March 3, 2006
Movie Gallery Inc.
Commission file #: 000-24548
Responses to Staff's Comments on letter dated December 21,2005
Form 10-K for the year ended January 2, 2005
1. We note your disclosure on page 9 that you have a customer loyalty
program, Reel Players, which is based on a point system and provides
customers the opportunity to earn free rentals and discounts on movie
purchases. Please tell us and explain in the notes to your financial
statements in future filings, how you value and account for free rentals and
discounts awarded to customers under this program.
Response
Customers who choose to participate in our Reel Players program accumulate
points on their account each time they rent or purchase movies or games in
our store. After accumulating a defined level of points, the customer
receives a coupon printed by our point of sale system for a free rental or a
discount off the purchase of a previously viewed movie or game. The coupon
expires 45 days after issuance to the customer. The coupon cannot be
redeemed for new merchandise. Similar to our accounting for all other
promotional coupons included in periodic mailings or promotions, no entry is
made when the coupon is given to the customer. In order to redeem the
coupon, the customer must bring it with them on a subsequent visit (it is not
automatically offered at the register). When the coupon is redeemed by the
customer, rental revenue is recognized for the current rental price of the
movie or game or the current sale price of the previously viewed movie or
game. A corresponding promotional credit is also recorded against rental
revenue to offset the value of the transaction. We note that this type of
transaction was addressed by the EITF in the discussion of EITF 00-22 (Issue
1) and that the EITF did not reach a consensus. Nevertheless, we considered
the alternative views discussed in that EITF Issue and concluded that due to
the volume of redemptions, the relatively short expiration of the coupons
offered and the historical non-redemption rate, the effect of applying a
different accounting model to this activity would be insignificant. We will
revise future filings to include the following disclosure in our revenue
recognition policy footnote:
We offer a point based loyalty program, Reel Players, to our customers. The
program provides customers the opportunity to earn free rentals or discounts
on previously viewed inventory purchases. The Reel Players coupon is issued
to a customer upon accumulation of a predefined number of points that are
earned for previous rental or sale transactions. Rental revenue is
recognized when the coupon is redeemed by the customer for the current rental
price of the movie or game or the current sale price of the previously viewed
movie or game. A corresponding promotional credit is recorded against rental
revenue to offset the value of the transaction in accordance with the terms
of the coupon.
2. We note from your table of Selected Financial Statement and Operational
Data that you present "equity in losses of unconsolidated entities" above the
operating income line item. For consistency with your financial statement
presentation, please revised future filings to present the "equity in losses
of unconsolidated entities" below operating income if you continue to
separately present the caption in this table.
Response
We note the Staff's comment and will revise future filings if we continue to
separately present "equity in losses of unconsolidated entities" in the MD&A
Selected Financial Statement and Operational Data table to be consistent with
our financial statement presentation.
3. We note that you have presented purchases of rental inventory-base stock
as a component of investing activities. Please revise to also present
proceeds from the sale of base stock rental inventory as a component of cash
flows from investing activities, as including declines in base stock rental
inventories in operating cash flows results in an overstatement of cash flows
from operations.
Response
The Staff's comment is noted. The Company generally does not sell base stock
or catalog rental inventories. Base stock inventory is sold only if a format
or specific title is being phased out (e.g. VHS catalog rental inventory
being replaced by DVD or some future format). Prior to being sold, base
stock inventory is converted to previously viewed product available for sale
and is indistinguishable from other previously viewed product. Accordingly
we historically have been unable to determine the proceeds generated by the
sales of specific units that were formerly classified as base stock rental
inventory. While we believe our current presentation, which classifies most
of our rental inventory purchases as operating activities already, but treats
purchases of base stock inventory as an investing activity is appropriate, we
acknowledge that there could be some cash inflows attributable to base stock
that is not matched with the related cash flows in the investing activities.
To minimize the potential overstatement of cash flows from operations, we
will reclassify purchases of rental inventory-base stock from investing
activities to operating activities for all periods presented in our
Consolidated Statement of Cash Flows included in our Form 10K filed on or
before March 17, 2006 and all future filings. We will also revise all other
disclosures of operating and investing cash flows made in our Form 10-K to be
consistent with the financial statement presentation.
