10-Q 1 r10q-3q.txt 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 2, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______ Commission File Number 0-24548 Movie Gallery, Inc. (Exact name of registrant as specified in charter) DELAWARE 63-1120122 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 900 West Main Street, Dothan, Alabama 36301 (Address of principal executive offices) (zip code) (334) 677-2108 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] The number of shares outstanding of the registrant's common stock as of November 2, 2005 was 31,885,416. Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Movie Gallery, Inc. Consolidated Balance Sheets (In thousands, except per share amounts) ------------------------- January 2, October 2, 2005 2005 ----------- ----------- (Unaudited) Assets Current assets: Cash and cash equivalents $ 25,518 $ 68,755 Extended viewing fees receivable, net - 1,110 Merchandise inventory, net 27,419 143,209 Prepaid expenses 12,712 42,457 Store supplies and other 9,493 29,757 Deferred income taxes 3,358 15,813 ----------- ----------- Total current assets 78,500 301,101 Rental inventory, net 126,541 342,227 Property, furnishings and equipment, net 128,182 355,436 Goodwill, net 143,761 625,885 Other intangibles, net 7,741 190,706 Deferred income taxes, net - 13,203 Deposits and other assets 7,417 41,530 ----------- ----------- Total assets $ 492,142 $ 1,870,088 =========== =========== Liabilities and stockholders' equity Current liabilities: Current maturities of long-term obligations $ - $ 27,286 Current maturities of financing obligations - 7,973 Accounts payable 68,977 159,814 Accrued liabilities 30,570 137,578 Accrued interest - 29,233 Deferred revenue 10,843 31,687 ----------- ---------- Total current liabilities 110,390 393,571 Long-term obligations, less current portion - 1,142,882 Deferred income taxes 50,618 - Stockholders' equity: Preferred stock, $.10 par value; 2,000 shares authorized, no shares issued or outstanding - - Common stock, $.001 par value; 65,000 shares authorized, 31,076 and 31,662 shares issued and outstanding, respectively 31 32 Additional paid-in capital 188,098 202,542 Unearned compensation - (4,830) Retained earnings 136,750 128,592 Accumulated other comprehensive income 6,255 7,299 ----------- ----------- Total stockholders' equity 331,134 333,635 ----------- ----------- Total liabilities and stockholders' equity $ 492,142 $ 1,870,088 =========== =========== The accompanying notes are an integral part of this financial statement. Movie Gallery, Inc. Consolidated Statements of Operations (Unaudited, in thousands, except per share amounts) Thirteen Weeks Ended Thirty-Nine Weeks Ended --------------------- ----------------------- October 3, October 2, October 3, October 2, 2004 2005 2004 2005 --------- --------- --------- --------- Revenue: Rentals $ 176,058 $ 473,086 $ 538,054 $1,109,661 Product sales 13,797 99,356 44,694 201,301 --------- --------- --------- --------- Total revenue 189,855 572,442 582,748 1,310,962 Cost of sales: Cost of rental revenue 51,110 136,236 152,763 345,159 Cost of product sales 8,673 70,080 29,745 141,896 --------- --------- --------- --------- Gross profit 130,072 366,126 400,240 823,907 Operating costs and expenses: Store operating expenses 97,962 319,919 287,788 690,592 General and administrative 14,397 39,485 41,879 91,916 Amortization of intangibles 673 1,163 1,962 2,718 Stock compensation 755 535 795 1,098 -------- -------- -------- -------- Operating income 16,285 5,024 67,816 37,583 Interest expense, net (225) (24,427) (390) (41,430) Write-off of bridge financing costs - - - (4,234) Equity in losses of unconsolidated entities (955) - (4,891) (806) -------- -------- -------- -------- Income (loss) before income taxes 15,105 (19,403) 62,535 (8,887) Income taxes (benefit) 5,891 (6,934) 24,435 (2,622) -------- -------- -------- -------- Net income (loss) $ 9,214 $(12,469) $ 38,100 $ (6,265) ======== ======== ======== ======== Net income (loss) per share: Basic $ 0.29 $ (0.39) $ 1.17 $ (0.20) Diluted $ 0.29 $ (0.39) $ 1.16 $ (0.20) Weighted average shares outstanding: Basic 31,444 31,640 32,436 31,471 Diluted 31,807 31,640 32,933 31,471 Cash dividends per common share $ 0.03 $ - $ 0.09 $ 0.06 The accompanying notes are an integral part of this financial statement. Movie Gallery, Inc. Consolidated Statements of Cash Flows (Unaudited, in thousands) Thirty-Nine Weeks Ended ----------------------- October 3, October 2, 2004 2005 --------- ---------- Operating activities: Net income (loss) $ 38,100 $ (6,265) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Rental inventory amortization 107,690 206,134 Purchases of rental inventory (109,315) (174,251) Depreciation and intangibles amortization 22,151 61,569 Amortization of debt issuance cost - 2,235 Stock based compensation 28 1,098 Tax benefit of stock options exercised 4,689 3,301 Deferred income taxes 12,496 (11,557) Changes in operating assets and liabilities, net of business acquisitions: Extended viewing fees receivable, net - 20,259 Merchandise inventory 1,281 8,516 Other current assets 985 (3,948) Deposits and other assets 897 (2,053) Accounts payable (15,785) (82,258) Accrued interest - 29,193 Accrued liabilities and deferred revenue (2,521) 13,336 --------- --------- Net cash provided by operating activities 60,696 65,309 Investing activities: Business acquisitions, net of cash acquired (9,599) (1,096,265) Purchases of rental inventory-base stock (11,085) (16,569) Purchase of property, furnishings and equipment (34,699) (48,873) Proceeds from disposal of property, furnishings and equipment - 2,107 Acquisition of construction phase assets, net - 2,154 --------- --------- Net cash used in investing activities (55,383) (1,157,446) Financing activities: Repayment of capital lease obligations - (265) Decrease in financing obligations - (2,412) Net borrowings on credit facilities - 9,046 Long term debt financing fees - (32,452) Proceeds from issuance of long-term debt 20,000 1,166,120 Principal payments on long-term debt - (8,367) Proceeds from exercise of stock options 5,516 5,318 Proceeds from employee stock purchase plan 168 169 Purchases and retirement of common stock (47,390) - Payment of dividends (2,958) (2,827) --------- --------- Net cash (used in) provided by financing activities (24,664) 1,134,330 Effect of exchange rate changes on cash and cash equivalents 579 1,044 --------- --------- (Decrease) increase in cash and cash equivalents (18,772) 43,237 Cash and cash equivalents at beginning of period 38,006 25,518 --------- --------- Cash and cash equivalents at end of period $ 19,234 $ 68,755 ========= ========= The accompanying notes are an integral part of this financial statement. Movie Gallery, Inc. Notes to Consolidated Financial Statements (Unaudited) October 2, 2005 1. Accounting Policies Principles of Consolidation The accompanying unaudited financial statements present the consolidated financial position, results of operations and cash flows of Movie Gallery, Inc. ("Movie Gallery" or the "Company"), and subsidiaries. Investments in unconsolidated subsidiaries where the Company has significant influence but does not have control are accounted for using the equity method of accounting for investments in common stock. All material intercompany accounts and transactions have been eliminated. Basis of Presentation Movie Gallery completed the acquisition of Hollywood Entertainment Corporation ("Hollywood") on April 27, 2005. Movie Gallery is the nation's second largest specialty home video retailer with approximately 4,800 retail stores located throughout North America, operating under the Movie Gallery and Hollywood Video trade names. In addition, the Company operates 650 Game Crazy departments located within Hollywood Video stores and 20 free-standing Game Crazy stores where game enthusiasts can buy, sell and trade new and used video game hardware, software and accessories. The Company's common stock is traded on The NASDAQ Stock Market under the symbol "MOVI". The merger of Movie Gallery and Hollywood has been treated as a purchase business combination for accounting purposes, with Movie Gallery designated as the acquirer. The accompanying condensed consolidated statements of operations and cash flows for the thirteen week and thirty-nine week periods ended October 2, 2005 include the results of operations of Hollywood since April 27, 2005, the date of acquisition. Therefore, the results for the thirty-nine week period ended October 2, 2005 include approximately 23 weeks of Hollywood's results and 39 weeks of Movie Gallery's results. Note 2 to the consolidated financial statements provides summary unaudited pro forma information and details on the purchase accounting. These interim unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission ("SEC"). Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the interim period are not necessarily indicative of the results that may be expected for the full year. There is a distinct seasonal pattern to the home video business. Compared to other months during the year, we experience peak revenues during the months of November, December and January due to the holidays in these months as well as inclement weather conditions. Additionally, revenues generally rise in the months of June, July and August when most schools are out of session, providing people with additional discretionary time to spend on entertainment. Readers of these interim period statements should refer to the audited consolidated financial statements and notes thereto which are included in Movie Gallery's Annual Report on Form 10-K for its fiscal year ended January 2, 2005. For information relating to Hollywood prior to the merger, readers should refer to the audited consolidated financial statements and notes thereto which are included in Hollywood's Annual Report on Form 10-K for its fiscal year ended December 31, 2004. Readers should also refer to Movie Gallery's 8-K/A filed on July 11, 2005 that includes the annual and interim financial statements of Hollywood and pro forma financial information. Reclassifications Certain reclassifications have been made to the prior year financial statements to conform to the current year presentation. These reclassifications had no impact on stockholders' equity or net income. Rental Inventory Amortization Estimates The Company manages its rental inventories of movies as two distinct categories, new releases and catalog. New releases, which represent the majority of all movies acquired, are those movies which are primarily purchased on a weekly basis in large quantities to support demand upon their initial release by the studios and are generally held for relatively short periods of time. Catalog, or library, represents an investment in those movies the Company intends to hold for an extended period of time and represents a historic collection of movies which are maintained on a long-term basis for rental to customers. In addition, the Company acquires catalog inventories to support new store openings and to build-up its title selection, primarily as it relates to changes in format preferences such as an increase in DVD from VHS. Purchases of new release movies are amortized over six months on an accelerated basis to current estimated average residual values of $1.00 for VHS and $4.00 for DVD. Purchases of DVD catalog are currently amortized on an accelerated basis over twenty-four months to an estimated residual value of $4.00. VHS catalog is amortized on an accelerated basis to an estimated $1.00 residual value over twenty-four months for new store purchases and six months for all other catalog purchases. Video games are currently amortized over twelve months to an estimated residual value of $5.00. For new release movies and games acquired under revenue sharing arrangements, the studios' share of rental revenue is charged to cost of rental as revenue is earned on the respective revenue sharing titles. Amortization periods, carrying values and residual values are approximately equal to non-revenue sharing purchases as outlined above. Cooperative Advertising Credits The Company receives cooperative credits from its inventory suppliers, primarily studios, to promote their respective titles. The credits that represent a reimbursement of specific, incremental, identifiable costs are included in operating and selling expense on the consolidated statements of operations, offsetting the related costs, in the period the promotion takes place. Credits that exceed such costs are classified as a reduction of the cost of product purchased, thereby reducing cost of revenue on the consolidated statements of operations. Change in Accounting Estimate for Rental Inventory The Company regularly evaluates and updates rental amortization accounting estimates. Effective April 4, 2005, the Company changed its estimated residual value on VHS movies from $2.00 to $1.00 due to continued declines in the average selling prices of older VHS product. The change was accounted for as a change in accounting estimate, which decreased rental inventory and increased amortization expense by approximately $10.1 million for the current year second quarter. This reduced net income by $5.9 million (net of tax), or $0.19 per diluted share for the thirty-nine weeks ended October 2, 2005. This change in estimate reduces future cost of rental when the previously viewed VHS units are sold. Revenue Recognition Movie Gallery recognizes extended viewing fee revenue when payment is received from the customer. Hollywood historically recorded these fees on an accrual basis and maintained an accounts receivable balance (net of estimated bad debt reserve) for the extended viewing fee revenue expected to be collected. At the time of the merger the receivable balance was $21.4 million. In order to conform Hollywood's accounting process to Movie Gallery's accounting process, in periods subsequent to the merger, the portion of the extended viewing fees collected from Hollywood customers that relate to the acquired receivable will reduce the receivable balance and extended viewing fee revenue will no longer be accrued in advance of payment. As a result, revenue recorded by Hollywood for extended viewing fees will be less than cash collected until the receivable balance is depleted. In the thirteen and thirty-nine week periods ended October 2, 2005, this transition in accounting process reduced rental revenue by $7.5 million and $20.3 million, respectively, and reduced operating income by $6.6 million and $18.0 million, respectively, after adjusting accrued revenue sharing on accrued extended viewing fees. This reduced net income by $4.7 million and $12.7 million, or $0.15 and $0.40 per diluted share, for the thirteen and thirty-nine weeks ended October 2, 2005, respectively. The balance sheet as of October 2, 2005, includes $1.1 