e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended October 31, 2005


o		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		(I.R.S. 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 þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ

Number of shares outstanding of the registrant’s common stock, as of October 31, 2005:


Class		Shares Outstanding

Common Stock, $.01 par value per share		11,380,373

PART 1 — FINANCIAL INFORMATION

ITEM 1 — FINANCIAL STATEMENTS.

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES

Consolidated Balance Sheets
October 31, 2005 and 2004, and January 31, 2005
(Dollars in thousands, except par value)


	October 31,			October 31,			January 31,
	2005			2004			2005
	(Unaudited)			(Unaudited)			(as restated)
				(as restated)
Assets
Current assets:
Cash	$	7,906		$	7,081		$	9,543
Merchandise inventories, net		164,373			182,524			155,452
Deferred income taxes		3,322			4,657			3,198
Prepaid expenses and other current assets		6,569			6,275			6,945

Total current assets		182,170			200,537			175,138
Property and equipment, net of accumulated depreciation of $162,140, $153,509, and $156,613 at October 31, 2005 and 2004, and January 31, 2005, respectively		75,732			77,434			78,112
Deferred income taxes		2,315			—			308
Intangible assets, net		475			564			542
Other assets		51			16			16

Total Assets	$	260,743		$	278,551		$	254,116


Liabilities and Shareholders’ Equity
Current liabilities:
Current maturities on capital lease obligations	$	132		$	237		$	243
Trade accounts payable		84,471			102,381			86,082
Accrued expenses and other current liabilities		32,103			31,601			36,166

Total current liabilities		116,706			134,219			122,491
Long term debt, excluding current maturities on capital lease obligations		54,383			56,906			39,603
Deferred income taxes		—			245			—
Other liabilities		2,128			2,515			2,248

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 11,380,373 shares outstanding at October 31, 2005; 11,944,544 shares issued and 11,419,421 shares outstanding at October 31, 2004; 11,944,544 shares issued and 11,455,569 shares outstanding at January 31, 2005		119			119			119
Additional paid-in capital		36,076			36,295			36,382
Retained earnings		54,465			50,935			55,771
Treasury stock, at cost 564,471 shares, 525,123 shares and 488,975 shares at October 31, 2005, and 2004 and January 31, 2005, respectively		(3,134	)		(2,683	)		(2,498	)

Total Shareholders’ Equity		87,526			84,666			89,774

Total Liabilities and Shareholders’ Equity	$	260,743		$	278,551		$	254,116

See accompanying notes to unaudited consolidated financial statements.

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES

Unaudited Consolidated Statements of Operations
For the Three and Nine Months Ended October 31, 2005 and 2004
(Dollars in thousands, except per share amounts)


	Three Months Ended October 31,						Nine Months Ended October 31,
	2005			2004			2005			2004
				(as restated)						(as restated)
Merchandise revenue	$	93,581		$	96,257		$	298,483		$	294,755
Rental revenue		21,006			23,322			67,954			74,173

Total revenues		114,587			119,579			366,437			368,928

Merchandise cost of revenue		64,995			70,387			210,458			211,710
Rental cost of revenue		8,543			9,028			25,791			28,796

Total cost of revenues		73,538			79,415			236,249			240,506


Gross profit		41,049			40,164			130,188			128,422

Selling, general and administrative expenses		44,867			42,250			130,570			125,380
Pre-opening expenses		—			26			92			360


Operating income (loss)		(3,818	)		(2,112	)		(474	)		2,682

Other income (expense):
Interest expense		(778	)		(539	)		(1,920	)		(1,353	)
Other, net		66			56			209			232


Income (loss) before income taxes		(4,530	)		(2,595	)		(2,185	)		1,561

Income tax expense (benefit)		(1,799	)		(973	)		(879	)		589


Net income (loss)	$	(2,731	)	$	(1,622	)	$	(1,306	)	$	972


Basic income (loss) per share	$	(0.24	)	$	(0.14	)	$	(0.11	)	$	0.09


Diluted income (loss) per share	$	(0.24	)	$	(0.14	)	$	(0.11	)	$	0.08


Weighted-average common shares outstanding:
Basic		11,367			11,421			11,426			11,400
Dilutive effect of stock options		—			—			—			519


Diluted		11,367			11,421			11,426			11,919

See accompanying notes to unaudited consolidated financial statements.

