) (224) - (89,331) Equity in earnings (loss) of subsidiaries 57,109 (2,956) - (54,153) - -------- --------- -------- -------- --------- Income (loss) before income taxes (10,165) 57,345 (4,734) (54,153) (11,707) Income taxes (benefit) 494 236 (1,778) - (1,048) -------- --------- -------- -------- --------- Net income (loss) $(10,659) $ 57,109 $ (2,956) $(54,153) $(10,659) ======== ========= ======== ======== ========= 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 October 1, 2006 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- -------- --------- --------- Assets Current assets: Cash and cash equivalents $ - $ 19,450 $ 184 $ - $ 19,634 Merchandise inventory, net - 120,457 3,472 - 123,929 Prepaid expenses - 49,342 1,884 - 51,226 Store supplies and other - 19,304 1,260 - 20,564 Deferred income taxes, net - - - - - --------- --------- -------- ------- --------- Total current assets - 208,553 6,800 - 215,353 Rental inventory, net - 325,815 14,263 - 340,078 Property, furnishings and equipment, net - 257,425 14,916 - 272,341 Goodwill, net - 117,613 13 - 117,626 Other intangibles, net - 182,490 313 - 182,803 Deposits and other assets 33,004 4,174 548 - 37,726 Investments in subsidiaries 871,487 18,110 - (889,597) - --------- --------- -------- --------- ---------- Total assets $ 904,491 $1,114,180 $ 36,853 $(889,597) $1,165,927 ========= ========= ======= ======== ========== Liabilities and stockholders' equity (deficit): Current liabilities: Current maturities of long-term obligations $ 781,366 $ 193 $ - $ - $ 781,559 Current maturities of financing obligations - 982 - - 982 Accounts payable - 73,816 4,983 - 78,799 Accrued liabilities (10,704) 88,260 955 - 78,511 Accrued payroll 413 41,260 1,053 42,726 Accrued interest 16,146 9 52 - 16,207 Deferred revenue - 32,588 426 - 33,014 ---------- --------- -------- -------- --------- Total current liabilities 787,221 237,108 7,469 - 1,031,798 Long-term obligations, less current portion 321,905 466 - - 322,371 Other accrued liabilities - 30,480 2,090 - 32,570 Deferred income taxes - (345) 433 - 88 Intercompany promissory note (receivable) (384,200) 384,200 - - - Payable to(receivable from) affiliate 400,465 (409,216) 8,751 - - Stockholders' equity (deficit) (220,900) 871,487 18,110 (889,597) (220,900) --------- --------- -------- -------- --------- Total liabilities and stockholders' equity (deficit) $ 904,491 $1,114,180 $36,853 $(889,597) $1,165,927 ========= ========== ======== ========== ========== Consolidating Condensed Statement of Cash Flow Thirty-nine weeks ended October 2, 2005 (unaudited, in thousands) ------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated -------- --------- -------- -------- --------- Operating Activities: Net income (loss) $ (6,265) $ 23,118 $ 2,543 $ (25,661) $ (6,265) Equity earnings in subsidiaries (23,118) (2,543) - 25,661 - Adjustments to reconcile net income to cash provided by (used in) operating activities: Rental inventory amortization - 142,815 9,203 - 152,018 Purchases of rental inventory - (111,656) (8,479) - (120,135) Purchase of rental inventory-base stock - (15,136) (1,433) - (16,569) Depreciation and intangibles amortization - 57,927 2,279 - 60,206 (Gain) loss on disposal of property, furnishings, and equipment - 706 657 - 1,363 Stock based compensation 705 393 - - 1,098 Tax benefit of stock options exercised 3,301 - - - 3,301 Amortization of debt issuance cost 2,235 - - - 2,235 Deferred income taxes (18,398) 5,313 1,528 - (11,557) Changes in operating assets and liabilities, net of business acquisitions: Extended viewing fees receivable, net - 20,259 - - 20,259 Merchandise inventory - 8,658 (142) - 8,516 Other current assets (10) (3,098) (840) - (3,948) Deposits and other assets 493 (2,418) (128) - (2,053) Accounts payable - (77,603) (4,655) - (82,258) Accrued interest 29,168 (2) 27 - 29,193 Accrued liabilities and deferred revenue 2,013 9,498 1,825 - 13,336 -------- --------- -------- -------- --------- Net cash (used in) provided by operating activities (9,876) 56,231 2,385 - 48,740 Investing Activities: Business acquisitions, net of cash acquired (1,092,282) 12,142 (16,125) - (1,096,265) Purchase of property, furnishings and equipment - (44,156) (4,717) - (48,873) Proceeds from disposal of Property, furnishings and Equipment - 2,107 - - 2,107 Acquisition of construction phase assets, net - 2,154 - - 2,154 Investment in subsidiaries (354) (8,149) - 8,503 - -------- --------- -------- -------- --------- Net cash used in investing activities (1,092,636) (35,902) (20,842) 8,503 (1,140,877) Financing Activities: Repayment of capital lease obligations - (265) - - (265) Intercompany payable/ receivable (31,165) 36,550 (5,385) - - Decrease in financing obligations - (2,412) - - (2,412) Net borrowings on credit facilities - - 9,046 - 9,046 Debt financing fees (32,452) - - - (32,452) Proceeds from issuance of debt 1,166,120 - - - 1,166,120 Principal payments on debt (6,625) - (1,742) - (8,367) Proceeds from exercise of stock options 5,318 - - - 5,318 Proceeds from employee stock purchase plan 169 - - - 169 Capital contribution from parent - 354 8,149 (8,503) - Dividend to parent 3,973 (3,973) - - - Payment of dividends (2,827) - - - (2,827) -------- --------- -------- -------- --------- Net cash provided by (used in) financing activities 1,102,511 30,254 10,068 (8,503) 1,134,330 Effect of exchange rate changes on cash and cash equivalents - 1,044 - - 1,044 -------- --------- -------- -------- --------- Increase (decrease) in cash and cash equivalents (1) 51,627 (8,389) - 43,237 Cash and cash equivalents at beginning of period 1 15,711 9,806 - 25,518 -------- --------- -------- -------- --------- Cash and cash equivalents at end of period $ - $ 67,338 $ 1,417 $ - $ 68,755 ======== ========= ======== ======== ========= Consolidating Condensed Statement of Cash Flow Thirty-nine weeks ended October 1, 2006 (unaudited, in thousands) ------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated -------- --------- -------- -------- --------- Operating Activities: Net income (loss) $(10,659) $ 57,109 $ (2,956) $(54,153) $ (10,659) Equity earnings in subsidiaries (57,109) 2,956 - 54,153 - Adjustments to reconcile net income to cash provided by (used in) operating activities: Rental inventory amortization - 155,113 12,146 - 167,259 Purchases of rental inventory - (116,585) (8,661) - (125,246) Purchase of rental inventory-base stock - (10,252) (275) - (10,527) Depreciation and intangibles amortization - 76,245 2,969 - 79,214 Accretion on asset retirement obligations - 3,022 - - 3,022 Gain on disposal of property, furnishings, and equipment - 3,196 479 - 3,675 Stock based compensation 1,977 96 - - 2,073 Amortization of debt issuance cost 4,952 - - - 4,952 Deferred income taxes (4) 4 18 - 18 Changes in operating assets and liabilities, net of business acquisitions: Merchandise inventory - 12,413 221 - 12,634 Other current assets 19 (7,846) 752 - (7,075) Deposits and other assets - 2,540 27 - 2,567 Accounts payable - (155,884) (1,570) - (157,454) Accrued interest 9,015 (49) 20 - 8,986 Accrued liabilities and deferred revenue 2,577 (10,349) (736) - (8,508) -------- --------- -------- -------- --------- Net cash provided by (used in) operating activities (49,232) 11,729 2,434 - (35,069) Investing Activities: Business acquisitions, net of cash acquired - (300) (19) - (319) Purchase of property, furnishings and equipment - (17,502) (1,643) - (19,145) Proceeds from disposal of property, furnishings and equipment - 1,320 - - 1,320 Acquisition of construction phase assets, net - 3,553 - - 3,553 Investment in subsidiaries 88,576 (1,276) - (87,300) - -------- --------- -------- -------- --------- Net cash provided by (used in) investing