UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended April 2, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______ to _______
Commission File Number 0-24548
Movie Gallery, Inc.
(Exact name of registrant as specified in charter)
DELAWARE 63-1120122
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
900 West Main Street, Dothan, Alabama 36301
(Address of principal executive offices) (zip code)
(334) 677-2108
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value (including associated rights to purchase shares
of Series A Junior Participating Preferred Stock or Common Stock)
(Title of class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes [ ] No [X]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes [ ] No [X]
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
The number of shares outstanding of the registrant's common stock as of May 2,
2006 was 31,787,888.
Part I - Financial Information
Forward Looking Statements
This quarterly report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, which represent
our expectations or beliefs about future events and financial performance.
Forward-looking statements are identifiable by the fact that they do not relate
strictly to historical information and may include words such as "believe,"
"anticipate," "expect," "intend," "plan," "will," "may," "estimate" or other
similar expressions and variations thereof. In addition, any statements that
refer to expectations, projections or other characterizations of future events
or circumstances are forward-looking statements. Our forward-looking
statements are based on management's current intent, belief, expectations,
estimates and projections regarding our company and our industry. Forward-
looking statements are subject to known and unknown risks and uncertainties,
including those described 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 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 that, but not
limited to:
- - revenues are less than projected;
- - the Company is unable to comply with the revised financial covenants
contained in its senior credit facility;
- - the Company's real estate subleasing program and other initiatives fail
to generate anticipated cost reductions;
- - the availability of new movie releases priced for sale negatively impacts
the consumers' desire to rent movies;
- - unforeseen issues with the continued integration of the Hollywood
Entertainment business;
- - the Company's 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 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 Form 10-Q that the important factors
described 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, except per share amounts)
-------------------------
January 1, April 2,
2006 2006
----------- -----------
(Unaudited)
Assets
Current assets:
Cash and cash equivalents $ 135,238 $ 34,468
Merchandise inventory, net 136,450 127,049
Prepaid expenses 41,393 45,543
Store supplies and other 24,194 25,692
----------- -----------
Total current assets 337,275 232,752
Rental inventory, net 371,565 358,038
Property, furnishings and equipment, net 332,218 310,609
Goodwill, net 118,404 117,664
Other intangibles, net 184,671 184,159
Deposits and other assets 40,995 44,982
----------- -----------
Total assets $ 1,385,128 $ 1,248,204
=========== ===========
Liabilities and stockholders' deficit
Current liabilities:
Current maturities of long-term obligations $ 78,146 $ 773,380
Current maturities of financing obligations 4,492 2,148
Accounts payable 236,989 132,976
Accrued liabilities 88,460 82,191
Accrued payroll 38,624 35,416
Accrued interest 7,220 15,891
Deferred revenue 39,200 33,604
----------- ----------
Total current liabilities 493,131 1,075,606
Long-term obligations, less current portion 1,083,083 322,126
Other accrued liabilities 21,662 21,773
Deferred income taxes 70 70
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 31,777
shares issued and outstanding, respectively 32 32
Additional paid-in capital 199,151 195,206
Unearned compensation (4,128) -
Retained deficit (417,882) (377,532)
Accumulated other comprehensive income 10,009 10,923
----------- -----------
Total stockholders' deficit (212,818) (171,371)
----------- -----------
Total liabilities and stockholders' deficit $ 1,385,128 $ 1,248,204
=========== ===========
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
-----------------------
April 3, April 2,
2005 2006
--------- ---------
Revenue:
Rentals $ 216,741 $ 570,427
Product sales 17,050 123,938
--------- ---------
Total revenue 233,791 694,365
Cost of sales:
Cost of rental revenue 66,360 173,577
Cost of product sales 12,190 93,879
-------- ---------
Gross profit 155,241 426,909
Operating costs and expenses:
Store operating expenses 108,479 314,079
General and administrative 15,592 44,589
Amortization of intangibles 600 733
-------- --------
Operating income 30,570 67,508
Interest expense, net (80) (27,454)
Equity in losses of
unconsolidated entities (337) -
-------- --------
Income before income
taxes 30,153 40,054
Income taxes 11,760 (293)
-------- --------
Net income $ 18,393 $ 40,347
======== ========
Net income per share:
Basic $ 0.59 $ 1.27
Diluted $ 0.58 $ 1.27
Weighted average shares outstanding:
Basic 31,199 31,691
Diluted 31,588 31,754
Cash dividends per common share $ 0.03 $ -
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Consolidated Statements of Cash Flows
(Unaudited, in thousands)
Thirteen Weeks Ended
-----------------------
April 3, April 2,
2005 2006
--------- ----------
Operating activities:
Net income $ 18,393 $ 40,347
Adjustments to reconcile net income
to net cash provided by (used in) operating
activities:
Rental inventory amortization 20,429 65,372
Purchases of rental inventory (20,441) (45,943)
Purchases of rental inventory-base stock (3,258) (5,903)
Depreciation and intangibles amortization 8,801 26,718
Stock based compensation 141 420
Tax benefit of stock options exercised 2,175 -
Amortization of debt issuance cost - 1,532
Deferred income taxes 3,584 -
Changes in operating assets and liabilities, net of
business acquisitions:
Merchandise inventory (894) 9,465
Other current assets (6,138) (5,558)
Deposits and other assets (755) 946
Accounts payable (14,575) (104,012)
Accrued interest - 8,669
Accrued liabilities and deferred revenue 2,590 (12,636)
--------- ---------
Net cash provided by (used in) operating
activities 10,052 (20,583)
Investing activities:
Business acquisitions, net of cash acquired (4,654) (243)
Purchase of property, furnishings and equipment (10,612) (8,983)
Proceeds from disposal of property,
furnishings and equipment - 533
Acquisition of construction phase assets,
net (non-cash) - 2,331
--------- ---------
Net cash used in investing activities (15,266) (6,362)
Financing activities:
Repayment of capital lease obligations - (163)
Decrease in financing obligations (non-cash) - (2,345)
Net borrowings (repayments) on credit facilities - (6,862)
Debt financing fees - (5,528)
Principal payments on debt - (58,839)
Proceeds from exercise of stock options 3,475 -
Proceeds from employee stock purchase plan 169 -
Payment of dividends (945) -
--------- ---------
Net cash provided by (used in)
financing activities 2,699 (73,737)
Effect of exchange rate changes on cash
and cash equivalents (394) (88)
--------- ---------
Decrease in cash and cash
equivalents (2,909) (100,770)
Cash and cash equivalents at
beginning of period 25,518 135,238
--------- ---------
Cash and cash equivalents
at end of period $ 22,609 $ 34,468
========= =========
The accompanying notes are an integral part of this financial statement.
Movie Gallery, Inc.
Notes to Consolidated Financial Statements (Unaudited)
April 2, 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
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 accruals) considered necessary for a fair
presentation have been included. Operating results for the thirteen week
period ended April 2, 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' equity or net income.
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
thirteen weeks ended April 3, 2005 has been revised to reflect all purchases of
rental inventory as operating cash flows. The statement of cash flows for the
thirteen weeks ended April 3, 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 of the current year first quarter.
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. 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 weeks ended April 3, 2005 has been
reclassified in the statement of operations to correspond to current period
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 $6.8 million and reduced net income by $6.8
million (net of tax), or $0.21 per diluted share for the thirteen weeks ended
April 2, 2006.
Earnings Per Share
Basic earnings per share are computed based on the weighted average number of
shares of common stock outstanding during the periods presented. Diluted
earnings per share is computed based on the weighted average number of shares
of common stock outstanding during the periods presented, increased by the
effects of non-vested stock, and shares to be issued from the exercise of
dilutive common stock options (389,000 and 64,000 for the thirteen weeks ended
April 3, 2005 and April 2, 2006, respectively).
Stock Based Compensation
In June 2003, our Board of Directors adopted, and our stockholders approved,
the Movie Gallery, Inc. 2003 Stock Plan, which was subsequently amended in June
2005 (Second Amendment) to reserve an additional 3,500,000 shares of our common
stock for future grants of awards. The plan provides for the award of stock
options, restricted stock and stock appreciation rights to employees, directors
and consultants. Prior to adoption of the 2003 plan, stock option awards were
subject to our 1994 Stock Plan which expired in 2004. As of April 2, 2006,
5,417,033 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 during the first quarter of 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 were as follows:
Thirteen
Weeks
Fiscal Year Ended Ended
----------------------- ----------
January 2, January 1, April 2,
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; therefore, no cumulative
adjustment from accounting change is included in our consolidated statement of
operations.
Valuation of awards of service-based non-vested shares were 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 remeasurement.
Prior to the adoption of SFAS No. 123(R), cash retained as the result of cash
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 first quarter of fiscal 2006.
Fair Value Disclosures - Prior to SFAS No. 123(R) Adoption
Stock-based compensation for the three months ended April 3, 2005 was
determined using the intrinsic value method. The following table provides
supplemental information for the first quarter of fiscal year 2005 as if stock-
based compensation had been computed under SFAS No. 123 (in thousands, except
per share data):
Thirteen Weeks Ended
--------------------
April 3,
2005
---------
Net income, as reported $ 18,393
Add: Stock based compensation
included in reported net income,
net of tax 86
Deduct: Stock based compensation
determined under fair value based
methods for all awards, net of tax (279)
---------
Pro forma net income $ 18,200
=========
Net income per share, as reported:
Basic $ 0.59
Diluted $ 0.58
Pro forma net income per share:
Basic $ 0.58
Diluted $ 0.58
A summary of our stock option activity and related information is as follows:
Weighted-
Outstanding Average Exercise
Options Price Per Share
------------ ---------------
Outstanding at January 4, 2004 2,636,093 10.36
Granted 102,000 19.36
Exercised (875,884) 6.31
Cancelled (268,653) 13.71
------------
Outstanding at January 2, 2005 1,593,556 12.59
Granted 29,500 17.33
Exercised (575,148) 9.25
Cancelled (71,157) 17.83
------------
Outstanding at January 1, 2006 976,751 14.33
Granted - 0.00
Exercised - 0.00
Cancelled (43,375) 18.38
------------
Outstanding at April 2, 2006 933,376 14.14
============
Exercisable at January 2, 2005 1,024,181 9.34
Exercisable at January 1, 2006 976,751 14.33
Exercisable at April 2, 2006 933,376 14.14
The total intrinsic value of options exercised was $8.9 million and $0 for the
fiscal year ended January 1, 2006 and for the thirteen weeks ended April 2,
2006, respectively.
