-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, OueXQi30s8UCESruKYu1UY1/q7sqvJZnYyJvFMz2TRXW2dQF9jOVjhV9erzMXNTE oidKolRIRrjH1mr+q12q9g== 0000950134-02-015358.txt : 20021209 0000950134-02-015358.hdr.sgml : 20021209 20021209164957 ACCESSION NUMBER: 0000950134-02-015358 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20021031 FILED AS OF DATE: 20021209 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HASTINGS ENTERTAINMENT INC CENTRAL INDEX KEY: 0001054579 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL- COMPUTER & PRERECORDED TAPE STORES [5735] IRS NUMBER: 751386375 STATE OF INCORPORATION: TX FISCAL YEAR END: 0131 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-24381 FILM NUMBER: 02852572 BUSINESS ADDRESS: STREET 1: 3601 PLANS BLVD STREET 2: SUITE 1 CITY: AMARILLO STATE: TX ZIP: 79102 BUSINESS PHONE: 8063512300 MAIL ADDRESS: STREET 1: P O BOX 35350 CITY: AMARILLO STATE: TX ZIP: 79120-5350 10-Q 1 d01884e10vq.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 31, 2002 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------------ ------------------ COMMISSION FILE NUMBER 000-24381 HASTINGS ENTERTAINMENT, INC. (Exact name of registrant as specified in its charter) TEXAS 75-1386375 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 3601 PLAINS BOULEVARD, AMARILLO, TEXAS 79102 (Address of principal executive offices) (Zip Code) (806) 351-2300 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X) Number of shares outstanding of the registrant's common stock, as of December 6, 2002: Class Shares Outstanding - --------------------------------------- ------------------------------------ Common Stock, $.01 par value per share 11,365,396 HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES FORM 10-Q FOR THE THREE AND NINE MONTHS ENDED OCTOBER 31, 2002 INDEX
PAGE ---- PART I - FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets as of October 31, 2002 (Unaudited), October 31, 2001 (Unaudited) and January 31, 2002 3 Unaudited Consolidated Statements of Operations for the Three and Nine Months Ended October 31, 2002 and 2001 4 Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended October 31, 2002 and 2001 5 Notes to Unaudited Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures about Market Risk 21 Item 4. Controls and Procedures 21 PART II - OTHER INFORMATION Item 1. Legal Proceedings 22 Item 6. Exhibits and Reports on Form 8-K 22 SIGNATURE PAGE 23 CERTIFICATIONS 24 INDEX TO EXHIBITS 26
2 PART 1 ITEM 1 - FINANCIAL STATEMENTS HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES Consolidated Balance Sheets October 31, 2002 and 2001, and January 31, 2002 (Dollars in thousands, except par value)
OCTOBER 31, OCTOBER 31, JANUARY 31, 2002 2001 2002 ----------- ----------- ----------- ASSETS (UNAUDITED) (UNAUDITED) Current assets: Cash $ 3,421 $ 3,844 $ 4,319 Merchandise inventories, net 166,269 146,143 148,265 Income taxes receivable 24 6,756 5,377 Other current assets 4,635 5,347 5,331 ----------- ----------- ----------- Total current assets 174,349 162,090 163,292 Property and equipment, net of accumulated depreciation of $132,117, $120,184 and $124,644, respectively 76,163 65,061 64,811 Deferred income taxes, net 946 -- 1,091 Intangible assets, net 676 645 646 Other assets 37 11 11 ----------- ----------- ----------- $ 252,171 $ 227,807 $ 229,851 =========== =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current maturities on capital lease obligations $ 169 $ 153 $ 169 Trade accounts payable 100,535 85,271 86,704 Accrued expenses and other current liabilities 30,342 27,347 26,507 ----------- ----------- ----------- Total current liabilities 131,046 112,771 113,380 Long term debt, excluding current maturities on capital lease obligations 46,475 38,458 33,263 Other liabilities 4,925 6,391 5,864 Commitments and contingencies -- -- -- Shareholders' equity: Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued -- -- -- Common stock, $.01 par value; 75,000,000 shares authorized; 11,944,544 shares issued and 11,363,729 shares outstanding at October 31, 2002 11,944,544 shares issued and 11,832,331 shares outstanding at October 31, 2001; 11,918,035 shares issued and 11,304,022 shares outstanding at January 31, 2002; 119 119 119 Additional paid-in capital 36,763 36,846 36,850 Retained earnings 35,688 33,848 43,368 Treasury stock, at cost; 580,815 shares, 112,213 shares and 614,013 shares at October 31, 2002, and 2001 and January 31, 2002, respectively (2,845) (626) (2,993) ----------- ----------- ----------- 69,725 70,187 77,344 ----------- ----------- ----------- $ 252,171 $ 227,807 $ 229,851 =========== =========== ===========
See accompanying notes to unaudited consolidated financial statements. 3 HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES Unaudited Consolidated Statements of Operations For the Three and Nine Months Ended October 31, 2002 and 2001 (Dollars in thousands, except per share amounts)
THREE MONTHS ENDED OCTOBER 31, NINE MONTHS ENDED OCTOBER 31, 2002 2001 2002 2001 ------------ ------------ ------------ ------------ Merchandise revenue $ 86,445 $ 82,373 $ 267,026 $ 255,864 Rental video revenue 24,191 20,802 71,493 66,524 ------------ ------------ ------------ ------------ Total revenues 110,636 103,175 338,519 322,388 Merchandise cost of revenue 66,370 61,491 199,408 190,669 Rental video cost of revenue 10,222 9,615 29,387 30,510 ------------ ------------ ------------ ------------ Total cost of revenues 76,592 71,106 228,795 221,179 ------------ ------------ ------------ ------------ Gross profit 34,044 32,069 109,724 101,209 Selling, general and administrative expenses 40,117 37,064 117,030 105,107 Pre-opening expenses 150 47 331 81 ------------ ------------ ------------ ------------ Operating loss (6,223) (5,042) (7,637) (3,979) Other income (expense): Interest expense (481) (514) (1,497) (1,656) Interest income 24 -- 1,290 -- Other, net 53 39 164 133 ------------ ------------ ------------ ------------ Loss before income taxes (6,627) (5,517) (7,680) (5,502) Income tax expense -- -- -- -- ------------ ------------ ------------ ------------ Net loss $ (6,627) $ (5,517) $ (7,680) $ (5,502) ============ ============ ============ ============ Basic and diluted loss per share $ (0.58) $ (0.46) $ (0.68) $ (0.47) ============ ============ ============ ============ Weighted-average common shares outstanding: Basic and diluted 11,364 11,865 11,341 11,821 ============ ============ ============ ============
See accompanying notes to unaudited consolidated financial statements. 4 HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES Unaudited Consolidated Statements of Cash Flows For the Nine Months Ended October 31, 2002 and 2001 (Dollars in thousands)
NINE MONTHS ENDED OCTOBER 31, 2002 2001 ------------ ------------ Cash flows from operating activities: Net loss $ (7,680) $ (5,502) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization expense 29,048 25,054 Loss on rental videos lost, stolen and defective 4,001 3,940 Loss on disposal of non-rental video assets 253 293 Non-cash compensation 133 111 Changes in operating assets and liabilities: Merchandise inventory (13,599) (13,108) Other current assets 697 650 Trade accounts payable and accrued expenses 17,667 11,185 Income taxes receivable 5,497 1,003 Other assets and liabilities, net (966) (337) ------------ ------------ Net cash provided by operating activities 35,051 23,289 ------------ ------------ Cash flows from investing activities: Purchases of rental video assets (27,992) (18,351) Purchases of property and equipment (21,100) (12,976) Purchase of retail locations -- (1,167) ------------ ------------ Net cash used in investing activities (49,092) (32,494) ------------ ------------ Cash flows from financing activities: Borrowings under revolving credit facility 372,911 349,116 Repayments under revolving credit facility (359,573) (340,006) Payments under capital lease obligations (124) (108) Purchase of treasury stock (355) (650) Proceeds from exercise of stock options 284 440 ------------ ------------ Net cash provided by financing activities 13,143 8,792 ------------ ------------ Net decrease in cash (898) (413) Cash at beginning of period 4,319 4,257 ------------ ------------ Cash at end of period $ 3,421 $ 3,844 ============ ============