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES
Unaudited Consolidated Statements of Cash Flows
For the Nine Months Ended October 31, 2005 and 2004
(Dollars in thousands)


	Nine Months Ended
	October 31,
	2005			2004
				(as restated)
Cash flows from operating activities:
Net income (loss)	$	(1,306	)	$	972
Adjustments to reconcile net income to net cash used in operating activities:
Rental asset depreciation expense		12,723			16,668
Purchases of rental inventory		(20,786	)		(25,197	)
Property and equipment depreciation expense		14,671			14,251
Amortization expense		67			66
Deferred income taxes		(2,131	)		521
Loss on rental assets lost, stolen and defective		3,544			3,623
Loss on disposal of non-rental assets		826			665
Non-cash compensation		28			60
Changes in operating assets and liabilities:
Merchandise inventory		(3,930	)		(36,629	)
Prepaid expenses and other current assets		376			821
Trade accounts payable		(1,611	)		20,309
Accrued expenses and other current liabilities		(4,063	)		(4,066	)
Other assets and liabilities, net		(155	)		(344	)

Net cash used in operating activities		(1,747	)		(8,280	)

Cash flows from investing activities:
Purchases of property and equipment		(13,898	)		(18,749	)

Net cash used in investing activities		(13,898	)		(18,749	)

Cash flows from financing activities:
Borrowings under revolving credit facility		396,437			411,235
Repayments under revolving credit facility		(381,287	)		(383,775	)
Payments under capital lease obligations		(172	)		(161	)
Purchase of treasury stock		(1,611	)		(904	)
Proceeds from exercise of stock options		641			591

Net cash provided by financing activities		14,008			26,986

Net decrease in cash		(1,637	)		(43	)
Cash at beginning of period		9,543			7,124

Cash at end of period	$	7,906			7,081

See accompanying notes to unaudited consolidated financial statements.

Hastings Entertainment, Inc. and Subsidiaries

Notes to Unaudited Consolidated Financial Statements
October 31, 2005 and 2004
(Tabular amounts in thousands, except per share data or unless otherwise noted)

1. Basis of Presentation

The accompanying unaudited consolidated financial statements of Hastings Entertainment, Inc. and its subsidiaries (“Hastings,” the “Company,” “we,” “our,” “us”) have been prepared in accordance with U.S. 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 U.S. generally accepted accounting principles have been condensed or omitted pursuant to such principles and regulations of the Securities and Exchange Commission. All adjustments, consisting 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. As is the case with many retailers, a significant portion of our revenues, and an even greater portion of our operating profit, is generated in the fourth fiscal quarter, which includes the Christmas selling season. The unaudited consolidated financial statements contained herein should be read in conjunction with the audited consolidated financial statements and notes thereto included in our annual report on Form 10-K for the fiscal year ended January 31, 2005.

The balance sheet at January 31, 2005 has been derived from the audited consolidated financial statements at that date but does not include all of the information and notes required by U.S. generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended January 31, 2005.

Certain prior year amounts have been reclassified to conform with the fiscal 2005 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, 2006 is referred to as fiscal year 2005.

Hastings Entertainment, Inc. and Subsidiaries
Notes to Unaudited Consolidated Financial Statements
October 31, 2005 and 2004
(Tabular amounts in thousands, except per share data or unless otherwise noted)

2. Restatement of Prior Period Financial Statements

In light of SEC clarification on the subject, the Company reevaluated its lease accounting practices during fiscal 2004. As a result, the Company corrected its accounting for rent holidays and the amortization of certain leasehold improvements (the “Restatement”), as further discussed in the Company’s most recent Annual Report on Form 10-K. The Restatement of third quarter 2004 results increased net income for the three months ended October 31, 2004 by approximately $0.1 million, or $0.01 per share, decreased total assets by $2.9 million and decreased shareholders’ equity by $2.6 million. Net income for the nine months ended October 31, 2004 was increased approximately $0.4 million, or $0.03 per share, due to the Restatement.

Furthermore, in response to an SEC comment letter, the Company reevaluated its historical presentation of purchases of rental assets in the Statement of Cash Flows. While the historical presentation and related disclosures were consistent with industry practice and believed to be adequate, our reevaluation has concluded that the presentation of the Statement of Cash Flows was not in accordance with SFAS 95, Statement of Cash Flows. Accordingly, the Company has restated its presentation of purchases of rental assets not associated with new store openings to reclassify these purchases in the operating section of the Company’s Statement of Cash Flows, which is a change from our historical presentation of inclusion of such purchases in the investing section. Purchases and sales of rental assets placed as initial stock in our new stores, if material, will be presented in the investing section of the Statement of Cash Flows. The net impact of this reclassification increased cash flows used in operating activities and decreased cash flows used in investing activities by $25.2 million for the nine months ended October 31, 2004. In addition, we have reclassified $1.9 million on the Consolidated Balance Sheets for October 31, 2004 and January 31, 2005, for rental assets that have been converted to previously viewed tapes for sale, from ‘Property and equipment’ to ‘Merchandise inventories.’ The transfer to ‘Merchandise Inventories’ is now recorded at the time of conversion, which is the first date the product is available for sale. This restatement had no effect on Net Income or Shareholders’ equity for any period restated.