4. We note that the fiscal 2003 balance sheet reflects the reclassification
of certain outstanding checks that were made between cash and cash
equivalents, prepaid expenses and accounts payable. Please tell us the
nature of these reclassifications including your accounting basis for the
past and current balance sheet and cash flow presentations.
Response
In the third quarter of 2004, during our financial statement close process,
we noted a misclassification of outstanding checks that should have been
offset against available cash in our concentration account versus being
classified as a current liability. The outstanding checks included rent
payments under operating leases (that are actually due on or about the first
day of the month) for the following month that are typically paid during the
last week of the prior month. This misclassification was also contained in
the fiscal 2003 balance sheet. Accordingly, we reclassified outstanding
checks in the balance sheets for all prior periods affected by the
misclassifications and made corresponding reclassifications in the statements
of cash flows for all affected periods to reflect the reclassifications in
the fiancial statements for the third quarter of 2004. We have consistently
classified the outstanding checks in all subsequent periods, to the extent
that sufficient funds were on deposit in our bank accounts to cover checks
issued and released prior to month end. For any period where cash on hand in
our concentration accounts were/are not sufficient to cover the outstanding
checks issued, we have and will continue to classify those as current
liabilities.
5. We note that you recorded a cumulative fourth quarter adjustment to
correct depreciation expense of $6.3 million, related to a correction in your
accounting for leases and leasehold improvements, of which $2.9 million
related to years prior to 2004 and was not considered material to warrant a
restatement. Please show us your analysis of the materiality of the 2004
adjustment to the quarterly operating results for each of the quarterly
periods comprising 2004 and explain why you do not believe that restatement
of the first through third quarter of 2004 is necessary. Additionally, tell
us the amount of the $2.9 million adjustment related to prior years that
related to fiscal years 2003 and 2002. We may have further comment upon
review of your response.
Response
Our analysis of the materiality of the fourth quarter adjustment to
depreciation expense was based on a consideration of both quantitative and
qualitative factors, pursuant to SAB 99. The schedule below illustrates our
quantitative analysis of the adjustments on income for the full fiscal years
2002 through 2004, as well as the interim periods of fiscal 2004. Based on
the immateriality of the cumulative difference to the 2004 income statement
and the immateriality of the year-to-year differences in 2002 and 2003, we
recorded the impact of this lease accounting review as a fourth quarter
charge in fiscal 2004. We also considered the impact of the error on the
previously reported results for each of the first three quarters and
determined that the uncorrected error was not material to any of the prior
quarters within fiscal 2004.
FY 2002 FY 2003 Q1 Q2 Q3 Q4 FY 2004
Net income before tax, 34,857 81,423 29,997 17,433 15,105 18,669 81,204
as reported (NIBT)
Depreciation expense (665) (1,858) (803) (875) (879) 5,431 2,874
adjustment
% of NIBT -1.91% -2.28% -2.68% -5.02% -5.82% 29.09% 3.54%
Adjusted net income 34,192 79,565 29,194 16,558 14,226 24,100 84,078
before tax (ANIBT)
% of ANIBT -1.9% -2.3% -2.8% -5.3% -6.2% 22.5% 3.4%
Our qualitative analysis included the following considerations:
- - The effect of not correcting the errors through restatement was not
material to the trend of earnings or debt covenants;
- - The adjustment was non-cash and had no impact on cash flow from
operations.
Furthermore, we considered the provisions of par. 29 of APB 28, which state
that for purposes of evaluating the materiality of such adjustments on the
results of operations for interim periods, the measure of "materiality"
should be based on what is material to the annual financial statements, not
on the interim period operating results.
6. We note from your Schedule 14A Proxy Statement filed May 6, 2005, that
under the Certain Relationships and Related Party Transactions section, you
disclose a number of related party transactions which are not included in the
notes to your financial statements in your Form 10-K. In the notes to your
financial statements in future filings, please disclose the nature of the
relationship of the parties involved, a description of the transactions,
including transactions to which no amounts or nominal amounts were ascribed,
and the dollar amounts of transactions for each of the periods for which
income statements are presented. Your revised disclosure should include all
transactions between the Company and entities affiliated with its officers
and directors.
