MOVIE GALLERY, INC.

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 8-K/A

CURRENT REPORT

Pursuant to Section 13 OR 15(d) of
The Securities Exchange Act of 1934

Date of Report (Date of earliest event reported) April 27, 2005

MOVIE GALLERY, INC.

(Exact name of registrant as specified in its charter)


Delaware (State or Other Jurisdiction of Incorporation)		0-24548 (Commission File Number)		63-1120122 (IRS Employer Identification No.)


900 West Main Street
Dothan, Alabama		36301
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code
(334) 677-2108

(Former name or former address, if changed since last report)

Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the registrant under any of the following provisions:

¨ Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425)

¨ Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12)

¨ Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b))

¨ Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))

TABLE OF CONTENTS


Item 2.01. Completion of Acquisition or Disposition of Assets
Item 9.01. Financial Statements and Exhibits
SIGNATURES
EX-23.1 CONSENT OF PRICEWATERHOUSECOOPERS LLP

Item 2.01. Completion of Acquisition or Disposition of Assets.

As previously reported in our Current Report on Form 8-K dated April 27, 2005 and filed April 29, 2005, on April 27, 2005, we acquired Hollywood Entertainment Corporation in a merger transaction. The disclosures set forth under Items 1.01, 2.01 and 2.03 of such Form 8-K are hereby incorporated by reference into this Item 2.01 of this amended report. The required historical financial statements and pro forma financial information is contained herein under Item 9.01 of this report.

Item 9.01. Financial Statements and Exhibits.

(a) Financial Statements of Business Acquired.

The historical financial statements of Hollywood Entertainment Corporation are included in this report beginning at page F-1.

(b) Pro-Forma Financial Information.

Pro forma financial information is included in this report beginning at page F-65.

23.1 Consent of PricewaterhouseCoopers LLP

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 hereunto duly authorized.


	MOVIE GALLERY, INC.

Date: July 11, 2005

	BY:	/s/ Timothy R. Price

		Timothy R. Price
		Executive Vice President and
		Chief Financial Officer

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of
Hollywood Entertainment Corporation:

We have completed an integrated audit of Hollywood Entertainment Corporation’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements

In our opinion, the consolidated balance sheets and the related consolidated statements of operations, of shareholders’ equity and of cash flows present fairly, in all material respects, the financial position of Hollywood Entertainment Corporation and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 3 to the consolidated financial statements, the 2003 and 2002 financial statements have been restated to correct errors in accounting for leases.

Internal control over financial reporting

Also, we have audited management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing on page F-45, of this Current Report on Form 8-K/A, that Hollywood Entertainment Corporation did not maintain effective internal control over financial reporting as of December 31, 2004, because the Company did not maintain effective controls over the selection, application and monitoring of its accounting policies related to leasing transactions, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

F- 2

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment. As of December 31, 2004, the Company did not maintain effective controls over the selection, application and monitoring of its accounting policies related to leasing transactions. Specifically, the Company’s controls over its selection, application and monitoring of its accounting policies related to the effect of lessee involvement in asset construction, lease incentives, rent holidays and leasehold amortization periods were ineffective to ensure that such transactions were accounted for in conformity with generally accepted accounting principles. This control deficiency resulted in the restatement of the Company’s annual and interim consolidated financial statements for 2003 and 2002 and for the first, second and third quarters of 2004 as well as an audit adjustment to the fourth quarter 2004 financial statements. Additionally, this control deficiency could result in a misstatement of prepaid rent, leasehold improvements, deferred rent, rent expense and depreciation expense that would result in a material misstatement to annual or interim financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency constitutes a material weakness. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2004 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.

In our opinion, management’s assessment that Hollywood Entertainment Corporation did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the COSO. Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Hollywood Entertainment Corporation has not maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the COSO.

PricewaterhouseCoopers LLP

Portland, Oregon
March 17, 2005

F- 3

HOLLYWOOD ENTERTAINMENT CORPORATION

CONSOLIDATED BALANCE SHEETS


				December 31,
	December 31,			2003
	2004			(Restated)
	(In thousands,
	except share amounts)
ASSETS
Current assets:
Cash and cash equivalents	$	46,160		$	48,057
Marketable securities		147,600			26,076

Total Cash, cash equivalents, and marketable securities		193,760			74,133
Receivables, net		37,922			33,987
Merchandise inventories		148,154			129,864
Prepaid expenses and other current assets		22,835			13,233

Total current assets		402,671			251,217
Rental inventory, net		289,144			268,748
Property and equipment, net		227,824			243,413
Goodwill		69,465			68,406
Deferred income tax asset, net		87,980			122,598
Prepaid rent		27,194			34,019
Other assets		15,249			17,654

	$	1,119,527		$	1,006,055

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term obligations	$	555		$	647
Current maturities of financing obligations		15,581			3,245
Accounts payable		174,427			159,586
Accrued expenses		150,436			117,867
Accrued interest		6,445			6,489
Income taxes payable		3,404			284

Total current liabilities		350,848			288,118
Long-term obligations, less current portion		350,701			370,669
Deferred rent		44,346			50,056

		745,895			708,843
Commitments and contingencies (Note 21)
Shareholders’ equity:
Preferred stock, 25,000,000 shares authorized; no shares issued and outstanding		—			—
Common stock, 100,000,000 shares authorized; 60,970,105 and 59,666,347 shares issued and outstanding, respectively		494,246			489,247
Unearned compensation		—			(133	)
Accumulated deficit		(120,614	)		(191,902	)

Total shareholders’ equity		373,632			297,212

	$	1,119,527		$	1,006,055

See notes to Consolidated Financial Statements

F- 4

HOLLYWOOD ENTERTAINMENT CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS


	Twelve Months Ended December 31,
				2003			2002
	2004			(Restated)			(Restated)
	(In thousands,
	except per share amounts)
REVENUE:
Rental product revenue	$	1,388,298		$	1,386,590		$	1,324,017
Merchandise sales		394,066			295,958			166,049

		1,782,364			1,682,548			1,490,066

COST OF REVENUE:
Cost of rental product		417,588			441,034			447,278
Cost of merchandise		299,074			223,598			126,251

		716,662			664,632			573,529

GROSS PROFIT		1,065,702			1,017,916			916,537
Operating costs and expenses:
Operating and selling		793,317			727,024			647,483
General and administrative		123,946			106,024			89,602
Store opening expenses		2,141			4,768			3,093
Restructuring charge for closure of internet business		—			—			(12,430	)
Restructuring charge for store closures		(190	)		(2,106	)		(828	)

		919,214			835,710			726,920

INCOME FROM OPERATIONS		146,488			182,206			189,617
Non-operating expense:
Interest expense, net		(29,993	)		(35,507	)		(42,057	)
Early debt retirement		—			(12,467	)		(3,534	)

Income before income taxes		116,495			134,232			144,026
Benefit (provision) for income taxes		(45,207	)		(54,162	)		115,719

NET INCOME	$	71,288		$	80,070		$	259,745

Net income per share:
Basic	$	1.18		$	1.32		$	4.54
Diluted		1.14			1.25			4.16
Weighted average shares outstanding:
Basic		60,496			60,439			57,202
Diluted		62,765			64,162			62,390

See notes to Consolidated Financial Statements.

F- 5

HOLLYWOOD ENTERTAINMENT CORPORATION

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY (DEFICIT)


	Common Stock						Unearned			Accumulated
	Shares			Amount			Compensation			Deficit			Total
	(In thousands, except share amounts)
Balance at December 31, 2001 as previously reported		49,428,763		$	375,503		$	(1,655	)	$	(487,402	)	$	(113,554	)

Restatement of prior periods (see note 3)		—			—			—			(44,315	)		(44,315	)

Balance at December 31, 2001 as Restated		49,428,763			375,503			(1,655	)		(531,717	)		(157,869	)

Issuance of common stock:
Stock issuance		8,050,000			120,750			—			—			120,750
Equity offering costs		—			(7,677	)		—			—			(7,677	)
Stock options exercised		2,317,810			4,604			—			—			4,604
Stock option tax benefit		—			12,814			—			—			12,814
Stock compensation		—			(2,591	)		958			—			(1,633	)
Net income Restated		—			—			—			259,745			259,745

Balance at December 31, 2002 Restated		59,796,573			503,403			(697	)		(271,972	)		230,734

Issuance of common stock:
Stock options exercised		1,615,947			4,066			—			—			4,066
Stock option tax benefit		—			8,053			—			—			8,053
Stock compensation		—			—			564			—			564
Repurchase of common stock		(1,746,173	)		(26,275	)		—			—			(26,275	)
Net income Restated		—			—			—			80,070			80,070

Balance at December 31, 2003 Restated		59,666,347		$	489,247		$	(133	)	$	(191,902	)	$	297,212

Issuance of common stock:
Stock options exercised		1,598,897			2,419			—			—			2,419
Stock option tax benefit		—			6,245			—			—			6,245
Stock compensation		—			—			133			—			133
Repurchase of common stock		(295,139	)		(3,665	)		—			—			(3,665	)
Net income		—			—			—			71,288			71,288

Balance at December 31, 2004		60,970,105		$	494,246		$	—		$	(120,614	)	$	373,632

See notes to Consolidated Financial Statements.

F- 6

HOLLYWOOD ENTERTAINMENT CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS


	Year Ended December 31,
				2003			2002
	2004			(Restated)			(Restated)
	(In thousands)
Operating activities:
Net income	$	71,288		$	80,070		$	259,745
Adjustments to reconcile net income to cash provided by operating activities:
Write-off deferred financing costs		—			5,827			2,226
Amortization of rental product		186,847			211,806			218,905
Depreciation		59,971			61,129			57,057
Amortization of prepaid rent		8,654			8,525			8,416
Impairment of long-lived assets		18,182			—			—
Amortization of deferred financing costs		2,937			4,481			3,785
Tax benefit from exercise of stock options		6,245			8,053			12,814
Change in deferred rent		(5,709	)		(6,612	)		(7,297	)
Change in deferred taxes		34,618			42,826			(127,027	)
Non-cash stock compensation		133			564			(1,633	)
Net change in operating assets and liabilities:
Receivables		(3,935	)		1,010			(5,940	)
Merchandise inventories		(18,291	)		(32,557	)		(35,722	)
Accounts payable		14,841			1,163			(9,056	)
Accrued interest		(44	)		3,512			(3,249	)
Other current assets and liabilities		24,988			1,658			(11,479	)

Cash provided by operating activities		400,725			391,455			361,545

Investing activities:
Purchases of rental inventory, net		(207,243	)		(220,364	)		(288,079	)
Purchase of property and equipment, net		(59,574	)		(89,081	)		(38,876	)
Purchases of marketable securities		(390,685	)		(211,283	)		—
Sales of marketable securities		269,161			185,207			—
Increase in intangibles and other assets		(5,310	)		(7,292	)		(3,268	)
Proceeds from indenture trustee		—			218,531			(218,531	)

Cash used in investing activities		(393,651	)		(124,282	)		(548,754	)

Financing activities:
Proceeds from issuance of common stock		—			—			120,750
Equity financing costs		—			—			(7,677	)
Issuance of subordinated debt		—			—			225,000
Repayment of subordinated debt		—			(250,000	)		—
Borrowings under term loan		—			200,000			150,000
Repayment of revolving loan		—			(107,500	)		(240,000	)
Decrease in credit facilities		(20,000	)		(55,000	)		(42,500	)
Debt financing costs		—			(7,453	)		(11,966	)
Repayments of capital lease obligations		(590	)		(10,291	)		(13,816	)
Repurchase of common stock		(3,665	)		(26,275	)		—
Proceeds from capital lease obligation		529			1,422			—
Increase (decrease) in financing obligations		12,336			(1,230	)		(2,851	)
Proceeds from exercise of stock options		2,419			4,066			4,604

Cash (used in) provided by financing activities		(8,971	)		(252,261	)		181,544

Increase (decrease) in cash and cash equivalents		(1,897	)		14,912			(5,665	)
Cash and cash equivalents at beginning of year		48,057			33,145			38,810

Cash and cash equivalents at end of year	$	46,160		$	48,057		$	33,145

Other cash flow information:
Interest expense paid	$	27,147		$	36,381		$	41,415
Income taxes paid, net		1,224			4,157			2,613

See notes to Consolidated Financial Statements

F- 7

HOLLYWOOD ENTERTAINMENT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003, 2002

1. Significant Accounting Policies

Corporate Organization and Consolidation

The accompanying financial statements include the accounts of Hollywood Entertainment Corporation and its wholly owned subsidiaries (the “Company”). The Company’s only subsidiary during 2004, 2003 and 2002 was Hollywood Management Company.

Nature of the Business

The Company operates a chain of video stores (“Hollywood Video”) throughout the United States. The Company was incorporated in Oregon on June 2, 1988 and opened its first store in October 1988. As of December 31, 2004, 2003 and 2002, the Company operated 2,006 stores in 47 states, 1,920 stores in 47 states and 1,831 stores in 47 states, respectively. As of December 31, 2004, 695 Hollywood Video stores included an in-store game department (“Game Crazy”) where game enthusiasts can buy, sell and trade new and used video game hardware, software and accessories. A typical Game Crazy department carries over 2,500 video game titles and occupies an area of approximately 700 to 900 square feet within the store.

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates relative to the Company include revenue recognition, merchandise inventory valuation, amortization of rental inventory, impairment of long-lived assets and goodwill, income taxes, lease accounting and legal contingencies.

Restatement of Prior Year Amounts

The Company recently reviewed its accounting practices with respect to store operating leases and concluded that it needed to correct certain technical errors in its accounting for leases and restate prior periods. See note 3 for a discussion of the accounting changes and their impact to the financial statements.

Reclassification of Prior Year Amounts

In addition to the restatement of prior year amounts noted above and discussed in Note 3, certain prior year amounts have been reclassified to conform to the presentation used for the current year. These reclassifications had no impact on previously reported net income or shareholders’ equity.

Revision of Classification

The Company recently reviewed its accounting practices with respect to balance sheet classification of marketable securities. As a result, the Company determined it was inappropriate to classify its marketable securities as cash equivalents as stated in SFAS 95. See Note 1.

F- 8

Recently Issued Accounting Standards

In December 2004, the FASB issued Statements of Financial Accounting Standards No. 123R (SFAS 123R), “Share-Based Payment,” which replaces SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim or annual period after June 15, 2005. Pro forma disclosure is no longer an alternative. See Note 19 for the impact on Net Income. SFAS 123R is effective for the Company beginning July 1, 2005. The Company is in the process of evaluating the effect of SFAS 123R on the Company’s overall results of operations, financial position and cash flows.

Rental Revenue and Merchandise

The Company recognizes revenue upon the rental and sale of its products. Revenue for extended rental periods (when the customer chooses to keep the product beyond the original rental period) is recognized when the extended rental period begins. Revenue recorded for extended rental periods includes an estimate of future cash collections for extended rental periods that have been incurred but not yet collected in cash. Because our estimate is based upon cash collections, the amount recorded is net of estimated amounts that the Company does not anticipate collecting based upon historical experience.

Revenue generated from subscription sales or similar customer loyalty programs where a customer receives free rentals, reduced rental prices or discounted game prices in exchange for an up-front payment is recognized as revenue evenly over the time period the customer receives the benefit. Upon the sale of a loyalty program, a liability is recorded that is amortized to revenue over the applicable time period.

Gift Card and Gift Certificate Liability

Gift card and gift certificate liabilities are recorded at the time of sale. Costs of designing, printing and distributing the cards and certificates, and transactional processing costs, are expensed as incurred. The liability is relieved and revenue is recognized upon redemption of the gift cards or gift certificate for rental or purchase at any Hollywood Video store.

Cost of Rental Product

Cost of rental product includes revenue sharing expense, amortization of DVD and VHS movies, games, capitalized shipping and handling, the book value of previously viewed movies and games, disk repair and the book value of rental inventory loss.

Cost of Merchandise Sales

Cost of merchandise sales is determined using an average costing method at an item level (by title) for movies, games and game accessories in the game departments and by using product groupings of similar products for concessions. Cost of merchandise sales includes product shipping and handling and valuation adjustments or markdowns that are necessary to record inventory at the lower of cost or market.

Cash and Cash Equivalents

The Company considers highly liquid investment instruments, with an original maturity of three months or less, to be cash equivalents. The carrying amounts of cash and equals fair value.

Marketable Securities

The Company accounts for marketable securities in accordance with SFAS 95, “Accounting for Certain Investments in Debt and Equity Securities.” Substantially all of the marketable securities are auction rate

F- 9

preferred securities and classified as “available for sale.” Accordingly, its investments in these AAA-rated securities are recorded at cost, which approximates fair value due to their variable interest rate, which typically resets every seven days. All income generated from these securities is recorded as interest income. At December 31, 2004, the available for sale securities had maturities of less than 30 years. Despite the long-term nature of their stated contractual maturities, the Company has the ability to quickly liquidate these securities upon the interest reset dates.

Inventories

Merchandise inventories, consisting primarily of video games, new movies for sale, previously viewed movies for sale, concessions, and accessories held for resale, are stated at the lower of cost or market (or, in the case of rental inventory transferred to merchandise inventory at the carrying value thereof at the time of transfer). Used video game inventory includes games accepted as trade-ins from customers. Games are accepted from customers in exchange for in-store credit. At the time of trade-in, the inventory is recorded as well as the corresponding liability for the trade credit. The liability is relieved when the trade credit is redeemed.

Rental inventory, which includes DVD and VHS movies and video games is stated at cost and amortized over its estimated useful life to a specified residual value. Shipping and handling charges related to rental and merchandise inventory are included in the cost of such inventory. See Notes 6 and 7 for a discussion of the amortization policy applied to rental inventory.