3. Stock Option Plans

We account for our stock option plans in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations. Compensation expense is recorded on the date of grant only if the market price of the underlying stock exceeds the exercise price. Under Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation (“SFAS 123”), we may elect to recognize expense for stock-based compensation based on the fair value of the awards, or continue to account for stock-based compensation under APB 25 and disclose in the financial statements the effects of SFAS 123 as if the recognition provisions were adopted. We have elected to continue to apply the provisions of APB 25 and provide pro forma disclosure of the effects of SFAS 123. The following schedule reflects the impact on net income and income per share if we had applied the fair value recognition provisions of SFAS 123 to stock based compensation.


	Three Months Ended October						Nine Months Ended October
	31,						31,
	2005			2004			2005			2004
				(as restated)						(as restated)
Net income, as reported	$	(2,731	)	$	(1,622	)	$	(1,306	)	$	972
Add: Stock-based compensation included in reported net income, net of tax		17			—			17			36
Less: Stock-based compensation expense determined under fair value based method, net of tax		(131	)		(181	)		(399	)		(506	)


Pro forma net income	$	(2,845	)	$	(1,803	)	$	(1,688	)	$	502


Income per share:
Basic, as reported	$	(0.24	)	$	(0.14	)	$	(0.11	)	$	0.09
Basic, pro forma	$	(0.25	)	$	(0.16	)	$	(0.15	)	$	0.04
Diluted, as reported	$	(0.24	)	$	(0.14	)	$	(0.11	)	$	0.08
Diluted, pro forma	$	(0.25	)	$	(0.16	)	$	(0.15	)	$	0.04

4. Store Closing Reserve

From time to time and in the normal course of business, we evaluate our store base to determine if we need to close one or more stores. Such evaluations include, among other factors, current and future profitability, market trends, age of store and lease status.

Amounts in accrued expenses and other liabilities at October 31, 2005 include 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. Expenses related to store closings are included in selling, general and administrative expenses in our consolidated statements of operations.

The following tables provide a rollforward of reserves that were established for these charges for the nine months ended October 31, 2005 and 2004.


	Future Lease
	Payments			Other Costs			Total
Balance at January 31, 2005	$	1,283		$	—			1,283
Changes in estimates		98			8			106
Additions to provision		394			—			394
Cash outlay		(866	)		(8	)		(874	)

Balance at October 31, 2005	$	909		$	—		$	909


	Future Lease
	Payments			Other Costs			Total
Balance at January 31, 2004	$	2,015		$	13			2,028
Changes in estimates		(275	)		—			(275	)
Additions to provision		156			—			156
Cash outlay		(576	)		(13	)		(589	)

Balance at October 31, 2004	$	1,320		$	—		$	1,320

As of October 31, 2005, the reserve balance, which is net of estimated sublease income, is expected to be paid over the next five years.

5. Income (loss) per Share

The computations for basic and diluted income (loss) per share are as follows:


	Three Months Ended October 31,						Nine Months Ended October 31,
	2005			2004			2005			2004
Net income (loss)	$	(2,731	)	$	(1,622	)	$	(1,306	)	$	972


Average shares outstanding:
Basic		11,367			11,421			11,426			11,400
Effect of stock options		—			—			—			519

Diluted		11,367			11,421			11,426			11,919


Income (loss) per share:
Basic	$	(0.24	)	$	(0.14	)	$	(0.11	)	$	0.09


Diluted	$	(0.24	)	$	(0.14	)	$	(0.11	)	$	0.08

The following options to purchase shares of common stock were not included in the computation of diluted income per share because their inclusion would have been antidilutive:

Three Months Ended October 31,

Nine Months Ended October 31,

2005

2004

2005

2004

Shares of common stock underlying options

1,632

1,921

1,632

521

Exercise price range per share

$1.33 to 14.03

$1.33 to $14.03

$1.33 to 14.03

$7.30 to $14.03

6. Litigation and Contingencies

During the past fiscal year, we were named as defendants in lawsuits alleging that our extended viewing fees for movie and game rentals are illegal under the Uniform Commercial Code. On October 27, 2005, the Company petitioned the court for summary judgment in one such lawsuit pending in the state of New Mexico. On November 28, 2005, the judge granted the Company’s petition for summary judgment and dismissed all pending claims in that lawsuit.

While we intend to vigorously defend the remaining matters and anticipate favorable results, the ultimate outcome of these matters cannot be estimated at this time. In the event an adverse judgment was rendered, the impact on the Company’s consolidated financial statements could be material.

We are 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 our financial position, results of operations and cash flows.

7. Recent Accounting Pronouncements

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs” (“SFAS 151”), an amendment of Accounting Research Bulletin No. 43, Chapter 44. SFAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The statement will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company has evaluated the provisions of SFAS 151 and does not anticipate that adoption will have an impact on its consolidated balance sheets or statements of operations, shareholders’ equity and cash flows.