See accompanying notes to unaudited consolidated financial statements. 5 Hastings Entertainment, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements October 31, 2002 and 2001 (Tabular amounts in thousands, except per share data or as otherwise noted) 1. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements of Hastings Entertainment, Inc. and its subsidiaries (the "Company", "We", "Our", "Us") have been prepared in accordance with generally accepted accounting principles for interim financial information and with instructions in Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such principles and regulations of the Securities and Exchange Commission. All adjustments, consisting only of normal recurring adjustments, have been made which, in the opinion of management, are necessary for a fair presentation of the results of the interim periods. The results of operations for such interim periods are not necessarily indicative of the results that may be expected for a full year because of, among other things, seasonality factors in the retail business. The unaudited consolidated financial statements contained herein should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's annual report on Form 10-K for the fiscal year 2001. Certain prior year amounts have been reclassified to conform with the fiscal 2002 presentation. Our fiscal year ends on January 31 and is identified as the fiscal year for the immediately preceding calendar year. For example, the fiscal year that will end on January 31, 2003 is referred to as fiscal 2002. 2. CONSOLIDATION POLICY The unaudited consolidated financial statements present the results of Hastings Entertainment, Inc. and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. 3. STORE CLOSING RESERVE From time to time and in the normal course of business, we evaluate our store base to determine if a need to close a store(s) is present. Such evaluations include, among other factors, current and future profitability, market trends, age of store and lease status. Included in accrued expenses and other liabilities are accruals for the net present value of future minimum lease payments and other costs attributable to closed or relocated stores, net of estimated sublease income. A charge of approximately $0.8 million was recorded in the third quarter of fiscal 2002 for the net present value of minimum lease payments relating to one underperforming superstore to be closed during the fourth quarter of fiscal 2002. Offsetting this charge was a change in estimate during the third quarter of fiscal 2002 of approximately $0.3 million, as a result of negotiating an early buy-out of lease liability on one closed superstore. Additions to the provision during the third quarter of fiscal 2001 included charges totaling approximately $0.3 million related to the net present value of minimum lease payments on certain closed and relocated superstores. In addition, a charge of approximately $0.3 million was recorded resulting from changes in estimates primarily related to sublease activity on certain closed superstores. 6 Hastings Entertainment, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements October 31, 2002 and 2001 (Tabular amounts in thousands, except per share data or as otherwise noted) 3. STORE CLOSING RESERVE (CONT'D) The following tables provide a rollforward of reserves that were established for these charges for the nine months ended October 31, 2002 and 2001.
Future Lease Payments Other Costs Total ------------ ----------- ------- Balance at January 31, 2001 $ 6,350 $ 255 $ 6,605 Changes in estimates 263 -- 263 Additions to provision 369 -- 369 Cash outlay (764) (123) (887) ------------ ----------- ------- Balance at October 31, 2001 $ 6,218 $ 132 $ 6,350 ============ =========== =======
Future Lease Payments Other Costs Total ------------ ----------- ------- Balance at January 31, 2002 $ 5,919 $ 13 $ 5,932 Changes in estimates (224) -- (224) Additions to provision 946 134 1,080 Cash outlay (1,178) (117) (1,295) ------------ ----------- ------- Balance at October 31, 2002 $ 5,463 $ 30 $ 5,493 ============ =========== =======
Payments during the next five years that are to be charged against the reserve are expected to be approximately $1.6 million per year. 4. AMENDMENT TO CREDIT FACILITY On August 23, 2002, we executed an amendment to our Revolving Credit Facility agreement with Fleet Retail Finance and The CIT Group/Business Credit, Inc. Under the amendment, the borrowing limit ceiling was increased from $70 million to $80 million and the maturity date was extended by an additional two years to August 20, 2005. All other terms and conditions of the Revolving Credit Facility in place at July 31, 2002 remain essentially the same. 5. INTEREST INCOME During the second quarter of fiscal 2002, we recorded interest income of approximately $1.3 million as a result of interest earned on income tax refunds for amended returns filed for fiscal years 1995 through 1998. The Company was notified in July 2002 that the payment of the refunds, which totaled approximately $5.4 million, would be processed in August 2002 and would be accompanied by interest payments. All refunds, including interest, were received by October 31, 2002. 6. LOSS PER SHARE Options to purchase 1,784,784 and 1,594,755 shares of common stock at exercise prices ranging from $1.27 per share to $14.03 per share outstanding at October 31, 2002 and 2001, respectively, were not included in the computation of diluted income per share because their inclusion would have been antidilutive. 7 Hastings Entertainment, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements October 31, 2002 and 2001 (Tabular amounts in thousands, except per share data or as otherwise noted) 7. LITIGATION AND CONTINGENCIES In 2000, the Company restated its consolidated financial statements for the first three quarters of fiscal 1999 and the prior four fiscal years. Following the Company's initial announcement in March 2000 of the requirement for such restatements, nine purported class action lawsuits were filed in the United States District Court for the Northern District of Texas against the Company and certain of the current and former directors and officers of the Company asserting various claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Although four of the lawsuits were originally filed in the Dallas Division of the Northern District of Texas, all of the five pending actions have been transferred to the Amarillo Division of the Northern District and have been consolidated. One of the Section 10(b) and 20(a) lawsuits filed in the Dallas Division was voluntarily dismissed. On May 15, 2000, a lawsuit was filed in the United States District Court for the Northern District of Texas against the Company, its current and former directors and officers at the time of the Company's June 1998 initial public offering and three underwriters, Salomon Smith Barney, A.G. Edwards & Sons, Inc. and Furman Selz, LLC asserting various claims under Sections 11, 12(2) and 15 of the Securities Act of 1933. Motions to dismiss these actions were filed by the Company and, on September 25, 2001, were denied by the Court. On September 12, 2002, the Company announced that an agreement in principle to settle the actions described above had been reached. The settlement requires a payment of $5.75 million ($3.25 million of which the Company estimates will be funded from amounts remaining under the Company's director and officer insurance policy after the payment of litigation expenses) and the assignment to the plaintiff settlement class of any claims the Company may have had against KPMG Peat Marwick, LLP, the Company's outside auditors at the time of the March 7, 2000 announcement. The settlement resolves all claims against the Company, its current and former defendant officers and directors and the defendant underwriters. Based on the foregoing, the Company recorded a loss contingency of $2.5 million, or $0.22 per share, during the second quarter of fiscal 2002. Before completion of the settlement agreements, plaintiffs' counsel informed the Company that the plaintiff settlement class had settled all claims against KPMG, including the claims assigned by the Company. Amended settlement agreements that added the terms of the KPMG settlement with the plaintiff settlement class are expected to be filed in mid December 2002. The settlement is subject to Court approval. The Company is also involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company's financial position, results of operations and cash flows. 