Property, Equipment, Depreciation and Amortization

Property is stated at cost and is depreciated on a straight-line basis for financial reporting purposes over the estimated useful life of the assets, which range from approximately five to ten years. Leasehold improvements are amortized over the lesser of the assets economic life of 10 years or the contractual term of the lease. Optional renewal periods are included in the contractual term of the lease if renewal is reasonably assured at the time the asset is placed in service.

Additions to property and equipment are capitalized and include acquisitions of property and equipment, costs incurred in the development and construction of new stores, including in some cases the fair value of lessor development in accordance with EITF 97-10, major improvements to existing property and major improvements in management information systems including certain costs incurred for internally developed computer software. Maintenance and repair costs are charged to expense as incurred, while improvements that extend the useful life of the assets are capitalized. As property and equipment is sold or retired, the applicable cost and accumulated depreciation and amortization are eliminated from the accounts and any gain or loss thereon is recorded.

Long-lived Assets

The Company reviews for impairment of long-lived assets to be held and used in the business whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company periodically reviews and monitors its internal management reports for indicators of impairment. The Company considers a trend of unsatisfactory operating results that are not in line with management’s expectations to be its primary indicator of potential impairment. When an indicator of impairment is noted, assets are evaluated for impairment at the lowest level for which there are identifiable cash flows (e.g., at the store level). The Company deems a store to be impaired if a forecast of undiscounted future operating cash flows directly related to the store, including estimated disposal value, if any, is less than the asset carrying amount. If a store is determined to be impaired, the loss is measured as the amount by which the carrying amount of the store exceeds its fair value. Fair value is estimated using a discounted future cash flow valuation technique similar to that used by management in making a new investment decision. Considerable management judgment and assumptions are necessary to identify indicators of impairment and to estimate discounted future cash flows. Accordingly, actual results could vary significantly from such estimates.

F- 10

In the fourth quarter of 2004 the Company’s video store same store sales decreased 3%. These results were not in line with earlier management expectations and management felt that the recent trend of negative video store same store sales could continue. Accordingly, the Company evaluated its store assets and determined that certain stores were impaired. As a result, the Company recorded a $13.8 million charge for the period ended December 31, 2004, consisting of $11.8 million in property and equipment and $2.0 million in prepaid rent. There was not an impairment charge in 2003 and 2002. See Note 8 for additional discussion.

Goodwill & Intangible Assets

The Company reviews goodwill and intangible assets on an annual basis or whenever events or circumstances occur indicating that goodwill may be impaired. When the Company is evaluating for possible impairment of goodwill, it compares the present value of future cash flows of its reporting unit, which is defined as the Company’s 2,006 video stores, to the goodwill recorded. If this indicates that the goodwill is impaired, the Company would record a charge to the extent that the goodwill balance would be adjusted to that of the present value of future cash flows.

Store Closure Reserves

Reserves for store closures were established by calculating the present value of the remaining lease obligation, adjusted for estimated subtenant agreements or lease buyouts, were expensed along with any leasehold improvements. Store furniture and equipment was either transferred at historical costs to another location or disposed of and written-off.

Legal Contingencies Reserve

All legal contingencies, which are judged to be both probable and estimable, are recorded as liabilities in the Consolidated Financial Statements in amounts equal to the Company’s best estimates of the costs of resolving or disposing of the underlying claims. These estimates are based upon judgments and assumptions. The Company regularly monitors its estimates in light of subsequent developments and changes in circumstances and adjusts its estimates when additional information causes the Company to believe that they are no longer accurate. If no particular amount is determined to constitute the Company’s best estimate of a particular legal contingency, the amount representing the low end of the range of the Company’s estimate of the costs of resolving or disposing of the underlying claim is recorded as a liability and the range of such estimates is disclosed. Legal costs are expensed as incurred.

Self-Insurance

The Company is self-insured for worker’s compensation, general liability costs and certain insurance plans with per occurrence and aggregate limits on losses. The self-insurance liability recorded in the financial statements is based on claims filed and an estimate of claims incurred but not yet reported.

Treasury Stock

In accordance with Oregon law, shares of common stock are automatically retired and classified as available for issuance upon repurchase.

F- 11

Income Taxes

The Company calculates income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes”, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements and tax returns. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

Deferred Rent

Many of the Company’s operating leases contain predetermined fixed increases of the minimum rental rate during the initial lease term and/or rent holiday periods in which the Company does not pay rent. For these leases, the Company recognizes the related rental expense on a straight-line basis beginning on the date the property is delivered to the Company for construction and records the difference between the amount charged to expense and the rent paid as deferred rent, which is included in other liabilities.

Financing Obligations

In accordance with EITF 97-10, the Company is considered the owner of the assets during the construction period for certain stores in which the Company has considerable construction risk. As a result the assets and corresponding financing obligation are recorded on the Company’s balance sheet. Once the construction is completed, the Company removes the asset and financing obligation from its books in accordance FAS 98 “Accounting for Leases”. If upon completion of construction the project does not qualify for sale lease back accounting per FAS 98, the financing obligation would be considered long-term. See Note 3 for additional discussion.

Fair Value of Financial Instruments

In accordance with SFAS No. 107, “Disclosure about Fair Value of Financial Instruments”, the Company has disclosed the fair value, related carrying value and method for determining the fair value for the following financial instruments in the accompanying notes as referenced: cash and cash equivalents (see above), accounts receivable (see Note 4), and long-term obligations (see Note 15).

The Company’s receivables do not represent significant concentrations of credit risk at December 31, 2004, due to the wide variety of customers, markets and geographic areas to which the Company’s products are rented and sold.

Accounting for Stock Based Compensation

The Company accounts for its stock option plans under the recognition and measurement principles of Accounting Principles Board opinion No. 25, “Accounting for Stock Issued to Employees, and related Interpretations.” Pursuant to the disclosure requirements of Statement of Financial Accounting Standards No. 123 (SFAS 123), “Accounting for Stock-Based Compensation” and Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of SFAS 123,” the following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123.


	Year Ended December 31,
	2004			2003			2002
Net income as reported	$	71,288		$	80,070		$	259,745
Add: Stock-based compensation expense included in reported net income, net of tax		81			337			596
Deduct: Total stock-based Employee compensation expense under fair value based method for all awards, net tax		(4,782	)		(8,257	)		(7,941	)

F- 12


	Year Ended December 31,
	2004		2003		2002
Pro forma net income	$	66,587	$	72,150	$	252,400

Earnings per share:
Basic — as reported	$	1.18	$	1.32	$	4.54
Basic — pro forma		1.10		1.19		4.41
Diluted — as reported		1.14		1.25		4.16
Diluted — pro forma		1.08		1.16		4.16

Comprehensive Income

Comprehensive income is equal to net income for all periods presented.

Advertising

The Company receives cooperative reimbursements from vendors as eligible expenditures are incurred relative to the promotion of rental and sales product. Advertising costs, net of these reimbursements, are expensed as incurred. Advertising expense was $19.3 million, $16.2 million and $4.5 million for 2004, 2003 and 2002, respectively. The increase in 2004 was related to an increase in advertising for Game Crazy.

2. Merger Agreement

On January 9, 2005 the Company signed a definitive merger agreement with Movie Gallery, Inc. and its wholly owned subsidiary, TG Holdings, Inc., which provides for the merger of TG Holdings into Hollywood, with Hollywood surviving the merger as a wholly owned subsidiary of Movie Gallery. Under the terms of the merger agreement, its shareholders will be entitled to receive $13.25 per share in cash upon completion of the merger.

The Company had previously entered into an amended and restated merger agreement, dated as of October 13, 2004, with Carso Holdings Corporation (“Carso”) and Hollywood Merger Corp., both affiliates of Leonard Green & Partners, L.P. Under the terms of this amended and restated merger agreement, its shareholders were to receive $10.25 per share in cash upon completion of the merger contemplated by the amended and restated merger agreement. By a termination agreement dated January 9, 2005, between the Company, Carso and its affiliates, and related documents, the Company terminated the amended and restated merger agreement. The termination of the merger agreement with Carso required its payment of Carso’s transaction expenses of $4.0 million.

The Company terminated the agreement with Carso and entered into the merger agreement with Movie Gallery following a unanimous recommendation in favor of these actions by a special committee of its board of directors consisting of the independent directors of its board of directors. The special committee and our board of directors received a fairness opinion from Lazard Freres & Company, LLC as to the consideration to be received by its shareholders pursuant to the merger agreement with Movie Gallery.

The closing of the merger with TG Holdings is subject to terms and conditions customary for transactions of its type, including shareholder approval, antitrust clearance and the completion of financing. The parties to the merger agreement anticipate completing the merger in the second quarter of 2005.

Blockbuster, Inc. has commenced unsolicited tender offers for all of its outstanding shares of common stock and for all of its outstanding 9.625% Senior Subordinated Notes due 2011. Blockbuster has also made filings under federal antitrust laws seeking clearance for a possible acquisition of Hollywood. The Company’s board of directors has recommended to shareholders that they not tender their shares of common stock to Blockbuster, based in large part on the uncertainty of completing a transaction with Blockbuster; the board has taken no position with respect to the tender of outstanding senior subordinated notes. The Company’s board may change its views depending on whether or not Blockbuster

F- 13

is cleared by federal agencies to acquire Hollywood and if so on what conditions. In addition to antitrust clearance, Blockbuster’s tender offers are subject to a number of other contingencies, including the tender of at least a majority of Hollywood’s shares, and they may not be completed.

3. Restatement

Like many other publicly traded retail companies, the Company reviewed its accounting practices with respect to store operating leases. This review was triggered in part by a February 7, 2005 letter issued from the Office of the Chief Accountant of the Securities and Exchange Commission (“SEC”) to the American Institute of Certified Public Accountants expressing the SEC’s views regarding proper accounting for certain operating lease matters under GAAP. The Company concluded that it needed to correct certain errors in its accounting for leases and restate prior periods. The restatement resulted in a $44.3 million charge to beginning retained earnings on January 1, 2002.

Classification of Store Build-out Costs

The Company coordinates and directly pays for a varying amount of the construction of new stores based upon executed lease agreements. For some stores the Company is responsible for overseeing the construction while in others the lessor may be fully responsible for building the store to the Company’s specification. In all cases, however, the Company is reimbursed by the lessor for most of the construction costs. Historically the Company accounted for the unreimbursed portion of the construction as leasehold improvement assets that depreciated over 10 years, which approximated the term of the lease. Upon further review of the applicable accounting guidance, the Company has determined that the amount of assets recorded as leasehold improvements depends upon a number of factors, including the nature of the assets and the amount of construction risk the Company has during the construction period.

Nature of the assets: Store build-out costs have been segregated between structural elements that benefit the lessor beyond the term of the lease and assets that are considered normal tenant improvements. In accordance with EITF 96-21 “Implementation Issues in Accounting for Leasing Transactions involving Special-Purpose Entities”, payments made by the Company for structural elements that are not reimbursed by the lessor should be considered a prepayment of rent that should be amortized as rent expense over the term of the lease. As a result, income from operations increased by $0.9 million and $0.9 million for the years ended December 31, 2003 and 2002, respectively.

Construction risk: In store construction projects where the Company either pays directly for a portion of the construction cost of a new store and is not reimbursed by the lessor and/or is responsible for cost overruns, the Company may be deemed the owner of all store assets during construction under the provisions of EITF 97-10 “The Effect of Lessee Involvement in Asset Construction.” Upon completion of construction, if the Company complies with the provisions of FAS 98, the Company is considered to have sold and leased back the asset from the lessor. The Company has analyzed all of the projects in which they were deemed the owner under the provisions of EITF 97-10 and have concluded that they complied with the provision of FAS 98 for sale-leaseback treatment upon completion of the project. As a result of the above, at December 31, 2003, we had an additional $3.2 million of property and equipment assets and financing obligations of which the Company was deemed to be the owner of during construction.

Classification of Tenant Improvement Allowances

The Company historically accounted for tenant improvement allowances as a reduction to the related leasehold improvement assets. The Company has concluded that certain allowances should be considered lease incentives as discussed in Financial Accounting Standards Board Technical Bulletin No. 88-1, “Issues Relating to Accounting for Leases,” (FTB 88-1). For allowances determined to be incentives, FTB 88-1 requires lease incentives to be recorded as deferred rent liabilities on the balance sheet, a reduction in rent expense on the statement of operations and as a component of operating activities on the consolidated statements of cash flows. There is no impact to income from operations for this reclassification.

F- 14

Rent Holidays

The Company historically recognized rent on a straight-line basis over the lease term commencing with the store opening date. Upon re-evaluating FASB Technical Bulletin No. 85-3, “Accounting for Operating Leases with Scheduled Rent Increases,” the Company has determined that the lease term should commence on the date the property is ready for normal tenant improvements. As a result, income from operations increased $1.8 million and $2.3 million for the years ended December 31, 2003 and 2002, respectively.

Depreciation of Leasehold Improvements

Historically the Company depreciated leasehold improvements over 10 years, which approximates the contractual term of the lease. The Company also depreciated leasehold improvements acquired subsequent to store opening, such as remodels, over 10 years. The Company has concluded that such leasehold improvements should be amortized over the lesser of the assets economic life of 10 years or the contractual term of the lease. Optional renewal periods are included in the contractual term of the lease if renewal is reasonably assured at the time the asset is placed in service. As a result, income from operations decreased $9.0 million and $6.3 million for the years ended December 31, 2003 and 2002, respectively.

Lease Incentive

During 1996 to 2000, certain landlords reimbursed a portion of the Company’s grand opening events and advertising expenses. The Company has historically recorded these marketing allowances received for grand opening costs as a reduction of its advertising expense in the period that the marketing allowance was received. The Company now believes that these allowances should be considered lease incentives as discussed in Financial Accounting Standards Board Technical Bulletin No. 88-1, “Issues Relating to Accounting for Leases,” (FTB 88-1). FTB 88-1 requires lease incentives to be recorded as deferred rent liabilities on the balance sheet, and amortized against rent expense over the term of the lease. As a result, income from operations increased by $3.4 million and $3.4 million for the years ended December 31, 2003 and 2002, respectively.

F- 15

The effect of this restatement and the revision of the classification of Marketable Securities was as follows:

CONSOLIDATED BALANCE SHEET


	At December 31, 2003
	As
	Previously
	Reported			As Restated
	(In thousands,
	except share amounts)
ASSETS
Current assets:
Cash and cash equivalents	$	74,133		$	48,057
Marketable securities		—			26,076

Total cash, cash equivalents, and marketable securities		74,133			74,133
Receivables, net		33,987			33,987
Merchandise inventories		129,864			129,864
Prepaid expenses and other current assets		13,233			13,233

Total current assets		251,217			251,217
Rental inventory, net		268,748			268,748
Property and equipment, net		288,857			243,413
Goodwill		66,678			68,406
Deferred income tax asset, net		104,302			122,598
Prepaid rent		—			34,019
Other assets		17,655			17,654

	$	997,457		$	1,006,055

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term obligations	$	647		$	647
Financing obligations		—			3,245
Accounts payable		159,586			159,586
Accrued expenses		117,867			117,867
Accrued interest		6,467			6,489
Income taxes payable		284			284

Total current liabilities		284,851			288,118
Long-term obligations, less current portion		370,669			370,669
Other liabilities		16,108			50,056

		671,628			708,843
Common stock		489,247			489,247
Unearned compensation		(133	)		(133	)
Accumulated deficit		(163,285	)		(191,902	)

Total shareholders’ equity		325,829			297,212

	$	997,457		$	1,006,055

F- 16

CONSOLIDATED STATEMENTS OF CASH FLOWS


	Twelve Months Ended
	December 31, 2003
	As
	Previously
	Reported			As Restated
	(In thousands)
Operating activities:
Net income	$	82,272		$	80,070
Adjustments to reconcile net income to cash provided by operating activities:
Write-off deferred financing costs		5,827			5,827
Amortization of rental product		211,806			211,806
Depreciation		60,762			61,129
Amortization of prepaid rent					8,525
Amortization of deferred financing costs		4,481			4,481
Tax benefit from exercise of stock options		8,053			8,053
Change in deferred rent		(1,364	)		(6,612	)
Change in deferred taxes		43,512			42,826
Non-cash stock compensation		564			564
Net change in operating assets and liabilities:
Receivables		1,010			1,010
Merchandise inventories		(32,557	)		(32,557	)
Accounts payable		1,163			1,163
Accrued interest		3,544			3,512
Other current assets and liabilities		1,657			1,658

Cash provided by operating activities		390,730			391,455

Investing activities:
Purchases of rental inventory, net		(220,364	)		(220,364	)
Purchase of property and equipment, net		(94,123	)		(89,081	)
Purchase of marketable securities		—			(211,283	)
Sales of marketable securities		—			185,207
Increase in intangibles and other assets		(2,755	)		(7,292	)
Proceeds from indenture trustee		218,531			218,531

Cash used in investing activities		(98,711	)		(124,282	)

Financing activities:
Extinguishment of subordinated debt		(250,000	)		(250,000	)
Borrowings under term loan		200,000			200,000
Repayment of revolving loan		(107,500	)		(107,500	)
Decrease in credit facilities		(55,000	)		(55,000	)
Debt financing costs		(7,453	)		(7,453	)
Repayments of capital lease obligations		(10,291	)		(10,291	)
Repurchase of common stock		(26,275	)		(26,275	)
Proceeds from capital lease obligation		1,422			1,422
Increase (decrease) in financing obligations		—			(1,230	)
Proceeds from exercise of stock options		4,066			4,066

Cash used in financing activities		(251,031	)		(252,261	)

Increase (decrease) in cash and cash equivalents		40,988			14,912
Cash and cash equivalents at beginning of year		33,145			33,145

