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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q/A

(Amendment No. 1)

(Mark One)


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

For the quarterly period ended July 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 July 31, 2005:


Class		Shares Outstanding

Common Stock, $.01 par value per share		11,347,354

Explanatory Note

Hastings Entertainment, Inc. is amending its Form 10-Q for the fiscal quarter ended July 31, 2005, to reflect certain adjustments to restate the Company’s consolidated financial statements.

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 $11.4 million and $15.3 million for the six months ended July 31, 2005 and 2004, respectively. In addition, we have reclassified $2.2 million, $2.0 million, and $1.9 million on the Consolidated Balance Sheets for July 31, 2005, July 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. This Form 10-Q/A contains changes to Item I – Financial Statements, and Item II – Management’s Discussion and Analysis of Financial Condition and Results of Operations to reflect this restatement.

There are no other significant changes to the original Form 10-Q other than those outlined above. This Form 10-Q/A does not reflect events occurring after the filing of the original Form 10-Q, or modify or update disclosures therein in any way other than as required to reflect the amendment set forth below.

PART I

ITEM 1 — FINANCIAL STATEMENTS

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES

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


	July 31,			July 31,			January 31,
	2005			2004			2005
	(Unaudited)			(Unaudited)			(As restated)
	(As restated)			(As restated)
Assets
Current assets:
Cash	$	8,286		$	5,911		$	9,543
Merchandise inventories, net		145,709			152,095			155,452
Deferred income taxes		3,141			2,018			3,198
Prepaid expenses and other current assets		6,772			7,827			6,945

Total current assets		163,908			167,851			175,138
Property and equipment, net of accumulated depreciation of $159,218, $151,421, and $156,613 at July 31, 2005 and 2004, and January 31, 2005, respectively		73,850			74,271			78,112
Deferred income taxes		2,528			2,841			308
Intangible assets, net		497			586			542
Other assets		63			16			16

Total Assets	$	240,846		$	245,565		$	254,116


Liabilities and Shareholders’ Equity
Current liabilities:
Current maturities on capital lease obligations	$	254		$	191		$	243
Trade accounts payable		63,986			73,058			86,082
Accrued expenses and other current liabilities		34,750			34,841			36,166

Total current liabilities		98,990			108,090			122,491
Long term debt, excluding current maturities on capital lease obligations		49,654			48,292			39,603
Other liabilities		2,067			2,598			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 11,347,354 shares outstanding at July 31, 2005; 11,944,544 shares issued and 11,442,994 shares outstanding at July 31, 2004; 11,944,544 shares issued and 11,455,569 shares outstanding at January 31, 2005		119			119			119
Additional paid-in capital		36,137			36,409			36,382
Retained earnings		57,196			52,557			55,771
Treasury stock, at cost 597,190 shares, 501,550 shares and 488,975 shares at July 31, 2005, and 2004 and January 31, 2005, respectively		(3,317	)		(2,500	)		(2,498	)

Total Shareholders’ Equity		90,135			86,585			89,774

Total Liabilities and Shareholders’ Equity	$	240,846		$	245,565		$	254,116

See accompanying notes to unaudited consolidated financial statements.

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES

Unaudited Consolidated Statements of Operations

For the Three and Six Months Ended July 31, 2005 and 2004
(Dollars in thousands, except per share amounts)


	Three Months Ended July 31,						Six Months Ended July 31,
	2005			2004			2005			2004
				(as restated)						(as restated)
Merchandise revenue	$	100,038		$	97,396		$	204,902		$	198,498
Rental revenue		22,688			25,016			46,948			50,851

Total revenues		122,726			122,412			251,850			249,349

Merchandise cost of revenue		69,383			69,427			145,463			141,323
Rental cost of revenue		8,243			9,238			17,248			19,768

Total cost of revenues		77,626			78,665			162,711			161,091


Gross profit		45,100			43,747			89,139			88,258

Selling, general and administrative expenses		43,376			42,189			85,703			83,130
Pre-opening expenses		3			240			92			334


Operating income		1,721			1,318			3,344			4,794

Other income (expense):
Interest expense		(649	)		(449	)		(1,142	)		(814	)
Other, net		42			68			143			176


Income before income taxes		1,114			937			2,345			4,156

Income tax expense		443			305			920			1,562


Net income	$	671		$	632		$	1,425		$	2,594


Basic income per share	$	0.06		$	0.06		$	0.12		$	0.23


Diluted income per share	$	0.06		$	0.05		$	0.12		$	0.22


Weighted-average common shares outstanding:
Basic		11,436			11,413			11,456			11,389
Dilutive effect of stock options		297			644			366			529


Diluted		11,733			12,057			11,822			11,918

See accompanying notes to unaudited consolidated financial statements.