activities 88,576 (14,205) (1,662) (87,300) (14,591) Financing Activities: Repayment of capital lease obligations - (412) - - (412) Intercompany payable/ receivable 16,567 (20,285) 3,718 - - Decrease in financing obligations - (3,510) - - (3,510) Net borrowings (repayments) on credit facilities 20,004 - (6,862) - 13,142 Debt financing fees (5,528) - - - (5,528) Proceeds from issuance of long-term debt 1,948 - - - 1,948 Principal payments on debt (72,335) - (57) - (72,392) Capital contribution from parent - (88,576) 1,276 87,300 - -------- --------- -------- -------- --------- Net cash provided by (used in) financing activities (39,344) (112,783) (1,925) 87,300 (66,752) Effect of exchange rate changes on cash and cash equivalents - 808 - - 808 -------- --------- -------- -------- --------- Decrease in cash and cash equivalents - (114,451) (1,153) - (115,604) Cash and cash equivalents at beginning of period - 133,901 1,337 - 135,238 -------- --------- -------- -------- --------- Cash and cash equivalents at end of period $ - $ 19,450 $ 184 $ - $ 19,634 ======== ========= ======== ======== ========= Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Overview On April 27, 2005, we completed our acquisition of Hollywood Entertainment Corporation, or Hollywood. This acquisition increased our store count to over 4,700 stores and substantially increased our urban market presence. We believe that the Company's eastern-focused rural and secondary market presence under the Movie Gallery brand and its western-focused, prime urban and suburban superstore locations under the Hollywood brand combine to form a strong nationwide geographical store footprint. We currently plan to open approximately 120 new Movie Gallery and Hollywood Video stores for the full fiscal year 2006 period, subject to market and industry conditions. We continue to evaluate underperforming stores and stores that have overlapping trade areas in order to close the smaller cash flow stores in those markets at an accelerated pace. We anticipate closing approximately 230 underperforming and overlapping stores during fiscal 2006. We believe we can transfer a sufficient percentage of the customer base to our Movie Gallery and Hollywood Video stores in these markets to improve our market level profitability. 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 approximate 45 day period during which they can rent and sell new releases before they are made available on pay-per-view or other distribution channels. According to Kagan Research, the domestic home video industry accounted for approximately 51% of domestic studio movie revenue in 2005. For this reason, we believe movie studios have a significant interest in maintaining a viable home video industry. Our strategies have been designed to maximize store revenues and profitability in a mature industry. We strive to minimize the operating and overhead costs associated with our business in both the Movie Gallery and Hollywood brands. 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 primarily a cash business with initial rental fees paid upfront by the customer. Our management team continuously reviews inventory levels, marketing and sales promotions, real estate strategies, and staffing requirements in order to maximize revenues at each location. Additionally, our team monitors revenue performance on a daily basis to quickly identify trends or issues in our store base or in the industry as a whole. Our management closely monitors same-store revenues, which we define as revenues at stores that we have operated for at least twelve full months, to assess the performance of our business. - - Product purchasing economics. In order to maintain the desired profit margin in our business, purchases of inventory for both rental and sale must be carefully managed. Our purchasing models are designed to analyze the impact of the economic factors inherent in the various pricing strategies employed by the studios. We believe that we are able to achieve purchasing levels tailored for the customer demographics of each of our markets and to maximize the return on investment of our inventory purchase dollars. - - Store level cost control. The most significant store expenses are payroll and rent, followed by facilities-related and supply expenditures. We attempt to control these expenses primarily through budgeting systems and centralization of purchases in our corporate support centers. This enables us to measure performance against expectations and to leverage our purchasing power. 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. 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, January and February due to the holidays at year end as well as inclement weather conditions during the winter months. 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. Hollywood Acquisition On April 27, 2005, we completed our cash acquisition of Hollywood, refinanced substantially all of the existing indebtedness of Hollywood, and replaced our existing unsecured revolving credit facility. We paid $862.1 million to purchase all of Hollywood's outstanding common stock and $384.7 million to refinance Hollywood's debt. As part of the refinancing of Hollywood's debt, Hollywood executed a tender offer for its $225.0 million principal amount 9.625% senior subordinated notes due 2011, pursuant to which $224.6 million were tendered. The Hollywood acquisition was financed using Hollywood's cash on-hand of approximately $180.0 million, a senior secured credit facility guaranteed by all of our domestic subsidiaries in an aggregate principal amount of $870.0 million, and an issuance of $325.0 million of 11% senior unsecured notes. The acquisition substantially increased our presence on the West Coast and in urban areas. Hollywood's predominantly West Coast urban superstore locations present little overlap with Movie Gallery's rural and suburban store locations concentrated in the eastern half of the United States. In the fourth quarter of fiscal 2005, we closed 64 Movie Gallery stores with trade areas that overlapped with acquired Hollywood Video stores. In the thirty-nine weeks ended October 1, 2006, we have closed an additional 189 overlapping or underperforming stores, predominantly from our Movie Gallery segment. We will continue to evaluate the closure of stores with overlapping trade areas 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 to date have primarily focused on consolidating the leadership functions in the brands. This effort is complete with the exception of the Operations and Marketing functions, which we currently do not intend to consolidate. The respective leaders of our support organizations continue to evaluate opportunities to leverage both Movie Gallery's and Hollywood's best practices and generate general and administrative cost savings. To date, we have identified cost savings opportunities in both Movie Gallery's and Hollywood's cost structures, and we anticipate that we will identify additional opportunities in the future. The combined companies also are evaluating opportunities to reap the benefits of increased purchasing leverage to reduce costs. However, we can make no assurances that we will successfully integrate Hollywood's business or that we will achieve any further cost savings. 