Response
The Staff's comment is noted. We evaluate all related party transactions in
terms of materiality -- taking into consideration both qualitative and
quantitative factors such as:
1. Relevance of the information regarding the related party transaction
and whether the operating results or financial position of the company
would be significantly different had the related party transaction not
taken place and/or
2. Impact that related party transactions would have on the users of the
financial statements ability to compare the company's results of
operations and financial position with those of prior periods and with
those of other enterprises.
To the extent related party transactions are material, the company will
disclose the transactions in accordance with SFAS 57. Future filings of the
company's Form 10-K will include all material related party transactions in
accordance with SFAS 57 paragraph 2.
7. Please advise us in further detail regarding the nature of the
adjustments to the deferred tax asset valuation allowance during the fiscal
years ended January 5, 2003 and January 4, 2004 that are described as
"revision of allowance to offset true-up of preliminary estimated net
operating loss carryforwards to actual". Similarly explain the nature of the
$1,291 adjustment recognized during the fiscal year ended January 2, 2005
that is described as "reduction to true-up preliminary estimated state net
operating losses to actual". Your response should clearly explain why
management does not believe these adjustments represent corrections of errors
pursuant to paragraph 36 of APB 20. We may have further comment upon review
of your response.
Response
On December 21, 2001, we purchased the stock of Video Update, Inc. and its
subsidiaries out of bankruptcy. We applied purchase accounting to the
acquired assets and liabilities, including net operating loss ("NOL")
carryforwards. We estimated the deferred tax asset related to the NOL's
available at the end of the fiscal year ended January 6th, 2002, at $25.5
million with a valuation allowance of $18.4 million for a net deferred
tax asset of $7.1 million. Subsequent adjustments to the NOL were the
result of new information regarding the nature and amount of the NOL's.
In each case, the adjustments to the NOL were offset by a corresponding
adjustment to the valuation allowance resulting in no impact to income tax
expense, as our estimate of the net realizable amount of NOL's was
unchanged. Other changes in the valuation allowance as a result of
utilization of NOL's or other miscellaneous adjustments were properly
adjusted to income tax expense. Accordingly, we do not believe any of
these adjustments represent corrections of an error. We will clarify
footnote disclosures in Schedule II in future filings by eliminating the
parenthetical references.
The following table illustrates the adjustments to the valuation allowance
and the corresponding impact to the net deferred tax asset:
Deferred Valuation Net Deferred
Tax Asset Allowance Tax Asset
Balance YE 2001 (1/6/2002) 25,490 (18,412) 7,078
- ----------------------------------------------------------------------------
True-up estimated NOLs (1) 6,541 (6,541) -
Miscellaneous adjustments (87) - (87)
YE 2002 (1/5/2003) 31,944 (24,953) 6,991
- ----------------------------------------------------------------------------
True-up estimated NOLs (1) 9,491 (9,491) -
Utilization of NOL in return (600) - (600)
Miscellaneous adjustments (214) - (214)
YE 2003 (1/4/2004) 40,621 (34,444) 6,177
- ----------------------------------------------------------------------------
True-up estimated NOLs (1) (1,291) 1,291 -
Utilization of state NOL in return (411) 411 -
Miscellaneous adjustments (202) 100 (102)
YE 2004 (1/2/2005) 38,717 (32,642) 6,075
- ----------------------------------------------------------------------------
(1) The true-ups of the estimated NOLs were a result of the following
factors:
- - Video Update was acquired out of bankruptcy with very few long-term
employees in place and poor record keeping;
- - Acquisition occurred late in the year leaving an inadequate
amount of time to perform a complete review of the status of the
NOLs;
- - The original purchase price allocation was based on an estimate
based on the best information available at that time;
- - Video Update did business in approximately 30 states; Individual
state NOLs had to be researched and analyzed in addition to the
federal NOLs;
- - First round of NOL true-ups did not take place until September
2002 when the short period returns from 2001 were filed;
- - Subsequent to filing of the 2001 returns, it was discovered that
there was a subsidiary of Video Update that was dissolved prior
to the acquisition but the related NOLs were not included in the
original computation of the purchase price allocation nor in the
2001 tax returns; This true-up was made during 2003.