8 Hastings Entertainment, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements October 31, 2002 and 2001 (Tabular amounts in thousands, except per share data or as otherwise noted) 8. SEGMENT DISCLOSURES The Company has two operating segments, retail stores and Internet operations. Our chief operating decision maker, as that term is defined in the relevant accounting standard, regularly reviews financial information about each of the above operating segments for assessing performance and allocating resources. Revenue for retail stores is derived from the sale of merchandise and rental of videocassettes, video games and DVDs. Revenue for Internet operations is derived solely from the sale of merchandise. Segment information regarding our retail stores and Internet operations for the three and nine months ended October 31, 2002 and 2001 is presented below.
For the three months ended October 31, 2002: Retail Internet Stores Operations Total --------- ---------- --------- Total revenue $ 110,598 $ 38 $ 110,636 Depreciation and amortization 10,111 61 10,172 Operating loss (5,890) (333) (6,223) Total assets 251,931 240 252,171 Capital expenditures $ 19,659 $ -- $ 19,659
For the three months ended October 31, 2001: Retail Internet Stores Operations Total --------- ---------- --------- Total revenue $ 103,135 $ 40 $ 103,175 Depreciation and amortization 7,959 69 8,028 Operating loss (4,802) (240) (5,042) Total assets 227,252 555 227,807 Capital expenditures $ 13,843 $ -- $ 13,843
For the nine months ended October 31, 2002: Retail Internet Stores Operations Total --------- ---------- --------- Total revenue $ 338,388 $ 131 $ 338,519 Depreciation and amortization 28,853 195 29,048 Operating loss (6,823) (814) (7,637) Total assets 251,931 240 252,171 Capital expenditures $ 49,090 $ 2 $ 49,092
For the nine months ended October 31, 2001: Retail Internet Stores Operations Total --------- ---------- --------- Total revenue $ 322,275 $ 113 $ 322,388 Depreciation and amortization 24,846 208 25,054 Operating loss (3,261) (718) (3,979) Total assets 227,252 555 227,807 Capital expenditures $ 32,494 $ -- $ 32,494
9 Hastings Entertainment, Inc. and Subsidiaries Notes to Unaudited Consolidated Financial Statements October 31, 2002 and 2001 (Tabular amounts in thousands, except per share data or as otherwise noted) 9. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board ("FASB") issued Statements of Financial Accounting Standards ("SFAS") No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets (the "Statements"), effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill is no longer amortized but is subject to annual impairment tests in accordance with the Statements. Other intangible assets continue to be amortized over their useful lives. The Company applied the new rules on accounting for goodwill and other intangible assets as of February 1, 2002 and adoption did not have a material impact on its consolidated financial position or results of operations. In July 2001, the FASB issued Statement No. 143, "Accounting for Asset Retirement Obligations" ("SFAS 143"), effective for fiscal years beginning after June 15, 2002. SFAS 143 addresses the financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS 143 requires the capitalization of any retirement costs as part of the total cost of the related long-lived asset and the subsequent allocation of the total expense to future periods using a systematic and rational method. The Company is required to implement SFAS 143 on February 1, 2003, and it has not determined the impact that this statement will have on its consolidated financial position or results of operations. In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations for a disposal of a segment of a business. SFAS 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted SFAS 144 as of February 1, 2002 and such adoption did not have a significant impact on the Company's financial position or results of operations. In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This statement changes certain aspects of financial accounting and reporting for costs associated with exit or disposal activities. This statement is effective for exit or disposal activities that are initiated after December 31, 2002. We do not expect the adoption of this statement to have a material effect on our consolidated financial position or results of operations. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-looking Statements Certain written and oral statements set forth below or made by Hastings or with the approval of an authorized executive officer of the company constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The words "believe," "expect," "intend," "anticipate," "project," "will" and similar expressions identify forward-looking statements, which generally are not historical in nature. All statements which address operating performance, events or developments that we expect or anticipate will occur in the future including statements relating to the impact on our financial statements of any adjustment to fair value of interest rate swaps, inflation, effect of critical accounting policies including lower of cost or market for inventory adjustments, the returns process, rental video amortization and our store closing reserve and statements expressing general optimism about future operating results are forward-looking statements. Such statements are based upon our management's current estimates, assumptions and expectations, which are based on information available at the time of the disclosure, and are subject to a number of factors and uncertainties, including, but not limited to, whether our assumptions turn out to be correct, our inability to attain such estimates and expectations, a downturn in market conditions in any industry relating to the products we inventory, sell or rent, the effects of or changes in economic conditions in the U.S. and or the markets in which we operate our superstores, our success in forecasting customer demand for products, and whether or not the court approves the settlement of the securities litigation (see the discussion of Legal Proceedings in Part II, Item 1 of this Form 10-Q for the three and nine months ended October 31, 2002 and subsequent SEC filings) any of which could cause actual results to differ materially from those described herein. We undertake no obligation to affirm, publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. The following discussion should be read in conjunction with the unaudited consolidated financial statements of the Company and the related notes thereto appearing elsewhere in the report. General Hastings Entertainment is a leading multimedia entertainment retailer that combines the sale of books, music, software, periodicals, videocassettes, video games and DVDs with the rental of videocassettes, video games and DVDs in a superstore and Internet Web site format. As of October 31, 2002, we operated 145 superstores averaging approximately 20,000 square feet in small to medium-sized markets located in 21 states, primarily in the Western and Midwestern United States. Each of our superstores is company-operated under the name of Hastings. Our operating strategy is to enhance our position as a multimedia entertainment retailer by expanding existing superstores, opening new superstores in selected markets and expanding our offering of products through our Internet Web site. References herein to fiscal