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 are required to render service for a range of 10 to 49 weeks in order to receive termination benefits. We currently estimate that the total cost of providing severance, retention incentives and outplacement services to the impacted associates will be approximately $2.5 million, of which approximately $1.2 million and $1.3 million were recognized during the fiscal year ended January 1, 2006 and the thirty-nine weeks ended October 1, 2006, respectively, in accordance with SFAS No. 146, "Accounting for Costs Associated with Disposal and Exit Activities." There were cash payments charged to the reserve of $1.4 million during the thirty-nine weeks ended October 1, 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 the Dothan, Alabama corporate offices, and the affected Hollywood employees were notified that their positions will be relocated. We estimate the integration-related efficiencies and savings achieved during fiscal 2005 to be in excess of $20 million. These savings were driven principally by improvements in the supply chain for Movie Gallery branded stores, consolidation of our Real Estate and Architecture functions, inventory utilization, and elimination of duplicative executive management. We continue to identify and implement additional savings opportunities. We expect that total savings, including new projects in 2006 combined with the full year fiscal 2006 impact of the savings already achieved in 2005 will be in excess of $50 million. Real Estate Initiatives We have entered into an agreement with Excess Space Retail Services, Inc. to explore opportunities for us to sublease retail space at more than 2,200 existing Movie Gallery and Hollywood Video stores. In addition, on April 17, 2006, we entered into an agreement with Hilco Real Estate, LLC under which we and Hilco will initiate a program to restructure lease terms at more than 1,000 existing Movie Gallery and Hollywood Video stores. 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 October 1, 2006, the purchase price has not yet been determined. It is anticipated that the transaction will close in fiscal 2007. Developments in the Fiscal Year On April 7, 2006, Timothy R. Price, Movie Gallery's Executive Vice President and Chief Financial Officer, resigned for personal reasons and Mark D. Moreland, Senior Vice President and Treasurer, was appointed Interim Chief Financial Officer. Additionally, Bart Walker, Senior Vice President and Controller, resigned effective April 28, 2006. On June 1, 2006, we announced that Thomas D. Johnson, Jr., Senior Vice President, Corporate Finance and Business Development, was appointed Interim Chief Financial Officer in addition to his current responsibilities following the resignation of Mark D. Moreland. We have retained Alvarez & Marsal, LLC, a global professional services firm, specializing in providing turnaround management, restructuring and corporate advisory services, to immediately fill several leadership vacancies in our accounting and finance functions, shorten the lead-time for implementing specific turnaround initiatives, and to assist us with remediation of our previously identified material weaknesses and deficiencies in internal control over financial reporting. Results of Operations The following discussion of our results of operations, liquidity and capital resources is intended to provide further insight into our performance for the thirteen and thirty-nine weeks ended October 2, 2005 and October 1, 2006. The financial information provided in the Selected Financial Statement and Operational Data is not comparable on a year-over-year basis for the thirty- nine week period due to the acquisition of Hollywood, which occurred April 27, 2005. The results of operations for the thirty-nine weeks ended October 2, 2005 only includes Hollywood results starting from the April 27, 2005 merger date, while the thirty-nine weeks ended October 1, 2006 includes Hollywood results for the full thirty-nine weeks. Selected Financial Statement and Operational Data: Thirteen Weeks Ended Thirty-nine Weeks Ended --------------------- ----------------------- October 2, October 1, October 2, October 1, 2005 2006 2005 2006 --------- --------- --------- --------- ($ in thousands, except per share and store data) Rental revenue $ 473,086 $ 475,779 $1,109,661 $1,539,754 Product sales 99,356 107,210 201,301 338,888 --------- --------- --------- ---------- Total revenue 572,442 582,989 1,310,962 1,878,642 Cost of rental revenue 136,236 141,589 345,159 470,073 Cost of product sales 70,080 78,160 141,896 249,455 --------- --------- ---------- ---------- Total gross profit $ 366,126 $ 363,240 $ 823,907 $1,159,114 ========= ========= ========== ========== Store operating expenses $ 319,919 $ 322,643 $ 690,592 $ 944,495 General and administrative expenses $ 40,020 $ 44,022 $ 93,014 $ 134,853 Operating income $ 5,024 $ (4,126) $ 37,583 $ 77,624 Interest expense, net $ 24,427 $ 31,185 $ 41,430 $ 89,331 Net loss $ (12,469) $ (36,111) $ (6,265) $ (10,659) Net loss per diluted share $ (0.39) $ (1.13) $ (0.20) $ (0.34) Cash dividends per common share $ - $ - $ 0.06 $ - Rental margin 71.2% 70.2% 68.9% 69.5% Product sales margin 29.5% 27.1% 29.5% 26.4% Total gross margin 64.0% 62.3% 62.8% 61.7% Percent of total revenue: Rental revenue 82.6% 81.6% 84.6% 82.0% Product sales 17.4% 18.4% 15.4% 18.0% Store operating expenses 55.9% 55.3% 52.7% 50.3% General and administrative expenses 7.0% 7.6% 7.1% 7.2% Operating income 0.9% (0.7%) 2.9% 4.1% Interest expense, net 4.3% 5.3% 3.2% 4.8% Net loss (2.2%) (6.2%) (0.5%) (0.6%) Total same-store revenues (9.0%) (0.4%) (3.1%) (4.0%) Movie Gallery same-store revenues (9.8%) 3.0% (5.3%) 0.0% Hollywood same-store revenues(1) (8.6%) (1.9%) (2.2%) (5.9%) Total same-store rental revenues(10.3%) (1.9%) (5.2%) (5.2%) Movie Gallery same-store revenues (10.8%) 3.1% (5.5%) (0.8%) Hollywood same-store revenues(1)(10.1%) (4.6%) (5.1%) (7.5%) Total same-store product sales (2.2%) 6.5% 7.8% 1.1% Movie Gallery same-store sales 2.5% 1.0% (3.1%) 8.8% Hollywood same-store sales(1) (3.0%) 7.5% 10.0% (0.2%) Store count: Beginning of period 4,730 4,763 2,482 4,749 New store builds 80 13 234 115 Stores acquired - - 2,138 - Stores closed (25) (101) (69) (189) --------- --------- ---------- --------- End of period 4,785 4,675 4,785 4,675 ========= ========= ========== ========= (1) The information above reflects the historical store operating statistics previously reported by Hollywood Entertainment. Hollywood's store operating statistics for periods prior to April 27, 2005 are not otherwise included in the consolidated statements of operations. Hollywood same-store revenues are presented on a pro forma basis as if the merger had been completed at the beginning of fiscal 2005 and are inclusive of the Game Crazy operating segment. Revenue. For the thirteen weeks and thirty-nine weeks ended October 1, 2006, consolidated total revenues increased 1.8% and 43.3%, respectively, from the comparable periods in 2005. The large increase for the thirty-nine week period was primarily due to the acquisition of Hollywood. Same-store total revenues were negative 0.4% for the third quarter of fiscal 2006, which consisted of a 1.9% decline in same-store rental revenue and a 6.5% increase in same-store product revenue. With the acquisition of Hollywood for the thirty-nine weeks ended October 1, 2006, our revenue has shifted more to product revenue and away from rental revenues versus the comparable period in fiscal 2005. The Game Crazy operating segment is the primary driver of this shift in revenue mix. For the thirteen weeks and thirty-nine weeks ended October 1, 2006, the Movie Gallery operating segment total revenues increased 2.7% and 4.2%, respectively, from the comparable periods in fiscal 2005. The increase for the thirteen week period was primarily due to a 3.0% increase in same-store sales, which consisted of a 3.1% increase in same-store rental revenue and a 1.0% increase in same-store product revenue. The same-store rental revenue increases were a result of increased movie rental