From 10-QSB for the quarter ended July 3, 2005
8. We note your disclosure that purchases of DVD catalog are currently
amortized on an accelerated basis over twenty-four months and VHS catalog is
amortized on an accelerated basis over twenty-four months for new store
purchases and six months for all other catalog purchases. This disclosure
appears to be inconsistent from that in Note 1 to the financial statements
included in your Form 10-K for the year ended January 3, 2005 which states
that base stock movie inventory is amortized on an accelerated basis over the
first twelve months and then on a straight-line basis over the next twelve
months for DVD and VHS. Please reconcile these inconsistencies for us and
revise further filings as appropriate.
Response
We note the Staff's comment regarding the differences in the description of
our amortization policy in the footnote disclosures in Movie Gallery's 2004
Form 10-K versus the similar disclosure in the second quarter 2005 Form 10-Q.
To clarify, there have been no changes in our amortization methods or rates
for catalog VHS and DVD inventory. We simply shortened the description to
omit unnecessary detail. As many accelerated methods of amortization convert
to straight-line at some point during the useful life, we felt that
disclosure of the specific point at which our amortization method switches to
straight-line was not necessary to an understanding of our policy. Although
our prior footnote wording did include this level of detail, we no longer
believe that it is necessary to an understanding of our amortization policy,
and we have decided to eliminate that level of detail from the description of
our policy. We believe the current disclosure is more appropriate and
therefore we propose that we do not revert to our former language in future
filings.
9. We note the disclosure indicating that in order to conform Hollywood's
accounting method of extended viewing fees to that used by Movie Gallery, the
Company has reflected the portion of extended viewing fees that related to
receivables from customers at the date of the merger as a reduction of the
receivable balance and extended viewing fees are no longer being recognized
in advance of collection. We further note that as a result, in the thirteen
and twenty-six week periods ended July 3, 2005, this transition in accounting
methods reduced rental revenue by $12.8 million and reduced operating income
by $11.2 million after for adjusting accrued revenue sharing on accrued
extended viewing fees.
We believe this disclosure is not entirely accurate since Hollywood's results
were not included in you results of operations prior to the merger, and
therefore you rental revenues and operating income were not actually reduced
by these amounts. A more accurate statement would be to indicate that
extended viewing fees subsequent to the merger were lower than in periods
prior to the merger as a result of this transition in accounting policy.
Please confirm that you will clarify your disclosure regarding this matter in
any future filings.
Response
The staff's comment is noted and the disclosure will be clarified in future
filings. The disclosure in future filings will read as follows:
The Company has reflected the portion of extended viewing fees collected that
related to receivables from customers at the date of the merger as a
reduction of the receivable balance and extended viewing fees are no longer
being recognized in advance of collection. As a result of this transition in
accounting policy, in the ten week period ended July 3, 2005 for the
Hollywood segment, extended viewing fees recognized as rental revenue and
operating income were $12.8 million and $11.2 million, respectively, less
than in the comparable period of 2004 (prior to the merger).
10. We note from your disclosure in Note 2 that you allocated $170.9 million
of the purchase price of Hollywood Entertainment to the indefinite lived
trade name of Hollywood Video. Please tell us in detail how you determined
the fair value of this intangible asset. Also, please tell us why you have
determined that the asset does not have a 15-year useful life, especially
considering you have assigned a useful life to the intangible asset related
to the Game Crazy trademark. Include in your response an analysis that
considers all of the relevant factors in paragraph 11 of SFAS No. 142 and any
additional information such as any restrictions or limitations that exist
regarding the life of the trade name. Also, tell us the methods you plan to
utilize for assessing the asset for impairment.
Response
The Company retained Houlihan Lokey Howard & Zukin Financial Advisors, Inc.
to value the Hollywood trade name. The valuation specialists used the Relief
from Royalty method, a specific Discounted Cash Flow (DCF) approach to
analyze cash flows attributable to the Hollywood trade name. The fair value
of the Hollywood trade name is the present value of the income associated
with the trade name based on a 2.0% royalty rate and a 16.0% discount rate.
Management provided revenue projections for the years 2005 through 2011. The
income associated with the Hollywood trade name is calculated by using the
revenue projections multiplied by the 2.0% royalty rate and then applying a
38.5% marginal tax rate. A terminal value was calculated using a 1.5%
terminal growth rate and discount rate. These cash flows were discounted
back to the transaction date and an amortization tax shield value was added
to trade name cash flows based on current tax legislation.