Cash and cash equivalents at end of year(1)	$	74,133		$	48,057

(1)

Restated cash and cash equivalents excludes Marketable Securities of $26.1 million at the end of the year

F- 19

CONSOLIDATED STATEMENTS OF CASH FLOWS


	Twelve Months Ended
	December 31, 2002
	As
	Previously
	Reported			As Restated
	(In thousands)
Operating activities:
Net income	$	241,845		$	259,745
Adjustments to reconcile net income to cash provided by operating activities:
Extraordinary loss on extinguishment of debt		2,226			2,226
Amortization of rental product		218,905			218,905
Depreciation		59,343			57,057
Amortization of prepaid rent					8,416
Amortization of deferred financing costs		3,785			3,785
Tax benefit from exercise of stock options		12,814			12,814
Change in deferred rent		(1,368	)		(7,297	)
Change in deferred taxes		(109,417	)		(127,027	)
Non-cash stock compensation		(1,633	)		(1,633	)
Net change in operating assets and liabilities:
Receivables		(5,940	)		(5,940	)
Merchandise inventories		(35,722	)		(35,722	)
Accounts payable		(9,056	)		(9,056	)
Accrued interest		(2,649	)		(3,249	)
Other current assets and liabilities		(11,478	)		(11,479	)

Cash provided by operating activities		361,655			361,545

Investing activities:
Purchases of rental inventory, net		(288,079	)		(288,079	)
Purchase of property and equipment, net		(44,254	)		(38,876	)
Increase in intangibles and other assets		(851	)		(3,268	)
Proceeds from indenture trustee		(218,531	)		(218,531	)

Cash used in investing activities		(551,715	)		(548,754	)

Financing activities:
Proceeds from issuance of common stock		120,750			120,750
Equity financing costs		(7,677	)		(7,677	)
Issuance of subordinated debt		225,000			225,000
Repayment of subordinated debt		—			—
Borrowings under term loan		150,000			150,000
Repayment of revolving loan		(240,000	)		(240,000	)
Decrease in credit facilities		(42,500	)		(42,500	)
Debt financing costs		(11,966	)		(11,966	)
Repayments of capital lease obligations		(13,816	)		(13,816	)
Repurchase of common stock		—			—
Proceeds from capital lease obligation		—			—
Increase (decrease) in financing obligations		—			(2,851	)
Proceeds from exercise of stock options		4,604			4,604

Cash provided by financing activities		184,395			181,544

Increase (decrease) in cash and cash equivalents		(5,665	)		(5,665	)
Cash and cash equivalents at beginning of year		38,810			38,810

Cash and cash equivalents at end of year	$	33,145		$	33,145

F- 20

4. Receivables

Accounts receivable as of December 31, 2004 and 2003 consists of (in thousands):


	2004			2003
Construction receivables	$	5,455		$	4,826
Additional rental fees, net		21,690			19,970
Marketing		5,894			8,468
Licensee receivables		1,361			1,509
Other		4,837			1,029

		39,237			35,802
Allowance for doubtful accounts		(1,315	)		(1,815	)

	$	37,922		$	33,987

The carrying amount of accounts receivable approximates fair value because of the short maturity of those receivables. The allowance for doubtful accounts is primarily for marketing.

5. Rental Inventory

Rental inventory as of December 31, 2004 and 2003 consists of (in thousands):


	2004			2003
Rental inventory	$	813,910		$	773,953
Less accumulated amortization		(524,766	)		(505,205	)

	$	289,144		$	268,748

Amortization expense related to rental inventory was $186.8 million, $211.8 million and $218.9 million in 2004, 2003 and 2002, respectively, and is included in cost of rental product. As rental inventory is transferred to merchandise inventory and sold as previously-viewed product, the applicable cost and accumulated amortization are eliminated from the rental inventory accounts, determined on a first-in-first-out (“FIFO”) basis applied in the aggregate to monthly purchases.

6. Rental Inventory Amortization Policy

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 indefinite 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 four months to current estimated average residual values of approximately $2.00 for VHS and $4.00 for DVD (net of estimated allowances for losses). Purchases of VHS and DVD catalog are currently amortized on a straight-line basis over twelve months and sixty months, respectively, to estimated residual values of $2.00 for VHS and $4.00 for DVD.

For new release movies 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, net of average estimated carrying values that are set up in the first four months following the movies release. The carrying value set up on VHS movies approximates the carrying value of VHS non-revenue sharing purchases after four months. The carrying value set up on DVD movies approximates the carrying value of DVD non-revenue sharing purchases after four months less anticipated revenue sharing payments on the sales of previously viewed DVD movies.

F- 21

The majority of games purchased are amortized over four months to an average residual value below $5.00. Games that the Company expects to keep in rental inventory for an indefinite period of time are amortized on a straight-line basis over two years to a current estimated residual value of $5.00. For games acquired under revenue sharing arrangements, the manufacturers share of rental revenue is charged to cost of rental as revenue is earned on the respective revenue sharing games, net of an average estimated carrying value of approximately $11.00 that is set up in the first four months following the games release. Revenue sharing games that the Company expects to keep in rental inventory for an indefinite period of time are then amortized on a straight-line basis over the remaining 20 months to an estimated residual value of $5.00.

7. Change in Accounting Estimate for Rental Inventory

The Company regularly evaluates and updates rental inventory accounting estimates. Effective October 1, 2004, the Company changed estimates relating to the carrying value that is set up on DVD movies that are purchased under revenue sharing arrangements. The Company reduced the set-up carrying value of DVD movies to approximate the carrying value of non-revenue sharing purchases less anticipated revenue sharing payments per unit on the sales of previously viewed DVD movies. Prior to October 1, 2004, the estimated carrying value was not reduced by an estimate of revenue sharing payments per unit on the sales of previously viewed DVD movies. The Company believes the change results in better matching of revenue and expense and the net impact to the fourth quarter of 2004 was immaterial.

Effective October 1, 2002, estimated average residual values on new release movies was reduced from $3.16 to $2.00 for VHS and from $4.67 to $4.00 for DVD. In addition, the estimated residual value of catalog DVD inventory was reduced from $6.00 to $4.00. As a result of these changes in estimate, cost of rental product revenue in 2002 was $4.1 million higher and net income per share (basic and diluted) was $0.04 lower.

8. Property and Equipment

Property and equipment as of December 31, 2004 and 2003 consists of (in thousands):


				2003
	2004			(Restated)
Fixtures and equipment	$	252,165		$	232,379
Leasehold improvements		420,712			378,098
Equipment under capital lease		2,047			4,644
Leasehold improvements under capital lease		—			6,725

		674,924			621,846
Less accumulated depreciation and amortization		(447,100	)		(378,433	)

	$	227,824		$	243,413

Accumulated depreciation and amortization, as presented above, includes accumulated amortization of assets under capital leases of $0.4 million and $6.4 million at December 31, 2004 and 2003, respectively. Depreciation expense related to property, plant and equipment was $60.0 million, $61.1 million and $57.1 million in 2004, 2003 and 2002, respectively.

The Company reviews for impairment of long-lived assets to be held and used in the business whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company deems a store to be impaired if a forecast of undiscounted future operating cash flows directly related to the store, including estimated disposal value, if any, is less than the asset carrying amount.

F- 22

negative video store same store sales could continue. Accordingly, the Company evaluated the store assets and determined that certain stores were impaired. As a result, the Company recorded a $13.8 million non-cash charge in operating and selling expense consisting of $11.8 million in property and equipment and $2.0 million in prepaid rent. There were no impairment charges in 2003 and 2002.

In the fourth quarter of 2004 the Company concluded that certain software development capitalized costs qualified for impairment per AICPA SOP 98-1 “Software for Internal Use” and FAS 144 “Accounting for Impairment or Disposal of Long-Lived Assets”. As a result, the Company recorded a $4.4 million impairment charge included in general and administrative expenses.

9. Store Closure Restructuring

In December 2000, the Company approved a restructuring plan involving the closure and disposition of 43 stores that were not operating to its expectations (the “Restructuring Plan”). In the fourth quarter of 2000, the company recorded charges aggregating $16.9 million, including an $8.0 million write down of property and equipment, a $1.5 million write down of goodwill and an accrual for store closing costs of $7.4 million. The established reserve for cash expenditures is for lease termination fees and other store closure costs. The Company has liquidated and plan to continue liquidating related store inventories through store closing sales; any remaining product will be used in other stores.

Revenue for the stores subject to the store Restructuring Plan was $6.0 million and $6.3 million in 2003 and 2002, respectively. Operating results (defined as income or loss before interest expense and income taxes) was $0.3 million loss and $0.9 million loss in 2003 and 2002, respectively. The operating results for the stores in the closure plan were included in the Consolidated Statement of Operations.

During the twelve months ended December 31, 2001, the Company closed 12 of the stores included in the plan and incurred $329,867 in expenses related to the closures and received $450,000 to exit one of the leases. During the twelve months ended December 31, 2002, the company closed one store included in the plan and incurred $90,000 in closure expenses.

In December of 2001, 2002 and 2003, the Company amended the Restructuring Plan and removed 16 stores, 2 stores and 9 stores from the closure list, respectively. In accordance with the amended plans, and updated estimates on closing costs, the company reversed $3.8 million, $0.8 million and $2.1 of the original $16.9 million charge, leaving a $3.7 million, $2.8 million and $0.7 million accrual balance at December 31, 2001, 2002 and 2003, respectively, for store closing costs. At December 31, 2004, 0 stores remained to be closed under the Restructuring Plan.

During the twelve months ended December 31, 2004, the Company closed two stores included in the plan and incurred $0.5 million in expenses related to the closures. At December 31, 2004 there were no remaining stores to be closed pursuant to the Company’s store closure plan. As a result, the remaining balance of $0.2 million was reversed in 2004.

10. Goodwill and Intangible Assets

Goodwill was $69.5 million and $68.4 million as of December 31, 2004 and 2003, respectively, and represents the excess of cost over the fair value of net assets purchased net of impairment charges and accumulated amortization recorded prior to the adoption of FAS 142.

The increase in goodwill was the result of four stores acquired in four separate transactions during the year ended December 31, 2004. The aggregate purchase price was $1.3 million, of which, $1.1 million was allocated to goodwill. The remaining purchase price represented the fair market value of the assets acquired that were allocated to store inventory and leasehold improvements.

In July 2001, the FASB issued SFAS Nos. 141 and 142, “Business Combinations” and “Goodwill and Other Intangible Assets,” respectively. SFAS 141 supersedes Accounting Principles Board (APB) Opinion

F- 23

No. 16 and eliminates pooling-of-interests accounting. It also provides guidance on purchase accounting related to the recognition of intangible assets and accounting for negative goodwill. SFAS 142 changes the accounting for goodwill from an amortization method to an impairment only approach. Under SFAS 142, goodwill and non-amortizing intangible assets shall be adjusted whenever events or circumstances occur indicating that goodwill has been impaired. The Company has completed its impairment testing of the valuation of its goodwill and has determined that there is no impairment. SFAS 141 and 142 were effective for all business combinations completed after June 30, 2001. Upon adoption of SFAS 142, amortization of goodwill recorded for business combinations consummated prior to July 1, 2001 ceased, and intangible assets acquired prior to July 1, 2001 that did not meet criteria for recognition under SFAS 141 were reclassified to goodwill. The Company adopted SFAS 142 on January 1, 2002, the beginning of fiscal 2002.

The components of intangible assets are as follows (in thousands):


	December 31,				December 31,
	2003		Additions		2004
Goodwill	$	68,406	$	1,059	$	69,465
Trade-name rights		6,224		514		6,738

	$	74,630	$	1,573	$	76,203

11. Reel.com Discontinued E-Commerce Operations

On June 12, 2000, the Company announced that it would close down the e-commerce business of Reel.com. Although the Company had developed a leading web-site over the seven quarters after Reel.com was purchased in October of 1998, Reel.com’s business model of rapid customer acquisition led to large operating losses and required significant cash funding. Due to market conditions, the Company was unable to obtain outside financing for Reel.com, and could not justify continued funding from its video store cash flow. As a result of the discontinuation of Reel.com’s e-commerce operations, the Company recorded a total charge of $69.3 million in the second quarter of 2000, of which $27.3 million was accrued liabilities for contractual obligations, lease commitments, anticipated legal claims, legal fees, financial consulting, and other professional services incurred as a direct result of the closure of Reel.com. The accrual was reduced by $1.6 million, $3.3 million and $12.4 million in 2000, 2001 and 2002, respectively, because the Company was able to negotiate termination of certain obligations and lease commitments more favorably than originally anticipated. The Company has paid for all accrued liabilities, net of reductions, and does not anticipate further adjustments.

12. Accounts Payable and Accrued Liabilities

Accounts payable includes accrued revenue sharing (amounts accrued pursuant to revenue sharing arrangements in which the Company had not yet received an invoice).

Accrued liabilities as of December 31, 2004 and 2003 consist of (in thousands):


	2004		2003
Payroll and benefits	$	30,946	$	27,236
Property taxes and rent and related		16,387		12,218
Gift cards and deferred revenue		30,725		22,908
Marketing		6,758		5,709
Store closures and lease terminations		—		1,127
Property, plant and equipment		7,013		5,050
Accrued insurance		12,519		5,425
Accrued sales tax		12,543		13,320
Legal commitments and contingencies		13,296		6,803
Other operating and general administration		20,249		18,071

	$	150,436	$	117,867

F- 24

13. Employee Benefit Plans

The Company is self-insured for employee medical benefits under the Company’s group health plan. The Company maintains stop loss coverage for individual claims in excess of $150,000. While the ultimate amount of claims incurred is dependent on future developments, in management’s opinion, recorded reserves are adequate to cover the future payment of claims. Adjustments, if any, to recorded estimates of the Company’s potential claims liability will be reflected in results of operations for the period in which such adjustments are determined to be appropriate on the basis of actual payment experience or other changes in circumstances.

The Company has a 401(k) plan in which eligible employees may elect to contribute up to 20% of their earnings. Eligible employees are at least 21 years of age, have completed at least one year of service and work at least 1,000 hours in a year. The Company matched 25% of the employee’s first 6% of contributions until June 30, 2003, when the Company elected to end the match.

Beginning January 1, 2005, the Company will reinstate the match program. The 2005 Company match program will match 25% of the eligible employee’s first 6% of contributions.

Beginning in April 2000 and ending January 1, 2005, the Company offered a deferred compensation plan to certain key employees designated by the Company. The plan allowed for the deferral and investment of current compensation on a pre-tax basis. The Company accrued $332,689 and $247,923 related to this plan at December 31, 2004 and 2003, respectively.

Beginning in January 2002 and ending January 1, 2005, the Company offered a 401(k) supplemental plan that allowed its highly compensated employees the ability to receive the full 25% employer match on the first 6% of contributions (through June 30, 2003 when the Company elected to end the match) that were not available to them under the Company’s 401(k) plan. The plan allows for the deferral and investment of current compensation on a pre-tax basis. The Company accrued approximately $784,723 and $738,326 related to this plan at December 31, 2004 and 2003, respectively.

14. Related Party Transactions

In July 2001, Boards, Inc. (Boards) began to open Hollywood Video stores as a licensee of the Company pursuant to rights granted by the Company and approved by the Board of Directors in connection with Mark J. Wattles’ employment agreement in January 2001. These stores are operated by Boards and are not included in the 2,006 stores operated by the Company. Mark Wattles, the Company’s founder and former Chief Executive Officer, is the majority owner of Boards. Under the license arrangement, Boards pays the Company an initial license fee of $25,000 per store, a royalty of 2.0% of revenue and also purchases products and services from the Company at the Company’s cost. Boards is in compliance with the 30 day payment terms under the arrangement. The outstanding balance of $1.4 million due the Company is related to current activity. As of December 31, 2004, Boards operated 20 stores.

The following table reconciles the net receivable balance due from Boards, Inc. (in thousands):


	Twelve Months
	Ended
	December 31,
	2004			2003
Beginning Receivable Balance	$	1,509		$	631

License fee		25			275
(2%)Royalty Fees		579			376
Products & Services		11,780			10,380

Expenses		12,384			11,031
Payments		(12,532	)		(10,153	)

Ending Receivable Balance	$	1,361		$	1,509

F- 25

15. Long-term Obligations and Liquidity

The Company had the following long-term obligations as of December 31, 2004 and 2003 (in thousands):


	December 31,
	2004		2003
Borrowings under credit facilities	$	125,000	$	145,000
Senior subordinated notes due 2011(1)		225,000		225,000
Obligations under capital leases		1,256		1,316

		351,256		371,316
Current portions:
Capital leases		555		647

		555		647

Total long-term obligations net of current portion	$	350,701	$	370,669

(1)	Coupon payments at 9.625% are due semi-annually in March and September.

On December 18, 2002, the Company completed the sale of $225 million 9.625% senior subordinated notes due 2011. The Company delivered the net proceeds to an indenture trustee to redeem $203.9 million of the $250 million 10.625% senior subordinated notes due 2004 including accrued interest and the required call premium. At December 31, 2002, the trustee was holding $218.5 million and the Company continued to carry the $250 million 10.625% senior subordinated notes on its balance sheet. On January 17, 2003, the redemption of $203.9 million of the notes was completed.

The senior subordinated notes due 2011 are redeemable, at the option of the Company, beginning in March 15, 2007, at rates starting at 104.8% of principal amount reduced annually through March 15, 2009, at which time they become redeemable at 100% of the principal amount. The terms of the notes may restrict, among other things, payment of dividends and other distributions, investments, the repurchase of capital stock or subordinated indebtedness, the making of certain other restricted payments, the incurrence of additional indebtedness or liens by the Company or any of the company’s subsidiaries, and certain mergers, consolidations and disposition of assets. Additionally, if a change of control occurs, as defined, each holder of the notes will have the right to require the Company to repurchase such holder’s notes at 101% of principal amount thereof. Blockbuster, Inc. has commenced unsolicited tender offers for all of the company’s outstanding shares of common stock and for all of the company’s outstanding 9.625% Senior Subordinated Notes due 2011.