revenue, including previously viewed revenue, offset by a decline in game rental revenues. Same-store product revenue gains were achieved in the sale of new movies and concession sales. The revenue increase for the thirty-nine week period was primarily due to an increase of approximately 2.7% in the average number of stores operated during the current year period versus the comparable period of fiscal 2005. The addition of Hollywood operating segment revenue for the thirty-nine weeks ended October 1, 2006 accounted for 95.4% of the total revenue increase. Hollywood total same-store revenues were negative 1.9% for the third quarter of fiscal 2006, which consisted of a 4.6% decline in same-store rental revenue partially offset by a 7.5% increase in same-store product sales revenue. Movie rental revenue, including previously viewed sales, declined and was adversely impacted by the soft home video release schedule, the maturation of the DVD life cycle, and the overabundance of DVD titles available in the marketplace and through alternative delivery channels. In addition, game rental revenue declined, reflecting the weakness of the new game titles currently being released and the industry softness that occurs in anticipation of the introduction of new game platforms currently scheduled for release later in 2006. Cost of Sales. The cost of rental revenue includes the amortization of rental inventory, revenue sharing expenses and the cost of previously viewed rental inventory sold. The gross margin on rental revenue for the thirteen weeks and thirty-nine weeks ended October 1, 2006 was 70.2% and 69.5%, respectively, compared to 71.2% and 68.9% for the comparable periods of fiscal 2005. The decrease in gross margin for the thirteen week period was primarily due to an increase in promotionally discounted sales of previously viewed movies. Charges totaling $11.3 million were recorded against rental margins in the thirty-nine weeks ended October 1, 2006 to reflect changes in rental amortization estimates. In addition, a charge of $10.1 million was recorded against rental margins in the thirty-nine weeks ended October 2, 2005 to reflect a change in the estimate of the residual value of VHS movies from $2.00 to $1.00 for the Movie Gallery segment. Factors contributing to the gross margin improvement in the thirty-nine weeks ended October 1, 2006 include the increase in the percentage of DVD movies acquired under revenue sharing arrangements and efficiencies in rental product distribution and processing. Cost of product sales includes the costs of new and used video game merchandise taken in on trade for the Game Crazy operating segment, new movies, concessions and other goods sold. New movies and new game merchandise typically have a much lower margin than used game merchandise and concessions. The gross margin on product sales is subject to fluctuations in the relative mix of the products that are sold. The gross margin on product sales for the thirteen weeks and thirty-nine weeks ended October 1, 2006 was 27.1% and 26.4%, respectively, compared to29.5% and 29.5% for the comparable periods of fiscal 2005. The decrease in product sales margin was primarily caused by higher new game merchandise sales. 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 55.3% and 50.3% for the thirteen weeks and thirty-nine weeks ended October 1, 2006, respectively, compared to 55.9% and 52.7% for the comparable periods of fiscal 2005. For the thirteen and thirty-nine weeks ended October 1, 2006, we recorded a charge of $7.3 million to recognize asset retirement obligations in accordance with SFAS 143 (see note 11). The decrease in the thirteen-week period was driven by reductions in depreciation expense, store labor expense, and rent and related expenses. These savings were partially offset by increases in store closure expenses of approximately $6.6 million and a charge of $7.3 million for the set up of asset retirement obligations (see note 11). The decrease in the thirty-nine week period was primarily due to the acquisition of Hollywood and its lower operating costs and expenses as a percentage of revenue. General and Administrative Expenses. General and administrative expenses as a percentage of revenue were 7.6% and 7.2% for the thirteen and thirty-nine weeks ended October 1, 2006, respectively, compared to 7.0% and 7.1% for the comparable periods of fiscal 2005. The increase in the thirteen-week period was primarily due to increased professional fees, additional bonus expense, and increased stock compensation expense. The increase in general and administrative expenses as a percentage of revenue for the thirty-nine week period was primarily due to professional fees incurred during the thirteen weeks ended October 1, 2006, accrued severance fees of $2.8 million and additional compensation expense. The additional expenses were partially offset by the acquisition of Hollywood and its lower general and administrative costs as a percentage of revenue. Effective with our fiscal year beginning January 2, 2006, to account for stock- based compensation, 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 Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." Compensation expense charged to general and administrative expenses related to stock-based compensation was $1.2 million and $1.6 million for the fiscal year ended January 1, 2006 and for the thirty-nine weeks ended October 1, 2006, respectively. Total compensation cost related to all non-vested awards that is not yet recognized was $9.2 million at October 1, 2006, and is expected to be recognized over a weighted-average period of approximately three years. Interest Expense, net. Interest expense, net increased $6.8 million from $24.4 million for the thirteen weeks ended October 2, 2005 to $31.2 million for the thirteen weeks ended October 1, 2006. The increase is primarily attributed to increased borrowings on the credit facility and higher average interest rates. Interest expense, net increased $47.9 million from $41.4 million for the thirty-nine weeks ended October 2, 2005 to $89.3 million for the thirty-nine weeks ended October 1, 2006. The increase is primarily attributed to increased borrowings and higher average interest rates. Additionally, borrowings related to the Hollywood acquisition were outstanding for approximately twenty-three weeks during the period ended October 1, 2005 compared to thirty-nine weeks for the period ended October 1, 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. We do not anticipate that any of these alternatives will replace our base video rental business. As of January 1, 2006, we have completely written off our investments in these unconsolidated entities, either through recognizing our proportionate share of the investee losses under the equity method, by disposing of the related interests, or through write-offs for investments we deemed to be worthless. Although we have no present intentions to do so, in the future we may make, subject to covenant limitations, similar investments that we will be required to account for as equity investments similar to the investments we have made in the past. The remaining balances in these investments were written off during fiscal 2005. Income Taxes. The effective tax rate was an expense of 2.3% and a benefit of 8.9% for the thirteen and thirty-nine weeks ended October 1, 2006, respectively, as compared to a benefit of 35.7% and 29.5% for corresponding periods in fiscal 2005. The projected annual effective tax rate is a benefit of 4.2%, which differs from the expense of 2.3% for the quarter ended October 1, 2006 due to the interaction between valuation allowances against our deferred tax assets and net operating losses that have been incurred and changes to contingent liabilities and equity compensation. The low annual effective rate is primarily a result of changes in previously established valuation allowances for our deferred tax assets. 