million of accounts receivable for acquired extended viewing fees in connection with Hollywood's former accrual accounting process. Stock Based Compensation The Company accounts for stock-based employee compensation under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Stock compensation is reflected in net income for non-vested restricted stock granted and variable options outstanding that were repriced in March 2001. No stock compensation is reflected in net income for fixed options granted to employees, as the exercise price was equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income/(loss) and earnings/(loss) per share if we had applied the fair value recognition provision of FASB Statement No. 123, Accounting for Stock-Based Compensation, as amended, to stock-based employee compensation. Thirteen Weeks Ended Thirty-Nine Weeks Ended -------------------- ----------------------- October 3, October 2, October 3, October 2, 2004 2005 2004 2005 --------- --------- --------- --------- (in thousands, except per share data) Net income (loss), as reported $ 9,214 $ (12,469) $ 38,100 $ (6,265) Add: Stock based compensation included in reported net income, net of tax 461 442 $ 485 774 Deduct: Stock based compensation determined under fair value based methods for all awards, net of tax (426) (1,087) $ (1,013) (1,887) --------- --------- --------- --------- Pro forma net income/(loss) $ 9,249 (13,114) $ 37,572 $ (7,378) ========= ========= ========= ========= Net income/(loss) per share, as reported: Basic $ 0.29 $ (0.39) $ 1.17 $ (0.20) Diluted $ 0.29 $ (0.39) $ 1.16 $ (0.20) Pro forma net income/(loss) per share: Basic $ 0.29 $ (0.41) $ 1.16 $ (0.23) Diluted $ 0.29 $ (0.41) $ 1.14 $ (0.23) Recently Issued Accounting Pronouncements In December 2004, the FASB issued a revised Statement No. 123, Share Based Payment ("Statement 123R"), to address the accounting for stock-based employee plans. The statement eliminates the ability to account for share-based compensation transactions using APB 25 and instead requires that such transactions be accounted for using a fair value based method of accounting. The future impact of adoption of Statement 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted Statement 123R in prior periods, the impact of that standard would have approximated the impact of Statement 123 as shown in the table above. Statement 123R also requires the benefits of 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 the amount of net operating cash flows recognized in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options, and the market price of our common stock on the dates of future stock option exercises), the amount of operating cash flows recognized for such excess tax deductions were $4.7 million and $3.3 million for the thirty-nine weeks ended October 3, 2004 and October 2, 2005, respectively. We will adopt the requirements of Statement 123R beginning January 2, 2006. 2. Business Combinations Merger of Movie Gallery and Hollywood On April 27, 2005, Movie Gallery and Hollywood completed their previously announced merger pursuant to the Agreement and Plan of Merger, dated as of January 9, 2005 (the "Merger Agreement"). Upon the consummation of the merger, Hollywood became a wholly-owned subsidiary of Movie Gallery. As of the date of the merger, Hollywood operated 2,031 specialty home video retail stores and 20 free-standing video game stores throughout the United States. The merger was made as a strategic expansion of our geographic and urban markets in accordance with our growth plans. Under the terms of the Merger Agreement, Hollywood shareholders received $13.25 in cash for each Hollywood share owned. Approximately $862.1 million in cash was paid in consideration for (i) all outstanding common stock of Hollywood and (ii) all outstanding vested stock options of Hollywood. Existing Hollywood indebtedness was repaid for a total of $381.5 million. $161.4 million was paid by Hollywood with the remainder funded by Movie Gallery with proceeds from a new credit facility and the issuance of $325.0 million principal amount of 11% senior notes due 2012. The total consideration paid was approximately $1.1 billion, including transaction costs of $10.0 million. The merger has been treated as a purchase business combination for accounting purposes, and as such, Hollywood's assets acquired and liabilities assumed have been recorded at their fair value. The purchase price for the acquisition, including transaction costs, has been allocated to the assets acquired and liabilities assumed based on estimated fair values at the date of acquisition, April 27, 2005. The purchase price allocation is preliminary and further adjustments are expected. The purchase price allocation changed during the third quarter of 2005. The revised preliminary purchase price allocation is as follows (in thousands): April 27, 2005 Adjustment Amount -------------- ---------- ---------- Current Assets: Cash and cash equivalents $ 18,733 $ - $ 18,733 Extended viewing fees receivable, net 21,369 - 21,369 Merchandise inventory 122,468 - 122,468 Prepaid expenses 27,632 - 27,632 Store supplies and other 18,146 337 18,483 ---------- --------- ---------- Total current assets 208,348 337 208,685 Rental inventory 227,800 - 227,800 Property, furnishings and equipment 238,279 (110) 238,169 Goodwill 474,990 (11,247) 463,743 Other intangibles 183,894 - 183,894 Deferred income taxes, net 64,944 - 64,944 Deposits and other assets 1,662 - 1,662 ---------- --------- ---------- Total assets acquired $1,399,917 $ (11,020) $1,388,897 Liabilities Current Liabilities: Current maturities of long-term obligations $ 557 - $ 557 Current maturities of financing obligations 10,385 - 10,385 Accounts payable 182,963 (13,369) 169,594 Accrued liabilities 85,198 8,833 94,031 Accrued interest 39 - 39 Deferred revenue 27,552 (6,484) 21,068 ---------- --------- ---------- Total current liabilities 306,694 (11,020) 295,674 Long-term obligations, less current portion 941 - 941 Total liabilities 307,635 (11,020) 296,615 ---------- --------- ---------- Net Assets Acquired $1,092,282 $ - $1,092,282 ========== ========= ========== The Company has allocated approximately $183.9 million to identifiable intangible assets, of which approximately $170.9 relates to the indefinite lived trade name of Hollywood Video. The remaining intangible assets include finite lived trade names and customer lists, which will be amortized over their estimated useful lives which are 15 years and 5 years, respectively. The unaudited pro forma financial information in the table below summarizes the combined results of operations of Movie Gallery and Hollywood Entertainment for the thirteen-week and thirty-nine week periods ended October 2, 2005 and October 3, 2004 as though the companies had been combined as of the beginning of those respective periods. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the merger had taken place as of the beginning of 2004, nor is it indicative of future results. In addition, the following pro forma information has not been adjusted to reflect any operating efficiencies that may be realized as a result of the merger, except for the elimination of certain redundant executive compensation costs as a result of departures of corporate personnel, substantially all of which occurred shortly before or after the merger. (unaudited, in thousands, except share data) ------------------------------------------------ Thirteen Weeks Ended Thirty-Nine Weeks Ended ---------------------- ------------------------ October 3, October 2, October 3, October 2, 2004 2005 2004 2005 ---------- ---------- ---------- ----------- Total revenue $ 602,178 $ 579,934 $1,860,583 $1,926,705 Operating income 45,986(1) 12,517 174,630(2) 100,087(3) Net income(loss) 14,548(1) (7,654) 64,634(2) 14,396(3) Net income(loss) per share: Basic 0.46 (0.24) 1.99 0.46 Diluted 0.46 (0.24) 1.96 0.45 (1) Includes $1.7 million (before taxes) of transaction costs and professional services incurred by Hollywood related to merger activities. (2) Includes $5.3 million (before taxes) of transaction costs and professional services incurred by Hollywood related to merger activities. (3) Includes $21.1 million (before taxes) of transaction costs and professional services incurred by Hollywood related to merger activities which were recorded prior to the merger and therefore are not included in the reported Movie Gallery results. Includes $10.1 million in charges (before taxes) related to the VHS residual value adjustment by Movie Gallery, $1.5 million (before taxes) in transaction bonuses paid by Movie Gallery as a result of the completion of the merger and net income also includes a $4.2 million (before taxes) write off of bridge financing costs related to the acquisition financing by Movie Gallery. The Company has established reserves relating to employee separation costs pursuant to the integration of certain functions. Costs associated with these integration actions do not impact current earnings and are recognized as a component of purchase accounting, resulting in an adjustment to goodwill. During the second quarter of 2005, the Company notified 78 Hollywood employees of the decision to eliminate their positions in connection with these integration efforts. A $6.2 million reserve was recorded for costs associated with severance and benefits for the impacted individuals. Payments to these individuals will be made over the severance period in accordance with the Company's severance agreements. Payments year-to-date of $1.6 million have been made, leaving a $4.6 million reserve as of October 2, 2005. This reserve may be adjusted in the future when more information becomes available. The Company closed 50 Game Crazy departments since the acquisition date for a total cash cost of $0.3 million. The costs associated with these department closures do not impact current earnings and are recognized as a component of the purchase accounting, resulting in an adjustment to goodwill. Other Acquisitions During the second quarter, the Company acquired VHQ Entertainment, Inc. ("VHQ"). VHQ currently operates 57 stores in Canada. VHQ's results of operations have been included in our results since May 17, 2005. In addition to the VHQ acquisition, during the thirty-nine weeks ended October 2, 2005, Movie Gallery purchased 26 stores in 11 separate transactions for a total cash consideration, including VHQ, of $22.7 million. The aggregate preliminary purchase price allocation of these individually immaterial acquisitions is as follows: (in thousands) ------------- Rental inventory $ 3,200 Other tangible assets 4,880 Goodwill (including $4,179 of tax deductible goodwill) 18,381 Other intangible assets 1,960 Liabilities assumed (5,705) ---------- Total purchase price $ 22,716 ========== The pro-forma effects on consolidated revenues and net income of these acquisitions are not presented herein because they are not material. By letter dated August 29, 2005, Boards Video Company LLC ("Boards"), an entity controlled by Mark Wattles, the founder and former Chief Executive Officer of Hollywood,, exercised a contractual right to require Hollywood to purchase all of the 20 Hollywood Video stores and 17 Game Crazy stores owned and operated by Boards pursuant to a "put" option contained in the license agreement for these stores. In accordance with the terms of the license agreement, Hollywood and Boards have agreed to the retention of a valuation expert and are proceeding with the valuation of the stores. It is anticipated that the transaction will close by the end of first quarter 2006. 3. Property, Furnishings and Equipment Property, furnishings and equipment as of January 2, 2005 and October 2, 2005 consists of the following(in thousands): ----------- ---------- January 2, October 2, 2005 2005 ----------- ---------- Land and buildings $ 13,578 $ 17,943 Fixtures and equipment 185,490 275,253 Leasehold improvements 69,904 247,334 Construction phase assets - 8,008 Equipment under capital lease - 1,786 ----------- ---------- 268,972 550,324 Less accumulated depreciation and amortization (140,790) (194,888) ----------- ---------- $ 128,182 $ 355,436 =========== ========== Accumulated depreciation and amortization, as presented above, includes accumulated amortization of assets under capital leases of $0.0 and $0.2 million at January 2, 2005 and October 2, 2005, respectively. Depreciation expense related to property, furnishings and equipment was $30.3 million and $57.5 million for the thirteen and thirty-nine weeks ended October 2, 2005, respectively, compared to $6.9 million and $19.8 million for the corresponding periods in 2004. For the Hollywood operating segment, a change in estimate was recorded in the thirteen weeks ended October 2, 2005, to conform the lives of Hollywood's long lived assets to Movie Gallery's policy and to record the increase in depreciation expense generated by recording Hollywood's long lived assets at their increased fair value in the business combination accounting. A charge of $7.1 million in depreciation expense was recorded in the thirteen weeks ended October 2, 2005, of which $2.7 million related to the ten weeks ended July 3, 2005. This reduced net income by $1.9 million, or $0.06 per diluted share for both the thirteen and thirty-nine weeks ended October 2, 2005. These changes will continue to increase depreciation expense in future periods. 4. Income Taxes The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes," which requires that deferred assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the financial reporting and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion of or all of the deferred tax asset will not be realized. In the ordinary course of business, there may be many transactions and calculations where the ultimate tax outcome is uncertain. The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax laws. No assurance can be given that the final outcome of these matters will not be different than what is reflected in the current and historical income tax provisions and accruals. The effective tax rate was a benefit of 35.7% and 29.5% for the thirteen and thirty-nine weeks ended October 2, 2005, respectively, as compared to a provision of 39.0% for both of the corresponding prior year periods. The decrease in the effective rate is a result of several factors including a decrease in book income and limitations on the recognition of the tax benefit of a loss. It is anticipated that the effective rate should be more reflective of historical effective tax rates in the future tax periods. 