Blockbuster has also made filings under federal antitrust laws seeking clearance for a possible acquisition of Hollywood. The Company’s board of directors has recommended to shareholders that they not tender their shares of common stock to Blockbuster, based in large part on the uncertainty of completing a transaction with Blockbuster. The board has taken no position with respect to the tender of outstanding senior subordinated notes. The Company’s board may change the company’s views depending on whether or not Blockbuster is cleared by federal agencies to acquire Hollywood and if so on what conditions. In addition to antitrust clearance, Blockbuster’s tender offers are subject to a number of other contingencies, including the tender of at least a majority of Hollywood’s shares, and they may not be completed.

On January 16, 2003, the Company completed the closing of new senior secured credit facilities from a syndicate of lenders led by UBS Warburg LLC. The new facilities consist of a $200.0 million term loan facility and a $50.0 million revolving credit facility, each maturing in 2008. The Company used the net proceeds from the transaction to repay amounts outstanding under the Company’s existing credit facilities which were due in 2004, redeem the remaining $46.1 million outstanding principal amount of

F- 26

the Company’s 10.625% senior subordinated notes due 2004 and for general corporate purposes. The Company completed the redemption of the 10.625% senior subordinated notes on February 18, 2003. The Company has prepaid $75 million of the term loan facility principal payments due through 2006, including a $20 million payment made on January 5, 2004.

Revolving credit loans under the new facility bear interest, at the Company’s option, at an applicable margin over the bank’s base rate loan or the LIBOR rate. The initial margin over LIBOR was 3.5% for the term loan facility and will step down if certain performance targets are met. The credit facility contains financial covenants (determined in each case on the basis of the definitions and other provisions set forth in such credit agreement), some of which may become more restrictive over time, that include a (1) maximum debt to adjusted EBITDA test, (2) minimum interest coverage test, and (3) minimum fixed charge coverage test. Amounts outstanding under the credit agreement are collateralized by substantially all of the assets of the Company. Hollywood Management Company, and any future subsidiaries of Hollywood Entertainment Corporation, are guarantors under the credit agreement.

As of December 31, 2004 and 2003, the Company was in violation of certain covenants restricting our investments in cash equivalents and marketable securities under our credit facility and our indenture for senior subordinated notes because it invested in rated marketable securities with maturities beyond those allowed. The lenders under its credit facility have waived the default through March 31, 2005; if the Company corrects the violation by that time, it will not need a waiver from holders of its senior subordinated notes. The Company expects to correct the violation and be in compliance with its credit facility and indenture covenants by transferring its investments to instruments authorized in the debt covenants by March 31, 2005.

Maturities on long-term obligations at December 31, 2004 for the next five years is as follows (in thousands):


					Capital
					Leases
Year Ending	Subordinated		Credit		&
December, 31	Notes		Facility		Other		Total
2005		—		—		555		555
2006		—		—		612		612
2007		—		20,000		89		20,089
2008		—		105,000		—		105,000
2009		—		—		—		—
Thereafter		225,000		—		—		225,000

	$	225,000	$	125,000	$	1,256	$	351,256

Interest income was $1.4 million, $0.8 million, and $0.5 million for the years ended December 31, 2004, 2003, and 2002, respectively. Total interest cost incurred was $31.6 million, $36.5 million, and $42.6 million for the years ended December 31, 2004, 2003, and 2002, respectively, while interest capitalized was $0.2 million, $0.2 million, and $0.1 million, for the years ended December 31, 2004, 2003, and 2002, respectively.

The fair value of the 9.625% senior subordinated notes due 2011 was $240.8 million and $243.6 million as of December 31, 2004 and 2003, respectively, based on quoted market prices. The revolving credit facility is a variable rate loan, and thus, the fair value approximates the carrying amount as of December 31, 2004 and 2003.

As of December 31, 2004 the Company had $15.7 million of outstanding letters of credit issued upon the revolving credit facility.

16. Off Balance Sheet Arrangements

F- 27

expense was $251.9 million, $232.9 million and $221.4 million for the years ended December 31, 2004, 2003, and 2002, respectively. Most operating leases require payment of additional occupancy costs, including property taxes, utilities, common area maintenance and insurance. These additional occupancy costs were $49.9 million, $46.2 million and $42.1 million for the years ended December 31, 2004, 2003, and 2002, respectively.

At December 31, 2004, the future minimum annual rental commitments under non-cancelable operating leases were as follows (in thousands):


Year Ending	Operating
December 31,	Leases
2005	$	258,703
2006		240,881
2007		207,383
2008		168,011
2009		135,709
Thereafter		324,641

Total sublease income was $4.9 million, $5.4 million, and $6.2 million for the years ended December 31, 2004, 2003, and 2002, respectively.

At December 31, 2004, the future minimum annual sublease income under operating subleases were as follows (in thousands):


Year Ending	Sublease
December 31,	Income
2005	$	2,402
2006		2,237
2007		1,737
2008		1,124
2009		722
Thereafter		1,036

17. Income Taxes

The provision for (benefit from) income taxes from continuing operations for the years ended December 31, 2004, 2003 and 2002 consists of (in thousands):


			2003		2002
	2004		(Restated)		(Restated)
Current:
Federal	$	2,855	$	2,265	$	(3,507	)
State		1,512		1,018		2,107

Total current provision (benefit)		4,367		3,283		(1,400	)
Deferred:
Federal		36,537		40,952		(95,938	)
State		4,303		9,927		(18,381	)

Total deferred provision (benefit)		40,840		50,879		(114,272	)

Total provision (benefit)	$	45,207	$	54,162	$	(115,719	)

The Company is subject to minimum state taxes in excess of statutory state income taxes in many of the states in which it operates. These taxes are included in the current provision for state and local income taxes. The difference between the tax provision at the statutory federal income tax rate and the tax provision attributable to income from continuing operations before income taxes for the three years ended December 31 is analyzed below:

F- 28

temporary differences that give rise to significant portions of deferred tax assets and liabilities from continuing operations at December 31 are as follows (in thousands):


				2003
	2004			(Restated)
Deferred tax assets:
Tax loss carryforward	$	107,507		$	117,953
Deferred rent		39,355			38,518
Accrued liabilities and reserves		12,559			11,300
Tax credit carryforward		10,089			6,820
Restructure charges		5,335			2,604
Inventory valuation		18,444			23,957
Amortization		(2,720	)		1,474

Total deferred tax assets		190,569			202,626
Deferred tax liabilities:
Depreciation and amortization		(99,592	)		(76,541	)
Capitalized and financing leases		(2,997	)		(3,487	)

Total deferred tax liabilities		(102,589	)		(80,028	)

Net deferred tax asset	$	87,980		$	122,598

As of December 31, 2004, the Company had approximately $274.4 million of federal net operating loss carryforwards available to reduce future taxable income. The carryforward periods expire in years 2019 through 2023. The Company has federal Alternative Minimum Tax (AMT) credit carryforwards of $4.9 million which are available to reduce future regular taxes in excess of AMT. These credits have no expiration date. The Company has federal and state tax credit carryforwards of $5.2 million which are available to reduce future taxes. The carryforward periods expire in years 2012 through 2024, or have no expiration date.

In the fourth quarter of 2000, in light of significant doubt that existed regarding the Company’s future income and therefore the Company’s ability to use its net operating loss carryforwards, the Company recorded a $229.8 million valuation allowance against our $229.8 million net deferred tax asset. In 2002 and 2001, as a result of our operating performance for each year, as well as anticipated future operating performance, the Company determined that it was more likely than not that future tax benefits would be realized. Consequently, the Company benefited by the reversal of $165.5 million and $64.3 million of the valuation allowance in 2002 and 2001, respectively.

Federal tax laws impose restrictions on the utilization of net operating loss carryforwards and tax credit carryforwards in the event of an “ownership change,” as defined by the Internal Revenue Code. Such ownership changes occurred in October 2000 and December 2001 as a result of significant changes in stock ownership. The Company’s ability to utilize its net operating loss carryforwards and tax credit carryforwards 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 carryforwards ranges between $52.4 million and $209.5 million and varies due to the fact that there were two ownership changes. The Company believes it is more likely than not that it will fully realize all net operating loss carryforwards and tax credit carryforwards and therefore a valuation reserve is not necessary at December 31, 2004 and December 31, 2003.

The Company realized a tax benefit in the amount of $6.2 million and $8.1 million in 2004 and 2003, respectively, as a result of the exercise of employee stock options. For financial reporting purposes, the impact of this tax benefit is credited directly to shareholders’ equity.

F- 30

18. Shareholders’ Equity

Preferred Stock

At December 31, 2004, the Company was authorized to issue 25,000,000 shares of preferred stock in one or more series. With the exception of 3,119,737 shares which have been designated as “Series A Redeemable Preferred Stock” but have not been issued, the Board of Directors has authority to designate the preferences, special rights, limitations or restrictions of such shares.

Common Stock

During the first quarter of 2004, the Company repurchased a total of 295,139 shares of its common stock for an aggregate purchase price of $3.7 million.

During the third and fourth quarters of 2003, the Company repurchased a total of 1,746,173 shares of its common stock for an aggregate purchase price of $26.3 million.

On March 11, 2002, the Company completed a public offering of 8,050,000 shares of its common stock.

19. Stock Option Plans

In general, the Company’s stock option plans provide for the granting of options to purchase Company shares at a fixed price. It has been the Company’s Board of Directors general policy to set the price at the market price of such shares as of the option grant date. The options generally have a nine year term and become exercisable on a pro rata basis over the first three years or at such other periods as determined by the Board. The Company adopted stock option plans in 1993, 1997 and 2001 providing for the granting of non-qualified stock options, stock appreciation rights, bonus rights and other incentive grants to employees up to an aggregate of 21,000,000 shares of common stock. The Company granted non-qualified stock options pursuant to the 1993, 1997 and 2001 Plans totaling 86,000, 1,485,667, and 3,311,368 in 2004, 2003 and 2002, respectively. The Company cancelled 0.8 million, 1.3 million, and 2.2 million of stock options in 2004, 2003 and 2002, respectively.

The Company has elected to follow APB Opinion 25; “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations in accounting for its employee stock options. Under APB 25, because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized upon the date of grant. Pro forma information regarding net income per share is required by SFAS No. 123, “Accounting for Stock-Based Compensation”, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement. The fair value of these options was estimated at the date of grant using Black-Scholes option pricing model with the following weighted-average assumptions for 2004, 2003 and 2002:


	2004			2003			2002
Risk free interest rate		2.44	%		2.33	%		2.17	%
Expected dividend yield		0	%		0	%		0	%
Expected lives	5 years			5 years			4 years
Expected volatility		93.7	%		96.9	%		108	%

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the Company’s opinion, the existing available models do not necessarily provide a reliable single measure of the fair value of the Company’s employee stock options.

F- 31

Using the Black-Scholes option valuation model, the weighted average grant date value of options granted during 2004, 2003 and 2002 was $8.17, $10.70, and $10.03 per share subject to the option, respectively.

For the purpose of pro forma disclosures, the estimated fair value of the options is amortized over the option’s vesting period. The Company’s pro forma information is as follows (in thousands, except per share amounts):


	Year Ended December 31,
				2003			2002
	2004			(Restated)			(Restated)
Net income as reported	$	71,288		$	80,070		$	259,745
Add: Stock-based compensation expense included in reported net income, net of tax		81			337			596
Deduct: Total stock- based employee compensation expense under fair value based method for all awards, net of tax		(4,782	)		(8,257	)		(7,941	)

Pro forma net income	$	66,587		$	72,150		$	252,400

Earnings per Share:
Basic — as reported	$	1.18		$	1.32		$	4.54
Basic — pro forma		1.10			1.19			4.41
Diluted — as reported		1.14			1.25			4.16
Diluted — pro forma		1.08			1.16			4.16

A summary of the Company’s stock option activity and related information for 2004, 2003 and 2002 is as follows (in thousands, except per share amounts):


				Weighted
				Average
				Exercise
	Shares			Price
Outstanding as December 31, 2001		12,354		$	3.52
Granted		3,311			13.47
Exercised		(2,318	)		2.39
Cancelled		(2,199	)		7.32

Outstanding as December 31, 2002		11,148			5.96
Granted		1,486			14.73
Exercised		(1,616	)		2.96
Cancelled		(1,287	)		8.35

Outstanding as December 31, 2003		9,731			7.48
Granted		86			11.31
Exercised		(1,599	)		1.86
Cancelled		(786	)		13.67

Outstanding as December 31, 2004		7,432		$	8.08

F- 32

A summary of options outstanding and exercisable at December 31, 2004 is as follows (in thousands, except per share amounts):


	Options Outstanding						Options Exercisable
			Weighted
			Average		Weighted				Weighted
			Remaining		Average				Average
Range of			Life (in		Exercise				Exercise
Exercise Prices	Options		years)		Price		Options		Price
$1.000 — $1.090		3,367		5.24	$	1.09		3,367	$	1.09
1.094 — 12.000		1,514		5.98		10.68		257		4.94
12.020 — 16.310		1,400		6.49		13.76		435		14.08
16.340 — 20.320		1,151		4.39		18.23		803		18.43

		7,432		5.50	$	8.08		4,862	$	5.35

In the first quarter of 2000, the Company granted stock options to approximately fifty key employees. The grants were for the same number of shares issued to these employees prior to January 1, 2000. In the third quarter of 2000, the Company cancelled the stock options that were issued prior to January 1, 2000 for the fifty employees. The grant and cancellation of the same number of options for these employees resulted in variable accounting treatment for the related options for 850,000 shares of the Company’s common stock. Variable accounting treatment resulted in unpredictable stock-based compensation impacted by fluctuations in quoted prices for the Company’s common stock. In 2002, the variable options were canceled and the Company reversed expense that was recognized in 2001 on the canceled options. As a result, the Company reversed compensation expense in 2002 of $2.6 million relating to the variable stock options.

The Company recorded compensation expense related to certain stock options issued below the fair market value of the related stock in the amount of $0.1 million, $0.6 million and $1.0 million for the year ended December 31, 2004, 2003 and 2002, respectively.

20. Earnings Per Share

A reconciliation of the basic and diluted per share computations for 2004, 2003 and 2002 is as follows (in thousands, except per share data):


	2004
			Weighted
			Average		Per Share
	Income		Shares		Amount
Income per common share	$	71,288		60,496	$	1.18
Effect of dilutive securities:
Stock options		—		2,269		(.04	)

Income per share assuming dilution	$	71,288		62,765	$	1.14


	2003
	(Restated)				(Restated)
			Weighted
			Average		Per Share
	Income		Shares		Amount
Income per common share	$	80,070		60,439	$	1.32
Effect of dilutive securities:
Stock options		—		3,723		(.07	)

Income per share assuming dilution	$	80,070		64,162	$	1.25

F- 33


	2002
	(Restated)				(Restated)
			Weighted
			Average		Per Share
	Income		Shares		Amount
Income per common share	$	259,745		57,202	$	4.54
Effect of dilutive securities:
Stock options		—		5,188		(0.38	)

Income per share assuming dilution	$	259,745		62,390	$	4.16

Antidilutive stock options excluded from the calculation of diluted income in 2004, 2003, and 2002 were 4.0 million, 1.3 million and 0.8 million, respectively.

21. Legal Contingencies

On January 3, 2005, the Company received a letter from The Nasdaq Stock Market, Inc. indicating that its securities were subject to delisting from The Nasdaq National Market because it failed to comply with Marketplace Rules 4350(e) and 4350(g), which requires that the Company hold an annual shareholder meeting and distribute a proxy statement and solicit proxies for the meeting. The Company requested and received a hearing before a Nasdaq Listing Qualifications Panel to review the staff determination. On February 15, 2005, the Panel informed the Company that its securities would be delisted at the opening of business on February 17, 2005. The Company requested that the Panel reconsider its decision, which it did. The Panel has agreed to continue listing its securities under specified conditions, including that the Company holds an annual meeting on or before March 30, 2005. The Company has set a March 30, 2005 annual meeting date. If we are unable to hold a meeting on that date, our securities may be delisted and thus no longer eligible to trade on The Nasdaq National Market System, which may affect the liquidity of our securities and their trading price.

The Company was named as a defendant in several purported class action lawsuits asserting various causes of action, including claims regarding its membership application and additional rental period charges. The Company has vigorously defended these actions and maintains that the terms of its additional rental charge policy are fair and legal. The Company has been successful in obtaining dismissal of three of the actions filed against it. A statewide class action entitled George Curtis v. Hollywood Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8 SEA was certified on June 14, 2002 in the Superior Court of King County, Washington. On May 20, 2003, a nationwide class action entitled George DeFrates v. Hollywood Entertainment Corporation, No. 02 L 707 was certified in the Circuit Court of St. Clair County, Twentieth Judicial Circuit, State of Illinois. The Company reached a nationwide settlement with the plaintiffs. This settlement encompasses all of the legal claims asserted in each of the related actions. Preliminary approval of settlement was granted on August 10, 2004. The Company has agreed to pay plaintiffs’ legal counsel $2.675 million and to give class members a rent-one-get-one coupons on a claims made basis with a guaranteed total redemption of $9 million along with other remedial relief. A hearing to obtain final court approval of the settlement is set for June 24, 2005. Notice began on October 10, 2004 and will last for six months. Coupons will likely be distributed to the class beginning in the fall of 2005 and payment will be made to plaintiffs’ legal counsel following final court approval in June 2005. The Company believes it has provided adequate reserves in connection with these lawsuits.