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 revolver portion of our $836.4 million senior secured credit facility (the "Credit Facility"). For the 39-weeks ended October 1, 2006, net cash from operating activities resulted in a use of cash of $35.1 million, resulting in an increased use of borrowings under our credit facility to fund our capital needs. At October 1, 2006, we had cash and cash equivalents of $19.6 million and $31.2 million in available borrowings under the Credit Facility. We believe that cash flow available from operations and borrowings under the Credit Facility will be sufficient to operate our business, satisfy our working capital and capital expenditure requirements, and meet our foreseeable liquidity requirements, including debt service for the remainder of fiscal 2006. However, the financial covenants contained in the Credit Facility will become significantly more restrictive beginning with the measurement following the first quarter of fiscal 2007. Unless we are successful in obtaining an additional amendment to the financial covenants in the Credit Facility, our projected operating results indicate that we will fail the more restrictive financial covenant tests effective as of April 1, 2007. To the extent such a breach occurs, one or more events of default, including cross-defaults between multiple components of our indebtedness, could result. These events of default could permit our creditors to declare all amounts owing to be immediately due and payable and to terminate any commitments to make further extensions of credit. If we are unable to repay our indebtedness, our secured creditors could proceed against the collateral securing the indebtedness owed to them. Because of the likelihood that we will violate the financial covenants contained in our Credit Facility, in accordance with EITF 86-30, "Classification of Obligations When a Violation is Waived by a Creditor," or EITF 86-30, all amounts outstanding under the Credit Facility have been classified as current liabilities as of October 1, 2006. If amounts outstanding under the Credit Facility were called by the lenders due to a covenant violation, amounts under other agreements, such as the indenture governing our 11% Senior Notes and certain leases, could also become due and payable immediately. Should the amounts outstanding under the Credit Facility be accelerated and become due and payable because of our failure to comply with applicable debt covenants in the future, we would be required to search for alternative measures to finance current and ongoing obligations of our business. There can be no assurance that such financing would be available on acceptable terms, if at all. Our ability to obtain future financing or to sell assets to provide additional funding could be adversely affected because we have substantial indebtedness and substantially all of our assets have been secured as collateral under the Credit Facility. In addition, our financial results, our substantial indebtedness, and our reduced credit ratings could adversely affect the availability and terms of financing for us. Further, uncertainty surrounding our ability to finance our obligations has caused some of our trade creditors to impose increasingly less favorable terms, and continuing uncertainty could result in even more unfavorable terms from our trade creditors. Any of these scenarios could adversely impact our liquidity and results of operations. We are exploring several alternative strategies to facilitate further amendments to or a refinancing of our Credit Facility, 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, or that further debt amendments or additional debt or equity financings can be obtained on acceptable terms, if at all. Credit Facility The Credit Facility, which we entered into in connection with our acquisition of Hollywood Entertainment Corporation ("Hollywood"), provides for aggregate borrowings of $836.4 million, consisting of a five-year $75.0 million revolving credit facility due April 27, 2010 (the "Revolver") and two term loans in an aggregate principal amount of $761.4 million as of October 1, 2006. Term Loan A is a $71.5 million loan that matures on April 27, 2010, and Term Loan B is a $689.9 million loan that matures on April 27, 2011. At October 1, 2006, we had $43.8 million drawn under the Revolver, comprised of $23.8 million in letters of credit and $20.0 million in borrowings. On March 15, 2006, we executed a second amendment to the Credit Facility, effective through the fourth quarter of 2006 that relaxed financial covenants, increased restrictive operating covenants and increased interest rate margins. The quarterly financial covenants revert to the original covenants commencing with 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 $19.0 million of unamortized deferred financing costs associated with the Credit Facility. We incurred significant fees related to the second amendment totaling $5.5 million, which have been deferred in accordance with EITF 96-19 and will be amortized over the remaining term of the Credit Agreement. Borrowings under the Term Loan A and the Revolver bear interest at LIBOR plus the following margin based upon a leverage ratio described below: Leverage Ratio LIBOR Margin > 4.00 5.00% 3.25 - 4.00 3.50% 2.75 - 3.25 2.75% 2.25 - 2.75 2.50% 1.75 - 2.25 2.25% < 1.75 2.00% Borrowings under the Term Loan B bear interest at a rate of LIBOR plus 5.25% if our leverage ratio exceeds 4.00; otherwise the rate will be LIBOR plus 3.75%. As of October 1, 2006, the Revolver/Term Loan A and Term Loan B interest rates are 10.37% and 10.62%, respectively. When the leverage ratio is greater than or equal to 4.00, at our discretion, we can elect to defer payment of 0.50% of the Term Loan A, Term Loan B and Revolver interest as non-cash interest, which will be capitalized into the loans (with compounding interest). For the thirteen and thirty-nine weeks ended October 1, 2006, we have recapitalized $1.0 million and $2.0 million of interest, respectively. The Credit Facility requires us to meet certain financial covenants including a leverage ratio test, a fixed charge coverage ratio test and an interest coverage test. Each of these covenants is calculated on trailing four quarter results based on specific definitions that are contained in the credit agreement. In general terms, the leverage ratio is a measurement of total net indebtedness relative to operating cash flow. The fixed charge coverage ratio is a measurement of operating cash flow plus rent relative to total fixed charges including rent, scheduled principal payments, and cash interest. The interest coverage ratio is a measurement of operating cash flow relative to interest expense. The covenant levels under the Credit Facility are as follows: Leverage Fixed Charge Interest Coverage Ratio Coverage Ratio Ratio 2006 Q3 6.75 1.00 1.45 2006 Q4 6.50 1.00 1.45 2007 Q1 2.25 1.10 3.00 2007 Q2 2.25 1.10 3.00 The 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; 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. Term Loan A and Term Loan B require aggregate quarterly prepayments of principal in the amounts of 5.0% and 0.25%, respectively, of the outstanding balances through the first quarter of fiscal 2010, after which the mandatory Term Loan B prepayments escalate. In addition to these prepayments, the Credit Facility also requires us to make prepayments in an amount equal to 100% of any excess cash flow, which generally represents the amount of cash generated by the Company but not used towards operations, debt service, or investments. Based upon our operating results for the thirty-nine weeks ended October 1, 2006 and projected operating results for the remainder of fiscal 2006, we do not believe that we that we will be required to make an excess cash flow prepayment for fiscal 2006. The Credit Facility is fully and unconditionally guaranteed on a joint and several basis by our domestic subsidiaries. The Credit Facility is secured by first priority security interests in, and liens on, substantially all of our direct and indirect subsidiaries' tangible and intangible assets (other than leasehold mortgages on stores) and first priority pledges of all the equity interests owned by us in our existing and future direct and indirect wholly owned domestic subsidiaries and 66 2 / 3 % of the equity interests owned by us in our existing and future wholly owned non-domestic subsidiaries. 