Options outstanding as of April 2, 2006 had a weighted-average remaining
contractual life of approximately 6 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 78,750 672,762
Weighted-average exercise price $1.64 $6.22 $18.44
Weighted-average remaining
contractual life 3.7 years 0.6 years 7.1 years
Options exercisable 181,864 78,750 672,762
Weighted-average exercise price
of exercisable options $1.64 $6.22 $18.44
Service-based nonvested 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 of the
shares, is charged to earnings over the vesting period. Compensation expense
charged to operations related to these stock grants was $1.2 million and $0.3
million for the fiscal year ended January 1, 2006 and for the thirteen weeks
ended April 2, 2006, respectively. The total grant date fair value of service-
based share awards vested during the fiscal year ended January 1, 2006 and the
thirteen weeks ended April 2, 2006 was $0 and $1.1 million, respectively.
Following is a summary of our service-based nonvested 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 - -
Vested (50,006) 22.94
Cancelled (50,472) 29.20
----------
Outstanding at April 2, 2006 105,953 25.18
==========
Performance-based nonvested share awards entitle participants to acquire shares
of stock upon attainment of specified performance goals. Compensation cost of
$0.4 million and $0.1 million for performance-based stock grants were
recognized for the fiscal year ended January 1, 2006 and for the thirteen weeks
ended April 2, 2006, respectively, using the accelerated expense attribution
method under SFAS Interpretation No. 28 (EITF 00-23).
Following is a summary of our performance-based nonvested 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 (40,875) 29.48
Cancelled (31,250) 12.83
----------
Outstanding at April 2, 2006 34,625 28.94
==========
The total grant date fair value of performance-based share awards vested during
the fiscal year ended January 1, 2006 and the thirteen weeks ended April 2,
2006 was $0 and $1.2 million, respectively.
Total compensation cost related to all non-vested awards that is not yet
recognized was $2.8 million at April 2, 2006, and is expected to be recognized
over a weighted-average period of approximately two years.
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 owned. Approximately $862.1 million in cash
was paid in exchange for (i) all outstanding common stock of Hollywood and
(ii) all outstanding vested and unvested stock options of Hollywood.
Hollywood's outstanding indebtedness was repaid at the time of the merger for a
total of $381.5 million, of which $161.4 million was paid by Hollywood with the
remainder funded by Movie Gallery with proceeds from a new credit facility and
the issuance of $325.0 million principal amount of 11% Senior notes due 2012.
The total consideration paid was approximately $1.1 billion, including
transaction costs of $10.0 million.
The merger has been treated as a purchase business combination for accounting
purposes, and as such, Hollywood's assets acquired and liabilities assumed have
been recorded at their estimated fair values. The purchase price for the
acquisition, including transaction costs, has been allocated to the assets
acquired and liabilities assumed based on estimated fair values at the date of
acquisition, April 27, 2005. The purchase price allocation is substantially
final for all items except deferred income taxes, and further adjustments may
be required in 2006 as we complete the analysis of the acquired tax basis of
certain assets and carryover tax attributes of Hollywood.
The purchase price allocation has been revised in the periods following the
acquisition in accordance with SFAS 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):
Initial Subsequent As
Allocation Revisions Adjusted
Current Assets:
Cash and cash equivalents $ 18,733 $ - $ 18,733
Extended viewing fees receivable, net 21,369 - 21,369
Merchandise inventory 122,468 - 122,468
Prepaid expenses 27,632 - 27,632
Store supplies and other 18,146 (5,307) 12,839
---------- --------- ----------
Total current assets 208,348 (5,307) 203,041
Rental inventory 227,800 - 227,800
Property, furnishings and equipment 238,279 (83) 238,196
Goodwill 474,990 3,752 478,742
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 (15,346) 1,384,571
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 6,697 72,204
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 (15,346) 291,348
Long-term obligations, less current portion 941 - 941
Total liabilities 307,635 (15,346) 292,289
---------- --------- ----------
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 first quarter of 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 thirteen weeks ended April 2, 2006, adjustments were made to the purchase
price allocation for accrued liabilities, deferred income taxes, and accounts
receivable. 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 $0.1 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 $1.2 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 $3.4 million in reserves for store closures in accordance with
EITF 95-3 to reflect the cost of remaining lease obligations for closed
stores and other costs associated with 50 Game Crazy departments that were
closed shortly after the merger.
- recorded a reduction of $3.0 million in income tax and franchise tax
liabilities based on subsequent analyses of Hollywood's tax accounts, after
giving consideration to the effects of merger related transactions.
- - 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.
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, of which an impairment charge
of $361.2 million was recorded against in 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 4,773 store locations for the combined company.
In addition, in order to acquire Hollywood, we participated in a competitive
bidding process against Leonard Green & Partners L.L.P. and Blockbuster, Inc.
Our successful bid was $1.25 per share lower than Blockbuster, Inc.'s bid.
However, Hollywood's stock (NASDAQ: HLYW) was trading at a significant premium
to book value due, in part, to merger and acquisition speculation.
The operations of Hollywood Entertainment have been included in our
consolidated results of operations from April 27, 2005 forward. The following
pro forma financial information is presented for informational purposes only
and is not indicative of the results of operations that would have been
achieved if the merger had taken place as of the beginning of 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
thirteen weeks ended April 3, 2005 as though the companies had been combined as
of the beginning of fiscal year 2005. (in thousands, except per share data).
(unaudited)
13 weeks ended
April 3, 2005
--------------
Total revenue $ 709,276
Operating income 80,132
Net income 35,294
Net income per share:
Basic 1.13
Diluted 1.12
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 year 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 $5.8 million (before taxes) of transaction costs and professional
services related to merger activities incurred in the thirteen weeks ended
April 3, 2005.
Merger Reserves
We established merger reserves, which were treated as liabilities of the
acquired business at the date of acquisition, relating to executives and other
employees that were terminated shortly after the merger, including some that
were terminated as part of our integration efforts, in accordance with EITF 95-
3, "Recognition of Liabilities in Connection with a Purchase Business
Combination." During the second quarter of 2005, we notified 92 Hollywood
employees of the decision to eliminate their positions in connection with these
integration efforts. We recorded a $6.6 million reserve for costs associated
with severance and benefits for the impacted individuals. Payments to these
individuals will be made over the severance period in accordance with our
severance agreements. Total payments of $2.5 million and $0.8 million were
made for the fiscal year ended January 1, 2006 and the thirteen weeks ended
April 2, 2006, respectively, leaving a $3.3 million reserve as of April 2,
2006.
We closed 50 Game Crazy departments shortly after the acquisition date for a
total cash cost of $0.3 million. The costs associated with these department
closures were not charged to current operations, but rather were recognized as
acquired liabilities in purchase accounting, resulting in an increase to
goodwill.
3. Property, Furnishings and Equipment
Property, furnishings and equipment consists of the following (in thousands):
----------- ----------
January 1, April 2,
2006 2006
----------- ----------
Land and buildings $ 19,372 $ 20,379
Fixtures and equipment 280,532 280,474
Leasehold improvements 248,525 247,579
Construction phase assets 4,542 2,211
Equipment under capital lease 1,659 1,659
----------- ----------
554,630 552,302
Less accumulated depreciation
and amortization (222,412) (241,693)
----------- ----------
$ 332,218 $ 310,609
=========== ==========
Accumulated depreciation and amortization, as presented above, includes
accumulated amortization of assets under capital leases of $0.3 and $0.4
million at January 1, 2006 and April 2, 2006, respectively. Depreciation
expense related to property, furnishings and equipment was $ 8.1 million and
$25.0 million for the thirteen weeks ended April 3, 2005 and April 2, 2006,
respectively.
4. Income Taxes
We account for income taxes in accordance with SFAS No. 109, "Accounting for
Income Taxes," which requires that deferred assets and liabilities be
recognized using enacted tax rates for the effect of temporary differences
between the financial reporting and tax bases of recorded assets and
liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by
a valuation allowance if it is more likely than not that some portion of or all
of the deferred tax asset will not be realized.
In the ordinary course of business, there may be many transactions and
calculations where the ultimate tax outcome is uncertain. The calculation of
tax liabilities involves dealing with uncertainties in the application of
complex tax laws. No assurance can be given that the final outcome of these
matters will not be different than what is reflected in the current and
historical income tax provisions and accruals.