HASTINGS ENTERTAINMENT, INC. AND SUBSIDIARIES

Unaudited Consolidated Statements of Cash Flows

For the Six Months Ended July 31, 2005 and 2004
(Dollars in thousands)


	Six Months Ended
	July 31,
	2005			2004
	(as restated)			(as restated)
Cash flows from operating activities:
Net income	$	1,425		$	2,594
Adjustments to reconcile net income to net cash used in operating activities:
Rental asset depreciation expense		8,227			10,992
Purchases of rental inventory		(11,360	)		(15,303	)
Property and equipment depreciation expense		9,654			9,393
Amortization expense		45			44
Deferred income taxes		(2,163	)		74
Loss on rental assets lost, stolen and defective		2,675			2,444
Loss on disposal of non-rental assets		313			469
Non-cash compensation		—			60
Changes in operating assets and liabilities:
Merchandise inventory		13,250			(7,795	)
Prepaid expenses and other current assets		173			(731	)
Trade accounts payable		(22,096	)		(9,014	)
Accrued expenses and other current liabilities		(1,416	)		(826	)
Other assets and liabilities, net		(228	)		(261	)

Net cash used in operating activities		(1,501	)		(7,860	)


Cash flows from investing activities:
Purchases of property and equipment		(8,754	)		(11,976	)

Net cash used in investing activities		(8,754	)		(11,976	)


Cash flows from financing activities:
Borrowings under revolving credit facility		272,575			279,401
Repayments under revolving credit facility		(262,395	)		(260,657	)
Payments under capital lease obligations		(118	)		(105	)
Purchase of treasury stock		(1,611	)		(452	)
Proceeds from exercise of stock options		547			436

Net cash provided by financing activities		8,998			18,623


Net decrease in cash		(1,257	)		(1,213	)
Cash at beginning of period		9,543			7,124

Cash at end of period	$	8,286		$	5,911

See accompanying notes to unaudited consolidated financial statements.

Hastings Entertainment, Inc. and Subsidiaries

Notes to Unaudited Consolidated Financial Statements

July 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.

2. Restatement of Financial Information

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 second quarter 2004 results increased net income for the three months ended July 31, 2004 by approximately $0.1 million, or $0.01 per share, decreased total assets by $1.4 million and decreased shareholders’ equity by $2.8 million. Net income for the six months ended July 31, 2004 was increased approximately $0.3 million, or $0.02 per share, due to the Restatement.

Furthermore, in response to an SEC comment letter received in August 2005, 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 $11.4 million and $15.3 million for the six months ended July 31, 2005 and 2004, respectively. In addition, we have reclassified $2.2 million, $2.0 million, and $1.9 million on the Consolidated Balance Sheets for July 31, 2005, July 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.

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

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 July 31,						Six Months Ended July 31,
	2005			2004			2005			2004
				(as restated)						(as restated)
Net income, as reported	$	671		$	632		$	1,425		$	2,594
Add: Stock-based compensation included in reported net income, net of tax		—			36			—			36
Less: Stock-based compensation expense determined under fair value based method, net of tax		(132	)		(120	)		(268	)		(215	)

Pro forma net income	$	539		$	548		$	1,157		$	2,415


Income per share:
Basic, as reported	$	0.06		$	0.06		$	0.12		$	0.23
Basic, pro forma	$	0.05		$	0.05		$	0.10		$	0.21
Diluted, as reported	$	0.06		$	0.05		$	0.12		$	0.22
Diluted, pro forma	$	0.05		$	0.05		$	0.10		$	0.21

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 July 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 six months ended July 31, 2005 and 2004.