years are to the twelve-month periods that end in January of the following calendar year. For example, the twelve-month period ending January 31, 2003 is referred to as fiscal 2002. Critical Accounting Policies Our financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the reported amounts of assets, liabilities at the date of the financial statements, the disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We believe the following critical accounting policies affect our more significant estimates and assumptions used in the preparation of our financial statements. Our significant estimates and assumptions are reviewed, and any required adjustments are recorded, on a monthly basis. Lower of Cost or Market for Merchandise Inventory. Our merchandise inventories are recorded at the lower of standard cost or market. As with any retailer, economic conditions, cyclical customer demand and changes in purchasing or distribution can affect the carrying value of inventory. As circumstances warrant, we record lower of 11 cost or market ("LCM") inventory adjustments. In some instances, these adjustments can have a material effect on the financial results of an annual or interim period. In order to determine such adjustments, we evaluate the age, inventory turns and estimated fair value of merchandise inventory by product category and record any adjustment if estimated fair value is below cost. Through merchandising and an automated-progressive markdown program, we quickly take the steps necessary to increase the sell-off of slower moving merchandise to eliminate or lessen the effect of any LCM adjustment. Returns Process. In general, merchandise inventory owned by us is returnable based upon return agreements with our merchandise vendors. We continually return merchandise to vendors based on, among other factors, current and projected sales trends, overstock situations, authorized return timelines or change in product offerings. At the end of any reporting period, there is inventory that has been returned to vendors, or is in the process of being returned to vendors, or has been identified to be returned to vendors, for which cost accruals are required. These costs can include freight, valuation and quantity differences, and other fees charged by a vendor. In order to appropriately match the costs associated with the return of merchandise with the process of returning such merchandise, we utilize an allowance for cost of inventory returns (the "Allowance"). To accrue for such costs and estimate the Allowance, we utilize historical experience adjusted for significant estimated or contractual modifications. Certain adjustments to the Allowance can have a material effect on the financial results of an annual or interim period. We continually evaluate the returns process and initiate improvements as needed. Rental Video Cost Amortization. We have a series of direct revenue-sharing agreements with major studios and we anticipate that our future involvement in revenue-sharing agreements will be similar to that of the current fiscal year. Revenue sharing allows us to acquire rental video assets at a lower up-front capital cost than traditional buying arrangements. We then share with studios a percentage of the actual net rental revenues generated over a contractually determined period of time. The increased access to additional copies of new releases under revenue-sharing agreements allows customer demand for new releases to be satisfied over a shorter period of time at a time when the new releases are most popular. We expense revenue-sharing payments through rental video cost of revenue, under the terms of the specific contracts with supplying studios, as revenues are recognized. The capitalized cost of all rental video assets acquired for a fixed price is being amortized on an accelerated basis over six months to a salvage value of $4 per unit, except for rental video assets purchased for the initial stock of a new superstore, which are being amortized on a straight line basis over 36 months to a salvage value of $4. Certain events, including a downturn in the rental video industry as a whole or in the markets within which we operate our superstores, further consolidation of rental video retailers, substantial change in customer demand and change in the mix of rental video revenues, could affect the salvage value we have assigned to our rental video assets. The effect could result in a material reduction of the carrying value of our rental video assets and have a material impact on the financial results of an annual or interim period. In particular, the growth of the DVD market and the shift of consumer purchases from VHS (videocassettes) to DVD could result in a decrease in the salvage value of rental videos. At some point during the rental cycle, a VHS item, as with DVD and games, is available for purchase by a customer as a previously viewed tape ("PVT"). Our current experience is that the amount received for the PVT is higher than our salvage value of that item in our rental inventory. Based in part on this factor and sales of PVTs, we believe our estimate of salvage value is appropriate. Store Closing Reserve. On a quarterly basis, and in the normal course of business, we evaluate our store base to determine if a need to close or relocate a store(s) is present. Management will evaluate, among other factors, current and future profitability, market trends, age of store and lease status. Upon the appropriate executive approval to close a location, we record charges related to the costs of store closings or relocations. The primary expense items associated with these charges relate to the net present value of minimum lease payments (the present value of remaining lease payments under an active lease) and the write-off of leasehold improvements and other assets not remaining in our possession at the time the location is closed or relocated. The amount recorded can fluctuate based on the age of the closing location, term and remaining years of the lease and the number of stores being closed or relocated. These charges can have a material effect on the financial results of an annual or interim period. Although we actively pursue sublease tenants on all closed or relocated locations, we do not record any estimated sublease income as an offset to any closing or relocation charges until a sublease agreement is executed. 12 Revenue Recognition. The Company's revenue is primarily from retail sales and rental of our products. Merchandise and rental revenues are recognized at the point of sale or rental or at the time merchandise is shipped to the customer. Revenues are presented net of returns and exclude all taxes. Customers may return certain merchandise for exchange or refund within the Company's policies, and an allowance has been established to provide for projected returns. There are no provisions for uncollectible amounts since payment is received at the time of sale. The Company, as with most retailers, also offers gift cards for sale. Deferred revenue, a current liability, is recognized at the time a gift card is sold with the costs of designing, printing and distributing the cards recorded as an expense as incurred. The deferred revenue liability is relieved and revenue is recognized upon the redemption of the gift cards. From time to time the Company will offer sales incentives, in the form of customer rebates, to its customers. Revenue is reduced by the amount of estimated redemptions, based on experience of similar types of rebate offers, and a deferred revenue liability is established. The deferred revenue liability is relieved when the customer has completed all criteria necessary to file a valid rebate claim. Any remaining portion of deferred revenue is recorded as revenue following the termination of the extended redemption period and following completion of all outstanding rebate claims. 13 Results of Operations The following tables present our statement of operations data, expressed as a percentage of revenue, and the number of superstores open at the end of the periods presented herein.