The effective tax rate was a provision of 39.0% and a benefit of 0.7% for the
thirteen weeks ended April 3, 2005 and April 2, 2006 respectively. The
projected annual effective tax rate is a provision of 3.8% which differs from
the benefit of 0.7% for the quarter ended April 2, 2006 due to unique items the
Company recognized during the quarter, including a tax benefit related to a
decrease in the valuation allowance and a change in estimate of state taxes
payable for the year ended January 1, 2006. The decrease in the 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, we generally expect that
our federal income tax provision will be very low or negligible until such time
as the valuation allowance is depleted through future taxable income or 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 April 2, 2006
Weighted- ------------------------ ---------------------
Average Gross Gross
Amortization Carrying Accumulated Carrying Accumulated
Period Amount Amortization Amount Amortization
------------ -------- ------------ -------- ------------
Goodwill
Segments:
Movie Gallery - $ - $ - $ 141 $ -
Hollywood Video - 118,404 - 117,523 -
-------- ------------ -------- ------------
Total goodwill $118,404 $ - $117,664 $ -
======== ============ ======== ============
Other intangible assets:
Non-compete
agreements 8 years $ 12,205 $ (10,110) $ 12,242 $ (10,326)
Trademarks:
Hollywood Video Indefinite 170,959 - 171,142 -
Game Crazy 15 years 4,000 (178) 4,000 (244)
Customer lists 5 years 8,994 (1,199) 8,994 (1,649)
-------- ------------ -------- ------------
$196,158 $ (11,487) $196,378 $ (12,219)
======== ============ ======== ============
Estimated amortization expense for other intangible assets for fiscal year 2006
and the five succeeding fiscal years is as follows (in thousands):
2006 2,315
2007 2,690
2008 2,471
2009 2,285
2010 954
2011 24
The changes in the carrying amounts of goodwill for the fiscal year ended
January 1, 2006 and the thirteen weeks ended April 2, 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 141
Change in goodwill (881)
-----------
Net balance as of April 2, 2006 $ 117,664
===========
6. Store Closure, Merger and Restructuring Reserves
During the fourth quarter of fiscal year ended January 1, 2006, we notified 101
Movie Gallery associates that their positions will 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 these associates will be approximately
$2.7 million, of which approximately $1.2 million and $0.9 million was
recognized during the fiscal year ended January 1, 2006 and the thirteen weeks
ended April 2, 2006, respectively, with the remainder to be expensed over the
remaining retention service period for the impacted associates in 2006 in
accordance with SFAS No. 146, "Accounting for Costs Associated with Disposal
and Exit Activities." There were cash payments charged to the reserve of $0.2
million during the thirteen weeks ended April 2, 2006.
In the fourth quarter of 2005, we decided to close 64 Movie Gallery stores that
overlapped trade areas served by competing Hollywood stores. We recorded store
closure costs of $9.6 million related to these store closures, which included
$1.8 million in non-cash write-offs of store fixtures and equipment and $7.6
million of reserves for operating lease obligations payable through the end of
the lease terms, net of probable sublease income, and $0.3 million for other
cash costs associated with these store closures, all of which were closed in
the fourth quarter. Cash payments charged to the reserve were $1.6 million
during the thirteen weeks ended April 2, 2006. The remaining reserves for
future lease payments are expected to be paid in fiscal 2006 through 2012.
We established merger reserves, which were treated as liabilities of the
acquired business at the date of acquisition, relating to executives and other
employees that were terminated shortly after the merger, including some that
were terminated as part of our integration efforts, in accordance with EITF 95-
3, "Recognition of Liabilities in Connection with a Purchase Business
Combination." During the second quarter of 2005, we notified 92 Hollywood
employees of the decision to eliminate their positions in connection with these
integration efforts. We recorded a $6.6 million reserve for costs associated
with severance and benefits for the impacted individuals. Payments to these
individuals will be made over the severance period in accordance with the our
severance agreements. Total payments of $2.5 million and $0.8 million were
made for the fiscal year ended January 1, 2006 and the thirteen weeks ended
April 2, 2006, respectively, leaving a $3.3 million reserve as of April 2,
2006.
Movie Hollywood
Gallery Video Total
---------- --------- ---------
Store closure reserve:
Balance as of January 1, 2006 $ 10,112 $ 3,613 $ 13,725
Additions and
adjustments (1,339) - (1,339)
Payments (1,605) (166) (1,771)
---------- ---------- --------
Balance as of April 2, 2006 $ 7,168 $ 3,447 $ 10,615
========== ========= ========
Termination benefits:
Balance as of January 1, 2006 $ 1,190 $ 4,116 $ 5,306
Additions and
adjustments 809 - 809
Payments (178) (769) (947)
---------- --------- --------
Balance as of April 2, 2006 $ 1,821 $ 3,347 $ 5,168
========== ========= ========
Estimated future
additions and
adjustments $ 701 $ - $ 701
Total termination
benefits cost $ 2,700 $ 6,655 $ 9,355
7. Long-Term Debt
Long term debt consists of the following (in thousands):
January 1, April 2,
Instrument 2006 2006
- ----------------------------------- -------------------------
Movie Gallery senior notes $ 321,489 $ 321,628
Credit Facility:
Term A Loan 85,500 79,650
Term B Loan 746,250 693,318
Revolving credit facility 6,862 -
Hollywood senior notes 450 450
Capital leases 678 460
----------- ----------
Total 1,161,229 1,095,506
Less current portion (78,146) (773,380)
----------- ----------
$1,083,083 $ 322,126
=========== ==========
On March 15, 2006, we executed a second amendment to our Credit Facility
effective through the fourth quarter 2006. 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 Agreement. We incurred 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.
The second amendment made various changes to the Credit Facility which
included:
- - A requirement for us to provide monthly financial reporting and cash flow
forecasts to the bank group.
- - More restrictive operating covenants regarding our ability to incur
indebtedness, pay dividends, redeem our capital stock, make capital
expenditures, make acquisitions, and other covenants. Also, certain
mandatory prepayment provisions have been modified.
- - New pricing for the interest rates on the Term Loans and Revolver. For
the period starting April 1, 2006, through the submission of the first
quarter 2006 covenant package to the administrative agent, the interest
rate for the Term Loan A and Revolver will be set at LIBOR plus 5.00%.
After submission of the covenant package, the pricing is as follows:
Leverage Ratio LIBOR Margin
> 4.00 5.00%
3.25 - 4.00 3.50%
2.75 - 3.25 2.75%
2.25 - 2.75 2.50%
1.75 - 2.25 2.25%
< 1.75 2.00%
The Term Loan B pricing was revised to reflect a rate of LIBOR plus 5.25%
starting April 1, 2006 through the submission of the first quarter
covenant package. After submission of the covenant package, the interest
rate will be LIBOR plus 5.25% if our leverage ratio exceeds 4.00;
otherwise the rate will be LIBOR plus 3.75%.
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).
- - The second amendment provides relief through the fourth quarter of 2006
related to our compliance with the quarterly leverage ratio, fixed charge
coverage ratio, and interest coverage tests. The quarterly financial
covenants revert to the original covenants commencing with the first
quarter of 2007. The covenant levels contained in the second amendment
are as follows:
Leverage Fixed Charge Interest Coverage
Ratio Coverage Ratio Ratio
2006 Q1 5.00 1.05 2.00
2006 Q2 5.75 1.05 1.75
2006 Q3 6.75 1.00 1.45
2006 Q4 6.50 1.00 1.45
2007 Q1 2.25 1.10 3.00
2007 Q2 2.25 1.10 3.00
2007 Q3 2.25 1.10 3.00
2007 Q1 2.00 1.10 3.00
As of April 2, 2006, we were in compliance with our Credit Facility financial
covenants as a result of the debt covenant relief we obtained in the second
amendment. However, while we anticipate complying with the financial covenants
contained in the Credit Facility, as amended, at each test date through the
remainder of fiscal 2006, based on projected operating results it is probable
that we could 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 April 2, 2006.
Assuming continued compliance with the applicable debt covenants under the
Credit Facility, as amended, we expect cash on hand, cash from operations, cash
from non-core asset sales, and available borrowings under our revolving credit
facility to be sufficient to fund the anticipated cash requirements for working
capital purposes and capital expenditures under our normal operations,
including any additional spending on our initiatives, as well as commitments
and payments of principal and interest on borrowings for the remainder of 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 Senior Notes and certain leases, could also become due and
payable immediately. Should the outstanding obligation 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 a
large majority 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 and could result in even more
unfavorable terms from our trade creditors. Any of these scenarios could
adversely impact our liquidity and results of operations.
Our ability to comply with these covenants may be affected by events and
circumstances beyond management's control. If we breach any of these
covenants, one or more events of default, including cross-defaults between
multiple components of our indebtedness, could result. These events of default
could permit creditors to declare all amounts owing to be immediately due and
payable, and to terminate any commitments to make further extensions of credit.
If we were unable to repay our debt service obligations under the Credit
Facility or the Senior Notes our secured creditors could proceed against the
collateral securing the indebtedness owed to them.
8. Comprehensive Income
Comprehensive income is as follows (in thousands):
April 3, April 2,
2005 2006
---------- ----------
Net income $ 18,393 $ 40,347
Foreign currency translation
adjustment (394) (88)
Change in value of interest rate swap - 1,002
--------- ---------
Comprehensive income $ 17,999 $ 41,261
========= =========
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 LPG. The Clackamas County actions were later
consolidated and the plaintiffs filed an Amended Consolidated Complaint
alleging four claims for relief against Hollywood's former board members
arising out of the merger of Hollywood with Movie Gallery. The purported four
claims for relief are breach of fiduciary duty, misappropriation of
confidential information, failure to disclose material information in the proxy
statement in support of the Movie Gallery merger, and a claim for attorneys'
fees and costs. The Amended Consolidated Complaint also names UBS Warburg and
LGP as defendants. Following the merger with Movie Gallery, the plaintiffs
filed a Second Amended Consolidated Complaint. The plaintiffs restated their
causes of action and generally allege that the defendants adversely impacted
the value of Hollywood through the negotiations and dealings with LGP.
Hollywood and the former members of its board have also been named as
defendants in a separate lawsuit entitled JDL Partners, L.P. v. Mark J. Wattles
et al. filed in Clackamas County, Oregon, Circuit Court on December 22, 2004.