In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”). This statement replaces FASB Statement No. 123, “Accounting for Stock-Based Compensation,” and supercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires all companies to measure compensation cost for all share-based payments, including stock options, at fair value. The statement will be effective for public companies no later than the beginning of the first fiscal year commencing after June 15, 2005, which for the Company is the beginning of fiscal 2006. The Company is currently evaluating the effect that SFAS 123R will have on its consolidated balance sheets and its statements of shareholders’ equity and cash flows. The Company believes the adoption of SFAS 123R in the future will not have a materially different impact on results of operations than what the Company has disclosed in its pro forma footnote disclosures regarding stock compensation assuming expense recognition provisions of FAS 123 had been adopted. SFAS 123R also requires that the benefits associated with the tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce operating cash flows and increase net financing cash flows in periods after the effective date. These future amounts cannot be estimated, because they depend on, among other things, when employees exercise stock options. However, the amount of operating cash flows recognized for such excess tax deductions for the years ended January 31, 2005, 2004, and 2003 was not material.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATONS.

Forward-looking Statements

Certain written and oral statements set forth below or made by Hastings with the approval of an authorized executive officer 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 convey the uncertainty of future events and 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 business, expansion, merchandising and marketing strategies of Hastings, industry projections or forecasts, the impact on our financial statements of inflation, legal actions, revenue sharing arrangements, our warehouse management system, future debt levels, sufficiency of cash flow from operations and borrowings under our amended revolving credit facility 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 ability to attain such estimates and expectations;

	-		a downturn in market conditions in any industry, including the economic state of retailing, relating to the products we inventory, sell or rent;

	-		the effects of, or changes in, economic and political conditions in the U.S. and the markets in which we operate our superstores, including the price of gasoline, the effects of inflation, deflation, recession, war, terrorism, changes in interest and tax rates, the availability of consumer credit and any other matters that influence customer confidence;

	-		our ability to forecast and meet customer demand for products;

	-		our ability to access suitable merchandise on acceptable terms from merchandise vendors;

	-		our continued ability to integrate our new warehouse management system;

	-		our ability to attract quality employees and control our labor costs; and

	-		our ability to find new sites to lease for our superstores upon acceptable terms.

Any of the foregoing factors and uncertainties, as well as others, 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.

Restatement of Financial Statements

As discussed in Note 2 to the consolidated financial statements, during fiscal 2004, we re-evaluated our lease accounting practices and corrected the way we account for our leases, specifically the accounting for rent holidays and the amortization of certain leasehold improvements.

In addition, as discussed in Note 2, we have restated our cash flow presentation of rental video purchases.

Throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” all referenced amounts for prior periods and prior period comparisons reflect the balances and amounts on a restated basis.

General

Hastings Entertainment, Inc. is a leading multimedia entertainment retailer. We operate entertainment superstores that buy, sell, trade, and rent various home entertainment products, including books, music, software, periodicals, new and used CDs, DVDs, books, video games and videocassettes, video game consoles, and DVD players, as well as trendy products such as t-shirts, action figures, posters, and greeting cards. As of October 31, 2005, we operated 153 superstores primarily in small- to medium-sized markets located in 20 states, primarily in the Western and Midwestern United States. We also operate a multimedia entertainment e-commerce Web site offering a broad selection of books, music, software, videocassettes, video games and DVDs. We operate two wholly-owned subsidiaries: Hastings Properties, Inc. and Hastings Internet, Inc. References herein to fiscal years are to the twelve-month periods that end in January of each following calendar year. For example, the twelve-month period ending January 31, 2006 is referred to as fiscal 2005, and the twelve-month period ended January 31, 2005 is referred to as fiscal 2004.

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 and liabilities at the date of the financial statements, the disclosure of contingent 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 cost or market value. 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 cost or market value 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 an adjustment if estimated market 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 these adjustments.

Returns Process. Merchandise inventory owned by us is generally 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 changes in product offerings. At the end of any reporting period, cost accruals are required for inventory that has been returned to vendors, is in the process of being returned to vendors, or has been identified to be returned to vendors. 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. To accrue for such costs and estimate this 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.

Rental Asset Depreciation. 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 fiscal year 2004. 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 the shorter period of time when the

new releases are most popular. Under the terms of the specific contracts with supplying studios, we expense revenue-sharing payments through rental video cost of revenue, 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. Rental video assets purchased for less than $4 are not amortized.

We monitor closely the recovery value of our rental video assets. Our current experience is that the recovery value of our rental video assets is higher than our estimated salvage value of that item in our rental inventory. Based in part on this factor and sales of previously viewed tapes, we believe our estimate of salvage value is appropriate. However, if future demand or market conditions are less favorable than management projections, inventory adjustments, including possible changes to rental video asset cost amortization methods or salvage values, may be required.