Three Months Ended Nine Months Ended October 31, October 31, 2002 2001 2002 2001 ---------- ---------- ---------- ---------- Merchandise revenue 78.1 % 79.8 % 78.9 % 79.1 % Rental video revenue 21.9 20.2 21.1 20.9 ---------- ---------- ---------- ---------- Total revenues 100.0 100.0 100.0 100.0 Merchandise cost of revenue 76.8 74.6 74.7 74.5 Rental video cost of revenue 42.3 46.2 41.1 45.9 ---------- ---------- ---------- ---------- Total cost of revenues 69.2 68.9 67.6 68.6 ---------- ---------- ---------- ---------- Gross profit 30.8 31.1 32.4 31.4 Selling, general and administrative expenses 36.3 35.9 34.6 32.6 Pre-opening expenses 0.1 0.0 0.1 0.0 ---------- ---------- ---------- ---------- Operating loss (5.6) (4.8) (2.3) (1.2) Other income (expense): Interest expense (0.4) (0.5) (0.4) (0.5) Interest income 0.0 -- 0.4 -- Other, net 0.0 0.0 0.0 0.0 ---------- ---------- ---------- ---------- Loss before income taxes (6.0) (5.3) (2.3) (1.7) Income tax expense (benefit) -- -- -- -- ---------- ---------- ---------- ---------- Net loss (6.0)% (5.3)% (2.3)% (1.7)% ========== ========== ========== ==========
Summary of Superstore Activity
Three Months Ended Nine Months Ended Year Ended October 31, October 31, January 31, 2002 2001 2002 2001 2002 -------- ---------- -------- ---------- ----------- Beginning number of stores 143 139 142 142 142 Openings 3 2 5 3 5 Closings 1 -- (2) (4) (5) -------- ---------- -------- ---------- ----------- Ending number of stores 145 141 145 141 142 ======== ========== ======== ========== ===========
14 Three months ended October 31, 2002 compared to October 31, 2001 Revenues. Total revenues increased $7.5 million, or 7.2%, for the third quarter of fiscal 2002 to $110.6 million compared to $103.1 million a year ago due primarily to an increase in total comparable store revenues ("Comps") of 6.1%. Elements of total Comps were as follows: Merchandise Comps 4.0% Rental video Comps 14.2% Total Comps 6.1%
Total merchandise revenue for the third quarter increased $4.0 million, or 4.9%, to $86.4 million compared to $82.4 million last year. Contributing to the increase in total merchandise revenue were increases in DVD and video game revenues of 67% and 171%, respectively, and book revenues of 5.6% for the three months ended October 31, 2002 over the same period in the prior year. Book Comps increased 4.7% over the comparable period in the prior year resulting from improved inventory selection and programs initiated over the past year to grow revenue and improve inventory turns. Partially offsetting these Comp increases was a decline in music Comps resulting primarily from a (12.2%) decrease in new release compact disc revenues for the current quarter, which we believe is the result of the continuing downturn of the music industry. Partially offsetting this decline were higher revenues generated from other music related products resulting in our overall music Comps decreasing (8.4%) for the current quarter when compared to the same period last year. Total rental video revenue for the quarter grew $3.4 million, or 16.3%, to $24.2 million, up from $20.8 million a year earlier. This increase was primarily driven by a 109% increase in DVD rentals over the same period last year and was partially offset by a 16% decline in VHS rentals. The acceptance of DVD by the consumer is the primary reason for the decline in VHS rental revenue, but part of the decline resulted from studios increasing the percentage of rental titles released simultaneously for sale at a lower price-point, which entices the consumer to purchase a title on VHS instead of renting. Gross Profit. Total gross profit of $34.0 million in the third quarter of fiscal 2002 increased $2.0 million, or 6.2%, from $32.0 million in the third quarter of fiscal 2001. Total gross profit as a percent of total revenue decreased slightly for the three months ended October 31, 2002 to 30.8% compared to 31.1% for the same period last year. Merchandise gross profit as a percent of merchandise revenue decreased to 23.2% for the current quarter compared to 25.4% for the same quarter last year. Significant changes in the components of merchandise gross profit were: (i) an increase in our product cost from 65.2% of merchandise revenue for the three months ended October 31, 2001 to 68.1% for the three months ended October 31, 2002. Factoring in the increase in revenues, this higher cost percentage resulted in lower merchandise gross profit of approximately $1.1 million for the current quarter and was due primarily to reduced margins in music and sale video, resulting from lowering sales prices to meet competitor prices. Partially offsetting these declines was an increase in book gross profit due primarily to a planned move toward higher margin products in this category; (ii) an increase in inventory markdowns during the third quarter of fiscal 2002 of approximately $0.5 million compared to the same period last year due primarily to a higher level of non-returnable, non-saleable book items being disposed of during the third quarter; (iii) an increase in net freight expense of approximately $0.2 million, caused primarily by an earlier build-up of inventory for the holiday season when compared to the prior year; and (iv) an increase of approximately $0.1 million in the costs associated with the returning of merchandise inventory. The volume of returns shipped from our returns facility increased approximately 27.4% for the three months ended October 31, 2002 compared to the same period in the prior year, which resulted in an increase of approximately $0.6 million in overhead and variable labor costs. Those increases were partially offset by a decrease in total returns fees of approximately $0.5 million as a result of improved efficiency and accuracy of the product return process. 15 Partially offsetting these decreases in gross profit was: (i) a decrease of approximately $0.7 million in the costs associated with distributing merchandise inventory due primarily to lower markdowns on certain products being purchased through our distribution facility; and (ii) a decrease in merchandise shrinkage of approximately $0.2 million. Rental video gross profit as a percent of rental video revenue increased to 57.7% for the current quarter from 53.8% for the same quarter last year. This increase was due primarily to non-revenue sharing titles, which have historically reflected higher margins, representing a higher percentage of total rental video revenue for the third quarter of fiscal 2002 compared to the third quarter of fiscal 2001 and a decline in rental video shrinkage of approximately $0.1 million. Selling, General and Administrative Expenses. Selling, general and administrative ("SG&A") expenses as a percent of total revenues increased to 36.3% for the quarter ended October 31, 2002 from 35.9% for the same period last year. The increase was primarily the result of: (i) an increase in store variable human resource expenses, excluding group healthcare costs, of approximately $1.0 million for the three months ended October 31, 2002 compared to the same period in the prior year. Store human resource productivity remained constant at 13.7% of total revenues for the quarterly periods presented. (ii) a planned increase of approximately $0.9 million in advertising expenditures designed to drive Comp sales and customer traffic; (iii) an increase of approximately $0.5 million primarily related to increases in depreciation and consultant fees in connection with the implementation of new financial software and upgrades in our human resource systems; (iv) an increase in occupancy related costs of approximately $0.4 million due to the increase in operating a greater number of superstore units during the current quarter when compared to last year; (v) an increase of approximately $0.3 million in the costs associated with expanding or relocating four superstores and the write-off of fixed assets related to the closing of one superstore during the third quarter of fiscal 2002; (vi) an unplanned increase of approximately $0.2 million in the costs associated with our group healthcare plan due primarily to higher than anticipated claims activity; and (vii) a planned increase in corporate human resource expenses, excluding group healthcare costs, of approximately $0.2 million. Partially offsetting these increases in SG&A were lower estimated legal fees of approximately $0.3 million relating to our exposure to various claims and legal actions arising in the ordinary course of business and a reduction of approximately $0.2 million in other SG&A expenses. Also included in SG&A during the third quarter of fiscal 2002 were net charges of approximately $0.5 million related to the net present value of future minimum lease payments for one superstore to be closed during the fourth quarter 2002 and the effect of a negotiated early buy-out of the lease liability on one closed superstore. These charges compare to net charges of approximately $0.6 million during the third quarter of fiscal 2001 related to the net present value of minimum lease payments on certain closed and relocated superstores and changes in estimates primarily related to sublease activity on certain closed superstores. 