This lawsuit, filed before Hollywood's announcement of the merger agreement
with Movie Gallery, alleges breaches of fiduciary duties related to a bid by
Blockbuster Inc. to acquire Hollywood, as well as breaches related to a loan to
Mr. Wattles that Hollywood forgave in December 2000. On April 25, 2005, the JDL
Partners action was consolidated with the other Clackamas County lawsuits. The
plaintiffs seek damages and attorneys' fees and costs. Hollywood denies these
allegations and is vigorously defending this lawsuit.
Hollywood was named as a defendant in a sexual harassment lawsuit filed in the
Supreme Court of the State of New York, Bronx County on April 17, 2003. The
action, filed by eleven former female employees, alleges that an employee, in
the course of his employment as a store director for Hollywood, sexually
harassed and assaulted certain of the plaintiffs, and that Hollywood and its
members of management failed to prevent or respond adequately to the employee's
alleged wrongdoing. The plaintiffs seek unspecified damages, pre-judgment
interest and attorneys' fees and costs. Hollywood denies these allegations and
is vigorously defending this lawsuit.
In addition, we have been named to various other claims, disputes, legal
actions and other proceedings involving contracts, employment and various other
matters. A negative outcome in certain of the ongoing litigation could harm
our business, financial condition, liquidity or results of operations. In
addition, prolonged litigation, regardless of which party prevails, could be
costly, divert management attention or result in increased costs of doing
business. We believe we have provided adequate reserves for contingencies and
that the outcome of these matters should not have a material adverse effect on
our consolidated results of operation, financial condition or liquidity.
At April 2, 2006, the legal contingencies reserve, net of expected recoveries
from insurance carriers, was $3.0 million of which $2.3 million relates to pre-
acquisition contingencies. The recorded reserves for some matters may require
adjustment in future periods and those adjustments could be material. Under
SFAS No. 141 "Business Combinations," some or all of any future revisions to
the recorded reserves for pre-acquisition contingencies may be required to be
treated as revisions to the preliminary purchase price allocation (described in
Note 2) which generally would be recorded as adjustments to goodwill.
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, an entity controlled by Mark Wattles,
the founder and former Chief Executive Officer of Hollywood, exercised a
contractual right to require Hollywood to purchase all of the 20 Hollywood
Video stores and 17 Game Crazy stores owned and operated by Boards pursuant to
a "put" option contained in the license agreement for these stores. In
accordance with the terms of the license agreement, Hollywood and Boards have
agreed to the retention of a valuation expert and are proceeding with the
valuation of the stores. We anticipate that the transaction will close in
fiscal 2006.
10. Segment Reporting
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
2,700 video stores serving mainly rural markets in the U.S, Canada, and Mexico,
Hollywood Video represents 2,056 video stores serving predominantly urban
markets, and Game Crazy represents 649 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
April 2, 2006
-------------------------------------------
Movie Hollywood Game
Gallery Video Crazy Total
---------- --------- -------- ----------
Revenues $ 244,394 $ 377,415 $ 72,556 $ 694,365
Depreciation and
amortization 9,395 14,546 2,777 26,718
Rental amortization 28,787 36,585 - 65,372
Operating income(loss) 15,364 53,706 (1,562) 67,508
Goodwill, net 141 117,523 - 117,664
Total assets 391,975 755,638 100,591 1,248,204
Purchases of property,
furnishings and
equipment 6,819 2,090 74 8,983
For the comparable period ended April 2, 2005, there was only one reportable
segment, which was Movie Gallery. Prior year consolidated results are the
Movie Gallery segment totals for those periods.
11. Subsequent Events
On April 7, 2006, our Executive Vice President and Chief Financial Officer
resigned for personal reasons. Our Senior Vice President and Treasurer has
been appointed interim Chief Financial Officer. In addition to these changes,
several other management and administrative positions were consolidated or
eliminated. We will record severance costs totaling $2.8 million in the second
quarter of fiscal year 2006 related to the consolidation of these positions.
On April 17, 2006, we entered into a management agreement with Hilco Real
Estate, LLC under which we and Hilco will initiate a program to restructure
leases at more than 1,000 existing Movie Gallery and Hollywood video stores.
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 April 3, 2005
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- --------- --------- ---------
Revenue:
Rentals $ - $ 200,499 $ 16,242 $ - $ 216,741
Product sales - 15,601 1,449 - 17,050
--------- --------- --------- --------- ---------
Total revenue - 216,100 17,691 - 233,791
Cost of sales:
Cost of rental revenue - 61,315 5,045 - 66,360
Cost of product sales - 11,231 959 - 12,190
--------- --------- --------- --------- ---------
Gross profit - 143,554 11,687 - 155,241
Operating costs and expenses:
Store operating expenses - 99,856 8,623 - 108,479
General and administrative 59 14,244 1,289 - 15,592
Amortization of intangibles - 559 41 - 600
-------- -------- -------- -------- ---------
Operating income(loss) (59) 28,895 1,734 - 30,570
Interest expense, net - (107) 27 - (80)
Equity in losses of
unconsolidated entities (337) - - - (337)
Equity in earnings of
subsidiaries 18,651 1,038 - (19,689) -
-------- -------- -------- -------- ---------
Income before income
taxes 18,255 29,826 1,761 (19,689) 30,153
Income taxes (benefit) (138) 11,175 723 - 11,760
-------- -------- -------- -------- ---------
Net income $ 18,393 $ 18,651 $ 1,038 $(19,689) $ 18,393
======== ======== ======== ======== =========
Consolidating Statement of Operations
Thirteen weeks ended April 2, 2006
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- --------- --------- --------
Revenue:
Rentals $ - $ 547,597 $ 22,830 $ - $ 570,427
Product sales - 121,115 2,823 - 123,938
--------- --------- --------- --------- ---------
Total revenue - 668,712 25,653 - 694,365
Cost of sales:
Cost of rental revenue - 164,863 8,714 - 173,577
Cost of product sales - 91,233 2,646 - 93,879
--------- --------- --------- --------- ---------
Gross profit - 412,616 14,293 - 426,909
Operating costs and expenses:
Store operating expenses - 301,010 13,069 - 314,079
General and administrative 2,791 40,595 1,203 - 44,589
Amortization of intangibles - 697 36 - 733
-------- -------- -------- -------- ---------
Operating income(loss) (2,791) 70,314 (15) - 67,508
Interest expense, net (19,826) (7,547) (81) - (27,454)
Equity in earnings of
subsidiaries 62,935 (70) - (62,865) -
-------- -------- -------- -------- ---------
Income before income
taxes 40,318 62,697 (96) (62,865) 40,054
Income taxes (29) (238) (26) - (293)
-------- -------- -------- -------- ---------
Net income $ 40,347 $ 62,935 $ (70) $(62,865) $ 40,347
======== ======== ======== ======== =========
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
April 2, 2006
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
--------- --------- -------- --------- ---------
Assets
Current assets:
Cash and cash equivalents $ - $ 31,748 $ 2,720 $ - $ 34,468
Merchandise inventory,net - 124,011 3,038 - 127,049
Prepaid expenses 5 43,669 1,869 - 45,543
Store supplies and other - 23,785 1,907 - 25,692
Deferred income taxes, net - - - - -
--------- --------- -------- ------- ---------
Total current assets 5 223,213 9,534 - 232,752
Rental inventory, net - 341,529 16,509 - 358,038
Property, furnishings and
equipment, net - 294,415 16,194 - 310,609
Goodwill, net - 117,651 13 - 117,664
Other intangibles, net - 183,790 369 - 184,159
Deposits and other assets 37,428 6,948 606 - 44,982
Investments in
subsidiaries 876,417 19,752 - (896,169) -
--------- --------- -------- --------- ----------
Total assets $ 913,850 $1,187,298 $ 43,225 $(896,169) $1,248,204
========= ========= ======= ======== ==========
Liabilities and stockholders' equity (deficit):
Current liabilities:
Current maturities of
long-term obligations 772,968 412 - - 773,380
Current maturities of
financing obligations - 2,148 - - 2,148
Accounts payable - 128,842 4,134 - 132,976
Accrued liabilities (13,002) 92,547 2,646 - 82,191
Accrued payroll 225 34,501 690 35,416
Accrued interest 15,840 65 (14) - 15,891
Deferred revenue - 33,254 350 - 33,604
---------- --------- -------- -------- ---------
Total current liabilities 776,031 291,769 7,806 - 1,075,606
Long-term obligations,less
current portion 321,627 497 2 - 322,126
Other accrued liabilities - 20,296 1,477 - 21,773
Deferred income taxes - (345) 415 - 70
Intercompany promissory note
(receivable) (384,200) 384,200 - - -
Payable to(receivable from)
affiliate 371,763 (385,536) 13,773 - -
Stockholders' equity
(deficit) (171,371) 876,417 19,752 (896,169) (171,371)
--------- --------- -------- -------- ---------
Total liabilities and
stockholders' equity
(deficit) $ 913,850 $1,187,298 $43,225 $(896,169) $1,248,204
========= ========== ======== ========== ==========
Consolidating Condensed Statement of Cash Flow
Thirteen weeks ended April 3, 2005
(unaudited, in thousands)
-------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
-------- --------- -------- -------- ---------
Operating Activities:
Net income $ 18,393 $ 18,651 $ 1,038 $ (19,689) $ 18,393
Equity earnings in
subsidiaries (18,651) (1,038) - 19,689 -
Adjustments to reconcile
net income to cash
provided by (used in)
operating activities:
Rental inventory
amortization - 17,747 2,682 - 20,429
Purchases of rental
inventory - (18,471) (1,970) - (20,441)
Purchases of rental
inventory-base stock - (2,902) (356) - (3,258)
Depreciation and
intangibles amortization - 8,119 682 - 8,801
Stock based compensation (non
Cash) 141 - - - 141
Tax benefit of stock
options exercised 2,175 - - - 2,175
Deferred income taxes - 3,498 86 - 3,584
Changes in operating
assets and liabilities, net
of business acquisitions:
Merchandise inventory - (555) (339) - (894)
Other current assets (29) (5,778) (331) - (6,138)
Deposits and other assets 75 (935) 105 - (755)
Accounts payable - (12,697) (1,878) - (14,575)
Accrued liabilities and
deferred revenue (1,356) 3,225 721 - 2,590
-------- --------- -------- -------- ---------