The Company and the members of its board are defendants in several lawsuits pending in Clackamas County, Oregon (and one in Multnomah County, Oregon). The lawsuits assert breaches of duties associated with the merger agreement executed with a subsidiary of Leonard Green & Partners, L.P. With the termination of the Leonard Green transaction, the Company is uncertain as to whether these cases will proceed and if so, in what form. The Company and the members of its board have also been named as defendants in a separate lawsuit, JDL Partners, L.P. v. Mark J. Wattles et al., filed in Clackamas County, Oregon Circuit Court. This lawsuit, filed before the Company’s announcement of the merger agreement with Movie Gallery, alleges breaches of fiduciary duties related to a recent bid by Blockbuster for the Company as well as breaches related to a loan to Mr. Wattles that the Company forgave in December 2000. A motion is pending in Clackamas County to consolidate this lawsuit with the previously filed actions. It is not clear how the Merger Agreement with Movie Gallery will affect the pending litigation and there is no assurance that a settlement will be effected or that current reserves for this litigation will be adequate.

F- 34

The Company was named as a defendant in three actions asserting wage and hour claims in California. The plaintiffs sought to certify a statewide class action alleging that certain California employees were denied meal and rest periods. There were several additional related claims for unpaid overtime, unpaid off the clock work, and penalties for late payment of wages and record keeping violations. Mediation took place on September 9, 2004 and the parties reached a settlement of all claims alleged in each of the actions. Pursuant to the settlement, two of the actions were dismissed and all claims asserted by plaintiffs were alleged in a single action. The Company received preliminary approval of the settlement on January 10, 2005. Notice was sent directly to class members on February 4, 2005. Final approval is scheduled for hearing on April 21, 2005. The Company believes it has provided adequate reserves in connection with these lawsuits.

In addition, the Company has been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. The Company believes it has provided adequate reserves for contingencies and that the outcome of these matters should not have a material adverse effect on its consolidated results of operations, financial condition or liquidity. As of December 31, 2004 and 2003, the legal contingencies reserve was $13.3 million and $6.8 million, respectively.

22. Segment Reporting

The Company’s management regularly evaluates the performance of two segments, Hollywood Video and Game Crazy, in its assessment of performance and in deciding how to allocate resources. Hollywood Video represents the Company’s 2,006 video stores excluding the operations of Game Crazy. Game Crazy represents 715 in-store departments and free-standing stores that allows game enthusiasts to buy, sell, and trade used and new video game hardware, software and accessories. The Company measures segment profit as operating income (loss), which is defined as income (loss) before interest expense and income taxes. Information on segments and reconciliation to operating income (loss) are as follows (in thousands):


	Year Ended December 31, 2004
	Hollywood		Game
	Video		Crazy			Total
Revenues	$	1,495,830	$	286,534		$	1,782,364
Depreciation		53,259		6,712			59,971
Impairment of Assets		16,174		2,008			18,182
Income (loss) from operations		168,040		(21,552	)		146,488
Goodwill		69,050		415			69,465
Total assets		1,000,495		119,032			1,119,527
Purchases of property and equipment		50,704		8,870			59,574

F- 35


	Year Ended December 31, 2003
	(Restated)
	Hollywood		Game
	Video		Crazy			Total
Revenues	$	1,502,416	$	180,132		$	1,682,548
Depreciation		57,077		4,052			61,129
Income (loss) from operations		206,891		(24,685	)		182,206
Goodwill		67,991		415			68,406
Total assets		905,773		100,282			1,006,055
Purchases of property and equipment		61,760		27,321			89,081

Game Crazy’s loss from operations included an overhead allocation for information support services, treasury and accounting functions, and other general and administrative services. Game Crazy revenue for 2002 was $56.7 million. Information regarding Game Crazy’s results of operations, total assets and purchases of property and equipment as reported above for 2004 and 2003 is not available for prior periods before 2003 due to Game Crazy’s smaller scale when costs were not segregated and captured.

23. Consolidating Financial Statements

Hollywood Entertainment Corporation (HEC) had only one wholly owned subsidiary as of December 31, 2004, Hollywood Management Company (HMC). HMC is a guarantor of certain indebtedness of HEC, including the obligations under the new credit facilities and the 9.625% senior subordinated notes due 2011. Prior to June 2000, HEC had a wholly owned subsidiary, Reel.com (Reel),that was merged with and into HEC in June 2000. The consolidating condensed financial statements below present the results of operations and financial position of the subsidiaries of the Company.

Consolidating Condensed Balance Sheet


	December 31, 2004
	HEC		HMC		Eliminations			Consolidated
	(in thousands)
ASSETS
Cash and cash equivalents	$	2,346	$	43,814	$	—		$	46,160
Marketable Securities		—		147,600		—			147,600
Accounts receivable, net		27,119		469,279		(458,476	)		37,922
Merchandise inventories		148,154		—		—			148,154
Prepaid expenses and other current assets		6,703		16,132		—			22,835
Total current assets		184,322		676,825		(458,476	)		402,671
Rental inventory, net		289,144		—		—			289,144
Property & equipment, net		205,286		22,538		—			227,824
Goodwill, net		69,465		—		—			69,465
Deferred income tax asset		87,980		—		—			87,980
Prepaid Rent		27,194		—		—			27,194
Other assets, net		410,641		7,907		(403,299	)		15,249
Total assets	$	1,274,032	$	707,270	$	(861,775	)	$	1,119,527
LIABILITIES & SHAREHOLDERS’ EQUITY (DEFICIT)
Current maturities of long-term obligations	$	555	$	—	$	—		$	555
Financing Obligations		15,581		—		—			15,581
Accounts payable		458,476		174,427		(458,476	)		174,427
Accrued expenses		30,672		119,764		—			150,436
Accrued interest		69		6,376		—			6,445
Income taxes payable		—		3,404		—			3,404
Total current liabilities		505,353		303,971		(458,476	)		350,848
Long-term obligations, less current portion		350,701		—		—			350,701
Other liabilities		44,346		—		—			44,346
Total liabilities		900,400		303,971		(458,476	)		745,895

F- 36


	December 31, 2004
	HEC			HMC		Eliminations			Consolidated
	(in thousands)
Common stock		494,246			4,008		(4,008	)		494,246
Unearned compensation		—			—		—			—
Retained earnings (accumulated deficit)		(120,614	)		399,291		(399,291	)		(120,614	)
Total shareholders’ equity equity (deficit)		373,632			403,299		(403,299	)		373,632
Total liabilities and shareholders equity (deficit)	$	1,274,032		$	707,270	$	(861,775	)	$	1,119,527

Consolidating Condensed Balance Sheet


	December 31, 2003 Restated
	HEC			HMC		Eliminations			Consolidated
	(in thousands)
ASSETS
Cash and cash equivalents	$	2,259		$	45,798	$	—		$	48,057
Marketable Securities		—			26,076		—			26,076
Accounts receivable, net		24,796			489,188		(479,997	)		33,987
Merchandise inventories		129,864			—		—			129,864
Prepaid expenses and other current assets		10,041			3,192		—			13,233
Total current assets		166,960			564,254		(479,997	)		251,217
Rental inventory, net		268,748			—		—			268,748
Property & equipment, net		219,812			23,601		—			243,413
Goodwill, net		68,406			—		—			68,406
Deferred income tax asset		122,598			—		—			122,598
Prepaid Rent		34,019			—		—			34,019
Other assets, net		344,212			7,193		(333,751	)		17,654
Total assets	$	1,224,755		$	595,048	$	(813,748	)	$	1,006,055
LIABILITIES & SHAREHOLDERS’ EQUITY (DEFICIT)
Current maturities of long-term obligations	$	647		$	—	$	—		$	647
Financing Obligations		3,245			—		—			3,245
Accounts payable		479,997			159,586		(479,997	)		159,586
Accrued expenses		22,907			94,960		—			117,867
Accrued interest		22			6,467		—			6,489
Income taxes payable		—			284		—			284
Total current liabilities		506,818			261,297		(479,997	)		288,118
Long-term obligations, less current portion		370,669			—		—			370,669
Other liabilities		50,056			—		—			50,056
Total liabilities		927,543			261,297		(479,997	)		708,843
Common stock		489,247			4,008		(4,008	)		489,247
Unearned compensation		(133	)		—		—			(133	)
Retained earnings (accumulated deficit)		(191,902	)		329,743		(329,743	)		(191,902	)
Total shareholders’ equity equity (deficit)		297,212			333,751		(333,751	)		297,212
Total liabilities and shareholders equity (deficit)	$	1,224,755		$	595,048	$	(813,748	)	$	1,006,055

F- 37

Consolidating Condensed Statement of Operations


	Twelve months ended December 31, 2004
	HEC			HMC			Eliminations			Consolidated
	(in thousands)
Revenue	$	1,785,239		$	169,317		$	(172,192	)	$	1,782,364
Cost of revenue		716,662			—			—			716,662
Gross profit		1,068,577			169,317			(172,192	)		1,065,702
Operating costs & expenses:
Operating and selling		767,882			25,435			—			793,317
General & administrative		231,281			64,857			(172,192	)		123,946
Store opening expenses		2,141			—			—			2,141
Restructuring charges:
Closure of Internet business		—			—			—			—
Store closures		(190	)		—			—			(190	)
Income from operations		67,463			79,025			—			146,488
Interest income		—			35,552			(34,126	)		1,426
Interest expense		(65,545	)		—			34,126			(31,419	)
Early debt retirement		—			—			—			—
Equity earnings in Subsidiary		69,748			—			(69,748	)		—
Income before income taxes		71,666			114,577			(69,748	)		116,495
(Provision for) income taxes		(378	)		(44,829	)		—			(45,207	)
Net income	$	71,288		$	69,748		$	(69,748	)	$	71,288

Consolidating Condensed Statement of Operations


	Twelve months ended December 31, 2003 Restated
	HEC			HMC			Eliminations			Consolidated
	(in thousands)
Revenue	$	1,685,424		$	151,186		$	(154,062	)	$	1,682,548
Cost of revenue		664,632			—			—			664,632
Gross profit		1,020,792			151,186			(154,062	)		1,017,916
Operating costs & expenses:
Operating and selling		703,365			23,659			—			727,024
General & administrative		211,914			48,172			(154,062	)		106,024
Store opening expenses		4,768			—			—			4,768
Restructuring charges:
Closure of Internet business		—			—			—			—
Store closures		(2,106	)		—			—			(2,106	)
Income from operations		102,851			79,355			—			182,206
Interest income		—			38,818			(38,059	)		759
Interest expense		(74,325	)		—			38,059			(36,266	)
Early debt retirement		(12,467	)		—			—			(12,467	)
Equity earnings in subsidiary		70,734			—			(70,734	)		—
Income before income taxes		86,793			118,173			(70,734	)		134,232
(Provision for) income taxes		(6,723	)		(47,439	)		—			(54,162	)
Net income	$	80,070		$	70,734		$	(70,734	)	$	80,070

F- 38

Consolidating Condensed Statement of Cash Flows


	Twelve months ended December 31, 2004
	HEC			HMC			Elimination			Consolidated
	(unaudited, in thousands)
OPERATING ACTIVITIES:
Net income	$	71,288		$	69,548		$	(69,548	)	$	71,288
Equity Earnings in subsidiary		(69,548	)		—			69,548			—
Adjustments to reconcile net income to cash provided by operating activities:
Write-off of deferred financing costs		—			—			—			—
Amortization of Rental		186,847			—			—			186,847
Product Depreciation & amortization		53,836			6,135			—			59,971
Amortization of Prepaid Rent		8,654			—			—			8,654
Impairment of Long Lived Assets		18,182			—			—			18,182
Amortization of Deferred Financing Costs		2,937			—			—			2,937
Tax benefit from exercise of stock options		6,245			—			—			6,245
Change in deferred tax asset		34,618			—			—			34,618
Change in deferred rent		(5,709	)		—			—			(5,709	)
Non cash stock compensation		133			—			—			133
Net change in operating assets & liabilities		(31,940	)		49,499			—			17,559
Cash provided by (used in) Operating activities		275,543			125,182			—			400,725
INVESTING ACTIVITIES:
Purchases of rental inventory, net		(207,243	)		—			—			(207,243	)
Purchase of property & equipment, net		(54,500	)		(5,074	)		—			(59,574	)
Increase in intangibles & other assets		(4,741	)		(569	)		—			(5,310	)
Purchases of Marketable Securities		—			(390,685	)		—			(390,685	)
Sale of Marketable Securities		—			269,161			—			269,161
Cash used in investing activities		(266,484	)		(127,167	)		—			(393,651	)
FINANCING ACTIVITIES:
Repayments of capital lease obligations		(590	)		—			—			(590	)
Repurchase of Common Stock		(3,665	)		—			—			(3,665	)
Proceeds from exercise of stock options		2,419			—			—			2,419
Decrease in Credit Facility		(20,000	)		—			—			(20,000	)
Debt financing costs		—			—			—			—
Proceeds from Capital lease Obligations		529			—			—			529
Increase/Decrease in Financing Obligations		12,336			—			—			12,336
Cash used in financing activities		(8,971	)		—			—			(8,971	)
Increase in cash and cash equivalents		88			(1,985	)		—			(1,897	)
Cash and cash equivalents at beginning of year		2,259			45,798			—			48,057
Cash and cash equivalents at the end of the third quarter	$	2,347		$	43,813		$	—		$	46,160

F- 40

Consolidating Condensed Statement of Cash Flows


	Twelve months ended December 31, 2003 Restated
	HEC			HMC			Elimination			Consolidated
	(unaudited, in thousands)
OPERATING ACTIVITIES:
Net income	$	80,070		$	70,733		$	(70,733	)	$	80,070
Equity Earnings in subsidiary		(70,733	)		—			70,733			—
Adjustments to reconcile net income to cash provided by operating activities:
Write-off of deferred financing costs		—			—			—			—
Depreciation & amortization		284,296			7,472			—			291,768
Tax benefit from exercise of stock options		8,053			—			—			8,053
Change in deferred rent		(6,612	)		—			—			(6,612	)
Change in deferred income taxes		42,826			—			—			42,826
Non cash stock compensation		564			—			—			564
Net change in operating assets & liabilities		218,698			(243,912	)		—			(25,214	)
Cash provided by (used in) Operating activities		557,162			(165,707	)		—			391,455
INVESTING ACTIVITIES:
Purchases of rental inventory, net		(220,364	)		—			—			(220,364	)
Purchase of property & equipment, net		(77,867	)		(11,214	)		—			(89,081	)
Purchase of Marketable Securities		—			(211,283	)		—			(211,283	)
Sale of Marketable Securities		—			185,207			—			185,207
Increase in intangibles & other assets		(6,454	)		(838	)		—			(7,292	)
Refinancing proceeds		—			218,531			—			218,531
Cash used in investing activities		(304,685	)		180,403			—			(124,282	)
FINANCING ACTIVITIES:
Repayment of subordinated debt		(250,000	)		—			—			(250,000	)
Repayments of capital lease obligations		(8,869	)		—			—			(8,869	)
Repurchase of common stock		(26,275	)		—			—			(26,275	)
Proceeds from exercise of stock options		4,066			—			—			4,066
Decrease in revolving loans, net		30,047			—			—			30,047
Decrease in financing obligations		(1,230	)		—			—			(1,230	)
Cash provided by financing activities		(252,261	)		—			—			(252,261	)
Increase in cash and cash equivalents		216			14,696			—			14,912
Cash and cash equivalents at beginning of year		2,045			31,100			—			33,145
Cash and cash equivalents at end of year	$	2,259		$	45,798		$	—		$	48,057

F- 41

Consolidating Condensed Statement of Cash Flows


	Twelve months ended December 31, 2002 Restated
	HEC			HMC			Elimination			Consolidated
	(unaudited, in thousands)
OPERATING ACTIVITIES:
Net income	$	259,745		$	79,894		$	(79,894	)	$	259,745
Equity Earnings in subsidiary		(79,894	)		—			79,894			—
Adjustments to reconcile net income to cash provided by operating activities:
Extraordinary loss on extinguishment of debt		2,226			—			—			2,226
Depreciation & amortization		282,635			5,528			—			288,163
Tax benefit from exercise of stock options		12,814			—			—			12,814
Change in deferred rent		(7,297	)		—			—			(7,297	)
Change in deferred income taxes		(127,027	)		—			—			(127,027	)
Non cash stock compensation		(1,633	)		—			—			(1,633	)
Net change in operating assets & liabilities		(201,561	)		136,115			—			(65,446	)
Cash provided by (used in) operating activities		140,008			221,537			—			361,545
INVESTING ACTIVITIES:
Purchases of rental inventory, net		(288,079	)		—			—			(288,079	)
Purchase of property & equipment, net		(30,948	)		(7,928	)		—			(38,876	)
Increase in intangibles & other assets		(2,478	)		(790	)		—			(3,268	)
Refinancing proceeds		—			(218,531	)		—			(218,531	)
Cash used in investing activities		(321,505	)		(227,249	)		—			(548,754	)
FINANCING ACTIVITIES:
Proceeds from sale of common stock, net		113,073			—			—			113,073
Issuance of subordinated debt		225,000			—			—			225,000
Cash used in financing activities		(13,816	)		—			—			(13,816	)
Decrease in financing obligations		(2,851	)		—			—			(2,851	)
Proceeds from exercise of stock options		4,604			—			—			4,604
Decrease in revolving loans, net		(144,466	)		—			—			(144,466	)
Cash provided by financing activities		181,544			—			—			181,544
Increase in cash and cash equivalents		47			(5,712	)		—			(5,665	)
Cash and cash equivalents at beginning of year		1,999			36,811			—			38,810
Cash and cash equivalents at end of year	$	2,046		$	31,099		$	—		$	33,145