The life of the Hollywood trade name is considered to be indefinite because
we expect to use the trade name in the home movie entertainment business
indefinitely, and we expect to generate cash flows using this trade name
indefinitely. The relevant factors in paragraph 11 of SFAS 142 were
considered as follows in determining the indefinite life.
a) The expected use of the asset by the entity - Management intends to
maintain the Hollywood brand and store format indefinitely. The Hollywood
trade name is a national brand with significant brand recognition in the
marketplace.
b) The expected useful life of another asset or a group of assets to which
the useful life of the intangible asset may relate - The Hollywood trade name
is not dependent on the store format. The trade name is being used on the
internet, on video kiosks outside of the stores, and the company has plans to
use the trade name in other alternative delivery vehicles such as video on
demand and home delivery.
c) Any legal, regulatory, or contractual provisions that may limit the useful
life - The Hollywood trade name was first used in 1989, was registered in
1994 and the United States Office of Patents and Trademarks acknowledged a
Section 15 affidavit on November 30, 2001. There are no legal, regulatory or
contractual provisions that limit the useful life.
d) Any legal, regulatory, or contractual provisions that enable the renewal
or extension of the asset's legal or contractual life without substantial
cost -The trade name can be renewed or extended at a nominal cost.
e) The effects of obsolescence, demand, competition, and other economic
factors - The theatrical movie business has been in existence for over 100
years. The home entertainment industry is expected to benefit from the
release of high definition DVDs in the near future. The Company is pursing
alternative delivery channels including kiosks, internet, video on demand,
and home delivery in addition to the existing store base.
f) The level of maintenance expenditures required to obtain the expected
future cash flows from the asset - The level of maintenance expenditures
required to obtain the expected future cash flows from exploitation of the
trade name are not incremental to running our business.
The 15 year life of the Game Crazy trade name was based on a limited history,
its historically negative operating margin and its relative dependency on the
Hollywood trade name. In reaching the conclusion that the life of the Game
Crazy trade name was finite, rather than indefinite, we also considered the
competitive position of our Game Crazy business relative to its competitors,
and noted that it does not have the same dominant market share position that
the Hollywood trade name enjoyed immediately prior to the acquisition. We
therefore considered this trade name to be fundamentally different, in terms
of the criteria referred to in paragraph 11 of SFAS 142, from the Hollywood
trade name.
The Hollywood trade name will be tested annually (or upon the occurrence of
other "triggering" event) for impairment using the same Relief from Royalty
method (DCF) used to establish the fair value in accordance with SFAS 142
paragraphs 17 and 23-24.
11. We note your disclosure that the changes in the carrying amounts of
goodwill during the fiscal year ended January, 2005 included approximately
$8.4 million in adjustments to acquired goodwill. Please explain and
disclose in future filings the nature of those adjustments to goodwill.
Response
The $8.4 million in adjustments to acquired goodwill were adjustments to the
preliminary purchase price allocation of the Hollywood acquisition detailed
in note 2 Business Combinations for the period ended July 3, 2005. The $8.4
million is comprised of adjustments for:
a) $5.9 million in employee separation costs for Hollywood employees detailed
in note 2 Business Combinations in accordance with EITF 95-3
b) $2.1 million in costs to close 50 Game Crazy departments ($1.8 million in
asset disposals and $0.3 million in cash costs) detailed in note 2 Business
Combinations in accordance with SFAS 141 Business combinations
c) $0.3 million in adjustments to fixed asset fair value
d) $0.1 million in the carrying value of merger related expense accruals.
The dollar amount and nature of the above items will be included in the
adjusted acquired goodwill total in future filings.
Form 10-QSB for the quarter ended October 3, 2005
12. Please tell us and explain in the notes to your financial statements in
future filings the facts or circumstances that resulted in the change in the
purchase price allocation for the acquisition of Hollywood during the third
quarter of 2005.
Response
The purchase price allocation and fair value evaluations were in process as
of the opening balance sheet and were further revised in the third quarter.