5. Goodwill and Other Intangible Assets The components of goodwill and other intangible assets are as follows (in thousands): January 2, 2005 October 2, 2005 Weighted- ------------------------ --------------------- Average Gross Gross Amortization Carrying Accumulated Carrying Accumulated Period Amount Amortization Amount Amortization ------------ -------- ------------ -------- ------------ Goodwill --- $175,172 $ (31,411) $657,296 $ (31,411) ======== ============ ======== ============ Other intangible assets: Non-compete agreements 8 years $ 7,426 $ (4,937) $ 6,146 $ (3,842) Trademarks: Hollywood Video --- - - 170,942 - Game Crazy 15 years - - 4,000 (111) Customer lists 5 years 7,628 (2,376) 17,771 (4,200) -------- ------------ -------- ------------ $ 15,054 $ (7,313) $198,859 $ (8,153) ======== ============ ======== ============ Estimated amortization expense for other intangible assets for the remainder of 2005 and the five succeeding fiscal years is as follows (in thousands): 2005 (remainder) $ 1,147 2006 4,364 2007 4,221 2008 3,679 2009 2,806 2010 1,025 The changes in the carrying amounts of goodwill for the fiscal year ended January 2, 2005 and the thirty-nine weeks ended October 2, 2005, are as follows (in thousands): Net balance as of January 4, 2004 $ 136,008 Goodwill acquired 7,753 ----------- Net balance as of January 2, 2005 143,761 Goodwill acquired (including revised estimates) 482,124 ----------- Net balance as of October 2, 2005 $ 625,885 =========== 6. Long-Term Debt On April 27, 2005, the Company completed its cash acquisition of Hollywood, refinanced substantially all of the existing indebtedness of Hollywood, and replaced its existing unsecured revolving credit facility. To effect this transaction, the Company obtained a new senior secured credit facility ("Credit Facility") from a lending syndicate led by Wachovia and Merrill Lynch and issued $325.0 million of 11% senior unsecured notes ("Senior Notes"), due 2012. On September 21, 2005, the Company executed an amendment to the Credit Facility that relaxed certain financial covenants for a one-year period, provided for an additional $50.0 million of borrowings under the Term Loan B tranche, and increased the letter of credit sub-limit under the revolving credit facility from $30.0 million to $40.0 million. The Credit Facility is in an aggregate amount of $913.4 million, consisting of a five-year, $75.0 million revolving credit facility ("Revolver") currently bearing floating rate interest of London Interbank Offered Rate ("LIBOR") plus 3.50%, and two term loan facilities in an aggregate principal amount of $838.4 million. Term Loan A is a $90.3 million, five-year facility currently bearing floating rate interest of LIBOR plus 3.50%. Term Loan B is a $748.1 million, six-year facility currently bearing floating interest of LIBOR plus 3.75%. Term Loan A and Term Loan B require aggregate quarterly prepayments in the amounts of 5% and 0.25%, respectively, of the outstanding balances beginning September 30, 2005 through the first fiscal quarter of 2010, after which the mandatory Term Loan B prepayments escalate. The Credit Facility is fully and unconditionally guaranteed on a joint and several basis by Movie Gallery's domestic subsidiaries. The Credit Facility is secured by first priority security interests in, and liens on, substantially all of Movie Gallery's and its direct and indirect subsidiaries' tangible and intangible assets (other than leasehold mortgages on stores) and first priority pledges of all the equity interests owned by Movie Gallery in its existing and future direct and indirect wholly-owned domestic subsidiaries and 66 2 / 3 % of the equity interests owned by Movie Gallery in its existing and future wholly-owned non- domestic subsidiaries. As required by the Credit Facility, the Company has entered into a two-year floating-to-fixed interest rate swap with Wachovia and Merrill Lynch for an amount of $280.0 million. Under the terms of the swap agreement, the Company pays fixed interest on the $280.0 million at a rate of 4.06% and receives floating interest based on three-month LIBOR. The termination date for the swap is June 29, 2007. As of October 2, 2005, the Company had $9.0 million and $19.1 million in borrowings and letters of credit, respectively, drawn against the Revolver. The 11% Senior Unsecured Notes Due 2012 were sold at 98.806% of their face amount and were issued pursuant to an indenture dated April 27, 2005 between Movie Gallery, the subsidiary guarantors named in the indenture, and SunTrust Bank. The Senior Notes (i) have interest payment dates of May 1 and November 1 of each year; (ii) are redeemable in cash at the Company's option after the dates and at the prices (expressed in percentages of principal amount on the redemption date) as set forth below: Year Percentage ------------------------ ---------- May 1, 2008 105.500% May 1, 2009 103.667% May 1, 2010 101.833% May 1, 2011 & thereafter 100.000% And (iii) are senior unsecured obligations and are senior in right of payment to any of our future subordinated obligations. Long term debt consists of the following (in thousands): Instrument January 2, 2005 October 2, 2005 ---------- --------------- --------------- 11% Senior Unsecured Notes Due 2012 (net of discount $3,650) $ - $ 321,350 Term A loan - 90,250 Term B loan - 748,125 Revolving credit facility - 9,046 Hollywood 9.625% senior notes - 450 VHQ debt - 95 Capital leases - 852 --------------- ------------ Subtotal $ - $ 1,170,168 Less: Current Portion - (27,286) --------------- ------------ $ - $ 1,142,882 =============== ============ The current portion of long term debt included on the balance sheet as of October 2, 2005 is based on maturities of debt for the following twelve fiscal periods. Calender year maturities for the next five years and thereafter are as follows (in thousands): Year Total ----------- --------- 2005 $ 6,804 2006 27,149 2007 26,619 2008 26,500 2009 35,546 Thereafter 1,051,200 ---------- Total $1,173,818 Discount on senior notes (3,650) ---------- Net $1,170,168 ========== The Credit Facility and Indenture governing the Company's 11% notes impose certain restrictions, including restrictions on the Company's ability to: incur debt; grant liens; provide guarantees in respect of obligations of any other person; pay dividends; make loans and investments; sell the Company's assets; make redemptions and repurchases of capital stock; make capital expenditures; prepay, redeem or repurchase debt; engage in mergers or consolidations; engage in sale/leaseback transactions and affiliate transactions; change the business; amend certain debt and other material agreements; issue and sell capital stock of subsidiaries; and make distributions from subsidiaries. The Credit Facility also requires the Company to meet certain financial covenants including a leverage ratio test, a fixed charge coverage ratio test and an interest coverage test. Each of these covenants is calculated on trailing four quarter results based on specific definitions that are contained in the credit agreement. In general terms, the leverage ratio is a measurement of total net indebtedness relative to operating cash flow. The fixed charge coverage ratio is a measurement of operating cash flow plus rent relative to total fixed charges including rent, scheduled principal payments, and cash interest. The interest coverage ratio is a measurement of operating cash flow relative to interest expense. 7. Earnings (Loss) Per Share Basic earnings (loss) per share is computed based on the weighted average number of shares of common stock outstanding during the periods presented. Diluted earnings (loss) per share is computed based on the weighted average number of shares of common stock outstanding during the periods presented, increased by the effects of non-vested restricted stock and shares that could be issued from the exercise of dilutive common stock options (363,000 for the thirteen weeks ended October 3, 2004; 497,000 for the thirty-nine weeks ended October 3, 2004). No adjustments were made to net income in the computation of basic or diluted earnings (loss) per share. Due to the Company's loss for the thirteen weeks and thirty-nine weeks ended October 2, 2005, securities consisting of options convertible into 982,000 shares of common stock and 216,000 shares of non-vested restricted stock were excluded from the calculation of diluted earnings (loss) per share, as their inclusion in the diluted earnings (loss) per share calculation would have been anti-dilutive. 8. Comprehensive Income Comprehensive income is as follows (in thousands): Thirteen Weeks Ended Thirty-Nine Weeks Ended --------------------- ------------------------ October 3, October 2, October 3, October 2, 2004 2005 2004 2005 --------- --------- --------- --------- Net income (loss) $ 9,214 $ (12,469) $ 38,100 $ (6,265) Foreign currency translation adjustment 1,663 2,398 579 1,044 --------- --------- --------- ---------- Comprehensive income (loss) $ 10,877 $ (10,071) $ 38,679 $ (5,221) ========= ========= ========= ========== 9. Commitments and Contingencies Certain of the Company's subsidiaries have been named in various claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. The Company believes that it has provided adequate reserves for contingencies and that the outcome of these matters should not have a material adverse effect on the Company's future consolidated results of operations, financial condition or liquidity. At October 2, 2005, the legal contingencies reserve was $8.9 million of which $8.5 million relates to pre- acquisition contingencies. The recorded reserves for some matters may require adjustment in future periods and those adjustments could be material. Under FASB Statement 141, some or all of any future revisions to the recorded reserves for pre-acquisition contingencies may be required to be treated as revisions to the preliminary purchase price allocation (described in Note 2) which generally would be recorded as adjustments to goodwill. All other adjustments related to matters existing as of the date of acquisition of Hollywood will be recognized in the income statement in the period when such revisions are made. At January 2, 2005, the legal contingencies reserve was $0.3 million. A negative outcome in certain of the ongoing litigation could harm the Company's business, financial condition, liquidity or results of operations. In addition, prolonged litigation, regardless of which party prevails, could be costly, divert management attention or result in increased costs of doing business. 10. Segment Reporting As of April 27, 2005, management began evaluating the operating results of the Company based on three segments, Movie Gallery, Hollywood Video, and Game Crazy. Movie Gallery represents 2,714 video stores, Hollywood Video represents 2,051 video stores and Game Crazy represents 650 in-store departments and 20 free-standing stores. The Company measures segment profit as operating income (loss), which is defined as income (loss) before interest, and other financing costs, equity in losses of unconsolidated entities and income taxes. Information on segments and reconciliation to operating income (loss) are as follows (unaudited, in thousands): Thirteen Weeks Ended October 2, 2005 ------------------------------------------- Movie Hollywood Game Gallery Video Crazy Total ---------- --------- -------- ---------- Revenues $ 197,185 $ 316,115 $ 59,142 $ 572,442 Depreciation and amortization 10,291 19,728 2,278 32,297 Rental amortization 40,632 34,687 - 75,319 Operating income(loss) (652) 10,508 (4,832) 5,024 Total assets 523,108 1,230,589 116,391 1,870,088 Purchases of property, furnishings and equipment, net 11,672 4,351 400 16,423 Thirty-Nine Weeks Ended October 2, 2005 ------------------------------------------- Movie Hollywood Game Gallery(1) Video Crazy Total ---------- --------- -------- ---------- Revenues $ 630,038 $ 572,650 $108,274 $1,310,962 Depreciation and amortization 28,675 27,493 5,401 61,569 Rental amortization 138,983 67,151 - 206,134 Operating income(loss) 18,462 25,873 (6,752) 37,583 Total assets 523,108 1,230,589 116,391 1,870,088 Purchases of property, furnishings and equipment, net 40,403 7,874 596 48,873 (1) Rental amortization includes $10.1 million of VHS residual value adjustment. For the comparable periods ending October 3, 2004, there was only one reportable segment, which was Movie Gallery. Last year's consolidated results are the Movie Gallery segment totals. 11. Subsequent Events As of October 25, 2005, Movie Gallery notified 92 Movie Gallery associates that their positions will be relocated or eliminated as part of integration efforts through the consolidation of the primary functions of Finance, Accounting, Treasury, Product, Logistics, Human Resources and Payroll at the Company's Wilsonville, Oregon office. As this action impacts the acquiring Company's associates, these costs are charged to the condensed consolidated statement of operations as they are incurred. The Company estimates that the total cost of providing severance, retention incentives and outplacement services to these associates will be approximately $1.9 million and will be expensed within the condensed consolidated statement of operations in future periods over the retention service period for the impacted associates in accordance with Statement of Financial Accounting Standards, ("SFAS") No. 146, "Accounting for Costs Associated with Disposal and Exit Activities". The consolidation of these corporate functions will allow the Company to reduce its salaried and administrative office staff by approximately 10% over the next twelve months, primarily in the Dothan office. The Company expects to realize annualized pre-tax savings of approximately $2.1 million. 