F- 42

24. Quarterly Financial Data (Unaudited)

Selected quarterly financial data is as follows (in thousands, except per share data):


	Quarter Ended
	March		June		September
2004 As Previously Reported
Total revenue	$	442,791	$	423,129	$	410,554
Gross profit		270,526		258,220		256,792
Income from Operations		45,584		41,213		34,405
Net income		22,698		20,225		15,980
Net income per share:
Basic		0.38		0.33		0.26
Diluted		0.36		0.32		0.25


	Quarter Ended
	March		June		September		December
2004 As Restated
Total revenue	$	442,791	$	423,129	$	410,554	$	505,891
Gross profit		270,526		258,220		256,792		280,164
Income from Operations		46,851		40,658		33,729		25,249
Net income		23,471		19,887		15,568		12,363
Net income per share:
Basic		0.39		0.33		0.26		0.20
Diluted		0.38		0.32		0.25		0.20


	Quarter Ended
	March		June		September		December
2003 As Previously Reported
Total revenue	$	417,592	$	389,443	$	401,958	$	473,555
Gross profit		261,900		240,818		250,645		264,553
Income from operations		55,036		39,871		41,985		48,201
Net income		19,578		19,178		20,469		23,046
Net income per share:
Basic		0.33		0.32		0.34		0.38
Diluted		0.31		0.30		0.32		0.36


	Quarter Ended
	March		June		September		December
2003 As Restated
Total revenue	$	417,592	$	389,443	$	401,958	$	473,555
Gross profit		261,900		240,818		250,645		264,553
Income from operations		54,423		39,441		41,011		47,330
Net income		19,210		18,920		19,886		22,055
Net income per share:
Basic		0.32		0.31		0.33		0.37
Diluted		0.30		0.29		0.31		0.35

F- 43

Management’s Report on Internal Control Over Financial Reporting

The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

The management of the Company has assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004. In making its assessment of internal control over financial reporting, management used the criteria described in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. As of December 31, 2004, the Company did not maintain effective controls over the selection, application and monitoring of its accounting policies related to leasing transactions. Specifically, the Company’s controls over its selection, application and monitoring of its accounting policies related to the effect of lessee involvement in asset construction, lease incentives, rent holidays and leasehold amortization periods were ineffective to ensure that such transactions were accounted for in conformity with generally accepted accounting principles. This control deficiency resulted in the restatement of the Company’s annual and interim consolidated financial statements for 2003 and 2002 and for the first, second and third quarters of 2004 as well as an audit adjustment to the fourth quarter 2004 financial statements. Additionally, this control deficiency could result in a misstatement of prepaid rent, leasehold improvements, deferred rent, rent expense and depreciation expense that would result in a material misstatement to annual or interim financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency constitutes a material weakness. Because of this material weakness, we have concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, based on criteria in “Internal Control-Integrated Framework” issued by the COSO.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.

F-45

HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except share amounts)


	March 31,			December 31,
	2005			2004
ASSETS
Current assets:
Cash and cash equivalents	$	203,919		$	46,160
Marketable securities		—			147,600

Total cash, cash equivalents, and marketable securities		203,919			193,760
Receivables, net		35,630			37,922
Merchandise inventories		148,334			148,154
Prepaid expenses and other current assets		35,843			22,835

Total current assets		423,726			402,671

Rental inventory, net		297,578			289,144
Property and equipment, net		211,289			227,824
Goodwill		69,465			69,465
Deferred income tax asset, net		86,517			87,980
Prepaid rent		26,416			27,194
Other assets		15,229			15,249

	$	1,130,220		$	1,119,527


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term obligations	$	554		$	555
Current maturities of financing obligations		5,837			15,581
Accounts payable		165,053			174,427
Accrued expenses		136,018			150,436
Accrued interest		876			6,445
Income taxes payable		3,840			3,404

Total current liabilities		312,178			350,848
Long-term obligations, less current portion		350,546			350,701
Deferred Rent		43,052			44,346

		705,776			745,895

Commitments and contingencies (Note 10)
Shareholders’ equity:
Preferred stock, 25,000,000 shares authorized; no shares issued and outstanding		—			—
Common stock, 100,000,000 shares authorized; 64,450,291 and 60,970,105 shares issued and outstanding, respectively		517,008			494,246
Accumulated deficit		(92,564	)		(120,614	)


Total shareholders’ equity		424,444			373,632

	$	1,130,220		$	1,119,527

The accompanying notes are an integral part of this financial statement.

F- 46

HOLLYWOOD ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)


	Three Months Ended
	March 31,
	2005			2004 (Restated)

Operating activities:
Net income	$	28,050		$	23,471
Adjustments to reconcile net income to cash provided by operating activities:
Amortization of rental product		46,184			51,596
Depreciation		14,132			15,276
Amortization of prepaid rent		1,709			2,173
Amortization of deferred financing costs		221			888
Tax benefit from exercise of stock options		15,204			2,457
Change in deferred rent		(1,295	)		(1,452	)
Change in deferred taxes		1,463			11,726
Non-cash stock compensation		—			133
Net change in operating assets and liabilities:
Receivables		2,292			2,528
Merchandise inventories		(180	)		10,145
Accounts payable		(9,373	)		(36,542	)
Accrued interest		(5,569	)		(5,354	)
Other current assets and liabilities		(26,250	)		(119	)


Cash provided by operating activities		66,588			76,926


Investing activities:
Purchases of rental inventory, net		(54,619	)		(46,682	)
Purchases of property and equipment, net		(7,223	)		(10,884	)
Acquisition of construction phase assets, net		9,627			(12,948	)
Purchase of marketable securities		—			(67,432	)
Sales of marketable securities		147,600			59,508
Increase in intangibles and other assets		(1,872	)		(634	)


Cash provided by (used in) investing activities		93,513			(79,072	)


Financing activities:
Decrease in credit facilities		—			(20,000	)
Debt financing costs		—			(114	)
Repayments of capital lease obligations		(156	)		(140	)
Repurchase of common stock		—			(3,665	)
Proceeds from capital lease obligation		—			233
Proceeds from exercise of stock options		7,558			829
Increase (decrease) in financing obligations		(9,744	)		13,475


Cash used in financing activities		(2,342	)		(9,382	)


Increase (decrease) in cash and cash equivalents		157,759			(11,528	)
Cash and cash equivalents at beginning of year		46,160			48,057

Cash and cash equivalents at end of first quarter	$	203,919		$	36,529

The accompanying notes are an integral part of this financial statement.

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HOLLYWOOD ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles (GAAP) have been condensed or omitted pursuant to those rules and regulations, although Hollywood Entertainment Corporation (the “Company”) believes that the disclosures made are adequate to make the information presented not misleading. The information furnished reflects all adjustments (consisting of normal recurring adjustments) that are, in the opinion of management, necessary to provide a fair statement of the results for the interim periods presented. These financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004 filed with the Securities and Exchange Commission. Results of operations for interim periods may not necessarily be indicative of the results that may be expected for the full year or any other period.

(1) Accounting Policies

The Consolidated Financial Statements included herein have been prepared in accordance with the accounting policies described in Note 1 to audited Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004.

As of December 31, 2004, the Company reviewed its accounting practices with respect to store operating leases and concluded that it needed to correct certain technical errors in its accounting for leases and restate prior periods. See note 3 for a discussion of the accounting changes and their impact to the financial statements.

In addition to the restatement of prior year amounts noted above and discussed in Note 3, certain prior year amounts have been reclassified to conform to the presentation used for the current year. These classifications had no impact on previously reported net income or shareholders’ equity.

As of December 31, 2004, the Company reviewed its accounting practices with respect to balance sheet classification of auction rate securities. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days. Auction rate securities have interest rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every 7, 28 or 35 days. They trade at par and are callable at par on any interest payment date at the option of the issuer. Interest paid during a given period is based upon the interest rate determined during the prior auction. Although these securities are issued and rated as long-term bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset. The Company had historically classified these instruments as cash equivalents if the period between interest rate resets was 90 days or less, which was based the ability to either liquidate the holdings or roll the investment over to the next reset period. Based upon our re-evaluation of the maturity dates associated with the underlying bonds, we have revised our classification of our auction rate securities, previously classified as cash equivalents, as marketable securities in accordance with FAS 95 as of March 31, 2004. We have classified these investments as available for sale investments and consider them to be current assets based on the availability

F- 49

of these assets to fund current operations. The purchase and sale of marketable securities are now displayed in the investing section of the cash flow statement.

The Company accounts for its stock option plans under the recognition and measurement principles of Accounting Principles Board opinion No. 25, “Accounting for Stock Issued to Employees, and related Interpretations.” Pursuant to the disclosure requirements of Statement of Financial Accounting Standards No. 123 (SFAS 123), “Accounting for Stock-Based Compensation” and Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure - - an Amendment of SFAS 123.” The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 (in thousands, except per share amounts).


	Three Months Ended March 31,
	2005		2004
	(Restated)

Net income, as reported	$	28,050	$	23,471
Add: Stock-based compensation expense included in reported net income, net of tax		—		81
Deduct: Total stock-based employee compensation expense under fair value based method for all awards, net of tax		1,988		(1,681	)


Pro forma net income	$	30,038	$	21,871


Earnings per Share:
Basic—as reported	$	0.44	$	0.39
Basic—pro forma		0.48		0.37
Diluted—as reported		0.44		0.38
Diluted—pro forma		0.47		0.36

In December 2004, the FASB issued Statements of Financial Accounting Standards No. 123R (SFAS 123R), “Share-Based Payment,” which replaces SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim or annual period after December 31, 2005. Pro forma disclosure is no longer an alternative. See above for the impact on net income. SFAS 123R is effective for the Company beginning January 1, 2006. The Company is in the process of evaluating the effect of SFAS 123R on the Company’s overall results of operations, financial position and cash flows as well as its method of adoption.

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(2) Merger Agreement

On January 9, 2005 the Company signed a definitive merger agreement with Movie Gallery, Inc. and its wholly owned subsidiary, TG Holdings, Inc., which provides for the merger of TG Holdings into Hollywood, with Hollywood surviving the merger as a wholly owned subsidiary of Movie Gallery. Under the terms of the merger agreement, the Company’s shareholders will be entitled to receive $13.25 per share in cash upon completion of the merger.

The merger with TG Holdings, Inc. was completed on April 27, 2005.

(3) Restatement of Prior Periods

Like many other publicly traded retail companies, we reviewed our accounting practices with respect to store operating leases. This review was triggered in part by the February 7, 2005 letter issued from the Office of the Chief Accountant of the Securities and Exchange Commission (“SEC”) to the American Institute of Certified Public Accountants expressing the SEC’s views regarding proper accounting for certain operating lease matters under GAAP. We concluded that we needed to correct certain errors in our accounting for leases and restate prior periods.

Classification of Store Build-out Costs

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Nature of the assets: Store build-out costs have been segregated between structural elements that benefit the lessor beyond the term of the lease and assets that are considered normal tenant improvements. In accordance with EITF 96-21 “Implementation Issues in Accounting for Leasing Transactions Involving Special-Purpose Entities”, payments made by the Company for structural elements that are not reimbursed by the lessor should be considered a prepayment of rent that should be amortized as rent expense over the term of the lease. As a result, income from operations increased by $0.3 million for the three months ended March 31, 2004.

Classification of Tenant Improvement Allowances

Rent Holidays

The Company historically recognized rent on a straight-line basis over the lease term commencing with the store opening date. Upon re-evaluating FASB Technical Bulletin No. 85-3, “Accounting for Operating Leases with Scheduled Rent Increases,” the Company has determined that the lease term should commence on the date the property is ready for normal tenant improvements. As a result, income from operations increased $0.4 million for the three months ended March 31, 2004.

Depreciation of Leasehold Improvements

Historically the Company depreciated leasehold improvements over 10 years, which approximates the contractual term of the lease. The Company also depreciated leasehold improvements acquired subsequent to store opening, such as remodels, over 10 years. The Company has concluded that such leasehold improvements should be amortized over the lesser of the assets economic life of 10 years or the contractual term of the lease. Optional renewal periods are included in the contractual term of the lease if renewal is reasonably assured at the time the asset is placed in service. As a result, income from operations decreased $0.3 million for the three months ended March 31, 2004.

Lease Incentive

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CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months Ended March 31, 2004
(In thousands)


	As Previously
	Reported			As Restated
Operating activities:
Net income	$	22,698		$	23,471
Adjustments to reconcile net income to cash provided by operating activities:
Amortization of rental product		51,596			51,596
Depreciation		17,223			15,276
Amortization of prepaid rent					2,173
Amortization of deferred financing costs		888			888
Tax benefit from exercise of stock options		2,457			2,457
Change in deferred rent		(129	)		(1,452	)
Change in deferred taxes		11,232			11,726
Non-cash stock compensation		133			133
Net change in operating assets and liabilities:
Receivables		2,528			2,528
Merchandise inventories		10,145			10,145
Accounts payable		(36,542	)		(36,542	)
Accrued interest		(5,403	)		(5,354	)
Other current assets and liabilities		773			(119	)

Cash provided by operating activities		76,053			76,926


Investing activities:
Purchases of rental inventory, net		(46,682	)		(46,682	)
Purchase of property and equipment, net		(10,812	)		(10,884	)
Acquisition of construction phase assets, net		—			(12,948	)
Purchase of marketable securities		—			(67,432	)
Sales of marketable securities		—			59,508
Increase in intangibles and other assets		694			(634	)

Cash used in investing activities		(56,800	)		(79,072	)


Financing activities:
Decrease in credit facilities		(20,000	)		(20,000	)
Debt financing costs		(114	)		(114	)
Repayments of capital lease obligations		(140	)		(140	)
Repurchase of common stock		(3,665	)		(3,665	)
Proceeds from capital lease obligation		233			233
Proceeds from exercise of stock options		829			829
Increase in financing obligations		—			13,475

Cash used in financing activities		(22,857	)		(9,382	)


Decrease in cash and cash equivalents		(3,604	)		(11,528	)
Cash and cash equivalents at beginning of year		74,133			48,057

Cash and cash equivalents at end of first quarter (1)	$	70,529		$	36,529

(1) Restated cash and cash equivalents excludes Marketable Securities of $34.0 million as of March 31, 2004.

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(4) Rental Inventory Amortization Policy

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(5) Property and Equipment

Property and equipment as of March 31, 2005 and December 31, 2004 consists of (in thousands):


	2005			2004
Fixtures and equipment	$	257,928		$	252,165
Leasehold improvements		406,911			405,462
Construction phase assets		5,623			15,250
Equipment under capital lease		2,047			2,047

		672,509			674,924

Less accumulated depreciation and amortization		(461,220	)		(447,100	)

	$	211,289		$	227,824

Accumulated depreciation and amortization, as presented above, includes accumulated amortization of assets under capital leases of $0.5 million and $0.4 million at March 31, 2005 and December 31, 2004, respectively. Depreciation expense related to property, plant and equipment was $14.1 million and $15.3 million for the three months ended March 31, 2005 and March 31, 2004, respectively.

The Company reviews for impairment its long-lived assets to be held and used in the business whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company deems a store to be impaired if a forecast of undiscounted future operating cash flows directly related to the store, including estimated disposal value, if any, is less than the asset carrying amount.

In the fourth quarter of 2004 the Company’s video store same store sales decreased 3%. These results were not in line with earlier management expectations and management felt that the recent trend of negative video store same store sales could continue. Accordingly, the Company evaluated the store assets and determined that certain stores were impaired. As a result, in the fourth quarter of 2004, the Company recorded a $13.8 million non-cash charge in operating and selling expense consisting of $11.8 million in property and equipment and $2.0 million in prepaid rent. There were no impairment charges in 2002, 2003, or in the first quarter of 2005.

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(6) Statements of Changes in Shareholders’ Equity

A summary of changes to shareholders’ equity amounts for the three months ended March 31, 2005 is as follows (in thousands, except share amounts):


	Common Stock				Accumulated
	Shares		Amount		Deficit			Total
Balance at 12/31/2004		60,970,105	$	494,246	$	(120,614	)	$	373,632

Issuance of common stock:
Stock options exercised		3,480,186		7,558					7,558
Stock options tax benefit				15,204					15,204
Net income						28,050			28,050

Balance at 03/31/2005		64,450,291	$	517,008	$	(92,564	)	$	424,444

(7) Off Balance Sheet Arrangements

The Company leases all of its stores, corporate offices, distribution centers and zone offices under non-cancelable operating leases. The Company’s stores generally have an initial operating lease term of five to fifteen years and most have options to renew for between five and fifteen additional years. Rent expense was $64.9 million and $61.0 million for the three months ended March 31, 2005 and 2004, respectively. Most operating leases require payment of additional occupancy costs, including property taxes, utilities, common area maintenance and insurance. These additional occupancy costs were $13.4 million and $12.2 million for the three months ended March 31, 2005 and 2004, respectively.

At December 31, 2004, last fiscal year-end date, the future minimum annual rental commitments under non- cancelable operating leases were as follows (in thousands):


Year Ending	Operating
December 31,	Leases

2005	$	258,703
2006		240,881
2007		207,383
2008		168,011
2009		135,709
Thereafter		324,641

Total sublease income was $1.3 million and $1.2 million for the three months ended March 31, 2005 and 2004 respectively.