Net cash provided by
operating activities 748 8,864 440 - 10,052
Investing Activities:
Business acquisitions,
net of cash acquired - (4,756) 102 - (4,654)
Purchase of property,
furnishings and equipment - (9,175) (1,437) - (10,612)
Investment in subsidiaries (6,380) (90) - 6,470 -
-------- --------- -------- -------- ---------
Net cash used in investing
activities (6,380) (14,021) (1,335) 6,470 (15,266)
Financing Activities:
Proceeds from exercise
of stock options 3,475 - - - 3,475
Intercompany payable/
receivable - (377) 377 - -
Proceeds from employee
stock purchase plan 169 - - - 169
Capital contribution
from parent - 6,380 90 (6,470) -
Dividend to parent 2,933 (2,933) - - -
Payment of dividends (945) - - - (945)
-------- --------- -------- -------- ---------
Net cash provided
by financing activities 5,632 3,070 467 (6,470) 2,699
Effect of exchange rate
changes on cash and
cash equivalents - (394) - - (394)
-------- --------- -------- -------- ---------
Decrease in cash and
cash equivalents - (2,481) (428) - (2,909)
Cash and cash equivalents at
beginning of period 1 15,711 9,806 - 25,518
-------- --------- -------- -------- ---------
Cash and cash equivalents
at end of period $ 1 $ 13,230 $ 9,378 $ - $ 22,609
======== ========= ======== ======== =========
Consolidating Condensed Statement of Cash Flow
Thirteen Weeks ended April 2, 2006
(unaudited, in thousands)
--------------------------------------------------
Non-
Guarantor Guarantor
Subsid- Subsid- Elimin- Consol-
Parent iaries iaries ations idated
-------- --------- --------- -------- ---------
Operating Activities:
Net income (loss) $ 40,347 $ 62,935 $ (70) $(62,865) $ 40,347
Equity earnings in
subsidiaries (62,935) 70 - 62,865 -
Adjustments to reconcile
net income to cash
provided by (used in)
operating activities:
Rental inventory
amortization - 60,241 5,131 - 65,372
Purchases of rental
inventory - (42,031) (3,912) - (45,943)
Purchases of rental
inventory base stock - (5,649) (254) - (5,903)
Depreciation and
intangibles amortization - 25,604 1,114 - 26,718
Stock based compensation 693 (273) - - 420
Amortization of debt
issuance cost 1,532 - - - 1,532
Changes in operating
assets and liabilities, net
of business acquisitions:
Merchandise inventory - 8,809 656 - 9,465
Other current assets 14 (5,693) 121 - (5,558)
Deposits and other assets - 977 (31) - 946
Accounts payable - (101,594) (2,418) - (104,012)
Accrued interest 8,709 6 (46) - 8,669
Accrued liabilities and
deferred revenue (120) (12,435) (81) - (12,636)
--------- --------- -------- -------- ---------
Net cash provided by
(used in) operating
activities (11,760) (9,033) 210 - (20,583)
Investing Activities:
Business acquisitions,
net of cash acquired - (223) (20) - (243)
Purchase of property,
furnishings and equipment - (8,323) (660) - (8,983)
Proceeds from disposal of
property, furnishings and
equipment - 533 - - 533
Acquisition of construction
phase assets, net (non cash) - 2,331 - - 2,331
Investment in subsidiaries 88,570 (30) - (88,540) -
--------- --------- -------- -------- ---------
Net cash provided by
(used in)investing
activities 88,570 (5,712) (680) (88,540) (6,362)
Financing Activities:
Repayment of capital
lease obligations - (163) - - (163)
Intercompany payable/
receivable (12,498) 3,758 8,740 - -
Decrease in financing
obligations (non cash) - (2,345) - - (2,345)
Net borrowings on credit
facilities - - (6,862) - (6,862)
Debt financing fees (5,528) - - - (5,528)
Principal payments on
debt (58,784) - (55) - (58,839)
Capital contribution from
parent - - 30 (30) -
Dividend to parent - (88,570) - 88,570 -
-------- -------- -------- -------- ---------
Net cash (used in)
provided by financing
activities (76,810) (87,320) 1,853 88,540 (73,737)
Effect of exchange rate
changes on cash and
cash equivalents - (88) - - (88)
-------- -------- -------- -------- ---------
Increase (decrease) in
cash and cash equivalents - (102,153) 1,383 - (100,770)
Cash and cash equivalents at
beginning of period - 133,901 1,337 - 135,238
-------- --------- -------- -------- ---------
Cash and cash equivalents
at end of period $ - $ 31,748 $ 2,720 $ - $ 34,468
======== ========= ======== ======== =========
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 total revenues to
over $2.6 billion on a pro-forma annual basis with a store count of over 4,700
stores and substantially increased our urban market presence. We currently
plan to maintain the Hollywood brand and store format and to open approximately
140 new Movie Gallery and Hollywood Video stores for the full year 2006 period,
subject to market and industry conditions and the integration of Hollywood.
Movie Gallery's eastern-focused rural and secondary market presence and
Hollywood's western-focused prime urban and suburban superstore locations
combine to form a strong nationwide geographical store footprint.
We believe the most significant dynamic in our industry is the relationship our
industry maintains with the movie studios. The studios have historically
maintained an exclusive window for home video distribution (DVDs and video
cassettes available for rental and sale), which provides the home video
industry with an 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 business.
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. We intend to apply these same disciplines to the
Hollywood brand where appropriate.
In addition to the relationship between our industry and the movie studios, our
operating results are driven by revenue, inventory, rent and payroll. Given
those key factors, we believe that by monitoring the five operating performance
indicators described below, we can continue to be successful in executing our
operating plans and our strategy.
- - Revenues. Our business is a cash business with initial rental fees paid
upfront by the customer. Our management teams continuously review inventory
levels, marketing and sales promotions, real estate strategies, and staffing
requirements in order to maximize revenues at each location. Additionally, our
teams monitor revenue performance on a daily basis to quickly identify trends
or issues in our store base or in the industry as a whole. Our management
closely monitors same-store revenues, which we define as revenues at stores
that we have operated for at least twelve full months, to assess the
performance of our business.
- - Product purchasing economics. In order to maintain the desired profit margin
in our business, purchases of inventory for both rental and sale must be
carefully managed. Our purchasing models are designed to analyze the impact of
the economic factors inherent in the various pricing strategies employed by the
studios. We believe that we are able to achieve purchasing levels tailored for
the customer demographics of each of our markets and to maximize the return on
investment of our inventory purchase dollars.
- - Store level cost control. The most significant store expenses are payroll
and rent, followed by 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. We have generated significant levels of cash flow from
operations for several years. We have historically been able to fund the
majority of our store growth and acquisitions, as well as ongoing inventory
purchases, from cash flow generated from operations. An exception to this was
the acquisition of Hollywood, which we funded through a combination of
significant long-term debt and cash on-hand.
There is a distinct seasonal pattern to the home video and game retail
business. Compared to other months during the year, we typically experience
peak revenues during the months of November, December and January due to the
holidays in these months as well as inclement weather conditions.
Additionally, revenues generally rise in the months of June, July and August
when most schools are out of session, providing consumers with additional
discretionary time to spend on entertainment. September is typically the
lowest revenue period with schools back in session and the premiere of "new"
fall broadcast television programs. The Game Crazy operating segment
experiences more traditional retail revenue peaks, which are more significantly
weighted towards holiday periods and when schools are out of session.
On April 7, 2006, Timothy R. Price, Movie Gallery's Executive Vice President
and Chief Financial Officer, resigned for personal reasons. Mark D. Moreland,
Senior Vice President and Treasurer, was appointed Interim Chief Financial
Officer in addition to his current responsibilities. In addition to these
changes, several other management and administrative positions were
consolidated or eliminated. We will record severance costs totaling $2.8
million in the second quarter of fiscal 2006 related to the consolidation of
these positions. In addition, on April 17, 2006, we entered into a management
agreement with Hilco Real Estate, LLC under which we and Hilco will initiate a
program to restructure leases at more than 1,000 existing Movie Gallery and
Hollywood Video stores.
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 2005, we closed 64 Movie Gallery stores with trade areas that overlapped
with acquired Hollywood Video stores. We will continue to evaluate the closure
of stores with overlapping trade areas such as these as market conditions
warrant.
We will maintain the Hollywood store format and brand separately from our Movie
Gallery business because of Hollywood's distinct operational model and to
ensure customer continuity. There has been a conscious effort not to interrupt
the field management organizations at Movie Gallery and Hollywood to ensure
they remain focused on revenue and customer service. Integration efforts to
date have primarily focused on consolidating the leadership functions in the
brands. This is complete for the Human Resources, Real Estate, Legal, Lease
Administration, Finance, Information Systems, Loss Prevention, Product,
Merchandising, and Distribution functions. The respective leaders of these
support organizations continue to evaluate opportunities to leverage both Movie
Gallery's and Hollywood's best practices and generate general and
administrative cost savings. To date, we have identified cost savings
opportunities in both Movie Gallery's and Hollywood's cost structures, and we
anticipate that we will identify additional opportunities in the future. The
combined companies also are evaluating opportunities to reap the benefits of
increased purchasing leverage to reduce costs. However, we can make no
assurances that we will successfully integrate Hollywood's business with our
business or that we will achieve any further cost savings.