We stated in note 2 paragraph 3 of the second quarter Form 10-Q, that the
purchase price allocation was preliminary and adjustments were expected.
Below are the explanations of the adjustments to the preliminary purchase
price allocations:
a) Accounts Payable - During the third quarter we completed an analysis as to
the amount we believe we owed to the studios as of the opening balance sheet
date. The analysis was based on revised estimates, detailed reconciliations
and true up of accrual estimates made in Hollywood's April 27 closing balance
sheet to their actual amounts.
b) Accrued liabilities - The adjustments as of the acquisition date include:
- - recording a liability for employee separation costs for Hollywood
employees (EITF 95-3) as explained in the response to Staff comment #11
above;
- - adjusting to fair value of Hollywood favorable and unfavorable operating
leases based on a report received from the valuation consultant in the
third quarter;
- - adjusting pre-acquisition legal contingencies to the amount determined
by Movie Gallery to be more probable based on management's assessment of
the individual matters using all available information;
- - adjusting accrued bonuses estimated at the acquisition date (April 27,
2005) to actual amounts subsequently paid (considering the impact of
employee separations and changes to the bonus plans implemented as of
the transaction date by Movie Gallery);
- - adjusting the accruals for Hollywood pre-merger expenses included in the
April 27, 2005 Hollywood balance sheet to their actual amounts;
- - adjusting the store closure accrual (EITF 95-3)to reflect the cost to
close 50 Game Crazy stores that we determined to close shortly after the
merger was completed (as explained in the response to staff comment #11
above).
c) Deferred revenue - The adjustment of deferred revenue liability balances,
related to adjusting deferred revenue associated with stored value (gift)
cards to fair value in accordance with EITF 01-3. This adjustment was
determined, in part, based on an analysis of the fair value completed by our
valuation advisors in the third quarter.
These adjustments account for substantially all of the goodwill adjustments
related to the purchase price allocation for the acquisition of Hollywood
during the third quarter of 2005. We will expand our disclosure in future
filings to include the facts and circumstances resulting in the change in
purchase price allocation.
13. Please tell us and revise the notes to your financial statements to
disclose the factors that contributed to a purchase price that resulted in
recognition of goodwill in connection with the Hollywood and VHQ acquisition
transactions. Refer to the requirements of paragraph 51b of SFAS No. 141.
Response
Movie Gallery, Inc. was willing to pay a premium to acquire Hollywood based
on the following factors:
a) Geographic footprint of combined companies - The merger forms 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 possess
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.
b) Cost savings - We expect the combined operation 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.
c) Operating efficiencies - We expect to improve operational performance due
to greater distribution density, consolidation of duplicative functions and
the adoption of best practices at the approximately 4,570 store locations
that the combined company will have after the merger.
d) In order to make this acquisition, Movie Gallery participated in a
competitive bidding process against Leonard Green & Partners L.P. and
Blockbuster, Inc. Movie Gallery's successful bid was $1.25 per share lower
than Blockbuster, Inc.'s bid.
e) Hollywood's stock (NASDAQ symbol HLYW) was trading at a premium to book
value due to merger and acquisition speculation.
These factors contributed to a purchase price that resulted in recognition of
goodwill in connection with the acquisition of Hollywood. The notes in
future filings will be revised to include the requested information regarding
the Hollywood acquisition.
With respect to VHQ, we were willing to pay a premium for this acquisition in
order to eliminate a direct competitor, strengthen our market share position
in Canada, and take advantage of operational and overhead synergies.
However, we did not include this disclosure in our Form 10-Q because we do
not consider VHQ to be an individually significant acquisition. The purchase
price of VHQ was insignificant in relation to the Hollywood acquisition and
its impact on our operating results and financial condition are insignificant
relative to the size of the combined company. In this regard, we specifically
considered the disclosure requirements listed under paragraph 51 of SFAS No.
141 pertaining to a "material" business combination. To determine
materiality, we looked to the guidance in Section 210.11-01(b) and Section
210.1-02(w) of Regulation S-X. In our view, neither VHQ, individually, nor
the sum of VHQ and the other immaterial acquisitions, in the aggregate, meet
the conditions set forth in determining materiality (i.e., a "significant
subsidiary"). Please note that we have disclosed substantially more
information about these acquisitions than is otherwise called for in
paragraphs 53 (individually immaterial business combinations) and 52
(materiality of goodwill in relation to total acquisition cost) of SFAS No.