Store Closing Reserve. On a quarterly basis, and in the normal course of business, we evaluate our store base to determine if we need to close or relocate a store(s). Management will evaluate, among other factors, current and future profitability, market trends, age of store and lease status. The primary expense items associated with the closure of a store 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.

In accordance with the adoption of SFAS No. 146, we recognize such expense items 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. We actively pursue sublease tenants on all closed or relocated locations and, as part of the final estimation of store closing liability, the impact of any sublease income is estimated. The net of the described charges and sublease income estimates can have a material effect on the financial results of an annual or interim period.

Revenue Recognition. We generate revenue 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 estimated returns and exclude all taxes. Customers may return certain merchandise for exchange or refund within our 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. We, as with most retailers, also offer 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 we will offer sales incentives to customers, in the form of rebates. 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.

Comparable-Store Revenue. Stores included in the comparable-store revenues calculation are those stores that have been open for a minimum of 60 weeks. Also included are stores that are remodeled or relocated. Revenue via the Internet is not included and closed stores are removed from each comparable period for the purpose of calculating comparable-store revenues.

Cost of Goods Sold. Expenses included in cost of sales include cost of product purchased from vendors; rental video depreciation expense; shrinkage; markdowns; inventory write-offs; freight charges; receiving costs; inspection costs; and internal transfer costs. In addition, the Company includes in cost of goods sold all expenses associated with our distribution center, including freight, warehouse personnel costs, supplies, maintenance, depreciation, occupancy, property tax, and utility costs; as well as costs associated with our returns center, including vendor refused product, handling charges, return fees, freight, return center personnel costs, supplies, maintenance, depreciation, rent, and utilities. Some retailers include occupancy costs of their retail locations in cost of sales. We include such costs in SG&A expenses. As a result, our presentation may be different than that of our competitors.

Vendor Allowances. In 2003, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”), which addresses the accounting for cash consideration received from a vendor by a reseller for various vendor-funded allowances, including cooperative advertising support. The EITF determined that cash consideration received from a vendor should be presumed to be a reduction of the prices of vendor’s products and, therefore, should be shown as a reduction in the cost of goods sold when recognized in the reseller’s income statements. The only exception to this rule is if the reimbursement is for specific, incremental identifiable costs. If the amount of cash consideration received exceeds the cost being reimbursed, that excess amount should be characterized as a reduction of cost of goods sold when recognized in the reseller’s income statements. In January 2003, the EITF issued transition guidance concluding that this interpretation should be applied to all new or modified arrangements entered into after December 31, 2002. Accordingly, a portion of our vendor advertising allowances have been recorded as a reduction of merchandise inventory and the cost of rental assets and will be recognized in cost of revenues as inventory is sold and as rental assets are rented. Certain amounts that we receive from vendors, such as cooperative advertising payments, are considered reimbursement for specific, identifiable costs and, therefore, continue to be recorded as a reduction of SG&A.

Derivative Instruments. In June 2005, the Company entered into an interest rate cap agreement with a major bank as further discussed in the Capital Structure section of this MD&A. Statement of Financial Accounting Standards No. 133 requires us to recognize all derivatives on the balance sheet at fair value. We have designated this derivative as a hedge, and to the extent the hedge is considered effective, changes in the fair value of the derivative will be recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. The Company has capitalized the cost of the interest rate cap, and is amortizing this cost over 24 months.

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,
	2005			2004			2005			2004
Merchandise revenue		81.7	%		80.5	%		81.5	%		79.9	%
Rental revenue		18.3			19.5			18.5			20.1

Total revenues		100.0			100.0			100.0			100.0

Merchandise cost of revenue		69.5			73.1			70.5			71.8
Rental cost of revenue		40.7			38.7			38.0			38.8

Total cost of revenues		64.2			66.4			64.5			65.2


Gross profit		35.8			33.6			35.5			34.8

Selling, general and administrative expenses		39.1			35.4			35.6			34.0
Pre-opening expenses		—			—			—			0.1


Operating income (loss)		(3.3	)		(1.8	)		(0.1	)		0.7

Other income (expense):
Interest expense		(0.7	)		(0.4	)		(0.5	)		(0.4	)
Other, net		—			—			—			0.1


Income (loss) before income taxes		(4.0	)		(2.2	)		(0.6	)		0.4

Income tax expense (benefit)		(1.6	)		(0.8	)		(0.2	)		0.1


Net income (loss)		(2.4	)%		(1.4	)%		(0.4	)%		0.3	%

Summary of Superstore Activity


	Three Months Ended				Nine Months Ended				Year Ended
	October 31,				October 31,				January 31,
	2005		2004		2005		2004		2005
Beginning number of stores		153		151		152		148		148
Openings		—		1		1		4		5
Closings		—		—		—		—		(1	)