	Future Lease
	Payments			Other Costs			Total
Balance at January 31, 2005	$	1,283		$	—			1,283
Changes in estimates		94			8			102
Additions to provision		—			—			—
Cash outlay		(334	)		(8	)		(342	)

Balance at July 31, 2005	$	1,043		$	—		$	1,043


	Future Lease
	Payments			Other Costs			Total
Balance at January 31, 2004	$	2,015		$	13			2,028
Changes in estimates		25			—			25
Additions to provision		30			—			30
Cash outlay		(383	)		(13	)		(396	)

Balance at July 31, 2004	$	1,687		$	—		$	1,687

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

5. Income per Share

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


	Three Months Ended July 31,				Six Months Ended July 31,
	2005		2004		2005		2004
Net income	$	671	$	632	$	1,425	$	2,594


Average shares outstanding:
Basic		11,436		11,413		11,456		11,389
Effect of stock options		297		644		366		529

Diluted		11,733		12,057		11,822		11,918


Income per share:
Basic	$	0.06	$	0.06	$	0.12	$	0.23


Diluted	$	0.06	$	0.05	$	0.12	$	0.22

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 July 31,

Six Months Ended July 31,

2005

2004

2005

2004

Shares of common stock underlying options

749

504

696

531

Exercise price range per share

$6.00 to $14.03

$8.17 to $14.03

$6.59 to $14.03

$7.30 to $14.03

6. Litigation and Contingencies

During the past fiscal year, we were named as defendants in complaints alleging that our extended viewing fees for movie and game rentals are illegal under the Uniform Commercial Code. While we intend to vigorously defend these 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 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. Changes in Accounting Principle

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 the same note to the consolidated financial statements, we have restated our presentation of purchases of rental assets not associated with new store openings on the Statement of Cash Flows and our presentation of rental assets that have been converted to previously viewed tapes on the Consolidated Balance Sheets.

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 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 July 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, which end in January of each following calendar year. For example, the twelve-month period ended January 31, 2006 is referred to as fiscal 2005, and the twelve-month period ending 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. Prior to December 31, 2002, such expense items were recorded as of the date that management made the decision to close or relocate a store and sublease income was not recorded as part of the estimate until a contract with a sublet tenant had been signed.

Subsequent to December 31, 2002, and in accordance with the adoption of SFAS No. 146, we now 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						Six Months Ended
	July 31,						July 31,
	2005			2004			2005			2004
Merchandise revenue		81.5	%		79.6	%		81.4	%		79.6	%
Rental revenue		18.5			20.4			18.6			20.4

Total revenues		100.0			100.0			100.0			100.0

Merchandise cost of revenue		69.4			71.3			71.0			71.2
Rental cost of revenue		36.3			36.9			36.7			38.9

Total cost of revenues		63.3			64.3			64.6			64.6


Gross profit		36.7			35.7			35.4			35.4

Selling, general and administrative expenses		35.3			34.5			34.0			33.4
Pre-opening expenses		—			0.1			0.1			0.1


Operating income		1.4			1.1			1.3			1.9

Other income (expense):
Interest expense		(0.5	)		(0.4	)		(0.5	)		(0.3	)
Other, net		—			0.1			0.1			0.1


Income before income taxes		0.9			0.8			0.9			1.7

Income tax expense		0.4			0.3			0.3			0.6


Net income		0.5	%		0.5	%		0.6	%		1.1	%

Summary of Superstore Activity


	Three Months Ended				Six Months Ended				Year Ended
	July 31,				July 31,				January 31,
	2005		2004		2005		2004		2005
Beginning number of stores		153		149		152		148		148
Openings		—		2		1		3		5
Closings		—		—		—		—		(1	)

Ending number of stores		153		151		153		151		152

Financial Results for the Second Quarter of Fiscal Year 2005

Revenues. Total revenues for the second quarter increased $0.3 million, or 0.3%, to $122.7 million compared to $122.4 million for the second quarter of fiscal 2004, resulting primarily from the opening of new superstores. The following is a summary of our revenue results (dollars in thousands):


	Three Months Ended July 31,
	2005						2004					Increase/(Decrease)
				Percent of					Percent of
	Revenues			Total			Revenues		Total			Dollar			Percent
Merchandise revenue	$	100,038			81.5	%	$	97,396		79.6	%	$	2,642			2.7	%
Rental revenue		22,688			18.5	%		25,016		20.4	%		(2,328	)		-9.3	%

Total revenues	$	122,726			100.0	%	$	122,412		100.0	%	$	314			0.3	%


Comparable-store revenues (“Comps”):
Total		-0.8	%
Merchandise		1.7	%
Rental		-10.2	%