141. Although the sum of the VHQ acquisition and the other individually
immaterial acquisitions are not, in the aggregate, material, we have
presented this information in the belief that it is useful to investors. We
do not propose to add further disclosure in our future filings concerning the
VHQ acquisition.
14. We note from your disclosure in Note 2 that on August 29, 2005 Boards
Video Company LLC exercised a contractual right to require Hollywood to
purchase all of the 20 Hollywood Video stores and 17 Game Crazy stores
pursuant to a "put" option contained in the license agreement for these
stores. Please explain to us, and disclose in future filings, the date at
which you issued the "put" option and the nature of the terms of the "put"
option, including the amount or formula for determining the purchase price of
the stores. Also, please tell us how you accounted for this "put" option
liability at the time it was issued and the literature that supports you
accounting treatment. Additionally, please explain how this "put" option was
valued and accounted for in the Hollywood acquisition transaction.
Response
The contingent "put" option, and a related contingent "call" option, was
contained in the License Agreement between Hollywood and Boards (Licensee)
which was effective January 25, 2001, and related to certain stores and
related assets. On a change of control (as defined in the agreement)
Hollywood had an option to purchase the stores from the Licensee within six
months. Likewise, on a change in control, the Licensee had the option to
require Hollywood to purchase the stores within six months. In both cases,
the price of the option to purchase or option to sell was detailed in the
License Agreement and was at fair value as determined by an appraisal
process.
This feature of the license was determined not to be a derivative (or
embedded derivative) under FASB Statement No. 133 because it did not meet the
definition of a derivative. The put and call features were not net
settleable as there was no provision for net cash settlement, there was no
market for the option features, and the underlying asset (the stores) were
not readily convertible to cash. We did consider the Staff's preference that
written options, regardless of whether they are derivatives under the
literature or not, be reflected in the financial statements at fair value.
However, there was no asset assigned to the call option nor liability
assigned to the written put option both a) when the License agreement was
signed by Hollywood and Boards, and b) as of the acquisition (in our purchase
accounting) since both the written "put" and the "call" would be exercised as
fair value transactions, and an option to transact at fair value has a fair
value of zero. Paragraph 37 (k) of SFAS 141 requires establishing a value for
favorable and unfavorable contracts and since both the "put" and the "call"
are fair value, there is no favorable or unfavorable component to value in
purchase accounting.
The purchase of Hollywood by the Company met the definition of a "change of
control" per the License agreement and the "put" option was exercised by
Boards Video Company LLC. As disclosed in note 2 in our third quarter Form
10-Q, we expect to complete the acquisition of these stores in first quarter
2006.
Disclosures in future filings will be revised to contain the requested
information.
15. We note that a change in estimate was recorded in the quarter ended
October 2, 2005 to conform the lives of Hollywood's long lived assets to
Movie Gallery's policy and record the increase in depreciation expense
generated by recording Hollywood's long lived assets at their increased fair
value in the business combination accounting. Please explain to us why you
did not make the change to conform the lives of Hollywood's long lived assets
to Movie Gallery's policy during the second quarter of 2005 when the
acquisition took place. Also tell us why the increased in depreciation
expense generated by the increased fair value in Hollywood long lived assets
is considered a change in accounting estimate, as it appears from Note 2 that
the value of the acquired long lived assets did not change between the second
and third quarter. Also, tell us why you believe it is appropriate to charge
the portion of the amount that related to the ten weeks ended July 3, 2005 in
the thirteen weeks ended October 2, 2005, rather than restating the second
quarter Form 10-Q. We may have further comment upon receipt of your
response.
Response
As of the second quarter of 2005, Hollywood had received only a summary level
long-lived asset schedule from the valuation specialist. This schedule
provided an appropriate basis to record an estimate of the increased fair
value of property, furnishings and equipment in the second quarter, but we
were unable to calculate the precise impact on depreciation of conforming the
lives to Movie Gallery's depreciation policies or the impact on depreciation
expense attributable to the change in asset fair values without the detail
asset files. The detail asset files were needed, for example, to match up
the revised fair values of the leasehold improvements by store with the
remaining lives of the leases as of the acquisition date. We estimated the
depreciation for the Hollywood assets based on the historical quarterly
depreciation trends and the aggregate fair value, but were unable to make
precise computations of depreciation expense in the second quarter with the
best information available and we disclosed that the purchase price
allocation was preliminary. Implicit in this disclosure, we believe, is an
understanding that subsequent changes in the allocation could have an impact
on post-combination operating results.