Ending number of stores		153		152		153		152		152

Financial Results for the Third Quarter of Fiscal Year 2005

Revenues. Total revenues for the third quarter decreased $5.0 million, or 4.2%, to $114.6 million compared to $119.6 million for the third quarter of fiscal 2004. The following is a summary of our revenue results (dollars in thousands):


	Three Months Ended October 31,
	2005						2004					Increase/(Decrease)
				Percent of					Percent of
	Revenues			Total			Revenues		Total			Dollar			Percent
Merchandise revenue	$	93,581			81.7	%	$	96,257		80.5	%	$	(2,676	)		-2.8	%
Rental revenue		21,006			18.3	%		23,322		19.5	%		(2,316	)		-9.9	%

Total revenues	$	114,587			100.0	%	$	119,579		100.0	%	$	(4,992	)		-4.2	%


Comparable-store revenues:
Total		- 4.5	%
Merchandise		- 3.1	%
Rental		- 10.1	%

Below is a summary of the Comp results for those categories:


	Three Months Ended October 31,
	2005			2004
Music		-2.4	%		-0.7	%
Books		-2.7	%		1.9	%
Video for sale		-1.4	%		9.8	%
Video games		-9.4	%		51.2	%
Sidelines		-1.7	%		2.8	%

Music Comps decreased 2.4%, which was primarily attributable to a weaker release schedule compared to prior year’s quarter, as well as lower used CD sales. Book Comps decreased 2.7% as a result of a weaker hardback release schedule. Video for sale Comps fell 1.4% due to lower VHS sales, partially offset by increased DVD sales, in particular TV on DVD boxed sets. Video game Comps decreased 9.4% due to a weaker release schedule compared to prior year, as video game distributors prepare for release of new gaming systems in the next two quarters. Sidelines Comps decreased 1.7%, primarily due to fewer sales of greeting cards and collectible cards. We expect total merchandise Comps to be up 3-4% in the 4^th quarter.

Rental video Comps decreased 10.1% from the same period last year reflecting continued rental weakness industry-wide. We expect the downward trend in the rental business to continue and project 4^th quarter rental Comps to be down 7-8%.

Gross Profit. For the third quarter, total gross profit dollars increased approximately $0.8 million, or 2.0%, to $41.0 million from $40.2 million for the same period last year, primarily as a result of increased productivity in our Distribution Center as well as improved productivity in areas of returns expense and shrinkage. As a percentage of total revenues, gross profit increased to 35.8% for the quarter compared to 33.6% for the same quarter in the prior year.

Selling, General and Administrative expenses (“SG&A”). SG&A increased approximately $2.6 million to $44.9 million for the current quarter compared to $42.3 million for the same quarter in the prior year, due in part to approximately $0.6 million in increased health care costs and approximately $0.3 million of costs in connection with documentation of controls and procedures related to the pending adoption of Section 404 of the Sarbanes-Oxley Act. Additionally, we recognized proportionally higher human resource and occupancy costs associated with the operation of a greater number of new, expanded and relocated superstores. As a percentage of total revenues, SG&A increased to 39.2% for the current quarter compared to 35.3% for the same quarter in the prior year.

Financial Results for the Nine Months Ended October 31, 2005

Revenues. Total revenues for the first nine months of fiscal 2005 decreased $2.5 million, or 0.7%, to $366.4 million compared to $368.9 million for the same period in the prior year. The following is a summary of our revenue results (dollars in thousands):


	Nine Months Ended October 31,
	2005						2004					Increase/(Decrease)
				Percent of					Percent of
	Revenues			Total			Revenues		Total			Dollar			Percent
Merchandise revenue	$	298,483			81.5	%	$	294,755		79.9	%	$	3,728			1.3	%
Rental revenue		67,954			18.5	%		74,173		20.1	%		(6,219	)		-8.4	%

Total revenues	$	366,437			100.0	%	$	368,928		100.0	%	$	(2,491	)		-0.7	%


Comparable-store revenues:
Total		- 1.8	%
Merchandise		0.0	%
Rental		- 8.8	%

Below is a summary of the Comp results for our merchandise categories:


	Nine Months Ended October 31,
	2005			2004
Music		-1.5	%		3.4	%
Books		-1.6	%		2.7	%
Video for sale		0.3	%		19.9	%
Video games		10.9	%		20.7	%
Sidelines		8.8	%		3.2	%

Music Comps decreased 1.5%, primarily due to decreased sales of new release CDs, used CDs, and cassette tapes, partially offset by increased sales of music hardware including guitars, keyboards, and stereo equipment. Book Comps fell 1.6% as a result of decreased sales of mass-market paperbacks, books on cassette, and bargain books. Video for sale Comps rose 0.3% year-to-date due to strong first quarter sales of TV on DVD boxed sets and used DVDs, offset partially by declining VHS sales. Video game Comps rose 10.9% on strong sales of new and used XBOX games as well as video game hardware. Our boutique Comp increase of 8.8% was headlined by the increased sales of body jewelry, novelty t-shirts, and action figures.