12. Consolidating Financial Statements The following tables present condensed consolidating financial information for: (a) Movie Gallery, Inc. (the "Parent") on a stand-alone basis; (b) on a combined basis, the guarantors of the 11% Senior Notes ("Subsidiary Guarantors"), which include Movie Gallery US, Inc.; Hollywood Entertainment Corporation; Hollywood Management Company; Movie Gallery Finance, Inc.; Movie Gallery Licensing, Inc.; Movie Gallery Services, Inc.; M.G.A. Realty I, LLC; M.G. Digital, LLC; Movie Gallery Asset Management, Inc., and (c) on a combined basis, the Non-Guarantor Subsidiaries, which include Movie Gallery Canada, Inc., VHQ Entertainment, Inc., Movie Gallery Mexico, Inc., S. de R.L. de C.V., and MG Automation, Inc. Each of the Subsidiary Guarantors is wholly-owned by Movie Gallery, Inc. The guarantees issued by each of the Subsidiary Guarantors are full, unconditional, joint and several. Accordingly, separate financial statements of the wholly-owned Subsidiary Guarantors are not presented because the Subsidiary Guarantors are jointly, severally and unconditionally liable under the guarantees, and we believe separate financial statements and other disclosures regarding the Subsidiary Guarantors are not material to investors. Furthermore, there are no significant legal restrictions on the Parent's ability to obtain funds from its subsidiaries by dividend or loan. The Parent is a Delaware holding company and has no independent operations other than investments in subsidiaries and affiliates. Consolidating Statement of Operations Thirteen weeks ended October 3, 2004 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- --------- --------- --------- Revenue: Rentals $ - $ 162,507 $ 13,551 $ - $ 176,058 Product sales - 12,511 1,286 - 13,797 --------- --------- --------- --------- --------- Total revenue - 175,018 14,837 - 189,855 Cost of sales: Cost of rental revenue - 47,697 3,413 - 51,110 Cost of product sales - 7,730 943 - 8,673 --------- --------- --------- --------- --------- Gross profit - 119,591 10,481 - 130,072 Operating costs and expenses: Store operating expenses - 91,335 6,627 - 97,962 General and administrative 33 12,983 1,381 - 14,397 Amortization of intangibles - 634 39 - 673 Stock compensation - 755 - - 755 -------- -------- -------- -------- --------- Operating income(loss) (33) 13,884 2,434 - 16,285 Interest expense, net - (229) 4 - (225) Equity in losses of unconsolidated entities (955) - - - (955) Equity in earnings of subsidiaries 9,831 1,454 - (11,285) - -------- -------- -------- -------- --------- Income before income taxes 8,843 15,109 2,438 (11,285) 15,105 Income taxes (benefit) (371) 5,278 984 - 5,891 -------- -------- -------- -------- --------- Net income $ 9,214 $ 9,831 $ 1,454 $(11,285) $ 9,214 ======== ======== ======== ======== ========= Consolidating Statement of Operations Thirteen weeks ended October 2, 2005 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- --------- --------- -------- Revenue: Rentals $ - $ 452,502 $ 20,584 $ - $ 473,086 Product sales - 96,679 2,677 - 99,356 --------- --------- --------- --------- -------- Total revenue - 549,181 23,261 - 572,442 Cost of sales: Cost of rental revenue - 131,161 5,075 - 136,236 Cost of product sales - 68,465 1,615 - 70,080 --------- ---------- --------- --------- -------- Gross profit - 349,555 16,571 - 366,126 Operating costs and expenses: Store operating expenses - 307,766 12,153 - 319,919 General and administrative 171 38,026 1,288 - 39,485 Amortization of intangibles - 1,070 93 - 1,163 Stock compensation - 535 - - 535 -------- -------- -------- -------- --------- Operating income(loss) (171) 2,158 3,037 - 5,024 Interest expense, net (24,052) (241) (134) - (24,427) Equity in earnings(loss) of subsidiaries 3,194 1,745 - (4,939) - -------- -------- -------- -------- -------- Income (loss) before income taxes (21,029) 3,662 2,903 (4,939) (19,403) Income taxes (benefit) (8,560) 468 1,158 - (6,934) -------- -------- -------- -------- -------- Net income (loss) $(12,469) $ 3,194 $ 1,745 $ (4,939) $(12,469) ======== ======== ======== ======== ======== Consolidating Statement of Operations Thirty-Nine weeks ended October 3, 2004 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- --------- --------- --------- Revenue: Rentals $ - $ 500,479 $ 37,575 $ - $ 538,054 Product sales - 40,678 4,016 - 44,694 --------- --------- --------- --------- --------- Total revenue - 541,157 41,591 - 582,748 Cost of sales: Cost of rental revenue - 142,286 10,477 - 152,763 Cost of product sales - 26,973 2,772 - 29,745 --------- --------- --------- --------- --------- Gross profit - 371,898 28,342 - 400,240 Operating costs and expenses: Store operating expenses - 267,964 19,824 - 287,788 General and administrative 79 38,307 3,493 - 41,879 Amortization of intangibles - 1,850 112 - 1,962 Stock compensation - 795 - - 795 --------- -------- --------- --------- --------- Operating income(loss) (79) 62,982 4,913 - 67,816 Interest expense, net - (404) 14 - (390) Equity in losses of unconsolidated entities (4,891) - - - (4,891) Equity in earnings of subsidiaries 41,203 2,945 - (44,148) - --------- -------- -------- --------- --------- Income before income taxes 36,233 65,523 4,927 (44,148) 62,535 Income taxes (benefit) (1,867) 24,320 1,982 - 24,435 --------- -------- -------- -------- -------- Net income $ 38,100 $ 41,203 $ 2,945 $(44,148) $ 38,100 ========= ======== ======== ======== ======== Consolidating Statement of Operations Thirty-Nine weeks ended October 2, 2005 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- ---------- --------- ------- ---------- Revenue: Rentals $ - $1,056,278 $ 53,383 $ - $1,109,661 Product sales - 195,300 6,001 - 201,301 --------- --------- --------- ------- --------- Total revenue - 1,251,578 59,384 - 1,310,962 Cost of sales: Cost of rental revenue - 328,867 16,292 - 345,159 Cost of product sales - 137,981 3,915 - 141,896 --------- --------- --------- ------- --------- Gross profit - 784,730 39,177 - 823,907 Operating costs and expenses: Store operating expenses - 659,461 31,131 - 690,592 General and administrative 372 88,027 3,517 - 91,916 Amortization of intangibles - 2,544 174 - 2,718 Stock compensation - 1,098 - - 1,098 -------- -------- -------- ------ --------- Operating income(loss) (372) 33,600 4,355 - 37,583 Interest expense, net (40,606) (669) (155) - (41,430) Write-off of bridge financing costs (4,234) - - - (4,234) Equity in losses of unconsolidated entities (806) - - - (806) Equity in earnings of subsidiaries 23,118 2,543 - (25,661) - -------- -------- -------- -------- -------- Income (loss) before income taxes (22,900) 35,474 4,200 (25,661) (8,887) Income taxes (benefit) (16,635) 12,356 1,657 - (2,622) -------- -------- -------- -------- -------- Net income (loss) $ (6,265) $ 23,118 $ 2,543 $(25,661) $ (6,265) ======== ======== ======== ======== ======== Condensed Consolidating Balance Sheet January 2, 2005 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- -------- --------- --------- Assets Current assets: Cash and cash equivalents $ 1 $ 15,711 $ 9,806 $ - $ 25,518 Merchandise inventory, net - 24,806 2,613 - 27,419 Prepaid expenses - 11,607 1,105 - 12,712 Store supplies and other 23 8,344 1,126 - 9,493 Deferred income taxes, net - 2,994 364 - 3,358 --------- --------- -------- --------- --------- Total current assets 24 63,462 15,014 - 78,500 Rental inventory, net - 113,939 12,602 - 126,541 Property, furnishings and equipment, net - 116,462 11,720 - 128,182 Goodwill, net - 133,292 10,469 - 143,761 Other intangibles, net - 7,144 597 - 7,741 Deposits and other assets 806 6,028 583 - 7,417 Investments in subsidiaries 328,494 30,644 - (359,138) - --------- --------- -------- --------- --------- Total assets $ 329,324 $ 470,971 $ 50,985 $(359,138) $ 492,142 ========= ========= ======== ========= ========= Liabilities and stockholders' equity: Current liabilities: Accounts payable - 63,465 5,512 - 68,977 Accrued liabilities (1,810) 27,323 5,057 - 30,570 Deferred revenue - 10,415 428 - 10,843 --------- --------- -------- --------- --------- Total current liabilities (1,810) 101,203 10,997 - 110,390 Deferred income taxes - 47,468 3,150 - 50,618 Payable to affiliate - (6,194) 6,194 - - Stockholders' equity 331,134 328,494 30,644 (359,138) 331,134 --------- --------- -------- --------- --------- Total liabilities and Stockholders' equity $ 329,324 $ 470,971 $ 50,985 $(359,138) $ 492,142 ========= ========= ======== ========= ========= Condensed Consolidating Balance Sheet October 2, 2005 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated --------- --------- -------- --------- --------- Assets Current assets: Cash and cash equivalents $ - $ 67,338 $ 1,417 $ - $ 68,755 Extended viewing fees receivable, net - 1,110 - - 1,110 Merchandise inventory,net - 139,334 3,875 - 143,209 Prepaid expenses 33 40,477 1,947 - 42,457 Store supplies and other - 28,410 1,347 - 29,757 Deferred income taxes, net - 15,633 180 - 15,813 --------- --------- -------- --------- -------- Total current assets 33 292,302 8,766 - 301,101 Rental inventory, net - 326,450 15,777 - 342,227 Property, furnishings and equipment, net - 338,937 16,499 - 355,436 Goodwill, net - 601,213 24,672 - 625,885 Other intangibles, net - 189,361 1,345 - 190,706 Deferred income taxes 18,398 (475) (4,720) - 13,203 Deposits and other assets 30,761 10,058 711 - 41,530 Investments in subsidiaries 1,441,318 41,336 - (1,482,654) - --------- --------- -------- --------- --------- Total assets $1,490,510 $1,799,182 $ 63,050$(1,482,654)$1,870,088 ========= ========= ======= ========= ========= Liabilities and stockholders' equity: Current liabilities: Current maturities of long-term obligations 26,500 652 134 - 27,286 Current maturities of financing obligations - 7,973 - - 7,973 Accounts payable - 155,456 4,358 - 159,814 Accrued liabilities (731) 131,389 6,920 - 137,578 Accrued interest 29,168 38 27 - 29,233 Deferred revenue - 31,297 390 - 31,687 ---------- --------- -------- --------- --------- Total current liabilities 54,937 326,805 11,829 - 393,571 Long-term obligations,less current portion 1,133,225 581 9,076 - 1,142,882 Deferred income taxes - - - - - Payable to(receivable from)affiliate (31,287) 30,478 809 - - Stockholders' equity 333,635 1,441,318 41,336 (1,482,654) 333,635 --------- --------- -------- --------- --------- Total liabilities and stockholders' equity $1,490,510 $1,799,182 $63,050$(1,482,654)$1,870,088 ========= ========= ======== ========= ========= Consolidating Condensed Statement of Cash Flow Thirty-Nine weeks ended October 3, 2004 (unaudited, in thousands) ------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated -------- --------- -------- -------- --------- Operating Activities: Net income $ 38,100 $ 41,203 $ 2,945 $ (44,148) $ 38,100 Equity earnings in subsidiary (41,203) (2,945) - 44,148 - Adjustments to reconcile net income to cash provided by operating activities: Rental inventory amortization - 99,371 8,319 - 107,690 Purchases of rental inventory - (100,194) (9,121) - (109,315) Depreciation and intangibles amortization - 20,605 1,546 - 22,151 Stock based compensation 28 - - - 28 Tax benefit of stock options exercised 4,689 - - - 4,689 Deferred income taxes - 9,028 3,468 - 12,496 Changes in operating assets and liabilities, net of business acquisitions: Merchandise inventory - 1,106 175 - 1,281 Other current assets - 1,117 (132) - 985 Deposits and other assets 700 (137) 334 - 897 Accounts payable - (14,743) (1,042) - (15,785) Accrued liabilities and deferred revenue (2,144) 557 (934) - (2,521) Intercompany payables/ receivables - (1,084) 1,084 - - -------- --------- -------- -------- --------- Net cash provided by operating activities 170 53,884 6,642 - 60,696 Investing Activities: Business acquisitions, net of cash acquired - (9,346) (253) - (9,599) Purchases of rental inventory-base stock - (10,212) (873) - (11,085) Purchase of property, furnishings and equipment - (31,317) (3,382) - (34,699) Investment in subsidiaries (31,397) (2,079) - 33,476 - -------- --------- -------- -------- --------- Net cash used in investing activities (31,397) (52,954) (4,508) 33,476 (55,383) Financing Activities: Proceeds from issuance of long-term debt 20,000 - - - 20,000 Proceeds from exercise of stock options 5,516 - - - 5,516 Proceeds from employee stock purchase plan 168 - - - 168 Purchases and retirement of common stock (47,390) - - - (47,390) Capital contribution from parent - 31,397 2,079 (33,476) - Dividend to parent 55,891 (55,891) - - - Payment of dividends (2,958) - - - (2,958) -------- --------- -------- -------- --------- Net cash (used in) provided by financing activities 31,227 (24,494) 2,079 (33,476) (24,664) Effect of exchange rate changes on cash and cash equivalents - 579 - - 579 -------- --------- -------- -------- --------- Increase (decrease) in cash and cash equivalents - (22,985) 4,213 - (18,772) Cash and cash equivalents at beginning of period - 34,849 3,157 - 38,006 -------- --------- -------- -------- --------- Cash and cash equivalents at end of period $ - $ 11,864 $ 7,370 $ - $ 19,234 ======== ========= ======== ======== ========= Consolidating Condensed Statement of Cash Flow Thirty-Nine Weeks ended October 2, 2005 (unaudited, in thousands) -------------------------------------------------- Non- Guarantor Guarantor Subsid- Subsid- Elimin- Consol- Parent iaries iaries ations idated -------- --------- --------- -------- --------- Operating Activities: Net income $ (6,265) $ 23,118 $ 2,543 $(25,661) $ (6,265) Equity earnings in subsidiary (23,118) (2,543) - 25,661 - Adjustments to reconcile net income to cash provided by operating activities: Rental inventory amortization - 192,740 13,394 - 206,134 Purchases of rental inventory - (161,581) (12,670) - (174,251) Depreciation and intangibles amortization - 58,633 2,936 - 61,569 Amortization of debt issuance cost 2,235 - - - 2,235 Stock based compensation 705 393 - - 1,098 Tax benefit of stock options exercised 3,301 - - - 3,301 Deferred income taxes (18,398) 5,313 1,528 - (11,557) Changes in operating assets and liabilities, net of business acquisitions: Extended viewing fees receivable, net - 20,259 - - 20,259 Merchandise inventory - 8,658 (142) - 8,516 Other current assets (10) (3,098) (840) - (3,948) Deposits and other assets 493 (2,418) (128) - (2,053) Accounts payable - (77,603) (4,655) - (82,258) Accrued interest 29,168 (2) 27 - 29,193 Accrued liabilities and deferred revenue 2,013 9,498 1,825 - 13,336 --------- --------- -------- -------- --------- Net cash provided by operating activities (9,876) 71,367 3,818 - 65,309 Investing Activities: Business acquisitions, net of cash acquired (1,092,282) 12,142 (16,125) - (1,096,265) Purchases of rental inventory-base stock - (15,136) (1,433) - (16,569) Purchase of property, furnishings and equipment - (44,156) (4,717) - (48,873) Proceeds from disposal of Property, furnishings and Equipment - 2,107 - - 2,107 Acquisition of construction phase assets, net - 2,154 - - 2,154 Investment in subsidiaries (354) (8,149) - 8,503 - --------- --------- -------- -------- --------- Net cash used in investing activities (1,092,636) (51,038) (22,275) 8,503 (1,157,446) Financing Activities: Repayment of capital lease obligations - (265) - - (265) Intercompany payable/ receivable (31,165) 36,550 (5,385) - - Decrease in financing obligations - (2,412) - - (2,412) Net borrowings on credit facilities - - 9,046 - 9,046 Long term debt financing fees (32,452) - - - (32,452) Proceeds from issuance of long-term debt 1,166,120 - - - 1,166,120 Principal payments on long-term debt (6,625) - (1,742) - (8,367) Proceeds from exercise of stock options 5,318 - - - 5,318 Proceeds from employee stock purchase plan 169 - - - 169 Capital contribution from parent - 354 8,149 (8,503) - Dividend to parent 3,973 (3,973) - - - Payment of dividends (2,827) - - - (2,827) -------- -------- -------- -------- --------- Net cash (used in) provided by financing activities 1,102,511 30,254 10,068 (8,503) 1,134,330 Effect of exchange rate changes on cash and cash equivalents - 1,044 - - 1,044 -------- -------- -------- -------- --------- Increase (decrease) in cash and cash equivalents (1) 51,627 (8,389) - 43,237 Cash and cash equivalents at beginning of period 1 15,711 9,806 - 25,518 -------- --------- -------- -------- --------- Cash and cash equivalents at end of period $ - $ 67,338 $ 1,417 $ - $ 68,755 ======== ========= ======== ======== ========= ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Overview As of October 2, 2005, we operated approximately 4,800 home video retail stores that rent and sell movies and video games in urban, rural and suburban markets. On April 27, 2005, we completed our acquisition of Hollywood Entertainment Corporation ("Hollywood"). This acquisition increased our store count to over 4,700 stores and substantially increased our urban market presence. We currently plan to maintain the Hollywood brand and store format. However, we believe the most significant expansion opportunities continue to be in the rural and suburban markets. We estimate that there are approximately 2,500 to 3,500 markets still available for expansion in rural America, where there is less competition from other national and regional chains, as well as additional opportunities throughout Canada and Mexico. We currently plan to open approximately 300 new stores for the full year 2005 period, subject to market and industry conditions and the integration of Hollywood. We believe the most significant dynamic in our industry is the relationship our industry maintains with the movie studios. The studios have historically maintained an exclusive window for home video distribution (packaged goods), which provides the home video industry with an approximately 45 day period during which they can rent and sell new releases before they are made available on pay-per-view or other distribution channels. According to Kagan Research, the percentage of domestic studio movie revenue provided by the domestic home video industry has increased substantially in recent years, from approximately 50% in 1998 to approximately 57% in 2004. For this reason, we believe movie studios have a significant interest in maintaining a viable home video business. Our strategies have been designed to achieve reasonable, moderate and consistent growth in same-store revenues and profitability in a mature industry. We strive to minimize the operating and overhead costs associated with our business, which allows us to maximize profitability and which has proven to be a successful operating model for us. Our compound annual growth rate for consolidated revenue and operating income from 2000 to 2004 was 25.5% and 45.2% respectively. We intend to apply these same disciplines to the Hollywood brand where appropriate. In addition to the relationship between our industry and the movie studios, our operating results are driven by revenue, inventory, rent and payroll. Given those key factors, we believe that by monitoring the five operating performance indicators described below, we can continue to be successful in executing our operating plans and our growth strategy. - Revenues. Our business is a cash business with initial rental fees paid upfront by the customer. Our management teams continuously review inventory levels, marketing and sales promotions, real estate strategies, and personnel issues in order to maximize profitable revenues at each location. Additionally, our teams monitor revenue performance on a daily basis to quickly identify trends or issues in our store base or in the industry as a whole. Our management relies heavily on same-store revenues, which we define as revenues at stores that we have operated for at least 12 full months, to assess the performance of our business. - Product purchasing economics. In order to maintain the desired profit margin in our business, purchases of inventory for both rental and sale must be carefully managed. Our purchasing models are designed to analyze the impact of the economic factors inherent in the various pricing strategies employed by the studios. We believe that we are able to achieve purchasing levels tailored for the customer demographics of each of our markets and to maximize the return on investment of our inventory purchase dollars. - Store level cost control. The most significant store expenses are payroll and rent, followed by other supply and service expenditures. We attempt to control these expenses primarily through budgeting systems and centralization of purchases into our corporate support centers. This enables us to measure performance against expectations and to leverage our purchasing power. We also have the benefit in that a significant portion of our store base is in rural markets where we enjoy reduced labor and real estate costs versus the higher costs associated with the larger urban markets. - Leverage of overhead expenses. We apply the same principles of budgeting, accountability and conservatism in our overhead spending that we employ in managing our store operating costs. Our general and administrative expenses include the costs to maintain our corporate support centers as well as the overhead costs of our field management team. Our integration strategy is focused on eliminating duplication, leveraging best practices and reaping the financial benefits of economies of scale to reduce costs. - Operating cash flows. We have generated significant levels of cash flow for several years. We have historically been able to fund the majority of our store growth and acquisitions, as well as ongoing inventory purchases, from cash flow generated from operations. An exception to this was the acquisition of Hollywood which we funded through a combination of cash on hand and long-term debt. The following discussion of our results of operations, liquidity and capital resources is intended to provide further insight into our performance for the third quarter and year-to-date period of 2005 versus the comparable periods of 2004. Hollywood Acquisition On April 27, 2005, we completed our cash acquisition of Hollywood, refinanced substantially all of the existing indebtedness of Hollywood, and replaced our existing unsecured revolving credit facility. We paid $862.1 million to purchase all of Hollywood's outstanding common stock and $384.7 million to refinance Hollywood's debt. As part of the refinancing of Hollywood's debt, Hollywood executed a tender offer for its $225.0 million principal amount 9.625% senior subordinated notes due 2011, pursuant to which $224.6 million were tendered. The Hollywood acquisition was financed by Movie Gallery and Hollywood's cash on-hand of approximately $180.0 million and a senior secured credit facility guaranteed by all of our domestic subsidiaries in an aggregate amount of $870.0 million, and an issuance of $325.0 million of 11% senior unsecured notes. The combination of Movie Gallery and Hollywood created the second largest North American video rental company with pro-forma combined annual revenue in excess of $2.5 billion and approximately 4,800 stores located in all 50 U.S. states, Canada and Mexico. The acquisition substantially increased our presence on the West Coast and in urban areas. Hollywood's predominantly West Coast urban superstore locations present little overlap with Movie Gallery's rural and suburban store locations concentrated in the eastern half of the United States. We will maintain the Hollywood store format and brand separately from our Movie Gallery business because of Hollywood's distinct operational model and to ensure customer continuity. There has been a conscious effort not to interrupt the field management organizations at Movie Gallery and Hollywood to ensure they remain focused on revenue and customer service. Integration efforts to date have primarily focused on consolidating the leadership functions in all three operating segments. This is complete for the Human Resources, Real Estate, Legal, Lease Administration, Finance, Information Systems, Loss Prevention and Distribution functions. The respective leaders of these support organizations are evaluating opportunities to leverage both Movie Gallery's and Hollywood's best practices and generate general and administrative cost savings. To date, these savings have been found in both Movie Gallery's and Hollywood's cost structures which we anticipate will continue in the future. The combined companies also are evaluating opportunities to reap the benefits of increased purchasing leverage to reduce costs. However, we can make no assurances that we will successfully integrate Hollywood's business with our business or that we will achieve the anticipated cost savings. As of October 25, 2005, we notified 92 Movie Gallery associates that their positions will be relocated or eliminated as part of integration efforts through the consolidation of the primary functions of Finance, Accounting, Treasury, Product, Logistics, Human Resources and Payroll at our Wilsonville, Oregon office. As this action impacts the acquiring company's associates, these costs are charged to the condensed consolidated statement of operations as they are incurred. We estimate that the total cost of providing severance, retention incentives and outplacement services to these associates will be approximately $1.9 million and will be expensed within the condensed consolidated statement of operations in future periods over the retention service period for the impacted associates in accordance with Statement of Financial Accounting Standards, ("SFAS") No. 146, "Accounting for Costs Associated with Disposal and Exit Activities". The consolidation of these corporate functions will allow us to reduce our salaried and administrative office staff by approximately 10% over the next twelve months, primarily in the Dothan office. We expect to realize annualized pre-tax savings of approximately $2.1 million. During our integration of the operations of Hollywood, we will evaluate our operational, growth, dividend and other strategies and policies discussed in this report and will modify our strategies and policies as appropriate or required by industry and operating conditions. Other Acquisitions During the second quarter of 2005, we acquired VHQ Entertainment, Inc., ("VHQ"). VHQ operates 57 stores in Canada. VHQ's results of operations have been included in our results since May 17, 2005. In addition to the VHQ acquisition, during the thirty-nine weeks ended October 2, 2005, Movie Gallery purchased 26 stores in 11 separate transactions for a total cash consideration, including VHQ, of $22.7 million. By letter dated August 29, 2005, Boards Video Company LLC ("Boards"), an entity controlled by Mark Wattles, the founder and former Chief Executive Officer of Hollywood,, exercised a contractual right to require Hollywood to purchase all of the 20 Hollywood Video stores and 17 Game Crazy stores owned and operated by Boards pursuant to a "put" option contained in the license agreement for these stores. In accordance with the terms of the license agreement, Hollywood and Boards have agreed to the retention of a valuation expert and are proceeding with the valuation of the stores. It is anticipated that the transaction will close by the end of first quarter 2006. Results of Operations Selected Financial Statement and Operational Data: Thirteen Weeks Ended Thirty-Nine Weeks Ended --------------------- ----------------------- October 3, October 2, October 3, October 2, 2004 2005 2004 2005 --------- --------- --------- ---------- (unaudited) ($ in thousands, except per share and store data) Rental revenue $ 176,058 $ 473,086 $ 538,054 $1,109,661 Product sales 13,797 99,356 44,694 201,301 --------- --------- --------- ---------- Total revenue 189,855 572,442 582,748 1,310,962 Cost of rental revenue 51,110 136,236 152,763 345,159 Cost of product sales 8,673 70,080 29,745 141,896 --------- --------- --------- ---------- Total gross profit $ 130,072 $ 366,126 $ 400,240 $ 823,907 ========= ========= ========= ========== Store operating expenses $ 97,962 $ 319,919 $ 287,788 $ 690,592 General and administrative expenses $ 14,397 $ 39,485 $ 41,879 $ 91,916 Stock compensation $ 755 $ 535 $ 795 $ 1,098 Equity in losses of unconsolidated entities $ 955 $ - $ 4,891 $ 806 Operating income $ 16,285 $ 5,024 $ 67,816 $ 37,583 Interest expense, net $ 225 $ 24,427 $ 390 $ 41,430 Net income (loss) $ 9,214 $ (12,469) $ 38,100 $ (6,265) Net income (loss) per diluted share $ 0.29 $ (0.39) $ 1.16 $ (0.20) Cash dividends per common share $ 0.03 $ - $ 0.09 $ 0.06 Rental margin 71.0% 71.2% 71.6% 68.9% Product sales margin 37.1% 29.5% 33.4% 29.5% Total gross margin 68.5% 64.0% 68.7% 62.8% Percent of total revenue: Rental revenue 92.7% 82.6% 92.3% 84.6% Product sales 7.3% 17.4% 7.7% 15.4% Store operating expenses 51.6% 55.9% 49.4% 52.7% General and administrative expenses 7.6% 6.9% 7.2% 7.0% Stock compensation 0.4% 0.1% 0.1% 0.1% Operating income 8.6% 0.9% 11.6% 2.9% Interest expense, net 0.1% 4.3% 0.1% 3.2% Net income (loss) 4.9% (2.2%) 6.5% (0.5%) Total same-store revenues (2.3%) (9.0%) (0.3%) (3.1%) Movie Gallery same-store revenues(2.3%) (9.8%) (0.3%) (5.3%) Hollywood same-store revenues (2.4%) (8.6%) 1.3% (2.2%) Total same-store rental revenues (2.1%) (10.3%) (0.1%) (5.2%) Movie Gallery same-store revenues(2.1%) (10.8%) (0.1%) (5.5%) Hollywood same-store revenues (8.0%) (10.1%) (4.8%) (5.1%) Total same-store product sales (4.5%) (2.2%) (2.3%) 7.8% Movie Gallery same-store sales (4.5%) 2.5% (2.3%) (3.1%) Hollywood same-store sales 26.8% (3.0%) 37.6% 10.0% Store count: Beginning of period 2,331 4,730 2,158 2,482 New store builds 65 80 221 234 Stores acquired 5 - 60 2,138 Stores closed (18) (25) (56) (69) --------- --------- --------- ---------- End of period 2,383 4,785 2,383 4,785 ========= ========= ========= ========== Hollywood same-store revenues are presented for full thirteen and thirty-nine week periods and are inclusive of the Game Crazy operating segment. Hollywood same-store revenues exclude the effects of the process change for extended viewing fees recognition described in Note 1 to the accompanying consolidated financial statements. Revenue. For the thirteen weeks and thirty-nine weeks ended October 2, 2005, consolidated total revenues increased 201.5% and 125.0% from the comparable periods in 2004. Same-store total revenues were negative 9.0% for the third quarter and negative 3.1% for the year-to-date period in 2005. Same-store rental revenue declined 10.3% in the third quarter of 2005 and declined 5.2% year-to-date in 2005. Product same-store revenue declined 2.2% in the third quarter and grew 7.8% for the year-to-date period in 2005. With the acquisition of Hollywood our revenue has shifted more to product revenue and away from rental revenues versus comparative periods last year. The Game Crazy operating segment is the primary driver of this shift in the revenue mix. We expect this trend to continue. For the thirteen weeks and thirty-nine weeks ended October 2, 2005, the Movie Gallery operating segment total revenues increased 3.9% and 8.1% from the comparable periods in 2004. The increases were due to an increase of