The merchandise Comps for our primary merchandise departments were as follows:


	Three Months Ended July 31,
	2005			2004
Music		-0.9	%		4.8	%
Books		1.2	%		-1.2	%
Video for sale		-0.1	%		26.2	%
Video games		14.6	%		9.4	%
Boutique		11.8	%		1.6	%

Music Comps decreased –0.9% as a result of a weaker new release schedule compared to prior year. Book Comps increased 1.2% during the current quarter primarily due to the July release of the sixth book in the Harry Potter series. Video for sale decreased slightly, while video games Comps rose 14.6% due to strong sales of new and used XBOX games as well as video game hardware. Our boutique product line showed an 11.8% Comp increase, headlined by the increased sales of body jewelry, novelty t-shirts, and action figures. Rental video Comps decreased 10.2% from the same period last year reflecting general rental weakness industry-wide. Rental video revenues, as a percentage of sales and in absolute terms, have trended down from period to period over the past 18 months, and we expect this trend to continue through the remainder of the year.

Gross Profit. For the second quarter, total gross profit dollars increased approximately $1.4 million, or 3.2%, to $45.1 million from $43.7 million for the same period last year, primarily as a result of increases in both merchandise and rental margin rates. The increase in merchandise margin rates resulted from increased efficiencies in our returns process of $1.0 million, specifically lower vender product returns and related expense, as well as improved efficiencies in our return center operations of $0.2 million. As a percentage of total revenues, gross profit increased to 36.7% for the quarter compared to 35.7% for the same quarter in the prior year.

Selling, General and Administrative expenses (“SG&A”). SG&A increased approximately $1.2 million to $43.4 million for the current quarter compared to $42.2 million for the same quarter in the prior year, due primarily to higher human resource and occupancy costs associated with the operation of a greater number of new, expanded and relocated superstores. Additionally, we recognized an asset impairment charge of $0.2 million and expenses of approximately $0.3 million in connection with the implementation of Section 404 of the Sarbanes-Oxley Act. As a percentage of total revenues, SG&A increased to 35.3% for the current quarter compared to 34.5% for the same quarter in the prior year.

Financial Results for the Six Months Ended July 31, 2005

Revenues. Total revenues for the first six months of fiscal 2005 increased $2.5 million, or 1.0%, to $251.8 million compared to $249.3 million for the same period in the prior year, resulting primarily from the opening of new superstores. The following is a summary of our revenue results (dollars in thousands):


	Six Months Ended July 31,
	2005						2004					Increase/(Decrease)
				Percent of					Percent of
	Revenues			Total			Revenues		Total			Dollar			Percent
Merchandise revenue	$	204,902			81.4	%	$	198,498		79.6	%	$	6,404			3.2	%
Rental revenue		46,948			18.6	%		50,851		20.4	%		(3,903	)		-7.7	%

Total revenues	$	251,850			100.0	%	$	249,349		100.0	%	$	2,501			1.0	%


Comparable-store revenues:
Total		-0.5	%
Merchandise		1.6	%
Rental		-8.2	%

The merchandise Comps for our primary merchandise departments were as follows:


	Six Months Ended July 31,
	2005			2004
Music		-1.1	%		3.1	%
Books		-1.1	%		5.4	%
Video for sale		1.2	%		25.4	%
Video games		22.8	%		8.0	%
Boutique		14.4	%		3.4	%

Music Comps decreased 1.1% as a result of a weaker new release schedule as compared to the same period in the prior year. Book Comps also decreased 1.1% primary as a result of decreased sales of mass-market front-line books.
Video for sale Comps rose 1.2% due to higher DVD sales, which were partially offset by declining VHS sales. Video games Comps rose 22.8% due to strong sales of new and used XBOX games as well as video game hardware. Our Boutique Comp increase of 14.4% was headlined by the increased sales of body jewelry, novelty t-shirts, and action figures. Rental video Comps decreased 8.2% from the same period last year reflecting general rental weakness industry-wide. Rental video revenues, as a percentage of sales and in absolute terms, have trended down from period to period over the past 18 months, and we expect this trend to continue through the remainder of the year.