Rental video Comps decreased 8.8% from the same period last year reflecting continued rental weakness industry-wide.

Gross Profit. For the current nine months, total gross profit dollars increased approximately $1.8 million, or 1.4%, to $130.2 million from $128.4 million for the same period last year, primarily as a result of improved margin rates and improved cost controls. As a percentage of total revenues, gross profit increased to 35.5% for the nine month period compared to 34.8% for the same period in the prior year.

Selling, General and Administrative expenses (“SG&A”). SG&A increased approximately $5.2 million to $130.6 million for the current nine month period compared to $125.4 million for the same period in the prior year, due to additional costs associated with the operation of a greater number of new, expanded and relocated superstores, impairment charges, and costs associated with the documentation of controls and procedures related to the pending adoption of Section 404 of the Sarbanes-Oxley Act. As a percentage of total revenues, SG&A increased to 35.6% for the nine months ended October 31, 2005 compared to 34.0% for the nine months ended October 31, 2004.

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 assets, 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. We believe our cash flow from operations and borrowings under our amended revolving credit facility will be sufficient to fund our ongoing operations, new superstores and superstore expansions through fiscal 2005.

Historically, we have experienced an increase in our debt level during the third and early fourth quarters of our fiscal year as we build merchandise inventories for the holiday selling season. We reached a borrowing level of approximately $58.3 million in mid-November 2005 and we anticipate that our debt level will be reduced to approximately $25.0 million to $30.0 million during the fourth quarter due to a higher level of repayments following the holiday selling season.

Consolidated Cash Flows

		Operating activities. Net cash used in operating activities decreased approximately $6.6 million, from $8.3 million for the nine months ended October 31, 2004 to $1.7 million for the nine months ended October 31, 2005. This decrease primarily resulted from a smaller increase in inventory for the nine months ended October 31, 2005 of approximately $3.9 million compared to an increase of approximately $36.6 million during the first nine months of fiscal 2004. The higher inventory levels at October 31, 2004 were primarily the result of earlier seasonal build-up of merchandise inventory compared to the prior year, particularly in our book and music categories. Partially offsetting this change in merchandise inventory was a decrease in accounts payable of $1.6 million for the nine months ended October 31, 2005, compared to an increase of $20.3 million for the nine months ended October 31, 2004.

		Investing activities. Net cash used in investing activities decreased $4.8 million to $13.9 million for the nine months ended October 31, 2005 from $18.7 million for the nine months ended October 31, 2004. This decrease was the result of a decrease in the purchases of property and equipment associated with opening, expanding, relocating, or remodeling of fewer stores.

		Financing activities. Cash provided by or used in financing activities is primarily associated with borrowings and payments made under debt agreements. For the nine months ended October 31, 2005, net borrowings under debt agreements were $15.2 million compared to $27.5 million for the nine months ended October 31, 2004.

Capital structure. On December 9, 2003, we executed an amendment to our syndicated secured Loan and Security Agreement with certain commercial lenders (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 permits borrowings at various interest-rate options based on the prime rate or London Interbank Offering Rate (“LIBOR”) plus applicable margin depending upon the level of our minimum availability. 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. Lenders may increase specifically defined reserves to reduce availability in

the event of adverse changes in our industry that are projected to impact the value of our assets pledged as collateral. 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 $15 million of our common stock and requires a minimum availability of $10 million at all times. The Facility is secured by substantially all the assets of the Company and our subsidiaries and is guaranteed by each of our consolidated subsidiaries. The Facility matures on August 29, 2007. At October 31, 2005, we had $8.1 million in excess availability, after the $10 million availability reserve, under the Facility. However, excess availability may be reduced in the future as changes in the borrowing base occur or the lenders increase availability reserves. The Company is permitted to repurchase up to $15.0 million of our common stock, subject to maintaining a minimum availability of $20.0 million, including the $10 million availability reserve, for 30 days prior to purchase, and one day looking forward after the purchase. At October 31, 2005 and 2004, respectively, we had borrowings outstanding of $54.4 million and $56.5 million under the Facility. The average rate of interest being charged under the Facility for the three and nine months ended October 31, 2005 was 5.7% and 5.3%, respectively.

We utilize standby letters of credit to support certain insurance policies. The aggregate amount of the letters of credit at October 31, 2005 was approximately $0.9 million, which reduces the excess availability under the Facility.