During the fourth quarter of 2005, we notified 101 Movie Gallery associates
that their positions will be relocated or eliminated as part of our integration
plan through the consolidation of Finance, Accounting, Treasury, Product,
Logistics, Human Resources and Payroll functions at our Wilsonville, Oregon
support center. 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 these associates will be approximately $2.7 million,
of which approximately $1.2 million and $0.9 million were recognized during the
fiscal year ended January 1, 2006 and the thirteen weeks ended April 2, 2006,
respectively, with the remainder to be expensed over the remaining retention
service period for the impacted associates in 2006 in accordance with SFAS
No. 146, "Accounting for Costs Associated with Disposal and Exit Activities."
There were cash payments charged to the reserve of $0.2 million during the
thirteen weeks ended April 2, 2006.
We estimate the integration-related efficiencies and savings achieved during
fiscal 2005 to be in excess of $20 million. These savings have been driven
principally by improvements in the supply chain for Movie Gallery branded
stores, consolidation of our Real Estate and Architecture functions, inventory
utilization, and elimination of duplicative executive management. We continue
to identify and implement additional savings opportunities. We expect that
total savings, including new projects in 2006 combined with the full year 2006
impact of the savings already achieved in 2005 will be in excess of $50
million.
Other Acquisitions
By letter dated August 29, 2005, Boards Inc., or Boards, an entity controlled
by Mark Wattles, the founder and former Chief Executive Officer of Hollywood,
exercised a contractual right to require Hollywood to purchase all of the 20
Hollywood Video stores and 17 Game Crazy stores owned and operated by Boards
pursuant to a put option. The put option, and a related call option, were
contained in the license agreement between Hollywood and Boards which was
effective January 25, 2001. On a change of control (as defined in the license
agreement), Hollywood had an option to purchase the stores within six months.
Likewise, on a change of control, Boards had the option to require Hollywood to
purchase the stores within six months. In both cases, the process by which the
price would be determined was detailed in the license agreement and was at fair
value as determined by an appraisal process. In accordance with the terms of
the license agreement, Hollywood and Boards have agreed to the retention of a
valuation expert and are proceeding with the valuation of the stores. It is
anticipated that the transaction will close in 2006.
The following discussion of our results of operations, liquidity and capital
resources is intended to provide further insight into our performance for the
thirteen weeks ended April 3, 2005 and April 2, 2006.
Results of Operations
The financial information provided in the Selected Financial Statement and
Operational Data is not comparable on a year-over-year basis due to the
acquisition of Hollywood, which occurred April 27, 2005. The results of
operations for the thirteen weeks ended April 3, 2005 does not include
Hollywood results, whereas the results of operations for the thirteen weeks
ended April 2, 2006 includes Hollywood results.
Selected Financial Statement and Operational Data:
Thirteen Weeks Ended
-----------------------
April 3, April 2,
2005 2006
--------- ----------
(unaudited)
($ in thousands, except
per share and store data)
Rental revenue $ 216,741 $ 570,427
Product sales 17,050 123,938
--------- ----------
Total revenue 233,791 694,365
Cost of rental revenue 66,360 173,577
Cost of product sales 12,190 93,879
--------- ----------
Total gross profit $ 155,241 $ 426,909
Store operating expenses $ 108,479 $ 314,079
General and administrative expenses $ 15,592 $ 44,589
Operating income $ 30,570 $ 67,508
Interest expense, net $ (80) $ (27,454)
Equity in losses of unconsolidated entities $ (337) $ -
Net income $ 18,393 $ 40,347
Net income per diluted share $ 0.58 $ 1.27
Cash dividends per common share $ 0.03 $ -
Rental margin 69.4% 69.6%
Product sales margin 28.5% 24.3%
Total gross margin 66.4% 61.5%
Percent of total revenue:
Rental revenue 92.7% 82.2%
Product sales 7.3% 17.8%
Store operating expenses 46.4% 45.2%
General and administrative expenses 6.7% 6.4%
Operating income 13.1% 9.7%
Interest expense, net 0.0% 4.0%
Net income 7.9% 5.8%
Total same-store revenues 1.5% (6.5%)
Movie Gallery same-store revenues 1.5% (3.7%)
Hollywood same-store revenues (1) 3.7% (7.7%)
Total same-store rental revenues 2.5% (7.7%)
Movie Gallery same-store revenues 2.5% (5.6%)
Hollywood same-store revenues (1) 0.1% (8.8%)
Total same-store product sales (9.3%) (0.8%)
Movie Gallery same-store sales (9.3%) 18.2%
Hollywood same-store sales (1) 19.4% (3.9%)
Store count:
Beginning of period 2,482 4,749
New store builds 62 70
Stores acquired 18 -
Stores closed (19) (46)
--------- ----------
End of period 2,543 4,773
========= ==========
(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 ended April 2, 2006, consolidated total
revenues increased 197.0% from the comparable period in 2005, primarily due to
the acquisition of Hollywood. Same-store total revenues were negative 6.5% for
the first quarter of 2006, which consisted of a 7.7% decline in same-store
rental revenue and a 0.8% decline in same-store product revenue.
With the acquisition of Hollywood, 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. We expect this trend to continue.
For the thirteen weeks ended April 2, 2006, the Movie Gallery operating segment
total revenues increased 4.5% from the comparable period in 2005. The increase
was due to an increase of approximately 7.2% in the average number of stores
operated during the first quarter of 2006 compared to the first quarter of
2005. The increase was partially offset by a same-store total revenue decrease
of 3.7% for the first quarter of 2006, which consisted of a 5.6% decline in
same-store rental revenue and an 18.2% increase in same-store product sales
revenue.
The addition of Hollywood operating segment revenue for the thirteen weeks
ended April 2, 2006 accounted for 97.7% of the total revenue increases.
Hollywood total same-store revenues were negative 7.7% for the first quarter of
2006, which consisted of an 8.8% decline in same-store rental revenue and a
3.9% decline in same-store product sales revenue.
The following factors contributed to a decrease in our total same-store
revenues for both the Movie Gallery and Hollywood operating segments for the
first quarter of 2006 versus the first quarter of 2005:
- -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, the overabundance of DVD titles
available in the marketplace and alternative delivery channels.
- -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 revenues includes the amortization of rental
inventory, revenue sharing expenses incurred and the cost of previously viewed
rental inventory sold. The gross margin on rental revenue for the first quarter
of 2006 was 69.6% versus 69.4% for the comparable quarter of 2005. A charge of
$6.8 million, or $0.21 per diluted share, was recorded against rental margins
in the first quarter of 2006 to reflect changes in rental amortization
estimates. Factors contributing to the gross margin increase include an
increase in the percentage of DVD movies acquired under revenue sharing
arrangements and a decrease in the percentage of revenue from promotionally
discounted previously viewed movies.
Cost of product sales includes the costs of new video 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
ended April 2, 2006 was 24.3% compared to 28.5% for the comparable quarter of
2005. The decrease in product sales margin was primarily caused by the higher
penetration of new movies and new game merchandise sales. The acquisition of the
Game Crazy operating segment acquired with Hollywood will continue to increase
the percent to total revenue of new game merchandise sales for the first and
second quarters of 2006.
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 46.4% and 45.2% for the thirteen weeks ended April 3, 2005 and
April 2, 2006, respectively. The decrease was 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 revenues were 6.7% and 6.4% for the thirteen weeks ended April 3,
2005, and thirteen weeks ended April 2, 2006, respectively. The decrease in
general and administrative expenses as a percentage of revenue was primarily
due to the acquisition of Hollywood and its lower general and administrative
costs as a percentage of revenue.
Stock Compensation Expense.
In June 2003, our Board of Directors adopted, and our stockholders approved,
the Movie Gallery, Inc. 2003 Stock Plan, which was subsequently amended in June
2005 (Second Amendment) to reserve an additional 3,500,000 shares of our common
stock for future grants of awards. The plan provides for the award of stock
options, restricted stock and stock appreciation rights to employees, directors
and consultants. Prior to adoption of the 2003 plan, stock option awards were
subject to our 1994 Stock Plan which expired in 2004. As of April 2, 2006,
5,417,033 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 during the first quarter of 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 adoption of SFAS No. 123(R) did not result in any changes in our
assumptions regarding estimated future forfeitures; therefore, no cumulative
adjustment from accounting change is included in our consolidated statement of
operations.
Valuation of awards of service-based non-vested shares were 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 remeasurement.
Prior to the adoption of SFAS No. 123(R), cash retained as the result of cash
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 first quarter of fiscal year of 2006.
Service-based nonvested 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 of the
shares, is charged to earnings over the vesting period. Compensation expense
charged to operations related to these stock grants was $1.2 million and $0.3
million for the fiscal year ended January 1, 2006 and for the thirteen weeks
ended April 2, 2006, respectively. The total grant date fair value of service-
based share awards vested during the fiscal year ended January 1, 2006 and the
thirteen weeks ended April 2, 2006 was $0 and $1.1 million, respectively.
Performance-based nonvested share awards entitle participants to acquire shares
of stock upon attainment of specified performance goals. Compensation cost of
$0.4 million and $0.1 million for performance-based stock grants were
recognized for the fiscal year ended January 1, 2006 and for the thirteen weeks
ended April 2, 2006, respectively, using the accelerated expense attribution
method under SFAS Interpretation No. 28 (EITF 00-23).
The total grant date fair value of performance-based share awards vested during
the fiscal year ended January 1, 2006 and the thirteen weeks ended April 2,
2006 was $0 and $1.2 million, respectively.
Total compensation cost related to all non-vested awards that is not yet
recognized was $2.8 million at April 2, 2006, and is expected to be recognized
over a weighted-average period of approximately two years.
Interest Expense, net.
Net income for the first quarter of 2006 includes $27.5 million pre-tax, or
$0.86 per diluted share, in interest expense, principally related to borrowings
used to fund the acquisition of Hollywood. We expect to incur significant
interest expense for the foreseeable future. Interest expense for the first
quarter of 2005 amounted to $0.1 million, a substantial portion of which
related to credit facility fees and expenses.