We did not receive detail asset files from the valuation specialist until
August 2005. The impact on depreciation of the increase in fair value and
conforming the useful lives of Hollywood to the Movie Gallery's policy was
calculated and recorded in the third quarter.
The disclosure regarding the change in estimate in the second paragraph
following the table in note 3 of the third quarter Form 10Q referred to
conforming the lives of Hollywood's long lived assets to the Company's policy
only. The disclosure will be clarified in future filings. Movie Gallery and
Hollywood followed the same accounting policy for amortizing leasehold
improvements-both companies amortized leasehold improvements over the lesser
of the "lease term" or the assets' useful lives, as determined under FASB
Statement 13.
We believe that the effects of this adjustment were appropriately accounted
for as a revision in estimate in the third quarter with appropriate
disclosure of the portion attributable to the ten weeks ended July 3, 2005 in
accordance with APB 28 paragraph 26, and SFAS No. 154 paragraph 19.
16. We note your disclosure in Note 6 that you have entered into a two-year
floating-to-fixed interest rate swap for an amount of $280 million. Please
tell us, and disclose in future filings, how you have accounted for the swap
in accordance with the guidance in SFAS No. 133.
Response
The interest rate swap is a cash flow hedge. The hedge is structured such
that all of the terms match exactly to the hedged debt and there is no hedge
ineffectiveness. The terms of the debt and the fixed rate payments to be
received on the swap coincide (notional amounts, payment dates, terms and
rates) and the hedge is considered perfectly effective. We designated the
swap, at inception, as a cash flow hedge and documented our hedge designation
contemporaneously. At the end of each reporting period, we assess hedge
effectiveness by making sure that the terms match exactly the designated
hedged debt instrument. On each reset date (the 5th of each quarter) after
the variable rate has been determined, the ultimate payment or receipt is
calculated and recorded as an increase or decrease of interest expense on a
weighted average basis over the period in accordance with SFAS 133 paragraph
132.
Disclosures in future filings will be revised to include requested
information.
17. We note that at October 2, 2005, the legal contingencies reserve was
$8.9 million of which $8.5 million relates to pre-acquisition contingencies.
Please tell us if this amount has been included in the purchase price
allocation of Hollywood Entertainment or your other recent acquisitions.
Also, please tell us and disclose in future filings the nature of the legal
or other contingencies outstanding and the reasons the amounts may require
future adjustments. See SAB Topic 2A.7 and paragraphs 9-12 of SFAS 5.
Response
Movie Gallery, Inc. is requesting confidential treatment under FOIA Rule 83 for
this item.
18. We note your disclosure that on October 25, 2005 you notified 92 Movie
Gallery associates that their positions will be relocated or eliminated as
part of integration efforts that the cost will be expensed in future periods
over the retention period for the impacted associates. Please tell us the
length of the retention period for the associates and if it is less than 60
days, please tell us your basis for not recording the liability at the time
the plan was communicated to the employees. See paragraphs 9 through 11 of
SFAS No. 146.
Response
The required service periods for the 92 Movie Gallery associates range
between 126 days and 365 days. Therefore the liability for the termination
benefits was measured initially at the communication date based on the fair
value of the liability as of the termination date. The liability is being
recognized ratably over the future service period in accordance with the
guidance in SFAS No. 146 paragraph 11.
Report on Form 8-K/A dated April 27, 2005
19. The presentation in your pro forma balance sheet is somewhat confusing as
you have presented various pro forma adjustments included in the balance
sheet on a net rather than gross basis. In future filings, please ensure
that all adjustments in your pro forma balance sheet are presented on a gross
rather than net or combined basis.
Response
We note the Staff's comment and will make appropriate revisions to the
presentation of our pro forma adjustments in any future filings requiring a
pro forma balance sheet.