From time to time, we enter into interest rate agreements with financial institutions 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 June 29, 2005, the Company agreed to a two-year interest rate cap agreement, expiring June 29, 2007, with a major bank to hedge $20 million of the Company’s variable-rate debt (30-day LIBOR) against interest rate increases. The terms of the transaction call for the Company to pay the bank $99,700 upon execution of the agreement. In return, the bank will “cap” the Company’s interest rate at 4.00% for the first $20 million of outstanding debt over the next two years. Should the 30-day LIBOR rate remain at 4.00% or lower, the interest rate cap will result in no settlement. Should the rate climb above 4.00% in the next two years, the bank will settle with the Company on the 29^th of each month. Settlement will occur regardless of whether or not the Company has paid down its debt below $20 million. At October 31, 2005 the 30-day LIBOR was 4.08%.

At October 31, 2005, our minimum lease commitments for the remaining three months of fiscal 2005 were approximately $6.2 million. The present value of total existing minimum operating lease commitments for fiscal years 2006 through 2024 discounted at 9.0% was approximately $100.9 million as of October 31, 2005.

Contractual obligations and off-balance sheet arrangements. We have contractual obligations associated with ongoing business and financing activities, which will result in cash payments in future periods. These obligations include long-term debt, capital and operating leases and certain revenue-sharing arrangements. As of October 31, 2005, other than operating leases and standby letters of credit, we had not entered into any off-balance sheet arrangements or third-party guarantees, but for the interest rate cap agreement discussed above, nor does our business ordinarily require us to do so. At October 31, 2005, there have been no material changes in our contractual obligations or off-balance sheet arrangements from those reported in our Annual Report on Form 10-K for the year ended January 31, 2005.

Seasonality and Inflation

As is the case with many retailers, a significant portion of our revenues, and an even greater portion of our operating profit, is generated in the fourth fiscal quarter, which includes the holiday selling season. As a result, a substantial portion of our annual earnings has been, and will continue to be, dependent on the results of the fourth quarter. Less than satisfactory net sales for such period could have a material adverse effect on the Company’s financial condition or results of operations for the year and may not be sufficient to cover any losses that may have been incurred in the first three quarters of the year. We experience reduced video rental 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 superstore openings, the number and popularity of new book, music and video 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 our operations.

We do 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 our operating results to the extent such increases are not passed along to customers.

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 lender’s 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, 2005 outstanding balance of the variable rate debt would be approximately $0.3 million. The impact of an interest rate increase is mitigated by the interest rate cap agreement discussed in the Capital Structure section of Item 2. – “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” 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.

ITEM 4. CONTROLS AND PROCEDURES.

As required by Exchange Act Rules 13a-15 and 15d-15, an evaluation was conducted under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of October 31, 2005 to determine whether our disclosure controls and procedures were effective as of such date to ensure that information required to be disclosed by us in our reports filed or submitted under the Exchange Act is (a) accumulated and communicated to our management, including our principal executive and financial officers, as appropriate to allow timely decisions regarding required disclosure, and (b) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. In performing this evaluation, management considered our historical presentation of purchases of rental assets in our Statements of Cash Flows in light of SFAS 95, Statement of Cash Flows. We concluded that our historical presentation was not in accordance with generally accepted accounting principles and that certain previously issued quarterly and annual financial statements should be restated. See Note 2 to the Consolidated Financial Statements for a discussion of these changes. Based solely on this change in classification of rental asset purchases, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective. As of October 31, 2005, we have cured the identified weakness in our controls and procedures.

Except for changes designed to effect our reclassification of purchases of rental assets on the Statement of Cash Flows (See Note 2 of Notes to Consolidated Financial Statements), there has not been any change in our internal control over financial reporting during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

ITEM 6. EXHIBITS.

Listing of exhibits


Exhibit
Number		Description of Documents
	31.1	Principal Executive Officer Certification Pursuant to Exchange Act Rule 13a-14(a)/15d-14(a)

	31.2	Principal Financial Officer Certification Pursuant to Exchange Act Rule 13a-14(a)/15d-14(a)

	32.1	Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


	Page
PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

Consolidated Balance Sheets as of October 31, 2005 (Unaudited), October 31, 2004 (Unaudited) and January 31, 2005		3

Unaudited Consolidated Statements of Operations for the Three and Nine Months Ended October 31, 2005 and 2004		4

Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended October 31, 2005 and 2004		5

Notes to Unaudited Consolidated Financial Statements		6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.		12

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.		22

SIGNATURES		23

INDEX TO EXHIBITS		24
Certification of Principal Executive Officer
Certification of Principal Financial Officer
Certification Pursuant to Section 906


	HASTINGS ENTERTAINMENT, INC.
Date: December 15, 2005	/s/ Dan Crow
	Dan Crow
	Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

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