16 Pre-opening Expenses. Pre-opening expenses were $0.1 million for the three months ended October 31, 2002, as the Company opened three new superstores during the period. Pre-opening expenses include human resource costs, travel, rent, advertising, supplies and certain other costs incurred prior to a superstore's opening. Interest Expense. Interest expense remained unchanged at $0.5 million for the three months ended October 31, 2002, compared to the three months ended October 31, 2001. Income Taxes. We did not record any income tax benefit for the three months ended October 31, 2002 or 2001 due to application of valuation allowances related to the net deferred tax asset. Nine months ended October 31, 2002 compared to October 31, 2001 Revenues. Total revenues increased $16.1 million, or 5.0%, for the nine months to $338.5 million compared to $322.4 million a year ago due primarily to an increase in total Comps of 5.4%. Elements of total Comps were as follows: Merchandise Comps 5.3% Rental video Comps 5.9% Total Comps 5.4%
Total merchandise revenue for the nine months increased $11.2 million, or 4.4%, to $267.0 million compared to $255.8 million last year. Contributing to the increase in gross merchandise revenue were increases in DVD and video game revenues of 57% and 167%, respectively, for the nine months ended October 31, 2002 over the same period in the prior year. On a percentage basis, Comp merchandise revenue increases were higher than gross merchandise revenue increases primarily because of increased revenue generated from "going-out-of-business" sales for the closing of four stores during the nine months ended October 31, 2001, that were excluded from the Comp calculation. Book Comps increased 4.9% over the comparable period last year resulting from improved inventory selection and programs initiated over the past year to grow revenue and improve inventory turns. The music industry recorded a decline in shipments of (10.5%) for the year as of the end of October 2002, which sustains a downward pressure on retail sales for the industry. In comparison, our revenue generated from the sale of new release compact discs decreased (9.1%) for the nine months ended October 31, 2002; however, with our diverse music product offering including used CDs, music accessories and musical instruments, our overall music category decreased only (5.2%) for the nine-month period. Total rental video revenue for the nine months ended October 31, 2002 grew $5.0 million, or 7.5%, to $71.5 million, up from $66.5 million a year earlier driven primarily by a 105% increase in DVD rentals over the same period last year and was partially offset by a 21% decline in VHS rentals. Gross Profit. Total gross profit of $109.7 million for the nine months ended October 31, 2002 increased $8.5 million, or 8.4%, from $101.2 million for the nine months ended October 31, 2001. Total gross profit as a percent of total revenues increased for the nine months ended October 31, 2002 to 32.4% compared to 31.4% for the same period last year. Merchandise gross profit as a percent of merchandise revenue decreased slightly to 25.3% for the current nine months from 25.5% for the same period last year due primarily to: (i) a slight increase in our product cost of approximately 60 basis points from 66.3% of merchandise revenue for the nine months ended October 31, 2001 to 66.9% for the nine months ended October 31, 2002. However, with the increases in revenue as detailed above, merchandise gross profit dollars increased approximately $2.2 million for the current nine months; (ii) an increase of approximately $1.6 million in the costs associated with returning merchandise inventory primarily related to an increase of approximately $16.0 million, or 30%, in the volume of product returned to vendors during the first nine months of fiscal 2002 compared to the same period last year. The higher level of returns was mainly attributable to a planned reduction in inventory levels; 17 (iii) an increase in net freight expense of approximately $1.0 million, which was primarily caused by the increases in shipments from our distribution and returns facilities of approximately 21% for the nine months ended October 31, 2002 compared to the same period in the prior year; and (iv) higher occupancy related costs of approximately $0.9 million due to the increase in operating a greater number of superstore units during the nine months ended October 31, 2002 when compared to last year. Partially offsetting these decreases in gross profit was: (i) a decline in inventory markdowns of approximately $1.5 million compared to the same period last year due primarily to our automated-progressive markdown programs, which improve our sell-through on slower moving merchandise; (ii) an increase of approximately $0.4 million in the amount of income from certain trade and purchase discounts primarily resulting from volume rebates related to merchandise inventory purchases; and (iii) a decrease in merchandise shrinkage of approximately $0.3 million. Rental video gross profit increased as a percent of rental video revenue to 58.9% for the nine months ended October 31, 2002 from 54.1% for the same period last year. This increase was due primarily to non-revenue sharing titles, which generally reflect higher margins, representing a higher percentage of total rental revenues. In addition, rental video shrinkage decreased by approximately $0.5 million for the nine months ended October 31, 2002 when compared to the nine months ended October 31, 2001. Selling, General and Administrative Expenses. SG&A expenses as a percent of total revenues increased to 34.6% for the nine months ended October 31, 2002 from 32.6% for the same period last year. The increase was primarily the result of: (i) a $2.5 million charge, recorded at July 31, 2002, for the settlement of the shareholder class action lawsuits (See the discussion of legal proceedings in Part II, Item 1 of this Form 10-Q); (ii) an increase of approximately $2.9 million in store variable human resource expenses, excluding group healthcare costs, for the nine months ended October 31, 2002 compared to the same period last year. As a percent of total revenues, store human resource productivity decreased slightly to 13.1% of total revenues for the current nine month period compared to 12.8% for the same period in the prior year; (iii) a planned increase of approximately $2.3 million in advertising expenditures designed to increase Comp sales and customer traffic; (iv) an increase of approximately $1.4 million primarily related to increase in depreciation and consultant fees in connection with the implementation of new financial software and upgrades in our human resource systems; (v) an unplanned increase of approximately $0.7 million in the costs associated with our group healthcare plan, the majority of which was the result of two large medical claims incurred at the end of July 2002; (vi) an increase in corporate human resource expenses, excluding group healthcare costs, of approximately $0.5 million; (vii) an increase of approximately $0.4 million in the costs associated with expanding or relocating seven superstores and the write-off of fixed assets related to the closing of one superstore; and (viii) an increase of approximately $0.3 million in other SG&A costs. 