approximately 14.5% in the average number of stores operated during both the quarter and year-to-date period of 2005. These increases were partially offset by same-store revenue decreases of 9.8% for the third quarter and 5.3% for the year-to-date period of 2005. Same-store rental revenue declined 10.8% in the third quarter of 2005 and declined 5.5% year-to-date in 2005. Same-store product sales increased 2.5% in the third quarter and declined 3.1% for the year-to-date period in 2005. The addition of Hollywood operating segment revenue for the thirteen weeks and thirty-nine weeks ended October 2, 2005 accounted for 98.1% and 93.5%, respectively, of the total revenue increases. Hollywood total same-store revenues were negative 8.6% for the third quarter and negative 2.2% for the year-to-date period. Same-store rental revenue declined 10.1% in the third quarter of 2005 and declined 5.1% year-to-date in 2005. To conform Hollywood's extended viewing fees accounting process to Movie Gallery's accounting process, Hollywood's rental revenue was reduced by $7.5 million and $20.3 million in the thirteen weeks and thirty-nine weeks ended October 2, 2005. The same-store total revenue and rental revenue have been presented excluding this process change. The same-store product sales decreased 3.0% in the third quarter and increased 10.0% for the year-to-date period in 2005. The year-to-date growth in Hollywood same-store product sales is primarily driven by the results of the in-store Game Crazy departments. The year-to-date same-store revenue percentage changes provided for Hollywood are for the full thirty-nine weeks. The following factors contributed to a decrease in our total same-store revenues for the third quarter of 2005 versus 2004: -Movie rental revenue, including previously viewed sales, declined and was adversely impacted by the weak home video release schedule, the maturation of the DVD life cycle and the overabundance of DVD titles available in the marketplace. -Game rental revenue declined reflecting the weakness of the new game titles currently being released and the industry softness that occurs in anticipation of the introduction of new game platforms currently scheduled for late 2005 and early 2006 release. Cost of Sales. The cost of rental revenues includes the amortization of rental inventory, revenue sharing expenses incurred and the cost of previously viewed rental inventory sold. The gross margin on rental revenue for the third quarter and year-to-date period of 2005 was 71.2% and 68.9%, respectively, versus 71.0% and 71.6% for the comparable quarter and year-to-date period of 2004. A charge of $10.1 million was recorded against rental margins in the second quarter to reflect a change in estimate of the residual value of VHS movies from $2.00 to $1.00. Excluding the extended viewing fees adjustment for Hollywood and the VHS residual value adjustment in the second quarter for Movie Gallery, gross margin on rental revenue would have been 71.5% and 70.1% for the thirteen and thirty- nine weeks ending October 2, 2005, respectively. We have presented gross margins on rental revenue adjusted to exclude charges related to the extended viewing fee and VHS residual value adjustments because we believe it provides our investors a more accurate view of the current period operating results and our management uses this information to analyze our results from continuing operations and to view trends and changes in these results. The remaining decrease in the year-to-date period compared to the corresponding period last year is primarily the result of the acquisition of the Hollywood Video stores as their gross margins are historically lower than those of Movie Gallery stores because Hollywood generally invests more in rental inventory as a percentage of revenue to compete effectively in urban markets. Higher than expected same-store revenue declines for movie rental revenue, and higher than normal promotional activity of previously viewed products also contributed to the reduced rental gross margins. Cost of product sales includes the costs of new video and used video game merchandise taken in on trade for the Game Crazy operating segment, new movies, concessions and other goods sold. New movies and new game merchandise typically have a much lower margin than used game merchandise and concessions. The gross margin on product sales is subject to fluctuations in the relative mix of the products that are sold. The gross margin on product sales for the thirteen weeks and thirty-nine weeks ended October 2, 2005 was 29.5%, compared to 37.1% and 33.4% for the comparable quarter and year-to-date periods of 2004. The decrease in product sales margin was primarily caused by the higher penetration of new movies and new game merchandise sales. The acquisition of the Game Crazy operating segment acquired with Hollywood will continue to increase the percent to total revenue of new game merchandise sales versus comparable periods last year. Operating Costs and Expenses. Store operating expenses include store-level expenses such as lease payments, in-store payroll, utilities, repair and maintenance costs and start-up costs associated with new store openings. Store operating expenses as a percentage of total revenue was 55.9% and 52.7% for the thirteen weeks and thirty-nine weeks ended October 2, 2005, respectively, in comparison to 51.6% and 49.4% for the comparable periods in 2004. Store operating expense increased 226.6% for the third quarter and 140.0% for the year-to-date period versus comparable periods. The acquisition of Hollywood is the primary reason for the increase in total store operating expenses, however the Hollywood stores generally have lower operating expense as a percentage of revenue than do the Movie Gallery stores. The Movie Gallery operating segment store operating expenses as a percentage of total revenue was 58.7% and 53.3% for the thirteen weeks and thirty-nine weeks ended October 2, 2005, respectively, in comparison to 51.6% and 49.4% for the comparable periods in 2004. For the Movie Gallery operating segment, the increases in operating expense as a percentage of revenue are attributable to higher total spending based on a 14.5% increase in year-over-year store counts, and declines in same-store revenues. For the thirteen weeks ended October 2, 2005, store operating expenses were higher due to market increases in rent expense, higher salaries and wages, higher depreciation related to lease accounting changes made in the fourth quarter of 2004 as disclosed in Movie Gallery's Annual Report on Form 10-K for the fiscal year ended January 2, 2005, and increased store closure related write-offs. A charge of $0.4 million was recorded in the third quarter to account for three stores destroyed by Hurricane Katrina. These increases were partially offset by reductions in the cost of store supplies. For the thirty-nine weeks ended October 2, 2005, store operating expenses as a percentage of revenues were higher due to the increase in year-over-year store counts, market increases in rent expense, higher depreciation related to lease accounting changes made in the fourth quarter of 2004 as disclosed in Movie Gallery's Annual Report on Form 10-K for the fiscal year ended January 2, 2005, increased repair and maintenance expense, higher store closure and hurricane damage related write-offs. Marketing expense increased due to a reduction in the amount of vendor rebates versus the prior year allowed to be offset against marketing expense and which will be offset against the cost of rental revenue in accordance with our rental inventory amortization policy. These increases were partially offset by a decrease in salaries and wages due to reductions in store hours and a reduction in supplies expense. For the Hollywood operating segment, a change in estimate was recorded in the thirteen weeks ended October 2, 2005, to conform the lives of Hollywood's long lived assets to Movie Gallery's policy and to record the increase in depreciation expense generated by recording Hollywood's long lived assets at their increased fair value in the business combination accounting. A charge of $7.1 million in depreciation expense was recorded in the thirteen weeks ended October 2, 2005, of which $2.7 million related to the ten weeks ended July 3, 2005. These changes will continue to increase depreciation expense in future periods. General and Administrative Expenses. General and administrative expenses include the costs to maintain our corporate support centers as well as the overhead costs of our field management team. General and administrative expenses as a percentage of total revenue were 6.9% and 7.0% for the thirteen weeks and thirty-nine weeks ended October 2, 2005, respectively, in comparison to 7.6% and 7.2% for the comparable periods in 2004. General and administrative expenses increased 174.3% for the third quarter and 119.5% for the year-to-date period primarily as the result of the acquisition of Hollywood. General and administrative expenses as a percentage of total revenue has decreased versus comparable periods last year due to the addition of the Hollywood revenue and reductions in duplicate general and administrative functions. General and administrative expenses for the thirty-nine week period include $1.5 million in transaction bonuses paid to certain employees who were instrumental in completing the Hollywood merger. Excluding transaction bonuses, general and administrative expense as a percentage of revenue would have been 6.9% for the thirty-nine weeks ended October 2, 2005. We have presented general and administrative expense as a percentage of revenues adjusted to exclude transaction bonuses related to the Hollywood merger because we believe it provides our investors a more accurate view of the current period operating results, and our management uses this information to analyze our results from continuing operations and to view trends and changes in these results. Stock Compensation Expense. Stock compensation expense represents the non-cash charge associated with non-vested stock grants. Time based stock grants are amortized over the vesting period. Performance based stock grants are accrued based on predicted achievement and the current stock price. The thirty-nine week period ended October 2, 2005 also includes the non-cash charge associated with certain stock options that were repriced during the first quarter of fiscal 2001 and accounted for as variable stock options. Operating Income. As a result of the impact of the above factors on revenues and expenses, operating income decreased by 69.1% and 44.6% for the third quarter and year-to-date period of 2005 to $5.0 million and $37.6 million, respectively. The reported operating income was reduced by $6.6 million and $18.0 million for the third quarter and year-to-date period of 2005, respectively, to conform Hollywood's extended viewing fees accounting process to Movie Gallery's accounting process after adjusting accrued revenue sharing on accrued extended viewing fees. Interest Expense, net. Net income for the thirteen and thirty-nine weeks ended October 2, 2005 includes $24.4 million and $41.4 million pre-tax, or $0.54 and $0.93 per diluted share in interest expense, respectively, related to the financing agreements used to fund the acquisitions of Hollywood and VHQ. Write-off of Bridge Financing. Reflects the write-off of $4.2 million, or $0.09 per diluted share of fees and expenses associated with the bridge commitment feature of the senior credit facility in the second quarter of 2005. The bridge facility was never used and therefore the associated fees did not qualify to be deferred and amortized. The fees were expensed in the third quarter. Equity in Losses of Unconsolidated Entities. During the last half of 2003, Movie Gallery began to make investments in various alternative delivery vehicles (both retail and digital) for movie content. We do not anticipate that any of these alternatives will replace our base video rental business. However, we do believe it is appropriate to make selective investments in synergistic opportunities that could potentially provide ancillary sources of revenue and profitability to our base rental business. As of October 2, 2005, the company has completely written off the equity in unconsolidated entities. In the future, we may make additional investments in existing or new unconsolidated entities that may require adjustments. The expenses associated with our investments in alternative delivery vehicles are reflected as equity in losses of unconsolidated entities on our statements of income. Income Taxes. The effective tax rate was a benefit of 35.7% and 29.5% for the thirteen and thirty-nine weeks ended October 2, 2005, respectively, as compared to a provision of 39.0% for both of the corresponding prior year periods. The decrease in the effective rate is a result of several factors including a decrease in book income and limitations on the recognition of the tax benefit of a loss. It is anticipated that the effective rate should be more reflective of historical effective tax rates in the future tax periods. Liquidity and Capital Resources Our primary capital needs are for debt service, opening and acquiring new stores and for purchasing inventory. Other capital needs include refurbishing, remodeling and relocating existing stores and refreshing, re-branding and supplying new computer hardware for acquired stores. We fund our capital needs primarily by cash flow from operations and, as necessary, loans under our new senior secured credit facility ("Credit Facility"). At October 2, 2005, we had cash and cash equivalents of $68.8 million and $46.9 million in available borrowings under our Credit Facility. Although there can be no assurances, we believe that cash flow available from operations and availability under the $75.0 million revolving portion of the Credit Facility (the "Revolver") will be sufficient to operate our business, satisfy our working capital and capital expenditure requirements, and meet our foreseeable liquidity requirements, including debt service on our $325.0 million principal amount, 11% senior notes due 2012 (the "Senior Notes") and the Credit Facility. The Credit Facility and Indenture governing our 11% notes impose certain restrictions on us, including restrictions on our ability to: incur debt; grant liens; provide guarantees in respect of obligations of any other person; pay dividends; make loans and investments; sell our assets; make redemptions and repurchases of capital stock; make capital expenditures; prepay, redeem or repurchase debt; engage in mergers or consolidations; engage in sale/leaseback transactions and affiliate transactions; change our business; amend certain debt and other material agreements; issue and sell capital stock of subsidiaries; and make distributions from