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At December 31, 2004, the future minimum annual sublease income under operating subleases were as follows (in thousands):


Year Ending	Sublease
December 31,	Income

2005	$	2,402
2006		2,237
2007		1,737
2008		1,124
2009		722
Thereafter		1,036

(8) Long-term Obligations and Liquidity

The Company had the following long-term obligations as of March 31, 2005 and December 31, 2004 (in thousands):


	March 31,		December 31,
	2005		2004
Borrowings under credit facilities	$	125,000	$	125,000
Senior subordinated notes due 2011 (1)		225,000		225,000
Obligations under capital leases		1,100		1,256

		351,100		351,256

Current portion:
Capital leases		554		555

		554		555


Total long-term obligations net of current portion and notes to be retired with cash held by trustee	$	350,546	$	350,701

(1)	Coupon payments at 9.625% are due semi-annually in March and September.

On March 24, 2005, the Company commenced an offer to purchase for cash and consent solicitation relating to any and all of the outstanding 9.625% senior subordinated notes. On April 27, 2005, the Company accepted for payment $224,550,000 principal amount of the notes which had been tendered in the offer. The Company paid $1,142.13 per $1,000 principal amount of notes validly tendered before 5:00 p.m., New York City time, on April 12, 2005 and $1,112.13 per $1,000 principal amount of notes validly tendered after 5:00 p.m., New York City time, on April 12, 2005 plus, in both cases, accrued but unpaid interest. Pursuant to the Second Supplemental Indenture dated as of April 15, 2005, many of the restrictive convenants previously applicable to the notes were deleted or modified.

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remaining $46.1 million outstanding principal amount of the Company’s 10.625% senior subordinated notes due 2004 and for general corporate purposes.

Revolving credit loans under the facility bore interest, at the Company’s option, at an applicable margin over the bank’s base rate loan or the LIBOR rate. The initial margin over LIBOR was 3.5% for the term loan facility and would step down if certain performance targets were met. The credit facility contained financial covenants that included a (1) maximum debt to adjusted EBITDA test, (2) minimum interest coverage test, and (3) minimum fixed charge coverage test. Amounts outstanding under the credit agreement were collateralized by substantially all of the assets of the Company. Hollywood Management Company was a guarantor under the credit agreement.

As of December 31, 2004 and 2003, the Company was in violation of certain covenants restricting its investments in cash equivalents and marketable securities under its credit facility and its indenture for senior subordinated notes. The Company obtained a waiver from the lenders under the credit facilities for the violations, which expired on March 31, 2005. The Company corrected the violation by updating its investment profiles and was in compliance with its credit facility and indenture covenants as of March 31, 2005.

These senior secured credit facilities were terminated on April 27, 2005 in connection with the acquisition of the Company by Movie Gallery, and all amounts outstanding were repaid.

Maturities on long-term obligations at March 31, 2005 for the next five years are as follows (in thousands):


					Capital
Year Ending	Subordinated		Credit		Leases
December, 31	Notes		Facility		& Other		Total
2005	$	—	$	—	$	400	$	400
2006		—		—		612		612
2007		—		20,000		88		20 088
2008		—		105,000		—		105,000
2009		—		—		—		—
Thereafter		225,000		—		—		225,000

	$	225,000	$	125,000	$	1,100	$	351,100

Interest income was $1.0 million and $0.1 million for the three months ended March 31, 2005 and 2004, respectively. Total interest cost incurred was $6.6 million and $7.8 million for the three months ended March 31, 2005 and 2004 respectively, while interest capitalized was $0.04 million and $0.03 million, for the three months ended March 31, 2005 and 2004 respectively.

The fair value of the 9.625% senior subordinated notes due 2011 was $254.3 million and $240.8 million as of March 31, 2005 and December 31, 2004, respectively, based on quoted market prices. The revolving credit facility is a variable rate loan, and thus, the fair value approximates the carrying amount as of March 31, 2005 and December 31, 2004.

As of March 31, 2005 the Company had $15.7 million of outstanding letters of credit issued upon the revolving credit facility.

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(9) Earnings per Share

Earnings per basic share are calculated based on income available to common shareholders and the weighted-average number of common shares outstanding during the reported period. Earnings per diluted share include additional dilution from the effect of potential issuances of common stock, such as stock issuable pursuant to the exercise of stock options.

The following tables are reconciliations of the earnings per basic and diluted share computations (in thousands, except per share amounts):


	Three Months Ended March 31,
	2005						2004 (Restated)
	Net				Per Share		Net				Per Share
	Income		Shares(1)		Amounts		Income		Shares(1)		Amounts
Income per basic share:	$	28,050		63,061	$	0.44	$	23,471		59,647	$	0.39

Effect of dilutive securities:
Stock options		—		1,015				—		2,665

Income per diluted share:	$	28,050		64,076	$	0.44	$	23,471		62,312	$	0.38

(1)

Represents weighted average shares outstanding.

Antidilutive stock options excluded from the calculation of income per diluted share were 1.5 million shares and 4.3 million shares for the three months ended March 31, 2005 and 2004, respectively.

(10) Commitments and Contingencies

On January 3, 2005, the Company received a letter from The Nasdaq Stock Market, Inc. indicating that its securities were subject to delisting from The Nasdaq National Market because it failed to comply with Marketplace Rules 4350(e) and 4350(g), which require listed companies hold an annual shareholder meeting and distribute a proxy statement and solicit proxies for the meeting. The Company requested and received a hearing before a Nasdaq Listing Qualifications Panel to review the staff determination. On February 15, 2005, the Panel informed the Company that its securities would be delisted at the opening of business on February 17, 2005. The Company requested that the Panel reconsider its decision, which it did. The Panel agreed to continue listing the Company’s securities under specified conditions, including that it hold an annual meeting on or before March 30, 2005. The Company held its annual meeting on March 30, 2005, notified Nasdaq that it is in compliance with listing standards and requested confirmation from Nasdaq that its securities are no longer subject to delisting. On April 5, 2005, the Company received a compliance letter from Nasdaq informing it that its securities would continue to be listed on the Nasdaq National Market and that the hearing file has been closed. On April 27, 2005 following the acquisition of the Company by Movie Gallery, the Company’s common stock ceased to be listed for trading on the Nasdaq National Market.

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The Company was named as a defendant in several purported class action lawsuits asserting various causes of action, including claims regarding its membership application and additional rental period charges. The Company has vigorously defended these actions and maintains that the terms of its additional rental charge policy are fair and legal. The Company has been successful in obtaining dismissal of three of the actions filed against it. A statewide class action entitled George Curtis v. Hollywood Entertainment Corp., dba Hollywood Video, Defendant, No. 01-2-36007-8 SEA was certified on June 14, 2002 in the Superior Court of King County, Washington. On May 20, 2003, a nationwide class action entitled George DeFrates v. Hollywood Entertainment Corporation, No. 02 L 707 was certified in the Circuit Court of St. Clair County, Twentieth Judicial Circuit, State of Illinois. Hollywood reached a nationwide settlement with the plaintiffs. This settlement encompasses all of the various claims asserted in each of the related actions. Preliminary approval of settlement was granted on August 10, 2004. Hollywood has agreed not to oppose plaintiffs’ application for an award of $2.675 million for fees and costs to class counsel and plaintiffs counsel, and up to $50K in class representative incentive awards. Class members will receive rent-one-get-one coupons on a claims-made basis with a guaranteed total redemption of $9 million along with other remedial relief. The final approval hearing is scheduled for June 24, 2005. Notice began on October 10, 2004 and will last through June 10, 2005. Coupons will likely be distributed to the class beginning in the fall of 2005 and payment will be made to class counsel following final approval in June 2005. The Company believes it has provided adequate reserves in connection with these lawsuits.

The Company and the members of its board (including its former chairman Mark Wattles) are defendants in several lawsuits pending in Clackamas County, Oregon (and one in Multnomah County, Oregon). The lawsuits asserted breaches of duties associated with the merger agreement executed with a subsidiary of Leonard Green & Partners, L.P. (“LGP”). The Clackamas County actions were later consolidated and the plaintiffs filed an Amended Consolidate Complaint alleging four claims for relief against the board members arising out of the pending sale of Hollywood. The purported four claims for relief are breach of fiduciary duty; misappropriation of confidential information; failure to disclose material information in the proxy statement in support of the Movie Gallery Merger; and a claim for attorney’s fees and costs. The Amended Consolidate Complaint also names UBS Warburg and LGP as defendants. On April 7, 2005, the plaintiffs filed a motion seeking to enjoin the Company’s merger with Movie Gallery. The Company and its board members moved to dismiss the Amended Consolidate Complaint and opposed the effort to enjoin the merger. On April 19, 2005, the plaintiffs withdrew their request for an injunction and stated their intent to file another amended complaint seeking damages. The Company does not know when plaintiff will do so. The Company and the members of its board have also been named as defendants in a separate lawsuit—JDL Partners, L.P. v. Mark J. Wattles et. al,—filed in Clackamas County, Oregon Circuit Court. This lawsuit, filed before the Company’s announcement of the merger agreement with Movie Gallery, alleges breaches of fiduciary duties related to a bid by Blockbuster for the Company as well as breaches related to a loan to Mr. Wattles that the Company forgave in December 2000. On April 25, 2005, the JDL Partners action was consolidated with the other Clackamas County lawsuits. The Company was unable to determine that the likelihood of an unfavorable outcome of the above-described litigation is either probable or remote. The Company was unable to estimate the dollar amount or range of potential loss.

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The Company was named as a defendant in three actions asserting wage and hour claims in California. The plaintiffs sought to certify a statewide class action alleging that certain California employees were denied meal and rest periods. There were several additional related claims for unpaid overtime, unpaid off the clock work, and penalties for late payment of wages and record keeping violations. A mediation took place on September 9, 2004 and the parties reached a settlement of all claims alleged in each of the actions. Pursuant to the settlement, two of the actions were dismissed and all claims asserted by plaintiffs were alleged in a single action. The Company received preliminary approval of the settlement on January 10, 2005. Notice was sent directly to class members on February 4, 2005. Final approval is scheduled for hearing on May 31, 2005. The Company believes it has provided adequate reserves in connection with these lawsuits.

In addition, the Company has been named to various other claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. The Company believes it has provided adequate reserves for contingencies and that the outcome of these matters should not have a material adverse effect on its consolidated results of operation, financial condition or liquidity. At March 31, 2005, the legal contingencies reserve was $13.9 million. At December 31, 2004, the legal contingencies reserve was $13.3 million.

(11) Related Party Transactions

In July 2001, Boards, Inc. (Boards) began to open Hollywood Video stores as licensee of the Company pursuant to rights granted by the Company and approved by the Board of Directors in connection with Mark J. Wattles’ employment agreement in January 2001. These stores are operated by Boards and are not included in the 2,027 stores operated by the Company. Mark Wattles, the Company’s founder, is the majority owner of Boards. Mr. Wattles resigned all positions with the Company effective February 3, 2005. Under the license arrangement, Boards pays the Company an initial license fee of $25,000 per store, a royalty of 2.0% of revenue and also purchases products and services from the Company at the Company’s cost. Boards is in compliance with the 30 day payment terms under the arrangement. The outstanding balance of $1.7 million due the Company is related to current activity. As of March 31, 2005, Boards operated 20 stores.

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The following table reconciles the net receivable balance due from Boards, Inc (in thousands):


	Three Months Ended
	2005			2004
Receivable Balance Beginning of Year	$	1,361		$	1,509

License fee		—			—
(2%) Royalty fee		151			132
Products & Services		3,274			1,904

Expenses – First Quarter		3,425			2,036
Payments – First Quarter		(3,097	)		(3,101	)

Receivable Balance Ending March 31	$	1,689		$	444

(12) SEGMENT REPORTING

The Company’s management regularly evaluates the performance of two segments, Hollywood Video and Game Crazy, in its assessment of performance and in deciding how to allocate resources. Hollywood Video represents the Company’s 2,027 video stores excluding the operations of Game Crazy. Game Crazy represents 718 in-store departments and free-standing stores that allow game enthusiasts to buy, sell, and trade used and new video game hardware, software and accessories. The Company measures segment profit as operating income (loss), which is defined as income (loss) before interest expense and income taxes. Information on segments and reconciliation to operating income (loss) are as follows (in thousands):


	As of And For The
	Three Months Ended March 31, 2005
	Hollywood		Game
	Video		Crazy			Total
Revenues	$	401,669	$	74,358		$	476,027
Depreciation		12,149		1,983			14,132
Impairment of Assets		—		—			—
Income (loss) from operations		54,390		(2,186	)		52,204
Goodwill		69,050		415			69,465
Total assets		1,010,441		119,779			1,130,220
Purchases of property and Equipment		6,907		316			7,223


	As of And For the
	Three Months Ended March 31, 2004
	(Restated)
	Hollywood		Game
	Video		Crazy			Total
Revenues	$	385,423	$	57,368		$	442,791
Depreciation		13,307		1,969			15,276
Income (loss) from operations		51,475		(4,624	)		46,851

F- 63

UNAUDITED PRO FORMA CONSOLIDATED CONDENSED FINANCIAL INFORMATION

The following unaudited pro forma consolidated condensed financial information is presented to illustrate the effects on our historical financial statements and results of operations of our merger with Hollywood Entertainment Corporation (“Hollywood”) and the application of the proceeds from the offering of $325.0 million principal amount of senior notes and the refinancing transactions described below (the “refinancing”). Historical amounts as of and for the first quarter of 2005 are derived from Movie Gallery and Hollywood’s unaudited consolidated financial statements. Historical amounts for 2004 are derived from Movie Gallery and Hollywood’s audited 2004 consolidated financial statements. The statements reflect adjustments for the following:

• the completion of the merger with Hollywood (including the application of purchase accounting);

• the receipt of the net proceeds from our $325.0 million senior note offering;

• the receipt of $795.0 million pursuant to our new senior credit facility; and

• the application of the remaining proceeds from the senior note offering and our new senior credit facility after the purchase of the Hollywood equity, to pay down the $125.0 million outstanding balance under Hollywood’s credit facility, to repurchase $224.6 million of Hollywood’s outstanding 9.625% Senior Subordinated Notes due 2011, and to pay fees and expenses incurred in connection with the refinancing and merger.

The unaudited pro forma consolidated condensed balance sheet as of April 3, 2005 assumes that the merger and the refinancing occurred on April 3, 2005. The unaudited pro forma consolidated condensed statement of operations for 2004 assumes that the merger and the refinancing took place on January 5, 2004, the beginning of our 2004 fiscal year. The unaudited pro forma consolidated condensed statement of operations for the first quarter of 2005 assumes that the merger and refinancing took place on January 3, 2005, the beginning of our 2005 fiscal year. This information is not necessarily indicative of our financial condition or results of operations had the merger and the refinancing been completed as of the dates indicated, nor should it be construed as representative of our future financial condition or results of operations. The unaudited pro forma consolidated condensed financial information reflects a preliminary allocation of the purchase price assuming the merger had been completed on April 3, 2005. The preliminary allocation is subject to change based on finalization of the fair values of the tangible and intangible assets acquired and liabilities assumed, (including, but not limited to, the valuation of Hollywood’s operating leases and accruals for restructuring costs related to the integration of Hollywood with Movie Gallery’s operational and administrative systems) and final determination of the purchase consideration (including direct costs of the acquisition). The pro forma results of operations include merger related expenses for Hollywood of $9.5 million and $5.8 million in 2004 and the first quarter of 2005, respectively, as reflected in Hollywood’s historical financial statements for those periods. Although these expenses would not have been incurred if our merger with Hollywood had occurred at the beginning of the periods presented herein, we have not made a pro forma adjustment to exclude these or any other unusual or non-recurring expenses, reflected in Hollywood’s historical financial statements. Additionally, the pro forma results have not been adjusted to reflect any operating efficiencies that may be realized by the combined company as a result of the merger, except for the elimination of certain redundant executive compensation costs as a result of departures in corporate personnel, substantially all of which occurred shortly before or after the merger.

The unaudited pro forma consolidated condensed financial statements should be read in conjunction with the related notes and other information included herein.

F- 65

Unaudited Pro Forma Consolidated Balance Sheet


	Historical			Historical
	Movie			Hollywood						Combined
	Gallery			Entertainment						Company
	April 3, 2005			March 31, 2005*			Adjustments			Pro Forma
	(In thousands)
Assets

Current assets:

Cash and cash equivalents	$	22,609		$	203,919		$	(180,035	)(A),(B),(E),(F)	$	46,493
Accounts receivable, net		—			35,630			—			35,630
Merchandise inventory		28,535			148,334			(34,001	)(D)		142,868
Prepaid expenses and other		28,343			35,843			(2,449	)(B),(C),(E)		61,737
Deferred income taxes		4,000			—			25,417	(B),(F)		29,417

Total current assets		83,487			423,726			(191,068	)		316,145
Rental inventory, net		130,402			297,578			(69,778)	(B),(D)		358,202
Property, furnishings and equipment, net		130,743			211,289			25,606	(B)		367,638
Goodwill, net		147,035			69,465			413,786	(B)		630,286
Other intangibles, net		7,583			6,930			176,964	(B)		191,477
Deposits and other assets		8,172			34,715			(3,926	)(B),(E)		38,961
Deferred income taxes		—			86,517			(46,748	)(B)
								(39,769	)(G)		—

Total assets	$	507,422		$	1,130,220		$	265,067		$	1,902,709


Liabilities and stockholders’ equity

Current liabilities:

Accounts payable	$	54,402		$	165,053		$	—		$	219,455
Accrued liabilities		44,028			140,734			8,281	(B),(C)		193,043
Current maturities of financing obligations		—			5,837			—			5,837
Current portion of long term debt		—			554			26,000	(A)		26,554

Total current liabilities		98,430			312,178			34,281			444,889
Long term debt, less current portion		—			350,546			740,570	(A)		1,091,116
Deferred income taxes		54,844			—			(39,769	)(G)		15,075
Other liabilities		—			43,052			(43,052	)(B)		—

Total liabilities		153,274			705,776			692,030			1,551,080

Stockholders’ equity:
Preferred stock		—			—			—			—
Common stock		31			517,008			(517,008	)(B)		31
Additional paid in capital		197,186			—			—			197,186
Unearned compensation		(3,128	)		—			—			(3,128	)
Retained earnings		154,198			(92,564	)		90,045	(B),(F)		151,679
Accumulated other comprehensive income		5,861			—			—			5,861

Total stockholders’ equity		354,148			424,444			(426,963	)		351,629

Total liabilities and stockholders’ equity	$	507,422		$	1,130,220		$	265,067		$	1,902,709

Certain reclassifications have been made to the historical presentation of Hollywood to conform to the presentation used by Movie Gallery and in the unaudited pro forma consolidated balance sheet.