18 Also included in SG&A for the nine months ended October 31, 2002 were net charges of approximately $0.8 million primarily related to the net present value of future minimum lease payments for the closing of two superstores, one of which was closed during the third quarter of fiscal 2002 and the other to be closed during the fourth quarter 2002, and the effect of a negotiated early buy-out of lease liability on one closed superstore. These charges compare to net charges of approximately $0.6 million for the nine months ended October 31, 2001 related to the net present value of minimum lease payments on certain closed and relocated superstores and changes in estimates primarily related to sublease activity on certain closed superstores. Pre-opening Expenses. Pre-opening expenses were $0.3 million for the nine months ended October 31, 2002, as the Company opened five new superstores during the period. Pre-opening expenses include human resource costs, travel, rent, advertising, supplies and certain other costs incurred prior to a superstore's opening. Interest Expense. Interest expense was $1.5 million, or 0.4% of revenues, for the nine months ended October 31, 2002, compared to $1.7 million, or 0.5% of revenues, in the nine months ended October 31, 2001. The slight decrease was due to a decline in interest rates period over period, despite a higher average loan balance outstanding. Interest Income. During the second quarter, we recorded interest income of $1.3 million as a result of interest earned on income tax refunds for amended returns filed for fiscal years 1995 through 1998. The Company was notified in July 2002 that the payment of the refunds, which totaled approximately $5.4 million, would be processed in August 2002 and would be accompanied by interest payments. All refunds, including interest, were received by October 31, 2002. Income Taxes. We did not record any income tax benefit for the nine months ended October 31, 2002 or 2001 due to application of valuation allowances related to the net deferred tax asset. Liquidity and Capital Resources We generate cash from operations exclusively from the sale of merchandise and the rental of video products and we have substantial operating cash flow because most of our revenue is received in cash and cash equivalents. Other than our principal capital requirements arising from the purchase, warehousing and merchandising of inventory and rental videos, opening new superstores and expanding existing superstores and updating existing and implementing new information systems technology, we have no anticipated material capital commitments. Our primary sources of working capital are cash flow from operating activities, trade credit from vendors and borrowings under our amended revolving credit facility (the "Facility"). We believe our cash flow from operations and borrowings under the Facility will be sufficient to fund our ongoing operations, new superstores and superstore expansions through fiscal 2005. Consolidated Cash Flows Operating Activities. Net cash flows from operating activities increased $11.8 million, from $23.3 million for the nine months ended October 31, 2001 to $35.1 million for the nine months ended October 31, 2002. Offsetting the increase in our net loss for the nine-month period was a greater increase in trade accounts payable and accrued expenses for the current year-to-date period of approximately $6.5 million associated with extended dating on our trade payables for our seasonal build-up of merchandise inventory. In addition, we recorded a greater decline in income taxes receivable of approximately $4.5 million relating to the receipt of federal income tax refunds during the third quarter of fiscal 2002. Investing Activities. Net cash used in investing activities increased $16.6 million, or 51.1%, to $49.1 million for the nine months ended October 31, 2002 from $32.5 million for the nine months ended October 31, 2001. This increase was the result of opening five superstores, growth in remodeling and expansion activity of certain existing superstores compared to the prior year, and higher procurement of rental video assets relating to the growth of DVD and a higher percentage of purchases of non-revenue sharing titles, which generally cost more per unit than revenue sharing titles. 19 Financing Activities. Cash provided by financing activities is primarily associated with net borrowings under debt agreements. For the nine months ended October 31, 2002, such net borrowings increased $4.2 million compared to the nine months ended October 31, 2001. The increase for fiscal 2002 primarily resulted from items described under Operating Activities and Investing Activities above. Capital Structure. On August 23, 2002, we executed an amendment to our syndicated secured Loan and Security Agreement with Fleet Retail Finance, Inc. and The CIT Group/Business Credit, Inc, (the "Facility"). The amount outstanding under the Facility is limited by a borrowing base predicated on eligible inventory, as defined, and certain rental video assets, net of accumulated depreciation less specifically defined reserves and is limited to a ceiling of $80 million, less a $10 million availability reserve. The Facility's interest rate is based on the prevailing prime rate or LIBOR plus a margin percentage, at our option. The borrowing base under the Facility is limited to an advance rate of 65% of eligible inventory and certain rental video assets net of accumulated amortization less specifically defined reserves, which can be adjusted to reduce availability under the Facility. The Facility contains no financial covenants, restricts the payment of dividends and includes certain other debt and acquisition limitations, allows for the repurchase of up to $7.5 million of our common stock and requires a minimum availability of $10 million at all times. The Facility is secured by substantially all of the assets of the company and our subsidiaries and is guaranteed by each of our three consolidated subsidiaries. The Facility matures on August 20, 2005. At October 31, 2002, we had $19.5 million in excess availability, after the $10 million availability reserve, under the Facility. At October 31, 2002 and January 31, 2002, respectively, we had borrowings outstanding of $45.6 million and $32.2 million under the Facility. The average rate of interest being charged under the Facility was 4.2% and 6.1% at October 31, 2002 and January 31, 2002, respectively. From time to time, we enter into interest rate swap agreements in order to obtain a fixed interest rate on a portion of our outstanding floating rate debt thereby reducing our exposure to interest rate volatility. On October 4, 2002, we cancelled, at no cost, two swap agreements entered into in November and December of 2001 for $10 million each and replaced those agreements with one interest rate swap agreement with a financial institution. The notional value of the swap is $20 million of our revolving credit facility at a fixed interest rate of 2.45% for two years. We have designated the interest rate swap as a hedging instrument. At October 31, 2002, the fair value of the interest rate swap was not significant. At October 31, 2002, the Company's minimum operating lease commitments remaining for fiscal 2002 were approximately $4.6 million. The present value of total existing minimum operating lease commitments for fiscal years 2003 through 2019 discounted at 9.0% was approximately $69.7 million as of October 31, 2002. Seasonality and Inflation As is the case with many retailers, a significant portion of the Company's revenues, and an even greater portion of its operating profit, is generated in the fourth fiscal quarter, which includes the Christmas selling season. As a result, a substantial portion of the Company's annual earnings has been, and will continue to be, dependent on the results of the fourth fiscal quarter. The Company experiences reduced rentals of video activity in the spring because customers spend more time outdoors. Major world or sporting events, such as the Super Bowl, the Olympic Games or the World Series, also have a temporary adverse effect on revenues. Future operating results may be affected by many factors, including variations in the number and timing of store openings, the number and popularity of new book, music and videocassette titles, the cost of the new release or "best renter" titles, changes in comparable-store revenues, competition, marketing programs, increases in the minimum wage, weather, special or unusual events, and other factors that may affect retailers in general and the Company in particular. The Company does not believe that inflation has materially impacted operating results during the past three years. Substantial increases in costs and expenses could have a significant impact on the Company's operating results to the extent such increases are not passed along to customers. 