11% Senior Notes due 2012 Also in connection with the Hollywood acquisition, we issued $325.0 aggregate principal amount of 11% senior notes due 2012 (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. 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. Accordingly, prior to filing this Quarterly Report on Form 10-Q, the Company was in violation of this covenant. We believe that with this filing the violation was cured. In addition, the senior notes may be accelerated if an event of default occurs under our Credit Facility. Because no events of default have occurred under the Credit Facility as of October 1, 2006 and through the date of our filing of the Form 10-Q no events of acceleration have occurred. Therefore, we believe that the Senior Notes continue to be appropriately classified as long-term as of October 1, 2006. Interest Rate Hedge Our Credit Facility requires 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 three-month LIBOR. The scheduled termination date for both of these swaps was June 29, 2007. Subsequent to the thirty-nine weeks ended October 1, 2006, 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 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 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 October 1, 2006. The operating lease information presented is as of January 1, 2006; however, these amounts approximate the obligations as of October 1, 2006 (in thousands): Contractual 2-3 4-5 More than Obligations Total 1 Year Years Years 5 Years - --------------- ---------- ---------- -------- -------- ---------- Principal Payments Credit Facility Term Loan A (1) $ 71,447 $ 71,447 $ - $ - $ - Term Loan B (1) 689,915 689,915 - - - Revolver 20,004 20,004 - - - Senior Notes 325,450 - - - 325,450 Capital leases 209 193 16 - - Interest Term Loan A (2) 3,581 3,581 - - - Term Loan B (2) 36,585 36,585 - - - Hedge agreement 28 28 - - - Senior Notes 199,844 35,793 71,586 71,586 20,879 Capital leases 3 3 - - - Operating leases 1,612,492 367,033 578,443 356,577 310,439 ---------- ---------- -------- --------- ---------- Total $2,959,558 $1,224,582 $650,045 $ 428,163 $ 656,768 ---------- ---------- -------- --------- ---------- (1) In accordance with EITF 86-30, all amounts outstanding under the Credit Facility as of October 1, 2006 have been classified as current liabilities. See "Liquidity and Capital Resources-Summary". Future prepayments of indebtedness under the amended Credit Facility will be required in an amount equal to our Excess Cash Flow, as defined in the Credit Facility. Based upon our operating results for the thirty-nine weeks ended October 1, 2006 and projected operating results for the remainder of fiscal 2006, we do not believe that we that we will be required to make an excess cash flow prepayment for fiscal 2006. (2) Interest rates are based on current LIBOR rates plus margin. As of October 1, 2006, the Term Loan A and Term Loan B rates are 10.37% and 10.62%, 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. Actual amounts will differ from these estimates, and the difference based on interest rate changes and our leverage coverage ratio may be material. Statements of Cash Flow Data: Thirty-nine Weeks Ended ------------------------- October 2, October 1, 2005 2006 ----------- ---------- ($ in thousands) Net cash provided by (used in) operating activities $ 48,740 $ (35,069) Net cash (used in) investing activities (1,140,877) (14,591) Net cash provided by (used in) financing activities 1,134,330 (66,752) Operating Activities The decrease in net cash provided by operating activities was primarily attributable to an increased use of cash for accounts payable, changes in accrued liabilities and the change in accounting for extended viewing fees, offset by increases in non-cash expenses including rental inventory amortization, property and equipment depreciation and intangible amortization for the first three quarters of fiscal 2006 versus the comparable period in fiscal 2005. During the thirty-nine weeks ended October 1, 2006, we used $157.5 million of cash toward payment of our accounts payable balances. This was driven by the seasonal pay down of accounts payable and credit restrictions on the part of certain vendors. Investing Activities Net cash used in investing activities includes the cost of business acquisitions, new store builds and other capital expenditures. In the thirty- nine weeks ended October 1, 2006, our net cash used in investing activities was $14.6 million, which included 115 new store builds. For the same period in fiscal 2005, our net cash used in investing activities was $1.1 billion, which included the purchases of Hollywood, VHQ Entertainment and 234 new store builds. Capital requirements to fund our projected new store growth of 120 stores for fiscal 2006 and other on-going capital expenditure requirements for the existing store base are estimated at $34 million. 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 is expected to occur in fiscal 2007; however, no purchase price has been negotiated to date related to this pending acquisition. Financing Activities Net cash flow related to financing activities for the thirty-nine weeks ended October 1, 2006 was a use of cash of $66.8 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 Credit Facility. Net cash flow related to financing activities for the thirty-nine weeks ended October 2, 2005 was a source of cash of $1.1 billion, which included borrowings under the Credit Facility and the proceeds from the sale of the Senior Notes used to fund the Hollywood acquisition. At October 1, 2006, we had a working capital deficit of $816.4 million. Apart from the reclassification of all amounts outstanding under the Credit Facility as current liabilities, 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 the major portion of our revenue, the classification of this asset as non-current results in its exclusion from working capital. The aggregate amount payable for this inventory, however, is reported as a current liability until paid and, accordingly, is reflected as a reduction in working capital. Consequently, we believe that working capital is not an appropriate measure of our liquidity, and we anticipate that we will continue to operate with a working capital deficit. Critical Accounting Policies and Estimates Our critical accounting policies are described in our Annual Report on Form 10- K for the fiscal year ended January 1, 2006. Except as noted below, no changes have occurred to our critical accounting policies during the thirty-nine weeks ended October 1, 2006. Rental Inventory 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 by approximately $0 and $11.3 million for the thirteen and thirty-nine