Gross Profit. For the current six months, total gross profit dollars increased approximately $0.8 million, or 0.9%, to $89.1 million from $88.3 million for the same period last year, primarily as a result of higher revenues. In addition, we experienced higher rental gross margin rates as we, as a response to the decline in the rental video industry, reduced rental video purchases, which resulted in lower depreciation on rental videos, a component of cost of sales. As a percentage of total revenues, gross profit remained stable at 35.4% for the six months ended July 31, 2005 compared to the same period in the prior year.

Selling, General and Administrative expenses (“SG&A”). SG&A increased approximately $2.6 million to $85.7 million for the current six month period compared to $83.1 million for the same period in the prior year, due primarily to 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 34.0% for the six months ended July 31, 2005 compared to 33.3% for the six months ended July 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 quarter of each fiscal year. For the third quarter of fiscal 2005, we are projecting our debt level to increase to approximately $51.0 million to $56.0 million. However, we expect this balance to reduce to approximately $25.0 million to $30.0 million in the fourth quarter due to a higher level of repayments following the holiday selling season. At July 31, 2005, total outstanding debt (including capital lease obligations) was $49.7 million.

Consolidated Cash Flows

Operating activities. Net cash used in operating activities decreased approximately $6.4 million, from $7.9 million for the six months ended July 31, 2004 to $1.5 million for the six months ended July 31, 2005. This improvement primarily resulted from a decrease in merchandise inventory levels of $13.3 million during the six months, due mostly to $8.2 million in excess inventory in the second quarter of fiscal 2004 which resulted from issues in implementing our new warehouse inventory management system, compared to an increase in merchandise inventory levels of $7.8 million in the prior year as well as approximately $3.9 million in fewer rental video inventory purchases. These changes were partially offset by a decrease in the balance of accounts payable of $22.1 million compared to a decrease of $9.0 million in the prior year, and several smaller factors including, reduced depreciation expense, an increased balance in the deferred tax asset account, and reduced net income.

Investing activities. Net cash used in investing activities decreased $3.2 million to $8.8 million for the six months ended July 31, 2005 from $12.0 million for the six months ended July 31, 2004. This decrease was the result of a decrease in the purchases of property and equipment associated with lower acquisitions of equipment and leasehold improvements for new, expanded, relocated and remodeled stores.

Financing activities. Cash provided by or used in financing activities is primarily associated with borrowings and payments made under debt agreements. For the six months ended July 31, 2005, net borrowings under debt agreements were $10.2 million compared to $18.7 million for the six months ended July 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 July 31, 2005, we had $12.9 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. At July 31, 2005 and 2004, respectively, we had borrowings outstanding of $49.4 million and $47.8 million under the Facility. The average rate of interest being charged under the Facility for the three and six months ended July 31, 2005 was 5.2% and 5.1%, respectively.

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

From time to time, we enter into interest rate swap 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 July 31, 2005, our minimum lease commitments for the remaining six months of fiscal 2005 were approximately $12.3 million. The present value of total existing minimum operating lease commitments for fiscal years 2006 through 2024 discounted at 9.0% was approximately $92.0 million as of July 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 July 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, nor does our business ordinarily require us to do so. At July 31, 2005, there have been no material changes in our contractual obligations or off-balance sheet arrangements from those reported in our 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 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 July 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 non-catalog 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.


			Page
PART I — FINANCIAL INFORMATION

	Item 1.	Financial Statements

		Consolidated Balance Sheets as of July 31, 2005 (Unaudited), July 31, 2004 (Unaudited) and January 31, 2005		2

		Unaudited Consolidated Statements of Operations for the Three and Six Months Ended July 31, 2005 and 2004		3

		Unaudited Consolidated Statements of Cash Flows for the Six Months Ended July 31, 2005 and 2004		4

		Notes to Unaudited Consolidated Financial Statements		5

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations.		10

	Item 4.	Controls and Procedures		19

PART II — OTHER INFORMATION

	Item 6.	Exhibits.		20

SIGNATURES				21

INDEX TO EXHIBITS				22
Certification of CEO Pursuant to Rule 13a-14(a)
Certification of CFO Pursuant to Rule 13a-14(a)
Certification Pursuant to 18 U.S.C. Section 1350


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


		HASTINGS ENTERTAINMENT, INC.

Date: January 13, 2006		/s/ Dan Crow

		Dan Crow
		Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)


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

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