20 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK In the ordinary course of our business, we are exposed to certain market risks, primarily changes in interest rates. Our exposure to interest rate risk consists of variable rate debt based on the lenders base rate or LIBOR plus a specified percentage at our option. The annual impact on our results of operations of a 100 basis point interest rate change on the October 31, 2002 outstanding balance of the variable rate debt would be approximately $0.3 million, including the effect of our interest rate swap. After an assessment of these risks to our operations, we believe that the primary market risk exposures (within the meaning of Regulation S-K Item 305) are not material and are not expected to have any material adverse impact on our financial position, results of operations or cash flows for the next fiscal year. In addition, we do not believe changes in the fair value of our interest rate swap entered into in October of 2002 with a notional amount of $20 million will be material. ITEM 4. CONTROLS AND PROCEDURES Within 90 days prior to the date of the filing date of this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934, as amended). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Subsequent to the date of their evaluation, we did not make any significant changes in, nor take any corrective actions regarding, our internal controls or other factors that could significantly affect these controls. 21 PART II ITEM 1. LEGAL PROCEEDINGS In 2000, the Company restated its consolidated financial statements for the first three quarters of fiscal 1999 and the prior four fiscal years. Following the Company's initial announcement in March 2000 of the requirement for such restatements, nine purported class action lawsuits were filed in the United States District Court for the Northern District of Texas against the Company and certain of the current and former directors and officers of the Company asserting various claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Although four of the lawsuits were originally filed in the Dallas Division of the Northern District of Texas, all of the five pending actions have been transferred to the Amarillo Division of the Northern District and have been consolidated. One of the Section 10(b) and 20(a) lawsuits filed in the Dallas Division was voluntarily dismissed. On May 15, 2000, a lawsuit was filed in the United States District Court for the Northern District of Texas against the Company, its current and former directors and officers at the time of the Company's June 1998 initial public offering and three underwriters, Salomon Smith Barney, A.G. Edwards & Sons, Inc. and Furman Selz, LLC asserting various claims under Sections 11, 12(2) and 15 of the Securities Act of 1933. Motions to dismiss these actions were filed by the Company and, on September 25, 2001, were denied by the Court. On September 12, 2002, the Company announced that an agreement in principle to settle the actions described above had been reached. The settlement requires a payment of $5.75 million ($3.25 million of which the Company estimates will be funded from amounts remaining under the Company's director and officer insurance policy after the payment of litigation expenses) and the assignment to the plaintiff settlement class of any claims the Company may have had against KPMG Peat Marwick, LLP, the Company's outside auditors at the time of the March 7, 2000 announcement. The settlement resolves all claims against the Company, its current and former defendant officers and directors and the defendant underwriters. Based on the foregoing, the Company recorded a loss contingency of $2.5 million, or $0.22 per share, during the second quarter of fiscal 2002. Before completion of the settlement agreements, plaintiffs' counsel informed the Company that the plaintiff settlement class had settled all claims against KPMG, including the claims assigned by the Company. Amended settlement agreements that added the terms of the KPMG settlement with the plaintiff settlement class are expected to be filed in mid December 2002. The settlement is subject to Court approval. The Company is also involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company's financial position, results of operations and cash flows. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K a. List of Exhibits 99.1 Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 b. Reports on Form 8-K On September 12, 2002, the Company filed a current report on Form 8-K reporting, under "Item 5. Other Information," that an agreement in principle had been reached with respect to the shareholder class action lawsuits filed against the Company in fiscal 2000. On September 12, 2002, the Company filed a current report on Form 8-K reporting, under "Item 9. Regulation FD Disclosure," that in connection with the filing of the quarterly report on Form 10-Q of the Company that John H. Marmaduke, President and Chief Executive Officer (Principal Executive Officer) and Dan Crow, Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) had provided certifications pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 22 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized: HASTINGS ENTERTAINMENT, INC. Date: December 09, 2002 /s/ Dan Crow --------------------------- Dan Crow Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) 23 CERTIFICATIONS I, John H. Marmaduke, President and Chief Executive Officer (Principal Executive Officer) of Hastings Entertainment, Inc., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Hastings Entertainment, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: December 09, 2002 /s/ John H. Marmaduke -------------------------- John H. Marmaduke President and Chief Executive Officer (Principal Executive Officer) 24 I, Dan Crow, Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) of Hastings Entertainment, Inc., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Hastings Entertainment, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: December 09, 2002 /s/ Dan Crow --------------------------- Dan Crow Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) 25 INDEX TO EXHIBITS
Exhibit Number Description of Documents ------- ------------------------ 99.1 Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
26 EX-99.1 3 d01884exv99w1.txt CERTIFICATIONS PURSUANT TO SECTION 906 EXHIBIT 99.1 [HASTINGS LOGO] December 09, 2002 Securities and Exchange Commission Judiciary Plaza 450 Fifth Street, N.W. Washington, DC 20549 Re: Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Ladies and Gentlemen; Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, in connection with the filing of the quarterly report on Form 10-Q of Hastings Entertainment, Inc., a Texas Corporation (the "Company"), for the quarterly period ended October 31, 2002, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), each of the undersigned officers of the Company certifies that, to such officer's knowledge: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of the dates and for the periods expressed in the Report. /s/ John H. Marmaduke - --------------------------- John H. Marmaduke President and Chief Executive Officer (Principal Executive Officer) /s/ Dan Crow - --------------------------- Dan Crow Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) -----END PRIVACY-ENHANCED MESSAGE-----