weeks ended October 1, 2006, respectively. This reduced net income by $0 and $12.2 million (net of tax), or $0.00 and $0.38 per diluted share, for the thirteen and thirty-nine weeks ended October 1, 2006, respectively. Recently Issued Accounting Pronouncements On March 28, 2006, the Financial Accounting Standards Board ("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)" (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. We are in the process of evaluating the effect of EITF 06- 03 on our financial statements. On July 13, 2006, the FASB issued Interpretation No. 48 (FIN 48), "Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109," 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 April 2006, the FASB issued FSP FIN 46(R)-6, "Determining the Variability to be Considered in Applying FASB Interpretation No. 46(R)-6," (FSP FIN 46(R)-6) which addresses certain major implementation issues related to FASB Interpretation No. 46(R)-6. FSP FIN 46(R)-6 is effective prospectively for to all entities (including newly created entities) with which that enterprise first becomes involved and to all entities previously required to be analyzed under FIN 46(R). We are in the process of evaluating the effect of FSP FIN 46(R)-6 on our financial statements. In September 2006, the FASB issued FASB Statement No. 157 (SFAS 157), "Fair Value Measurements", 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 157 is effective for us for fiscal years beginning after November 15, 2007. We are in the process of evaluating the effect of SFAS 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" (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. We are in the process of evaluating the effect of SAB 108 on our financial statements. Item 3. Quantitative and Qualitative Disclosures About Market Risk Market risk represents the risk of loss that may impact our financial position, operating results, or cash flows due to adverse changes in financial and commodity market prices and rates. We have entered into certain market-risk- sensitive financial instruments for other than trading purposes, principally to hedge against fluctuation in variable interest rates on our short-term and long-term debt. The interest payable on the Credit Facility is based on variable interest rates equal to a specified Eurodollar rate or base rate and is therefore affected by changes in market interest rates. However, as required by the Credit Facility, we have entered into 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%, our interest expense on an annual basis would increase by approximately $5.9 million on the non-hedged principal, based on both the outstanding balance on the Credit Facility as of October 1, 2006 and the Credit Facility's mandatory principal payment schedule. Item 4. Controls and Procedures The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. As of the end of the period covered by this Quarterly Report on Form 10-Q, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Securities and Exchange Act Rule 13a-15. Based upon this evaluation as of October 1, 2006, management concluded that the Company's disclosure controls and procedures were not effective for the reasons more fully described below, related to the unremediated material weaknesses in the Company's internal control over financial reporting identified during the Company's evaluation pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 as of the fiscal year ended January 1, 2006. To address these control weaknesses, the Company performed additional analysis and performed other procedures in order to prepare this Quarterly Report on Form 10-Q, including the unaudited quarterly consolidated financial statements in accordance with generally accepted accounting principles in the United States. Accordingly, management believes that the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, results of operations and cash flows for the periods presented. Management's assessment identified material weaknesses in the Company's internal control over financial reporting as of January 1, 2006 that are in the process of being remediated as of October 1, 2006, as described further below. This section of Item 4, "Controls and Procedures," should be read in conjunction with Item 9A, "Controls and Procedures," included in the Company's Annual Report on Form 10-K for the year ended January 1, 2006 for additional information on Management's Report on Internal Controls Over Financial Reporting. As of October 1, 2006, the unremediated material weaknesses were: Ineffective management review of account analyses and reconciliations. Management's ineffective review of significant account analyses and reconciliations prepared as part of the financial reporting process, arising from a shortage of, and turnover in, qualified personnel, did not function to reduce to remote the likelihood that material misstatement of certain accrued liability accounts in the financial statements would not be prevented or detected in a timely manner. This material weakness resulted in adjustments to several accrued liability accounts and related expenses and could affect substantially all of our significant accounts. Ineffective communication of accounting policy for capitalizing costs and lack of effective review process. Controls related to capitalization of property, furnishings and equipment, including invoice approval, coding and review processes, did not function to reduce to remote the likelihood that material misstatements of property, furnishings and equipment and store operating expenses would not be prevented or detected in a timely manner. This material weakness resulted in adjustments to property, furnishings and equipment, depreciation expense, accumulated depreciation, and store operating expenses. Inaccurate or lack of timely updating of accounting inputs for key estimates and assumptions. Controls that reasonably assure the accurate and timely updating of accounting data used in making estimates for financial reporting purposes did not function to reduce to remote the likelihood that errors in accounts affected by estimation processes could result in material misstatements that would not be prevented or detected in a timely manner. This deficiency is due, in part, to a lack of, and turnover in, qualified people with sufficient skills and experience, and in part to ineffective or incomplete policies and procedures surrounding periodic review and updating of key estimates and assumptions. This material weakness resulted in adjustments to rental inventory amortization, store supplies, merchandise inventory, accrued liabilities, and asset retirement obligations. Remediation The Company has taken the following actions to address these material weaknesses: Capitalizing costs - Management issued a Capital Expenditures policy on June 30, 2006 that includes guidance and thresholds in accounting for fixed asset additions and developed a monitoring control to regularly review the details of fixed asset additions in accordance with the policy. Management has taken the action described above, which it believes addresses the material weakness related to properly capitalizing costs. Tests for effectiveness of these controls will likely be completed in the fourth quarter of fiscal 2006. As a result, management will not be able to determine whether or not the remediation was successful until that time. Remediation efforts surrounding ineffective management review of account analyses and reconciliations, and inaccurate or lack of timely updating of accounting inputs for key estimates and assumptions will likely occur in the fourth quarter of fiscal 2006 in conjunction with integrating the majority of the Company's accounting functions into its Wilsonville, Oregon location. Other Changes in Internal Control over Financial Reporting Pursuant to ongoing merger and process integration efforts arising out of the Hollywood acquisition, there continues to be a transition of certain financial reporting functions from the Company's headquarters in Dothan, Alabama to the Wilsonville, Oregon location. There have been no other changes in the Company's internal control over financial reporting, other than those previously noted, during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Part II - Other Information Item 1. 