F- 66

Unaudited Pro Forma Consolidated Statements of Income


			Historical
	Historical		Hollywood
	Movie Gallery		Entertainment					Combined
	Fiscal Year Ended		Year Ended					Company
	January 2, 2005		December 31, 2004*		Adjustments			Pro Forma
			(In thousands, except per share data)
Revenues:
Rentals	$	729,167	$	1,388,298	$	(1,720	)(H)	$	2,115,745
Product sales		62,010		394,066		—			456,076

Total revenues		791,177		1,782,364		(1,720	)		2,571,821
Cost of sales:
Cost of rental revenues		208,160		417,588		9,879	(K)		635,627
Cost of product sales		41,942		299,074		—			341,016

Gross margin		541,075		1,065,702		(11,599	)		1,595,178
Operating costs and expenses
Store operating expenses		395,425		795,268		5,477	(J)		1,196,170
General and administrative		54,644		123,813		(8,671	)(L)		169,786
Amortization of intangibles		2,601		—		2,051	(J)		4,652
Stock option compensation		831		133		—			964

Operating income		87,574		146,488		(10,456	)		223,606
Interest expense, net		624		29,993		53,926	(I)		84,543
Equity in losses of unconsolidated entities		5,746		—		—			5,746

Income before income taxes		81,204		116,495		(64,382	)		133,317
Income tax expense (benefit)		31,716		45,207		(26,074	)(M)		50,849

Net income	$	49,488	$	71,288	$	(38,308	)	$	82,468

Earnings per share:
Basic	$	1.54						$	2.57
Diluted	$	1.52						$	2.53
Weighted average shares outstanding:
Basic		32,096							32,096
Diluted		32,552							32,552

Certain reclassifications have been made to the historical presentation of Hollywood to conform to the presentation used by Movie Gallery and in the unaudited pro forma consolidated statements of income.

F- 67

Unaudited Pro Forma Consolidated Statements of Income


			Historical
	Historical		Hollywood
	Movie Gallery		Entertainment					Combined
	Quarter Ended		Quarter Ended					Company
	April 3, 2005		March 31, 2005*		Adjustments			Pro Forma
			(In thousands, except per share data)
Revenues:
Rentals	$	216,741	$	372,216	$	(542	)(N)	$	588,415
Product sales		17,050		103,811		—			120,861

Total revenues		233,791		476,027		(542	)		709,276
Cost of sales:
Cost of rental revenues		66,360		111,694		1,723	(Q)		179,777
Cost of product sales		12,190		75,899		—			88,089

Gross margin		155,241		288,434		(2,265	)		441,410
Operating costs and expenses
Store operating expenses		108,479		199,618		1,369	(P)		309,466
General and administrative		15,451		36,612		(1,505	)(R)		50,558
Amortization of intangibles		600		—		513	(P)		1,113
Stock option compensation		141		—		—			141

Operating income		30,570		52,204		(2,642	)		80,132
Interest expense, net		80		6,594		16,095	(O)		22,769
Equity in losses of unconsolidated entities		337		—		—			337

Income before income taxes		30,153		45,610		(18,737	)		57,026
Income tax expense (benefit)		11,760		17,560		(7,588	)(S)		21,732

Net income	$	18,393	$	28,050	$	(11,149	)	$	35,294

Earnings per share:
Basic	$	0.59						$	1.13
Diluted	$	0.58						$	1.12
Weighted average shares outstanding:
Basic		31,199							31,199
Diluted		31,588							31,588

F- 68

(B) To record payment of the purchase price for Hollywood’s equity, eliminate Hollywood’s common stock of $517,008, eliminate Hollywood’s accumulated deficit of $92,564, and record the fair value adjustments to Hollywood’s carrying values, including goodwill.


Purchase of Hollywood equity for cash⁽¹⁾											$	862,056
Direct costs of acquisition (including $2,905 reclassified from prepaids)												10,033

Total purchase consideration											$	872,089

Net assets of Hollywood at March 31, 2005											$	424,444




Adjustments to Hollywood’s pre-acquisition retained earnings:
	Hollywood merger costs paid at closing											(13,190	)
	Payment of the premium on extinguishment of Hollywood’s 9.625% senior notes											(31,970	)
	Write-off Hollywood’s debt issue costs related to pre- acquisition indebtedness extinguished at the merger date											(6,612	)
	Tax effect of adjustments at 40.5%											20,968

Adjusted net assets of Hollywood at March 31, 2005												393,640

								Pro Forma
		Book Value			Fair Value			Adjustment
Adjust Hollywood’s assets and liabilities to fair value:
	Rental inventory⁽²⁾	$	331,579		$	227,800		$	(103,779	)
	Property, furnishings and equipment		211,289			236,895			25,606
	Other intangibles⁽³⁾		6,930			183,894			176,964
	Prepaid rent		26,416			—			(26,416	)
	Severance accrual		—			(6,750	)		(6,750	)
	Deferred rent		(43,052	)		—			43,052

Total adjustment to record net assets at fair value			533,162			641,839						108,677
To recognize deferred taxes on purchase price allocation⁽⁴⁾												(44,014	)
Allocation of the excess purchase price to goodwill												413,786

											$	872,089

The pro forma adjustment to goodwill reflects the following:
Hollywood’s historical goodwill at March 31, 2005											$	69,465
Allocation of the excess purchase price to goodwill												413,786

Adjusted Hollywood goodwill											$	483,251

⁽¹⁾		Includes $858,882 for the purchase of Hollywood’s outstanding common stock at a price of $13.25 per share and $3,174 for the settlement of Hollywood’s outstanding vested stock options.

⁽²⁾		The estimated fair value of Hollywood’s rental inventory was determined by an independent valuation specialist using discounted cash flow analysis based on the estimated future revenues to be received from the rental inventory on hand as of the acquisition date, reduced for product costs, operating costs, capital costs, working capital costs, work force costs, and intangibles costs associated with the generation of those future revenues. Estimated future revenues were determined based on Hollywood’s historical revenue attrition curve.

⁽³⁾		Includes the following:


					Pro Forma
	Book Value		Fair Value		Adjustment

Hollywood trade name (indefinite life)	$	6,719	$	170,900	$	164,181
Game Crazy tradename (15 year useful life)		211		4,000		3,789
Customer lists (5 year useful life)		—		8,994		8,994


⁽⁴⁾		Includes $2,734 classified as current deferred tax assets and $(46,748) classified as non-current deferred tax liabilities.

(D) To reclassify Hollywood’s previously viewed movies of $34,001 from merchandise inventory to rental inventory to conform to Movie Gallery’s balance sheet presentation.

(E) To reflect the capitalization of an estimated $29,102 in financing costs that will be amortized over the life of the borrowings. ($28,027 paid in cash at closing and $1,075 paid by Movie Gallery prior to closing and reclassified from prepaid expenses)

(F) Reflects Movie Gallery’s write-off of $2,519 (net of taxes of $1,715) of fees and expenses associated with the bridge commitment feature of the senior credit facility that will be written off in the second quarter of fiscal 2005. This charge is excluded from the pro forma statements of income because it is a non-recurring charge directly attributable to the transaction.

(G) To reclassify Hollywood’s residual non-current deferred tax assets of $39,769 to offset Movie Gallery’s non-current deferred tax liabilities.

Income Statement – Fiscal 2004

(H) To conform Hollywood’s method of accounting for extended viewing fees to Movie Gallery’s accounting method. 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 appropriate bad debt reserves) for the extended viewing fee revenue expected to be collected. This pro forma adjustment reflects the difference in Hollywood’s historical rental revenue and the rental revenue that Hollywood would have recognized under Movie Gallery’s policy. Actual consolidated rental revenue for the combined company in periods subsequent to the merger will be lower than if Hollywood had followed the Movie Gallery policy due to the accrual of the extended viewing fee receivables at the acquisition date. It is estimated that the majority of these collections will be realized within two quarters following the closing of the acquisition. The pro forma balance sheet as of April 3, 2005, includes $22,232 of accounts receivable for extended viewing fees.

(I) Reflects interest expense on the borrowings, including the 11% Senior Notes, as described in Note (A). The adjustment reflects a reduction in interest expense resulting from the retirement of Hollywood’s 9.625% Senior Subordinated Notes tendered in the 9.625% Senior Subordinated Notes Tender Offer, and interest expense on outstanding borrowings under its existing credit agreement. The adjustment to interest expense is presented as if the borrowings and retirements of borrowings occurred on the first day of fiscal 2004 according to the terms of the borrowings, including an interest rate swap related to 35% of the principal amount outstanding under the Senior Credit Facility. For purposes of calculating the pro forma interest expense, the assumed incremental interest expense related to the interest rate swap was $6.6 million. The assumed interest rates presented in the table below used to compute pro forma interest expense were based on the average LIBOR index rates in effect during fiscal 2004, plus the margin applicable to each debt instrument. A 1/8% variance in interest rates versus those we have assumed would change interest expense by approximately $0.6 million per year based on the pro forma principal amount of variable rate debt we will incur that will not be effectively fixed by our interest rate swap. The amortization of deferred financing costs and the accretion of interest expense on the initial issuance discount on the 11% Senior Notes is presented as if the financing costs and initial issuance discount were incurred on the first day of 2004 and amortized over the terms of the agreements on a straight-line basis, which approximates the effective interest rate method.

F- 70


	Average		Assumed			Pro Forma
	Amount		Interest			Interest
	Outstanding		Rate			Expense
Revolver	$	—		4.42	%	$	—
Term Loan A		85,500		4.42	%		3,781
Term Loan B		696,500		4.67	%		32,541
11% Senior Notes		325,000		11.0	%		35,750

	$	1,107,000

Pro forma interest expense							72,072
Accretion of discount on 11% Senior Notes							554
Incremental interest expense related to the interest rate swap							6,617
Amortization of deferred financing costs							4,633

							83,876
Elimination of Hollywood interest expense (excluding 9.625% Senior Subordinated Notes not tendered)							(29,950	)

Pro forma adjustment to interest expense						$	53,926

(J) To reflect an increase in depreciation and intangibles amortization expense resulting from the adjustment to property, furnishings and equipment and identifiable intangible assets based on the adjustments of such assets to fair value as discussed in Note (B).


Increase in depreciation expense (estimated remaining useful life of four years).	$	5,477
Increase in intangibles amortization expense (estimated remaining useful life of five years)	$	2,051

(K) To reflect a net increase to cost of rental revenues of $9,879 resulting from the application of Movie Gallery’s rental inventory amortization method to the allocated fair value of Hollywood’s rental inventory as discussed in Note (A). Pro forma rental inventory amortization is increased over Hollywood’s historical rental inventory amortization due primarily to Movie Gallery’s method utilizing a shorter economic life of two years for catalog DVD than Hollywood’s historical method of five years. The pro forma cost of previously viewed inventory sold is reduced as a result of the lower overall carrying value of rental inventory as discussed in Note (B).


Increase in rental inventory amortization	$	22,427
Decrease in cost of previously viewed inventory sold	$	(12,548	)

(L) To reflect the reduction in Hollywood general and administrative expense of $8,671, primarily as a result of departures of redundant corporate personnel, substantially all of which have already occurred.

(M) To reflect the tax effect of the net pro forma adjustments and record income tax expense at an estimated effective tax rate of approximately 40.5%.

Income Statement – First Quarter 2005

(N) To conform Hollywood’s method of accounting for extended viewing fees to Movie Gallery’s accounting method. 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 appropriate bad debt reserves) for the extended viewing fee revenue expected to be collected. This pro forma adjustment reflects the difference in Hollywood’s historical rental revenue and the rental revenue that Hollywood would have recognized under Movie Gallery’s policy. Actual consolidated rental revenue for the combined company in periods subsequent to the merger will be lower than if Hollywood had followed the Movie Gallery policy due to the accrual of the extended viewing fee receivables at the acquisition date. It is estimated that the majority of these collections will be realized within two quarters following the closing of the acquisition. The pro forma balance sheet as of April 3, 2005, includes $22,232 of accounts receivable for extended viewing fees.

(O) Reflects interest expense on the borrowings, including the 11% Senior Notes, as described in Note (A). The adjustment reflects a reduction in interest expense resulting from the retirement of Hollywood’s 9.625% Senior Subordinated Notes tendered in the 9.625% Senior Subordinated Notes Tender Offer and interest expense on outstanding borrowings under its existing credit agreement. The adjustment to interest expense is presented as if the borrowings and retirements of borrowings occurred on the first day of fiscal 2005 according to the terms of the borrowings, including an interest rate swap related to 35% of the principal amount outstanding under the Senior Credit Facility. For purposes of calculating the pro forma interest expense, the assumed incremental interest expense related to the interest rate swap was $0.8 million. The assumed interest rates presented in the table below used to compute pro forma interest expense were based on the average LIBOR index rates in effect during the first quarter of 2005, plus the margin applicable to each debt instrument. A 1/8% variance in interest rates versus those we have assumed would change interest expense by approximately $0.6 million per year based on the pro forma principal amount of variable rate debt we will incur that will not be effectively fixed by our interest rate swap. The amortization of deferred financing costs and the accretion of interest expense on the initial issuance discount on the 11% Senior Notes is presented as if the financing costs and initial issuance discount were

F- 71

incurred on the first day of 2005 and amortized over the terms of the agreements on a straight-line basis, which approximates the effective interest rate method.


	Average		Assumed			Pro Forma
	Amount		Interest			Interest
	Outstanding		Rate			Expense
Revolver	$	—		5.67	%	$	—
Term Loan A		92,625		5.67	%		1,313
Term Loan B		699,125		5.92	%		10,343
11% Senior Notes		325,000		11.0	%		8,938

	$	1,116,750

Pro forma interest expense						$	20,594
Accretion of discount on 11% Senior Notes							138
Incremental interest expense related to the interest rate swap							788
Amortization of deferred financing costs							1,158

							22,678
Elimination of Hollywood interest expense (excluding 9.625% Senior Subordinated Notes not tendered)							(6,583	)

Pro forma adjustment to interest expense						$	16,095

(P) To reflect an increase in depreciation and intangibles amortization expense resulting from the adjustment to property, furnishings and equipment and identifiable intangible assets based on the adjustments of such assets to fair value as discussed in Note (B).


Increase in depreciation expense (estimated remaining useful life of four years)	$	1,369
Increase in intangibles amortization expense (estimated remaining useful life of five years)	$	513

(Q) To reflect a net increase to cost of rental revenues of $1,723 resulting from the application of Movie Gallery’s rental inventory amortization method to the allocated fair value of Hollywood’s rental inventory as discussed in Note (A). Pro forma rental inventory amortization is increased over Hollywood’s historical rental inventory amortization due primarily to Movie Gallery’s method utilizing a shorter economic life of two years for catalog DVD than Hollywood’s historical method of five years. The pro forma cost of previously viewed inventory sold is reduced as a result of the lower overall carrying value of rental inventory as discussed in Note (B).


Increase in rental inventory amortization	$	4,666
Decrease in cost of previously viewed inventory sold	$	(2,943	)

(R) To reflect the reduction in Hollywood general and administrative expense of $1,505, primarily as a result of departures of redundant corporate personnel, substantially all of which have already occurred.

(S) To reflect the tax effect of the net pro forma adjustments and record income tax expense at an estimated effective tax rate of approximately 40.5%.


Report of Independent Registered Public Accounting Firm			F- 2
Consolidated Balance Sheets at December 31, 2004 and 2003			F- 4
Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002			F- 5
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2004, 2003 and 2002			F- 6
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002			F- 7
Notes to Consolidated Financial Statements			F- 8
Management’s Report on Internal Control Over Financial Reporting			F-45

Consolidated Balance Sheet at March 31, 2005 and December 31, 2004 (Unaudited)			F-46
Consolidated Statements of Operations for the quarters ended March 31, 2005 and 2004 (Unaudited)			F-47
Consolidated Statements of Cash Flows for the quarters ended March 31, 2005 and 2004 (Unaudited)			F-48
Notes to Consolidated Financial Statements (Unaudited)			F-49

	•		the completion of the merger with Hollywood (including the application of purchase accounting);

	•		the receipt of the net proceeds from our $325.0 million senior note offering;

	•		the receipt of $795.0 million pursuant to our new senior credit facility; and

	•		the application of the remaining proceeds from the senior note offering and our new senior credit facility after the purchase of the Hollywood equity, to pay down the $125.0 million outstanding balance under Hollywood’s credit facility, to repurchase $224.6 million of Hollywood’s outstanding 9.625% Senior Subordinated Notes due 2011, and to pay fees and expenses incurred in connection with the refinancing and merger.


	Amount
Proceeds from:
Term Loan A	$	95,000
Term Loan B		700,000
11% Senior Notes (net of discount of $3,880)		321,120

		1,116,120
Retirement of Hollywood’s long term debt, at historical carrying value		(349,550	)

Pro forma adjustment to outstanding debt		766,570
Current portion of borrowings		(26,000	)

Non-current portion of pro forma adjustment	$	740,570