subsidiaries. The Credit Facility also requires us to meet certain financial covenants including a leverage ratio test, a fixed charge coverage ratio test and an interest coverage test. Each of these covenants is calculated on trailing four quarter results based on specific definitions that are contained in the credit agreement. In general terms, the leverage ratio is a measurement of total net indebtedness relative to operating cash flow. The fixed charge coverage ratio is a measurement of operating cash flow plus rent relative to total fixed charges including rent, scheduled principal payments, and cash interest. The interest coverage ratio is a measurement of operating cash flow relative to interest expense. On September 21, 2005, the Company executed an amendment to the Credit Facility that relaxed certain financial covenants for a one-year period, provided for an additional $50.0 million of borrowings under the Term Loan B tranche, and increased the letter of credit sub-limit under the revolving credit facility from $30.0 million to $40.0 million. The instruments governing any future indebtedness may impose similar or other restrictions and may require us to meet similar or other financial ratios and tests. Our ability to comply with covenants contained in the instruments governing our existing and future indebtedness may be affected by events and circumstances beyond our control. If we breach any of these covenants, one or more events of default, including cross-defaults between multiple components of our indebtedness, could result. These events of default could permit our creditors to declare all amounts owing to be immediately due and payable, and to terminate any commitments to make further extensions of credit. If we were unable to repay indebtedness owed to our secured creditors, they could proceed against the collateral securing the indebtedness owed to them. Contractual Obligations. The following table discloses our contractual obligations and commercial commitments as of October 2, 2005. The operating lease information presented is as of January 2, 2005, however, these amounts are believed to approximate the obligations as of October 2, 2005 (in thousands): Contractual 2-3 4-5 More than Obligations Total 1 Year Years Years 5 Years --------------- ---------- -------- -------- -------- ---------- Term Loan A $ 90,250 $ 19,000 $ 38,000 $ 33,250 $ - Term Loan B 748,125 7,500 15,000 191,250 534,375 Senior Notes 325,450 - - - 325,450 VHQ debt 95 95 - - - Interest Term Loan A (1) 15,720 5,810 7,637 2,273 - Interest Term Loan B (1) 281,733 53,961 106,292 104,120 17,360 Interest on Hedge Agreement 2,744 1,568 1,176 - - Interest payment on Senior Notes 235,639 35,793 71,587 71,587 56,672 Capital leases 852 650 202 - - Interest payment on capital leases 31 28 3 - - Revolver borrowings 9,046 - - 9,046 - Operating leases 1,678,195 268,983 687,944 369,158 352,110 ---------- -------- -------- -------- ---------- Total $3,387,880 $393,388 $927,841 $780,684 $1,285,967 ---------- -------- -------- -------- ---------- (1)Interest rates based on current Libor rates plus margin. As of October 2, 2005, the Term Loan A and Term Loan B rates are 6.99% and 7.24%, respectively. Thirty-Nine Weeks Ended ------------------------ October 3, October 2, 2004 2005 ---------- ---------- ($ in thousands) Statements of Cash Flow Data: Net cash provided by operating activities $ 60,696 $ 65,309 Net cash used in investing activities (55,383) (1,157,446) Net cash (used in) provided by financing activities (24,664) 1,134,330 The increase in net cash provided by operating activities was primarily attributable to increases in rental amortization, accrued liabilities, depreciation and amortization and extended viewing fees offset by lower net income and increased uses of cash for purchases of rental inventory, accounts payable and deferred income taxes for the first three quarters of 2005 versus the comparable periods in 2004. Net cash used in investing activities includes the costs of business acquisitions, new store builds and investment in base stock rental inventory. The increase in cash used in investing activities was primarily due to the acquisitions of Hollywood and VHQ which amounted to $1.1 billion in the aggregate, versus much smaller acquisitions during the first three quarters of 2004. Net cash flow related to financing activities for the thirty-nine weeks ended October 2, 2005 includes the proceeds from the Credit Facility and the issuance of the Senior Notes. The Credit Facility is in an aggregate amount of $913.4 million, consisting of a five-year, $75.0 million revolving credit facility ("Revolver") currently bearing floating rate interest of London Interbank Offered Rate ("LIBOR") plus 3.50%, and two term loan facilities in an aggregate principal amount of $845.0 million. The Term Loan A is a $95.0 million, five- year facility currently bearing floating rate interest of LIBOR plus 3.50%. Term Loan B is a $750.0 million, six-year facility currently bearing floating rate interest of LIBOR plus 3.75%. The Term Loan A and Term Loan B require aggregate quarterly prepayments in the amounts of 5% and 0.25%, respectively, of the outstanding balances beginning September 30, 2005 through the first fiscal quarter of 2010, after which the mandatory Term Loan B prepayments escalate. This new financing source is compared to a use of cash towards our $25 million stock buyback program that was completed in the second quarter of 2004 with the Company repurchasing 1,336,312 shares of common stock at an average price of $18.71 per share. As required by the Credit Facility, we have entered into a two-year floating- to-fixed interest rate swap with Wachovia and Merrill Lynch for an amount of $280.0 million. Under the terms of the swap agreement, we pay fixed interest on the $280.0 million at a rate of 4.06% and receive floating interest based on three-month LIBOR. The termination date for the swap is June 29, 2007. In June 2004, our board of directors declared a quarterly cash dividend of $0.03 per share be paid under our dividend policy instituted in December 2003. On September 26, 2005, we announced that our board of directors would not declare a quarterly cash dividend for the third quarter of 2005 due to the challenging conditions currently affecting the home video industry. The payment of future dividends is subject to the discretion of our board of directors. Future dividends may be increased, decreased or suspended from time to time based on a number of factors, including changes in tax laws related to dividends, our financial condition, capital requirements, future business prospects, the restrictive covenants governing our indebtedness and any other factors that our board of directors considers relevant. At October 2, 2005, we had a working capital deficit of $92.5 million, due to the accounting treatment of rental inventory. Rental inventory is treated as a noncurrent asset under accounting principles generally accepted in the United States because it is a depreciable asset and a portion of this asset is not reasonably expected to be completely realized in cash or sold in the normal business cycle. Although the rental of this inventory generates the major portion of our revenue, the classification of this asset as noncurrent results in its exclusion from working capital. The aggregate amount payable for this inventory, however, is reported as a current liability until paid and, accordingly, is reflected as a reduction in working capital. Consequently, we believe that working capital is not an appropriate measure of our liquidity and we anticipate that we will continue to operate with a working capital deficit. We grow our store base through both internally developed and acquired stores. We opened 234 internally developed stores, acquired 2,138 stores which include the acquisitions of Hollywood and VHQ and closed 69 stores during the year-to-date period ended October 2, 2005. We plan on opening another 42 internally developed stores during the last quarter of 2005. We will continue to evaluate acquisition opportunities in 2005 as they arise although we anticipate the majority of our future growth will most likely occur through new store development. To the extent available, new stores and future acquisitions may be completed using cash on-hand, funds available under our credit facility, financing provided by sellers or alternative financing arrangements such as funds raised in public or private debt or equity offerings. However, we cannot assure you that financing will be available to us on terms which will be acceptable, if at all. We believe our projected cash flow from operations, cash on hand, borrowing capacity under our credit facility and trade credit will provide the necessary capital to service our debt and fund our current plan of operations, including our anticipated new store openings and acquisition program, through fiscal 2005. Capital requirements to fund new store growth for fiscal 2005, including the new store build-out costs and our rental and merchandise inventory investment are estimated at $55 million. Additionally in fiscal 2005, we estimate $35 million in other on-going capital expenditure requirements for the existing store base. However, to fund a major acquisition, or to provide funds in the event that our need for funds is greater than expected, or if the financing sources identified above are not available to the extent anticipated or if we increase our growth plan, we may need to seek additional or alternative sources of financing. This financing may not be available on satisfactory terms. Failure to obtain financing to fund our expansion plans or for other purposes could have a material adverse effect on our operating results. Our ability to fund our current plan of operations and our growth plan will depend upon our future performance, which is subject to general economic, financial, competitive and other factors that are beyond our control. We cannot assure you that our business will continue to generate sufficient cash flow from operations in the future to fund capital resource needs, cover the ongoing costs of operating the business and service our current level of indebtedness or any debt we may incur in the future. If we are unable to satisfy these requirements with cash flow from operations and cash on hand, we may be required to sell assets or to obtain additional financing. We cannot assure you that any such sales of assets or additional financing could be obtained. Critical Accounting Policies and Estimates Our significant accounting policies are described in Note 1 to the consolidated financial statements of Movie Gallery as filed in our Annual Report on Form 10- K for the fiscal year ended January 2, 2005. Our discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of the financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate the estimates that we have made. These estimates have been based upon historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different conditions or using different assumptions. We believe our most critical accounting estimates include our policies with respect to rental inventory amortization, impairment of long-lived assets, purchase price allocation of acquired businesses and deferred income taxes. A major component of our cost structure is the amortization of our rental inventory. Rental inventory is amortized to an estimated residual value over an estimated useful life of up to two years. We amortize the cost of rental inventory using an accelerated method designed to approximate the rate of revenue recognition. This method is based on historical customer demand patterns from "street date" (the date studios release various titles for distribution to our stores) through the end of the average useful life. In order to determine the appropriate useful lives and residual values, we analyzed the actual historical performance trends of our rental inventory. We quantified the average rate of revenue recognition on our products and developed amortization rates and useful lives that approximate the rental turns of our inventory. Our established residual values are based on an evaluation of the sale prices we are able to realize from our customers on used inventory, prices observed in bulk sale transactions and prices observed in other open market purchases of used inventory, as well as the residual values established by competitors in our industry. Effective April 4, 2005, we changed our estimated residual value on VHS movies from $2.00 to $1.00 due to continued declines in the market value of VHS product. We believe our updated estimated useful lives and residual values are appropriately matched to our current rental business and are consistent with industry trends. However, should rental patterns of consumers change or should market values of previously viewed inventory continue to decline due to the acceptance of new formats (e.g., ongoing VHS transition to DVD, anticipated transition to high definition DVD within one to three years, release of new video game formats, etc.), this could necessitate an acceleration in our current rental amortization rates, a reduction in residual values or a combination of both courses of action. We believe that any acceleration in the rental amortization rates would not have a long-lasting impact as the majority of our current rental purchases are substantially depreciated within the first two to three months after "street date" under our existing policy. In the past we have generally been able to anticipate the rate of transition from one format to another and manage our purchases, as well as inventory mix, to avoid significant losses on the ultimate disposition of previously viewed movies. However, we cannot assure you that we will be able to fully anticipate the impact of continued transition to DVD or any other formats in the future and we could incur losses on sales of previously viewed movies in the future. As of January 2, 2005 and October 2, 2005, we had $126.5 million and $342.2 million, respectively, in rental inventory on our balance sheet. As of October 2, 2005, the net book value of our VHS rental inventory is approximately 8.5% of the net book value of our total rental inventory. We assess the fair value and recoverability of our long-lived assets, including property, furnishings and equipment and intangible assets with finite lives, whenever events and circumstances indicate the carrying value of an asset may not be recoverable from estimated future cash flows expected to result from its use and eventual disposition. In doing so, we make assumptions and estimates regarding future cash flows and other factors in order to make our determination. The fair value of our long-lived assets is dependent upon the forecasted performance of our business, changes in the video retail industry and the overall