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 by Hollywood 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. Hollywood denies these allegations and is vigorously defending this lawsuit. Hollywood was named as a defendant in a sexual harassment lawsuit filed in the Supreme Court of the State of New York, Bronx County on April 17, 2003. The action, filed by eleven former female employees, alleges that an employee, in the course of his employment as a store director for Hollywood, sexually harassed and assaulted certain of the plaintiffs, and that Hollywood and its members of management failed to prevent or respond adequately to the employee's alleged wrongdoing. The plaintiffs seek unspecified damages, pre-judgment interest and attorneys' fees and costs. Hollywood denies these allegations and is vigorously defending this lawsuit. In addition, we have been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. A negative outcome in certain of the ongoing litigation could harm our business, financial condition, liquidity or results of operations. In addition, prolonged litigation, regardless of which party prevails, could be costly, divert management attention or result in increased costs of doing business. We believe we have provided adequate reserves for contingencies and that the outcome of these matters should not have a material adverse effect on our consolidated results of operation, financial condition or liquidity. At October 1, 2006, the legal contingencies reserve, net of expected recoveries from insurance carriers, was $1.6 million, of which $1.1 million relates to pre-acquisition contingencies. Adjustments related to pre-acquisition contingencies made after the anniversary date of the acquisition will be recognized in the income statement in the period when such revisions are made. All other adjustments related to matters existing as of the date of acquisition of Hollywood will be recognized in the income statement in the period when such revisions are made. Item 1A. Risk Factors Our Annual Report on Form 10-K for the year ended January 1, 2006 includes a detailed discussion of our risk factors. The information presented below amends, updates and should be read in conjunction with the risk factors and information disclosed in our Annual Report on Form 10-K for the fiscal year ended January 1, 2006. Our projected inability to maintain the financial ratios in our Credit Facility may require us to seek alternative sources of financing. Our Credit Facility requires us to maintain certain financial ratios. The financial covenants contained in the Credit Facility will become significantly more restrictive beginning with the measurement following the first quarter of 2007. Unless we are successful in obtaining an additional amendment to the financial covenants in the Credit Facility, our projected operating results indicate that we will fail the more restrictive financial covenant tests effective as of April 1, 2007. We cannot assure you that such amendments or additional debt or equity financings can be obtained on acceptable terms, if at all. Our financial condition, in particular our significant indebtedness, may make it difficult for us to obtain such an amendment. In order to obtain such an amendment, we may be forced to incur significant expenses or agree to other restrictive covenants that limit our operating flexibility. Any failure to comply with the financial or other covenants contained in our Credit Facility may allow our creditors to accelerate the related debt and may result in the acceleration of any other debt to which cross-acceleration or cross-default provisions apply. In addition, these creditors may be able to terminate any commitments they had made to provide us with further funds. See Management's Discussion and Analysis of Financial Condition and Results of Operations, "Liquidity and Capital Resources," for more information on our restrictive and financial covenants. Uncertainty surrounding our ability to meet our financial obligations has adversely impacted and could continue to adversely impact our ability to obtain sufficient product on favorable terms. Since our acquisition of Hollywood in April 2005, we have entered into two amendments of the Credit Facility pursuant to which certain covenants in our Credit Facility were amended or waived. This, coupled with the continued declines and uncertainty in the rental industry, has caused negative publicity surrounding our business. As a result, our flexibility with our suppliers has been affected, and this risk may be exacerbated by the reclassification of borrowings under our Credit Facility as current liabilities on our balance sheet. We cannot assure you that our trade creditors will not further change their terms for payment on goods and services provided to us or that we will continue to be able to receive products and services on acceptable terms. To the extent our trade creditors change their terms in a manner that is adverse to us, this will increase the amount of cash that we need to operate our business, which may not be available on acceptable terms from lenders, or at all. 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. There can be no assurance that we will not be required to pay additional amounts, which may be material, as a result of these audits. Further, some of our agreements may be terminated on short notice. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits a) Exhibits 31.1 Certification of Chief Executive Officer pursuant to Rule 13a- 14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a- 14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934. 32.1 Certification of Chief Executive Officer pursuant to Rule 13a- 14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C Section 1350. 32.2 Certification of Chief Financial Officer pursuant to Rule 13a- 14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C Section 1350. Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Movie Gallery, Inc. ------------------- (Registrant) Date: January 19, 2007 /s/ Thomas D. Johnson, Jr. ------------------------------- Thomas D. Johnson, Jr., Senior Vice President and Chief Financial Officer


DELAWARE (State or other jurisdiction of incorporation or organization)		63-1120122 (I.R.S. Employer Identification No.)

900 West Main Street, Dothan, Alabama (Address of principal executive offices)		36301 (zip code)


	Item 5. Other Information
	Item 6. Exhibits
Signatures
EX-10.1 EXECUTIVE EMPLOYMENT AGREEMENT
EX-31.1 SECTION 302 CERTIFICATION OF CEO
EX-31.2 SECTION 302 CERTIFICATION OF CFO
EX-32.1 SECTION 906 CERTIFICATION OF CEO
EX-32.2 SECTION 906 CERTIFICATION OF CFO


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

	10.1		Executive Employment Agreement between Movie Gallery US, LLC and Keith A. Cousins dated August 23, 2006.

	31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a) of the Securities Exchange Act of 1934.


	Movie Gallery, Inc.
	(Registrant)
Date: March 13, 2007	/s/ Thomas D. Johnson, Jr.
	Thomas D. Johnson, Jr.,
	Senior Vice President and Interim Chief Financial Officer