Equity in Losses of Unconsolidated Entities.
During the last half of 2003, we began to make investments in various
alternative delivery vehicles (both retail and digital) for movie content. We
do not anticipate that any of these alternatives will replace our base video
rental business. As of January 1, 2006, we have completely written off our
investments in these unconsolidated entities, either through recognizing our
proportionate share of the investee losses under the equity method, by
disposing of the related interests, or through write-offs for investments we
deemed to be worthless. Although we have no present intentions to do so, in
the future we may make, subject to covenant limitations, similar investments
that we will be required to account for as equity investments similar to the
investments we have made in the past. The write-offs of our share of investee
losses were higher for the first quarter of 2005, as the remaining balances
were written off in 2005.
Income Taxes.
The effective tax rate was a provision of 39.0% and a benefit of 0.7% for the
thirteen weeks ended April 3, 2005 and April 2, 2006, respectively. The
projected annual effective tax rate is a provision of 3.8% which differs from
the benefit of 0.7% for the quarter ended April 2, 2006, due to unique items
the Company recognized during the quarter, including a tax benefit related to a
decrease in the valuation allowance and a change in estimate of state taxes
payable for the year ended January 1, 2006. The decrease in the 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, we generally expect that
our federal income tax provision will be very low or negligible until such time
as the valuation allowance is depleted through future taxable income or 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 benefits 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.
Liquidity and Capital Resources
Our primary capital needs are for seasonal working capital, debt service, new
store investment, and remodeling and relocating existing stores. We fund our
capital needs primarily by cash flow from operations and, as necessary, loans
under our senior secured credit facility (the "Credit Facility"). The Credit
Facility, which we entered into in connection with the acquisition of Hollywood
and the refinancing of Hollywood's existing indebtedness, is in an aggregate
amount of $848.0 million, consisting of a five-year $75.0 million revolving
credit facility (the "Revolver") and two term loan facilities in an aggregate
principal amount of $773.0 million as of April 2, 2006. Term Loan A is a $79.7
million five-year facility that matures on April 27, 2010 and Term Loan B is a
$693.3 million six-year facility that matures on April 27, 2011. Also in
connection with the Hollywood acquisition and refinancing, we issued $325.0
million in aggregate principal amount of 11% senior unsecured notes due 2012
(the "Senior Notes").
At April 2, 2006, we had cash and cash equivalents of $34.5 million, $48.8
million in available borrowings under our Credit Facility, and $26.2 million
drawn under the Revolver, comprised entirely of letters of credit. Although
there can be no assurances, we believe that cash flow available from
operations, availability under the $75.0 million Revolver, and sales of non-
core assets will be sufficient to operate our business, satisfy our working
capital and capital expenditure requirements, and meet our foreseeable
liquidity requirements, including debt service for fiscal 2006.
Our ability to fund our current plan of operations will depend upon our future
performance, which is subject to general economic, financial, competitive,
industry and other factors that are beyond our control. We cannot assure you
that our business will continue to generate sufficient cash flow from
operations in the future to fund capital resource needs, cover the ongoing
costs of operating the business, remain in compliance with the financial
covenants contained in the Credit Facility, or service our current level of
indebtedness or any debt we may incur in the future. If we are unable to
satisfy these requirements with our available cash resources, we may be
required to sell assets or to obtain additional financing. There are no
assurances that we can complete these sales or obtain financing on reasonable
terms.
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 beginning September 30, 2005 through the first quarter of 2010, after
which the mandatory Term Loan B prepayments escalate. In addition to these
prepayments, the Credit Facility also requires us to make prepayments in an
amount equal to 100% of any Excess Cash Flow, which generally represents the
amount of cash generated by the Company but not used towards operations, debt
service, or investments. The Excess Cash Flow payment for fiscal 2005 was $56.9
million, paid on March 31, 2006, applied to repay $5.8 million Term Loan A
indebtedness and $51.1 million Term Loan B indebtedness.
On March 15, 2006, we executed a second amendment to the Credit Facility,
effective through the fourth quarter of 2006, that relaxed the financial
covenants, restricted our ability to fund capital expenditures, perform asset
sales, and use equity proceeds, and increased interest rates.
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.
The second amendment made various changes to the Credit Facility which
included:
- - A requirement for us to provide monthly financial reporting and cash flow
forecasts to the bank group.
- - More restrictive operating covenants regarding our ability to incur
indebtedness, pay dividends, redeem our capital stock, make capital
expenditures, make acquisitions, and other covenants. Also, certain
mandatory prepayment provisions have been modified.
- - New pricing for the interest rates on the Term Loans and Revolver. For
the period starting April 1, 2006, through the submission of the first
quarter 2006 covenant package to the administrative agent, the interest
rate for the Term Loan A and Revolver will be set at LIBOR plus 5.00%.
After submission of the covenant package, the pricing is as follows:
Leverage Ratio LIBOR Margin
> 4.00 5.00%
3.25 - 4.00 3.50%
2.75 - 3.25 2.75%
2.25 - 2.75 2.50%
1.75 - 2.25 2.25%
< 1.75 2.00%
The Term Loan B pricing was revised to reflect a rate of LIBOR plus 5.25%
starting April 1, 2006 through the submission of the first quarter
covenant package. After submission of the covenant package, the interest
rate will be LIBOR plus 5.25% if our leverage ratio exceeds 4.00;
otherwise the rate will be LIBOR plus 3.75%.
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).
- - The second amendment provides relief through the fourth quarter of 2006
related to our compliance with the quarterly leverage ratio, fixed charge
coverage ratio, and interest coverage tests. The quarterly financial
covenants revert to the original covenants commencing with the first
quarter of 2007. Each of these covenants is calculated on trailing four
quarter results based on specific definitions that are contained in the
credit agreement. In general terms, the leverage ratio is a measurement
of total net indebtedness relative to operating cash flow. The fixed
charge coverage ratio is a measurement of operating cash flow plus rent,
less capital expenditures relative to total fixed charges including rent,
scheduled principal payments, and cash interest. The interest coverage
ratio is a measurement of operating cash flow relative to cash interest
expense.
The covenant levels contained in the Credit Facility, as amended, are as
follows:
Leverage Fixed Charge Interest Coverage
Ratio Coverage Ratio Ratio
2006 Q1 5.00 1.05 2.00
2006 Q2 5.75 1.05 1.75
2006 Q3 6.75 1.00 1.45
2006 Q4 6.50 1.00 1.45
2007 Q1 2.25 1.10 3.00
2007 Q2 2.25 1.10 3.00
2007 Q3 2.25 1.10 3.00
2007 Q1 2.00 1.10 3.00
The Credit Facility and indenture governing our 11% Senior Notes impose certain
restrictions on us, including restrictions on our ability to: incur debt; grant
liens; provide guarantees in respect of obligations of any other person; pay
dividends; make loans and investments; sell our assets; make redemptions and
repurchases of capital stock; make capital expenditures; prepay, redeem or
repurchase debt; engage in mergers or consolidations; engage in sale/leaseback
transactions and affiliate transactions; change our business; amend certain
debt and other material agreements; issue and sell capital stock of
subsidiaries; and make distributions from subsidiaries.
As of April 2, 2006, we were in compliance with our Credit Facility financial
covenants as a result of the debt covenant relief we obtained in the second
amendment. However, while we anticipate complying with the financial covenants
contained in the Credit Facility, as amended, at each test date through the
remainder of fiscal 2006, based on projected operating results it is probable
that we could 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 April 2, 2006.
Assuming continued compliance with the applicable debt covenants under the
Credit Facility, as amended, we expect cash on hand, cash from operations, cash
from non-core asset sales, and available borrowings under the Revolver to be
sufficient to fund the anticipated cash requirements for working capital
purposes and capital expenditures under our normal operations, including any
additional spending on our initiatives, as well as commitments and payments of
principal and interest on borrowings for the remainder of 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 Senior Notes and certain leases, could also become due and
payable immediately. Should the outstanding obligation 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 a
large majority 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 and 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 remain in compliance with
the terms of our Credit Facility, including, among other things, operational
improvement through capitalizing on merger integration synergy opportunities,
raising additional equity, divesting certain non-core assets, 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 any sales of
assets, additional debt or equity financings or further debt amendments can be
obtained.
Our ability to comply with covenants contained in the instruments governing our
existing and future indebtedness may be affected by events and circumstances
beyond our control. If we breach any of these covenants, one or more events of
default, including cross-defaults between multiple components of our
indebtedness, could result. These events of default could permit our creditors
to declare all amounts owing to be immediately due and payable and to terminate
any commitments to make further extensions of credit. If we are unable to
repay our debt service obligations under the Credit Facility or the Senior
Notes, our secured creditors could proceed against the collateral securing the
indebtedness owed to them.
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
and 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.
Contractual Obligations. The following table discloses our contractual
obligations and commercial commitments as of April 2, 2006. The operating
lease information presented is as of January 1, 2006; however, these amounts
approximate the obligations as of April 2, 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) $ 79,650 $ 79,650 $ - $ - $ -
Term Loan B (1) 693,318 693,318 - - -
Revolver - - - - -
Excess Cash
Flow Sweep (2)
Term A - - - - -
Term B - - - - -
Senior Notes 325,450 - - - 325,450
Capital leases 460 412 48 - -
Interest
Term Loan A (3) 7,320 7,320 - - -
Term Loan B (3) 70,639 70,639 - - -
Hedge agreement (2,576) (2,576) - - -
Senior Notes 217,743 35,793 71,587 71,587 38,776
Capital leases 13 12 1 - -
Operating leases 1,612,492 367,033 578,443 356,577 310,439
---------- ---------- -------- --------- ----------
Total $3,004,509 $1,251,601 $650,079 $ 428,164 $ 674,665
---------- ---------- -------- --------- ----------
(1) As of April 2, 2006, we were in compliance with the applicable financial
covenant tests as a result of the debt covenant relief obtained in the second
amendment to the Credit Facility. However, while we anticipate complying with
the financial covenants at each test date through the remainder of fiscal 2006,
based on projected operating results, it is probable that we could 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
Agreement as of April 2, 2006 have been classified as current liabilities.