economic environment. When we determine that the carrying value of our long-lived assets may not be recoverable, we measure any impairment based upon the excess of the carrying value over the estimated fair value of the assets. If we do not meet our operating forecasts, we may have to record impairment charges not previously recognized. We test goodwill for impairment on an annual basis. Additionally, goodwill is tested for impairment between annual tests if an event occurs or circumstances change that indicate the fair value of a reporting unit is below its carrying value. With the acquisition of Hollywood, the reporting units for Movie Gallery are as follows: Movie Gallery, Hollywood Video and Game Crazy. These events or circumstances would include a significant change in the business climate, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business or other factors. We have not recorded any impairment losses on goodwill since a fiscal 2001 impairment charge of $700,000. If we do not meet our operating forecasts we may have to record additional impairment charges not previously recognized. As of October 2, 2005, we have $625.9 million in goodwill on our balance sheet of which the Hollywood acquisition accounts for $463.7 million. We estimate the fair value of assets and liabilities of acquired businesses based on historical experience and available information at the acquisition date. We engage independent valuation specialists to assist when necessary. If information becomes available subsequent to the acquisition date that would materially impact the valuation of assets acquired or liabilities assumed in business combinations, we may be required to adjust the purchase price allocation. With the exception of the Video Update acquisition in 2001 and the Hollywood acquisition, we have not experienced any significant adjustments to the valuation of assets or liabilities acquired in business combinations in the last seven years. Prior to the Hollywood acquisition our acquisitions have typically been small businesses for which we generally do not assume liabilities and for which the assets acquired consist primarily of inventory, fixtures, equipment and intangibles. We treated the acquisition of Hollywood as a purchase business combination for accounting purposes, and as such, Hollywood's assets acquired and liabilities assumed have been recorded at their fair value as determined based on a preliminary valuation report performed by an independent valuation specialist. The purchase price for the acquisition, including transaction costs, has been allocated to the assets acquired and liabilities assumed based on estimated fair values at the date of acquisition, April 27, 2005. The purchase price allocation is preliminary and we expect further adjustments. We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based upon historical losses, projected future taxable income and the expected timing of the reversals of existing temporary differences. As a result of this review, we have established a valuation allowance against our deferred tax assets related to net operating loss carry forwards that we acquired in the 2001 acquisition of Video Update. In forming our conclusion about the future recoverability of the net operating losses from our 2001 acquisition of Video Update, we considered, among other things, the applicable provisions of the federal income tax code, which limit the deductibility of net operating loss carry forwards to the post-acquisition taxable income (cumulative basis) of the acquired subsidiary on a separate return basis, as well as other limitations that may apply to the future deductibility of these net operating losses. We also considered the availability of reversing taxable temporary differences during the carry forward period, the length of the available carry forward period, recent operating results, our expectations of future taxable income during the carry forward period, changes in tax law, Internal Revenue Service (IRS) interpretive guidance and judicial rulings. If facts and circumstances in the future should warrant elimination or reduction of the valuation allowance related to these net operating losses, our effective income tax rate, which was 40%, 39% and 39% for fiscal 2002, 2003 and 2004, respectively, could be reduced. Federal tax laws impose restrictions on the utilization of net operating loss carry forwards and tax credit carry forwards in the event of an "ownership change," as defined by the federal income tax code. Such an ownership change occurred on April 27, 2005 concurrent with our acquisition of Hollywood. Our ability to utilize our net operating loss carry forwards and tax credit carry forwards is subject to restrictions pursuant to these provisions. Utilization of the federal net operating loss and tax credits will be limited annually and any unused limitation in a given year may be carried forward to the next year. The annual limitation on utilization of the net operating loss carry forwards is currently being determined. If we determine it is more likely than not that we will not fully realize all net operating loss carry forwards and tax credit carry forwards a valuation allowance may be necessary. As part of our accounting for business combinations, some of the purchase price is allocated to goodwill and intangible assets. Future impairment charges associated with goodwill will not be tax deductible and will result in an increased income tax expense in the quarter the impairment is recorded. Amortization expense associated with separately identified, finite-lived intangible assets is likewise not tax deductible, but the tax will be offset by deferred taxes created in purchase accounting, and therefore, will not affect our income tax expense. In the fourth quarter of 2003 Hollywood applied for a change in accounting method with the IRS to accelerate the deduction of store pre-opening supplies and the amortization of DVD and VHS movies and video games. Permission has been granted for the change in accounting method to accelerate the deduction of store pre-opening supplies. The application for the accelerated deduction of DVD and VHS movies and video games is under review by the IRS. Forward Looking Statements This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which represent our expectations or beliefs about future events and financial performance. Forward-looking statements are identifiable by the fact that they do not relate strictly to historical information and may include words such as "believe," "anticipate," "expect," "intend," "plan," "will," "may," "estimate" or other similar expressions and variations thereof. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Our forward-looking statements are based on management's current intent, belief, expectations, estimates and projections regarding our company and our industry. Forward- looking statements are subject to known and unknown risks and uncertainties, including those described in our Annual Report on Form 10-K for the fiscal year ended January 2, 2005. Forward-looking statements include statements regarding our ability to continue our expansion strategy, our ability to make projected capital expenditures and our ability to achieve cost savings in connection with our acquisition of Hollywood, as well as general market conditions, competition and pricing. Our forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially, including that: - we may not successfully integrate the operations of Hollywood into our operations and may be subjected to liabilities as a result of our acquisition of Hollywood; - our management information systems may fail to perform as expected; - we may fail to manage merchandise inventory effectively; - movie studios may alter their current movie distribution practices or revenue sharing programs; - advances in technologies may adversely affect our business; - customers may choose to purchase, rather than rent, movies in greater proportion than anticipated; - video game hardware and software manufacturers may fail to introduce new products in a timely manner; and - the other risks described in "Risk Factors" in our Annual Report on Form 10- K for the fiscal year ended January 2, 2005 and the Registration Statement Form S-4 filed on July 26, 2005. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this Form 10-Q might not occur. In addition, actual results could differ materially from those suggested by the forward-looking statements, and therefore you should not place undue reliance on the forward- looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. We desire to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and in that regard we caution the readers of this Form 10-Q that the important factors described in our Annual Report on Form 10-K for the fiscal year ended January 2, 2005, among others, could affect our actual results of operations and may cause changes in our strategy with the result that our operations and results may differ materially from those expressed in any forward-looking statements made by us, or on our behalf. Item 3. Quantitative and Qualitative Disclosures About Market Risk Market risk represents the risk of loss that may impact our financial position, operating results, or cash flows due to adverse changes in financial and commodity market prices and rates. We have entered into certain market-risk- sensitive financial instruments for other than trading purposes, principally short-term and long-term debt. The interest payable on the Credit Facility is based on variable interest rates equal to a specified Eurodollar rate or base rate and is therefore affected by changes in market interest rates. However, as required by the Credit Facility, we have entered into a two-year interest rate swap to exchange $280 million of the variable-rate Credit Facility debt for 4.06% fixed rate debt. If variable base rates were to increase 1%, our interest expense on an annual basis would increase by approximately $5.7 million on the non-hedged principal based on both the outstanding balance on the Credit Facility as of October 2, 2005 and the Credit Facility's mandatory principle payment schedule. We are exposed to foreign exchange risks associated with our Canadian and Mexican operations. Historically, Canadian exchange rates have been relatively stable, and we believe the impact of fluctuations in the currency exchange rates will be immaterial to our financial position and results of operations. Based on pro-forma fiscal 2004 results including VHQ, a hypothetical 10% change in the Canadian exchange rate would not have a significant effect on either our consolidated financial position or results of operations. Our Mexican operations are currently limited to six locations. Growth in Mexico in 2005 is not expected to be significant enough to result in a material impact from fluctuations in currency exchange rates. Item 4. Controls and Procedures Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act" )) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective. On April 27, 2005, the Company completed the acquisition of Hollywood, which the Company believes is material to its results of operations, financial position and cash flows. Management continues to assess the internal controls of Hollywood. Other than changes arising out of the Hollywood acquisition, including the transition of certain financial reporting functions from the Company's headquarters in Dothan, Alabama to Portland, Oregon, there has been no significant change in the Company's internal control over financial reporting during the most recent fiscal quarter that has materially affected, or are likely to materially affect, the Company's internal control over financial reporting. The Company does not expect that its disclosure controls and procedures will prevent all errors and all fraud. A system of controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the system are met. Because of the limitations in all such systems, no evaluation can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Furthermore, the design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how unlikely. Because of these inherent limitations in a cost-effective system of controls and procedures, misstatements or omissions due to error or fraud may occur and not be detected. Part II - Other Information Item 1. Legal Proceedings Certain of our subsidiaries have been named in various claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. We believe that we have provided adequate reserves for contingencies and that the outcome of these matters should not have a material future adverse effect on our consolidated results of operation, financial condition or liquidity. At October 2, 2005, the legal contingencies reserve was $8.9 million of which the acquisition of Hollywood added $8.5 million. At January 2, 2005, the legal contingencies reserve was $0.3 million. A negative outcome in certain of the ongoing actions could harm our business, financial condition, liquidity or results of operations. In addition, prolonged litigation, regardless of which party prevails, could be costly, divert management attention or result in increased costs of doing business. Item 6. Exhibits a) Exhibits 10.1 First Amendment, dated September 21, 2005 by and among Movie Gallery, Inc., Movie Gallery Canada, Inc., Wachovia Bank, N.A., and Congress Financial Corporation (Canada), to the Credit Agreement dated April 27, 2005. (Incorporated by Reference from the Registrant's Current Report on Form 8-K, dated September 21, 2005) 10.2 Second Amendment to the Movie Gallery, Inc. 2003 Stock Plan (Incorporated by Reference from the Registrant's Current Report on Form 8-K/A, dated June 9, 2005) 10.3 Form of Employee Restricted Stock Purchase Agreement (service- based vesting for employees)(Incorporated by Reference from the Registrant's Current Report on Form 8-K, dated June 9, 2005) 10.4 Form of Non-Employee Director Restricted Stock Purchase Agreement (for non-employee directors)(Incorporated by Reference from the Registrant's Current Report on Form 8-K, dated June 9, 2005) 10.5 Form of Employee Restricted Stock Purchase Agreement (one-year performance based on vesting for employees)(Incorporated by Reference from the Registrant's Current Report on Form 8-K, dated June 9, 2005) 10.6 Form of Employee Restricted Stock Purchase Agreement (two-year performance based vesting for employees)(Incorporated by Reference from the Registrant's Current Report on Form 8-K, dated June 9, 2005) 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a- 14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a- 14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Movie Gallery, Inc. ------------------- (Registrant) Date: November 11, 2005 /s/ Timothy R. Price ---------------------------- Timothy R. Price, Executive Vice President and Chief Financial Officer