(2) 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. The amount of these prepayments cannot be estimated at this
time.
(3)Interest rates based on current LIBOR rates plus margin. As of April 2,
2006, the Term Loan A and Term Loan B rates are 9.98% and 10.23%, 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.
Thirteen Weeks Ended
------------------------
April 3, April 2,
2005 2006
---------- ----------
($ in thousands)
Statements of Cash Flow Data:
Net cash provided by (used in) operating
activities $ 10,052 $ (20,583)
Net cash (used in) investing activities (15,266) (6,362)
Net cash provided by (used in)
financing activities 2,699 (73,737)
Net income increased by $22.0 million for the thirteen weeks ended April 2,
2006 over the same period in fiscal 2005 primarily due to the inclusion of
Hollywood operating results. Significant non-cash operating activity changes
primarily driven by Hollywood include a $17.9 million increase in depreciation
expense, a $44.9 million change in rental amortization and a $25.5 million
change in rental purchases. These changes include a $6.8 million charge
related to a change in accounting estimates of amortization and an $11.9
million reduction in rental purchases during the quarter. During the thirteen
weeks ended April 2, 2006, we used $104.0 million of cash toward payment of our
accounts payable balances. This was driven by seasonal pay down of accounts
payable, lower first quarter of 2006 inventory purchases, credit restrictions
on the part of certain vendors and inclusion of Hollywood operating results.
The decrease in net cash used in investing activities during the thirteen weeks
ended April 2, 2006 compared to the same period in fiscal 2005 is primarily due
to lower purchases of property, furnishings, and equipment and limited business
acquisitions. During the thirteen weeks ended April 2, 2005, we purchased 18
stores in separate transactions totaling $4.7 million. While we did not
acquire any stores during the thirteen weeks ended April 2, 2006, we did
acquire $0.2 million in inventory from a competitive store location. In
addition, we opened 70 internally developed stores and closed 46 stores during
the thirteen weeks ended April 2, 2006 compared to opening 62 internally
developed stores and closing 19 stores during the thirteen weeks ended April 3,
2005. We expect the majority of our planned fiscal 2006 new stores will be
internally developed. Capital requirements to fund our projected new store
growth of 140 stores for fiscal 2006 are estimated at $16 million.
Additionally in fiscal year 2006, we estimate $19 million in other on-going
capital expenditure requirements for the existing store base. These estimates
do not include capital required to fund our acquisition of the Boards stores
pursuant to a contractual put provision. The Boards stores acquisition is
expected to occur in fiscal 2006; however, no purchase price has been
negotiated to date related to this pending acquisition.
Net cash flow related to financing activities decreased for the thirteen weeks
ended April 2, 2006 as a result of the excess cash flow payment required under
our Credit Facility and the second amendment to the Credit Facility. The
excess cash flow payment is an annual requirement and our fiscal 2005 payment
of $58.8 million was made in accordance with the provisions of the Credit
Facility on March 31, 2006. In addition, in order to complete the second
amendment to the Credit Facility, we paid off the outstanding Revolver loans of
$6.9 million and pay lenders fees of $5.5 million on March 15, 2006.
At April 2, 2006, we had a working capital deficit of $842.9 million, due to
the accounting treatment of rental inventory and the reclassification of our
Credit Facility to current liabilities. 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 thirteen weeks
ended April 2, 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, to remain current 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 $6.8 million and reduced net income by $6.8 million (net of tax),
or $0.21 per diluted share, for the thirteen weeks ended April 2, 2006.
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 a two-year interest rate swap to exchange $280 million of
the variable-rate Credit Facility debt for 4.06% fixed rate debt. If variable
base rates were to increase 1%, our interest expense on an annual basis would
increase by approximately $4.8 million on the non-hedged principal, based on
both the outstanding balance on the Credit Facility as of April 2, 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 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 the Securities
and Exchange Act Rule 13a-15. Based upon this evaluation as of April 2, 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 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 April 2, 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
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 April 2, 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, and
accrued liabilities.
Remediation
The Company has taken the following actions to address these material
weaknesses:
Ineffective procurement and receiving processes. As reported in the Company's
Form 10-K for the year ended January 1, 2006, several key controls did not
function effectively to provide reasonable assurance that rental and
merchandise inventory received at Company-operated distribution centers were
appropriately accumulated, processed and recorded in the proper period. This
combination of control deficiencies resulted in adjustments to accounts
payable, rental inventory, merchandise inventory, costs of product sales, and
rental inventory. As of April 2, 2006, the affected procurement and receiving
processes have been integrated with other Company processes that have been
operating effectively. As such, this integration effort has effectively
remediated these control deficiencies.
Capitalizing costs. Management has drafted a capital policy 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 draft policy.
Management has taken the actions described above, which it believes address the
material weakness related to properly capitalizing costs. Tests for
effectiveness of these controls will be completed in future quarters. As a
result, management will not be able to conclude on the success of the
remediation 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 occur in future quarters in conjunction with integrating the Company's two
accounting departments into a single department. Additionally, effectiveness
in these areas will be dependent upon obtaining and maintaining qualified staff
in these control areas, including finding a replacement for Bart Walker, Senior
Vice President and Controller, who resigned from the company effective April
28, 2006.
Other Changes in Internal Control over Financial Reporting
On April 7, 2006, Timothy R. Price, the Company's Chief Financial Officer
resigned and Mark D. Moreland was appointed interim Chief Financial Officer.
Additionally, Bart Walker, Senior Vice President and Controller, resigned
effective April 28, 2006. Further, 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. Other
than these changes and the remediation of the material weaknesses described
above, there have been no changes in the Company's internal control over
financial reporting 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 LPG. The Clackamas County actions were later
consolidated and the plaintiffs filed an Amended Consolidated Complaint
alleging four claims for relief against Hollywood's former board members
arising out of the merger of Hollywood with Movie Gallery. The purported four
claims for relief are breach of fiduciary duty, misappropriation of
confidential information, failure to disclose material information in the proxy
statement in support of the Movie Gallery merger, and a claim for attorneys'
fees and costs. The Amended Consolidated Complaint also names UBS Warburg and
LGP as defendants. Following the merger with Movie Gallery, the plaintiffs
filed a Second Amended Consolidated Complaint. The plaintiffs restated their
causes of action and generally allege that the defendants adversely impacted
the value of Hollywood through the negotiations and dealings with LGP.
Hollywood and the former members of its board have also been named as
defendants in a separate lawsuit entitled JDL Partners, L.P. v. Mark J. Wattles
et al. filed in Clackamas County, Oregon, Circuit Court on December 22, 2004.
This lawsuit, filed before Hollywood's announcement of the merger agreement
with Movie Gallery, alleges breaches of fiduciary duties related to a bid by
Blockbuster Inc. to acquire Hollywood, as well as breaches related to a loan to
Mr. Wattles that Hollywood forgave in December 2000. On April 25, 2005, the JDL
Partners action was consolidated with the other Clackamas County lawsuits. The
plaintiffs seek damages and attorneys' fees and costs. Hollywood denies these
allegations and is vigorously defending this lawsuit.
Hollywood was named as a defendant in a sexual harassment lawsuit filed in the
Supreme Court of the State of New York, Bronx County on April 17, 2003. The
action, filed by eleven former female employees, alleges that an employee, in
the course of his employment as a store director for Hollywood, sexually
harassed and assaulted certain of the plaintiffs, and that Hollywood and its
members of management failed to prevent or respond adequately to the employee's
alleged wrongdoing. The plaintiffs seek unspecified damages, pre-judgment
interest and attorneys' fees and costs. Hollywood denies these allegations and
is vigorously defending this lawsuit.
In addition, we have been named to various other claims, disputes, legal
actions and other proceedings involving contracts, employment and various other
matters. A negative outcome in certain of the ongoing litigation could harm
our business, financial condition, liquidity or results of operations. In
addition, prolonged litigation, regardless of which party prevails, could be
costly, divert management attention or result in increased costs of doing
business. We believe we have provided adequate reserves for contingencies and
that the outcome of these matters should not have a material adverse effect on
our consolidated results of operation, financial condition or liquidity.
At April 2, 2006, the legal contingencies reserve, net of expected recoveries
from insurance carriers, was $3.0 million of which $2.3 million relates to pre-
acquisition contingencies. The recorded reserves for some matters may require
adjustment in future periods and those adjustments could be material. Under
SFAS No. 141 "Business Combinations," some or all of any future revisions to
the recorded reserves for pre-acquisition contingencies may be required to be
treated as revisions to the preliminary purchase price allocation (described in
Note 2) which generally would be recorded as adjustments to goodwill.
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 of 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 year ended
January 1, 2006.
Uncertainty surrounding our ability to meet our financial obligations has
adversely impacted and could continue to adversely impact our ability to obtain
sufficient product on favorable terms.
Since our acquisition of Hollywood in April 2005, we have entered into two
amendments of our senior credit facility pursuant to which certain covenants in
our senior credit facility were amended or waived. This, coupled with the
continued declines and uncertainty in the rental industry, has caused negative
publicity surrounding our business. As a result, our flexibility with our
suppliers has been affected, and this risk may be exacerbated by the
reclassification of borrowings under our senior 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.
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: May 12, 2006 /s/ Mark D. Moreland
------------------------------
Mark D. Moreland,
Senior Vice President, Interim
Chief Financial Officer and
Treasurer